TMEN ThermoEnergy Corp (CE)

Security Ownership by Certain Beneficial Owners and Management and Related Stockholder Matters

Common Stock

The following table sets forth certain information as of January 31, 2013 with respect to beneficial ownership of our Common Stock by each shareholder known by the Company to be the beneficial owner of more than 5% of our Common Stock and by each of our directors and executive officers and by all of the directors, nominees for election as director, and executive officers as a group.

 As investment adviser to the Funds, Security Investors, LLC may be deemed to be the beneficial owner of such securities.

Series A Convertible Preferred Stock

As of January 31, 2013, there were 208,334 shares of Series A Convertible Preferred Stock issued and outstanding, all of which were held by Mr. Gregg Frankel.  Shares of Series A Convertible Preferred Stock are convertible into shares of Common Stock on a 1-for-1 basis.  The shares of Series A Convertible Preferred Stock held by Mr. Frankel represent a beneficial ownership of less than 1% of our issued and outstanding Common Stock.  None of our directors or executive officers owns any shares of Series A Convertible Preferred Stock.

Series B Convertible Preferred Stock

As of January 31, 2013, there were 11,664,993 shares of Series B Convertible Preferred Stock issued and outstanding.  The following table sets forth certain information as of January 31, 2013 with respect to beneficial ownership of our Series B Convertible Preferred Stock by each shareholder known by the Company to be the beneficial owner of more than 5% of our Series B Convertible Preferred Stock and by each of our directors and executive officers and by all of the directors, nominees for election as director, and executive officers as a group.  Shares of Series B Convertible Preferred Stock are convertible into shares of Common Stock on a 10-for-1 basis.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

You should read the following discussion and analysis in conjunction with our consolidated financial statements and the related notes for the year ended December 31, 2011 and for the nine month period ended September 30, 2012, which are included in this Proxy Statement beginning at Page F-1.  This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions.  Actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under "Special Cautionary Note Regarding Forward-Looking Statements" and elsewhere in this Proxy Statement.

Overview

Founded in 1988, we are a diversified technologies company engaged in the worldwide development, sale and commercialization of patented and/or proprietary technologies for the recovery and recycling of wastewater, chemicals, metals, and nutrients from waste streams at oil & gas, biogas, power plant, industrial, and municipal operations. In addition, we hold patents on pressurized oxy-combustion technology for clean, coal-fired power generation.

Wastewater Solutions

We have spent nearly two decades developing sustainable water treatment and recovery systems that help industry and municipalities operate more efficiently, save money, reduce their carbon footprint and meet their sustainability goals.

Award-Winning Technology

We believe our TurboFrac system provides versatile and cost effective solutions to recover and recycle clean, usable water from contaminated produce water created by the hydraulic fracturing of oil and gas wells. Our FracGen systems create hydrofracking-grade water from briny water in local aquifers located in arid areas. FracGen reduces demand on local potable water supplies and reduces the cost of transporting fresh water from other geographic locations.

Our versatile, award-winning CAST® (Controlled Atmospheric Separation Technology), RCAST®, and high-flow TurboCAST systems can be utilized as an effective stand-alone wastewater, chemical, metal or nutrient recovery system, or as part of an integrated recovery solution. These state-of-the-art vacuum assisted distillation units offer significant advantages over other evaporative technologies such as thin film and nucleate boiling. They are specially designed for high-strength wastewaters with high Total Dissolved Solids and Total Suspended Solids typically found in industrial, municipal and agricultural recovery processes.

In industrial applications, our Zero-Liquid-Discharge (ZLD) Systems can recover nearly 100% of valuable chemical resources or wastewater for immediate reuse or recycling with no liquid leaving the facility. CAST concentrates mixed hazardous waste down to as little as 5% of its original volume for economical disposal or reclaim. This patented technology is designed and constructed to exceed the demands of harsh chemical environments.

Fast Return on Customer Investment

We believe our wastewater recovery systems reduce costs by recovering process chemicals, metals, and clean water for reuse or recycling and eliminating most of the costly disposal of hazardous waste or process effluent. These solutions offer a solid return on our customers’ investments and a quick payback with continued savings and efficiency for many years.

Our wastewater treatment systems not only meet local, state and federal environmental regulations, but typically provide a rapid rate of return on investment by recovering and reusing expensive feedstocks, reducing contaminated wastewater discharge and recovering and reusing wastewater used in process operations. Our systems utilize proven technology to cost effectively process and treat brackish, flowback and produced water in the hydraulic fracturing (“fracking”) process in the oil and gas industries. Our wastewater treatment systems also have global applications in aerospace, food and beverage processing, metal finishing, pulp & paper, petrochemical, refining, microchip and circuit board manufacturing, heavy manufacturing and municipal wastewater.

Specific wastewater solutions include:

Power Generation Technologies

We are also the owner of a patented pressurized oxycombustion technology that converts fossil fuels (including coal, oil and natural gas) and biomass into electricity while producing near zero air emissions, and at the same time removing and capturing carbon dioxide in liquid form for sequestration or beneficial reuse. This technology can be used to build new or retrofit old fossil fuel power plants around the world that produce near zero air emissions while capturing carbon dioxide as a liquid for ready sequestration far more economically than any other competing technology. The technology is held by our subsidiary, ThermoEnergy Power Systems, LLC (“TEPS”) and will be developed and commercialized through our new joint venture, Unity Power Alliance (UPA). 

On June 20, 2012, we entered into an Agreement with Itea S.p.A. (“ITEA”) for the development of pressurized oxycombustion in North America. The two parties, through UPA, will utilize their patented technologies to advance, develop and promote the use of the coal application of pressurized oxycombustion, construct a pilot plant utilizing the technology, and subsequently construct a demonstration facility based on the technology as implemented in the pilot plant. ITEA was granted the option to acquire a 50% ownership interest in UPA for nominal consideration. On July 16, 2012, ITEA exercised its option and acquired the 50% ownership interest in UPA. As of September 30, 2012, the financial results of UPA are accounted for as a joint venture under the equity method of accounting and are not consolidated in our financial statements as a variable interest entity as defined by ASC 810.

In September 2012, Unity Power Alliance was awarded a $1 million Phase 1 grant from the U.S. Department of Energy to help fund a project under a special DOE program to advance technologies for efficient, clean coal power and carbon capture. After successful completion of the first phase of the program, it is anticipated that a much larger Phase 2 grant could be awarded in the $10-20 million range to be applied toward the construction of a pilot scale plant. As part of UPA's project, in October 2012, we received a $850,000 contract from UPA to build a bench-scale “flameless” combustion reactor under the grant.

We currently generate revenues from the sale and development of wastewater treatment systems. We enter into contracts with our customers to provide a wastewater treatment solution that meets the customer’s present and future needs. Our revenues are tied to the size and scale of the wastewater treatment system required by the customer, as well as the progress made on each customer contract.

Historically we marketed and sold our products primarily in North America. In 2011, we began marketing and selling our products in Asia and Europe. These marketing and sales activities are performed by our direct sales force and authorized independent sales representatives.

On August 22, 2012, the New York City Department of Environmental Regulation (“NYCDEP”) issued a stop work order to us relative to our contract to install an Ammonia Removal Process (“ARP”) system at the NYCDEP’s wastewater treatment facility in the 26 ^th Ward.  On November 13, 2012, the NYCDEP notified us that it is terminating the contract, effective November 29, 2012.

We suspended all work on this contract as of August 22, 2012 and have halted all work with our major vendors. We have accordingly ceased recognition of revenues as of August 22, 2012 and have recorded all incremental costs as period costs on its Consolidated Statement of Operations.

Because of this contract termination, our revenues, expenses, and income will be adversely affected in future periods, as this contract represented approximately 80% of our revenues for the year ended December 31, 2011 and approximately 63% and 81% of our revenues for the three and nine-month periods ended September 30, 2012, respectively. We have begun settlement discussions with NYCDEP and expect to complete all remaining contractual obligations during the first half of 2013.

We have made significant progress over the past year in resolving our past legal and financial issues, strengthening our balance sheet, hiring key management personnel and building our business for future growth. However, we have incurred net losses and negative cash flows from operations since inception. We incurred net losses of $5.9 million for the nine-month period ended September 30, 2012 and $17.4 million for the year ended December 31, 2011. Cash outflows from operations totaled $5.1 million for the nine-month period ended September 30, 2012 and $6.1 million for the year ended December 31, 2011. As a result, we will require additional capital to continue to fund our operations.

Research and Development

We own or license all of the technologies that we use in our business.

We conduct research and development of water/wastewater treatment products and services in a number of areas including testing various waste streams for potential clients and other third parties, Chemcad and Aspen modeling for the pressurized oxycombustion process, centrate testing related to our New York project and Ammonia Recovery Process (“ARP”) flow modifications.   

Critical Accounting Policies and Estimates

We have identified the policies and estimates below as critical to our current and future business operations and the understanding of our results of operations. These policies and estimates are considered "critical" because they either had a material impact or they have the potential to have a material impact on our financial statements, and because they require significant judgments, assumptions or estimates. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect both the results of operations as well as the carrying values of our assets and liabilities. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. We base estimates on historical experience and/or on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities as of the date of the financial statements that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, making it possible that a change in these estimates could occur in the near term. Set forth below is a summary of our most critical accounting policies.

Principles of consolidation and basis of presentation

The consolidated financial statements include the accounts of ThermoEnergy and our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from those estimates.

The 15% third party ownership interest in TEPS is recorded as a noncontrolling interest in the consolidated financial statements. As of  December 31, 2011, the noncontrolling interest in TEPS was immaterial to the consolidated financial statements taken as a whole.

Revenue recognition

We recognize revenues using the percentage of completion method. Under this approach, revenue is earned in proportion to total costs incurred in relation to total costs expected to be incurred. Contract costs include all direct material and labor costs and indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs and depreciation.

Recognition of revenue and profit is dependent upon a number of factors, including the accuracy of a variety of estimates made at the balance sheet date such as engineering progress, materials quantities, the achievement of milestones, penalty provisions, labor productivity and cost estimates made. Due to uncertainties inherent in the estimation process, actual completion costs may vary from estimates. Changes in job performance, job conditions and estimated profitability may result in revisions to costs and income and are recognized beginning in the period in which they become known.  Provisions for estimated losses on uncompleted contracts are made in the period in which the estimated loss first becomes known.

Certain long-term contracts include a number of different services to be provided to the customer. We record separately revenues, costs and gross profit related to each of these services if they meet the contract segmenting criteria in ASC 605-35. This policy may result in different interim rates of profitability for each segment than if we had recognized revenues using the percentage-of-completion method based on the project’s estimated total costs.

Variable interest entities

The Company assesses whether its involvement with another related entity constitutes a variable interest entity (“VIE”) through either direct or indirect variable interest in that entity. If an entity is deemed to be a VIE, the Company must determine if it is the primary beneficiary (i.e. the party that consolidates the VIE), in accordance with the accounting standard for the consolidation of variable interest entities. VIEs are entities that, by design, either (1) lack sufficient equity to permit the entity to finance its activities without additional subordinated financial support from other parties, or (2) have equity investors that do not have the ability to make significant decisions relating to the entity’s operations through voting rights, or do not have the obligation to absorb the expected losses and/or the right to receive the residual returns of the entity. The Company qualitatively evaluates if it is the primary beneficiary of the VIE’s based on whether the Company has (i) the power to direct those matters that most significantly impacted the activities of the VIE; and (ii) the obligation to absorb losses or the right to receive benefits of the VIE.

Accounts receivable, net

Accounts receivable are recorded at their estimated net realizable value. Receivables related to the Company’s contracts have realization and liquidation periods of less than one year and are therefore classified as current.

The Company maintains allowances for specific doubtful accounts based on estimates of losses resulting from the inability of customers to make required payments and record these allowances as a charge to general and administrative expense. The Company’s method for estimating its allowance for doubtful accounts is based on judgmental factors, including known and inherent risks in the underlying balances, adverse situations that may affect the customer’s ability to pay and current economic conditions. Amounts considered uncollectible are written off based on the specific customer balance outstanding.

Property and equipment

Property and equipment are stated at cost and are depreciated over the estimated useful life of each asset.  Depreciation is computed using the straight-line method.  We evaluate long-lived assets based on estimated future undiscounted net cash flows or other fair value measures whenever significant events or changes in circumstances occur that indicate the carrying amount may not be recoverable.  If that evaluation indicates that an impairment has occurred, a charge is recognized to the extent the carrying amount exceeds the undiscounted cash flows or fair values of the asset, whichever is more readily determinable.

Contingencies

We accrue for costs relating to litigation, including litigation defense costs, claims and other contingent matters, including liquidated damage liabilities, when such liabilities become probable and reasonably estimable.  Such estimates may be based on advice from third parties or on management’s judgment, as appropriate.  Revisions to payroll tax and other accrued expenses are reflected in income in the period in which different facts or information become known or circumstances change that affect our previous assumptions with respect to the likelihood or amount of loss.  Amounts paid upon the ultimate resolution of contingent liabilities may be materially different from previous estimates and could require adjustments to the estimated liability to be recognized in the period such new information becomes known.

Stock options

We account for stock options in accordance with Accounting Standards Codification (“ASC”) Topic 718, “Compensation – Stock Compensation”.  These topics require that the cost of all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values on the measurement date, which is generally the date of grant.  Such cost is recognized over the vesting period of the awards.  We use the Black-Scholes option pricing model to estimate the fair value of stock option awards.

Income taxes

We use the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax basis of assets and liabilities and are measured using enacted rates and laws that will be in effect when the deferred tax assets or liabilities are expected to be realized or settled. A valuation allowance for deferred tax assets is provided if it is more likely than not that all or a portion of the deferred tax assets will not be realized. We recognize interest and penalties related to underpayments of income taxes as a component of interest and other expenses on our Consolidated Statements of Operations.

We estimate contingent income tax liabilities based on the guidance for accounting for uncertain tax positions as prescribed in ASC Topic 740, “Income Taxes.” We use a two-step process to assess each income tax position.  We first determine whether it is more likely than not that the income tax position will be sustained, based on technical merits, upon examination by the taxing authorities.  If the income tax position is expected to meet the more likely than not criteria, we then record the benefit in the financial statements that equals the largest amount that is greater than 50% likely to be realized upon its ultimate settlement.

We are subject to taxation in the U.S. and various states. As of December 31, 2011 our tax years for 2008, 2009 and 2010 are subject to examination by the tax authorities. With few exceptions, as of December 31, 2011, we are no longer subject to U.S. federal, state or local examinations by tax authorities for years before 2008.

Series B Convertible Preferred Stock

We determine the initial value of the Series B Convertible Preferred Stock and investor warrants using valuation models we consider to be appropriate.  Because the Series B Convertible Preferred Stock has an indefinite life, it is classified within the stockholders’ deficiency section of our consolidated balance sheets.  The value of beneficial conversion features are considered a “deemed dividend” and are added as a component of net loss attributable to common stockholders on our consolidated statements of operations.

Recent Accounting Pronouncement s

In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRS,” which converges fair value measurement and disclosure guidance in U.S. GAAP with fair value measurement and disclosure guidance issued by the International Accounting Standards Board (“IASB”). The amendments in the authoritative guidance do not modify the requirements for when fair value measurements apply. The amendments generally represent clarifications on how to measure and disclose fair value under ASC 820, “Fair Value Measurement.” The authoritative guidance is effective prospectively for interim and annual periods beginning after December 15, 2011. Early adoption of the authoritative guidance is not permitted. The adoption of the provisions of ASU 2011-04 did not have a material impact on our financial statements or disclosures.

Restatement of Financial Statements

In connection with the preparation and audit of our consolidated financial statements as of, and for the year ended, December 31, 2011, we reviewed the accounting treatment of our debt and equity transactions during such year. During this review we uncovered errors that impacted our previously issued unaudited 2011 interim consolidated financial statements for the quarterly periods ended March 31, 2011, June 30, 2011 and September 30, 2011 (collectively, the “2011 Interim Consolidated Financial Statements”).

We have concluded that we incorrectly accounted for a series of related transactions effected pursuant to certain Note Amendment and Forbearance Agreements, effective as of January 4, 2011 (the “Note Amendment and Forbearance Agreements”), with the holders of our Convertible Promissory Notes due May 31, 2010 (the “Old Notes”), including the partial repayment of the Old Notes, the conversion of a portion of the Old Notes into shares of our Series B Convertible Preferred Stock, the issuance to the holders of the Old Notes of warrants for the purchase of shares of our Common Stock and the issuance to the holders of the Old Notes, upon cancellation of the Old Notes, of Amended and Restated Promissory Notes due February 29, 2012 (the “Restated Notes”) by treating such transactions as debt modifications rather than debt extinguishment. Our management also concluded that, due to deficiencies in the methodology we had used to calculate our derivative warrant liabilities, we had overstated the quarterly valuation of such liabilities.

Upon discovering these errors, we re-examined our accounting for similar transactions and the calculation of our derivative warrant liabilities in prior years and, although similar errors occurred in accounting for certain transactions in prior periods, the effect of such errors were not material.

In our Annual Report on Form 10-K as of and for the year ended December 31, 2011, we restated in Item 8, “Financial Statements and Supplementary Data,” our consolidated balance sheets and consolidated statements of operations for the first three quarters of 2011. This restatement is more fully described in Note 3, “Restatement and Condensed Quarterly Financial Information (Unaudited)” to our audited consolidated financial statements for the year ended December 31, 2011. We do not intend to restate separately our Quarterly Reports on Form 10-Q for the first three quarters of 2011. The financial statements included in such reports should not be relied on.

None of the errors related to our cash position, revenues or loss from operations for any of the periods in which such errors occurred. The net effect of these errors is (i) a $4.7 million understatement of our net loss to common stockholders in the quarter ended March 31, 2011, (ii) a $1.5 million overstatement of our net loss to common stockholders in the quarter ended June 30, 2011 and (iii) a $3.9 million overstatement of our net loss to common stockholders in the quarter ended September 30, 2011. The net effect is that our net loss to common stockholders for the nine-month period ended September 30, 2011 was overstated by approximately $0.7 million.

Results of Operations

Comparison of Years Ended December 31, 2011 and 2010 (as restated)

Revenues for 2011 were $5,583,000 compared to $2,874,000 in 2010. In 2010, we substantially completed production on two large industrial contracts in the first half of 2010 and started engineering and design work on our $27.9 million contract with NYCDEP in the third quarter of 2010.  In 2011, we completed engineering and design work on our NYCDEP contract and started system construction activities, which resulted in significantly higher revenues from the NYCDEP contract in 2011 compared to 2010. This contract, along with other new contracts, is expected to generate further increases in revenues in 2012.

Gross profit increased to $404,000 or 7.2% of revenues in 2011 compared to gross profit of $75,000 or 2.6% in 2010. The increase is mainly due to higher gross margins realized on the NYCDEP contract in 2011 as we completed engineering and design work and shifted toward higher margin system construction activities in the third quarter of 2011.

General and administrative expenses totaled $4,807,000 in 2011, a decrease of $993,000 compared to 2010.  The decrease is attributable to lower non-cash stock option expense in 2011 as certain tranches of stock options for our executive officers vested ratably at the end of 2010 and ended in early 2011.

Engineering, research and development expenses totaled $299,000 in 2011, a decrease of $344,000 compared to 2010. Our engineering group was fully utilized in the first three quarters of 2011 performing design and system fabrication work related to our NYCDEP contract. Our engineering group was not fully utilized until the third quarter of 2010. As a result, we charged $679,000 of engineering costs to costs of revenues in 2011 compared to $324,000 in 2010.

Selling expenses totaled $2,448,000 in 2011, an increase of $1,167,000 compared to 2010. The increase is due to increased sales headcount in 2011, as we focused on building our sales force to generate new business, as well as increased marketing and business development activity in 2011, as we began to market our product offerings in Europe and Asia.

Because of our various financing transactions, including the amendment of existing debt issuances and the extinguishment of convertible debt in 2011 and 2010, we recognized losses on the extinguishment of debt of $12,551,000 and $5,620,000 in 2011 and 2010, respectively. Losses recognized in 2011 relate to the restructuring of our CASTion Notes and our 2010 Bridge Notes in the first quarter of 2011 and the extinguishment of these issuances in the third quarter of 2011; losses in 2010 relate primarily to the writeoff of unamortized debt discounts for beneficial conversion features and warrants issued with the various debt issuances.

We did not incur any warrant-related expenses in 2011. Warrant totaling $107,000 expense in 2010 related to the issuance of warrants to our investment advisor in partial consideration for its services in connection with our private placement of shares of our Series B Convertible Preferred Stock in August 2010.

In 2011, we recorded income of $3,936,000 related to the net change in fair value on our derivative instruments. We recorded an expense on these derivative instruments totaling $293,000 in 2010.

We did not recognize any additional gains on payroll tax settlement in 2011 as a result of the IRS accepting our Offer in Compromise in March 2011. We recorded a gain on payroll tax settlement of approximately $2.3 million in 2010 related to this Offer in Compromise.

In 2011, we recorded losses in our joint venture with Babcock Power, Inc. totaling $389,000, an increase of $315,000 compared to 2010. The joint venture performed significant development work related to our pressurized oxycombustion technology in 2011; losses in 2010 related primarily to start-up related costs.

Interest and other expense in 2011 totaled $1,232,000 in 2011, a decrease of approximately $2.1 million compared to 2010. This decrease is due to reduced amortization of debt discount in 2011 and our repaying and converting all of our secured debt by August 2011.

Comparison of Quarters Ended September 30, 2012 and 2011 (as restated)

Revenues totaled $2,032,000 for the third quarter of 2012, an increase of 70% compared to $1,193,000 for the third quarter of 2011. Revenues in the third quarter of 2012 were primarily driven by revenues from our New York City Department of Environmental Protection ("NYCDEP") contract as well as our first sale of a mobile FracGen water production system to the oil and gas industry. In the third quarter of 2011, we substantially completed production on one industrial contract and were in the later stages of engineering and design work on the NYCDEP contract.

Gross profit for the third quarter of 2012 was $1,000 compared to gross profit of $120,000 in the third quarter of 2011. The decrease in gross profit is attributable to lower margins on our first mobile FracGen water production system due to higher than expected production costs on the first unit as well as a stop work order issued in August 2012 on the NYCDEP contract. Due to the stop work order, we incurred ongoing production related costs that could not be charged to the project in the quarter. The contract was terminated in November, which will result in fourth quarter and early 2013 revenues and gross margin to be adversely affected. However, given our focus on the oil & gas and biogas industries, we expect the short-term effect of the termination of the NYCDEP contract will be offset by implementing our long-term strategy. Gross profit in the third quarter of 2011 related to work performed on NYCDEP and a completed industrial project, which generated higher margins.

General and administrative expenses for the third quarter of 2012 was $1,035,000 compared to $897,000 for the third quarter of 2011. The increase in expenses were primarily due to increased legal costs attributable to our third quarter financings and patent applications.

Engineering, research and development expenses for the third quarter of 2012 was $160,000 compared to $132,000 for the third quarter of 2011. The increase is attributable to reduced utilization of our engineering team in the third quarter of 2012 compared to 2011. Engineering costs directly related to our projects are charged to Cost of Sales.

Sales and marketing expenses for the third quarter of 2012 was $598,000 compared to $561,000 in the third quarter of 2011. The Company's sales and marketing efforts in the third quarter of 2012 were redirected and increased to focus on the oil & gas and biogas industries over the municipal and other traditional markets in the prior year.

Changes in the fair value of our derivative warrant liabilities resulted in the recognition of derivative mark-to-market income of $574,000 in the third quarter of 2012 compared to $440,000 in the third quarter of 2011. Income in the third quarter of 2012 and 2011 relate primarily to the passage of time and the decrease in our stock price and an increase in warrants that are classified as derivative liabilities.

Other derivative expense of $565,000 in the third quarter of 2012 represents the amounts by which the initial valuation of derivative liabilities created in conjunction with our financing transactions in July and August of 2012 exceeded the amounts raised by these financing transactions. We had no such expenses in the third quarter of 2011.

There was no loss on extinguishment of debt in the third quarter of 2012 in comparison to a loss of $5,159,000 in the third quarter of 2011. The loss on extinguishment of debt in the third quarter of 2011 relates to the conversion of our CASTion Notes, 2010 Bridge Notes and 2011 Bridge Notes into shares of our Series B Convertible Preferred Stock.

Interest and other expense decreased during the third quarter of 2012 compared to 2011 by $111,000, due mainly to lower debt levels in 2012.

We recognized income related to our joint ventures totaling $24,000 in the third quarter of 2012 compared to losses of $117,000 in the third quarter of 2011. Income in the third quarter of 2012 is attributable to Itea assuming certain expenses of UPA in the third quarter of 2012.

Since the beginning of 2011, we have continued to make significant progress in resolving our past legal and financial issues, strengthening our balance sheet and building our business for future growth. In the past year, we have:

However, we have historically lacked the financial and other resources necessary to market the Technologies or to build demonstration projects without the financial backing of government or industrial partners. During 2011 and 2010, we funded our operations primarily from the sale of convertible debt, short-term borrowings, preferred stock and common stock, generally from stockholders and other parties who are sophisticated investors in clean technology. Although we will require substantial additional funding to continue existing operations, we believe that we will be able to obtain additional equity or debt financing on reasonable terms; however, there is no certainty that we will be able to do so.

Cash used in operations amounted to $6,101,000 and $5,628,000 for the years ended December 31, 2011 and 2010, respectively. The increase in cash used in operations in 2011 is primarily due to higher operating expenses attributed to building our sales and marketing functions throughout 2011. Cash used in investing activities included purchases of property and equipment of $135,000 for the year ended December 31, 2011 and investments in our joint venture with Babcock Power (subsequently dissolved) of $400,000 and $61,000 for the years ended December 31, 2011 and 2010, respectively.

At September 30, 2012, we did not have sufficient working capital to satisfy our anticipated operating expenses for the next 12 months. As of September 30, 2012, we had a cash balance of $528,000 and current liabilities of approximately $8.8 million, which consisted primarily of accounts payable of approximately $2.2 million, billings in excess of costs of approximately $3.3 million, convertible debt of $1.25 million, derivative liabilities of $41,000 and other current liabilities of approximately $1.9 million.

The following financing transactions provided our sources of funding for 2010, 2011 and 2012:

On March 10, 2010, we entered into a Bridge Loan Agreement (the “2010 Bridge Loan Agreement”), effective as of March 1, 2010, with six of our principal investors (The Quercus Trust, Robert S. Trump, Focus Fund, L.P., Empire Capital Partners, LP, Empire Capital Partners, Ltd, and Empire Capital Partners Enhanced Master Fund Ltd) (collectively, the “Investors”) pursuant to which the Investors agreed to make bridge loans to us in the following amounts:

We issued 3% Secured Convertible Promissory Notes in the principal amount of each Investor’s funding commitment (the “2010 Bridge Notes”).  The 2010 Bridge Notes bore interest at the rate of 3% per annum and were originally due and payable on February 28, 2011.  The entire unpaid principal amount, together with all interest then accrued and unpaid under each 2010 Bridge Note, was convertible, at the election of the holder, into shares of our Common Stock at a conversion price of $0.24 per share.  The 2010 Bridge Notes were secured by a lien on all of our assets except for the shares of our subsidiary, CASTion Corporation.

On June 30, 2010 we amended the 2010 Bridge Loan Agreement to provide for $2 million of additional funding from the following investors:

The new loans made under the amended 2010 Bridge Loan Agreement were on terms identical to the original loans under the 2010 Bridge Loan Agreement. We received $4.6 million in proceeds under the Bridge Loan Agreement.

On July 8, 2010, upon our receipt of an Order to Commence under our contract with the New York City Department of Environmental Protection which triggered a purchase obligation on the part of the Investors under the Securities Purchase Agreement dated as of November 19, 2009 between us and the Investors, the Investors surrendered an aggregate of $1.9 million of principal and accrued interest under the 2010 Bridge Notes as payment for an aggregate of 791,668 shares of Series B Convertible Preferred Stock and warrants to purchase approximately 8.3 million shares of stock at $0.24 per share.

On February 25, 2011 we entered into Note Extension and Amendment Agreements with the Investors holding our 2010 Bridge Notes, further amending the terms of the remaining balance of the 2010 Bridge Notes.  As amended, the 2010 Bridge Notes bore interest at the rate of 10% per annum with a maturity date of February 29, 2012.  The 2010 Bridge Notes were convertible into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share at any time at the election of the holders.  Pursuant to the Note Extension and Amendment Agreements, on August 11, 2011 following the retirement of certain notes issued to former stockholders in our subsidiary, CASTion Corporation, (the “CASTion Notes”) the entire outstanding balance of principal and interest due under the 2010 Bridge Notes ($2,932,107.65 in the aggregate) was converted into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share.

On July 1, 2011 we repaid 50% of the balance of the CASTion Notes and, in accordance with the terms of the CASTion Notes, the remaining balance automatically converted into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share.  On August 11, 2011 we elected to convert the balance of the 2010 Bridge Notes into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share.

On August 9, 2010, we entered into a Securities Purchase Agreement with the following investors, all of which are affiliates of Security Investors, LLC and which are the selling stockholders in the offering to which this Prospectus relates:  Security Equity Fund, Mid Cap Value Fund; SBL Fund, Series V (Mid Cap Value);  Security Equity Fund, Mid Cap Value Institutional Fund;  SBL Fund, Series Q (Small Cap Value); and  Security Equity Fund, Small Cap Value Fund (collectively, the “Security Investors”).  Pursuant to the Securities Purchase Agreement, we issued to the Security Investors an aggregate of 2,083,334 shares of our Series B Convertible Preferred Stock at a purchase price of $2.40 per share and Common Stock Purchase Warrants (the “Warrants”) entitling the holders to purchase up to an aggregate of 33,333,344 shares of our Common Stock, at an exercise price of $0.30 per share, as follows:

On January 7, 2011 we entered into Note Amendment and Forbearance Agreements (the “Agreements”) with the following holders of the CASTion Notes which had come due on May 31, 2010 but remained outstanding: Spencer Trask Specialty Group LLC; Massachusetts Technology Development Corporation; BCLF Ventures I, LLC; Essex Regional Retirement Board; and BancBoston Ventures Inc.  Pursuant to the Agreements, (i) we made an aggregate of $1,144,336 in payments against the outstanding balances of the CASTion Notes; (ii) the Noteholders converted an aggregate of $902,710 in principal and accrued interest under the CASTion Notes into shares of our Series B Convertible Preferred Stock at a conversion price of $2.40 per share; (iii) we issued to the Noteholders restated promissory notes (the “Restated CASTion Notes”) for an aggregate of $11,300,309 representing the remaining balance due under the CASTion Notes, (iv) we issued to the Noteholders warrants for the purchase of an aggregate of 17,585,127 shares of our Common Stock at an exercise price of $0.40 per share and an aggregate of 6,018,065 shares of our Common Stock at an exercise price of $0.30 per share; and (v) the Noteholders agreed to forbear until February 29, 2012 from exercising their rights and remedies under the Restated CASTion Notes.

The original principal amount of each CASTion Noteholder’s Restated CASTion Note, the number of shares of our Series B Convertible Preferred Stock issued to each CASTion Noteholder, and the number of shares of our Common Stock issuable upon exercise of the Warrants issued to each are as follows:

Prior to the Agreements and the issuance of the Restated CASTion Notes, we had been in default of our obligations under the original CASTion Notes since January 2008 as a result of our failure to apply to payment of the CASTion Notes a portion of the proceeds from our equity and convertible debt financings, as required by the CASTion Notes.  Further, our failure to pay the entire outstanding balance of principal and interest due of the CASTion Notes at maturity (May 31, 2010) constituted a separate event of default under the CASTion Notes.  As part of the Agreements in January 2011, the holders of the CASTion Notes waived these defaults.

The Restated CASTion Notes bore interest at the rate of 10% per annum (with penalty interest at the rate of 18% per annum following maturity or an event of default).  Installment payments (based on a 10-year amortization schedule) were due on the last day of each month beginning January 31, 2011 and continuing through February 29, 2012, at which time the entire unpaid principal amount of, and accrued interest on, the Restated Notes would be due and payable.  The Restated CASTion Notes were convertible, in whole or in part, at any time at the election of the Noteholders, into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share.  The Agreements and the Restated CASTion Notes provided that, in the event we made any payments of principal or accrued interest on the Restated CASTion Notes on or before July 5, 2011, then simultaneously with the making of each such payment a portion of the remaining principal and accrued and unpaid interest on the Restated Notes in an amount equal to the amount of such payment would automatically convert into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share.

On the last business day of each month from January 31, 2011 through and including May 31, 2011, we made payments of principal and interest on the CASTion Notes in the aggregate amount of $45,290 (totaling $226,448 over the course of the 5-month period). Simultaneously with each payment, an additional aggregate amount of $45,283 (totaling $226,416 over the course of the 5-month period) of principal and accrued interest on the CASTion Notes was converted into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share.

On July 1, 2011 we made payments totaling $1,568,267 to the holders of the Restated CASTion Notes, which represented 50% of the outstanding principal and accrued interest balance.  In accordance with the terms of the Restated CASTion Notes, the remaining balance of the CASTion Notes automatically converted into shares of our Series B Convertible Preferred Stock.

On June 17, 2011, we entered into a Bridge Loan and Warrant Amendment Agreement (the “2011 Bridge and Warrant Agreement”) with Robert S. Trump; Focus Fund L.P.; Hughes Capital; Scott A. Fine; Peter J. Richards, Empire Capital Partners, LP; Empire Capital Partners, Ltd; and Empire Capital Partners Enhanced Master Fund, Ltd (collectively, the “Bridge Investors”), who held warrants for the purchase, in the aggregate, of 22,379,232 shares of our Common Stock (collectively, the “Warrants”).

Pursuant to the 2011 Bridge and Warrant Agreement, the Bridge Investors made loans to us in the respective principal amounts set forth below opposite the name of each Bridge Investor, against our issuance to each Bridge Investor of our Promissory Note (collectively, the “2011 Bridge Notes”) in such amount:

Pursuant to the 2011 Bridge and Warrant Agreement, we agreed, subject to the satisfaction of certain conditions, to amend the Warrants (i) to provide that they would be exercisable for the purchase of shares of our Series B Convertible Preferred Stock (the “Series B Stock”) instead of Common Stock (with the number of shares of the Series B Stock determined by dividing by ten (10) the number of shares of Common Stock for which the Warrants were previously exercisable) and (ii) to change the exercise prices of all Warrants (which ranged from $0.30 to $1.82 per share of Common Stock) to $1.30 per share of Series B Stock (the equivalent of $0.13 per share of Common Stock).  The Bridge Investors agreed, subject to the satisfaction of certain conditions, to exercise all of the Warrants.  The principal amount of the 2011 Bridge Notes was equal to the aggregate exercise price of the Warrants (after they were amended as described above).

The 2011 Bridge Notes were payable on demand at any time on or after February 29, 2012 (the “Maturity Date”).  They did not bear interest until the Maturity Date and would bear interest at the rate of 10% per annum from and after the Maturity Date. 

On July 12, 2011, we amended the 2011 Bridge and Warrant Agreement to provide for the extension to us by Mr. Trump and the Empire Capital funds of additional bridge loans in the following amounts:

The new loans made under the amended 2011 Bridge Loan Agreement were made on terms identical to the original loans under the 2011 Bridge Loan Agreement.

On August 11, 2011, upon satisfaction of all of the conditions set forth in the 2011 Bridge and Warrant Agreement, the Bridge Investors exercised all of the Warrants in accordance with the 2011 Bridge and Warrant Agreement and surrendered all of the 2011 Bridge Notes in payment of the exercise price for the purchase under the Warrants of an aggregate of 3,469,387 shares of our Series B Convertible Preferred Stock at a price of $1.30 per share.

On December 2, 2011 we entered into a Bridge Loan Agreement with the following investors, pursuant to which the investors made bridge loans (the “December 2011 Bridge Loans”) to us in the following amounts in anticipation of an equity investment in a new series of our Preferred Stock (the “New Preferred Stock”), subject to the satisfaction of certain conditions which have not yet been satisfied:

The December 2011 Bridge Loans (which total $1.25 million) accrue interest at the rate of 12.5% per annum.

On December 30, 2011, we entered into Warrant Amendment Agreements (the “Agreements”) with 21 individuals and entities who acquired warrants from five funds affiliated with Security Investors, LLC for the purchase of an aggregate of 27.7 million shares of our Common Stock (collectively, the “Warrants”). Pursuant to the Agreements, we amended the Warrants to change the exercise prices from $0.30 per share to $0.095 per share, and the Investors agreed to exercise all of the Warrants immediately for cash. We received proceeds totaling $2,436,000, net of issuance costs, from the exercise of the Warrants.

On January 10, 2012, we entered into additional Warrant Amendment Agreements (the “Agreements”) with 6 individuals who acquired warrants from five funds affiliated with Security Investors, LLC for the purchase of an aggregate of 5,633,344 shares of our Common Stock. Pursuant to the Agreements, we amended the Warrants to change the exercise prices from $0.30 per share to $0.095 per share, and the Investors agreed to exercise all of the Warrants immediately for cash. We received proceeds totaling $498,000, net of issuance costs, from the exercise of the Warrants.

On July 11, 2012, we issued 17,316,250 shares of our Common Stock and warrants for the purchase of an additional 17,316,250 shares at an exercise price of $0.15 per share for an aggregate purchase price of $1,731,625.

On August 9, 2012, we issued 8,287,500 shares of our Common Stock and warrants for the purchase of an additional 8,287,500 shares at an exercise price of $0.15 per share for an aggregate purchase price of $828,750.

On October 4, 2012, we and our subsidiaries, CASTion Corporation and ThermoEnergy Power Systems, LLC, entered into a Loan Agreement (the “Loan Agreement”) with C13 Thermo LLC (the “Lender”) pursuant to which the Lender established a credit facility allowing us to borrow up to $700,000 (the “Credit Facility”) to finance the fabrication and testing of an Ammonia Reduction Process system utilizing our proprietary technology (the “Project”). We may draw against the Credit Facility from time to time to pay expenses incurred under the budget for the Project. As evidence of our obligation to repay all amounts that may be borrowed under the Credit Facility, on October 4, 2012 we and our subsidiaries that are parties to the Loan Agreement issued to the Lender a promissory note in the principal amount of $700,000.

On October 9, 2012 we issued 3,765,000 shares of our Common Stock and warrants for the purchase of an additional 3,765,000 shares at an exercise price of $0.15 per share for an aggregate purchase price of $376,500.

On November 30, 2012, we entered into a Bridge Loan Agreement with a group of investors, all of whom are holders of our Series B Convertible Preferred Stock, pursuant to which such investors made loans to us in the aggregate principal amount of $3,700,000 in anticipation of our designation, offer and issuance of a new series of Preferred Stock to be designated as Series C Convertible Preferred Stock.

During the period from January 1, 2011 through November 30, 2012, pursuant to the financing transactions described above, we raised an aggregate of $10,078,229 in equity. During such period, an aggregate of $6,295,045 of debt (over and above bridge loans reflected in the $10,078,229 of equity financing) was converted into shares of our Series B Convertible Preferred Stock at the rate of $2.40 per share and we repaid in cash an additional aggregate amount of $2,939,051 of outstanding debt.

As of September 30, 2012, we had outstanding convertible debt of approximately $3,194,000 (exclusive of debt discounts).  Of this amount, debt totaling $1,944,000 is convertible into shares of our Common Stock at the rate of $0.50 per share.

Although our financial condition has improved, there can be no assurance that we will be able to obtain the funding necessary to continue our operations and development activities.

Off-Balance Sheet Arrangements

We do not use off-balance-sheet arrangements with unconsolidated entities or related parties, nor do we use other forms of off-balance-sheet arrangements such as special purpose entities and research and development arrangements. Accordingly, we are not exposed to any financing or other risks that could arise if we had such relationships.