-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QNMagvzk90gEjmuJS5BG3ZrZQ+AvL2k1YL4tsz8cBx0U1kLL9Q0sukObHu3RjOk0 9OJSqdFQ3WP4DqzDIQ0iZA== 0000101594-04-000073.txt : 20040330 0000101594-04-000073.hdr.sgml : 20040330 20040330135220 ACCESSION NUMBER: 0000101594-04-000073 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 20031231 FILED AS OF DATE: 20040330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: US ENERGY CORP CENTRAL INDEX KEY: 0000101594 STANDARD INDUSTRIAL CLASSIFICATION: METAL MINING [1000] IRS NUMBER: 830205516 STATE OF INCORPORATION: WY FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-06814 FILM NUMBER: 04699708 BUSINESS ADDRESS: STREET 1: 877 NORTH 8TH WEST STREET 2: GLEN L LARSEN BLDG CITY: RIVERTON STATE: WY ZIP: 82501 BUSINESS PHONE: 3078569271 MAIL ADDRESS: STREET 1: 877 NORTH 8TH WEST CITY: RIVERTON STATE: WY ZIP: 82501 FORMER COMPANY: FORMER CONFORMED NAME: WESTERN STATES MINING INC DATE OF NAME CHANGE: 19851229 10-K 1 doc1.txt USE 10-K 12-31-03 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 (Mark One) [X] Annual report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2003 or [ ] Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from June 1, 2002 to December 31, 2002 Commission file number 000-6814 U.S. ENERGY CORP. - -------------------------------------------------------------------------------- (Exact Name of Registrant as Specified in its Charter) Wyoming 83-0205516 - ----------------------------------------- -------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 877 North 8th West Riverton, WY 82501 - ----------------------------------------------- -------------------- (Address of principal executive offices) (Zip Code) Registrant's Telephone Number, including area code: (307) 856-9271 -------------- Securities registered pursuant to Section 12(b) of the Act: NONE - -------------------------------------------------------------------------------- Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $0.01 PAR VALUE - -------------------------------------------------------------------------------- (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12B-2 of the Act). YES [ ] NO [X] The aggregate market value of the shares of voting stock held by non-affiliates of the Registrant as of June 30, 2003, computed by reference to the average of the bid and asked prices of the Registrant's common stock as reported on Nasdaq Small Cap on that date, was $61,728,467. Class Outstanding at March 24, 2004 - --------------------------------------- ------------------------------------ Common Stock, $0.01 par value 13,992,750 shares Documents incorporated by reference: Portions of the documents listed below - --------------------------------------- have been incorporated by reference into the indicated parts of this report as specified in the responses to the referenced sections of this filing. Proxy Statement for the Meeting of Shareholders to be held in June 2004, into Part III of the filing. Indicate by check mark if disclosure of delinquent filers, pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ ]. -1- DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K includes "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All statements other than statements of historical fact included in this Report, are forward-looking statements, including without limitation the statements under Management's Discussion and Analysis of Financial Condition and Results of Operations and the disclosures about Rocky Mountain Gas, Inc. and plans for developing its coalbed methane acreage. In addition, whenever words like "expect," "anticipate" or "believe" are used, we are making forward-looking statements. Although we believe that our forward-looking statements are reasonable, we don't know if our expectations will prove to be correct. Important future factors that could cause actual results to differ materially from expectations include: Domestic consumption rates and market prices for natural gas; the amounts of gas we will be able to produce from our coalbed methane properties; the availability of permits to drill and operate coalbed methane wells; whether and when gas transmission lines will be built in reasonable proximity to the coalbed methane properties; and whether and on what terms the capital necessary to develop the properties can be obtained. The forward-looking statements should be carefully considered in the context of all the information set forth in this Annual Report. PART I ITEM 1 AND ITEM 2. BUSINESS AND PROPERTIES. (A) GENERAL. U.S. Energy Corp. is a Wyoming corporation (formed in 1966) in the business of acquiring, exploring, developing and/or selling or leasing mineral properties. In this Annual Report, "we," "Company" or "USE" refer to U.S. Energy Corp. including subsidiaries unless otherwise specifically noted. Our fiscal year ends December 31; this is the first full year of our new fiscal year (the prior year ended May 31, and the last Annual Report was a transition report for the seven months ended December 31, 2002 (filed April 1, 2003)). In 2003, most of our business activity was devoted to the coalbed methane ("CBM") business, which is conducted through Rocky Mountain Gas, Inc ("RMG") a subsidiary of the Company. In 2003, RMG transferred certain of its CBM assets including a producing, and several non-producing, CBM properties to Pinnacle Gas Resources, Inc. ("Pinnacle"), a newly-organized Delaware corporation. Other parties to this transaction included CCBM, Inc. and its parent company Carrizo Oil & Gas, Inc. ("CRZO") of Houston Texas; and seven affiliates of Credit Suisse First Boston Private Equity. As a result of the transaction, RMG became a 37.5% shareholder of Pinnacle and RMG accounts for its investment on the equity method. RMG recorded revenues from gas sales from mid-2002 until the transfer to Pinnacle was completed in mid-2003. See "Transaction with Pinnacle Gas Resources, Inc." On January 30, 2004, RMG acquired producing and non-producing CBM properties located near Gillette, Wyoming, from Hi-Pro Production, LLC ("Hi-Pro"). These properties contain proven gas reserves. A portion of the purchase price was paid with a loan from institutional lenders under a $25 million mezzanine lending facility, which was established in connection with the Hi-Pro purchase; additional loans will be available to acquire more CBM properties, subject to lenders' approval. In the first quarter of 2004, RMG raised $1.8 million in working capital from institutional investors. See "Coal Bed Methane - RMG Equity Financing." -2- RMG's properties are located in Wyoming and southeastern Montana. As of the filing date of this Annual Report, RMG holds approximately 264,300 gross (128,200 net) mineral acres of CBM properties. A limited amount of exploratory drilling and testing was conducted on some of the non-producing properties in 2003, but in general, significant additional work is needed before we can determine if those properties contain gas reserves. No prediction is made when such determinations can be made. In 2003, the Company sold an indirect subsidiary (Canyon Resources) which owns commercial properties in Ticaboo, Utah. Canyon Resources was acquired in the 1990s from a utility as part of an acquisition of uranium properties and a uranium mill near Ticaboo, Utah. See "Oil And Gas, and Other Properties." The uranium properties and mill, presently inactive, have not been sold. See "Inactive Mining Properties - Uranium." Historically, gas prices for production in the Powder River Basin (our area of activity) have been lower than national prices due to limited pipeline "takeaway capacity." This limitation was somewhat eased in late 2002 and 2003 by new pipeline construction and enlargement of existing lines, and will be further improved with more capacity in 2005. For example, a new large pipeline is planned to be in service in January 2005, running from the Cheyenne hub in Cheyenne, Wyoming, to Kansas. See "Gas Markets." However, on both historical and seasonal bases, gas prices have been volatile. A return to low gas prices, particularly if aggravated by the negative price differential experienced by Powder River Basin producers, could adversely impact not only the economics of current production but also the economics of exploration projects as they move into production in the future. USE and Crested originally were independent companies, with two common affiliates (John L. Larsen and Max T. Evans; Mr. Evans died in February 2002). In 1980, USE and Crested formed a joint venture ("USECC") to do business together (unless one or the other elected not to pursue an individual project). As a result of USE funding certain of Crested's obligations from time to time (due to Crested's lack of cash on hand), Crested subsequently paid a portion of this debt by issuing common stock to USE, Crested became a majority-owned subsidiary of USE in fiscal 1993. In fiscal 2001, Crested issued another 6,666,666 shares of its common stock to reduce Crested's debt owed to USE by $3.0 million, which increased USE's ownership of Crested to 71.5%. All the operations of USE (and Crested) are in the United States. In the first quarter 2004, USE obtained $350,000 of equity funding from an accredited investor (100,000 restricted shares of common stock, three year warrants to purchase 50,000 shares at $3.00 per share; and five year warrants to purchase 200,000 shares at $3.00 per share). Proceeds will be used as working capital. Principal executive offices of USE are located in the Glen L. Larsen building at 877 North 8th Street West, Riverton, Wyoming 82501, telephone 307-856-9271. RMG has a field office in Gillette, Wyoming. Most of the Company's operations are conducted through subsidiaries, the USECC Joint Venture with Crested, and jointly-owned subsidiaries of USE and Crested. -3- The Company's subsidiaries are: Percent Primary Subsidiary Owned by USE* Business Conducted ---------- ------------- ------------------ Plateau Resources Ltd. 100.0% Uranium (Utah) - inactive mill - shut down Motel/real estate - sold Rocky Mountain Gas, Inc. 88.5% Coalbed methane - active Energx, Ltd. 90.0% Gas - inactive - shut down Crested Corp. 71.5% Uranium, gold and molybdenum Properties (all inactive and shut down), and exploration activities on coalbed methane properties Sutter Gold Mining Company 78.5% Gold (California) - inactive - Being reactivated Four Nines Gold, Inc. 50.9% Contract Drilling/Construction - inactive USECC Joint Venture 50.0% Uranium (Wyoming, Utah), gold and molybdenum,** all inactive and shut down; real estate management and coalbed methane exploration Yellowstone Fuels Corp. 35.9% Uranium (Wyoming) - inactive - Shut down Pinnacle Gas Resources, Inc. 37.5% CBM exploration and production - active * Includes ownership of Crested Corp. in RMG and Sutter. ** There are no plans to put the molybdenum property into production in the foreseeable future. See "Inactive Mining Properties - Molybdenum and Item 3, "Legal Proceedings". Until September 11, 2000, USE, USECC and Kennecott Uranium Company ("Kennecott") owned the Green Mountain Mining Venture ("GMMV"), which held a large uranium deposit and uranium mill in Wyoming. On September 11, 2000, USE and Crested settled litigation with Kennecott involving the GMMV by selling their interest in the GMMV and its properties back to Kennecott for $3,250,000, receiving a royalty interest in the uranium properties and miscellaneous equipment. The GMMV properties are shut down. Kennecott also assumed all reclamation obligations on the GMMV properties; reclamation obligations for an ion exchange facility located on properties outside the GMMV were not assumed by Kennecott, see "Sheep Mountain Partners - Properties" below. Other uranium properties and a uranium mill in southeast Utah are held by Plateau Resources Ltd., a wholly-owned subsidiary of USE. The Utah uranium properties are shut down. Activities on the mineral properties held by Sutter Gold Mining Company ("SGMC") were shut down because the historical market price of gold did not permit raising the necessary capital to build a mill and put the properties into production. However, improved gold prices over the last 12 months have revived the capital markets, particularly in Canada. See "Sutter Gold Mining Company, below." In coalbed methane, we compete against many companies, some of which are much larger and better financed than the Company. The principal area of competition is encountered in the financial ability to acquire good acreage positions and drill wells to explore coalbed methane potential, then, if warranted, drill production wells and install production equipment (gathering systems, compressors, etc.). We own a royalty interest in a molybdenum property in Colorado; the property is owned by Phelps Dodge Corporation. We believe, at the present time, that Phelps Dodge does not have a plan to place the molybdenum property into production. -4- In the motel, real estate and airport operations area (significant as a percentage of revenues for 2003, but not our primary business focus), we own and manage an office building (where the Company's headquarters are located), and small parcels of land, in Riverton, Wyoming, and a small amount of other land in Wyoming and Colorado. An indirect subsidiary (Canyon Resources), owned a townsite, motel, convenience store and other commercial facilities in Utah, which was sold in August 2003, thus greatly reducing activities in this commercial segment. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. During 2003, the seven months ended December 31, 2002, and the (former) fiscal year ended May 31, 2002, for technical financial presentation purposes, we operated in two business segments: (i) coalbed methane gas exploration (and holding shut down mines and mineral properties); and (ii) commercial (motel, real estate, and airport operations). While we technically had two segments in this 31 month period, by December 31, 2003, all activities in minerals (except coalbed methane) and commercial (motel/real estate/airport), had ceased or were severely curtailed, and the motel/commercial properties in Utah had been sold. As of the date of this Annual Report, the only current activities of a material and recurring nature are in coalbed methane. The principal products of operating units within each of the reportable industry segments for the full year 2003, the seven months ended December 31, 2002 and the (former) fiscal year ended May 31, 2002 are shown below. For more information, see note I to the financial statements. INDUSTRY SEGMENTS PRINCIPAL PRODUCTS Minerals: CBM Acquisition of coalbed methane properties, Exploration and Production production of properties for coalbed methane. (and shut down mineral This activity is material and recurring, and properties) is our principal business focus. Sales and leases of mineral-bearing properties and, from time to time, the production and/or marketing of uranium, gold and receipt of advance royalties on molybdenum. Activities in uranium, gold and molybdenum are shut down as recurring activities. Gold properties are being reactivated at the date of this Report. Commercial: Operation of a motel and rental of real Motel/Real Estate/ estate, operation of an aircraft fixed base Airport FBO operation (fuel sales, flight instruction and aircraft maintenance, which was shut down in the (former) fiscal year 2002; and motel and real estate activities (sold in 2003)). Various contract services, including managerial services for subsidiary companies, continue. -5- C) NARRATIVE DESCRIPTION OF BUSINESS (INCLUDING ITEM 2 - PROPERTIES). COALBED METHANE GENERAL. Rocky Mountain Gas, Inc. ("RMG") was incorporated in Wyoming on November 1, 1999 for business in the coalbed methane industry in Wyoming and Montana. RMG is a subsidiary of the Company (owned 50.3% by the Company and 39.8% by Crested as of December 31, 2003 (as of the date of this Annual Report, 49.4% by the Company and 39.1% by Crested). In 2003, RMG transferred all of its interest in certain coalbed methane properties, including a producing property, to Pinnacle. At the same time, Carrizo Oil & Gas, Inc.'s wholly owned subsidiary CCBM, Inc. ("CCBM") (with which RMG has an agreement to jointly acquire and explore properties) transferred to Pinnacle all of its interests in the same properties, and affiliates of Credit Suisse First Boston contributed equity financing to Pinnacle. See "Transaction with Pinnacle Gas Resources, Inc." On January 30, 2004, RMG (through its wholly-owned, newly organized subsidiary RMG I LLC, "RMGI") acquired coalbed methane properties in the Powder River Basin of Wyoming. See "Acquisition of Producing and Non-Producing Properties from Hi-Pro Production, LLC." Part of the purchase price was financed under a $25 million mezzanine credit facility. RMG I plans to drill five development wells on the Hi-Pro properties in 2004 and upgrade existing infrastructure to improve gas production, and, subject to raising equity funding, drill up to 120 exploratory wells on undeveloped Hi-Pro acreage in 2004 and 2005. In addition, RMG plans to drill exploratory wells on the Castle Rock and Oyster Ridge properties, and seek to acquire other producing coalbed methane properties, primarily in Wyoming. Financing may be available under the mezzanine credit facility for more acquisitions, if approved by the lenders. As of the filing date of this Annual Report, RMG does not have any agreements to acquire other producing properties. RMG raised $1.8 million of equity financing in the first quarter of 2004. As of the filing date of this Annual Report, RMG holds leases and options on approximately 264,300 gross mineral acres of federal, state and private (fee) land in the Powder River Basin ("PRB") of Wyoming and Montana and adjacent to the Green River Basin of Wyoming, not including acreage held by Pinnacle. As of the filing date of this Annual Report, there are 108 producing wells on the properties bought by RMG from Hi-Pro Production, LLC. RMG owns an average 58% working interest (46.4% average net revenue interest, before deduction of overriding royalty interests held by lenders) in these properties. From RMG's inception, through December 31, 2003, 72 exploratory wells have been drilled, almost all with funds provided by industry partner CCBM and former industry partner SENGAI (see below). 43 of the wells were on properties transferred to Pinnacle in mid-2003. The balance of 29 wells (15 of which have been plugged and abandoned) are on properties held by RMG. Reserves have not been established for any of the properties on which these wells were drilled. The Castle Rock property in southeast Montana , and the Oyster Ridge property adjacent to the Green River Basin (southwest Wyoming), are large properties which will require the drilling of numerous exploratory wells and extended dewatering for each group or "pod" of wells (possibly as much as 24 months after drilling and completion) before an assessment of reserves can be made. -6- Among the uncertainties we face in determining if our coalbed methane investments will yield value are the following: Prices for gas sold in the Powder River Basin are typically lower than national prices, and therefore, the economics of Powder River Basin properties can be adversely affected more readily by lower gas prices. The Hi-Pro properties, and all revenues therefrom, are pledged to service $3,635,000 of debt. To continue exploration efforts, additional capital (in addition to RMG's one-half of remaining balance under the CCBM $5.0 million drilling commitment, which one half of remaining balance was $305,100 at December 31, 2003) will be needed. Permitting issues for new wells on undeveloped acreage may be delayed. An unfavorable confluence of these uncertainties could result in a write-down of the carrying value of those properties which don't produce enough gas at low prices to be economic; in a write-down of the carrying value of other properties which need more wells drilled and dewatered to establish or improve the economics of production; and/or the delay (whether from lack of capital or permitting problems) in establishing reserves for the larger prospects where many wells will have to be drilled to assess their value. Certain technical terms used in the oil and gas industry appear in this Annual Report. The following are general definitions of those terms: Working interests percentages of a mineral lease total 100%; the working interest owners together (an aggregate of 100%) pay all of the costs to hold undeveloped leases, drill and complete wells on leases, and produce minerals from the leased property (including pump costs, gathering and transmission costs and marketing costs). Net revenue interests are the percentages of production which the working interest owners own, after deduction for payment of royalties to the owners of the minerals under lease (private parties, the Bureau of Land Management, or the State, as applicable). Owners of royalty interests pay none of the costs to drill, complete, or operate wells on a lease. An overriding royalty interest is carved out of the total net revenue interest; overriding royalty interest holders pay none of the costs to hold, drill, or produce the minerals. All owners pay their share of ad valorem and severance taxes. TRANSACTION WITH PINNACLE GAS RESOURCES, INC. On June 23, 2003, RMG, CCBM and its parent company Carrizo Oil & Gas, Inc.; and seven affiliates of Credit Suisse First Boston Private Equity (the "CSFB Parties") signed and closed agreements for a transaction with Pinnacle. The transaction included: (1) the contribution to Pinnacle by RMG and CCBM of all of their ownership of a portion of the CBM properties owned by RMG and CCBM, in exchange for common stock and options to buy common stock in Pinnacle; and (2) $17,640,000 cash to Pinnacle by the CSFB Parties for common stock and series A preferred stock of Pinnacle, and warrants to purchase series A preferred stock of Pinnacle. Pinnacle is a private corporation. Only such information about Pinnacle, as its board of directors elects to release, is available to the public. All other information about Pinnacle is subject to confidentiality agreements between Pinnacle, RMG, and the other parties to the June 2003 transaction. At December 31, 2003, RMG's ownership in Pinnacle's common stock was 37.5%. RMG's ownership of Pinnacle on a fully-diluted basis will change if the CSFB Parties fund subsequent capital requests from Pinnacle and/or exercise their warrants to buy equity in Pinnacle, and/or if RMG and/or CCBM exercise their options to buy equity in Pinnacle, or other events occur. See the discussion under Pinnacle Equity Transaction below. Immediately following, and in connection with, the transaction, Pinnacle acquired additional producing and non-producing CBM properties located in the Powder River Basin of Wyoming from Gastar Exploration, Ltd. ("Gastar," listed on the Toronto Stock Exchange), referred to below as the "Gastar acquisition." The transaction and the follow-on Gastar acquisition provide (1) Pinnacle the funded opportunity to explore and develop the contributed and acquired assets, and to acquire and explore, and if warranted, -7- develop, additional CBM properties in Wyoming and Montana; and (2) RMG (through its ownership interest in Pinnacle) the opportunity to benefit (on a passive basis) from the continued development of the contributed assets and other properties which Pinnacle may acquire in the future. Since June 2003, Pinnacle has acquired additional acreage, and drilled numerous exploratory and development wells. RMG now has interests in approximately 264,300 gross (128,200 net) mineral acres:(A) 173,400 gross (66,900 net) acres in the Castle Rock, Oyster Ridge, and Baggs properties, which were not contributed to Pinnacle (these properties are operated by RMG and held with its industry partner CCBM, Inc.); and (B) 52,700 gross (47,000 net) mineral acres acquired from Hi-Pro Production, LLC. The acreage total does not reflect properties held by Pinnacle. The acreage total for Oyster Ridge includes the proposed acquisition from Kerr McGee (38,184 gross, 11,455 fully diluted net). See "Oyster Ridge". CCBM is a wholly-owned subsidiary of Carrizo Oil & Gas, Inc. ("Carrizo," a Nasdaq listed company). Carrizo, CCBM and RMG entered into an agreement in July 2001 for CCBM to buy a 50% interest in, and fund exploration and development of, RMG's CBM properties then owned. Prior to and in connection with the Pinnacle transaction, CCBM paid RMG approximately $1.8 million cash to complete its purchase of 50% of RMG's contributed CBM properties, thus enabling CCBM to contribute its interests in the CBM properties to Pinnacle as having been fully paid for. See "Continuing Operations of RMG, Continuing Agreement with CCBM, and the AMI Agreement, After the Pinnacle Transaction" below. - PINNACLE EQUITY TRANSACTION Pinnacle is authorized to issue common stock (100 million shares, $0.01 par value) and preferred stock (100 million shares, $0.01 par value). Pinnacle has established series A preferred stock with the following provisions: Liquidation preference of $100.00 per share; 10.5% compounded cumulative annual dividend (12.5% after July 1, 2010); redeemable at Pinnacle's option after July 1, 2004 at a premium declining to par after July 1, 2009 (mandatory redemption if there is a change in control of RMG or CCBM); and with voting rights (a) pari passu with the common stock on regular matters, and (b) as a separate class, to authorize changes in the series A preferred stock, to authorize issuance of stock senior to or in parity with the series A preferred stock, to approve any reorganization or merger of Pinnacle, to approve Pinnacle's sale of substantially all its assets, and similar matters. Pinnacle's board of directors has eight directors (two each from RMG and CCBM, and four from the CSFB Parties). The chart below summarizes (a) the contributions made by the parties to the transaction at the closing, and (b) as of the closing, the subsequent contributions which would be made by the CSFB Parties in response to future capital requests from Pinnacle. As of the filing date of this Annual Report, as a result of a capital request funded after the closing by the CSFB parties, RMG owns 37.5% of the common stock of Pinnacle. -8-
Equity in Pinnacle -------------------- Series A Equity Rights in Pinnacle Parties Contribution Common Stock Preferred Stock Warrants(1) Options Common Stock(2) ------- --------------- -------------- --------------- ----------- ----------------------- RMG All CBM 75,000 shares -0- -0- 30,000 shares properties (except Castle Rock, Baggs and Oyster Ridge) CCBM All CBM 75,000 shares -0- -0- 30,000 shares properties (except Castle Rock, Baggs and Oyster Ridge) CSFB $ 17,640,000 50,000 shares 130,000 shares 130,000 -0- Parties CSFB $ 11,760,000(3) 120,000 shares 120,000 -0- Parties
- ---------------------------------------- (1) At $100 per share of common stock. (2) Options to buy common stock at $100.00 per share, as increased by 10% per annum compounded quarterly for the first 15,000 shares, and 20% per annum for the second 15,000 shares. (3) Commitment to fund subsequent capital requests from Pinnacle, not more than $11,760,000, if made prior to July 1, 2004, for development work on CBM wells, or (if approved by CSFB Parties) a property acquisition. The commitment price is $980,000 for each 10,000 shares of series A stock (coupled with warrants to purchase 10,000 shares of common stock, exercisable at $100 per share). As a result, RMG has recorded its 37.5% equity investment in pinnacle at the carrying value of its coalbed methane properties of approximately $922,600. Sanders Morris Harris Inc. ("SMH") of Houston, Texas acted as financial advisor to RMG on the Pinnacle transaction. For its services in connection with the transaction and the Gastar acquisition, SMH was paid $650,000 by Pinnacle. As additional compensation for SMH's services, USE issued to SMH 50,000 restricted shares of common stock and warrants to purchase (until June 30, 2006) another 50,000 restricted shares of common stock (at $5.00 per share). SMH did not receive any equity or equity rights in Pinnacle in connection with the transaction or the Gastar acquisition. - GASTAR ACQUISITION With proceeds from the CSFB financing, Pinnacle paid Gastar $6.2 million for approximately 50% of Gastar's working interest in existing producing and non-producing CBM properties which included 95 producing wells in the early stages of dewatering and approximately 36,529 gross developed and undeveloped acres. The majority of the leases are either part of or located adjacent to the producing Bobcat property, which RMG and CCBM contributed to Pinnacle. Pinnacle also agreed to fund up to $14.5 million of future drilling and development costs on behalf of Gastar and Pinnacle prior to December 31, 2005, on the properties purchased from Gastar. -9- - CONTINUING OPERATIONS OF RMG, CONTINUING AGREEMENT WITH CCBM, AND THE AMI AGREEMENT AFTER THE PINNACLE TRANSACTION RMG retained ownership, with CCBM, of the Castle Rock, Oyster Ridge, and Baggs projects, totaling about 189,000 gross acres (currently about 173,400 gross acres net of 15,200 gross acres returned to Anadarko after the transaction date and expiration of one lease). RMG and CCBM plan to continue exploration and development activities on these properties as well as acquiring other properties in Wyoming and Montana, under their July 2001 agreement (see "Carrizo - Purchase and Sale Agreement"). Presently there are no agreements for RMG and CCBM to acquire producing properties. CCBM paid RMG approximately $1.8 million for CCBM's outstanding purchase obligation (under the July 2001 agreement) on CCBM's interests in those properties it contributed to Pinnacle. The balance on the note at December 31, 2003 was $836,200. The balance of CCBM's original purchase obligation is payable in monthly installments of approximately $52,800 through November 2004 with a balloon payment of $282,400 due on December 31, 2004. In connection with the transaction with Pinnacle, RMG and Pinnacle signed a transition services agreement, for Pinnacle to pay RMG to assist in setting up operational accounting systems for Pinnacle through December 2003. The agreement was terminated by RMG effective January 1, 2004. Also in connection with the transaction, RMG, CCBM, Carrizo, USE and the CSFB Parties signed an area of mutual interest ("AMI") agreement: Until June 23, 2008, Pinnacle has the right to acquire from the other parties up to 100% of any interest in oil and gas leases, or interests therein or mineral interests or rights to acquire same, which the other parties acquire, at the same price paid or payable by the other parties, within the Powder River Basin in Montana and Wyoming (excluding most of Powder River County, Montana). The original AMI agreement between CCBM and RMG from July 2001 is superseded by the new AMI agreement, except for areas outside the new AMI agreement territory, wherein the original agreement is still in effect. With respect to the properties acquired from Hi-Pro (see below), CCBM and Pinnacle waived their rights to buy any of the producing or undeveloped acreage. ACQUISITION OF PRODUCING AND NON-PRODUCING PROPERTIES FROM HI-PRO PRODUCTION, LLC On January 30, 2004, RMG I, LLC ("RMG I"), a wholly-owned subsidiary of RMG, purchased coalbed methane properties from Hi-Pro for $6,800,000. This transaction was closed after December 31, 2003. See the subsequent event footnote to the financial statements in this Annual Report. The purchased properties (all located in the Powder River Basin of Wyoming) include 247 completed wells and 40,120 undeveloped fee acres. As of the filing date for this Annual Report, 108 wells now are producing approximately 5.9 million cubic feet (Mmcf) of gas per day (approximately 3.1 Mmcf per day net to RMG I). Net daily Mmcf sales are less than gross production, due to produced gas being consumed to run compressors, and from adjustments by purchasers for thermal content (gas is sold based on BTU heat content). RMG I owns an average 58% working (average 46.4% net revenue) interest in the producing wells and proved developed acreage, and a 100% working (average 80% net revenue) interest in all of the undeveloped acreage. The net revenue interest percentage after deduction of the overriding royal interests held by lenders (see "Mezzanine Credit Facility") are 44.66% for the producing and five future wells to the Wyodak coal, and 78.0% for production from deeper coals and all of the undeveloped acreage. The transaction was structured as an asset purchase, with RMG I as the purchaser, in connection with the establishment of a mezzanine credit facility for up to $25,000,000 of secured loans to acquire and develop more proven coalbed methane reserves. RMG may utilize RMG I for future acquisitions (none are presently -10- under contract or agreement in principle). See "Mezzanine Credit Facility." A substantial portion of the cash consideration paid to Hi-Pro was funded with the initial advance on the credit facility. RMG I replaced Hi-Pro as the contract operator for 89% of the wells that were acquired. RMG negotiated the purchase based on the $7,113,000 present value, discounted 10%, of gas reserves recoverable (and the estimated future net revenues to be derived) from proved reserves in the Hi-Pro properties, as estimated as of November 1, 2003 by Netherland Sewell and Associates, Inc. See "Reserve Date" below for the estimate as of December 31, 2003. The $6,800,000 purchase price reflects a deduction, negotiated by the parties in January 2004, to account for the decrease in gas production from October 2003 due to the impact on production from deferred maintenance on the properties, and the expected cost of such maintenance work after closing. - TERMS OF THE PURCHASE. The purchase price of $6,800,000 was paid: X $ 776,700 cash by RMG. X $ 588,300 net revenues from November 1, 2003 to December 31, 2003, which were retained by Hi-Pro.(1) X $ 500,000 by USE's 30 day promissory note (secured by 166,667 restricted shares of USE common stock, valued at $3.00 per share). X $ 600,000 by 200,000 restricted shares of USE common stock (valued at $3.00 per share).(2) X $ 700,000 by 233,333 restricted shares of RMG common stock (valued at $3.00 per share).(3) X $3,635,000 cash, loaned to RMG I under the credit facility ---------- agreement. (4) $6,800,000 (1) RMG paid all January operating costs at closing. Net revenues from the purchased properties for January 2003 were credited to RMG I's obligations under the credit facility agreement. These net revenues were considered by the parties to be a reduction in the purchase price which RMG otherwise would have paid at the January 30, 2004 closing. (2) USE has agreed to file a resale registration statement with the SEC to cover public resale of these 200,000 shares. (3) From November 1, 2004 to November 1, 2006, the RMG shares shall be convertible at Hi-Pro's sole election into restricted shares of common stock of USE. The number of USE shares to be issued to Hi-Pro shall equal (A) the number of RMG shares to be converted, multiplied by $3.00 per share, divided by (B) the average closing sale price of the shares of USE for the 10 trading days prior to notice of conversion. The conversion right is exercisable cumulatively, as to at least 16,666 RMG shares per conversion. (4) See "Mezzanine Credit Facility." - PROPERTIES PURCHASED. RESERVE DATA Netherland Sewell and Associates, Inc. ("NSAI," Houston, Texas), independent petroleum engineers, have prepared a report on the proved reserves, as of December 31, 2003, estimating recoverable reserves from the Hi-Pro properties, and the present value (discounted 10%) of future cash flow therefrom. NSAI's report takes into account fixed pricing for some production in 2004 and 2005, reflects the reduction in RMG's net revenue interests due to the overriding royalty interests held by lenders, and (except for fixed pricing in 2004 and 2005) is based on the Henry Hub Spot market price of $5.965 per mmbtu, adjusted by lease for energy content, transportation fees and regional price differentials on December 31, 2003, without price escalation. -11- NET PRESENT RESERVES VALUE (Mmcf) (discounted at 10%) ------ --------------------- Proved Developed Producing 2,206.490 $4,589,600 Proved Developed Non-Producing 464.423 $1,084,800 Proved Undeveloped 733.780 $1,382,000 ---------- ---------- Total 3,404.693 $7,056,400 ========= ========== The present value, discounted 10% value ("PV10 value") was prepared after ad valorem and production taxes on a pre-income tax basis, and is not intended to represent the current market value of the estimated gas reserves purchased from Hi-Pro. The PV10 discount factor is not the same as the standardized measure of present value calculations which are determined on an after-income tax basis. Reserves as of November 1, 2003 were calculated by NSAI based on actual production up to June 30, 2003, with production decline curves to November 1, 2003 estimated based on that production, resulting in total net proven reserves of 4,034.5 Mmcf. For estimates as of December 31, 2003, NSAI was supplied with actual production data through that date. Because actual production was below the production predicted for the same period by the November 1, 2003 decline curves, the decline curves for the later report had a lower starting point on January 1, 2004 and a steeper rate of decline. These new decline curves thus predict lower future production (3,404.693 Mmcf net to RMG) as of December 31, 2003. We expect production in 2004 from producing wells, and hence proven reserves (after adjustments for actual gas produced), will increase as maintenance work now in progress (which had been deferred by Hi-Pro in the last two quarters of 2003) is completed in the second quarter 2004. The reduction in the present value, discounted 10%, of proven reserves at November 1, 2003 ($7,113,000) as compared to December 31, 2003 ($7,056,400) was less than 1%, notwithstanding the decreased volume of reserves, due to the higher price at the later date compared with prices used in the November 1, 2003 estimate ($4.50 per mcf in 2003, $4.29 in 2004, and $4.25 in 2005). There are numerous uncertainties inherent in estimating gas reserves and their estimated values. Reservoir engineering is a subjective process of estimating underground accumulations of gas that cannot be measured exactly. Estimates of economically recoverable gas, and the future net cash flows which may be realized from the reserves, necessarily depend on a number of variable factors and assumptions, such as historical production from the area compared with production from other areas, the assumed effects of regulations by government agencies, assumptions about future gas prices and operating costs, severance and excise taxes, development costs, and work-over and remedial costs. The outcomes in fact may vary considerably from the assumptions. The PV10 value takes into account RMG I's contracts to sell 2,000 Mmbtu per day in 2004 at a fixed price of $4.76 per Mmbtu, and 1,000 Mmbtu per day in 2005 at a fixed price of $4.14 per Mmbtu. From time to time, RMG I may sign fixed price contracts for more production. In addition, gas market prices will vary, possibly by significant amounts, throughout each year, and on an average basis from year to year. For these reasons, the cash flow realized from production likely will vary from the estimates of cash flow used to determine the PV10 value. Estimates of the economically recoverable quantities of gas attributable to any particular property, the classification of reserves as to proved developed and proved undeveloped based on risk of recovery, and estimates of the future net cash flows expected from the properties, as prepared by different engineers or by the same engineers but at different times, may vary substantially, and the estimates may be revised up or down as assumptions change. In addition, it is likely that actual production volumes will vary from the estimates. -12- The PV10 discount factor, which is required by the SEC for use in calculating discounted future net cash flows for reporting purposes, is not necessarily the most appropriate discount factor, based on interest rates in effect in the financial markets, and risks associated with the gas business. The business of exploring for, developing, or acquiring reserves is capital intensive. To the extent operating cash flow is reduced and external capital becomes unavailable or limited, RMG's ability to make the necessary capital investment to maintain or expand the gas reserves asset base would be impaired. There is no assurance future exploration, development, and acquisition activities will result in additional proved reserves. Even if revenues increase because of higher gas prices, increased exploration and development costs could neutralize cash flows from the increased revenues. - FUTURE PLANS FOR THE HI-PRO PRODUCTION PROPERTIES In the second quarter of 2004, RMG I plans to drill five proven undeveloped locations to the Wyodak coal, continue a remedial workover program on a number of existing wells, and upgrade the gas gathering and pipeline facilities included in the purchase. The workover program is estimated to cost $250,000 and will be funded by the working interest partners. The drilling and gathering upgrade is estimated to cost approximately $640,000, and is being funded with a loan from the mezzanine credit facility. The programs are designed to enhance production from current levels. After the 5 new wells to the Wyodak are drilled, there will be no more undrilled locations on the currently producing properties available for the Wyodak coal. The first coals of interest under the undeveloped acreage are the Anderson and Canyon coals (for example under the Reno property); the Wyodak coal is not present under the undeveloped acreage. In addition to the 5 new wells, RMG-I plans to hook up 2 additional wells that were previously drilled by Hi-Pro and are in close proximity to the 5 new wells. The Wyodak coal formation is 200 to 600 feet from surface. Existing infrastructure for the Wyodak wells (gathering lines, compressors, and water disposal) should significantly reduce drilling and completion costs for new wells to the deeper Dannar and Moyer coals (1,100 to 1,800 feet). Subject to raising capital, up to 120 wells could be drilled and completed to these deeper coals in 2004 and 2005, all on locations now producing from the Wyodak. This development activity is contingent upon obtaining future financing. We do not expect that funding for this activity will be available through the mezzanine credit facility. No reserves have been established for the Dannar and Moyer coals. Because no other operators are producing gas from or dewatering these coals in the vicinity of the Hi-Pro properties, we expect several pods of wells will have to be drilled and completed to these coals, with an extended dewatering period (which could be up to 24 months), before significant gas production begins. RMG is also developing plans to put five coalbed methane wells from the Reno property on production during 2004. The Reno property was part of the Hi-Pro acquisition. The target coals on the Reno property are the Anderson coal, which is about 600-650 feet in depth and approximately 40 feet in thickness and the Canyon coal which is about 700-850 feet in depth and 35 feet in thickness. Four wells were previously drilled by Hi-Pro, at the Reno Property which were completed in both the Anderson and Canyon coals, with slotted screening in each. In addition, in March 2004, RMG I drilled a fifth well, which has been completed in the Canyon coal. The shallower Anderson coal may be completed at a later date. Four additional well locations exist at the Reno property based upon 80-acre spacing. The Reno property consists of 760 gross and net acres, all on fee acreage. It is located in Campbell County, Wyoming, approximately 50 miles south of Gillette. RMG owns a 100% working interest in this property. -13- - MEZZANINE CREDIT FACILITY. RMG I has signed a credit agreement with Petrobridge Investment Management, LLC (Houston , Texas) as lead arranger, and institutional lenders, for up to $25,000,000 of loans to RMG I. The loan commitment is through June 30, 2006. All loans will have a three year term from funding date. Funding to acquire and/or improve any project is subject to the lenders' approval of the transaction and RMG I's development plan. The first loan ($4,340,000 on January 29, 2004) under the credit facility has been applied to the Hi-Pro asset purchase ($3,700,000) including transaction costs and professional fees; and for a Phase I development program ($640,000). Terms for all loans under the credit facility include the following: X Principal is not amortized, but interest must be paid monthly. All revenues from the properties owned by RMG I (including all current and new wells) is paid to a lock box account controlled by the lenders, from which is paid by the lenders, the lease operating costs, revenue distributions, RMG I operating fees and RMG pumping fees (all approved by the lenders). With the exception of operating and pumping fees, no revenues will be available for RMG operations until all loans are paid off. X The loans are secured by all of RMG I's properties and by RMG's equity interest in RMG I. X The lenders, in the aggregate, receive an overriding royalty interest of 3% of production from the wells producing when the acquisition was closed, and 2% of production from new wells on an 8/8ths working interest basis, proportionately reduced where less than 100% of the working interest is owned by RMG I. For the Hi-Pro properties, the 3% rate applies to all wells (producing and to be drilled) to the Wyodak formation (an aggregate override of 1.74%), and 2% to all wells to deeper formations (aggregate override to be determined based on working interest ownership by well). Override payments to the lenders are not applied to the loan balances. The percentage of overrides on future properties may vary. X Negative covenants: RMG I will not permit the ratio of (a) total debt to EBITDA to exceed 2.00 to 1.00; (b) EBITDA to interest expense and rents (lease expense) to be less than 3.00 to 1.00; c) current assets to current liabilities to be less than 1.00 to 1.00; or (d) PV 10 (proved developed producing reserves) to total debt to be less than 1.00 to 1.00. All these ratios are to be determined quarterly. In addition, RMG I shall not permit net sales volume of gas from its properties to be less than 270 Mmcf, 230 Mmcf, 230 Mmcf and 210 Mmcf for each quarter in 2004, or less than 180 Mmcf per quarter in 2005 and the first two quarters of 2006. At closing of the Hi-Pro acquisition, USE issued to the participating lenders three year warrants to purchase a total of 318,465 shares of common stock of USE (subject to vesting) at $3.30 cash per share. At closing of the Hi-Pro Acquisition, warrants on 63,693 shares vested. The remaining warrants will vest at the rate of the right to buy one USE share for each $157 which RMG I subsequently borrows under the credit facility. Regardless of when vested, all warrants will expire on the earlier of January 30, 2007, or the 180th day after USE notifies the warrant holders that USE' stock price has achieved or exceeded $6.60 per share for a consecutive 15 business day period. USE has agreed to file a registration statement with the SEC to cover public resale of the warrant shares. The preceding is a summary of some of the terms of the credit agreement, and is qualified by the text of the agreement, filed with this Annual Report as an exhibit. -14- - RMG EQUITY TRANSACTION In the first quarter, RMG raised $1,800,000 of equity financing from the sale of shares of Series A Preferred Stock in RMG, and warrants to purchase shares of common stock of USE, to institutional investors. Proceeds are being used for RMG working capital. The terms of the securities sold are: X 600,000 shares of Series A Preferred Stock at $3.00 per share. The Series A Preferred Stock bears a 10% cumulative annual dividend (payable on March 1 of each year, beginning March 1, 2005), payable at RMG's election in cash or shares of common stock of RMG (at $3.00 per share) or shares of common stock of USE (at 90% of USE' volume weighted average price for the five days, referred to as the "set price"). The Series A Preferred Stock is convertible at the holder's election into shares of common stock of RMG, at $3.00 per share, or shares of common stock of USE at the set price, until February 2006, at which time all Series A Preferred Stock shares not previously converted shall automatically be converted into shares of common stock of RMG. The Series A Preferred Stock carries a liquidation preference of $4.05 per share. X Warrants to purchase 150,000 shares of common stock of USE, at the set price. The investors did not pay additional consideration for the warrants issued in connection with the purchase of the Series A Preferred Stock. The warrants are exercisable as to 25% of the underlying shares beginning in May 2004, and an additional 25% of the underlying shares on each of the six months, nine months, and twelve months thereafter, at which time the warrants are exercisable for the full number of underlying shares. USE may call the warrants for exercise if USE's volume weighted average price (VWAP) for its stock exceeds $6.00 for any consecutive 15 trading days; warrants not exercised by the tenth trading day after a call notice is sent will be cancelled. X The number of shares of RMG or USE common stock issuable in payment of dividends on, or conversion of, the Series A Preferred Stock, and the number of shares of common stock of USE issuable on exercise of the warrants, are subject to adjustment in certain events to protect the holders from dilution. The first anti-dilutive provision is 'full ratchet': If RMG or USE issue shares of common stock, or derivative securities exercisable for or convertible into such shares of common stock, at a price less than $3.00 per share for RMG stock or the set price for USE stock, at any time until 30 days after a registration statement (to be filed by USE) has been declared effective by the SEC to permit the resale to the public by the holders of the USE common stock issuable on payment of dividends, in conversion, and on exercise of warrants, then the issue price for the dividends and conversions, and the exercise price of the warrants (for RMG and USE common stock, as applicable) shall be reduced (ratcheted down) to equal the lower issue price, until the 30th day after the registration statement is declared effective. X The second anti-dilutive provision would take effect after that 30th day: The issue price would be adjusted up to a fully weighted adjusted price, and would continue to be adjusted for any other issuance by RMG or USE of stock or derivative securities at a price less than $3.00 or the set price, as applicable, until the Series A Preferred Stock is converted to common stock or RMG or USE, or until the expiration of the warrants, as applicable. As an example of fully weighted anti-dilution protection, if RMG were to sell 3,200,000 shares of common stock at $2.50 per share, the dividend and conversion price on the Series A Preferred Stock would be $2.91. The preceding is a summary of some of the terms of the Series A Preferred stock designation, and the USE warrants, and is qualified by the text of the documents filed with this annual report as exhibits. VOLUMES, PRICES AND GAS OPERATING EXPENSE - BOBCAT PROPERTY (TRANSFERRED TO PINNACLE GAS RESOURCES, INC. IN JUNE 2003) This table shows RMG's 27.6% working (22% net revenue) sales volumes of gas produced, average sales prices received for gas sold, and average production costs for those sales, for the seven months ended -15- December 31, 2002, and for the year ended December, 2003, all from the Bobcat property which was transferred to Pinnacle in June 2003. Year Ended Seven Months Ended December 31, 2003 December 31, 2002 ------------------- ------------------- Sales volumes (mcf) 81,516 64,314 Average sales price per mcf(1) $3.71 $1.86 Average cost (per mcf)(2) $1.91 $1.91 (1) From time to time, we sold some of the production at a set price and the balance at daily market prices. For the six months ended June 30, 2003, we sold 37.0% of our share of production at contract prices and 63.0% at the market. There were no gas sales after June 30, 2003. (2) Includes direct lifting costs (labor, repairs and maintenance, materials and supplies, workover costs, insurance and property, gathering, compression, marketing and severance taxes). ACQUISITION AND EXPLORATION CAPITAL EXPENDITURES - ALL PROPERTIES THROUGH DECEMBER 31, 2003 From inception on November 1, 1999 through December 31, 2003, RMG incurred net acquisition (purchase price and holding costs) and exploration costs (drilling and completion) on CBM properties of approximately $1,353,900, which does not include approximately $2,194,900 funded by CCBM on RMG's behalf for leasehold, drilling and completion costs. Unproved properties on the balance sheet at December 31, 2003 reflect the reduction (by $5,143,000) to reflect the reduction of the full cost price as a result of principal payments made by CCBM under its agreement with RMG and by payments from other industry partners. The foregoing data does not include $922,600 spent by RMG on properties transferred to Pinnacle. The $922,600 was recorded at December 31, 2003 as an investment in Pinnacle. The following table shows certain information regarding the gross costs incurred by RMG. Costs associated with the Hi-Pro acquisition after December 31, 2003 are not included.
Year Ended Seven Months Ended Year Ended December 31, December 31, May 31, ------------- ------------------- ----------- 2003 2002 2002 ------------- ------------------- ----------- Acquisition costs $ 107,100 $ 936,200 $ 192,600 Development 158,300 97,200 87,400 ------------- ------------------- ----------- $ 265,400 $ 1,033,400 $ 280,000 ============= =================== ===========
The acquisition costs included amounts paid for properties, delay rentals, lease option payments, and general and administrative costs directly attributable to the acquisitions. The recorded amounts for acquisition and exploration of $265,400, $1,033,400, and $280,000 represent 1.1%, 3.6%, and 1.0% of total assets at December 31, 2003, December 31, 2002, and May 31, 2002, respectively. We use the full-cost method of accounting for gas properties. Under this method, all acquisition and exploration costs are capitalized in a "full-cost pool" as incurred. Depletion of the pool will be recorded using the unit-of-production method. To the extent capitalized costs in the full-cost pool (net of depreciation, depletion and amortization and related deferred taxes) exceed the present value (using a 10% discount rate) of -16- estimated future net pre-tax cash flows from proved gas reserves as established by reserve reports, the excess costs will be charged to operations. All acquisition and exploration costs for a property are capitalized until such time as reserves can be established, or not, for the property. If no reserves are established, those capitalized costs will be transferred to the amortization basis and be subject to an impairment testTo the extent reserves are established for an exploration property to be less than such costs, the costs will be written-down to the amount of present value of the reserves. In this event, assets would decrease and expenses would increase. Once incurred, a write-down of gas properties can't later be reversed. In addition, if future exploration work (in particular the larger prospects) is delayed because of lack of capital or permitting delays, or both, with the result that it cannot be established whether or not proved reserves exist on the properties, the exploration costs for those properties would be written-off. COALBED METHANE PROPERTIES As of the filing of this Annual Report, we hold leases and options to develop approximately 264,300 gross mineral acres (including 69,895 acres under options - see "Oyster Ridge" below) under leases from the United States Bureau of Land Management, the states of Wyoming and Montana, and private landowners. Table 1 shows the total gross and net lease acres held in each prospect, and the amount of such acreage held by RMG and by companies with which RMG has agreements (CCBM, Inc. and Quaneco, L.L.C.). These agreements are summarized under "Carrizo - Purchase and Sale Agreement" and "Quaneco - Agreement." Acreage data assumes CCBM completes its obligations; CCBM will own its 50% working interest in wells drilled under CCBM's drilling fund commitment, but if CCBM does not complete its purchase obligations, CCBM would be entitled to a reduced working interest in the remaining undrilled acreage. CCBM currently has purchase rights to acquire a 6.25% working interest in the Castle Rock prospect, and owns a 6.25% working interest in eight wells in Castle Rock, which were drilled by Suncor Energy Natural Gas America, Inc. ("SENGAI"). RMG's and CCBM's interests in the Castle Rock prospect, as shown in Table 1, reflect the completion of SENGAI's drilling program in late calendar 2001. SENGAI elected not to exercise its option under an Option and Farmin Agreement on February 8, 2002. Prospects are evaluated for coal potential using available public and industry data, taking into account proximity to other positions held by RMG and existing or planned gas transmission lines, and whether drilling and production permits can be obtained and the costs thereof. The final decision to acquire a prospect is made by the executive officers of RMG. Well drilling and testing is done by outside contract drilling companies. Drilling results (cores, gas and water flow rates, and other data) are evaluated by RMG staff, using customary technical methods, to determine if any coal zones encountered in the well should be completed for production. Completion requires setting casing pipe down to the coal zone(s), installing pumps, and installing and setting up the necessary surface equipment (for example, water disposal lines and water holding tanks and/or holding ponds for evaluation wells, pending production permitting), and dewatering the well sufficiently so production can start. The decision whether to complete the well is made by the executive officers of RMG. Table 1 reflects RMG's, Quaneco's and CCBM's acreage position as of the filing of this Annual Report. Table 1 does not reflect the reduction in net acreage held by RMG if Anadarko Petroleum, Inc. exercises its options to back-in for a 25% working interest on 31,711 gross acres or Kerr McGee exercises its option to back-in for a 40% working interest on 38,184 gross acres within the Oyster Ridge prospect. Also, 69,895 of the acres shown as held in Oyster Ridge assume we continue to earn acreage under the drill-to-earn-acreage provisions of the option agreements with Anadarko and Kerr McGee. See "Description of Prospects - Oyster Ridge" below. -17- TABLE 1 - -------------------------------------------------------------------------------- Project and Date Gross Lease Net Lease RMG Net Quaneco Net CCBM Net Acquired Acres Acres Acres Acres Acres - -------------------------------------------------------------------------------- Castle Rock 123,840 111,567 48,811 55,784 6,973 Jan. 2000 Oyster Ridge 87,642 87,642 32,380 0 32,380 Dec. 1999 Baggs North 120 120 60 0 60 Jan. 2000 Hi-Pro 52,740 51,938 46,974 0 0 Jan.2003 - -------------------------------------------------------------------------------- TOTAL 264,342 251,267 128,225 55,784 39,413 - -------------------------------------------------------------------------------- We own a 43.75% working interest (35% net revenue interest) in the Castle Rock prospect on 123,840 gross and 111,567 net acres in southeast Montana. CCBM can purchase a 6.25% working interest in our acreage (6,973 net acres) of the Castle Rock prospect if they meet certain payment obligations. In July 2001, we sold a 50% working interest in all our coalbed methane leases, except at Castle Rock, to CCBM for $7,500,000, plus other consideration. The acreage data in Table 1 reflects these transactions. CCBM agreed to pay up to $5,000,000 for drilling and completing CBM wells on the properties owned by RMG and CCBM. We have a carried working interest in all of the wells drilled on properties owned in July 2001 (after the Pinnacle transaction, those properties consist of the Castle Rock, Baggs, and the Oyster Ridge property (not including the Kerr-McKee earn-in acreage)). To date, CCBM has not indicated whether they will participate in the Kerr McGee acreage under the AMI agreement as it is still under review by CCBM under the AMI review timeline. CCBM has the right to participate as to 50% of the working interest we acquire in properties RMG or RMG I acquires in the future; if CCBM elects to participate, RMG or RMG I would not have a carried interest in wells on future properties. A total of 72 wells have been drilled on RMG acreage through December 31, 2003: 5 in (former) fiscal year 2001; 53 in (former) fiscal year 2002; 12 in the seven months ended December 31, 2002; and 2 in 2003. 43 of the wells were drilled on properties transferred to Pinnacle in mid-2003. Nineteen of the wells were drilled by SENGAI in Castle Rock under the terms of a option and farmin agreement. Eleven of those 19 wells were stratigraphic wells and have been plugged by SENGAI; 8 of those 19 wells were completed and are owned by RMG (93.75% working interest) and CCBM (6.25% working interest), as Quaneco opted out of maintaining a working interest in the 8 wells. Other than the Castle Rock wells, RMG and CCBM both have a 50% working interest in all of these wells (see Table 2 below). As of December 31, 2003, CCBM and RMG have spent approximately $2,194,900 of the $2,500,000 drilling fund CCBM is committed to spend on RMG's behalf. This reflects a reduction of $391,000 for RMG's participation in two of Carrizo's Gulf Coast wells. We are relying on the $305,100 balance to pay for continued drilling and completion work on the Castle Rock and Oyster Ridge properties, as to which RMG will have a carried working interest with no financial obligation of RMG for drilling and completion costs until the drilling fund is exhausted. For other properties we acquire in which CCBM elects to participate, CCBM would bear 50% of drilling and completion costs for their 50% working interest. Future annual financial obligations for coalbed methane properties consist of approximately $173,100 gross in rental fees to the lessors for 2004 ($81,800 net to RMG). Table 2 lists the number of wells drilled, the total exploration costs and the remaining number of wells currently permitted for drilling as of December 31, 2003. Wells permitted for drilling on the Hi-Pro properties are shown; exploration costs and numbers of wells drilled by Hi-Pro Production are not shown. -18- TABLE 2
FY 2001 FY 2002 New Year 2002 FY 2003 Prospect 6/1/00-5/31/01 6/1/01-5/31/02 6/1/02-12/31/02 1/1/03-12/31/03 TOTAL Remaining Wells $ Wells $ Wells $ Wells $ Wells $ Permits - --------------------------------------------------------------------------------------------------------------------------- Castle Rock 3* $283,900 19** $2,500,000 $ 4,300 0 0 22 $2,788,200 5 - --------------------------------------------------------------------------------------------------------------------------- Oyster Ridge 2 150,500 5 464,200 3,400 0 0 7*** 618,100 4 - --------------------------------------------------------------------------------------------------------------------------- Hi-Pro n/a n/a n/a n/a n/a n/a n/a 0 n/a n/a 9 - --------------------------------------------------------------------------------------------------------------------------- TOTAL 5 434,400 24 2,964,200 7,700 0 0 29 3,406,300 18
* one well has been plugged and abandoned ** drilled by SENGAI, 11 have been plugged and abandoned *** includes 3 wells that have been plugged and abandoned CARRIZO - PURCHASE AND SALE AGREEMENT. On July 10, 2001, RMG closed a Purchase and Sale Agreement with CCBM, Inc., a Delaware corporation which is wholly-owned by Carrizo Oil & Gas, Inc., Houston, Texas (NMS "CRZO"). The agreement between CCBM and RMG is intended to finance the further exploration of the properties held in Montana and Wyoming, and to acquire and develop more properties. RMG assigned CCBM an undivided 50% interest in all of RMG's then current coalbed methane properties (with the exception of Castle Rock of which only a 6.25% working interest was assigned) for a purchase price of $7,500,000 by a promissory note payable in principal amounts of $125,000 per month plus interest at an annual rate of 8%, over 41 months (starting July 31, 2001) with a balloon payment due on the forty-second month. This note was reduced in connection with CCBM's contribution of properties to Pinnacle (see "Transaction with Pinnacle Gas Resources, Inc. - Continuing Operations of RMG, Continuing Agreement with CCBM, and the AMI Agreement, after the Pinnacle Transaction"), and the balance on the note is secured with a 50% undivided interest in the remaining properties (Oyster Ridge and Baggs North (but not Hi-Pro). CCBM has the right to participate in other properties RMG may acquire under an area of mutual interest ("AMI") agreement. This agreement has been modified by the AMI agreement signed in connection with the Pinnacle transaction; CCBM waived its right to participate in the Hi-Pro acquisition. For information on the original AMI agreement, see "Carrizo - Purchase and Sale Agreement" in the Annual Report (Form 10-K/A1) for the former fiscal year ended May 31, 2002. In addition to its one-half share of revenues in proportion to its one-half share of the working interest, CCBM was entitled to a credit (applied as a prepayment of the purchase price for the undivided 50% interest in RMG's acreage), equal to 20% of RMG's net revenue interest from wells drilled with the $5,000,000 drilling budget, until the amount of that credit in favor of CCBM equals $1,250,000. At the formation of Pinnacle, CCBM paid RMG approximately $1.8 million to complete is purchase value on the contracts properties. The payment of $1.8 million was a reduction to the principal on the original $7.5 million note from CCBM. The $1.25 million that CCBM was to recover from 20% of RMG's revenue interest on the contributed properties was netted against the total purchase price on the contributed properties which yielded the $1.8 million cash payment. CCBM is not entitled to any additional disproportionate revenue distributions. QUANECO - AGREEMENT. On January 3, 2000, RMG purchased a 50% working interest and 40% net revenue interest in the Castle Rock and Kirby prospects in the Powder River Basin of southeast Montana consisting of approximately 185,000 net mineral acres from Quaneco, L.L.C. (formerly Quantum Energy, L.L.C., Cleveland, Ohio and Oklahoma City, Oklahoma). The acreage includes 88,409 net acres of Bureau of Land Management ("BLM") land; 14,916 net acres of state land (Montana), and 82,775 net acres of fee land. -19- In fiscal 2000 and 2001, RMG paid Quaneco the cash purchase price of $5,500,000 for the acreage plus a drilling commitment of $2,500,000. RMG and CCBM transferred their interests in the Kirby prospect to Pinnacle in mid-2003. For information on the Quaneco agreement, see "Quaneco Agreement" in the Annual Report (Form 10-K/A1) for the (former) fiscal year ended May 31, 2002. DESCRIPTION OF PROSPECTS Leases of federal mineral rights are obtained from the United States Bureau of Land Management and expire from 2004 to 2009, unless RMG establishes production on the lease, in which event the lease is held so long as coalbed methane or other gas or oil is produced. A royalty interest of 12.5% on the production is paid to the BLM. State leases expire from 2004 to 2009 in Wyoming and Montana, unless RMG establishes production on the lease, in which event the lease is held so long as coalbed methane or other gas or oil is produced. The royalty paid to the State of Wyoming is from 12.5 % to 16.67%, and 12.5% to the State of Montana. Annual renewal fees for non-producing Federal leases is $1.50 to $2.00 per acre, and $1.00 and $2.75 for non-producing Wyoming and Montana leases. An environmental group has filed a lawsuit against the BLM, RMG and others, challenging the validity of numerous BLM leases in the Powder River Basin of Montana. See Item 3, Legal Proceedings ("Rocky Mountain Gas Litigation"). Leases on private (fee) land for coalbed methane and conventional gas expire at various times from 2004 to 2011, unless production is established, in which event the lease is held so long as there is production. The landowner is paid a royalty from production of 12.5% to 20.0% , depending on the lease terms. Table 3 presents total acreage (developed and undeveloped) held by RMG at December 31, 2003, and the Hi-Pro acreage as of the filing date of this Annual Report. TABLE 3
Net Net Net Net Leased Leased Leased Gross Net Leased from from from Leased Leased from State of State of Private Prospect Acres Acres BLM Wyoming Montana Owners ------- ------- -------- ------- ------- ------ Castle Rock 123,840 111,567 55,104 0 10,860 45,603 Oyster Ridge* 20,306 20,306 17,107 639 0 2,560 Baggs North 120 120 0 120 0 0 Hi-Pro (undeveloped) 40,120 40,120 0 112 0 40,008 ------- ------- ------ ----- ------ ------ Total Undeveloped Acres 184,386 172,113 72,211 871 10,860 88,171 Hi-Pro (developed) 12,620 11,818 460 280 0 11,078 ------- ------- ------ ----- ------ ------ Total Acres 197,006 183,931 72,671 1,151 10,860 99,249 ======= ======= ====== ===== ====== ======
*Does not include 29,151 acres under option from Anadarko Petroleum and 38,184 acres under option from Kerr McGee. See "Description of Properties - Oyster Ridge." -20- RMG's properties and mineral leases of BLM, state and fee lands require annual cash payments of approximately $173,100 during 2004. CCBM is obligated for $59,600 of the $173,100 required to keep undeveloped coalbed methane leases in effect. CASTLE ROCK: The Castle Rock project consists of 123,840 gross and 111,567 net acres located in the northeastern portion of the Powder River Basin of Montana, west of Broadus, Montana. Coals present are in the Tongue River member of the Fort Union formation and appear comparable to coals currently being developed by other operators south of the Castle Rock acreage near the Montana/Wyoming border. Currently, there are no pipelines in this area. OYSTER RIDGE: The Oyster Ridge project consists of two acreage positions: (1) 49,457 gross and net acres located in southwestern Wyoming in the Ham's Fork Coal Field adjacent to the Green River Basin; RMG and CCBM have a 100% working interest (50% each) in 20,765 acres within this play, which is held with Anadarko Petroleum, Inc. Oyster Ridge; and (2) 38,184 gross and net acres held by Kerr-McGee Rocky Mountain Corporation, which are at the north and south ends of the Anadarko acreage. The area is prospective for coalbed methane production from two primary Cretaceous age coals, the Frontier and the Adaville. The Kern River pipeline, which services southern California, crosses the property. Through December 31, 2003, $799,500 has been spent on drilling and completion at Oyster Ridge. (1) Anadarko Petroleum, Inc. is successor to Union Pacific Land Resources Corporation, which sold the acreage subject to UPLRC's back-in option to third parties, from whom RMG acquired the acreage in December 1999. The agreement with Anadarko is a drill-to-earn-acreage agreement: We must drill at least four wells each year, each on a new section (640 acres), to earn a lease on each drilled section, and also to keep in force previously earned leases in the 31,711 acres area. Wells drilled by our seller, and by us (with CCBM), have earned 2,560 acres, which are included in the 20,306 acres leased presently. Another 29,151 gross acres in the Oyster Ridge project are subject to an option held by Anadarko Petroleum, Inc. to participate as a 25% working interest owner on all wells drilled each year. Anadarko has not yet elected to participate, and has no working interest in the wells drilled to date on this prospect. If Anadarko elects to participate in the future, working interest ownership in affected wells would be 37.5% RMG, 37.5% CCBM, and 25% Anadarko. (2) Effective March 31, 2004, RMG signed a letter of intent to enter into an earn-in agreement to acquire a 60% working interest from Kerr-McGee Rocky Mountain Corporation ("KM") in 38,184 gross and net mineral acres held by KM under federal and Wyoming state leases. When executed, the earn-in agreement will be for a total of six years, with three phases: drilling commitment, pilot program, and development program. The earn-in agreement is expected to be executed by March 31, 2004. The following is a summary of terms. Drilling Commitment. On or before September 30, 2004, RMG will drill, complete and attempt to produce for at least 30 days (at its sole expense) two coalbed methane wells (one to the Frontier coal seams and one to the Adaville Cretaceous coal seams), to earn 60% of KM's working and net revenue interest in the 640 acre section surrounding each well, down to the deepest depth drilled. Drilling and completion costs for the two wells will be a minimum of $300,000. RMG will receive all production revenues from each well until RMG reaches payout (total drilling and completion costs) from the wells, at which time KM will begin to participate for its 40% working interest. KM's leases will be delivered to RMG with a 82.5% net revenue interest. -21- Pilot Program. If RMG determines the drilling program results to be favorable, in its exclusive judgment, a pilot program for four wells (at RMG's sole expense) will be initiated by September 30, 2005. Development Program. If RMG determines the pilot program results to be favorable, in its exclusive judgment, RMG will notify KM by December 31, 2005 of its election to commit to a development program. If this commitment is made, RMG shall drill at least 10 wells per year on KM lands beginning in 2006. Each well will earn for RMG a 60% working interest in the 640 acre section surrounding the well, and each lease will be delivered to RMG with a 82.5% net revenue interest. KM may elect to participate for a 40% working interest in any development well. If KM elects not to participate in the first well in the section, KM will be deemed to relinquish the 40% working (and associated net revenue) interest in the well until RMG reaches payout. If KM elects not to participate in the second well in any section previously earned by RMG, then KM shall have relinquished all of its interest in the entire section. RMG will be the operator for each stage of the KM project. As of the filing date of this Annual Report, CCBM has not determined whether to participate with us in the Kerr-McGee earn-in agreement. However, our net acreage calculations assume that CCBM will participate. BAGGS NORTH: This prospect contains 120 gross and net acres located in Carbon County, Wyoming. This State lease is located 7 miles north of Baggs, Wyoming. RMG holds a 50% working interest in this prospect. To date, RMG has not conducted any significant exploration on the property. GENERAL INFORMATION ABOUT COALBED METHANE. Methane is the primary commercial component of natural gas produced from conventional gas wells. Methane also exists in its natural state in coal seams. Natural gas produced from conventional wells generally contains other hydrocarbons in varying amounts which require the natural gas to be processed. Methane gas produced from coalbeds generally contains only methane and is pipeline-quality gas after simple water dehydration. Coalbed methane ("CBM") production is similar to conventional natural gas production in terms of the physical producing facilities. However, the subsurface mechanisms that allow gas movement to the wellbore are very different. Conventional natural gas wells require a porous and permeable reservoir, hydrocarbon migration and a natural structural or stratigraphic trap. Coalbed methane is stored in four ways: 1) as free gas within the micropores (pores with a diameter of less than .0025 inch) and cleats (set of natural fractures in the coal; 2) as dissolved gas in water within the coal; 3) as absorbed gas held by molecular attraction on surfaces of macerals (organic constituents that comprise the coal mass), micropores, and cleats in the coal; and 4) as absorbed gas within the molecular structure of the coal molecules. Coals at shallower depth with good cleat development contain significant amounts of free and dissolved gas while the percentage of absorbed methane generally increases with increasing pressure (depth) and coal rank. Coalbed methane gas is released by pressure changes when the water in the coal is removed. In contrast to conventional gas wells, new coalbed methane wells initially produce water for several months. As the formation water pressure decreases, methane gas is released from the structure. -22- Methane production is a direct result of reducing the hydrostatic (water) pressure in the coal formation. Three principal stages are involved: X Drill wells (typically eight or more in a 'pod') down to the same coal formation, in contiguous 80 acre spacing per well; test the water in the formation and test coal samples taken from the formation. Water testing determines if the geochemical environment of the coal seam is conducive to the formation of CBM. X Install gathering lines to hook up and put wells on pump to "dewater" the coal formation. Hydrostatic pressure must be reduced to about 50% of initial pressure before enough data is obtained (water flow rates, CBM gas flows) to determine how much CBM the wells may produce. This dewatering stage may take 6 to 18 months, and in some instances 24 months (where there is no dewatering of the coal seam occurring from wells drilled by others on adjacent properties). X Installing (or have a transmission company install) a compressor and transport line to carry produced gas to a gas transmission line for sale to end users. Gas production starts gradually then continues to grow in volume as hydrostatic pressure is reduced; optimal production won't occur until hydrostatic pressure is reduced approximately 90% from initial levels. COALBED METHANE WELL PERMITTING Operators drilling for coalbed methane are subject to many rules and regulations and must obtain drilling, water discharge and other permits from various governmental agencies depending on the type of mineral ownership and location of the property. Intermittent delays in the permitting process can reasonably be expected throughout the development of all RMG projects. As with all governmental permit processes, there is no assurance that permits will be issued in a timely fashion or in a form consistent with the plan of operations. Drilling and production operations on our Powder River Basin leases in Wyoming and Montana are subject to environmental rules, requirements and permits issued by various federal authorities for drilling and operating on all land, regardless of ownership, and state and local regulatory agencies for land owned by the state or in fee by private interests. The primary Federal agency with related responsibilities is the Bureau of Land Management of the U.S. Department of the Interior ("BLM") which has imposed environmental limitations and conditions on coalbed methane drilling, production and related construction activities on federal leases in the PRB. These conditions and requirements are imposed through Records of Decision ("ROD") issued pursuant to Environmental Impact Statements ("EIS"). The BLM may also impose site-specific conditions on development activities, such as drilling and the construction of rights-of-way, before it approves required applications for permits to drill and plans of development. In April 2003 the BLM issued Records of Decision finalizing two impact statements: The Powder River Basin Oil and Gas EIS (PRB-EIS) for the Wyoming portion of the basin, and the Statewide Oil and Gas EIS and Proposed Amendment for the Powder River and Billings Resource Management Plans in Montana. Together, the impact statements authorize the development of some 77,000 coalbed methane gas wells in the Powder River Basin, most of which would be drilled on the Wyoming side of the basin. With the EIS completed, the BLM will be able to consider drilling or development proposals in the geographic areas studied, however, before any permits are approved, the BLM will conduct an additional round of environmental review to identify site-specific environmental impacts and appropriate mitigation measures. Three lawsuits have been filed challenging the Record of Decisions, however, no stays have been issued. (See I.3. Legal Proceedings, Rocky Mountain Gas, Inc.) -23- The state-based environmental agencies primarily concern themselves with the issuance of permits related to drilling, land, air quality and water discharge. The primary state-based agencies for which coalbed methane operators are subject to include: X Wyoming Department of Environmental Quality ("WDEQ") X Wyoming Oil and Gas Conservation Commission ("WOGCC") X Montana Department of Environmental Quality ("MDEQ") X Montana Board of Oil and Gas Conservation ("MBOGC") While the BLM is primarily responsible for issuing broadly based EISs for each state, its jurisdiction over related matters and the actual issuance of drilling permits is primarily reserved for federal leases. Permits for drilling on state or fee owned land are issued by the WOGCC and MBOGC. In contrast to Wyoming, Montana authorities have been very slow in undertaking CBM environmental studies and granting permits to drill wells. In fact, to date, only the Redstone (Fidelity) project is producing CBM gas in Montana. With the exception of a relatively small number of drilling permits available from earlier issuance (including those held by RMG which have allowed some drilling on the Castle Rock project), a drilling moratorium had been in effect during the last three years, prior to the approval of the two environmental impact statements. The DEQs are primarily responsible for issuing air quality and water discharge permits, among other things. Water disposal has been and is expected to continue to be a significant issue, particularly with respect to coalbed methane gas production, which typically entails substantial water production at least during the dewatering phase of completion of a new well. The primary issue of concern is the salinity content in the produced water, which is measured by the sodium absorption ratio ("SAR"), which, depending upon a location, can range from slightly less than that in surface water to a substantially greater amount. Due to the discrepancies of the SAR content found in water from coalbed methane wells, the disposal of this water is tightly regulated. If the SAR content is low, the water can be used for irrigation, livestock drinking water or even as a water supply for cities. If the SAR content is higher, the water quality does not merit use for drinking water or irrigation and, under these measures, the DEQ has outlined various other methods of water disposal. Man-made ponds may also be built right beside the wells, enabling the wells to drain their water into the ponds (called surface discharge). Additionally, there might be drainages which the produced water can flow into. Finally, the water might be reinjected through wells into the ground below levels from which the water was produced. Thus far, the vast majority of associated water produced has been discharged on the surface, primarily captured in reservoirs and ponds and allowed to evaporate. Overall, RMG has not experienced any difficulty in obtaining air quality and water discharge permits from the WDEQ, and those permits are in place for the Hi-Pro properties. RMG has not has applied for such permits in Montana. The following summarizes permits now in place. -24- Table 4 Expiration Prospect Remaining Permits or Renewal Date -------- ------------------ ----------------- Castle Rock 5 May - July 2004 Hi-Pro 9 August - September 2004 Oyster Ridge 4 September 2004 ------------------ Total 18 Drilling permits issued by the State of Wyoming allow one year for drilling completion; permits issued by the State of Montana allow six months. Once drilled, all wells in Wyoming are subject to a National Pollution Discharge Elimination System ("NPDES") permit relating to water testing and discharge. All wells in the Castle Rock prospect remain subject to the Montana Board of Oil and Gas Commission approval. Upon completion of drilling, wells are subject to monthly reporting regarding status and production to the respective state agencies in which they are located. Due to the low pressure characteristics of the coalbeds, the production of coalbed methane is dependent on the installation of multi-stage compression facilities. Gas is gathered from the wells, and transported to a low level compression station, then on to a high level compression station and finally to the transmission pipeline. The water is commonly collected through another pipeline from each of the wells and pumped into a surface reservoir. Companies involved in coalbed methane production generally outsource gas gathering, compression and transmission. RMG and industry partners have and will likely continue to outsource their compression and gathering to third parties at fixed charges per mcf transported. GAS MARKETS Gas production from the Powder River Basin is significant. Since this area is sparsely populated, most of the gas must be exported to distant markets. The existing Wyoming pipeline infrastructure is already substantial and continues to expand with gathering systems and intrastate lines, yet is ultimately dependent on large interstate pipelines. With the exception of a portion of the gathering systems, this pipeline system is typically owned and operated by independent mid-stream energy companies, rather than oil and gas operators. The pipelines generally will not be financed and constructed until appropriate amounts of gas have been proven and committed for transport on the new lines. While the total current take away capacity from the PRB is approximately 1.25 billion cubic feet per day (Bcfd), excess capacity over current production rates does not exist in all locations and not all producers have a ready market for the sale of their gas at all times. Some major producers in the region reserve portions of pipeline capacity beyond their current requirements, resulting in less than stated maximum capacity being available for other producers. In addition, total stated capacity is unavailable at times as pipelines are shut down for maintenance or construction activities. Based on the existing pipeline systems and the gas sales markets in its area of operations in Wyoming, RMG expects that, at least for the next few years, the markets in which it sells its gas, and the spot prices to which it will be subject, will be dependent upon three major sales points: X The Colorado Interstate Gas ("CIG") station near Cheyenne in southeastern Wyoming, which primarily feeds regional markets or markets in the Midwest. -25- X The Ventura market ("Ventura") located in Ventura, Iowa, which prices gas on the Northern Border pipeline where it interconnects with Northern Natural Gas and feeds markets in the Northern Plains and Midwest. X The Opal market ("Opal") in southwestern Wyoming, which delivers to the Kern River pipeline for delivery to Utah, Nevada, Arizona and California. PIPELINES THAT SERVE THE CIG MARKET Two large diameter intrastate pipelines, the Fort Union and the Thunder Creek, were constructed in the Basin in 1999, and gathering system infrastructure has continued to grow significantly. These two major intrastate pipelines currently provide almost 1.1 Bcfd capacity, flowing south out of the Basin to the CIG Hub in Southeast Wyoming. - Fort Union. The Fort Union Gas Gathering pipeline consists of a 106 ----------- mile,24 inch, 434 Mmcfd capacity line completed in August 1999 and a 20" pipeline with a capacity of 200 Mmcfd completed in September 2001. It is believed that capacity could be increased by another 200 Mmcfd by adding additional compression to this line. - Thunder Creek. Thunder Creek Gas Services pipeline is a 126-mile, 24 -------------- inch pipeline which commenced operations on September 1, 1999 with a capacity of 450 Mmcfd. The Hi-Pro production is delivered to the Thunder Creek pipeline where it is carried south and delivered to the CIG market. El Paso Corporation's subsidiary Cheyenne Plains Gas Pipeline Co. received approval from the Federal Energy Regulatory Commission in March 2004 for construction of a new 380 mile pipeline from Cheyenne, Wyoming to Greensburg, Kansas, with a capacity of 560 Mmcf per day. Cheyenne Plains has announced its intent to apply to the FERC for permission to enlarge the line to handle 760 Mmcf per day. This line, with the enlarged capacity, is expected by Cheyenne Plains to be in-service in January 2005, and may help narrow the negative price differential for CIG prices compared to national prices. PIPELINES THAT SERVE THE VENTURA MARKET There are currently only two significant pipelines capable of transporting gas out of the Basin to the north, the Bitter Creek pipeline, which connects with the Northern Border interstate pipeline and the Glasslands pipeline. However, one additional line that is well along in its planning stages, would also deliver gas to the Northern Border pipeline. Descriptions are as follows: X Bitter Creek. The Bitter Creek pipeline is owned by Williston Basin ------------- Interstate Pipeline Company ("WBI"), a subsidiary of MDU Resources Group, Inc. It was completed in 2001 with initial capacity of 150 Mmcfd. X Grasslands. In response to the need for expandable access to the ---------- Ventura market, the Grasslands pipeline, also owned by WBI, went into service in November 2003. It is a 245 mile, 16 inch line with an initial capacity of 80 Mmcfd and expandable to 200 Mmcfd. -26- THE OPAL MARKET The Opal market, in southwestern Wyoming, is a major pipeline connection point, with several intrastate and interstate lines connecting to the major interstate Kern River line (with a recently enlarged capacity of 1.73 Bcfd, delivering to markets in Utah, Nevada, Arizona and California. If the Oyster Ridge property is put into production, gas could be sold into this market. GAS PRICES Historically, spot gas prices received by producers at the Ventura, CIG and Opal markets have generally been at discounts to the NYMEX front month contract and Henry Hub spot cash prices, although with lesser discounts during the winter months. Prices at CIG can trade at a further discount to the Ventura prices, and again with an even higher discount during the second and third quarters, because CIG is partially based on local demand which can drop outside the heating season, while Ventura serves larger national markets and is highly correlated to Chicago market prices. The negative price differential in the prices realized by Powder River Basin producers in 2003, as compared to prices realized on the national gas market, ranged from 10% to 45% (higher outside the heating season). The negative price differential in the fourth quarter 2003 and first quarter 2004 narrowed in comparison to the fourth quarter 2002. However, there is no guarantee that increased capacity will eliminate the negative price differential or even significantly reduce it. INACTIVE MINING PROPERTIES - URANIUM GENERAL. We have interests in several uranium-bearing properties in Wyoming and Utah and in a uranium processing mill in southeastern Utah (the "Shootaring Mill" in Garfield County). All the uranium-bearing properties are in areas which produced significant amounts of uranium in the 1970s and 1980s. At some future date, we could sell, develop and/or operate these properties (directly or through a subsidiary company or a joint venture) with companies having the necessary capital to mine and mill the uranium bearing material to produce uranium concentrates ("U3O8") for sale to public utilities that operate nuclear powered electricity generating plants. Currently there is no operating uranium mill in Wyoming and it would take a substantial increase in the market price of uranium concentrate over a period of time before a company with the financial wherewithal would build a mill and place the deposits in production. Therefore, until uranium oxide prices improve significantly, the uranium properties will remain shut down. At the dates of the consolidated balance sheets in this Report, there are no values carried on the balance sheets for uranium properties. SHEEP MOUNTAIN - WYOMING Unpatented lode mining claims, underground and open pit uranium mines and mining equipment in the Crooks Gap area are located on Sheep Mountain in Fremont County, Wyoming. From December 21, 1988 to June 1, 1998, these properties were held by Sheep Mountain Partners ("SMP"). On June 1, 1998, the Company received back from SMP all of the Sheep Mountain mineral properties and equipment, in partial settlement of certain disputes with Nukem, Inc. ("Nukem") and its subsidiary Cycle Resource Investment Corp. ("CRIC"). The judgment against Nukem impressing the CIS uranium supply contracts in a constructive trust with SMP remains unresolved. See "Legal Proceedings." We have recorded reclamation liabilities for the SMP properties. All historical costs in the SMP properties were offset against a monetary award which was received from Nukem during fiscal 1999. -27- UTAH Plateau Resources Limited ("Plateau") is a wholly-owned subsidiary of USE. In 2003, reclamation work on uranium properties (the Tony M, Velvet, and Woods Complex) in San Juan County, Utah was completed. PLATEAU'S SHOOTARING CANYON MILL AND PROPERTIES In August 1993, USE purchased from Consumers Power Company ("CPC"), all of the outstanding stock of Plateau which owns the Shootaring Canyon uranium processing mill and support facilities in southeastern Utah (the "Shootaring Mill") for a nominal cash consideration. The Shootaring Mill holds a source materials license from the NRC. In the purchase of the stock from CPC, we agreed to various obligations, as disclosed in USE's 1998 Form 10-K at pages 15 and 16. The Shootaring Mill is located in southeastern Utah and occupies 19 acres of a 265 acre plant site. The mill was designed to process 750 tpd, but only operated on a trial basis for two months in mid-summer of 1982. In 1984, Plateau placed the mill on standby because CPC had canceled the construction of an additional nuclear energy plant. For information on the Shootaring mill facility and related real estate property at Ticaboo, please see "Plateau's Shootaring Canyon Mill and Properties" in the annual report (Form 10-K/A1) for the former fiscal year ended May 31, 2002. THE GREEN MOUNTAIN MINING VENTURE ("GMMV") PROJECT For information on the GMMV agreement, see "Green Mountain Mining Venture" in the annual report (Form 10-K/A1) for the (former) fiscal year ended May 31, 2002. SHEEP MOUNTAIN PARTNERS ("SMP") SMP PARTNERSHIP. In February 1988, USE acquired uranium mines, mining equipment and mineralized properties (Sheep Mountain Mines) at Crooks Gap in south-central Fremont County, Wyoming, from Western Nuclear, Inc. These Crooks Gap mining properties are adjacent to the Green Mountain uranium properties. USECC mined and milled uranium ore from one of the underground Sheep Mines during fiscal 1988 and 1989. In December 1988, USECC sold 50 percent of the interests in the Crooks Gap properties to Nukem's subsidiary Cycle Resource Investment Corporation ("CRIC") for cash. The parties thereafter contributed the properties to and formed Sheep Mountain Partners ("SMP"), in which USECC received an undivided 50 percent interest. SMP is a Colorado general partnership formed on December 21, 1988, between USECC and Nukem, Inc. then of Stamford, CT ("Nukem") through its wholly-owned subsidiary CRIC. SMP was directed by a management committee, with three members appointed by USECC and three members appointed by Nukem/CRIC. The committee has not met since 1991 as a result of the SMP arbitration/litigation. During fiscal 1991, disputes arose between the SMP partners which resulted in litigation. See Item 3, Legal Proceedings. PROPERTIES. USE, Crested and/or USECC own 98 unpatented lode mining claims and a 644 acre Wyoming State Mineral Lease in the Crooks Gap area. An ion exchange plant located on the properties (to remove natural soluble uranium from mine water) was reclaimed and the plant disposed of at the Sweetwater Mill impoundment facility in fiscal 2002. -28- Permits to operate existing mines (now shut down) on the Crooks Gap properties had been issued by the State of Wyoming, but amendments would be needed to re-open them. A NPDES water discharge permit under the Clean Water Act has been obtained; monitoring and treatment of water removed from the mines and discharged in nearby Crooks Creek is generally required. However, for the last three years, USECC has not discharged wastewater into Crooks Creek, and the water instead is being discharged into the USECC McIntosh Pit at the Sweetwater mill owned by Kennecott (the Sweetwater mill had been part of the Green Mountain Mining venture). INACTIVE MINING PROPERTIES - GOLD SUTTER GOLD MINING COMPANY. In fiscal 1991, USE acquired an interest in Sutter properties located in the Mother Lode Mining District of Amador County, California. The entire Lincoln Project (which is the name we use for the properties) is owned by Sutter Gold Mining Company, a Wyoming corporation ("SGMC"), and a majority-owned subsidiary of USE. This property has never been in production. Persistent low prices for gold made financing difficult, and in fiscal 1999 resulted in a substantial write down of the SGMC properties. Due to the depressed gold prices in the past, litigation (since resolved) and lack of funding, SGMC has deferred the start of construction of a gold mill complex and extension of existing underground workings. A tourist visitors center has been set up (see below) and leased to a third party for $1,500 per month plus a 4% gross royalty on revenues. There is one caretaker employee at the Sutter operation. The conditional use permit is being kept current as necessary to allow for possible mining activities on the properties in the future. In 1998 and 1999, the Company took impairments (write-downs) in the amounts of $1,500,000 and $10,718,800, respectively, of the carrying value of the gold properties. These two impairments wrote off almost 85% of our investment in these properties. As a result of low market prices for gold at the time, we determined that we could not produce gold from these properties at a profit. The impairments taken in 1998 and 1999 resulted in no value for mine exploration, and the remaining assets relating to this property include raw land which is no longer needed for mining activity, and buildings and equipment. A significant portion of the raw land has been sold. We have not obtained a final feasibility study to support a determination that the Sutter property contains proven or probable reserves of gold. In late 2003, SGMC signed a letter of intent for an acquisition of SGMC by Globemin Resources Inc., a British Columbia corporation listed on the TSX-V. Completion of the acquisition is subject to negotiation and execution of a share exchange agreement, approval by the TSX-V, Canadian regulatory authorities, and the boards of directors and if necessary, shareholders of SGMC and Globemin. If the acquisition is consummated, a majority of the stock of Globemin would be owned by the (former) SGMC shareholders. Globemin thereafter would seek to raise financing in Canada to begin mining the Lincoln Project and build a mill. PROPERTIES. SGMC holds approximately 435 acres of surface and mineral rights: (87 acres of surface rights (owned), 73 acres of surface rights (leased), 146 acres of mineral rights (leased), and 289 acres of mineral rights (owned), all on patented mining claims near Sutter Creek, Amador County, California. The properties are located in the western Sierra Nevada Mountains at from 1,000 to 1,500 feet in elevation; year round climate is temperate. Access is by California State Highway 16 from Sacramento to California State Highway 49, then by paved county road approximately .4 mile outside of Sutter Creek. -29- Surface and mineral rights holding costs, and property taxes, will be approximately $130,000 and $9,900 for 2004. The leases are for varying terms and require rental fees, annual royalty payments and payment of real property taxes and insurance. PERMITS. The Amador County Board of Supervisors has issued a Conditional Use Permit ("CUP") allowing mining of the SGM and milling of production, subject to conditions relating to land use, environmental and public safety issues, road construction and improvement, and site reclamation. Applications will be made in the second quarter of 2004 to California regulatory authorities for a waste water discharge permit to allow the Company to utilize mill tails as mine backfill and to store tails in a surface fill unit. VISITORS CENTER. In fiscal 2000, SGMC spent approximately $298,000 for surface infrastructure related to improving access to the mine site, and to a lesser extent tourist related improvements. The visitors center is being operated by a third party. The visitors center is an exhibit of the pictures and memorabilia from mining operations on other properties in the Sutter district in the nineteenth century, and a guided tour of the underground workings at the Lincoln Project. Revenues from this tourist operation were $48,800 for 2003, $49,200 for the seven months ended December 31, 2002, and $41,200 in (former) fiscal year 2002, and are included in "real estate" in the consolidated statements of operations included in this report. These revenues offset a majority of costs for holding the Sutter properties. MOLYBDENUM As a holder of royalty, reversionary and certain other interests in properties located at Mt. Emmons near Crested Butte, Colorado, USE and Crested are entitled to receive annual advance royalties of 50,000 pounds of molybdenum, or cash equivalent. AMAX Inc. (which was acquired by Cyprus Minerals Company and was renamed Cyprus Amax Minerals Company in November 1993, then later acquired later by Phelps Dodge) delineated a deposit of molybdenum containing approximately 146,000,000 tons of mineralization averaging 0.43% molybdenum disulfide on the properties of USE and Crested. Advance royalties are required to be paid in quarterly installments until: (i) commencement of production; (ii) failure to obtain certain licenses, permits, etc., that are required for production; or (iii) AMAX's return of the properties to USE and Crested. The advance royalty payments reduce the operating royalties (6% of gross production proceeds) which would otherwise be due out of production. There is no obligation to repay the advance royalties if the property is not placed in production. USE recognized $108,500 advance royalty revenues in (former) fiscal 2001. Phelps Dodge ceased making payments in July 2001. USE and Crested also are entitled to receive $2,000,000 if the Mt. Emmons properties are put into production and, in the event of a sale of Mt. Emmons Mining Company (which owns the properties) or of its interest in the properties, USE and Crested are entitled to receive 15% of the first $25,000,000 of sale proceeds. AMAX Inc. and its successor companies have sought to put the Mt. Emmons molybdenum property into production for 20 years. Due to local opposition to mining (the property is close to the Crested Butte, Colorado recreational resort area) and AMAX's successors' failure to diligently pursue obtaining the permits needed to start mining, we know of no plans at this time to put the property into production. USE and Crested are in litigation with Phelps Dodge concerning the properties and related agreements, see "Item 3 - Legal Proceedings." -30- OIL AND GAS AND OTHER PROPERTIES FORT PECK LUSTRE FIELD (MONTANA). We operate a small oil production facility (three wells) at the Lustre Oil Field on the Ft. Peck Indian Reservation in northeastern Montana. We receive a fee based on oil produced. This fee and other assets of the Company collateralize a $750,000 line of credit from a bank. WYOMING. The Company and Crested own a 14-acre tract in Riverton, Wyoming, with a two-story 30,400 square foot office building (including underground parking). The first floor is rented to non-affiliates and government agencies; the second floor is occupied by the Company. The property is mortgaged to the WDEQ as security for future reclamation work on the Sheep Mountain Crooks Gap uranium properties. The Company also owns a fixed base aircraft facility at the Riverton Regional Airport, including a 10,000 square foot aircraft hangar and 7,000 square feet of associated offices and facilities. This facility is on land leased from the City of Riverton for a term ending December 16, 2005, with an option to renew on mutually agreeable terms for five years. The aircraft fueling operation to the public was shut down late in fiscal 2002. The Company owns three mountain sites covering 16 acres in Fremont County, Wyoming. In Riverton, Wyoming, the Company owns four city lots and improvements including two smaller office buildings. COLORADO. USECC owns 182 acres of undeveloped land in and near Gunnison, Colorado. UTAH. On August 14, 2003, USE's wholy-owned subsidiary Plateau Resources Limited (and Plateau's wholly-owned subsidiary Canyon Homesteads, Inc.) sold all of the outstanding stock of Canyon Homesteads to The Cactus Group, LLC, for $3,470,000: $349,250 cash and $3,120,750 with The Cactus Group's five year promissory note. The note is secured with all the assets of The Cactus Group and Canyon (and is personally guaranteed by the six principals of The Cactus Group). The note is payable monthly (with annual interest at 7.5%) with a $2,940,581 balloon payment due in August 2008. The sold properties are in Ticaboo, Utah, near Lake Powell, and included a motel, restaurant and lounge, convenience store, recreational boat storage and service facility, and improved residential and mobile home lots. RESEARCH AND DEVELOPMENT No research and development expenditures have been incurred, either on the Company's account or sponsored by customers, during the past three fiscal years. ENVIRONMENTAL GENERAL. Operations are subject to various federal, state and local laws and regulations regarding the discharge of materials into the environment or otherwise relating to the protection of the environment, including the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act ("RCRA"), and the Comprehensive Environmental Response Compensation Liability Act ("CERCLA"). With respect to mining operations conducted in Wyoming, Wyoming's mine permitting statutes, Abandoned Mine Reclamation Act and industrial development and siting laws and regulations also impact us. Similar laws and regulations in California affect SGMC operations and Utah laws and regulations effect Plateau's operations. Management believes the Company complies in all material respects with existing environmental regulations. -31- As of December 31, 2003, we have recorded estimated reclamation obligations of $7,264,700. We anticipate paying for those reclamation efforts over several years. For further information on the approximate reclamation costs (decommissioning, decontamination and other reclamation efforts for which we are primarily responsible or potentially responsible), see note K to the consolidated financial statements included with this report. OTHER ENVIRONMENTAL COSTS. Actual costs for compliance with environmental laws may vary considerably from estimates, depending upon such factors as changes in environmental laws and regulation (e.g., the new Clean Air Act), and conditions encountered in minerals exploration and mining. USE does not anticipate that expenditures to comply with laws regulating the discharge of materials into the environment, or which are otherwise designed to protect the environment, will have any substantial adverse impact on the competitive position of the Company. EMPLOYEES As of the filing date of this Annual Report, USE had 34 full-time employees, including 11 employees working only for RMG. Crested uses approximately 50 percent of the time of USE employees, and reimburses USE on a cost reimbursement basis. MINING CLAIM HOLDINGS TITLE. Nearly all the uranium mining properties held by the Company are on federal unpatented claims. Unpatented claims are located upon federal public land pursuant to procedure established by the General Mining Law. Requirements for the location of a valid mining claim on public land depend on the type of claim being staked, but generally include discovery of valuable minerals, erecting a discovery monument and posting thereon a location notice, marking the boundaries of the claim with monuments, and filing a certificate of location with the county in which the claim is located and with the BLM. If the statutes and regulations for the location of a mining claim are complied with, the locator obtains a valid possessory right to the contained minerals. To preserve an otherwise valid claim, a claimant must also pay certain rental fees annually to the federal government (currently $100 per claim) and make certain additional filings with the county and the BLM. Failure to pay such fees or make the required filings may render the mining claim void or voidable. Because mining claims are self-initiated and self-maintained, they possess some unique vulnerabilities not associated with other types of property interests. It is impossible to ascertain the validity of unpatented mining claims solely from public real estate records and it can be difficult or impossible to confirm that all of the requisite steps have been followed for location and maintenance of a claim. If the validity of an unpatented mining claim is challenged by the government, the claimant has the burden of proving the present economic feasibility of mining minerals located thereon. Thus, it is conceivable that during times of falling metal prices, claims which were valid when located could become invalid if challenged. PROPOSED FEDERAL LEGISLATION. The U.S. Congress has, in legislative sessions in recent years, actively considered several proposals for major revision of the General Mining Law, which governs mining claims and related activities on federal public lands. If any of the recent proposals become law, it could result in the imposition of a royalty upon production of minerals from federal lands and new requirements for mined land reclamation and other environmental control measures. It remains unclear whether the current Congress will pass such legislation and, if passed, the extent such new legislation will affect existing mining claims and operations. The effect of any revision of the General Mining Law on operations cannot be determined conclusively until such revision is enacted; however, such legislation could materially increase the carrying costs of mineral properties which are located on federal unpatented mining claims, and could increase both the capital and operating costs for such projects and impair the ability to hold or develop such properties. -32- ITEM 3. LEGAL PROCEEDINGS Material pending proceedings are summarized below. Certain of the Company's affiliates are involved in ordinary routine litigation incidental to their business. Other proceedings which were pending during the year ended December 31, 2003 have been settled or otherwise finally resolved. SHEEP MOUNTAIN PARTNERS ARBITRATION/LITIGATION In 1991, disputes arose between USE/Crested d/b/a/ USECC, and Nukem, Inc. and its subsidiary Cycle Resource Investment Corp. ("CRIC"), concerning the formation and operation of their equally owned Sheep Mountain Partners (SMP) partnership. Arbitration proceedings were initiated by CRIC in June 1991 and in July 1991, USECC filed a lawsuit against Nukem, CRIC and others in the U.S. District Court of Colorado in Civil No. 91B1153. The Federal Court stayed the arbitration proceedings and discovery proceeded. In February 1994, all of the parties agreed to consensual and binding arbitration of all of their disputes over SMP before an arbitration panel (the "Panel"). After 73 hearing days, the Panel entered an Order and Award on April 18, 1996 and clarified the Order on July 3, 1996, finding generally in favor of USE and Crested on certain of their claims and imposed a constructive trust in favor of Sheep Mountain Partners on uranium contracts Nukem entered into to purchase uranium from CIS republics. The Panel also awarded SMP damages of $31,355,070 against Nukem. USECC filed a petition for confirmation of the Order and on June 27, 1997, the U.S. District Court confirmed the Panel's Orders in its Second Amended Judgment. Thereafter, Nukem/CRIC appealed the Judgment to the 10th Circuit Court of Appeals ("CCA"). On October 22, 1998, the 10th CCA issued an Order and Judgment affirming the U.S. District Court's Second Amended Judgment without modification. The ruling affirmed (i) the imposition of a constructive trust in favor of SMP on Nukem's rights to purchase CIS uranium, the uranium acquired pursuant to those rights, and the profits therefrom; and (ii) the damage award in favor of SMP against Nukem. The 10th CCA held that the Panel's Awards "clearly retains both a constructive trust and a damage award," and the --- Arbitration Awards and the Second Amended Judgment were "clear and unambiguous." On February 8, 1999, the U.S. District Court ordered Nukem to pay USECC the balance of the damage award. Nukem did so, but then moved for a satisfaction of judgment without accounting for the monies earned in the Constructive Trust. The District Court denied Nukem's motion and Nukem filed its second appeal to the 10th CCA. On October 16, 2000, the 10th CCA again affirmed the order of the District Court. The 10th CCA held that Nukem had not "provided an accounting of the partnership assets," finding that "the district court order presented for our review does not decide which CIS contracts are covered by the constructive trust." On November 3, 2000, USECC filed a motion for a further accounting of the Constructive Trust. On February 15, 2001, the District Court entered an Order of Reference appointing a Special Master to "conduct an accounting" of the Constructive Trust. The accounting was conducted and on May 1, 2003, the Special Master filed his Report with the District Court. Both parties filed objections to the Report. On July 30, 2003, the U.S. District Court adopted the Report in part and rejected it in part. Judgment was then entered by the Court on August 1, 2003 in favor of USECC and against Nukem in the amount of $20,044,183. On August 15, 2003, Nukem filed a "Motion to Remand to the Arbitration Panel or in the Alternative, to Alter, Amend and/or Correct the Court's August 1, 2003 Judgment and July 30, 2003 Order," and a "Motion to Correct Certain Findings or Statements in the Court's Order of July 30, 2003." On the same day, USECC filed a motion under Fed.R.Civ.P. 52(b) and 59(e) to alter or amend the July 30, 2003 Order and the -33- August 1, 2003 Judgment. The District Court denied the parties' motions on September 10 and 11, 2003, respectively. Nukem's appeal and USECC's cross-appeal followed. Nukem's opening brief was filed on January 16, 2004 and on February 24, 2004, USECC filed an opening brief in its cross-appeal and an answer to Nukem's brief. Nukem has until March 29, 2004 or any extension thereof to file an answer to USECC's opening brief. USECC may then file a reply brief 14 days after service of Nukem's answer. Management believes that the ultimate outcome of this matter will not have an adverse affect on the Company's financial condition or result of operations. CONTOUR DEVELOPMENT LITIGATION On July 28, 1998, USE and Crested filed a lawsuit in the U. S. District Court of Colorado in Case No. 98WM1630, against Contour Development Company, L.L.C. and entities and persons associated with Contour Development Company, L.L.C. (together, "Contour") seeking compensatory and consequential damages of more than $1.3 million from the defendants for dealings in real estate owned by USE and Crested in Gunnison, Colorado. The Contour defendants asserted a counterclaim asking for payment of attorneys fee and costs. The parties settled the litigation in 2004. In the settlement, USE and Crested received $25,000 in cash; two lots in the City of Gunnison, Colorado (one of which has been sold for a net of $65,326 and the other lot is under contract to sell for $180,000), and an additional five development lots covering 175 acres north of Gunnison, Colorado. PHELPS DODGE LITIGATION U.S. Energy Corp. (USE) and Crested Corp. (Crested), d/b/a USECC, were served with a lawsuit on June 19, 2002, filed in the U.S. District Court of Colorado (Case No. 02-B-0796(PAC)) by Phelps Dodge Corporation (PD) and its subsidiary, Mt. Emmons Mining Company (MEMCO), over contractual obligations in USECC's agreement with PD's predecessor companies, concerning mining properties on Mt. Emmons, near Crested Butte, Colorado. The litigation stems from agreements that date back to 1974 when USE and Crested leased the mining claims AMAX Inc., PD's predecessor company. The mining claims cover one of the world's largest and richest deposits of molybdenum discovered by AMAX. AMAX reportedly spent over $200 million on the acquisition, exploration and mine planning activities on the Mt. Emmons properties. The complaint filed by PD and MEMCO seeks a determination that PD's acquisition of Cyprus Amax was not a sale. Under a 1986 agreement between USECC and AMAX, if AMAX sold MEMCO or its interest in the mining properties, USE and Crested would receive 15% (7.5% each) of the first $25 million of the purchase price ($3.75 million). In 1991, Cyprus Minerals Company acquired AMAX to form Cyprus Amax Minerals Co. USECC's counter and cross-claims allege that in 1999, PD formed a wholly-owned subsidiary CAV Corporation, for the purpose of purchasing the controlling interest of Cyprus Amax and its subsidiaries (including MEMCO) at an estimated value in cash and PD stock exceeding $1 billion and making Cyprus Amax a subsidiary of PD. Therefore, USECC asserts the acquisition of Cyprus Amax by PD was a sale of MEMCO and the properties that triggers the obligation of Cyprus Amax to pay USECC the $3.75 million plus interest. The other issue in the litigation is whether USECC must, under terms of a 1987 Royalty Deed, accept PD's and MEMCO's conveyance of the Mt. Emmons properties back to USECC, which properties now include a plant to treat mine water, costing in excess of $1 million a year to operate in compliance with State of Colorado regulations. PD's and MEMCO's claim seek to obligate USECC to assume the operating costs of the water treatment plant. USECC refuses to have the water treatment plant included in the return of the properties because, the USECC counterclaim argues, the properties must be in the same condition as when they were acquired by AMAX before the water treatment plant was constructed by AMAX. -34- As added counterclaims, USECC seeks (i) damages for PD's breach of covenants of good faith and fair dealing; (ii) damages for PD's failure to develop the Mt. Emmons properties and not protecting USECC's rights as a revisionary owner of the mining rights to the properties, (iii) damages for unjust enrichment of PD; (iv) damages for breach of the PD's fiduciary duties owed to USECC as revisionary owner of the property, and for neglecting to maintain the mining rights and interests in the properties. On March 17, 2003, PD filed additional motions for partial summary judgment on various claims. On January 22, 2004, the District Court heard the motions and responses of USECC and additional briefs were thereafter filed with the Court. The Court is considering the motions. Management believes that the ultimate outcome of this matter will not have an adverse affect on the Company's financial condition or result of operations. ROCKY MOUNTAIN GAS, INC. (RMG) LITIGATION INVOLVING LEASES ON COALBED METHANE PROPERTIES IN MONTANA On or about April 1, 2001, RMG, a subsidiary of USE and Crested, was served with a Second Amended Complaint wherein the Northern Plains Resource Council had filed suit in the U.S. District Court of Montana, Billings Division in Case No. CV-01-96-BLG-RWA against the United States Bureau of Land Management ("BLM"), RMG, certain of its affiliates (including USE and Crested) some 20 other defendants. The plaintiff is seeking to cancel oil and gas leases issued to RMG et. al. by the BLM in the Powder River Basin of Montana and for other relief. The basis for the complaint appears to be that the BLM's regulations require the BLM to respond to objections filed by persons owning land or lease rights adjacent to the coalbed properties which the BLM is offering to lease to the public. The argument of plaintiff appears to be that if objections are not responded to by the BLM prior to issuing CBM leases, the leases are invalid. Based on this argument, the plaintiff appears to have been successful in forcing cancellation of some CBM leases granted to others in the Powder River Basin of Montana, because the BLM did not respond to some objecting adjacent landowners. However, all of the BLM leases in Montana held by RMG (none are held by U.S. Energy Corp. or Crested Corp. in their own corporate names) are at least four years old, and there is no record of any objections being made to the issue of those leases. Based on filings in the case to date, it appears that the BLM is taking the initiative in responding to the plaintiff. We believe RMG's leases were validly issued in compliance with BLM procedures, and do not believe the plaintiff's lawsuit will adversely affect any of RMG's Montana BLM leases. LAWSUITS CHALLENGING BLM'S RECORDS OF DECISIONS Three lawsuits are currently pending in the Montana Federal District Court challenging BLM's Records of Decisions for the Powder River Basin Oil and Gas EIS (PRB-EIS) for the Wyoming portion of the basin, and the Statewide Oil and Gas EIS and Proposed Amendment for the Powder River and billings Resource Management Plans in Montana. Neither the Company, nor RMG is a party to any of these lawsuits. LITIGATION INVOLVING DRILLING ON A COALBED METHANE LEASE A drilling company, Eagle Energy Services, LLC filed a lien on RMG's leasehold in southwestern Wyoming for drilling services performed at RMG's Oyster Ridge Property and filed a lawsuit foreclosing the lien. Eagle Energy's bank, Community First National Bank of Sheridan, Wyoming, filed a similar suit for the same amount on an assignment from Eagle Energy against RMG, Eagle Energy Services, LLC and others -35- who guaranteed a loan to Eagle Energy in Civil Action No. C02-9-328 in the 4th Judicial District of Sheridan County, Wyoming. Eagle Energy's claim is for a contract to drill a well for coalbed methane. RMG terminated the agreement because of the dangerous conditions of Eagle Energy's equipment and other reasons. The claim against RMG is for approximately $49,300. Negotiations to settle the lien and lawsuits are pending. Management believes that the ultimate outcome of this matter will not have an adverse affect on the Company's financial condition or result of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On June 6, 2003, the annual meeting of shareholders was held for voting on the re-election of two directors: John L. Larsen and Keith G. Larsen. These directors were re-elected for a term expiring on the third succeeding Annual Meeting of Shareholders and until their successors are duly elected or appointed and qualified. With respect to the re-election of the two directors, the votes cast were as follows: Name of Director For Abstain ------------------ --- ------- John L. Larsen 9,243,517 61,281 Keith G. Larsen 9,243,517 61,281 -36- PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES (a) Market Information Shares of USE common stock are traded on the over-the-counter market, and prices are reported on a "last sale" basis on the Nasdaq Small Cap of the National Association of Securities Dealers Automated Quotation System ("Nasdaq"). The range by quarter of high and low sales prices was:
High Low ----- ----- Fiscal year ended December 31, 2003 - ----------------------------------- First quarter ended 3/31/03 $3.85 $2.95 Second quarter ended 6/30/03 5.92 3.12 Third quarter ended 9/30/03 5.70 3.15 Fourth quarter ended 12/31/03 3.68 2.30 Transition period ended December 31, 2002 - ----------------------------------------- First quarter 8/31/02 $3.95 $2.00 Second quarter ended 11/30/02 4.20 3.38 Month ended 12/31/02 3.98 3.08 Fiscal year ended May 31, 2002 - ------------------------------ First quarter ended 8/31/01 $6.05 $3.56 Second quarter ended 11/30/01 4.15 3.09 Third quarter ended 2/29/02 5.27 3.50 Fourth quarter ended 5/31/02 4.30 3.29 Fiscal year to ended May 31, 2001 - --------------------------------- First quarter ended 8/31/00 $3.00 $1.75 Second quarter ended 11/30/00 3.38 1.75 Third quarter ended 2/28/01 4.00 2.00 Fourth quarter ended 5/31/01 6.25 3.56
(b) Holders (1) At March 23, 2004 the closing market price was $2.54 per share and there were approximately 660 shareholders of record, with 13,992,750 shares of common stock issued and outstanding, including shares owned by our subsidiaries and shares in officers' and directors' names that are subject to forfeiture. (2) Not applicable. c) We have not paid any cash dividends with respect to common stock. There are no contractual restrictions on our present or future ability to pay cash dividends, however, we intend to retain any earnings in the near future for operations. -37- d) Equity Plan Compensation Information - Information about Compensation Plans as of December 31, 2003: Plan category Number of securities to Weighted average Number of securities be issued upon exercise exercise price of remaining available of outstanding options outstanding future issuance options under equity compensation plans (excluding securities reflected in column (a)) (a) (b) (c) - -------------------------------------------------------------------------------- Equity compensation plans approved by security holders 1998 USE SOP 3,250,000 shares of common stock on exercise of outstanding options 1,464,646 $2.69 -0- 2001 USE ISOP 3,000,000 shares of common stock on exercise of outstanding options 1,409,000 $3.09 1,464,664 - -------------------------------------------------------------------------------- Equity compensation plans not approved by security holders None -- -- -- - -------------------------------------------------------------------------------- Total 2,873,646 $2.74 1,464,664 Sales of Unregistered Securities in 2003: As of December 31, 2003, pursuant to the shareholder-approved 2001 Stock Compensation Plan, 100,000 shares were issued to officers of the Company at the rate of 20,000 shares each: John L. Larsen, Keith G. Larsen, Harold F. Herron, Robert Scott Lorimer, and Daniel P. Svilar. The shares were issued at the closing market price of $3.10 on December 19, 2003. On March 24, 2003, 43,378 shares were issued to four officers (John L. Larsen, Daniel P. Svilar, Harold F. Herron and Robert Scott Lorimer) being the balance of shares issuable under the 1996 stock award program (now closed out). Options to purchase 18,000 shares at $3.00 were issued to Robert A. Nicholas on February 3, 2003 and expiring February 2, 2004, as partial payment for legal services. Mr. Nicholas is not an accredited investor, and prior to the filing date of this Annual Report, he was an employee of the Company. He was -38- provided all information about the Company prior to the issuance of the options. This transaction is believed to be exempt under section 4(2) of the Securities Act of 1933. The expiration date of the options has been extended to August 9, 2004. On October 28, 2003, the Company and Caydal, LLC and Tsunami Partners, L.P. amended separate secured convertible loans to the Company from Caydal ($1,000,000) and Tsunami Partners ($500,000) in 2002, to (i) reduce the interest rate, starting September 1, 2003, from the original 8% annual rate, to be equal to the Federal Short Term Rate for annual compounding (the "Federal Short Term Rate" as defined in section 1274(d) of the Internal Revenue Code), as that rate changes from time to time; (ii) allow conversion of interest, as well as principal, to shares; (iii) not require quarterly payment of interest with cash, but add accruing interest to principal; (iv) extend the maturity date for the loan to December 31, 2004; (v) reduce the conversion rate for principal to (and establish the conversion rate for interest at) 1 share for each $2.25 of principal and interest; and (vi) provide for mandatory conversion of principal and accrued interest outstanding at maturity to shares at the same conversion rate of 1 share for each $2.25 of principal and interest. Optional conversion of principal and accrued interest prior to maturity is permitted. Also, in connection with the restructuring of debt, the expiration date of warrants on 120,000 shares (at $3.00 per share) which were issued to Caydal, and warrants on 60,000 shares (at $3.00 per share) issued to Tsunami Partners, in 2002, was extended 12 months (from the original May 30, 2005 to the new date of May 30, 2006). In 2003, Caydal converted $500,000 of debt to 211,109 shares of common stock (33,333 shares at the original $3.00 conversion price, and 177,776 shares at the restructured price of $2.25). The outstanding principal balance on the debts owed to Caydal and Tsunami Partners was $500,000 and $500,000, convertible at December 31, 2003 into 222,220 and 222,220 shares, respectively. Tsunami Partners did not convert any debt to shares in 2003. Caydal and Tsunami Partners are accredited investors. On July 7, 2003, the Company issued 50,000 shares, and warrants to purchase an additional 50,000 shares (exercisable at $5.00 per share, expiring June 30, 2006) to Sanders Morris Harris Inc. ("SMH"), a financial advisory firm and registered broker-dealer, in partial payment of SMH's services provided to RMG in connection with RMG's transfer of certain coalbed methane properties to Pinnacle Gas Resources, Inc. SMH is an accredited investor. These securities were not issued in connection with the sale of any securities by SMH. On May 30, 2003, the Company entered into a consulting agreement with Riches In Resources, Inc., a financial consulting firm. In June 2003, 7,920 shares were issued to Riches In Resources, Inc. for services to the Company provided from November 15, 2002 through July 15, 2003. Up to another 7,080 shares may be issued for services during the remaining term of the agreement (through May 15, 2004) with this consultant. Riches In Resources, Inc. is not an accredited investor. Riches In Resources, Inc. was provided all information about the Company prior to the issuance of the shares. This transaction is believed to be exempt under section 4(2) of the Securities Act of 1933. In March 2003, 24,000 shares were issued to C.C.R.I. Corporation, a financial consulting firm, for services to the Company provided through September 2003. Pursuant to the same agreement, the Company issued to C.C.R.I. warrants to purchase 75,000 shares, 25,000 exercisable at $3.75 per share, 25,000 shares exercisable at $4.50 per share and 25,000 shares exercisable at $5.50 per share; and issued to an individual (Jason Wayne Assad) associated with C.C.R.I. a warrant to purchase 12,500 shares, exercisable at $3.75 per share. All of these warrants expire March 16, 2006. CCRI and Mr. Assad are not accredited investors. Each was provided all information about the Company prior to the issuance of the securities These transactions are believed to be exempt under section 4(2) of the Securities Act of 1933. In June 2003, 34,000 shares were issued to Burg Simpson Eldredge Hersh Jardine PC, a law firm representing the Company in litigation, in partial payment of legal services provided to the Company. This -39- firm is not an accredited investor. The firm was provided all information about the Company prior to the issuance of the securities. This transaction is believed to be exempt under section 4(2) of the Securities Act of 1933. 10,000 shares were issued to Tim and Betty Crotty in June 2003 in settlement of a lease obligation relating to a property owned by the Company's subsidiary, Sutter Gold Mining Company. Mr. and Mrs. Crotty are not accredited investors. They were provided all information about the Company prior to the issuance of the securities. This transaction is believed to be exempt under section 4(2) of the Securities Act of 1933. In June and July 2003, Caydal, LLC and five individuals invested $750,000 in the Company's majority-owned subsidiary Rocky Mountain Gas, Inc. ("RMG") for 333,333 shares of RMG stock (at $2.25 per share); warrants on 62,500 RMG shares at $3.00 per share, exercisable until June 3, 2006; and warrants on 46,875 shares of the Company at $4.00 per share, exercisable until June 3, 2006. Under the terms of the original transaction, each share of RMG stock was convertible into that number of shares of the Company obtained by dividing (i) $2.25 (subject to anti-dilution adjustments) by (ii) 85% of the then-current market price of the Company's shares, provided that (a) the conversion price cannot exceed $5.00, and (b) the exchange rights expire 20 business days after the Company's stock price exceeds $7.50 for 20 consecutive trading days. None of the RMG shares had been converted to shares of the Company at December 31, 2003. Caydal and each of the five individuals are accredited investors. In partial compensation for services provided by McKim & Company, LLC (a registered broker-dealer) to RMG and USE in connection with the foregoing investments in RMG, the Company paid a cash commission of $30,000 to McKim & Company, and issued to McKim & Company warrants to purchase 19,500 shares of USE common stock, exercisable at $4.00 per share. The warrants expire June 3, 2006. Warrants to purchase an additional 3,000 shares, on the same terms, were issued to John Schlie, an employee of McKim & Company. On October 28, 2003, Caydal and one individual (James McCaughey) accepted the Company's and RMG's offer, made to all of the investors in RMG in June and July 2003 (see above), to restructure that transaction by (i) refunding 50% of the investment (Caydal was refunded $250,000 and Mr. McCaughey was refunded $50,000), and reducing the conversion rate for their remaining total of 133,333 RMG shares down to 77.5%. The other four individuals elected to remain fully invested, for which election the Company and RMG reduced the conversion rate for their remaining total of 66,666 RMG shares down to 70%. On December 12, 2003, a non-qualified option was granted to Karl Eppich to purchase 10,000 shares at $2.90 per share for one year. Mr. Eppich provides title services to RMG. This transaction is believed to be exempt under section 4(2) of the Securities Act of 1933. All of the foregoing securities have been issued with restrictive legend under the Securities Act of 1933. ITEM 6. SELECTED FINANCIAL DATA. The selected financial data is derived from and should be read with the financial statements for USE included in this Report. -40-
December 31, May 31, ------------------------------------- --------------------------------------------------- 2003 2002 2001 2002 2001 2000 1999 ----------- ----------- ----------- ----------- ----------- ------------ ----------- (Unaudited) Current assets $ 5,191,400 $ 4,755,300 $ 4,597,900 $ 4,892,600 $ 3,330,000 $ 3,456,800 $12,718,900 Current liabilities 1,909,700 2,044,400 2,563,800 1,406,400 2,396,700 6,617,900 5,355,600 Working capital (deficit) 3,281,700 2,710,900 2,034,100 3,486,200 933,300 (3,161,100) 7,363,300 Total assets 23,929,700 28,190,600 30,991,700 30,537,900 30,465,200 30,876,100 33,391,000 Long-term obligations(1) 12,036,600 14,047,300 13,596,400 13,804,300 13,836,700 14,025,200 14,526,900 Shareholders' equity 6,760,800 8,501,600 8,018,700 11,742,000 8,465,400 4,683,800 10,180,300 (1)Includes $7,657,900, of accrued reclamation costs on properties at December 31, 2003, and $8,906,800, at December 31, 2002, 2001 and May 31, 2002, 2001, 2000, and 1999, respectively. See Note K of Notes to Consolidated Financial Statements.
Year Ended Seven Months Ended December 31, December 31, For Former Fiscal Years Ended May 31, ------------ -------------------------- ---------------------------------------- 2003 2002 2001 2002 2001 2000 ------------ ------------ ------------ ------------ ------------ ------------- (Unaudited) Operating revenues $ 837,300 $ 673,000 $ 545,900 $ 2,004,100 $ 3,263,000 $ 3,303,900 ----------- ----------- ----------- ----------- ----------- ------------ Loss from continuing operations (7,237,900) (3,524,900) (3,914,900) (7,454,200) (7,517,800) (11,356,100) Other income & expenses (73,000) (387,100) 1,005,000 1,319,500 8,730,800 802,200 (Loss) income before minority interest, equity in income (loss) of affiliates, income taxes, discontinued operations, and cumulative effect of ----------- ----------- ----------- ----------- ----------- ------------ accounting change (7,310,900) (3,912,000) (2,909,900) (6,134,700) 1,213,000 (10,553,900) Minority interest in loss (income) of consolidated subsidiaries 235,100 54,800 24,500 39,500 220,100 509,300 Equity in loss of affiliates -- -- -- -- -- (2,900) Income taxes -- -- -- -- -- -- Discontinued operations, net of tax (349,900) 17,100 175,000 (85,900) 488,100 (594,300) Cumulative effect of accounting change 1,615,600 -- -- -- -- -- Preferred stock dividends -- -- (75,000) (86,500) (150,000) (20,800) ------------ ----------- ----------- ----------- ----------- ------------ Net (loss) income to common shareholders $(5,810,100) $(3,840,100) $(2,785,400) $(6,267,600) $ 1,771,200 $(10,662,600) ============ ============ ============ ============ ============ ============= 1999 ------------- Operating revenues $ 3,788,600 ------------ Loss from continuing operations (22,713,300) Other income & expenses 6,655,500 (Loss) income before minority interest, equity in income (loss) of affiliates, income taxes, discontinued operations, and cumulative effect of ----------- accounting change (16,057,800) Minority interest in loss (income) of consolidated subsidiaries 4,468,400 Equity in loss of affiliates (59,100) Income taxes -- Discontinued operations, net of tax -- Cumulative effect of accounting change -- Preferred stock dividends -- ------------ Net (loss) income to common shareholders $(11,648,500) =============
-41-
Year Ended Seven Months Ended For Former December 31, December 31, Fiscal Years Ended May 31, ------------ ---------------- ---------------------------------- (Unaudited) 2003 2002 2001 2002 2001 2000 1999 -------- ------- ------- ------- ------- ------- ------- Per share financial data Operating revenues $ 0.07 $ 0.06 $ 0.07 $ 0.22 $ 0.42 $ 0.43 $ 0.53 ------ ------ ------ ------ ------ ------ ------ Loss from continuing operations (0.64) (0.33) (0.47) (0.80) (0.96) (1.39) (3.18) Other income & expenses (0.01) (0.03) 0.12 0.14 1.11 0.01 0.93 (Loss) income before minority interest, equity in income (loss) of affiliates, income taxes, discontinued operations, and cumulative effect of ------ ------ ------ ------ ------ ------ ------ accounting change (0.65) (0.36) (0.35) (0.66) 0.15 (1.38) (2.25) Minority interest in loss (income) of consolidated subsidiaries 0.02 -- -- 0.01 0.03 0.07 0.63 Equity in loss of affiliates -- -- -- -- -- -- (0.01) Income taxes -- -- -- -- -- -- -- Discontinued operations, net of tax (0.03) -- 0.02 (0.01) 0.06 (0.08) -- Cumulative effect of accounting change 0.14 -- -- -- -- -- -- Preferred stock dividends -- -- (0.01) (0.01) (0.01) -- -- ------- ------- ------- ------- ------- ------- ------- Net (loss) income per share, basic $(0.52) $(0.36) $(0.34) $(0.67) $ 0.23 $(1.39) $(1.63) ======= ======= ======= ======= ======= ======= ======= Net (loss) income per share, diluted $(0.52) $(0.36) $(0.34) $(0.67) $ 0.21 $(1.39) $(1.63) ======= ======= ======= ======= ======= ======= =======
-42- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is Management's Discussion and Analysis of significant factors, which have affected the Company's liquidity, capital resources and results of operations during the periods included in the accompanying financial statements. The discussion contains forward-looking statements that involve risks and uncertainties. Due to uncertainties in the minerals business, the Company's actual results may differ materially from the results discussed in any such forward-looking statements. GENERAL OVERVIEW U.S. Energy Corp. ("USE" or the "Company") and its subsidiaries historically have been involved in the acquisition, exploration, development and production of properties prospective for hard rock minerals including lead, zinc, silver, molybdenum, gold, uranium, oil and gas and commercial real estate. The Company manages all of its operations through a joint venture, USECC Joint Venture ("USECC"), with one of its subsidiary companies, Crested Corp. ("Crested") of which it owns a consolidated 71.5%. The narrative discussion of this MD&A refers only to USE or the Company but includes the consolidated financial statement of Crested, Rocky Mountain Gas, Inc. ("RMG"), Plateau Resources Ltd. ("Plateau"), USECC and other subsidiaries. The Company has entered into partnerships through which it either joint ventured or leased properties with non-related parties for the development and production of certain of its mineral properties. Due to either depressed metal market prices or disputes in certain of the partnerships, all mineral properties have either been sold, reclaimed or are shut down. See Items 2 and 3 above except coalbed methane. The Company has had no production from any of its mineral properties during the periods from May 31, 2001 through December 31, 2003, except coalbed methane. The Company formed RMG to enter into the coalbed methane (CBM) business in 1999. The acquisition of leases and acreage for the exploration, development and production of coalbed methane has become the primary business focus of the Company. At December 31, 2003, the Company on a consolidated basis, owned 90.1% of RMG. RMG has purchased or leased acreage for CBM exploration and development. RMG has entered into various agreements and joint operating agreements to develop and produce coalbed methane from these properties. Management of the Company plan to create value in RMG by growing RMG into an industry recognized producer of CBM. Management believes the fundamentals of natural gas supply and demand are, and will remain favorable well into the future. Management further believes that the investments the Company has made in RMG will provide a solid base of cash flows into the future. The price that RMG receives for the sale of its coalbed methane is based on the Colorado Interstate Gas Index ("CIG") for the Northern Rockies. Historically, the highest prices realized on the CIG over a twelve-month period are during the months of December and January and the lowest prices realized are during the months of late summer or early fall. Calendar 2003 did not follow this trend as gas prices rose from a low of $3.14 per mcf (thousand cubic feet) in January 2003 to a high of $5.01 per mcf in March 2003. The following table represents a summary of historical CIG prices:
Prices per mcf ---------------- 2003 2002 2001 2000 ----- ----- ----- ----- 12 Month High $5.01 $3.33 $8.63 $5.95 12 Month Low $3.14 $1.09 $1.05 $2.15 12 Month Average $3.98 $1.97 $3.50 $3.37 December 31 $4.44 $3.33 $2.13 $5.95
Although management believes that gas prices will increase over the long term from present levels, no assurance can be given that will happen. Gas prices are directly affected by 1) weather conditions, which -43- impact heating and cooling requirements; 2) electrical generation needs and 3) the amount of gas being produced by those companies in the gas production business. All of these factors are variable and cannot be accurately predicted. Many of the Company's industry competitors are very large international companies that are well funded. CRITICAL ACCOUNTING POLICIES Asset Impairments - We assess the impairment of property and equipment whenever events or circumstances indicate that the carrying value may not be recoverable. Oil and Gas Producing Activities - We follow the full cost method of accounting for oil and gas properties. Accordingly, all costs associated with acquisition, exploration and development of oil and gas reserves, including directly related overhead costs, are capitalized. Reclamation Liabilities - The Company's policy is to accrue the liability for future reclamation costs of its mineral properties based on the current estimate of the future reclamation costs as determined by internal and external experts. Revenue Recognition - Revenues are reported on a gross revenue basis and are recorded at the time services are provided or the commodity is sold. Use of Accounting Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. RECENT ACCOUNTING PRONOUNCEMENTS SFAS 143 Effective January 1, 2003, the Company adopted SFAS No. 143, "Accounting for Asset Retirement Obligation." The statement requires the Company to record the fair value of the reclamation liability on its shut-down mining and gas properties as of the date the liability is incurred. The statement further requires the Company to review the liability each quarter and determine if a change is required as well as accrete the total liability on a quarterly basis for the future liability. The Company will also deduct any actual funds expended for reclamation during the quarter in which it occurs. As a result of the Company taking impairment allowances in prior periods on its shut-down mining properties, it has no remaining book value for these properties. See Note B. LIQUIDITY AND CAPITAL RESOURCES During the year ended December 31, 2003, operations resulted in a loss of $5,810,100 and consumed $5,673,600 of cash. The Company increased cash and cash equivalents during the same period by $2,343,800. Investing activities provided $6,964,000 as a result of the sale of CBM properties, sale of property and the reduction, after the approval of the Nuclear Regulatory Commission ("NRC"), of the cash bond for reclamation obligations. The increase in cash from investing activities of $1,053,400 was as a result of the sale of the Company's and RMG's common stock. Cash provided by investing activities was partly used to pay down third party debt. During the year ended December 31, 2003, the Company contributed its interest in producing methane gas properties to a new entity, Pinnacle Gas Resources, Inc. ("Pinnacle") See Item 2 above and Note -44- F. The Company will therefore not be receiving revenues from those properties. RMG continues to evaluate CBM properties and plans on generating cash flows from methane gas production. See Note P. CAPITAL RESOURCES A major component of the Company's future cash flow projections is the ultimate resolution of litigation with Nukem, Inc. ("Nukem") over issues relating to Sheep Mountain Partners ("SMP") Partnership. On August 1, 2003, the U.S. District Court of Colorado entered a Judgment in favor of the Company against Nukem in the amount of $20,044,200. Nukem has appealed this Judgment to the 10th Circuit Court of Appeals ("CCA"). The Company has filed a cross-appeal and answer to Nukem's appeal. See Item 3 above. Should the 10th CCA affirm the District Court's Order and Judgment and/or grant the additional claims made by the Company, the liquidity of the Company will be significantly improved. Although no assurance can be given as to the outcome of the appeal, Nukem was required to post a supersedeas bond in the full amount of the Judgment with interest. During the year ended December 31, 2003, the Company sold its interests in the town site operations to a non-affiliated entity, The Cactus Group ("Cactus"). As a result of the sale of the town site, USE received cash of $349,300 and a promissory note from Cactus in the amount of $3,120,700. USE is to receive $203,000 in payments from Cactus during calendar 2004. All of these payments will be applied to interest only. Cactus will continue to make monthly payments, primarily interest, until August 2008 at which time a balloon payment of $2.8 million is due. Other sources of capital are cash on hand; collection of receivables; receipt of monthly payments from an industry partner for the purchase of an interest in RMG's CBM properties; contractual funding of drilling and development programs by non-affiliates; sale of excess equipment and real estate properties; a line of credit with a commercial bank, and equity financing of the Company's subsidiaries. The Company has a $750,000 line of credit with a commercial bank. The line of credit is secured by certain real estate holdings and equipment. At December 31, 2003, the full line of credit was available. The line of credit could be used for short-term working capital needs associated with operations. CAPITAL REQUIREMENTS The Company will continue to maintain its uranium properties in a shut down mode during 2004 unless an industry partner funds the development costs of the properties. The Company anticipates funding its gold property through 2004 and completing an equity funding in Canada which will provide the funds necessary to place that property into production. The Company will also use its capital resources during 2004 to pay down debt and general and administrative expenses and reclamation costs associated with the SMP and Plateau uranium properties. MAINTAINING URANIUM PROPERTIES ------------------------------ SMP URANIUM PROPERTIES The care and maintenance costs associated with the Sheep Mountain uranium mineral properties decreased by $11,500 from $28,000 as of December 31, 2002 to approximately $16,500 per month at December 31, 2003. Included in the average monthly cost during the year ended December 31, 2003, is ongoing reclamation work on the SMP properties. It is anticipated that a total of $125,000 in reclamation costs will be incurred during 2004. -45- PLATEAU RESOURCES URANIUM PROPERTIES Plateau owns and maintains the Shootaring Canyon Uranium Mill (the "Shootaring Mill"). During the year ended December 31, 2003, Plateau requested a change in the status of the Shootaring Mill from active to reclamation from the NRC. The NRC granted the change in license status, which generated a surplus in the cash bond account of approximately $2.9 million, which was released to Plateau. During the year ended December 31, 2003, Plateau performed approximately $209,600 in reclamation on the Velvet and Tony M mines and the Shootaring Mill. No further reclamation expenses are anticipated on the Velvet and Tony M mine properties. It is estimated that the Company will incur approximately $500,000 in reclamation costs at the Shootaring Mill during calendar 2004. Although reclamation has been initiated on the Plateau properties, management of the Company continues to evaluate the future of the properties as a result of the significant increases in the market price for uranium to approximately $17.50/lb. U3O8 in March 2004 from approximately $10.10/lb. in March 2003. The cash costs per month, including reclamation costs, at the Plateau properties during calendar 2003 were approximately $100,000 per month. These costs are projected to decrease to $55,000 per month during the year ending December 31, 2004. SUTTER GOLD MINING COMPANY (SGMC)PROPERTIES Due to the recent increase in the price of gold, management of SGMC has decided to place its properties into production. No extensive development work or mill construction will be initiated until such time as funding from either debt or equity sources is in place. The goal of the Company's management is to have SGMC properties be self-supporting and not require any capital resources commitment from the Company. Until such time as SGMC is able to raise its own capital, the Company will continue to fund SGMC. Management projects that the total cash costs to be incurred in getting SGMC funded either through debt or equity will not exceed $120,000. (See Note P). No reclamation costs are projected to be incurred on the SGMC properties during 2004. DEVELOPMENT OF COALBED METHANE PROPERTIES ----------------------------------------- The majority of the costs during the year ended December 31, 2003 for the development of RMG's CBM properties, was funded through an agreement that RMG entered into with CCBM, Inc. ("CCBM") a subsidiary of Carrizo Oil and Gas of Houston, Texas. At December 31, 2003, the balance remaining under this arrangement was $610,200, one half of which was for the benefit of RMG. See Part 2 above. After this drilling commitment is completed by CCBM, RMG will have to fund its working interest amount on wells drilled. During the year ended December 31, 2003, RMG and CCBM entered into a Subscription and Contribution Agreement with Credit Suisse First Boston Private Equity parties ("CSFB") to form Pinnacle Gas Resources, Inc. ("Pinnacle"). As a result of the formation of Pinnacle, RMG and CCBM contributed certain undeveloped and producing CBM properties to Pinnacle. RMG has the opportunity to increase its ownership in Pinnacle by purchasing common stock in Pinnacle through the exercise of options. Any increase in RMG's equity would be offset by contributions made by the other owners of Pinnacle. See Part I "Transaction with Pinnacle Gas Resources, Inc." Management of the Company does not anticipate exercising these options during calendar 2004 unless surplus capital resources are received. RMG has no capital commitments on the properties contributed to Pinnacle. See Note F. -46- RMG continues to pursue other investment and production opportunities in the CBM business. On January 30, 2004, RMG purchased the assets of a non-affiliated entity, which included both producing and non-producing properties. The purchase of these CBM assets was accomplished by the issuance of common stock and warrants of both RMG and USE and cash, the majority of which was borrowed as a result of mezzanine financing through Petrobridge Investment Management, LLC ("Petrobridge"). See Part I "Acquisition of Producing and Non-Producing Properties from Hi-Pro Production, LLC" and Note P. All cash flows from the sale of gas from the Hi-Pro properties are pledged to Petrobridge for the loan to purchase the Hi-Pro property. See Note P and Part I, Acquisition of Producing and Non-Producing Properties from Hi-Pro Production, LLC . The Hi-Pro acquisition debt also requires minimum net production volumes through June 30, 2006 and maintenance of financial ratios. The Hi-Pro properties are held by RMG I, LLC, a wholly-owned subsidiary of RMG and are the sole collateral of the debt financing entity. In addition, we don't expect the lenders under the mezzanine credit facility to fund more than the drilling and completion of five wells on proved undeveloped locations on the properties. Future equity financing by RMG, or industry financings, will be needed for RMG I, LLC to drill and complete wells on the substantial undeveloped acreage acquired from Hi-Pro. New production from this acreage could be needed to service the acquisition debt to offset the impact of declining production from the producing properties and/or low gas prices. The Petrobridge credit facility will fund the drilling and completion of five wells on proved undeveloped locations on the Hi-Pro properties. Future equity financing by RMG, or industry financings, will be needed for RMG I, LLC to drill and complete wells on the substantial undeveloped acreage acquired from Hi-Pro. As a result of RMG's sale of property interests and the formation of joint operating ventures with industry partners, it is not anticipated that the Company's capital resources will be used to fund RMG operations during the balance of 2004. LIQUIDITY SUMMARY The Company's capital resources on hand at December 31, 2003 were sufficient to fund mine standby costs, limited reclamation and general and administrative expenses. Development of our gold property and undeveloped CBM properties will require funding from either debt or equity sources. RESULTS OF OPERATIONS --------------------- During the periods presented, the Company has discontinued certain operations. Reclassifications to previously published financial statements have therefore been made to reflect ongoing operations and the effect of the discontinued operations. The Company changed its year end to December 31 effective December 31, 2002. The Company began focusing its direction on the coal bed methane industry during the year ended May 31, 2002. At the same time the Company began selling its other assets that produced revenues from commercial real estate operations, construction and drilling operations and the commercial repair of aircraft. The Company has entered the coal bed methane industry and anticipates revenues from the production of coal bed methane during calendar 2004. Cash flows are projected to begin being recognized in calendar 2005 after debt on the Company's newly acquired coal bed methane properties is retired. -47- YEAR ENDED DECEMBER 31, 2003 COMPARED TO THE YEAR ENDED MAY 31, 2002 Revenues: - --------- Revenues for the twelve months ended December 31, 2003 consisted of $334,300 from real estate operations, $287,400 from gas sales and $215,600 from management fees. Revenues from real estate operations during the fiscal year ended May 31, 2002 were $1,276,200. The decrease in real estate revenues was as a result of reduced sales of commercial real estate during the twelve months ended December 31, 2003. During fiscal 2002 the Company sold a tract of land in California which was no longer needed for the SGMC development plan for operations. During the year ended December 31, 2003 the Company reported $287,400 in gas sales. There were no similar revenues during the twelve months ended May 31, 2002 as the Company had no production of coal bed methane gas at May 31, 2002. The Company recognized a minimal increase in management fee revenues during the year ended December 31, 2003 to $215,600 over the $208,200 recognized in management fee revenues during the twelve months ended May 31, 2002. Management fee revenues were actually reduced after June 2003 when RMG contributed its producing and certain undeveloped properties to Pinnacle. Although RMG provided the transitional accounting services for Pinnacle through December 31, 2003, it received only its actual cost for those services. Costs and Expenses: - -------------------- Costs and expenses for the year ended December 31, 2003 were $8,075,200 as compared to $8,877,800 for the year ended May 31, 2002. Costs and expenses of real estate operations and the cost of real estate sold decreased by $1,045,500 during that twelve months ended December 31, 2003 when compared to the costs and expenses incurred during the fiscal year ended May 31, 2002. This decrease was primarily as a result of a tract of no longer needed. Real estate was sold by SGMC during the year ended May 31, 2002 while no similar sales occurred during the year ended December 31, 2003. During the year ended December 31, 2003 the Company recognized $313,100 in gas operating expenses. No similar expenses were recorded during the fiscal year ended May 31, 2002 as the Company had not yet begun producing gas at that time. Mineral holding costs decreased by $246,100 to $1,461,700 at December 31, 2003 from $1,707,800 at May 31, 2002. This decrease was as a result of the Company placing all its mining properties on a shut-down status and reducing costs of holding those properties. General and administrative costs increased by $2,050,700 during the twelve months ended December 31, 2003 over the twelve months ended May 31, 2002. This increase was as a result of several non cash items. Non cash items which were expensed during the year ended December 31, 2003 were: depreciation and amortization of $554,200; accretion of asset retirement obligations of $366,700; amortization of debt discount of $537,700; amortization of non cash services of $134,700, and non cash compensation of $893,500 for a total of $2,486,800. The amortization of debt discount increased primarily as a result of the acceleration in the discount amortization due to the conversion of approximately one half of the debt under the terms of $1.0 million of debt to common shares of the Company's common stock. -48- On January 1, 2003, the Company adopted SFAS 143, Accounting for Asset Retirement Obligation. Under the terms of this accounting standard, the Company is required to record the fair value of the reclamation liability on its shut-down mining and gas properties as of the date that the liability was incurred. The accounting standard further requires the Company to review the liability and determine if a change in estimate is required as well as accrete the total liability for the future liability. As a result of the adoption of this accounting standard, the Company recorded the non cash accretion of $366,700. Non cash compensation increased as a result of the initial funding of the 2001 Stock Award Plan whereby five of the executive officers of the company were granted a total of 100,000 shares of common stock at $3.10 per share. Under the plan, each officer is to receive 10,000 shares of common stock annually under the condition that the shares cannot be sold until the officer's death or retirement. The plan was effective in 2001 and had not been funded. The funding for the twelve months ended December 2003 was therefore retroactive for two years. In addition to the increase due to the funding of the 2001 Stock Award Plan, the funding for the ESOP as well as the amortization of the deferred compensation recorded in prior periods were both for a full twelve months as compared to only seven months in the prior period. The increase in the amortization of non cash services during the year ended December 31, 2003 resulted from the issuance of additional stock and warrants for legal and financial consulting services. These services related to the formation of Pinnacle and litigation with Phelps Dodge. Other Income and Expenses: - ---------------------------- During the fiscal year ended May 31, 2002 the Company recognized $812,700 in gains from the sale of assets while during the year ended December 31, 2003 the Company recognized only $198,200. The Company was selling the majority of its construction equipment during the years ended May 31, 2002 and 2001. The majority of the surplus equipment to be sold was sold during those two years. Interest Income decreased $291,800 during the year ended December 31, 2003 when compared to the year ended May 31, 2002. This reduction in revenues occurred as a result of the company having less amounts of cash invested in interest bearing accounts during the year ended December 31, 2003. In May of 2002 the Company borrowed $1.5 million from third party lenders. During the year ended December 31, 2003 the Company recorded interest on this debt while there was not interest paid on this debt during fiscal 2002. Effective January 1, 2003 the Company adopted SFAS 143 "Accounting for Asset Retirement Obligations" which requires the Company to record the fair value of the reclamation liability on its shut down mining and gas properties as of the date that the liability is incurred. The Company is further required to accrete the total liability for the full value of the future liability. As a result of adopting this new accounting policy the Company recorded a cumulative effect of accounting change of $1,615,600 as well as an accretion expense of 366,700. Operations for the year ended December 31, 2003 resulted in a loss of $5,810,100 or $0.52 per share as compared to a loss of $6,181,100 or $0.66 per share during fiscal 2002. SEVEN MONTHS ENDED DECEMBER 31, 2002 COMPARED TO THE SEVEN MONTHS ENDED DECEMBER 31, 2001 Revenues: - --------- During the seven months ended December 31, 2002, the Company recognized $673,000 in revenues as compared to $545,900 in revenues during the seven months ended December 31, 2001. This increase of $127,100 in revenues was primarily as a result of the production and sale of CBM gas during the seven -49- months ended December 31, 2002 of $119,400 while no revenues from CBM production were recognized during the same period of the previous year. Through the purchase of the Bobcat Field, RMG began selling CBM gas during the seven months ended December 31, 2002. As anticipated, production from these newly developed wells was lower than it will be in the future. Additionally, the market price for natural gas was very low during the summer and fall months of 2002. These reasons along with high start up and operating costs of $355,200, resulted in a loss from operations for CBM of $235,800. Management believes with increased production volumes, reduced ongoing operating costs and increased market prices for natural gas, the CBM properties will show profits and cash flows during 2003. Costs and Expenses: - -------------------- Costs and expenses during the seven months ended December 2002 were $4,197,900 as compared to costs and expenses of $4,460,800 during the seven months ended December 31, 2001. This reduction of $262,900 was as a result of a reduction in the holding costs of shut-down mineral properties and an ongoing cost cutting program. These reductions in operating costs were offset primarily by the operating costs associated with CBM. Other Income and Expenses: - ---------------------------- During the seven months ended December 31, 2002, the Company recognized a loss on the sale of assets of $342,600 while it recognized a gain on the sale of assets during the seven months ended December 31, 2001 of $592,600. The Company also had an increase in interest expense of $234,500 during the seven months ended December 31, 2002 over the same period of the previous year as a result of the interest on the Company's convertible debt. Operations for the seven months ended December 31, 2002, resulted in a loss of $3,840,100 or $0.36 per share as compared to a loss of $2,785,400 or $0.34 per share for the seven months ended December 31, 2001. FISCAL 2002 COMPARED TO FISCAL 2001 - ---------------------------------------- Revenues: - --------- Revenues from operations decreased by $1,038,400 to $1,484,400 during fiscal 2002 from the $2,522,800 recognized during fiscal 2001. Components of this decrease are reductions mineral sales of $334,300; mineral royalties of $108,500; and management fees of $389,600. Mineral sales during fiscal 2001 resulted from the purchase of uranium oxide on the open market to fill uranium sales contracts and the sale of a uranium contract to a third party. We did not supply any of the uranium sold under the contracts from production out of our mines. We have not produced any minerals from mines for several years. The uranium contracts expired and no molybdenum advance royalties have been received since 2001. There were no mineral sales during fiscal 2002 while there was one delivery under a uranium contract as well as the sale of one of the Company's uranium contracts to a third party during fiscal 2001. Currently, the Company does not have any delivery contracts for uranium or any other mineral. Depending on the outcome of the SMP litigation, the Company may well have CIS pounds of uranium for which it will need to obtain delivery contracts. The Company holds a 6% gross royalty on the Mt. Emmons molybdenum deposit near Crested Butte, CO. Under the provisions of the royalty agreement, the Company and Crested are to receive 50,000 pounds -50- of molybdenum or its cash equivalent annually as an advance royalty. The royalty agreement was originally made with AMAX Inc. ("AMAX"), which was purchased by Cyprus Minerals Company in 1993 and changed its name to Cyprus Amax Minerals Company ("Cyprus Amax"). In 1999, Cyprus Amax was purchased by Phelps Dodge Corporation ("PD"). AMAX and Cyprus Amax had made the advance royalty payments to USECC on a timely basis. PD made one advance royalty payment and ceased making payments in fiscal 2001. PD suspended payments under the advance royalty agreement and has sued the Company. The Company has filed counter claims against Phelps Dodge requesting that the advance royalty be reinstated and other issues. It is not known what the outcome of this litigation will be. Management fees were reduced by $389,600 in fiscal 2002 from the prior period due to reduced activity in the entities from which management fees are collected. Costs and Expenses: - -------------------- During fiscal 2002, costs and expenses were reduced by $1,061,100. This reduction came about as a result of holding costs of mineral properties being reduced by $1,661,500 as a result of the Company reducing costs associated with mineral properties that are shut down. The general and administrative costs were reduced by $104,700. In addition to these reductions in costs and expenses, the Company recognized an expense of $123,800 in abandonment of mining equipment during fiscal 2001. There was no abandonment expense in fiscal 2002. These reductions in costs and expenses were offset by increases in impairment of goodwill of $1,622,700; provision for doubtful accounts of $171,200, and other expenses of $80,900. The impairment of goodwill came as a result of the Company purchasing an additional 8.7% of RMG equity or 1,105,499 shares of RMG stock by issuing 912,233 shares of the Company's common stock. The shares of the Company's common stock were valued at $3.92 per share. An impairment of $1,622,700 was taken on this investment in RMG as RMG had no gas production and the impairment brought the total investment in RMG in line with the fair market value of the RMG assets. A provision for doubtful accounts was provided on the balance of a note receivable that the Company held for the sale of Ruby Mining Company to Admiralty Corporation. The note was in the original amount of $225,000 and had been reduced to $171,200. The note went in default during fiscal 2002 at which time the Company began negotiations with Admiralty to resolve the issue of the outstanding balance. Terms were reached which required Admiralty to pay interest on the note, plus accrued interest, through August 2003, at which time the entire note balance would come due. Because of the financial condition of Admiralty, it is not known if that company will be able to pay the balance of the note when due. The entire amount of the note was therefore reserved. Other Income and Expenses: - ---------------------------- Gain on sale of assets income decreased by $350,900 during fiscal 2002 to $812,700. This decrease was as a result of the sale of a majority of the surplus mining equipment that the Company had for sale during the prior year. During fiscal 2002, there was no income from litigation settlements while during fiscal 2001 there was $7,132,800 in litigation settlement as a result of the Company settling all issues pertaining to the litigation initiated by Kennecott. Interest income increased by $152,400 during fiscal 2002 over fiscal 2001 as did interest expense which increased by $80,000 for the same period. These increases were as a result of larger amounts of cash invested in interest bearing accounts and increased debt. Operations for the twelve months ended May 31, 2002, resulted in a net loss of $6,267,600 or $0.67 per share as compared to net income of $1,771,200 or $0.23 per share for the previous year. -51- FUTURE OPERATIONS ----------------- We have generated operating losses for the year ended December 31, 2003, the seven months ended December 31, 2002 and in each of the three fiscal years ended May 31, 2002 as a result of costs associated with shut down mineral properties. We have discontinued our focus on these properties and at December 31, 2003, we are committed to be in the CBM business well into the future. EFFECTS OF CHANGES IN PRICES ---------------------------- Mineral operations are significantly affected by changes in commodity prices. As prices for a particular mineral increase, prices for prospects for that mineral also increase, making acquisitions of such properties costly, and sales advantageous. Conversely, a price decline facilitates acquisitions of properties containing that mineral, but makes sales of such properties more difficult. Operational impacts of changes in mineral commodity prices are common in the mining industry. NATURAL GAS. Our decision to expand into the CBM gas industry was predicated on the projections for natural gas demand and prices. The Company is confident that it can maintain its costs at CBM industry standards but cannot predict what will happen to the price of CBM gas. URANIUM AND GOLD. Changes in the prices of uranium and gold are not expected to materially affect our operations during 2004. MOLYBDENUM AND OIL. Changes in prices of molybdenum and petroleum are not expected to materially affect our operations during 2004. CONTRACTUAL OBLIGATIONS. The Company had two divisions of contractual obligations as of December 31, 2003: Debt to third parties of $2,249,800, the payments are $932,200, $112,800, $116,600, $1,056,500, $22,600 and $9,200 for the years ended December 31, 2004 through 2008, and thereafter, respectively, and asset retirement obligations of $7,264,700 which will be paid over a period of five to seven years. ITEM 8. FINANCIAL STATEMENTS Financial statements meeting the requirements of Regulation S-X for the Company follow immediately. -52- REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS -------------------------------------------------- To U.S. Energy Corp.: We have audited the accompanying consolidated balance sheets of U.S. Energy Corp. and subsidiaries as of December 31, 2003 and 2002 and May 31, 2002, and the related consolidated statements of operations, shareholders' equity and cash flows for the year ended December 31, 2003, the seven months ended December 31, 2002 and the fiscal years ended May 31, 2002 and 2001. 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 auditing standards generally accepted in the United States of America. 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 present fairly, in all material respects, the financial position of U.S. Energy Corp. and subsidiaries as of December 31, 2003 and 2002 and May 31, 2002, and the results of their operations and their cash flows for the year ended December 31, 2003, the seven months ended December 31, 2002 and the fiscal years ended May 31, 2002 and 2001 in conformity with accounting principles generally accepted in the United States of America. As discussed in Note B to the financial statements effective January 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations, and changed its method of accounting for asset retirement obligations. As discussed in Note A to the financial statements, certain errors resulting in overstatement of previously reported deferred tax liability as of December 31, 2002 and prior, were discovered by Company management during the year ended December 31, 2003. Accordingly, an adjustment has been made to accumulated deficit as of June 1, 2000 to correct the error. The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note A to the financial statements, the Company has experienced significant losses from operations and has a substantial accumulated deficit. These factors raise substantial doubt about the ability of the Company to continue as a going concern. Management's plans in regards to these matters are also described in Note A. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. GRANT THORNTON LLP Oklahoma City, Oklahoma February 27, 2004 -53-
U.S. ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS December 31, December 31, May 31, 2003 2002 2002 ------------------- -------------- ------------ (Restated, Note A)(Restated, Note A) CURRENT ASSETS: Cash and cash equivalents $ 4,084,800 $ 1,741,000 $ 2,564,300 Accounts receivable Trade, net of allowance of $27,800 300,900 1,655,700 768,800 Affiliates 96,800 117,600 132,800 Current portion of long-term notes receivable, net 102,500 165,900 229,000 Assets held for resale -- 532,800 532,800 Prepaid Expenses 584,700 528,300 578,300 Inventories 21,700 14,000 86,600 ------------------ ------------- ----------- Total current assets 5,191,400 4,755,300 4,892,600 INVESTMENTS: Non-affiliated company 957,700 -- -- Restricted investments 6,874,200 9,911,700 10,015,500 ------------------- -------------- ------------ Total investments and advances 7,831,900 9,911,700 10,015,500 PROPERTIES AND EQUIPMENT: Land 570,000 576,300 1,764,100 Buildings and improvements 5,777,700 7,811,300 8,501,300 Machinery and equipment 4,762,800 4,737,100 5,107,700 Proved oil and gas properties, full cost method 1,773,600 2,423,600 1,773,600 Unproved coal bed methane properties excluded from amortization 1,204,400 4,254,000 4,995,600 ------------------ ------------- ----------- Total property and equipment 14,088,500 19,802,300 22,142,300 Less accumulated depreciation, depletion and amortization (6,901,400) (7,214,800) (7,584,200) ------------------- -------------- ------------ Net property and equipment 7,187,100 12,587,500 14,558,100 OTHER ASSETS: Notes receivable trade 2,950,600 -- 36,800 Notes receivable employees -- 48,800 65,000 Deposits and other 768,700 887,300 969,900 ------------------ ------------- ----------- Total other assets 3,719,300 936,100 1,071,700 ------------------- -------------- ------------ Total assets $ 23,929,700 $ 28,190,600 $30,537,900 =================== ============== ============
The accompanying notes are an integral part of these statements. -54-
U.S. ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS LIABILITIES AND SHAREHOLDERS' EQUITY December 31, December 31, May 31, 2003 2002 2002 ------------------- -------------- ------------- (Restated, Note A)(Restated, Note A) CURRENT LIABILITIES: Accounts payable and accrued expenses $ 977,500 $ 1,592,800 $ 758,600 Prepaid drilling costs -- 134,400 242,100 Current portion of long-term debt 932,200 317,200 205,700 Line of credit -- -- 200,000 ------------------- -------------- ------------- Total current liabilities 1,909,700 2,044,400 1,406,400 LONG-TERM DEBT 1,317,600 2,820,600 2,353,300 ASSET RETIREMENT OBLIGATIONS 7,264,700 8,906,800 8,906,800 OTHER ACCRUED LIABILITIES 2,158,600 2,319,900 2,544,200 DEFERRED GAIN ON SALE OF ASSET 1,295,700 -- -- MINORITY INTERESTS 496,000 587,400 575,300 COMMITMENTS AND CONTINGENCIES FORFEITABLE COMMON STOCK, $.01 par value 465,880, 500,788 and 500,788 shares issued, forfeitable until earned 2,726,600 3,009,900 3,009,900 PREFERRED STOCK, $.01 par value; 100,000 shares authorized No shares issued or outstanding; -- -- -- SHAREHOLDERS' EQUITY: Common Stock, $.01 par value; unlimited shares authorized; 12,824,698, 11,826,396, and 11,720,818 shares issued respectively 128,200 118,300 117,200 Additional paid-in capital 52,961,200 48,877,100 48,278,500 Accumulated deficit (43,073,000) (37,262,900) (33,422,800) Treasury stock at cost, 966,306, 959,725 and 959,725 shares respectively (2,765,100) (2,740,400) (2,740,400) Unallocated ESOP contribution (490,500) (490,500) (490,500) ------------------- -------------- ------------- Total shareholders' equity 6,760,800 8,501,600 11,742,000 ------------------- -------------- ------------- Total liabilities and shareholders' equity $ 23,929,700 $ 28,190,600 $ 30,537,900 =================== ============== =============
The accompanying notes are an integral part of these statements. -55-
U.S. ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Year ended Seven months ended December 31, December 31, Year Ended May 31, ------------ ------------ -------------------------- 2003 2002 2002 2001 ------------ ------------ ------------ ------------ OPERATING REVENUES: Real estate operations $ 334,300 $ 394,500 $ 1,276,200 $ 1,482,200 Gas sales 287,400 119,400 -- -- Mineral sales -- -- -- 334,300 Mineral royalties -- -- -- 108,500 Management fees 215,600 159,100 208,200 597,800 ----------- ----------- ----------- ----------- 837,300 673,000 1,484,400 2,522,800 OPERATING COSTS AND EXPENSES: Real estate operations 302,900 189,700 1,348,400 2,394,300 Gas operations 313,100 355,200 -- -- Mineral holding costs 1,461,700 737,200 1,707,800 3,369,300 General and administrative 5,997,500 2,915,800 3,946,800 4,051,500 Impairment of goodwill -- -- 1,622,700 -- Abandonment of mining equipment -- -- -- 123,800 Other -- -- 80,900 -- Provision for doubtful accounts -- -- 171,200 -- ----------- ----------- ----------- ------------ 8,075,200 4,197,900 8,877,800 9,938,900 ------------ ------------ ------------ ------------ OPERATING LOSS: (7,237,900) (3,524,900) (7,393,400) (7,416,100) OTHER INCOME & EXPENSES: Gain on sales of assets 198,200 (342,600) 812,700 1,163,600 Gain on sale of investment (32,400) (207,800) -- -- Litigation settlements, net -- -- -- 7,132,800 Interest income 560,300 524,500 852,100 699,700 Interest expense (799,100) (361,200) (345,300) (265,300) ----------- ----------- ----------- ----------- (73,000) (387,100) 1,319,500 8,730,800 ------------ ------------ ------------ ------------ (LOSS) INCOME BEFORE MINORITY INTEREST PROVISION FOR INCOME TAXES, DISCONTINUED OPERATIONS AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE: (7,310,900) (3,912,000) (6,073,900) 1,314,700 MINORITY INTEREST IN LOSS OF CONSOLIDATED SUBSIDIARIES 235,100 54,800 39,500 220,100 ------------ ------------ ------------ ------------ (LOSS) INCOME BEFORE PROVISION FOR INCOME TAXES DISCONTINUED OPERATIONS AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE (7,075,800) (3,857,200) (6,034,400) 1,534,800 PROVISION FOR INCOME TAXES -- -- -- -- ------------ ------------ ------------ ------------ (continued)
The accompanying notes are an integral part of these statements. -56-
U.S. ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Year ended Seven months ended December 31, December 31, Year Ended May 31, ------------ ------------ ------------------------- 2003 2002 2002 2001 ------------ ------------ ------------ ----------- NET (LOSS) INCOME FROM CONTINUING OPERATIONS (7,075,800) (3,857,200) (6,034,400) 1,534,800 DISCONTINUED OPERATIONS, NET OF TAX (349,900) 17,100 (146,700) 386,400 CUMULATIVE EFFECT OF ACCOUNTING CHANGE 1,615,600 -- -- -- ------------ ------------ ------------ ----------- NET (LOSS) INCOME: (5,810,100) (3,840,100) (6,181,100) 1,921,200 PREFERRED STOCK DIVIDENDS $ -- $ -- $ (86,500) $ (150,000) ------------ ------------ ------------ ----------- NET (LOSS) INCOME AVAILABLE TO COMMON SHAREHOLDERS $(5,810,100) $(3,840,100) $(6,267,600) $1,771,200 ============ ============ ============ =========== NET (LOSS) INCOME PER SHARE BASIC CONTINUED OPERATIONS (0.63) (0.36) (0.65) 0.20 DISCONTINUED OPERATIONS (0.03) -- (0.01) 0.05 PREFERRED DIVIDENDS -- -- (0.01) (0.02) EFFECT OF ACCOUNTING ACCOUNTING CHANGE 0.14 -- -- -- ------------ ------------ ------------ ----------- $ (0.52) $ (0.36) $ (0.67) $ 0.23 ============ ============ ============ =========== NET (LOSS) INCOME PER SHARE DILUTED CONTINUED OPERATIONS (0.63) (0.36) (0.65) 0.18 DISCONTINUED OPERATIONS (0.03) -- (0.01) 0.05 PREFERRED DIVIDENDS -- -- (0.01) (0.02) EFFECT OF ACCOUNTING ACCOUNTING CHANGE 0.14 -- -- -- ------------ ------------ ------------ ----------- $ (0.52) $ (0.36) $ (0.67) $ 0.21 ============ ============ ============ =========== BASIC WEIGHTED AVERAGE SHARES OUTSTANDING 11,180,975 10,770,658 9,299,359 7,826,001 ============ ============ ============ =========== DILUTED WEIGHTED AVERAGE SHARES OUTSTANDING 11,180,975 10,770,658 9,299,359 8,487,680 ============ ============ ============ ===========
The accompanying notes are an integral part of these statements. -57-
U.S. ENERGY & AFFILIATES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (RESTATED, NOTE A) Additional Unallocated Total Common Stock Paid-In Accumulated Treasury Stock --------------- ESOP Shareholders' Shares Amount Capital Deficit Shares Amount Contribution --------- ------- ----------- ------------- ------- ------------ -------------- Balance June 1, 2000 as previously presented 8,763,155 $87,700 $37,797,700 $(30,071,200) 944,725 $(2,639,900) $ (490,500) Adjustment for deferred taxes See note A -- -- -- 1,144,800 -- -- -- --------- ------- ----------- ------------- ------- ------------ -------------- Balance June 1, 2000 as restated 8,763,155 87,700 37,797,700 (28,926,400) 944,725 (2,639,900) (490,500) Funding of ESOP 53,837 500 287,500 -- -- -- -- Issuance of common stock to outside directors 8,532 100 19,100 -- -- -- -- Issuance of common stock for services rendered 15,000 200 70,400 -- -- -- -- Forfeitable shares earned 29,820 300 193,900 -- -- -- -- Treasury stock from payment on balance of note receivable -- -- -- -- 5,000 (20,600) -- Sale of Ruby Mining -- -- 25,800 -- -- -- -- Issuance of common stock from employee options 118,703 1,200 287,200 -- -- -- -- Net income -- -- -- 1,771,200 -- -- -- --------- ------- ----------- ----------- ------- ----------- -------------- Balance May 31, 2001 8,989,047 $90,000 $38,681,600 $(27,155,200) 949,725 $(2,660,500) $ (490,500) ========= ======= =========== ============= ======= ============ ============== Equity ----------- Balance June 1, 2000 as previously presented $4,683,800 Adjustment for deferred taxes See note a 1,144,800 ----------- Balance June 1, 2000 as restated 5,828,600 Funding of ESOP 288,000 Issuance of common stock to outside directors 19,200 Issuance of common stock for services rendered 70,600 Forfeitable shares earned 194,200 Treasury stock from payment on balance of note receivable (20,600) Sale of Ruby Mining 25,800 Issuance of common stock from employee options 288,400 Net income 1,771,200 ---------- Balance May 31, 2001 $8,465,400 =========== Total Shareholders' Equity at May 31, 2001 does not include 433,788 shares currently issued but forfeitable if certain conditions are not met by the recipients. "Basic and Diluted Weighted Average Shares Outstanding" also includes 814,496 shares of common stock held by majority-owned subsidiaries, which, in consolidation, are treated as treasury shares.
The accompanying notes are an integral part of this statement. -58-
U.S. ENERGY & AFFILIATES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (RESTATED, NOTE A) (CONTINUED) Additional Unallocated Total Common Stock Paid-In Accumulated Treasury Stock ESOP --------------- Shareholders' Shares Amount Capital Deficit Shares Amount Contribution ---------- -------- ----------- ------------- ------- ------------ -------------- Balance May 31, 2001 8,989,047 $ 90,000 $38,681,600 $(27,155,200) 949,725 $(2,660,500) $ (490,500) Funding of ESOP 70,075 700 236,200 -- -- -- -- Issuance of common stock to outside directors 3,429 -- 14,400 -- -- -- -- Issuance of common stock for services rendered 45,000 500 147,600 -- -- -- -- Issuance of common stock warrants for services rendered -- -- 592,900 -- -- -- -- Treasury stock from payment on balance of note receivable -- -- -- -- 10,000 (79,900) -- Issuance of common stock in exchange for preferred stock 513,140 5,100 1,846,400 -- -- -- -- Issuance of common stock in exchange for subsidiary stock 912,233 9,100 3,566,900 -- -- -- -- Issuance of common stock to purchase property 61,760 600 246,200 -- -- -- -- Issuance of common stock through private placement 871,592 8,700 2,341,800 -- -- -- -- Issuance of common stock for exercised stock warrants 1,205 -- 4,500 -- -- -- -- Issuance of common stock from employee options (1) 253,337 2,500 600,000 -- -- -- -- Net loss -- -- -- (6,267,600) -- -- -- ---------- -------- ----------- ------------ ------ ------------ -------------- Balance May 31, 2002(2) 11,720,818 $117,200 $48,278,500 $(33,422,800) 959,725 $(2,740,400) $ (490,500) ========== ======== =========== ============= ======= ============ ============== Equity ------------ Balance May 31, 2001 $ 8,465,400 Funding of ESOP 236,900 Issuance of common stock to outside directors 14,400 Issuance of common stock for services rendered 148,100 Issuance of common stock warrants for services rendered 592,900 Treasury stock from payment on balance of note receivable (79,900) Issuance of common stock in exchange for preferred stock 1,851,500 Issuance of common stock in exchange for subsidiary stock 3,576,000 Issuance of common stock to purchase property 246,800 Issuance of common stock through private placement 2,350,500 Issuance of common stock for exercised stock warrants 4,500 Issuance of common stock from employee options (1) 602,500 Net loss (6,267,600) ------------ Balance May 31, 2002(2) $11,742,000 ============ (1)Net of 15,285 shares surrendered by employees for the exercise of 268,622 employee stock options. (2)Total Shareholders' Equity at May 31, 2002 does not include 500,788 shares currently issued but forfeitable if certain conditions are not met by the recipients. "Basic and Diluted Weighted Average Shares Outstanding" also includes 814,496 shares of common stock held by majority-owned subsidiaries, which, in consolidation, are treated as treasury shares.
The accompanying notes are an integral part of this statement. -59-
U.S. ENERGY & AFFILIATES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (RESTATED, NOTE A) (CONTINUED) Additional Unallocated Total Common Stock Paid-In Accumulated Treasury Stock --------------- ESOP Shareholders' Shares Amount Capital Deficit Shares Amount Contribution ---------- -------- ------------ ------------- ------- ------------ -------------- Balance May 31, 2002 11,720,818 $117,200 $48,278,500 $(33,422,800) 959,725 $(2,740,400) $ (490,500) Funding of ESOP 43,867 400 134,700 -- -- -- -- Issuance of common stock to outside consultants 15,000 200 60,700 -- -- -- -- Issuance of common stock warrants -- -- 325,900 -- -- -- -- Issuance of common stock for settlement of law suit 20,000 200 77,600 -- -- -- -- Issuance of common stock from employee options (1) 26,711 300 (300) -- -- -- -- Net loss -- -- -- (3,840,100) -- -- -- ---------- -------- ----------- ------------ ------- ----------- -------------- Balance December 31, 2002(2) 11,826,396 $118,300 $48,877,100 $(37,262,900) 959,725 $(2,740,400) $ (490,500) ========== ======== ============ ============= ======= ============ ============== Equity ------------ Balance May 31, 2002 $11,742,000 Funding of ESOP 135,100 Issuance of common stock to outside consultants 60,900 Issuance of common stock warrants 325,900 Issuance of common stock for settlement of law suit 77,800 Issuance of common stock from employee options (1) -- Net loss (3,840,100) ------------ Balance December 31, 2002(2) $ 8,501,600 ============ (1)Net of 44,456 shares surrendered by employees for the exercise of 71,167 employee stock options. (2)Total Shareholders' Equity at December 31, 2002 does not include 500,788 shares currently issued but forfeitable if certain conditions are not met by the recipients. "Basic and Diluted Weighted Average Shares Outstanding" also includes 814,496 shares of common stock held by majority-owned subsidiaries, which, in consolidation, are treated as treasury shares.
The accompanying notes are an integral part of this statement. -60-
U.S. ENERGY & AFFILIATES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (RESTATED, NOTE A) (CONTINUED) Additional Unallocated Total Common Stock Paid-In Accumulated Treasury Stock ESOP --------------- Shareholders' Shares Amount Capital Deficit Shares Amount Contribution ---------- -------- ----------- ------------- ------- ------------ -------------- Balance December 31, 2002 11,826,396 $118,300 $48,877,100 $(37,262,900) 959,725 $(2,740,400) $ (490,500) Funding of ESOP 76,294 700 235,700 -- -- -- -- Issuance of common stock to outside directors 3,891 -- 14,400 -- -- -- -- Issuance of common stock by release of forfeitable stock 78,286 800 434,400 -- -- -- -- Issuance of common stock from stock warrants 131,596 1,300 465,300 -- -- -- -- Issuance of common stock in stock compensation plan 100,000 1,000 309,000 -- -- -- -- Treasury stock from sale of subsidiary -- -- -- -- 1,581 (4,200) -- Treasury stock from payment on balance of note receivable -- -- -- -- 5,000 (20,500) -- Issuance of common stock to outside consultants 121,705 1,200 581,600 -- -- -- -- Issuance of common stock warrants to outside consultants -- -- 886,300 -- -- -- -- Issuance of common stock for settlement of lawsuit 10,000 100 49,900 -- -- -- -- Issuance of common stock in payment of debt 211,109 2,100 497,900 -- -- -- -- Issuance of common stock from employee options (1) 265,421 2,700 609,600 -- -- -- -- Net loss -- -- -- (5,810,100) -- -- -- ---------- -------- ----------- ------------ ------- ----------- -------------- Balance December 31, 2003(2) 12,824,698 $128,200 $52,961,200 $(43,073,000) 966,306 $(2,765,100) $ (490,500) ========== ======== =========== ============= ======= ============ ============== Equity ------------ Balance December 31, 2002 $ 8,501,600 Funding of ESOP 236,400 Issuance of common stock to outside directors 14,400 Issuance of common stock by release of forfeitable stock 435,200 Issuance of common stock from stock warrants 466,600 Issuance of common stock in stock compensation plan 310,000 Treasury stock from sale of subsidiary (4,200) Treasury stock from payment on balance of note receivable (20,500) Issuance of common stock to outside consultants 582,800 Issuance of common stock warrants to outside consultants 886,300 Issuance of common stock for settlement of lawsuit 50,000 Issuance of common stock in payment of debt 500,000 Issuance of common stock from employee options (1) 612,300 Net Loss (5,810,100) ------------ Balance December 31, 2003(2) $ 6,760,800 ============ (1)Net of 10,200 shares surrendered by employees for the exercise of 275,621 employee stock options. (2)Total Shareholders' Equity at December 31, 2003 does not include 465,880 shares currently issued but forfeitable if certain conditions are not met by the recipients. "Basic and Diluted Weighted Average Shares Outstanding" also includes 814,496 shares of common stock held by majority-owned subsidiaries, which in consolidation, are treated as treasury shares.
The accompanying notes are an integral part of this statement. -61-
U.S. ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended Seven Months Ended Year Ended December 31, December 31, May 31, ------------ ------------ ------- 2003 2002 2002 2001 ------------ ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income $(5,810,100) $(3,840,100) $(6,267,600) $ 1,771,200 Adjustments to reconcile net (loss) income to net cash used in operating activities: Minority interest in loss of consolidated subsidiaries (235,100) (54,800) (39,500) (220,100) Depreciation and amortization 554,200 360,100 541,500 1,254,000 Accretion of asset retirement obligations 366,700 -- -- -- Amortization of debt discount 537,700 211,200 -- -- Impairment of goodwill -- -- 1,622,700 -- Impairment of mineral interests -- -- -- 123,800 Noncash services 134,700 31,500 787,700 19,100 Noncash dividend -- -- 11,500 -- Provision for doubtful accounts -- -- 171,200 -- Deferred income -- -- -- (4,000,000) (Gain) loss on sale of assets (199,300) 342,600 (812,700) (1,163,600) Write off of properties -- 21,500 -- -- Cumulative effect of accounting change (1,615,600) -- -- -- Noncash compensation 893,500 314,800 535,200 501,700 Lease holding costs 50,000 -- -- -- Net changes in assets and liabilities: Accounts and notes receivable (461,500) (755,600) 799,900 1,241,000 Other assets 1,466,000 8,700 (47,500) (112,700) Accounts payable and accrued expenses (827,200) 609,900 (879,300) (887,300) Prepaid drilling costs (134,400) (107,700) 242,100 -- Decrease in asset retirement obligation (393,200) -- -- -- ----------- ----------- ----------- ------------ NET CASH USED IN OPERATING ACTIVITIES (5,673,600) (2,857,900) (3,334,800) (1,472,900)
The accompanying notes are an integral part of these statements. -62-
U.S. ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Year Ended Seven Months Ended Year Ended December 31, December 31, May 31, ----------- ----------- ------------------------- 2003 2002 2002 2001 ----------- ----------- ----------- ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Exploration of coalbed methane gas properties (176,400) (883,400) (142,100) (1,187,800) Proceeds from sale of gas interests 2,813,800 1,125,000 1,125,000 -- Proceeds from sale of property and equipment 1,604,400 1,566,000 752,000 2,608,000 Net change in restricted investments 3,037,500 66,100 (236,800) (417,700) Purchase of property and equipment (92,700) (411,200) (82,300) (311,400) Net change in investments in affiliates (222,600) 104,600 406,500 292,400 --------- --------- --------- ---------- NET CASH PROVIDED BY INVESTING ACTIVITIES 6,964,000 1,567,100 1,822,300 983,500 CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock 1,078,900 -- 2,957,400 288,400 Proceeds from issuance of stock by subsidiary 650,000 -- 1,000,000 -- Proceeds from third party debt 2,600 892,800 631,700 619,100 Net activity from lines of credit -- (200,000) (650,000) 200,000 Purchase of treasury stock -- -- -- (20,600) Repayments of third party debt (678,100) (225,300) (547,800) (828,400) ---------- ---------- ---------- ------------ NET CASH PROVIDED BY FINANCING ACTIVITIES 1,053,400 467,500 3,391,300 258,500 ----------- ----------- ----------- ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 2,343,800 (823,300) 1,878,800 (230,900) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,741,000 2,564,300 685,500 916,400 ----------- ----------- ----------- ------------ CASH AND CASH EQUIVALENTS AT END OF PERIOD $4,084,800 $1,741,000 $2,564,300 $ 685,500 =========== =========== =========== ============ SUPPLEMENTAL DISCLOSURES: Income tax paid $ -- $ -- $ -- $ -- =========== =========== =========== ============ Interest paid $ 799,100 $ 361,200 $ 345,300 $ 265,300 =========== =========== =========== ============
The accompanying notes are an integral part of these statements. -63-
U.S. ENERGY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Year Ended Seven Months Ended Year Ended December 31, December 31, May 31, ------------ ------------ ---------------------- 2003 2002 2002 2001 -------- -------- ---------- ---------- NON-CASH INVESTING AND FINANCING ACTIVITIES: Sale of assets through issuance of a note receivable $ -- $ -- $ 442,200 $1,164,500 ======== ======== ========== ========== Acquisition of assets through issuance of debt $ 26,300 $ -- $ 180,600 $1,631,700 ======== ======== ========== ========== Acquisition of assets through issuance of stock $ -- $150,000 $ 96,800 $ - ======== ======== ========== ========== Issuance of stock warrants for services $563,400 $ 26,100 $ -- $ -- ======== ======== ========== ========== Issuance of stock warrants in conjunction with notes payable $ -- $299,800 $ 592,900 $ -- ======== ======== ========== ========== Issuance of stock as deferred compensation $151,900 $ -- $ 261,300 $ 358,400 ======== ======== ========== ========== Issuance of stock to satisfy debt $500,000 $ -- $3,568,500 $ -- ======== ======== ========== ========== Issuance of stock to retire preferred stock $ -- $ -- $1,840,000 $ - ======== ======== ========== ========== Issuance of stock for retired employees $435,200 $ -- $ - $ 194,400 ======== ======== ========== ========== Issuance of stock for services $582,800 $ 60,900 $ 14,400 $ 70,500 ======== ======== ========== ========== Satisfaction of receivable - affiliate with stock in affiliate $ -- $ -- $ -- $3,000,000 ======== ======== ========== ========== Satisfaction of receivable - employee with stock in company $ 20,500 $ -- $ 79,900 $ -- ======== ======== ========== ==========
The accompanying notes are an integral part of these statements. -64- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 A. BUSINESS ORGANIZATION AND OPERATIONS: U.S. Energy Corp. was incorporated in the State of Wyoming on January 26, 1966. U.S. Energy Corp. and subsidiaries (the "Company" or "USE") engages in the acquisition, exploration, holding, sale and/or development of mineral and coalbed methane gas properties, the production of petroleum properties and marketing of minerals and methane gas. Principal mineral interests are in coalbed methane, uranium, gold and molybdenum. The Company's uranium and gold properties are currently all in a shut down status. The Company holds various real and personal properties used in commercial activities. Most of the Company's activities are conducted through subsidiaries and through the joint venture discussed below and in Note D. The Company was engaged in the maintenance of two uranium properties, one in southern Utah, and the second in Wyoming known as Sheep Mountain Partners ("SMP"). SMP has been involved in significant litigation (see Note K). Sutter Gold Mining Company ("SGMC"), a Wyoming corporation owned 78.5% by the Company at December 31, 2003, manages the Company's interest in gold properties. The Company also owns 100% of the outstanding stock of Plateau Resources Limited ("Plateau"), which owns a nonoperating uranium mill in southeastern Utah. Currently, the mill is nonoperating but has been granted a license to operate subject to certain conditions. Rocky Mountain Gas, Inc. ("RMG") was formed in November 1999 to consolidate all methane gas operations of the Company. The Company owns and controls 90.1% of RMG as of December 31, 2003. The Company's Board of Directors changed the Company's year end to December 31 effective December 31, 2002. RESTATEMENT OF BALANCE SHEETS AND SHAREHOLDERS' EQUITY ------------------------------------------------------------ The balance sheets at December 31, 2002 and May 31, 2002 and statements of shareholders' equity have been restated to reflect the correction of an overstatement in deferred tax liability of $1,144,800. Accumulated deficit at June 1, 2000 has been decreased by $1,144,800. The liability overstatement occurred prior to any accompanying statements of operations presented; therefore, there was no effect on net earnings for any periods presented in the accompanying financial statements. Therefore, the statements of operations and cash flows for the years ended December 31, 2003, seven months ended December 31, 2002 and the years ended May 31, 2002 and 2001 have not been restated. MANAGEMENT'S PLAN ------------------ The Company has generated significant net losses during recent years and has an accumulated deficit of approximately $43,073,000 at December 31, 2003. The Company has working capital of approximately $3,281,700 at December 31, 2003 and its cash balance has increased from $1,741,000 at December 31, 2002 to $4,084,800 at December 31, 2003. The Company used cash in its operating activities of $5,673,700 and $3,334,800 during the years ended December 31, 2003 and May 31, 2002 and used cash of $2,857,800 during the seven moths ended December 31, 2002. During the year ended December 31, 2003 and the fiscal year ended May 31, 2002 the Company experienced positive cash flow of $2,343,800 and $1,878,800 respectively. The Company experienced negative cash flow of $823,300 and $230,900, respectively, for the seven months ended December 31, 2002 and the fiscal year ended May 31, 2001. -65- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) The Company has entered into agreements to provide funding for the development of coalbed methane properties (See Note F). After these work commitments are fully funded, the Company does not have sufficient capital available to fund its portion of the anticipated exploration and development activities on its coalbed methane properties. Additionally, the Company's known cash flows through December 31, 2004 from current operations and associated overhead are negative based on current projections. In order to improve liquidity of the Company, management intends to do the following: X Continue to reduce its mining activities. X Sell raw land in Riverton, Wyoming and Gunnison, Colorado. Management intends to sell this land at its fair market value. The land is not needed for the operations of the Company now or into the future. X Seek equity funding or a joint venture partner to place the SGMC property into production or sell the entire property to an industry partner. X Raise additional capital through a private placement and a public offering of its subsidiary Rocky Mountain Gas, Inc. The timing of such a public offering will depend on the market prices for methane gas. X Reduce overhead expenses and concentrate on its primary business - coalbed methane. X Successfully resolve disputes relating to SMP assets. (See Note K) As a result of these plans, management believes that they will generate sufficient cash flows to meet its cash requirements in calendar 2004, although there is no assurance the plans will be accomplished. B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION The consolidated financial statements of USE and subsidiaries include the accounts of the Company, the accounts of its majority-owned or controlled subsidiaries Plateau (100%), Energx, Ltd ("Energx") (90%), Four Nines Gold, Inc. ("FNG") (50.9%), SGMC (78.5%), Crested Corp. ("Crested") (71.5%), Yellowstone Fuels Corp. ("YSFC") (35.9%) Rocky Mountain Gas ("RMG") (88.5%) and the USECC Joint Venture ("USECC"), a consolidated joint venture which is equally owned by U.S. Energy Corp. and Crested, through which the bulk of their operations are conducted. Investments in all 20% to 50% owned companies are accounted for using the equity method. Investments of less than 20% are accounted for by the cost method. All material intercompany profits, transactions and balances have been eliminated. -66- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) CASH EQUIVALENTS The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. The Company maintains its cash and cash equivalents in bank deposit accounts which exceed federally insured limits. At December 31, 2003, the Company had approximately 99% of its cash and cash equivalents with one financial institution. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. RESTRICTED INVESTMENTS Based on the provisions of Statement of Financial Accounting Standards No. 115 ("SFAS 115"), the Company accounts for its restricted investment in certain securities as held-to-maturity. Held-to-maturity securities are measured at amortized cost. If a decline in fair value of such investments is determined to be other than temporary, the investment is written down to fair value. ACCOUNTS RECEIVABLE The majority of the Company's accounts receivable are due from industry partners for drilling and operating expenses associated with coalbed methane gas wells for which RMG acts as operator and from sales of land. The Company determines any required allowance by considering a number of factors including length of time trade accounts receivable are past due and the Company's previous loss history. The Company writes off accounts receivable when they become uncollectable, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. In addition, the Company is due $863,200 from CCBM under a non-recourse promissory note receivable which arose as part of the sale of a portion of RMG's coalbed methane properties to CCBM. The note receivable is fully reserved due to its non-recourse nature with payments received credited against natural gas properties in accordance with the full cost method of accounting. INVENTORIES Inventories consist of aviation fuel and well casing and tubing. Inventories are stated at lower of cost or market using the average cost method. PROPERTIES AND EQUIPMENT Land, buildings, improvements, machinery and equipment are carried at cost. Depreciation of buildings, improvements, machinery and equipment is provided principally by the straight-line method over estimated useful lives ranging from 3 to 45 years. Following is a breakdown of the lives over which assets are depreciated. -67- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) Office Equipment 3 to 5 years Field Tools and Hand Equipment 5 to 7 years Vehicles and Trucks 3 to 7 years Heavy Equipment 7 to 10 years Service Buildings 20 years Corporate Headquarter's Building 45 years The Company capitalizes all costs incidental to the acquisition of mineral properties as incurred. Costs are charged to operations if the Company determines that the property is not economical. Mineral exploration costs are expensed as incurred. When it is determined that a mineral property can be economically developed as a result of establishing proved and probable reserves, costs subsequently incurred are capitalized and amortized using units of production over the estimated recoverable proved and probable reserves. Costs and expenses related to general corporate overhead are expensed as incurred. The Company has acquired substantial mining properties and associated facilities at minimal cash cost, primarily through the assumption of reclamation and environmental liabilities. Certain of these properties are owned by various ventures in which the Company is either a partner or venturer. (See Note F). OIL AND GAS PROPERTIES The Company follows the full cost method of accounting for oil and gas properties. Accordingly, all costs associated with acquisition, exploration, and development of oil and gas reserves, including directly related overhead costs, are capitalized. All capitalized costs of oil and gas properties subject to amortization and the estimated future costs to develop proved reserves, are amortized on the unit-of-production method using estimates of proved reserves. Investments in unproved properties and major exploration and development projects are not amortized until proved reserves associated with the projects can be determined or until impairment occurs. If the results of an assessment indicate that the properties are impaired, the capitalized cost of the property will be added to the costs to be amortized. After there are proven reserves, the capitalized costs associated with those reserves are subject to a "ceiling test," which basically limits such costs to the aggregate of the "estimated present value," discounted at a 10-percent interest rate of future net revenues from proved reserves, based on current economic and operating conditions, plus the lower of cost or fair market value of unproved properties. Sales of proved and unproved properties are accounted for as adjustments of capitalized costs with no gain or loss recognized, unless such adjustments would significantly alter the relationship between capitalized costs and proved reserves of oil and gas, in which case the gain or loss is recognized in income. Abandonments of properties are accounted for as adjustments of capitalized costs with no loss recognized. LONG-LIVED ASSETS The Company evaluates its long-lived assets (other than oil and gas properties which are discussed above) for impairment when events or changes in circumstances indicate that the related carrying amount may not be recoverable. If the sum of estimated future cash flows on an undiscounted basis is less than the carrying amount of the related asset, an asset impairment is considered to exist. The related impairment loss is -68- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) measured by comparing estimated future cash flows on a discounted basis to the carrying amount of the asset. Changes in significant assumptions underlying future cash flow estimates may have a material effect on the Company's financial position and results of operations. An uneconomic commodity market price, if sustained for an extended period of time, or an inability to obtain financing necessary to develop mineral interests, may result in asset impairment. During the fiscal year ended May 31, 2002, the Company recorded a $1,622,700 impairment of goodwill that arose as part of the purchase of an additional 1,105,499 shares of RMG common stock. These shares of stock were purchased by issuing 910,320 shares of the Company's common stock pursuant to conversion rights granted RMG private placement investors. During fiscal 2001, the Company recorded an impairment on its mineral properties of $123,800 in YSFC. As of December 31, 2003, management believes no further impairment is necessary and that the fair market of remaining assets exceeds the carrying value. See Note F for further discussion. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount of cash equivalents, receivables, other current assets, accounts payable and accrued expenses approximates fair value because of the short-term nature of those instruments. The recorded amounts for short-term and long-term debt, approximate fair market value due to the variable nature of the interest rates on the short term debt, and the fact that interest rates remain generally unchanged from issuance of the long term debt. REVENUE RECOGNITION Revenues from real estate operations are from the rental of office space in office buildings in Riverton, Wyoming. Airport operations consist of the sale of aviation fuel, repair and maintenance of aircraft and rental of hanger space. All these revenues are reported on a gross revenue basis and are recorded at the time the service is provided. The Company, through its subsidiary, RMG, utilizes the entitlements method of accounting for natural gas revenues whereby revenues are recognized as the Company's share of the gas is produced and delivered to a purchaser based upon its working interest in the properties. The Company will record a receivable (payable) to the extent that it receives less (more) than its proportionate share of the gas revenues. Revenues from mineral sales consist of the sale of uranium to a delivery contract and the sale of that contract to a third party supplier. The sale of uranium is reported on a net basis. The Company has not produced any uranium from its properties during the period covered by the enclosed financial statements and during the year ended May 31, 2001 purchased all uranium delivered under its supply contracts from the open market as all the Company's uranium operations are shut down. Mineral royalties which are non-refundable are recognized as revenue when received (see Note F). Management fees are recorded as a percentage of actual costs for services provided for subsidiaries and partnerships for which the Company provides management services. The Company is also paid a management fee for overseeing oil production on the Fort Peck Reservation in Montana. Management fees are recorded when the service is provided. -69- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) STOCK BASED COMPENSATION SFAS 123, "Accounting for Stock-Based Compensation," ("SFAS 123") defines a fair value based method of accounting for employee stock options or similar equity instruments. However, SFAS 123 allows the continued measurement of compensation cost for such plans using the intrinsic value based method prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), provided that pro forma disclosures are made of net income or loss and net income or loss per share, assuming the fair value based method of SFAS 123 had been applied. The Company has elected to account for its stock-based compensation plans under APB 25; accordingly, for purposes of the pro forma disclosures presented below, the Company has computed the fair values of all options granted using the Black-Scholes pricing model and the following weighted average assumptions:
Year Ended Seven Months ended December 31, December 31, Year ended May 31, ------------- ------------- --------------------- 2003 2002 2002 2001 ------ ------ ------ ----- Risk-free interest rate 5.61% 4.4% 5.6% 4.29% Expected lives (years) 7 8.5 10 10 Expected volatility 58.95% 50.38% 62.65% 73.1% Expected dividend yield -- -- -- --
To estimate expected lives of options for this valuation, it was assumed options will be exercised at the end of their expected lives. All options are initially assumed to vest. Cumulative compensation cost recognized in pro forma net income or loss with respect to options that are forfeited prior to vesting is adjusted as a reduction of pro forma compensation expense in the period of forfeiture. If the Company had accounted for its stock-based compensation plans in accordance with SFAS 123, the Company's net (loss) income and pro forma net loss per common share would have been reported as follows:
Year Ended Seven Months Ended December 31, December 31, Year Ended May 31, ----------------------------- 2003 2002 2002 2001 -------------- -------------- --------------- ------------ Net (loss) income to common shareholders as reported $ (5,810,100) $ (3,840,100) $ (6,267,600) $ 1,771,200 Deduct: Total stock based employee expense determined under fair value based method (652,900) (1,410,850) (3,079,700) (2,746,600) -------------- -------------- --------------- ------------ Pro forma net loss $ (6,463,000) $ (5,250,950) $ (9,347,300) $ (975,400) ============== ============== =============== ============ As reported, Basic $ (.52) $ (.36) $ (.67) $ .23 As reported, Diluted $ (.52) $ (.36) $ (.67) $ .21 Pro forma, Basic $ (.58) $ (.49) $ (1.01) $ (.12) Pro forma, Diluted $ (.58) $ (.49) $ (1.01) $ (.12)
Weighted average shares used to calculate pro forma net loss per share were determined as described in Note B, except in applying the treasury stock method to outstanding options, net proceeds assumed received upon exercise were increased by the amount of compensation cost attributable to future service periods and not yet recognized as pro forma expense. -70- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) INCOME TAXES The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes". This statement requires recognition of deferred income tax assets and liabilities for the expected future income tax consequences, based on enacted tax laws, of temporary differences between the financial reporting and tax bases of assets, liabilities and carryforwards. SFAS 109 requires recognition of deferred tax assets for the expected future effects of all deductible temporary differences, loss carryforwards and tax credit carryforwards. Deferred tax assets are reduced, if deemed necessary, by a valuation allowance for any tax benefits which, based on current circumstances, are not expected to be realized. NET (LOSS) INCOME PER SHARE The Company reports net (loss) income per share pursuant to Statement of Financial Accounting Standards No. 128 ("SFAS 128"). SFAS 128 specifies the computation, presentation and disclosure requirements for earnings per share. Basic earnings per share is computed based on the weighted average number of common shares outstanding. Diluted earnings per share is computed based on the weighted average number of common shares outstanding adjusted for the incremental shares attributed to outstanding options to purchase common stock, if dilutive. Potential common shares relating to options and warrants are excluded from the computation of diluted earnings (loss) per share, because they were antidilutive, totaled 3,790,370, 4,910,900, 3,999,468 and 3,316,011 at December 31, 2003 and 2002 and May 31, 2002 and 2001, respectively. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. RECLASSIFICATIONS Certain reclassifications have been made in the prior years financial statements in order to conform with the presentation for the current year. RECENT ACCOUNTING PRONOUNCEMENTS - ---------------------------------- SFAS 143 Effective January 1, 2003, the Company adopted SFAS No. 143, "Accounting for Asset Retirement Obligation." The statement requires the Company to record the fair value of the reclamation liability on its shut down mining and gas properties as of the date that the liability is incurred. The statement further requires that the Company review the liability each quarter and determine if a change is estimate is required as well as accrete the total liability on a quarterly basis for the future liability. -71- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) The Company will also deduct any actual funds expended for reclamation during the quarter in which it occurs. As a result of the Company taking impairment allowances in prior periods on its shut down mining properties, it has no remaining book value for these properties. The following is a reconciliation of the total liability for asset retirement obligations Balance December 31, 2002 $ 8,906,800 Impact of adoption of SFAS No. 143 (1,615,600) Addition to Liability -0- Liability Settled (393,200) Accretion Expense 366,700 --------------- Balance December 31, 2003 $ 7,264,700 =============== The following table shows the Company's net income (loss) and net income (loss) per share on a pro forma basis as if the provisions of SFAS No. 143 had been applied retroactively in all periods presented.
Seven Month Year ended ended December 31, December 31, Year ended 2003 2002 2002 2001 -------------- -------------- ------------ ----------- NET INCOME (LOSS): Reported net income (loss) from continuing operations $ (7,075,800) $ (3,857,200) $(6,034,400) $1,534,800 Pro-forma adjustments net of tax -- (200,000) (333,000) (317,000) -------------- -------------- ------------ ----------- Pro-forma net income (loss) $ (7,075,800) $ (4,057,200) $(6,367,400) $1,217,800 ============== ============== ============ =========== PER SHARE OF COMMON STOCK: Reported net income (loss) basic from continuing operations $ (0.63) $ (0.36) $ (0.65) $ 0.20 Pro-forma adjustments net of tax -- (0.02) (0.03) (0.04) -------------- -------------- ------------ ----------- Pro-forma net income (loss) basis $ (0.63) $ (0.38) $ (0.68) $ 0.16 ============== ============== ============ =========== Reported net income (loss) diluted $ (0.63) $ (0.36) $ (0.65) $ 0.18 Pro-forma adjustments -- (0.02) (0.03) (0.04) -------------- -------------- ------------ ----------- Pro-forma net income (loss) diluted $ (0.63) $ (0.38) $ (0.68) $ 0.14 -------------- ============== ============ ===========
Computed on a pro-forma basis, the provisions of SFAS No. 143 would have been $7,291,200, $7,091,200, $6,758,200 and $6,441,200 at December 31, 2002, May 31, 2002 and 2001 and June 1, 2000, respectively. The Company has reviewed other current outstanding statements from the Financial Accounting Standards Board and does not believe that any of those statements will have a material adverse affect on the financial statements of the Company when adopted. -72- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) C. RELATED-PARTY TRANSACTIONS: The Company provides management and administrative services for affiliates under the terms of various management agreements. Revenues from services provided by the Company to unconsolidated affiliates were $33,400 during the year ended December 31, 2003, $55,900 during the seven months ended December 31, 2002, and $78,800 and $132,500 for the years ended May 31, 2002 and 2001, respectively. The Company has $96,800 of receivables from unconsolidated subsidiaries as of December 31, 2003. D. USECC JOINT VENTURE: The Company operates the Glen L. Larsen office complex; holds interests in various mineral operations; conducts oil and gas operations; and transacts all operating and payroll expenses through a joint venture with Crested, the USECC joint venture. E. INVESTMENTS IN AND ADVANCES TO AFFILIATES: The Company's restricted investments secure various decommissioning, reclamation and holding costs. Investments are comprised of debt securities issued by the U.S. Treasury that mature at varying times from three months to one year from the original purchase date. As of December 31, 2003, December 31, 2002 and May 31, 2002, the cost of debt securities was a reasonable approximation of fair market value. These investments are classified as held-to-maturity under SFAS 115 and are measured at amortized cost. F. MINERAL CLAIMS TRANSACTIONS: GMMV During fiscal 1990, the Company entered into an agreement with Kennecott, a wholly-owned, indirect subsidiary of The RTZ Corporation PLC, for Kennecott to acquire a 50% interest in certain uranium mineral properties in Wyoming known as the Green Mountain Properties. During the life of the venture, the parties entered into various amendments to the GMMV Agreement. As a result of sustained depressed uranium prices, the GMMV properties were maintained on a shut down basis. During fiscal 2000, certain differences arose in the GMMV and Kennecott sued the Company and USE. On September 11, 2000, the parties settled all disputes and Kennecott paid the Company and USE $3.25 million and assumed reclamation liability for the Sweetwater Mill, Jackpot and Big Eagle Mine properties. (Note K.) SMP During fiscal 1989, USE and Crested, through USECC, entered into an agreement to sell a 50% interest in their Sheep Mountain properties to a subsidiary of Nukem Inc., CRIC. USECC and CRIC immediately contributed their 50% interests in the properties to a newly-formed partnership, SMP. SMP was established to further develop and mine the uranium claims on Sheep Mountain, acquire uranium supply contracts and market uranium. Certain disputes arose among USECC, CRIC and its parent Nukem, Inc. over the operation of SMP. These disputes have been in litigation/arbitration for the past thirteen years. See Note K for the status of the related litigation/arbitration. -73- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) Due to the litigation and arbitration proceedings involving SMP, the Company has expensed all of its costs related to SMP and has no carrying value of its investment in SMP at December 31, 2003, December 31, 2002 and May 31, 2002. (see Note K). PHELPS DODGE During prior years, the Company conveyed interests in mining claims to AMAX Inc. ("AMAX") in exchange for cash, royalties, and other consideration. AMAX merged with Cyprus Minerals ("Cyprus Amax") which was purchased by Phelps Dodge Mining Company ("Phelps Dodge") in December of 1999. The properties have not been placed into production as of December 31, 2003. Amax and later Cyprus Amax paid the Company an annual advance royalty of 50,000 pounds of molybdenum (or its cash equivalent). During fiscal 2000, Phelps Dodge assumed this obligation and made its first advance royalty payment to USE during the first quarter of 2001. Phelps Dodge is entitled to a partial credit against future royalties for any advance royalty payments made, but such royalties are not refundable if the properties are not placed into production. The Company recognized $60,300 of revenue from the advance royalty payments during the year ended May 31, 2001. If Phelps Dodge formally decides to place the properties into production, it is obligated to pay $2,000,000 to the Company. Per the contract with AMAX, the Company is to receive 15% of the first $25,000,000, or $3,750,000, if the properties are sold, which the Company believes occurred when Phelps Dodge purchased Cyprus Amax. Phelps Dodge filed suit against the Company on June 19, 2002 regarding these matters (See Note K). SUTTER GOLD MINING COMPANY Sutter Gold Mining Company ("SGMC") was established in 1990 to conduct operations on mining leases and to produce gold from the Lincoln Project in California. SGMC has not generated any significant revenue and has no assurance of future revenue. All acquisition and mine development costs since inception were capitalized. Due to the decline in the spot price for gold and the lack of adequate financing, SGMC has put the property on a shut down status and has impaired the associated assets. During fiscal 2000, a visitor's center was developed and became operational. Management has leased the visitor's center to partially cover stand-by costs of the property. At December 31, 2003, the spot market price for gold had attained levels management believe that will allow SGMC to produce gold from the property on an economic basis. This conclusion is based on engineering analysis completed on the property. Management of SGMC is therefore pursuing the equity capital market and non-affiliated industry partners to obtain sufficient capital to complete the development of the mine, construct a mill and place the property into production. (See Note P). PLATEAU RESOURCES LIMITED During fiscal 1994, USE entered into an agreement with Consumers Power Company to acquire all the issued and outstanding common stock of Plateau Resources Limited ("Plateau"), a Utah corporation. Plateau owns a uranium processing mill and support facilities and certain other real estate assets through its wholly-owned subsidiary, Canyon Homesteads, Inc., in southeastern Utah. USE paid nominal cash consideration for -74- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) the Plateau stock and agreed to assume all environmental liabilities and reclamation bonding obligations. At December 31, 2003, Plateau had a cash security in the amount of $6.8 million to cover reclamation and annual licensing of the properties (see Note K). The Company is currently evaluating the best utilization of Plateau's assets. Evaluations are ongoing to determine when, or if, the mine and mill properties should be placed into production. The primary factor in these evaluations relates to uranium market prices. Due to uranium market conditions in 2002, Plateau decided to change the license status from operational back to reclamation and filed a new reclamation plan. The Nuclear Regulatory Commission (NRC) reviewed the revised reclamation and decommissioning plan and agreed to a $6.1 million reclamation plan. Therefore, Plateau received about $2.9 Million of excess reclamation bond funds on the Shootaring Canyon Uranium Mill. During the year ended December 31, 2003, management of Plateau determined that the mine and mill properties should be reclaimed. On August 1, 2003, the Company sold all of the stock of Canyon Resources as a result of Plateau entering into a Stock Purchase Agreement to sell all the outstanding shares of Canyon Homesteads, Inc. ("Canyon") to The Cactus Group LLC, a newly formed Colorado limited liability company. The Cactus Group purchased all of the outstanding stock of Canyon for $3,370,000. Of that amount, $349,300 was paid in cash at closing and the balance of $3,120,700 is to be paid under the terms of a promissory note. The sale did not qualify for gain recognition under the full accrual method. A gain of $1,295,700 was deferred and reported in the consolidated balance sheet at December 31, 2003. The sale will be recognized by the installment method as cash payments are received from the purchaser. An installment note receivable of $2,988,000 at December 31, 2003 will be reduced as payments are received. Pursuant to the promissory note, the Company is to receive $5,000 per month for the months of November 2003 to March 2004 and $10,000 for the months of November 2004 to March 2005 and $24,000 per month for the months of April to October 2004 and $24,000 per month on a monthly basis after March of 2005 from The Cactus Group until August of 2008, at which time, a balloon payment of $2.8 million is due. The note is secured with all the assets of The Cactus Group and Canyon along with personal guarantees by the six principals of The Cactus Group. As additional consideration for the sale, the Company will also receive the first $210,000 in gross proceeds from the sale of either single family or mobile home lots in Ticaboo. ROCKY MOUNTAIN GAS, INC. During fiscal 2000, the Company organized Rocky Mountain Gas, Inc. ("RMG") to enter into the coalbed methane gas/natural gas business. RMG is engaged in the acquisition of coalbed methane gas properties and the future exploration, development and production of methane gas from those properties. At December 31, 2003, RMG is owned 90.1% by the Company. On January 3, 2000, RMG entered into an agreement with Quantum Energy, L.L.C. (Quantum formed a subsidiary "Quaneco" to conduct its business with RMG) to purchase a 50% working interest and 40% net revenue interest in approximately 185,000 acres of unproven leasehold interests in the Powder River Basin of southeastern Montana. -75- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) RMG also acquired a 100% working interest (82% revenue interest) in 65,247 net mineral acres in southwest Wyoming during the year ended May 31, 2000. CCBM - ---- On July 10, 2001, RMG completed a sale of gas properties to CCBM, Inc., a Delaware corporation, which is wholly-owned by Carrizo Oil & Gas, Inc., Houston, Texas (NMS "CRZO"). The agreement between CCBM and RMG is to finance the further development of coalbed methane acreage currently owned by RMG in Montana and Wyoming, and to acquire and develop more acreage in Wyoming and the Powder River Basin of Montana. RMG is the designated operator under a Joint Operating Agreement ("JOA") between RMG and CCBM., which will govern all operations on the properties subject to a Purchase and Sale Agreement between RMG and CCBM, subject to pre-existing JOA's with other entities, and operations or properties in the area of mutual interest ("AMI"). CCBM has the right to participate in other properties RMG may acquire under the area of mutual interest ("AMI"). RMG assigned CCBM an undivided 50% interest in all of RMG's existing coalbed methane properties (with the exception of Castle Rock of which only a 6.25% working interest was assigned) for a sales price of $7,500,000 in the form of a non-recourse promissory note payable in principal amounts of $125,000 per month plus interest at an annual rate of 8% over 41 months (starting July 31, 2001) with a balloon payment due on the forty-second month. This note is accounted for on a cash basis because it is non-recourse with its principle payments reducing the natural gas properties in accordance with the full cost method of accounting. The balance due under the note at December 31, 2003 is $863,200. (See Pinnacle below) Interest income of $232,100, $269,700 and $505,000 was recognized for the year ended December 31, 2003, the nine months ended December 31, 2002 and the year ended March 31, 2002, respectively. These properties sold to CCBM consisted of the Kirby, Oyster Ridge, Clearmont, Sussex, Finley, Baggs North, and Gillette North properties. CCBM's 50% undivided interest is pledged back to RMG to collateralize the promissory note. To start development, and as part of the consideration for the acquisition, CCBM agreed to pay $5,000,000 to drill and complete from 30 to 60 wells on the coalbed properties. RMG is "carried" for its 50% interest in these wells, and will not be required to pay any of such costs. After the initial $5,000,000 has been spent, RMG and CCBM each will pay for their 50% share of costs in subsequent wells, and also will pay for their 50% share of operating costs for the wells drilled and completed in this drilling program. Without CCBM's consent, none of the drilling funds can be used for operations associated with water disposal wells, gas compression beyond 100 PSIG, or for facilities downstream of compression beyond 100 PSIG. CCBM will earn a 50% working interest in each well location (80 acres) and gas production therefrom, regardless of the status of payments on the promissory note. The balance under the work commitment at December 31, 2003 was $305,100. In 2003, a portion of these interests were exchanged for common stock of Pinnacle Gas Resources. (See Pinnacle below). Bobcat - ------ On April 12, 2002, RMG signed an agreement to purchase working interests in approximately 1,940 gross acres of coalbed methane properties in the Powder River Basin of Wyoming. The contract closed on June 4, 2002. RMG paid the seller $500,000 cash and another $150,000 by having USE issue 37,500 shares of its restricted common stock to the seller; CCBM paid $500,000 cash to the seller and CRZO issued its -76- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) restricted shares of common stock valued at $150,000. The properties are located approximately 25 miles north of Gillette, in Campbell County, Wyoming. In 2003 these interests were exchanged for common stock of Pinnacle Gas Resources. (See Pinnacle below). Pinnacle - -------- On June 23, 2003, a Subscription and Contribution Agreement was executed by RMG, CCBM, and the seven affiliates of Credit Suisse First Boston Private Equity ("CSFB Parties"). Under the Agreement, RMG and CCBM contributed certain of their respective interests, having an estimated fair value of approximately $7.5 million each, carried on RMG's books at a cost of $922,600, comprised of (1) leases in the Clearmont, Kirby, Arvada and Bobcat CBM project areas and (2) oil and gas reserves in the Bobcat project area, to a newly formed entity, Pinnacle Gas Resources, Inc., a Delaware corporation ("Pinnacle"). In exchange for the contribution of these assets, RMG and CCBM each received 37.5% of the common stock of Pinnacle ("Pinnacle Common Stock") as of the closing date and options to purchase Pinnacle Common Stock ("Pinnacle Stock Options"). The CSFB Parties contributed $5.0 million for 25% of the common stock in Pinnacle. CSFB Parties also contributed approximately $13 million of cash to Pinnacle in return for the Redeemable Preferred Stock of Pinnacle ("Pinnacle Preferred Stock"), 25% of the Pinnacle Common Stock as of the closing date and warrants to purchase Pinnacle Common Stock ("Pinnacle Warrants"). The CSFB Parties also agreed to contribute additional cash, under certain circumstances, of up to approximately $11.8 million to Pinnacle to fund future drilling, development and acquisitions. The CSFB Parties currently have greater than 50% of the voting power of the Pinnacle capital stock through their ownership of Pinnacle Common Stock and Pinnacle Preferred Stock. Currently, on a fully diluted basis, assuming that all parties exercised their Pinnacle Warrants and Pinnacle Options, the CSFB Parties, RMG and CCBM would have ownership interest of approximately 46.2%, 26.9% and 26.9%, respectively. On a fully-diluted basis, assuming the additional $11.8 million of cash was contributed by the CSFB Parties and all Pinnacle Warrants and Pinnacle Options were exercised by all parties, the CSFB Parties would own 54.6% of Pinnacle and RMG and CCBM would each own 22.7% of Pinnacle. Prior to and in connection with its contribution of assets to Pinnacle, CCBM paid RMG approximately $1.8 million in cash as part of its outstanding purchase obligation on the coalbed methane property interests CCBM previously acquired from RMG. CCBM was also given a credit of $1,250,000 against the note payable pursuant to the original Purchase and Sale Agreement which allowed CCBM to recover $1,250,000 from 20% of RMG's net revenue interest from any production from the properties contributed to Pinnacle. After these payments and credits, there was a balance of approximate $1.2 million remaining on the obligation from CCBM to RMG at December 31, 2003, the balance on the note receivable for CCBM was $863,200. The principal reductions to the note receivable from CCBM are accounted for on a cash basis because it is non-recourse. Pinnacle is a private corporation. Only such information about Pinnacle as its board of directors elects to release is available to the public. All other information about Pinnacle is subject to confidentiality agreements between Pinnacle, RMG, and the other parties to the June 2003 transaction. -77- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) OIL AND GAS PROPERTIES AND EQUIPMENT INCLUDED THE FOLLOWING: - --------------------------------------------------------------------
December 31, May 31, -------------------------- -------------------------- 2003 2002 2002 2001 ------------ ------------ ------------ ------------ Oil and gas properties: Subject to amortization $ 1,773,600 $ 1,773,600 $ 1,773,600 $ 1,773,600 Acquired in calendar 2003 -- -- -- -- Acquired in calendar 2002 650,000 650,000 -- -- ------------ ------------ ------------ ------------ 2,423,600 2,423,600 1,773,600 1,773,600 Not subject to amortization: Acquired in calendar 2003 265,400 -- -- -- Acquired in calendar 2002 508,400 508,400 -- -- Acquired in fiscal 2002 363,900 363,900 363,900 -- Acquired in fiscal 2001 1,154,500 1,154,500 1,154,500 1,154,500 Acquired in fiscal 2000 4,727,200 4,727,200 4,727,200 4,727,200 Less prior year's sales (2,500,000) (1,250,000) -- -- ------------ ------------ ------------ ------------ 4,519,400 5,504,000 6,245,600 5,881,700 Sale of gas property interests (3,815,600) (1,250,000) (1,250,000) -- ------------ ------------ ------------ ------------ 703,800 4,254,000 4,995,600 5,881,700 ------------ ------------ ------------ ------------ Total oil and gas properties 3,127,400 6,677,600 6,769,200 7,655,300 Accumulated depreciation, depletion and amortization (1,923,000) (1,834,100) (1,773,600) (1,773,600) ------------ ------------ ------------ ------------ Net oil and gas properties $ 1,204,400 $ 4,843,500 $ 4,995,600 $ 5,881,700 ============ ============ ============ ============
The Company began drilling of its coalbed methane properties during 2001 and acquired producing properties in June of 2002. The following sets forth costs incurred for oil and gas property acquisition and development activities, whether capitalized or expensed:
December 31, May 31, -------------------- -------------------- 2003 2002 2002 2001 -------- ---------- -------- ---------- Acquisition of properties/facilities $107,100 $ 936,200 $192,600 $ 870,600 Development 158,300 97,200 87,400 283,900 -------- ---------- -------- ---------- $265,400 $1,033,400 $280,000 $1,154,500 ======== ========== ======== ==========
As of February 27, 2004, the Company had approximately 128,200 net acres for the potential development of coalbed methane ("CBM") natural gas production in Wyoming and Montana with a cost basis of $1,204,400. These properties were mostly acquired in 2000 and drilling projects on these properties are in the early stage of evaluation and thus no reserves are recorded at year end associated with these properties. -78- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) The results from operations of oil and gas activities for the year ended December 31, 2003 and the seven months ended December 31, 2002 are as follows:
Year Ended Seven Months Ended December 31, 2003 December 31, 2002 ------------------- ------------------- Sales to third parties $ 287,400 $ 119,400 Production costs (224,200) (355,200) Depreciation, depletion and amortization (88,900) (65,200) ------------------- ------------------- Loss from oil and gas production activities $ (25,700) $ (301,000) =================== ===================
Depreciation, depletion and amortization was $1.09 and $1.14 per equivalent mcf of production for the year ended December 31, 2003 and the seven months ended December 31, 2002, respectively. G. DEBT: LINES OF CREDIT - ----------------- The Company has a $750,000 line of credit from a commercial bank. The line of credit has a variable interest rate (5.0% as of December 31, 2003). The weighted average interest rate for the year ended December 31, 2003 was 5.12%. As of December 31, 2003, none of the line of credit had been borrowed. The line of credit is collateralized by certain real property and a share of the net proceeds of fees from production from certain oil wells. LONG-TERM DEBT - --------------- The components of long-term debt as of December 31, 2003, 2002 and May 31, 2002 are as follows:
December 31, May 31, ------------------------ ----------- 2003 2002 2002 ----------- ----------- ----------- USECC installment notes - collateralized by equipment; interest at 5.0% to 9.0%, matures in 2004 - 2009 $1,407,900 $1,839,400 $1,611,600 SGMC installment notes - collateralized by certain properties, interest at 7.5% to 8.0% maturity from 2004 - 2007 62,900 531,100 579,500 USE convertible notes - net of discount of 221,000 at December 31, 2003, $620,100 at December 31, 2002 and $620,100 at May 31, 2002 collateralized by equipment and real estate, interest at 8.0%; 779,000 741,300 329,900 PLATEAU installment note - collateralized by equipment, interest at 8.0% -- 26,000 38,000 ----------- ----------- ----------- 2,249,800 3,137,800 2,559,000 Less current portion (932,200) (317,200) (205,700) ----------- ----------- ----------- $1,317,600 $2,820,600 $2,353,300 =========== =========== ===========
Principal requirements on long-term debt are $932,200, $112,800; $116,600; $1,056,500; $22,600 and $9,100 for the years ended December 31, 2004 through 2008, and thereafter, respectively. -79- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) In 2003, Caydal converted $500,000 of debt to 211,109 shares of commons stock (33,333 shares at the original $3.00 conversion price, and 177,776 shares at the restructured price of $2.25). The outstanding principal balance on the debts owed to Caydal and Tsunami Partners was $500,000 and $500,000, convertible at December 31, 2003 into 222,220 and 222,220 shares, respectively. Tsunami Partners did not convert any debt to shares in 2003. Caydal and Tsunami Partners are accredited investors. H. INCOME TAXES: The components of deferred taxes as of December 31, 2003, 2002 and May 31, 2002 are as follows:
December 31, May 31, --------------------------- ------------ 2003 2002 2002 ------------- ------------ ------------ Deferred tax assets: Deferred compensation $ 445,400 $ 345,500 $ 273,400 Net operating loss carryforwards 11,596,000 9,560,000 9,028,600 Non-deductible reserves and other 437,200 622,800 622,800 Tax basis in excess of book basis 106,700 250,000 250,000 ------------- ------------ ------------ Total deferred tax assets 12,585,300 10,778,300 10,174,800 ------------- ------------ ------------ Deferred tax liabilities: Book basis in excess of tax basis 486,200 721,300 767,700 Development and exploration costs 107,600 107,600 107,600 ------------- ------------ ------------ Total deferred tax liabilities 593,800 828,900 875,300 ------------- ------------ ------------ 11,991,500 9,949,400 9,299,500 Valuation allowance (11,991,500) (9,949,400) (9,299,500) ------------- ------------ ------------ Net deferred tax liability $ -- $ -- $ -- ============= ============ ============
A valuation allowance for deferred tax assets is required when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of this deferred tax asset depends on the Company's ability to generate sufficient taxable income in the future. Management believes it is more likely than not that the net deferred tax asset will not be realized by future operating results. Deferred tax component for December 31, 2002 and May 31, 2002 have been restated (Note A). The valuation allowance increased $2,042,100 for the year ended December 31, 2003, increased $649,900 for the seven months ended December 31, 2002 and decreased $2,740,300 and $2,641,300 for the years ended May 31, 2002 and 2001, respectively. The income tax provision (benefit) is different from the amounts computed by applying the statutory federal income tax rate to income before taxes. The reasons for these differences are as follows:
December 31, Year Ended May 31, -------------------------- -------------------------- 2003 2002 2002 2001 ------------ ------------ ------------ ------------ Expected federal income tax $(2,405,800) $(1,305,600) $(2,131,000) $ 602,200 Net operating losses not previously benefited and other 363,700 655,700 4,871,300 2,039,100 Valuation allowance 2,042,100 649,900 (2,740,300) (2,641,300) ------------ ------------ ------------ ------------ Income tax provision $ -- $ -- $ -- $ -- ============ ============ ============ ============
There were no taxes currently payable as of December 31, 2003, December 31, 2002, May 31, 2002, or May 31,2001 related to continuing operations. -80- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) At December 31, 2003, the Company and its subsidiaries had available, for federal income tax purposes, net operating loss carryforwards of approximately $33,300,000 which will expire from 2006 to 2023. The Internal Revenue Code contains provisions which limit the NOL carryforwards available which can be used in a given year when significant changes in Company ownership interests occur. In addition, the NOL amounts are subject to examination by the tax authorities. The Internal Revenue Service has audited the Company's and subsidiaries tax returns through the year ended May 31, 2000. The Company's income tax liabilities are settled through fiscal 2000. I. SEGMENTS AND MAJOR CUSTOMERS: The Company's primary business activity is coalbed methane gas property acquisition and exploration and production (and holding shut down mining properties). The Company has no producing mines. The other reportable industry segment is commercial activities through motel, real estate and airport operations. The Company discontinued its drilling/construction segment in the third quarter of fiscal 2002. The following is information related to these industry segments:
Year Ended December 31, 2003 ------------------------------------------------ Coalbed Methane Motel/ (and holding Real Estate/ costs for inactive Airport mining properties) Operations Consolidated ------------------- ----------- -------------- Revenues $ 287,400 $ 334,300 $ 621,700 ================== =========== Other revenues 215,600 ------------- Total revenues $ 837,300 ============= Operating (loss) income $ (1,487,400) $ 31,400 $ (1,456,000) ================== =========== Other revenue 215,600 General corporate and other expenses (5,997,500) Other income and expenses (73,000) Minority interest in loss of affiliates 235,100 ------------- Loss before income taxes $ (7,075,800) ============= Identifiable net assets at December 31, 2003 $ 9,365,000 $ 3,030,100 $ 12,395,100 ================== =========== Investment in non-affiliated company 957,600 Corporate assets 10,577,100 ------------- Total assets at December 31, 2003 $ 23,929,800 ============= Capital expenditures $ 176,400 $ -- =================== =========== Depreciation, depletion and amortization $ 217,600 $ 102,400 =================== ===========
-81- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued)
Seven Months Ended December 31, 2002 ------------------------------------------------ Coalbed Methane Motel/ (and holding Real Estate/ costs for inactive Airport mining properties) Operations Consolidated ------------------- ----------- -------------- Revenues $ 119,400 $ 749,100 $ 868,500 ================== =========== Other revenues 159,100 ------------- Total revenues $ 1,027,600 ============= Operating (loss) income $ (973,000) $ 221,900 $ (751,100) =================== =========== Other revenue 159,100 General corporate and other expenses (2,915,800) Other income and expenses (387,100) Discontinued operations, net of tax -- Equity in loss of affiliates and minority interest in subsidiaries 54,800 ------------- Loss before income taxes $ (3,840,100) ============= Identifiable net assets at December 31, 2002 $ 16,022,800 $ 4,564,700 $ 20,587,500 =================== =========== Corporate assets 7,603,100 ------------- Total assets at December 31, 2002 $ 28,190,600 ============= Capital expenditures $ 1,033,400 $ 37,800 =================== =========== Depreciation, depletion and amortization $ 94,800 $ 78,200 =================== ===========
-82- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued)
Year Ended May 31, 2002 ------------------------------------------------- Coalbed Methane Motel/ (and holding Real Estate/ costs for inactive Airport mining properties) Operations Consolidated ------------------- ------------ -------------- Revenues $ -- $ 1,795,900 $ 1,795,900 =================== ============ Other revenues 208,200 ------------- Total revenues $ 2,004,100 ============= Operating loss $ (1,707,800) $ (133,000) $ (1,840,800) =================== ============ Other revenue 208,200 General corporate and other expenses (5,821,600) Other income and expenses 1,319,500 Discontinued operations, net of tax (85,900) Equity in loss of affiliates and minority interest in subsidiaries 39,500 ------------- Loss before income taxes $ (6,181,100) ============= Identifiable net assets at May 31, 2002 $ 18,138,500 $ 4,351,600 $ 22,490,100 =================== ============ Investments in affiliates -- Corporate assets 8,047,800 ------------- Total assets at May 31, 2002 $ 30,537,900 ============= Capital expenditures $ 151,300 $ 101,500 =================== ============ Depreciation, depletion and amortization $ 167,600 $ 254,300 =================== ============
-83- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued)
Year Ended May 31, 2001 -------------------------------------------------------------- Coalbed Methane Motel Contract (and holding Real Estate/ Drilling/ costs for inactive Airport Construction mining properties) Operations Operations Consolidated ------------------- ------------ ----------- -------------- Revenues $ 442,800 $ 2,222,400 $ 2,238,600 $ 4,903,800 =================== ============ =========== Other revenues 597,800 ------------- Total revenues $ 5,501,600 ============= Operating (loss) profit $ (2,866,400) $(1,013,800) $ 488,100 $ (3,392,100) =================== ============ =========== Other revenue, income and expenses 9,328,600 General corporate and other expenses (4,235,400) Equity in loss of affiliates and minority interest in subsidiaries 220,100 ------------- Income before income taxes $ 1,921,200 ============= Identifiable net assets at May 31, 2001 $ 18,424,900 $ 5,616,400 $ 1,050,500 $ 25,091,800 =================== ============ =========== Investments in affiliates 16,200 Corporate assets 5,357,200 -------------- Total assets at May 31, 2001 $ 30,465,200 ============= Capital expenditures $ 1,280,200 $ 1,326,800 $ 256,000 =================== ============ =========== Depreciation, depletion and amortization $ 129,700 $ 271,100 $ 324,700 =================== ============ ===========
-84- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) J. SHAREHOLDERS' EQUITY: STOCK OPTION PLANS The Board of Directors adopted the U.S. Energy Corp. 1989 Stock Option Plan for the benefit of USE's key employees. The Option Plan, as amended and renamed the 1998 Incentive Stock Option Plan ("1998 ISOP"), reserved 3,250,000 shares of the Company's $.01 par value common stock for issuance under the 1998 ISOP. Options which expired without exercise were available for reissue. During the year ended December 31, 2003, the seven months ended December 31, 2002 and the years ended May 31, 2002 and 2001 the following activity occurred under the 1998 ISOP:
Year Ended Seven Months December 31, Ended December 31, Year Ended May 31, ------------------ ------------------- -------------------- 2003 2002 2002 2001 ------------------ ------------------- -------- ---------- Grants - ------ Qualified -- -- -- 542,726 Non-Qualified -- -- -- 888,774 ------------------ ------------------ --------- ---------- -- -- -- 1,431,500 ================== ================== ========= ========== Price of Grants - --------------- High -- -- -- $ 2.40 Low -- -- -- $ 2.40 Exercises - --------- Qualified 77,832 71,166 243,250 56,985 Non-Qualified 71,453 1 55,372 31,718 ------------------ ------------------ --------- ---------- 149,285 71,167 298,622 88,703 ================== =================== ======== ========== Total Cash Received $ 364,200 $ 170,800 $742,000 $ 216,400 ================== =================== ======== ========== Forfeitures/Cancellations - ------------------------- Qualified 34,782 -- 78,244 75,000 Non-Qualified 64,233 -- 346,018 42,000 ------------------ ------------------ -------- ---------- 99,015 -- 424,262 117,000 ================== =================== ======== ==========
In December 2001, the Board of Directors adopted (and the shareholders approved) the U.S. Energy Corp. 2001 Incentive Stock Option Plan (the "2001 ISOP") for the benefit of USE's key employees. The 2001 ISOP reserves 3,000,000 shares of the Company's $.01 par value common stock for issuance for a period of 10 years. -85- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) The following table represents the activity in the 2001 ISOP for the periods covered by the Annual Report for the year ended December 31, 2003:
Year Ended Seven Months Year Ended ----------- December 31, Ended December 31, May 31, ------------------- -------- 2003 2002 2002 ------------ ------------------- -------- Grants - ------------------- Qualified -- 459,996 10,000 Non-Qualified -- 473,004 950,000 ------------- ------------------- -------- -- 933,000 960,000 ============= =================== ======== Price of Grant - ------------------- High -- $2.25 $3.90 Low -- $2.25 $3.82 Exercises - ------------------- Qualified 73,780 -- -- Non-Qualified 52,556 -- -- ------------- ------------------- -------- 126,336 -- -- ============= =================== ======== Total Cash Received $ 284,300 $ -- $ -- ============= =================== ======== Forfeited - ------------------- Qualified 65,108 -- -- Non-Qualified 252,556 50,000 -- ------------- ------------------- -------- 317,664 50,000 -- ============= =================== ========
The 2001 ISOP replaces the 1998 ISOP, however, options granted under the 1998 ISOP remain exercisable until their expiration date under the terms of that Plan. -86- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) The following table represents the activity in employee options for the periods covered by the Annual Report for the year ended December 31, 2003 that are not in employee stock option plans:
Year Ended Seven Months Year Ended December 31, Ended December 31, May 31, 2003 2002 2002 ------------- ------------------- -------- Grants - ------ Qualified -- -- 10,000 Non-Qualified 10,000 -- -- ------------- ------------------- -------- 10,000 -- 10,000 ============= =================== ======== Price of Grant - -------------- High $ 2.90 -- $ 3.82 Low $ 2.90 -- $ 3.82 Exercises - --------- Qualified -- -- -- Non-Qualified -- -- -- ------------- ------------------- -------- -- -- -- ============= =================== ======== Total Cash Received $ -- $ -- $ -- ============= =================== ======== Forfeited - --------- Qualified -- -- -- Non-Qualified 10,000 100,000 200,000 ------------- ------------------- -------- 10,000 100,000 200,000 ============= =================== ========
-87- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) A summary of the Employee Stock Option Plans activity in all plans for the year ended December 31, 2003; the seven months ended December 31, 2002 and the years ended May 31, 2002 and 2001 is as follows:
Year Ended Seven Months December 31, Ended December 31, Year Ended May 31, -------------------------------------- 2003 2002 2002 2001 ---------------------- --------------------- -------------------- ----------------- Weighted Weighted Weighted Weighted Average Average Average Average Exercise Exercise Exercise Exercise Options Price Options Price Options Price Options Price ----------- --------- ----------- -------- ---------- -------- ---------- ----- Outstanding at beginning of the period 3,565,946 $ 2.76 2,854,113 $ 2.92 2,606,997 $ 2.69 1,581,200 $ 3.40 Granted 10,000 2.90 933,000 2.25 970,000 3.90 1,431,500 2.40 Forfeited (426,679) 3.17 (150,000) 2.63 (424,262) 3.30 (317,000) 6.03 Expired -- -- -- -- -- -- -- -- Exercised (275,621) 2.35 (71,167) 2.40 (298,622) 2.84 ( 88,703) 2.44 ----------- ----------- ---------- ---------- Outstanding at period end 2,873,646 2.74 3,565,946 2.76 2,854,113 2.92 2,606,997 2.56 =========== =========== ========== ========== Exercisable at period end 2,873,646 2.74 2,612,946 2.94 1,984,113 2.49 1,478,463 2.69 =========== =========== ========== ========== Weighted average fair value of options granted during the period $ 0.68 $ 1.15 $ 1.99 $ 1.36
The following table summarized information about employee stock options outstanding and exercisable at December 31, 2003: Weighted Weighted Number of Average Number Average Options Remaining of Options Exercise Outstanding at Contractual Exercisable at Price December 31, 2003 Life in years December 31, 2003 -------- ------------------- --------------- ------------------ $2.74 2,873,646 7.02 2,873,646 EMPLOYEE STOCK OWNERSHIP PLAN The Board of Directors of USE adopted the U.S. Energy Corp. 1989 Employee Stock Ownership Plan ("ESOP") in 1989, for the benefit of USE employees. During the year ended December 31, 2003 the Board of Directors of USE contributed 76,294 shares to the ESOP at the price of $3.10 for a total expense of $236,400. This compares to contributions to the ESOP during the seven months ended December 31, 2002 and fiscal years ended May 31, 2002 and 2001 of 43,867, 70,075 and 53,837 shares to the ESOP at prices of $3.08, $3.29 and $5.35 per share, respectively. The Company has expensed $236,400, $135,100, $236,900 and $288,000 during the year ended December 31, 2003; the seven months ended December 31, 2002 and the fiscal years ended May 31, 2002 and 2001, respectively related to these contributions. As of December 31, 2003, all shares of the USE stock that have been contributed to the ESOP have been allocated. The estimated fair value of shares that are not vested is approximately $84,800. USE has loaned the ESOP $1,014,300 to purchase 125,000 shares from the Company and 38,550 shares on the open market. During the year ended May 31, 1996, 10,089 of these shares were used to fund the Company's annual funding commitment and reduce the loan -88- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) to the Company by $87,300. These loans, which are secured by pledges of the stock purchased, bear interest at the rate of 10% per annum. The loans are reflected as unallocated ESOP contribution in the equity section of the accompanying Consolidated Balance Sheets. EXECUTIVE OFFICER COMPENSATION In May 1996, the Board of Directors of USE approved an annual incentive compensation arrangement ("1996 Stock Award Program") for its CEO and four other officers of the Company payable in shares of the Company's common stock. The 1996 Stock Award Program was subsequently modified to reflect the intent of the directors which was to provide incentive to the officers of the Company to remain with USE. The shares were issued annually pursuant to the recommendation of the Compensation Committee on or before January 15 of each year, beginning January 15, 1997, as long as each officer is employed by the Company. The officers received up to an aggregate total of 67,000 shares per year for the years 1997 through 2002. The shares under the plan are forfeitable until retirement, death or disability of the officer. The shares are held in trust by the Company's treasurer and are voted by the Company's non-employee directors. As of December 31, 2003, 392,536 shares had been issued to the five officers of the Company under the 1996 Stock Award Plan and 62,536 shares had been released to the estate of one of the officers. The 1996 Stock award program was closed out in the year ended December 31, 2003. In December 2001, the Board of Directors adopted (and the shareholders approved) the 2001 Stock Award Plan to compensate five of its executive officers and the president of RMG. Under the Plan, an aggregate of 100,000 shares may be issued each year from 2002. 100,000 shares were issued under the Plan during the year ended December 31, 2003. No shares were issued under this Plan during the seven month ended December 31, 2002 and the fiscal year ended May 31, 2002. OPTIONS AND WARRANTS TO OTHERS As of December 31, 2003, there are 906,724 options and warrants outstanding to purchase shares of the Company's common stock. The Company values these warrants using the black-scholes option pricing model and expenses that value over the life of the service period. Activity for the periods ended December 31, 2003 for warrants is represented in the following table: -89- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued)
Year Ended Seven Months December 31, Ended December 31 Year Ended May 31, ----------------------------------- 2003 2002 2002 2001 ----------------- -------------------- ----------------- ---------------- Weighted Weighted Weighted Weighted Average Average Average Average Exercise Exercise Exercise Exercise Warrants Price Warrants Price Warrants Price Warrants Price --------- ------ --------- --------- --------- ------ -------- ------ Outstanding at beginning of the period 989,908 $3.367 859,677 $ 3.427 313,683 $3.048 253,683 $2.960 Granted 224,875 $4.323 145,147 $ 2.950 572,364 $3.620 60,000 $3.310 Forfeited (176,453) $3.671 (14,916) (25,165) $2.880 Expired Exercised (131,596) $3.546 (1,205) $3.750 --------- --------- --------- -------- Outstanding at period end 906,734 $3.506 989,908 $ 3.355 859,677 $3.427 313,683 $3.027 ========= ========= ========= ======== Exercisable at period end 831,724 $3.409 979,908 $ 3.367 859,677 $3.427 303,683 $3.048 ========= ========= ========= ======== The following table presents summarized information about warrants outstanding and exercisable at December 31, 2003. Weighted Average Number of Average Number of Options Remaining Options Exercise Outstanding at Contractual Exercisable at Price December 31, 2003 Life in Years December 31, 2003 $ 3.506 906,734 2.94 831,724
These options and warrants are held by persons or entities other than employees, officers and directors of the Company. FORFEITABLE SHARES Certain of the shares issued to officers, directors, employees and third parties are forfeitable if certain conditions are not met. Therefore, these shares have been reflected outside of the Shareholders' Equity section in the accompanying Consolidated Balance Sheets until earned. During fiscal 1993, the Company's Board of Directors amended the stock bonus plan. As a result, the earn-out dates of certain individuals were extended until retirement. The Company recorded $284,700 of compensation expense for the year ended December 31, 2003 compared to $178,300 for the seven months ended December 31, 2002; $298,300 and $201,000 for the years ended May 31, 2002 and 2001, respectively. A schedule of total forfeitable shares for the Company is set forth in the following table: -90- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued)
Issue Number Issue Total Date of Shares Price Compensation --------------- --------- --------- ------------ Balance at June 1, 2000 396,608 $ 2,584,600 May 2001 67,000 $ 5.35 358,400 Shares earned (29,820) -- (194,400) -------- --------- Balance at May 31, 2001 433,788 2,748,600 May 2002 67,000 $ 3.90 261,300 -------- --------- Balance at May 31, 2002 and December 31, 2002 500,788 3,009,900 March 24, 2003 43,378 $ 3.50 151,900 Shares earned (78,286) -- (435,200) -------- --------- Balance at December 31, 2003 465,880 $ 2,726,600 ======== ===========
K. COMMITMENTS, CONTINGENCIES AND OTHER: LEGAL PROCEEDINGS Material pending proceedings are summarized below. Certain of the Company's affiliates are involved in ordinary routine litigation incidental to their business. Other proceedings which were pending during the year ended December 31, 2003 have been settled or otherwise finally resolved. SHEEP MOUNTAIN PARTNERS ARBITRATION/LITIGATION In 1991, disputes arose between the U.S. Energy Corp. ("USE")/Crested Corp. ("Crested") d/b/a/ USECC, and Nukem, Inc. and its subsidiary Cycle Resource Investment Corp. ("CRIC"), concerning the formation and operation of their equally owned Sheep Mountain Partners (SMP) partnership. Arbitration proceedings were initiated by CRIC in June 1991 and in July 1991, USECC filed a lawsuit against Nukem, CRIC and others in the U.S. District Court of Colorado in Civil No. 91B1153. The Federal Court stayed the arbitration proceedings and discovery proceeded. In February 1994, all of the parties agreed to consensual and binding arbitration of all of their disputes over SMP before an arbitration panel (the "Panel"). After 73 hearing days, the Panel entered an Order and Award on April 18, 1996 and clarified the Order on July 3, 1996, finding generally in favor of USE and Crested on certain of their claims and imposed a constructive trust in favor of Sheep Mountain Partners on uranium contracts Nukem entered into to purchase uranium from CIS republics. The Panel also awarded SMP damages of $31,355,070 against Nukem. USECC filed a petition for confirmation of the Order and on June 27, 1997, the U.S. District Court confirmed the Panel's Orders in its Second Amended Judgment. Thereafter, Nukem/CRIC appealed the Judgment to the 10th Circuit Court of Appeals ("CCA"). On October 22, 1998, the 10th CCA issued an Order and Judgment affirming the U.S. District Court's Second Amended Judgment without modification. The ruling affirmed (i) the imposition of a constructive trust in favor of SMP on Nukem's rights to purchase CIS uranium, the uranium acquired pursuant to those rights, and the profits therefrom; and (ii) the damage award in favor of SMP against Nukem. The 10th CCA held that the -91- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) Panel's Awards "clearly retains both a constructive trust and a damage award," --- and the Arbitration Awards and the Second Amended Judgment were "clear and unambiguous." On February 8, 1999, the U.S. District Court ordered Nukem to pay USECC the balance of the damage award. Nukem did so, but then moved for a satisfaction of judgment without accounting for the monies earned in the Constructive Trust. The District Court denied Nukem's motion and Nukem filed its second appeal to the 10th CCA. On October 16, 2000, the 10th CCA again affirmed the order of the District Court. The 10th CCA held that Nukem had not "provided an accounting of the partnership assets," finding that "the district court order presented for our review does not decide which CIS contracts are covered by the constructive trust." On November 3, 2000, USECC filed a motion for a further accounting of the Constructive Trust. On February 15, 2001, the District Court entered an Order of Reference appointing a Special Master to "conduct an accounting" of the Constructive Trust. The accounting was conducted and on May 1, 2003, the Special Master filed his Report with the District Court. Both parties filed objections to the Report. On July 30, 2003, the U.S. District Court adopted the Report in part and rejected it in part. Judgment was then entered by the Court on August 1, 2003 in favor of USECC and against Nukem in the amount of $20,044,183. On August 15, 2003, Nukem filed a "Motion to Remand to the Arbitration Panel or in the Alternative, to Alter, Amend and/or Correct the Court's August 1, 2003 Judgment and July 30, 2003 Order," and a "Motion to Correct Certain Findings or Statements in the Court's Order of July 30, 2003." On the same day, USECC filed a motion under Fed.R.Civ.P. 52(b) and 59(e) to alter or amend the July 30, 2003 Order and the August 1, 2003 Judgment. The District Court denied the parties' motions on September 10 and 11, 2003, respectively. Nukem's appeal and USECC's cross-appeal followed. Nukem's opening brief was filed on January 16, 2004 and on February 24, 2004, USECC filed an opening brief in its cross-appeal and an answer to Nukem's brief. Nukem has until March 29, 2004 or any extension thereof to file an answer to USECC's opening brief. USECC may then file a reply brief 14 days after service of Nukem's answer. Management believes that the ultimate outcome of this matter will not have an adverse affect on the Company's financial condition or result of operations. CONTOUR DEVELOPMENT LITIGATION On July 28, 1998, USE and Crested filed a lawsuit in the U. S. District Court of Colorado in Case No. 98WM1630, against Contour Development Company, L.L.C. and entities and persons associated with Contour Development Company, L.L.C. (together, "Contour") seeking compensatory and consequential damages of more than $1.3 million from the defendants for dealings in real estate owned by USE and Crested in Gunnison, Colorado. The Contour defendants asserted a counterclaim asking for payment of attorneys fee and costs. The parties settled the litigation in 2004. In the settlement, USE and Crested received $25,000 in cash; two lots in the City of Gunnison, Colorado (one of which has been sold for a net of $65,326 and the other lot is under contract to sell for $180,000), and an additional five development lots covering 175 acres north of Gunnison, Colorado. PHELPS DODGE LITIGATION U.S. Energy Corp. (USE) and Crested Corp. (Crested), d/b/a USECC, were served with a lawsuit on June 19, 2002, filed in the U.S. District Court of Colorado (Case No. 02-B-0796(PAC)) by Phelps Dodge Corporation (PD) and its subsidiary, Mt. Emmons Mining Company (MEMCO), over contractual obligations -92- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) in USECC's agreement with PD's predecessor companies, concerning mining properties on Mt. Emmons, near Crested Butte, Colorado. The litigation stems from agreements that date back to 1974 when USE and Crested leased the mining claims from AMAX Inc., PD's predecessor company. The mining claims cover one of the world's largest and richest deposits of molybdenum discovered by AMAX. AMAX reportedly spent over $200 million on the acquisition, exploration and mine planning activities on the Mt. Emmons properties. The complaint filed by PD and MEMCO seeks a determination that PD's acquisition of Cyprus Amax was not a sale. Under a 1986 agreement between USECC and AMAX, if AMAX sold MEMCO or its interest in the mining properties, U.S. Energy and Crested would receive 15% (7.5% each) of the first $25 million of the purchase price ($3.75 million). In 1991, Cyprus Minerals Company acquired AMAX to form Cyprus Amax Minerals Co. USECC's counter and cross-claims allege that in 1999, PD formed a wholly-owned subsidiary CAV Corporation, for the purpose of purchasing the controlling interest of Cyprus Amax and its subsidiaries (including MEMCO) at an estimated value in cash and PD stock exceeding $1 billion and making Cyprus Amax a subsidiary of PD. Therefore, USECC asserts the acquisition of Cyprus Amax by PD was a sale of MEMCO and the properties that triggers the obligation of Cyprus Amax to pay USECC the $3.75 million plus interest. The other issue in the litigation is whether USECC must, under terms of a 1987 Royalty Deed, accept PD's and MEMCO's conveyance of the Mt. Emmons properties back to USECC, which properties now include a plant to treat mine water, costing in excess of $1 million a year to operate in compliance with State of Colorado regulations. PD's and MEMCO's claim seek to obligate USECC to assume the operating costs of the water treatment plant. USECC refuses to have the water treatment plant included in the return of the properties because, the USECC counterclaim argues, the properties must be in the same condition as when they were acquired by AMAX before the water treatment plant was constructed by AMAX. As added counterclaims, USECC seeks (i) damages for PD's breach of covenants of good faith and fair dealing; (ii) damages for PD's failure to develop the Mt. Emmons properties and not protecting USECC's rights as a revisionary owner of the mining rights to the properties, (iii) damages for unjust enrichment of PD; (iv) damages for breach of the PD's fiduciary duties owed to USECC as revisionary owner of the property, and for neglecting to maintain the mining rights and interests in the properties. On March 17, 2003, PD filed additional motions for partial summary judgment on various claims. On January 22, 2004, the District Court heard the motions and responses of USECC and additional briefs were thereafter filed with the Court. The Court is considering the motions. Management believes that the ultimate outcome of this matter will not have an adverse affect on the Company's financial condition or result of operations. ROCKY MOUNTAIN GAS, INC. (RMG) LITIGATION INVOLVING LEASES ON COALBED METHANE PROPERTIES IN MONTANA On or about April 1, 2001, Rocky Mountain Gas, Inc. (RMG), a subsidiary of USE and Crested, was served with a Second Amended Complaint wherein the Northern Plains Resource Council had filed suit in the U.S. District Court of Montana, Billings Division in Case No. CV-01-96-BLG-RWA against the United States Bureau of Land Management ("BLM"), RMG, certain of its affiliates (including U.S. Energy Corp. and -93- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) Crested Corp.) and some 20 other defendants. The plaintiff is seeking to cancel oil and gas leases issued to RMG et. al. by the BLM in the Powder River Basin of Montana and for other relief. The basis for the complaint appears to be that the BLM's regulations require the BLM to respond to objections filed by persons owning land or lease rights adjacent to the coalbed properties which the BLM is offering to lease to the public. The argument of plaintiff appears to be that if objections are not responded to by the BLM prior to issuing CBM leases, the leases are invalid. Based on this argument, the plaintiff appears to have been successful in forcing cancellation of some CBM leases granted to others in the Powder River Basin of Montana, because the BLM did not respond to some objecting adjacent landowners. However, all of the BLM leases in Montana held by RMG (none are held by USE in its corporate name) are at least four years old, and there is no record of any objections being made to the issue of those leases. Based on filings in the case to date, it appears that the BLM is taking the initiative in responding to the plaintiff. We believe RMG's leases were validly issued in compliance with BLM procedures, and do not believe the plaintiff's lawsuit will adversely affect any of RMG's Montana BLM leases. LAWSUITS CHALLENGING BLM'S RECORDS OF DECISIONS Three lawsuits are currently pending in the Montana Federal District Court challenging BLM's Records of Decisions for the Powder River Basin Oil and Gas EIS (PRB-EIS) for the Wyoming portion of the basin, and the Statewide Oil and Gas EIS and Proposed Amendment for the Powder River and billings Resource Management Plans in Montana. Neither the Company, nor RMG is a party to any of these lawsuits. LITIGATION INVOLVING DRILLING ON A COALBED METHANE LEASE A drilling company, Eagle Energy Services, LLC filed a lien on RMG's leasehold in southwestern Wyoming for drilling services performed at RMG's Oyster Ridge Property and filed a lawsuit foreclosing the lien. Eagle Energy's bank, Community First National Bank of Sheridan, Wyoming, filed a similar suit for the same amount on an assignment from Eagle Energy against RMG, Eagle Energy Services, LLC and others who guaranteed a loan to Eagle Energy in Civil Action No. C02-9-328 in the 4th Judicial District of Sheridan County, Wyoming. Eagle Energy's claim is for a contract to drill a well for coalbed methane. RMG terminated the agreement because of the dangerous conditions of Eagle Energy's equipment and other reasons. The claim against RMG is for $49,309.50. Negotiations to settle the lien and lawsuits are pending. Management believes that the ultimate outcome of the matters will not have a material effect on the Company's financial condition or results of operations. RECLAMATION AND ENVIRONMENTAL LIABILITIES Most of the Company's exploration activities are subject to federal and state regulations that require the Company to protect the environment. The Company conducts its operations in accordance with these regulations. The Company's current estimates of its reclamation obligations and its current level of expenditures to perform ongoing reclamation may change in the future. At the present time, however, the Company cannot predict the outcome of future regulation or impact on costs. Nonetheless, the Company has recorded its best estimate of future reclamation and closure costs based on currently available facts, technology and enacted laws and regulations. Certain regulatory agencies, such as the Nuclear Regulatory Commission ("NRC"), the Bureau of Land Management ("BLM") and the Wyoming Department of Environmental Quality ("WDEQ") review the Company's reclamation, environmental and decommissioning -94- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) liabilities, and the Company believes the recorded amounts are consistent with those reviews and related bonding requirements. To the extent that planned production on its properties is delayed, interrupted ordiscontinued because of regulation or the economics of the properties, the future earnings of the Company would be adversely affected. The Company believes it has accrued all necessary reclamation costs and there are no additional contingent losses or unasserted claims to be disclosed or recorded. The majority of the Company's environmental obligations relate to former mining properties acquired by the Company. Since the Company currently does not have any properties in production, the Company's policy of providing for future reclamation and mine closure costs on a unit-of-production basis has not resulted in any significant annual expenditures or costs. For the obligations recorded on acquired properties, including site-restoration, closure and monitoring costs, actual expenditures for reclamation will occur over several years, and since these properties are all considered future production properties, those expenditures, particularly the closure costs, may not be incurred for many years. The Company also doe not believe that any significant capital expenditures to monitor or reduce hazardous substances or other environmental impacts are currently required. As a result, the near term reclamation obligations are not expected to have a significant impact on the Company's liquidity. As of December 31, 2003, estimated reclamation obligations related to the above mentioned mining properties total $7,264,700. The Company currently has three mineral properties or investments that account for most of their environmental obligations, SMP, Plateau and SGMC. The environmental obligations and the nature and extent of cost sharing arrangements with other potentially responsible parties, as well as any uncertainties with respect to joint and several liability of each are discussed in the following paragraphs: SMP --- The Company is responsible for the reclamation obligations, environmental liabilities and liabilities for injuries to employees in mining operations with respect to the Sheep Mountain properties. The reclamation obligations, which are established by regulatory authorities, were reviewed by the Company and the regulatory authorities during fiscal 2002 and they jointly determined that the reclamation liability was $2,106,600. The Company is self bonded for this obligation by mortgaging certain of their real estate assets, including the Glen L. Larsen building, and by posting cash bonds. GMMV ---- During fiscal 1991, the Company acquired mineral properties on Green Mountain known as the Big Eagle Property. The GMMV also acquired a uranium mill known as the Sweetwater Mill. As part of the settlement of the GMMV litigation with Kennecott in September 2000, the Company was released from any and all reclamation and environmental obligations related to the GMMV except the Ion Exchange Plant. During fiscal 2002, the Company completed the required reclamation on the Ion Exchange Plant. The reclamation work has been completed and a final report has been submitted to and is being reviewed by the regulatory agencies. No further monitoring of the site is required and no additional reclamation work is anticipated. SUTTER GOLD MINING COMPANY ----------------------------- SGMC's mineral properties are currently on shut down status and have never been in production. There has been minimal surface disturbance on the Sutter properties. Reclamation obligations consist of -95- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) closing the mine entry and removal of a mine shop. The reclamation obligation to close the property has been set by the State of California at $27,800 which is covered by a cash reclamation bond. This amount was recorded by SGMC as a reclamation liability as of December 31, 2003. PLATEAU RESOURCES LIMITED --------------------------- The environmental and reclamation obligations acquired with the acquisition of Plateau include obligations relating to the Shootaring Mill. Based on the bonding requirements, Plateau transferred $2,500,000 to a trust account as financial surety to pay future costs of mill decommissioning, site reclamation and long-term site surveillance. In fiscal 1997, Plateau requested that the mill be place on operational status. The NRC increased the reclamation liability to $6,784,000 as a result of this request. As of December 31, 2003, a cash deposit for reclamation in the amount of $6,874,200 was held by Plateau's escrow agent to satisfy the obligation of reclamation of $5,130,300. EXECUTIVE COMPENSATION - ----------------------- The Company is committed to pay the surviving spouse or dependant children of certain of their officers one years' salary and an amount to be determined by the Boards of Directors, for a period of up to five years thereafter. This commitment applies only in the event of the death or total disability of those officers who are full-time employees of the Company at the time of total disability or death. Certain officers and employees have employment agreements with the Company. The maximum compensation due under these agreements for the officers covered by the agreement for the first year after their deaths, should they die in the same year, is $311,400 at December 31, 2003. L. DISCONTINUED OPERATIONS. During the third quarter of the fiscal year ended May 31, 2002, the Company made the decision to discontinue its drilling/construction segment. The assets associated with this business segment are being sold and or converted for use elsewhere in the Company. The financial statements for the fiscal year ended May 31, 2001 have been revised to present the effect of discontinued operations. There is no material income or loss from discontinued operations from the measurement date to December 31, 2002. During the third quarter of the year ended December 31, 2003, the Company sold its motel and retail operations in southern Utah. The financial statements for all of the periods presented have been revised to present these operations as discontinued. M. SUPPLEMENTAL NATURAL GAS RESERVE INFORMATION (UNAUDITED): The following estimates of proved gas reserves, both developed and undeveloped, represent interests owned by the Company located solely within the United States. Proved reserves represent estimated quantities of natural gas which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed gas reserves are the quantities expected to be recovered through existing wells with existing equipment and operating methods. Proved undeveloped gas reserves are reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells for which relatively major expenditures are required for completion. -96- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) The Company began natural gas production in June, 2002. Disclosures of gas reserves which follow are based on estimates prepared by independent engineering consultants as of December 31, 2002. Such estimates are subject to numerous uncertainties inherent in the estimation of quantities of proved reserves and in the projection of future rates of production and the timing of development expenditures. These estimates do not include probable or possible reserves. The information provided does not represent Management's estimate of the Company's expected future cash flows or value of proved oil and gas reserves. RMG's sales volumes of gas produced, average sales prices received for gas sold, and average production costs for those sales, for the seven months ended December 31, 2002, and for the year ended December, 2003, all from the Bobcat property which was transferred to Pinnacle in June 2003 are as follows:
Year Ended Seven Months Ended December 31, 2003 December 31, 2002 ------------------ ------------------ Sales volumes (mcf) 81,516 64,315 Average sales price per mcf $ 3.71 $ 1.86 Average cost (per mcf) $ 1.91 $ 1.91
Changes in estimated reserve quantities The net interest in estimated quantities of proved developed and undeveloped reserves of crude oil and natural gas and changes in such quantities and discounted future net cash flow were as follows:
(Unaudited) - Unescalated ---------------------------------------------------------- Discounted MCF Future Net Cash Flow Cubic Feet (10% Discount) -------------------------------------- ------------------ Seven Months Seven Months Year Ended Ended Ended December 31, 2003 December 31, 2002 December 31, 2002 ------------------ ------------------ ------------------ Proved developed and undeveloped reserves: Beginning of period 585,603 -- Purchase of reserves in place -- 649,918 Exchange of reserves in place (1) (504,087) -- Production (81,516) (64,315) ------------------ ------------------ End of period -- 585,603 ================== ================== Proved developed producing -- 489,684 $ 793,481 Proved undeveloped -- 95,919 94,947 ------------------ ------------------ ------------------ Total proved reserves -- 585,603 $ 888,428 ================== ================== ==================
The standardized measure has been prepared assuming year end sales prices adjusted for fixed and determinable contractual price changes, current costs. No provision has been made for income taxes due to available operating loss carryforwards. No deduction has been made for depletion, depreciation or any indirect costs such as general corporate overhead or interest expense. -97- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) Standardized measure of discounted future net cash flows from estimated production of proved gas reserved: Seven Months Ended December 31, 2002 ------------------- Future cash inflows $ 1,756,809 Future production and development costs (705,505) ----------------- Future net cash flows 1,051,304 10% annual discount for estimated timing of cash flows (162,876) --------------- Standardized measure of discounted future net cash flows $ 888,428 =============== Changes in standard measure of discounted future net cash flows from proved gas reserves:
Seven Months Year Ended Ended December 31, 2003 December 31, 2002 ------------------- ------------------ Standardized measure - beginning of period $ 888,428 $ -- Purchase of reserves in place -- 652,628 Exchange of reserves in place (1) (825,228) -- Sales of gas produced, net of production costs (63,200) 235,800 ------------------- ------------------ Standardized measure - end of period $ -- $ 888,428 =================== ==================
(1) During June 2003, RMG contributed proved and unproved properties in exchange for a 37.5% interest in Pinnacle (See Note F). -98- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) N. TRANSITION PERIOD COMPARATIVE DATA The following table presents certain financial information for the seven months ended December 31, 2002 and 2001, respectively:
Seven Months Ended December 31, -------------------------- 2002 2001 ------------ ------------ (Unaudited) Revenues $ 673,000 $ 545,900 Costs and expenses 4,197,900 4,460,800 ------------ ------------ Operating loss (3,524,900) (3,914,900) Other income and expenses (387,100) 1,005,000 ------------ ------------ Loss before minority interest (3,912,000) (2,909,900) Minority interest in loss of subsidiaries 54,800 24,500 ------------ ------------ Loss before income taxes (3,857,200) (2,885,400) Provision for income taxes -- -- ------------ ------------ Net loss from continuing operations (3,857,200) (2,885,400) Discontinued operations, net of tax 17,100 175,000 ------------ ------------ Net loss (3,840,100) (2,710,400) Preferred stock dividends -- (75,000) ------------ ------------ Net loss available to common stock shareholders $(3,840,100) $(2,785,400) ============ ============ PER SHARE DATA: Revenues $ 0.06 $ 0.07 Operating loss (0.33) (0.47) =========== =========== Loss from continuing operations (0.36) (0.35) =========== =========== Net loss (0.36) (0.33) Preferred Stock dividends -- (0.01) ------------ ------------ Net loss available to common stock shareholders $ (0.36) $ (0.34) ============ ============ Weighted average common shares outstanding Basic 10,770,658 8,386,672 ============ ============ Diluted 10,770,658 8,386,672 ============ ============
-99- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) O. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Three Months Ended ----------------------------------------------------------- December 31, September 30, June 30, March 31, 2003 2003 2003 2003 -------------- --------------- ------------ ------------ Operating Revenues $ 109,000 $ 119,300 $ 241,300 $ 367,700 ============= ============== =========== =========== Operating loss $ (1,664,800) $ (1,988,400) $(2,418,800) $(1,165,900) ============= ============== =========== =========== (Loss) income from continuing operations $ (1,780,800) $ (1,893,000) $(2,214,100) $(1,187,900) Discontinued operations, net of tax $ (124,800) $ (88,700) $ (17,400) $ (119,000) Cumulative effect of accounting change $ -- $ -- $ -- $ 1,615,600 ------------- -------------- ----------- ----------- Net (loss) income $ (1,905,600) $ (1,981,700) $(2,231,500) $ 308,700 ============= ============== =========== =========== (Loss) income per Share, basic Continuing operations $ (0.16) $ (0.17) $ (0.20) $ (0.11) Discontinued operations $ (0.01) $ (0.01) $ -- $ (0.01) Cumulative effect of accounting change $ -- $ -- $ -- $ 0.15 -------------- --------------- ------------ ------------ $ (0.17) $ (0.18) $ (0.20) $ 0.03 ============== =============== ============ ============ Basic weighted average shares outstanding 11,383,576 11,127,796 10,916,971 10,881,394 (Loss) per share, diluted Continued operations $ (0.17) $ (0.17) $ (0.20) $ (0.10) Discontinued operations $ (0.01) $ (0.01) $ -- $ (0.01) $ -- $ -- $ -- $ 0.14 -------------- --------------- ------------ ------------ $ (0.17) $ (0.18) $ (0.20) $ 0.03 ============== =============== ============ ============ Diluted weighted average shares outstanding 11,383,576 11,127,796 10,916,971 11,385,593
-100- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued)
Month Ended Three Months Ended ---------------------------- December 31, November 30, August 31, 2002 2002 2002 -------------- -------------- ------------ Operating Revenues $ 74,300 $ 359,600 $ 221,400 ============= ============= =========== Operating (loss) $ (664,200) $ (1,487,500) $(1,390,400) ============= ============= =========== Loss from continuing operations $ (1,427,200) $ (1,195,600) $(1,252,200) Discontinued operations, net of tax $ (26,400) $ (69,100) $ 130,400 -------------- -------------- ------------ Net loss $ (1,453,600) $ (1,264,700) $(1,121,800) ============== ============== ============ Loss per Share, basic and diluted Continuing operations $ (0.14) $ (0.11) $ (0.11) Discontinued operations $ -- $ (0.01) $ 0.01 -------------- -------------- ------------ $ (0.14) $ (0.12) $ (0.10) ============== ============== ============ Basic and diluted weighted average shares outstanding 10,766,672 10,765,889 10,761,093
Three Months Ended ---------------------------------------------------------- May 31, February 28, November 30, August 31, 2002 2002 2001 2001 ------------ -------------- -------------- ------------ Operating Revenues $ 408,800 $ 238,700 $ 724,200 $ 632,400 =========== ============= ============= =========== Operating (loss) $(1,588,300) $ (3,066,700) $ (1,197,600) $(1,601,600) =========== ============= ============= =========== Loss from continuing operations $(1,109,700) $ (3,172,000) $ (550,900) $(1,349,100) Discontinued operations, net of tax $ (22,200) $ (9,600) $ (37,300) $ (16,800) ------------ -------------- -------------- ------------ Net loss $(1,131,900) $ (3,181,600) $ (588,200) $(1,365,900) ============ ============== ============== ============ Loss per Share, basic and diluted Continuing operations $ (0.10) $ (0.32) $ (0.07) $ (0.17) Discontinued operations $ (0.01) $ -- $ -- $ -- ------------ -------------- -------------- ------------ $ (0.11) $ (0.32) $ (0.07) $ (0.17) ============ ============== ============== ============ Basic and diluted weighted average shares outstanding 10,579,828 9,837,494 8,580,904 8,192,316
Quarterly and year to day computation of per share amounts are made independently. Therefore, the sum of quarterly per share amounts may not agree with per share amounts for the year. -101- U.S. ENERGY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002, MAY 31, 2002 AND MAY 31, 2001 (Continued) P. SUBSEQUENT EVENT ROCKY MOUNTAIN GAS, INC. On January 30, 2004 the Company's affiliate, RMG, acquired Wyoming coalbed methane (CBM) properties from a non-affiliated party. The purchase price of $6.8 million was paid with $5.0 million of cash, $500,000 in a 30 day secured note, $600,000 in restricted USE stock and $700,000 in restricted RMG stock. RMG financed $3.7 million of the cash component from a recently established $25 million credit facility arranged by Petrobridge Investment Management, LLC (Petrobridge), a mezzanine lender headquartered in Houston, TX. As defined by the agreement, terms under the credit facility include the following: (1) Advances under the credit facility are subject to lenders approval; (2) All revenues from oil and gas properties securing the credit facility will be paid to a lock bos controlled by the lender. All disbursements for lease operating costs, revenue distributions and operating expenses will require approval by the lender before distributions are made, and (3) The Company must maintain certain financial ratios and production volume, among other things. The properties acquired include 247 completed wells of which 138 wells were producing at the time of the acquisition, approximately 6.0 million cubic feet of gas per day (mmcfd) (approximately 3.2 mmcfd net to RMG) and 40,120 undeveloped fee acres, of which RMG owns 100%. RMG will operate 89% of the wells and owns an average 58% working interest in the producing wells and a 100% working interest in all of the undeveloped acreage. The properties purchased serve as the sole collateral for the credit facility. With the acquisition, RMG's gross and net acreage holdings increase to approximately 264,300 and 128,200, respectively. SUTTER GOLD MINING CO. On January 5, 2004, the Company, through Suttter, entered into a Letter of Intent to merge, via a reverse takeover, with Globemin Resources, Inc. a public company headquartered in Vancouver, Canada. Pursuant to the Letter of Intent, after the reverse trakeover is closed, Sutter plans on raising equity funds and begin further exploration work on the properties and the construction of a new secondary access raise to comply with US Mine Safety Health Administration regulations and improve ventilation as well as to better define known mineralization. The exploration work will be run through the Comet mineralized zone as soon as funds are made available through equity or debt financing. The current resource production plan is to initially produce a stockpile of mineralized material sufficient to operate a mill at 300 tons-per-day (tpd) while the mill is being built. The second stage of development will be to construct a conventional 300 tpd mill on site, which will be designed so that it can easily be expanded to accommodate the planned production of 500 tpd. Closing of the reverse takeover is subject to negotiation and approval of the share exchange agreements by the directors and shareholders of both companies and approval by Canadian Regulatory Authorities. -102- REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON SCHEDULE To U.S. Energy Corp: In connection with our audit of the consolidated financial statements of U.S. Energy Corp. and subsidiaries referred to in our report dated February 27, 2004, which is included in the Company's annual report on Form 10-K, we have also audited Schedule II for the year ended December 31, 2003, the seven months ended December 31, 2002 and the years ended May 31, 2002 and 2001. In our opinion, this schedule presents fairly, in all material respects, the information to be set forth therein. GRANT THORNTON LLP Oklahoma City, Oklahoma February 27, 2004 -103- U.S. ENERGY CORP. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Balance Additions beginning charged to Deductions Balance end of period expenses and Other of period ---------- ---------- ---------- ------------ May 31, 2001 $ 27,800 -- -- $ 27,800 ========== ========== ========== ============ May 31, 2002 $ 27,800 -- -- $ 27,800 ========== ========== ========== ============ December 31, 2002 $ 27,800 -- -- $ 27,800 ========== ========== ========== ============ December 31, 2003 $ 27,800 -- -- $ 27,800 ========== ========== ========== ============
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. ITEM 9A. CONTROLS AND PROCEDURES The Company's Principal Executive Officer and Principal Financial Officer have reviewed and evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rule 240.13a-15(e)) as of the end of the period covered by this report. Based on that evaluation, the Principal Executive Officer and the Principal Financial Officer have concluded that the Company's current disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. There was no change in the Company's internal controls that occurred during the fourth quarter of the period covered by this report that has materially affected, or is reasonably likely to affect, the Company's internal controls over financial reporting. -104- PART III In the event a definitive proxy statement containing the information being incorporated by reference into this Part III is not filed within 120 days of December 31, 2003, we will file such information under cover of a Form 10-K/A. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by Item 10 with respect to directors and certain executive officers is incorporated herein by reference to our Proxy Statement for the Meeting of Shareholders to be held in June 2004, under the captions "Proposal 1: Election of Directors," Filing of Reports Under Section 16(a)," and" Business Experience and Other Directorships of Directors and Nominees." The information regarding the remaining executive officers follows: The Company has adopted a Code of Ethics. A copy of the Code of Ethics will be provided to any person, without charge, upon written request addressed to Daniel P. Svilar, Secretary, 877 N. 8th W., Riverton, Wyoming 82501. INFORMATION CONCERNING EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS. The following are the two executive officers of USE as of the date of this Form 10-K; these persons devote their full time to the Company's business. ROBERT SCOTT LORIMER, age 53, has been the Chief Accounting Officer for both USE and Crested for more than the past five years. Mr. Lorimer also has been Chief Financial Officer for both these companies since May 25, 1991, their Treasurer since December 14, 1990, and Vice President Finance since April 1998. He serves at the will of each board of directors. There are no understandings between Mr. Lorimer and any other person, pursuant to which he was named as an officer, and he has no family relationship with any of the other executive officers or directors of USE or Crested. During the past five years, Mr. Lorimer has not been involved in any Reg. S-K Item 401(f) listed proceeding. DANIEL P. SVILAR, age 75, has been General Counsel for USE and Crested for more than the past five years. He also has served as Secretary and a director of Crested, and Assistant Secretary of USE. On March 25, 2002, Mr. Svilar was appointed Secretary of USE. His positions of General Counsel to, and as officers of the companies, are at the will of each board of directors. There are no understandings between Mr. Svilar and any other person pursuant to which he was named as officer or General Counsel. He has no family relationships with any of the other executive officers or directors of USE or Crested, except his nephew Nick Bebout is a USE director. During the past five years, Mr. Svilar has not been involved in any Reg. S-K Item 401(f) proceeding. ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 is incorporated herein by reference to the Proxy Statement for the Meeting of Shareholders to be held in June 2004, under the captions "Executive Compensation" and "Director's Fees and Other Compensation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS MATTERS. The information required by Item 12 is incorporated herein by reference to the Proxy Statement for the Meeting of Shareholders to be held in June 2004, under the caption "Principal Holders of Voting Securities." -105- ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Item 13 is incorporated herein by reference to the Proxy Statement for the Meeting of Shareholders to be held in June 2004, under the caption "Certain Relationships and Related Transactions." ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES (1) - (4) Grant Thornton LLP billed us as follows for the year ended December 31, 2003 and the seven months ended December 31, 2002: Year Ended Seven Months Ended December 31, 2003 December 31, 2002 Audit Fees(a) $ 80,100 $ 68,900 Audit-Related Fees(b) $ -- $ -- Tax Fees(c) $ 15,800 $ 8,000 All Other Fees(d): $ 13,100 $ 11,000 (a) Includes fees for audit of the annual financial statements and review of quarterly financial information filed with the Securities and Exchange Commission ("SEC"). (b) For assurance and related services that were reasonably related to the performance of the audit or review of the financial statements, which fees are not included in the Audit Fees category. The Company had no Audit-Related Fees for the periods ended December 31, 2003, and 2002, respectively. (c) For tax compliance, tax advice, and tax planning services, relating to any and all federal and state tax returns as necessary for the periods ended December 31, 2003 and 2002, respectively. (d) For services in respect of any and all other reports as required by the SEC and other governing agencies. (5)(i) Our audit committee approves the terms of engagement before we engage Grant Thornton for audit and non-audit services, except as to engagements for services outside the scope of the original terms, in which instances the services have been provided pursuant to pre-approval policies and procedures, established by the audit committee. These pre-approval policies and procedures are detailed as to the category of service and the audit committee is kept informed of each service provided. These policies and procedures, and the work performed pursuant thereto, do not include delegation any delegation to management of the audit committees responsibilities under the Securities Exchange Act of 1934. (5)(ii) The percentage of services provided for Audit-Related Fees, Tax Fees and All Other Fees, which services were delivered pursuant to pre-approval policies and procedures established by the audit committee, in 2003 (and the seven months ended December 31, 2002) were: Audit-Related Fees 74% (78%); Tax Fees 14% (9%); and All Other Fees 12% (13%). -106- ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, REPORTS AND FORMS 8-K. (a) Financial Statements and Exhibits (1) The following financial statements are filed as a part of the Report in Item 8: Consolidated Financial Statements Page No. --------- U.S. Energy Corp. and Subsidiaries Report of Independent Public Accountants Grant Thornton LLP . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Consolidated Balance Sheets - December 31, 2003, and December 31, 2002 and May 31, 2002 . . . . . . . . . . . . . . .54-55 Consolidated Statements of Operations for the Year Ended December 31, 2003, the Seven Months Ended December 31, 2002 and the Years Ended May 31, 2002 and 2001. . . . . . . . . . .56-57 Consolidated Statements of Shareholders' Equity for the Year Ended December 31, 2003, the Seven Months Ended December 31, 2002, and the Years Ended May 31, 2002 and 2001. . . . . . . . . . .58-61 Consolidated Statements of Cash Flows for the Year Ended December 31, 2003, the Seven Months Ended December 31, 2002, and the Years Ended May 31, 2002 and 2001. . . . . . . . . . .62-64 Notes to Consolidated Financial Statements . . . . . . . . . . . 65-102 Report of Independent Certified Public Accountants on Schedule. . . . . . . . . . . . . . . . . . . .103 Schedule II - Valuation and Qualifying Accounts. . . . . . . . . .104 (2) All other schedules have been omitted because the required information in inapplicable or is shown in the notes to financial statements. (3) Exhibits
SEQUENTIAL EXHIBIT NO. TITLE OF EXHIBIT PAGE NO. - ------------ ---------------- -------- 3.1 USE Restated Articles of Incorporation. . . . . . . . . . . . . [2] 3.1(a) USE Articles of Amendment to Restated Articles of Incorporation . . . . . . . . . . . . . . . [4] 3.1(b) USE Articles of Amendment (Second) to Restated Articles of Incorporation (Establishing Series A Convertible Preferred Stock . . . . . . . [9] -107- 3.1(c) Articles of Amendment (Third) to Restated Articles of Incorporation (Increasing number of authorized shares) . . . . . . . . . . . . [14] 3.1(d) Articles of Amendment to the Articles of Incorporation of Rocky Mountain Gas, Inc. (to establish Series A Preferred Stock in March 2004). . . . . . * 3.2 USE Bylaws, as amended through April 22, 1992. . . . . . . . . . [4] 4.1 Amendment to USE 1998 Incentive Stock Option Plan .. . . . . .. [11] 4.2 USE 1998 Incentive Stock Option Plan and Form of Stock Option Agreement . . . . . . . . . . . . . . . [8] 4.3-4.8 [intentionally left blank] 4.9 Form of USE Warrant held by investors in RMG (Caydal, LLC-31,250, Karns-6,250, Monahan/Cotner-1,875, Van Buren-1,250, 2nd McCaughey-6,250). . . . . . . . . . . . . . [23] 4.10 [intentionally left blank] 4.11 Rights Agreement, dated as of September 19, 2001 between U.S. Energy Corp. and Computershare Trust Company, Inc. as Rights Agent. The Articles of Amendment to Articles of Incorporation creating the Series P Preferred Stock is included herewith as an exhibit to the Rights Agreement. Form of Right Certificate (as an exhibit to the Rights Agreement). Summary of Rights, which will be sent to all holders of record of the outstanding shares of Common Stock of the registrant, also included as an exhibit to the Rights Agreement.. . . . . . . . . . . . . . . . . . . . . . . . [12] 4.12-4.20 [intentionally left blank] 4.21 USE 2001 Officers' Stock Compensation Plan . . . . . . . . . . . [18] 4.22-4.23 [intentionally left blank] 4.24 Form of warrant held by Sanders Morris Harris, Inc.. . . . . . . . . . . . . . . . . . . [23] 4.25 [intentionally left blank] 4.26 Exchange Agreement (for conversion of RMG shares into USE shares) . . . . . . . . . . . . . . . . . [23] 4.26(a) Form of Amendment to Exchange Agreement (Caydal and McCaughey) . . . . . . . . . . . . . . . . . . . . . [23] -108- 4.26(b) Form of Amendment to Exchange Agreement (Karns, Monahan/Cotner,Van Buren). . . . . . . . . . . . . . . . [23] 4.27 Form of warrant held by McKim & Company- 19,500 and John Schlie-3,000. . . . . . . . . . [23] 4.28 Amendment to Secured Convertible Note (Caydal) . . . . . . . . . [23] 4.29 Amendment to Secured Convertible Note (Tsunami) .. . . . . . . . [23] 4.30 Form of Warrant (issued to mezzanine credit facility lenders). . * 10.1 USECC Joint Venture Agreement. . . . . . . . . . . . . . . . . . [1] 10.2 Management Agreement with USECC. . . . . . . . . . . . . . . . . [3] 10.3-10.60 [intentionally left blank] 10.61 Closing Agreement - Addendum to Agreement for Purchase and Sale of Assets (see Exhibit 10.62). . . . . . . [11] 10.62 Agreement for Purchase and Sale of Assets (Rocky Mountain Gas, Inc. and Quantum Energy LLC). . . . . . . . [9] 10.63 Purchase and Sale Agreement CCBM, Inc. (subsidiary of Carrizo Oil & Gas, Inc.) and Rocky Mountain Gas, Inc. . . . . . . . . . . . . . . . . . . [16] 10.64 [intentionally left blank] 10.65 Convertible Promissory Note and Security Agreement dated May 30, 2002. . . . . . . . . . . . . . [17] 10.66 Convertible Promissory Note and Security Agreement dated November 19, 2002 . . . . . . . . . . . [19] 10.67 Contribution and Subscription Agreement (to which RMG, Pinnacle Gas Resources and others are parties). . . . . . . [22] 10.68 Purchase and Sale Agreement, with three amendments (for purchase of Hi - Pro assets). . . . . . . . . . . . . . . . [24] 10.69 Credit Agreement (mezzanine credit facility with Petrobridge Investment Management) . . . . . . . . . . . . . . . [24] 10.70 Stock Purchase Agreement (sale of stock of subsidiary Canyon Resources, Inc., owner of Utah commercial properties). . . . . . * 14.0 Code of Ethics . . . . . . . . . . . . . . . . . . . . . . . . . * 21.1 Subsidiaries of Registrant . . . . . . . . . . . . . . . . . . . [11] -109- 23.0 Consent of Netherland, Sewell & Associates, Inc., independent petroleum engineers. . . . . . . . . . . . . . . . . . . . . . . * 31.1 Certification under Rule 13a-14(a) John L. Larsen. . . . . . . . * 31.2 Certification under Rule 13a-14(a) Robert Scott Lorimer. . . . . * 32.1 Certification under Rule 13a-14(b) John L. Larsen. . . . . . . . * 32.2 Certification under Rule 13a-14(b) Robert Scott Lorimer. . . . . *
* Filed herewith _____________ [1] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended May 31, 1989, filed August 29, 1989. [2] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended May 31, 1990, filed September 14, 1990. [3] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended May 31, 1991, filed September 13, 1991. [4] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended May 31, 1992, filed September 14, 1991. [5] Intentionally left blank. [6] Intentionally left blank. [7] Intentionally left blank. [8] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended May 31, 1998, filed September 14, 1998. [9] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended May 31, 2000, filed September 13, 2000. [10] Intentionally left blank. [11] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended on May 31, 2001, filed August 29, 2001, and amended on June 18, 2002 and September 25, 2002. [12] Incorporated by reference to exhibit number 4.1 to the Registrant's Form 8-A12G filed, September 20, 2001. [13] Incorporated by reference from the like-numbered exhibit to the Registrant's Form S-3 registration statement (SEC File No. 333-73546), filed November 16, 2001. [14] Incorporated by reference from the like-numbered exhibit to the Registrant's Form S-3 registration statement (SEC File No. 333-75864), filed December 21, 2001. -110- [15] Intentionally left blank. [16] Incorporated by reference from the like-numbered exhibit to the Registrant's Form S-3 registration statement, amendment no. 1 (SEC File No. 333-83040), filed May 17, 2002. [17] Incorporated by reference from the like-numbered exhibit to the Registrant's Form 8-K, filed June 6, 2002. [18] Incorporated by reference from the like-numbered exhibit to the Registrant's Annual Report on Form 10-K for the year ended May 31, 2002, filed September 13, 2002. [19] Incorporated by reference from the like-numbered exhibit to the Registrant's Form 8-K, filed December 9, 2002. [20] Intentionally left blank. [21] Intentionally left blank. [22] Incorporated by reference from the exhibit filed with the Registrant's Form 8-K, filed July 15, 2003 [23] Incorporated by reference from the like-numbered exhibit to the Registrant's Form S-3 registration statement (SEC File No. 333-110882), filed December 3, 2003. [24] Incorporated by reference from the exhibit filed with the Registrant's Form 8-K, filed March 5, 2004. _________________ (b) Reports on Form 8-K. In the last quarter of 2003, the Registrant filed four Reports on Form 8-K, all for Item 5 events, on November 5, 12 and 20, and December 24, 2003. (c) See paragraph a(3) above for exhibits. (d) Financial statement schedules, see paragraph (a)(1) above. No other financial statements are required to be filed. -111- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amended report to be signed on its behalf by the undersigned, thereunto duly authorized. U.S. ENERGY CORP. (Registrant) Date: March 26, 2004 By: /s/ John L. Larsen --------------------------------------- John L. Larsen, 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: March 26, 2004 By: /s/ John L. Larsen --------------------------------------- John L. Larsen, Director Date: March 26, 2004 By: /s/ Keith G. Larsen --------------------------------------- Keith G. Larsen, Director Date: March 26, 2004 By: /s/ Harold F. Herron --------------------------------------- Harold F. Herron, Director Date: March 26, 2004 By: /s/ Don C. Anderson --------------------------------------- Don C. Anderson, Director Date: March 26, 2004 By: /s/ Nick Bebout --------------------------------------- Nick Bebout, Director Date: March 26, 2004 By: /s/ H. Russell Fraser --------------------------------------- H. Russell Fraser, Director Date: March 26, 2004 By: /s/ Michael T. Anderson --------------------------------------- Michael T. Anderson, Director Date: March 26, 2004 By: /s/ R. Scott Lorimer --------------------------------------- Robert Scott Lorimer, Principal Financial Officer/ Chief Accounting Officer -112-
EX-3.1(D) 3 doc2.txt ARTICLES OF AMENDMENT RMG Amended and Restated Articles of Amendment to the Articles of Incorporation of Rocky Mountain Gas, Inc. The articles of incorporation of Rocky Mountain Gas, Inc. (the "Corporation") are amended by the creation of Series A Preferred Stock, pursuant ----------- to W.S. 17-16-602(d) of the Wyoming Business Corporation Act (the "Act"): --- (i) The name of the Corporation is Rocky Mountain Gas, Inc. (ii) The text of the amendment, to create the Series A Preferred Stock out of the general unlimited class of preferred stock, follows. No change is made to the provisions of article FOURTH of the original articles of incorporation with respect to the common stock. TERMS OF SERIES A PREFERRED STOCK Section 1. Designation, Amount and Par Value. The series of preferred stock --------------------------------- shall be designated as its 10% Series A Convertible Preferred Stock (the "Preferred Stock") and the number of shares so designated shall be 1,333,333 ---------------- (which shall not be subject to increase without the consent of all of the holders of the Preferred Stock (each, a "Holder" and collectively, the ------ "Holders")). Each share of Preferred Stock shall have no par value and a stated ------- value equal to $3.00 (the "Stated Value"). Capitalized terms not otherwise ------------- defined herein shall have the meaning given such terms in Section 8 hereof. Section 2. Dividends. --------- (a) Holders shall be entitled to receive and the Corporation shall pay, cumulative dividends at the rate per share (as a percentage of the Stated Value per share) of 10% per annum (subject to increase pursuant to Sections 6(a) and 7(a)), payable annually on March 1, beginning with March 1, 2005 and on any Conversion Date (except that, if such date is not a Trading Day, the payment date shall be the next succeeding Trading Day)("Dividend -------- Payment Date"). The form of dividend payments to each Holder shall be made, ------------ (i) if funds are legally available for the payment of dividends and the Equity Conditions are not met, in cash only, (ii) if funds are legally available for the payment of dividends and the Equity conditions are met, subject to the notice conditions contained herein, at the option of the Corporation, (A) in cash (in lieu thereof and at the option of a Holder, the Holder may elect to receive shares of Corporation Common Stock which shall be valued at $3.00 per share (subject to adjustment for any stock splits, reverse splits and similar capital events after the Original Issuance Date)) or (B) in Parent Common Stock, which shall be valued at 90% of the average of the 5 VWAPs immediately prior to the Dividend Payment Date (but in no event less than $1.50 per share, as adjusted for any stock splits or similar capital events subsequent to the Original Issue Date) or (iii) if funds are not legally available for the payment of dividends and the Equity conditions are met, in Parent Common Stock, which shall be valued at 90% of the average of the 5 VWAPs immediately prior to the Dividend Payment Date (but in no event less than $1.50 per share, as adjusted for any stock splits or similar capital events subsequent to the Original Issue Date), and (iv) if funds are not legally available for the payment of dividends and the Equity conditions are not met, at the election of the Holder, (A) in unregistered Parent Common Stock, which shall be valued at 90% of the average of the 5 VWAPs immediately prior to the Dividend Payment Date (but in no event less than $1.50 per share, as adjusted for any stock splits or similar capital events subsequent to the Original Issue Date), (B) in shares of Corporation Common Stock which shall be valued at $3.00 per share (subject to adjustment for any stock splits, reverse splits and similar capital events after the Original Issuance Date), (C) by the accrual of such dividend payment to the next Dividend Payment Date or (D) by the accretion of such dividend payment to the outstanding Stated Value. The Holders shall have the same rights and remedies with respect to the delivery of any such shares as if such shares were being issued pursuant to Section 5. 30 days prior to the first Interest Payment Date, the Corporation shall have notified the Holders whether it may lawfully pay cash dividends. The Corporation shall promptly notify the Holders at any time the Corporation shall become able or unable, as the case may be, to lawfully pay cash dividends. If at any time the Corporation has the right to pay dividends in cash and Parent Common Stock, the Corporation must provide the Holder with at least 20 Trading Days' prior notice of its election to pay a regularly scheduled dividend in Parent Common Stock. Dividends on the Preferred Stock shall be calculated on the basis of a 360-day year, shall accrue daily commencing on the Original Issue Date, and shall be deemed to accrue from such date whether or not earned or declared and whether or not there are profits, surplus or other funds of the Corporation legally available for the payment of dividends. Any dividends, whether paid in cash or shares, that are not paid within three Trading Days following a Dividend Payment Date shall continue to accrue and shall entail a late fee, which must be paid in cash, at the rate of 18% per annum or the lesser rate permitted by applicable law (such fees to accrue daily, from the Dividend Payment Date through and including the date of payment). (b) So long as any Preferred Stock shall remain outstanding, neither the Corporation nor any subsidiary thereof shall redeem, purchase or otherwise acquire directly or indirectly any Junior Securities. So long as any Preferred Stock shall remain outstanding, neither the Corporation nor any subsidiary thereof shall directly or indirectly pay or declare any dividend or make any distribution (other than a dividend or distribution described in Section 5 or dividends due and paid in the ordinary course on preferred stock of the Corporation at such times when the Corporation is in compliance with its payment and other obligations hereunder) upon, nor shall any distribution be made in respect of, any Junior Securities so long as any dividends due on the Preferred Stock remain unpaid, nor shall any monies be set aside for or applied to the purchase or redemption (through a sinking fund or otherwise) of any Junior Securities or shares pari passu with the Preferred Stock. Section 3. Voting Rights. Except as otherwise provided herein and as -------------- otherwise required by law, the Preferred Stock shall have no voting rights. However, so long as any shares of Preferred Stock are outstanding, the Corporation shall not, without the affirmative vote of the Holders of a seventy-five percent majority of the shares of the Preferred Stock then outstanding, (a) alter or change adversely the powers, preferences or rights given to the Preferred Stock or alter or amend this Certificate of Designation, (b) authorize or create any class of stock ranking as to dividends, redemption or distribution of assets upon a Liquidation (as defined in Section 4) senior to or otherwise pari passu with the Preferred Stock, (c) amend its certificate of incorporation or other charter documents so as to affect adversely any rights of the Holders, (d) increase the authorized number of shares of Preferred Stock, or (e) enter into any agreement with respect to the foregoing. Section 4. Liquidation. Upon any liquidation, dissolution or winding-up of ----------- the Corporation, whether voluntary or involuntary (a "Liquidation"), the Holders ----------- shall be entitled to receive out of the assets of the Corporation, whether such assets are capital or surplus, for each share of Preferred Stock an amount equal to the $4.05 per share plus any accrued and unpaid dividends thereon and any other fees or liquidated damages owing thereon before any distribution or payment shall be made to the holders of any Junior Securities, and if the assets of the Corporation shall be insufficient to pay in full such amounts, then the entire assets to be distributed to the Holders shall be distributed among the Holders ratably in accordance with the respective amounts that would be payable on such shares if all amounts payable thereon were paid in full. A Fundamental Transaction or Change of Control Transaction shall not be treated as a Liquidation. The Corporation shall mail written notice of any such Liquidation, not less than 45 days prior to the payment date stated therein, to each record Holder. Section 5. Conversion. ---------- (a) (i) Conversions at Option of Holder. Each share of Preferred Stock shall be convertible into that number of shares of Parent Common Stock (subject to the limitations set forth in Sections 5(a)(ii) and (iii)) or Corporation Common Stock determined by dividing the Stated Value of such share of Preferred Stock by the applicable Set Price, at the option of the Holder, at any time and from time to time from and after the Original Issue Date. Holders shall effect conversions by providing the Corporation with the form of conversion notice attached hereto as Annex A (a "Conversion ------- ---------- Notice"). Each Conversion Notice shall specify the number of shares of ------ Preferred Stock to be converted (which shall not be less than 25,000 shares, unless the Holder then holds less than 25,000 shares), the number of shares of Preferred Stock owned prior to the conversion at issue, the number of shares of Preferred Stock owned subsequent to the conversion at issue and the date on which such conversion is to be effected, which date may not be prior to the date the Holder delivers such Conversion Notice to the Corporation by facsimile (the "Conversion Date"). If no Conversion Date --------------- is specified in a Conversion Notice, the Conversion Date shall be the date that such Conversion Notice to the Corporation is deemed delivered hereunder. The calculations and entries set forth in the Conversion Notice shall control in the absence of manifest or mathematical error. (ii) Beneficial Ownership Limitation. The Corporation shall not effect any conversion of the Preferred Stock into Parent Common Stock, and the Holder shall not have the right to convert any portion of the Preferred Stock into Parent Common Stock to the extent that after giving effect to such conversion, the Holder (together with the Holder's affiliates), as set forth on the applicable Conversion Notice, would beneficially own in excess of 4.99% of the number of shares of the Parent Common Stock outstanding immediately after giving effect to such conversion. For purposes of the foregoing sentence, the number of shares of Parent Common Stock beneficially owned by the Holder and its affiliates shall include the number of shares of Parent Common Stock issuable upon conversion of the Preferred Stock with respect to which the determination of such sentence is being made, but shall exclude the number of shares of Parent Common Stock which would be issuable upon (A) conversion of the remaining, nonconverted Stated Value of Preferred Stock beneficially owned by the Holder or any of its affiliates and (B) exercise or conversion of the unexercised or nonconverted portion of any other securities of the Parent (including the Warrants) subject to a limitation on conversion or exercise analogous to the limitation contained herein beneficially owned by the Holder or any of its affiliates. Except as set forth in the preceding sentence, for purposes of this Section 5(a)(ii), beneficial ownership shall be calculated in accordance with Section 13(d) of the Exchange Act. To the extent that the limitation contained in this Section 5(a)(ii) applies, the determination of whether the Preferred Stock is convertible (in relation to other securities owned by the Holder together with any affiliates) and of which shares of Preferred Stock is convertible shall be in the sole discretion of such Holder, and the submission of a Conversion Notice into Parent Common Stock shall be deemed to be such Holder's determination of whether the shares of Preferred Stock may be converted (in relation to other securities owned by such Holder) and which shares of the Preferred Stock is convertible, in each case subject to such aggregate percentage limitations. To ensure compliance with this restriction, the Holder will be deemed to represent to the Corporation each time it delivers a Conversion Notice that such Conversion Notice has not violated the restrictions set forth in this paragraph and the Corporation shall have no obligation to verify or confirm the accuracy of such determination. For purposes of this Section 5(a)(ii), in determining the number of outstanding shares of Parent Common Stock, the Holder may rely on the number of outstanding shares of Parent Common Stock as reflected in the most recent of the following: (A) the Parent's most recent Form 10-Q or Form 10-K, as the case may be, (B) a more recent public announcement by the Parent or (C) any other notice by the Parent or the Parent's transfer agent setting forth the number of shares of Parent Common Stock outstanding. In any case, the number of outstanding shares of Parent Common Stock shall be determined after giving effect to the conversion or exercise of securities into Parent Common Stock, including the Preferred Stock, by the Holder or its affiliates since the date as of which such number of outstanding shares of Parent Common Stock was reported. (iii) Limitation on Number of Shares Issuable. Notwithstanding anything herein to the contrary, the Corporation shall not issue to any Holder any shares of Parent Common Stock, including pursuant to any rights herein, including, without limitation, any conversion rights or right to issue shares of Common Stock in payment of dividends, to the extent such shares, when added to the number of shares of Parent Common Stock issued or issuable (A) upon conversion of any shares of Preferred Stock pursuant to Section 5(a)(i) and (B) upon exercise of those certain warrants issued pursuant to that certain Securities Purchase Agreement would exceed 2,479,327 [19.999% of the Parent's outstanding Parent Common Stock immediately prior to the Closing Date], or such greater or lesser number of shares of Parent Common Stock permitted pursuant to the corporate governance rules of the Nasdaq Stock Market Inc. or other Principal Market that is at the time the principal trading exchange or market for the Parent Common Stock, based upon share volume, as confirmed in writing by counsel to the Parent (the "Maximum Aggregate Share Amount"), unless the Parent ------------------------------ first obtains shareholder approval permitting such issuances in accordance with Nasdaq Stock Market Inc. rules or other Principal Market rules ("Shareholder Approval"). Each Holder shall be entitled to a portion of the -------------------- Maximum Aggregate Share Amount equal to the quotient obtained by dividing (x) such the number of shares of Preferred Stock initially purchased by such Holder by (y) the aggregate number of shares purchased by all Holders. Such portions shall be adjusted upward ratably in the event all of the shares of Preferred Stock of any Holder are no longer outstanding. If at any time the number of shares of Parent Common Stock which could, notwithstanding the limitation set forth herein, be issuable and sold to all Holders during the following 12 months (assuming all dividends are paid in shares of Parent Common Stock during such period of determination) equals or exceeds the Maximum Aggregate Share Amount, then the Preferred Stock shall thereafter only be convertible into Corporation Common Stock. (b) (i) Not later than five Trading Days after each Conversion Date (the "Share Delivery Date"), the Corporation shall deliver to the Holder (A) a --------------------- certificate or certificates which, after the Effective Date, shall be free of restrictive legends and trading restrictions (other than those required by Section 4.1 of the Purchase Agreement) representing the number of shares of Corporation Common Stock or Parent Common Stock being acquired upon the conversion of shares of Preferred Stock, and (B) a bank check in the amount of accrued and unpaid dividends (if the Corporation is required to pay accrued dividends in cash). After the Effective Date, the Corporation shall, upon request of the Holder, deliver any certificate or certificates required to be delivered by the Corporation under this Section which represent Parent Common Stock electronically through the Depository Trust Corporation or another established clearing corporation performing similar functions. If in the case of any Conversion Notice such certificate or certificates are not delivered to or as directed by the applicable Holder by the fifth Trading Day after the Conversion Date, the Holder shall be entitled to elect by written notice to the Corporation at any time on or before its receipt of such certificate or certificates thereafter, to rescind such conversion, in which event the Corporation shall immediately return the certificates representing the shares of Preferred Stock tendered for conversion. (ii) The Corporation's obligations to issue and deliver the Conversion Shares (whether of Corporation Common Stock or Parent Common Stock) upon conversion and redemption of Preferred Stock in accordance with the terms hereof are absolute and unconditional, irrespective of any action or inaction by the Holder to enforce the same, any waiver or consent with respect to any provision hereof, the recovery of any judgment against any Person or any action to enforce the same, or any setoff, counterclaim, recoupment, limitation or termination, or any breach or alleged breach by the Holder or any other Person of any obligation to the Corporation or any violation or alleged violation of law by the Holder or any other person, and irrespective of any other circumstance which might otherwise limit such obligation of the Corporation to the Holder in connection with the issuance of such Conversion Shares. If the Corporation fails to deliver to the Holder such certificate or certificates pursuant to Section 5(b)(i) by the Share Delivery Date applicable to such conversion, the Corporation shall pay to such Holder, in cash, as liquidated damages and not as a penalty, for each $5,000 of Stated Value of Preferred Stock being converted, $50 per Trading Day (increasing to $100 per Trading Day after 3 Trading Days and increasing to $200 per Trading Day 6 Trading Days after such damages begin to accrue) for each Trading Day after the Share Delivery Date until such certificates are delivered. Nothing herein shall limit a Holder's right to pursue actual damages for the Corporation's failure to deliver certificates representing shares of Corporation Common Stock or Parent Common Stock, as applicable, upon conversion within the period specified herein and such Holder shall have the right to pursue all remedies available to it hereunder, at law or in equity including, without limitation, a decree of specific performance and/or injunctive relief. (iii) If the Corporation fails to deliver to the Holder such certificate or certificates pursuant to Section 5(b)(i) by a Share Delivery Date, and if after such Share Delivery Date the Holder purchases (in an open market transaction or otherwise) Parent Common Stock to deliver in satisfaction of a sale by such Holder of the Conversion Shares which the Holder was entitled to receive upon the conversion relating to such Share Delivery Date (a "Buy-In"), then the Corporation shall pay in cash to the ------ Holder the amount by which (x) the Holder's total purchase price (including brokerage commissions, if any) for the Parent Common Stock so purchased exceeds (y) the product of (1) the aggregate number of shares of Parent Common Stock that such Holder was entitled to receive from the conversion at issue multiplied by (2) the price at which the sell order giving rise to such purchase obligation was executed. For example, if the Holder purchases Parent Common Stock having a total purchase price of $11,000 to cover a Buy-In with respect to an attempted conversion of shares of Preferred Stock with respect to which the aggregate sale price giving rise to such purchase obligation is $10,000, under clause (A) of the immediately preceding sentence the Corporation shall be required to pay the Holder $1,000. The Holder shall provide the Corporation written notice indicating the amounts payable to the Holder in respect of the Buy-In, together with applicable confirmations and other evidence reasonably requested by the Corporation. Nothing herein shall limit a Holder's right to pursue any other remedies available to it hereunder, at law or in equity including, without limitation, a decree of specific performance and/or injunctive relief with respect to the Corporation's failure to timely deliver certificates representing shares of Parent Common Stock or Corporation Common Stock upon conversion of the shares of Preferred Stock as required pursuant to the terms hereof. (c) (i) The conversion price for each share of Preferred Stock into Parent Common Stock shall be 90% of the average of the 5 VWAPs immediately prior to the Conversion Date (but in no event less than $1.50, as adjusted for any stock splits or similar capital events subsequent to the Original Issue Date), or in shares of the Corporation Common Stock which shall be valued at $3.00 per share (the "Set Price"), subject to adjustment as set forth --------- below. (ii) if the Corporation, at any time while the Preferred Stock is outstanding: (A) shall pay a stock dividend or otherwise make a distribution or distributions on shares of its Corporation Common Stock or any other equity or equity equivalent securities payable in shares of Corporation Common Stock, (B) subdivide outstanding shares of Corporation Common Stock into a larger number of shares, (C) combine (including by way of reverse stock split) outstanding shares of Corporation Common Stock into a smaller number of shares, or (D) issue by reclassification of shares of the Corporation Common Stock any shares of capital stock of the Corporation, then the Set Price shall be multiplied by a fraction of which the numerator shall be the number of shares of Corporation Common Stock Outstanding before such event and of which the denominator shall be the number of shares of Corporation Common Stock Outstanding after such event. Any adjustment made pursuant to this Section shall become effective immediately after the record date for the determination of stockholders entitled to receive such dividend or distribution and shall become effective immediately after the effective date in the case of a subdivision, combination or reclassification. (iii) if the Corporation, at any time while the Preferred Stock is outstanding, shall issue rights, options or warrants to all holders of Corporation Common Stock (and not to Holders) entitling them to subscribe for or purchase shares of Corporation Common Stock at a price per share less than the Set Price at the record date mentioned below, then the Set Price shall be multiplied by a fraction, of which the denominator shall be the number of shares of the Corporation Common Stock Outstanding on the date of issuance of such rights or warrants plus the number of additional shares of Corporation Common Stock offered for subscription or purchase, and of which the numerator shall be the number of shares of the Corporation Common Stock Outstanding on the date of issuance of such rights or warrants plus the number of shares which the aggregate offering price of the total number of shares so offered (assuming receipt by the Corporation in full of all consideration payable upon exercise of such rights, options or warrants) would purchase at the Set Price. Such adjustment shall be made whenever such rights or warrants are issued, and shall become effective immediately after the record date for the determination of stockholders entitled to receive such rights, options or warrants. (iv) if the Corporation or any subsidiary thereof at any time while the Preferred Stock is outstanding, shall offer, sell, grant any option or warrant to purchase or offer, sell or grant any right to reprice its securities, or otherwise dispose of or issue any Corporation Common Stock or any equity or equity equivalent securities (including any equity, debt or other instrument that is at any time over the life thereof convertible into or exchangeable for Corporation Common Stock) (collectively, "Common ------ Stock Equivalents") entitling any Person to acquire shares of Corporation ------------------ Common Stock, at an effective price per share less than the Set Price (a "Dilutive Issuance"), as adjusted hereunder (if the holder of the ------------------ Corporation Common Stock or Common Stock Equivalent so issued shall at any time, whether by operation of purchase price adjustments, reset provisions, floating conversion, exercise or exchange prices or otherwise, or due to warrants, options or rights per share which are issued in connection with such issuance, be entitled to receive shares of Corporation Common Stock at a price per share which is less than the Set Price, such issuance shall be deemed to have occurred for less than the Set Price), then (A) from the Original Issue Date until the 30th day following the Effective Date (if the Registration Statement is unavailable for use by the Holder during such period, such period shall be extended for such number of unavailable days), the Set Price shall be reduced to equal the effective conversion, exchange or purchase price for such Corporation Common Stock or Common Stock Equivalents (including any reset provisions thereof), at issue and (B) after 30th day following the Effective Date (as extended in clause (A) above), the Set Price shall be reduced by multiplying the Set Price by a fraction, the numerator of which is the number of shares of Corporation Common Stock Outstanding immediately prior to the Dilutive Issuance plus the number of shares of Corporation Common Stock which the offering price for such Dilutive Issuance would purchase at the Set Price, and the denominator of which shall be the sum of the number of shares of Corporation Common Stock Outstanding immediately prior to the Dilutive Issuance plus the number of shares of Corporation Common Stock so issued or issuable in connection with the Dilutive Issuance. Such adjustment shall be made whenever such Corporation Common Stock or Common Stock Equivalents are issued. The Corporation shall notify the Holder in writing, no later than the Business Day following the issuance of any Corporation Common Stock or Common Stock Equivalent subject to this section, indicating therein the applicable issuance price, or of applicable reset price, exchange price, conversion price and other pricing terms. (v) if the Corporation, at any time while the Preferred Stock is outstanding, shall distribute to all holders of Corporation Common Stock (and not to Holders) evidences of its indebtedness or assets or rights or warrants to subscribe for or purchase any security other than the Corporation Common Stock (which shall be subject to Section 5(c)(iii), then in each such case the Set Price shall be adjusted by multiplying the Set Price in effect immediately prior to the record date fixed for determination of stockholders entitled to receive such distribution by a fraction of which the denominator shall be the Set Price determined as of the record date mentioned above, and of which the numerator shall be such Set Price on such record date less the then per share fair market value at such record date of the portion of such assets or evidence of indebtedness so distributed applicable to one outstanding share of the Corporation Common Stock as determined by the Board of Directors in good faith. In either case the adjustments shall be described in a statement provided to the Holders of the portion of assets or evidences of indebtedness so distributed or such subscription rights applicable to one share of Corporation Common Stock. Such adjustment shall be made whenever any such distribution is made and shall become effective immediately after the record date mentioned above. (vi) All calculations under this Section 5(c) shall be made to the nearest cent or the nearest 1/100th of a share, as the case may be. The number of shares of Corporation Common Stock outstanding at any given time shall not include shares owned or held by or for the account of the Corporation, and the disposition of any such shares shall be considered an issue or sale of Corporation Common Stock. For purposes of this Section 5(c), the number of shares of Corporation Common Stock deemed to be outstanding (the "Corporation Common Stock Outstanding") as of a given date ------------------------------------ shall be the sum of the number of shares of Corporation Common Stock (excluding treasury shares, if any) issued and outstanding. (vii) Notwithstanding anything to the contrary herein, no adjustment shall be made hereunder in connection with the following (a) the granting or issuance of shares of Corporation Common Stock or options to employees, officers and directors of the Corporation pursuant to any stock option plan or employee incentive plan or agreement duly adopted or approved by a majority of the non-employee members of the Board of Directors of the Corporation or a majority of the members of a committee of non-employee directors established for such purpose, (b) the conversion or exercise of any Preferred Stock or any other security issued by the Corporation in connection with the offer and sale of this Corporation's securities pursuant to this Agreement, (c) the exercise of or conversion of any convertible securities, options or warrants issued and outstanding on the date hereof, provided that such securities have not been amended since the date hereof, or (d) acquisitions or strategic investments, the primary purpose of which is not to raise capital. (viii) Whenever the Set Price is adjusted pursuant to this Section the Corporation shall promptly mail to each Holder, a notice setting forth the Set Price after such adjustment and setting forth a brief statement of the facts requiring such adjustment. (d) Mandatory Conversion. Any shares of Preferred Stock which have not been converted or redeemed on the second year anniversary of the Original Issue Date shall be automatically converted into shares of Corporation Common Stock at the Set Price then in effect. Section 6. [Intentionally Omitted]. Section 7. Redemption Upon Triggering Events. ------------------------------------ (a) Upon the occurrence of a Triggering Event, each Holder shall (in addition to all other rights it may have hereunder or under applicable law) have the right, exercisable at the sole option of such Holder, to require the Corporation to redeem all of the Preferred Stock then held by such Holder for a redemption price, in cash, equal to the Triggering Redemption Amount. The Triggering Redemption Amount, in cash shall be due and payable within 5 Trading Days of the date on which the notice for the payment therefore is provided by a Holder (the "Triggering Redemption Payment ----------------------------- Date"). If the Corporation fails to pay the Triggering Redemption Amount ---- hereunder in full pursuant to this Section on the date such amount is due in accordance with this Section, the Corporation will pay interest thereon at a rate of 18% per annum (or such lesser amount permitted by applicable law), accruing daily from such date until the Triggering Redemption Amount, plus all such interest thereon, is paid in full. For purposes of this Section, a share of Preferred Stock is outstanding until such date as the Holder shall have received Conversion Shares upon a conversion (or attempted conversion) thereof that meets the requirements hereof or has been paid the Triggering Redemption Amount plus all accrued but unpaid dividends and all accrued but unpaid liquidated damages in cash. (b) "Triggering Event" means any one or more of the following events ----------------- (whatever the reason and whether it shall be voluntary or involuntary or effected by operation of law or pursuant to any judgment, decree or order of any court, or any order, rule or regulation of any administrative or governmental body): (i) the failure of the Registration Statement to be declared effective by the Commission on or prior to the 210th day after the Original Issue Date; (ii) if, during the Effectiveness Period, the effectiveness of the Registration Statement lapses for any reason for more than an aggregate of 60 calendar days (which need not be consecutive days) during any 12 month period, or the Holder shall not be permitted to resell Registrable Securities under the Conversion Shares Registration Statement for more than an aggregate of 60 calendar days (which need not be consecutive days) during any 12 month period; (iii) the Corporation shall fail to deliver certificates representing Conversion Shares issuable upon a conversion hereunder that comply with the provisions hereof prior to the 10th Trading Day after such shares are required to be delivered hereunder, or the Corporation shall provide written notice to any Holder, including by way of public announcement, at any time, of its intention not to comply with requests for conversion of any shares of Preferred Stock in accordance with the terms hereof; (iv) one of the Events (as defined in the Registration Rights Agreement) described in subsections (i), (ii) or (iii) of Section 2(c) of the Registration Rights Agreement shall not have been cured to the satisfaction of the Holders prior to the expiration of 30 days from the Event Date (as defined in the Registration Rights Agreement) relating thereto (other than an Event resulting from a failure of an Registration Statement to be declared effective by the Commission on or prior to the 210th day after the Original Issue Date, which shall be covered by Section 7(b)(i)); (v) the Corporation shall fail for any reason to pay in full the amount of cash due pursuant to a Buy-In within 10 days after notice therefor is delivered hereunder or shall fail to pay all amounts owed on account of an Event within five days of the date due; (vi) the Corporation shall fail to have available a sufficient number of authorized and unreserved shares of Corporation Common Stock or Parent Common Stock to issue to such Holder upon a conversion hereunder; (vii) the Corporation shall fail to observe or perform any other covenant, agreement or warranty contained in, or otherwise commit any breach of the Transaction Documents, and such failure or breach shall not, if subject to the possibility of a cure by the Corporation, have been remedied within 30 calendar days after the date on which written notice of such failure or breach shall have been given; (ix) The occurrence of a Change of Control Transaction or the Corporation shall redeem more than a de minimis number of Junior Securities; (x) there shall have occurred a Bankruptcy Event; or (xi) the Common Stock shall fail to be listed or quoted for trading on a Principal Market for more than 5 consecutive Trading Days. Section 8. Definitions. For the purposes hereof, the following terms shall ----------- have the following meanings: "Bankruptcy Event" means any of the following events: (a) the Corporation, ----------------- Parent or any Significant Subsidiary (as such term is defined in Rule 1.02(s) of Regulation S-X) thereof commences a case or other proceeding under any bankruptcy, reorganization, arrangement, adjustment of debt, relief of debtors, dissolution, insolvency or liquidation or similar law of any jurisdiction relating to the Corporation or any Significant Subsidiary thereof; (b) there is commenced against the Corporation, Parent or any Significant Subsidiary thereof any such case or proceeding that is not dismissed within 60 days after commencement; (c) the Corporation, Parent or any Significant Subsidiary thereof is adjudicated insolvent or bankrupt or any order of relief or other order approving any such case or proceeding is entered; (d) the Corporation, Parent or any Significant Subsidiary thereof suffers any appointment of any custodian or the like for it or any substantial part of its property that is not discharged or stayed within 60 days; (e) the Corporation, Parent or any Significant Subsidiary thereof makes a general assignment for the benefit of creditors; (f) the Corporation, Parent or any Significant Subsidiary thereof calls a meeting of its creditors with a view to arranging a composition, adjustment or restructuring of its debts; or (g) the Corporation, Parent or any Significant Subsidiary thereof, by any act or failure to act, expressly indicates its consent to, approval of or acquiescence in any of the foregoing or takes any corporate or other action for the purpose of effecting any of the foregoing. "Change of Control Transaction" means the occurrence after the date hereof of -------------------------------- any of (a) an acquisition after the date hereof by an individual or legal entity or "group" (as described in Rule 13d-5(b)(1) promulgated under the Exchange Act) of effective control (whether through legal or beneficial ownership of capital stock of the Corporation or Parent, by contract or otherwise) of in excess of 33% of the voting securities of the Corporation (other than by Parent) or Parent, or (b) a replacement at one time or within a one year period of more than one-half of the members of the Corporation's or Parent's board of directors which is not approved by a majority of those individuals who are members of the board of directors on the date hereof (or by those individuals who are serving as members of the board of directors on any date whose nomination to the board of directors was approved by a majority of the members of the board of directors who are members on the date hereof), or (c) the execution by the Corporation or Parent of an agreement to which the Corporation or Parent is a party or by which it is bound, providing for any of the events set forth above in (a) or (b). "Closing" means closing of the purchase and sale of the Preferred Stock. ------- "Commission" means the Securities and Exchange Commission. ---------- "Conversion Amount" means the sum of the Stated Value at issue. ------------------ "Conversion Date" shall have the meaning set forth in Section 5(b)(i). ---------------- "Conversion Shares" means, collectively, the shares of Corporation Common Stock ------------------ or Parent Common Stock into which the shares of Preferred Stock are convertible (and issuable in lieu of cash dividends) in accordance with the terms hereof. "Corporation Common Stock" means the Corporation's Common Stock, and stock of -------------------------- any other class into which such shares may hereafter have been reclassified or changed. "Corporation Common Stock Outstanding" shall have the meaning set forth in --------------------------------------- Section 5(c)(vi). "Dividend Payment Date" shall have the meaning set forth in Section 2(a). ----------------------- "Effective Date" means the date that the Registration Statement is declared --------------- effective by the Commission. "Equity Conditions" Unless waived by a Holder as to a particular event (which ------------------ waiver shall apply only to such Holder), as of such event date, the following conditions have been met: (i) the Corporation shall have duly honored all conversions and redemptions scheduled to occur or occurring prior to such date, (ii) there is an effective Registration Statement pursuant to which the Holders are permitted to utilize the prospectus thereunder to resell all of the Parent Conversion Shares issued to the Holders and all of the Parent Conversion Shares as are issuable to the Holders upon conversion in full of the Preferred Stock (and the Corporation believes, in good faith, that such effectiveness will continue uninterrupted for the foreseeable future), (iii) the Parent Common Stock is listed for trading on the Principal Market (and the Corporation believes, in good faith, that trading of the Parent Common Stock on the Principal Market will continue uninterrupted for the foreseeable future), (iv) all liquidated damages and other amounts owing in respect of the Preferred Stock shall have been paid or will, concurrently with the issuance of the Conversion Shares, be paid in cash; (v) there is a sufficient number of authorized but unissued and otherwise unreserved shares of Parent Common Stock and Corporation Common Stock for the issuance of all the Conversion Shares as are issuable to the Holder upon conversion in full of the Preferred Stock; (vi) no Triggering Event has occurred and is continuing; (vii) all of the Parent Conversion Shares issuable to the Holder upon conversion in full of the Preferred Stock will not violate the limitations set forth in Sections 5(a)(ii) and (iii); (viii) the average of the 5 VWAPs immediately prior to the date in question is greater than $1.67, as adjusted for any stock splits or similar capital events subsequent to the Original Issue Date, and (ix) no public announcement of a pending or proposed Fundamental Transaction or Change of Control Transaction has occurred that has not been consummated. "Exchange Act" means the Securities Exchange Act of 1934, as amended. ------------- "Fundamental Transaction" means the occurrence after the date hereof of any of ------------------------ (a) the Corporation or Parent effects any merger or consolidation of the Corporation with or into another Person, (b) the Corporation or Parent effects any sale of all or substantially all of its assets in one or a series of related transactions, (c) any tender offer or exchange offer (whether by the Corporation, Parent or another Person) is completed pursuant to which holders of Common Stock or Parent Common Stock, as the case may be, are permitted to tender or exchange their shares for other securities, cash or property, or (d) the Corporation or Parent effects any reclassification of the Common Stock or Parent Common Stock, as the case may be, or any compulsory share exchange pursuant to which the Common Stock or Parent Common Stock, as the case may be, is effectively converted into or exchanged for other securities, cash or property. "Holder" shall have the meaning given such term in Section 1 hereof. ------ "Junior Securities" means the Common Stock and all other equity or equity ------------------ equivalent securities of the Corporation other than those securities that are (a) outstanding on the Original Issue Date and (b) which are explicitly senior in rights or liquidation preference to the Preferred Stock. "Original Issue Date" shall mean the date of the first issuance of any shares of ------------------- the Preferred Stock regardless of the number of transfers of any particular shares of Preferred Stock and regardless of the number of certificates which may be issued to evidence such Preferred Stock. "Parent" means U.S. Energy Corp., a Wyoming corporation. ------ "Parent Common Stock" means the common stock of the Parent, and stock of any other class into which such shares may hereafter have been reclassified or changed. "Parent Conversion Shares" means the shares of Parent Common Stock into which -------------------------- the shares of Preferred Stock are convertible (and issuable in lieu of cash dividends) in accordance with the terms hereof. "Person" means a corporation, an association, a partnership, an organization, a ------ business, an individual, a government or political subdivision thereof or a governmental agency. "Principal Market" shall initially mean the Nasdaq Small-Cap Market and shall ----------------- also include the New York Stock Exchange, the NASDAQ National Market, or the American Stock Exchange, whichever is at the time the principal trading exchange or market for the Parent Common Stock, based upon share volume. "Purchase Agreement" means the Securities Purchase Agreement, dated as of ------------------- February __, 2004, to which the Corporation, the Parent and the original Holders are parties, as amended, modified or supplemented from time to time in accordance with its terms. "Registration Rights Agreement" means the Registration Rights Agreement, dated ------------------------------- as of February __, 2004, to which the Parent and the original Holders are parties, as amended, modified or supplemented from time to time in accordance with its terms. "Registration Statement" means a registration statement that meets the ----------------------- requirements of the Registration Rights Agreement and registers the resale of all Parent Conversion Shares by each Holder, who shall be named as a "selling stockholder" thereunder, all as provided in the Registration Rights Agreement. "Securities Act" means the Securities Act of 1933, as amended. --------------- "Set Price" shall have the meaning set forth in Section 5(c)(i). --------- "Trading Day" shall mean any day during which the Principal Market shall be open ----------- for business. "Transaction Documents" shall mean the Purchase Agreement and all agreements ---------------------- entered into in connection therewith, including the Registration Rights Agreement and the Warrants. "Triggering Event" shall have the meaning set forth in Section 7(b). ----------------- "Triggering Redemption Amount" for each share of Preferred Stock means the sum ------------------------------ of (i) the greater of (A) 130% of the Stated Value and (B) the product of (a) the VWAP on the Trading Day immediately preceding the date of the Triggering Event and (b) the Stated Value divided by the then Set Price as it relates to Parent Conversion Shares, (ii) all accrued but unpaid dividends thereon and (iii) all liquidated damages and other amounts due in respect of the Preferred Stock. "VWAP" means, for any date, the per share price of Parent Common Stock ---- determined by the first of the following clauses that applies: (a) if the Parent Common Stock is then listed or quoted on a Principal Market, the daily volume weighted average price of the Parent Common Stock for such date (or the nearest preceding date) on the Principal Market on which the Parent Common Stock is then listed or quoted as reported by Bloomberg Financial L.P. (based on a trading day from 9:30 a.m. Eastern Time to 4:02 p.m. Eastern Time); (b) if the Parent Common Stock is not then listed or quoted on a Principal Market and if prices for the Parent Common Stock are then quoted on the OTC Bulletin Board, the volume weighted average price of the Parent Common Stock for such date (or the nearest preceding date) on the OTC Bulletin Board; (c) if the Parent Common Stock is not then listed or quoted on the OTC Bulletin Board and if prices for the Parent Common Stock are then reported in the "Pink Sheets" published by the National Quotation Bureau Incorporated (or a similar organization or agency succeeding to its functions of reporting prices), the most recent bid price per share of the Parent Common Stock so reported; or (d) in all other cases, the fair market value of a share of Parent Common Stock as determined by an independent appraiser selected in good faith by the Holders and reasonably acceptable to the Corporation. Section 9. Fundamental Transactions and Change of Control Transactions. If ----------------------------------------------------------- a Fundamental Transaction occurs, then upon any subsequent conversion of shares of Preferred Stock, the Holder shall have the right to receive, for each Conversion Share that would have been issuable upon such conversion absent such Fundamental Transaction, the same kind and amount of securities, cash or property as it would have been entitled to receive upon the occurrence of such Fundamental Transaction if it had been, immediately prior to such Fundamental Transaction, the holder of one share of either Parent Common Stock or Corporation Common Stock, as the case may be (the "Alternate Consideration"). ----------------------- For purposes of any such conversion, the determination of the Set Price shall be appropriately adjusted to apply to such Alternate Consideration based on the amount of Alternate Consideration issuable in respect of one share of Parent Common Stock or Corporation Common Stock in such Fundamental Transaction, and the Corporation shall apportion the Set Price among the Alternate Consideration in a reasonable manner reflecting the relative value of any different components of the Alternate Consideration. If holders of Parent Common Stock or Corporation Common Stock are given any choice as to the securities, cash or property to be received in a Fundamental Transaction, then the Holder shall be given the same choice as to the Alternate Consideration it receives upon any conversion of shares of Preferred Stock following such Fundamental Transaction. To the extent necessary to effectuate the foregoing provisions, any successor to the Corporation or surviving entity in such Fundamental Transaction shall issue to the Holder new preferred stock consistent with the foregoing provisions and evidencing the Holder's right to convert such preferred stock into Alternate Consideration. The terms of any agreement pursuant to which a Fundamental Transaction is effected shall include terms requiring any such successor or surviving entity to comply with the provisions of this Section 9 and insuring that the Preferred Stock (or any such replacement security) will be similarly adjusted upon any subsequent transaction analogous to a Fundamental Transaction. Section 10. Miscellaneous. ------------- (a) If (i) the Corporation shall declare a dividend (or any other distribution) on the Corporation Common Stock, (ii) the Corporation shall declare a special nonrecurring cash dividend on or a redemption of the Corporation Common Stock, (iii) the Corporation shall authorize the granting to all holders of Corporation Common Stock rights or warrants to subscribe for or purchase any shares of capital stock of any class or of any rights, (iv) the approval of any stockholders of the Corporation shall be required in connection with any Fundamental Transaction or Change of Control Transaction, or (v) the Corporation shall authorize the voluntary or involuntary dissolution, liquidation or winding up of the affairs of the Corporation; then the Corporation shall file a press release or Current Report on Form 8-K to disclose such occurrence and notify the Holders at their last addresses as they shall appear upon the stock books of the Corporation, at least 20 calendar days prior to the applicable record or effective date hereinafter specified, a notice stating (x) the date on which a record is to be taken for the purpose of such dividend, distribution, redemption, rights or warrants, or if a record is not to be taken, the date as of which the holders of Corporation Common Stock of record to be entitled to such dividend, distributions, redemption, rights or warrants are to be determined or (y) the date on which any such Fundamental Transaction or Change of Control Transaction is expected to become effective or close, and the date as of which it is expected that holders of Corporation Common Stock of record shall be entitled to exchange their Corporation Common Stock for securities, cash or other property deliverable upon any such Fundamental Transaction or Change of Control Transaction. Holders are entitled to convert the Conversion Amount of Preferred Stock during the 20-day period commencing the date of such notice to the effective date of the event triggering such notice. (b) The Corporation covenants that it will at all times reserve and keep available out of its authorized and unissued shares of Corporation Common Stock solely for the purpose of issuance upon conversion of Preferred Stock, each as herein provided, free from preemptive rights or any other actual contingent purchase rights of persons other than the Holders, not less than such number of shares of Corporation Common Stock as shall be issuable upon the conversion of all outstanding shares of Preferred Stock. The Corporation covenants that all shares of Corporation Common Stock that shall be so issuable shall, upon issue, be duly and validly authorized, issued and fully paid and nonassessable. (c) Upon a conversion hereunder the Corporation shall not be required to issue stock certificates representing fractions of shares of Corporation or Parent Common Stock, but may if otherwise permitted, make a cash payment in respect of any final fraction of a share based on the fair market value at such time. (d) The issuance of certificates for Parent or Corporation Common Stock on conversion of Preferred Stock shall be made without charge to the Holders thereof for any documentary stamp or similar taxes that may be payable in respect of the issue or delivery of such certificate, provided that the Corporation shall not be required to pay any tax that may be payable in respect of any transfer involved in the issuance and delivery of any such certificate upon conversion in a name other than that of the Holder of such shares of Preferred Stock so converted. (e) To effect conversions or redemptions, as the case may be, of shares of Preferred Stock, a Holder shall not be required to surrender the certificate(s) representing such shares of Preferred Stock to the Corporation unless all of the shares of Preferred Stock represented thereby are so converted, in which case the Holder shall deliver the certificate representing such share of Preferred Stock promptly following the Conversion Date at issue. Shares of Preferred Stock converted into Parent or Corporation Common Stock or redeemed in accordance with the terms hereof shall be canceled and may not be reissued. (f) Any and all notices or other communications or deliveries to be provided by the Holders of the Preferred Stock hereunder, including, without limitation, any Conversion Notice, shall be in writing and delivered personally, by facsimile or sent by a nationally recognized overnight courier service, addressed to the attention of the Chief Financial Officer of the Corporation addressed to Robert Scot Lorimer Fax Number: (307) 857-3050 or to such other address or facsimile number as shall be specified in writing by the Corporation for such purpose. Any and all notices or other communications or deliveries to be provided by the Corporation hereunder shall be in writing and delivered personally, by facsimile or sent by a nationally recognized overnight courier service, addressed to each Holder at the facsimile telephone number or address of such Holder appearing on the books of the Corporation, which address shall initially be the address of such Holder set forth on the signature pages of the Purchase Agreement, or such other address as the Corporation or a Holder may designate by ten days advance written notice to the other parties hereto. Any notice or other communication or deliveries hereunder shall be deemed given and effective on the earliest of (i) the date of transmission, if such notice or communication is delivered via facsimile at the facsimile telephone number specified in this Section prior to 6:30 p.m. (New York City time) (with confirmation of transmission), (ii) the date after the date of transmission, if such notice or communication is delivered via facsimile at the facsimile telephone number specified in this Section later than 6:30 p.m. (New York City time) on any date and earlier than 11:59 p.m. (New York City time) on such date (with confirmation of transmission), (iii) five days after having been sent by registered or certified mail, return receipt requested, postage prepaid, (iv) one day after deposit with a nationally recognized overnight courier service, specifying next day delivery, with written verification of service, or (v) upon actual receipt by the party to whom such notice is required to be given. (g) For purposes hereof, a share of Preferred Stock is outstanding until such date as the Holder shall have received the Conversion Shares or redemption amount (as the case may be) issuable or payable to it in accordance with this Articles of Amendment. This Amendment was adopted on February 25, 2004 and is effective on February 25, 2004. This Amendment was duly adopted by the Board of Directors of Rocky Mountain Gas, Inc. Dated: February 25, 2004. ----------- - ------------------------------------ ----------------------------- Name: Keith G. Larsen Title: Chief Executive Officer ANNEX A NOTICE OF CONVERSION (To be Executed by the Registered Holder in order to Convert shares of Preferred Stock) The undersigned hereby elects to convert the number of shares of 10% Series A Convertible Preferred Stock indicated below, into shares of common stock of (the "Common Stock"), of ------------- /_/ U.S Energy Corporation, a Wyoming corporation /_/ Rocky Mountain Gas, Inc., a Wyoming Corporation according to the conditions hereof, as of the date written below. If shares are to be issued in the name of a person other than undersigned, the undersigned will pay all transfer taxes payable with respect thereto and is delivering herewith such certificates and opinions as reasonably requested by the issuing corporation in accordance therewith. No fee will be charged to the Holder for any conversion, except for such transfer taxes, if any. Conversion calculations: Date to Effect Conversion ----------------------------------------- Number of shares of Preferred Stock owned prior to Conversion ----------------------------------------- Number of shares of Preferred Stock to be Converted ----------------------------------------- Stated Value of shares of Preferred Stock to be Converted ----------------------------------------- Number of Conversion Shares to be Issued ----------------------------------------- Applicable Set Price ----------------------------------------- Number of shares of Preferred Stock subsequent to Conversion ----------------------------------------- [HOLDER] By:_______________________ Name: Title: EX-4.30 4 doc3.txt FORM OF WARRRANT MEZZANINE EXHIBIT C NEITHER THIS SECURITY NOR THE SECURITIES INTO WHICH THIS SECURITY IS EXERCISABLE HAVE BEEN REGISTERED WITH THE SECURITIES AND EXCHANGE COMMISSION OR THE SECURITIES COMMISSION OF ANY STATE IN RELIANCE UPON AN EXEMPTION FROM REGISTRATION UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ---------- ACT"), AND, ACCORDINGLY, MAY NOT BE OFFERED OR SOLD EXCEPT PURSUANT TO AN - --- EFFECTIVE REGISTRATION STATEMENT UNDER THE SECURITIES ACT OR PURSUANT TO AN AVAILABLE EXEMPTION FROM, OR IN A TRANSACTION NOT SUBJECT TO, THE REGISTRATION REQUIREMENTS OF THE SECURITIES ACT AND IN ACCORDANCE WITH APPLICABLE STATE SECURITIES LAWS AS EVIDENCED BY A LEGAL OPINION OF COUNSEL TO THE TRANSFEROR REASONABLY ACCEPTABLE TO THE COMPANY TO SUCH EFFECT, THE SUBSTANCE OF WHICH SHALL BE REASONABLY ACCEPTABLE TO THE COMPANY. THIS SECURITY MAY BE PLEDGED IN CONNECTION WITH A BONA FIDE MARGIN ACCOUNT WITH A REGISTERED BROKER-DEALER OR OTHER LOAN WITH A FINANCIAL INSTITUTION THAT IS AN "ACCREDITED INVESTOR" AS DEFINED IN RULE 501(a) UNDER THE SECURITIES ACT. COMMON STOCK PURCHASE WARRANT To Purchase __________ Shares of Common Stock of U.S. ENERGY CORP. THIS COMMON STOCK PURCHASE WARRANT (the "Warrant") CERTIFIES that, for ------- value received, _____________ (the "Holder"), is entitled, upon the terms and ------ subject to the limitations on exercise and the conditions hereinafter set forth, from the day beginning three months after the date of the Purchase Agreement (the "Initial Exercise Date") as to 25% of the Warrant Shares and an additional --------------------- 25% of the Warrant Shares on each of the six month, nine month and twelve month anniversary dates of the date of the Purchase Agreement, and on or prior to the third anniversary of the Initial Exercise Date (the "Termination Date") but not ---------------- thereafter, to subscribe for and purchase from U.S. Energy Corp., a Wyoming corporation (the "Company"), up to ____________ shares (the "Warrant Shares") of ------- -------------- Common Stock, par value $0.01 per share, of the Company (the "Common Stock"); ------------ provided that if the Company exercises its right to Call this Warrant pursuant to Section 13, the Holder shall have the right to immediately exercise this Warrant for all Warrant Shares. The purchase price of one share of Common Stock (the "Exercise Price") under this Warrant shall be 90% of the average of the --------------- five VWAPs immediately preceding the date of exercise, but in no event less than $1.50 per Warrant Share (subject to adjustment for any stock splits, reverse stock splits and similar capital events after the issuance date of this Warrant), and subject to further adjustment hereunder. CAPITALIZED TERMS USED AND NOT OTHERWISE DEFINED HEREIN SHALL HAVE THE MEANINGS SET FORTH IN THAT CERTAIN SECURITIES PURCHASE AGREEMENT (THE "PURCHASE AGREEMENT"), DATED FEBRUARY ------------------ ___, 2004, AMONG THE COMPANY, ROCKY MOUNTAIN GAS, INC. AND THE PURCHASERS SIGNATORY THERETO. 1. - ------ 1. Title to Warrant. Prior to the Termination Date and subject to ------------------ compliance with applicable laws and Section 7 of this Warrant, this Warrant and all rights hereunder are transferable, in whole or in part, at the office or agency of the Company by the Holder in person or by duly authorized attorney, upon surrender of this Warrant together with the Assignment Form annexed hereto properly endorsed. The transferee shall sign an investment letter in form and substance reasonably satisfactory to the Company. 2. Authorization of Shares. The Company covenants that all Warrant Shares ------------------------ which may be issued upon the exercise of the purchase rights represented by this Warrant will, upon exercise of the purchase rights represented by this Warrant, be duly authorized, validly issued, fully paid and nonassessable and free from all taxes, liens and charges in respect of the issue thereof (other than taxes in respect of any transfer occurring contemporaneously with such issue). 3. Exercise of Warrant. --------------------- (a) Exercise of the purchase rights represented by this Warrant may be made at any time or times on or after the Initial Exercise Date (as to that number of Warrant Shares for which this Warrant is then exercisable) and on or before the Termination Date by delivery to the Company of a duly executed facsimile copy of the Notice of Exercise Form annexed hereto (or such other office or agency of the Company as it may designate by notice in writing to the registered Holder at the address of such Holder appearing on the books of the Company); provided, however, within 5 Trading Days of the -------- ------- date said Notice of Exercise is delivered to the Company, the Holder shall have surrendered this Warrant to the Company and the Company shall have received payment of the aggregate Exercise Price of the shares thereby purchased by wire transfer or cashier's check drawn on a United States bank. Certificates for shares purchased hereunder shall be delivered to the Holder within 3 Trading Days from the delivery to the Company of the Notice of Exercise Form, surrender of this Warrant and payment of the aggregate Exercise Price as set forth above ("Warrant Share Delivery Date"). This --------------------------- Warrant shall be deemed to have been exercised on the date the Exercise Price is received by the Company. The Warrant Shares shall be deemed to have been issued, and Holder or any other person so designated to be named therein shall be deemed to have become a holder of record of such shares for all purposes, as of the date the Warrant has been exercised by payment to the Company of the Exercise Price and all taxes required to be paid by the Holder, if any, pursuant to Section 5 prior to the issuance of such shares, have been paid. If the Company fails to deliver to the Holder a certificate or certificates representing the Warrant Shares pursuant to this Section 3(a) by the third Trading Day following the Warrant Share Delivery Date, then the Holder will have the right to rescind such exercise. In addition to any other rights available to the Holder, if the Company fails to deliver to the Holder a certificate or certificates representing the Warrant Shares pursuant to an exercise by the third Trading Day after the Warrant Share Delivery Date, and if after such day the Holder is required by its broker to purchase (in an open market transaction or otherwise) shares of Common Stock to deliver in satisfaction of a sale by the Holder of the Warrant Shares which the Holder anticipated receiving upon such exercise (a "Buy-In"), then the Company shall (1) pay ------ in cash to the Holder the amount by which (x) the Holder's total purchase price (including brokerage commissions, if any) for the shares of Common Stock so purchased exceeds (y) the amount obtained by multiplying (A) the number of Warrant Shares that the Company was required to deliver to the Holder in connection with the exercise at issue times (B) the price at which the sell order giving rise to such purchase obligation was executed, and (2) at the option of the Holder, either reinstate the portion of the Warrant and equivalent number of Warrant Shares for which such exercise was not honored or deliver to the Holder the number of shares of Common Stock that would have been issued had the Company timely complied with its exercise and delivery obligations hereunder. For example, if the Holder purchases Common Stock having a total purchase price of $11,000 to cover a Buy-In with respect to an attempted exercise of shares of Common Stock with an aggregate sale price giving rise to such purchase obligation of $10,000, under clause (1) of the immediately preceding sentence the Company shall be required to pay the Holder $1,000. The Holder shall provide the Company written notice indicating the amounts payable to the Holder in respect of the Buy-In, together with applicable confirmations and other evidence reasonably requested by the Company. Nothing herein shall limit a Holder's right to pursue any other remedies available to it hereunder, at law or in equity including, without limitation, a decree of specific performance and/or injunctive relief with respect to the Company's failure to timely deliver certificates representing shares of Common Stock upon exercise of the Warrant as required pursuant to the terms hereof. (b) If this Warrant shall have been exercised in part, the Company shall, at the time of delivery of the certificate or certificates representing Warrant Shares, deliver to Holder a new Warrant evidencing the rights of Holder to purchase the unpurchased Warrant Shares called for by this Warrant, which new Warrant shall in all other respects be identical with this Warrant. (c) The Holder shall not have the right to exercise any portion of this Warrant, pursuant to Section 3(a) or otherwise, to the extent that after giving effect to such issuance after exercise, the Holder (together with the Holder's affiliates), as set forth on the applicable Notice of Exercise, would beneficially own in excess of 9.99% of the number of shares of the Common Stock outstanding immediately after giving effect to such issuance. For purposes of the foregoing sentence, the number of shares of Common Stock beneficially owned by the Holder and its affiliates shall include the number of shares of Common Stock issuable upon exercise of this Warrant with respect to which the determination of such sentence is being made, but shall exclude the number of shares of Common Stock which would be issuable upon (A) exercise of the remaining, nonexercised portion of this Warrant beneficially owned by the Holder or any of its affiliates and (B) exercise or conversion of the unexercised or nonconverted portion of any other securities of the Company (including, without limitation, any other Warrants or the Preferred Stock) subject to a limitation on conversion or exercise analogous to the limitation contained herein beneficially owned by the Holder or any of its affiliates. Except as set forth in the preceding sentence, for purposes of this Section 3(c), beneficial ownership shall be calculated in accordance with Section 13(d) of the Exchange Act, it being acknowledge by Holder that the Company is not representing to Holder that such calculation is in compliance with Section 13(d) of the Exchange Act and Holder is solely responsible for any schedules required to be filed in accordance therewith. To the extent that the limitation contained in this Section 3(c) applies, the determination of whether this Warrant is exercisable (in relation to other securities owned by the Holder) and of which a portion of this Warrant is exercisable shall be in the sole discretion of such Holder, and the submission of a Notice of Exercise shall be deemed to be such Holder's determination of whether this Warrant is exercisable (in relation to other securities owned by such Holder) and of which portion of this Warrant is exercisable, in each case subject to such aggregate percentage limitation, and the Company shall have no obligation to verify or confirm the accuracy of such determination. For purposes of this Section 3(c), in determining the number of outstanding shares of Common Stock, the Holder may rely on the number of outstanding shares of Common Stock as reflected in (x) the Company's most recent Form 10-Q or Form 10-K, as the case may be, (y) a more recent public announcement by the Company or (z) any other notice by the Company or the Company's Transfer Agent setting forth the number of shares of Common Stock outstanding. Upon the written or oral request of the Holder, the Company shall within two Trading Days confirm orally and in writing to the Holder the number of shares of Common Stock then outstanding. In any case, the number of outstanding shares of Common Stock shall be determined after giving effect to the conversion or exercise of securities of the Company, including this Warrant, by the Holder or its affiliates since the date as of which such number of outstanding shares of Common Stock was reported. The foregoing limitation may be waived by the Holder upon not less than 61 calendar days' prior written notice to the Company. (d) If at any time after one year from the date of issuance of this Warrant there is no effective Registration Statement registering the resale of the Warrant Shares by the Holder, this Warrant may also be exercised at such time by means of a "cashless exercise" in which the Holder shall be entitled to receive a certificate for the number of Warrant Shares equal to the quotient obtained by dividing [(A-B) (X)] by (A), where: (A) = the VWAP on the Trading Day immediately preceding the date of such election; (B) = the Exercise Price of this Warrant, as adjusted; and (X) = the number of Warrant Shares issuable upon exercise of this Warrant in accordance with the terms of this Warrant by means Of a cash exercise rather than a cashless exercise. 4. No Fractional Shares or Scrip. No fractional shares or scrip --------------------------------- representing fractional shares shall be issued upon the exercise of this Warrant. As to any fraction of a share which Holder would otherwise be entitled to purchase upon such exercise, the Company shall pay a cash adjustment in respect of such final fraction in an amount equal to such fraction multiplied by the Exercise Price. 5. Charges, Taxes and Expenses. Issuance of certificates for Warrant Shares --------------------------- shall be made without charge to the Holder for any issue or transfer tax or other incidental expense in respect of the issuance of such certificate, all of which taxes and expenses shall be paid by the Company, and such certificates shall be issued in the name of the Holder or in such name or names as may be directed by the Holder; provided, however, that in the event certificates for -------- ------- Warrant Shares are to be issued in a name other than the name of the Holder, this Warrant when surrendered for exercise shall be accompanied by the Assignment Form attached hereto duly executed by the Holder; and the Company may require, as a condition thereto, the payment of a sum sufficient to reimburse it for any transfer tax incidental thereto. 6. Closing of Books. The Company will not close its stockholder books or ------------------ records in any manner which prevents the timely exercise of this Warrant, pursuant to the terms hereof. 7. Transfer, Division and Combination. ------------------------------------- (a) Subject to compliance with any applicable securities laws and the conditions set forth in Sections 1 and 7(e) hereof and to the provisions of Section 4.1 of the Purchase Agreement, this Warrant and all rights hereunder are transferable, in whole or in part, upon surrender of this Warrant at the principal office of the Company, together with a written assignment of this Warrant substantially in the form attached hereto duly executed by the Holder or its agent or attorney and funds sufficient to pay any transfer taxes payable upon the making of such transfer. Upon such surrender and, if required, such payment, the Company shall execute and deliver a new Warrant or Warrants in the name of the assignee or assignees and in the denomination or denominations specified in such instrument of assignment, and shall issue to the assignor a new Warrant evidencing the portion of this Warrant not so assigned, and this Warrant shall promptly be cancelled. A Warrant, if properly assigned, may be exercised by a new holder for the purchase of Warrant Shares without having a new Warrant issued. (b) This Warrant may be divided or combined with other Warrants upon presentation hereof at the aforesaid office of the Company, together with a written notice specifying the names and denominations in which new Warrants are to be issued, signed by the Holder or its agent or attorney. Subject to compliance with Section 7(a), as to any transfer which may be involved in such division or combination, the Company shall execute and deliver a new Warrant or Warrants in exchange for the Warrant or Warrants to be divided or combined in accordance with such notice. (c) The Company shall prepare, issue and deliver at its own expense (other than transfer taxes) the new Warrant or Warrants under this Section 7. (d) The Company agrees to maintain, at its aforesaid office, books for the registration and the registration of transfer of the Warrants. (e) If, at the time of the surrender of this Warrant in connection with any transfer of this Warrant, the transfer of this Warrant shall not be registered pursuant to an effective registration statement under the Securities Act and under applicable state securities or blue sky laws, the Company may require, as a condition of allowing such transfer (i) that the Holder or transferee of this Warrant, as the case may be, furnish to the Company a written opinion of counsel (which opinion shall be in form, substance and scope customary for opinions of counsel in comparable transactions) to the effect that such transfer may be made without registration under the Securities Act and under applicable state securities or blue sky laws, (ii) that the holder or transferee execute and deliver to the Company an investment letter in form and substance acceptable to the Company and (iii) that the transferee be an "accredited investor" as defined in Rule 501(a)(1), (a)(2), (a)(3), (a)(7), or (a)(8) promulgated under the Securities Act or a qualified institutional buyer as defined in Rule 144A(a) under the Securities Act. 8. No Rights as Shareholder until Exercise. This Warrant does not -------------------------------------------- entitle the Holder to any voting rights or other rights as a shareholder of the Company prior to the exercise hereof. Upon the surrender of this Warrant and the payment of the aggregate Exercise Price (or by means of a cashless exercise), the Warrant Shares so purchased shall be and be deemed to be issued to such Holder as the record owner of such shares as of the close of business on the later of the date of such surrender or payment. 9. Loss, Theft, Destruction or Mutilation of Warrant. The Company ------------------------------------------------------ covenants that upon receipt by the Company of evidence reasonably satisfactory to it of the loss, theft, destruction or mutilation of this Warrant or any stock certificate relating to the Warrant Shares, and in case of loss, theft or destruction, of indemnity or security reasonably satisfactory to it (which, in the case of the Warrant, shall not include the posting of any bond), and upon surrender and cancellation of such Warrant or stock certificate, if mutilated, the Company will make and deliver a new Warrant or stock certificate of like tenor and dated as of such cancellation, in lieu of such Warrant or stock certificate. 10. Saturdays, Sundays, Holidays, etc. If the last or appointed day for the --------------------------------- taking of any action or the expiration of any right required or granted herein shall be a Saturday, Sunday or a legal holiday, then such action may be taken or such right may be exercised on the next succeeding day not a Saturday, Sunday or legal holiday. 11. Adjustments of Exercise Price and Number of Warrant Shares. ------------------------------------------------------------------- (a) Stock Splits, etc. The number and kind of securities purchasable ------------------- upon the exercise of this Warrant and the Exercise Price shall be subject to adjustment from time to time upon the happening of any of the following. In case the Company shall (i) pay a dividend in shares of Common Stock or make a distribution in shares of Common Stock to holders of its outstanding Common Stock, (ii) subdivide its outstanding shares of Common Stock into a greater number of shares, (iii) combine its outstanding shares of Common Stock into a smaller number of shares of Common Stock, or (iv) issue any shares of its capital stock in a reclassification of the Common Stock, then the number of Warrant Shares purchasable upon exercise of this Warrant immediately prior thereto shall be adjusted so that the Holder shall be entitled to receive the kind and number of Warrant Shares or other securities of the Company which it would have owned or have been entitled to receive had such Warrant been exercised in advance thereof. Upon each such adjustment of the kind and number of Warrant Shares or other securities of the Company which are purchasable hereunder, the Holder shall thereafter be entitled to purchase the number of Warrant Shares or other securities resulting from such adjustment at an Exercise Price per Warrant Share or other security obtained by multiplying the Exercise Price in effect immediately prior to such adjustment by the number of Warrant Shares purchasable pursuant hereto immediately prior to such adjustment and dividing by the number of Warrant Shares or other securities of the Company that are purchasable pursuant hereto immediately thereafter. An adjustment made pursuant to this paragraph shall become effective immediately after the effective date of such event retroactive to the record date, if any, for such event. (b) Anti-Dilution Provisions. During the Exercise Period, the Exercise ------------------------ Price shall be subject to adjustment from time to time as provided in this Section 11(b). In the event that any adjustment of the Exercise Price as required herein results in a fraction of a cent, such Exercise Price shall be rounded up or down to the nearest cent. (i) Adjustment of Exercise Price. If and whenever the Company ------------------------------- issues or sells, or in accordance with Section 11(b)(ii) hereof is deemed to have issued or sold, any shares of Common Stock for an effective consideration per share of less than the then Exercise Price or for no consideration (such lower price, the "Base Share Price" and such issuances collectively, a "Dilutive Issuance"), then, (a) from ----------------- the Initial Exercise Date until the 30th day following the Effective Date (if the Registration Statement is unavailable for use by the Holder during such period, such period shall be extended for such number of unavailable days), the Exercise Price shall be reduced to a price equal to the Base Share Price and (b) after 30th day following the Effective Date (as extended in clause (a) above), the Exercise Price shall be reduced by multiplying the Exercise Price by a fraction, the numerator of which is the number of shares of Corporation Common Stock Outstanding immediately prior to the Dilutive Issuance plus the number of shares of Corporation Common Stock which the offering price for such Dilutive Issuance would purchase at the Exercise Price, and the denominator of which shall be the sum of the number of shares of Corporation Common Stock Outstanding immediately prior to the Dilutive Issuance plus the number of shares of Corporation Common Stock so issued or issuable in connection with the Dilutive Issuance. Such adjustment shall be made whenever shares of Common Stock or Common Stock Equivalents are issued. In no event shall the Exercise Price be reduced to a price below $1.00 (as adjusted for any stock splits, reverse splits and similar capital events after the issuance date of this Warrant. (ii) Effect on Exercise Price of Certain Events. For purposes of ------------------------------------------ determining the adjusted Exercise Price under Section 11(b) hereof, the following will be applicable: (A) Issuance of Rights or Options. If the Company in any -------------------------------- manner issues or grants any warrants, rights or options, whether or not immediately exercisable, to subscribe for or to purchase Capital Shares or Capital Shares Equivalents (such warrants, rights and options to purchase Capital Shares or Capital Shares Equivalents are hereinafter referred to as "Options") and the ------- effective price per share for which Common Stock is issuable upon the exercise of such Options is less than the Exercise Price ("Below Base Price Options"), then the maximum total number of --------------------------- shares of Common Stock issuable upon the exercise of all such Below Base Price Options (assuming full exercise, conversion or exchange of Capital Shares Equivalents, if applicable) will, as of the date of the issuance or grant of such Below Base Price Options, be deemed to be outstanding and to have been issued and sold by the Company for such price per share and the maximum consideration payable to the Company upon such exercise (assuming full exercise, conversion or exchange of Capital Shares Equivalents, if applicable) will be deemed to have been received by the Company. For purposes of the preceding sentence, the "effective price per share for which Common Stock is issuable upon the exercise of such Below Base Price Options" is determined by dividing (i) the total amount, if any, received or receivable by the Company as consideration for the issuance or granting of all such Below Base Price Options, plus the minimum aggregate amount of additional consideration, if any, payable to the Company upon the exercise of all such Below Base Price Options, plus, in the case of Capital Shares Equivalents issuable upon the exercise of such Below Base Price Options, the minimum aggregate amount of additional consideration payable upon the exercise, conversion or exchange thereof at the time such Capital Shares Equivalents first become exercisable, convertible or exchangeable, by (ii) the maximum total number of shares of Common Stock issuable upon the exercise of all such Below Base Price Options (assuming full conversion of Capital Shares Equivalents, if applicable). No further adjustment to the Exercise Price will be made upon the actual issuance of such Common Stock upon the exercise of such Below Base Price Options or upon the exercise, conversion or exchange of Capital Shares Equivalents issuable upon exercise of such Below Base Price Options. (B) Issuance of Capital Shares Equivalents. If the Company --------------------------------------- in any manner issues or sells any Capital Shares Equivalents, whether or not immediately convertible (other than where the same are issuable upon the exercise of Options) and the effective price per share for which Common Stock is issuable upon such exercise, conversion or exchange is less than the Exercise Price, then the maximum total number of shares of Common Stock issuable upon the exercise, conversion or exchange of all such Capital Shares Equivalents will, as of the date of the issuance of such Capital Shares Equivalents, be deemed to be outstanding and to have been issued and sold by the Company for such price per share and the maximum consideration payable to the Company upon such exercise (assuming full exercise, conversion or exchange of Capital Shares Equivalents, if applicable) will be deemed to have been received by the Company. For the purposes of the preceding sentence, the "effective price per share for which Common Stock is issuable upon such exercise, conversion or exchange" is determined by dividing (i) the total amount, if any, received or receivable by the Company as consideration for the issuance or sale of all such Capital Shares Equivalents, plus the minimum aggregate amount of additional consideration, if any, payable to the Company upon the exercise, conversion or exchange thereof at the time such Capital Shares Equivalents first become exercisable, convertible or exchangeable, by (ii) the maximum total number of shares of Common Stock issuable upon the exercise, conversion or exchange of all such Capital Shares Equivalents. No further adjustment to the Exercise Price will be made upon the actual issuance of such Common Stock upon exercise, conversion or exchange of such Capital Shares Equivalents. (C) Change in Option Price or Conversion Rate. If there is a ----------------------------------------- change at any time in (i) the amount of additional consideration payable to the Company upon the exercise of any Options; (ii) the amount of additional consideration, if any, payable to the Company upon the exercise, conversion or exchange of any Capital Shares Equivalents; or (iii) the rate at which any Capital Shares Equivalents are convertible into or exchangeable for Common Stock (in each such case, other than under or by reason of provisions designed to protect against dilution), the Exercise Price in effect at the time of such change will be readjusted to the Exercise Price which would have been in effect at such time had such Options or Capital Shares Equivalents still outstanding provided for such changed additional consideration or changed conversion rate, as the case may be, at the time initially granted, issued or sold. (D) Calculation of Consideration Received. If any Common ---------------------------------------- Stock, Options or Capital Shares Equivalents are issued, granted or sold for cash, the consideration received therefor for purposes of this Warrant will be the amount received by the Company therefor, before deduction of reasonable commissions, underwriting discounts or allowances or other reasonable expenses paid or incurred by the Company in connection with such issuance, grant or sale. In case any Common Stock, Options or Capital Shares Equivalents are issued or sold for a consideration part or all of which shall be other than cash, the amount of the consideration other than cash received by the Company will be the fair market value of such consideration, except where such consideration consists of securities, in which case the amount of consideration received by the Company will be the fair market value (closing bid price, if traded on any market) thereof as of the date of receipt. In case any Common Stock, Options or Capital Shares Equivalents are issued in connection with any merger or consolidation in which the Company is the surviving corporation, the amount of consideration therefor will be deemed to be the fair market value of such portion of the net assets and business of the non-surviving corporation as is attributable to such Common Stock, Options or Capital Shares Equivalents, as the case may be. The fair market value of any consideration other than cash or securities will be determined in good faith by an investment banker or other appropriate expert of national reputation selected by the Company and reasonably acceptable to the holder hereof, with the costs of such appraisal to be borne by the Company. (E) Exceptions to Adjustment of Exercise Price. ----------------------------------------------- Notwithstanding the foregoing, no adjustment will be made under this Section 11(b) in respect of (1) the granting of options to employees, officers or directors of the Company pursuant to any stock option plan duly adopted by a majority of the non-employee members of the Board of Directors of the Company or a majority of the members of a committee of non-employee directors established for such purpose or (2) upon the exercise of or conversion of any Capital Shares Equivalents or Options issued and outstanding on the Initial Exercise Date, provided that the securities have not been amended since the date of the Purchase Agreement except as a result of the Purchase Agreement. (iii) Minimum Adjustment of Exercise Price. No adjustment of the ------------------------------------ Exercise Price shall be made in an amount of less than 1% of the Exercise Price in effect at the time such adjustment is otherwise required to be made, but any such lesser adjustment shall be carried forward and shall be made at the time and together with the next subsequent adjustment which, together with any adjustments so carried forward, shall amount to not less than 1% of such Exercise Price. 12. Reorganization, Reclassification, Merger, Consolidation or -------------------------------------------------------------- Disposition of Assets. In case the Company shall reorganize its capital, - ----------------------- reclassify its capital stock, consolidate or merge with or into another corporation (where the Company is not the surviving corporation or where there is a change in or distribution with respect to the Common Stock of the Company), or sell, transfer or otherwise dispose of its property, assets or business to another corporation and, pursuant to the terms of such reorganization, reclassification, merger, consolidation or disposition of assets, shares of common stock of the successor or acquiring corporation, or any cash, shares of stock or other securities or property of any nature whatsoever (including warrants or other subscription or purchase rights) in addition to or in lieu of common stock of the successor or acquiring corporation ("Other Property"), are -------------- to be received by or distributed to the holders of Common Stock of the Company, then the Holder shall have the right thereafter to receive, at the option of the Holder upon exercise of this Warrant, the number of shares of Common Stock of the successor or acquiring corporation or of the Company, if it is the surviving corporation, and Other Property receivable upon or as a result of such reorganization, reclassification, merger, consolidation or disposition of assets by a Holder of the number of shares of Common Stock for which this Warrant is exercisable immediately prior to such event. In case of any such reorganization, reclassification, merger, consolidation or disposition of assets, the successor or acquiring corporation (if other than the Company) shall expressly assume the due and punctual observance and performance of each and every covenant and condition of this Warrant to be performed and observed by the Company and all the obligations and liabilities hereunder, subject to such modifications as may be deemed appropriate (as determined in good faith by resolution of the Board of Directors of the Company) in order to provide for adjustments of Warrant Shares for which this Warrant is exercisable which shall be as nearly equivalent as practicable to the adjustments provided for in this Section 12. For purposes of this Section 12, "common stock of the successor or acquiring corporation" shall include stock of such corporation of any class which is not preferred as to dividends or assets over any other class of stock of such corporation and which is not subject to redemption and shall also include any evidences of indebtedness, shares of stock or other securities which are convertible into or exchangeable for any such stock, either immediately or upon the arrival of a specified date or the happening of a specified event and any warrants or other rights to subscribe for or purchase any such stock. The foregoing provisions of this Section 12 shall similarly apply to successive reorganizations, reclassifications, mergers, consolidations or disposition of assets. 13. Call Provision. Subject to the provisions of this Section 13, if --------------- after the Effective Date the volume weighted average price of the Common Stock as reported by Bloomberg Financial LP ("VWAP") for each of fifteen consecutive ---- Trading Days (the "Measurement Price", which period shall not have commenced ------------------ until after the Effective Date) exceeds $6.00 (subject to adjustment for any stock splits, reverse stock splits and similar capital events after the issuance date of this Warrant) (the "Threshold Price"), then the Company may, within ten --------------- Trading Days of such period, call for cancellation of all or any portion of this Warrant for which a Notice of Exercise has not yet been delivered (such right, a "Call"); provided, however, that effective upon delivery of such notice of a ---- -------- ------- Call, the Holder shall have the right to exercise this Warrant for all Warrant Shares notwithstanding the vesting schedule set forth in the first paragraph of this Warrant. To exercise this right, the Company must deliver to the Holder an irrevocable written notice (a "Call Notice"), indicating therein the portion of ----------- unexercised portion of this Warrant to which such notice applies. If the conditions set forth below for such Call are satisfied from the period from the date of the Call Notice through and including the Call Date (as defined below), then any portion of this Warrant subject to such Call Notice for which a Notice of Exercise shall not have been received from and after the date of the Call Notice will be cancelled at 6:30 p.m. (New York City time) on the tenth Trading Day after the date the Call Notice is received by the Holder (such date, the "Call Date"). Any unexercised portion of this Warrant to which the Call Notice ---------- does not pertain will be unaffected by such Call Notice. In furtherance thereof, the Company covenants and agrees that it will honor all Notices of Exercise with respect to Warrant Shares subject to a Call Notice that are tendered from the time of delivery of the Call Notice through 6:30 p.m. (New York City time) on the Call Date, including, without limitation, Notices of Exercise which otherwise could not be delivered by the Holder because the time periods set forth in the preamble to this Warrant had not otherwise elapsed. For clarity, it is agreed that this entire Warrant may be exercised by the Holder upon receipt of a Call Notice. Notwithstanding anything to the contrary set forth in this Warrant, the Company may not deliver a Call Notice or require the cancellation of this Warrant (and any Call Notice will be void), unless, from the beginning of the 15 consecutive Trading Days used to determine whether the Common Stock has achieved the Threshold Price through the Call Date, (i) the Company shall have honored in accordance with the terms of this Warrant all Notices of Exercise delivered by 6:30 p.m. (New York City time) on the Call Date, (ii) the Registration Statement shall be effective as to all Warrant Shares and the prospectus thereunder available for use by the Holder for the resale of all such Warrant Shares and (iii) the Common Stock shall be listed or quoted for trading on the Principal Market. The Company's right to Call the Warrant shall be exercised ratably among the Purchasers based on each Purchaser's initial purchase of Common Stock pursuant to the Purchase Agreement. 14. Notice of Adjustment. Whenever the number of Warrant Shares or number ---------------------- or kind of securities or other property purchasable upon the exercise of this Warrant or the Exercise Price is adjusted, as herein provided, the Company shall give notice thereof to the Holder, which notice shall state the number of Warrant Shares (and other securities or property) purchasable upon the exercise of this Warrant and the Exercise Price of such Warrant Shares (and other securities or property) after such adjustment, setting forth a brief statement of the facts requiring such adjustment and setting forth the computation by which such adjustment was made. 15. Notice of Corporate Action. If at any time: ----------------------------- (a) the Company shall take a record of the holders of its Common Stock for the purpose of entitling them to receive a dividend or other distribution, or any right to subscribe for or purchase any evidences of its indebtedness, any shares of stock of any class or any other securities or property, or to receive any other right, or (b) there shall be any capital reorganization of the Company, any reclassification or recapitalization of the capital stock of the Company or any consolidation or merger of the Company with, or any sale, transfer or other disposition of all or substantially all the property, assets or business of the Company to, another corporation or, (c) there shall be a voluntary or involuntary dissolution, liquidation or winding up of the Company; then, in any one or more of such cases, the Company shall give to Holder (i) at least 20 days' prior written notice of the date on which a record date shall be selected for such dividend, distribution or right or for determining rights to vote in respect of any such reorganization, reclassification, merger, consolidation, sale, transfer, disposition, liquidation or winding up, and (ii) in the case of any such reorganization, reclassification, merger, consolidation, sale, transfer, disposition, dissolution, liquidation or winding up, at least 20 days' prior written notice of the date when the same shall take place. Such notice in accordance with the foregoing clause also shall specify (i) the date on which any such record is to be taken for the purpose of such dividend, distribution or right, the date on which the holders of Common Stock shall be entitled to any such dividend, distribution or right, and the amount and character thereof, and (ii) the date on which any such reorganization, reclassification, merger, consolidation, sale, transfer, disposition, dissolution, liquidation or winding up is to take place and the time, if any such time is to be fixed, as of which the holders of Common Stock shall be entitled to exchange their Warrant Shares for securities or other property deliverable upon such disposition, dissolution, liquidation or winding up. Each such written notice shall be sufficiently given if addressed to Holder at the last address of Holder appearing on the books of the Company and delivered in accordance with Section 17(d). 16. Authorized Shares. The Company covenants that during the period ------------------ the Warrant is outstanding, it will reserve from its authorized and unissued Common Stock a sufficient number of shares to provide for the issuance of the Warrant Shares upon the exercise of any purchase rights under this Warrant. The Company further covenants that its issuance of this Warrant shall constitute full authority to its officers who are charged with the duty of executing stock certificates to execute and issue the necessary certificates for the Warrant Shares upon the exercise of the purchase rights under this Warrant. The Company will take all such reasonable action as may be necessary to assure that such Warrant Shares may be issued as provided herein without violation of any applicable law or regulation, or of any requirements of the Principal Market upon which the Common Stock may be listed. Except and to the extent as waived or consented to by the Holder, the Company shall not by any action, including, without limitation, amending its certificate of incorporation or through any reorganization, transfer of assets, consolidation, merger, dissolution, issue or sale of securities or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms of this Warrant, but will at all times in good faith assist in the carrying out of all such terms and in the taking of all such actions as may be necessary or appropriate to protect the rights of Holder as set forth in this Warrant against impairment. Without limiting the generality of the foregoing, the Company will (a) not increase the par value of any Warrant Shares above the amount payable therefor upon such exercise immediately prior to such increase in par value, (b) take all such action as may be necessary or appropriate in order that the Company may validly and legally issue fully paid and nonassessable Warrant Shares upon the exercise of this Warrant, and (c) use commercially reasonable efforts to obtain all such authorizations, exemptions or consents from any public regulatory body having jurisdiction thereof as may be necessary to enable the Company to perform its obligations under this Warrant. Before taking any action which would result in an adjustment in the number of Warrant Shares for which this Warrant is exercisable or in the Exercise Price, the Company shall obtain all such authorizations or exemptions thereof, or consents thereto, as may be necessary from any public regulatory body or bodies having jurisdiction thereof. 17. Miscellaneous. ------------- (a) Jurisdiction. All questions concerning the construction, validity, ------------ enforcement and interpretation of this Warrant shall be determined in accordance with the provisions of the Purchase Agreement. (b) Restrictions. The Holder acknowledges that the Warrant Shares ------------ acquired upon the exercise of this Warrant, if not registered, will have restrictions upon resale imposed by state and federal securities laws. (c) Nonwaiver and Expenses. No course of dealing or any delay or ------------------------ failure to exercise any right hereunder on the part of Holder shall operate as a waiver of such right or otherwise prejudice Holder's rights, powers or remedies, notwithstanding all rights hereunder terminate on the Termination Date. If the Company willfully and knowingly fails to comply with any provision of this Warrant, which results in any material damages to the Holder, the Company shall pay to Holder such amounts as shall be sufficient to cover any costs and expenses including, but not limited to, reasonable attorneys' fees, including those of appellate proceedings, incurred by Holder in collecting any amounts due pursuant hereto or in otherwise enforcing any of its rights, powers or remedies hereunder. (d) Notices. Any notice, request or other document required or ------- permitted to be given or delivered to the Holder by the Company shall be delivered in accordance with the notice provisions of the Purchase Agreement. (e) Limitation of Liability. No provision hereof, in the absence of ------------------------- any affirmative action by Holder to exercise this Warrant or purchase Warrant Shares, and no enumeration herein of the rights or privileges of Holder, shall give rise to any liability of Holder for the purchase price of any Common Stock or as a stockholder of the Company, whether such liability is asserted by the Company or by creditors of the Company. (f) Remedies. Holder, in addition to being entitled to exercise all -------- rights granted by law, including recovery of damages, will be entitled to specific performance of its rights under this Warrant. The Company agrees that monetary damages would not be adequate compensation for any loss incurred by reason of a breach by it of the provisions of this Warrant and hereby agrees to waive the defense in any action for specific performance that a remedy at law would be adequate. (g) Successors and Assigns. Subject to applicable securities laws, ------------------------ this Warrant and the rights and obligations evidenced hereby shall inure to the benefit of and be binding upon the successors of the Company and the successors and permitted assigns of Holder. The provisions of this Warrant are intended to be for the benefit of all Holders from time to time of this Warrant and shall be enforceable by any such Holder or holder of Warrant Shares. (h) Amendment. This Warrant may be modified or amended or the --------- provisions hereof waived with the written consent of the Company and the Holder. (i) Severability. Wherever possible, each provision of this Warrant ------------ shall be interpreted in such manner as to be effective and valid under applicable law, but if any provision of this Warrant shall be prohibited by or invalid under applicable law, such provision shall be ineffective to the extent of such prohibition or invalidity, without invalidating the remainder of such provisions or the remaining provisions of this Warrant. (j) Headings. The headings used in this Warrant are for the -------- convenience of reference only and shall not, for any purpose, be deemed a part of this Warrant. ******************** IN WITNESS WHEREOF, the Company has caused this Warrant to be executed by its officer thereunto duly authorized. Dated: February ____, 2004 U.S. Energy Corp. By: ___________________________________ Name: Title: NOTICE OF EXERCISE To: U.S Energy Corp. (1) The undersigned hereby elects to purchase ________ Warrant Shares of the Company pursuant to the terms of the attached Warrant (only if exercised in full), and tenders herewith payment of the exercise price in full, together with all applicable transfer taxes, if any. (2) Payment shall take the form of (check applicable box): [ ] in lawful money of the United States; or [ ] the cancellation of such number of Warrant Shares as is necessary, in accordance with the formula set forth in subsection 3(d), to exercise this Warrant with respect to the maximum number of Warrant Shares purchasable pursuant to the cashless exercise procedure set forth in subsection 3(d). (3) Please issue a certificate or certificates representing said Warrant Shares in the name of the undersigned or in such other name as is specified below: ---------------------------------- The Warrant Shares shall be delivered to the following: ---------------------------------- ---------------------------------- ---------------------------------- (4) Accredited Investor. The undersigned is an "accredited investor" as -------------------- defined in Regulation D under the Securities Act of 1933, as amended. [PURCHASER] By: ----------------------------------- Name: Title: Dated: -------------------------------- ASSIGNMENT FORM (To assign the foregoing warrant, execute this form and supply required information. Do not use this form to exercise the warrant.) FOR VALUE RECEIVED, the foregoing Warrant and all rights evidenced thereby are hereby assigned to _______________________________________________ whose address is _______________________________________________________________. _______________________________________________________________ Dated: ______________, _______ Holder's Signature: _____________________________ Holder's Address: _____________________________ _____________________________ Signature Guaranteed: ___________________________________________ NOTE: The signature to this Assignment Form must correspond with the name as it appears on the face of the Warrant, without alteration or enlargement or any change whatsoever, and must be guaranteed by a bank or trust company. Officers of corporations and those acting in a fiduciary or other representative capacity should file proper evidence of authority to assign the foregoing Warrant. EX-10.70 5 doc4.txt 8949\1\801146.7 8949\1\801146.7 STOCK PURCHASE AGREEMENT BY AND AMONG PLATEAU RESOURCES LIMITED CANYON HOMESTEADS, INC., CACTUS GROUP LLC, AND JOSEPH DEFFERT D. PAIGE DEFFERT ERNST DEFFERT AILEEN DEFFERT MARTIN VIALPANDO MARY EILEEN VIALPANDO DATED AUGUST 1, 2003 8949\1\801146.7 STOCK PURCHASE AGREEMENT This STOCK PURCHASE AGREEMENT (the "AGREEMENT") is entered into as of August 1, 2003, by and among Cactus Group LLC, a Colorado limited liability company ("CGL"), Joseph Deffert, D. Paige Deffert, Ernst Deffert, Aileen Deffert, Martin Vialpando and Mary Eileen Vialpando (each, a "BUYER" and collectively, the "BUYERS"), Canyon Homesteads, Inc., a Utah corporation (the "COMPANY"), and Plateau Resources Limited, a Utah corporation (the "SHAREHOLDER"). RECITALS A. The Shareholder owns 4,478 shares of the outstanding common stock of the Company (the "SHARES"), which Shares constitute all of the issued and outstanding shares of capital stock of the Company. B. The Buyers, through their wholly owned entity, CGL, desire to acquire from the Shareholder and the Shareholder desires to sell to the Buyers all of the Shares, on the terms and subject to the conditions set forth in this Agreement (the "ACQUISITION"). C. The Board of Directors of the Company and the Shareholder and the members of CGL shall have approved and adopted this Agreement and the transactions contemplated hereby. AGREEMENT NOW, THEREFORE, in consideration of the premises and the mutual promises herein made, and in consideration of the representations, warranties and covenants in this Agreement, CGL, the Company and the Shareholder (individually, a "PARTY" and collectively, the "PARTIES") agree as follows: ARTICLE 1 DEFINITIONS AND INTERPRETATIONS 1.1 DEFINITIONS. Capitalized terms used in this Agreement, but not otherwise defined herein, shall have the meaning set out below: "ACTION" means any judicial or administrative action, claim, suit, investigation, hearing, demand or proceeding by or before any Governmental Authority "AFFILIATE" has the meaning set forth in Rule 12b-2 of the regulations promulgated under the Securities Exchange Act of 1934, as amended. "AGREEMENT" means this Stock Purchase Agreement. "ASSETS" has the meaning set forth in Section 4.10. ------------- "CLOSING" has the meaning set forth in Section 2.4. ------------ "CLOSING DATE" has the meaning set forth in Section 2.7. ------------ "CODE" means the Internal Revenue Code of 1986, as amended, and the rules and regulations promulgated thereunder. "CONTRACTS" has the meaning set forth in Section 4.14. ------------- "DEED OF TRUST" means that certain deed of trust executed by CGL relating to the properties and improvements in such form reasonably acceptable to the Shareholder. "EFFECTIVE DATE" means August 1, 2003. "ENVIRONMENT" means soil, land surface or subsurface strata, real property (excluding buildings, other structures or fixtures thereon), surface waters (including navigable waters, ocean waters, streams, ponds, drainage basins and wetlands), groundwater, water body sediments, drinking water supply, stream sediments, plant and animal life and any other environmental medium or natural resource. "ENVIRONMENTAL LAW" means any federal, state or local law, including regulations promulgated thereunder, or common law relating to emissions, discharges, releases or threatened releases of pollutants, petroleum, petroleum products, contaminants, chemicals or toxic or hazardous substances or wastes into the environment, including ambient air, soil, surface water, ground water, wetlands, land or subsurface strata, or otherwise relating to the manufacture, processing, distribution, use, treatment, storage, disposal, transport or handling of pollutants, petroleum, petroleum products, contaminants, chemicals or toxic or hazardous substances or wastes. "ENVIRONMENTAL LIABILITY(IES) AND COST(S)" means all Liabilities and losses incurred (i) to comply with any Environmental Law, (ii) as a result of a Release of any Hazardous Substance or (iii) as a result of any environmental conditions present at, created by or arising out of the past or present operations of the Company and its business through the Effective Date. "ENVIRONMENTAL PERMITS" mean any permit, registration, filing, approval or authorization from any Governmental Authority required under, issued pursuant to, or authorized by any Environmental Law. "ENVIRONMENTAL REPORT" means the Environmental Assessment Report for Ticaboo, Utah prepared on behalf of Shareholder by Jay W. Davis dated July 23, 2003, provided by Shareholder to CGL and Buyers prior to the execution of this Agreement. "EXCLUDED ASSETS" means those assets set forth on Exhibit A attached --------- hereto. "EXCLUDED LIABILITIES" means the following Liabilities of the Company, relating to any period on or prior to the Effective Date: (i) any liabilities or obligations of the Company with respect to any debt or trade payable (other than accounts payable or debt of the Company which have been incurred in the Ordinary Course of Business and are outstanding as of the Effective Date), (ii) any liabilities or obligations of any officer or employee of the Company, or of the Shareholder or its Affiliates that provided services to or on behalf of the Company, (iii) any costs of any such employees, including without limitation any accrued vacation, sick leave, COBRA obligations, personal time, and any other prerequisites (including accrued bonuses), (iv) any liabilities or obligations with respect to worker's compensation claims (v) any Taxes, including any Taxes resulting from the transactions contemplated hereby, and (vi) the Company's relationship, contractual or otherwise, with the subtenant at Pier 84, (vii) the pending litigation between the Company and Phil Snyder, as further described on Schedule 4.15 ("SNYDER LITIGATION"), and (viii) Company's relationship, - -------------- contractual or otherwise, with Ticaboo Townsite Joint Venture. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended. "GAAP" means United States generally accepted accounting principles as in effect on the date hereof. "GOVERNMENTAL AUTHORITY" means the United States of America, any Indian tribe, any state or other political subdivision thereof, any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government, or any court, tribunal, arbitrator or arbitral body. "GUARANTY AGREEMENT" means the Guaranty Agreement, by and between each Buyer and the Shareholder, in a form reasonably acceptable to CGL, Buyers and the Shareholder. "HAZARDOUS SUBSTANCE" means, collectively, (i) any petroleum or petroleum products, explosives, radioactive materials, asbestos, urea formaldehyde foam insulation, and transformers or other substances that contain polychlorinated biphenyls, (ii) any chemicals or other materials or substances that are defined as or included in the definition of "hazardous substances," "hazardous wastes," "hazardous materials," "extremely hazardous wastes," "restricted hazardous wastes," "toxic substances," "toxic pollutants," "contaminants," "pollutants" or words of similar import under any Environmental Law and (iii) any other chemical or other material or substance, exposure to which is prohibited, limited or regulated under any Environmental Law. "INDEBTEDNESS" means, with respect to any Person, any and all obligations of such Person (i) for borrowed money, (ii) evidenced by notes, bonds, debentures or similar instruments, (iii) under or relating to letters of credit (including any obligation to reimburse the letter of credit issuer with respect to amounts drawn on such instruments), (iv) for the deferred purchase price of goods or services (other than trade payables or accruals incurred and paid in the Ordinary Course of Business), (v) under capital leases, (vi) with respect to bank overdrafts or otherwise reflected as negative cash in financial statements of such Person, (vii) for deferred compensation, (viii) to pay any accrued dividends or dividends that have otherwise been declared and not yet paid, and (ix) in the nature of guarantees of the obligations described in clauses (i) through (viii) above of any other Person. "INVESTMENTS" means (i) any share of capital stock, partnership or other equity interest, evidence of Indebtedness or other security issued by any other Person, (ii) any loan, advance, prepayment or extension of credit to, or contribution to the capital of, any other Person, (iii) any acquisition of all or any part of the business of any other entity or the assets comprising such business or part thereof, (iv) any commitment or option to make any investment or (v) any other similar investment. "KNOWLEDGE" means a Person's actual knowledge after reasonable investigation, including the knowledge of a particular fact or matter by any executive officer employed by or serving a Person; provided, however, the Company's knowledge shall mean the actual knowledge of only Mark Larsen, Hal Herron and Daryl Winters. "LAWS" means all laws, statutes, rules, regulations, codes, injunctions, judgments, orders, decrees, ruling, interpretations, constitutions, ordinances, common law or treaties of any federal, state, local, municipal and foreign, international or multinational Government Authority. "LIABILITY" means any liability or obligation (whether known or unknown, whether asserted or unasserted, whether absolute or contingent, whether accrued or unaccrued, whether liquidated or unliquidated, whether incurred directly or consequentially and whether due or to become due), including any liability for Taxes. "MATERIAL ADVERSE EFFECT" means a material adverse effect on the Party's business, financial condition, operations, results of operations. "ORDINARY COURSE OF BUSINESS" means the ordinary course of business consistent with past custom and practice (including with respect to quantity and frequency). "PERSON" means an individual, a partnership, a limited liability company, a corporation, an association, a joint stock company, a trust, a joint venture, an unincorporated organization, or a governmental entity (or any department, agency or political subdivision thereof). "PROMISSORY NOTE" means that certain secured promissory note in the principal amount of $3,003,200.00 payable to the Shareholder in a form reasonably acceptable to the Shareholder. "PURCHASE PRICE" has the meaning set forth in Section 2.2. ------------ "PROPERTY(IES)"means collectively the Real Property and Assets of the Company. "REAL PROPERTY" has the meaning set forth in Section 4.10. ------------- "RELEASE" means any actual, threatened or alleged spilling, leaking, pumping, pouring, emitting, dispersing, emptying, discharging, injecting, escaping, leaching, dumping or disposing of any Hazardous Substance into the Environment that may cause an Environmental Liability and Cost (including the disposal or abandonment of barrels, containers, tanks or other receptacles containing or previously containing any Hazardous Substance). "SCHEDULES" has the meaning set forth in Article 3. "SECURITY AGREEMENT" means that certain Security Agreement, by and among the CGL, the Company and the Shareholder in the form reasonably acceptable to the Shareholder. "SECURITY INTEREST" means any mortgage, pledge, lien, encumbrance, charge, claim, equitable interest, restriction on transfer or other security interest, other than (a) mechanic's, materialmen's, and similar liens, securing payment of sums not yet due and payable, (b) liens for Taxes not yet due and payable or for Taxes that the taxpayer is contesting in good faith through appropriate proceedings and (c) other liens arising in the Ordinary Course of Business and not incurred in connection with the borrowing of money as set forth on Schedule 4.14. "TAX" means any federal, state, local, or foreign income, gross receipts, license, payroll, employment, excise, severance, stamp, occupation, premium, windfall profits, capital gain, intangible, environmental (including taxes under Code Section 59A), customs duties, capital stock, franchise, profits, withholding, social security (or similar), unemployment, disability, real property, personal property, sales, use, transfer, registration, value added, alternative or add-on minimum, estimated, or other tax of any kind whatsoever, including any interest, penalty, or addition thereto, whether disputed or not, and any obligation to indemnify, assume or succeed to the liability of any other Person in respect to the foregoing. "TAX RETURN" means any federal, state, local, or foreign return, declaration, report, claim for refund, or information return or statement relating to Taxes, including any schedule or attachment thereto, and including any amendment thereof. "TITLE COMPANY" means South Eastern Utah Title Company located 175 East 100 South, P.O. Box 855, Price, Utah 84501. "TREASURY REGULATION" or "TREAS. REG." means the proposed, temporary, and final regulations promulgated under the Code. 1.2 Terms denoting the singular only shall include the plural, and vice versa. 1.3 Unless otherwise stated, a reference to a Recital, Article, Section, Schedule or Exhibit is a reference to a Recital, Article, Section, Schedule or Exhibit of this Agreement. 1.4 Section numbers and headings are for convenience of reference only, and shall not affect the interpretation of this Agreement. 1.5 Reference to any gender includes the other. 1.6 Reference to "including" means including, but not by way of limitation. 1.7 Unless otherwise expressly provided in this Agreement, reference to an Agreement (including this Agreement), document, or instrument is the same as amended, modified, novated or replaced from time to time. 1.8 Reference to a statute or other legislative act, by-law, rule, regulation, or order is to the same as amended, modified or replaced from time to time and to any rule, regulation or order promulgated pursuant to such law. ARTICLE 2 PURCHASE AND SALE; INITIAL DELIVERIES; CLOSING 2.1 PURCHASE AND SALE. Upon the basis of the representations and warranties, for the consideration, and subject to the terms and conditions hereof, the Shareholder agrees to sell, convey, transfer and deliver to CGL at the Closing (as defined in Section 2.4 below), and CGL agrees to purchase and accept from the Shareholder at the Closing, effective as of the Closing Date, the Shares free and clear of any and all Security Interests. 2.2 PURCHASE PRICE. Subject to the adjustments set forth in Section 2.3, the aggregate purchase price for the Shares shall be $3,470,000.00 (the "PURCHASE PRICE"), and shall be payable to the Shareholder as follows: a. Within five (5) business days following the Effective Date, CGL shall wire at least one-half of an amount equal to $466,800 (the "Deposit") to the Title Company. The remainder of the Deposit will be wired to the Title Company within ten (10) business days following the Effective Date. Title Company shall place the Deposit in an insured, interest-bearing account. If prior to Closing, this Agreement is terminated pursuant to Section 11.1(c), $100,000 of the Deposit shall be transmitted by the Title Company to Shareholder, with the balance transmitted to CGL. At Closing, the Deposit shall be released from escrow to the Shareholder pursuant to certain escrow closing instructions to be delivered by CGL to the Title Company; and b. At Closing, CGL shall deliver the Promissory Note, dated as of the Closing Date, to the Shareholder, as well as the Security Agreement and the Deed of Trust, and each Buyer shall deliver a Guaranty Agreement. 2.3 INTENTIONALLY DELETED. 2.4 TITLE COMMITMENT AND SURVEY. a. Title Insurance Commitment. The Shareholder has delivered to ---------------------------- the Buyers and CGL, a commitment (the "TITLE COMMITMENT") from the Title Company. CGL shall deliver a Lender's title insurance policy to Shareholder. Buyers and CGL and Shareholder shall share the cost of the Title Commitment and Lender's title insurance policy equally. b. Surveys. The Shareholder shall deliver to the Buyers and CGL ------- any boundary and improvement surveys of the Property in the Shareholder's or the Company's possession. 2.5 WATER RIGHTS. The Shareholder has provided the Buyers and CGL all information it and the Company have in their possession related to sanitary sewer and other information with respect to the water rights, well permits and other documentation related to adequacy of water supply for the Property. 2.6 UTILITIES AND POWER. The Shareholder has provided the Buyers and CGL with all information and documentation it and the Company have in their possession related to the adequacy of power and utilities to service the operation of the Property, including without limitation, all information pertaining to power generators and the like. 2.7 TENANT RELATIONSHIPS. Within ten (10) days following the date hereof, the Shareholder shall provide the Buyers and CGL with any financial information of subtenants of the Property within its or the Company's possession. Within ten (10) days prior to the Closing Date, the Shareholder shall use commercially reasonable efforts to have the following subtenants execute estoppel certificates confirming that such subtenant's lease is in full force and effect and that neither the tenant nor the Company is in default under their applicable lease: (i) Slick Rock Services, Inc., sublease dated June 1, 2003; (ii) Stephen Lama, sublease for Motel Room No. 112 dated March 27, 2001; and (iii) Wendy Schmitz, sublease for restaurant and bar dated March 15, 2003. Each of the foregoing subleases shall also be assigned to the Company as of the date of Closing. 2.8 CLOSING. The closing of the transactions contemplated by this Agreement (the "CLOSING") shall take place at the offices of Davis Graham & Stubbs LLP in Denver, Colorado, commencing at 9:00 a.m., local time, or at such other place and time as is agreed upon by the Parties, on August 12, 2003 or as soon as practicable thereafter following the satisfaction or waiver of all conditions to the obligations of the Parties to consummate the transactions contem-plated hereby (other than conditions with respect to actions the respective Parties will take at the Closing itself) or such other date as the Parties may mutually determine (the "CLOSING DATE"). Notwithstanding the actual date of the Closing, the Closing shall be effective for accounting purposes as of the 11:59 p.m. on the date immediately preceding the Effective Date. ARTICLE 3 REPRESENTATIONS AND WARRANTIES OF THE SHAREHOLDER The disclosure schedules (the "SCHEDULES") contemplated by this Article 3, Article 4 and Article 5 will be arranged to correspond to the numbered and lettered sections contained in Article 3, Article 4 and Article 5 and will be delivered concurrently with the execution of this Agreement. As a material inducement to the Buyers and CGL to enter into this Agreement and consummate the transactions contemplated hereby, the Shareholder represents and warrants to the Buyers and CGL as follows: 3.1 ORGANIZATION, QUALIFICATION, AND CORPORATE POWER. The Shareholder is a corporation duly organized, validly existing and in good standing under the laws of the State of Utah and has the corporate power to own its property and to carry on its business as now being conducted. The Shareholder is duly qualified and/or licensed, as may be required, and in good standing in each of the jurisdictions in which the nature of the business conducted by it or the character of the property owned, leased or used by it makes such qualification and/or licensing necessary, except in such jurisdictions where the failure to be so qualified and/or licensed would not individually or in the aggregate have a Material Adverse Effect on the Company or the Shareholder. 3.2 NO LIENS ON SHARES. The Shareholder is the beneficial and record owner of all of the Shares free and clear of any Security Interests other than the rights and obligations arising under this Agreement except as disclosed on Schedule 3.2. No Share is subject to any outstanding option, warrant, call, or similar right of any other Person to acquire the same, and no Share is subject to any restriction on transfer thereof, except for restrictions related to registration of the Shares under the Securities Act of 1933, as amended (the "SECURITIES ACT"). The Shareholder has full power and authority to convey the Shares, free and clear of any Security Interests. Upon Closing, CGL will hold the entire equity interest in the Company, free and clear of all Security Interests, other than those Security Interests to be created by the transactions contemplated by this Agreement or Security Interests otherwise created by CGL. 3.3 AUTHORIZATION OF TRANSACTION. The Shareholder has the full limited liability company power and authority to execute, deliver and perform this Agreement and to carry out the transactions contemplated hereby. The execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby have been duly and validly authorized by all requisite limited liability company action of the Shareholder. This Agreement has been duly and validly executed and delivered by the Shareholder and constitutes the valid and legally binding obligation of the Shareholder, enforceable against the Shareholder in accordance with its terms and conditions, subject, as to enforcement, to bankruptcy, insolvency, fraudulent transfer, moratorium, reorganization and other laws of general applicability relating to or affecting creditors' rights and to general equity principles. 3.4 NONCONTRAVENTION. Except for filings, permits, authorizations, consents and approvals, all of which are set forth on Schedule 3.4, neither the execution ------------ and delivery of this Agreement by the Shareholder nor the consummation by the Shareholder of the transactions contemplated herein nor compliance by the Shareholder with any of the provisions hereof will (i) conflict with or result in any breach of the articles of incorporation or bylaws of the Shareholder, (ii) result in a violation or breach of any provisions of, or constitute a default (or an event which, with notice or lapse of time or both, would constitute a default) under, or result in the termination, cancellation of, or accelerate the performance required by, or result in a right of termination or acceleration under, or result in the creation of any Security Interest upon any of the properties or assets of the Shareholder, or require the notice to any Person under, any of the terms, conditions or provisions of any note, bond, mortgage, indenture, deed of trust, license, contract, lease, agreement or other instrument or obligation of any kind to which the Shareholder is a party or by which the Shareholder's properties or assets, may be bound or (iii) subject to compliance with applicable Utah corporate laws, the Securities Act and applicable "blue sky" laws, violate Laws applicable to the Shareholder or any of the Shareholder's properties or assets. Except as set forth on Schedule 3.4, the ------------ Shareholder is not required by applicable Laws or other obligations to give any notice to, make any filing with, or obtain any authorization, consent or approval of any Governmental Authority or other Person in order for the consummation by the Parties of the transactions contemplated herein. 3.5 CLAIMS AND PROCEEDINGS. Except as set forth on Schedule 3.5, there are ------------ no Actions pending or, to the Shareholder's Knowledge, threatened against the Shareholder that would reasonably be expected to have a Material Adverse Effect on the Company or the Shareholder, or that question the validity of this Agreement or of any action taken or to be taken pursuant to or in connection with the provisions of this Agreement nor, to the Shareholder's Knowledge, is there any fact (past or present), situation, circumstance, status, condition, activity , practice, plan occurrence, event, incident, action, failure to act or transaction that could reasonably be expected to form the basis of an Action. The Shareholder is not subject to any order, judgment, writ, injunction or decree of any Governmental Authority which, individually or in the aggregate, has a Material Adverse Effect on Shareholder. 3.6 BROKER'S FEES. Except as set forth on Schedule 3.6, the Shareholder has ------------ no Liability to pay any fees or commissions to any broker, finder, or agent with respect to the transactions contemplated by this Agreement for which CGL could become liable. 3.7 POWERS OF ATTORNEY. There are no outstanding powers of attorney executed on behalf of Shareholder in respect of the Shares. 3.8 DISCLOSURE. The representations and warranties contained in this Article 3 (including the Schedules to this Agreement and any other schedules and exhibits required to be delivered by the Shareholder to the Buyers and CGL pursuant to this Agreement) and any certificate furnished or to be furnished by the Shareholder to the Buyers and CGL hereunder do not contain and will not contain any untrue statement of material fact or omit to state any fact necessary in order to make the statements and information contained in this Section 3 not misleading. To the Shareholder's Knowledge, there is no material fact relating to the Shareholder (other than general economic or industry conditions) which may have a Material Adverse Effect on the Company or the Shareholder or materially effect the ability of the Shareholder to perform any of its material obligations hereunder which has not been disclosed in writing in this Agreement to the Buyers or CGL by the Shareholder. ARTICLE 4 REPRESENTATIONS AND WARRANTIES OF THE COMPANY As a material inducement to the Buyers and CGL to enter into this Agreement and consummate the transactions contemplated hereby, the Company represents and warrants to the Buyers and CGL as follows: 4.1 ORGANIZATION, QUALIFICATION, AND CORPORATE POWER. The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Utah and has the corporate power to own its property and to carry on its business as now being conducted. The Company is duly qualified and/or licensed, as may be required, and in good standing in each of the jurisdictions in which the nature of the business conducted by it or the character of the property owned, leased or used by it makes such qualification and/or licensing necessary, except in such jurisdictions where the failure to be so qualified and/or licensed would not individually or in the aggregate have a Material Adverse Effect on the Company. 4.2 CAPITALIZATION. As of the date of this Agreement, the authorized capital stock of the Company consists of 20,000 shares of common stock, no par value, of which 4,478 are issued and outstanding. This 4,478 issued and outstanding shares of common stock consist of all the Shares and constitute all of the issued and outstanding shares of capital stock of the Company. The Shares are held beneficially and of record by the Shareholder. No shares of common stock are held in the treasury of the Company. The Shares have been duly authorized, validly issued, are fully paid and nonassessable and free of preemptive rights. None of the Shares were issued in violation of the Securities Act or applicable "blue sky" laws. There are no outstanding options, warrants or other rights to subscribe for, purchase or acquire from the Company any capital stock of the Company or securities convertible into or exchangeable for capital stock of the Company. Immediately following the Closing, CGL will own the entire ownership interest of the Company. 4.3 AUTHORIZATION OF TRANSACTION. The Company has the full corporate power and authority to execute, deliver and perform this Agreement and to carry out the transactions contemplated hereby. The execution, delivery and performance of this Agreement and the consummation of the transactions contemplated hereby have been duly and validly authorized by all requisite corporate action of the Company. This Agreement has been duly and validly executed and delivered by the Company and constitutes the valid and legally binding obligation of the Company, enforceable against the Company in accordance with its terms and conditions, subject, as to enforcement, to bankruptcy, insolvency, fraudulent transfer, moratorium, reorganization and other laws of general applicability relating to or affecting creditors' rights and to general equity principles. 4.4 NONCONTRAVENTION. Except for filings, permits, authorizations, consents and approvals, all of which are set forth on Schedule 4.4, neither the execution ------------ and delivery of this Agreement by the Company nor the consummation by the Company of the transactions contemplated herein nor compliance by the Company with any of the provisions hereof will (i) conflict with or result in any breach of the articles of incorporation or bylaws of the Company, (ii) result in a violation or breach of any provisions of, or constitute a default (or an event which, with notice or lapse of time or both, would constitute a default) under, or result in the termination, cancellation of, or accelerate the performance required by, or result in a right of termination or acceleration under, or result in the creation of any Security Interest upon any of the Properties of the Company or require the notice to any Person under, any of the terms, conditions or provisions of any note, bond, mortgage, indenture, deed of trust, license, Contracts, lease, agreement or other instrument or obligation of any kind to which the Company is a party or by which the Company's Properties, may be bound, or (iii) subject to compliance with applicable Utah corporate laws, the Securities Act and applicable "blue sky" laws, violate Laws applicable to the Company or any of the Company's properties or assets, other than any such event described in items (i), (ii) or (iii) which would not (x) prevent the consummation of the transactions contemplated hereby or (y) have a Material Adverse Effect on the Company. Except as set forth on Schedule 4.4, the Company ------------ is not required by applicable Laws or other obligations to give any notice to, make any filing with, or obtain any authorization, consent or approval of any Governmental Authority or other Person in order for the consummation by the Parties of the transactions contemplated herein. 4.5 REVENUE AND OPERATING COST SUMMARIES. Attached hereto as Schedule 4.5 ------------ are the Company's monthly revenue and operating cost summaries covering the period from January 1, 2000 to June 30, 2003 (collectively, the "Revenue Summaries"). The Revenue Summaries have been prepared consistent with the books and records of the Company and the Shareholder and are correct and complete in all material respects, present fairly the financial condition of the Company as of such dates and the results of operations of the Company for such periods. 4.6 SUBSEQUENT EVENTS; CORPORATE TRANSACTIONS. Except as set forth on Schedule 4.6, since June 30, 2003, the Company has conducted its business in the - ------------ Ordinary Course of Business and has not (a) suffered a Material Adverse Effect; (b) incurred any Liabilities that would reasonably be expected to have a Material Adverse Effect on the Company; (c) incurred any Indebtedness or become the guarantor or otherwise liable for any Indebtedness of any Person, (d) suffered any change in its relationship with any of the suppliers, customers, distributors, lessors, licensors, licensees or other third parties which would reasonably be expected to have a Material Adverse Effect on the Company; (e) waived any claims or rights of material value; (f) sold, leased, licensed or otherwise disposed of any of its Property, other than in the Ordinary Course of Business; (g) amended, modified or terminated any material contract to which it is or was a party; (h) suffered any creation or imposition of any Security Interest upon any of the Company's Property or suffered any occurrence, event, incident, action, omission or transaction which could reasonably be expected to materially affect the ability of the Company to hold its Property free and clear of all Security Interests, (i) incurred any capital expenditure (or series of related capital expenditures) involving more than $25,000 in the aggregate, (j) incurred any Investment in, loan to or any acquisition of the securities or assets of any other Person which exceeds $25,000, (k) permitted any delay or postponement of accounts payable or any other Liabilities outside the Ordinary Course of Business, (l) declared any dividend or distribution (whether in case or in kind) or repurchase, redemption or retirement of any securities of the Company, (m) suffered any damage, destruction or loss (whether covered by insurance) to the Property of the Company, which damage, destruction or loss singly or in the aggregate exceeds $25,000, (n) entered into any agreement or transaction with an Affiliate of the Company or (o) committed pursuant to a legally binding agreement to do any of the things set forth above. 4.7 LEGAL COMPLIANCE. Except as set forth on Schedule 4.7, to the Company's ------------ knowledge, the Company is in compliance with all applicable Laws currently in effect, except where non-compliance would not reasonably be expected to have a Material Adverse Effect on the Company. The Company has received no notices of any noncompliance with any applicable Laws. 4.8 ABSENCE OF UNDISCLOSED LIABILITIES. The Company has no Liabilities except for (i) Liabilities reflected on the Revenue Summaries, or any related balance sheets provided by the Shareholder to the Buyers and CGL, (ii) Liabilities under Contracts listed on Schedule 4.14, (iii) Liabilities in -------------- connection with Actions disclosed on Schedule 4.15. (none of which have had or ------------- could reasonably be expected to have a Material Adverse Effect on the Company) or (iv) Liabilities which have arisen since the date of the Revenue Summaries in the Ordinary Course of the Business. 4.9 TAX MATTERS. a. The Company's Tax Returns are filed on a consolidated basis with its parent companies. To the extent of the Company's information, all such Tax Returns were correct and complete in all material respects. All Taxes owed by the Company shown on any Tax Return have been paid in a timely fashion. The Company currently is not the beneficiary of any extension of time within which to file any Tax Return. The Company has not received written notice from an authority in a jurisdiction where the Company does not file Tax Returns that it is or may be subject to taxation by that jurisdiction. There are no Security Interests on any of the assets of the Company that arose in connection with any failure (or alleged failure) to pay any Tax. b. The Company has withheld and paid all material Taxes required to have been withheld and paid in connection with amounts paid or owed to any independent contractor, creditor, shareholder, or other third party. c. There is no dispute or claim concerning any Tax Liability of the Company either (i) claimed or raised by any authority in writing or (ii) as to which the Company has Knowledge. d. The Company has not waived any statute of limitations in respect of Taxes or agreed to any extension of time with respect to a Tax assessment or deficiency. e. The Company has not been a United States real property holding corporation within the meaning of Code Section 897(c)(2) during the applicable period specified in Code Section 897(c)(1)(A)(ii). f. The Company does not have any Liability for the Taxes of any Person (other than the Company) under Treas. Reg. Section 1.1502-6 (or any similar provision of state, local, or foreign law), as a transferee or successor, by contract, or otherwise. 4.10 PROPERTIES/ASSETS. a. Attached hereto as Schedule 4.10(a) is a legal description of all of ---------------- the Company's interests in real property (including, without limitation, leasehold interests) used or occupied by it in the conduct of the business, as well as a list reflecting the Company's good faith understanding of all other related real property interests (the "REAL PROPERTY"). Except as expressly set forth on Schedule 4.10(a)the Title Commitment, or applicable zoning, land use, ---------------- or similar restrictions, such Real Property is free and clear of Security Interests and is not subject to any rights of way, building use restrictions, exceptions, variances or limitations which interfere with the use of such Real Property in the conduct of the business. All Real Property leases used in the conduct of the business are described in Schedule 4.10(a), are in full force and ---------------- effect, the Company holds a valid and existing leasehold interest under each of the leases for the terms set forth on such Schedule and any and all rent payments owing under the leases have been paid to date, except as expressly set forth on Schedule 4.10(a). The Company has not received written notice of any ----------------- default under the leases and the Company is not in default under any of the leases. No person has the right to terminate or accelerate performance under or otherwise modify (including upon the giving notice or the passage of time) any of such leases, except in accordance with the provisions thereof. The Company has provided CGL with true and correct copies of all the Real Property leases listed on Schedule 4.10(a), including any amendments or modifications thereto. ---------------- b. Attached hereto as Schedule 4.10(b) is a list containing a good ---------------- faith estimate description of each of the Company's assets, tangible and intangible, owned or leased, having a value exceeding $10,000, located on its premises, used in the conduct of the Company's business, other than the Real Property (the "ASSETS"). Schedule 4.10(b)is a good faith estimate of other ----------------- assets of the Company owned as of the Effective Date (other than the Assets). All Assets are conveyed by Shareholder "AS IS, WHERE IS", and without warranty of any nature from the Shareholder or Company. The Company has good title to, or a valid leasehold interest or related rights in, all of the Assets free and clear of all Security Interests, except for (a) minor imperfections of title and encumbrances that do not materially detract from or materially interfere with the present use or value of such assets; and (b) Security Interests disclosed on Schedule 4.14. ------------- 4.11 SUBSIDIARIES AND INVESTMENTS. The Company does not have and has never had any Subsidiaries. Except as set forth on Schedule 4.11, the Company does not ------------- have any Investments. 4.12 LICENSES AND PERMITS. The Company has the governmental permits, licenses and authorizations set forth on Schedule 4.12. Such permits, licenses ------------- and authorizations are in full force and effect. 4.13 INSURANCE. Attached hereto as Schedule 4.13 is a list and brief -------------- description of all policies of fire, casualty, liability, property or other forms of insurance and all fidelity bonds held by or applicable to the Company, and as amended or modified to date. The Company is not in default with respect to its obligations under any of such insurance policies or bonding arrangements and the Company has not received any notification of cancellation or modification of any of such insurance policies or bonding arrangements nor is any claim outstanding which could be expected to cause a material increase in the Company's insurance rates. The consummation of the transactions contemplated by this Agreement will not result in the termination of such insurance policies. Schedule 4.13 sets forth a description of any self-insurance - -------------- arrangements maintained by the Company. 4.14 CONTRACTS. Schedule 4.14 contains a list of all written or oral -------------- contracts, commitments, leases, and other agreements (including, without limitation, promissory notes, loan agreements, and other evidences of indebtedness, guarantees, agreements with distributors, suppliers, dealers, franchisers and customers, and service agreements) to which the Company is a party or by which the Company or its properties are bound, including all contracts (a) concerning a partnership or joint venture, (b) concerning noncompetition or otherwise creating or proposing to create any restrictions on the Company's ability to engage in any business or to operate in any geographical area, (c) regarding an agreement between the Company and any of its Affiliates, (d) concerning any profit sharing, option, purchase or any other similar plan permitting the acquisition of capital stock in the Company, deferred compensation, severance or other similar plan or arrangement for the benefit of its current or former directors, officers or employees, (e) regarding any employment agreement or consulting agreement or providing severance or retirement benefits, (f) pursuant to which the consequences of a default or termination could have a Material Adverse Effect on the Company, (g) which are service contracts and equipment leases used in connection with the operation and maintenance of the Property and/or (h) regarding any personal guarantees of the foregoing (collectively, the "CONTRACTS"). Except as set forth on Schedule -------- 4.14, each Contract is legal, valid, binding, enforceable, and in full force and - ---- effect, and the Company is not in material breach or default, and, to the Company's Knowledge, the other party to the Contract is not in material breach or default of and no event has occurred which, with notice or lapse of time would constitute a material breach or default, or permit termination, modification, or acceleration, under the Contract. 4.15 CLAIMS AND PROCEEDINGS. Except as set forth on Schedule 4.15, there ------------- are no Actions pending or, to the Company's Knowledge, threatened against the Company. To the Company's Knowledge there are no facts (past or present), situations, circumstances, conditions, activities, omissions, practices, plans, occurrences, events or transactions that could reasonably be expected to be the basis for an Action. The Company is not subject to any order, judgment, writ, injunction or decree of any Governmental Authority which would have a Material Adverse Effect on the Company. 4.16 EMPLOYEES AND LABOR MATTERS. The Company has no employees. 4.17 ENVIRONMENTAL MATTERS. Except as set forth in the Environmental Report, the Company has materially complied and is in material compliance with all Environmental Laws. There are no Actions pending or, to the Company's Knowledge, threatened against the Company in respect of (i) noncompliance by the Company with any Environmental Laws, (ii) the Release into the Environment of any Hazardous Substance by the Company or (iii) the handling, storage, use, transportation or disposal of any Hazardous Substance by the Company. The Company has obtained and complied, and is in compliance, with all Environmental Permits. The Company has not received any written notice, report or other written information regarding any actual or alleged violation of Environmental Laws or any Liabilities or potential Liabilities (whether accrued, absolute, contingent, unliquidated or otherwise) thereunder, including any investigatory, remedial or corrective obligations, relating to the Company or any of its facilities, arising under Environmental Laws. Except as set forth on Schedule -------- 4.17 or the Environmental Report, the Company has not treated, stored, disposed - ---- of, arranged for or permitted the presence, disposal of, transport, handling or Release of any Hazardous Substance, or owned, leased or operated any property or facility in a manner that has given or would give rise to Environmental Liabilities and Costs, including any Liability for response costs, corrective action costs, personal injury, property damage, natural resources damages or attorneys' fees, pursuant to any Environmental Laws. Except as set forth on Schedule 4.17 or the Environmental Report, none of the Property is contaminated - -------------- by any Hazardous Substance. The Company has not, either expressly or by operation of law, assumed, undertaken or otherwise become subject to any Liability, including any obligation for corrective or remedial action, of any other Person relating to Environmental Laws. To the Knowledge of the Company, no facts, events or conditions relating to the past or present facilities, properties or operations of the Company (or its predecessors or Affiliates insofar as they affect the Company and the Assets) are reasonably likely to prevent, hinder or limit continued compliance with Environmental Laws or give rise to any investigatory, remedial or corrective obligations pursuant to Environmental Laws. 4.18 AFFILIATE TRANSACTIONS. Except as set forth on Schedule 4.18 (the ------------- "AFFILIATE TRANSACTIONS"), the Company is not a party to or bound by any contract, commitment or understanding with any of its directors, officers, or any other Affiliates of the Company, and none of such directors, officers, Affiliates or other Persons owns or otherwise has any rights to or interests in any asset, tangible or intangible, which constitutes a part of the Property or is used in or related to the Company's business. 4.19 BROKER'S FEES. Except as set forth on Schedule 4.19, the Company does ------------- not have any Liability to pay any fees or commissions to any broker, finder, or agent with respect to the transactions contemplated by this Agreement for which CGL could become liable. 4.20 NO ILLEGAL PAYMENTS, ETC. Neither the Company nor any of its Affiliates, directors, officers, employees or agents has directly or indirectly given or agreed to give any illegal gift, contribution, payment or similar benefit to any supplier, customer, governmental official or employee or other Person who was, is or may be in a position to help or hinder the Company or assist in connection with any actual or proposed transaction, or made or agreed to make any illegal contribution, or reimbursed any illegal political gift or contribution made by any other Person, to any candidate for federal, state, local or foreign public office (i) which could reasonably be expected to subject the Company to any damage or penalty in any civil, criminal or governmental litigation or proceeding or (ii) the non-continuation of which has had or could reasonably be expected to have a Material Adverse Effect on the Company. 4.21 BOOKS AND RECORDS. The books, company records and financial records of the Company are complete and correct in all material respects and have been maintained in accordance with the Company's past business practices and Laws. The Company has provided the Buyers and CGL with true and correct copies of the Company's books, records and financial records. 4.22 POWERS OF ATTORNEY. There are no outstanding powers of attorney executed on behalf of the Company in respect of the Company, its Property, Liabilities, or the Shares. 4.23 DISCLOSURE. The representations and warranties contained in this Article 4 (including the Schedules to this Agreement and any other schedules and exhibits required to be delivered by the Company to the Buyers or CGL pursuant to this Agreement) and any certificate furnished or to be furnished by the Company to the Buyers or CGL hereunder do not contain and will not contain any untrue statement of material fact or omit to state any fact necessary in order to make the statements and information contained in this Article 4 not misleading. There is no material fact relating to the Company which may have a Material Adverse Effect on the Company or materially effect the ability of the Company to perform any of its material obligations hereunder which has not been disclosed in writing in this Agreement to the Buyers or CGL by the Company. ARTICLE 5 CGL'S REPRESENTATIONS AND WARRANTIES As a material inducement to the Shareholder and the Company to enter into this Agreement and consummate the transactions contemplated hereby, the Company and each Buyers jointly and severally represent and warrant to the Company and the Shareholder as follows. 5.1 ORGANIZATION. CGL is a limited liability company duly organized, validly existing and in good standing under the laws of Colorado. CGL is duly authorized to conduct business and is in good standing under the laws of each jurisdiction, in which the nature of the business conducted by it or the character of the property owned, leased or used by it makes such qualified and/or licensing necessary, except in such jurisdiction where the failure to be so qualified and/or licensed would not individually or in the aggregate have a Material Adverse Effect on CGL. 5.2 AUTHORIZATION OF TRANSACTION. CGL has the full limited liability company power and authority to execute and deliver this Agreement and to perform its obligations hereunder. The execution, delivery and performance of this Agreement, and the consummation of the transactions contemplated hereby, by CGL has been duly and validly authorized by all requisite limited liability company action. This Agreement constitutes the valid and legally binding obligation of CGL and the Buyers enforceable against them in accordance with its terms and conditions, subject, as to enforcement, to bankruptcy, insolvency, reorganization and other laws of general applicability relating to or affecting creditors' rights and to general equity principles. 5.3 NONCONTRAVENTION. Except for filings, permits, authorizations, consents and approvals, all of which are set forth on Schedule 5.3, neither the execution ------------ and the delivery of this Agreement, nor the consummation of the transactions contemplated hereby, will (a) violate any constitution, statute, regulation, rule, injunction, judgment, order, decree, ruling, charge, or other restriction of any Governmental Authority to which CGL or the Buyers are subject or any provision of the certificate of formation or operating agreement of CGL or (b) conflict with, result in a breach of, constitute a default under, result in the acceleration of, create in any party the right to accelerate, terminate, modify, or cancel, or require any notice to any Person under any agreement, contract, lease, license, instrument, or other arrangement to which CGL or any Buyer is a party or by which they are bound or to which any of their assets is subject, except in each case for such violations, conflicts, breaches or defaults that do not have a Material Adverse Effect on CGL or any Buyer. Neither CGL nor any Buyer is not required to give any notice to, make any filing with, or obtain any authorization, consent, or approval of any Governmental Authority in order for the Parties to consummate the transactions contemplated by this Agreement. 5.4 BROKERS' FEES. Neither CGL nor any Buyer has any Liability to pay any fees or commissions to any broker, finder, or agent with respect to the transactions contemplated by this Agreement for which the Shareholder could become liable. 5.5 LITIGATION. There are no Actions pending or, to CGL's or any Buyer's Knowledge, threatened against or affecting CGL or any Buyer that would reasonably be expected to have a Material Adverse Effect on CGL's or any Buyer's performance under this Agreement or the consummation of the transactions contemplated hereby. There are no injunctions, decrees or unsatisfied judgments outstanding against or related to CGL or any Buyer that could interfere with CGL's or any Buyer's ability to consummate the transactions contemplated by this Agreement. 5.6 INVESTIGATION BY BUYERS. Prior to the Closing, the Buyers and CGL shall have directly and through their representatives, at the Buyers' sole expense, in cooperation with the management of the Company, made such investigation of the Company as the Buyers and CGL deemed necessary or advisable, and each Buyer acknowledges that he or she is and shall be relying solely on his or her own investigation and the representations and warranties contained in this Agreement and the Schedules in deciding on the value of the Company and deciding to proceed with the purchase of the Shares. Further, each Buyer expressly represents that he or she (i) prior to the Closing Date, has had the opportunity to have exercised due diligence in his or her examination of the affairs of the business of the Company, and (ii) has not relied on any representation or warranty by the Shareholder or the Company, or its respective agents, officers, or employees, in entering into this Agreement, except as may be expressly stated or provided herein and the Schedules. 5.7 HELD FOR INVESTMENT. The Buyers, through CGL, are acquiring the Shares pursuant to this Agreement for investment only and not with a view to the distribution thereof in violation of federal or state securities laws. CGL and the Buyers understand that the Shares have not been registered under the Securities Act, or under any applicable "blue sky" laws and must be held indefinitely unless such securities are subsequently registered under the Securities Act and such state laws or an exemption from such registration is available. 5.8 FUNDS. At the Closing, the Buyers or CGL will have, sufficient funds on hand or available pursuant to unconditional commitments to pay the portion of the Purchase Price set forth in Section 2.2(a). 5.9 DISCLOSURE. The representations and warranties contained in this Article 5 (including the Schedules to this Agreement and any other schedules and exhibits required to be delivered by the Buyers and CGL to the Shareholder or the Company pursuant to this Agreement) and any certificate furnished or to be furnished by the Buyers and CGL to the Shareholder and the Company hereunder do not contain and will not contain any untrue statement of material fact or omit to state any fact necessary in order to make the statements and information contained in this Article 5 not misleading. There is no material fact relating to the Buyers or CGL which may have a Material Adverse Effect on the Buyers or CGL or materially effect the ability of the Buyers or CGL to perform any of their material obligations hereunder which have not been disclosed in writing in this Agreement to the Shareholder and the Company by the Buyers or CGL. ARTICLE 6 PRE-CLOSING COVENANTS 6.1 The Parties agree as follows with respect to the period between the date hereof and the Closing Date: a. GENERAL. Each of the Parties will use its commercially reasonable efforts to take all action and to do all things necessary, proper, or advisable in order to consummate and make effective the transactions contemplated by this Agreement (including satisfaction, but not waiver, of the closing conditions set forth in Article 8). b. NOTICES AND CONSENTS. Each of the Parties will give any notices to third parties, and will use its reasonable best efforts to obtain any third party consents, that the other Party may request and as required pursuant to Schedule 8.1(f). - ---------------- c. REGULATORY MATTERS AND APPROVALS. The Parties shall prepare and submit for filing any and all applications, filings, and registrations with, and notifications to, all Governmental Authorities required on the part of the Company or the Shareholder for the Acquisition to be consummated as contemplated by this Agreement. Thereafter, all Parties shall pursue all such applications, filings, registrations, and notifications diligently and in good faith, and shall file such supplements, amendments, and additional information in connection therewith as may be reasonably necessary for the Acquisition to be consummated at the Closing Date. 6.2 PRESERVATION AND OPERATION OF THE BUSINESS. At all times prior to the Closing, the Company and the Shareholder will use commercially reasonable efforts to keep the Company, its business and Property substantially intact and operate the Company in the Ordinary Course of the Business, except for actions required or permitted to be taken pursuant to Article 6. 6.3 TRANSFER OF SHARES. The Shareholder will not sell or otherwise dispose of any of the Shares. The Shareholder will not grant any rights to purchase or obtain (including upon conversion, exchange or exercise) or otherwise control any Shares. 6.4 ACCESS TO INFORMATION. Upon reasonable notice and subject to applicable laws relating to the exchange of information, the Company and the Shareholder shall afford to CGL and CGL Principals and their authorized representatives, access during normal business hours during the period prior to the Closing Date, to all of the Company's Properties, books, Contracts, commitments and records for the purpose of updating any review of such items performed prior to the date of this Agreement and, during such period, the Company and the Shareholder shall make available all other information concerning its business, Properties and personnel as CGL or the CGL principals may reasonably request. 6.5 PIER 84 SUBLEASES. Prior to Closing, the Shareholder shall obtain from principals of Pier Marine Inc., d/b/a Pier 84 ("PIER 84") a written commitment to cooperate in an operational transition of the boat service, boat storage services and the convenience store operations to CGL pursuant to the terms and conditions of that certain letter agreement dated July 29, 2003 from Hal Herron to Pier 84 (the "LETTER AGREEMENT"). In addition, the Shareholder shall obtain written Lease Termination Agreements for the following subleases: oral lease agreement pertaining to the Model Home, that certain written sublease dated April 1, 2001 with respect to a portion of the Ticaboo Boat Storage Facility, that certain sublease dated April 1, 2000 with respect to a portion of the Ticaboo Boat Center, and that certain sublease dated April 1, 2001 with respect to a portion of the Leapin' Lizard Convenience Store. In the event that lease payments for the month of August, 2003 (C-Store) and August/September, 2003 (Boat Service and Boat Storage) are not timely paid to the Company in full as required by the Letter Agreement, such amounts shall be offset against the next principal installment owing under the Promissory Note. 6.6 ENVIRONMENTAL REPORT/REMEDIATION. The Environmental Report identifies a "release of diesel fuel at the powerhouse." Within thirty (30) days following the Closing Date, the Shareholder shall (i) remediate this release by removing contaminated soils and disposing of them in accordance with applicable legal requirements, and (ii) procure a third party review and field inspection of the remediation by the author of the Environmental Report prior to backfilling the area where the contaminated soils have been removed (collectively, the "REMEDIATION WORK"). In the event the Shareholder fails to perform the foregoing Remediation Work within the thirty (30) period set forth above, CLG may obtain a reasonable estimate to have such Remediation Work performed by a third party consultant acceptable to CGL and the cost thereof shall be offset against the next principal installment owing under the Promissory Note. ARTICLE 7 POST-CLOSING COVENANT 7.1 FURTHER ASSURANCE. From time to time after the Closing, the Shareholder will timely execute and deliver to CGL such instruments of sale, transfer, conveyance, assignment and delivery, and such consents, assurances, powers of attorney and other instruments, as may be reasonably requested by CGL or its counsel in order to vest in CGL all right, title and interest in and to the Shares and otherwise in order to carry out the purpose and intent of this Agreement. In addition, the Parties agree that if, at any time after the Closing, any further action is necessary or desirable to carry out the purposes of this Agreement, each of the Parties will take such further action and execute and deliver any document and instrument as any other Party reasonably may request, all at the sole cost and expense of the requesting Party (unless the requesting Party is entitled to indemnification therefor under Article 10). 7.2 SALE PROCEEDS. CGL agrees to pay, and shall cause the Company to pay, to the Shareholder the net sale proceeds from the Company's sale of all single family home lots ("SFH Lots") and mobile home lots ("MH Lots") included in the Real Property, until and to the extent that such sales (utilizing the gross sales proceeds of each sale) equal an aggregate $210,000.00 ("Threshold Amount"), provided that any related sales expenses are reasonable and customary. CGL and the Buyers shall notify, and shall cause the Company to notify, the Shareholder when any SFH Lots or MH Lots are sold, and transmit the applicable net sales proceeds to the Shareholder promptly thereafter. After the Company has satisfied the Threshold Amount, CGL and the Buyers agree that 75% of the net proceeds of any sales of SFH Lots or MH Lots beyond such Threshold Amount shall be applied directly to a reduction of the principal amount outstanding under the Promissory Note until such Promissory Note is fully repaid. If CGL or Buyers transfer the Capital Stock of the Company or substantially all of the assets of the Company to a third party, CGL and the Buyer shall pay to the Shareholder any unpaid balance of the Threshold Amount. 7.3 TICABOO LODGE CREDITS. CGL hereby grants, and shall cause the Company to grant, to Shareholder and its designees 1,000 room night credits at the Ticaboo Lodge from the Effective Date through the date that the Promissory Note is fully repaid, each of which credits shall be valued at 50% of the standard room rate on the night which such credit is used, but in no event greater than $50.00 ("Credits"). The value of the Credits shall be calculated on a monthly basis and CGL and the Buyers shall cause the Company to provide the Shareholder with a monthly report detailing the value of the Credits used and the remaining balance of unused Credits. The Parties agree that the Credits used shall be applied against the outstanding principal amount under the Promissory Note. Notwithstanding anything herein to the contrary, if the Ticaboo Lodge is at 85% occupancy or greater, Credits shall be valued at 100% of the standard room rate. 7.4 CERTAIN TAX MATTERS. a. TAX PERIODS ENDING ON OR BEFORE THE EFFECTIVE DATE. The Shareholder shall prepare or cause to be prepared and file or cause to be filed, at the Shareholder's expense, all Tax Returns for the Company for all periods ending on or prior to the Effective Date which are filed after the Effective Date. Subject to CGL signing a confidentiality agreement with the Shareholder and its parent company, the Shareholder shall permit CGL to review and comment on each such Tax Return described in the preceding sentence prior to filing. The Shareholder shall reimburse CGL for any Taxes of the Company with respect to such periods within 15 days after payment by CGL or the Company of such Taxes to the extent such Taxes are not reflected in the reserve for Tax Liability (excluding any reserve for deferred Taxes established to reflect timing differences between book and Tax income) shown in any balance sheet related to such liability. b. COOPERATION ON TAX MATTERS. (i) Each of the Parties shall cooperate fully, as and to the extent reasonably requested by another Party, in connection with the filing of Tax Returns pursuant to this Section 7.6 and any audit, litigation or other proceeding with respect to Taxes. Such cooperation shall include, without limitation, the retention and (upon the other Party's request) the provision of records and information which are reasonably relevant to any such audit, litigation or other proceeding and making employees available on a mutually convenient basis to provide additional information and explanation of any material provided hereunder. The Shareholder agrees (1) to retain or cause to be retained all books and records with respect to Tax matters pertinent to the Company relating to any taxable period beginning before the Effective Date until the expiration of the statute of limitations (and, to the extent notified by CGL or the Shareholder, any extensions thereof) of the respective taxable periods, and to abide by all record retention agreements entered into with any taxing authority, and (2) to give CGL reasonable written notice prior to transferring, destroying or discarding any such books and records and, if the other Parties so request, shall allow the other Parties to take possession of such books and records. (ii) The Parties further agree, upon request, to use their commercially reasonable efforts to obtain any certificate or other document from any Governmental Authority or any other Person to mitigate, reduce or eliminate any Tax that could be imposed (including with respect to the Transaction). c. CERTAIN OTHER TAX LIABILITIES. All transfer, documentary, sales, use, stamp, registration and other such Taxes and fees (including any penalties and interest) incurred by or assessed against the parties in connection with the transfer of the Shares pursuant to this Agreement (including transfer or similar Tax imposed in any states or subdivisions) shall be paid by the Shareholder when due, and the Shareholder will, at their own expense, file all necessary Tax Returns and other documentation with respect to all such transfer, documentary, sales, use, stamp, registration and other Taxes and fees, and, if required by applicable Law, CGL and the Company will join in the execution of any such Tax Returns and other documentation. 7.5 PLATTING OF LOTS The Shareholder agrees to perform, within ninety (90) days following the Closing Date, all necessary actions required by any applicable governmental entities with respect to the surveying and legal platting of that certain unplatted property apart which the model home is located, into six platted home lots. To the extent that the Shareholder does not complete the platting of such lots within the ninety (90) day period set forth above, CGL shall endeavor to have such lots platted and the cost incurred in connection therewith shall be offset against the next principal and interest installments owing under the Promissory Note. 7.6 COMPANY SOFTWARE. The Company shall continue to use the business software systems in use as of the Effective Date until such time as the entire balance of the Promissory Note is paid in full. If CGL or Buyers wish to revise, change or upgrade the business software systems in use by the Company prior to the payment in full of the Promissory Note, CGL and Buyers shall do so in consultation with Shareholder, and any change in the business software used by the Company shall be subject to the prior written consent of the Shareholder, such consent not to be unreasonably withheld or delayed. ARTICLE 8 CONDITIONS TO OBLIGATION TO CLOSE 8.1 CONDITIONS TO OBLIGATION OF THE BUYERS AND CGL. The obligation of the Buyers and CGL to consummate the transactions to be performed by them in connection with the Closing is subject to satisfaction of the following conditions: a. The Company and the Shareholder shall have performed in all material respects all obligations and agreements and complied in all material respects with all covenants contained in this Agreement to be performed and complied with by each of them prior to or at the Closing Date. The representations and warranties of the Company and the Shareholder set forth in this Agreement shall be true and correct at and as of the Closing Date with the same force and effect as though made on and as of the Closing Date except (i) for any changes resulting from activities or transactions which may have taken place after the date hereof and which are permitted or contemplated by the Agreement, (ii) for such matters as would not, individually or in the aggregate, have a Material Adverse Effect on the Company to the extent that any such representation and warranty is expressly made as of another specified date and, as to such representation or warranty, the same shall be true as of such specified date. b. All statutory requirements for the valid consummation by the Company and the Shareholder of the transactions contemplated by this Agreement and the Acquisition shall have been fulfilled and all authorizations, consents and approvals including all of the third-party consents specified in Schedule -------- 8.1(f), and those of all Governmental Authorities required to be obtained in - ------ order to permit the consummation of the Acquisition and the transactions contemplated hereby shall have been obtained in form and substance reasonably satisfactory to CGL. All approvals of the Board of Directors of the Company and the Shareholder necessary for the consummation of this Agreement, the Acquisition and the transactions contemplated hereby shall have been obtained. c. No Action shall be pending or threatened before any court or quasi-judicial or administrative agency of any federal, state, local, or foreign jurisdiction or before any arbitrator wherein an unfavorable injunction, judgment, order, decree, ruling, or charge would (i) prevent consummation of any of the transactions contemplated by this Agreement, (ii) cause any of the transactions contemplated by this Agreement to be rescinded following consummation, or (iii) affect adversely the right of the CGL to own the capital stock of the Company and to control the Company. d. The Company and the Shareholder shall have delivered to Buyer a certificate to the effect that each of the conditions specified in Sections -------- 8.1(a)-(c) is satisfied in all respects. - ---------- e. The Company shall have delivered to CGL and the Buyers (i) a copy of the articles of incorporation of the Company certified by an appropriate authority of the jurisdiction of its incorporation, (ii) a copy of the bylaws of the Company certified by the Secretary thereof, (iii) the books and records of the Company, (iv) a copy of the resolutions of the Board of Directors of the Company and the Shareholder approving the transactions contemplated by this Agreement certified by the Secretary thereof, and (v) certificates of good standing/existence of the Company certified by and appropriate authority of the jurisdiction issuing such certificate. f. The Shareholder shall have procured all governmental approvals, consents or authorization and third party consents specified on Schedule 8.1(f). --------------- g. Each director and officer of the Company shall have executed and delivered a resignation letter for such positions held with the Company. h. The following additional documents shall be delivered at the Closing by the Company and the Shareholder: (i) Payoff of the two existing bank Loans and an executed release of the existing deeds of trust ("TRUST RELEASE"). (ii) The stock certificates representing the Shares, accompanied by duly executed stock powers; provided, however, that Shareholder shall retain all Shares in escrow at the offices of Shareholder's legal counsel as security for the Promissory Note, which shall be released to CGL upon full and final payment of the Promissory Note. CGL and the Buyers may waive any condition specified in this Section 8.1 if it ----------- executes a writing so stating at or prior to the Closing. 8.2 CONDITIONS TO OBLIGATION OF THE COMPANY AND THE SHAREHOLDER. The obligation of the Company and the Shareholder to consummate the transactions to be performed by it in connection with the Closing is subject to satisfaction of the following conditions: a. CGL shall have performed in all material respects all obligations and agreements and complied in all material respects with all covenants contained in this Agreement to be performed and complied with by them prior to or at the Closing Date. The representations and warranties of CGL set forth in this Agreement shall be true and correct at and as of the Closing Date with the same force and effect as though made on and as of the Closing Date except (i) for any changes resulting from activities or transactions which may have taken place after the date hereof and which are permitted or contemplated by the Agreement, (ii) for such matters as would not, individually or in the aggregate, have a Material Adverse Effect on the CGL, or (iii) to the extent that any such representation and warranty is expressly made as of another specified date and, as to such representation or warranty, the same shall be true as of such specified date. b. All statutory requirements for the valid consummation by CGL of the transactions contemplated by this Agreement and the Acquisition shall have been fulfilled and all authorizations, consents and approvals including all of the third-party consents specified in Schedule 8.2(g), and those of all Governmental --------------- Authorities required to be obtained in order to permit the consummation of the Acquisition and the transactions contemplated hereby shall have been obtained in form and substance reasonably satisfactory to the Company and the Shareholder unless such failure shall not have a Material Adverse Effect on CGL. All approvals of the members of CGL necessary for the consummation of the Acquisition, this Agreement, and the transactions contemplated hereby shall have been obtained. c. No Action shall be pending or threatened before any court or quasi-judicial or administrative agency of any federal, state, local, or foreign jurisdiction or before any arbitrator wherein an unfavorable injunction, judgment, order, decree, ruling, or charge would (i) prevent consummation of any of the transactions contemplated by this Agreement, (ii) cause any of the transactions contemplated by this Agreement to be rescinded following consummation, or (C) affect adversely the right of CGL to own the Shares and to control the Company. d. CGL shall have delivered to the Company a certificate to the effect that each of the conditions specified in Sections 8.2(a)-(c) is satisfied in all ------------------- respects. e. CGL shall have delivered the Purchase Price, in accordance with Section 2.2. - ----------- f. CGL shall have executed and delivered the Promissory Note, the Security Agreement and the Deed of Trust. g. Each Buyer shall have executed and delivered a Guaranty Agreement. h. The Company shall have delivered to the Shareholder the Excluded Assets. i. CGL shall have procured all governmental approvals, consents and authorizations and third party consents specified in Schedule 8.2(g). --------------- j. CGL shall have provided evidence to the Shareholder that CGL has procured worker's compensation insurance for employment of the its employees and insurance policies with comparable coverage to the policies and limits maintained by the Company prior to the Effective Date. k. CGL shall have provided a Lenders Title Insurance Policy. l. The Boards of Directors of the Company, Shareholder, Crested Corp. and U.S. Energy Corp. shall have approved of the transaction contemplated by this Agreement. The Company and the Shareholder may waive any condition specified in this Section 8 if they execute a writing so stating at or prior to the Closing. - ---------- ARTICLE 9 SURVIVAL OF REPRESENTATIONS AND WARRANTIES The Parties agree that, notwithstanding any examination made by or on behalf of the respective Parties, the knowledge of the Parties or any of the respective agents of the Parties, or the acceptance by any Party of any certificate or opinion, each statement, representation, warranty, indemnity, covenant and agreement made by the Parties in this Agreement shall survive the consummation of the transactions contemplated hereby for a period of twelve (12) months following the Closing Date. ARTICLE 10 INDEMNIFICATION 10.1 SHAREHOLDER INDEMNITY. The Shareholder shall indemnify, defend and hold harmless the Buyers and CGL and their respective successors, heirs, assigns, and CGL's officers, directors, members, managers, equity holders, and employees (collectively, the "ACQUIROR GROUP") against any Actions, suits, proceedings, hearings, investigations, charges, complaints, claims, demands, injunctions, judgments, orders, decrees, rulings, damages, dues, penalties, fines, costs, amounts paid in settlement, Liabilities, obligations, Taxes, liens, losses, expenses, and fees, including court costs and reasonable attorneys' fees and expenses (collectively, "ADVERSE CONSEQUENCES") that any member of Acquiror Group may suffer, sustain or become subject to as the result of, or arising from or in connection with (a) any breach of any of the representations or warranties made by the Company or the Shareholder in this Agreement, (b) any breach of the covenants and agreements made by the Company or the Shareholder in this Agreement or any exhibit hereto delivered by the Company or the Shareholder in connection with the Closing, (c) any Excluded Liabilities. 10.2 CGL AND THE BUYERS INDEMNITY. CGL and the Buyers shall jointly and severally indemnify and hold harmless the Shareholder and its successors, assigns, officers, directors, equity holders, and employees against any Adverse Consequences which they may suffer, sustain or become subject to as the result of, arising from or in connection with (a) a breach of any representation, warranty, covenant or agreement by CGL contained in this Agreement or any exhibit or Schedule or (b) the ownership or operation of the Company after the Effective Date, except for (i) any amounts relating to Excluded Liabilities or (ii) the breach of any representation, warranty, covenant or agreement by the Company or the Shareholder in this Agreement. 10.3 INDEMNITY LIMITATION. Anything in Section 10.1 to the contrary notwithstanding, no amounts shall be payable by the Shareholder under Section 10.1(a) unless and until the Acquiror Group shall have incurred or reasonably expects that it will incur on a cumulative basis Adverse Consequences in an amount exceeding $10,000 (the "BASKET"), at which time the Shareholder shall be responsible for all amounts due, including amounts previously accumulated but unreimbursed. Notwithstanding the foregoing, no threshold shall be required to be met as a condition to indemnification with respect to willful breaches of representations and warranties or of covenants under this Agreement. Notwithstanding anything to the contrary contained herein, other than with respect to the Excluded Liabilities for which the Shareholder shall remain liable, no Party shall be liable for an amount in excess of the principal amount of the Promissory Note plus accrued interest at such time outstanding as of the date any claim is due and payable for Adverse Consequences, subject to indemnification as a result of a breach of representation or warranty, and any such valid claim shall be offset against the principal balance owing under the Promissory Note. 10.4 INDEMNIFICATION PROCEDURES. a. If any third party shall notify any Party to this Agreement (the "INDEMNIFIED PARTY") with respect to any matter which may give rise to a claim for indemnification against any other Party to this Agreement (the "INDEMNIFYING PARTY") under Article 10, then the Indemnified Party shall notify each ----------- Indemnifying Party thereof with five (5) days of the Indemnified Party's knowledge of such claim; provided, however, that no delay on the part of the -------- ------- Indemnified Party in notifying any Indemnifying Party shall relieve the Indemnifying Party from any liability or obligation hereunder unless (and then solely to the extent) the Indemnifying Party is prejudiced by the delay. Any Indemnifying Party will have the right to defend the Indemnified Party against the Third Party Claim with counsel of its choice reasonably satisfactory to the Indemnified Party so long as (A) the Indemnifying Party notifies the Indemnified Party in writing within 15 days after the Indemnified Party has given notice of the Third Party Claim that the Indemnifying Party will undertake the defense of such claim, (B) the Indemnifying Party provides the Indemnified Party with evidence reasonably acceptable to the Indemnified Party that the Indemnifying Party will have the financial resources to defend against the Third Party Claim and fulfill its indemnification obligations hereunder, and (C) the Indemnifying Party conducts the defense of the Third Party Claim actively and diligently. The Indemnified Party may participate in the defense of such claim with co-counsel of its choice; provided, however, that the fees and expenses of the -------- ------- Indemnified Party's counsel shall be at the expense of the Indemnified Party unless (A) the Indemnifying Party has agreed in writing to pay such fees and expenses, (B) the Indemnifying Party has failed to assume the defense and employ counsel as provided herein or (C) a claim shall have been brought or asserted against the Indemnifying Party as well as the Indemnified Party, and such Indemnified Party shall have been advised in writing by counsel that there may be one or more factual or legal defenses available to it that are in conflict with those available to the Indemnifying Party, in which case such co-counsel shall be at the expense of the Indemnifying Party; provided, however, that the -------- ------- Indemnifying Party will not be required to pay the fees and expenses of more than one separate principal counsel (and one appropriate local counsel) for all Indemnified Parties. If, within such 15-day period, the Indemnifying Party does not assume the defense of such matter or fails to defend the matter in the manner set forth above, the Indemnified Party may defend against the matter in any manner that it reasonably may deem appropriate and the Indemnifying Party will reimburse the Indemnified Party promptly and periodically for the costs of defending against such claim (including reasonable attorneys' fees and expenses) and the Indemnifying Party will remain responsible for any Adverse Consequences the Indemnified Party may suffer resulting from, arising out of, relating to, in the nature of, or caused by the claim to the fullest extent provided herein, provided, however, that the Indemnified Party may not consent to the entry of ----- ------- any judgment with respect to the matter or enter into any settlement with respect to such matter without the consent of the Indemnifying Party, which consent may not be unreasonably withheld. b. Except for (i) fraud, in which case all remedies at law or in equity shall be available to the Parties, and (ii) other remedies expressly provided for in this Agreement, the Parties hereby agree that the foregoing provisions of this Article 10 shall be the sole and exclusive means of recovery ---------- of a Party hereto or any other Person entitled to indemnification under this Article 10. - ----------- ARTICLE 11 TERMINATION 11.1 TERMINATION OF AGREEMENT. The Parties may terminate this Agreement as provided below: a. The Parties may terminate this Agreement by mutual written consent at any time prior to the Closing; b. CGL may terminate this Agreement by giving written notice to Shareholder at any time prior to the Closing (i) in the event Shareholder or the Company has breached any representation, warranty or covenant contained in this Agreement in any material respect, CGL has notified the Shareholder of the breach and the breach has continued without cure for a period of 30 days after the notice of breach or (ii) if the Closing shall not have occurred on or before September 2, 2003 by reason of the failure of any condition precedent under Section 8.1 hereof (unless the failure results primarily from CGL breaching any representation, warranty or covenant contained in this Agreement); and c. The Shareholder may terminate this Agreement by giving written notice to CGL at any time prior to the Closing (i) in the event CGL has breached any representation, warranty or covenant contained in this Agreement in any material respect, the Shareholder has notified CGL of the breach and the breach has continued without cure for a period of 30 days after the notice of breach or (ii) if the Closing shall not have occurred on or before September 2, 2003 by reason of the failure of any condition precedent under Section 8.2 hereof caused by CGL or Buyers (unless the failure results primarily from the Shareholder or Company breaching any representation, warranty or covenant contained in this Agreement). 11.2 EFFECT OF TERMINATION. If any Party terminates this Agreement pursuant to Section 11.1 hereof, all rights and obligations of the Parties hereunder shall terminate without any Liability of any Party to any other Party (other than pursuant to Article 11 hereof, including all sections and subsections thereof); provided, however, no termination shall relieve any Party from any Liability arising from or relating to such Party's breach at or prior to termination. ARTICLE 12 MISCELLANEOUS 12.1 CONFIDENTIALITY. Each Party agrees that it shall, and it shall direct and use its best efforts to cause its officers, directors, shareholders, employees, agents and representatives to, and the terms of the transactions contemplated hereby strictly confidential and to not disclose such matters to any third party without the other Party's prior written consent, provided, however, that U.S. Energy may make a public disclosure to comply with applicable securities law. 12.2 NO THIRD-PARTY BENEFICIARIES. This Agreement shall not confer any rights or remedies upon any Person other than the Parties and their respective successors and permitted assigns. 12.3 ENTIRE AGREEMENT. This Agreement (including the documents referred to herein) constitutes the entire agreement among the Parties and supersedes any prior understandings, agreements, or representations by or among the Parties, written or oral, to the extent they relate in any way to the subject matter hereof. 12.4 SUCCESSION AND ASSIGNMENT. This Agreement shall be binding upon and inure to the benefit of the Parties named herein and their respective successors and permitted assigns. No Party may assign either this Agreement or any of their rights, interests, or obligations hereunder without the prior written approval of CGL and the Shareholder. 12.5 COUNTERPARTS. This Agreement may be executed in one or more counterparts, each of which shall be deemed an original but all of which together will constitute one and the same instrument. 12.6 NOTICES. All notices, requests, demands, claims, and other communications hereunder will be in writing. Any notice, request, demand, claim, or other communication hereunder shall be deemed duly given if (and then two business days after) it is sent by registered or certified mail, return receipt requested, postage prepaid, or by expedited courier, next day delivery, and addressed to the intended recipient as set forth below: If to CGL or the Buyers: Copy to: Cactus Group, LLC Brownstein, Hyatt & Brownstein, P.C. 4855 W. Lakeridge Rd. 410 17th Street, 22nd Fl. Denver, Colorado 80219 Denver, Colorado 80202 Attn: Joseph Deffert Attn: Lea Ann T. Groesser Telephone: (303) 987-8855 Telephone: (303) 223-1182 Fax: (303) 977-4129 Fax: (303) 223-0982 If to the Shareholder: Copy to: Plateau Resources Limited Davis Graham & Stubbs LLP c/o U.S. Energy Corp. 1550 Seventeenth Street 877 North 8th West Suite 500 Riverton, Wyoming 82501 Denver, Colorado 80202 Attention: Daniel P. (Mike) Svilar Attention: Scot Anderson Telephone: (307) 856-9271 Telephone: (303) 892-7383 Fax: (307) 857-3050 Fax: (303) 893-1379 Any Party may send any notice, request, demand, claim, or other communication hereunder to the intended recipient at the address set forth above using any other means (including personal delivery, messenger service, facsimile, ordinary mail, or electronic mail), but no such notice, request, demand, claim, or other communication shall be deemed to have been duly given unless and until it actually is received by the intended recipient. Any Party may change the address to which notices, requests, demands, claims, and other communications hereunder are to be delivered by giving the other Parties notice in the manner herein set forth. 12.7 GOVERNING LAW; JURISDICTION; VENUE. This Agreement shall be governed by and construed in accordance with the laws of the State of Wyoming without regard to its rules of conflict of laws. Each Party hereby irrevocably and unconditionally consents and submits to the exclusive jurisdiction of the state courts of the State of Wyoming and of any federal court located in the State of Wyoming in connection with any actions, disputes or proceedings arising out of or relating to this Agreement. Each Party irrevocably and unconditionally waives, to the fullest extent he, she or it may legally and effectively do so, any objection that it or he may now or hereafter have to the laying of venue of any suit, action or proceeding arising out of or relating to the Agreement in any Wyoming state or federal court. Each of the Parties hereto irrevocably waives, to the fullest extent permitted by law, the defense of an inconvenient forum to the maintenance of such action or proceeding in any such court. In any such action, dispute or proceeding, each Party hereby absolutely and irrevocably waives personal service of any summons, complaint, declaration or other process and hereby absolutely and irrevocably agrees that service thereof may be made by certified or registered first class mail directed to such Party at its address in accordance with Section 12.6 hereof. ------------- 12.8 WAIVER OF JURY TRIAL. NO PARTY TO THIS AGREEMENT OR ANY ASSIGNEE, SUCCESSOR, HEIR OR PERSONAL REPRESENTATIVE OF A PARTY SHALL SEEK A JURY TRIAL IN ANY LAWSUIT, PROCEEDING, COUNTERCLAIM OR ANY OTHER LITIGATION PROCEDURE BASED UPON OR ARISING OUT OF THIS AGREEMENT OR THE DEALINGS OR THE RELATIONSHIP BETWEEN THE PARTIES. NO PARTY WILL SEEK TO CONSOLIDATE ANY SUCH ACTION, IN WHICH A JURY TRIAL HAS BEEN WAIVED, WITH ANY OTHER ACTION IN WHICH A JURY TRIAL CANNOT OR HAS NOT BEEN WAIVED. THE PROVISIONS OF THIS SECTION HAVE BEEN FULLY DISCUSSED BY THE PARTIES HERETO, AND THESE PROVISIONS SHALL BE SUBJECT TO NO EXCEPTIONS. NEITHER PARTY HAS IN ANY WAY AGREED WITH OR REPRESENTED TO THE OTHER PARTY THAT THE PROVISIONS OF THIS SECTION WILL NOT BE FULLY ENFORCED IN ALL INSTANCES. 12.9 AMENDMENTS AND WAIVERS. No amendment of any provision of this Agreement shall be valid unless the same shall be in writing and signed by the Buyers and the Shareholder. No waiver by any Party of any default, misrepresentation, or breach of warranty or covenant hereunder, whether intentional or not, shall be deemed to extend to any prior or subsequent default, misrepresentation, or breach of warranty or covenant hereunder or affect in any way any rights arising by virtue of any prior or subsequent such occurrence 12.10 SEVERABILITY. Any term or provision of this Agreement that is invalid or unenforceable in any situation in any jurisdiction shall not affect the validity or enforceability of the remaining terms and provisions hereof or the validity or enforceability of the offending term or provision in any other situation or in any other jurisdiction. 12.11 EXPENSES. Each of the Parties will bear their own costs and expenses (including legal, fees and expenses) incurred in connection with this Agreement and the transactions contemplated hereby. 12.12 CONSTRUCTION. The Parties intend that each representation, warranty, and covenant contained herein shall have independent significance. If any Party has breached any representation, warranty, or covenant contained herein in any respect, the fact that there exists another representation, warranty or covenant relating to the same subject matter (regardless of the relative levels of specificity) which the Party has not breached shall not detract from or mitigate the fact that the Party is in breach of the first representation, warranty, or covenant. REMAINDER OF PAGE INTENTIONALLY LEFT BLANK IN WITNESS WHEREOF, each of the parties hereto has caused this Agreement to be duly executed as of the date and year first above written. CANYON HOMESTEADS, INC. By: /s/ Mark J. Larsen ------------------------------------ Name: Mark J. Larsen ------------------------------------ Its: President ------------------------------------ SHAREHOLDER: PLATEAU RESOURCES LIMITED By: /s/ Hal Herron ------------------------------------ Name: Hal Herron ------------------------------------ Its: President ------------------------------------ CACTUS GROUP, LLC By: /s/ Joseph Deffert ------------------------------------ Name: Joseph Deffert ------------------------------------ Its: President ------------------------------------ BUYERS: /s/ Joseph Deffert ------------------------------------ JOSEPH DEFFERT /s/ D. Paige Deffert ------------------------------------ D. PAIGE DEFFERT /s/ Ernst Deffert ------------------------------------ ERNST DEFFERT /s/ Aileen Deffert ------------------------------------ AILEEN DEFFERT /s/ Martin Vialpando ------------------------------------ MARTIN VIALPANDO /s/ Mary Eileen Vialpando ------------------------------------ MARY EILEEN VIALPANDO EX-14.0 6 doc5.txt CODE OF ETHICS U.S. ENERGY CORP. CODE OF ETHICS AND CONDUCT U.S. ENERGY CORP. ("USE") will conduct its business honestly and ethically. Employees will constantly improve the quality of their services, products and operations and will create a reputation for honesty, fairness, respect, responsibility, and integrity, trust and sound business judgment. No illegal or unethical conduct on the part of officers, directors, employees or affiliates is in USE's best interest. USE will not compromise its principles for short-term advantage. The ethical performance of USE is the sum of the ethics of the men and women who manage it and work for it. Thus, each of USE's officers, directors and employees are expected to adhere to high standards of personal integrity. USE's officers, directors, and employees must never permit their personal interests to conflict, or appear to conflict, with the interests of USE, its clients or affiliates. USE's officers, directors and employees must be particularly careful to avoid representing USE in any transaction with others with whom there is any outside business affiliation or relationship. USE's officers, directors, and employees shall never use their company contacts to advance their private business or personal interests at the expense of USE, its clients or affiliates. USE's officers, directors and employees shall offer no bribes, kickbacks or other similar remuneration or consideration to any person or organization in order to attract or influence business activity. USE's officers, directors and employees shall not accept gifts, gratuities, fees, bonuses or excessive entertainment, in order to attract or influence business activity. USE's officers, directors and employees come into contact with, and have possession of, proprietary, confidential or business-sensitive information and must take appropriate steps to assure that such information is strictly safeguarded. This information, whether it relates to USE or to any of our customers, clients or affiliates, includes strategic business plans, operating results, marketing strategies, customer lists, personnel records, upcoming acquisitions and divestitures, new investments, and development and construction costs, processes and methods. Proprietary, confidential and sensitive business information about USE, other companies, individuals and entities with whom USE does or has done business of any nature should be treated with sensitivity and discretion and only be disseminated on a need-to-know basis only. Misuse of material inside information by USE's officers, directors or employees in connection with trading in USE's securities can expose the individual who misuses such information to civil liability and penalties under the Securities Exchange Act. Under this Act, directors, officers, and employees in possession of material information not available to the public are "insiders." Spouses, friends, suppliers, brokers, and others outside USE who may have acquired the information directly or indirectly from a director, officer or employee are also "insiders." The Act prohibits insiders from trading in, or recommending the sale or purchase of, USE's securities or the securities of any other corporation to which the information relates, while such inside information is regarded as "material", or if the information is important enough to influence you or any other person in the purchase or sale of securities of any company with which USE does business, which could be affected by the inside information. The following guidelines should be followed in dealing with inside information: X Until the material information has been publicly released by USE, USE's officers, directors and employees must not disclose it to anyone except those within USE whose positions require use of the information. X USE's officers, directors and employees must not buy or sell USE'S securities when they have knowledge of material information concerning USE until that information has been disclosed to the public and the public has had sufficient time to absorb the information. X USE's officers, directors and employees shall not buy or sell securities of another corporation, the value of which is likely to be affected by an action by USE of which the employee is aware and which has not been publicly disclosed. USE's officers, directors and employees will seek to report all information accurately and honestly, and as otherwise required by applicable reporting requirements. USE's officers, directors and employees will refrain from gathering a competitor's proprietary information by illegitimate means and, if such information is so obtained, shall refrain from acting on the knowledge which has been gathered in such a manner. USE's officers, directors and employees will seek to avoid exaggerating or disparaging comparisons of the properties, services and competence of their competitors. USE's officers, directors and employees will obey all Equal Employment Opportunity laws and act with respect and responsibility towards others in all of their dealings. USE's officers, directors and employees will strive at all times to conduct their personal life so that their personal life will not interfere with their ability to deliver quality products or services to USE and its customers and business associates. USE's officers, directors and employees are obligated and agree to promptly disclose to USE'S President and/or its board of directors any unethical, dishonest, fraudulent and illegal behavior, or the violation of USE policies and procedures by any officer, director and/or employee. Should any person having such information be insecure in disclosing the information to any officer, director or employee, such person must then promptly disclose the information to USE'S outside legal counsel: Stephen E. Rounds, 1544 York Street, Suite 110, Denver CO 80206, 303.377.6997. USE's management will establish and maintain a "WHISTLE BLOWER" procedure in compliance with Title VIII, Section 806 Paragraph 154A of the Sarbanes-Oxley Act. All notifications under this law of fraud and or financial misconduct by the company, its officers, directors and employees will be reported confidentially through this procedure to a designated member of the audit committee. Violation of this Code of Ethics WILL result in discipline, which discipline, among other possibilities, may include suspension without pay or termination for cause. The degree ofdiscipline relates in part to whether there was a voluntary disclosure of any ethical violation and whether or not the violator cooperated in any subsequent investigation. EX-23.0 7 doc6.txt NETHERLAND/SEWELL CONSENT [GRAPHIC OMITED] CONSENT OF INDEPENDENT PETROLEUM ENGINEERS AND GEOLOGISTS --------------------------------------------------------- We hereby consent to the filing of the Annual Report on Form 10-K, for the year ended December 31, 2003, for U.S. Energy Corp. in accordance with the requirements of the Securities Exchange Act of 1934, with the inclusion in such Annual Report of our Rocky Mountain Gas, Inc. reserve report incorporated therein, and references to our name in the form and context in which they appear. NETHERLAND, SEWELL & ASSOCIATES, INC. By: /s/ Frederic D. Sewell ---------------------------------------- Frederic D. Sewell Chairman and Chief Executive Officer Dallas, Texas March 26, 2004 EX-31.1 8 doc7.txt RULE 13A-14(A) JOHN L. LARSEN EXHIBIT 31.1 ------------ CERTIFICATION ------------- I, John L. Larsen, certify that: 1. I have reviewed this annual report on Form 10-K of U.S. Energy Corp.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this transition report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c. Disclosed in this report any change in the resented in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. DATED this 26th day of March, 2004. /s/ John L. Larsen --------------------------------------- John L. Larsen Chief Executive Officer EX-31.2 9 doc8.txt RULE 13A-14(A) R. SCOTT LORIMER EXHIBIT 31.2 ------------ CERTIFICATION ------------- I, Robert Scott Lorimer, certify that: 1. I have reviewed this annual report on Form 10-K of U.S. Energy Corp.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this transition report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c. Disclosed in this report any change in the resented in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. DATED this 26th day of March, 2004. /s/ Robert Scott Lorimer ----------------------------------------- Robert Scott Lorimer Chief Financial Officer EX-32.1 10 doc9.txt RULE 13A-14(B) JOHN L. LARSEN EXHIBIT 32.1 Certification of CEO Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Annual Report of U.S. Energy Corp. (the "Company") on Form 10-K for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on March 30, 2004 (the "Report"), John L. Larsen Chief Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, to the best of his knowledge, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ John L. Larsen ----------------------------------------- John L. Larsen, Chief Executive Officer March 26, 2004 This certification accompanies this Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. A signed original of this written statement required by Section 906 has been provided to Crested Corp. and will be retained by Crested Corp. and furnished to the Securities and Exchange Commission or its staff upon request. EX-32.2 11 doc10.txt RULE 13A-14(B) R. SCOTT LORIMER EXHIBIT 32.2 Certification of CFO Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Annual Report of U.S. Energy Corp. (the "Company") on Form 10-K for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on March 30, 2004 (the "Report"), Robert Scott Lorimer, Chief Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, to the best of his knowledge, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Robert Scott Lorimer ----------------------------- Robert Scott Lorimer, Chief Financial Officer March 26, 2004 This certification accompanies this Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. A signed original of this written statement required by Section 906 has been provided to Crested Corp. and will be retained by Crested Corp. and furnished to the Securities and Exchange Commission or its staff upon request.
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