UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

W. R. GRACE & CO.

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 o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o                                    Accelerated filer x                             Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o	No x

68,260,965 shares of Common Stock, $0.01 par value, were outstanding at October 31, 2006.

 

W. R. GRACE & CO. AND SUBSIDIARIES

Table of Contents

									Page No.
Part I.						Financial Information
Item 1.						Financial Statements		I-1
						Report of Independent Registered Public Accounting Firm		I-2
						Consolidated Statements of Operations		I-3
						Consolidated Statements of Cash Flows		I-4
						Consolidated Balance Sheets		I-5
						Consolidated Statements of Shareholders’ Equity (Deficit)		I-6
						Consolidated Statements of Comprehensive Income (Loss)		I-6
						Notes to Consolidated Financial Statements		I-7
Item 2.						Management’s Discussion and Analysis of Financial Condition and Results of Operations		I-29
Item 3.						Quantitative and Qualitative Disclosures About Market Risk		I-48
Item 4.						Controls and Procedures		I-51
Part II.						Other Information
Item 1.						Legal Proceedings		II-1
Item 1A.						Risk Factors		II-1
Item 6.						Exhibits		II-1

 

 

PART I.  FINANCIAL INFORMATION

Item 1.                          FINANCIAL STATEMENTS

Review by Independent Registered Public Accounting Firm

With respect to the interim consolidated financial statements included in this Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2006 and 2005, PricewaterhouseCoopers LLP, the company’s independent registered public accounting firm, has applied limited procedures in accordance with professional standards for a review of such information.  Their report on the interim consolidated financial statements, which follows, states that they did not audit and they do not express an opinion on the unaudited interim financial statements.  Accordingly, the degree of reliance on their report on the unaudited interim financial statements should be restricted in light of the limited nature of the review procedures applied.  This report is not considered a “report” within the meaning of Sections 7 and 11 of the Securities Act of 1933, and, therefore, the independent accountants’ liability under Section 11 does not extend to it.

 

I-1

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors of W. R. Grace & Co.:

We have reviewed the accompanying consolidated balance sheet of W. R. Grace & Co. and its subsidiaries as of September 30, 2006, and the related consolidated statements of operations, shareholders’ equity (deficit) and comprehensive income (loss) for each of the three-month and nine-month periods ended September 30, 2006 and September 30, 2005 and the consolidated statements of cash flows for the nine-month periods ended September 30, 2006 and September 30, 2005. These interim financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying interim consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

The accompanying interim consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  As discussed in Notes 1 and 2 to the interim consolidated financial statements, on April 2, 2001, the Company and substantially all of its domestic subsidiaries voluntarily filed for protection under Chapter 11 of the United States Bankruptcy Code, which raises substantial doubt about the Company’s ability to continue as a going concern in its present form.  Management’s intentions with respect to this matter are also described in Notes 1 and 2.  The accompanying interim consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2005, and the related consolidated statements of operations, cash flows, shareholders’ equity (deficit) and comprehensive income (loss) for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 and the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005; and in our report dated March 10, 2006, we expressed (i) an unqualified opinion on those consolidated financial statements with an explanatory paragraph relating to the Company’s ability to continue as a going concern and, (ii) unqualified opinions on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and on the effectiveness of the Company’s internal control over financial reporting. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2005, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.

/s/ PRICEWATERHOUSECOOPERS LLP
McLean, Virginia
November 8, 2006

 

I-2

W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Operations (Unaudited)
In millions, except per share amounts

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Net sales		$	741.4		$	653.4		$	2,129.1		$	1,933.1
Cost of goods sold, exclusive of depreciation and amortization shown separately below		483.8			426.0			1,392.0			1,258.4
Selling, general and administrative expenses, exclusive of net pension expense and depreciation and amortization shown separately below		148.6			109.5			418.3			344.9
Depreciation and amortization		29.2			30.5			85.7			91.2
Research and development expenses		15.5			14.9			46.1			45.1
Net pension expense		15.9			17.3			47.5			54.4
Interest expense and related financing costs		18.8			13.4			54.5			41.3
Provision for environmental remediation		—			—			30.0			—
Other (income) expense		(6.3		)	(4.4		)	(22.1		)	(34.4		)
		705.5			607.2			2,052.0			1,800.9
Income (loss) before Chapter 11 expenses, income taxes, and minority interest		35.9			46.2			77.1			132.2
Chapter 11 expenses, net		(12.0		)	(9.3		)	(32.2		)	(19.9		)
Income (loss) before income taxes and minority interest		23.9			36.9			44.9			112.3
Benefit from (provision for) income taxes		2.4			2.6			(5.4		)	(26.0		)
Minority interest in consolidated entities		(7.9		)	(7.4		)	(26.2		)	(18.4		)
Net income (loss)		$	18.4		$	32.1		$	13.3		$	67.9
Basic earnings (loss) per share:
Net income (loss)		$	0.27		$	0.48		$	0.20		$	1.02
Weighted average number of basic shares		68.3			66.9			67.7			66.8
Diluted earnings (loss) per share:
Net income (loss)		$	0.27		$	0.48		$	0.20		$	1.01
Weighted average number of diluted shares		68.5			67.2			68.1			67.3

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

I-3

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W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Cash Flows (Unaudited)
In millions

		Nine Months Ended September 30,
		2006			2005
OPERATING ACTIVITIES
Net income (loss)		$	13.3		$	67.9
Reconciliation to net cash provided by (used for) operating activities:
Chapter 11 expenses, net		32.2			19.9
(Benefit from) provision for income taxes		5.4			26.0
Minority interest in consolidated entities		26.2			18.4
Depreciation and amortization		85.7			91.2
Interest accrued on pre-petition liabilities subject to compromise		53.1			37.7
Net (gain) loss on sales of investments and disposals of assets		(2.6		)	(0.2		)
Loss on sale of business		—			1.1
Net pension expense		47.5			54.4
Payments to fund defined benefit pension arrangements		(109.5		)	(32.8		)
Net income from life insurance policies		(2.2		)	(1.6		)
Provision for uncollectible receivables		3.2			2.2
Provision for environmental remediation		30.0			—
Payments under postretirement benefit plans		(10.7		)	(8.3		)
Expenditures for environmental remediation		(8.7		)	(4.7		)
Expenditures for retained obligations of divested businesses		(2.7		)	(0.7		)
Changes in assets and liabilities, excluding effect of businesses acquired/divested and foreign currency translation:
Working capital items (trade accounts receivable, inventories and accounts payable)		(59.7		)	(60.8		)
Other accruals and non-cash items		11.5			(33.4		)
Income taxes paid, net of refunds		(36.2		)	(27.8		)
Net cash provided by (used for) operating activities before Chapter 11 expenses and settlement of noncore contingencies		75.8			148.5
Cash paid to settle noncore contingencies		—			(119.7		)
Chapter 11 expenses paid		(26.4		)	(14.0		)
Net cash provided by (used for) operating activities		49.4			14.8
INVESTING ACTIVITIES
Capital expenditures		(82.5		)	(59.2		)
Businesses acquired, net of cash acquired		(20.0		)	(2.5		)
Proceeds from termination of life insurance policies		—			14.8
Net investment in life insurance policies		0.2			0.4
Proceeds from sales of investments and disposals of assets		7.3			1.7
Proceeds from sale of business		—			4.5
Net cash provided by (used for) investing activities		(95.0		)	(40.3		)
FINANCING ACTIVITIES
Net payments of loans secured by cash value of life insurance policies		(0.1		)	(0.5		)
Net (repayments) borrowings under credit arrangements		0.5			(9.7		)
Fees under debtor-in-possession credit facility		(1.8		)	(1.5		)
Proceeds from exercise of stock options		15.8			3.1
Net cash provided by (used for) financing activities		14.4			(8.6		)
Effect of currency exchange rate changes on cash and cash equivalents		10.2			(12.8		)
Increase (decrease) in cash and cash equivalents		(21.0		)	(46.9		)
Cash and cash equivalents, beginning of period		474.7			510.4
Cash and cash equivalents, end of period		$	453.7		$	463.5

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

 

I-4

W. R. Grace & Co. and Subsidiaries
Consolidated Balance Sheets (Unaudited)
In millions, except par value and shares

 

		September 30,			December 31,
		2006			2005
ASSETS
Current Assets
Cash and cash equivalents		$	453.7		$	474.7
Trade accounts receivable, less allowance of $7.3 (2005–$5.0)		486.5			401.7
Inventories		287.4			278.3
Deferred income taxes		29.3			27.3
Other current assets		56.3			71.6
Total Current Assets		1,313.2			1,253.6
Properties and equipment, net of accumulated depreciation and amortization of $1,504.8 (2005–$1,420.2)		650.8			632.9
Goodwill		114.0			103.9
Cash value of life insurance policies, net of policy loans		86.9			84.8
Deferred income taxes		737.2			703.9
Asbestos-related insurance		500.0			500.0
Other assets		238.6			238.1
Total Assets		$	3,640.7		$	3,517.2
LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)
Liabilities Not Subject to Compromise
Current Liabilities
Debt payable within one year		$	3.2		$	2.3
Accounts payable		179.8			166.8
Income taxes payable		5.8			10.1
Other current liabilities		222.4			197.9
Total Current Liabilities		411.2			377.1
Debt payable after one year		0.4			0.4
Deferred income taxes		63.2			54.3
Minority interest in consolidated affiliates		63.6			36.4
Unfunded defined benefit pension liability		392.6			447.5
Other liabilities		42.2			41.7
Total Liabilities Not Subject to Compromise		973.2			957.4
Liabilities Subject to Compromise—Note 2		3,211.6			3,155.1
Total Liabilities		4,184.8			4,112.5
Commitments and Contingencies
Shareholders’ Equity (Deficit)
Common stock issued, par value $0.01; 300,000,000 shares authorized; outstanding: 2006–68,260,065 (2005–66,922,196)		0.8			0.8
Paid-in capital		423.2			423.4
Accumulated deficit		(492.6		)	(505.9		)
Treasury stock, at cost: shares: 2006–8,719,695; (2005–10,057,564)		(103.8		)	(119.7		)
Accumulated other comprehensive income (loss)		(371.7		)	(393.9		)
Total Shareholders’ Equity (Deficit)		(544.1		)	(595.3		)
Total Liabilities and Shareholders’ Equity (Deficit)		$	3,640.7		$	3,517.2

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

I-5

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W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Shareholders’ Equity (Deficit) (Unaudited)
In millions

 

		Common Stock and Paid-in Capital			Accumulated Deficit			Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity (Deficit)
Balance, June 30, 2006		$	424.0		$	(511.0	)	$	(103.8	)	$	(379.6	)	$	(570.4	)
Net income (loss)		—			18.4			—			—			18.4
Stock plan activity		—			—			—			—			—
Other comprehensive income (loss)		—			—			—			7.9			7.9
Balance, September 30, 2006		$	424.0		$	(492.6	)	$	(103.8	)	$	(371.7	)	$	(544.1	)
Balance, December 31, 2005		$	424.2		$	(505.9	)	$	(119.7	)	$	(393.9	)	$	(595.3	)
Net income (loss)		—			13.3			—			—			13.3
Stock plan activity		(0.2		)	—			15.9			—			15.7
Other comprehensive income (loss)		—			—			—			22.2			22.2
Balance, September 30, 2006		$	424.0		$	(492.6	)	$	(103.8	)	$	(371.7	)	$	(544.1	)

 

W. R. Grace & Co. and Subsidiaries
Consolidated Statements of Comprehensive Income (Loss) (Unaudited)
In millions

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Net income (loss)		$	18.4		$	32.1		$	13.3		$	67.9
Other comprehensive income (loss):
Foreign currency translation adjustments		8.3			(0.9		)	22.9			(23.3		)
Commodity hedging activities		(0.4		)	—			(0.7		)	—
Total other comprehensive income (loss)		7.9			(0.9		)	22.2			(23.3		)
Comprehensive income (loss)		$	26.3		$	31.2		$	35.5		$	44.6

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

 

I-6

W. R. Grace & Co. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)

1.              Basis of Presentation and Summary of Significant Accounting and Financial Reporting Policies

W. R. Grace & Co., through its subsidiaries, is engaged in specialty chemicals and specialty materials businesses on a worldwide basis through two operating segments: “Grace Davison,” which includes silica- and alumina-based catalysts and materials used in a wide range of industrial applications; and “Grace Performance Chemicals,” which includes specialty chemicals and materials used in commercial and residential construction and in rigid food and beverage packaging.

W. R. Grace & Co. conducts substantially all of its business through a direct, wholly-owned subsidiary, W. R. Grace & Co.-Conn. (“Grace-Conn.”). Grace-Conn. owns substantially all of the assets, properties and rights of W. R. Grace & Co. on a consolidated basis, either directly or through subsidiaries.

As used in these notes, the term “Company” refers to W. R. Grace & Co. The term “Grace” refers to the Company and/or one or more of its subsidiaries and, in certain cases, their respective predecessors.

Voluntary Bankruptcy Filing—During 2000 and the first quarter of 2001, Grace experienced several adverse developments in its asbestos-related litigation, including: a significant increase in personal injury claims, higher than expected costs to resolve personal injury and certain property damage claims, and class action lawsuits alleging damages from Zonolite Attic Insulation (“ZAI”) a former Grace attic insulation product.

After a thorough review of these developments, the Board of Directors concluded that a federal court-supervised bankruptcy process provided the best forum available to achieve fairness in resolving these claims and on April 2, 2001 (the “Filing Date”), Grace and 61 of its United States subsidiaries and affiliates, including Grace-Conn. (collectively, the “Debtors”), filed voluntary petitions for reorganization (the “Filing”) under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). The cases were consolidated and are being jointly administered under case number 01-01139 (the “Chapter 11 Cases”). Grace’s non-U.S. subsidiaries and certain of its U.S. subsidiaries were not included in the Filing.

Under Chapter 11, the Debtors have continued to operate their businesses as debtors-in-possession under court protection from creditors and claimants, while using the Chapter 11 process to develop and implement a plan for addressing the asbestos-related claims. Since the Filing, all motions necessary to conduct normal business activities have been approved by the Bankruptcy Court. (See Note 2 for Chapter 11-Related Information.)

Basis of Presentation—The interim Consolidated Financial Statements presented herein are unaudited and should be read in conjunction with the Consolidated Financial Statements presented in the Company’s 2005 Annual Report on Form 10-K.  Such interim Consolidated Financial Statements reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of the interim periods presented; all such adjustments are of a normal recurring nature. Potential accounting adjustments discovered during normal reporting and accounting processes are evaluated on the basis of materiality, both individually and in the aggregate, and are recorded in the accounting period discovered, unless a restatement of a prior period is necessary. All significant intercompany accounts and transactions have been eliminated.

The results of operations for the three-month and nine-month interim periods ended September 30, 2006 are not necessarily indicative of the results of operations for the year ending December 31, 2006.

Reclassifications—Certain amounts in prior years’ Consolidated Financial Statements have been reclassified to conform to the 2006 presentation.  Such reclassifications have not materially affected previously reported amounts in the Consolidated Financial Statements.

Use of Estimates—The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires that management make estimates and assumptions affecting the assets and liabilities reported at the date of the Consolidated Financial Statements, and the revenues and expenses reported for the periods presented. Actual amounts could differ from those estimates, and the differences could be

I-7

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material.  Changes in estimates are recorded in the period identified. Grace’s accounting measurements that are most affected by management’s estimates of future events are:

·                  Contingent liabilities which depend on an assessment of the probability of loss and an estimate of ultimate resolution cost, such as asbestos-related matters (see Notes 2 and 3), environmental remediation (see Note 12), income taxes (see Note 12), and litigation (see Note 12);

·                  Pension and postretirement liabilities that depend on assumptions regarding participant life spans, future inflation, discount rates and total returns on invested funds (see Note 13);

·                  Liabilities for employee incentive compensation and customer rebates that depend on estimates of future sales or earnings;

·                  Depreciation and amortization periods for long-lived assets, including property and equipment, intangible, and other assets that depend on utilization assessments, future product and production plans and expected sales and cash flows; and

·                  Realization values of various assets such as net deferred tax assets, trade receivables, inventories, insurance receivables, properties and equipment, and goodwill which depend on assessments of credit and other business risks, and projections of future income and cash flows.

The accuracy of these and other estimates may also be materially affected by the uncertainties arising under Grace’s Chapter 11 proceeding.

Effect of New Accounting Standards—In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.”  SFAS No. 158 requires an employer to recognize the funded status of defined benefit pension plans and other postretirement benefit plans as an asset or liability in its statement of financial position, and requires recognition in other comprehensive income of gains or losses and prior service costs or credits arising during the period but which are not included as components of net periodic benefit cost.  SFAS No. 158 is effective for the year ending December 31, 2006.  Grace is not currently able to quantify the estimated effects of the adoption of SFAS No. 158 to its statement of financial position, as actual amounts will depend on year-end assumptions and calculations.  If Grace had adopted SFAS No. 158 effective December 31, 2005, Grace estimates that, after tax effects, reported total assets would have decreased by approximately $55 million, reported total liabilities would have increased by approximately $43 million, and reported total shareholders’ deficit would have increased by approximately $98 million.  Grace does not expect adoption of SFAS No. 158 to have a material impact on its consolidated results of operations.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which prescribes a recognition threshold and measurement attribute for tax positions taken or expected to be taken in tax returns.  FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.  Grace is required to adopt FIN 48 in the first quarter of 2007, and is currently evaluating the impact to its Consolidated Financial Statements.

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment,” to require companies to measure and recognize in operations the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. The provisions of this standard are effective for Grace in 2006. Grace implemented SFAS 123(R) in the first quarter of 2006. Under the transition method selected by Grace, the modified prospective method, the only outstanding awards affected were stock appreciation rights granted to Grace’s former Chief Executive Officer. Grace measured the award at a fair value of $2.6 million using the Black-Scholes option pricing model at March 31, 2006 and recorded that amount as compensation cost (included in selling, general and administrative expenses) in the quarter ended March 31, 2006.  Grace recognized a $0.6 million decrease and a $0.4 million increase in the fair value of the stock appreciation rights in the quarters ended June 30, 2006 and September 30, 2006, respectively.  The cumulative effect of this new rule was $1.4 million

I-8

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at the beginning of the first quarter of 2006. Grace has not granted equity options or rights while in Chapter 11.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs—an Amendment of ARB No. 43, Chapter 4,” to provide clarification that abnormal amounts of idle facility expense, freight, handling costs, and wasted material be recognized as current-period costs. In addition, this standard requires that the allocation of fixed production overheads to the costs of inventory be based on the normal capacity of the production facilities.  Grace adopted this standard in 2006 and it has not had a material impact on Grace’s Consolidated Financial Statements.

 

2.         Chapter 11-Related Information

Official Parties to Grace’s Chapter 11 Proceedings—Three creditors’ committees, two representing asbestos claimants and the third representing other unsecured creditors, and a committee representing shareholders, have been appointed in the Chapter 11 Cases. These committees, and a legal representative of future asbestos claimants, have the right to be heard on all matters that come before the Bankruptcy Court and are likely to play important roles in the Chapter 11 Cases. The Debtors are required to bear certain costs and expenses of the committees and of the representative of future asbestos claimants, including those of their counsel and financial advisors.

Plan of Reorganization—On November 13, 2004 Grace filed a plan of reorganization, as well as several associated documents, including a disclosure statement, with the Bankruptcy Court.  On January 13, 2005, Grace filed an amended plan of reorganization (the “Plan”) and related documents to address certain objections of creditors and other interested parties. The Plan is supported by committees representing general unsecured creditors and equity holders, but is not supported by committees representing asbestos personal injury claimants and asbestos property damage claimants or the representative of future asbestos claimants.

Under the terms of the Plan, a trust would be established under Section 524(g) of the Bankruptcy Code to which all pending and future asbestos-related claims would be channeled for resolution.  Grace has requested that the Bankruptcy Court conduct an estimation hearing to, among other things, determine the amount that would need to be paid into the trust on the effective date of the Plan to satisfy the estimated liability for all classes of asbestos claimants and trust administration costs and expenses over time. The Plan provides that Grace’s asbestos-related liabilities would be satisfied using cash and securities from Grace and third parties.

The Plan will become effective only after a vote of eligible creditors and with the approval of the Bankruptcy Court and the U.S. District Court for the District of Delaware. Votes on the Plan may not be solicited until the Bankruptcy Court approves the disclosure statement. The Bankruptcy Court has currently deferred consideration of the disclosure statement and Plan until after completion of estimation hearings on the amount of Grace’s asbestos-related liability. The Debtors have received extensions of their exclusive right to propose a plan of reorganization through July 23, 2007.  The asbestos claimants committees and the representative of future asbestos claimants have appealed the latest extension of exclusivity to the U.S. District Court for the District of Delaware.

Under the terms of the Plan, claims would be satisfied under the Chapter 11 Cases as follows:

Asbestos-Related Claims and Costs

A trust would be established under Section 524(g) of the Bankruptcy Code to which all pending and future asbestos-related claims would be channeled for resolution.  The trust would utilize specified trust distribution procedures to satisfy the following allowed asbestos-related claims and costs:

1.                           Personal injury claims that meet specified exposure and medical criteria (Personal Injury—Symptomatic Eligible or “PI-SE” Claims)—In order to qualify for this class, claimants would have to prove that their health is impaired from meaningful exposure to asbestos-containing products formerly manufactured by Grace.

2.                           Personal injury claims that do not meet the exposure and medical criteria necessary to qualify as PI-SE Claims (Personal Injury-Asymptomatic and Other or “PI-AO” Claims)—This class would contain all asbestos-related personal injury claims against Grace that do not meet the specific requirements to be PI-SE Claims, but do meet certain other specified exposure and medical criteria.

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3.                           Property damage claims, including claims related to ZAI (“PD Claims”)—In order to qualify for this class, claimants would have to prove Grace liability for loss of property value or remediation costs related to products formerly manufactured by Grace that claimants allege contained asbestos.

4.                           Trust administration costs and legal expenses

The pending asbestos-related legal proceedings are described in “Asbestos-Related Litigation” (see Note 3). The claims arising from such proceedings would be subject to this classification process as part of the Plan.

The Bankruptcy Court has entered separate case management orders for estimating liability for pending and future personal injury claims and adjudicating pending property damage claims, excluding ZAI claims. Trial dates for estimating liability for personal injury claims have been scheduled for June 2007.  Hearings for the adjudication of various issues regarding property damage claims are currently scheduled to take place during the first and second quarters of 2007.  The Debtors expect that the estimated liability will provide the basis for determining the Funding Amount to be paid into the trust on the effective date of the Plan.

Asbestos personal injury claimants, including both PI-SE and PI-AO claims, would have the option either to litigate their claims against the trust in federal court in Delaware or, if they meet specified eligibility criteria, accept a settlement amount based on the severity of their condition. Asbestos property damage claimants would be required to litigate their claims against the trust in federal court in Delaware. The Plan provides that, as a condition precedent to confirmation, the maximum estimated aggregate funding amount for all asbestos-related liabilities (PI-SE, PI-AO and PD including ZAI) and trust administration costs and expenses as determined by the Bankruptcy Court cannot exceed $1,613 million, which Grace believes would fund over $2 billion in claims, costs and expenses over time.

The PI-SE Claims, the PD Claims and the related trust administration costs and expenses would be funded with (1) a payment of $512.5 million in cash (plus interest at 5.5% compounded annually from December 21, 2002) and nine million shares of common stock of Sealed Air Corporation (“Sealed Air”) to be made directly by Cryovac, Inc., a wholly owned subsidiary of Sealed Air (“Cryovac”), to the asbestos trust pursuant to the terms of a settlement agreement resolving asbestos-related, successor liability and fraudulent transfer claims against Sealed Air and Cryovac and (2) Grace common stock. The number of shares of Grace common stock required to satisfy these claims will depend on the price of Grace common stock on the effective date of the Plan, liability measures approved by the Bankruptcy Court, and the value of the Sealed Air settlement, which changes daily with the accrual of interest and the trading value of Sealed Air common stock. The Sealed Air settlement agreement has been approved by the Bankruptcy Court, but remains subject to the fulfillment of specified conditions.

The PI-AO Claims would be funded with warrants exercisable for that number of shares of Grace common stock which, when added to the shares issued directly to the trust on the effective date of the Plan, would represent 50.1% of Grace’s voting securities. If the common stock issuable upon exercise of the warrants is insufficient to pay all PI-AO Claims (the liability for which is uncapped under the Plan), then Grace would pay any additional liabilities in cash.

The amounts to fund PI-SE Claims, PD Claims and the expense of trust administration would be capped at the amount determined by the Bankruptcy Court. Amounts required to fund PI-AO Claims would not be capped, so if the amount funded in respect thereof later proved to be inadequate, Grace would be responsible for contributing additional funds into the asbestos trust to satisfy PI-AO Claims.  Because of the number and nature of the uncertainties involved, Grace is unable to determine the extent to which, if any, the liability for PI-AO claims may exceed the amount funded into the trust in respect thereof.

Other Claims

The Plan provides that all allowed administrative or priority claims would be paid 100% in cash and all general unsecured claims, other than those covered by the asbestos trust, would be paid 85% in cash and 15% in Grace common stock. Grace estimates that claims with a recorded value of approximately $1,227 million, including interest accrued through September 30, 2006, would be satisfied in this manner at the effective date of the Plan. Grace would finance these payments with cash on hand, cash from Fresenius Medical Care Holdings, Inc. (“Fresenius”) paid in settlement of asbestos and other Grace-related claims, new

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Grace debt, and Grace common stock.  Grace would satisfy other non-asbestos related liabilities and claims (primarily certain environmental, tax, pension and retirement medical obligations) as they become due and payable over time using cash flow from operations, insurance proceeds from policies and settlement agreements covering asbestos-related liabilities, and new credit facilities. Proceeds from available product liability insurance applicable to asbestos-related claims would supplement operating cash flow to service new debt and liabilities not paid on the effective date of the Plan.

Effect on Grace Common Stock

The Plan provides that Grace common stock will remain outstanding at the effective date of the Plan, but that the interests of existing shareholders would be subject to dilution by additional shares of common stock issued under the Plan. In addition, in order to preserve significant tax benefits from net operating loss carryforwards (“NOLs”) and certain future deductions, which are subject to elimination or limitation in the event of a change in control (as defined by the Internal Revenue Code) of Grace, the Plan places restrictions on the purchase of Grace common stock. The restrictions would prohibit (without the consent of Grace), for a period of three years after the effective date of the Plan, a person or entity from acquiring more than 4.75% of the outstanding Grace common stock or, for those persons already holding more than 4.75%, prohibit them from increasing or decreasing their holdings. The Bankruptcy Court has also approved the trading restrictions described above, excluding the restriction on sales, until the effective date of the Plan.

Grace intends to address all pending and future asbestos-related claims and all other pre-petition claims as outlined in the Plan. However, Grace may not be successful in obtaining approval of the Plan by the Bankruptcy Court and other interested parties. For example, the asbestos creditors committees and representative of future asbestos claimants have challenged the confirmability of the Plan, arguing that the Plan impairs the rights of asbestos creditors and impermissibly denies them voting rights, and have asserted that Grace’s asbestos-related liabilities exceed the fair value of Grace’s assets.  As a result of these challenges and other Bankruptcy Court rulings, a materially different plan of reorganization may ultimately be approved and, under the ultimate plan of reorganization, the interests of the Company’s shareholders could be substantially diluted or cancelled. The value of Grace common stock following a plan of reorganization, and the extent of any recovery by non-asbestos-related creditors, will depend principally on the allowed value of Grace’s asbestos-related claims as determined by the Bankruptcy Court.

Claims Filings—The Bankruptcy Court established a bar date of March 31, 2003 for claims of general unsecured creditors, asbestos-related property damage claims (other than ZAI claims) and medical monitoring claims related to asbestos. The bar date did not apply to asbestos-related personal injury claims or claims related to ZAI, which will be dealt with separately.

Approximately 14,900 proofs of claim were filed by the March 31, 2003 bar date. Of these claims, approximately 9,400 were non-asbestos related, approximately 4,300 were for asbestos-related property damage, and approximately 1,000 were for medical monitoring. The medical monitoring claims were made by individuals who allege exposure to asbestos through Grace’s products or operations. These claims, if sustained, would require Grace to fund ongoing health monitoring costs for qualified claimants. In addition, approximately 800 proofs of claim were filed after the bar date.

Approximately 7,000 of the non-asbestos related claims involve claims by employees or former employees for future retirement benefits such as pension and retiree medical coverage. Grace views most of these claims as contingent and has proposed a plan of reorganization that would retain such benefits. The other non-asbestos related claims include claims for payment of goods and services, taxes, product warranties, principal and interest under pre-petition credit facilities, amounts due under leases and other contracts, leases and other executory contracts rejected in the Bankruptcy Court, environmental remediation, indemnification or contribution to actual or potential co-defendants in asbestos-related and other litigation, pending non-asbestos-related litigation, and non-asbestos-related personal injury.

The Debtors have analyzed the claims as filed and have found that many are duplicates, represent the same claim filed against more than one of the Debtors, lack any supporting documentation, or provide insufficient supporting documentation. As of September 30, 2006, the Debtors had filed objections to approximately 5,500 claims (approximately 100 of which were subsequently withdrawn), approximately 3,950 of which were

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asbestos property damage claims. Of the 5,400 claims, approximately 2,300 have been expunged, approximately 250 have been resolved, approximately 2,150 have been withdrawn by claimants, and the remaining approximately 700 will be addressed through the claims objection process and the dispute resolution procedures approved by the Bankruptcy Court.

Grace believes that its recorded liabilities for claims subject to the bar date represent a reasonable estimate of the ultimate allowable amount for claims that are not in dispute or have been submitted with sufficient information to both evaluate the merit and estimate the value of the claim. The asbestos-related claims are considered as part of Grace’s overall asbestos liability and are being accounted for in accordance with the conditions precedent under the Plan, as described in “Accounting Impact” below. As claims are resolved, or where better information becomes available and is evaluated, Grace will make adjustments to the liabilities recorded in its financial statements as appropriate. Any such adjustments could be material to its consolidated financial position and results of operations.

Litigation Proceedings in Bankruptcy Court—In September 2000, Grace was named in a purported class action lawsuit filed in California Superior Court for the County of San Francisco, alleging that the 1996 reorganization involving a predecessor of Grace and Fresenius AG and the 1998 reorganization involving a predecessor of Grace and Sealed Air were fraudulent transfers. The Bankruptcy Court authorized the Official Committee of Asbestos Personal Injury Claimants and the Official Committee of Asbestos Property Damage Claimants to proceed with claims against Fresenius and Sealed Air and Cryovac on behalf of the Debtors’ bankruptcy estate.

On November 29, 2002, Sealed Air (and Cryovac) and Fresenius each announced that they had reached agreements in principle with such Committees to settle asbestos, successor liability and fraudulent transfer claims related to such transactions (the “litigation settlement agreements”). Under the terms of the Fresenius settlement, subject to the fulfillment of certain conditions, Fresenius would pay $115.0 million to the Debtors’ estate as directed by the Bankruptcy Court upon confirmation of the Debtors’ plan of reorganization. In July 2003, the Fresenius settlement was approved by the Bankruptcy Court. Under the terms of the Sealed Air settlement, subject to the fulfillment of certain conditions, Cryovac would make a payment of $512.5 million (plus interest at 5.5% compounded annually, commencing on December 21, 2002) and nine million shares of Sealed Air common stock (collectively valued at $1,114.5 million as of September 30, 2006), as directed by the Bankruptcy Court upon confirmation of the Debtors’ plan of reorganization. In June 2005, the Sealed Air settlement was approved by the Bankruptcy Court.

Debt Capital—All of the Debtors’ pre-petition debt is in default due to the Filing. The accompanying Consolidated Balance Sheets reflect the classification of the Debtors’ pre-petition debt within “liabilities subject to compromise.”

The Debtors have entered into a debtor-in-possession post-petition loan and security agreement with Bank of America, N.A. (the “DIP facility”) in the aggregate amount of $250 million.  The term of the DIP facility expires on April 1, 2008.

Accounting Impact—The accompanying Consolidated Financial Statements have been prepared in accordance with Statement of Position 90-7 (“SOP 90-7”), “Financial Reporting by Entities in Reorganization Under the Bankruptcy Code,” promulgated by the American Institute of Certified Public Accountants. SOP 90-7 requires that financial statements of debtors-in-possession be prepared on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business.  However, as a result of the Filing, the realization of certain of the Debtors’ assets and the liquidation of certain of the Debtors’ liabilities are subject to significant uncertainty. While operating as debtors-in-possession, the Debtors may sell or otherwise dispose of assets and liquidate or settle liabilities for amounts other than those reflected in the Consolidated Financial Statements. Further, the ultimate plan of reorganization could materially change the amounts and classifications reported in the Consolidated Financial Statements.

Pursuant to SOP 90-7, Grace’s pre-petition liabilities that are subject to compromise are required to be reported separately on the balance sheet at an estimate of the amount that will ultimately be allowed by the Bankruptcy Court. As of September 30, 2006, such pre-petition liabilities include fixed obligations (such as debt and contractual commitments), as well as estimates of costs related to contingent liabilities (such as

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asbestos-related litigation, environmental remediation, and other claims). Obligations of Grace subsidiaries not covered by the Filing continue to be classified on the Consolidated Balance Sheets based upon maturity dates or the expected dates of payment. SOP 90-7 also requires separate reporting of certain expenses, realized gains and losses, and provisions for losses related to the Filing as reorganization items.  Grace presents reorganization items as “Chapter 11 expenses, net,” a separate caption in its Consolidated Statements of Operations.

Grace has not recorded the benefit of any assets that may be available to fund asbestos-related and other liabilities under the litigation settlements with Sealed Air and Fresenius, as such agreements are subject to conditions which, although expected to be met, have not been satisfied and confirmed by the Bankruptcy Court. The value available under these litigation settlement agreements as measured at September 30, 2006, was $1,229.5 million comprised of $115.0 million in cash from Fresenius and $1,114.5 million in cash and stock from Cryovac. Payments under the Sealed Air settlement will be made directly to the asbestos trust by Cryovac, and will be accounted for as a satisfaction of a portion of Grace’s recorded asbestos-related liability and a credit to shareholder’s equity.

Grace’s Consolidated Balance Sheets separately identify the liabilities that are “subject to compromise” as a result of the Chapter 11 proceedings. In Grace’s case, “liabilities subject to compromise” represent pre-petition liabilities as determined under U.S. generally accepted accounting principles. Changes to the recorded amount of such liabilities will be based on developments in the Chapter 11 Cases and management’s assessment of the claim amounts that will ultimately be allowed by the Bankruptcy Court. Changes to pre-petition liabilities subsequent to the Filing Date reflect: 1) cash payments under approved court orders; 2) the terms of Grace’s proposed plan of reorganization, as discussed above, including the accrual of interest on pre-petition debt and other fixed obligations; 3) accruals for employee-related programs; and 4) changes in estimates related to other pre-petition contingent liabilities.

Components of liabilities subject to compromise are as follows:

(In millions)		September 30, 2006			December 31, 2005
Debt, pre-petition plus accrued interest		$	725.3		$	684.7
Asbestos-related liability		1,700.0			1,700.0
Income taxes		133.7			136.5
Environmental remediation		363.2			342.0
Postretirement benefits other than pension		86.4			101.3
Unfunded special pension arrangements		89.0			86.4
Retained obligations of divested businesses		14.8			18.1
Accounts payable		31.7			31.5
Other accrued liabilities		67.5			54.6
Total Liabilities Subject to Compromise		$	3,211.6		$	3,155.1

 

Note that the unfunded special pension arrangements reflected above exclude non-U.S. plans and qualified U.S. plans that became underfunded subsequent to the Filing. Contributions to qualified U.S. plans are subject to Bankruptcy Court approval.

Change in Liabilities Subject to Compromise—The following chart is a reconciliation of the changes in pre-filing date liability balances for the period from the Filing Date through September 30, 2006.

(In millions)		Cumulative Since Filing
Balance, Filing Date April 2, 2001		$	2,366.0
Cash disbursements and/or reclassifications under Bankruptcy Court orders:
Freight and distribution order		(5.7		)
Trade accounts payable order		(9.1		)
Settlements of noncore contingencies		(119.7		)
Other court orders including employee wages and benefits, sales and use tax, and customer programs		(325.2		)
Expense/(income) items:
Interest on pre-petition liabilities		256.7
Employee-related accruals		36.7
Change in estimate of asbestos-related contingencies		744.8
Change in estimate of environmental contingencies		295.6
Change in estimate of income tax contingencies		(2.8		)
Balance sheet reclassifications		(25.7		)
Balance, end of period		$	3,211.6

 

Additional liabilities subject to compromise may arise due to the rejection of executory contracts or unexpired leases, or as a result of the Bankruptcy Court’s allowance of contingent or disputed claims.

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Beginning January 1, 2006, Grace agreed to pay interest on pre-petition bank debt at the prime rate quoted by Bloomberg, adjusted for periodic changes, and compounded quarterly. The effective rates for the three months and nine months ended September 30, 2006 were 8.25% and 7.86%, respectively.  From the Filing Date through December 31, 2005, Grace accrued interest on pre-petition bank debt at a negotiated fixed annual rate of 6.09%, compounded quarterly.

Chapter 11 Expenses
(In millions)

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Legal and financial advisory fees		$	13.9		$	11.2		$	38.1		$	25.2
Interest income		(1.9		)	(1.9		)	(5.9		)	(5.3		)
Chapter 11 expenses, net		$	12.0		$	9.3		$	32.2		$	19.9

 

Pursuant to SOP 90-7, interest income earned on the Debtors’ cash balances must be offset against Chapter 11 expenses.  Cumulative legal and financial advisory fees since the Filing were $159.4 million through September 30, 2006.

Condensed Financial Information of the Debtors

W. R. Grace & Co.—Chapter 11 Filing Entities
Debtor-in-Possession
Statements of Operations
(In millions)

		Nine Months Ended September 30,
		2006			2005
Net sales, including intercompany		$	1,096.7		$	952.6
Cost of goods sold, including intercompany, exclusive of depreciation and amortization shown separately below		810.1			659.7
Selling, general and administrative expenses, exclusive of net pension expense and depreciation and amortization shown separately below		265.0			199.0
Research and development expenses		30.3			28.7
Depreciation and amortization		44.6			49.2
Net pension expense		34.8			39.2
Interest expense and related financing costs		54.2			40.8
Provision for environmental remediation		30.0			—
Other (income) expense		(48.7		)	(65.5		)
		1,220.3			951.1
Income (loss) before Chapter 11 expenses, income taxes, and equity in net income of non-filing entities		(123.6		)	1.5
Chapter 11 expenses, net		(32.1		)	(19.7		)
Benefit from (provision for) income taxes		35.2			4.2
Income (loss) before equity in net income of non-filing entities		(120.5		)	(14.0		)
Equity in net income of non-filing entities		133.8			81.9
Net income (loss)		$	13.3		$	67.9

 

 

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W. R. Grace & Co.—Chapter 11 Filing Entities
Debtor-in-Possession
Condensed Statements of Cash Flows
(In millions)

		Nine Months Ended September 30,
		2006			2005
Operating Activities
Net income (loss)		$	13.3		$	67.9
Reconciliation to net cash provided by (used for) operating activities:
Chapter 11 expenses, net		32.1			19.7
(Benefit from) provision for income taxes		(35.2		)	(4.2		)
Equity in net income of non-filing entities		(133.8		)	(81.9		)
Depreciation and amortization		44.6			49.2
Interest on pre-petition liabilities subject to compromise		53.1			37.7
Provision for environmental remediation		30.0			—
Other non-cash items, net		0.4			(1.6		)
Contributions to defined benefit pension plans		(99.2		)	(24.9		)
Cash paid to settle noncore contingencies		—			(119.7		)
Changes in other assets and liabilities, excluding the effect of businesses acquired/divested		(16.5		)	(49.1		)
Net cash provided by (used for) operating activities		(111.2		)	(106.9		)
Investing Activities
Capital expenditures		(60.2		)	(37.8		)
Loan repayments and other		80.9			81.0
Net cash provided by (used for) investing activities		20.7			43.2
Net cash provided by (used for) financing activities		(1.8		)	(2.1		)
Net increase (decrease) in cash and cash equivalents		(92.3		)	(65.8		)
Cash and cash equivalents, beginning of period		269.2			340.0
Cash and cash equivalents, end of period		$	176.9		$	274.2

 

W. R. Grace & Co.—Chapter 11 Filing Entities
Debtor-in-Possession
Balance Sheets
(In millions)

 

				September 30, 2006			December 31, 2005
ASSETS
Current Assets
Cash and cash equivalents				$	176.9		$	269.2
Trade accounts receivable, net				139.4			108.0
Receivables from non-filing entities, net				61.3			62.3
Inventories				73.2			86.8
Other current assets				43.8			53.5
Total Current Assets				494.6			579.8
Properties and equipment, net				392.1			378.9
Cash value of life insurance policies, net of policy loans				86.9			84.8
Deferred income taxes				734.2			701.0
Asbestos-related insurance				500.0			500.0
Loans receivable from non-filing entities, net				255.4			306.9
Investment in non-filing entities				703.2			527.9
Other assets				77.7			79.3
Total Assets				$	3,244.1		$	3,158.6
LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)
Liabilities Not Subject to Compromise
Current liabilities				$	207.4		$	187.3
Minority interest in consolidated affiliates				57.1			32.6
Other liabilities				312.1			378.9
Total Liabilities Not Subject to Compromise				576.6			598.8
Liabilities Subject to Compromise				3,211.6			3,155.1
Total Liabilities				3,788.2			3,753.9
Shareholders’ Equity (Deficit)				(544.1		)	(595.3		)
Total Liabilities and Shareholders’ Equity (Deficit)				$	3,244.1		$	3,158.6

 

In addition to Grace’s financial reporting obligations as prescribed by the U.S. Securities and Exchange Commission, the Debtors are also required, under the rules and regulations of the Bankruptcy Code, to periodically file certain statements and schedules and a monthly operating report with the Bankruptcy Court. This information is available to the public through the Bankruptcy Court. This information is prepared in a format that may not be comparable to information in Grace’s quarterly and annual financial statements as filed with the SEC. The monthly operating reports are not audited, do not purport to represent the financial position or results of operations of Grace on a consolidated basis, and should not be relied on for such purposes.

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3.

Asbestos-Related Litigation

 

Grace is a defendant in property damage and personal injury lawsuits relating to previously sold asbestos-containing products. As of the Filing Date, Grace was a defendant in 65,656 asbestos-related lawsuits, 17 involving claims for property damage (one of which has since been dismissed), and the remainder involving 129,191 claims for personal injury. Due to the Filing, holders of asbestos-related claims are stayed from continuing to prosecute pending litigation and from commencing new lawsuits against the Debtors. Separate creditors’ committees representing the interests of property damage and personal injury claimants, and a legal representative of future personal injury claimants, have been appointed in the Chapter 11 Cases. Grace’s obligations with respect to present and future claims will be determined through the Chapter 11 process.

Property Damage Litigation—The plaintiffs in asbestos property damage lawsuits generally seek to have the defendants pay for the cost of removing, containing or repairing the asbestos-containing materials in the affected buildings. Each property damage case is unique in that the age, type, size and use of the building, and the difficulty of asbestos abatement, if necessary, vary from structure to structure. Information regarding product identification, the amount of product in the building, the age, type, size and use of the building, the legal status of the claimant, the jurisdictional history of prior cases and the court in which the case is pending has provided meaningful guidance as to the range of potential costs.

Out of 380 asbestos property damage cases (which involved thousands of buildings) filed prior to the Filing Date, 140 were dismissed without payment of any damages or settlement amounts; judgments after trial were entered in favor of Grace in nine cases (excluding cases settled following appeals of judgments in favor of Grace); judgments after trial were entered in favor of the plaintiffs in eight cases (one of which is on appeal) for a total of $86.1 million; 207 property damage cases were settled for a total of $696.8 million; and 16 cases remain outstanding (including the one on appeal). Of the 16 remaining cases, eight relate to ZAI and eight relate to a number of former asbestos-containing products (two of which also are alleged to involve ZAI).

Approximately 4,300 additional property damage claims were filed prior to the March 31, 2003 claims bar date established by the Bankruptcy Court. (The bar date did not apply to ZAI claims.) Such claims were reviewed in detail by Grace, categorized into claims with sufficient information to be evaluated or claims that require additional information and, where sufficient information existed, the estimated cost of resolution was considered as part of Grace’s recorded asbestos-related liability. (Approximately 200 claims did not contain sufficient information to permit an evaluation.) Grace has objected to virtually all property damage claims on a number of different bases, including: no authorization to file a claim; the claim was previously settled or adjudicated; no or insufficient documentation; failure to identify a Grace product; the expiration of the applicable statute of limitations and/or statute of repose, and/or laches; and a defense that the product in place is not hazardous. As of October 31, 2006, following the reclassification, withdrawal or expungement of claims, approximately 640 property damage claims remain outstanding.

Eight of the ZAI cases were filed as purported class action lawsuits in 2000 and 2001. In addition, ten lawsuits were filed as purported class actions in 2004 and 2005 with respect to persons and homes in Canada. These cases seek damages and equitable relief, including the removal, replacement and/or disposal of all such insulation. The plaintiffs assert that this product is in millions of homes and that the cost of removal could be several thousand dollars per home. As a result of the Filing, the eight U.S. cases have been transferred to the Bankruptcy Court.  Based on Grace’s investigation of the claims described in these lawsuits, and testing and analysis of this product by Grace and others, Grace believes that the product was and continues to be safe for its intended purpose and poses little or no threat to human health. The plaintiffs in the ZAI lawsuits (and the U.S. government in the Montana criminal proceeding described in Note 12) dispute Grace’s position on the safety of ZAI. In July 2002, the Bankruptcy Court approved special counsel to represent, at the Debtors’ expense, the ZAI claimants in a proceeding to determine certain threshold scientific issues regarding ZAI. On October 18, 2004, the Bankruptcy Court held a hearing on motions filed by the parties to address a number of important legal and factual issues regarding the ZAI claims, and has taken the motions under advisement. No decision has yet been rendered.  Grace’s recorded asbestos-related liability at September 30, 2006 assumes the risk of loss from ZAI litigation is not probable.  If Grace’s view as to risk of loss were not

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sustained, management believes the cost to resolve the matter would be material.

Personal Injury Litigation—Asbestos personal injury claimants allege adverse health effects from exposure to asbestos-containing products formerly manufactured by Grace. Claims are generally similar to each other, differing primarily in the type of asbestos-related illness allegedly suffered by the plaintiff. Grace’s cost to resolve such claims has been influenced by numerous variables, including the solvency of other former producers of asbestos containing products, cross-claims by co-defendants, the rate at which new claims are filed, the jurisdiction in which the claims are filed, and the defense and disposition costs associated with these claims.

Cumulatively through the Filing Date, 16,354 asbestos personal injury lawsuits involving approximately 35,720 claims were dismissed without payment of any damages or settlement amounts (primarily on the basis that Grace products were not involved) and approximately 55,489 lawsuits involving approximately 163,698 claims were disposed of (through settlements and judgments) for a total of $645.6 million.  As of the Filing Date, 129,191 claims for personal injury were pending against Grace. Grace believes that a substantial number of additional personal injury claims would have been received between the Filing Date and September 30, 2006 had such claims not been stayed by the Bankruptcy Court.

Asbestos-Related Liability—The total recorded asbestos-related liability balance as of September 30, 2006 and December 31, 2005 was $1,700.0 million and is included in “liabilities subject to compromise” in the accompanying Consolidated Balance Sheets.  Grace adjusted its asbestos-related liability in the fourth quarter of 2004 based on its proposed plan of reorganization as discussed in Note 2. The amount recorded at September 30, 2006 includes the $1,613 million maximum amount reflected as a condition precedent to the Plan and $87 million related to pre-Chapter 11 contractual settlements and judgments included in general unsecured claims.

Under the Plan, Grace is requesting that the Bankruptcy Court determine the aggregate dollar amount, on a net present value basis, that must be funded on the effective date of the Plan into an asbestos trust (established under Section 524(g) of the Bankruptcy Code) to pay all allowed pending and future asbestos-related personal injury and property damage claims (including ZAI) and related trust administration costs and expenses on the later of the effective date of the Plan or when allowed (the “Funding Amount”). It is a condition to confirmation of the Plan that the Bankruptcy Court shall conclude that the Funding Amount is not greater than $1,613 million. This amount, which should be sufficient to fund over $2 billion in pending and future claims, is based in part on Grace’s evaluation of (1) existing but unresolved personal injury and property damage claims, (2) actuarially-based estimates of future personal injury claims, (3) the risk of loss from ZAI litigation, (4) proposed claim payments reflected in the Plan, and (5) the cost of the trust administration and litigation. This amount may not be consistent with what the Bankruptcy Court may conclude would be a sufficient Funding Amount.

The Bankruptcy Court has entered separate case management orders for estimating liability for pending and future personal injury claims and adjudicating pending property damage claims, excluding ZAI claims. The Debtors expect that the estimated liability will provide the basis for determining the Funding Amount to be paid into the trust on the effective date of the Plan.

For personal injury claims, the Bankruptcy Court has ordered that all claimants with claims pending as of the Filing Date (other than settled but unpaid claims) must complete detailed questionnaires providing information on, among other things, their medical condition, including diagnostic support, exposure to Grace and non-Grace asbestos-containing products, employment history, and pending lawsuits against other companies.

Approximately 60,000 questionnaires were returned in response to the July 12, 2006 deadline.  Grace has analyzed the questionnaires and believes that a substantial percentage of the submitted questionnaires provide insufficient or incomplete responses.  In response to a request by Grace to compel the asbestos personal injury claimants to cure these deficiencies, the Bankruptcy Court has issued a ruling clarifying the information required of claimants submitting questionnaire responses and allowing claimants additional time to supplement their responses.

In August 2006, the Bankruptcy Court established bar dates for filing asbestos personal injury claims pending as of the Filing Date.  Claimants asserting settled but unpaid pre-petition personal injury claims were required to file proofs of claim by

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October 16, 2006.  Approximately 35,000 of such claims were submitted.  Non-settled pre-petition personal injury proofs of claim must be filed by November 15, 2006.

Grace expects the estimation process for personal injury claims will include the compilation of data from the questionnaires, review and analysis of such data by experts, the preparation of expert reports, including estimates of the number of personal injury claims expected to be filed in the future, and depositions of witnesses and other pretrial discovery proceedings. Grace expects the process to conclude in an estimation hearing in mid-2007.

For property damage claims, the case management order provides that estimation will be preceded by litigation on certain common threshold issues affecting a substantial majority of claims. Such litigation will consist of determining, among other things, (1) whether asbestos-containing products formerly manufactured by Grace are hazardous in place, (2) the date by which building owners knew or should have known of the reported hazards of asbestos-containing materials in their buildings, which would provide the basis for a statute of limitations defense, and (3) the evidentiary admissibility of certain asbestos testing methodologies. During the period preceding the estimation hearing, Grace will also ask the Bankruptcy Court to rule on Grace’s specific objections to individual claims and groups of claims. Claims not resolved or expunged through the common issue litigation or the objection process are expected to be the subject of an estimation hearing that is currently scheduled to take place during the second quarter of 2007.

The Funding Amount will be primarily a function of the number of estimated allowed property damage and personal injury claims, and the amount payable per claim. Through the estimation process, Grace will seek to demonstrate that most claims have no value because they fail to establish any material property damage, health impairment or significant occupational exposure to asbestos from Grace’s operations or products. If the Bankruptcy Court agrees with Grace’s position on the number of, and the amounts to be paid in respect of, allowed personal injury and property damage claims, then Grace believes that the Funding Amount could be less than $1,613 million. However, this outcome is highly uncertain and will depend on a number of Bankruptcy Court rulings favorable to Grace’s position.

Conversely, the asbestos claimants committees and the representative of future asbestos claimants continue to assert that Grace’s asbestos-related liabilities are substantially higher than $1,613 million, and in fact are in excess of Grace’s business value.  If the Court accepts the position of the asbestos claimants committees, then any plan of reorganization likely would result in the loss of all or substantially all equity value by current shareholders. Therefore, due to the significant uncertainties of this process and asbestos litigation generally, Grace is not able to estimate a probable Funding Amount that would be accepted by the Bankruptcy Court.

However, as Grace is willing to proceed with confirmation of the Plan with a Funding Amount of up to $1,613 million (assuming that other conditions precedent to confirmation of the Plan are satisfied, including the availability of the payment from Cryovac directly to the asbestos trust under the settlement agreement described in Note 2), during the fourth quarter of 2004, Grace accrued a charge of $714.8 million to increase its recorded asbestos-related liability to reflect the maximum amount allowed as a condition precedent under the Plan. This amount, plus $87.0 million for pre-Chapter 11 contractual settlements and judgments, brings the total recorded asbestos-related liability as of September 30, 2006 and December 31, 2005 to $1,700 million. Any differences between the Plan as filed and as approved for confirmation could fundamentally change the accounting measurement of Grace’s asbestos-related liability and that change could be material.

Insurance Rights—Grace previously purchased insurance policies that provide coverage for years 1962 to 1985 with respect to asbestos-related lawsuits and claims. Since 1985, insurance coverage for asbestos-related liabilities has not been commercially available to Grace.

With one exception, coverage disputes regarding Grace’s primary insurance policies have been settled, and the settlement amounts paid in full. Grace’s excess coverage is for loss above certain levels.  The levels vary from policy to policy, creating “layers” of excess coverage, some of which are triggered before others. As of September 30, 2006, after subtracting previous reimbursements by insurers and allowing for discounts pursuant to certain settlement agreements, there remains approximately $959 million of excess coverage from approximately 54 presently solvent insurers.

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Grace has entered into settlement agreements with various excess insurance carriers. These settlements involve amounts paid and to be paid to Grace. The unpaid maximum aggregate amount for settled insurers available under these settlement agreements is approximately $476 million.  With respect to asbestos-related personal injury claims, the settlement agreements generally require that the claims be spread over the claimant’s exposure period and that each insurer pay a pro rata portion of each claim based on the amount of coverage provided during each year of the total exposure period.

Presently, Grace has no agreements in place with insurers with respect to approximately $483 million of excess coverage, which is at layers of coverage that have not yet been triggered, but certain layers would be triggered if the Plan were approved at the recorded asbestos-related liability of $1,700 million. Grace believes that any allowed ZAI claims also would be covered under the settlement agreements and unsettled policies discussed above to the extent they relate to installations of ZAI occurring after July 1, 1973.

In addition to the approximately $959 million of excess coverage with solvent insurers, Grace has approximately $318 million of excess coverage with insolvent or non-paying insurance carriers. Non-paying carriers are those that, although technically solvent, are not currently meeting their obligations to pay claims. Grace has filed and continues to file claims in the insolvency proceedings of insolvent carriers. Grace is currently receiving distributions from some of these insolvent carriers and expects to receive distributions in the future. Settlement amounts are recorded as income when received.

Grace estimates that, assuming an ultimate payout of asbestos-related claims equal to the recorded liability of $1,700 million, it should be entitled to approximately $500 million, on a net present value basis, of insurance recovery.

4.

Acquisitions and Joint Ventures

 

In June 2006, Grace acquired the custom catalyst manufacturing assets of Basell, USA, as well as Basell’s components business for cash consideration of $20.0 million.  The manufacturing assets and the results of operations of the acquired business have been included as part of the Grace Davison operating segment since the date of acquisition.

During the first nine months of 2005, Grace completed two acquisitions for a total cash cost of $2.5 million as follows:

·                  In February 2005, Grace acquired certain assets of Midland Dexter Venezuela, S.A. (“Midevensa”). Midevensa supplies coatings and sealants for rigid packaging in the local and export markets of Latin America.

·                  In March 2005, Grace acquired certain assets relating to the concrete admixtures business of Perstorp Peramin AB (“Perstorp”) located in Sweden. Perstorp supplies specialty chemicals and materials to the construction industry in Sweden and other Northern European countries.

5.

Other (Income) Expense

 

Components of other (income) expense are as follows:

 

 

Other (Income) Expense (In millions)		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Income from insurance settlements		$	(0.9	)	$	(4.2	)	$	(7.8	)	$	(24.5	)
COLI income, net		(0.5		)	0.3			(2.2		)	(1.6		)
Interest income		(1.7		)	(0.8		)	(4.7		)	(2.4		)
Net (gain) loss on sales of investments and disposals of assets		0.2			1.4			(2.6		)	0.9
Currency translation—intercompany loan		(2.4		)	1.1			(16.1		)	32.5
Value of currency contracts		1.6			(1.1		)	15.1			(32.3		)
Other currency transaction effects		(0.2		)	0.3			2.5			0.8
Other miscellaneous income		(2.4		)	(1.4		)	(6.3		)	(7.8		)
Total other (income) expense		$	(6.3	)	$	(4.4	)	$	(22.1	)	$	(34.4	)

 

Grace accounts for currency fluctuations on an intercompany loan between its subsidiaries in the United States and Germany as a component of operating results instead of as a component of other comprehensive income because Grace has determined that the loan is not part of its permanent capital structure in Germany.

 

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