UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2006 or |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to _________ Commission File Number 1-13612 CONGOLEUM CORPORATION (Exact name of registrant as specified in its charter) DELAWARE 02-0398678 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 3500 Quakerbridge Road P.O. Box 3127 Mercerville, NJ 08619-0127 (Address of principal executive offices, including zip code) (609) 584-3000 (Registrant's telephone number, including area code) 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 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 |_| Accelerated filer |_| Non-accelerated filer |X| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES |_| NO |X| Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at July 31, 2006 ---------------------------- ------------------------------ Class A Common Stock 3,663,390 Class B Common Stock 4,608,945 1 CONGOLEUM CORPORATION Index Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Consolidated Balance Sheets as of June 30, 2006 (unaudited) and December 31, 2005..............................4 Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005 (unaudited)...........................................5 Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005 (unaudited)............6 Notes to Unaudited Condensed Consolidated Financial Statements (unaudited).........................................7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................... 31 Item 3. Quantitative and Qualitative Disclosures About Market Risk...........40 Item 4. Controls and Procedures..............................................40 PART II. OTHER INFORMATION Item 1. Legal Proceedings................................................... 41 Item 1A. Risk Factors.........................................................41 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds..........49 Item 3. Defaults Upon Senior Securities......................................49 Item 4. Submission of Matters to a Vote of Security Holders..................49 Item 5. Other Information ...................................................50 Item 6. Exhibits.............................................................50 Signatures....................................................................51 2 FORWARD-LOOKING STATEMENTS Some of the information presented in or incorporated by reference in this report constitutes "forward-looking statements," within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks, uncertainties and assumptions. These statements can be identified by the use of the words such as "anticipate," "believe," "estimate," "expect," "intend," "plan," "project" and other words of similar meaning. In particular, these include statements relating to intentions, beliefs or current expectations concerning, among other things, future performance, results of operations, the outcome of contingencies such as bankruptcy and other legal proceedings, and financial conditions. These statements do not relate strictly to historical or current facts. These forward-looking statements are based on the Company's expectations, as of the date of this report, of future events, and the Company undertakes no obligation to update any of these forward-looking statements. Although the Company believes that these expectations are based on reasonable assumptions, within the bounds of its knowledge of its business and operations, there can be no assurance that actual results will not differ materially from its expectations. Readers are cautioned not to place undue reliance on any forward-looking statements. Any or all of these statements may turn out to be incorrect. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend on circumstances that may or may not occur in the future. Any forward-looking statements made in this report speak only as of the date of such statement. It is not possible to predict or identify all factors that could potentially cause actual results to differ materially from expected and historical results. Factors that could cause or contribute to the Company's actual results differing from its expectations include those factors discussed in Item 1A of Part II of this Quarterly Report on Form 10-Q and in the Company's other filings with the Securities and Exchange Commission. 3 PART I. FINANCIAL INFORMATION Item 1. Financial Statements CONGOLEUM CORPORATION CONSOLIDATED BALANCE SHEEETS (In thousands, except per share amounts) June 30, 2006 December 31, (Unaudited) 2005 ------------------------- ASSETS Current assets: Cash and cash equivalents ............................................................ $ 15,444 $ 24,511 Restricted cash ...................................................................... 11,967 11,644 Accounts receivable, less allowances of $1,388 and $1,142 as of June 30, 2006 and December 31, 2005, respectively ................................................ 24,235 17,092 Inventories .......................................................................... 39,481 34,607 Prepaid expenses and other current assets ............................................ 23,286 20,139 Deferred income taxes ................................................................ 16,735 16,735 --------- --------- Total current assets ............................................................. 131,148 124,728 Property, plant and equipment, net ................................................... 69,051 73,207 Other assets, net .................................................................... 9,954 9,412 --------- --------- Total assets .................................................................... $ 210,153 $ 207,347 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: Accounts payable ..................................................................... $ 10,748 $ 11,769 Accrued liabilities .................................................................. 22,507 23,072 Asbestos-related liabilities ......................................................... 23,439 28,369 Revolving credit loan ................................................................ 13,288 9,404 Accrued taxes ........................................................................ 233 107 Liabilities subject to compromise - current ............................................ 29,281 23,990 --------- --------- Total current liabilities ....................................................... 99,496 96,711 Deferred income taxes .................................................................. 16,735 16,735 Liabilities subject to compromise - long term .......................................... 137,935 138,861 --------- --------- Total liabilities ............................................................... 254,166 252,307 --------- --------- STOCKHOLDERS' EQUITY (DEFICIT) Class A common stock, par value $0.01; 20,000,000 shares authorized; 4,736,950 shares issued and 3,663,390 shares outstanding as of June 30, 2006 and 4,736,950 shares issued and 3,662,790 shares outstanding as of December 31, 2005, respectively........................................................................ 47 47 Class B common stock, par value $0.01; 4,608,945 shares authorized, issued and outstanding at June 30, 2006 and December 31, 2005, respectively ................... 46 46 Additional paid-in capital ............................................................. 49,236 49,126 Retained deficit ....................................................................... (64,568) (65,405) Accumulated other comprehensive loss ................................................... (20,961) (20,961) --------- --------- (36,200) (37,147) Less Class A common stock held in treasury, at cost; 1,073,960 shares at June 30, 2006 and 1,074,560 shares at December 31, 2005 respectively .............. 7,813 7,813 --------- --------- Total stockholders' equity (deficit) .............................................. (44,013) (44,960) --------- --------- Total liabilities and stockholders' equity (deficit) .............................. $ 210,153 $ 207,347 ========= ========= The accompanying notes are an integral part of the condensed consolidated financial statements. 4 CONGOLEUM CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended Six Months Ended June 30, June 30, --------------------- ----------------------- 2006 2005 2006 2005 (In thousands, except per share amounts) Net sales ......................................... $ 58,743 $ 58,108 $ 115,980 $ 115,738 Cost of sales ..................................... 45,139 44,338 89,099 88,307 Selling, general and administrative expenses ...... 10,261 10,673 20,657 22,406 Asbestos-related reorganization charges ........... -- 15,454 -- 15,454 -------- -------- --------- --------- Income (loss) from operations ..................... 3,343 (12,357) 6,224 (10,429) Other income (expense): Interest income ............................... 126 84 283 182 Interest expense .............................. (2,867) (2,618) (5,601) (5,118) Other income .................................. 89 293 47 415 -------- -------- --------- --------- Income (loss) before taxes ........................ 691 (14,598) 953 (14,950) Provision for income taxes ........................ 65 -- 116 -- -------- -------- --------- --------- Net income (loss) ................................. $ 626 $(14,598) $ 837 $ (14,950) ======== ======== ========= ========= Net income (loss) per common share, basic .... $ 0.08 $ (1.77) $ 0.10 $ (1.81) ======== ======== ========= ========= Net income (loss) per common share, diluted .. $ 0.08 $ (1.77) $ 0.10 $ (1.81) ======== ======== ========= ========= Weighted average number of common shares outstanding, basic ......................... 8,272 8,260 8,272 8,260 ======== ======== ========= ========= Weighted average number of common shares outstanding, diluted ....................... 8,333 8,260 8,328 8,260 ======== ======== ========= ========= The accompanying notes are an integral part of the condensed consolidated financial statements. 5 CONGOLEUM CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Six Months Ended June 30, ----------------------- 2006 2005 (In thousands) Cash flows from operating activities: Net income (loss) ...................................................... $ 837 $(14,950) Adjustments to reconcile net (loss) to net cash used in Operating activities: Depreciation ..................................................... 5,152 5,434 Amortization ..................................................... 193 192 Asbestos-related charge .......................................... -- 15,455 Stock-based compensation expense ................................. 110 -- Changes in certain assets and liabilities: Accounts and notes receivable .............................. (7,143) (3,202) Inventories ................................................ (4,874) (5,244) Prepaid expenses and other assets .......................... 1,888 1,400 Accounts payable ........................................... (1,021) 3,809 Accrued liabilities ........................................ 5,347 (1,024) Asbestos-related liabilities ............................... (11,321) (12,927) Asbestos-related expense reimbursements from insurance settlement ................................. -- 6,091 Other liabilities .......................................... (800) (518) --------- --------- Net cash used in operating activities ................ (11,632) (5,484) Cash flows from investing activities: Capital expenditures ............................................. (996) (2,155) --------- --------- Net cash used in investing activities ................ (996) (2,155) Cash flows from financing activities: Net short-term borrowings ........................................ 3,884 637 Net change in restricted cash .................................... (323) (1,311) --------- --------- Net cash provided by (used in) financing activities .. 3,561 (674) --------- --------- Net decrease in cash and cash equivalents ................................... (9,067) (8,313) Cash and cash equivalents: Beginning of period .............................................. 24,511 29,710 --------- --------- End of period .................................................... $ 15,444 $ 21,397 ========= ========= The accompanying notes are an integral part of the condensed consolidated financial statements. 6 CONGOLEUM CORPORATION NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS June 30, 2006 (Unaudited) 1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal and recurring adjustments) considered necessary for a fair presentation of Congoleum Corporation's (the "Company" or "Congoleum") condensed consolidated financial position, results of operations and cash flows have been included. Operating results for the six month period ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to the consolidated financial statements and related footnotes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2005. Based upon the nature of the Company's operations, facilities and management structure, the Company considers its business to constitute a single segment for financial reporting purposes. Certain amounts appearing in the prior period's condensed consolidated financial statements have been reclassified to conform to the current period's presentation. The financial statements of Congoleum have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Accordingly, the financial statements do not include any adjustments that might be necessary should the Company be unable to continue as a going concern. As described more fully below and in Note 6, there is substantial doubt about the Company's ability to continue as a going concern unless it obtains relief from its substantial asbestos liabilities through a successful reorganization under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code"). During 2003, Congoleum obtained the requisite votes of asbestos personal injury claimants necessary to seek approval of a proposed, pre-packaged Chapter 11 plan of reorganization as a means to resolve claims asserted against it related to the use of asbestos in its products decades ago. On December 31, 2003, Congoleum filed a voluntary petition with the United States Bankruptcy Court for the District of New Jersey (the "Bankruptcy Court") (Case No. 03-51524) seeking relief under Chapter 11 of the Bankruptcy Code. In January 2004, the Company filed its proposed plan of reorganization and disclosure statement with the Bankruptcy Court. In November 2004, Congoleum filed a modified plan of reorganization and related documents with the Bankruptcy Court (the "Fourth Plan") reflecting the result of further negotiations with representatives of the Asbestos Claimants' Committee (the "ACC"), the Future Claimants' Representative (the "FCR") and other asbestos claimant representatives. The Bankruptcy Court approved the disclosure statement and plan voting procedures in December 2004 and Congoleum obtained the requisite votes of asbestos personal injury claimants necessary to seek approval of the Fourth Plan. In April 2005, Congoleum announced that it had reached an agreement in principle with representatives of the ACC and the FCR to make certain 7 modifications to its proposed plan of reorganization and related documents governing the settlement and payment of asbestos-related claims against Congoleum. Under the agreed-upon modifications, asbestos claimants with claims settled under Congoleum's pre-petition settlement agreements would agree to forbear from exercising the security interest they were granted and share on a pari passu basis with all other present and future asbestos claimants in insurance proceeds and other assets of the trust to be formed upon confirmation of the plan under Section 524(g) of the Bankruptcy Code (the "Plan Trust") to pay asbestos claims against Congoleum. In July 2005, Congoleum filed an amended plan of reorganization (the "Sixth Plan") and related documents with the Bankruptcy Court which reflected the result of these negotiations, as well as other technical modifications. The Bankruptcy Court approved the disclosure statement and voting procedures and Congoleum commenced solicitation of acceptances of the Sixth Plan in August 2005. In September 2005, Congoleum learned that certain asbestos claimants were unwilling to agree to forbear from exercising their security interest as contemplated by the Sixth Plan and the Sixth Plan was subsequently withdrawn. In November 2005, the Bankruptcy Court denied a request to extend Congoleum's exclusive right to file a plan of reorganization and solicit acceptances thereof. In March 2006, Congoleum filed a new amended plan of reorganization (the "Eighth Plan"). In addition, an insurance company has filed a plan of reorganization (the "CNA Plan") and the Official Committee of Bondholders (the "Bondholders' Committee") (representing holders of the Company's 8 5/8% Senior Notes due August 1, 2008 (the "Senior Notes")) has also filed a plan of reorganization (the "Bondholder Plan"). In May 2006, the presiding judge of the Bankruptcy Court ordered all parties in interest in Congoleum's reorganization proceedings to participate in global mediation discussions. Several mediation sessions took place during June and July 2006. During the mediation negotiations, Congoleum reached an agreement in principle, subject to mutually agreeable definitive documentation, with the ACC, the FCR and the Company's controlling shareholder, American Biltrite, Inc. ("ABI"), on certain terms of a new amended plan (the "Ninth Plan"), which Congoleum filed and proposed jointly with the ACC on August 11, 2006. The proponents of the CNA Plan and the Bondholder Plan have indicated they will jointly file a new plan by August 18, 2006. The Bankruptcy Court has scheduled a hearing to consider the adequacy of the disclosure statements with respect to these plans for September 21, 2006. There can be no assurance that the Company will not amend the Ninth Plan, that the Company will obtain approval to solicit acceptances of its plan of reorganization, that the Company will receive the acceptances necessary for confirmation of its plan of reorganization, that its plan will not be modified further, that its plan will receive necessary court approvals from the Bankruptcy Court or the Federal District Court, or that such approvals will be received in a timely fashion, that its plan will be confirmed, that its plan, if confirmed, will become effective, or that there will be sufficient funds to pay for continued protracted litigation over its plan of reorganization. It is unclear whether the Bankruptcy Court will approve any new plan filed by CNA and the Bondholders' Committee or whether any such plan, if confirmed, would be feasible. Moreover, it is unclear whether any other person will attempt to propose a plan or what any such plan would provide or propose, and whether the Bankruptcy Court would approve a plan other than Congoleum's proposed plan. Congoleum is presently involved in litigation with certain insurance carriers related to disputed insurance coverage for asbestos related liabilities, and certain insurance carriers filed various objections to Congoleum's previously proposed plans of reorganization and related matters and are expected to file objections to the Ninth Plan. Certain other parties, including the Bondholders' Committee, have also filed various objections to Congoleum's previously proposed plans of reorganization and may file objections to the Ninth Plan. While Congoleum is seeking to obtain the required acceptances 8 of the Ninth Plan from all necessary classes of creditors, the Ninth Plan provides an alternative treatment for holders of the Senior Notes and stockholders, in the event sufficient note holders do not consent to the plan, which will materially affect the recoveries of these classes. In the event that the holders of the Senior Notes do not vote to accept the Ninth Plan by the requisite number and amount required by the Bankruptcy Code, then Plan confirmation shall be sought in accordance with the cram down provisions of the Bankruptcy Code (the "Cramdown Treatment"). Pursuant to the Cramdown Treatment, the Senior Notes and existing Class A and Class B Common Stock would be cancelled and the Senior Note holders would receive their pro rata share, with the Plan Trust, of newly issued Common Stock of Congoleum, in an amount determined by a Final Order of the Bankruptcy Court; provided, however, that in no event may the amount of such newly issued Common Stock to be allocated to the holders of the Senior Notes exceed 49% of the voting common shares and total economic equity value of Congoleum on a fully diluted basis. The Company expects that the terms of the Ninth Plan may be amended or modified as a result of further negotiations with various parties. The Company expects that the terms of any new plan filed by CNA and the Bondholders' Committee will be materially different from the terms of the Ninth Plan, and any such plan may also be amended or modified or may be withdrawn. There can be no assurance that the terms of the reorganization plan that is ultimately confirmed, if any, will not materially differ from the terms of the Ninth Plan. The Company expects that it will take until some time in the first quarter of 2007 at the earliest to obtain confirmation of any plan of reorganization. In anticipation of Congoleum's commencement of the Chapter 11 cases, Congoleum entered into a settlement agreement with various asbestos personal injury claimants (the "Claimant Agreement"), which provides for an aggregate settlement value of at least $466 million as well as an additional number of individually negotiated trial listed settlements with an aggregate value of approximately $25 million, for total settlements in excess of $491 million. As contemplated by the Claimant Agreement, Congoleum also entered into agreements establishing a pre-petition trust (the "Collateral Trust") to distribute funds in accordance with the terms of the Claimant Agreement and granting the Collateral Trust a security interest in Congoleum's rights under its applicable insurance coverage and payments from Congoleum's insurers for asbestos claims. In December 2005, Congoleum commenced an omnibus avoidance action and a sealed avoidance action (collectively, the "Avoidance Actions") seeking to void the security interest granted to the Collateral Trust and such settlements. In March 2006, Congoleum filed a motion for summary judgment in the Avoidance Actions seeking to avoid the Claimant Agreement settlements and liens under various bankruptcy theories, which motion was denied in June 2006 and the Avoidance Actions remain pending. Under the terms of the Ninth Plan, asbestos personal injury claimants voting to accept the plan would irrevocably consent or would be deemed to have irrevocably consented to the forbearance of any claim and lien rights under the Claimant Agreement and related agreements. Under the terms of the Ninth Plan, after the establishment of the Plan Trust, the assets in the Collateral Trust would be transferred to the Plan Trust and any asbestos claims would be paid in accordance with the terms of the Ninth Plan. Settlement values under the Ninth Plan differ from values under previous plans and the Claimant Agreement. As a result of such differences and the potential results of the Avoidance Actions, the liability associated with the asbestos personal injury claims against Congoleum may be materially different than the present estimates of such items. As a result of tabulating ballots on the Fourth Plan, the Company is also aware of claims by claimants whose claims were not determined under the Claimant Agreement but who have submitted claims with a value of approximately $512 million based on the settlement values applicable in the Sixth Plan. 9 Based on the Eighth Plan, the Company has made provision in its financial statements for the minimum amount of the range of estimates for its contribution to effect its plan to settle asbestos liabilities through the Plan Trust. The Company recorded charges aggregating approximately $51.3 million in prior years, and is not yet able to determine the amount of the additional cost that will be required to complete its reorganization as based on the Ninth Plan. Actual amounts that will be contributed to the Plan Trust and costs for pursuing and implementing the Ninth Plan or any other plan of reorganization could be materially higher than currently recorded. The Company may record significant additional charges should the minimum estimated cost increase. Delays in proposing, filing or obtaining approval of the Ninth Plan or any new amended plan of reorganization, or any new plan to be filed by CNA and the Bondholders' Committee, or the proposal of additional plans by other parties could result in a proceeding that takes longer and is more costly than the Company has estimated. For more information regarding the Company's asbestos liability and plan for resolving that liability, please refer to Note 6 of the Notes to Unaudited Condensed Consolidated Financial Statements. AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7") provides financial reporting guidance for entities that are reorganizing under the Bankruptcy Code. The Company implemented this guidance in consolidated financial statements for periods after December 31, 2003. Pursuant to SOP 90-7, companies are required to segregate pre-petition liabilities that are subject to compromise and report them separately on the balance sheet. Liabilities that may be affected by a plan of reorganization are recorded at the amount of the expected allowed claims, even if they may be settled for lesser amounts. Substantially all of the Company's liabilities at December 31, 2003 have been reclassified as liabilities subject to compromise. Obligations arising post-petition, and pre-petition obligations that are secured, are not classified as liabilities subject to compromise. Additional pre-petition claims (liabilities subject to compromise) may arise due to the rejection of executory contracts or unexpired leases, or as a result of the allowance of contingent or disputed claims. 2. Recent Accounting Principles: Share Based Payment On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued Statement No. 123 (revised 2004), Share-Based Payment ("SFAS 123R"), a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation ("SFAS 123"). SFAS 123R supersedes Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values at the date of grant. Pro forma disclosure is no longer permitted. 10 Effective January 1, 2006, the Company adopted SFAS 123R using the modified prospective method as permitted under SFAS 123R. Under this transition method, compensation cost recognized in the first six months of fiscal 2006 includes: (a) compensation cost for all share-based payments granted prior to but not yet vested as of December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. In accordance with the modified prospective method of adoption, the Company's results of operations and financial position for prior periods have not been restated. Prior to the adoption of SFAS 123R, the Company accounted for stock option grants in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees" (the intrinsic value method) and, accordingly, recognized no compensation expense for stock option grants if the intrinsic value of a grant was zero or less. As a result of adopting SFAS 123R effective January 1, 2006, our income before taxes, net income and basic and diluted earnings per share for the six months ended June 30, 2006 were $110 thousand, $96 thousand, $0.01 per share and $0.01 per share lower, respectively, than if we had continued to account for stock-based compensation under APB Opinion No. 25 for our stock option grants. The following table details the effect on net income and earnings per share had stock-based compensation expense been recorded for the first six months of fiscal year 2005 based on the fair-value method under SFAS 123. For the Six Months Ended June 30, 2005 ----------- Net income (loss): As reported ................................................ $ (14,950) Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects .............................................. 114 Pro forma .................................................. $ (15,064) ========== Net income (loss) per share: As reported basic and diluted .............................. $ (1.81) Pro forma compensation expense ............................. (0.01) ---------- Pro forma basic and diluted ...................................... $ (1.82) ========== The Company has elected to continue to use the Black-Scholes option pricing model to estimate the fair value of stock-based awards. The use of a Black-Scholes option pricing model requires the input of assumptions determined 11 by management of the Company at the measurement date. These assumptions include the risk-free interest rate, expected dividend yield, volatility factor of the expected market price of the Company's common stock and the expected life of stock option grants. During the six months ended June 2006 and 2005, the Company did not grant any stock-based awards. Stock compensation expense recognized in the six months of 2006 represents the vesting of options previously granted. The fair values of these options were estimated on the dates of grant using the Black-Scholes model and assumptions determined on the grant dates. At June 30, 2006, there was $0.2 million of unrecognized compensation expense related to share-based payments, which is expected to be recognized over a weighted-average period of 1.3 years. The Company currently grants stock options under the Company's 1995 Stock Option Plan (the "1995 Plan") and its 1999 Stock Option Plan for Non-Employee Directors (the "1999 Plan"). Under the 1995 Plan, options to purchase up to 800,000 shares of the Company's Class A common stock may be issued to officers and key employees. Such options may be either incentive stock options or nonqualified stock options, and the options' exercise price must be at least equal to the fair value of the Company's Class A common stock on the date of grant. All options granted under the 1995 Plan have ten-year terms and vest over five years at the rate of 20% per year beginning on the first anniversary of the date of grant Under the 1999 Plan, non-employee directors may be granted options to purchase up to 50,000 shares of the Company's Class A common stock. Options granted under the 1999 Plan have ten-year terms and vest six months from the grant date. The following table presents stock option activity for the six months ended June 30, 2006: Weighted- Weighted- Average Average Remaining Stock Exercise Contractual Options Price Term -------------- ------------- ------------ 1995 Plan: Outstanding at December 31, 2005 672,000 $2.03 6.65 years Forfeited/Cancelled (9,900) $1.98 6.60 years Exercised 600 $0.36 ------------- Outstanding at June 30, 2006 661,500 $2.03 6.15 years ============= Exercisable at June 30, 2006 398,400 $2.02 6.15 years 12 Weighted- Weighted- Average Average Remaining Stock Exercise Contractual Options Price Term ------------- -------------- ------------- 1999 Plan: Outstanding at December 31, 2005 21,500 $2.40 7.54 years Forfeited/Cancelled -- Exercised -- ------------- Outstanding at June 30, 2006 21,500 $2.40 7.04 years ============= Exercisable at June 30, 2006 21,500 $2.40 7.04 years Shares available for future share-based grants to employees and directors under existing plans were 152,800 at June 30, 2006. At June 30, 2006, the aggregate intrinsic value of options on outstanding shares was $46,854, and the aggregate intrinsic value of options exercisable was $29,183. The total intrinsic value of options vested during the six months ended June 30, 2006 was $(3,235). The following table summarizes our non-vested stock option activity for the six months ended June 30, 2006: Weighted-Average Number of Grant-Date Shares Fair Value -------------- ------------------ 1995 Plan: Non-vested stock options at January 1, 2006 288,400 $1.63 Granted -- Forfeited (3,400) $1.85 Vested (21,900) $1.84 -------------- Non-vested stock options at June 30, 2006 263,100 $2.04 ============== Weighted-Average Number of Grant-Date Shares Fair Value -------------- ------------------ 1999 Plan: Non-vested stock options at January 1, 2006 4,500 $4.14 Granted -- Forfeited -- Vested (4,500) $4.14 -------------- Non-vested stock options at June 30, 2006 -- -- ============== 13 3. Inventories A summary of the major components of inventories is as follows (in thousands): June 30, December 31, 2006 2005 --------------------------------------------- Finished goods $31,417 $25,548 Work-in-process 2,538 1,497 Raw materials and supplies 5,526 7,562 ----- ----- Total inventories $39,481 $34,607 ======= ======= 4. Income (Loss) Per Share Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income per share is calculated by dividing net income by the weighted average number of shares of common stock and common stock equivalents outstanding during the period, unless their effect is anti-dilutive. 5. Environmental and Other Liabilities The Company records a liability for environmental remediation claims when a cleanup program or claim payment becomes probable and the costs can be reasonably estimated. As assessments and cleanup programs progress, these liabilities are adjusted based upon the progress in determining the timing and extent of remedial actions and the related costs and damages. The recorded liabilities, totaling $4.5 million at June 30, 2006 and $4.3 million at December 31, 2005, respectively, are not reduced by the amount of insurance recoveries. Such estimated insurance recoveries approximated $2.1 million at June 30, 2006 and $1.9 million at December 31, 2005, respectively, and are reflected in other non-current assets. Receivables for expected insurance recoveries are recorded if the related carriers are solvent and paying claims under a reservation of rights or under an obligation pursuant to coverage in place or a settlement agreement. Substantially all of Congoleum's recorded insurance asset for environmental matters is collectible from a single carrier. The Company is named, together with a large number (in most cases, hundreds) of other companies, as a potentially responsible party ("PRP") in pending proceedings under the federal Comprehensive Environmental Response, Compensation and Liability Act, as amended ("CERCLA"), and similar state laws. In addition, in four other instances, although not named as a PRP, the Company has received a request for information. The pending proceedings relate to eight disposal sites in New Jersey, Pennsylvania, and Maryland in which recovery from generators of hazardous substances is sought for the cost of cleaning up the contaminated waste sites. The Company's ultimate liability and funding obligations in connection with those sites depends on many factors, including the volume of material contributed to the site, the number of other PRPs and their financial viability, the remediation methods and technology to be used and the extent to which costs may be recoverable from insurance. However, under CERCLA and certain other laws, the Company, as a PRP, can be held jointly and severally liable for all environmental costs associated with a site. 14 The most significant exposure for which the Company has been named a PRP relates to a recycling facility site in Elkton, Maryland (the "Galaxy/Spectron Superfund Site"). The PRP group at this site is made up of 81 companies, substantially all of which are large financially solvent entities. Two removal actions were substantially complete as of December 31, 1998 and a groundwater treatment system was installed thereafter. The Environmental Protection Agency ("EPA") has selected a remedy for the soil and shallow groundwater ("Operable Unit 1" or OU-1); however, the remedial investigation/feasibility study related to the deep groundwater (OU-2) has not been completed. The PRP group, of which the Company is a part, has entered into a Consent Decree to perform the remedy for OU-1 and resolve natural resource damage claims. The Consent Decree also requires the PRPs to perform the OU-2 remedy, assuming that the estimated cost of the remedy is not more than $10 million. If the estimated cost of the OU-2 remedy is more than $10 million, the PRPs may decline to perform it or they may elect to perform anyway. Cost estimates for the OU-1 and OU-2 work combined (including natural resource damages) range between $22 million and $34 million, with the Company's share ranging between approximately $1.0 million and $1.6 million. This assumes that all parties participate and that none cash-out and pay a premium; those two factors may account for some fluctuation in the Company's share. Fifty percent (50%) of Congoleum's share of the costs is presently being paid by one of its insurance carriers, Liberty Mutual Insurance Company, whose remaining policy limits for this claim will cover approximately $0.3 million in additional costs. Congoleum expects to fund the balance to the extent further insurance coverage is not available. The Company filed a motion before the Bankruptcy Court seeking authorization and approval of the Consent Decree and related settlement agreements for the Galaxy/Spectron Superfund Site, as well authorization for Liberty Mutual Insurance Company and the Company to make certain payments that have been invoiced to the Company with respect to the Consent Decree and related settlement agreements. A hearing on the motion is scheduled for August 21, 2006. The Company also accrues remediation costs for certain of the Company's owned facilities on an undiscounted basis. The Company has entered into an administrative consent order with the New Jersey Department of Environmental Protection and has established a remediation trust fund of $100 thousand as financial assurance for certain remediation funding obligations. Estimated total cleanup costs of $1.6 million, including capital outlays and future maintenance costs for soil and groundwater remediation, are primarily based on engineering studies. Of this amount, $0.3 million is included in current liabilities subject to compromise and $1.3 million is included in non-current liabilities subject to compromise. The Company anticipates that these matters will be resolved over a period of years and that after application of expected insurance recoveries, funding the costs will not have a material adverse impact on the Company's liquidity or financial position. However, unfavorable developments in these matters could result in significant expenses or judgments that could have a material adverse effect on the financial position of the Company. 15 6. Asbestos Liabilities Claims Settlement and Chapter 11 Reorganization In early 2003, the Company announced a strategy for resolving current and future asbestos claims liability through confirmation of a pre-packaged plan of reorganization under Chapter 11 of the Bankruptcy Code. Later in 2003, the Company entered into the Claimant Agreement, a settlement agreement with various asbestos personal injury claimants. As contemplated by the Claimant Agreement, the Company also entered into agreements establishing the Collateral Trust to distribute funds in accordance with the terms of the Claimant Agreement and granting the Collateral Trust a security interest in the Company's rights under its applicable insurance coverage and payments from the Company's insurers for asbestos claims. The Claimant Agreement established a compensable disease valuation matrix (the "Matrix") and allowed claimants who qualified to participate in the Claimant Agreement (the "Qualifying Claimants") to settle their claims for the Matrix value, secured in part (75%) by a security interest in the collateral granted to the Collateral Trust. The Collateral Trust provides for distribution of trust assets according to various requirements that give priority (subject to aggregate distribution limits) to participating claimants who had pre-existing unfunded settlement agreements ("Pre-Existing Settlement Agreements") with the Company and participating claimants who qualified for payment under unfunded settlement agreements entered into by the Company with plaintiffs that had asbestos claims pending against the Company and which claims were scheduled for trial after the effective date of the Claimant Agreement but prior to the commencement of the Company's anticipated Chapter 11 reorganization case ("Trial-Listed Settlement Agreements"). The Claimant Agreement incorporated Pre-Existing Settlement Agreements and the settlement of certain Trial-Listed Settlement Agreement claims for a fully secured claim against the Collateral Trust, and it settled all other claims for a secured claim against the Collateral Trust equal to 75% of the claim value and an unsecured claim for the remaining 25%. In December 2005, the Company commenced the Avoidance Actions seeking to void the security interest granted to the Collateral Trust and such settlements. In March 2006, Congoleum filed a motion for summary judgment in the Avoidance Actions seeking to avoid the Claimant Agreement settlements and liens under various bankruptcy theories, which motion was denied in June 2006. Settlement values under the Ninth Plan differ from values under previous plans and the Claimant Agreement. As a result of such differences and the potential results of the Avoidance Actions, the liability associated with the asbestos personal injury claims against Congoleum may be materially different than the present estimates of such items. In October 2003, the Company began soliciting acceptances for its proposed pre-packaged plan of reorganization and the Company received the votes necessary for acceptance of the plan in late December 2003. On December 31, 2003, Congoleum filed a voluntary petition with the Bankruptcy Court (Case No. 03-51524) seeking relief under Chapter 11 of the Bankruptcy Code. In January 2004, the Company filed its proposed plan of reorganization and disclosure statement with the Bankruptcy Court. 16 In November 2004, Congoleum filed the Fourth Plan with the Bankruptcy Court reflecting the result of further negotiations with representatives of the ACC, the FCR and other asbestos claimant representatives. The Bankruptcy Court approved the disclosure statement and plan voting procedures in December 2004 and Congoleum obtained the requisite votes of asbestos personal injury claimants necessary to seek approval of the Fourth Plan. In April 2005, Congoleum announced that it had reached an agreement in principle with representatives of the ACC and the FCR to make certain modifications to its proposed plan of reorganization and related documents governing the settlement and payment of asbestos-related claims against Congoleum. Under the agreed-upon modifications, asbestos claimants with claims settled under Congoleum's pre-petition settlement agreements would agree to forbear from exercising the security interest they were granted and share on a pari passu basis with all other present and future asbestos claimants in insurance proceeds and other assets of the Plan Trust. In July 2005, Congoleum filed the Sixth Plan and related documents with the Bankruptcy Court which reflected the result of these negotiations, as well as other technical modifications. The Bankruptcy Court approved the disclosure statement and voting procedures and Congoleum commenced solicitation of acceptances of the Sixth Plan in August 2005. In September 2005, Congoleum learned that certain asbestos claimants were unwilling to agree to forbear from exercising their security interest as contemplated by the Sixth Plan and subsequently withdrew the Sixth Plan. In November 2005, the Bankruptcy Court denied a request to extend Congoleum's exclusive right to file a plan of reorganization and solicit acceptances thereof. In March 2006, Congoleum filed the Eighth Plan. In addition, an insurance company has filed the CNA Plan and the Bondholders' Committee has filed the Bondholder Plan. In May 2006, the presiding judge of the Bankruptcy Court ordered all parties in interest in Congoleum's reorganization proceedings to participate in global mediation discussions. Several mediation sessions took place during June and July 2006. During the mediation negotiations, Congoleum reached an agreement in principle, subject to mutually agreeable definitive documentation, with the ACC, the FCR and ABI on certain terms of the Ninth Plan, which Congoleum filed and proposed jointly with the ACC on August 11, 2006. The proponents of the CNA Plan and the Bondholder Plan have indicated they will jointly file a new plan by August 18, 2006. The Bankruptcy Court has scheduled a hearing to consider the adequacy of the disclosure statements with respect to these plans for September 21, 2006. Under the terms of the Ninth Plan, asbestos personal injury claimants voting to accept the plan would irrevocably consent or would be deemed to have irrevocably consented to the forbearance of any claim and lien rights under the Claimant Agreement and related agreements. Under the terms of the Ninth Plan, after the establishment of the Plan Trust, the assets in the Collateral Trust would be transferred to the Plan Trust and any asbestos claims would be channeled to the Plan Trust and paid in accordance with the terms of the Ninth Plan. There can be no assurance that the Company will not amend the Ninth Plan, that the Company will obtain approval to solicit acceptances of its plan of reorganization, that the Company will receive the acceptances necessary for confirmation of its plan, that its plan will not be modified further, that its plan will receive necessary court approvals from the Bankruptcy Court or the Federal District Court, or that such approvals will be received in a timely fashion, that its plan will be confirmed, that its plan, if confirmed, will 17 become effective, or that there will be sufficient funds to pay for continued protracted litigation over its plan of reorganization. It is unclear whether the Bankruptcy Court will approve any new plan filed by CNA and the Bondholders' Committee or whether any such plan, if confirmed, would be feasible. Moreover, it is unclear whether any other person will attempt to propose a plan or what any such plan would provide or propose, and whether the Bankruptcy Court would approve a plan other than Congoleum's proposed plan. Congoleum is presently involved in litigation with certain insurance carriers related to disputed insurance coverage for asbestos related liabilities, and certain insurance carriers filed various objections to Congoleum's previously proposed plans of reorganization and related matters and are expected to file objections to the Ninth Plan. Certain other parties, including the Bondholders' Committee, have also filed various objections to Congoleum's previously proposed plans of reorganization and may file objections to the Ninth Plan. While Congoleum is seeking to obtain the required acceptances of the Ninth Plan from all necessary classes of creditors, the Ninth Plan provides an alternative treatment for holders of the Senior Notes and stockholders, in the event sufficient note holders do not consent to the plan, which will materially affect the recoveries of these classes. In the event that the holders of the Senior Notes do not vote to accept the Ninth Plan by the requisite number and amount required by the Bankruptcy Code, then Plan confirmation shall be sought in accordance with the Cramdown Treatment. Pursuant to the Cramdown Treatment, the Senior Notes and existing Class A and Class B Common Stock would be cancelled and the Senior Note holders would receive their pro rata share, with the Plan Trust, of newly issued Common Stock of Congoleum, in an amount determined by a Final Order of the Bankruptcy Court; provided, however, that in no event may the amount of such newly issued Common Stock to be allocated to the holders of the Senior Notes exceed 49% of the voting common shares and total economic equity value of Congoleum on a fully diluted basis. During 2005 and 2006 the Company has entered into a number of settlement agreements with excess insurance carriers over coverage for asbestos-related claims. In May 2005, certain AIG companies agreed to pay approximately $103 million over ten years to the Plan Trust. This settlement resolves coverage obligations of policies with a total of $114 million in liability limits for asbestos bodily injury claims. Payment is subject to various conditions, including without limitation, the effectiveness of a plan of reorganization that provides AIG with certain specified relief including a channeling injunction pursuant to Section 524(g) of the Bankruptcy Code. An insurer has appealed the approval order granted by the Bankruptcy Court to the U.S. District Court, where it is pending. In June 2005, the Company entered into a settlement agreement with certain underwriters at Lloyd's, London, pursuant to which the certain underwriters paid approximately $20 million into an escrow account in exchange for a release of insurance coverage obligations. The escrow agent will transfer the funds to the Plan Trust once a plan of reorganization with the Section 524(g) protection specified in the settlement agreement goes effective and the Bankruptcy Court approves the transfer of the funds. In August 2005, the Company entered into a settlement agreement with Federal Insurance Company pursuant to which Federal will pay $4 million to the Plan Trust, subject to certain adjustments, once a plan of reorganization with the Section 524(g) protection specified in the settlement agreement goes effective and the Bankruptcy Court approves the transfer of the funds. The FCR has appealed the approval order granted by the Bankruptcy Court to the U.S. District Court, where it is pending. In October 2005, Congoleum entered into a settlement agreement with Mt. McKinley Insurance Company and Everest Reinsurance Company pursuant to which Mt. McKinley and Everest have paid $21.5 million into an escrow account. The escrow agent 18 will transfer the funds to the Plan Trust once a plan of reorganization with the Section 524(g) protection specified in the settlement agreement goes effective and the Bankruptcy Court approves the transfer of the funds. An insurer and the FCR have appealed the approval order granted by the Bankruptcy Court to the U.S. District Court, where it is pending. In March 2006, Congoleum entered into a settlement agreement with Harper Insurance Limited. Under the terms of this settlement, Harper will pay $1.4 million to Congoleum or the Plan Trust once certain conditions are satisfied, including the effectiveness of a plan of reorganization containing the Section 524(g) protection specified in the settlement agreement. The Bankruptcy Court approved this settlement in April 2006. In April 2006, Congoleum entered into a settlement agreement with Travelers Casualty and Surety Company and St. Paul Fire and Marine Insurance Company (collectively, "Travelers"). Under the terms of this settlement, Travelers will pay $25 million in two installments over thirteen months to the Plan Trust once a plan of reorganization with the Section 524(g) protection specified in the settlement agreement goes effective and the Bankruptcy Court approves the transfer of the funds. A motion for Bankruptcy Court approval of this settlement is pending. In April 2006, Congoleum also entered into a settlement agreement with Fireman's Fund Insurance Company. Under the terms of this settlement, Fireman's Fund will pay $1 million to the Plan Trust once a plan of reorganization with the Section 524(g) protection specified in the settlement agreement goes effective and the Bankruptcy Court approves the transfer of the funds. A motion for Bankruptcy Court approval of this settlement is pending. It is possible that any of the settling insurers may argue that the Ninth Plan is not substantially similar to relevant provisions of earlier plans referenced in its respective settlement agreement and therefore is relieved of its settlement obligation. The Company expects that it will take until some time in the first quarter of 2007 at the earliest to obtain confirmation of the Ninth Plan. Under previous plans, Congoleum's assignment of insurance recoveries to the Plan Trust was net of costs incurred by Congoleum in connection with insurance coverage litigation, and Congoleum was entitled to withhold from recoveries, or seek reimbursement from the Plan Trust, for coverage litigation costs incurred after January 1, 2003 and for $1.3 million in claims processing fees paid in connection with claims settled under the Claimant Agreement. A receivable was recorded for these costs as they were paid. Under the Ninth Plan, Congoleum would be entitled to reimbursement of only approximately $3.7 million in cash for such coverage litigation costs and to reimbursement of the $1.3 million in claims processing costs and would not collect the balance of these receivables ($16.8 million at June 30, 2006). The write-off and any applicable forgiveness of indebtedness income pursuant to the Ninth Plan are expected to be recorded at a future date, the net effect of which cannot be determined. The Ninth Plan provides for the channeling of asbestos property damage claims in addition to asbestos personal injury claims to the Plan Trust. There were no asbestos related property damage claims asserted against the Company at the time of its bankruptcy filing. The Bankruptcy Court approved an order establishing a bar date of May 3, 2004 for the filing of asbestos property damage claims. The claims agent appointed in the Company's bankruptcy proceeding advised the Company that, as of the bar date, it received 35 timely filed asbestos property damage claims asserting liquidated damages in the amount of approximately $0.8 million plus additional unspecified amounts. The Company objected to certain claims on various grounds, and the Bankruptcy Court ultimately allowed 19 claims valued at $133 thousand. The Ninth Plan will provide for payment of those claims in full from certain insurance proceeds. 19 Under the terms of the Ninth Plan, on the effective date of the Ninth Plan (the "Effective Date"), the Plan Trust will provide a loan to Congoleum, which loan is intended, when combined with cash on hand and available drawings under the revolving credit facility, to provide Congoleum with $18 million of total liquidity, on a pro forma basis as of December 31, 2006 (the "Plan Trust Note"). If the Effective Date occurs after December 31, 2006, the total liquidity required by Congoleum, and thus the amount of the Plan Trust Note, will be as mutually agreed among the ACC, the FCR and Congoleum. The proceeds of the Plan Trust Note will only be used for working capital and general corporate purposes. The Plan Trust Note will be due and payable on December 31, 2011, shall bear interest at 10% per annum payable semi-annually until the maturity date, and will contain appropriate covenants, warranties, and representations as agreed among Congoleum, the ACC, the FCR and the Claimants' Representative. The principal amount of the Plan Trust Note, which is subject to review and approval by the FCR and the ACC, may not exceed $14 million unless both the FCR and ACC agree. There can be no assurance either or both would agree to any such request from Congoleum, or that Congoleum would obtain any other consents that might be necessary to increase the amount of the Plan Trust Note. On the Effective Date, if the holders of the Senior Note Claims (as a class) vote to accept the Ninth Plan, Congoleum will issue and contribute a convertible promissory note (the "New Convertible Security") to the Plan Trust in satisfaction of section 524(g) of the Bankruptcy Code. The New Convertible Security will have the following terms: (i) an initial aggregate principal amount of $2,738,234.75, such principal amount being subject to increase in the amount, if any, by which 36% of Congoleum's market capitalization based on average trading prices for Congoleum's Class A Common Stock at the close of trading for the 90 consecutive trading days beginning on the one year anniversary of the Effective Date, exceeds such initial principal amount; (ii) an initial interest rate equal to 9% of the principal amount per annum, payable semi-annually in arrears, with such interest rate to reset at the rate of 5% of the principal amount per annum on the tenth anniversary of the Effective Date and payable at such reset interest rate per annum until maturity; (iii) redeemable for the principal amount at the option of the Plan Trust or Congoleum on or anytime after the tenth anniversary of the Effective Date; (iv) a maturity date on the fifteenth anniversary of the Effective Date if not redeemed or otherwise paid earlier; (v) convertible into 5,700,000 shares of Class A Common Stock (on a fully diluted basis with all Class B Common Stock converted to Class A Common Stock) upon a specified default of the obligation to pay interest and a failure to cure such default within any cure period, which, when combined with the New Class A Common Stock, will result in the Plan Trust owning 51% of the voting common shares and 51% of the total economic equity value of Congoleum on a fully diluted basis; and (vi) no voting rights except upon conversion. The principal adjustment feature could result in the principal amount of the New Convertible Security increasing materially. Under the terms of the Ninth Plan, if holders of the Senior Notes vote to accept the Plan by the requisite number and amount required by the Bankruptcy Code, the Senior Notes would be cancelled and Congoleum would issue new notes (the "New Senior Notes") in the aggregate principal amount of $100 million which shall be payable semi-annually at the rate of 10% per annum until a maturity date of August 1, 2011; provided, however, that Reorganized Congoleum shall receive a credit against all interest payable under the New Senior Notes for all fees and expenses of the Bondholders' Committee incurred and paid after the date that the Plan is filed with the Bankruptcy Court. The New Senior Notes will be subordinate in priority and payment to the New Convertible Security and the Plan Trust Note. 20 While Congoleum is seeking to obtain the required acceptances of the Ninth Plan from all necessary classes of creditors, the Ninth Plan provides an alternative treatment for holders of the Senior Notes and stockholders in the event sufficient note holders do not consent to the Ninth Plan. This alternative treatment will materially affect the recoveries of these classes. In the event that the holders of the Senior Notes do not vote to accept the Ninth Plan by the requisite number and amount required by the Bankruptcy Code, then Plan confirmation will be sought in accordance with the Cramdown Treatment. Pursuant to the Cramdown Treatment, the Senior Notes and existing Class A and Class B Common Stock would be cancelled and the Senior Note holders would receive their pro rata share of newly issued Common Stock with the Plan Trust, as determined by a Final Order of the Bankruptcy Court; provided, however, that in no event may the amount of such newly issued Common Stock to be allocated to the holders of the Senior Notes exceed 49% of the voting common shares and total economic equity value of Congoleum on a fully diluted basis. As part of the Ninth Plan, Congoleum agreed to indemnify representatives of holders of pre-petition secured asbestos claims (the "Claimants' Representative") and the trustee of the Collateral Trust in connection with arranging and supporting the Ninth Plan and for effecting the forbearance of claimants from exercising any lien rights under the Claimant Agreement and related documents, for claims and costs, including attorneys' fees, up to a maximum of $3 million. Under the Ninth Plan and related documents, ABI has agreed to make a cash contribution in the amount of $250 thousand to the Plan Trust upon the formation of the Plan Trust and to forego certain indemnification rights it has from Congoleum for asbestos claims. Under the Ninth Plan, ABI would receive certain relief as may be afforded under Section 524(g)(4) of the Bankruptcy Code from asbestos claims that derive from claims made against the Company, which claims are expected to be channeled to the Plan Trust. However, the Ninth Plan does not provide that any other asbestos claims that may be asserted against ABI would be channeled to the Plan Trust. There are sufficient risks and uncertainties related to Congoleum's efforts to confirm a plan of reorganization such that no assurances of the outcome can be given. In addition, the remaining costs to effect the reorganization process, consisting principally of legal and advisory fees and contributions to the Plan Trust, are expected to be approximately $13.9 million at a minimum, not including any Market Reset Obligation arising from revaluation of the New Convertible Security or the principal amount of the Plan Trust Note, and could be materially higher. Based on the Eighth Plan, the Company has made provision in its financial statements for the minimum amount of the range of estimates for its contribution to effect its plan to settle asbestos liabilities through the Plan Trust. The Company recorded charges aggregating approximately $51.3 million in prior years, and is not yet able to determine the amount of the additional cost that will be required to complete its reorganization as based on the Ninth Plan. The Company is not yet able to determine the additional costs that may be required to effect the Ninth Plan or any other plan, and actual amounts that will be contributed to the Plan Trust and costs for pursuing and implementing any plan of reorganization could be materially higher than currently recorded. Delays in proposing, filing or obtaining approval of the Ninth Plan or any new amended plan of reorganization, or the any new plan to be filed by CNA and the Bondholders' Committee by the proponents of such plans, or the proposal of additional plans by other parties could result in a proceeding that takes longer and is more costly than the Company has estimated. The Company may record significant additional charges should the minimum estimated cost increase. 21 Pending Asbestos Claims In 2003, the Company was one of many defendants in approximately 22 thousand pending lawsuits (including workers' compensation cases) involving approximately 106 thousand individuals, alleging personal injury or death from exposure to asbestos or asbestos-containing products. Claims involving approximately 80 thousand individuals have been settled pursuant to the Claimant Agreement and litigation related to unsettled or new claims is presently stayed by the Bankruptcy Code. The Company expects unsettled and future claims to be handled in accordance with the terms of a plan of reorganization and the Plan Trust. In December 2005, the Company commenced the Avoidance Actions seeking to void the security interest granted to the Collateral Trust and such settlements. Nearly all asbestos-related claims that have been brought against the Company to date allege that various diseases were caused by exposure to asbestos-containing products, including resilient sheet vinyl and tile manufactured by the Company (or, in the workers' compensation cases, exposure to asbestos in the course of employment with the Company). The Company discontinued the manufacture of asbestos-containing sheet products in 1983 and asbestos-containing tile products in 1974. In general, governmental authorities have determined that asbestos-containing sheet and tile products are non-friable (i.e., cannot be crumbled by hand pressure) because the asbestos was encapsulated in the products during the manufacturing process. Thus, governmental authorities have concluded that these products do not pose a health risk when they are properly maintained in place or properly removed so that they remain non-friable. The Company has issued warnings not to remove asbestos-containing flooring by sanding or other methods that may cause the product to become friable. Status of Insurance Coverage During the period that Congoleum produced asbestos-containing products, the Company purchased primary and excess insurance policies providing in excess of $1 billion of coverage for general and product liability claims. Through August 2002, substantially all asbestos-related claims and defense costs were paid through primary insurance coverage. In August 2002, the Company received notice that its primary insurance limits had been paid in full. The payment of limits in full by one of the primary insurance companies was based on its contention that limits in successive policies were not cumulative for asbestos claims and that Congoleum was limited to only one policy limit for multiple years of coverage. Certain excess insurance carriers claimed that the non-cumulation provisions of the primary policies were not binding on them and that there remained an additional $13 million in primary insurance limits plus related defense costs before their policies were implicated. There is insurance coverage litigation currently pending between Congoleum and its excess insurance carriers, and the guaranty funds and associations for the State of New Jersey. The litigation was initiated in September 2001, by one of Congoleum's excess insurers (the "Coverage Action"). In April 2003, the New Jersey Supreme Court ruled in another case involving the same non-cumulation provisions as in the Congoleum primary policies (the "Spaulding Case") that the non-cumulation provisions are invalid under New Jersey law and that the primary policies provide coverage for the full amount of their annual limits for all successive policies. Congoleum has reached a settlement agreement (the "Insurance 22 Settlement") with the insurance carrier whose policies contained the non-cumulation provisions, pursuant to which the insurance carrier will pay Congoleum $15.4 million in full satisfaction of the applicable policy limits, of which $14.5 million has been paid to date. Pursuant to the terms of the Security Agreement, the Company is obligated to pay any insurance proceeds it receives under the Insurance Settlement, net of any fees and expenses it may be entitled to deduct, to the Collateral Trust. Payment of such fees and expenses are subject to Bankruptcy Court order or approval. The Company does not expect the Insurance Settlement to have a material effect on its financial condition or results of operations. As of December 31, 2002, the Company had entered into additional settlement agreements with asbestos claimants exceeding the amount of previously disputed coverage. The excess carriers have objected to the reasonableness of several of these settlements, and Congoleum believes that they will continue to dispute the reasonableness of the settlements and contend that their policies still are not implicated and will dispute their coverage for that and other various reasons in ongoing coverage litigation. The excess insurance carriers have also raised various objections to the Company's previously proposed plans of reorganization and may raise objections to any new amended plan that is proposed. The excess insurance carriers have objected to the global settlement of the asbestos claims currently pending against Congoleum as contemplated by the Claimant Agreement on the grounds that, among other things, the negotiations leading to the settlement and the Claimant Agreement violate provisions in their insurance policies, including but not limited to the carriers' right to associate in the defense of the asbestos cases, the duty of Congoleum to cooperate with the carriers and the right of the carriers to consent to any settlement. The excess insurance carriers also contend the Claimant Agreement is not fair, reasonable or in good faith. Additionally, certain insurers have argued that Congoleum's entering into the Claimant Agreement voids the insurance for the underlying claims in their entirety. Certain insurers also have claimed that the Claimant Agreement voids their entire policy obligations. Congoleum has disputed the allegations and contentions of the excess insurance carriers. In November 2003, the Court denied a motion for summary judgment by the excess insurance carriers that the Claimant Agreement was not fair, reasonable or in good faith, ruling that material facts concerning these issues were in dispute. In April 2004, the Court denied motions for summary judgment by the excess carriers that the Claimant Agreement was not binding on them because Congoleum had breached the consent and cooperation clauses of their insurance policies by, among other things, entering into the Claimant Agreement without their consent. Congoleum has argued, among other things, that it was entitled to enter into the Claimant Agreement and/or the Claimant Agreement was binding on the excess insurance carriers because they were in breach of their policies and/or had denied coverage and/or had created a conflict with Congoleum by reserving rights to deny coverage and/or the Claimant Agreement was fair, reasonable and in good faith and/or there was and is no prejudice to the excess insurance carriers from the Claimant Agreement and/or the excess insurance carriers had breached their duties of good faith and fair dealing. In August 2004, the Court entered a case management order that divided the trial into three phases. A new judge was assigned to the case in February 2005 and the schedule was modified as a result. In February 2005, the Court ruled on a series of summary judgment motions filed by various insurers. The Court denied a motion for summary judgment filed by certain insurers, holding that there were disputed issues of fact regarding whether the Claimant Agreement and other settlement agreements between Congoleum and the claimants had released Congoleum and the insurers from any liability for the asbestos bodily injury claims of the claimants who signed the Claimant Agreement and the other settlement agreements. 23 The Court also denied another motion for summary judgment filed by various insurers who argued that they did not have to cover the liability arising from the Claimant Agreement because they had not consented to it. The Court granted summary judgment regarding Congoleum's bad faith claims against excess insurers (other than first-layer excess insurers), holding that the refusal of these excess insurers to cover the Claimant Agreement was at least fairly debatable and therefore not in bad faith. The first phase of the trial began in August 2005 and is addressing all issues and claims relating to whether the insurers are obligated to provide coverage under the policies at issue in this litigation for the global Claimant Agreement entered into by Congoleum, including but not limited to all issues and claims relating to both Congoleum's decision and conduct in entering into the Claimant Agreement and filing a pre-packaged bankruptcy and the insurance company defendants' decisions and conduct in opposing the Claimant Agreement and Congoleum's pre-packaged bankruptcy, the reasonableness and good faith of the Claimant Agreement, whether the Claimant Agreement breached any insurance policies and, if so, whether the insurance companies suffered any prejudice, and whether the insurance companies' opposition to the Claimant Agreement and bankruptcy and various other conduct by the insurers has breached their duties of good faith and fair dealing such that they are precluded from asserting that Congoleum's decision to enter into the Claimant Agreement constitutes any breach(es) on the part of Congoleum. The Company believes, however, that even if the insurers were to succeed in the first phase of the Coverage Action, such result would not deprive individual claimants of the right to seek payment from the insurers who issued the affected insurance policies. Additionally, Congoleum could negotiate settlements with some or all of the signatories to the Claimant Agreement and seek payment from its insurers for such settlements. Such result would not preclude the Company from attempting to amend the Claimant Agreement and thereafter seek recovery under the Claimant Agreement as amended; moreover, the Company does not believe that it would be deprived of coverage-in-place insurance for future obligations of or demands upon the insurers under the applicable insurance policies. However, there can be no assurances of the outcome of these matters or their potential effect on the Company's ability to obtain approval of its plan of reorganization. The second phase of the trial will address all coverage issues, including but not limited to trigger and allocation. The final phase of the trial will address bad faith punitive damages, if appropriate. In March 2005, the Company filed a motion in the Bankruptcy Court asking the Bankruptcy Court to vacate its prior order lifting the automatic stay in bankruptcy to permit the Coverage Action to proceed. The Company requested that the Coverage Action proceedings be stayed until the Company has completed its plan confirmation process in the Bankruptcy Court. A hearing on the Company's motion was held in April 2005 and the motion was denied. 24 In October 2005, a federal appeals court ruled that the law firm of Gilbert Heintz & Randolph ("GHR"), which had been acting as the Company's insurance co-counsel in the Coverage Action, had other representations which were in conflict with its representation of Congoleum. As a result of this ruling, with Bankruptcy Court approval, Congoleum retained the firm of Covington & Burling to represent it as co-counsel with Dughi & Hewit in the insurance coverage litigation and insurance settlement matters previously handled by GHR. In or about mid-November 2005, and in early December 2005, certain insurers filed motions for summary judgment on the grounds, inter alia, that the decision of the United States Court of Appeals for the Third Circuit reversing the Bankruptcy Court's order approving the retention of the Gilbert Heinz & Randolph firm in In re Congoleum, 426 F.3d 675 (3d Cir. 2005), and/or Congoleum's filing of the Avoidance Actions in the Bankruptcy Court, entitled them to judgment as a matter of law on the Phase I issues. Congoleum opposed the motions. The motions were argued in January 2006, and in March 2006 the Court denied the motions for summary judgment. Congoleum completed the presentation of its case in April 2006. Certain insurers moved for a directed verdict in their favor during the first week of May 2006. Hearings of arguments on the directed verdict motion took place in June 2006. In July 2006 the Court denied the motion for a directed verdict. The trial is scheduled to resume in September 2006. Some insurers contend that, if there is a ruling adverse to Congoleum in the Coverage Litigation, then the insurers will not owe coverage for claims resolved under the Claimant Agreement and/or under other pre-petition settlements. Insurers further contend that such result would also deprive individual claimants who were parties to the Claimant Agreement and other pre-petition settlements of the right to seek payment from the insurers under their insurance policies or from negotiating settlements with some or all of the insurers. Insurers also contend that such result would preclude Congoleum and claimants from agreeing to forbear under or amending the Claimant Agreement and other pre-petition settlements and would preclude claimants from seeking recovery under other claims payment standards, including bankruptcy Trust Distribution Procedures (TDPs), or under any amended agreements. Congoleum intends to contest any attempt by the insurers to enlarge or expand upon a Phase 1 ruling that is adverse to Congoleum. However, there can be no assurances of the outcome of these matters. The Phase 2 trial will address all remaining coverage issues, including but not limited to trigger and allocation. Discovery is permitted on all issues, except for punitive damages. Pre-trial motions and trial dates for the Phase 2 and Phase 3 trials and discovery for the Phase 3 trial will be addressed by the Court after the Phase 1 trial decision. Given the actions of its excess insurance carriers, the Company believes it likely that it would currently have to fund any asbestos-related expenses for defense expense and indemnity itself. However, litigation by asbestos claimants against the Company is stayed pursuant to the Company's bankruptcy proceedings, and based on the anticipated channeling injunction in the Ninth Plan, the Company does not anticipate its future expenditures for defense and indemnity of asbestos-related claims, other than expenditures pursuant to a plan of reorganization, will be significant. 25 Accounting for Asbestos-Related Claims Under the terms of the Claimant Agreement, the Company's claims processing agent processed 79,630 claims meeting the requirements of the Claimant Agreement with a settlement value in excess of $466 million. In addition, Pre-Existing Settlement Agreements and Trial-Listed Settlement Agreements with claims secured by the Collateral Trust total approximately $25 million. As a result of tabulating ballots on its Fourth Plan, the Company is also aware of claims by claimants whose claims were not determined under the Claimant Agreement but who have submitted claims with a value of approximately $512 million based on the settlement values applicable in the Sixth Plan. The Company's gross liability of in excess of $491 million for these settlements and contingent liability for the additional approximately $512 million in unsettled claims is substantially in excess of the total assets of the Company. The Company believes that it does not have the necessary financial resources to litigate and/or fund judgments and/or settlements of the asbestos claims in the ordinary course of business. Therefore, the Company believes the most meaningful measure of its probable loss due to asbestos litigation is the amount it will have to contribute to the Plan Trust plus the costs to effect its reorganization under Chapter 11. At June 30, 2006, the Company estimates it will spend a further $13.9 million at a minimum in fees, expenses, and trust contributions in connection with obtaining confirmation of its plan of reorganization, which amount is recorded in its reserve for asbestos-related liabilities (in addition to the $9.5 million insurance settlement being held as restricted cash). It also expects to spend a further $7.9 million at a minimum in connection with insurance coverage litigation costs. Required expenditures could be materially higher than these estimates. The Company currently holds $3.7 million in restricted cash that may be available to offset costs incurred pursuing insurance coverage, subject to approval by the Bankruptcy Court. In February 2006, the Bankruptcy Court ordered GHR to disgorge all fees and certain expenses it was paid by Congoleum. GHR has appealed this ruling. The amount of the disgorgement is approximately $9.6 million. Pursuant to the terms of the Ninth Plan, the net proceeds of the GHR disgorgement would be used to reduce the obligations of Congoleum to the Plan Trust by first being applied to reduce or satisfy principal and accrued interest under the Plan Trust Note and thereafter to reduce or satisfy principal and accrued interest under the New Convertible Security. The Company recorded charges aggregating approximately $51.3 million in prior years, and is not yet able to determine the amount of the additional cost that will be required to complete its reorganization. Additional charges may be required in the future should the minimum estimated cost increase. The maximum amount of the range of possible asbestos-related losses is limited to the going concern or liquidation value of the Company, an amount which the Company believes is substantially less than the minimum gross liability for the known claims against it. The Company has not attempted to make an estimate of its probable insurance recoveries for financial statement purposes given the accounting for its estimate of future asbestos-related costs. Substantially all future insurance recoveries will be assigned to the Collateral Trust or Plan Trust. 26 Amounts Recorded in Financial Statements The table below provides an analysis of changes in the Company's asbestos reserves and related receivables from December 31, 2005 to June 30, 2006: Reimbursement from Balance at Reserve Insurance Balance at (in thousands) 12/31/05 Spending Addition Settlement 6/30/06 ------------------------------------------------------------- Reserves Current $ 19,469 $ (5,576) $ -- $ -- $ 13,893 Long-Term -- -- -- -- Receivables Current (14,793) (5,745) -- -- (20,538) Long-Term -- -- -- -- -- -------- -------- -------- ----- -------- Net Asbestos Liability $ 4,676 $(11,321) $ -- $ -- $ (6,645) ======== ======== ======== ===== ======== Restricted Cash Insurance Proceeds $ 8,901 $ -- $ 646 $ -- $ 9,547 Reimbursement from Balance at Reserve Insurance Balance at (in thousands) 12/31/04 Spending Addition Settlement 6/30/05 ------------------------------------------------------------- Reserves Current $ 6,550 $ (5,832) $ 13,092 $ -- $ 13,810 Long-Term 2,738 -- -- 2,738 Receivables Current (1,509) (7,095) 2,362 6,091 (151) Long-Term (7,300) -- -- -- (7,300) -------- -------- -------- -------- -------- Net Asbestos Liability $ 479 $(12,927) $ 15,454 $ 6,091 $ 9,097 ======== ======== ======== ======== ======== Restricted Cash Insurance Proceeds $ 14,530 $ (6,091) $ 182 $ -- $ 8,621 7. Product Warranties The Company provides product warranties for specific product lines and accrues for estimated future warranty cost in the period in which the revenue is recognized. The following table sets forth activity in the Company's warranty reserves (in millions): 27 Six Months Ended Six Months Ended June 30, June 30, 2006 2005 ---- ---- Beginning balance $ 2.1 $ 2.8 Accruals 2.1 1.7 Charges (2.1) (2.0) -------- -------- Ending balance $ 2.1 $ 2.5 ======== ======== 8. Liabilities Subject to Compromise As a result of the Company's Chapter 11 filing (see Notes 1 and 6), pursuant to SOP 90-7, the Company is required to segregate pre-petition liabilities that are subject to compromise and report them separately on the consolidated balance sheet. Liabilities that may be affected by a plan of reorganization are recorded at the amount of the expected allowed claims, even if they may be settled for lesser amounts. Substantially all of the Company's pre-petition debt is recorded at face value and is classified within liabilities subject to compromise. In addition, the Company's accrued interest expense on its Senior Notes is also recorded in liabilities subject to compromise. Liabilities subject to compromise at June 30, 2006 and December 31, 2005 are as follows: (In thousands) June 30, December 31, 2006 2005 ---- ---- Current Pre-petition other payables and accrued interest $ 29,281 $ 23,990 Non-current Debt (at face value) 100,000 100,000 Pension liability 15,914 16,871 Other post-retirement benefit obligation 8,419 8,407 Pre-petition other liabilities 13,602 13,583 ------ ------ Non-current 137,935 138,861 -------- -------- Total liabilities subject to compromise $167,216 $162,851 ======== ======== Additional pre-petition claims (liabilities subject to compromise) may arise due to the rejection of executory contracts or unexpired leases, or as a result of the allowance of contingent or disputed claims. 28 9. Accrued Liabilities A summary of the significant components of accrued liabilities consists of the following: (In thousands) June 30, December 31, 2006 2005 ---- ---- Accrued warranty, marketing and sales promotion $16,577 $19,129 Employee compensation and related benefits 3,330 3,674 Other 2,600 269 ---------- --------- Total accrued liabilities $22,507 $23,072 ========== ========= As a result of the Company's Chapter 11 bankruptcy filing and in accordance with SOP 90-7, certain liabilities are included in liabilities subject to compromise on the balance sheet as of June 30, 2006 and December 31, 2006 (see Note 8). 10. Pensions and Other Postretirement Plans The Company sponsors several non-contributory defined benefit pension plans covering most of the Company's employees. Benefits under the plans are based on years of service and employee compensation. Amounts funded annually by the Company are actuarially determined using the projected unit credit and unit credit methods and are equal to or exceed the minimum required by government regulations. The Company also maintains health and life insurance programs for retirees (reflected in the table below in "Other Benefits"). The following summarizes the components of the net periodic benefit cost for the Pension and Other Benefit Plans for the three months ended June 30, 2006 and 2005: (In thousands) Three Months Ended Three Months Ended June 30, 2006 June 30, 2005 ------------- ------------- Other Other Pension Benefits Pension Benefits ------- -------- ------- -------- Components of Net Periodic Benefit Cost: Service cost $ 361 $ 48 $ 355 $ 46 Interest cost 1,113 132 1,094 130 Expected return on plan assets (997) -- (881) -- Recognized net actuarial loss 365 16 385 15 Amortization of transition obligation -- -- (18) -- Amortization of prior service cost (54) 9 (72) (47) ------ ------ ------ ----- Net periodic benefit cost $ 788 $ 205 $ 863 $ 144 ====== ====== ====== ===== 29 The weighted average assumptions used to determine net periodic benefit cost were as follows: June 30, 2006 June 30, 2005 ------------- ------------- Other Other Pension Benefits Pension Benefits ------- -------- ------- -------- Discount rate 6.00% 6.00% 6.25% 6.25% Expected long-term return on plan assets 7.00% -- 7.00% -- Rate of compensation increase 4.00% -- 4.00% -- Income from operations 5.50% 5.50% The following summarizes the components of the net periodic benefit cost for the Pension and Other Benefit Plans for the six months ended June 30, 2006 and 2005: (In thousands) Six Months Ended Six Months Ended June 30, 2006 June 30, 2005 ------------- ------------- Other Other Pension Benefits Pension Benefits ------- -------- ------- -------- Components of Net Periodic Benefit Cost: Service cost $ 721 $ 96 $ 710 $ 92 Interest cost 2,226 264 2,188 260 Expected return on plan assets (1,994) -- (1,762) -- Recognized net actuarial loss 731 32 769 30 Amortization of transition obligation -- -- (36) -- Amortization of prior service cost (108) 18 (144) (94) ------- ------- ------- ------- Net periodic benefit cost $ 1,576 $ 410 $ 1,725 $ 288 ======= ======= ======= ======= The weighted average assumptions used to determine net periodic benefit cost were as follows: June 30, 2006 June 30, 2005 ------------- ------------- Other Other Pension Benefits Pension Benefits ------- -------- ------- -------- Discount rate 6.00% 6.00% 6.25% 6.25% Expected long-term return on plan assets 7.00% -- 7.00% -- Rate of compensation increase 4.00% -- 4.00% -- Income from operations 5.50% 5.50% 30 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Unaudited Condensed Consolidated Financial Statements and notes thereto contained in Item 1 of this Quarterly Report on Form 10-Q. Results of Operations The Company's business is cyclical and is affected by the same economic factors that affect the remodeling and housing industries in general, including the availability of credit, consumer confidence, changes in interest rates, market demand and general economic conditions. In addition to external economic factors, the Company's results are sensitive to sales and manufacturing volume, competitors' pricing, consumer preferences for flooring products, raw material costs and the mix of products sold. The manufacturing process is capital intensive and requires substantial investment in facilities and equipment. The cost of operating these facilities generally does not vary in direct proportion to production volume and, consequently, operating results fluctuate disproportionately with changes in sales volume. During 2003, Congoleum obtained the requisite votes of asbestos personal injury claimants necessary to seek approval of a proposed, pre-packaged Chapter 11 plan of reorganization as a means to resolve claims asserted against it related to the use of asbestos in its products decades ago. On December 31, 2003, Congoleum filed a voluntary petition with the Bankruptcy Court seeking relief under Chapter 11 of the Bankruptcy Code. In January 2004, the Company filed its proposed plan of reorganization and disclosure statement with the Bankruptcy Court. In November 2004, Congoleum filed the Fourth Plan with the Bankruptcy Court reflecting the result of further negotiations with representatives of the ACC, the FCR and other asbestos claimant representatives. The Bankruptcy Court approved the disclosure statement and plan voting procedures in December 2004 and Congoleum obtained the requisite votes of asbestos personal injury claimants necessary to seek approval of the Fourth Plan. In April 2005, Congoleum announced that it had reached an agreement in principle with representatives of the ACC and the FCR to make certain modifications to its proposed plan of reorganization and related documents governing the settlement and payment of asbestos-related claims against Congoleum. Under the agreed-upon modifications, asbestos claimants with claims settled under Congoleum's pre-petition settlement agreements would agree to forbear from exercising the security interest they were granted and share on a pari passu basis with all other present and future asbestos claimants in insurance proceeds and other assets of the Plan Trust. In July 2005, Congoleum filed the Sixth Plan and related documents with the Bankruptcy Court which reflected the result of these negotiations as well as other technical modifications. The Bankruptcy Court approved the disclosure statement and voting procedures and Congoleum commenced solicitation of acceptances of the Sixth Plan in August 2005. In September 2005, Congoleum learned that certain asbestos claimants were unwilling to agree to forbear from exercising their security interest as contemplated by the Sixth Plan and the Sixth Plan was subsequently withdrawn. In November 2005, the Bankruptcy Court denied a request to extend Congoleum's exclusive right to file a plan of reorganization and solicit acceptances thereof. In March 2006, Congoleum filed the Eighth Plan. In addition, an insurance company has filed the CNA Plan and the Bondholders' Committee (representing holders of the Senior Notes) has filed the Bondholder 31 Plan. In May 2006, the presiding judge of the Bankruptcy Court ordered all parties in interest in Congoleum's reorganization proceedings to participate in global mediation discussions. Several mediation sessions took place during June and July 2006. During the mediation negotiations, Congoleum reached an agreement in principle, subject to mutually agreeable definitive documentation, with the ACC the FCR and ABI on certain terms of the Ninth Plan, which Congoleum filed and proposed jointly with the ACC, on August 11, 2006. The proponents of the CNA Plan and the Bondholder Plan have indicated they will jointly file a new plan by August 18, 2006. The Bankruptcy Court has scheduled a hearing to consider the adequacy of the disclosure statements with respect to these plans for September 21, 2006. There can be no assurance that the Company will not amend the Ninth Plan, that the Company will obtain approval to solicit acceptances of its plan of reorganization, that the Company will receive the acceptances necessary for confirmation of its plan of reorganization, that its plan will not be modified further, that its plan will receive necessary court approvals from the Bankruptcy Court or the Federal District Court, or that such approvals will be received in a timely fashion, that its plan will be confirmed, that its plan, if confirmed, will become effective, or that there will be sufficient funds to pay for continued protracted litigation over its plan of reorganization. It is unclear whether the Bankruptcy Court will approve any new plan filed by CNA and the Bondholders' Committee or whether any such plan, if confirmed, would be feasible. Moreover, it is unclear whether any other person will attempt to propose a plan or what any such plan would provide or propose, and whether the Bankruptcy Court would approve a plan other than Congoleum's proposed plan. Congoleum is presently involved in litigation with certain insurance carriers related to disputed insurance coverage for asbestos related liabilities, and certain insurance carriers filed various objections to Congoleum's previously proposed plans of reorganization and related matters and are expected to file objections to the Ninth Plan. Certain other parties, including the Bondholders' Committee, have also filed various objections to Congoleum's previously proposed plans of reorganization and may file objections to the Ninth Plan. While Congoleum is seeking to obtain the required acceptances of the Ninth Plan from all necessary classes of creditors, the Ninth Plan provides an alternative treatment for holders of the Senior Notes and stockholders, in the event sufficient note holders do not consent to the plan, which will materially affect the recoveries of these classes. In the event that the holders of the Senior Notes do not vote to accept the Ninth Plan by the requisite number and amount required by the Bankruptcy Code, then Plan confirmation shall be sought in accordance with the Cramdown Treatment. Pursuant to the Cramdown Treatment, the Senior Notes and existing Class A and Class B Common Stock would be cancelled and the Senior Note holders would receive their pro rata share, with the Plan Trust, of newly issued Common Stock of Congoleum, in an amount determined by a Final Order of the Bankruptcy Court; provided, however, that in no event may the amount of such newly issued Common Stock to be allocated to the holders of the Senior Notes exceed 49% of the voting common shares and total economic equity value of Congoleum on a fully diluted basis. The Company expects that the terms of the Ninth Plan may be amended or modified as a result of further negotiations with various parties. The Company expects that the terms of any new plan filed by CNA and the Bondholders' Committee will be materially different from the terms of the Ninth Plan, and these plans may also be amended or modified or may be withdrawn. There can be no assurance that the terms of the reorganization plan that is ultimately confirmed, if any, will not materially differ from the terms of the Ninth Plan. The Company expects that it will take until some time in the first quarter of 2007 at the earliest to obtain confirmation of any plan of reorganization. 32 In anticipation of Congoleum's commencement of the Chapter 11 cases, Congoleum entered into the Claimant Agreement, which provides for an aggregate settlement value of at least $466 million as well as an additional number of individually negotiated trial listed settlements with an aggregate value of approximately $25 million, for total settlements in excess of $491 million. As contemplated by the Claimant Agreement, Congoleum also entered into agreements establishing the Collateral Trust to distribute funds in accordance with the terms of the Claimant Agreement and granting the Collateral Trust a security interest in Congoleum's rights under its applicable insurance coverage and payments from Congoleum's insurers for asbestos claims. In December 2005, Congoleum commenced the Avoidance Actions seeking to void the security interest granted to the Collateral Trust and such settlements. In March 2006, Congoleum filed a motion for summary judgment in the Avoidance Actions seeking to avoid the Claimant Agreement settlements and liens under various bankruptcy theories, which motion was denied in June 2006 and the Avoidance Actions remain pending. Under the terms of the Ninth Plan, asbestos personal injury claimants voting to accept the plan would irrevocably consent or would be deemed to have irrevocably consented to the forbearance of any claim and lien rights under the Claimant Agreement and related agreements. Under the terms of the Ninth Plan, after the establishment of the Plan Trust, the assets in the Collateral Trust would be transferred to the Plan Trust and any claims subject to the Claimant Agreement would be channeled to the Plan Trust and paid in accordance with the terms of the Ninth Plan. Settlement values under the Ninth Plan differ from values under previous plans and the Claimant Agreement. As a result of such differences and the potential results of the Avoidance Actions, the liability associated with the asbestos personal injury claims against Congoleum may be materially different than the present estimates of such items. As a result of tabulating ballots on the Fourth Plan, the Company is also aware of claims by claimants whose claims were not determined under the Claimant Agreement but who have submitted claims with a value of approximately $512 million based on the settlement values applicable in the Sixth Plan. Based on the Eighth Plan, the Company has made provision in its financial statements for the minimum amount of the range of estimates for its contribution to effect its plan to settle asbestos liabilities through the Plan Trust. The Company recorded charges aggregating approximately $51.3 million in prior years and is not yet able to determine the amount of the additional cost that will be required to complete its reorganization as based on the Ninth Plan. Actual amounts that will be contributed to the Plan Trust and costs for pursuing and implementing the Ninth Plan or any other plan of reorganization could be materially higher than currently recorded. The Company may record significant additional charges should the minimum estimated cost increase. Delays in proposing, filing or obtaining approval of the Ninth Plan or any new amended plan of reorganization, or any new plan to be filed by CNA and the Bondholders' Committee, or the proposal of additional plans by other parties could result in a proceeding that takes longer and is more costly than the Company has estimated. 33 Three and six months ended June 30, 2006 as compared to three and six months ended June 30, 2005: Three months ended Six months ended June 30, June 30, 2006 2005 2006 2005 (In thousands of dollars) (In thousands of dollars) Net sales $58,743 $ 58,108 $115,980 $115,738 Cost of sales 45,139 44,338 89,099 88,307 ------- --------- --------- --------- Gross profit 13,604 23.2% 13,770 23.7% 26,881 23.2% 27,431 23.7% Selling, general and administrative expenses 10,261 17.5% 10,673 18.4% 20,657 17.8% 22,406 19.4% Asbestos related reorganization charges -- 15,454 -- 15,454 ------- --------- --------- --------- Operating income (loss) 3,343 (12,357) 6,224 (10,429) Interest expense (2,867 (2,618) (5,601) (5,118) Other income, net 215 377 330 597 ------- --------- --------- --------- Income (loss) before taxes 691 (14,598) 953 (14,950) Provision for income taxes 65 -- 116 -- ------- --------- --------- --------- Net income (loss) $ 626 $(14,598) $ 837 $(14,950) ======= ========= ========= ========= Net sales for the three months ended June 30, 2006 totaled $58.7 million as compared to $58.1 million for the same period in the prior year, an increase of $0.6 million or 1.1%. The increase primarily reflected the impact of price increases taken in the second half of 2005 and the replenishment of inventories by the company's largest distributor. These increases were partially offset by weak retail demand for residential sheet products and softer sales in the commercial tile category. Net sales for the six months ended June 30, 2006 were $116.0 million as compared to $115.7 million for the six months ended June 30, 2005, an increase of $0.3 million. The increase reflected the impact of price increases instituted in the second half of 2005 and stronger sales of mid-priced resilient sheet products and higher sales of manufactured housing products. Offsetting these increases were weaker sales in high-end resilient sheet products and less demand for promotional product. Gross profit for the three months ended June 30, 2006 totaled $13.6 million or 23.2% of net sales, compared to $13.8 million, or 23.7% of net sales, for the same period last year. The deterioration in gross margins reflect the impact of higher raw material and utility costs which reduced margins by approximately 4% of net sales, partially offset by selling price increases totaling 3.6%. Gross profit for the six months ended June 30, 2006 totaled $26.9 million, or 23.2% of net sales, compared to $27.4 million, or 23.7% of net sales, for the same period last year. The major factors leading to the deterioration in gross margin were the increase in raw material costs and utility costs experienced during the second half of 2005, which reduced margins by approximately 3.2% of net sales. This was partially mitigated by the 2.6% increase in selling prices. 34 Selling, general and administrative expenses were $10.3 million for the three months ended June 30, 2006, as compared to $26.1 million for the same period last year. The reduction in expense reflects a $15.5 million charge for reorganization expense taken in the second quarter of 2005, lower merchandising expenses (down $0.2 million) and lower freight expense ($0.2 million). As a percent of net sales, selling, general and administrative expenses totaled 17.5% of net sales for the second quarter of 2006 versus 44.9% for the same period last year. Selling, general and administrative expenses were $20.7 million for the six months ended June 30, 2006 as compared to $37.9 million for the six months ended June 30, 2005, a decrease of $17.2 million. The reduction in expenses primarily reflects a reorganization related charge of $15.5 million taken in 2005. Additionally, 2006 expenses were lower as a result of reduced merchandising related expenses ($0.7 million), lower compensation costs related to workforce reduction ($0.5 million) and lower freight costs ($0.3 million). As a percent of net sales, selling, general and administrative costs were 17.8% for the six months ended June 30, 2006 compared to 32.7% for the same period last year. Income from operations totaled $3.3 million for the quarter ended June 30, 2006, compared to a loss from operations of $12.4 million. The 2005 numbers include a charge for reorganization expenses of $15.5 million which was the primary reason for the improvement in 2006. Income from operations was $6.2 million for the six months ended June 30, 2006 compared to a loss of $10.4 million for the six months ended June 30, 2005. The improvement in operating income in 2006 reflects the reorganization related charge taken in 2005, coupled with lower selling, general and administrative expenses experienced in 2006. Liquidity and Capital Resources The Unaudited Condensed Consolidated Financial Statements of the Company have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Accordingly, the Unaudited Condensed Consolidated Financial Statements do not include any adjustments that might be necessary should the Company be unable to continue as a going concern. As described more fully in the Notes to Unaudited Condensed Consolidated Financial Statements contained in Part I, Item 1 of this Quarterly Report on Form 10-Q, there is substantial doubt about the Company's ability to continue as a going concern unless it obtains relief from its substantial asbestos liabilities through a successful reorganization under Chapter 11 of the Bankruptcy Code. On December 31, 2003, Congoleum filed a voluntary petition with the Bankruptcy Court (Case No. 03-51524) seeking relief under the Bankruptcy Code. See Notes 1 and 17 of the Notes to the Consolidated Financial Statements, which are contained in Item 8 of the Company's Annual Report on Form 10-K for the year ended December 31, 2005, for a discussion of the Company's bankruptcy proceedings. These matters will have a material adverse impact on liquidity and capital resources. During the first six months of 2006, the Company paid $11.3 million in fees and expenses related to implementation of its planned reorganization under Chapter 11 and litigation with certain insurance companies. Under previous plans, Congoleum's assignment of insurance recoveries to the Plan Trust was net of costs incurred by Congoleum in connection with insurance coverage litigation, and Congoleum was entitled to withhold from recoveries, or seek reimbursement from the Plan Trust, for coverage litigation 35 costs incurred after January 1, 2003 and for $1.3 million in claims processing fees paid in connection with claims settled under the Claimant Agreement. A receivable was recorded for these costs as they were paid. Under the Ninth Plan, Congoleum would be entitled to reimbursement of only approximately $3.7 million in cash for such coverage litigation costs, and to reimbursement of the $1.3 million in claims processing fees and would not collect the balance of these receivables ($16.8 million at June 30, 2006). The write-off and any applicable forgiveness of indebtedness income pursuant to the Ninth Plan are expected to be recorded at a future date, the net effect of which cannot be determined. Congoleum expects to spend a further $13.9 million at a minimum in fees, expenses, and trust contributions in connection with obtaining confirmation of its plan of reorganization, which amount is recorded in its reserve for asbestos-related liabilities in addition to the $9.5 million insurance settlement being held as restricted cash. It also expects to spend a further $7.9 million at a minimum in connection with insurance coverage litigation costs, for which it expects to be reimbursed as discussed above. Required expenditures could be materially higher than these estimates. The Company currently holds $3.7 million in restricted cash that may be available to offset future costs incurred pursuing insurance coverage, subject to approval by the Bankruptcy Court. Due to the Chapter 11 proceedings, the Company has been precluded from making interest payments on its outstanding Senior Notes since January 1, 2004. The amount of accrued interest that is due but has not been paid on the Senior Notes at June 30, 2006 is approximately $27.8 million, including interest on the unpaid interest due, of which $3.6 million was owed at the time of the Chapter 11 filing. In February 2006, the Bankruptcy Court ordered GHR to disgorge all fees and certain expenses it was paid by Congoleum. The law firm has appealed this ruling. The amount of the disgorgement is approximately $9.6 million. Pursuant to the terms of the Ninth Plan, the net proceeds of the GHR disgorgement would be used to reduce the obligations of Congoleum to the Plan Trust by first being applied to reduce or satisfy principal and accrued interest under the Plan Trust Note and thereafter to reduce or satisfy principal and accrued interest under the New Convertible Security. Under the terms of the Ninth Plan, on the Effective Date, the Plan Trust will provide a loan to Congoleum, which loan is intended, when combined with cash on hand and available drawings under the revolving credit facility, to provide Congoleum with $18 million of total liquidity, on a pro forma basis as of December 31, 2006 (the "Plan Trust Note"). If the Effective Date occurs after December 31, 2006, the total liquidity required by Congoleum, and thus the amount of the Plan Trust Note, will be as mutually agreed among the ACC, the FCR and Congoleum. The proceeds of the Plan Trust Note will only be used for working capital and general corporate purposes. The Plan Trust Note will be due and payable on December 31, 2011, will bear interest at 10% per annum payable semi-annually until the maturity date, and will contain appropriate covenants, warranties, and representations as agreed among Congoleum, the ACC, the FCR and the Claimants' Representative. The principal amount of the Plan Trust Note, which is subject to review and approval by the FCR and the ACC, may not exceed $14 million unless both the FCR and ACC agree. There can be no assurance either or both would agree to any such request from Congoleum, or that Congoleum would obtain any other consents that might be necessary to increase the amount of the Plan Trust Note. Under the terms of the Ninth Plan, if holders of the Senior Notes vote to accept the Plan by the requisite number and amount required by the Bankruptcy Code, the Senior Notes would be cancelled and Congoleum would issue new notes 36 (the "New Senior Notes") in the aggregate principal amount of $100 million which shall be payable semi-annually at the rate of 10% per annum until a maturity date of August 1, 2011; provided, however, that Reorganized Congoleum shall receive a credit against all interest payable under the New Senior Notes for all fees and expenses of the Bondholders' Committee incurred and paid after the date that the Plan is filed with the Bankruptcy Court. The New Senior Notes will be subordinate in priority and payment to the New Convertible Security and the Plan Trust Note. There can be no assurance that the plan which is ultimately confirmed will provide for such maturity extension or other terms. While Congoleum is seeking to obtain the required acceptances of the Ninth Plan from all necessary classes of creditors, the Ninth Plan provides an alternative treatment for holders of the Senior Notes and stockholders in the event sufficient note holders do not consent to the Ninth Plan. This alternative treatment which will materially affect the recoveries of these classes. In the event that the holders of the Senior Notes do not vote to accept the Ninth Plan by the requisite number and amount required by the Bankruptcy Code, then Plan confirmation will be sought in accordance with the Cramdown Treatment. Pursuant to the Cramdown Treatment, the Senior Notes and existing Class A and Class B Common Stock would be cancelled and the Senior Note holders would receive their pro rata share of newly issued Common Stock with the Plan Trust, as determined by a Final Order of the Bankruptcy Court; provided, however, that in no event may the amount of such newly issued Common Stock to be allocated to the holders of the Senior Notes exceed 49% of the voting common shares and total economic equity value of Congoleum on a fully diluted basis. On the Effective Date, if the holders of the Senior Note Claims (as a class) vote to accept the Ninth Plan, Congoleum will issue and contribute the New Convertible Security to the Plan Trust in satisfaction of section 524(g) of the Bankruptcy Code. The New Convertible Security will have the following terms: (i) an initial aggregate principal amount of $2,738,234.75, such principal amount being subject to increase in the amount, if any, by which 36% of Congoleum's market capitalization based on average trading prices for Congoleum's Class A Common Stock at the close of trading for the 90 consecutive trading days beginning on the one year anniversary of the Effective Date, exceeds such initial principal amount; (ii) an initial interest rate equal to 9% of the principal amount per annum, payable semi-annually in arrears, with such interest rate to reset at the rate of 5% of the principal amount per annum on the tenth anniversary of the Effective Date and payable at such reset interest rate per annum until maturity; (iii) redeemable for the principal amount at the option of the Plan Trust or Congoleum on or anytime after the tenth anniversary of the Effective Date; (iv) a maturity date on the fifteenth anniversary of the Effective Date if not redeemed or otherwise paid earlier; (v) convertible into 5,700,000 shares of Class A Common Stock (on a fully diluted basis with all Class B Common Stock converted to Class A Common Stock) upon a specified default of the obligation to pay interest and a failure to cure such default within any cure period, which, when combined with the New Class A Common Stock, will result in the Plan Trust owning 51% of the voting common shares and 51% of the total economic equity value of Congoleum on a fully diluted basis; and (vi) no voting rights except upon conversion. The principal adjustment feature could result in the principal amount of the New Convertible Security increasing materially. Unrestricted cash and cash equivalents, including short-term investments at June 30, 2006, were $15.4 million, a decrease of $9.1 million from December 31, 2005. Under the terms of its revolving credit agreement, payments on the 37 Company's accounts receivable are deposited in an account assigned by the Company to its lender and the funds in that account are used by the lender to pay down any loan balance. Funds deposited in this account but not yet applied to the loan balance, which amounted to $2.4 million and $2.0 million at June 30, 2006 and December 31, 2005, respectively, are recorded as restricted cash. Additionally, $9.6 million remaining from a $14.5 million settlement received in August 2004 from an insurance carrier, which is subject to the lien of the Collateral Trust, is included as restricted cash at June 30, 2006. The Company expects to contribute these funds, less any amounts withheld pursuant to reimbursement arrangements, to the Plan Trust. Working capital was $31.7 million at June 30, 2006, up from $28.0 million at December 31, 2005. The ratio of current assets to current liabilities at June 30, 2006 was 1.3 to 1.0, which is unchanged from December 31, 2005. The ratio of debt to total capital at June 30, 2006 was 0.48 to 1.0 which is also unchanged since December 31, 2005. Net cash used by operations during the first six months of 2006 was $11.6 million, as compared to net cash used by operations of $5.5 million in the first six months of 2005. The increase in cash used by operations in the first six months of 2006 versus the first six months of 2005 was primarily due to higher working capital requirements and increased reorganization expenditures in 2006. Capital expenditures for the six months ended June 30, 2006 totaled $1.0 million. The Company is currently planning capital expenditures of approximately $5 million in 2006 and between $5 million and $7 million in 2007, primarily for maintenance and improvement of plants and equipment, which it expects to fund with cash from operations and credit facilities. In January 2004, the Bankruptcy Court authorized entry of a final order approving Congoleum's debtor-in-possession financing, which replaced its pre-petition credit facility on substantially similar terms. The debtor-in-possession financing agreement (as amended and approved by the Bankruptcy Court to date) provides a revolving credit facility expiring on December 31, 2006 with borrowings up to $30 million. Interest is based on 0.75% above the prime rate. This financing agreement contains certain covenants, which include the maintenance of minimum earnings before interest, taxes, depreciation and amortization ("EBITDA"). It also includes restrictions on the incurrence of additional debt and limitations on capital expenditures. The covenants and conditions under this financing agreement must be met in order for the Company to borrow from the facility. The Company was in compliance with these covenants at June 30, 2006. Borrowings under this facility are collateralized by inventory and receivables. At June 30, 2006, based on the level of receivables and inventory, $18.1 million was available under the facility, of which $4.8 million was utilized for outstanding letters of credit and $13.5 million was utilized by the revolving loan. The Company anticipates that its debtor-in-possession financing facility will be replaced with a revolving credit facility on substantially similar terms upon confirmation and effectiveness of its plan of reorganization. While the Company expects the facilities discussed above will provide it with sufficient liquidity, there can be no assurances that it will continue to be in compliance with the required covenants, that the Company will be able to obtain a similar or sufficient facility upon exit from bankruptcy, or that the debtor-in-possession facility (as extended) will be renewed prior to its expiration if the Company's plan of reorganization is not confirmed before that time. In addition to the provision for asbestos litigation discussed previously, the Company has also recorded what it believes are adequate provisions for environmental remediation and product-related liabilities (other than asbestos-related claims), including provisions for testing for potential 38 remediation of conditions at its own facilities. The Company is subject to federal, state and local environmental laws and regulations and certain legal and administrative claims are pending or have been asserted against the Company. Among these claims, the Company is a named party in several actions associated with waste disposal sites (more fully discussed in Note 5 to the Unaudited Condensed Consolidated Financial Statements contained in Item 1 of this Quarterly Report on Form 10-Q). These actions include possible obligations to remove or mitigate the effects on the environment of wastes deposited at various sites, including Superfund sites and certain of the Company's owned and previously owned facilities. The contingencies also include claims for personal injury and/or property damage. The exact amount of such future cost and timing of payments are indeterminable due to such unknown factors as the magnitude of cleanup costs, the timing and extent of the remedial actions that may be required, the determination of the Company's liability in proportion to other potentially responsible parties, and the extent to which costs may be recoverable from insurance. The Company has recorded provisions in its financial statements for the estimated probable loss associated with all known general and environmental contingencies. While the Company believes its estimate of the future amount of these liabilities is reasonable, and that they will be paid over a period of five to ten years, the timing and amount of such payments may differ significantly from the Company's assumptions. Although the effect of future government regulation could have a significant effect on the Company's costs, the Company is not aware of any pending legislation which would reasonably have such an effect. There can be no assurances that the costs of any future government regulations could be passed along to its customers. Estimated insurance recoveries related to these liabilities are reflected in other non-current assets. The outcome of these environmental matters could result in significant expenses incurred by or judgments assessed against the Company. The Company's principal sources of capital are net cash provided by operating activities and borrowings under its financing agreement. The Company has used $11.6 million in cash from operations in the first six months of 2006 (as more fully discussed above), which includes the benefit of $5.2 million of accrued but unpaid interest on long-term debt. The Company believes these sources will be adequate to fund working capital requirements, debt service payments, and planned capital expenditures for the remainder of 2006. Based on expected costs to complete its reorganization proceedings, the Company anticipates it will need to obtain the contemplated approximately $14 million from the Plan Trust Note to provide it with sufficient liquidity when the Ninth Plan goes effective. Actual sources and uses of funds to consummate the effectiveness of the Ninth Plan or any other plan may differ significantly from this description, but confirmation of any plan is dependent on such plan demonstrating it leaves the Company with sufficient liquidity that further reorganization will not be needed. The Company's inability to obtain confirmation of the Ninth Plan in a timely manner would have a material adverse effect on the Company's ability to fund its operating, investing and financing requirements. 39 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to changes in prevailing market interest rates affecting the return on its investments but does not consider this risk exposure to be material to its financial condition or results of operations. The Company invests primarily in highly liquid debt instruments with strong credit ratings and short-term (less than one year) maturities. The carrying amount of these investments approximates fair value due to the short-term maturities. Over 90% of the Company's outstanding long-term debt as of June 30, 2006 consisted of indebtedness with a fixed rate of interest which is not subject to change based upon changes in prevailing market interest rates. Under its current policies, the Company does not use derivative financial instruments, derivative commodity instruments or other financial instruments to manage its exposure to changes in interest rates, foreign currency exchange rates, commodity prices or equity prices and does not hold any instruments for trading purposes. Item 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures. The Company's Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the "Exchange Act")) as of the end of the period covered by this quarterly report (the "Evaluation Date"). Based on this evaluation, such officers have concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company required to be included in the Company's reports filed or submitted under the Exchange Act. (b) Changes in Internal Control Over Financial Reporting. There have not been any changes in the Company's internal controls over financial reporting during the last quarter covered by this Quarterly Report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 40 PART II. OTHER INFORMATION Item 1. Legal Proceedings: The information contained in Note 5 "Environmental and Other Liabilities" and Note 6 "Asbestos Liabilities" of the Notes to Unaudited Condensed Consolidated Financial Statements is incorporated herein by reference. Item 1A. Risk Factors: The Company has significant asbestos liability and funding exposure, and its Ninth Plan may not be confirmed. As more fully set forth in Notes 1 and 6 of the Notes to Consolidated Financial Statements, which are included in this Quarterly Unaudited Condensed Report on Form 10-Q, the Company has significant liability and funding exposure for asbestos claims. The Company has entered into settlement agreements with various asbestos claimants totaling in excess of $491 million. Under the terms of the Ninth Plan, asbestos personal injury claimants voting to accept the plan would irrevocably consent or would be deemed to have irrevocably consented to the forbearance of any claim and lien rights under such settlement agreements. The outcome of the Avoidance Actions could affect the outcome of plan voting and therefore confirmation of the Ninth Plan. There can be no assurance that the Company will not amend the Ninth Plan, that the Company will obtain approval to solicit acceptances of its plan of reorganization, that the Company will receive the acceptances necessary for confirmation of its plan, that its plan will not be modified further, that its plan will receive necessary court approvals from the Bankruptcy Court or the Federal District Court, or that such approvals will be received in a timely fashion, that its plan will be confirmed, that its plan, if confirmed, will become effective, or that there will be sufficient funds to pay for continued protracted litigation over its plan of reorganization. In November 2005, the Bankruptcy Court denied a request to extend Congoleum's exclusive right to file a plan of reorganization and solicit acceptances thereof, and plans have been filed by an insurance company and the Bondholders' Committee, who have further indicated an intent to file another plan jointly by August 18, 2006. It is unclear whether any other person will attempt to propose a plan or what any such plan would provide or propose, and whether the Bankruptcy Court would approve a plan other than Congoleum's proposed plan. The Ninth Plan and any alternative plan of reorganization pursued by the Company or another plan proponent or confirmed by the Bankruptcy Court and the Federal District Court could materially differ from the description of the Ninth Plan contained in this Quarterly Report on Form 10-Q. Furthermore, the estimated costs and contributions to effect the Ninth Plan or an alternative plan could be significantly greater than currently estimated. Any plan of reorganization pursued by 41 the Company will be subject to numerous conditions, approvals and other requirements, including Bankruptcy Court and Federal District Court approvals, and there can be no assurance that such conditions, approvals and other requirements will be satisfied or obtained. Confirmation of a plan of reorganization will depend on the Company obtaining exit financing to provide it with sufficient liquidity to fund obligations upon the plan becoming effective. If the Company's cash flow from operations is materially less than anticipated, and/or if the costs in connection with seeking confirmation of the Company's plan of reorganization or in connection with the Company's New Jersey state court insurance coverage litigation discussed elsewhere in this report are materially more than anticipated, or if sufficient funds from insurance proceeds or other sources are not available at confirmation to reimburse coverage litigation costs as expected, the Company may be unable to obtain exit financing, when combined with net cash provided from operating activities, that would provide it with sufficient funds, which would likely result in the Company not being able to confirm an amended plan of reorganization or have such plan become effective. Some additional factors that could cause actual results to differ from the Company's goals for resolving its asbestos liability through an amended plan of reorganization include: (i) the future cost and timing of estimated asbestos liabilities and payments, (ii) the availability of insurance coverage and reimbursement from insurance companies that underwrote the applicable insurance policies for the Company for asbestos-related claims, (iii) the costs relating to the execution and implementation of any plan of reorganization pursued by the Company, (iv) timely reaching agreement with other creditors, or classes of creditors, that exist or may emerge, (v) satisfaction of the conditions and obligations under the Company's outstanding debt instruments, (vi) the response from time to time of the lenders, customers, suppliers and other constituencies of the Company and ABI, the majority stockholder of the Company, to the ongoing process arising from the Company's strategy to settle its asbestos liability, (vii) the Company's ability to maintain debtor-in-possession financing sufficient to provide it with funding that may be needed during the pendency of its Chapter 11 case and to obtain exit financing sufficient to provide it with funding that may be needed for its operations after emerging from the bankruptcy process, in each case, on reasonable terms, (viii) timely obtaining sufficient creditor and court approval (including the results of any relevant appeals) of any reorganization plan pursued by it and the court overruling any objections to the Company's reorganization plan that may be filed, (ix) costs of, developments in and the outcome of insurance coverage litigation pending in New Jersey state court involving Congoleum and certain insurers, (x) the extent to which the Company is able to obtain reimbursement for costs of the coverage litigation, (xi) compliance with the Bankruptcy Code, including Section 524(g) and (xii) the possible adoption of another party's plan of reorganization which may prove to be unfeasible. In any event, if the Company is not successful in obtaining sufficient creditor and court approval of its amended plan of reorganization, such failure would have a material adverse effect upon its business, results of operations and financial condition. 42 In addition, there has been federal legislation proposed that, if adopted, would establish a national trust to provide compensation to victims of asbestos-related injuries and channel all current and future asbestos-related personal injury claims to that trust. Due to the uncertainties involved with the pending legislation, the Company does not know what effects any such legislation, if adopted, may have upon its business, results of operations or financial condition, or upon any plan of reorganization it may decide to pursue. To date, the Company has expended significant amounts pursuant to resolving its asbestos liability relating to its proposed amended plan of reorganization. To the extent any federal legislation is enacted, which does not credit the Company for amounts paid by the Company pursuant to its plan of reorganization or requires the Company to pay significant amounts to any national trust or otherwise, such legislation could have a material adverse effect on the Company's business, results of operations and financial condition. As a result of the Company's significant liability and funding exposure for asbestos claims, there can be no assurance that if it were to incur any unforecasted or unexpected liability or disruption to its business or operations it would be able to withstand that liability or disruption and continue as an operating company. For further information regarding the Company's asbestos liability, insurance coverage and strategy to resolve its asbestos liability, please see Notes 1 and 17 of Notes to the Consolidated Financial Statements, which are included in the Company's 2005 Annual Report on Form 10-K, and Notes 1 and 6 of Notes to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. The Ninth Plan could be confirmed in accordance with the cram down provisions of the Bankruptcy Code which would materially affect the recoveries of holders of the Senior Notes, eliminate interests of existing shareholders, and result in a change of control of Congoleum. The Ninth Plan provides that if the holders of the Senior Notes do not vote to accept the Ninth Plan by the requisite number and amount required by the Bankruptcy Code, then Plan confirmation will be sought in accordance with the cram down provisions of the Bankruptcy Code. Under the Cramdown Treatment, the Senior Notes and existing Class A and Class B Common Stock would be cancelled and the Senior Note holders would receive, with the Plan Trust, their pro rata share of newly issued Common Stock, in an amount determined by a Final Order of the Bankruptcy Court; provided, however, that in no event would the amount of newly issued Common Stock to be allocated to the holders of the Senior Notes exceed 49% of the voting common shares and total economic equity value of 43 Congoleum on a fully diluted basis. While the value of the shares that the holders of the Senior Notes would receive cannot be determined, the Company believes such value will be materially less than the value of the New Senior Notes that holders of the Senior Notes would receive if the Cramdown Treatment is not required. Cancellation of the existing shares and issuance of new shares would result in a complete change of the ownership and control of Congoleum. While the reaction by customers, suppliers, employees and others to such a change cannot be determined, it could have a material adverse effect on Congoleum's business, results of operations and financial condition. The American Stock Exchange has notified Congoleum that it does not meet the minimum income and stockholders' equity requirements for continued listing of its Class A Common Stock. On April 21, 2006, Congoleum received a letter from the American Stock Exchange (the "Amex") indicating that Congoleum is not in compliance with Section 1003(a)(i) of the Amex Company Guide, with stockholders' equity of less than $2,000,000 and losses from continuing operations and/or net losses in two of its three most recent fiscal years; and Section 1003(a)(ii) of the Amex Company Guide, with stockholders' equity of less than $4,000,000 and losses from continuing operations and/or net losses in three of its four most recent fiscal years. The letter also stated that the Company must submit a plan by May 22, 2006 advising the Amex of actions it has taken or will take to achieve compliance with the continued listing standards within eighteen months of receipt of the letter, and that this plan must be approved by the Amex, for Congoleum to maintain its listing. Congoleum submitted such a plan which was accepted by the Amex, who will continue to monitor Congoleum's progress toward compliance. There can be no assurance that Congoleum will be able to achieve such compliance, or that the Amex will remain satisfied with Congoleum's progress toward compliance. If Congoleum's Class A common stock is delisted on the Amex, it may have an adverse impact on the price and liquidity of the Company's Class A common stock. The Company may incur substantial liability for environmental, product and general liability claims in addition to asbestos-related claims, and its insurance coverage and its likely recoverable insurance proceeds may be substantially less than the liability incurred by the Company for these claims. Environmental Liabilities. Due to the nature of the Company's business and certain of the substances which are or have been used, produced or discharged by the Company, the Company's operations are subject to extensive federal, state and local laws and regulations relating to the generation, storage, disposal, handling, emission, transportation and discharge into the environment of hazardous substances. The Company has 44 historically expended substantial amounts for compliance with existing environmental laws or regulations, including environmental remediation costs at both third-party sites and Company-owned sites. The Company will continue to be required to expend amounts in the future for costs related to prior activities at its facilities and third party sites, and for ongoing costs to comply with existing environmental laws; such amounts may be substantial. There is no certainty that these amounts will not have a material adverse effect on its business, results of operations and financial condition because, as a result of environmental requirements becoming increasingly strict, the Company is unable to determine the ultimate cost of compliance with environmental laws and enforcement policies. Moreover, in addition to potentially having to pay substantial amounts for compliance, future environmental laws or regulations may require or cause the Company to modify or curtail its operations, which could have a material adverse effect on the Company's business, results of operations and financial condition. Product and General Liabilities. In the ordinary course of its business, the Company becomes involved in lawsuits, administrative proceedings, product liability claims (in addition to asbestos-related claims) and other matters. In some of these proceedings, plaintiffs may seek to recover large and sometimes unspecified amounts and the matters may remain unresolved for several years. These matters could have a material adverse effect on the Company's business, results of operations and financial condition if the Company is unable to successfully defend against or settle these matters, its insurance coverage is insufficient to satisfy unfavorable judgments or settlements relating to these matters, or the Company is unable to collect insurance proceeds relating to these matters. The Company is dependent upon a continuous supply of raw materials from third party suppliers and would be harmed if there were a significant, prolonged disruption in supply or increase in its raw material costs. The Company's business is dependent upon a continuous supply of raw materials from third party suppliers. The principal raw materials used by the Company in its manufacture of sheet and tile flooring are vinyl resins, plasticizers, latex, limestone, stabilizers, cellulose paper fibers, urethane and transfer print film. The Company purchases most of these raw materials from multiple sources. Although the Company has generally not had difficulty in obtaining its requirements for these materials, it has occasionally experienced significant price increases for some of these materials. Raw material prices in 2004 and 2005 increased significantly. During that period, there was a tight supply of specialty resins used in flooring, despite significant price increases, due to several factors, including an explosion at a large resin plant in 2004 that destroyed the plant, the decision by another major supplier to exit the business, and the effect of hurricanes in 2005. Although the Company has been able to obtain sufficient supplies of specialty resin and other raw materials, there can be no assurances that it may not experience difficulty in the future, particularly if global supply conditions deteriorate, which could have a material adverse effect on profit margins. 45 The Company believes that suitable alternative suppliers are generally available for substantially all of its raw material requirements, although quantities of certain materials available from alternative suppliers may be in limited supply and production trials may be required to qualify new materials for use. The Company does not have readily available alternative sources of supply for specific designs of transfer print film, which are produced utilizing print cylinders engraved to the Company's specifications. Although no loss of this source of supply is anticipated, replacement could take a considerable period of time and interrupt production of some of the Company's products. In an attempt to protect against this risk of loss of supply, the Company maintains a raw material inventory and continually seeks to develop new sources which will provide continuity of supply for its raw material requirements. However, there is no certainty that the Company's maintenance of its raw material inventory or its ongoing efforts to develop new sources of supply would be successful in avoiding a material adverse effect on its business, results of operations and financial condition if it were to realize an extended interruption in the supply of its raw materials. In addition, the Company could incur significant increases in the costs of its raw materials. Although the Company generally attempts to pass on increases in the costs of its raw materials to its customers, the Company's ability to do so is, to a large extent, dependent upon the rate and magnitude of any increase, competitive pressures and market conditions for its products. There have been in the past, and may be in the future, periods of time during which increases in these costs cannot be recovered. During those periods of time, there could be a material adverse effect on the Company's business, results of operations and financial condition. The Company operates in a highly competitive flooring industry and some of its competitors have greater resources and broader distribution channels than the Company. The market for the Company's products is highly competitive. The Company encounters competition from three other manufacturers in North America and, to a lesser extent, foreign manufacturers. Some of the Company's competitors have greater financial and other resources and access to capital than the Company. Furthermore, like the Company, one of the Company's major competitors has sought protection under Chapter 11 of the Bankruptcy Code. When such competitor emerges from bankruptcy as a continuing operating company it may have shed much of its pre-filing liabilities and have a competitive cost advantage over the Company as a result of having shed those liabilities. In addition, in order to maintain its competitive position, the Company may need to make substantial investments in its business, including its product development, manufacturing facilities, distribution 46 network and sales and marketing activities. Competitive pressures may also result in decreased demand for the Company's products and in the loss of the Company's market share for its products. Moreover, due to the competitive nature of the Company's industry, the Company may be commercially restricted from raising or even maintaining the sales prices of its products, which could result in the Company incurring significant operating losses if its expenses were to increase or otherwise represent an increased percentage of the Company's sales. The Company's business is subject to general economic conditions and conditions specific to the remodeling and housing industries. The Company is subject to the effects of general economic conditions. A sustained general economic slowdown could have serious negative consequences for the Company's business, results of operations and financial condition. Moreover, the Company's business is cyclical and is affected by the economic factors that affect the remodeling and housing industries in general and the manufactured housing industry specifically, including the availability of credit, consumer confidence, changes in interest rates, market demand and general economic conditions. The Company could realize shipment delays, depletion of inventory and increased production costs resulting from unexpected disruptions of operations at any of the Company's facilities. The Company's business depends upon its ability to timely manufacture and deliver products that meet the needs of its customers and the end users of the Company's products. If the Company were to realize an unexpected, significant and prolonged disruption of its operations at any of its facilities, including disruptions in its manufacturing operations, it could result in shipment delays of its products, depletion of its inventory as a result of reduced production and increased production costs as a result of taking actions in an attempt to cure the disruption or carry on its business while the disruption remains. Any resulting delay, depletion or increased production cost could result in increased costs, lower revenues and damaged customer and product end user relations, which could have a material adverse effect on the Company's business, results of operations and financial condition. The Company offers limited warranties on its products which could result in the Company incurring significant costs as a result of warranty claims. The Company offers a limited warranty on all of its products against manufacturing defects. In addition, as a part of its efforts to differentiate mid- and high-end products through color, design and other attributes, the Company offers enhanced warranties with respect to wear, moisture discoloration and other performance characteristics, which generally increase with the price of such products. If the Company were to incur a significant number of warranty claims, the resulting warranty costs could be substantial. 47 The Company is heavily dependent upon its distributors to sell the Company's products and the loss of a major distributor of the Company could have a material adverse effect on the Company's business, results of operations and financial condition. The Company currently sells its products through approximately 15 distributors providing approximately 86 distribution points in the United States and Canada, as well as directly to a limited number of mass market retailers. The Company considers its distribution network very important to maintaining its competitive position. Although the Company has more than one distributor in some of its distribution territories and actively manages its credit exposure to its distributors, the loss of a major distributor could have a materially adverse impact on the Company's business, results of operations and financial condition. The Company derives a significant percentage of its sales from two of its distributors, LaSalle-Bristol Corporation and Mohawk Industries, Inc. LaSalle-Bristol Corporation serves as the Company's manufactured housing market distributor and Mohawk Industries, Inc. serves as its retail market distributor. These two distributors accounted for 69% of the Company's net sales for the year ended June 30, 2006 and 67% of the Company's net sales for the year ended December 31, 2005. Stockholder votes are controlled by ABI; Congoleum's interests may not be the same as ABI's interests. ABI owns a majority (approximately 55% as of December 31, 2005) of the outstanding shares of the Company's common stock, representing a 69.4% voting interest. As a result, ABI can elect all of the Company's directors and can control the vote on all matters, including determinations such as: approval of mergers or other business combinations, sales of all or substantially all of the Company's assets, any matters submitted to a vote of the Company's stockholders, issuance of any additional common stock or other equity securities, incurrence of debt other than in the ordinary course of business, the selection and tenure of the Company's Chief Executive Officer, payment of dividends with respect to common stock or other equity securities and other matters that might be favorable to ABI. ABI's ability to prevent an unsolicited bid for Congoleum or any other change in control could have an adverse effect on the market price for the Company's common stock. In addition, certain officers of Congoleum are officers of ABI and members of the family group that owns a controlling interest in ABI. Possible future sales of shares by ABI could adversely affect the market for Congoleum's stock. 48 ABI may sell shares of the Company's common stock in compliance with the federal securities laws. By virtue of ABI's current control of Congoleum, ABI could sell large amounts of shares of the Company's common stock by causing the Company to file a registration statement that would allow them to sell shares more easily. In addition, ABI could sell shares of the Company's common stock without registration. Although the Company can make no prediction as to the effect, if any, that such sales would have on the market price of the Company's common stock, sales of substantial amounts of the Company's common stock, or the perception that such sales could occur, could adversely affect the market price of the Company's common stock. If ABI sells or transfers shares of the Company's common stock as a block, another person or entity could become the Company's controlling stockholder. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds: None Item 3. Defaults Upon Senior Securities: The commencement of the Chapter 11 proceedings constituted an event of default under the indenture governing the Company's 8 5/8% Senior Notes. In addition, due to the Chapter 11 proceedings, the Company was precluded from making the interest payments due February 1, 2004, August 1, 2004, February 1, 2005, August 1, 2005 and February 1, 2006, on the Senior Notes. The aggregate amount of accrued interest that was not paid on the Senior Notes on those dates is approximately $24.2 million. As of June 30, 2006, the principal amount of the Senior Notes, net of unamortized original issue discount, was $99.8 million. These amounts, which include $2.6 million of accrued interest on the interest due but not paid from February 1, 2004, August 1, 2004, February 1, 2005, August 1, 2005 and February 1, 2006, are included in "Liabilities Subject to Compromise." (See Note 8 "Liabilities Subject to Compromise" of the Notes to Unaudited Condensed Consolidated Financial Statements.) The company also did not make a scheduled payment of $4.3 million that was due on August 1, 2006. Item 4. Submission of Matters to a Vote of Security Holders: At the annual meeting of the Company's Stockholders held on May 9, 2006, all director nominees were elected. The three nominees who were elected as Class A directors will hold office until the meeting of stockholders to be held in 2009 and until their successors are duly elected and qualify. The results of the vote for the election of those directors are set forth below. Number of Number of Name Votes For Votes Withheld -------------------- -------------------- ----------------------- William M. Marcus 11,183,208 16,208 C. Barnwell Straut 11,182,126 17,110 Jeffrey H. Coats 11,183,436 15,800 49 The directors whose terms of office continued and the years their terms expire are as follows: Class B Directors - Term Expires in 2007 ---------------------------------------- Mark N. Kaplan Richard G. Marcus Mark S. Newman Class C Directors - Term Expires in 2008 ---------------------------------------- Roger S. Marcus John N. Irwin III Adam H. Slutsky Item 5. Other Information: None Item 6. Exhibits: (a) Exhibits Exhibit Number Exhibits ------ -------- 3.1 Amended Certificate of Incorporation of the Company 3.2 Amended and Restated Bylaws of the Company 31.1 Rule 13a-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a) Certification of Chief Financial Officer 32.1 Section 1350 Certification of the Chief Executive Officer. 32.2 Section 1350 Certification of the Chief Financial Officer. 99.1 Ninth Modified Joint Plan of Reorganization Under Chapter 11 of the Bankruptcy Code of Congoleum Corporation, et al., and the Asbestos Claimants' Committee, dated as of August 11, 2006, including the Exhibits thereto. 99.2 Disclosure Statement With Respect to the Ninth Modified Joint Plan of Reorganization Under Chapter 11 of the Bankruptcy Code of Congoleum Corporation, et al., and the Asbestos Claimants' Committee, dated as of August 11, 2006, including the Exhibits thereto with the exception of Exhibit A, which is included herein as Exhibit 99.1. 50 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CONGOLEUM CORPORATION (Registrant) Date: August 14, 2006 By: /s/ Howard N. Feist III ------------------------ Howard N. Feist III Chief Financial Officer (Duly Authorized Officer and Principal Financial & Accounting Officer) 51 Exhibit Index Exhibit Number Exhibits ------ -------- 3.1 Amended Certificate of Incorporation of the Company (1) 3.2 Amended and Restated Bylaws of the Company (1) 31.1 Rule 13a-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a) Certification of Chief Financial Officer 32.1 Section 1350 Certification of the Chief Executive Officer. 32.2 Section 1350 Certification of the Chief Financial Officer. 99.1 Ninth Modified Joint Plan of Reorganization Under Chapter 11 of the Bankruptcy Code of Congoleum Corporation, et al., and the Asbestos Claimants' Committee, dated as of August 11, 2006, including the Exhibits thereto. 99.2 Disclosure Statement With Respect to the Ninth Modified Joint Plan of Reorganization Under Chapter 11 of the Bankruptcy Code of Congoleum Corporation, et al., and the Asbestos Claimants' Committee, dated as of August 11, 2006, including the Exhibits thereto with the exception of Exhibit A, which is included herein as Exhibit 99.1. (1) Incorporated by reference to the exhibit bearing the same description filed with the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1996. 52