10KSB 1 advanced10ksb033105.txt PERIOD ENDED 03-31-05 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-KSB ANNUAL REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the fiscal year ended: Commission file number: March 31, 2005 0-19485 ADVANCED ENERGY RECOVERY, INC. -------------------------------------------- (Name of small business issuer in its charter) DELAWARE 84-1069416 ------------------------------ ---------------------------------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 5799 Broadmoor, Ste 750, Mission, KS 66218 -------------------------------------- -------- (Address of principal executive offices) (Zip Code) Issuer's telephone number (913) 535-1072 Securities registered under Section 12(g) of the Act: Title of Each Class ------------------- Common Stock $.003 par value Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act during the past 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 ----- ----- Check if there is no disclosure of delinquent files in response to Item 405 of Regulation S-B if not contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. X ----- Issuer's revenues for the fiscal year ended March 31, 2005 were $144,884. The aggregate market value of the voting stock held by non-affiliates computed by reference to the average bid and asked prices of such stock on March 31, 2005 and as of the date of filing this Annual Report was $0. State the number of shares outstanding of each of the issuer's classes of common equity as of March 31, 2005--2,396,503. Check whether the issuer has filed all documents and reports to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court. Yes X No ----- ----- Transactional Small Business Disclosure Format Yes No X ----- ----- TABLE OF CONTENTS ----------------- ITEM PAGE Part I ------ Item 1 - Description of Business 3 Item 2 - Description of Property 8 Item 3 - Legal Proceedings 8 Item 4 - Submission of Matters to a Vote of Security Holders 8 Part II ------- Item 5 - Market for Common Equity and Related Stockholder Matters 9 Item 6 - Management's Discussion and Analysis or Plan of Operation 9 Item 7 - Financial Statements 14 Part III -------- Item 9 - Directors, Executive Officers, Promoters and Control Persons; Compliance With Section 16(a) Of The Exchange Act 37 Item 10 - Executive Compensation 38 Item 11 - Security Ownership of Certain Beneficial Owners and Management 39 Item 12 - Certain Relationships and Related Transactions 40 Part IV ------- Item 13 - Exhibits and Reports 41 Signatures 44 ---------- Certification-Section 302 Certification-Section 906 2
PART I ITEM 1. DESCRIPTION OF BUSINESS ----------------------- History of the Company and Subsidiaries --------------------------------------- Advanced Energy Recovery, Inc. (Formerly known as Advanced Financial, Inc.) (the "Company" or "AER") is a Delaware corporation formed in September 1986. Advanced Financial, Inc. operated in the financial services sector through March 31, 2004. The Company, through its two wholly owned subsidiaries, AIH Receivable Management Services and AIH Early Recovery Systems ("AIH"), collected debts for others for a fee and purchased charged-off credit card debt to collect at a profit from debtors located throughout the United States. Through AIH, the Company was also engaged in the business of collecting nonperforming receivables on behalf of third parties. During the year 2004, the Company changed its focus and growth efforts to the energy industry with its primary emphasis on natural gas and entered into various agreements to dispose of the AIH operations. Advanced Energy Recovery, Inc., currently owns 100% of Allen Drilling Acquisition Company ("ADAC"). In addition, as of October 14, 2004, through ADAC, the Company owns 52.5% of Elgin Holdings, LLC ("Elgin"). ADAC and Elgin are engaged in operations in the energy industry. The AIH operations resulted in significant losses through the fiscal year ending March 31, 2004 despite the efforts by the Company to restructure and reorganize various AIH segment operations. These losses were funded by a related entity, ARGUS. The following sets forth in summary form the consolidated results of operations for five years: Fiscal Year Fiscal Year Fiscal Year Fiscal Year Fiscal Year Financial Position 03/31/00 03/31/01 03/31/02 03/31/03 03/31/04 ----------- ----------- ----------- ----------- ----------- Total assets $ 1,139,576 $ 742,348 $ 562,750 $ 435,032 $ 332,697 Total liabilities 1,027,060 1,272,620 1,589,521 1,873,184 2,234,107 Stockholders' equity $ 112,516 $ (530,272) $(1,026,771) $(1,438,152) $(1,901,410) Amounts due to ARGUS $ 560,000 $ 765,840 $ 1,129,772 $ 1,318,709 $ 1,442,618 Operations Total revenues $ 977,439 $ 1,423,153 $ 1,152,171 $ 1,128,441 $ 987,819 Total expenses 1,898,423 2,119,914 1,648,669 1,539,822 1,361,077 Net loss $ (920,984) $ (696,761) $ (496,498) $ (411,381) $ (373,258) The consolidated operations for the fiscal year ended March 31, 2004 included amounts with respect to the Company's wholly owned subsidiary's , (ADAC) participation in the Madisonville Project, later described herein. For the fiscal year then ended, ADAC reported net income of $105,616. As set forth in the summarized results of operations above, the Company had accumulated significant losses since its emergence from a Chapter XI filing in 1999. As of December 31, 2003, the accumulation of debt to ARGUS had grown to a point where the Company could no longer service this outstanding debt given the downsizing of the Company that was the result of the reorganization and restructuring of the various AIH segment operations. Also during these years, and to the current date, the current President and Treasurer of the Company did not draw a salary, nor were any amounts accrued with respect thereto. As discussed later, under Change In Business Strategy, with the Madisonville Project investment, and the joint venture with GulfWest Energy Inc., the Company had determined during the 2004 fiscal year that the ability to generate long-term value for the common shareholders could be enhanced if the Company's 3
AIH operations were sold and the Company concentrated its growth efforts in the energy industry focusing primarily on natural gas. In accordance with this business strategy, an agreement was entered into with ARGUS, subject to common shareholder approval, wherein the common shares of AIH would be exchanged for an assumption by ARGUS of all of the AIH liabilities (the "Exchange Transaction"). The Board of Directors engaged an investment banking firm (Morgan Stanley) to determine the fair market value of the AIH operations on a going concern basis. Morgan Stanley, through its SPARDATA affiliate, determined such value to be $345,000. Under date of February 27, 2004, the Company, through an Information Statement pursuant to Section 14 (c) of the Securities Exchange Act and Regulation 14A, solicited the consents of the common stockholders (the "Solicitation") to effect several transactions in an effort, among other things, to restructure the Company, to dispose of the financial service operations which have accumulated significant losses and to change its focus and growth efforts to the energy industry with its primary emphasis on natural gas. The consents solicited included the following: 1. To adopt an amendment to the Company's Certificate of Incorporation to; (i) change the name of the corporation to "Advanced Energy Recovery, Inc."; (ii) effect a 1 for three reverse split of the outstanding Common Stock of the Company; and (iii) set the authorized Common Stock of the Company at 10,000,000 common shares. 2. To obtain Stockholders' consent to an exchange of 100% of the outstanding stock of AIH for an assumption by the primary secured lender of the Company of all of the AIH liabilities. 3. To obtain Stockholders' consent and ratification of the engagement by the Board of Directors of Weaver and Martin L.P. as the Company's independent public accountants. 4. To obtain Stockholders' consent and ratification of the appointment by the Board of Directors of two directors to fill two vacancies created by resignations. Such directors will serve until the next annual meeting of Stockholders. On March 24, 2004, the Company, under a Form 8-K under date thereof, announced that it had received the requisite affirmative consent votes from the common shareholders to effect the four proposals set forth in the February 27, 2004 Solicitation. The Exchange Transaction was completed in August of 2004, but was effective as of 12:01 AM April 1, 2004. Change In Business Strategy --------------------------- AFi Capital Corporation Agreement In July, 2001, the Company entered into a four year Agreement with AFI Capital Corporation ("Capital") a Nebraska corporation. Pursuant to the Agreement, Capital provided financial, acquisition, and general public company business consulting services in other than the financial services industry. Compensation for such services was based on a "successful efforts" basis and primarily consisted of the Company's common equity and cash performance fees as earned. At March 31, 2004, $52,815 was due to Capital under the compensation portion of the Agreement. This amount was converted to 337,500 shares of Common Stock (post reverse split basis) in August, 2004 in accordance with the provisions of the Agreement. Upon issuance of the shares, the Agreement was terminated and all parties released from any obligations arising there from. 4 Gateway Energy Corporation Agreement On March 6, 2003, the Company executed an Agreement which was closed on April 30, 2003, with Gateway Energy Corporation and certain of its subsidiaries of Houston, Texas ("Gateway") under which it provided, through the Company's wholly-owned subsidiary, Allen Drilling Acquisition Company ("ADAC"), $900,000 of credit enhancements in the form of Letters of Credit. These credit enhancements enabled Gateway to obtain additional financing, in the form of a three year Balloon Note from a Houston bank to complete the construction of certain natural gas pipeline facilities ("Pipeline Facilities") located in Madison County, Texas, (The "Madisonville Project"). ADAC secured the Letters of Credit through the private placement of a new series of participating preferred stock (the "Series A"), to two investor groups. The Certificate of Designation for the Series A provides, among other things, for dividend payments to the named holders thereof, equal to sixty-six and two thirds, (66.67%) of cash distributions received by ADAC from Gateway, and an unanimous vote of the Series A to exercise the Equity Participation Option as further described below. The Agreement provides, among other things, that ADAC will receive, during the term of the additional financing, one-half (50%) of the price upside portion only, if any, of the monthly fee to be received by Gateway from the Madisonville Project. The Agreement also provides that ADAC will have the option to either: (i) receive at the end of the Balloon Note term a lump-sum payment, which when added to the payments received, if any, for the price upside portion, will result in a 15% pre-tax internal rate of return on the $900,000, or (ii) to exercise the Equity Participation Option by paying off the Balloon Note on or before the end of the Balloon Note term in exchange for a thirty-three and one-third (33.33%) ownership interest in the Pipeline Facilities from that date forward. Gateway is obligated to pay the periodic interest payments on the Balloon Note during the three year term of the Balloon Note. Further, Gateway has granted liens to ADAC, subordinate to its banks, on its economic interest in the Madisonville Project and certain other natural gas operating systems and natural gas operating assets. The Agreement contains cross collateral and cross default provisions linking it to an additional Gateway term note at the same bank, the proceeds of which were used by Gateway to fund the Madisonville Project. The Madisonville Project is operated under a long-term agreement between Gateway, Hanover Compression Limited Partnership, and Redwood Energy Production, L. P. and is designed to treat gas to remove impurities from the gas to enable the gas to meet pipeline sales quality specifications. The Madisonville Project employs the state-of-the-art, patented, absorption based technology developed by Advanced Extraction Technologies, Inc., for which Gateway has the exclusive U. S. license, to remove nitrogen from the gas. To implement the provisions, terms and conditions of the various agreements including the Certificate of Designation for the ADAC Series A Preferred Stock: (i) Larry J. Horbach and Christopher D. Davis were appointed to the Board of Directors of the Registrant to fill the vacancies created by the resignation of two directors following the Registrant's emergence from it's Chapter XI Reorganization, serving until elected at the next meeting of shareholders; and (ii) Mr. Horbach resigned as a director of ADAC, with that position then being filled by Mr. Davis. The Registrant, as the sole shareholder of ADAC, effected such ADAC director changes and entered into an agreement to amend the ADAC By-laws to provide that the number of ADAC directors shall be fixed at three as long as any Series A Preferred Shares remain outstanding. In addition, Mr. Davis as well as the Registrant's President, Charles Holtgraves, were elected to the ADAC board of directors. Mr. Holtgraves is currently a director of Gateway. Mr. Horbach, who was a director of Gateway for several years, resigned his directorship on August 27, 2004. Mr. Davis has no affiliation with Gateway. Mr. Holtgraves owns 14.65% of an entity that owns 55.56% of the ADAC Series A Preferred Stock. Mr. Davis serves as the Trustee of the Davis Investment Management Trust for the Davis Investments VI LP, which LP owns 44.44% of the ADAC Series A Preferred Stock. Mr. Horbach owns no ADAC common stock or Series A Preferred Stock. 5 GulfWest Energy Inc. Joint Venture On July 21, 2004, the Company entered into a Letter of Intent, subject to the execution of definitive agreements, with GulfWest Energy Inc. ("GWEI") located in Houston, Texas, under which the Company and GWEI, through one or more Joint Venture LLCs, would develop certain oil and gas assets owned by GWEI in Grimes and Madison County, Texas. Certain of the Madison County reserves, if developed and produced, are expected to require treatment similar to that as earlier described in the Madisonville Project. On October 14, 2004, the Company, through ADAC, became a member of a Texas LLC (Elgin Holdings, LLC) (the "LLC") ("Elgin") with GWEI for the purpose of initially developing certain portions of the GWEI oil and gas asset bases in Madison County and Hardin County, Texas. Participation in the development of the Grimes County asset base by ADAC was deferred and will not be a part of this LLC. GWEI contributed certain assets valued at approximately $540,000, and the Company committed to provide up to $595,000 in initial capital funding to the LLC as provided for in the LLC's Regulations. In December 2004 the Company funded $315,000. In March 2005, the Company funded an additional $170,000, leaving a balance of $110,000 remaining to be funded in fiscal year 2005. The capital funding is being raised by ADAC through a private placement of a new series (Series B) of participating preferred stock. The various agreement transaction requirements were completed on November 15, 2004. The Company owns 52.5% of the LLC, and holds two of the three manager positions, such positions filled by Charles A. Holtgraves and Larry J. Horbach, directors and officers of the Registrant. The initial capital funding was raised by ADAC through a private placement of 595 shares of a new series preferred stock. The Senior Series B Preferred Stock, Stated Value $1,000 per share provides, among other things, for a preferential dividend right based on the Company's proportionate interest in the operations and cash flow from Elgin, and a preferential liquidation right consisting of a proportionate share of the Company's Capital Account in Elgin. Charles Holtgraves, Philip Holtgraves, Larry Horbach and Christopher Davis are directors of the Registrant. Charles Holtgraves, Philip Holtgraves and Mr. Horbach are officers of the Registrant. Entities in which these individuals either control or have an interest in, have subscribed for 577 of the 595 authorized shares. AER/Elgin and Gateway Energy Corporation Agreement On November 15, 2004, AER and Elgin entered into a LICENSE AGREEMENT (the "Agreement") with Gateway Energy Corporation and certain of its subsidiaries. The Agreement, provides, among other things, for the granting of a sublicense to AER and Elgin to enable Elgin to treat the gas produced from the leasehold interests owned by Elgin in Madison County, Texas, which interests fall within a defined Area of Mutual Interest, ("AMI"). The AMI is described in certain agreements with respect to the "The Gateway Energy/Madisonville Project Agreement" discussed above. In addition, the Agreement provides that AER and Elgin will dedicate the gas produced from its interests in the AMI to the Madisonville Project plant and will advance up to $91,250 to Gateway, $30,413 of which will represent a prepayment by the Company of the license and other fees due Advanced Extraction Technologies ("AET") for the processing of a minimum of 5,000 Mcf per day. The balance of the advance ($60,837) will be repaid by Gateway from Gateway's share of the initial project cash flows. The funds were advanced in December 2004. The Agreement further grants to AER or its designees, an option to participate pari passu with Gateway, subject to certain limitations, interests in future projects which require the treatment of natural gas containing high nitrogen, which projects utilize the AET license held by Gateway. 6 Reference is made to the Registrant's SEC Form 8-K filed on November 19, 2004 for additional information with respect to the above. Risks Related To New Business Strategy -------------------------------------- The Company will be subject to all of the energy industry common and traditional risks associated with the economic production of hydrocarbons including, but not limited to, acquisition of reserves that can produce adequate returns to attract the necessary investment capital to develop such reserves, the petroleum engineering of underground oil and gas reserves, drilling of the wells, and the fluctuation of hydrocarbon prices. In addition, the Company has limited capital resources and management has limited experience with respect to this segment of the energy industry. Accordingly, the Company is utilizing the joint venture approach to mitigate these risks. Nature of the Business Conducted By the Company through March 31, 2004 ---------------------------------------------------------------------- The following information is provided in order to provide a historical perspective of the Company's operations since emergence from its Chapter XI filing and executive management's operating strategy. It should be noted, however, that the following business discussions relate to the AIH operations that were included in the Exchange Transaction. Delinquent Debt Recovery ------------------------ The majority of the Company's revenue was derived from the collection of delinquent accounts receivable for AIH's clients. AIH provided its services to clients that included various health care providers, financial institutions, and retail firms. All of AIH's clients were based in the states of Kansas and Missouri with the majority located in the Kansas City metro area. AIH earned a 25%-50% contingency fee depending on the size, age, and AIH's assessment of the collectability of the accounts placed for collection. Litigation Management --------------------- The Company realized that to provide effective and thorough receivable management services to clients, it needed to establish other services and systems to support its core operations. At times the Company recommended to its clients the need to take legal action to increase the probability of recovery of an account receivable. The Company made this recommendation on accounts with verified assets and significant balances. AIH had in place a department to manage all aspects of the litigation. AIH worked closely with a Kansas City law firm in preparing and filing legal actions on collection accounts and enforcement of judgments. Once a judgment was entered, AIH pursued the collection of the judgment by filing liens on the debtor's assets and the garnishment of wages as applicable. Litigation management services were also available to all of the AIH's clients. Consumer Receivables -------------------- The Company, through AIH and RMS acquired portfolios of charged off consumer debt and then collected on same for its own account. 7 Customers --------- AIH generally had a broad and well-diversified client base that includes hospitals, medical groups, laboratories, convalescent homes, banks, and credit unions. Although, AIH had several customers and the loss of any one of these customers could have a material adverse effect on operations, no customer comprises more than 10% of the Company's consolidated revenues. Markets and Competition ----------------------- AIH maintained a full-time sales representative that continuously solicits business by pursuing leads from existing clients, multiple business and commerce directories, and promotional material. Regulation ---------- The AIH operations were regulated by the Fair Debt Collection Practice Act (FDCPA) and the Telephone Consumer Protection Act (TCPA), which are enforced by the Federal Trade Commission (FTC). Employees --------- As of March 31, 2005, the Company and its subsidiaries had 3 employees, none of whom received any compensation during the year. ITEM 2. DESCRIPTION OF PROPERTY ----------------------- Property, Plant and Equipment ----------------------------- All property, furniture, and equipment as of March 31, 2004 was owned by AIH and accordingly included in the Exchange Transaction. At March 31, 2005, property, plant and equipment, all of which is held in Elgin, consists of approximately $481,000 related to pipeline and natural gas treating facilities located in Hardin County, Texas, and $530,000 of acreage and related costs for oil and gas properties located in Madison County, Texas. In addition Elgin has lease prepayments of approximately $27,000. Corporate Property ------------------ In addition to the operating properties described above, the Company leases office space and certain office equipment in its corporate office located at 5799 Broadmoor, Ste 750, Mission, KS. ITEM 3. LEGAL PROCEEDINGS ----------------- The Company is not involved in any lawsuits as of March 31, 2005. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- None. 8 PART II ------- ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS -------------------------------------------------------- The Company's common stock is traded on the OTC Pink Sheets under the symbol AVFI. The following table sets forth the high and low prices for the common stock as reported on the Pink Sheets for the four quarters of fiscal 2004 and 2005. The prices do not include retail mark-ups, markdowns, or other fees or commissions, and may not represent actual transactions. 2004 High Low ---------------------------------- ------------------- ------------------- Quarter ended June 30, 2003 $0.04 $.01 Quarter ended September 30, 2003 No transactions No transactions Quarter ended December 31, 2003 No transactions No transactions Quarter ended March 31, 2004 No transactions No transactions 2005 High Low ---------------------------------- ------------------- ------------------- Quarter ended June 30, 2004 No transactions No transactions Quarter ended September 30, 2004 No transactions No transactions Quarter ended December 31, 2004 No transactions No transactions Quarter ended March 31, 2005 No transactions No transactions At March 31, 2005, and as of the date of filing this Annual Report, no active market existed for the Company's common stock. On such date, 325 holders of record held the Company's common stock. At March 31, 2005, and as of the date of filing this Annual Report, the Company had not paid any cash dividends on its common stock. The Company was not subject to any restrictive covenants or agreements, which limit its ability to pay dividends. The Company has no plans to pay cash dividends on its common stock in the near future. ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION --------------------------------------------------------- GENERAL ------- Effective April 1, 2004, the Company completed a restructuring and changed its business focus to the energy industry, having disposed of all of its financial service related operations. Thus, any comparisons of results of operations and financial condition would be meaningless. However, the prior year's Management's Discussions are available in the Company's Form 10KSB for the year ended March 31, 2004. The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report particularly those dealing with the Exchange Transaction and the Subsequent Events footnote. This discussion contains forward-looking statements that involve risks and uncertainties. The Company's actual results may differ materially from those anticipated in any forward-looking statements included herein. In addition, 9 because of the change to a new business strategy, the Company will be subject to all of the energy industry common and traditional risks associated with the economic production of hydrocarbons including, but not limited to, acquisition of reserves that can produce adequate returns to attract the necessary investment capital to develop such reserves, the petroleum engineering of underground oil and gas reserves, drilling of the wells, and the fluctuation of hydrocarbon prices. The Company has limited capital resources and management has somewhat limited experience with respect to this segment of the energy industry. Accordingly, the Company is utilizing the joint venture approach to mitigate these risks. The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report. RESULTS OF OPERATIONS --------------------- Year Ended March 31, 2005 ------------------------- Liquidity and Capital Resources ------------------------------- As of December 31, 2003, the accumulation of debt to ARGUS had grown to a point where the Company could no longer service this outstanding debt given the downsizing of the Company that was the result of the reorganization and restructuring of the various AIH segment operations. Also during these years, and to the current date, the current President and Treasurer of the Company did not draw a salary, nor were any amounts accrued with respect thereto. With the Madisonville Project investment, and the joint venture with GulfWest Energy Inc. as discussed later, the Company had determined that the ability to generate long-term value for the common shareholders could be enhanced if the present Company operations, (AIH) were sold and the Company concentrated its growth efforts in the energy industry, focusing primarily on natural gas. In accordance with this business strategy, an agreement was entered into with ARGUS, subject to common shareholder approval, wherein the common shares of AIH would be exchanged for an assumption by ARGUS of all of the AIH liabilities (the "Exchange Transaction"). The Board of Directors engaged an investment banking firm (Morgan Stanley) to determine the fair market value of the AIH operations on a going concern basis. Morgan Stanley, through its SPARDATA affiliate, determined such value to be $345,000. On March 24, 2004, the Company received the requisite affirmative consent votes from the common shareholders to effect the Exchange Transaction. The Exchange Transaction was completed in August of 2004, but was effective as of 12:01 AM April 1, 2004. In the Exchange Transaction, ARGUS assumed $1,661,719 of liabilities, (including $1,308,858 of notes payable, substantially all of which carried a prime interest rate), resulting in a gain to the Company on the exchange of $1,569,476, which gain was reduced by $59,426 as a result of a final settlement of certain payables and certain additional costs related to the Exchange Transaction during the quarter ended December 31, 2004. In the quarter ended December 31, 2004, the Company entered into two transactions which significantly impacted the Company- GulfWest Energy Inc. Joint Venture On July 21, 2004, the Company entered into a Letter of Intent, subject to the execution of definitive agreements, with GulfWest Energy Inc. ("GWEI") located in Houston, Texas, under which the Company and GWEI, through one or more Joint Venture LLCs, would develop certain oil and gas assets owned by GWEI in Grimes and Madison County, Texas. Certain of the Madison County reserves, if developed and produced, are expected to require treatment similar to that described in the Madisonville Project as discussed earlier under the April 30, 2003 Gateway Energy Corporation Agreement. On October 14, 2004, the Company, through its wholly owned subsidiary, Allen Drilling Acquisition Company ("ADAC"), became a 10 member of a Texas LLC (Elgin Holdings, L.L.C.) (the "LLC") ("Elgin") with GWEI for the purpose of initially developing certain portions of the GWEI oil and gas asset bases in Madison County and Hardin County, Texas. Participation in the development of the Grimes County asset base, if any, by ADAC was deferred and will not be a part of this LLC. GWEI contributed certain assets valued at approximately $540,000, and the Company committed to provide up to $595,000 in initial capital funding to the LLC as provided for in the LLC's Regulations. In December, 2004, the Company funded $315,000. In March 2005, the Company funded an additional $170,000, leaving a balance of $110,000 remaining to be funded in fiscal year 2005. The capital funding is being raised by ADAC through a private placement of a new series (Series B) of participating preferred stock. The various agreement transaction requirements were completed on November 15, 2004. The Company owns 52.5% of the LLC, and holds two of the three manager positions, such positions filled by Charles A. Holtgraves and Larry J. Horbach, directors and officers of the Registrant The initial capital funding was raised by ADAC through a private placement of 595 shares of a new series preferred stock. The Senior Series B Preferred Stock, Stated Value $1,000 per share provides, among other things, for a preferential dividend right based on the Company's proportionate interest in the operations and cash flow from Elgin, and a preferential liquidation right consisting of a proportionate share of the Company's Capital Account in Elgin. Charles Holtgraves, Philip Holtgraves, Larry Horbach and Christopher Davis are directors of the Registrant. Charles Holtgraves, Philip Holtgraves and Mr. Horbach are officers of the Registrant. Entities in which these individuals either control or have an interest in, have subscribed for 577 of the 595 authorized shares. The Company/Elgin and Gateway Energy Corporation Agreement On November 15, 2004, the Company and Elgin entered into a LICENSE AGREEMENT (the "Agreement") with Gateway Energy Corporation and certain of its subsidiaries. The Agreement, provides, among other things, for the granting of a sublicense to the Company and Elgin to enable Elgin to treat the gas produced from the leasehold interests owned by Elgin in Madison County, Texas, which interests fall within a defined Area of Mutual Interest, ("AMI"). In addition, the Agreement provides that the Company and Elgin will dedicate the gas produced from its interests in the AMI to the Madisonville Project plant and will advance up to $91,250 to Gateway, $30,413 of which will represent a prepayment by the Company of the license and other fees due Advanced Extraction Technologies ("AET") for the processing of a minimum of 5,000 Mcf per day. The balance of the advance ($60,837) will be repaid by Gateway from Gateway's share of the initial project cash flows. This advance was completed in December 2004. The funds needed to meet the terms and conditions of the License Agreement were obtained from a bank term loan, which loan was guaranteed by two officers and directors of the Company, (Horbach and Holtgraves). The Agreement further grants to the Company or its designees, an option to participate pari passu with Gateway, subject to certain limitations, interests in future projects which require the treatment of natural gas containing high nitrogen, which projects utilize the AET license held by Gateway. Operations ---------- The revenues for the year ended March 31, 2005 consisted of the interest and guaranteed return from the Madisonville Project and a nominal amount of revenue from sales of gas from the testing of the Saratoga project which project was deemed in service in late March of 2005. During the year ended March 31, 2005, the Company's wholly owned subsidiary (ADAC) accrued $135,000, the minimum guaranteed return, and received $134,190, in price upside payments. These payments were offset to the accrued minimum guaranteed return. During the year ended March 31, 2005, ADAC also accrued Series A Preferred Stock dividends 11 payable of $90,000 representing 66-2/3% of such minimum guaranteed return and paid cash dividends of $44,321. The dividends are not payable until such time as ADAC receives project cash distributions from Gateway. The plant was deemed to be in service on October 1, 2003, which is the date that the price up side provisions of the agreement became effective. Operating income for the year was $31,290 after operating and general and administrative costs of $96,316 and interest of $17,278. Such general and administrative costs are not indicative of future operations as the sole three employees/officers of the Company (Charles Holtgraves, Philip Holtgraves and Larry Horbach) have waived current compensation in order to preserve cash flow for Company investment in on going projects. For such waiver of current compensation, these individuals have been given the right to invest on a pari-passu basis in these initial high risk capital projects along side the Company and other outside accredited investors. To date, entities in which these individuals either control or have an interest in, have provided a majority of all of the capital invested in the initial energy projects described above. During the three months ended June 30, 2004, the Company recognized a gain on the Exchange Transaction of $1,569,476. Such gain was the difference between the ARGUS obligations cancelled and the AIH operation's net assets (assets less liabilities assumed by ARGUS). During the quarter ended December 31, 2004, this gain was reduced by $59,426 as a result of a final settlement of certain payables and certain additional costs related to the Exchange Transaction resulting in a final reported gain of $1,510,050. SUBSEQUENT EVENT On July 26, 2005, ADAC executed an "Amendment To Agreement" (the "Amendment"), which Amendment modified certain provisions of the March 6, 2003, agreement between ADAC and Gateway Energy Corporation as related to the Madisonville Project Pipeline Facilities. The Amendment was necessary to enable Gateway to sell certain of the Pipeline Facilities. The Amendment provides among other things for; (a) a waiver of the notification by ADAC of it's election to pay off the $900,000 Term Note and exercise of the Equity Participation Option; (b) receipt by ADAC of certain consideration pursuant to a May 7, 2004 amendment to the 2003 agreement, and; (c) the transfer to a newly formed LLC, which LLC will be owned by ADAC (33.33%) and by Gateway (66.67%), of the 10" Transportation System along with certain ancillary equipment, and a Transportation Agreement between Gateway and the purchaser of the Pipeline Facilities. The transactions are required to be closed and funded by August 31, 2005. ACCOUNTING PRONOUNCEMENTS AND ----------------------------- RECENT REGULATORY DEVELOPMENTS ------------------------------ In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. Goodwill and other intangible assets having an indefinite useful life acquired in business combinations completed after June 30, 2001, are no longer subject to amortization to earnings. Effective April 1, 2002, all goodwill and other intangible assets having an indefinite useful life are no longer amortized to earnings. The useful lives of other intangible assets must be reassessed, and the remaining amortization periods must be adjusted accordingly. Goodwill and other intangible assets having an indefinite useful life will be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the assets might be impaired, using a two-step impairment assessment. The first step of the goodwill impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired, and the second step of the impairment test is not necessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to 12 measure the amount of impairment loss, if any. The Company adopted the provisions of SFAS 142 on April 1, 2002. The Company provided an impairment charge of $90,000 as of March 31, 2004. In January 2003, the SEC adopted rules implementing Sections 406 and 407 of the Act. Section 406 of the Act requires public companies to annually disclose whether the company has adopted a code of ethics for its principal executive and financial officers, and if it has not, to explain why it has not. Additionally, the rules will require disclosure on a Form 8-K filing any amendments to or waivers from the code of ethics relating to those officers. Section 407 of the Act required public companies to disclose annually whether it has at least one "audit committee financial expert", as defined in the rules, on the Company's audit committee, and if so, the name of the audit committee financial expert and whether the expert is independent of management. A company that does not have an audit committee financial expert will be required to disclose this fact and explain why it has no such expert. Both rules are effective for small business issuers' annual reports for fiscal years ending on or after December 15, 2003. As of March 31, 2005, because of its recent restructuring and small size of the Board, the Company did not have on its Board of Directors a member who could meet the qualifications as defined in the rules for serving on an audit committee, or a member who could meet the qualifications of an audit committee financial expert.. In January 2003, the FASB issued interpretation No. 46 "Consolidation of Variable Interest Entities, and interpretation of Accounting Research Bulletin No. 51" ("The Interpretation"). The Interpretation requires the consolidation of variable Interest Entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected returns, or both, as a result of ownership, contractual or other financial interests in the entity. The Interpretation was originally immediately effective for variable interest entities created after January 31, 2003, and effective in the fourth quarter of the Company's fiscal 2003 for those created prior to February 1, 2003. However, in October 2003, the FASB deferred the effective date for those variable interest entities created prior to February 1, 2003 until the fourth quarter of fiscal 2004. The Company has substantially completed the process of evaluating the Interpretation and believes its adoption will not have a material impact on its financial position or results of operations. In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149"). SFAS No.149 amends SFAS No. 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires that contracts with similar characteristics be accounted for on a comparable basis. The standard is effective for contracts entered into or modified after June 30, 2003. The Company's adoption of SFAS No. 149 did not have a material impact on its financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity" ("SFAS No. 150") SFAS No. 150 establishes how an issuer classifies and measures certain freestanding financial instruments with characteristics of liabilities and equity and requires that such instruments be classified as liabilities. The standard is effective for financial instruments entered into or modified after May 31, 2003, and is otherwise effective in the first quarter of the Company's fiscal 2004. The Company's adoption of SFAS No. 149 did not have a material impact on its financial position or results of operations. 13 ITEM 7. FINANCIAL STATEMENTS -------------------- Financial statements for the years ended March 31, 2005 and March 31, 2004 are presented on the following pages. 14 CONSOLIDATED FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ADVANCED ENERGY RECOVERY, INC. AND SUBSIDIARIES March 31, 2005 and 2004 15 Report of Independent Registered Public Accounting Firm Stockholders and Directors Advanced Energy Recovery, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheet of Advanced Energy Recovery, Inc. and Subsidiaries as of March 31, 2005 and 2004 and the related consolidated statements of operations, shareholders' equity (deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standard of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Advanced Energy Recovery, Inc. and Subsidiaries as of March 31, 2005 and 2004 and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note B to the financial statements, the Company has suffered recurring losses from operations and is dependent upon the continued sale of its securities or obtaining debt financing for funds to meet its cash requirements. These factors raise substantial doubt about the Company's ability to continue as a going concern. Management's plans with regard to these matters are also described in Note B. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Weaver & Martin, LLC ---------------------------------- Weaver & Martin, LLC Kansas City, Missouri August 10, 2005 16 THIS PAGE LEFT BLANK -------------------- 17 THIS PAGE LEFT BLANK -------------------- 18
ADVANCED ENERGY RECOVERY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS March 31, March 31, 2005 2004 Cash $ 81,787 $ -- Collection fees ($35,493) and finance receivables ($12,621) -- 48,114 Accrued interest receivable 157,742 96,095 Other receivables 13,015 -- Prepaid expenses and other 70,413 17,813 ----------- ----------- Current Assets 322,957 162,022 Property, plant and equipment, net 1,008,887 36,063 Customer lists, net of amortization of $217,236 in 2004 -- 134,612 Deferred project costs and prepaid lease 52,458 -- ----------- ----------- Total Assets $ 1,384,302 $ 332,697 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY) Accounts payable $ 175,648 $ 35,622 Checks issued in excess of cash balances -- 112,489 Accrued expenses 157,375 361,120 Accounts payable - related parties 7,725 52,815 Notes payable 366,400 1,594,658 Dividends accrued-preferred stock of subsidiary 123,108 77,403 ----------- ----------- Current Liabilities 830,256 2,234,107 ----------- ----------- Commitments and Contingencies- Minority interest 536,148 -- ----------- ----------- STOCKHOLDERS' EQUITY Preferred Stocks of Subsidiary- Series A, $10.00 Par Value; 900 shares authorized, 900 shares issued and outstanding 9,000 9,000 Paid in capital, Series A Preferred Stock 891,000 891,000 Subscriptions receivable, Series A Preferred Stock (900,000) (900,000) ----------- ----------- -- -- ----------- ----------- Series B, $10.00 Par Value; 595 shares authorized, 387.2 shares issued and outstanding 5,950 -- Paid in capital, Series A Preferred Stock 589,050 -- Subscriptions receivable, Series B Preferred Stock (207,784) -- ----------- ----------- 387,216 -- ----------- ----------- Preferred stock, Series B, $.005 par value; 1,000,000 shares authorized, none issued and outstanding -- -- ----------- ----------- Common stock, $.003 par value; 10,000,000 shares authorized, 2,396,503 and 1,955,379 issued an outstanding 7,189 5,866 Paid-in capital 1,330,503 1,253,261 Accumulated deficit (1,707,010) (3,160,537) ----------- ----------- (369,318) (1,901,410) ----------- ----------- Total Stockholders' Equity 17,898 (1,901,410) ----------- ----------- $ 1,384,302 $ 332,697 =========== =========== The accompanying notes are an integral part of these statements. 19
ADVANCED ENERGY RECOVERY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Year ended Year ended March 31, March 31, 2005 2004 ----------- ----------- REVENUES Collection, servicing, and other fees $ 0 $ 823,762 Other 9,884 29,031 Interest and guaranteed return 135,000 135,026 ----------- ----------- Total Revenues 144,884 987,819 ----------- ----------- EXPENSES Operating expenses, including general and administrative costs 94,583 1,162,323 Interest 17,278 72,299 Depreciation and amortization 1,733 36,455 Impairment charge 0 90,000 ----------- ----------- Total Expenses 113,594 1,361,077 ----------- ----------- OPERATING INCOME (LOSS) 31,290 (373,258) Gain on Exchange Transaction 1,510,050 0 ----------- ----------- INCOME (LOSS) BEFORE INCOME TAXES 1,541,340 (373,258) AND MINORITY INTEREST Income taxes 0 0 Minority interest 2,187 0 ----------- ----------- NET INCOME (LOSS) 1,543,527 (373,258) Subsidiary preferred stock dividends accrued (90,000) (90,000) ----------- ----------- EARNINGS (LOSS) FOR COMMON STOCK $ 1,453,527 $ (463,258) =========== =========== Weighted-average shares outstanding 2,260,004 1,955,379 =========== =========== Earnings (Loss) Per Common Share $ 0.64 $ (0.24) =========== =========== The accompanying notes are an integral part of this statement. 20
ADVANCED ENERGY RECOVERY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) Subsidiary Preferred Stock Series Series Common Paid-in Accumulated A B stock capital deficit Total ----------- ----------- ----------- ----------- ----------- ----------- Balance, March 31, 2003 $ 0 $ 0 $ 5,866 $ 1,253,261 $(2,697,279) $(1,438,152) Net loss for the year ended March 31, 2004 -- -- -- -- (373,258) (373,258) 900 shares authorized 900,000 -- -- -- -- 900,000 Subscriptions outstanding (900,000) -- -- -- -- (900,000) Subsidiary preferred stock dividends accrued -- -- -- -- (90,000) (90,000) ----------- ----------- ----------- ----------- ----------- ----------- Balance, March 31, 2004 0 0 5,866 1,253,261 (3,160,537) (1,901,410) Net income for year ended March 31, 2005 -- -- -- -- 1,543,527 1,543,527 595 shares authorized -- 595,000 -- -- -- 595,000 Subscriptions outstanding -- (207,784) -- -- -- (207,784) Issuance of common stock -- -- 1,323 77,242 -- 78,565 Subsidiary preferred stock dividends accrued -- -- -- -- (90,000) (90,000) ----------- ----------- ----------- ----------- ----------- ----------- Balance, March 31, 2005 $ 0 $ 387,216 $ 7,189 $ 1,330,503 $(1,707,010) $ 17,898 =========== =========== =========== =========== =========== =========== The accompanying notes are an integral part of this statement. 21
ADVANCED ENERGY RECOVERY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year ended Year ended March 31, March 31, 2005 2004 ----------- ----------- Cash flows from operating activities Net income ( loss) $ 1,543,527 $ (373,258) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 1,733 36,455 Impairment charge -- 90,000 Common stock issued for services 25,750 -- Gain on Exchange Transaction (1,569,476) -- Changes in assets and liabilities- Collection fees receivable -- 11,626 Accrued interest receivable (195,837) (96,095) Other receivables (13,015) -- Other assets (45,277) (222) Accounts payable and accrued expenses 296,868 39,259 ----------- ----------- Net cash used in operating activities 44,273 (292,235) ----------- ----------- Cash flows from investing activities Collections applied to finance receivables -- 18,375 Project price upside payments received 134,190 -- Acquisitions of property, plant, and equipment (1,010,620) -- Minority interest contributions 536,148 -- Deferred project costs and other (52,432) -- ----------- ----------- Net cash provided by (used in) investing activities (392,714) 18,375 ----------- ----------- Cash flows from financing activities Change in checks issued in excess of cash balances 6,733 112,489 Issuance of subsidiary preferred stock 387,216 -- Advances from related party,net -- (442,971) Subsidary preferred stock dividends paid (44,321) (12,597) Payments on notes payable (20,850) -- Proceeds from notes payable 101,450 574,743 ----------- ----------- Net cash provided by financing activities 430,228 231,664 ----------- ----------- Net increase (decrease) in cash 81,787 (42,196) Cash, beginning of year -- 42,196 ----------- ----------- Cash, end of year $ 81,787 $ -- =========== =========== Supplementary disclosures of cash flow information Cash paid for interest $ -- $ 23,393 =========== =========== Common stock issued for services $ 25,750 $ -- =========== =========== Common stock issued for liabilities $ 52,816 $ -- =========== =========== The accompanying notes are an integral part of these statements. 22
Advanced Energy Recovery, Inc. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 and 2004 NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A summary of the significant accounting policies applied in the preparation of the accompanying financial statements follows. 1. Organization and Principles of Consolidation Advanced Energy Recovery, Inc. (Formerly known as Advanced Financial, Inc.) (the "Company" or "AER") is a Delaware corporation formed in September 1986. Advanced Financial, Inc. operated in the financial services sector through March 31, 2004. Through its two wholly owned subsidiaries, AIH Receivable Management Services and AIH Early Recovery Systems ("AIH"), the Company collected debts for others for a fee and purchased charged-off credit card debt to collect at a profit from debtors located throughout the United States. Through AIH, the Company was also engaged in the business of collecting nonperforming receivables on behalf of third parties. During the year 2004, the Company changed its focus and growth efforts to the energy industry with its primary emphasis on natural gas. Advanced Energy Recovery, Inc., currently owns 100% of Allen Drilling Acquisition Company ("ADAC"). In addition, as of October 14, 2004, through ADAC, the Company owns 52.5% of Elgin Holdings, LLC ("Elgin"). ADAC and Elgin are engaged in operations in the energy industry. Under date of February 27, 2004, the Company, through an Information Statement pursuant to Section 14 (c) of the Securities Exchange Act and Regulation 14A, solicited the consents of the common stockholders (the "Solicitation") to effect several transactions in an effort, among other things, to restructure the Company, to dispose of the financial service operations which have accumulated significant losses and to change its focus and growth efforts to the energy industry with its primary emphasis on natural gas. The consents solicited included the following: 1. To adopt an amendment to the Company's Certificate of Incorporation to; (i) change the name of the corporation to "Advanced Energy Recovery, Inc."; (ii) effect a 1 for three reverse split of the outstanding Common Stock of the Company; and (iii) set the authorized Common Stock of the Company at 10,000,000 common shares. 2. To obtain Stockholders' consent to an exchange of 100% of the outstanding stock of AIH Receivable Management Services, Inc. ("AIH") (a wholly owned subsidiary of the Company) for an assumption by the primary secured lender of the Company of all of the AIH liabilities ("the Exchange Transaction"). 3. To obtain Stockholders' consent and ratification of the engagement by the Board of Directors of Weaver and Martin L.P. as the Company's independent public accountants. 4. To obtain Stockholders' consent and ratification of the appointment by the Board of Directors of two directors to fill two vacancies created by resignations. Such directors will serve until the next annual meeting of Stockholders. On March 24, 2004, the Company, under a Form 8-K under date thereof, announced that it had received the requisite affirmative consent votes from the common shareholders to effect the four proposals set forth in the February 27, 2004 Solicitation. 23
The Exchange Transaction was completed in August, but was effective as of 12:01 AM April 1, 2004. 2. The Exchange Transaction The AIH operations had resulted in significant losses despite the efforts by the Company to restructure and reorganize various AIH segment operations. These losses were funded by ARGUS. The following sets forth in summary form the consolidated results of operations for five years: Fiscal Year Fiscal Year Fiscal Year Fiscal Year Fiscal Year Financial Position 03/31/00 03/31/01 03/31/02 03/31/03 03/31/04 ----------- ----------- ----------- ----------- ----------- Total assets $ 1,139,576 $ 742,348 $ 562,750 $ 435,032 $ 332,697 Total liabilities 1,027,060 1,272,620 1,589,521 1,873,184 2,234,107 Stockholders' equity $ 112,516 $ (530,272) $(1,026,771) $(1,438,152) $(1,901,410) Amounts due to ARGUS $ 560,000 $ 765,840 $ 1,129,772 $ 1,318,709 $ 1,442,618 Operations Total revenues $ 977,439 $ 1,423,153 $ 1,152,171 $ 1,128,441 $ 987,819 Total expenses 1,898,423 2,119,914 1,648,669 1,539,822 1,361,077 Net loss $ (920,984) $ (696,761) $ (496,498) $ (411,381) $ (373,258) The consolidated operations for the fiscal year ended March 31, 2004, included amounts with respect to the Company's wholly owned subsidiary's, (ADAC) participation in the Madisonville Project as described in Note C herein. For the fiscal year then ended, ADAC reported net income of $105,616. As of December 31, 2003, the accumulation of debt to ARGUS had grown to a point where the Company could no longer service this outstanding debt given the downsizing of the Company that was the result of the reorganization and restructuring of the various AIH segment operations. Also during these years, and to the current date, the current President and Treasurer of the Company did not draw a salary, nor were any amounts accrued with respect thereto. With the completion of the Madisonville Project investment, and the joint venture with GulfWest Energy Inc. as discussed later, the Company had determined that the ability to generate long-term value for the common shareholders could be enhanced if the present Company operations, (AIH) were sold and the Company concentrated its growth efforts in the energy industry, focusing primarily on natural gas. In accordance with this business strategy, an agreement was entered into with ARGUS, subject to common shareholder approval, wherein the common shares of AIH would be exchanged for an assumption by ARGUS of all of the AIH liabilities (the "Exchange Transaction"). The Board of Directors engaged an investment banking firm (Morgan Stanley) to determine the fair market value of the AIH operations on a going concern basis. Morgan Stanley, through its SPARDATA affiliate, determined such value to be $345,000. On March 24, 2004, the Company received the requisite affirmative consent votes from the common shareholders to effect the Exchange Transaction. The Exchange Transaction was effective at the beginning of business on April 1, 2004. 24
The following sets forth the opening consolidated balance sheet on April 1, 2004, reflecting the Exchange Transaction : Condensed Consolidated Balance Sheet March 31,2004 Assets Actual Transaction April 1,2004 ----------- ----------- ----------- Cash (overdrafts) $ (112,489) $ 119,223 $ 6,734 Receivables and other 65,927 (40,791) 25,136 Accrued interest receivable 96,095 96,095 Property, net 36,063 (36,063) 0 Customer lists, net 134,612 (134,612) 0 Escrow deposit 75,000 75,000 Escrow depost reserve (75,000) (75,000) ----------- ----------- $ 220,208 $ 127,965 =========== =========== Liabilities Payables and accrued expenses $ 396,742 (352,861) 43,881 Payables to related parties 52,815 A 52,815 Notes payable 1,594,658 B (1,308,858) 285,800 Preferred stock dividends accrued 77,403 77,403 ----------- ----------- Total 2,121,618 459,899 ----------- ----------- Stockholders Equity (Deficiency) Subsidary preferred stock 900,000 900,000 Subscriptions receivable (900,000) (900,000) Series B Preferred stock 0 0 Common stock and paid in capital 1,259,126 1,259,126 Accumulated deficit (3,160,536) C 1,569,476 (1,591,060) ----------- ----------- Total (1,901,410) (331,934) ----------- ----------- $ 220,208 $ 127,965 =========== =========== Notes to Condensed Consolidated Balance Sheet: (A) At March 31, 2004, the amounts due to related parties consisted of $52,815 due to AFI Capital Corporation. In August, 2004, the $52,815 was settled by the issuance of common stock of the Company. (B) Notes payable at March 31, 2004, consisted of the following: Due ARGUS, $1,442,618, interest at prime, due on demand, secured by substantially all of the Company's assets. Due AFI Capital Corporation, $75,000, interest at 8%, unsecured, due on demand. Due bank, $77,040 under a $100,000 Line of Credit, interest at 2% over prime, unsecured, due March 31, 2004, guaranteed by a director of the Company. The ARGUS note payable included $185,900 which was used to fund general Company corporate operations since the Company's emergence from its Chapter XI filing in 1999. A new prime interest rate demand note (accrued interest of $33,381 with respect to such note is included in accrued expenses above) was issued to ARGUS. The balance ($1,308,858) related to the funding of the AIH operations and was included in the Exchange Transaction. 25 The AFI Capital Corporation note payable consists of two advances to ADAC in connection with a proposed acquisition transaction The bank note payable relates to the operations of AIH and was included in the Exchange Transaction. (C) The gain to the Company on the Exchange Transaction. Such gain was the difference between the ARGUS obligations cancelled and the AIH operation's net assets (assets less liabilities assumed by ARGUS). During the quarter ended December 31, 2004, this gain was reduced by $59,925 as a result of a final settlement of certain payables and certain additional costs related to the Exchange Transaction. 3. Finance Receivables and Revenue Recognition The Company accounted for its investment through March 31, 2004, in finance receivables under the guidance of the American Institute of Certified Public Accountants Practice Bulletin 6, Amortization of Discounts on Certain Acquired Loans (PB6) using unique and exclusive static pools. The pools were established with underlying accounts having similar attributes, based on acquisition timing and by seller. Once a static pool was established, the accounts in the pool were not changed. Each pool was initially recorded at cost. Until it was determined that the amount and timing of collections were reasonably estimable and collection was probable, PB6 required the receivable be accounted for under the cost-recovery method. All of the Company's pools were accounted for under the cost-recovery method. Application of the cost-recovery method required that any amounts received be applied first against the recorded amount of the pool; when that amount had been reduced to zero, any additional amounts received were recognized as income. The discount between the cost of each pool of receivables purchased and the contractual receivable of the accounts in the pool was not recorded since the Company expected to collect a relatively small percentage of each pool's contractual receivable balance. All pools were included in the Exchange Transaction. 4. Property, Plant and Equipment At March 31, 2005, property, plant and equipment, all of which is held in Elgin, consisted of approximately $481,000 related to a pipeline and natural gas treating facilities located in Hardin County, Texas, and $530,000 of acreage and related costs for oil and gas properties located in Madison County, Texas. The properties are stated at cost in the case of assets acquired within Elgin and at fair market value in the case of assets contributed to Elgin by the members. Property and Equipment ---------------------- All property, furniture, and equipment as of March 31, 2004 was owned by AIH and accordingly included in the Exchange Transaction and the determination of the gain thereon. Depreciation is provided on pipelines and treating facilities using the straight-line method over an estimated useful life of 10 years. Oil And Gas Properties ---------------------- The Company has elected to use the successful efforts method of accounting for oil and gas producing activities. Costs to acquire mineral interests in oil and gas properties, to drill and equip exploratory wells that find proved reserves, and to drill and equip development wells, will be capitalized. Costs to drill exploratory wells that do not find proved reserves, and geological and geophysical costs will be expensed. As the Company acquires significant oil and gas properties, any unproved property that is considered individually significant will be periodically assessed for impairment of value, and a loss will be recognized at the time of impairment by providing an impairment allowance. Capitalized costs of producing oil and gas properties and support 26 equipment, after considering estimated dismantlement and abandonment costs and salvage values, will be depreciated and depleted by the unit-of-production method. In the event of the sale of an entire interest in an unproved property, the gain or loss on the sale will be recognized, taking into consideration the amount of any recorded impairment if the property has been assessed individually. In the case of a sale of a partial interest in a proved property, the gain or loss will be recognized, based upon the fair values of the interests sold and retained. 5. Income Taxes The Company accounts for income taxes under the asset and liability method where deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are recognized to the extent management believes that it is more likely than not that they will be realized. 6. Loss Per Common Share Loss per common share is based on the weighted average number of common shares outstanding during the periods presented. 7. Stock-Based Compensation The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations in accounting for its employee stock options. Under APB 25, because the exercise price of employee stock options exceeds the market price of the underlying stock on the date of grant, no compensation expense is recorded. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). 8. Customer Lists Intangible assets at March 31, 2004 consisted of customer lists obtained in acquisitions. During the year ended March 31, 2004, the Company estimated that the value and future benefits of certain of these customer lists, based on discounted cash flow, indicated that the cost should be reduced. Accordingly, an impairment charge of $90,000 was recorded. At March 31, 2005, the Company no longer has any intangible assets. 9. Accounting Pronouncements and Recent Regulatory Developments In January 2003, the SEC adopted rules implementing Sections 406 and 407 of the Act. Section 406 of the Act requires public companies to annually disclose whether the company has adopted a code of ethics for its principal executive and financial officers, and if it has not, to explain why it has not. Additionally, the rules will require disclosure on a Form 8-K filing any amendments to or waivers from the code of ethics relating to those officers. Section 407 of the Act required public companies to disclose annually whether it has at least one "audit committee financial expert", as defined in the rules, on the Company's audit committee, and if so, the name of the audit committee financial expert and whether the expert is independent of management. A company that does not have an audit committee financial expert will be required to disclose this fact and explain why it has no such expert. Both rules are effective for small business issuers' annual reports for fiscal years ending on or after December 15, 2003. As of March 31, 2004, because of its recent restructuring and small size of the Board, the Company did not have on its Board of Directors a member who could 27 meet the qualifications as defined in the rules for serving on an audit committee, or a member who could meet the qualifications of an audit committee financial expert. 10. Use of Estimates In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates. NOTE B - GOING CONCERN At March 31, 2005, the Company's financial statements were subject to "Going Concern" issues, and the consolidated financial statements with respect thereto were prepared on going concern basis, which contemplated the Company's continuity of operations, realization of assets, and liquidation of liabilities in the ordinary course of business. Those statements, however, did not reflect adjustments that might result if the Company were unable to continue as a going concern. To address those issues, early in fiscal year 2004, management of the Company developed a plan to restructure the Company and to change its focus and business strategy as later described herein. The plan was implemented throughout the year, and culminated in the Exchange Transaction in August 2004, which transaction was effective on April 1, 2004. NOTE C - ACQUISITIONS AND AGREEMENTS 1. AFI Capital Corporation Agreement In July, 2001, the Company entered into a four year Agreement with AFI Capital Corporation ("Capital") a Nebraska corporation. Pursuant to the agreement, Capital provided financial, acquisition, and general public company business consulting services in other than the financial services industry. Compensation for such services was based on a "successful efforts" basis and primarily consisted of the Company's common equity and cash performance fees as earned. At March 31, 2004, $52,815 was due to Capital under the compensation portion of the Agreement, which amount was converted to 337,500 shares of Common Stock (post reverse split basis) subsequent to March 31, 2004, in accordance with the provisions of the Agreement. Upon issuance of the shares, the Agreement was terminated and all parties released from any obligations arising there from. Larry J. Horbach, who was appointed assistant secretary of the Company, and appointed to fill a vacant Company director position in March, 2003, is the president and a director of AFI Capital Corporation. Mr. Holtgraves is a founding director and an officer of Capital. Upon issuance of the shares, Mr. Holtgraves resigned as a director and officer of Capital and his Capital shares were redeemed by Capital. 2. The Gateway Energy/Madisonville Project Agreement On March 6, 2003, the Company executed an Agreement which was closed on April 30, 2003, with Gateway Energy Corporation and certain of its subsidiaries of Houston, Texas ("Gateway") under which it provided, through the Company's wholly-owned subsidiary, Allen Drilling Acquisition Company ("ADAC"), $900,000 of credit enhancements in the form of Letters of Credit. These credit enhancements enabled Gateway to obtain additional financing, in the form of a three year Balloon Note from a Houston bank to complete the construction of certain natural gas pipeline facilities ("Pipeline Facilities") located in Madison County, Texas, (The "Madisonville Project"). ADAC secured the Letters of Credit through the private placement of a new series of participating preferred stock (the "Series A"), to two investor groups. The Certificate of Designation 28 for the Series A provides, among other things, for dividend payments to the named holders thereof, equal to sixty-six and two thirds, (66.67%) of cash distributions received by ADAC from Gateway, and an unanimous vote of the Series A to exercise the Equity Participation Option as further described below. The Agreement provides, among other things, that ADAC will receive, during the term of the additional financing, one-half (50%) of the price upside portion only, if any, of the monthly fee to be received by Gateway from the Madisonville Project. The Agreement also provides that ADAC will have the option to either: (i) receive at the end of the Balloon Note term a lump-sum payment, which when added to the payments received, if any, for the price upside portion, will result in a 15% pre-tax internal rate of return on the $900,000, or (ii) to exercise the Equity Participation Option by paying off the Balloon Note on or before the end of the Balloon Note term in exchange for a thirty-three and one-third (33.33%) ownership interest in the Pipeline Facilities from that date forward. Gateway is obligated to pay the periodic interest payments on the Balloon Note during the three year term of the Balloon Note. Further, Gateway has granted liens to ADAC, subordinate to its banks, on its economic interest in the Madisonville Project and certain other natural gas operating systems and natural gas operating assets. The Agreement contains cross collateral and cross default provisions linking it to an additional Gateway term note at the same bank, the proceeds of which were used by Gateway to fund the Madisonville Project. The Madisonville Project is operated under a long-term agreement between Gateway, Hanover Compression Limited Partnership, and Redwood Energy Production, L. P. and is designed to treat gas to remove impurities from the gas to enable the gas to meet pipeline sales quality specifications. The Madisonville Project employs the state-of-the-art, patented, absorption based technology developed by Advanced Extraction Technologies, Inc., for which Gateway has the exclusive U. S. license, to remove nitrogen from the gas. During the year ended March 31, 2005, the Company's wholly owned subsidiary (ADAC) accrued $135,000, the minimum guaranteed return and received $134,190 in price upside payments. These payments were offset to the accrued minimum guaranteed return. During the year ADAC also accrued Series Preferred Stock dividends payable of $90,000, representing 66-2/3% of such minimum guaranteed return and paid cash dividends of $44,321. The dividends are not payable until such time as ADAC receives project cash distributions from Gateway. The plant was deemed to be in service on October 1, 2003, which is the date that the price up side provisions of the agreement became effective. To implement the provisions, terms and conditions of the various agreements including the Certificate of Designation for the ADAC Series A Preferred Stock: (i) Larry J. Horbach and Christopher D. Davis were appointed to the Board of Directors of the Registrant to fill the vacancies created by the resignation of two directors following the Registrant's emergence from it's Chapter XI Reorganization, serving until elected at the next meeting of shareholders; and (ii) Mr. Horbach resigned as a director of ADAC, with that position then being filled by Mr. Davis. The Registrant, as the sole shareholder of ADAC, effected such ADAC director changes and entered into an agreement to amend the ADAC By-laws to provide that the number of ADAC directors shall be fixed at three as long as any Series A Preferred Shares remain outstanding. In addition, Mr. Davis as well as the Registrant's President, Charles Holtgraves, were elected to the ADAC board of directors. Mr. Holtgraves is currently a director of Gateway. Mr. Horbach, who was a director of Gateway for several years, resigned his directorship on August 27, 2004. Mr. Davis has no affiliation with Gateway. Mr. Holtgraves owns 14.65% of an entity that owns 55.56% of the ADAC Series A Preferred Stock. Mr. Davis serves as the Trustee of the Davis Investment Management Trust for the Davis Investments VI LP, which LP owns 44.44% of the ADAC Series A Preferred Stock. Mr. Horbach owns no ADAC common stock or Series A Preferred Stock. 29 GulfWest Energy Inc. Joint Venture On July 21, 2004, the Company entered into a Letter of Intent, subject to the execution of definitive agreements, with GulfWest Energy Inc. ("GWEI") located in Houston, Texas, under which the Company and GWEI, through one or more Joint Venture LLCs, would develop certain oil and gas assets owned by GWEI in Grimes and Madison County, Texas. Certain of the Madison County reserves, if developed and produced, are expected to require treatment similar to that as earlier described in the Madisonville Project. On October 14, 2004, the Company, through ADAC, became a member of a Texas LLC (Elgin Holdings, LLC) (the "LLC") ("Elgin") with GWEI for the purpose of initially developing certain portions of the GWEI oil and gas asset bases in Madison County and Hardin County, Texas. Participation in the development of the Grimes County asset base by ADAC was deferred and will not be a part of this LLC. GWEI contributed certain assets valued at approximately $540,000, and the Company committed to provide up to $595,000 in initial capital funding to the LLC as provided for in the LLC's Regulations. In December 2004 the Company funded $315,000. In March 2005, the Company funded an additional $170,000, leaving a balance of $110,000 remaining to be funded in fiscal year 2005. The capital funding is being raised by ADAC through a private placement of a new series (Series B) of participating preferred stock. The various agreement transaction requirements were completed on November 15, 2004. The Company owns 52.5% of the LLC, and holds two of the three manager positions, such positions filled by Charles A. Holtgraves and Larry J. Horbach, directors and officers of the Registrant. The initial capital funding was raised by ADAC through a private placement of 595 shares of a new series preferred stock. The Senior Series B Preferred Stock, Stated Value $1,000 per share provides, among other things, for a preferential dividend right based on the Company's proportionate interest in the operations and cash flow from Elgin, and a preferential liquidation right consisting of a proportionate share of the Company's Capital Account in Elgin. Charles Holtgraves, Philip Holtgraves, Larry Horbach and Christopher Davis are directors of the Registrant. Charles Holtgraves, Philip Holtgraves and Mr. Horbach are officers of the Registrant. Entities in which these individuals either control or have an interest in, have subscribed for 577 of the 595 authorized shares. AER/Elgin and Gateway Energy Corporation Agreement On November 15, 2004, AER and Elgin entered into a LICENSE AGREEMENT (the "Agreement") with Gateway Energy Corporation and certain of its subsidiaries. The Agreement, provides, among other things, for the granting of a sublicense to AER and Elgin to enable Elgin to treat the gas produced from the leasehold interests owned by Elgin in Madison County, Texas, which interests fall within a defined Area of Mutual Interest, ("AMI"). The AMI is described in certain agreements with respect to the "The Gateway Energy/Madisonville Project Agreement" discussed above. In addition, the Agreement provides that AER and Elgin will dedicate the gas produced from its interests in the AMI to the Madisonville Project plant and will advance up to $91,250 to Gateway, $30,413 of which will represent a prepayment by the Company of the license and other fees due Advanced Extraction Technologies ("AET") for the processing of a minimum of 5,000 Mcf per day. The balance of the advance ($60,837) will be repaid by Gateway from Gateway's share of the initial project cash flows. The funds were advanced in December 2004. The Agreement further grants to AER or its designees, an option to participate pari passu with Gateway, subject to certain limitations, interests in future projects which require the treatment of natural gas containing high nitrogen, which projects utilize the AET license held by Gateway. 30 NOTE D - FINANCE RECEIVABLES AIH purchased defaulted consumer receivables at a discount from the actual principal balance. The following summarizes the change in finance receivables for the year ended March 31, 2004. (The finance receivables were included in the Exchange Transaction) : 2004 -------- Beginning balance, acquisition $ 30,996 Purchase of finance receivables 0 Collections applied to principal on finance receivables (18,375) -------- Balance, March 31, 2004, included in Exchange Transaction $ 12,621 ======== To the extent that the carrying amount of a pool of receivables exceeded its fair value, a valuation allowance would be recognized in the amount of such impairment. As of March 31, 2004, no provision for loss had been recorded. NOTE E - NOTES PAYABLE The following summarizes the Company's notes payable at: March 31 March 31 2004 2005 ---- ---- Borrowings under a line of credit from ARGUS, interest at prime, secured by substantially all of the Company's assets $1,442,618 - Due ARGUS, interest at prime, due on demand, secured by substantially all of the assets of AER - 199,950 Due to two officers and directors of the Company, under an assignment by AFI Capital Corporation, interest at 8%, unsecured, due on demand - 75,000 Due AFI Capital Corporation, interest at 8%, non secured 75,000 - Borrowings under bank line of credit, interest at two over prime, unsecured, guaranteed by a director 77,040 - Due to bank, interest at prime, due June 20, 2005, with renewable terms, guaranteed by Mr. Horbach and Mr. Holtgraves, officers and directors of the Company - 91,450 ---------- ---------- Notes Payable, All Current $1,594,658 $ 366,400 ---------- ---------- 31 NOTE F - LEASES Operating lease expense was approximately $12,000 and $100,000 for fiscal years 2005 and 2004 respectively. On August 31, 2004, upon notice of the present office lease termination, a subsidiary of the Company (RMS) entered into a new three year office lease for space located at 5799 Broadmoor, Suite 750, Mission, KS, 66203. Effective with the Exchange Transaction, the Company entered into a month to month lease for both office space and office equipment at a cost of $1,000 per month with RMS. Future rent obligations under the lease are; $12,000 for the fiscal years ended March 31, 2006 and 2007 respectively; and $5,000 for the fiscal year ended March 31, 2008. NOTE G - EMPLOYEE STOCK OPTIONS On February 19, 1999, the Company issued 50,000 shares of common stock at $0.50 per share, to a non-employee for service provided in connection with an acquisition. The options were immediately exercisable and will expire ten years from the date of issuance. Options to purchase 299,999 shares of the Company's common stock were issued to a former officer of the Company in February 1999. One hundred forty-nine thousand nine hundred ninety-nine (149,999) of the options were exercisable at $0.25 per share on or after November 13, 2000 through the expiration date of November 13, 2010, if the Company's common stock has attained and maintained bid prices of $1, $2, $3, and $4 for twenty consecutive trading days, respectively. The options vested during certain periods. In January, 2001, in connection with the resignation of the officer, the terms of the option were changed resulting in an immediate vesting of all options and a fixed exercise price of $.25 ($.75 post reverse split) per share exercisable to February 19, 2011. The stock options are accounted for as a variable plan under APB 25 and related Interpretations. No compensation cost has been recognized for the options. Had compensation cost for the options been determined based on the fair value of the options at the grant dates consistent with the method of SFAS 123, and to reflect the changes in January 2001, the Company's net loss and loss per common share and the pro forma amounts are set forth below for the year ended March 31, 2005 and 2004 respectively. 2005 2004 ------------------------- Income, loss for common stock As reported $ 1,451,340 $ (463,258) Pro forma 1,451,340 (463,258) Income, loss per common share As reported $ 0.64 $ (0.24) Pro forma 0.64 $ (0.24) The fair value of each option grant is estimated on the date of grant using the Black-Scholes options-pricing model with the following weighted-average assumptions used for grants: dividend yield of 0.0%; expected volatility of 289.1%; risk-free interest rates of 5.54%; and expected lives of 10 years. There have been no options granted since fiscal year 2001. At March 31, 2005, there were options outstanding with respect to 116,677 common shares (post reverse split), with an exercise price range of $0.75 to $1.50 per share, averaging $0.87 per share. All options are currently exercisable. 32
2004 Compensatory Stock Options ----------------------------------------------------------------------- Options Outstanding Options Exercisable ---------------------------------------------------------------------------- ----------------------------------- Weighted-average Range of Number remaining Weighted-average Number Weighted-average exercise prices outstanding contractual life exercise price exercisable exercisable price --------------- ----------- ---------------- -------------- ----------- ----------------- $0.75 to $1.50 116,667 5.1 years $ 0.86 116,667 $ 0.86 2005 Compensatory Stock Options ----------------------------------------------------------------------- Options outstanding Options Exercisable ---------------------------------------------------------------------------- ----------------------------------- Weighted-average Range of Number remaining Weighted-average Number Weighted-average exercise prices outstanding contractual life exercise price exercisable exercisable price --------------- ----------- ---------------- -------------- ----------- ----------------- $0.75 to $1.50 116,667 4.1 years $ 0.86 116,667 $ 0.86 NOTE H - INCOME TAXES The difference between actual income tax expense (benefit) and expected income tax expense (benefit) at the statutory federal income tax rate (34%) computed as follows at March 31, 2005 2004 --------- --------- Expected income tax at statutory rate $ 524,056 $(102,383) State income taxes, net 49,742 (9,718) Change in valuation allowance (573,798) 109,812 Other -- 2,289 --------- --------- Actual income tax expense $ -- $ -- ========= ========= The following is the tax effect of temporary differences that gave rise to the significant portions of deferred tax assets and liabilities at March 31: 2005 2004 ----------- ----------- Deferred tax assets Net operating loss carryforward $ 3,014,885 $ 4,341,011 Valuation allowance (3,014,885) (4,341,011) ----------- ----------- Net deferred tax asset $ -- $ -- =========== =========== 33
The Company had estimated net operating loss carryforwards ("NOLs") of approximately $10.4 million as of March 31, 2004. Such NOLs will be reduced by the taxable gain on the April 1, 2004, Exchange Transaction. The net operating losses will expire in the years ended March 31, 2009 through March 31, 2025. Total deferred taxes consist primarily of the benefit of the net operating loss carryforward. Management has established a valuation allowance to reduce the total deferred tax asset to $0. As of March 31, 2005, the Company has no recoverable income taxes previously paid. NOTE I - PROPERTY AND EQUIPMENT Property and equipment consisted of the following at: March 31, March 31, 2005 2004 ----------- ----------- Non evaluated, non producing leaseholds $ 529,819 $ -- Plant and equipment 480,801 -- Furniture and fixtures -- 297,977 ----------- ----------- 1,010,620 297,977 Accumulated depreciation (1,733) (261,914) ----------- ----------- $ 1,008,887 $ 36,063 =========== =========== Depreciation provided $ 1,733 $ 36,455 =========== =========== NOTE J - FAIR VALUE OF FINANCIAL INSTRUMENTS Financial Accounting Standards Board Statement No. 107, Disclosure About Fair Value of Financial Instruments, and Financial Accounting Standards Board Statement No. 119, Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments, require that the Company disclose estimated fair values for its financial instruments. Fair value estimates have been made as of March 31, 2005 and March 31, 2004 based on the current economic conditions, risk characteristics of the various financial instruments, and other subjective factors. The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate that value: Cash: The carrying amounts approximated fair value. Finance receivables: The Company recorded finance receivables at cost, which was discounted from the actual principal balance. This cost was reduced as collections were made. The carrying value of finance receivables approximates fair value at March 31, 2004. The finance receivables were included in the Exchange Transaction. Notes payable: The fair values of the notes payable are estimated based on discounted values of contractual cash flows using rates currently available for similar loan types. 34 The estimated fair value and carrying value of the Company's financial instruments are as follows at March 31, 2005 and 2004: 2005 2004 ----------------------- ----------------------- Carrying Fair Carrying Fair value value value value ---------- ---------- ---------- ---------- Financial assets: Cash $ 81,787 $ 81,787 $ -- $ -- Finance receivables -- -- 12,621 12,621 Financial liabilities: Notes payable 366,400 366,400 1,594,658 1,594,658 NOTE K - ACCOUNTS PAYABLE - RELATED PARTY Accounts payable - related parties at March 31, 2004 consisted of amounts advanced to the Company by AFI Capital ($52,815). No interest or repayment terms existed. In August, 2004, the $52,815 was settled by the issuance of common stock of the Company. At March 31, 2005 accounts payable related parties, consisted of amounts due and officer and director (Mr. Horbach) of the Company for un-reimbursed travel expenses. Effective October 1, 2003, $508,787 of open advances to the Company by ARGUS were converted to demand notes payable, with interest at prime. NOTE L- RELATED PARTIES Larry J. Horbach who was appointed to fill a vacant director's position in May 2003, and Charles A. Holtgraves, the Chairman of the Board and President of the Registrant are also directors of Gateway Energy Corporation. Mr. Horbach resigned as a director from Gateway on August 27, 2004. Mr. Horbach is the President and Chairman of the Board of AFI Capital Corporation. Mr. Holtgraves is a director of AFI Capital Corporation. Mr. Holtgraves resigned as a director of AFI Capital Corporation on August 27, 2004. Argus Investment Group, Inc. ("ARGUS ") is a family owned corporation involved in venture capital lending and financing. The stock of ARGUS is 100% owned by the Philip J. Holtgraves Irrevocable Trust DTD 9/20/93. Philip J. Holtgraves is the Chairman of ARGUS , a Director of the Registrant and the father of Charles A. Holtgraves. Charles A. Holtgraves is the President of ARGUS and Chairman, President and Director of the Registrant. Charles Holtgraves, Philip Holtgraves, Larry Horbach and Christopher Davis are directors of the Registrant. Charles Holtgraves, Philip Holtgraves and Mr. Horbach are officers of the Registrant. Entities in which these individuals either control or have an interest in, have subscribed for 577 of the 595 authorized ADAC Series B Preferred Stock shares being issued in connection with the Elgin Holdings, LLC joint venture. Mr. Holtgraves owns 14.65% of an entity that owns 55.56% of the ADAC Series A Preferred Stock. Mr. Davis serves as the Trustee of the Davis Investment Management Trust for the Davis Investments VI LP, which LP owns 44.44% of the ADAC Series A Preferred Stock. Mr. Horbach owns no ADAC common stock or Series A Preferred Stock. 35 Mr. Holtgraves is the President and the 100% owner of Balance In Full, Inc. ("BIF"). BIF places delinquent charged of credit card accounts with AIH Receivable Management Services, Inc., a wholly owned subsidiary of the Registrant as of March 31, 2004, ("AIH") for collection services. The fees paid by BIF for regular collections were 36% and 50% for legal accounts, which fees are comparable for non related party accounts. During the fiscal year ended March 31, 2004, gross collections were approximately $158,500. In December, 2004, 103,000 shares of the Company's common stock were issued to Mr. Horbach for services rendered in connection with the completion of the restructuring and recapitalization of the Company. NOTE M- SUBSEQUENT EVENT On July 26, 2005, ADAC executed an "Amendment To Agreement" (the "Amendment"), which Amendment modified certain provisions of the March 6, 2003, agreement between ADAC and Gateway Energy Corporation as related to the Madisonville Project Pipeline Facilities. The Amendment was necessary to enable Gateway to sell certain of the Pipeline Facilities. The Amendment provides among other things for; (a) a waiver of the notification by ADAC of it's election to pay off the $900,000 Term Note and exercise of the Equity Participation Option; (b) receipt by ADAC of certain consideration pursuant to a May 7, 2004 amendment to the 2003 agreement, and; (c) the transfer to a newly formed LLC, which LLC will be owned by ADAC (33.33%) and by Gateway (66.67%), of the 10" Transportation System along with certain ancillary equipment, and a Transportation Agreement between Gateway and the purchaser of the Pipeline Facilities. The transactions are required to be closed and funded by August 31, 2005. 36 PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL ---------------------------------------------------- PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT ---------------------------------------------------------- Directors and Executive Officers. --------------------------------- As of March 31, 2005, the following persons served as directors and executive officers of the Company. NAME AGE POSITION -------------------------------------------------------- Charles A. Holtgraves 39 Chairman/ President/Treasurer/ Director Philip J. Holtgraves 79 Director and Secretary Larry J. Horbach 63 Director and Assist Secretary Christopher D. Davis 53 Director Charles A. Holtgraves. From November 1998 to current, Mr. Holtgraves has been Chairman, President, Treasurer and Director of the Company and its subsidiaries.. Mr. Holtgraves is the President of Argus Investment Group, Inc. ("Argus") a family owned corporation involved in venture capital lending and financing. Mr. Holtgraves was the Chief Financial Officer and Vice President of First Mortgage Investment, Co., a full service mortgage banking operation, which he co-founded in 1988 until its sale of assets in August 1998. Mr. Holtgraves has been an officer and director of Gateway Energy Corporation, a publicly traded natural gas company, since 1988. Mr. Holtgraves graduated from McPherson College in 1988 with a dual degree in Finance and Accounting. Charles Holtgraves is the son of Philip J. Holtgraves. Philip J. Holtgraves. From November 1998 to current, Mr. Holtgraves has been a Director of the Company and also serves as the Secretary of the Company. Mr. Holtgraves is the Chairman of Argus a family owned corporation involved in venture capital lending and financing. Mr. Holtgraves was the principal owner of First Mortgage Investment, Co., a full service mortgage banking operation, which he co-founded in 1988. Mr. Holtgraves was president and Chief Operating Officer of Missouri Valley Investment, Co. from 1954 through 1987, becoming the sole shareholder in 1965. Mr. Holtgraves sold Missouri Valley Investment, Co. in 1987 to a Texas Savings Association. From 1950 to 1954, Mr. Holtgraves was employed by the Mid Continent regional office of the Prudential Insurance Co. in Kansas City. In addition Mr. Holtgraves was the principal owner of and President of Construction materials Inc., a chain lumber dealer in eastern Kansas. He sold his interest in the operation in 1976. Mr. Holtgraves was admitted to the Missouri Bar Association in 1951 and practiced law in the Kansas City area until 1952. Mr. Holtgraves has served on the board of directors of several banks including First National Bank of Chanute and Mark Twain Plaza Bank in Kansas City. Mr. Holtgraves was an agent for Rail Road Savings & Loan in the Olathe, Kansas area for over twenty-five years. Mr. Holtgraves also holds a Missouri Real Estate Broker's License. He is the father of Charles Holtgraves. Larry J. Horbach. Served as a director of Gateway Energy Corporation since 1990 resigning his directorship on August 27, 2004. He has also served in various executive capacities including Chairman and CEO and President of Gateway after founding this energy company with certain other individuals (including Mr. Holtgraves) in 1990. Mr. Horbach is the owner of L.J. Horbach & Associates, a firm specializing in corporate re-organizations, re-structurings and startups since 1976. Mr. Horbach is also a director of Templeton Savings Bank. 37
Christopher D. Davis. For the last several years Mr. Davis has managed a substantial family portfolio of liquid assets focusing on asset allocations, tax, insurance, financial analysis, portfolio insurance and evaluation of third party hedge and commodity advisory funds. From early 1974 to May 1977 he was employed by Gulf Oil Corporation working as an analyst in certain sections of Gulf's Strategic Planning Units. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934 and the related regulations require the Company's directors, executive officers and persons who own more than ten percent of the Company's Common Stock to file with the Securities and Exchange Commission initial reports of their beneficial ownership of the Company's Common Stock and other equity securities of the Company. In addition, such persons are required to furnish the Company with copies of all such filings. To the Company's knowledge, based solely upon a review of the copies of such reports furnished to the Company and written representations that no other reports were required during the fiscal year ended March 31, 2004, all Section 16(a) filing requirements applicable to its directors, executive officers and ten percent beneficial owners were complied with. ITEM 10. EXECUTIVE COMPENSATION No executive officer of the Company received compensation from the Company during the 2003, 2004 and 2005 fiscal years. OPTION/SAR GRANTS IN LAST FISCAL YEAR None ---- AGGREGATED OPTION/SAR EXERCISED IN YEAR ENDED MARCH 31, 2005 None ---- OPTION/SAR VALUES AS OF MARCH 31, 2005 (a) (b) (c) (d) (e) Values of Unexercised Number of In-the-Money Unexercised Options/SARs at Shares Options/SARs at FY-End ($) Acquired on Value FY-End (#) Exercisable/ Exercisable/ Name Exercise (#) Realized ($) Unexercisable Unexercisable ------------------------------------------------------------ --------------------------------------- William B. Morris (1) -0- -0- 0/100,000 $-0- (1) Mr. Morris resigned as an officer and director in January 2001, but was allowed, as a part of his severance package to retain his options. 38
Compensation of Directors The Company paid no director's fees. Employment Contracts and Termination of Employment and Change-in-Control Arrangements The Company has not entered into any employment contract with any executive officer or any other contract with respect to the resignation, retirement or any other termination of such executive officer's employment with the Company or its subsidiary or resulting from a change-in-control of the Company or a change in any executive officer's responsibility following a change-in-control. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -------------------------------------------------------------- The following table sets forth certain information regarding the ownership of the Company's common stock as of March 31, 2005: (i) each director; (ii) each executive officer named in the Summary Compensation Table; (iii) all executive officers and directors of the Company as a group; and (iv) all those known by the Company to be beneficial owners of more than five percent of its common stock. The percentage of ownership is based on 2,395,879 (post reverse split) shares outstanding on March 31, 2005. Beneficial Ownership (1) Beneficial Owner Number of Shares Percent of Total -------------------------------------------------------------------------------- Charles A. Holtgraves 5425 Martindale Shawnee, KS 66218 1,388,712 (2) 58.0% Philip J. Holtgraves 5425 Martindale Shawnee, KS 66218 1,388,712 (3) 58.0% Argus Investment Group, Inc. 5425 Martindale Shawnee KS, 66218 1,388,712 58.0% Christopher D. Davis 78,333 3.3% Larry J. Horbach 103,000 4.3% All Executive officers and directors as a group 1,570,045 (4) 65.5% (4 persons) (1) Unless otherwise indicated in the footnotes to this table and subject to community property laws where applicable, each of the stockholders named in this table has sole voting and investment power with respect to the shares indicated as beneficially owned. (2) Includes 1,388,712 shares controlled by Argus Investment Group, Inc. ("Argus"). Charles A. Holtgraves is the President of Argus. Argus is 100% owned by the Philip J. Holtgraves Irrevocable Trust DTD 9/20/93. Charles A. Holtgraves is the son of Philip J. Holtgraves. 39 (3) Includes 1,388,712 shares controlled by Argus. Philip J. Holtgraves is the Chairman of Argus. (4) Includes only shares actually issued and outstanding. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- Argus Investment Group, Inc. ("ARGUS ") is a family owned corporation involved in venture capital lending and financing. The stock of ARGUS is 100% owned by the Philip J. Holtgraves Irrevocable Trust DTD 9/20/93. Philip J. Holtgraves is the Chairman of ARGUS , a Director of the Company and the father of Charles A. Holtgraves. Charles A. Holtgraves is the President of ARGUS and Chairman, President and Director of the Company. Larry J. Horbach who was appointed to fill a vacant director's position in May 2003, and Charles A. Holtgraves, the Chairman of the Board and President of the Registrant are also directors of Gateway Energy Corporation as of March 31, 2004. Mr. Horbach resigned his Gateway directorship on August 27, 2004. Mr. Horbach is the President and Chairman of the Board of Capital. Mr. Holtgraves was a director, officer, and a stockholder of Capital resigning his director and officer positions on August 27, 2004, at which time his stock in Capital was redeemed by Capital. Although Mr. Holtgraves and Mr. Horbach are or were directors of Gateway, Mr. Davis has no affiliation with Gateway. Mr. Holtgraves owns 14.65% of an entity that owns 55.56% of the ADAC Series A Preferred Stock. Mr. Davis serves as the Trustee of the Davis Investment Management Trust for the Davis Investments VI LP, which LP owns 44.44% of the ADAC Series A Preferred Stock. Mr. Horbach owns no ADAC Series A Preferred Stock. Mr. Holtgraves is the President and the 100% owner of Balance In Full, Inc. ("BIF"). BIF places delinquent charged of credit card accounts with AIH Receivable Management Services, Inc., a wholly owned subsidiary of the Registrant as of March 31, 2004, ("AIH") for collection services. The fees paid by BIF for regular collections are 36% and 50% for legal accounts, which fees are comparable for non related party accounts. During the fiscal year ended March 31, 2004, gross collections were approximately $158,500. Reference is made to ITEM 1. Description of Business - History of the Company ------------------------------------------------ and Subsidiaries for additional information with respect to this ITEM 12. ---------------- 40 PART IV ITEM 13. EXHIBITS AND REPORTS -------------------- (a) Exhibits ------------ *2.1 First Amended Joint Plan of Reorganization dated July 29, 1998 of Advanced Financial, Inc. and AFI Mortgage Corp. (Exhibit 2.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on November 25, 1998). *3.1 Articles of incorporation and by-laws (Exhibit 3.2 to Registration Statement on Form S-2 of Advanced Financial, Inc. filed with the Securities and Exchange Commission on January 31, 1993 (No. 33-45406)). *4.1 Instruments Defining Rights of Holders (Exhibit 4.0 to Registration Statement on Form S-2 of Advanced Financial, Inc. filed with the Securities and Exchange Commission on January 31, 1993 (No. 33-45406)). *4.2 Variable Rate Commercial Note Secured With Loan Servicing Rights dated July 27, 1994 made by AFI Mortgage Corp., successor to Continental Mortgage, Inc. ("AFIM"), to order of Commercial Federal Bank, successor to Rail Road Savings Bank, FSB ("Lender") and agreement dated October 11, 1996 between Advanced Financial, Inc. and AFIM, as Borrower, and Lender and Matrix Financial Services Corporation (Exhibit 4.2 to Advanced Financial, Inc.'s Annual Report on Form 10-KSB for the fiscal year ended March 31, 1997 filed with the Securities and Exchange Commission on February 16, 1999). *4.3 Variable Rate Commercial Balloon Note For Purchase of Loan Servicing Rights dated December 31, 1993 made by AFI Mortgage Corp., successor to Continental Mortgage, Inc. ("Borrower"), to the order of Argo Federal Savings Bank, FSB ("Lender") and Security Agreement For Sale of Mortgage Loan Servicing Rights dated December 31, 1993 between Borrower and Lender (Exhibit 4.3 to Advanced Financial, Inc.'s Annual Report on Form 10-KSB for the fiscal year ended March 31, 1997 filed with the Securities and Exchange Commission on February 16, 1999). *10.1 Commercial Real Estate Contract with Standard Builders (Exhibit 10.1 to Registration Statement on Form S-2 of Advanced Financial, Inc. filed with the Securities and Exchange Commission on February 11, 1993 (No. 33-58186)). *10.2 Contract for Services between the Company and Rollie C. Johnson (Exhibit 10.1 to Registration Statement on Form S-2 of Advanced Financial, Inc. filed with the Securities and Exchange Commission on February 11, 1993 (No. 33-58186)). *10.3 Real Estate Mortgage to Secure a Loan from Citizen's National Bank of Fort Scott ("Bank") dated February 3, 1997 made by AFI Mortgage, Corp., as Mortgagee, to Bank and accompanying notes as amended (Exhibit 10.3 to Advanced Financial, Inc.'s Annual Report on Form 10-KSB for the fiscal year ended March 31, 1997 filed with the Securities and Exchange Commission on February 16, 1999). *10.4 Second Mortgage dated March 29, 1996 made by Advanced Financial, Inc. and AFI Mortgage, Corp., as Mortgagor, to First Mortgage Investment Co., as Mortgagee (Exhibit 10.4 to Advanced Financial, Inc.'s Annual Report on Form 10-KSB for the fiscal year ended March 31, 1997 filed with the Securities and Exchange Commission on February 16, 1999). 41 *10.5 AFI Capital Agreement. *10.6 Agreement by and between Gateway Energy Corporation and its wholly-owned subsidiaries and Allen Drilling Acquisition Company, filed as Exhibit A in Registrant's Form 8-K dated May 9, 2003. *10.7 The Certificate of Designation, Preferences and Rights of the Senior Series A Preferred Stock, Stated Value of $1,000 of Allen Drilling Acquisition Company, filed as Exhibit B in Registrant's Form 8-K dated May 9, 2003. *10.8 Agreement between Advanced Financial, Inc., Charles A. Holtgraves, Davis Investments VI LP, and Allen Drilling Acquisition Company, filed as Exhibit C in Registrant's Form 8-K dated May 9, 2003. *10.9 Exchange Agreement between Advanced Financial, Inc. and ARGUS Investment Group, Inc. filed as an Exhibit to the Registrants Form 10 KSB for the year ended March 31, 2004. *10.10 Agreement between Advanced Financial, Inc. and AFI Capital Corporation canceling the June 20, 2001, agreement between the parties filed as an Exhibit to the Registrants Form 10 KSB for the year ended March 31, 2004. *11.11 The Regulations of Elgin Holdings, L.L.C., filed as Exhibit A in Registrants Form 8-K dated November 19, 2004. *11.12 The Certificate of Designation, Preferences and Rights of the Senior Series B Preferred Stock, Stated Value of $1,000 of Allen Drilling Acquisition Company, filed as Exhibit B in Registrant's Form 8-K dated November 19, 2004. *11.13 The License Agreement between Advanced Energy Recovery, Inc., Elgin Holdings, L.L.C. and Gateway Energy Corporation, filed as Exhibit C in Registrant's Form 8-K dated November 19, 2004. *16 Letter regarding change in certifying accountant, filed as Exhibit 16 to Registrant's Form 8-K-A/1 dated May 13, 2003. 21 Subsidiaries of Registrant, filed herewith. 31.1 Section 302 Certification of Chief Executive Officer and Chief Financial Officer. 32 Section 906 Certification of Chief Executive Officer and Chief Financial Officer. (b) Reports on Form 8-K o Report dated November 19, 2004---Item 5. o Report dated August 1, 2005---Item 1.01 Asterisk indicates exhibits and reports on Form 8-K incorporated by reference as indicated; all other exhibits and reports are filed herewith. 42 THIS PAGE LEFT BLANK -------------------- 43 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ADVANCED ENERGY RECOVERY, INC. (Registrant) Dated: August 19, 2005 By: /s/ Charles A. Holtgraves -------------------------------- Charles A. Holtgraves Chairman, President, and Treasurer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signatures Title Date ----------------------------- --------- -------- /s/ Charles A. Holtgraves Director 8/19/05 ----------------------------- ------- Charles A. Holtgraves /s/ Philip J. Holtgraves Director 8/19/05 ----------------------------- ------- Philip J. Holtgraves /s/ Larry J. Horbach Director 8/19/05 ----------------------------- ------- Larry J. Horbach /s/ Christopher D. Davis Director 8/19/05 ----------------------------- ------- Christopher D. Davis 44