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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended September 30, 2002

or

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from                    to                   

Commission File Number: 001-13259

U S LIQUIDS INC.

411 N. Sam Houston Parkway East, Suite 400
Houston, Texas 77060-3545
281-272-4500
(Address and telephone number of registrant’s principal executive offices)

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. [X] Yes     [  ] No

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

Common Stock, $0.01 par value
16,095,222 shares as of November 11, 2002

U S LIQUIDS INC.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2002
INDEX

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

U S LIQUIDS INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

1

U S LIQUIDS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

2

U S LIQUIDS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1.     BUSINESS AND ORGANIZATION

U S Liquids Inc. and subsidiaries (collectively “U S Liquids” or the “Company”) was founded November 18, 1996 and is a leading provider of services for the collection, processing, recovery and disposal of liquid waste in North America. On December 13, 1996, the Company acquired its Oilfield Waste Division from Sanifill, Inc. through a transaction accounted for as a purchase. The Oilfield Waste Division treats and disposes of oilfield waste generated in oil and gas exploration and production. In June 1997, the Company formed the basis of its Wastewater Division by acquiring additional companies. These acquisitions were accounted for under the pooling-of-interests method of accounting. The Wastewater Division collects, processes and disposes of nonhazardous liquid waste and recovers by-products from certain waste streams. During 1998 and 1999, the Company continued acquiring companies, principally for the Wastewater Division. On July 1, 1999, the Company created a third division, known as the Industrial Wastewater Division, and changed the name of the Wastewater Division to the Commercial Wastewater Division. The Industrial Wastewater Division derives revenues from fees charged for the collection, processing and disposal of hazardous and nonhazardous liquid wastes.

2.     BASIS OF PRESENTATION

The interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures, normally included in annual financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to those rules and regulations; although management believes that the disclosures made are adequate to make the information presented not misleading. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to fairly present the financial position, results of operations and cash flows with respect to the interim condensed consolidated financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results for the entire year.

Certain prior year amounts have been reclassified to conform with the current year presentation.

It is suggested that these interim condensed consolidated financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the SEC.

3.     CREDIT FACILITIES

At September 30, 2002, approximately $88.5 million of principal payments on debt obligations were payable during the next twelve months. $87.0 million of these payments represent amounts due under the Company’s revolving credit facility, which the Company intends to extend or refinance prior to April 2003. The remaining $1.5 million of principal payments due are expected to be funded from operating cash flows and, if necessary, from borrowings under the revolving credit facility.

The Company has a revolving credit facility with a group of banks under which it may borrow to fund working capital requirements. Amounts outstanding under the credit facility are secured by a lien on substantially all of the Company’s assets. The credit facility, which matures on April 15, 2003, contains affirmative, negative and subjective covenants, requires the Company to comply with certain financial covenants and obtain the lenders’ consent before making any acquisitions or dispositions of assets, and prohibits the payment of cash dividends. Prior to the maturity of the credit facility on April 15, 2003, the Company must either extend the term of the credit facility or obtain an alternative source of financing. Because of the Company’s recent performance and conditions in the credit markets, it is likely that it will need to seek an extension of the existing credit facility. However, there can be no assurance that the Company will be successful in either extending the term of the facility or obtaining alternative financing.

During the first quarter of 2002, the terms of the credit facility were amended to, among other things, extend the maturity date to April 15, 2003, reduce the amount of the credit facility from $111.25 million to $99.7 million, increase the interest rates payable under the credit facility, limit the amount of capital expenditures that the Company makes, and waive its noncompliance with and modify the terms of certain financial covenants. In addition, the amount of the credit facility was permanently reduced by $250,000 on each of June 30, 2002 and September 30, 2002, and is required to be further reduced by $4.6 million on December 31, 2002 and by $2.1 million on March 31, 2003. Furthermore, the amendments provided that the amount of the credit facility will be permanently reduced by an amount equal to one

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U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

hundred percent of the net cash proceeds received from any sale of assets not in the ordinary course of business, the issuance of certain debt or, with certain specified exceptions, any issuance of equity. The terms of the credit facility significantly limit the Company’s ability to enter into leases or obtain additional debt outside of the facility.

During 1999, the Company had a $10.0 million credit facility with BankBoston, N.A. under which it was able to borrow funds to purchase equipment. The commitment for this facility expired on December 31, 1999, at which time the Company had borrowed approximately $2.5 million. This amount is being repaid in 60 monthly installments of principal and interest.

Outlook

The Company’s recent performance has caused it to violate various financial covenants of its credit agreement. Although the Company’s lenders have been issuing short-term waivers and amendments addressing these violations, the Company expects to again be out of compliance with certain financial covenants, pending another amendment of its line of credit, at December 31, 2002.

Between July 18, 2002 and November 12, 2002, the terms of the credit facility were further amended to, among other things, limit the amount of additional borrowings under the facility to $1.0 million, require that $1.2 million of the insurance proceeds received during the third quarter of 2002 be paid to the lenders and applied against the debt reduction required to be made on December 31, 2002, require the engagement of a financial advisor acceptable to the lenders, permit the sale of the Company’s Texas businesses in the Commercial Wastewater Division, permit the use of a portion of the Texas sales proceeds to complete the acquisition of certain assets of Trinity Storage Services, L.P., and waive the Company’s non-compliance with and modify the terms of certain of the financial covenants. The amendments also eliminated the Company’s ability to borrow funds at LIBOR, which is expected to increase interest expense by approximately $100,000 per month. The amendments to the financial covenants reduced the limitation on the Company’s annual capital expenditures, increased the limitation on its annual rent expenses, require that it maintain an accounts receivable coverage ratio of not less than 0.32:1 and adjusted the debt to adjusted EBITDA ratio for the prior twelve-month period required to be met at the end of each quarter. The Company maintained its debt balance below the required 3.70 times adjusted EBITDA for the twelve-month period ended September 30, 2002. The Company’s actual debt balance on September 30, 2002 was 3.50 times adjusted EBITDA for the prior twelve-month period. On December 31, 2002, this limitation will be reduced to 3.00 times adjusted EBITDA, as defined in the credit agreement. The Company does not expect to be able to meet this debt limitation. In that event, the Company will have to obtain an additional waiver or amendment from the lenders prior to year-end. There can be no assurance that the Company will be able to obtain an additional waiver or amendment from the lenders in the event of default.

The debt outstanding under the credit facility may be accelerated by the lenders if, among other things, a change in control of the Company occurs or John P. Miklich or Cary M. Grossman ceases to serve as an executive officer of the Company and is not replaced within sixty days by an individual reasonably satisfactory to the lenders. The lenders have waived through December 31, 2002 an event of default arising from the resignation of Michael P. Lawlor. On August 29, 2002, William DeArman, the Chairman of the Board of Directors, was appointed interim Chief Executive Officer (“CEO”). The Company’s Board of Directors has requested that Mr. DeArman become permanent CEO and he has agreed. The Company plans to request that the lenders accept Mr. DeArman as a satisfactory replacement for Mr. Lawlor. There can be no assurance that Mr. DeArman’s appointment will be approved by the lenders.

To address the factors that have caused the violations of the Company’s credit agreement, the Board of Directors and Company management have taken the following actions:

	•		employed a new executive management team;
	•		engaged a financial advisor, as requested by the Company’s lenders, to focus on financial restructuring plans;

	•		implemented cost cutting measures such as reductions in workforce and a temporary freeze on previously authorized pay increases;
	•		sold the Texas businesses, and used a substantial portion of the proceeds to reduce outstanding debt; and

5

U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

•

acquired six oilfield waste transfer stations in Louisiana and Texas to replace the business lost from the non-renewal of the contract with Newpark Resources, Inc.

Management is also:

•

exploring the possibility of selling other non-core operations;

•

analyzing each of the Company’s operations for opportunities to reduce costs, improve processes and increase efficiencies; and

•

exploring other opportunities for financing.

Management is working aggressively on the above matters and is continuing to explore opportunities for further improvement.

At September 30, 2002, the Company had borrowed approximately $87.0 million under the credit facility. As of November 11, 2002, the balance of the credit facility had been reduced to $76.8 million by using the proceeds from the sale of the Company’s Texas businesses and insurance proceeds received on a claim related to the temporary closure of its Detroit facility in 1999. Advances under the credit facility currently bear interest at the prime rate plus 4.0%. As of September 30, 2002 and November 11, 2002, amounts outstanding under the credit facility were accruing interest at approximately 12.5% and 13.0% per year, respectively.

Despite these actions, it is still unlikely that the Company will be in compliance at December 31, 2002 with the funded debt to adjusted EBITDA ratio. The Company intends to seek a waiver to this covenant prior to year-end. However, there can be no assurance that such a waiver or amendment will be obtained. Additionally, based on discussions with its lenders, the Company believes that any extension of the line of credit past the April 15, 2003 maturity date will require improvements in its operations and is unlikely to be granted until late March or early April 2003, if at all. Management is exploring other alternatives for financing; however, those options are highly uncertain.

4.     SPECIAL ITEMS

2001 Special Income, Net

During 2000, the Company filed suit against National Steel Corporation for failing to properly identify PCB contaminated materials as required by law when delivered to the Company’s Detroit facility. In filing the suit, the Company was seeking to recover the costs incurred and the losses suffered by the facility as a result of National Steel’s non-disclosure. In April 2001, the Company entered into a settlement agreement with National Steel. As a part of the settlement agreement, in April 2001, National Steel paid $7.5 million to the Company.

In addition to filing suit against National Steel, the Company also submitted a claim under its property damage insurance policy for losses incurred as a result of the temporary closing of the Detroit facility in August 1999. During the third quarter of 2001, the Company agreed to accept $3.75 million in complete satisfaction of its claim under this policy. These funds were received by the Company in August 2001.

During the fourth quarter of 2000, the Company recorded special charges relating primarily to decisions to dispose of or suspend certain of its non-core operations. Effective July 31, 2001, part of the Company’s Northeast operations was sold. An additional loss of $0.7 million was provided for this sale at June 30, 2001 based on the information available. In August and September 2001, additional portions of the Northeast operations were sold and losses of $0.8 million were recognized as a result of these sales.

2002 Special Income, Net

In connection with special charges recorded in the fourth quarter of 2000, an accrual was made to cover the cost of disposing of certain waste located at the Company’s Re-Claim facility in Houston, Texas. The disposal of this waste did not begin until the second quarter of 2002, at which time it was determined that a portion of the waste required incineration, thus making the disposal of the waste more costly. During the second quarter of 2002, the Company recorded a special charge of $0.7 million to cover these additional disposal costs. During

6

U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

the third quarter of 2002, management reassessed the reserve and determined an additional $0.3 million was required to process all remaining waste.

In addition to the claim filed and insurance proceeds received as discussed above, the Company submitted a claim with another insurance company for losses incurred as a result of the temporary closing of the Detroit facility. During the third quarter of 2002, the Company agreed to accept $2.4 million in complete satisfaction of its claim under this policy. $2.15 million of this amount was paid directly to the Company in September 2002 and the remainder was paid to the attorneys representing the Company in this matter.

5.     GOODWILL AND OTHER INTANGIBLE ASSETS

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which establishes new accounting and reporting requirements for goodwill and other intangible assets. Under SFAS No. 142, all goodwill amortization ceased effective January 1, 2002. As a result, $14.0 million of goodwill at September 30, 2002 is no longer subject to amortization. Goodwill amortization for the three and nine month periods ended September 30, 2002 would have otherwise been approximately $1.1 million and $3.4 million, respectively. Under SFAS No. 142, an impairment test is required to be performed upon adoption and at least annually thereafter. The impairment test is the result of adopting a fair value approach to testing goodwill as compared to the previous method utilized in which evaluations of goodwill impairment were made by the Company using the estimated future undiscounted cash flows compared to the assets carrying amount. Material amounts of recorded goodwill attributable to each of the Company’s reporting units were tested for impairment by comparing the fair value of each reporting unit with its carrying value. Fair value was determined using discounted cash flows, market sale transaction multiples and comparable market capitalization multiples. Significant estimates used in the methodologies include estimates of future cash flows, future short-term and long-term growth rates, weighted average cost of capital and estimates of market multiples for each of the reportable units. On an ongoing basis (absent any impairment indicators), the Company expects to perform its impairment tests during the first fiscal quarter.

Based on the initial impairment tests, the Company recognized a charge in the first quarter of 2002 of $87.2 million to reduce the carrying values of goodwill of the reporting units to their implied fair values. This first quarter charge was net of a $3.8 million tax benefit. However, as a result of the impairment recognized during the third quarter of 2002, as discussed below, the tax benefit of $3.8 million was reversed. Thus, the net charge related to the first quarter impairment was $91.0 million ($5.66 per share, on a year to date basis). During the third quarter of 2002, the Company determined that impairment indicators existed and performed another impairment test on existing goodwill. These additional impairment indicators included the departure of the Company’s CEO, the significant drop in the Company’s stock price and the downward revision of its revenues and earnings guidance, resulting in a failure to maintain compliance with certain of the financial covenants contained in the Company’s credit facility. As a result of this test, the Company recorded a charge in the third quarter of 2002 of $51.0 million ($3.18 per share, on a year to date basis). Under SFAS No. 142, the impairment adjustment recognized at adoption of the new rules was reflected as a cumulative effect of change in accounting principle in the first quarter 2002 statement of operations. The impairment adjustment recognized in the third quarter of 2002 was recognized as an operating expense.

The carrying amount of goodwill attributable to each reportable segment with goodwill balances and charges therein follows (in thousands, unaudited):

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U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

The unaudited results of operations presented below for the three and nine months ended September 30, 2002 and adjusted results of operations for the three and nine months ended September 30, 2001 reflect the operations of the Company had the Company adopted the non-amortization provisions of SFAS No. 142 effective January 1, 2001:

6.     INVENTORIES

Inventories are stated at the lower of cost or market and, at December 31, 2001 and September 30, 2002, consisted of processed by-products of $1.1 million and $0.8 million, respectively, and unprocessed by-products of $1.4 million and $2.0 million, respectively. Cost is determined using the first-in, first-out (FIFO) method.

8

U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

7.     DEPRECIATION AND AMORTIZATION EXPENSES

Depreciation and amortization expenses excluded from operating expenses and selling, general and administrative expenses in the condensed consolidated statements of operations are presented as follows:

8.     EARNINGS PER SHARE

The weighted average number of shares used to compute basic and diluted earnings per share for the three and nine month periods ended September 30, 2001 and 2002, respectively, is illustrated below:

For the periods ended September 30, 2001 and 2002, there were 1,073,620 and 2,908,270 employee stock options and warrants, respectively, which were not included in the computation of diluted earnings per share because to do so would have been antidilutive for the periods presented.

9

U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

9.     COMPREHENSIVE INCOME (LOSS)

The Company’s comprehensive income (loss), which encompasses net income (loss) and currency translation adjustments, is as follows:

10.     NEW ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” that addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and associated costs. SFAS No. 143 requires that the discounted fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of the fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The provisions of SFAS No. 143 will be effective for the Company as of January 1, 2003. The Company is considering the provisions of SFAS No. 143 and at present has not determined the impact of adopting SFAS No. 143.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” that addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 requires that one accounting model be used for long-lived assets to be disposed of by sale and broadens the presentation of discontinued operations to include more disposal transactions. The Company adopted SFAS No. 144 on January 1, 2002. Adoption of this statement did not have a material impact on the consolidated financial statements of the Company.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt” and an amendment of that statement, SFAS No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements.” SFAS No. 145 also rescinds SFAS No. 44, “Accounting for Intangible Assets of Motor Carriers.” SFAS No. 145 also amends SFAS No. 13, “Accounting for Leases,” to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions related to the rescission of SFAS No. 4 will be applied in fiscal years beginning after May 15, 2002. The provisions related to SFAS No. 13 will be effective for transactions occurring after May 15, 2002. All other provisions will be effective for financial statements issued on or after May 15, 2002, with early application encouraged. The Company does not believe that SFAS No. 145 will have a material effect on its consolidated financial statements.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally EITF Issue No. 94-3. The Company will adopt the provisions of SFAS No. 146 for restructuring activities initiated after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF Issue No. 94-3, a liability for an exit cost was recognized at the date of commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized. The Company will apply the effects of this statement on a prospective basis.

10

U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

11.     OPERATIONS HELD FOR SALE

During the fourth quarter of 2000, the Company’s Board of Directors approved a plan to sell certain non-core operations in the Commercial Wastewater Division. The types of liquid waste managed at these facilities held for sale included industrial wastewaters, biosolids and grease and grit trap waste. As discussed in Notes 2 and 3 to the financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, the Company recorded charges to write down the carrying value of certain assets to fair value, less costs to sell. In determining fair value, the Company considered, among other things, the range of preliminary purchase prices discussed with potential buyers. For operations that were classified as held for sale, the Company suspended depreciation on property, plant and equipment. In addition, the Company revalued goodwill and, therefore, adjusted the related amortization. Had the Company not classified any operations as held for sale, depreciation and amortization expenses for the three and nine month periods ended September 30, 2001 would have been greater by $0.4 million and $1.6 million, respectively. During 2001, certain operations were sold and additional losses were recognized. During the fourth quarter of 2001, the remaining assets classified as held for sale were further adjusted to fair value. Subsequently, as a result of senior management’s decision to assimilate the remaining operations back into the Company’s core business, the adjusted carrying value of the assets, after giving effect to the write-downs, were reclassified to held for use. The results of operations of these businesses are fully included in revenues and expenses in the condensed consolidated statements of operations.

12.     COMMITMENTS AND CONTINGENCIES

Regulatory Proceedings

In October 2002, U S Liquids of Detroit, Inc., a subsidiary of the Company, entered into an agreement with the U.S. Attorney in Detroit resolving the investigation of the Company’s Detroit facility that was commenced by the Environmental Protection Agency (“EPA”) and the Federal Bureau of Investigation in August 1999. Under the terms of the agreement, U S Liquids of Detroit agreed to enter a guilty plea to specified violations of the Resource Conservation and Recovery Act of 1976 and the Rivers and Harbors Act. The agreement requires, among other things, that the Company pay a $4.5 million penalty and contribute $1.0 million to certain community service organizations. These amounts will be paid over a five-year period. In addition, the agreement provides that the United States District Court for the Eastern District of Michigan will determine whether and to what extent interest must be paid on the deferred payments. During the fourth quarter of 2001, the Company took a charge of a $5.0 million to establish a reserve for this matter. Management believes this reserve is sufficient after considering the net present value of the total obligation. An additional charge may be required if interest is imposed by the court on the deferred payments.

The EPA notified the Company in 1999 that liquid waste received by its Re-Claim Louisiana facility and stored off-site contained hazardous constituents and, therefore, the waste could not be processed by the facility. The Company believed that the waste could be handled as nonhazardous waste. A reserve was established for costs to be incurred in the event that this waste had to be delivered to a third party for processing and disposal. As previously reported, the Re-Claim Louisiana facility ceased on-going operations in early 2001. As of September 30, 2002, the Company had a remaining reserve of approximately $0.2 million for the estimated cost to process and dispose of the remaining waste.

The Company acquired Romic Environmental Technologies Corporation (“Romic”) in January 1999. Prior to its acquisition by the Company, Romic had entered into an administrative consent order with the EPA relating to the cleanup of soil and groundwater contamination at its facility in East Palo Alto, California. A remedial investigation of the facility was completed by Romic and forwarded to the EPA. The EPA authorized Romic to conduct a pilot study utilizing in-situ enhanced bio-remediation to determine whether that method would be an effective corrective measure. Preliminary results from the pilot study were encouraging and the study has been expanded. If the study is determined to be successful, the EPA may approve this method or a combination of methods for final site remediation. Prior to its acquisition by the Company, Romic had also been notified by the EPA and the California Department of Toxic Substances Control that it was a potentially responsible party under applicable environmental legislation with respect to the Bay Area Drum Superfund Site in San Francisco, California, the Lorentz Barrel and Drum Superfund Site in San Jose, California and the Casmalia Resources Hazardous Waste Management Facility located near Santa Barbara, California, each of which was a drum reconditioning or disposal site previously used by Romic. With respect to each of these drum reconditioning or disposal sites, Romic and a number of other potentially responsible parties have entered into administrative consent orders and/or agreements allocating each party’s respective share of the cost of remediating the

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U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

sites. Romic’s share under these consent orders and/or agreements is as follows: Bay Area — 6.872%, Lorentz — 5.62% and Casmalia Resources — 0.29%. Remediation is either underway or substantially complete at all three sites. Based upon the information currently available, the Company has continued to maintain a reserve to cover Romic’s estimated costs to remediate the East Palo Alto facility and the three drum reconditioning or disposal sites. As of September 30, 2002, the balance of this reserve was $2.8 million, of which $0.3 million is classified as short-term and is expected to be paid in the next twelve months. Management believes that this reserve is sufficient to satisfy Romic’s obligations under the consent orders and agreements; however, due to the complex, ongoing and evolving process of investigating and remediating these sites, Romic’s actual costs may exceed the amount reserved.

The operations of the Innovative Services Group of the Company’s Commercial Wastewater Division are subject to regulation by the U. S. Bureau of Alcohol, Tobacco and Firearms (“ATF”). In addition to regulating the production, distribution and sale of alcohol and alcohol containing products, the ATF is also responsible for collecting the federal excise taxes (“FET”) that must be paid on distilled spirits, wine and beer. If alcoholic beverages on which the FET have been paid are returned to bond at the Company’s premises for destruction, the party who has paid the FET on the destroyed product is entitled to a refund. When customers return distilled spirits, wine or beer from commerce to one of the Company’s facilities for destruction, the Company generally files a claim with the ATF on behalf of that customer for refund of the FET paid on that product. The ATF periodically inspects the Company’s facilities both to insure compliance with its regulations and to substantiate claims for FET refunds. During 2000, the ATF conducted inspections at the Company’s Louisville, Kentucky and Rancho Cucamonga, California facilities. At the conclusion of these inspections, the ATF preliminarily notified the Company that it intended to deny certain refund claims, some of which had already been paid by the ATF to the Company’s customers, due to what the ATF alleges was inadequate, incomplete or unsubstantiated supporting documentation. In addition, the ATF proposed a civil penalty of $30,000 based on the alleged defects in the Company’s documentation. During the third quarter of 2001, the ATF notified the Company that, in order to recoup refund claims previously paid to the Company’s customers, the ATF was assessing taxes of $1.175 million against the facilities. During the fourth quarter of 2001, the Company offered to pay $450,000 to the ATF to resolve all of the ATF’s claims against the facilities and delivered a check for such amount to the ATF. Based upon discussions with the ATF, the Company believes that the offer will be accepted by the ATF. The proposed assessment by the ATF does not address approximately $525,000 of refund claims that were submitted on behalf of the Company’s customers that either have already been denied or are likely to be denied as a result of the alleged defects in the documentation. The Company is currently engaged in discussions with the affected customers concerning the refund claims in question. Settlements have been reached with certain customers and the Company believes that satisfactory settlements can be reached with all of the other affected customers. Based upon the information available, the Company has continued to maintain a reserve for this matter. As of September 30, 2002, the total reserve remaining was $0.5 million. Management believes that this reserve is sufficient.

Litigation

During the third quarter of 1999, six purported securities class action lawsuits were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of Texas, Houston Division. These lawsuits have been consolidated into a single action styled In re: U S Liquids Securities Litigation, Case No. H-99-2785, and the plaintiffs have filed a consolidated complaint alleging violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 (“Securities Act”) on behalf of purchasers of the Company’s common stock in the Company’s March 1999 public offering and violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder on behalf of purchasers of the Company’s common stock during the period beginning on May 12, 1998 and ending on August 25, 1999. The plaintiffs generally allege that the defendants made false and misleading statements and failed to disclose allegedly material information regarding the operations of the Company’s Detroit facility and the Company’s financial condition in the prospectus relating to the March 1999 stock offering and in certain other public filings and announcements made by the Company. The remedies sought by the plaintiffs include designation of the action as a class action, unspecified damages, attorneys’ and experts’ fees and costs, rescission to the extent any members of the class still hold common stock, and such other relief as the court deems proper. In January 2001, the court dismissed the claims asserted by the plaintiffs under Sections 10(b) and 20(a) and Rule 10b-5 of the Exchange Act and in April 2002 the court dismissed the claims asserted by the plaintiffs under Section 12(a)(2) of the Securities Act. Accordingly, the lawsuit is proceeding only with respect to the claims asserted under Sections 11 and 15 of the Securities Act.

In June 2002, the court determined that two individuals designated by the plaintiffs are adequate class representatives for plaintiffs’ claim under Section 11 of the Securities Act. In August 2002, the court entered an order defining the plaintiff class as all persons who purchased

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U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

or otherwise acquired Company common stock pursuant or traceable to the Company’s March 1999 stock offering. The lawsuit is currently set for trial on April 14, 2003; however, further proceedings and discovery in the lawsuit have been suspended pending the resolution of the Company’s dispute with its insurance carrier over whether insurance coverage exists for the claims asserted by the plaintiffs.

In addition, one stockholder of the Company has filed a lawsuit against certain former and current officers and directors of the Company in connection with the operation of the Company’s Detroit facility and the securities class action described above. Benn Carmicia v. U S Liquids Inc., et al., was filed in the United States District Court for the Southern District of Texas, Houston Division, on September 15, 1999 and was subsequently consolidated with the claims asserted in the securities class action described above. The plaintiff purports to allege derivative claims on behalf of the Company against the officers and directors for alleged breaches of fiduciary duty resulting from their oversight of the Company’s affairs. The lawsuit names the Company as a nominal defendant and seeks compensatory and punitive damages on behalf of the Company, interest, equitable and/or injunctive relief, costs and such other relief as the court deems proper. The Company believes that the stockholder derivative action was not properly brought and has filed a motion to dismiss this action in order to allow the Board of Directors to consider whether such litigation is in the best interest of the Company and its stockholders. As of the date of this report, no ruling has been made by the court on the motion to dismiss. This lawsuit is currently set for trial in February 2003.

On April 21, 1998, the Company acquired substantially all of the assets of Parallel Products, a California limited partnership (“Parallel”). In addition to the consideration paid at closing, the Company agreed that, if the earnings before interest, taxes, depreciation and amortization (“EBITDA”) of the businesses acquired from Parallel exceeded a specified amount in any four consecutive quarters during the three year period after the closing of the acquisition, the Company would pay to Parallel an additional $2.1 million in cash and an additional $2.1 million in the Company’s common stock. During the third quarter of 2000, Parallel filed suit against the Company alleging that the acquired businesses achieved the specified EBITDA amount for the four quarters ended December 31, 1999 and for the four quarters ended March 31, 2000. Parallel is seeking a declaratory judgment that the EBITDA amount specified in the acquisition agreement was achieved and that it is entitled to receive the contingent cash and stock payments described above. Parallel also alleges that it is entitled to recover compensatory damages of $4.2 million, punitive damages, interest, attorneys’ fees and costs, and such other relief as the court deems proper. The Company has denied that it has any liability to Parallel and has filed a counterclaim against Parallel alleging that Parallel breached certain of the representations and warranties made in the acquisition agreement. This lawsuit is currently set for trial on July 14, 2003.

During the third quarter of 2002, the Company settled the claims asserted against it by Keith Betts, Betts Pump and Betts Environmental, Inc. The cost of the settlement was not material to the operating results of the Company.

From September 4, 1998 through September 3, 2000, Reliance Insurance Company or one of its affiliated companies (“Reliance”) provided casualty insurance coverage for the Company and its subsidiaries. In addition, Reliance provided similar coverage, for pre-acquisition periods, for several companies that the Company acquired between 1997 and 2000. During the Reliance coverage periods, various incidents occurred that resulted in claims being made against the Company for which insurance coverage was to be provided by Reliance. In some cases, the claim resulted in a lawsuit being filed against the Company. Reliance had been adjusting and/or defending these claims; however, in October 2001, Reliance was declared insolvent by the Insurance Commissioner of the State of Pennsylvania and placed into liquidation. As a result, insurance coverage may not be available for any claims or lawsuits that were not resolved prior to Reliance being placed into liquidation. To the extent that insurance coverage is not available to cover settlement of a claim asserted against the Company or a judgment entered against the Company, the settlement or judgment would have to be paid by the Company. Many states have established insurance guarantee funds to pay claims insured by insolvent insurance companies; however, the amount available from such funds for a single claim is generally limited to the lesser of the amount of the insured’s coverage and a dollar amount specified by statute. During the fourth quarter of 2001, the Company established a reserve to cover the Company’s estimated costs to satisfy its obligations with respect to all such claims that were not resolved prior to Reliance being placed into liquidation, net of the amounts expected to be received by the Company from state insurance guarantee funds. As of September 30, 2002, the balance of this reserve was $3.5 million. Certain of these claims have been resolved and the Company has made payments totaling $0.5 million in October 2002. The Company has committed to making additional payments of $1.0 million during 2003 and $0.7 million in 2004. After considering the known payments at this time, management believes that the reserve is sufficient to satisfy the Company’s obligations with respect to all such remaining claims for which insurance coverage was to be provided by Reliance; however, there can be no assurance that the Company’s actual costs will not exceed the amount reserved.

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U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)

In February 1998, the Company entered into an employment agreement with its former chief financial officer, Earl J. Blackwell. The employment agreement provided, among other things, that (i) if the agreement was terminated by Mr. Blackwell without cause, Mr. Blackwell would not be entitled to receive any further compensation or benefits under the agreement, and (ii) if the agreement was terminated by Mr. Blackwell with cause, Mr. Blackwell would be entitled to continue to receive his annual salary of $220,000 and employee benefits for the remainder of the term of the agreement. On July 31, 2002, Mr. Blackwell terminated his employment with the Company alleging that the Company breached the terms of his employment agreement by usurping his duties and responsibilities as chief financial officer of the Company. On October 2, 2002, Mr. Blackwell initiated an arbitration proceeding against the Company seeking to recover approximately $1.1 million in damages, interest, attorneys’ fees and costs. The Company denies that it has any liability to Mr. Blackwell.

On September 9, 2002, Allan Rosen, a former employee of the Company, filed suit in the Superior Court of Los Angeles County, California against the Company and certain of its current and former officers. Mr. Rosen alleges, among other things, that the Company breached various oral agreements relating to the compensation to be paid to Mr. Rosen for his services and that he was wrongfully terminated in October 2001 because, among other things, he complained about the operational and accounting systems of certain subsidiaries of the Company and because he refused to certify, for the Company's internal purposes, various financial information and reports relating to the operations of such subsidiaries. Mr. Rosen is seeking unspecified compensatory and punitive damages, interest, attorneys’ fees and costs. Mr. Rosen is also seeking a declaratory judgment that a noncompete provision contained in his employment agreement is not enforceable. The Company denies that it has any liability to Mr. Rosen.

The Company’s business is subject to numerous federal, state and local laws, regulations and policies that govern environmental protection, zoning and other matters. During the ordinary course of business, the Company has become involved in a variety of legal and administrative proceedings relating to land use and environmental laws and regulations, including actions or proceedings brought by governmental agencies, adjacent landowners, or citizens’ groups. In the majority of the situations where proceedings are commenced by governmental agencies, the matters involved relate to alleged technical violations of licenses or permits pursuant to which the Company operates or is seeking to operate, or laws or regulations to which its operations are subject or are the result of different interpretations of applicable requirements. From time to time, the Company pays fines or penalties in governmental proceedings relating to its operations. The Company believes that these matters will not have a material adverse effect on its business or consolidated financial statements. However, the outcome of any particular proceeding cannot be predicted with certainty, and the possibility remains that technological, regulatory or enforcement developments, results of environmental studies, or other factors could materially alter this expectation at any time.

It is not possible at this time to predict the impact the above lawsuits, proceedings, investigations and inquiries may have on the Company, nor is it possible to predict whether any other suits or claims may arise out of these matters in the future. However, it is reasonably possible that the outcome of any present or future litigation, proceedings, investigations or inquiries may have a material adverse impact on the Company’s consolidated financial statements in one or more future periods. The Company intends to defend itself vigorously in all the above matters.

The Company is involved in various other legal actions arising in the ordinary course of business. Management does not believe that the outcome of such legal actions will have a material adverse effect on the Company’s consolidated financial statements.

13.     SEGMENT INFORMATION

The Company’s subsidiaries are organized into three divisions — the Commercial Wastewater Division, the Industrial Wastewater Division and the Oilfield Waste Division. The Commercial Wastewater Division collects, processes and disposes of nonhazardous liquid waste and recovers saleable by-products from certain waste streams. The Industrial Wastewater Division collects, processes and disposes of hazardous and nonhazardous waste and recovers saleable by-products from certain waste streams. The Oilfield Waste Division processes and disposes of waste generated in oil and gas exploration and production.

The accounting policies of the segments are the same as those for the Company described in the summary of significant accounting policies set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the SEC. The following is a summary of key business segment information:

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U S LIQUIDS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)