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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004 Commission File Number 333-63825
SCOTIA PACIFIC COMPANY LLC
(Exact name of Registrant as Specified in its Charter)
Delaware 68-0414690
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
P. O. Box 712 95565
125 Main Street, 2nd Floor (Zip Code)
Scotia, California
(Address of Principal Executive Offices)
Registrant's telephone number, including area code: (707) 764-2330
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Securities registered pursuant to Section 12(b) of the Act: None.
Securities registered pursuant to Section 12(g) of the Act: None.
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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 voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was last sold, as of the last business day of the registrant's most recently
completed second fiscal quarter: $0.00
Registrant meets the conditions set forth in General Instruction (I)(1)(a)
and (b) of Form 10-K and is therefore filing this Form with the reduced
disclosure format.
DOCUMENTS INCORPORATED BY REFERENCE: Not applicable.
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TABLE OF CONTENTS
Part I
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
Balance Sheet
Statement of Loss
Statement of Cash Flows
Notes to Financial Statements
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Item 9A. Controls and Procedures
Item 9B. Other Information
Part III
Items
10-13. Not applicable
Item 14. Principal Accounting Fees and Services
Part IV
Item 15. Exhibits and Financial Statement Schedules
Signatures
Index of Exhibits
PART I
ITEM 1. BUSINESS
General
Scotia Pacific Company LLC (the "Company"), a special purpose Delaware
limited liability company wholly owned by The Pacific Lumber Company ("Palco"),
was organized by Palco in May 1998 to facilitate the sale of the Company's 6.55%
Series B Class A-1 Timber Collateralized Notes due 2028, (the "Class A-1
Notes"), 7.11% Series B Class A-2 Timber Collateralized Notes due 2028 (the
"Class A-2 Notes") and 7.71% Series B Class A-3 Timber Collateralized Notes due
2028 (the "Class A-3 Notes," together with the Class A-1 Timber Notes and the
Class A-2 Timber Notes, the "Timber Notes"). The Indenture governing the Timber
Notes is referred to herein as the "Indenture." Palco is a wholly owned
subsidiary of MAXXAM Group Inc. ("MGI"), and Palco also wholly owns Salmon Creek
LLC ("Salmon Creek") and Britt Lumber Co., Inc. ("Britt"). MGI is an indirect
wholly owned subsidiary of MAXXAM Inc. ("MAXXAM"). Any reference to a company
includes the subsidiaries of that company unless otherwise noted or the context
indicates otherwise.
Except as otherwise indicated, all references herein to "Notes" represent
the Notes to the Company's Financial Statements contained herein.
This Annual Report on Form 10-K contains statements which constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 ("PSLRA"). These statements appear in a number of
places (see Item 1. "Business--Harvesting Practices" and "--Regulatory and
Environmental Factors," Item 3. "Legal Proceedings" and Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Background," "--Results of Operations" and "--Financial Condition
and Investing and Financing Activities"). Such statements can be identified by
the use of forward-looking terminology such as "believes," "expects," "may,"
"estimates," "will," "should," "plans" or "anticipates" or the negative thereof
or other variations thereon or comparable terminology, or by discussions of
strategy. Readers are cautioned that any such forward-looking statements are not
guarantees of future performance and involve significant risks and
uncertainties, and that actual results may vary materially from the
forward-looking statements as a result of various factors. These factors include
the effectiveness of management's strategies and decisions, general economic and
business conditions, developments in technology, new or modified statutory or
regulatory requirements, litigation developments, and changing prices and market
conditions. This Report identifies other factors which could cause differences
between such forward-looking statements and actual results. No assurance can be
given that these are all of the factors that could cause actual results to vary
materially from the forward-looking statements.
The Company's operations have been adversely affected by the failure of the
California North Coast Regional Water Quality Control Board to release for
harvest a number of the Company's timber harvesting plans even though the plans
have already been approved by the other government agencies which review its
timber harvesting plans and are in compliance with its comprehensive
multi-species habitat conservation plan. See "--Regulatory and Environmental
Factors--Water Quality" and See Item 7. "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Financial Condition and Financing
and Investing Activities."
Timber and Timberlands
This section contains statements which constitute "forward-looking
statements" within the meaning of the PSLRA. See this section and
"Business--General" above for cautionary information with respect to such
forward-looking statements.
The Company owns, and the obligations of the Company under the Timber Notes
are secured by, (i) approximately 204,000 acres of timberlands, (ii) the timber
and related harvesting rights (the "Company Timber Rights") with respect to an
additional approximately 12,200 acres of timberlands that are owned by Palco and
Salmon Creek, (iii) certain computer hardware and software, including a
geographic information system ("GIS") containing information on numerous aspects
of the Company's timberlands (subject to certain rights of concurrent use by
Palco) and (iv) certain other assets. Substantially all of the Company's assets
serve as security for the Timber Notes. The timberlands owned by the Company and
the timberlands subject to the Company Timber Rights are hereinafter
collectively referred to as the "Company Timberlands." The timber located on the
Company Timberlands is hereinafter referred to as the "Company Timber."
In March 1999, Palco, the Company and Salmon Creek (collectively, the
"Palco Companies") consummated the Headwaters Agreement (the "Headwaters
Agreement") with the United States and California. Pursuant to the agreement,
approximately 5,600 acres of timberlands owned by the Palco Companies (the
"Headwaters Timberlands") were transferred to the United States government in
exchange for (i) an aggregate of $300.0 million, (ii) approximately 7,700 acres
of timberlands, and (iii) approval by the federal and state governments of
habitat conservation and sustained yield plans (the "Environmental Plans") in
respect of substantially all of the Company Timberlands. California also agreed
to offer to purchase other timberlands owned by the Company and Palco (which
purchases were subsequently consummated).
Timber generally is categorized by species and the age of a tree when it is
harvested. "Old growth" trees are often defined as trees which have been growing
for approximately 200 years or longer, and "young growth" trees are those which
have been growing for less than 200 years. The forest products industry grades
lumber into various classifications according to quality. The two broad
categories into which all grades fall based on the absence or presence of knots
are called "upper" and "common" grades, respectively. Old growth trees have a
higher percentage of upper grade lumber than young growth trees. The overall
supply of premium upper grade lumber has diminished greatly due to increasing
environmental and regulatory restrictions and other factors.
The Company Timber is comprised of predominantly young growth and old
growth redwood, Douglas-fir and other conifer timber. The Company's conifers
consist (by volume) of approximately 66% redwood, 30% Douglas-fir, and 4% other
conifer timber. In May 2002, the first timber cruise of the Company Timberlands
since 1986 was completed. The results of the timber cruise provided the Company
with an estimate of the volume of merchantable Company Timber. The 2002 cruise
data reflected a 0.1 million MBF decrease in estimated overall timber volume as
compared to the estimated volumes reported as of December 31, 2001 using the
1986 cruise data (adjusted for harvest and estimated growth). The 2002 cruise
data indicated that the Company Timber has significantly less old growth timber
than estimated as of December 31, 2001, using the 1986 cruise data. There was
also an estimated increase in young growth timber volume almost equal to the
estimated decrease in old growth timber volume. This shift in timber volume
between classifications decreased the overall timber volume reported in Mbfe
(see the following paragraph) by 0.2 to 2.9 million. These timber volume numbers
do not reflect substantial quantities of sub-merchantable trees which exist but
are not yet mature enough to be included within the inventory of Company Timber.
Under the Mbfe concept, one thousand board feet, net Scribner scale, of old
growth redwood timber equals one Mbfe. One thousand board feet, net Scribner
scale, of each other species and category of timber included in the Company
Timber was assigned a value equal to a fraction of an Mbfe (in order to account
for their relative values). This fraction was generally determined by dividing
the June 1998 SBE Price applicable to such species and category by the June 1998
SBE Price applicable to old growth redwood. "SBE Price" is the applicable
stumpage price for each species of timber and category thereof pursuant to a
schedule published periodically by the California State Board of Equalization.
See "--Operation of Company Timberlands" and "--Harvesting Practices" below.
See "--Regulatory and Environmental Factors," Item. 3 "Legal Proceedings,"
and Item 7. "Management's Discussion and Analysis of Financial Condition and
Results of Operations" for various legal, regulatory, environmental and other
challenges being faced by the Company in connection with timber harvesting and
other operations on the Company Timberlands.
Redwood lumber is a premium, high value-added product which has different
supply and demand characteristics from the general lumber market. Redwood is
known for its natural beauty, superior ability to retain paints and finishes,
dimensional stability and its innate resistance to decay, insects and chemicals.
As a result, redwood lumber is generally not used for commodity applications
such as structural frames for construction, but is used instead for specialty
applications such as exterior siding, trim and fascia for both residential and
commercial construction, outdoor furniture, decks, planters and retaining walls.
Redwood also has a variety of industrial applications because of its resistance
to chemicals and because it does not impart any taste or odor to liquids or
solids. Redwood lumber has historically commanded a substantial price premium to
other softwood timber types. Redwood is commercially available only in North
America in a region that extends for approximately 375 miles along the coast of
the Pacific Northwest. The combination of excellent soil conditions and climate
makes this region one of the most productive timber regions in North America.
Douglas-fir is used primarily for new construction and some decorative
purposes and is widely recognized for its strength, hard surface and attractive
appearance. Douglas-fir is grown commercially along the west coast of North
America and in Chile and New Zealand.
The Company and Palco engage in extensive efforts to supplement the natural
regeneration of the Company Timber and increase the amount of timber on the
Company Timberlands. The Company is required to comply with California forestry
regulations regarding reforestation, which generally require that an area be
reforested to specified standards within an established period of time. Palco's
regeneration efforts are required by, and conducted pursuant to, the Services
Agreement described below (see "--Operation of Company Timberlands").
Regeneration of redwood timber generally is accomplished through redwood sprouts
from harvested trees and the planting of redwood seedlings at levels designed to
optimize growth. Douglas-fir timber is regenerated almost entirely by planting
seedlings. During 2004, Palco planted an estimated 1,350,000 redwood and
Douglas-fir seedlings on the Company Timberlands.
California law requires large timberland owners, including the Company, to
demonstrate that their timber operations will not decrease the sustainable
productivity of their timberlands. The applicable regulations require timber
companies to project timber growth and harvest on their timberlands over a
100-year planning period and to demonstrate sustained yield, i.e. that their
projected average annual harvest for any decade within the 100-year planning
period will not exceed the average annual growth level at the end of the
100-year planning period. A timber company may comply with this requirement by
submitting a sustained yield plan to the California Department of Forestry and
Fire Protection ("CDF") for review and approval. Timber companies which do not
have a sustained yield plan are allowed to follow alternative procedures (see
below).
The Company is also subject to federal and state laws providing for the
protection and conservation of wildlife species which have been designated as
endangered or threatened, certain of which are found on the Company Timberlands.
These laws generally prohibit certain adverse impacts on such species (referred
to as a "take"), except for incidental take which does not jeopardize the
continued existence of the affected species and is made in accordance with an
approved habitat conservation plan and related incidental take permit. A habitat
conservation plan analyzes the impact of the incidental take and specifies
measures to monitor, minimize and mitigate such impact. As part of the
Headwaters Agreement, the federal and state governments approved the
Environmental Plans, which consisted of a sustained yield plan (the "SYP") and a
multi-species habitat conservation plan (the "HCP"), in respect of substantially
all of the Company Timberlands. However, in connection with two lawsuits filed
against Palco and the Company, a California court invalidated the SYP and the
incidental take permits issued by California in connection with the
Environmental Plans (the "California Permits"), a decision which Palco has
appealed. See Item 3, "Legal Proceedings."
As a result of these cases, the Company has since October 2002 been
obtaining review and approval of its timber harvesting plans ("THPs") under the
alternative procedure in the California forest practice rules known as "Option
C." Option C is available to landowners who have submitted an "Option A" plan to
the CDF for review (as was done by the Palco Companies), and may be used during
the review and approval period for the Option A plan. An approved Option A plan
is an alternative to obtaining approval of a sustained yield plan. In December
2004, the Palco Companies revised and resubmitted the Option A plan, which
document (the "Option A Plan") is currently under review by the CDF.
Operation of Company Timberlands
The Company's foresters, wildlife and fisheries biologists, geologists,
botanists and other personnel provide a number of forest stewardship techniques,
including protecting the Company Timber from forest fires, erosion, insects and
other damage, overseeing reforestation activities, and implementing and
monitoring environmental and regulatory compliance. The Company's personnel also
prepare THPs and maintain and update the GIS that contains information on
numerous aspects of the Company Timberlands. See "--Harvesting Practices" below
for a description of the Company's GIS updating process and the THP preparation
process.
The Company is a party with Palco to a master purchase agreement (the
"Master Purchase Agreement") which governs the sale to Palco of logs harvested
from the Company Timberlands. As Palco purchases logs from the Company pursuant
to the Master Purchase Agreement, Palco is responsible, at its own expense, for
harvesting and removing the standing Company Timber covered by approved THPs,
with the purchase price being based upon "stumpage prices." Title to, and the
obligation to pay for, harvested logs passes to Palco once the logs are
measured. The Master Purchase Agreement contemplates that all sales of logs by
the Company to Palco will be at fair market value (based on stumpage prices) for
each species and category of timber. The Master Purchase Agreement provides that
if the purchase price equals or exceeds the SBE Price and a structuring price
set forth in a schedule to the Indenture, the purchase price is deemed to be at
fair market value. If the purchase price equals or exceeds the SBE Price, but is
less than the structuring price, then the Company is required to engage an
independent forestry consultant to confirm that the purchase price reflects fair
market value. SBE Price is the stumpage price for each species and category of
timber as set forth in the most recent "Harvest Value Schedule" (or any
successor publication) published by the California State Board of Equalization
(or any successor agency) applicable to the timber sold during the applicable
period. Harvest Value Schedules are published twice a year for purposes of
computing a yield tax imposed on timber harvested between January 1 through June
30 and July 1 through December 31. SBE Prices are not necessarily representative
of actual prices that would be realized from unrelated parties at subsequent
dates. See also Item 7. "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Results of Operations--General--Master
Purchase Agreement Provisions" and "--Financial Condition and Investing and
Financing Activities."
After obtaining an approved THP, the Company offers for sale the logs to be
harvested pursuant to such THP. While the Company may sell logs to third
parties, it derives substantially all of its revenue from the sale of logs to
Palco pursuant to the Master Purchase Agreement. Each sale of logs by the
Company to Palco is made pursuant to a separate log purchase agreement that
relates to the Company Timber covered by an approved THP and incorporates the
provisions of the Master Purchase Agreement. Each such log purchase agreement
provides for the sale to Palco of the logs harvested from the Company Timber
covered by such THP and generally constitutes an exclusive agreement with
respect to the timber covered thereby, subject to certain limited exceptions.
However, the timing and amount of log purchases by Palco is affected by factors
outside the control of the Company, including regulatory and environmental
factors, the financial condition of Palco, and the supply and demand for lumber
products (which, in turn, will be influenced by demand in the housing,
construction and remodeling industries). See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Financial Condition
and Financing and Investing Activities" for recent developments regarding
Palco's financial condition.
The Company relies on Palco to provide a number of operational, management
and related services not performed by its own employees with respect to the
Company Timberlands pursuant to a services agreement (the "Services Agreement").
These services include protecting the Company Timberlands from fire, disease and
insects; maintaining and rehabilitating roads on the Company Timberlands;
building new roads to permit the harvesting of Company Timber; providing certain
timber management services, such as replanting and reforestation, designed to
supplement the natural regeneration of, and increase the amount of, Company
Timber; assisting the Company to comply with all applicable environmental laws;
advising and consulting with the Company regarding legislative matters;
preparing and filing on behalf of the Company (at Palco's cost) all pleadings
and motions, and otherwise diligently pursuing, appeals of any denial and
defense of any challenge to approval of any THP or the Environmental Plans or
similar plan or permit and related matters; and otherwise furnishing all
equipment, personnel and expertise not within the Company's possession and
reasonably necessary for the operation and maintenance of the Company
Timberlands and the Company Timber.
Palco is required to provide all services under the Services Agreement in a
manner consistent in all material respects with prudent business practices which
are consistent with then-current applicable industry standards and are in
compliance in all material respects with all applicable timber laws. The Company
pays Palco a services fee ("Services Fee") which is adjusted annually based on a
specified government price index relating to wood products and reimburses Palco
for the cost of constructing, rehabilitating and maintaining roads, and
performing reforestation services, on the Company Timberlands. Certain of such
reimbursable expenses vary in relation to the amount of timber to be harvested
in any given period.
The Company provides certain services to Palco pursuant to an additional
services agreement (the "Additional Services Agreement"). These services include
(i) assisting Palco to operate, maintain and harvest its own timber properties,
(ii) updating and providing access to the GIS with respect to information
concerning Palco's own timber properties and (iii) assisting Palco with its
statutory and regulatory compliance. The Additional Services Agreement provides
that Palco shall pay the Company a fee for such services equal to the Company's
actual cost of providing such services, as determined in accordance with
generally accepted accounting principles.
The Palco Companies are also parties to a reciprocal rights agreement (the
"Reciprocal Rights Agreement") whereby, among other things, the parties have
granted to each other certain reciprocal rights of egress and ingress through
their respective properties in connection with the operation and maintenance of
such properties and their respective businesses. In addition, Palco and the
Company are parties to an environmental indemnification agreement (the
"Environmental Indemnification Agreement"), pursuant to which Palco has agreed
to indemnify the Company from and 6 against certain present and future
liabilities arising with respect to hazardous materials, hazardous materials
contamination or disposal sites, or under environmental laws with respect to the
Company Timberlands. In particular, Palco is liable with respect to any
contamination which occurred on the Company Timberlands prior to the date of
their transfer to the Company.
Harvesting Practices
This section contains statements which constitute "forward-looking
statements" within the meaning of the PSLRA. See this section and
"Business--General" above for cautionary information with respect to such
forward-looking statements.
The ability to harvest Company Timber will depend in large part upon the
ability to obtain regulatory approval of THPs prepared by the Company's
foresters. Prior to harvesting timber in California, companies are obligated to
obtain the CDF's approval of a detailed THP for the area to be harvested. A THP
must be submitted by a Registered Professional Forester and is required to
include information regarding the method of proposed timber operations for a
specified area, whether the operations will have any adverse impact on the
environment and, if so, the mitigation measures to be used to reduce any such
impact. The CDF's evaluation of THPs incorporates review and analysis of such
THPs by several California and federal agencies and public comments received
with respect to such THPs. The number of the Company's approved THPs and the
amount of timber covered by such THPs varies significantly from time to time,
depending upon the timing of agency review and other factors. Timber covered by
an approved THP is typically harvested within a one- year period from the date
that harvesting first begins.
The Indenture requires the Company to use its best efforts (consistent with
prudent business practices) to maintain a number of pending THPs which, together
with THPs previously approved, would cover rights to harvest a quantity of
Company Timber adequate to pay interest and principal amortization based on the
Minimum Principal Amortization schedule (as set forth in the Indenture) for the
Timber Notes for the next succeeding twelve month period. See Item 7.
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition and Investing and Financing Activities"
regarding delays by the North Coast Water Board in releasing already-approved
THPs for harvest. Also see"--Regulatory and Environmental Factors" and Item 3.
"Legal Proceedings--Timber Harvesting Litigation" for various legal, regulatory,
environmental and other challenges being faced by the Company in connection with
timber harvesting and other operations on the Company Timberlands.
The GIS maintained by the Company contains information regarding numerous
aspects of the Company Timberlands, including timber type, site productivity
class, wildlife and botanical data, geological information, roads, rivers and
streams. Pursuant to the Services Agreement, Palco, to the extent necessary,
assists the Company in updating, upgrading and improving the GIS and the other
computer systems owned by the Company. By carefully monitoring and updating this
data base and conducting field studies, the Company's foresters are better able
to develop detailed THPs addressing the various regulatory requirements. The
Company also utilizes a Global Positioning System ("GPS") which can provide
precise location of geographic features through satellite positioning. Use of
the GPS greatly enhances the quality and efficiency of the GIS data.
The Company employs a variety of well-accepted methods of selecting trees
for harvest designed to achieve optimal growth and regeneration. These methods,
referred to as "silvicultural systems" in the forestry profession, range from
very light thinnings (aimed at enhancing the growth rate of retained trees) to
clear cutting which results in the harvest of nearly all trees in an area (with
the exception of sub-merchantable trees and trees retained for wildlife
protection and future stand enhancement) and replacement with a new forest
stand. In between are a number of varying levels of partial harvests which can
be employed.
Employees
As of March 1, 2005, the Company employed 125 persons, 118 of whom were
Registered Professional Foresters, geologists, wildlife and fisheries
biologists, botanists or otherwise involved in the management of the Company
Timberlands. None of the Company's employees are covered by a collective
bargaining agreement.
Principal Executive Offices
The principal executive offices of the Company are located at 125 Main
Street, 2nd Floor, P.O. Box 712, Scotia, California 95565. The telephone number
of the Company is (707) 764-2330.
Regulatory and Environmental Factors
This section contains statements which constitute "forward-looking
statements" within the meaning of the PSLRA. See this section and
"Business--General" above for cautionary information with respect to such
forward-looking statements.
General
The Company's business is subject to a variety of California and federal
laws and regulations, as well as the HCP, dealing with timber harvesting
practices, threatened and endangered species and habitat for such species, and
air and water quality. Compliance with such laws and regulations also plays a
significant role in the Company's business. The California Forest Practice Act
(the "Forest Practice Act") and related regulations adopted by the California
Board of Forestry and Fire Protection (the "BOF") set forth detailed
requirements for the conduct of timber harvesting operations in California.
These requirements include the obligation of timber companies to obtain
regulatory approval of detailed THPs containing information with respect to
areas proposed to be harvested. See "--Harvesting Practices" above. California
law also requires large timberland owners, including the Company, to demonstrate
that their proposed timber operations constitute the maximum sustainable
production of their timberlands over time. See "--Timber and Timberlands" above.
The federal Endangered Species Act (the "ESA") and California Endangered
Species Act (the "CESA") provide in general for the protection and conservation
of specifically listed wildlife and plants. These laws generally prohibit the
take of certain species, except for specifically authorized incidental take
pursuant to otherwise lawful activities which do not jeopardize the continued
existence of the affected species and which are made in accordance with an
approved habitat conservation plan and related incidental take permits. A
habitat conservation plan, among other things, specifies measures to minimize
and mitigate the potential impact of the incidental take of species and to
monitor the effects of the activities covered by the plan. The Company is also
subject to the California Environmental Quality Act (the "CEQA"), which provides
for protection of the state's air and water quality and wildlife, and the
California Porter-Cologne Water Quality Control Act and federal Clean Water Act
(the "CWA"), which require that the Company conduct its operations so as to
reasonably protect the water quality of nearby rivers and streams. Compliance
with such laws, regulations and judicial and administrative interpretations,
together with other regulatory and environmental matters, have resulted in
substantial restrictions on the scope and timing of timber operations on the
Company Timberlands, increased operational costs significantly, and engendered
continual litigation and other challenges to its operations. Moreover, the cash
flows of the Company have recently been adversely affected by the failure of the
North Coast Water Board to release for harvest THPs which have already been
approved by the other government agencies that approve the Company's THPs. See
"--Water Quality" below.
Environmental Plans
The Environmental Plans, consisting of the HCP and the SYP, which cover the
substantial portion of the timberlands of the Palco Companies, were approved by
the federal and state governments upon the consummation of the Headwaters
Agreement. In connection with approval of the Environmental Plans, incidental
take permits (the "Permits") were issued with respect to certain threatened,
endangered and other species found on the timberlands covered by the
Environmental Plans. The Permits were to cover the 50-year term of the HCP and
allow incidental take of 17 different species covered by the HCP, including nine
species which are found on the Company Timberlands that have been listed under
the ESA and/or the CESA. On October 31, 2003, the Court hearing the
EPIC-SYP/Permits lawsuit (as defined below), entered a judgment invalidating the
SYP and the California Permits, and that decision is now on appeal. See Item 3.
"Legal Proceedings--Timber Harvesting Litigation" for further information
regarding this matter. The agreements which implement the Environmental Plans
also provide for various remedies (including the issuance of written stop orders
and liquidated damages) in the event of a breach by the Palco Companies of these
agreements or the Environmental Plans.
Under the HCP, harvesting activities are prohibited or restricted on
certain areas of the Company Timberlands. Some of these restrictions continue
for the entire 50-year term of the HCP. For example, several areas (consisting
of substantial quantities of timber, including old growth redwood and
Douglas-fir timber) are designated as habitat conservation areas for the marbled
murrelet, a coastal seabird, and certain other species. Harvesting in certain
other areas of the Company Timberlands is currently prohibited while these areas
are evaluated for the potential risk of landslide. Further, additional areas
alongside streams have been designated as buffers, in which harvesting is
prohibited or restricted, to protect aquatic and riparian habitat. Restrictions
on harvest in streamside buffers and potential landslide prone acres may be
adjusted up or down, subject to certain minimum and maximum buffers, based upon
the ongoing watershed analysis process described below. The adaptive management
process described below may also be used to modify most of these restrictions.
The first analysis of a watershed, Freshwater, was released in June 2001.
This analysis was used by the Palco Companies and the government agencies to
develop proposed harvesting prescriptions. Prescriptions for the Van Duzen
watershed were approved in January 2004. Prescriptions for a third watershed
(Lower Eel - Eel Delta) were approved in March 2004. The Freshwater, Van Duzen
and Lower Eel prescriptions each resulted in a reduction in the size of the
streamside buffers set forth in the Environmental Plans and also provide for
geologic reviews in order to conduct any harvesting activities on potential
landslide-prone areas. This effectively reduced both the size and operational
restrictions in respect of landslide-prone areas. The analysis for a fourth
watershed, Elk River, was submitted in mid-2004 for agency and public review,
and prescriptions for Elk River have been developed and are undergoing review by
the relevant agencies.
The HCP required the Palco Companies, together with the government
agencies, to establish a schedule resulting in completion of the initial
watershed analysis process for all covered lands within five years. However, due
largely to the number of agencies involved and the depth and complexity of the
analyses, the process has proven to require more time than originally
anticipated. Accordingly, the Palco Companies have been working with the
government agencies to establish an appropriate timeline and to streamline the
process for implementation of watershed analysis on the remaining portions of
Company Timberlands to ensure that such studies are time and cost efficient, and
that such studies continue to provide scientific results necessary to evaluate
potential changes to the harvesting restrictions on those lands. The Palco
Companies have received an extension to March 2007 of the time in which the
watershed analysis process must be completed. A proposed streamlined process is
undergoing review by the relevant agencies.
The HCP imposes certain restrictions on the use of roads on the timberlands
covered by the HCP during several months of the year and during periods of wet
weather. However, some harvesting has been conducted during these periods, and
the Company expects that in the future some harvesting will still be able to be
conducted during these periods. An adaptive management change approved in 2003
for the road restrictions has improved the ability to construct and use roads on
the Company Timberlands in ways that are consistent with the operational needs
of the Palco Companies. The HCP also requires that 75 miles of roads be
stormproofed (i.e., reconstructed to reduce sediment generation) on an annual
basis and that certain other roads must be improved or repaired. The nature of
this work requires that it be performed in the dry periods of the year. To date,
over 450 miles of roads have been stormproofed.
The HCP contains an adaptive management provision, which both the state and
federal governments have clarified will be implemented on a timely and efficient
basis, and in a manner which will be both biologically and economically sound.
This provision allows the Palco Companies to propose changes to many of the HCP
prescriptions based on, among other things, economic considerations. The
regulatory agencies have also clarified that in applying this adaptive
management provision, to the extent the changes proposed do not result in the
jeopardy of a particular species, the regulatory agencies will consider the
practicality of the suggested changes, including the cost and economic
feasibility and viability. The Palco Companies and the agencies have implemented
various adaptive management changes related to wildlife and rare plants, and
other changes relating to roads and streamside buffers. These adaptive
management changes have increased the ability to conduct harvesting operations
on the Company Timberlands and/or reduce operating costs while still meeting the
obligations of the Environmental Plans.
Water Quality
Laws and regulations dealing with water quality are impacting the Palco
Companies primarily in four areas: efforts by the federal Environmental
Protection Agency (the "EPA") and the North Coast Water Board to establish total
maximum daily load limits ("TMDLs")in watercourses that have been declared to be
water quality impaired; actions by the North Coast Water Board to impose waste
discharge reporting requirements in respect of watersheds on the Company
Timberlands and in some cases, clean-up or prevention measures; actions by the
North Coast Water Board during the THP approval process which impose certain
operational requirements on individual THPs; and a directive of the North Coast
Water Board to its staff to develop watershed-wide waste discharge requirements
("WWDRs") for the Freshwater and Elk River watersheds.
Under the CWA, the EPA is required to establish TMDLs for relevant
contaminants in watercourses that have been declared to be "water quality
impaired." The EPA and the North Coast Water Board are in the process of
establishing TMDLs for many northern California rivers and certain of their
tributaries, including nine watercourses that flow within the Company
Timberlands. On the Company Timberlands, the relevant contaminant is simple
sediment - dust, dirt and gravel - that is abundant in watercourses largely as a
function of the area's normally heavy rainfall and soil that erodes easily. The
Company expects this process to continue into 2010. In December 1999, the EPA
issued a report dealing with TMDLs on two of the nine watercourses. The agency
indicated that the requirements under the HCP would significantly address the
sediment issues that resulted in TMDL requirements for these watercourses. The
North Coast Water Board has begun the process of establishing the TMDL
requirements applicable to two other watercourses on the Company Timberlands,
with a targeted completion of 2006 for these two watercourses. The Company's
scientists are actively working with North Coast Water Board staff to ensure
these TMDLs recognize and incorporate the environmental protection measures of
the HCP. The final TMDL requirements applicable to the Company Timberlands may
require aquatic protection measures that are different from or in addition to
those in the HCP or that result from the prescriptions to be developed pursuant
to the watershed analysis process provided for in the HCP.
For each of the three winter periods since 2002, the North Coast Water
Board has required the Palco Companies to submit "Reports of Waste Discharge" in
order to conduct winter harvesting operations in the Freshwater and Elk River
watersheds. After consideration of these reports, the North Coast Water Board
imposed requirements on the Palco Companies to implement additional mitigation
and erosion control practices in these watersheds for each of the three winter
operating periods. The North Coast Water Board has also extended the
requirements for certain mitigation and erosion control practices in three
additional watersheds (Bear, Jordan and Stitz Creek). The Palco Companies and
the North Coast Water Board are currently in discussions to determine what these
measures will be. The requirements imposed to date by the North Coast Water
Board have significantly increased operating costs; additional requirements
imposed in the future could further increase costs and cause delays in THP
approvals.
The North Coast Water Board has also issued a clean up and abatement order
(the "Elk River Order") for the Elk River watershed, which is aimed at
addressing existing sediment production sites through clean up actions. The
North Coast Water Board has also initiated the process which could result in
similar orders for the Freshwater and Bear Creek watersheds, and is
contemplating similar actions for the Jordan and Stitz Creek watersheds. The Elk
River Order has resulted in increased costs to the Palco Companies that could
extend over a number of years. Additional orders in other watersheds (should
they be issued), may also result in further cost increases. Palco's appeal of
the Elk River Order to the State Water Resources Control Board (the "State Water
Board") was denied. Palco has appealed the decision of the State Water Board in
state court, but is holding such appeal in abeyance until resolution of the THP
No. 520 lawsuit discussed below. See Item 3. "Legal Proceedings--Timber
Harvesting Litigation.".
In addition to the foregoing actions, the North Coast Water Board in
December 2003 directed its staff to create WWDRs for the Freshwater and Elk
River watersheds. As harvesting activities on the Company Timberlands cannot
readily be moved between watersheds due to, among other things, historic harvest
patterns, adjacency restrictions, and the age classes of trees, that action and
the other matters described above could, in addition to the potential effects
noted above, individually or collectively result in reduced harvest. In that
regard, the staff of the North Coast Water Board has not yet formulated the
required WWDRs for the Freshwater and Elk River watersheds, and has on several
occasions postponed its projected date for their completion. As a result, the
North Coast Water Board has failed to release for harvest a number of the
Company's THPs that are located in the Freshwater and Elk River watersheds, even
though these THPs have already been approved by the other government agencies
which review its THPs and are in compliance with the HCP. The delay in receiving
the release of these THPs has adversely impacted the cash flows of both the
Company and Palco. Furthermore, it is likely that additional delays in the
development of the Freshwater and Elk River WWDRs will occur, and such delays
could have adverse impacts beyond those currently being experienced.
On February 25, 2005, the Executive Officer of the staff of the North Coast
Water Board publicly announced approval of the release of additional THPs that
would allow the harvest of up to 50% of the harvest limit established by the CDF
for the Freshwater and Elk River watersheds. Since this announcement, the
Company and Palco have continued their efforts with the North Coast Water Board
staff to obtain the release of additional THPs and will make a presentation to
the North Coast Water Board itself on March 16, 2005, in furtherance of these
efforts. No assurance can be given that the efforts of the Company and Palco
will be successful. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Financial Condition and Investing and
Financing Activities" for further information regarding this matter.
California Senate Bill 810, which became effective January 1, 2004,
provides regional water quality control boards with additional authority related
to the approval of THPs on land within impaired watersheds. Under this law, a
THP "may not be approved if the appropriate regional water quality control board
finds, based on substantial evidence, that the timber operations proposed in the
plan will result in a discharge into a watercourse that has been classified as
impaired due to sediment...that causes or contributes, to a violation of the
regional water quality control plan." The Company is uncertain of the
operational and financial effects which will ultimately result from Senate Bill
810. While this provision has not yet been invoked in respect of the Company
Timberlands, because substantially all rivers and waterbodies on the Company
Timberlands are classified as sediment-impaired, implementation of this law
could result in delays in obtaining approval of THPs, lower harvest levels and
increased costs and additional protection measures beyond those contained in the
HCP. Also see the description of the THP No. 520 lawsuit under Item 3. "Legal
Proceedings--Timber Harvesting Litigation", including extraordinary actions
which the Company and Palco could be forced to take if their efforts are not
successful.
Impact of Future Legislation
Laws, regulations and related judicial decisions and administrative
interpretations dealing with the Company's business are subject to change and
new laws and regulations are frequently introduced concerning the California
timber industry. From time to time, bills are introduced in the California
legislature and the U.S. Congress which relate to the business of the Company,
including the protection and acquisition of old growth and other timberlands,
threatened and endangered species, environmental protection, air and water
quality and the restriction, regulation and administration of timber harvesting
practices. In addition to existing and possible new or modified statutory
enactments, regulatory requirements and administrative and legal actions, the
California timber industry remains subject to potential California or local
ballot initiatives, and federal and California judicial decisions which could
affect timber harvesting practices. It is not possible to assess the effect of
such future legislative, judicial and administrative developments on the Company
or its business.
Timber Operators License
In order to conduct logging operations, road building, stormproofing and
certain other activities, a company must obtain a Timber Operator's License from
the CDF. In December 2003, Palco was granted a Timber Operator's License for
2004-2005.
ITEM 2. PROPERTIES
A description of the Company's properties is included under Item 1. above.
ITEM 3. LEGAL PROCEEDINGS
This section contains statements which constitute "forward-looking
statements" within the meaning of the PSLRA. See this section and
"Business--General" above for cautionary information with respect to such
forward-looking statements.
Timber Harvesting Litigation
A California state court has invalidated the SYP in connection with two
lawsuits filed against the Palco Companies, as described below, which decision
has been appealed. Other pending judicial and administrative proceedings could
affect the Company's ability to implement the HCP, implement certain approved
THPs, or carry out other operations, as discussed below. One such lawsuit was
resolved during 2004 (see below). Certain of the remaining pending cases are
described below. The Services Agreement requires Palco to prepare and file on
behalf of the Company (at Palco's cost) all pleadings and motions, and otherwise
diligently pursue, appeals of any denial, and defense of any challenge to
approval, of any THP or the Environmental Plans or similar plan or permit and
related matters.
In March 1999, an action entitled Environmental Protection Information
Association, Sierra Club v. California Department of Forestry and Fire
Protection, California Department of Fish and Game, The Pacific Lumber Company,
Scotia Pacific Company LLC, Salmon Creek Corporation, et al. (the
"EPIC-SYP/Permits lawsuit") was filed in Superior Court in Humboldt County,
California (No. CV-990445). This action alleged, among other things, various
violations of the CESA and the CEQA, and challenged, among other things, the
validity and legality of the SYP and the California Permits. The plaintiffs
sought, among other things, to set aside California's approval of the SYP and
the California Permits and injunctive relief to prevent implementation of THPs
approved in reliance upon these documents. In March 1999, a similar action,
entitled United Steelworkers of America, AFL-CIO, CLC, and Donald Kegley v.
California Department of Forestry and Fire Protection, The Pacific Lumber
Company, Scotia Pacific Company LLC and Salmon Creek Corporation (the "USWA
lawsuit"), was filed in Humboldt County Superior Court (No. CV-990452)
challenging the validity and legality of the SYP. The EPIC-SYP/Permits and USWA
lawsuits were consolidated for trial.
Following trial, the Court on October 31, 2003, entered a judgment
invalidating the SYP and the California Permits due to several deficiencies in
agency procedures and the failure of the Company and Palco to submit a complete
and comprehensible SYP. The Court's decision, however, allowed for harvesting on
THPs which rely on the SYP and were approved prior to July 23, 2003. The
short-term effect of the ruling was to preclude approval, under the SYP, of a
small number of THPs which were under review but had not been approved, and a
minor reduction in 2003 harvesting that had been expected from these specific
THPs. As a result of this case, the Company has since October 2002, when the
Court issued a stay order preventing future reliance upon the SYP, been
obtaining review and approval of new THPs under a procedure provided for in the
forest practice rules that does not depend upon the SYP and the California
Permits. The Company expects to follow this procedure until the Option A Plan is
approved. See Item 1. "Business--Timber and Timberlands." Palco and the State of
California have appealed the October 31, 2003, decision. In September 2004, the
Court granted the plaintiffs' request for reimbursement of an aggregate of $5.8
million in attorneys fees and other expenses incurred in connection with these
matters. Palco and the State of California have also appealed this decision.
In July 2001, an action entitled Environmental Protection Information
Center v. The Pacific Lumber Company, Scotia Pacific Company LLC (the "Bear
Creek lawsuit") was filed in the U.S. District Court for the Northern District
of California (No. C01-2821), and later amended to add the EPA as a defendant.
The lawsuit alleges that harvesting and other forestry activities under certain
of the Company's approved THPs will result in discharges of pollutants in
violation of the CWA. The plaintiff asserts that the CWA requires the defendants
to obtain a permit from the North Coast Water Board before beginning timber
harvesting and road construction activities and is seeking to enjoin these
activities until such permit has been obtained. The plaintiff also seeks civil
penalties of up to $27,500 per day for the defendant's alleged continued
violation of the CWA. On October 14, 2003, in connection with certain motions
that had been filed, the Court upheld the validity of an EPA regulation which
exempts harvesting and other forestry activities from certain discharge
requirements.
Both state and federal agencies, along with the Company and other timber
companies, have relied upon this regulation for more than 25 years. However, the
Court interpreted the regulation in such a way as to narrow the forestry
operations which are exempted, thereby limiting the regulation's applicability
and subjecting culverts and ditches to permit requirements. This ruling has
widespread implications for the timber industry in the United States. The case
is not yet final as the trial has not yet been held, and there are many
unresolved issues involving interpretation of the Court's decision and its
application to actual operations. Should the decision ultimately become final
and held to apply to all operations on the Company Timberlands, it may have some
or all of the following effects: imposing additional permitting requirements,
delaying approvals of THPs, increasing harvesting costs, and adding water
protection measures beyond those contained in the HCP. Nonetheless, it is not
likely that civil penalties will be awarded for operations that occurred prior
to the Court's decision due to the historical reliance by timber companies on
the regulation and the Company's belief that the requirements under the HCP are
adequate to ensure that sediment and pollutants from harvesting activities on
the Company Timberlands will not reach levels harmful to the environment. While
the impact of a conclusion to this case that upholds the October 14, 2003,
ruling may be adverse, the Company does not believe that such an outcome would
have a material adverse impact on the Company's financial condition, results of
operations or liquidity. Nevertheless, due to the numerous ways in which the
Court's interpretation of the regulation could be applied to actual operations,
there can be no assurance that this will be the case.
On November 20, 2002, two similar actions entitled Alan Cook, et al. v.
Gary Clark, et al. (the "Cook action") and Steve Cave, et al. v. Gary Clark, et
al. (the "Cave action") were filed in Humboldt County Superior Court (No.'s
DR020718 and DR020719, respectively), which also name the Company and certain
affiliates as defendants. On April 4, 2003, the plaintiffs in these actions
filed amended complaints and served the defendants with notice of the actions.
The Cook action alleges, among other things, that defendants' logging practices
have contributed to an increase in flooding along Freshwater Creek (which runs
through the Company Timberlands), resulting in personal injury and damage to the
plaintiffs' properties. Plaintiffs further allege that in order to have THPs
approved in the affected areas, the defendants engaged in certain unfair
business practices. The plaintiffs seek, among other things, compensatory and
exemplary damages, injunctive relief, and appointment of a receiver to ensure
that the watershed is restored. The Cave action contains similar allegations and
requests similar relief with respect to the Elk River watershed (a portion of
which is contained on the Company Timberlands). The Company does not believe the
resolution of these actions should result in a material adverse effect on its
financial condition, results of operations or liquidity.
On February 25, 2003, the District Attorney of Humboldt County filed a
civil suit entitled The People of the State of California v. The Pacific Lumber
Company, Scotia Pacific Holding Company and Salmon Creek Corporation in the
Humboldt County Superior Court (No. DR030070) (the "Humboldt DA action"). The
suit was filed under California's unfair competition law and alleges that the
Palco Companies used certain unfair business practices in connection with
completion of the Headwaters Agreement, and that this resulted in the Palco
Companies being able to harvest significantly more trees under the Environmental
Plans than would have otherwise been the case. The suit sought a variety of
remedies including a civil penalty of $2,500 for each additional tree that has
been or will be harvested due to this alleged increase in harvest, as well as
restitution and an injunction in respect of the additional timber harvesting
allegedly being conducted. In response to motions filed by the Company and Palco
for sanctions and dismissal of this suit, on April 30, 2004, the Court issued a
ruling requiring the District Attorney to amend his suit to prove that
"extrinsic" fraud occurred. In addition, the Court eliminated the remedies being
sought, other than for civil penalties, and suggested that it would be
inappropriate to base civil penalties on the additional trees harvested. The
Court also ruled that it declined "at this juncture" to impose sanctions on the
District Attorney. The District Attorney subsequently amended his suit, and the
Palco Companies later filed new motions to dismiss and for sanctions. After
delays resulting from the District Attorney's efforts to disqualify the trial
judge, and that judge's later self-disqualification, a hearing on these motions
was held on February 18, 2005. The Court rejected the sanctions motion, but has
not yet ruled on the motion for dismissal. The Company believes that this suit
is without merit and that the April 30, 2004, ruling diminished significantly its
exposure with respect to this matter; however, there can be no assurance that
the Palco Companies will ultimately prevail or that an adverse outcome would not
be material to the Company's consolidated financial condition, results of
operations or liquidity.
On December 17, 2003, an action entitled Humboldt Watershed Council, et al.
v. North Coast Regional Water Quality Board, et al. (the "HWC 2003 lawsuit"),
naming the Company and Palco as real parties in interest, was filed in the
Humboldt County Superior Court (No. CV030961). The plaintiffs allege that the
North Coast Water Board should have required waste discharge reports in respect
of all timber harvesting activities in the Freshwater and Elk River watersheds,
including those on the Company Timberlands. This action has been dismissed by
the plaintiffs.
On November 4, 2004, an action entitled Environmental Protection
Information Center, et al. v. California Department of Forestry and Fire
Protection, et al. was filed in Humboldt County Superior Court (No. CV04-0809).
This action sought an order staying or setting aside CDF's approval of six of
the Company's THPs along the Van Duzen river, and an order requiring CDF to
conduct further review and analysis of the six THPs and to refrain from reliance
on information not made available for public review and comment. Following
denial by the trial judge of the plaintiffs' request for injunctive relief and
various appellate proceedings which resulted in harvesting operations being
allowed to continue, the case was dismissed by the plaintiffs.
On November 2, 2004, an action entitled Environmental Protection
Information Center v. U.S. Fish & Wildlife Service, NOAA Fisheries, et al.
was filed in the U.S. District Court for the Northern District of California
(No. C04-4647). This lawsuit alleges that two federal agencies have violated
certain federal laws and related regulations in connection with their oversight
of the HCP and the related incidental take permits issued by the federal
government (the "Federal Permits"). The plaintiff also alleges that the Federal
Permit for the northern spotted owl was unlawfully issued and that the Company
and Palco violated California's unfair competition law by using false
advertising and making misleading environmental claims. The plaintiff seeks a
variety of remedies, including requiring additional actions by the federal
agencies and precluding them from authorizing take of the northern spotted owl,
an injunction requiring the Company and Palco to cease certain alleged unlawful
activities, as well as restitution and remediation by the Company and Palco.
Motions have been filed by the federal government and Palco seeking dismissal of
substantial portions of this case, but a hearing date on this motion has not yet
been set. The Company does not believe the resolution of this action should
result in a material adverse effect on its financial condition, results of
operations or liquidity.
On November 16, 2001, Palco filed a case entitled The Pacific Lumber
Company, et al. v. California State Water Resources Control Board (No. DR010860)
in Humboldt County Superior Court (the "THP No. 520 lawsuit") alleging that the
State Water Board had no legal authority to impose mitigation measures that were
requested by the staff of the North Coast Water Board during the THP review
process and rejected by the CDF prior to approving the THP. When the staff of
the North Coast Water Board attempted to impose these mitigation measures in
spite of the CDF's decision, Palco appealed to the State Water Board, which
imposed certain of the requested mitigation measures and rejected others. Palco
filed the THP No. 520 lawsuit challenging the State Water Board's decision, and
in January 2003, the Superior Court granted Palco's request for an order
invalidating the imposition of these additional measures. The State Water Board
appealed this decision, and on March 18, 2004 the appellate court reversed the
decision of the Superior Court. The appellate court's decision could result in
increased demands by the regional and state water boards and their staffs to
impose controls and limitations upon timber harvesting on the Company
Timberlands beyond those provided for by the Environmental Plans or could
provide additional regulatory powers to the regional and state water boards and
their staffs beyond those provided in Senate Bill 810. Palco filed a petition
for review of the appellate court's decision by the California Supreme Court,
which in June 2004 agreed to review the decision.
Other Litigation
The Company is involved in other claims, lawsuits and proceedings. While
uncertainties are inherent in the final outcome of such matters and it is
presently impossible to determine the actual costs that ultimately may be
incurred or their effect on the Company, management believes that the resolution
of such uncertainties and the incurrence of such costs should not result in
material adverse effect on the Company's financial position, results of
operations or liquidity.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
Palco holds a 100% member interest in the Company. Accordingly, there is no
established public trading market for the Company's equity securities. The
Company did not make any cash distributions in respect of such interest during
2004.
ITEM 6. SELECTED FINANCIAL DATA
Not applicable.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following should be read in conjunction with the Company's Financial
Statements and the Notes thereto appearing in Item 8.
Background
This section contains statements which constitute "forward-looking
statements" within the meaning of the PSLRA. See Item 1. "Business--General" and
below for cautionary information with respect to such forward-looking
statements.
Regulatory and environmental matters as well as certain pending legal
matters play a significant role in the Company's operations. See Item 1.
"Business - Regulatory and Environmental Matters" and Note 7 for further
discussion of these matters. Regulatory compliance and related litigation have
caused and may continue to cause delays in approval of THPs and delays in
harvesting on THPs once they are approved. This has resulted and may continue to
result in a decline in harvest.
The Company expects that without the release of additional THPs, its cash
flows from operations, together with funds available under its line of credit,
will be inadequate to pay the entire amount of interest due on the July 20,
2005, payment date for its Timber Notes. Delays by the staff of the North Coast
Water Board in formally releasing the THPs could further exacerbate matters. For
further information, see "--Financial Condition and Investing and Financing
Activities."
Results of Operations
This section contains statements which constitute "forward-looking
statements" within the meaning of the PSLRA. See this section and Item 1.
"Business--General" and below for cautionary information with respect to such
forward- looking statements.
General
Mbfe Concept. The Mbfe concept was used in structuring the Timber Notes in
order to take account of the relative values of the species and categories of
timber included in the Company Timber. Under the Mbfe concept, one thousand
board feet, net Scribner scale, of old growth redwood timber equates to one
Mbfe. One thousand board feet, net Scribner scale, of each other species and
category of timber included in the Company Timber was assigned a value in Mbfe
equal to a fraction of an Mbfe. This fraction was generally determined by
dividing the SBE Price applicable to such species and category for the first
half of 1998 by the SBE Price applicable to old growth redwood for the first
half of 1998.
Master Purchase Agreement Provisions. The Master Purchase Agreement
contemplates that all sales of logs by the Company to Palco will be at fair
market value (based on stumpage prices) for each species and category of timber.
The Master Purchase Agreement provides that if the purchase price equals or
exceeds the SBE Price and a structuring price set forth in a schedule to the
Indenture, the purchase price is deemed to be at fair market value. If the
purchase price equals or exceeds the SBE Price, but is less than the structuring
price, then the Company is required to engage an independent forestry consultant
to confirm that the purchase price reflects fair market value. Harvest Value
Schedules setting forth the SBE Prices are published by the California State
Board of Equalization twice a year for the purpose of computing a yield tax
imposed on timber harvested between January 1 and June 30 and July 1 and
December 31. Harvest Value Schedules are based on twenty-four months of actual
log and timber sales that occur within nine specified timber value areas. These
sales are arms length transactions adjusted for time by indexing the prices
(using log and lumber price trends) to a specific date, which is approximately
sixty days prior to the effective date of the Harvest Value Schedules. SBE
Prices may not necessarily be representative of actual prices that would be
realized from unrelated parties at subsequent dates.
In January 2004, the State Board of Equalization adopted the new Harvest
Value Schedule for the first half of 2004. The prices published in that schedule
reflected a 12.7% increase in the SBE Price for small redwood logs and a 3.4%
decrease for small Douglas-fir logs from the prices published for the second
half of 2003.
In June 2004, the State Board of Equalization adopted the new Harvest Value
Schedule for the second half of 2004. The prices published in that schedule
reflected a 1.6% increase in the SBE Price for small redwood logs and a 14.3%
increase for small Douglas-fir logs from the prices published for the first half
of 2004.
In December 2004, the State Board of Equalization adopted the new Harvest
Value Schedule for the first half of 2005. The prices published in that schedule
reflected a 14.3% increase in the SBE Price for small redwood logs and a 12.5%
increase for small Douglas-fir logs from the prices published for the second
half of 2004.
Seasonality. Logging operations on the Company Timberlands are highly
seasonal and have historically been significantly higher in the months of April
through November than in the months of December through March. Management
expects that the Company's revenues and cash flows will continue to be markedly
seasonal because of the harvesting, road use, wet weather and other restrictions
imposed by the HCP and regulation. As a result, a substantial majority of the
future harvesting on the Company's timberlands can be expected to be
concentrated during the period from June through October of each year.
Log Sales to Pacific Lumber
The following table presents price, volume and revenue amounts for the
Company for the periods indicated (revenues in millions).
Years Ended December 31,
---------------------------------------------------------------------------------
2004 2003 2002
--------------------------- -------------------------- --------------------------
Average Average Average
Price Price Price
MBFEs $/MBFE Revenues MBFEs $/MBFE Revenues MBFEs $/MBFE Revenues
-------- -------- -------- ------- ------- --------- ------- -------- --------
Redwood.... 73,000 $ 757 $ 55.3 96,900 $ 667 $ 64.7 98,700 $ 555 $ 54.8
Douglas-fir 21,200 505 10.7 18,100 446 8.1 23,300 394 9.2
Other...... 1,900 233 0.4 2,200 227 0.5 2,800 206 0.6
-------- --------- --------- -------- -------- -------
96,100 691 $ 66.4 117,200 $ 625 $ 73.3 124,800 518 $ 64.6
======== ========= ========= ======== ======= =======
The decrease in log sales for 2004 versus 2003 was due to an decrease in
harvest volumes, offset somewhat by an increase in SBE prices. The decrease in
harvest volumes was due largely to a decrease in the Company's available-to-log
THPs during 2004 as a result of an increase in THPs subject to seasonal
harvesting restrictions and increased THP approval time due to regulatory
constraints. The Company's average realized price in 2004 increased by 11% over
2003.
The increase in log sales for 2003 versus 2002 was due to an increase in
SBE Prices, offset somewhat by a decrease in harvest volumes. Overall, the
Company's average realized price in 2003 increased by 21% over 2002. The
decrease in harvest volumes was due largely to a decrease in the Company's
available-to-log THPs during 2003 as a result of an increase in THPs subject to
seasonal harvesting restrictions.
Operating Income and Net Loss
Operating income was $34.4 million and $47.0 million for the years ended
December 31, 2004 and 2003, respectively. This decrease in operating income was
principally due to the decrease in log sales revenue discussed above, and
because 2003 included a gain on sale of timberlands of $8.3 million. The
decrease in log sales revenue was partially offset by lower expenses relating to
THP preparation, winter road maintenance, insurance, employee benefits, and
security costs, and a decrease in depletion, depreciation and amortization
expense.
Net losses were $19.8 million in 2004 compared to $5.3 million in 2003, due
to the lower operating income discussed above, and lower returns on investments
(see also Note 3).
Operating income was $47.0 million and $30.2 million for the years ended
December 31, 2003 and 2002, respectively. The increase in operating income was
principally due to the increase in log sales discussed above, in addition to
gains resulting from the sale of timberlands. The increases were partially
offset by higher expenses relating to winter road maintenance, insurance,
employee benefits, and security costs.
Net losses were $5.3 million in 2003 compared to $23.1 million in 2002,
again principally due to the increase in log sales discussed above, gains
resulting from the sale of timberlands and repurchases of debt, and to a lesser
extent a decrease in interest expense. The favorable impact of these items was
offset somewhat by a decrease in interest income realized from investments.
Financial Condition and Investing and Financing Activities
This section contains statements which constitute "forward-looking
statements" within the meaning of the PSLRA. See this section and Item 1.
"Business--General" for cautionary information with respect to such
forward-looking statements.
Due to its highly leveraged condition, the Company is more sensitive than
less leveraged companies to factors affecting its operations, including low log
prices, governmental regulation and litigation affecting timber harvesting
practices on the Company Timberlands (see Item 1. "Business--Regulatory and
Environmental Factors," Item 3. "Legal Proceedings--Timber Harvesting
Litigation," and Note 7), and general economic conditions. The Company's cash
flows from operations are significantly impacted by harvest volumes and log
prices. The Master Purchase Agreement between the Company and Palco contemplates
that all sales of logs by the Company to Palco will be at fair market value
(based on stumpage prices) for each species and category of timber. See
"--Results of Operations--Master Purchase Agreement" above for further
information concerning this agreement.
Regulatory and environmental matters as well as certain pending legal
matters play a significant role in the Companys operations. See Item 1.
"Business--Regulatory and Environmental Matters" and Note 7 for further
discussion of these matters. Regulatory compliance and related litigation have
caused and may continue to cause delays in approval of the Company's THPs and
delays in harvesting on its THPs once they are approved. This has resulted and
may continue to result in a decline in harvest, an increase in the cost of
logging operations, and increased costs related to timber harvest litigation.
As discussed in Item 1. "Business--Regulatory and Environmental
Factors--Water Quality," the North Coast Water Board is requiring the Company
and Palco to apply various waste discharge reporting, mitigation and erosion
control requirements in respect of timber harvesting activities in several
watersheds, and may impose additional measures in the future. The North Coast
Water Board in December 2003 directed its staff to formulate WWDRs for the
Freshwater and Elk River watersheds. These requirements have not yet been
formulated, and the North Coast Water Board has failed to release for harvest a
number of THPs already approved by the other government agencies which review
the Company's THPs.
The failure of the North Coast Water Board to release these THPs for
harvest has adversely impacted the cash flows of both the Company and Palco. The
Company estimates that, without the prompt release of a substantial portion of
these THPs, its cash flows from operations, together with funds available under
the Line of Credit described below, will be inadequate to pay the entire amount
of interest due on the July 20, 2005, Timber Notes payment date, which would
constitute an event of default under the Indenture. Palco is in default under a
$30.0 million asset-based credit agreement with a bank (the "Palco Credit
Agreement") and estimates that, without the prompt release of a substantial
portion of these THPs and necessary amendments to the Palco Credit Agreement,
its cash flow from operations, together with funds available under the Palco
Credit Agreement, will not provide sufficient liquidity to fund its current
level of operations. The Company and Palco are continuing efforts to obtain the
clearance of the North Coast Water Board of sufficient THPs. Palco has received
a limited waiver of the default through March 18, 2005, from the lender under
the Palco Credit Agreement and is seeking a more permanent solution to the
default. There can be no assurance that these efforts with the North Coast Water
Board and the lender under the Palco Credit Agreement will be successful.
In the event of a failure to pay interest on the Timber Notes in full when
due, the trustee under the Indenture (the "Trustee") or the holders of at least
25% of the aggregate outstanding principal amount of the Timber Notes may cause
all principal, interest and other amounts related to the Timber Notes to become
immediately due and payable. Also, in the event of a failure by the Company or
Palco to perform its respective covenants or agreements under the Master
Purchase Agreement or by Palco to perform its covenants or agreements under the
Services Agreement that continues for 30 days after notice from the Trustee or
the holders of 25% or more of the outstanding principal amount of the Timber
Notes, the holders of a majority of the aggregate outstanding principal amount
of the Timber Notes may cause all principal, interest and other amounts related
to the Timber Notes to become immediately due and payable. In the event of any
such acceleration, the Agent under the Line of Credit may also accelerate the
advances then outstanding thereunder. If such accelerations of Timber Notes
and/or advances under the Line of Credit occur, the Trustee may exercise all
rights under the Indenture and related security documents, including applying
funds to pay accelerated amounts, and selling the Company Timberlands and other
assets and using the proceeds thereof to pay accelerated amounts. In the event
that the Company were to seek protection by filing under the U. S. Bankruptcy
Code (the "Bankruptcy Code"), all amounts related to the Timber Notes would
become immediately due and payable under the Indenture and all advances under
the Line of Credit agreement could be accelerated. The foregoing rights of the
Trustee and holders of Timber Notes are subject to the rights of the Company
under the Bankruptcy Code.
Palco will require funds available under the Palco Credit Agreement in
order to meet its working capital and capital expenditure requirements for the
next year. Palco's ability to meet such requirements could be adversely affected
should Palco be unsuccessful in its efforts to obtain a more permanent solution
to the default discussed above. Furthermore, Palco's cash flows from operations
may be adversely affected by diminished availability of logs from the Company,
lower lumber prices, adverse weather conditions, pending legal, regulatory and
environmental matters or increased funding requirements for its pension plan.
See "--Background" above, as well as Note 7 for further discussion of the
regulatory, environmental and legal matters affecting harvest levels and
operating costs. Without an extension of the limited waiver of Palco's default
under the Palco Credit Agreement and a restructuring or replacement of that
facility, Palco's lender may take any of the following actions: reduce the
amount of funds available to Palco for borrowing; refuse to make new loans to or
issue new letters of credit for the benefit of Palco; declare any or all loans
and other amounts owed under the agreement to be immediately due and payable;
require Palco to cash collateralize all outstanding letters of credit; or pursue
its other rights and remedies under the Palco Credit Agreement and related
security agreements. The existence of the default also requires Palco to pay
interest on amounts borrowed under the Palco Credit Agreement at a per annum
rate 2% higher than the rate at which interest would be owed if no default
existed. If any acceleration under the Palco Credit Agreement occurs, then the
agent for the lender may exercise all rights under that agreement and related
security documents, including selling Palco's assets and using the proceeds
thereof to pay the accelerated amounts. In the event that Palco were to seek
protection by filing under the Bankruptcy Code, all loans and other amounts owed
under the Palco Credit Agreement would become immediately due and payable. The
foregoing rights of the lender under the Palco Credit Agreement are subject to
the rights of Palco under the Bankruptcy Code.
In the event of a Company default or a Palco liquidity shortfall, whether
resulting from a failure to extend the limited waiver past March 18, 2005, any
action described above taken by Palco's lender, or otherwise, the Company and
Palco could be forced to take extraordinary actions, which may include: reducing
expenditures by laying off employees and shutting down various operations;
seeking other sources of liquidity, such as from asset sales; and seeking
protection by filing under the Bankruptcy Code.
As discussed further below, on December 8, 2004, Standard & Poor's
Ratings Services ("S&P") lowered Palco's credit rating from B- to CCC+. As a
result, Palco may be required to post a security deposit for workers
compensation liabilities in July 2005, in an amount that has not been determined
but that could be material to Palco's liquidity, capital resources, and results
of operations. If improvements in Palco's liquidity, capital resources, and
results of operations produce an upward revision in Palco's credit rating, or if
a waiver of this requirement is allowed under applicable law, then posting of
such a security deposit may not be necessary. Palco management is in the process
of evaluating the potential amount of such a security deposit, if required.
There can be no assurance that such a security deposit will not be required or
that, if required, the amount will not be material. Palco management is also
evaluating whether other potential obligations or unanticipated adverse
financial reports may result from the S&P credit action described above.
In addition, there can be no assurance that certain other pending legal,
regulatory and environmental matters or future governmental regulations,
legislation or judicial or administrative decisions, adverse weather conditions,
or low log prices, will not have a material adverse effect on the Company's
financial condition, results of operations or liquidity. See Item 1.
"Business--Regulatory and Environmental Factors," Item 3. "Legal Proceedings"
and Note 7 for further information regarding regulatory and legislative matters
and legal proceedings.
The Company has an agreement with a group of banks which allows it to
borrow up to one year's interest on the Timber Notes (the "Line of Credit"). On
June 20, 2003, the Line of Credit was extended to July 7, 2006. At or near the
completion of such extension, the Company intends to request that the Line of
Credit be extended for an additional period of not less than 364 days. If not
extended, the Company may draw upon the full amount available. The amount drawn
would be repayable in 12 semiannual installments on each note payment date
(after the payment of certain other items, including the Aggregate Minimum
Principal Amortization Amount, as defined, then due), commencing approximately
two and one-half years following the date of the draw. At December 31, 2004, the
Company could have borrowed a maximum of $57.1 million under the Line of Credit,
and there was $18.2 million outstanding under the facility. At January 31, 2005,
the maximum availability under the Line of Credit was $55.9 million, and there
were $45.9 million in borrowings outstanding under this facility.
On the note payment date in January 2004, the Company had $4.1 million set
aside in the note payment account to pay the $27.2 million of interest due (net
of $2.0 million of additional interest due in respect of Timber Notes held by
the Company). The funds available under the Line of Credit were used to pay the
remaining amount of interest due. The Company repaid $12.7 million of principal
on the Timber Notes (an amount equal to Scheduled Amortization, as set forth in
the Indenture ("Scheduled Amortization;" see Note 5)) using funds held in the
Scheduled Amortization Reserve Account, a reserve account used to support
principal payments on the Timber Notes (the "SAR Account").
On the note payment date in July 2004, the Company used $26.6 million (net
of $2.1 million of additional interest due in respect of Timber Notes held by
the Company) of the funds available under the Line of Credit to pay the entire
amount of interest due. The Company repaid $4.5 million of principal on the
Timber Notes (an amount equal to Scheduled Amortization) using funds held in the
SAR Account.
On the note payment date in January 2005, the Company used $26.3 million
(net of $2.2 million of additional interest due in respect of Timber Notes held
by the Company) of the funds available under the Line of Credit to pay the
entire $26.3 million of interest due. The Company repaid $10.6 million of
principal on the Timber Notes (an amount equal to Scheduled Amortization) using
funds held in the SAR Account.
With respect to the note payment date in July 2005, as a result of the
matters discussed above, the Company may not have adequate funds available under
the Line of Credit to pay the entire $25.9 million of interest which will be due
(net of $2.0 million of additional interest which would be due in respect of
Timber Notes held by the Company). Should this occur, the Company would be in
default under the Indenture. Should a default not occur, the Company anticipates
paying the $5.0 million of principal on the Timber Notes (an amount equal to
Scheduled Amortization) by using funds held in the SAR Account.
During 2004, $10.9 million of funds from the SAR Account were used to
repurchase $11.0 million principal amount of Timber Notes, as permitted under
the Indenture, resulting in a loss of $0.3 million (net of unamortized deferred
financing costs) on the repurchase of debt.
On January 27, 2005, S&P announced that it was placing its ratings on
all classes of Timber Notes on CreditWatch with negative implications. S&P
indicated that the CreditWatch placements reflected the Company's difficulties
in obtaining approval from the North Coast Water Board to move forward with
harvesting related to certain THPs. S&P also indicated that any additional
delays in the ability to harvest on the Company Timberlands (and the inability
to generate adequate revenue) could put into question whether the Company will
have sufficient funds to make payment of full and timely interest on the July
2005 Timber Notes note payment date. In addition, on February 7, 2005, Moody's
Investors Services lowered the ratings on all classes of the Timber Notes,
reflecting concerns over continued weak cash flow from timber operations due to
difficulties in obtaining approval of THPs. The rating on the Class A-1 Timber
Notes was lowered from A1 to Baa2; the rating on the Class A-2 Timber Notes was
lowered from A3 to Baa3; and the rating on the Class A-3 Timber Notes was
lowered from Baa2 to Ba1. All three ratings will remain on review for possible
downgrade, as Moody's noted that there is some risk that there will be
insufficient cash to make full payment of interest on the July 2005 note payment
date.
Off-Balance Sheet Arrangements
The Company does not have any off-balance sheet financing or unconsolidated
special purpose entities. The Company does not utilize interest rate swaps,
hedging arrangements or any other type of derivative instruments.
Contractual Obligations
The following table presents information with respect to the Company's
contractual obligations as of December 31, 2004 (in millions).
Payments Due by Period
-----------------------------------------------
Less than 1 1-3 3-5 More than
Contractual Obligations Total year years years 5 years
- ------------------------------------------------- --------- --------- --------- ------- --------
Long-term debt obligations(1)................. $ 721.5 $ 33.7 $ 44.7 $ 44.7 $ 598.4
Interest due on long-term debt obligations (2). 431.7 51.9 100.3 93.7 185.8
--------- -------- --------- ------- -------
Total.................................... $1,153.2 $ 85.6 $ 145.0 $138.4 $ 784.2
======== ======= ======== ======= =======
(1) The table above reflects principal payments on the Timber Notes in
accordance with Scheduled Amortization. If all payments of principal and
interest are made in accordance with Scheduled Amortization, the scheduled
maturity dates for the Class A-1, Class A-2, and Class A-3 Timber Notes are
January 20, 2007, January 20, 2014, and January 20, 2014, respectively. If
the Timber Notes were amortized in accordance with the minimum principal
which the Company must pay on any note payment date, subject to available
cash (as set forth in the Indenture ("Minimum Principal Amortization")),
the final installments of principal would be paid on January 20, 2010, July
20, 2017, and July 20, 2028 for the Class A-1, Class A-2 and Class A-3
Timber Notes, respectively. See Note 5 for further discussion of the Timber
Notes.
(2) Interest due on long-term debt obligations is net of additional interest
due in respect of Timber Notes held by the Company.
Critical Accounting Policies and Estimates
The discussion and analysis of the Company's financial condition and
results of operations is based upon the Company's financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States of America. The preparation of these financial statements
requires the Company to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. Estimates are based on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances. The result of this process forms the basis for making
judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. The Company re-evaluates its estimates and
judgments on a regular, ongoing basis. Actual results may differ from these
estimates due to changed circumstances and conditions.
The following accounting policies and estimates are considered critical in
light of the potentially material impact that the estimates, judgments and
uncertainties affecting the application of these policies might have on the
Company's reported financial information.
Loss Contingencies
The Company is involved in various claims, lawsuits and other proceedings
discussed in Note 7. Such litigation involves uncertainty as to possible losses
the Company may ultimately realize when one or more future events occur or fail
to occur. The Company accrues and charges to income estimated losses from
contingencies when it is probable (at the balance sheet date) that an asset has
been impaired or liability incurred and the amount of loss can be reasonably
estimated. Differences between estimates recorded and actual amounts determined
in subsequent periods are treated as changes in accounting estimates (i.e., they
are reflected in the financial statements in the period in which they are
determined to be losses, with no retroactive restatement).
The Company estimates the probability of losses on legal contingencies
based on the advice of internal and external counsel, the outcomes from similar
litigation, the status of the lawsuits (including settlement initiatives),
legislative and regulatory developments, and other factors. Risks and
uncertainties are inherent with respect to the ultimate outcome of litigation.
Palco provides services to the Company with respect to the defense of certain
legal actions. The Services Agreement requires Palco to (at its cost) prepare
and file on behalf of the Company all pleadings and motions, and otherwise
diligently pursue, appeals of any denial, and defense of any challenge to
approval, of any THP or the Environmental Plans or similar plan or permit and
related matters. See Note 7 for further discussion of the Company's material
legal contingencies.
Depletion
Depletion of the Company Timber and Company Timberlands is computed
utilizing the units-of-production method based upon estimates of timber
quantities. The depletion base is the total historical cost attributable to the
Company Timberlands. Depletion for the period is determined by multiplying the
depletion base by the ratio of harvested units for the period over the total
expected recoverable units. The Company's total for expected recoverable units
is reviewed on a periodic basis and revised, if necessary. Any adjustments are
made prospectively (i.e., the remaining undepleted cost is expensed over the
remaining recoverable units).
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to changes in interest rates under the Line of
Credit, which was established in conjunction with the offering of the Timber
Notes. This facility bears interest at either the prime interest rate or LIBOR
plus a specified percentage point spread. As of December 31, 2004, there was
$18.2 million of borrowings outstanding under the Line of Credit. Based on the
amount of borrowings outstanding under the Line of Credit during 2004, the
impact of a 1% change in interest rates effective from the beginning of the year
would not have been material to the Company's interest expense for 2004.
All of the Company's other debt is fixed-rate, and therefore, does not
expose the Company to the risk of higher interest payments due to changes in
market interest rates. The Company does not utilize interest rate swaps or
similar hedging arrangements.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Managers and Member of
Scotia Pacific Company LLC:
We have audited the accompanying balance sheet of Scotia Pacific Company
LLC (a Delaware limited liability company and a wholly owned subsidiary of The
Pacific Lumber Company ("Palco")) (the "Company") as of December 31, 2004 and
2003, and the related statements of loss and of cash flows for each of the three
years in the period ended December 31, 2004. 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 the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. Our audit included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements referred to above present fairly,
in all material respects, the financial position of Scotia Pacific Company LLC
as of December 31, 2004 and 2003, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 2004, in
conformity with accounting principles generally accepted in the United States of
America.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, at December 31, 2004, the cash flows of the Company and
Palco, have been adversely affected by delays in obtaining regulatory approvals
to harvest timber. Palco was in default under an asset-based credit agreement
with a bank. The Company has estimated that without additional timber harvest
plan approvals, the Company will be unable to pay the entire amount of interest
due in July, 2005, on its timber notes. Such failure to pay interest would
constitute an event of default under the indenture governing the timber notes.
The difficulties of the Company and Palco in meeting their loan agreement
covenants and paying the interest on the timber notes raise substantial doubts
about the Company's ability to continue as a going concern. Further, the
difficulties of the Company raises substantial doubt about the Company's ability
to realize its timber related assets and discharge its timber related
liabilities in the normal course of business and to continue as a going concern.
The financial statements do not include any adjustments that might result from
the outcome of these uncertainties.
DELOITTE & TOUCHE LLP
Portland, Oregon
March 14, 2005
SCOTIA PACIFIC COMPANY LLC
BALANCE SHEET
(In millions of dollars)
December 31,
-------------------
2004 2003
--------- --------
Assets
Current assets:
Cash, cash equivalents, and restricted cash..........................................$ 0.5 $ 0.9
Marketable securities, including restricted amounts of $25.1 and $24.6, respectively. 28.2 26.5
Receivables from Palco............................................................... 3.3 4.9
Prepaid timber harvesting costs...................................................... 6.2 5.6
Other current assets................................................................. 1.1 1.2
-------- --------
Total current assets.............................................................. 39.3 39.1
Timber and timberlands, net of accumulated depletion of $290.1 and
$282.2, respectively................................................................. 225.1 230.0
Property and equipment, net of accumulated depreciation of $19.6 and
$17.1, respectively................................................................. 28.1 25.7
Deferred financing costs, net........................................................... 11.8 13.5
Restricted cash, marketable securities and other investments............................ 9.2 35.4
Intangible assets....................................................................... 3.8 4.7
-------- --------
$ 317.3 $ 348.4
======== ========
Liabilities and Member Deficit
Current liabilities:
Payables to Palco....................................................................$ 1.5 $ 0.9
Accrued interest..................................................................... 23.8 24.5
Other accrued liabilities............................................................ 1.9 2.4
Short-term borrowings and current maturities of long-term debt, excluding
$9.5 and $4.6, respectively, of repurchased Timber Notes held in the
SAR Account....................................................................... 33.8 17.6
------- --------
Total current liabilities......................................................... 61.0 45.4
Long-term debt, less current maturities and excluding $55.4 and $54.3, respectively,
of repurchased Timber Notes held in the SAR Account..................................... 687.7 713.9
Other noncurrent liabilities............................................................ 0.2 0.3
------- --------
Total liabilities................................................................. 748.9 759.6
------- --------
Contingencies (See Note 7)
Member deficit.......................................................................... (431.6) (411.2)
------- --------
$ 317.3 $ 348.4
======== ========
The accompanying notes are an integral part of these financial statements.
SCOTIA PACIFIC COMPANY LLC
STATEMENT OF LOSS
(In millions of dollars)
Years Ended December 31,
----------------------------------
2004 2003 2002
----------- --------- ----------
Log sales to Palco............................................$ 66.4 $ 73.3 $ 64.6
---------- --------- ----------
Operating expenses:
General and administrative................................. 20.6 21.5 20.6
Depletion, depreciation and amortization................... 11.4 13.1 13.8
Gain on sales of timberlands and other assets.............. - (8.3) -
---------- --------- ----------
32.0 26.3 34.4
---------- --------- ----------
Operating income.............................................. 34.4 47.0 30.2
---------- --------- ----------
Other income (expense):
Gain (loss) on repurchases of debt......................... (0.3) 0.7 -
Interest and other income.................................. 1.3 3.9 4.6
Interest expense........................................... (55.2) (56.9) (57.9)
---------- --------- ----------
(54.2) (52.3) (53.3)
---------- --------- ----------
Net loss......................................................$ (19.8) $ (5.3) $ (23.1)
========== ========= ==========
The accompanying notes are an integral part of these financial statements.
SCOTIA PACIFIC COMPANY LLC
STATEMENT OF CASH FLOWS
(In millions of dollars)
Years Ended December 31,
----------------------------------
2004 2003 2002
---------- --------- ---------
Cash flows from operating activities:
Net loss .......................................................... $ (19.8) $ (5.3) $ (23.1)
Adjustments to reconcile net loss to net cash used for
operating activities:
Gain on sales of timberlands and other assets................... - (8.3) -
Loss (gain) on repurchases of debt.............................. 0.3 (0.7) -
Depletion, depreciation and amortization........................ 11.4 13.1 13.8
Amortization of deferred financing costs........................ 1.3 1.4 1.4
Increase (decrease) in cash resulting from changes in:
Receivables from Palco........................................ 1.6 (2.3) 1.2
Prepaid timber harvesting costs............................... (0.6) 1.7 0.6
Payables to Palco............................................. 0.6 0.1 (0.2)
Accrued interest.............................................. (0.7) (0.4) (0.4)
Other accrued liabilities..................................... (0.5) 0.3 (0.8)
Other......................................................... (0.2) (0.4) (0.3)
----------- --------- ----------
Net cash used for operating activities........................ (6.6) (0.8) (7.8)
----------- --------- ----------
Cash flows from investing activities:
Proceeds from sales of assets...................................... - 11.4 -
Capital expenditures............................................... (7.8) (7.7) (7.2)
----------- --------- ----------
Net cash provided by (used for) investing activities.......... (7.8) 3.7 (7.2)
----------- --------- ----------
Cash flows from financing activities:
Principal payments on Timber Notes and other timber related debt... (17.2) (16.6) (15.0)
Net changes in restricted cash and marketable securities........... 13.0 13.8 59.2
Borrowings under line of credit agreement, net..................... 18.2 - -
Member distributions............................................... - - (29.4)
----------- --------- ----------
Net cash provided by (used for) financing activities.......... 14.0 (2.8) 14.8
---------- --------- ----------
Net decrease in cash, cash equivalents, and restricted cash........... (0.4) 0.1 (0.2)
Cash, cash equivalents and restricted cash at beginning of period..... 0.9 0.8 1.0
----------- --------- ----------
Cash, cash equivalents and restricted cash at end of period........... $ 0.5 $ 0.9 $ 0.8
=========== ========= ==========
Supplemental disclosure of non-cash investing and financing activities:
Transfer of marketable debt securities from held-to-maturity to
available-for-sale.............................................. $ - $ 11.9 $ -
Repurchases of debt using restricted cash.......................... 10.9 5.4 -
Supplemental disclosure of cash flow information:
Interest paid...................................................... $ 54.6 $ 56.0 $ 57.0
The accompanying notes are an integral part of these financial statements.
SCOTIA PACIFIC COMPANY LLC
NOTES TO FINANCIAL STATEMENTS
1. Basis of Presentation and Summary of Significant Accounting Policies
Basis of Presentation
Scotia Pacific Company LLC (the "Company") is a Delaware limited
liability company wholly owned by The Pacific Lumber Company ("Palco"),
which is a wholly owned subsidiary of MAXXAM Group Inc. ("MGI"). MGI is an
indirect wholly owned subsidiary of MAXXAM Inc. ("MAXXAM"). The Company is
a special purpose limited liability company organized in May 1998 to
facilitate the offering of the 6.55% Class A-1, 7.11% Class A-2 and 7.71%
Class A-3 Timber Collateralized Notes due 2028 of the Company (the "Timber
Notes"). Concurrent with the closing in July 1998 (the "Closing") of the
Timber Notes offering, Scotia Pacific Holding Company ("Scotia Pacific")
was merged into the Company and Palco and Salmon Creek LLC, a wholly owned
subsidiary of Palco ("Salmon Creek,"and together with the Company and
Palco; the "Palco Companies"), transferred to the Company approximately
13,500 acres of timberlands and the timber and related timber harvesting
rights (but not the underlying land) with respect to an additional
approximately 19,700 acres of timberlands. The Company in turn transferred
to Palco the timber and related timber harvesting rights (but not the
underlying land) with respect to approximately 1,400 acres of timberlands.
The merger and the transfers have been accounted for as a reorganization of
entities under common control which requires the Company to record the
assets, liabilities and results of operations of Scotia Pacific after
giving effect to the transfers as well as the assets, liabilities and
results of operations acquired from Palco and Salmon Creek at their
respective historical cost. Accordingly, the Company is the successor
entity to all of Scotia Pacific's historical operations (exclusive of the
assets transferred to Palco) and to the historical operations attributable
to the timberlands and timber and related timber harvesting rights acquired
from Palco and Salmon Creek.
Consistent with the Company's purpose and pursuant to the terms of the
indenture governing the Timber Notes (the "Indenture"), the Company is obligated
to set aside each month a portion of the funds it receives from the sale of logs
to Palco sufficient to make the specified payments of principal and interest on
the Timber Notes computed in accordance with the Indenture and to retain a
sufficient amount to pay operating expenses and capital improvements.
Use of Estimates and Assumptions
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America requires the use
of estimates and assumptions that affect (i) the reported amounts of assets and
liabilities, (ii) the disclosure of contingent assets and liabilities known to
exist as of the date the financial statements are published and (iii) the
reported amount of revenues and expenses recognized during each period
presented. The Company reviews all significant estimates affecting its financial
statements on a recurring basis and records the effect of any necessary
adjustments prior to filing the financial statements with the Securities and
Exchange Commission. Adjustments made to estimates often relate to improved
information not previously available. Uncertainties regarding such estimates and
related assumptions are inherent in the preparation of the Company's financial
statements; accordingly, actual results could differ from these estimates. Risks
and uncertainties are inherent with respect to the ultimate outcome of the
litigation discussed in Note 7. The results of a resolution of such
uncertainties could have a material effect on the Company's financial position,
results of operations and liquidity.
Liquidity and Cash Resources
Regulatory and environmental matters as well as certain pending legal
matters play a significant role in the Company's operations. See Note 7 for
discussion of these matters. Regulatory compliance and related litigation have
caused and may continue to cause delays in approval of the Company's timber
harvesting plans ("THPs") and delays in harvesting on its THPs once they are
approved. This has resulted and may continue to result in a decline in harvest,
an increase in the cost of logging operations, and increased costs related to
timber harvest litigation.
As discussed in Note 7, the California North Coast Regional Water Quality
Control Board (the "North Coast Water Board") is requiring the Company and Palco
to apply various waste discharge reporting, mitigation and erosion control
requirements in respect of timber harvesting activities in several watersheds,
and may impose additional measures in the future. The North Coast Water Board in
December 2003 directed its staff to formulate watershed-wide waste discharge
requirements ("WWDRs") for the Freshwater and Elk River watersheds. These
requirements have not yet been formulated, and the North Coast Water Board has
failed to release for harvest a number of THPs already approved by the other
government agencies which review the Company's THPs.
The failure of the North Coast Water Board to release these THPs for
harvest has adversely impacted the cash flows of both the Company and Palco. The
Company estimates that, without the prompt release of a substantial portion of
these THPs, its cash flows from operations, together with funds available under
an agreement (the "Line of Credit") with a group of banks pursuant to which the
Company may borrow to pay interest on the Timber Notes will be inadequate to pay
the entire amount of interest due on the July 20, 2005, Timber Note payment
date, which would constitute an event of default under the Indenture. Palco is
in default under a $30.0 million asset-based credit agreement with a bank (the
"Palco Credit Agreement") and estimates that, without the prompt release of a
substantial portion of these THPs and necessary amendments to the Palco Credit
Agreement, its cash flow from operations, together with funds available under
the Palco Credit Agreement, will not provide sufficient liquidity to fund its
current level of operations. The Company and Palco are continuing efforts to
obtain the clearance of the North Coast Water Board of sufficient THPs. Palco
has received a limited waiver of the default through March 18, 2005, from the
lender under the Palco Credit Agreement and is seeking a more permanent solution
to the default. There can be no assurance that these efforts with the North
Coast Water Board and the lender under the Palco Credit Agreement will be
successful.
In the event of a failure to pay interest on the Timber Notes in full when
due, the trustee under the Indenture (the "Trustee") or the holders of at least
25% of the aggregate outstanding principal amount of the Timber Notes may cause
all principal, interest and other amounts related to the Timber Notes to become
immediately due and payable. Also, in the event of a failure by the Company or
Palco to perform its respective covenants or agreements under the master
purchase agreement (the "Master Purchase Agreement") which governs the sale to
Palco of logs harvested from the timberlands owned by the Company (the "Company
Timberlands") or by Palco to perform its covenants or agreements under a
services agreement between the Company and Palco (the "Services Agreement")
relating to the provision of operational, management and related services not
performed by the Company's own employees with respect to the Company
Timberlands, which failure continues for 30 days after notice from the Trustee
or the holders of 25% or more of the outstanding principal amount of the Timber
Notes, the holders of a majority of the aggregate outstanding principal amount
of the Timber Notes may cause all principal, interest and other amounts related
to the Timber Notes to become immediately due and payable. In the event of any
such acceleration, the Agent under the Line of Credit may also accelerate the
advances then outstanding thereunder. If such accelerations of Timber Notes
and/or advances under the Line of Credit occur, the Trustee may exercise all
rights under the Indenture and related security documents, including applying
funds to pay accelerated amounts, and selling the Company Timberlands and other
assets and using the proceeds thereof to pay accelerated amounts. In the event
that the Company were to seek protection by filing under the U. S. Bankruptcy
Code (the "Bankruptcy Code"), all amounts related to the Timber Notes would
become immediately due and payable under the Indenture and all advances under
the Line of Credit agreement could be accelerated. The foregoing rights of the
Trustee and holders of Timber Notes are subject to the rights of the Company
under the Bankruptcy Code.
Palco will require funds available under the Palco Credit Agreement in
order to meet its working capital and capital expenditure requirements for the
next year. Palco's ability to meet such requirements could be adversely affected
should Palco be unsuccessful in its efforts to obtain a more permanent solution
to the default discussed above. Furthermore, Palco's cash flows from operations
may be adversely affected by diminished availability of logs from the Company,
lower lumber prices, adverse weather conditions, pending legal, regulatory and
environmental matters or increased funding requirements for its pension plan.
See Note 7 for further discussion of the regulatory, environmental and legal
matters affecting harvest levels and operating costs. Without an extension of
the limited waiver of Palco's default under the Palco Credit Agreement and a
restructuring or replacement of that facility, Palco's lender may take any of
the following actions: reduce the amount of funds available to Palco for
borrowing; refuse to make new loans to or issue new letters of credit for the
benefit of Palco; declare any or all loans and other amounts owed under the
agreement to be immediately due and payable; require Palco to cash collateralize
all outstanding letters of credit; or pursue its other rights and remedies under
the Palco Credit Agreement and related security agreements. The existence of the
default also requires Palco to pay interest on amounts borrowed under the Palco
Credit Agreement at a per annum rate 2% higher than the rate at which interest
would be owed if no default existed. If any acceleration under the Palco Credit
Agreement occurs, then the agent for the lender may exercise all rights under
that agreement and related security documents, including selling Palco's assets
and using the proceeds thereof to pay the accelerated amounts. In the event that
Palco were to seek protection by filing under the Bankruptcy Code, all loans and
other amounts owed under the Palco Credit Agreement would become immediately due
and payable. The foregoing rights of the lender under the Palco Credit Agreement
are subject to the rights of Palco under the Bankruptcy Code.
In the event of a Company default or a Palco liquidity shortfall, whether
resulting from a failure to extend the limited waiver past March 18, 2005, any
action described above taken by Palco's lender, or otherwise, the Company and
Palco could be forced to take extraordinary actions, which may include: reducing
expenditures by laying off employees and shutting down various operations;
seeking other sources of liquidity, such as from asset sales; and seeking
protection by filing under the Bankruptcy Code.
As discussed further below, on December 8, 2004, Standard & Poor's
Ratings Services ("S&P") lowered Palco's credit rating from B- to CCC+. As a
result, Palco may be required to post a security deposit for workers
compensation liabilities in July 2005, in an amount that has not been determined
but that could be material to Palco's liquidity, capital resources, and results
of operations. If improvements in Palco's liquidity, capital resources, and
results of operations produce an upward revision in Palco's credit rating, or if
a waiver of this requirement is allowed under applicable law, then posting of
such a security deposit may not be necessary. Palco management is in the process
of evaluating the potential amount of such a security deposit, if required.
There can be no assurance that such a security deposit will not be required or
that, if required, the amount will not be material. Palco management is also
evaluating whether other potential obligations or unanticipated adverse
financial reports may result from the S&P credit action described above.
In addition, there can be no assurance that certain other pending legal,
regulatory and environmental matters or future governmental regulations,
legislation or judicial or administrative decisions, adverse weather conditions,
or low lumber or log prices, will not have a material adverse effect on the
Company's financial condition, results of operations or liquidity. See Note 7
for further information regarding regulatory and legislative matters and legal
proceedings relating to the Company's operations.
Summary of Significant Accounting Policies
Concentrations of Credit Risk
Cash equivalents and marketable securities are invested primarily in short
to medium-term investment grade debt instruments as well as other types of
corporate and government debt obligations. The Company mitigates its
concentration of credit risk with respect to these investments by generally
purchasing investment grade products (ratings of A1/P1 short- term or at least
BBB/Baa3 long-term). No more than 5% is invested in the same issue.
Securities Available-for-Sale
Management determines the appropriate classification of investment
securities at the time of purchase and re-evaluates such designation as of each
balance sheet date. Available-for-sale securities are stated at fair market
value, with the unrealized gains and losses reported in other comprehensive
loss, a separate component of member deficit. Realized gains and losses and
declines in value judged to be other-than-temporary on available-for-sale
securities are included in interest and other income. Interest and dividends on
securities classified as available-for-sale are also included in interest and
other income. The cost of securities sold is determined using the first-in,
first-out method. The fair value of substantially all securities is determined
by quoted market prices. The fair value of marketable debt securities includes
accrued interest.
Prepaid Timber Harvesting Costs and Other Assets
Direct costs associated with the preparation of THPs are capitalized and
reflected in prepaid timber harvesting costs on the balance sheet. These costs
are expensed as the timber covered by the related THP is harvested. Costs
associated with the preparation of the Company's sustained yield plan ("SYP")
and the Company's multi-species habitat conservation plan ("HCP") were
capitalized and are reflected in other assets. These costs are being amortized
on a straight-line basis over 10 years.
The carrying amounts of the Company's SYP and HCP intangible assets are as
follows (in millions):
December 31,
-----------------------------------
2004 2003 2002
---------- ---------- -----------
SYP/HCP.........................................$ 8.3 $ 8.3 $ 8.3
Less: Accumulated amortization................. (4.5) (3.6) (2.7)
--------- ---------- ----------
$ 3.8 $ 4.7 $ 5.6
========== =========== ==========
The Company evaluates its intangible assets with finite lives for
impairment whenever events or changes in circumstances indicate that such assets
might be impaired. The remaining useful life of intangible assets with finite
lives are evaluated annually to determine whether events or circumstances
warrant changes in the estimated useful lives of such assets.
Amortization of intangible assets for the years ended December 31, 2004,
2003 and 2002, was $0.9 million per year. The estimated amortization expense for
2005 through 2008 is $0.9 million per year, and $0.2 million for 2009. Estimated
amortization will change if events or circumstances warrant the revision of
estimated useful lives.
Property and Equipment
Property and equipment is stated at cost, net of accumulated depreciation.
Depreciation is computed principally utilizing the straight-line method at rates
based upon the estimated useful lives of the various classes of assets. The
carrying value of property and equipment is assessed when events and
circumstances indicate that an impairment might exist. The existence of an
impairment is determined by comparing the net carrying value of the asset to its
estimated undiscounted future cash flows. A probability-weighted approach is
used for situations in which alternative courses of action to recover the
carrying amount of long-lived assets are under consideration or a range is
estimated for the amount of possible future cash flows. If an impairment is
present, assets are written down to fair value and a loss is recognized.
Timber and Timberlands
Timber and timberlands were recorded at the historical cost of Scotia
Pacific, Palco and Salmon Creek. Depletion is computed utilizing the
units-of-production method based upon estimates of timber quantities.
Periodically, the Company will review its depletion rates considering currently
estimated merchantable timber and will adjust the depletion rates prospectively.
Revenue Recognition
Revenues from the sale of logs are recorded when the legal ownership and
the risk of loss passes to the buyer, which is at the time each log is measured.
Deferred Financing Costs
Costs incurred to obtain debt financing are deferred and amortized,
generally on a straight-line basis, over the estimated term of the related
borrowing. The amortization of deferred financing costs is included in interest
expense on the Statement of Loss.
Legal Contingencies
The Company is currently involved in various claims and proceedings which
are reviewed for potential financial exposure on a regular basis. If the
potential loss from any claim or legal proceeding is considered probable and is
reasonably estimable as of the balance sheet date, a liability is accrued. The
Company estimates the probability of losses on legal contingencies based on the
advice of internal and external counsel, the outcomes from similar litigation,
the status of the lawsuits (including settlement initiatives), legislative
developments, and other factors. See Note 7 for a description of the Company's
material legal proceedings.
Income Taxes
The Company, a single member limited liability company, has not made an
election to be treated as an association and, therefore, is disregarded as a
separate taxable entity solely for income tax purposes. The Company is treated
as a division of Palco for tax purposes. All income taxes with respect to the
Company are shown on Palco's financial statements, and all deferred income tax
assets and deferred income tax liabilities with respect to the Company at
December 31, 2004 and 2003, are reflected in Palco's financial statements.
Reclassifications
Certain reclassifications have been made to the prior years' financial
statements to be consistent with the current year's presentation. The
reclassification of prior year balances includes $4.3 million of auction rate
securities which were reclassified from cash and cash equivalent to marketable
securities in the Balance Sheet.
2. Significant Acquisitions and Dispositions
In November 2003, Palco and the Company sold approximately 681 acres of
timberlands within an area known as the Grizzly Creek grove. The Company
received $8.2 million in cash, resulting in a gain of $7.5 million.
3. Cash, Cash Equivalents, Marketable Securities and Other Investments
Cash equivalents consist of highly liquid money market instruments with
original maturities of three months or less. As of December 31, 2004 and 2003,
carrying amounts of the Company's cash equivalents approximated fair value.
The following is a summary of available-for-sale securities (in millions):
December 31,
------------------------
2004 2003
----------- -----------
Cost......................................................$ 15.9 $ 38.8
Estimated fair value...................................... 15.8 39.6
During 2003, marketable debt securities classified as held-to-maturity were
sold to generate funds for principal payments on long-term debt and for the
repurchase of Timber Notes. The amortized cost of the securities sold was $11.7
million, and the realized gain on the sale of such securities was $0.1 million.
There were no such sales during 2004.
At December 31, 2003, management re-evaluated the classification of its
investment securities in accordance with Statement of Financial Accounting
Standard No. 115, "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS No. 115"). As a result, marketable debt securities previously
classified as held-to-maturity were transferred to the available-for-sale
category. The amortized cost and fair value of the transferred securities was
$11.8 million and $11.9 million, respectively, at December 31, 2003. There were
no investments classified as held-to-maturity at December 31, 2004 and 2003.
Interest and other income includes gross realized gains and losses on sales
of available-for-sale securities for each of the three years in the period ended
December 31, 2004, as follows (in millions):
Years Ended December 31,
--------------------------------
2004 2003 2002
---------- --------- ---------
Gross realized gains...............................$ 0.4 $ 0.3 $ 2.4
Gross realized losses.............................. (0.2) - (0.1)
The net adjustment to unrealized holding gains (losses) on
available-for-sale securities included as a separate component of member deficit
totaled $(0.6) million, $(0.4) million, and $(0.7) million in 2004, 2003, and
2002, respectively. Gross unrealized losses on investment securities at December
31, 2004, were not material, and investment securities in an unrealized loss
position for twelve months or more totaled $3.6 million.
Available-for-sale securities generally consist of U.S. corporate debt
securities, U.S. treasury obligations, and other debt securities with
contractual maturities ranging from one year to five years. Held-to-maturity
securities during 2003 consisted of U.S. government agency obligations with
contractual maturities ranging from one year to five years. Amounts invested in
auction rate securities are classified as marketable securities.
Restricted Cash, Cash Equivalents, Marketable Securities and Other Investments
Cash, marketable securities and other investments include the following
amounts which are restricted under the terms of the Company's debt agreements
(in millions):
December 31,
-------------------
2004 2003
------------ ------
Current assets:
Restricted cash and cash equivalents............................................... $ - $ 0.2
Marketable securities, restricted:
Amounts held in SAR Account..................................................... 25.1 22.2
Other amounts restricted under the Indenture.................................... - 1.2
--------- --------
25.1 23.6
Long-term restricted cash, cash equivalents, marketable securities and other investments:
Amounts held in SAR Account........................................................ 68.5 87.7
Other amounts restricted under the Indenture....................................... 2.5 2.5
Less: Amounts attributable to Timber Notes held in
SAR Account..................................................................... (61.8) (54.8)
-------- --------
9.2 35.4
-------- --------
Total restricted cash, cash equivalents, marketable securities and other investments.. $ 34.3 $ 59.0
======== ========
Amounts in the Scheduled Amortization Reserve Account, which is a reserve
account used to support principal payments on the Timber Notes (the "SAR
Account") are being held by the trustee under the Indenture to support principal
payments on the Timber Notes. See Note 5 for further discussion on the SAR
Account.
Other Investments
Funds held in the SAR Account include interests in several limited
partnerships which invest in diversified portfolios of common stocks and equity
securities, in addition to exchange traded options, futures, forward foreign
currency contracts, and other arbitrage opportunities. The Company's ownership
percentages in these partnerships are not significant. As of December 31, 2004
and 2003, these investments amounted to $16.0 million and $15.5 million,
respectively.
Interest and other income includes income from the Company's investment in
these partnerships for each of the three years in the period ended December 31,
2004, as follows (in millions):
Years Ended December 31,
-------------------------------
2004 2003 2002
---------- --------- ---------
Earnings from investments in partnerships........$ 0.5 $ 2.2 $ 0.6
========== ======== =========
4. Property and Equipment
The major classes of property and equipment are as follows (dollar amounts
in millions):
December 31,
Estimated ----------------------
Useful Lives 2004 2003
----------- ---------- ----------
Logging roads ..................................... 15 years $ 45.4 $ 40.8
Other............................................... 5 - 15 years 2.3 2.0
---------- ----------
47.7 42.8
Less: accumulated depreciation..................... (19.6) (17.1)
---------- ----------
$ 28.1 $ 25.7
========== ==========
Depreciation expense for the years ended December 31, 2004, 2003 and 2002
was $2.6 million, $2.2 million and $2.0 million, respectively.
5. Debt
In July 1998, the Company issued $867.2 million aggregate principal amount
of Timber Notes, which are due at various times through July 20, 2028. The
Timber Notes are senior secured obligations of the Company and do not constitute
obligations of, and are not guaranteed by, Palco or any other person. The Timber
Notes were issued in three classes: Class A-1 Timber Notes aggregating $160.7
million, Class A-2 Timber Notes aggregating $243.2 million and Class A-3 Timber
Notes aggregating $463.3 million. Pursuant to the terms of the Indenture, the
Company is permitted to incur up to $75.0 million at any one time of
non-recourse indebtedness secured by purchase money mortgages to acquire
additional timberlands, an unspecified amount of Additional Timber Notes (as
defined in the Indenture) provided certain conditions are met, and certain other
debt on a limited basis. The Company is not permitted to incur any other
indebtedness for borrowed money. The Timber Notes and the Line of Credit are
secured by a lien on (i) the Company's timber, timberlands and timber rights,
(ii) certain contract rights and other assets, (iii) the proceeds of the
foregoing and (iv) funds held by the Trustee in various accounts relating to the
Timber Notes. Amounts payable on the Timber Notes are paid semi- annually,
generally on January 20 and July 20 of each year (each, a "Note Payment Date").
In the event of a failure to pay interest in full, the Trustee and/or the
holders of at least 25% of the Timber Notes may declare all amounts related to
the Timbers Notes immediately due and payable. If, upon demand, the Company
fails to pay such amounts, then the Trustee may exercise all rights under the
Indenture and the Deed of Trust, including instituting a court proceeding and /
or exercising the note holders' rights to sell the Company's timberlands and use
the proceeds from such a sale to pay all amounts due under the Indenture. In the
event that the Company seeks protection by filing under the United States
Bankruptcy Code, then all amounts related to the Timber Notes would become
immediately due and payable.
The Timber Notes were structured to link, to the extent of cash available,
the deemed depletion of the Company's timber (through the harvest and sale of
logs) to the required amortization of the Timber Notes. The required amount of
amortization on any Note Payment Date is determined by various mathematical
formulas set forth in the Indenture."Scheduled Amortization" of the Timber Notes
represents the amount of principal which the Company must pay through each Note
Payment Date in order to avoid payment of prepayment or deficiency premiums, as
described below. The Scheduled Maturity Dates for the Class A-1 and Class A-2
Timber Notes, which are January 20, 2007 and January 20, 2014, respectively,
represent the Note Payment Dates on which the Company will pay the final
installment of principal if all payments of principal are made in accordance
with Scheduled Amortization. The Scheduled Maturity Date for the Class A-3
Timber Notes is also January 20, 2014. The Scheduled Amortization for the Class
A-3 Timber Notes does not include any principal amortization prior to their
Scheduled Maturity Date. If the Class A-3 Timber Notes are not paid in full on
or before their Scheduled Maturity Date, a Cash Retention Event (as defined in
the Indenture) will occur as a result of which 75% of all Excess Funds (as
defined in the Indenture) will be deposited in the note payment account
("Payment Account") until all classes of Timber Notes are paid in full,
generally in sequential order.
"Minimum Principal Amortization" of the Timber Notes represents the minimum
amount of principal which the Company must pay (on a cumulative basis and
subject to available cash) on such Class, to the extent of available funds on
deposit in the Payment Account, through any Note Payment Date. If the Timber
Notes were amortized in accordance with Minimum Principal Amortization, the
final installments of principal would be paid on January 20, 2010, July 20, 2017
and July 20, 2028 for the Class A-1, Class A-2 and Class A-3 Timber Notes,
respectively.
In November 1999, $169.0 million of funds from the sale of 5,600 acres of
timberlands (the "Headwaters Timberlands") were contributed to the Company and
set aside in the SAR Account. Amounts in the SAR Account are part of the
collateral securing the Timber Notes and are used to make principal payments to
the extent that cash flows from operations are insufficient to pay Scheduled
Amortization on the Class A-1 and Class A-2 Timber Notes. In addition, during
the six years beginning January 20, 2014, any amounts then remaining in the SAR
Account would be used to amortize the Class A-3 Timber Notes. Funds may from
time to time be released to the Company from the SAR Account if the amount in
the account at that time exceeds the Required Scheduled Amortization Reserve
Balance (as defined and set forth in the Indenture). If the balance in the SAR
Account falls below the Required Scheduled Amortization Reserve Balance, up to
50% of any Remaining Funds (funds that could otherwise be released to the
Company free of the lien securing the Timber Notes) are required to be used on
each monthly deposit date to replenish the SAR Account. As of December 31, 2004,
the amount held in the SAR Account was $27.6 million below the Required
Scheduled Amortization Reserve Balance.
If the principal of the Timber Notes is paid in advance of Scheduled
Amortization, the Company must pay a prepayment premium on such accelerated
payment. The prepayment premium on any Note Payment Date is equal to the excess,
if any, of (a) the sum of (i) the present value of the prepayment amount
(discounted from the date(s) that the prepayment amount would otherwise have
been paid under the Scheduled Amortization to the Note Payment Date) plus (ii)
the sum of the present values of the amounts of interest that would have accrued
thereafter with respect to the prepayment amount over (b) the amount of the
prepayment. The present value is computed using a "Reinvestment Yield" (as
defined in the Indenture) which is comparable to the yield of like term U.S.
Treasury securities plus 0.50% per annum. In addition to possible prepayments
under the mathematical formulas set forth in the Indenture, the Company has the
right to cause additional prepayments of principal to be made on any Note
Payment Date.
If the principal of the Timber Notes is paid later than as provided for
under Scheduled Amortization, the Company will pay a deficiency premium on such
deficient amount. The deficiency premium payable on any Note Payment Date equals
an amount of interest on the amount of the deficient principal amount from the
previous Note Payment Date to the current Note Payment Date at 1.50% per annum.
The amount attributable to Timber Notes held in the SAR Account of $61.8
million at December 31, 2004, reflected in Note 3 represents the amount paid to
acquire $64.9 million principal amount of Timber Notes. The following table
presents (in millions) the amortization of the Timber Notes outstanding
(excluding $61.8 million face value of repurchased Timber Notes held in the SAR
Account) based on Minimum Principal Amortization and Scheduled Amortization
(subject to available cash):
Minimum
Principal Scheduled
Amortization(1) Amortization (2)
--------------- ----------------
Years Ending December 31:
2005.....................................................$ - $ 15.6
2006..................................................... - 18.2
2007..................................................... 14.3 26.5
2008..................................................... 12.9 25.1
2009..................................................... 8.7 19.6
Thereafter............................................... 667.4 598.3
--------------- ----------------
$ 703.3 $ 703.3
=============== ================
(1) Minimum Principal Amortization amounts are net of additional amounts due in
respect of Timber Notes held by the Company and also reflect payments made
in accordance with Scheduled Amortization in excess of Minimum Principal
Amortization amounts.
(2) Scheduled Amortization amounts are net of additional amounts due in respect
of Timber Notes held by the Company.
As of December 31, 2004 and 2003, the estimated fair value of debt,
including current maturities, was $591.2 million and $562.5 million,
respectively. The estimated fair value of debt is determined based on the quoted
market price for the Timber Notes. The Timber Notes are thinly traded financial
instruments; accordingly, their market price at any balance sheet date may not
be representative of the price which would be derived from a more active market.
The Company has entered into a line of credit (the "Line of Credit") with a
group of banks pursuant to which the Company may borrow to pay interest on the
Timber Notes. The maximum amount the Company may borrow is equal to one year's
interest on the aggregate outstanding principal balance of the Timber Notes (the
"Required Liquidity Amount"). On June 20, 2003, the Line of Credit was extended
to July 7, 2006. At or near the completion of such extension, the Company
intends to request that the Line of Credit be extended for an additional period
of not less than 364 days. If not extended, the Company may draw upon the full
amount available. The amount drawn would be repayable in 12 semiannual
installments on each note payment date (after the payment of certain other
items, including the Aggregate Minimum Principal Amortization Amount, as
defined, then due), commencing approximately two and one-half years following
the date of the draw. At December 31, 2004, the Company could have borrowed a
maximum of $57.1 million under the Line of Credit, and there was $18.2 million
outstanding under this facility. At January 31, 2005, the maximum availability
under the Line of Credit was $55.9 million, and there were $45.9 million in
borrowings outstanding under this facility. As discussed further in Note 1, the
Company is experiencing financial difficulties due to the failure of the North
Coast Water Board to release for harvest already-approved THPs. As a result, the
Company may not have adequate availability under the Line of Credit to pay the
entire amount of interest due on the Timber Notes in July 2005. Such a failure
to pay interest would constitute an event of default under the Indenture.
On the note payment date in January 2004, the Company had $4.1 million set
aside in the note payment account to pay the $27.2 million of interest due (net
of $2.0 million of additional interest due in respect of Timber Notes held by
the Company). The funds available under the Line of Credit were used to pay the
remaining $26.6 million of interest due. The Company repaid $12.7 million of
principal on the Timber Notes (an amount equal to Scheduled Amortization) using
funds held in the SAR Account).
On the note payment date in July 2004, the Company used $26.6 million (net
of $2.1 million of additional interest due in respect of Timber Notes held by
the Company) of the funds available under the Line of Credit to pay the entire
$26.6 million of interest due. The Company repaid $4.5 million of principal on
the Timber Notes (an amount equal to Scheduled Amortization) using funds held in
the SAR Account.
On the note payment date in January 2005, the Company used $26.3 million
(net of $2.2 million of additional interest due in respect of Timber Notes held
by the Company) of the funds available under the Line of Credit to pay the
entire $26.3 million of interest due. The Company repaid $10.6 million of
principal on the Timber Notes (an amount equal to Scheduled Amortization) using
funds held in the SAR Account.
During 2004, $10.9 million of funds from the SAR Account were used to
repurchase $11.0 million principal amount of Timber Notes, as permitted under
the Indenture, resulting in a loss of $0.3 million (net of unamortized deferred
financing costs) on the repurchase of debt.
6. Related Party Transactions
At the time of the Closing, the Company and Palco entered into the "Master
Purchase Agreement" which governs all log sales by the Company to Palco.
Substantially all of the Company's revenues have been and are expected to
continue to be derived from the sale of logs to Palco. The harvested logs are
purchased by Palco (i.e., title passes and the obligation to make payment
therefor is incurred) at the time each log is measured. The Master Purchase
Agreement contemplates that all sales of logs by the Company to Palco will be at
fair market value (based on stumpage prices) for each species and category of
timber. The Master Purchase Agreement provides that if the purchase price equals
or exceeds the applicable stumpage price for each species of timber and category
thereof (the "SBE Price") as set forth in the most recent schedule published
periodically by the California State Board of Equalization (the "Harvest Value
Schedule") and a structuring price set forth in a schedule to the Indenture, the
purchase price is deemed to be at fair market value. If the purchase price
equals or exceeds the SBE Price, but is less than the structuring price, then
the Company is required to engage an independent forestry consultant to confirm
that the purchase price reflects fair market value.
SBE Prices improved in 2004 versus 2003. In December 2004, the State Board
of Equalization adopted the new Harvest Value Schedule for the first half of
2005. The prices published in that schedule reflected a 14.3% increase in the
SBE Price for small redwood logs and a 12.5% increase for small Douglas-fir logs
from the prices published for the second half of 2004.
The Company and Palco also entered into a services agreement at the time of
Closing (the "Services Agreement"), pursuant to which Palco provides a variety
of operational, management and related services in respect of the Company's
timber properties not provided by the Company employees, including
reforestation, fire protection and road maintenance, rehabilitation and
construction. In addition, Palco provides services to the Company with respect
to the defense of any legal challenges. The Company pays a Services Fee (as
defined in the Services Agreement) in an initial amount of $107,000 per month
adjusted annually based on a designated producer price index and reimburses
Palco for the cost of constructing, rehabilitating and maintaining roads and
performing reforestation services. For the years ended December 31, 2004, 2003,
and 2002, $10.9 million, $10.6 million, and $10.4 million, respectively, was
recorded under the Services Agreement.
7. Contingencies
Regulatory and environmental matters play a significant role in the
Company's business, which is subject to a variety of California and federal laws
and regulations, as well as the HCP, dealing with timber harvesting practices,
threatened and endangered species and habitat for such species, and air and
water quality.
Environmental Plans
From March 1999 until October 2002, the Company prepared THPs in accordance
with the SYP. The SYP was intended to comply with regulations of the California
Department of Forestry and Fire Protection ("CDF") requiring timber companies to
project timber growth and harvest on their timberlands over a 100-year planning
period and to demonstrate sustained yield, i.e. that their projected average
annual harvest for any decade within a 100-year planning period would not exceed
the average annual growth level during the last decade of the 100-year planning
period. The forest practice rules allow companies which do not have a sustained
yield plan to follow an alternative procedure to document compliance with the
sustained yield requirements. As discussed below, on October 31, 2003, the Court
hearing the EPIC-SYP/Permits lawsuit (as defined below) entered a judgment
invalidating the SYP and the incidental take permits issued by California
pursuant to the HCP ("California Permits"), and that decision is now on appeal.
As a result of an earlier stay order issued in this case, the Company has since
October 2002 been obtaining review and approval of THPs under this alternative
procedure and expects to follow this procedure until approval of its pending
Option A Plan ("Option A Plan"), which is an alternative to a sustained yield
plan.
The HCP and related incidental take permits issued by the federal
government pursuant to the HCP ("Federal Permits") allow incidental "take" of
certain federally listed species located on the Company's timberlands so long as
there is no "jeopardy" to the continued existence of such species. The HCP
identifies the measures to be instituted in order to minimize and mitigate the
anticipated level of take to the greatest extent practicable. The HCP and
Federal Permits have terms of 50 years. Since the consummation of the Headwaters
Agreement in March 1999, there has been a significant amount of work required in
connection with the implementation of the HCP and SYP (together, the
"Environmental Plans"), and this work is expected to continue for several more
years.
Water Quality
Laws and regulations dealing with water quality are impacting the Company
primarily in four areas: efforts by the federal Environmental Protection Agency
("EPA") and the North Coast Water Board to establish total maximum daily load
limits ("TMDLs") in watercourses that have been declared to be water quality
impaired; actions by the North Coast Water Board to impose waste discharge
reporting requirements in respect of watersheds on the Company's timberlands and
in some cases, clean-up or prevention measures; actions by the North Coast Water
Board during the THP approval process which impose certain operational
requirements on individual THPs; and a directive of the North Coast Water Board
to its staff to develop WWDRs for the Freshwater and Elk River watersheds.
Under the federal Clean Water Act ("CWA"), the EPA is required to establish
TMDLs in watercourses that have been declared to be "water quality impaired."
The EPA and the North Coast Water Board are in the process of establishing TMDLs
for many northern California rivers and certain of their tributaries, including
nine watercourses that flow within the Company's timberlands. The Company
expects this process to continue into 2010. The final TMDL requirements
applicable to the Company's timberlands may require aquatic protection measures
that are different from or in addition to those in the HCP or that result from
the prescriptions to be developed pursuant to the watershed analysis process
provided for in the HCP.
Beginning with the 2002-2003 winter operating period, the Company and Palco
has been required to submit "Reports of Waste Discharge" to the North Coast
Water Board each year in order to conduct winter harvesting activities in the
Elk River and Freshwater watersheds. After consideration of these reports, the
North Coast Water Board imposed requirements on the Company and Palco to
implement additional mitigation and erosion control practices in these
watersheds for these winter operating periods. In addition, the North Coast
Water Board has extended the requirements for certain mitigation and erosion
control practices to the Bear, Jordan and Stitz watersheds. Reporting and
mitigation requirements imposed by the North Coast Water Board have
significantly increased operating costs and may in the future further increase
costs or cause delays in THP approvals.
The North Coast Water Board has also issued a clean up and abatement order
(the "Elk River Order") which is aimed at addressing existing sediment
production sites in the Elk River watershed through clean up actions. The North
Coast Water Board has also initiated the process which could result in similar
orders for the Freshwater and Bear Creek watersheds, and is contemplating
similar actions for the Jordan and Stitz Creek watersheds. The Elk River Order
has resulted in increased costs to the Palco Companies that could extend over a
number of years. Additional orders in other watersheds (should they be issued)
may also result in further cost increases. Palco's appeal of the Elk River Order
to the State Water Resources Control Board (the "State Water Board") was denied.
Palco has appealed the decision of the State Water Board, but is holding such
appeal in abeyance until resolution of the THP No. 520 lawsuit discussed below.
In addition to the foregoing actions, the North Coast Water Board in
December 2003 directed its staff to create WWDRs for the Freshwater and Elk
River watersheds. As harvesting activities on the Company's timberlands cannot
readily be moved between watersheds due to, among other things, historic harvest
patterns, adjacency restrictions, and the age classes of trees, that action and
the other matters described above could, in addition to the potential effects
noted above, individually or collectively result in reduced harvest. In that
regard, the staff of the North Coast Water Board has not yet formulated the
required WWDRs for the Freshwater and Elk River watersheds. As a result, the
North Coast Water Board has failed to release for harvest a number of the
Company's THPs which have already been approved by the other government agencies
which review the Company's THPs. The unreleased THPs represent a significant
portion of the Company's planned harvest for the first half of 2005. The ongoing
delay in receiving the approval of the North Coast Water Board has adversely
impacted the cash flows of both the Company and Palco. See Note 1 for further
discussion.
Effective January 1, 2004, California Senate Bill 810 provides regional
water quality control boards with additional authority related to the approval
of THPs on land within impaired watersheds. The Company is uncertain of the
operational and financial effects which will ultimately result from Senate Bill
810; however, because substantially all rivers and waterbodies on the Company's
timberlands are classified as sediment-impaired, implementation of this law
could result in delays in obtaining approvals of THPs, lower harvest levels and
increased costs and additional protection measures beyond those contained in the
HCP. Also see the description of the THP No. 520 lawsuit below.
Timber Harvest Litigation
A California state court has invalidated the SYP in connection with two
lawsuits filed against the Palco Companies, as described below, which decision
has been appealed. Other judicial and administrative proceedings, as discussed
below, could affect the Company's ability to implement the HCP, implement
certain approved THPs, or carry out other operations, as discussed below. The
Services Agreement requires Palco to prepare and file on behalf of the Company
(at Palco's cost) all pleadings and motions, and otherwise diligently pursue,
appeals of any denial, and defense of any challenge to approval, of any THP or
the Environmental Plans or similar plan or permit and related matters.
In March 1999, an action entitled Environmental Protection Information
Association, Sierra Club v. California Department of Forestry and Fire
Protection, California Department of Fish and Game, The Pacific Lumber Company,
Scotia Pacific Company LLC, Salmon Creek Corporation, et al. (the
"EPIC-SYP/Permits lawsuit") was filed. This action alleged, among other things,
various violations of the CESA and the California Environmental Quality Act, and
challenged, among other things, the validity and legality of the SYP and the
California Permits. The plaintiffs sought, among other things, to set aside
California's approval of the SYP and the California Permits and injunctive
relief to prevent implementation of THPs approved in reliance upon these
documents. In March 1999, a similar action, entitled United Steelworkers of
America, AFL-CIO, CLC, and Donald Kegley v. California Department of Forestry
and Fire Protection, The Pacific Lumber Company, Scotia Pacific Company LLC and
Salmon Creek Corporation (the "USWA lawsuit"), was filed challenging the
validity and legality of the SYP. The EPIC-SYP/Permits and USWA lawsuits were
consolidated for trial.
Following trial, the Court on October 31, 2003, entered a judgment
invalidating the SYP and the California Permits due to several deficiencies in
agency procedures and the failure of the Company and Palco to submit a complete
and comprehensible SYP. The Court's decision, however, allowed for harvesting on
THPs which rely on the SYP and were approved prior to July 23, 2003. The
short-term effect of the ruling was to preclude approval, under the SYP, of a
small number of THPs which were under review but had not been approved, and a
minor reduction in 2003 harvesting that had been expected from these specific
THPs. As a result of this case, the Company has since October 2002, when the
Court issued a stay order preventing future reliance upon the SYP, been
obtaining review and approval of new THPs under a procedure provided for in the
forest practice rules that does not depend upon the SYP and the California
Permits. The Company expects to follow this procedure until the Option A Plan is
approved. Palco and the State of California have appealed the October 31, 2003,
decision. In September 2004, the Court granted the plaintiffs' request for
reimbursement of an aggregate of $5.8 million in attorneys fees and other
expenses incurred in connection with these matters. Palco and the State of
California have also appealed this decision.
In July 2001, an action entitled Environmental Protection Information
Center v. The Pacific Lumber Company, Scotia Pacific Company LLC (the "Bear
Creek lawsuit") was filed and later amended to add the EPA as a defendant. The
lawsuit alleges that harvesting and other forestry activities under certain of
the Company's approved THPs will result in discharges of pollutants in violation
of the CWA. The plaintiff asserts that the CWA requires the defendants to obtain
a permit from the North Coast Water Board before beginning timber harvesting and
road construction activities and is seeking to enjoin these activities until
such permit has been obtained. The plaintiff also seeks civil penalties of up to
$27,500 per day for the defendant's alleged continued violation of the CWA. On
October 14, 2003, in connection with certain motions that had been filed, the
Court upheld the validity of an EPA regulation which exempts harvesting and
other forestry activities from certain discharge requirements.
Both state and federal agencies, along with the Company and other timber
companies, have relied upon this regulation for more than 25 years. However, the
Court interpreted the regulation in such a way as to narrow the forestry
operations which are exempted, thereby limiting the regulation's applicability
and subjecting culverts and ditches to permit requirements. This ruling has
widespread implications for the timber industry in the United States. The case
is not yet final as the trial has not yet been held, and there are many
unresolved issues involving interpretation of the Court's decision and its
application to actual operations. Should the decision ultimately become final
and held to apply to all operations on the Company's timberlands, it may have
some or all of the following effects: imposing additional permitting
requirements, delaying approvals of THPs, increasing harvesting costs, and
adding water protection measures beyond those contained in the HCP. Nonetheless,
it is not likely that civil penalties will be awarded for operations that
occurred prior to the Court's decision due to the historical reliance by timber
companies on the regulation and the Company's belief that the requirements under
the HCP are adequate to ensure that sediment and pollutants from harvesting
activities on the Company's timberlands will not reach levels harmful to the
environment. While the impact of a conclusion to this case that upholds the
October 14, 2003, ruling may be adverse, the Company does not believe that such
an outcome would have a material adverse impact on the Company's financial
condition, results of operations or liquidity. Nevertheless, due to the numerous
ways in which the Court's interpretation of the regulation could be applied to
actual operations, there can be no assurance that this will be the case.
On November 20, 2002, two similar actions entitled Alan Cook, et al. v.
Gary Clark, et al. (the "Cook action") and Steve Cave, et al. v. Gary Clark, et
al. (the "Cave action") were filed, which also name the Company and certain
affiliates as defendants. On April 4, 2003, the plaintiffs in these actions
filed amended complaints and served the defendants with notice of the actions.
The Cook action alleges, among other things, that defendants' logging practices
have contributed to an increase in flooding along Freshwater Creek (which runs
through the Company's timberlands), resulting in personal injury and damage to
the plaintiffs' properties. Plaintiffs further allege that in order to have THPs
approved in the affected areas, the defendants engaged in certain unfair
business practices. The plaintiffs seek, among other things, compensatory and
exemplary damages, injunctive relief, and appointment of a receiver to ensure
that the watershed is restored. The Cave action contains similar allegations and
requests similar relief with respect to the Elk River watershed (a portion of
which is contained on the Company's timberlands). The Company does not believe
the resolution of these actions should result in a material adverse effect on
its financial condition, results of operations or liquidity.
On February 25, 2003, the District Attorney of Humboldt County filed a
civil suit entitled The People of the State of California v. The Pacific Lumber
Company, Scotia Pacific Holding Company and Salmon Creek Corporation (the
"Humboldt DA action"). The suit was filed under California's unfair competition
law and alleges that the Palco Companies used certain unfair business practices
in connection with completion of the Headwaters Agreement, and that this
resulted in these companies being able to harvest significantly more trees under
the Environmental Plans than would have otherwise been the case. The suit sought
a variety of remedies including a civil penalty of $2,500 for each additional
tree that has been or will be harvested due to this alleged increase in harvest,
as well as restitution and an injunction in respect of the additional timber
harvesting allegedly being conducted. In response to motions filed by the
Company and Palco for sanctions and dismissal of this suit, on April 30, 2004,
the Court issued a ruling requiring the District Attorney to amend his suit to
prove that "extrinsic" fraud occurred. In addition, the Court eliminated the
remedies being sought, other than for civil penalties, and suggested that it
would be inappropriate to base civil penalties on the additional trees
harvested. The Court also ruled that it declined "at this juncture" to impose
sanctions on the District Attorney. The District Attorney subsequently amended
his suit, and the Palco Companies later filed new motions to dismiss and for
sanctions. After delays resulting from the District Attorney's efforts to
disqualify the trial judge, and that judge's later self- disqualification, a
hearing on these motions was held on February 18, 2005. The Court rejected the
sanctions motion, but has not yet ruled on the motion for dismissal. The Company
believes that this suit is without merit and that the April 30, 2004, ruling
diminished significantly its exposure with respect to this matter; however,
there can be no assurance that the Palco Companies will ultimately prevail or
that an adverse outcome would not be material to the Company's financial
condition, results of operations or liquidity.
On December 17, 2003, an action entitled Humboldt Watershed Council, et al.
v. North Coast Regional Water Quality Board, et al. (the "HWC 2003 lawsuit"),
naming the Company and Palco as real parties in interest, was filed. The
plaintiffs allege that the North Coast Water Board should have required waste
discharge reports in respect of all timber harvesting activities in the
Freshwater and Elk River watersheds, including those on the Company Timberlands.
This action has been dismissed by the plaintiffs.
On November 2, 2004, an action entitled Environmental Protection
Information Center v. U.S. Fish & Wildlife Service, NOAA Fisheries, et al.
(the "EPIC-USFWS/NOAA lawsuit") was filed. This lawsuit alleges that two federal
agencies have violated certain federal laws and related regulations in
connection with their oversight of the HCP and Federal Permits. The plaintiff
also alleges that the Federal Permit for the northern spotted owl was unlawfully
issued and that the Company and Palco violated California's unfair competition
law by using false advertising and making misleading environmental claims. The
plaintiff seeks a variety of remedies including requiring additional actions by
the federal agencies and precluding them from authorizing take of the northern
spotted owl, an injunction requiring the Company and Palco to cease certain
alleged unlawful activities, as well as restitution and remediation by the
Company and Palco. The Company does not believe the resolution of this action
should result in a material adverse effect on its financial condition, results
of operations or liquidity.
On November 16, 2001, Palco filed a case entitled The Pacific Lumber
Company, et al. v. California State Water Resources Control Board(the "THP No.
520 lawsuit") alleging that the State Water Board had no legal authority to
impose mitigation measures that were requested by the staff of the North Coast
Water Board during the THP review process and rejected by the CDF prior to
approving the THP. When the staff of the North Coast Water Board attempted to
impose these mitigation measures in spite of the CDF's decision, Palco appealed
to the State Water Board, which imposed certain of the requested mitigation
measures and rejected others. Palco filed the THP No. 520 lawsuit challenging
the State Water Board's decision, and in January 2003, the Superior Court
granted Palco's request for an order invalidating the imposition of these
additional measures. The State Water Board appealed this decision, and on March
18, 2004, the appellate court reversed the decision of the Superior Court. The
appellate court's decision could result in increased demands by the regional and
state water boards and their staffs to impose controls and limitations on
harvesting on the Company's timberlands beyond those provided for by the
Environmental Plans or could provide additional regulatory powers to the
regional and state water boards and their staffs beyond those provided in Senate
Bill 810. Palco filed a petition for review of the appellate court's decision by
the California Supreme Court, which in June 2004 agreed to review the decision.
8. Comprehensive Loss and Member Deficit
Comprehensive loss includes the following (in millions):
Years Ended December 31,
-----------------------------------
2004 2003 2002
--------- --------- --------
Net loss....................................................... $ (19.8) $ (5.3) $ (23.1)
Other comprehensive loss:
Change in value of available-for-sale investments........... (0.6) (0.4) (0.7)
--------- --------- -------
Total comprehensive loss....................................... $ (20.4) $ (5.7) $ (23.8)
========= ========= =======
A reconciliation of the activity in member deficit is as follows (in
millions):
Years Ended December 31,
----------------------------------
2004 2003 2002
----------- --------- ----------
Balance at beginning of period...................................$ (411.2) $ (405.5) $ (352.3)
Comprehensive loss............................................... (20.4) (5.7) (23.8)
Distributions.................................................... - - (29.4)
---------- --------- ----------
Balance at end of period.........................................$ (431.6) $ (411.2) $ (405.5)
========== ========= ==========
9. Quarterly Financial Information (Unaudited)
Summary quarterly financial information for the years ended December 31,
2004 and 2003 is as follows (in millions):
Three Months Ended
-----------------------------------------------------------
March 31 June 30 September 30 December 31
-------------- -------------- -------------- --------------
2004:
Log sales to Palco..................$ 15.9 $ 13.3 $ 21.7 $ 15.5
Operating income.................... 7.9 6.1 12.0 8.4
Net loss............................ (4.7) (7.6) (2.0) (5.5)
2003:
Log sales to Palco..................$ 18.4 $ 15.1 $ 22.4 $ 17.4
Operating income.................... 9.2 8.7 12.6 16.5
Net income (loss)................... (4.8) (3.7) (0.5) 3.7
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Our management is responsible for establishing and maintaining disclosure
controls and procedures that are designed to ensure that information required to
be disclosed in the Company's reports under the Securities Exchange Act of 1934
is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the Securities and Exchange Commission, and
that such information is accumulated and communicated to our management,
including our Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required disclosure. In
designing and evaluating the disclosure controls and procedures, management
recognized that any controls and procedures, no matter how well designed and
operated, can provide only reasonable assurance of achieving the desired control
objectives, and management necessarily was required to apply its judgment in
evaluating the cost-benefit relationship of possible controls and procedures.
As of the end of the period covered by this report, our management carried
out an evaluation, under the supervision and with the participation of our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the Company's disclosure controls and procedures. Based
on the evaluation, our management, including our Chief Executive Officer and
Chief Financial Officer, concluded that the Company's disclosure controls and
procedures were effective as of December 31, 2004.
Changes in Internal Control over Financial Reporting
Since September 30, 2004, there have been no changes in the Company's
internal controls over financial reporting that materially affected or are
reasonably likely to materially affect the internal controls over financial
reporting.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEMS 10-13.
Not applicable.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table sets forth the aggregate fees billed to the Company for
professional services provided in 2004 and 2003 by Deloitte & Touche LLP
("Deloitte"), the Company's independent auditor and principal accounting firm:
Years Ended December 31,
---------------------------------
2004 2003
---------------- ----------------
Audit Fees(1)..............................................$ 110,670 $ 100,000
Audit-Related Fees......................................... - -
Tax Fees................................................... - -
All Other Fees............................................. - -
---------------- ----------------
Total...................................................$ 110,670 $ 100,000
================ ================
- ------------------------------------
(1) Consists of professional services rendered for the audit of the annual
financial statements of the Company and for the review of the quarterly
financial statements of the Company.
The Company is an indirect wholly owned subsidiary of MAXXAM. As such, the
Audit Committee of MAXXAM's Board of Directors (the "Audit Committee") is
charged with the oversight responsibility as to the audit process of the
Company. The Audit Committee has responsibility for appointing, setting
compensation and overseeing the work of the independent auditor. In recognition
of this responsibility, the Audit Committee's Charter requires pre-approval by
the Audit Committee of all audit and non-audit services to be furnished by the
independent auditor to the Company. Pre- approval is waived in those instances
permitted by applicable SEC regulation so long as the Audit Committee
subsequently approves such services within any applicable deadline. None of the
foregoing services were approved by the Audit Committee pursuant to the
provisions of Section 2-01(c)(7)(i)(C) of SEC Regulation S-X.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Index to Financial Statements
1. Financial Statements (included under Item 8):
Report of Independent Registered Public Accounting Firm
Balance Sheet at December 31, 2004 and 2003
Statement of Loss for the Years Ended December 31, 2004, 2003 and 2002
Statement of Cash Flows for the Years Ended December 31, 2004, 2003
and 2002
Notes to Financial Statements
2. Financial Statement Schedules:
Schedules are inapplicable or the required information is included in the
financial statements or the notes thereto.
(b) Exhibits
Reference is made to the Index of Exhibits immediately preceding the
exhibits hereto (beginning on page 40), which index is incorporated herein by
reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
SCOTIA PACIFIC COMPANY LLC
Date: March 16, 2005 By: ROBERT E. MANNE
------------------------------------------
Robert E. Manne
President and Chief Executive Officer
(Principal 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 16, 2005 By: J. KENT FRIEDMAN
------------------------------------------
J. Kent Friedman
Manager
Date: March 16, 2005 By: EZRA G. LEVIN
------------------------------------------
Ezra G. Levin
Manager
Date: March 16, 2005 By: ROBERT E. MANNE
------------------------------------------
Robert E. Manne
Manager
Date: March 16, 2005 By: PAUL N. SCHWARTZ
------------------------------------------
Paul N. Schwartz
Manager
Date: March 16, 2005 By: JACK M. WEBB
------------------------------------------
Jack M. Webb
Independent Manager
Date: March 16, 2005 By: SID C. WEISS
------------------------------------------
Sid C. Weiss
Independent Manager
Date: March 16, 2005 By: GARY L. CLARK
------------------------------------------
Gary L. Clark
Vice President - Finance and Administration
(Principal Financial and Accounting Officer)
INDEX OF EXHIBITS
Exhibit
Number Description
3.1 Certificate of Formation of the Company (incorporated herein by
reference to Exhibit 3.1 to the Company's Registration Statement on
Form S-4 dated September 21, 1998; Registration No. 333- 63825; the
"Company's Form S-4")
3.2 Agreement of Limited Liability Company of the Company (incorporated
herein by reference to Exhibit 3.2 to the Company's Form S-4)
4.1 Indenture, dated July 20, 1998, between the Company and State Street
Bank and Trust Company ("State Street") regarding the Timber Notes
(incorporated herein by reference to Exhibit 4.1 to the Quarterly
Report on Form 10-Q of MAXXAM Inc. for the quarter ended June 30,
1998; File No. 1-3924; the "MAXXAM June 1998 Form 10-Q")
4.2 First Supplemental Indenture, dated July 16, 1999, to the Indenture
(incorporated herein by reference to Exhibit 4.1 to the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1999; the
"Company June 1999 Form 10-Q")
4.3 Second Supplemental Indenture, dated November 18, 1999, to the
Indenture (incorporated herein by reference to Exhibit 99.3 to the
Company's Report on Form 8-K dated November 19, 1999)
4.4 Credit Agreement, dated July 20, 1998, among the Company, the
financial institutions party thereto and Bank of America National
Trust and Savings Association, as agent (incorporated herein by
reference to Exhibit 4.3 to the MAXXAM June 1998 Form 10-Q)
4.5 First Amendment, dated July 16, 1999, to the Credit Agreement
(incorporated herein by reference to the Company June 1999 Form 10-Q)
4.6 Second Amendment, dated June 15, 2001, to the Credit Agreement
(incorporated herein by reference to Exhibit 4.1 to the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 2001)
4.7 Third Amendment, dated June 30, 2003, to the Credit Agreement
(incorporated herein by reference to Exhibit 4.1 to the Company's Form
10-Q for the quarter ended June 30, 2003)
4.8 Deed of Trust, Security Agreement, Financing Statement, Fixture Filing
and Assignment of Proceeds, dated July 20, 1998, among the Company,
Fidelity National Title Insurance Company, as trustee, and State
Street, as collateral agent (incorporated herein by reference to
Exhibit 4.2 to the MAXXAM June 1998 Form 10-Q)
10.1 New Master Purchase Agreement, dated July 20, 1998, between the
Company and Palco (incorporated herein by reference to Exhibit 10.1 to
the Quarterly Report on Form 10-Q of MAXXAM Group Holdings Inc. for
the quarter ended June 30, 1998; File No. 333-18723; the "MGHI June
1998 Form 10-Q")
10.2 New Services Agreement, dated July 20, 1998, between Palco and the
Company (incorporated herein by reference to Exhibit 10.2 to the MGHI
June 1998 Form 10-Q)
10.3 New Additional Services Agreement, dated July 20, 1998, between the
Company and Palco (incorporated herein by reference to Exhibit 10.3 to
the MGHI June 1998 Form 10-Q)
10.4 New Reciprocal Rights Agreement, dated July 20, 1998, among Palco, the
Company and Salmon Creek Corporation ("Salmon Creek") (incorporated
herein by reference to Exhibit 10.4 to the MGHI June 1998 Form 10-Q)
10.5 New Environmental Indemnification Agreement, dated July 20, 1998,
between Palco and the Company (incorporated herein by reference to
Exhibit 10.5 to the MGHI June 1998 Form 10-Q)
10.6 Implementation Agreement with Regard to Habitat Conservation Plan for
the properties of Palco, the Company and Salmon Creek, dated March 1,
1999, by and among the United States Department of the Interior Fish
and Wildlife Service ("USFWS"), the National Marine Fisheries Service,
the California Department of Fish and Game ("CDF&G"), the CDF and
Pacific Lumber, Salmon Creek and the Company (incorporated herein by
reference to Exhibit 99.3 to the Company's Form 8-K dated March 19,
1999; the "Company March 19, 1999 Form 8-K")
10.7 Agreement Relating to Enforcement of AB 1986, dated February 25, 1999,
by and among The California Resources Agency, CDF&G, the CDF, The
California Wildlife Conservation Board, Palco, Salmon Creek and the
Company (incorporated herein by reference to Exhibit 99.4 to the
Company March 19, 1999 Form 8-K)
10.8 Habitat Conservation Plan, dated March 1, 1999 (incorporated herein by
reference to Exhibit 99.5 to the Company March 19, 1999 Form 8-K)
10.9 Letter, dated February 25, 1999, from the CDF to Palco (incorporated
herein by reference to Exhibit 99.8 to the Company March 19, 1999 Form
8-K)
10.10 Letter, dated March 1, 1999, from the CDF to Palco (incorporated
herein by reference to Exhibit 99.9 to the Company March 19, 1999 Form
8-K)
10.11 Letter, dated March 1, 1999, from the USFWS and the U.S. Department of
Commerce National Oceanic and Atmospheric Administration to Palco,
Salmon Creek and the Company (incorporated herein by reference to
Exhibit 99.10 to the Company March 19, 1999 Form 8-K)
*31.1 Section 302 Certification of Chief Executive Officer
*31.2 Section 302 Certification of Chief Financial Officer
*32.1 Section 906 Certification of Chief Executive Officer
*32.2 Section 906 Certification of Chief Financial Officer