Form 10-K

-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, LUvf1nsJw71piVaDMrBffgK8DVSxOAxGGcqar/EVlxOPIpy4KWGAsDrcLQvpqk5d 89SCbpXqGVUCluHTAFma3Q== 0001017062-03-000652.txt : 20030328 0001017062-03-000652.hdr.sgml : 20030328 20030328172901 ACCESSION NUMBER: 0001017062-03-000652 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 15 CONFORMED PERIOD OF REPORT: 20021231 FILED AS OF DATE: 20030328 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOUTHWEST WATER CO CENTRAL INDEX KEY: 0000092472 STANDARD INDUSTRIAL CLASSIFICATION: WATER SUPPLY [4941] IRS NUMBER: 951840947 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-08176 FILM NUMBER: 03626468 BUSINESS ADDRESS: STREET 1: 225 N BARRANCA AVE STREET 2: STE 200 CITY: WEST COVINA STATE: CA ZIP: 91791-1605 BUSINESS PHONE: 6269151551 MAIL ADDRESS: STREET 1: 225 N BARRANCA AVENUE STREET 2: SUITE 200 CITY: WEST COVINA STATE: CA ZIP: 91791-1605 FORMER COMPANY: FORMER CONFORMED NAME: SUBURBAN WATER SYSTEMS DATE OF NAME CHANGE: 19751202 10-K 1 d10k.htm FORM 10-K Form 10-K

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)
x	Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

	For the fiscal year ended December 31, 2002 or

o	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

	For the transition period from _____________ to _____________

Commission file number 0-8176

Southwest Water Company
(Exact name of registrant as specified in its charter)



Delaware				95-1840947
(State or other jurisdiction of incorporation or organization)				(I.R.S. Employer Identification No.)

225 North Barranca Avenue, Suite 200
West Covina, California				91791-1605
(Address of principal executive offices)				(Zip Code)

Registrant’s telephone number including area code:				(626) 915-1551

Securities registered pursuant to Section 12(b) of the Act:				None
Securities registered pursuant to Section 12(g) of the Act:
(1) Common Stock, $.01 par value				Nasdaq
(2) Series A, Preferred Stock, $.01 par value				None

(Title of each class)				(Name of each exchange on which registered)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x

No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III in this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes x

No o

The aggregate market value of the voting common equity held by non-affiliates of the registrant was approximately $120,068,000 based upon the average high and low prices of such common equity as of June 28, 2002. The registrant is unable to estimate the aggregate market value of its preferred shares held by non-affiliates of the registrant because there is no public market for such shares. On March 26, 2003, there were 9,770,832 common shares outstanding.

Documents incorporated by reference:		Form 10-K Reference

Portions of the Registrant’s definitive proxy statement for the 2003 annual meeting of stockholders to be filed pursuant to Regulation 14A within 120 days of the Registrant’s fiscal year end of December 31, 2002		Part III

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

INDEX

									Page

PART I

Item 1.	Description of Business								1
		A.	History						1
		B.	Acquisitions						1
		C.	Operating Segments						2
						1)	Services Group		2
							a.	Development of Business, Services and Regulation	2
							b.	Municipal Utility District (MUD) Contracts	3
							c.	Operations & Maintenance (O&M) Contracts	3
							d.	Construction Management Projects	4
							e.	Utility Submetering	4
							f.	Competition	4
							g.	Growth and Backlog	5
							h.	Seasonality	5
					2)		Utility Group		6
							a.	Development of Business, Services and Regulation	6
							b.	Sources of Water	7
							c.	Water Quality Regulation	8
							d.	Competition	10
							e.	Rate Establishment	10
							f.	Growth	11
							g.	Seasonality	12
		D.		Environmental Matters					12
		E.		Service Areas					13
		F.		Credit Concentration					13
		G.		Intellectual Property					13
		H.		Regulatory Matters					13
		I.		Employees					14
		J.		Dividend History					14
		K		Risk Factors					14
		L.		Company Information					19
Item 2.	Properties								20
Item 3.	Legal Proceedings								22
Item 4.	Submission of Matters to a Vote of Security Holders								23
Item 4a.	Executive Officers of the Registrant								23

PART II

Item 5.	Market for the Registrant’s Common Equity and Related Stockholder Matters								24
Item 6.	Selected Financial Data								25
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations								27
Item 7a.	Quantitative and Qualitative Disclosures About Market Risk								38
Item 8.	Financial Statements and Supplementary Data								39
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure								67

		Page

PART III

Item 10.	Directors and Executive Officers of the Registrant	68
Item 11.	Executive Compensation	68
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	68
Item 13.	Certain Relationships and Related Party Transactions	68
Item 14.	Controls and Procedures	68

PART IV

Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K	69
	Exhibit Index	76
	Signatures	83
	Certifications	84

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

FORWARD-LOOKING STATEMENTS

Certain written and oral statements made by our Company and subsidiaries or with the approval of an authorized executive officer of our Company may constitute “forward looking statements” as defined under the Private Securities Litigation Reform Act of 1995, including statements made in this report and other filings with the Securities and Exchange Commission. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” and similar expressions identify forward-looking statements, which generally are not historical in nature. All statements which address operating performance, events or developments that we expect or anticipate will occur in the future are forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. When made, we believe that these forward-looking statements are reasonable. However, caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements.

PART I

Item 1. Description of Business

A. History

Southwest Water Company (Southwest Water, the Company, “we,” “ us,” or “our”) was incorporated in California on December 10, 1954. We reincorporated in Delaware on June 30, 1988. We provide a broad range of services including water production and distribution, wastewater collection and treatment, public works services, customer billing and service, and utility submetering. We provide service for more than two million people in 31 states from coast to coast. Our business is operated by our subsidiaries and is segmented into two operating groups: our Utility Group, which owns and operates regulated water and wastewater utilities, and our Services Group, which manages our non-regulated businesses.

Our Services Group consists of our contract service businesses through which we operate and maintain water supply and wastewater treatment facilities owned by cities, public agencies, municipal utility districts and private entities primarily in Texas, New Mexico, California, Colorado, Mississippi and Georgia. Nationwide, we provide utility submetering and billing and collection services. While state and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations, the pricing of our services within the Services Group is not subject to regulation. Operating margins within our Services Group are generally low because these are service businesses and competition exists within the industry.

Within our Utility Group, we own and operate rate-regulated public water and wastewater utilities in California, New Mexico and Texas. State and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations, as well as establish the rates that we can charge for our water and wastewater services.

B. Acquisitions

In November 2002, we acquired 100% ownership of certain contract operations of AquaSource, Inc., a provider of contract water and wastewater services in Texas and Colorado. The purchase price consisted of approximately $10,317,000 in cash. Upon closing of the transaction on November 22, 2002, we began operating a part of this business under the name Aqua Services, LP (Aqua Services) while the remaining part was incorporated into one of our existing subsidiaries, ECO Resources, Inc. (ECO).

In August 2001, we purchased 90% of the outstanding shares of Operations Technologies, Inc. (OpTech), a provider of contract water and wastewater and public works services in the southeastern United States, for a

purchase price of $8,248,000. The purchase price consisted of cash payments of $3,530,000 in August 2001 and $418,000 in January 2002, in addition to 96,580 shares (restated for a 5% stock dividend on January 2, 2003) of our common stock with a market value of $1,300,000 at August 31, 2001 and promissory notes in the aggregate amount of $3,000,000. We also entered into an employment agreement and a non-compete agreement with the owner of the remaining 10% of OpTech. Under the terms of our purchase agreement, we have the right to acquire the remaining 10% of OpTech after a period of five years based upon a formula relating to the profitability of OpTech. After two years, the prior owner has the option to sell the remaining 10% of OpTech to us using the same formula.

In April 2000, we acquired 80% of the outstanding common stock of Master Tek International, Inc. (Master Tek) and entered the utility submetering, billing and collection services market. Master Tek was established in 1975, and incorporated in Colorado in 1985. The purchase price was $4,000,000, consisting of $2,000,000 in cash and a $2,000,000 10-year promissory note. Under the terms of the purchase agreement, the minority owner of Master Tek may require us to purchase his initial 20% minority interest in 5% increments at a price based on a formula but not less than $1,000,000 per year over a four–year period commencing in April 2002. In April 2002, we paid $1,000,000 to the minority owner for an additional 5% interest in Master Tek in accordance with the purchase agreement, thereby increasing our ownership to 85%. In February 2003, the minority owner exercised his right to require us to purchase an additional 5% interest in Master Tek, which will increase our ownership to 90% in April 2003. We may be required to purchase the remaining 10% minority interest for $2,000,000 over the course of the next two years. We also entered into an employment agreement, a consulting agreement and a non-compete agreement with the minority owner.

In 2000, our California utility purchased the city of West Covina’s water distribution system and facilities for a price of approximately $8,500,000. The sale closed February 25, 2000, and we assumed ownership and operation of the water system on that date. The transaction added approximately 7,000 connections to our California utility customer base, an increase of about 11%.

In 1996, we acquired a 49% interest in Windermere Utility Company (Windermere), a regulated water and wastewater utility located in the Austin, Texas area. In October 2000, we reached an agreement with the majority shareholder and purchased an additional 31% interest from the majority shareholder, thereby increasing our ownership in Windermere to 80%. The former majority shareholder retains a 20% ownership interest in Windermere. As part of this transaction, we also purchased 100% of Hornsby Bend Utility Company (Hornsby), a nearby water and wastewater utility. The purchase price for these two transactions consisted of Southwest Water common stock with a market value of $4,000,000 at October 1, 2000. The purchase agreement provides that we have the right to acquire the remaining 20% ownership in Windermere for a purchase price of $6,000,000 payable in our common stock at any time when the market value of our common stock increases to $18.14 per share (as adjusted for stock splits and dividends). The minority owner of Windermere has the right to sell the remaining 20% after October 1, 2005, for $6,000,000 payable in our common stock, subject to a limitation on the maximum and minimum number of issuable shares. We also entered into a consulting agreement with the minority owner to provide certain services to Southwest Water.

C. Operating Segments

Our operations are organized into two reportable business segments: Services Group and Utility Group. Our Services Group conducts our non-regulated segment operations, while our regulated segment operations are conducted by our Utility Group. Our reportable business segments are strategic business units that offer different services. They are managed separately because each business requires different operating and marketing strategies. A summary of the profit or loss and assets for our business segments is found in Note 13 to the accompanying consolidated financial statements in Item 8.

1) Services Group

a. Development of Business, Services and Regulation

Our Services Group provides water and wastewater services primarily in Texas, Mississippi, California, Georgia, New Mexico, and Colorado. These services include water and wastewater facility operations and maintenance services, equipment maintenance and repair, sewer pipeline cleaning, billing and collection services, and state-certified water and wastewater laboratory analysis. Typically, our Services Group does not own the water sources or utility facilities that we operate for our clients. Although not the owner, the Services Group is responsible

for operating water and wastewater facilities in compliance with all federal, state and local environmental and health standards and regulations. Our Services Group also facilitates the design, construction, project management, and operating aspects of various water and wastewater projects. During the construction phase of such a project, our Services Group may have an ownership interest in the project.

Additionally, our Services Group provides utility submetering for multiple family housing units such as apartment buildings. Submetering operations include installation of submeters, billing, collection and customer services.

In some instances, the companies in our Services Group may be subject to regulatory oversight; however, the pricing of our services is not subject to regulation. See Note 13 to the accompanying consolidated financial statements.

Our Services Group generally has three distinct types of contractual relationships: (1) time-and-material contracts, primarily with municipal utility districts in Texas, (2) fixed-fee operations and maintenance contracts and (3) hybrid contracts involving fixed fees for defined basic services with additional billings beyond the basic services.

Most contracts with municipal utility districts are short-term contracts and do not generally include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis. Our operations and maintenance contracts are generally longer-term water and wastewater service contracts, primarily with cities, and many include inflation adjustments, as measured by a consumer price index. Most contracts with management companies and owners of apartment or condominium communities are short-term contracts and generally do not include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis.

b. Municipal Utility District (MUD) Contracts

A MUD is created under the rules of the Texas Commission on Environmental Quality (TCEQ), formerly the Texas Natural Resource Conservation Commission, to provide water supply, wastewater treatment and drainage services to areas where existing municipal services are not available. Our Services Group has MUD contracts in the suburbs of Houston, Austin and El Paso, Texas. Under a typical MUD contract, we bill a monthly base fee to provide a specified level of services. Services typically include customer billing and collection, customer service, daily operation and maintenance of water and wastewater facilities and assets, and environmental monitoring and reporting. Our Services Group usually bills for any additional services provided beyond the basic contract on a time-and-materials basis as such services are rendered. Generally, MUD contracts are cancellable on 30 or 60-day notice by either party. Our experience indicates that, with high-quality service and strong focus on client satisfaction, MUD relationships can last for periods of 10 or more years. Most MUD contracts provide for an increase in the monthly base fee as the number of customer connections increases.

c. Operations and Maintenance (O&M) Contracts

O&M contracts are agreements with cities and private entities that provide specific services such as facility operation and maintenance, meter reading, customer billing and collection, or management of the entire water or wastewater system. Under a standard O&M contract, our Services Group companies charge a fee that covers a specified level of services. Although in some cases there may be some variation due to weather or seasonality, services are typically provided evenly throughout the contract period and are billed on a monthly basis. Our O&M contracts limit our liability in the event of a major system failure or catastrophic event. When our Services Group provides services beyond the scope of a contract, we bill for the additional services. If a major system failure or catastrophic event occurred as the result of flooding, earthquake, electrical strike or vandalism for example, the facility owner would likely call upon us to provide a variety of additional services on a time-and-materials basis. Such services could include running pumps, resealing manholes or replacing meters.

Most O&M contracts provide for annual increases based upon measures of inflation, and we typically have the right to increase our fixed operations fee if the system experiences growth beyond a specified level. Under the O&M contracts, our Services Group may pay certain costs such as chemical or utility expenses. The O&M contracts provide that we are reimbursed for certain of these costs.

In most cases, O&M contracts are cancellable only upon a specific breach of the contract by either party. O&M contracts have terms ranging from month-to-month up to 10 or more years, and our experience has been that approximately 90% of our O&M contracts are renewed upon expiration.

d. Construction Management Projects

In 1999, we agreed to provide the design, building, financing and operation of a $6,500,000 reverse osmosis water treatment plant near El Paso, Texas, for the El Paso County Water Authority (EPCWA). The project included drilling five wells and developing associated water lines and settling ponds. During construction of the treatment plant, we received monthly payments from the EPCWA. In addition, the EPCWA awarded us a 20-year, $22,000,000 extension of the existing operating contract. The construction of the plant was substantially completed in December 2000 and the facility began operating in February 2001, treating an average of 2,600,000 gallons of water per day. Reverse osmosis technology is a process that removes microscopic particles such as minerals and salts from a solution to produce potable water.

In September 2002, we agreed to facilitate the engineering and construction of a $25,000,000 reverse osmosis water treatment plant in the city of San Juan Capistrano, California, for the Capistrano Valley Water District (CVWD). The project will include the drilling of eight new wells and developing associated water lines. During construction of the treatment plant, we will receive payments upon completion of construction milestones until final completion of the construction. In addition, the CVWD awarded us a 20-year, $20,000,000 contract to operate the treatment plant after completion of construction. The construction of the plant commenced in December 2002, with completion expected in late 2004, at which time we will begin to operate the facility under the 20-year contract. Upon completion, the plant will have a capacity to treat approximately 5,000,000 gallons of water per day.

Our Services Group has contracted with our Texas utilities and our New Mexico utility to perform operating services, normal maintenance and construction work and, in addition, to manage capital projects for these utilities. These contracts were established utilizing terms and conditions equivalent to prevailing industry rates for similar work performed by our Services Group for non-affiliated entities. In accordance with Statement of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Types of Regulation, we recognize a profit margin from contract work performed and do not eliminate the intercompany profit on the contract work performed when the contract sales price is reasonable and it is probable that the costs and capital will be recoverable through the rate making process. Accordingly, the intercompany profit on such projects has not been eliminated in the accompanying consolidated financial statements.

e. Utility Submetering

Utility submetering involves the installation of electronic equipment in apartments, condominiums, mobile home parks and other multi-family dwellings to monitor each resident’s usage of utilities, allowing water, gas and electricity usage to be measured and charged to each individual residential unit. By making residents accountable for their own utility consumption, submetering tends to promote conservation of natural resources and allows for landlord utility cost recovery. Our Services Group has designed its own submetering equipment and also installs submetering equipment manufactured by others.

In addition to the sale and installation of submetering devices, our submetering company provides billing, collection and customer relation services. The billing process for submetered facilities usually involves the transmission of utility usage data via radio frequency and telephone lines to our facility near Denver, Colorado. As of December 31, 2002, our Services Group was providing submetering services to approximately 127,000 dwelling units in 29 states.

f. Competition

Competition in the O&M portion of our business includes a number of significantly larger companies that provide O&M services on a national and international basis, as well as regional competitors. New contracts are awarded based on a combination of customer relationships, service levels, competitive pricing, references and technical expertise. While our Services Group intends to expand its market share within the southwestern and southern United States, there is substantial competition in these markets. Cities themselves are also major competitors, since we must overcome reluctance on the part of city officials to outsource their water and wastewater services. Although industry renewal rates tend to be high, the contract water and wastewater management business is very competitive, and we cannot assure you that our Services Group will be able to increase or sustain its market share.

The utility submetering, installation, billing and collection business is highly competitive. While industry contract renewal rates are high, management companies and owners of multifamily dwellings periodically change billing and collection companies. In addition, we compete with several larger competitors whose size, customer base and capital resources may restrict our ability to compete successfully for certain contracts. Submetering is a relatively new industry and may attract other large competitors. We cannot assure you that our efforts in the submetering business will be successful in increasing or sustaining market share.

g. Growth and Backlog

During the past three years, our Services Group has increased revenues and service area by adding new MUD, O&M and submetering contracts, managing construction projects, aggressively pursuing renewal of its existing contracts and making acquisitions.

As the major cities in Texas (such as Houston and Austin) expand their boundaries, they periodically acquire MUD-owned facilities through annexation to city-owned facilities; however, during 2002, none of the MUD facilities operated by our Services Group was annexed to city-owned facilities.

As of December 31, 2002, our Services Group had 263 MUD contracts, an increase of 85 contracts compared to December 31, 2001. As of December 31, 2002, we had 196 O&M contracts compared to 66 contracts as of December 31, 2001. The acquisition of Aqua Services in November 2002 accounted for most of the increase in MUD and O&M contracts during 2002.

The following table indicates the number of Services Group contracts in effect as of the end of each of the three most recent years:

Table 1
Services Group – Number of Contracts

	Contracts as of December 31,

	2002		2001		2000

MUD contracts		263		178		173
O&M contracts		196		66		29

Our Services Group’s revenue backlog consists of new and existing contracts. We include new contracts in the backlog when both the client and we have signed the contracts. Revenues included in the backlog may be realized over a multi-year period. The O&M contracts signed by our Services Group typically have durations of three to five years, and the uncompleted remaining portion of these existing contracts is reflected in the backlog. MUD and submetering contracts are assumed to have a 36-month term, consistent with our experience, and are included in the backlog computation using an assumed 36-month term. We believe our backlog figures are firm, subject only to the cancellation and modification provisions contained in the contracts.

As of December 31, 2002 and 2001, our Services Group backlog was approximately $275,000,000 and $144,000,000, respectively. The increase in the backlog was primarily due to 1) the addition of several new O&M and MUD contracts resulting from the acquisition of Aqua Services and 2) the addition of a $25,000,000 construction project of a reverse osmosis water treatment plant in San Juan Capistrano, California. Of the backlog as of December 31, 2002, we anticipate that approximately $100,000,000 will be realized in revenues during calendar year 2003.

h. Seasonality

Our Services Group operations can be affected by severe weather and rainfall. In general, heavy rainfall or storm conditions may limit our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions may also result in additional labor and material costs to us that may not necessarily be recoverable from our various city contracts. However, such severe weather conditions are infrequent, and any additional costs that we incur that cannot be billed under our contracts are not material to our results of operations.

Revenues and earnings of our utility submetering business are generally not subject to seasonal fluctuations.

2) Utility Group

a. Development of Business, Services and Regulation

California

Our regulated public water utility in California produces and supplies water for residential, business, industrial and public authority use and for private and public fire protection service under the jurisdiction of the California Public Utilities Commission (CPUC). Our California utility service area contains a population of approximately 311,000 people in an area of approximately 43 square miles within Los Angeles and Orange counties, California.

Our California utility or its predecessor entities have supplied water since approximately 1907. From the mid-1950s to the late 1960s, our operations expanded rapidly as most of our service area was converted from agricultural use to residential, business and industrial use. We have experienced only modest connection growth since the late 1960s, principally due to the population saturation of our service area. In February 2000, our California utility purchased the City of West Covina’s (West Covina) water distribution system and facilities, which added approximately 7,000 connections to our customer base, an increase of approximately 11%.

The following table indicates by classification the number of water connections that our California utility served as of the end of each of the past three years:

Table 2
California Utility – Number of Water Connections by Classification

		Water Connections as of December 31,

		2002		2001		2000

Residential			70,657		70,495		70,527
Business and industrial			3,015		2,996		2,798
Other			1,174		1,174		1,158

	Totals		74,846		74,665		74,483

During 2002, our California utility’s annual revenues were approximately 72% from sales to residential connections, approximately 17% from sales to business and industrial connections, and approximately 11% from sales to other connections.

New Mexico

Our regulated public water utility in New Mexico provides water supply and sewage collection services for residential, commercial and irrigation use and for fire protection service under jurisdiction of the New Mexico Public Regulation Commission (NMPRC). Our New Mexico utility service area is located in the northwest part of the City of Albuquerque and in the northern portion of Bernalillo County, New Mexico, and contains a population of about 36,000 people in an area of approximately 34 square miles, of which an estimated 34% has been developed.

The following table indicates by classification the number of water connections served by our New Mexico utility as of the end of each of the most recent three years:

Table 3
New Mexico Utility – Number of Water Connections by Classification

		Water Connections as of December 31,

		2002		2001		2000

Residential			10,554		9,253		8,037
Business and industrial			707		668		631
Other			104		85		80

	Totals		11,365		10,006		8,748

Our New Mexico utility has grown from approximately 800 connections at the time of its acquisition in 1969 to over 11,000 connections. Most of this growth has resulted from the extension of water services and sewage

collection services into new residential subdivisions and new commercial development. During 2002, we added 1,359 new water connections and 1,317 new wastewater connections in New Mexico. Because of the continuing real estate development in its service area, our New Mexico utility expects continued connection growth in 2003. During 2002 and 2001, our revenues in New Mexico were approximately 61% and 58%, respectively, from sales to residential connections and approximately 39% and 42%, respectively, from sales to commercial and industrial connections.

Texas

Our Texas utilities currently provide water supply and sewage collection and treatment services to approximately 5,800 connections for residential, commercial, irrigation and fire protection under the jurisdiction of the Texas Commission on Environmental Quality (TCEQ), formerly the Texas Natural Resource Conservation Commission. Our service areas in Texas are located near the City of Austin, and contain a population of approximately 19,000 people in an area of approximately eight square miles, of which an estimated 46% has been developed. These service areas are experiencing continued real estate development, and we expect the number of connections to continue growing in 2003.

Table 4
Texas Utilities – Number of Water Connections by Classification

		Water Connections as of December 31,

		2002		2001		2000

Residential			5,602		5,171		4,864
Business and industrial			152		145		138

	Totals		5,754		5,316		5,002

b. Sources of Water

The wells owned and operated by our California utility pump water from two of the major groundwater basins in the Southern California coastal watershed: the Main San Gabriel Basin (the Main Basin) and the San Gabriel Central Basin (the Central Basin). Our rights to pump water from the Main and Central Basins are fully adjudicated under California law, and these adjudications establish our right to produce water at levels and at a cost prescribed each year by the Watermaster Boards (the Boards) that manage the Main and Central Basins. Our California utility is also allowed to produce water from the Main and Central Basins in excess of the amount prescribed by the Boards, but when such excess production occurs, an additional payment from our utility is required to provide for the replenishment of the water supply. As the water levels in the Main and Central Basins increase or decrease, the Boards may adjust the amount of water that we are allowed to pump without paying any additional charges. As discussed in Part D. Environmental Matters, in recent years, the availability of water from the Main Basin has decreased because of groundwater contamination issues. As a result, the amount of water that our California utility has pumped from the Main Basin has declined. During 2002, the Main and Central Basins were the source of approximately 28% of our California water supply, compared to approximately 54% and 60% in 2001 and 2000, respectively. Generally, purchased water is more expensive than water pumped from our own wells.

Our water supply in California is supplemented by water purchased from external sources. We purchase water from the Metropolitan Water District (MWD) of Southern California through member agencies and other customers of member agencies. We also purchase water from two mutual water companies that produce their water from the Main Basin. Our California utility’s ownership of shares in each of these mutual water companies has allowed it to purchase water at a cost that is lower than many other sources. In addition, in the past we have leased Main Basin pumping rights from other parties, which has reduced our cost of water in California. However, we cannot assure you that these sources of water will remain unaffected by the Main Basin groundwater contamination issues or that our California utility will be able to use these water sources indefinitely.

In Part D. Environmental Matters, we discuss certain groundwater issues impacting the Main Basin. In 2001 we were required to shut down some of our wells. This resulted in our California utility purchasing approximately 46% of its water supply from the MWD and other sources in 2001, compared to approximately 40% in 2000. During 2002, our California utility shut down additional wells. As a consequence, the Main and Central Basins were the source of approximately

28% of our California water supplies in 2002, and we were required to purchase approximately 72% of our water supply from the MWD and other water sources. Under an agreement made in early 2002, we have been reimbursed for certain costs of purchasing water needed to replace lost production as a result of the Main Basin contamination issues. We expect such reimbursement to continue until completion of remediation.

To date, we have been able to produce and purchase enough water to meet our current customer requirements in California. However, we cannot assure you that we will be able to produce or purchase enough water to fully satisfy future customer demand in our California service area. We are currently examining various options to increase our available water supply in California. These options include drilling new wells, adding connections to our existing MWD supply lines and constructing water treatment facilities. We cannot assure you that the results of drilling the wells will be successful, that we will be able to obtain necessary permits to add new supply lines and connections, or that we will be able to obtain regulatory or legislative approval to operate new water treatment facilities.

Our New Mexico utility owns five wells and four reservoirs, and we believe that we have adequate water capacity to serve our current customer base as well as new customers over the next decade, based upon the current growth rate. The wells that we own and operate in New Mexico produce water from the Rio Grande Underground Basin.

As customer growth continues in our New Mexico service area, we may have to increase our water supply capacity through additional well construction to ensure an adequate supply of water. If an interruption were to occur in our New Mexico water supply, our New Mexico utility also has an emergency supply of water available through an interconnection with another water purveyor.

Our Texas utilities own eight wells and 10 reservoirs in addition to distribution, collection and treatment facilities. Water is pumped out of the Edwards aquifer. We believe that we have adequate capacity to serve our existing customer base in Texas.

As customer growth continues in our Texas service areas, we may have to increase the water supply capacity of our Texas utilities through a combination of outside water purchases and the construction of additional wells. One of our Texas utilities has a 20-year agreement to purchase water from the City of Austin.

c. Water Quality Regulation

The water supplies available to our utilities in California, New Mexico and Texas are subject to regulation by the United States Environmental Protection Agency (EPA) under the 1996 Federal Safe Drinking Water Act (US Act). The US Act establishes uniform minimum national water quality standards, as well as specification of the types of treatment processes to be used for public drinking water. The EPA, as mandated under the US Act, issues regulations that require, among other things, disinfection of drinking water, specification of maximum contaminant levels (MCLs) and filtration of surface water supplies.

Our California water supplies are also subject to regulation by the Office of Drinking Water of the California Department of Health Services (DOHS) under the California Safe Drinking Water Act (Cal Act). The Cal Act and the rules of the DOHS are similar to the US Act and the mandates of the EPA, except that in many instances the requirements of the DOHS are more stringent than those of the EPA.

In addition to the EPA and the DOHS water quality regulations, our California water utility is also subject to water quality standards that may be set by the CPUC. The California Supreme Court has ruled that the CPUC has the authority to set standards that are more stringent than those set by the EPA and the DOHS.

The water supplied by our New Mexico utility is subject to regulation by the EPA and by the State of New Mexico Environmental Improvement Division. The water supplied by our Texas utilities is subject to regulation by the EPA and by the TCEQ.

In June 1998, we detected the substance N-nitrosodimethylamine (NDMA) in one of our California utility’s wells at a level in excess of the EPA reference dosage for health risks. Upon detection, the well was immediately

removed from service. In 1999, our California utility completed construction of a treatment facility that is intended to reduce NDMA in this well to non-detectable levels. In February 2001, we received final regulatory approval of the facility and in May 2001, our California utility began producing water from this well.

In January 2002, the DOHS set a more stringent recommended standard for the substance perchlorate, which was subsequently detected in this California well at levels in excess of the revised standard. We immediately removed this well from service. In 2000, in another of our California utility’s well fields, we detected amounts of contaminants in excess of the EPA reference dosage for health risks. All wells in that well field were immediately removed from service. The water production from these wells was replaced with purchased water, the excess costs of which were substantially funded by the Cooperating Respondents (CRs).

In February 2002, the EPA set a more stringent arsenic standard in drinking water from 50 parts per billion to 10 parts per billion, which must be fully met by 2006. At the present time, our water sources in California and Texas are in compliance with the new standards. The DOHS is holding discussions that could result in a more stringent arsenic standard effective in June 2004. We cannot predict the impact that such changes in the arsenic standard would have on our California and Texas water utility operations. If the arsenic standard remains at 10 parts per billion, we do not expect it to have a material adverse impact on our financial position or results of operations in California and Texas.

Although our New Mexico utility meets the current arsenic standard of 50 parts per billion, it does not meet the newly adopted arsenic standard of 10 parts per billion. To meet this new standard by the required 2006 implementation date, we are considering an option that includes the construction of an arsenic removal treatment plant. We anticipate that significant capital expenditures at our New Mexico facility may be required to comply with the new arsenic standard, and we anticipate that the change in standard may have an impact on our New Mexico water utility operations. However, we cannot determine the impact at this time. We believe that there may be funds available from state or federal agencies that could defray all or a part of the capital expenditures that we believe will be necessary to meet the new arsenic standards. If this new standard has an impact on our New Mexico operations, we will likely present a rate case to the NMPRC to recover these costs. We cannot assure you that funds will be made available to our New Mexico utility or that costs incurred or capital spent will ultimately be recoverable from the ratepayers.

Costs associated with testing of our water supplies in California have increased and are expected to further increase as regulatory agencies adopt additional monitoring requirements. We believe that costs associated with the additional monitoring and testing of our water supply in California will be recoverable from ratepayers through future rate increases. However, we cannot assure you that water sources currently available to our California utility will meet future EPA or DOHS requirements, that recovery of additional costs will be allowed, or that new or revised monitoring requirements will not necessitate additional capital expenditures by our California utility in the future. We believe that future incremental costs of complying with governmental regulations, including capital expenditures, will be recoverable through increased rates. However, we cannot assure you that recovery of such costs will be allowed.

Both the EPA and the DOHS have put into effect regulations and other pronouncements that require periodic testing and sampling of water to ensure that only permissible levels of organic and volatile and semi-volatile organic compounds (VOCs), herbicides, radio nuclides, pesticides and inorganic substances are present in water supplied to the public. Our California water quality personnel regularly sample and monitor the quality of water being distributed throughout the system. Our California utility conducts sampling, testing and inspections at the intervals, locations and frequencies required by EPA and DOHS regulations. Chlorination is performed as a safeguard against bacteriological contamination. In addition to water sampling and testing performed by our personnel, independent engineers retained by the Boards conduct sampling and testing for certain pollutants such as VOCs. Water samples from throughout our California water system are tested regularly by independent, state-certified laboratories for bacterial contamination, chemical contaminant content and for the presence of pollutants and contaminants for which MCLs have been established. The results of the sampling and testing are made available to DOHS and to all water purveyors that produce water from the Basins. The cost of such sampling and testing is covered by Board assessments to the producers.

Samples of water from throughout our water systems in California, New Mexico and Texas, as well as treated wastewater, are regularly tested by independent, state-certified laboratories, and the test results are sent to the respective state regulatory agencies. Chlorination is performed as a safeguard against bacteriological contamination.

Each of the companies in our Utility Group provides its customers with an annual water quality report that, among other matters, informs them of the sources and quality of the water being provided.

We believe that water supplied by our California utility meets all current requirements of the US Act, the Cal Act and the regulations put into effect under the related legislation and CPUC standards. We also believe that water supplied by our New Mexico utility and our Texas utilities complies with all current requirements of the EPA and the respective state regulatory agencies. However, we cannot assure you that water sources currently available to our water utilities will meet future EPA or state regulatory requirements, or that such future requirements will not necessitate future capital expenditures by our water utilities.

d. Competition

Our Utility Group companies in California, New Mexico and Texas each operate under a Certificate of Public Convenience and Necessity granted by the CPUC, NMPRC and TCEQ, respectively. These companies are also regulated by other state and local governmental authorities having jurisdiction over water and wastewater service and other aspects of our water utility businesses. Our Utility Group water businesses are dependent upon maintaining these certificates and upon various governmental and court decisions affecting our water rights and service areas.

California, Texas and New Mexico state laws provide that no public or private agency can install facilities within the service area of a public utility in order to compete with it, except upon payment of just compensation for all damages incurred by the public utility. Under these state laws, municipalities and certain other public agencies have the right to acquire private water utility plants and systems within their territorial limits by condemnation but must pay fair value for the condemned system. We are not aware of any impending proceeding for the condemnation of any portion of their facilities.

e. Rate Establishment

Under current CPUC practices, California customer water rates may be increased through general rate increases or by offsets for certain expense increases. Since September 30, 2002, the California Public Utilities Code has required that CPUC-regulated water utilities file general rate cases every three years. General rate cases require formal proceedings with the CPUC in which overall rate structure, expenses and rate base are examined by CPUC staff. Public participation hearings are also held. Historically, rate proceedings have required approximately 12 months from the time an application is filed to the CPUC’s authorization of new rates.

In addition to a general rate increase, the CPUC typically provides for a step increase in the second and third years after a general rate review. The step increases are intended to compensate for projected expense increases. Prior to their approval, step increases are subject to verification that earnings levels have not exceeded the rate of return authorized at the general rate proceeding. In recent years, our California utility succeeded in achieving efficiencies and cost savings that resulted in the deferral of rate requests. However, in accordance with a change in the law, our California utility made a filing on April 2, 2002 to start a new general rate case, and the rate case proceedings are currently underway. Both the Company and the CPUC staff have testified before an Administrative Law Judge and the judge has rendered a preliminary opinion. That opinion is pending with the CPUC. We anticipate a rate increase in the first half of 2003.

One of our Texas utilities filed for a general rate increase in June 2001, and new rates became effective in January 2002. Our other utilities are not currently seeking any rate increase; however, regulatory changes concerning water quality, future construction expenditures and increased operating expenses may result in periodic requests for rate increases.

Under prior CPUC procedures, rate increases to offset increases in certain expenses such as the cost of purchased water and energy costs to pump water were approved through an abbreviated proceeding that required approximately two months from the time a request was filed to the authorization of new rates. Under current CPUC guidelines, offset increases are no longer as readily available, have more restrictions and will no longer be considered by the CPUC unless they occur within a three-year general rate cycle.

adjustment in the income statement. In 2001, our California utility recorded approximately $700,000 of balancing account benefits in its income statement, and had a total balance of approximately $2,300,000 in deferred costs recorded as an asset on its balance sheet at the end of November 2001. As mentioned above, no such benefits were available in 2002. The disposition of pre-November 29, 2001 balancing accounts became the subject of a CPUC rulemaking. On December 17, 2002, the CPUC issued a decision considered favorable to the water industry that should allow our California utility to recover approximately $2,300,000 that was in its balancing account on November 29, 2001.

Subsequent to November 29, 2001, our California utility has accounted for the difference between actual and CPUC-adopted water production costs in current operations in the income statement. Such costs have been tracked on a memorandum basis, and the rules for the recovery, if any, of such costs are the subject of CPUC rulemaking. The changed CPUC rules resulted in a reduction in revenue and earnings before taxes of approximately $700,000 in 2002 compared to 2001, and we believe that the changed CPUC rules will result in fluctuations in revenues and earnings in future periods.

Historically, our utilities have been permitted to increase rates as necessary to achieve a reasonable rate of return, and we believe that this practice will continue in the future. However, the inability to increase rates in the event that certain costs increase could adversely affect the results of operations of our Utility Group.

Requests for rate increases for our New Mexico utility are submitted to the NMPRC with the test year typically being the previous year’s actual results. Because of the continued growth in its service area, our New Mexico utility has not found it necessary to request a general water rate increase during the past several years. The most recent general water rate increase granted to our New Mexico utility was in 1984, while the last general sewer rate increase granted to our New Mexico utility was in 1995.

In Texas, requests for rate increases are submitted to the TCEQ with the test year typically being the previous year’s actual results. One of our Texas utility companies filed for a rate increase in April 2001 and received approval from the TCEQ for a 48% increase in December 2001. In addition, we received annual step increases for 2002 through 2004.

f. Growth

In recent years, the growth of our California utility has been limited to extensions into new subdivisions along the periphery of its service area. There is little undeveloped land available for new business, industrial construction or residential growth in the California service area. As a result, we do not anticipate any significant increase in the number of connections in our current service area.

In February 2000, our California utility purchased West Covina’s water distribution system and facilities for a price of approximately $8,500,000. The sale closed February 25, 2000, and we assumed ownership and operation of the water system on that date. The transaction added approximately 7,000 connections to our California utility customer base, an increase of about 11%.

Although our utility service areas in California are mature, our California utility operations are capital intensive. Significant capital expenditures are necessary for the renovation and replacement of our facilities in California. Capital is generated from our California utility operations, periodic debt financing and lines of credit that we maintain with banks. To a lesser extent, our California utility receives contributions in aid of construction from developers, governmental agencies, municipalities or individuals to assist in the cost of facility replacement. For the years ended December 31, 2002, 2001 and 2000, capital expenditures in California approximated $10,000,000, $4,700,000 and $5,600,000, respectively. Of these amounts, our California utility received capital contributions and advances from developers of approximately $2,535,000, $339,000 and $1,110,000 in 2002, 2001 and 2000, respectively. Additions for 2002 included approximately $4,278,000 of expenditures reimbursed to our California utility under a settlement agreement relating to Main Basin groundwater contamination (see Part D. Environmental Matters below).

Because our New Mexico utility service area continues to experience rapid growth, our operations are capital intensive. Capital is generated from New Mexico operations, periodic debt financing, bank lines of credit extended to our New Mexico utility and to Southwest Water, contributions in aid of construction received from developers, and from advances received from developers, which must be repaid under rules of the NMPRC. For the years ended

December 31, 2002, 2001 and 2000, capital expenditures approximated $7,500,000, $3,700,000 and $3,500,000, respectively. Of these amounts, our New Mexico utility received capital contributions from developers of approximately $6,740,000, $3,103,000 and $2,847,000 in 2002, 2001 and 2000, respectively.

Because our Texas utility service areas are also in locations of rapid growth, these operations are capital intensive as well. Capital is generated from Texas operations, a bank term loan to the larger of our Texas utilities, and Living Unit Equivalent connection fees (LUEs) received from developers. For the years ended December 31, 2002 and 2001, capital expenditures were approximately $13,700,000 and $5,019,000, respectively. Of these amounts, our Texas utilities received contributions and LUEs from developers of approximately $4,800,000 in 2002 and $1,026,000 in 2001.

In recent years, the City of Albuquerque has annexed a significant portion of our service area in New Mexico; however, we have continued to serve the customers located in the annexed areas. Currently, 80% of our utility customers in New Mexico are located within Albuquerque’s city limits. In 1998, Albuquerque initiated an action in eminent domain to acquire our New Mexico utility operations. In September 2000, the Albuquerque City Council voted to withdraw the condemnation proceeding. We received a formal withdrawal of the condemnation in 2001 and Albuquerque reimbursed us for approximately $115,000 in legal fees incurred as a result of the condemnation proceeding. We are not aware of any impending proceedings for the condemnation of any portion of our facilities in New Mexico.

g. Seasonality

Our Utility Group water operations are seasonal because rainfall and weather conditions affect water consumption. The second and third quarters of each year typically account for the highest volume of water consumption when weather tends to be hot and dry. The results of operations for one quarter do not indicate results to be expected in another quarter. Drought conditions may result in consumer conservation efforts or water shortages, which can reduce consumption. Drought conditions may also result in increased water costs to us, which could adversely affect our profitability. Conversely, unusually wet conditions may result in decreased customer demand, lower revenues and lower profit in our utility operations. Utility Group wastewater operations are generally not affected by seasonality.

D. Environmental Matters

The water supply of our California water utility has been affected by the presence of certain groundwater contaminants. These contaminants consist mainly of chemicals (including NDMA and perchlorates) disposed of by various industrial companies in the 1940s and 1950s. In 2001 and 2002, this contamination necessitated the shutdown of a number of our wells in California (see Item 1. Description of Business - Part C. 2) c. Water Quality Regulation above).

In May 2002, a settlement was reached among some of the alleged polluters (the Cooperating Respondents or CRs) and a number of water companies, including our California water utility. As part of the settlement, in the second quarter of 2002, we recorded income of approximately $1,649,000 and received payments, primarily representing reimbursement of certain water and energy costs incurred in 2000 and 2001. Additionally, as part of the settlement, we have received payments in 2002 and expect to continue to receive payments in future periods from this settlement until completion of remediation. The payments represent the incremental cost of purchasing water over the cost that would have been incurred by us to pump our wells had they not been shut down as a result of the contamination. We bill and collect this reimbursement each month, and the amounts are recorded as a reduction of water costs included in direct operating expenses.

For our California utility, the settlement also provides capital contributions to construct two new wells, pipelines and additional interconnections with other water sources. In accordance with the terms of the settlement agreement, the CRs were required to provide financial assurances in the form of either irrevocable standby letters of credit or cash into an escrow account equal to the total amount of capital funds required to complete the clean-up process for all water companies impacted by the contamination, estimated at approximately $250,000,000. Funds from the settlement will also be used to develop long-term solutions that will potentially enable us to use our own less costly groundwater supplies in the future. During 2002, we received approximately $4,278,000 from the CRs to pay for capital expenditures related to these long-term solutions.

E. Service Areas

Our Services Group provides water and wastewater operations and maintenance services primarily in California, New Mexico, Texas, Colorado, Georgia, and Mississippi. This group is headquartered in Sugar Land, Texas. Our submetering efforts are headquartered near Denver, Colorado, where we support clients in 29 states. Our Utility Group owns and operates regulated water and wastewater facilities in California, New Mexico, and Texas. This group is headquartered in West Covina, California.

F. Credit Concentration

We have no individual customers who accounted for 10% or more of our consolidated revenues in 2002, or whose loss would have a material adverse effect on our consolidated or operating segment revenues.

G. Intellectual Property

The primary focus of the water and wastewater management industry is customer service, and the industry does not rely heavily on technological or proprietary manufacturing processes. We do not conduct significant research and development activities, although we have several patents pending for certain submetering equipment. Except for certain logos, trademarks and artwork used in marketing, we have no other patents, licenses or trademarks.

H. Regulatory Matters

The CPUC, the NMPRC and the TCEQ regulate the rates and operations of our Utility Group companies in California, New Mexico and Texas, respectively. The rates established by these agencies are intended to provide the utilities an opportunity to recover costs and earn a reasonable return on capital.

Under current CPUC practices, California customer water rates may be increased through general rate increases or by offsets for certain expense increases. An amendment to the California Public Utilities Code effective September 30, 2002 requires CPUC-regulated water utilities to file general rate cases every three years. General rate cases require formal proceedings with the CPUC in which overall rate structure, expenses and rate base are examined by CPUC staff. Public participation hearings are also held. Historically, rate proceedings have required approximately 12 months from the time an application is filed to the CPUC’s authorization of new rates. The previously mentioned change in the law requires the CPUC to render rate decisions in accordance with its rate case plan. It also provides that, if the CPUC does not issue its decision in accordance with the plan, utilities may implement interim rates subject to refund.

In addition to a general rate increase, the CPUC typically provides for step increases in the second and third years. The step increases are intended to compensate for projected expense increases. Prior to their approval, step increases are subject to verification that earnings levels have not exceeded the rate of return authorized at the general rate proceeding. In recent years, our California utility succeeded in achieving efficiencies and cost savings that resulted in the deferral of rate requests. However, in accordance with a change in the law, our California utility made a filing on April 2, 2002 to start a new general rate case, and the rate case proceedings are currently underway. Both the company and the CPUC staff have testified before an Administrative Law Judge and the judge has rendered a preliminary opinion. That opinion is pending with the CPUC. We anticipate a rate increase in the first half of 2003.

Under prior CPUC procedures, rate increases to offset increases in certain expenses such as the cost of purchased water and energy costs to pump water were approved through an abbreviated offset proceeding that required approximately two months from the time a request was filed to the authorization of new rates. Under current CPUC guidelines, offset increases are no longer as readily available as they have been in the past. Offset increases have more restrictions and will no longer be considered by the CPUC unless they occur within a three-year general rate cycle.

Prior to November 29, 2001, the CPUC permitted California water utilities to record the difference between actual and CPUC-adopted water production costs in balancing accounts on the balance sheet, with a corresponding adjustment in the income statement. In 2001, our California utility recorded approximately $700,000 of balancing account benefits in its income statement, and had a total balance of approximately $2,300,000 in deferred costs

recorded as an asset on its balance sheet at the end of November 2001. As mentioned above, no such benefits were available in 2002. The disposition of pre-November 29, 2001 balancing accounts became the subject of a CPUC rulemaking. On December 17, 2002, the CPUC issued a decision considered favorable to the water industry that should allow our California utility to recover approximately $2,300,000 that was in its balancing account on November 29, 2001.

For water production costs incurred on or after November 29, 2001, the CPUC eliminated the use of balancing accounts. In place of the balancing account, our California utility has accounted for the difference between actual and CPUC-adopted water production costs in current operations in the income statement. Such costs have been tracked on a memorandum basis, and the rules for the recovery of such costs are currently the subject of the previously mentioned CPUC rulemaking. The changed CPUC rules resulted in an increase in expense and a decrease in earnings before taxes of approximately $700,000 in 2002 compared to 2001, and we believe that the changed CPUC rules will result in fluctuations in revenues and earnings in future periods.

Southwest Water and its Utility Group closely monitor legislative, EPA, CPUC, NMPRC and TCEQ developments. The various water industry associations in which we participate also monitor these developments. We do not know the possible legislative, EPA, CPUC, NMPRC or TCEQ changes that will be enacted or the terms of such changes if enacted. Therefore, we cannot predict the impact, if any, of future legislative changes, EPA, CPUC, NMPRC or TCEQ developments or changes on our financial position, results of operations or cash flows. However, as discussed in Part D. Environmental Matters, future capital investments may be needed to meet new EPA arsenic requirements.

Our Services Group pricing is not subject to regulation by any public regulatory commissions.

I. Employees

At December 31, 2002, we employed approximately 1,200 people, none of whom is represented by an employee union. We believe that our labor relations are positive.

J. Dividend History

During the past five years, Southwest Water has paid a cash dividend in each quarter. For specific information relative to dividends paid during 2002 and 2001, see Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters. In addition, we have also declared stock splits, paid in the form of stock dividends, annually over the last five years.

K. Risk Factors

1) Risk Factors that impact our Utility Group operations

a) Weather conditions can impact the financial results of our Utility Group.

Rainfall and weather conditions affect our utility operations, with most water consumption occurring during the third quarter of each year when weather tends to be hot and dry. During this period, our marginal costs of water may exceed our marginal revenues as we use higher-cost purchased water to meet customer demand. Therefore, while our revenues may increase, we may experience lower profit margin ratios during periods of peak demand.

Drought or unusually wet conditions may also adversely impact our revenues and profitability. During a drought, we may experience both lower revenues due to consumer conservation efforts and higher water costs due to supply shortages. Since a fairly high percentage of our water is used outside of our customers’ homes to water yards and fill pools, unusually wet conditions could result in decreased customer demand, lower revenues and lower profit.

Consequently, the results of operations for one quarter should not be used to predict the results of future quarters.

b) Rates that we are allowed to charge customers are set by regulatory agencies.

The water and wastewater utilities owned by our Utility Group are subject to regulation by governmental agencies which establish the rates that we may charge our customers. These rates are intended, in concept, to permit our utilities to recover operating costs and earn a rate of return on our investment in utility plant and equipment. Each state regulatory agency sets the rules and policies that allow our utilities to file applications to increase rates as

expenses or investment needs increase. These rules and policies may require that we estimate future expenses or may require that we incur specific expenses before there can be a change in rates. As a result, our revenues and earnings may fluctuate depending on the accuracy of our estimates, timing of our investments or expenses, or other factors. For example, electric power costs in California have been volatile in recent years. While we are using energy-efficient techniques and new and better equipment, we are also seeking an increase in rates. If we were unable to obtain a rate increase that completely offsets the effect of higher power costs, we would realize a decrease in our profitability.

The regulatory agencies may change their rules and policies which may adversely impact our profitability. In some states regulators are elected by popular vote, and the results of elections may change the rules and policies of the agency. Changes in rules and policies may adversely impact our profitability. For example as discussed in Part C. 2) e., the California Public Utility Commission’s changes to the balancing account procedures in late 2001 impacted our earnings in 2002.

c) We own assets in areas subject to natural disasters.

Some of our utility operations are located in an area of southern California that is subject to earthquakes and other natural disasters. While we maintain insurance policies to help reduce our financial exposure, a significant seismic event could adversely impact our ability to deliver water.

d) We may not be able to provide an adequate supply of water to our customers.

Several factors impact our ability to provide water to our customers. The first factor is our ability to find water that meets all state, federal, state regulatory water quality standards. We face contamination and pollution issues regarding our water supplies. Improved detection technology, increasingly stringent regulatory requirements, and heightened consumer awareness of water quality issues contribute to an environment of increased focus on water quality. While we continuously treat and test our water supplies to ensure that the water we distribute complies with water quality standards, we cannot assure you that we will be able in the future to reduce the amounts of contaminants in our wells to acceptable levels. In addition, the standards that we must meet are constantly changing and becoming more stringent. For example, in February 2002, the EPA lowered the arsenic standard in drinking water from 50 parts per billion to 10 parts per billion. As discussed in Part C. 2) c., if we cannot find an adequate treatment method to reduce arsenic in our New Mexico utility’s well water, we would have to find alternative sources of supply.

Each of our utilities obtains its water from various sources. The preferred source is pumping water from aquifers within our service areas. In the event that our wells cannot meet the customer demand, we have the ability to purchase water from surrounding municipalities, agencies and other utilities. However, these alternative sources of supply may not always have an adequate supply to sell us. For example, our California utility purchases water from the Metropolitan Water District of California, which receives water from the Colorado River. In 2003, the US Department of the Interior restricted the amount of water that California may receive from the Colorado River. This restriction may impact the amount of water that the Metropolitan Water District can sell to our utility in the future. We can make no guarantee that we will always have access to an adequate supply of water that will meet all quality standards, or that the cost of our water will not adversely affect our revenues and profits.

e) We need access to capital to continue to invest in our utility assets.

To meet both the regulatory requirements for rates, increases in customer connections, and environmental challenges we need to continue our investment in utility plant and property. Currently we obtain the funds for our capital projects from shareholder equity, contributions by developers and the use of both short and long-term debt. In the event that the capital markets for any of these sources were not available, or if we could not raise the capital in a manner acceptable to the regulators, our financial performance could be adversely affected.

2) Risk factors that impact our Services Group operations

a) We operate in a competitive market with low operating margins.

Our Services Group competes with several larger companies whose size, larger balance sheets, customer base, technical expertise and capital resources may restrict our ability to compete successfully for certain operations and maintenance contracts.

Our utility submetering, installation, billing and collection business is also highly competitive. We strive to develop an expertise in managing each property we serve. However, the submetering industry does not typically use long-term contracts and management companies and owners of multi-family dwellings periodically change billing and collection companies. In addition, our utility submetering company competes with several larger competitors whose size, customer base and capital resources may restrict our ability to compete successfully for certain contracts. Submetering is a relatively new industry and may attract other large competitors.

Due to the nature of our contract operations business which provides utility services, primarily operations and operations management, to municipalities and municipal utility districts, and to the very competitive environment of the market, we operate in a low margin environment. We must accurately estimate the cost and profitability of each project while, at the same time, maintaining prices at a level low enough to compete with other large companies. Our inability to do so could adversely impact our future revenue growth and profitability.

b) We market our services in a political environment.

In the United States, municipalities own and municipal employees operate the majority of water and wastewater systems. A significant portion of our Services Group’s marketing and sales efforts is spent demonstrating the benefits of contract operations to elected officials and municipal authorities. Employee unions and certain “public interest” groups generally oppose the principle of outsourcing and are active opponents in this process. The political environment means that decisions are made based on many factors, not just economic factors.

Because we are selling in a political environment, we are subject to changing trends and municipal preferences. Recent terrorist acts have affected some political viewpoints relative to outsourcing of water or wastewater utility services. Our revenue growth depends upon our ability to generate new as well as renew operating contracts with smaller cities, other agencies and municipal utility districts.

c) Our business depends on trained, qualified employees.

State regulations set the training, experience and qualifications standards required to operate specific water and wastewater facilities. We must recruit, retain, and develop qualified employees, maintain training programs and support employee advancement. We must obtain the proper management and operational people, finding state-certified and qualified employees to support the operation of water and wastewater facilities. Failure to do so could put us at risk, among other things, for operational errors at the facilities, for improper billing and collection processes, and for loss of contracts and revenues.

d) Risk of events such as hurricanes, tornadoes and floods may impact our profitability.

Our Services Group contract operations can be impacted by heavy rainfall which may limit our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions, such as hurricanes, tornadoes and floods, may result in additional labor and material costs that may not necessarily be recoverable under our firm, fixed-price O&M contracts, and may adversely impact our revenues and profitability. However, for our non-fixed-priced contracts, these events may provide additional billable opportunities to provide cleanup and repair work.

e) Our Services Group contracts have certain performance risks.

Our Services Group operating contracts require high levels of service to our clients. If we are unable to provide such services, the client may refuse payment, terminate the contract and may initiate a claim against us. Though we provide training programs, maintain close management oversight, provide performance bonds to our clients and

follow other best practice activities, should we fail in providing these services properly, it may adversely impact our revenues and profitability.

Additionally, in certain circumstances our submetering business may use estimates in calculating invoices sent to tenants on behalf of our landlord clients. These estimates may involve allocations of common area space, extrapolation of usage data, allocation of usage between billing periods, correction of incorrect meter readings, and usage allocation based upon facility size, tenant load, occupancy term and other factors. We believe that estimates used in our submetering business are reasonable and reflect common practices in the industry. However, we cannot assure you that we will not face claims regarding the use of such estimates, which may impact our profitability.

f) Services Group contracts for the design and construction of water and wastewater projects may expose us to certain completion and performance risks.

We have entered into, and may continue to enter into, design and construction contracts for water and wastewater facilities. These construction activities may involve risks, including shortages of materials and labor, work stoppages, labor relations disputes, weather interference, engineering, environmental, permitting or geological problems and unanticipated cost increases for reasons beyond our control. These issues could give rise to delays, cost overruns or performance deficiencies, or otherwise adversely affect the design, construction or operation of the project. To minimize our exposure to the risks associated with construction projects, we procure maximum price contracts for significant subcontractors, and secure performance and completion bonds from those subcontractors.

Certain of our contracts are fixed-price contracts, where we may bear all, or a significant portion of, the risk for cost overruns. Under these fixed-price contracts, contract prices are established in part based on fixed, firm subcontractor quotes or contracts and on cost and scheduling estimates. These estimates may be based on a number of assumptions, including assumptions about prices and availability of labor, equipment and materials, and other issues. If these subcontractor quotations or cost estimates prove inaccurate, or if circumstances change, cost overruns may occur, and we could experience reduced profits or, in some cases, a loss for that project. There can be no assurance that we can avoid additional costs under these types of contracts.

We may have contracts where we guarantee project completion by a scheduled date. At times, we may guarantee that the project, when completed, will achieve certain performance standards. If we subsequently fail to complete the project as scheduled, or if the project subsequently fails to meet guaranteed performance standards, we may be held responsible for cost impacts and/or penalties to the client resulting from any delay or for the costs to cause the project to achieve the performance standards. To the extent that these events occur, and are not due to circumstances for which the customer accepts responsibility, and cannot be mitigated against performance bonds or our subcontractor contracts, the total costs of the project would exceed our original estimates and we could experience reduced profits or, in some cases, a loss for the project.

Our customers may require us to secure performance and completion bonds for certain contracts and projects. Since September 2001, the market environment for surety companies has become very risk averse. We secure performance and completion bonds for our contracts from these surety companies. To the extent we are unable to obtain bonds, new contracts would not be awarded to us and as a result, we could experience reduced revenues and profits. There can be no assurance that we can secure performance and completion bonds on new future projects, or obtain bond renewals on existing contracts or projects.

We may manage engineering and construction activities for water and wastewater facilities where design, construction or systems failures can result in injury or damage to third parties. Any liability in excess of claims against our subcontractors, the performance bonds and our insurance limits at facilities so managed could result in liability claims against us, which may adversely impact our profits. In addition, if there is a customer dispute regarding our performance of project management services, the customer may decide to delay or withhold payment to us. If we were ultimately unable to collect these payments, our profits would be reduced.

g) We use third party equipment and subcontractors.

Our submetering business relies on third parties for certain product design, product manufacture and assembly, and product installation and service. In selecting these third party service providers we attempt to ensure that they will provide a service that meets high quality standards. We receive guarantees from certain of these vendors, but we cannot guarantee you that such guarantees completely protect us from the risk of quality failure in the design,

manufacture, and installation of submetering equipment. We cannot assure you that we will not face claims regarding product and installation quality for equipment placed in service either before our after our acquisition of our submetering business. Such claims could have an adverse impact on our profitability.

h) Our Services Group is subject to environmental and water quality risks.

Our client, the municipality or public agency, is the owner of the facilities that we operate under contract. We operate each facility in accordance with various Federal and state water quality standards. We also handle certain hazardous materials at these facilities, primarily chlorine gas. Certain environmental issues could be attributed to any failures of our operation of the facilities, including sewage spills, noncompliance with water quality standards, hazardous material leaks and spills, etc. Should we fail to properly meet our contractual responsibilities relative to these issues, we could be subject to various claims and litigation costs.

Though we attempt to operate using best practices, proper training, maintain close management oversight and utilizing insurance policies to reduce risks, we cannot assure you that we will successfully manage these issues, and failure to do so could have a material adverse effect on our future results of operations.

i) We have risks associated with a large fleet of vehicles.

The Services Group has a fleet in excess of 500 vehicles. Our employees drive over 8,000,000 miles per year. We are subject to normal vehicle risks associated with operating a fleet this large, including automobile accidents causing damage or injury to our own leased vehicles or employees, as well as third party damage to other property, vehicles or possible injury to others. Although we have vehicle insurance that covers material third party damage and liability, if we are not successful in managing this large fleet, it could have a material adverse impact on our profitability.

j) Our operating costs may rise faster than our revenues.

Many of our contracts with municipalities include contractual price increases tied to national consumer price indices. However, our costs are subject to market conditions and other factors, which may increase significantly higher than a generalized price index. The largest component of our operating costs is made up of salaries and wages. These costs are impacted by the local supply and demand for qualified labor. Other large components of our costs are workers compensation insurance, employee benefits and health insurance costs. These costs may increase at rates higher than a price index and may have a material adverse effect on our future results of operations.

k) Our operating contracts may be cancelled by a municipality, impacting our backlog.

Our Service Group revenue backlog consists of new and existing contracts. We include new contracts in the backlog when both the client and we have signed the contracts. Revenues included in our backlog may be realized over a multi-year period. The O&M contracts signed by our Services Group typically have durations of three to five years, and the uncompleted remaining portion of these existing contracts is reflected in the backlog. Although our Services Group tends to experience high renewal rates, municipalities and cities periodically change operators or terminate outsourcing at the end of a contract. The inability to renew existing contracts could have a material adverse impact on our Services Group. In addition, a municipality could cancel a long-term contract without notice. This would result in loss of revenues and operating profits and could involve us in litigation if a breach of contract occurs.

As of December 31, 2002, our backlog was approximately $275,000,000. We believe that this backlog is firm. However, we cannot guarantee that the revenues projected in our backlog will be realized or, if realized, will result in profits.

3) Other risk factors

a) Our capital resources may restrict our ability to operate and expand our business.

Of the $24,000,000 total capacity under our lines of credit, we have approximately $3,842,000 in available borrowing capacity as of December 31, 2002 as a result of using approximately $10,317,000 in borrowings on our

lines of credit to fund the acquisition of Aqua Services in November 2002. In addition to this borrowing capacity we had cash and cash-equivalent balances totaling approximately $1,606,000 as of December 31, 2002.

As indicated in Note 17 to the accompanying consolidated financial statements, in March 2003, we entered into an agreement to amend one of our lines of credit under which the bank increased our line of credit capacity by $4,000,000 through December 31, 2003.

We are currently evaluating our capital structure and potential financing alternatives available to us to provide additional liquidity. These alternatives include increasing the size of our lines of credit, long-term asset backed financing capacity in our regulated utilities, sale and leaseback of certain fleet assets and administrative office space, and issuing debt or equity in either a public or private placement offering. We anticipate that these financing alternatives will enable us to substantially reduce the amounts currently outstanding on our lines of credit during 2003. While we believe that there will be lender and investor interest in these financing alternatives, there can be no assurance that we will be able to obtain such funding in 2003. Also we cannot assure you that any financing completed will not increase our interest expense, dilute the percentage ownership of our existing shareholders, or dilute our earnings per share.

We anticipate that our available line of credit borrowing capacity, cash balances, cash flow generated from operations, and execution of additional financing alternatives will enable us to continue operating and expanding our business. We may be unable to renew our credit facilities when they expire. We may be unable to execute additional financing alternatives at terms that we find acceptable. If we were unable to renew our existing lines of credit, or if we were unable to execute additional financing alternatives, our capital spending would be reduced or delayed, and any future acquisitions would be delayed or eliminated. While we have the ability to take these actions during 2003, these actions could negatively impact our revenues, revenue growth, and profitability.

b) We may fail to effectively manage growth.

During the past few years, we have expanded our business both through internal growth and through acquisitions. We may actively seek acquisitions and joint ventures in each of our business lines. The success of our future business development and growth opportunities depends on our ability to attract and retain experienced and qualified persons to operate and manage our new business ventures. We cannot assure you that we will successfully manage our growth, and failure to do so could have a material adverse effect on our future results of operations.

c) Our business may be impacted by the general economic conditions of real estate development in the United States.

Both our Services Group and our Utility Group operations are impacted by the general economic conditions for real estate, the pace and location of real estate development activities within the United States. Increases in the number of water and wastewater connections, connection fees and billing and collection accounts are the result of expanded real estate development in areas we serve. We have little or no ability to control the pace and location of real estate development activities which affect our business. We cannot assure you that we will be able to continue to increase the number of customer connections and accounts, which may adversely affect our revenue growth.

d) Our operations are subject to certain risks due to their location.

We own and/or operate water and wastewater facilities in numerous locations in eight or more states and, consequently, we are subject to weather, political, water supply, labor supply, utility cost, regulatory, economic and other risks in the areas we service. We cannot control these risks. However, we believe that our broad geographic service area, while exposing us to these risks in numerous local markets, provides us a certain amount of geographical diversification against these risks at a consolidated company level.

L. Company Information

We make available free of charge on or through our Internet website our press releases, Annual Reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission. Our Internet website address is “www.southwestwater.com”.

Item 2. Properties

Facilities

Administrative Offices

We lease administrative office and warehouse space at 13 locations in California, Texas, New Mexico, Colorado, Georgia, and Mississippi. In aggregate, these office and warehouse facilities total approximately 70,700 square feet. In addition we own administrative and warehouse space at four locations in California, Texas and New Mexico. In the aggregate, the facilities we own total approximately 19,300 square feet of office space and approximately 10 acres of land. We believe that these facilities are adequate to meet the needs of our existing operations and provide reasonable space for growth. Our operations do not require uniquely specialized facilities, and we believe that additional or alternative office space is available, if required, at reasonable prices. We may relocate some of our offices as leases terminate to improve the location or size of the facility, or to provide better coordination among our operating units.

Water Production and Distribution Facilities

Our California utility owns and operates water production and distribution systems consisting of well pumping plants, booster pumping stations, water treatment facilities, reservoir storage facilities, transmission and distribution mains, and service connections to individual customers. Our utility has rights-of-way and easements in its service area necessary to provide water services. As of December 31, 2002, our California utility owned approximately 858 miles of transmission and distribution mains and 30 storage reservoirs with a total capacity of approximately 71,000,000 gallons. As of December 31, 2002, this utility also owned five active wells with a total pumping capacity of approximately 9,600 gallons per minute, compared to eight active wells with a total pumping capacity of approximately 15,600 gallons per minute at December 31, 2001. In the first two months of 2002, we removed three wells from service. In 2002, our California utility constructed two new wells, which we expect to activate in early 2003. We intend to continue our capital expenditure program, constructing and replacing reservoirs, wells and transmission and distribution lines in future years as needed and as approved by the CPUC. Our utility employees perform normal maintenance and construction work on these facilities while major construction projects are performed by outside contractors chosen through competitive bidding. Ongoing maintenance and repairs performed by our utility in California were approximately $1,900,000, $1,700,000 and $1,700,000 in 2002, 2001 and 2000, respectively, and approximated 6% of its operating expenses in each of the three years ended December 31, 2002, 2001 and 2000. As previously discussed, in 2000 our California utility acquired the West Covina water distribution system, which added 87 miles of transmission and distribution mains and four storage reservoirs with a total capacity of 15,000,000 gallons to our California production and distribution systems.

Virtually all of our California utility’s property is subject to the lien of an Indenture of Mortgage and Deed of Trust dated October 1, 1986, as amended, (the California Indenture), securing our California utility’s First Mortgage Bonds. The California Indenture contains certain restrictions common to such types of instruments regarding the disposition of property and includes various covenants and restrictions, including limitations on the amount of cash dividends that our California utility may pay to Southwest Water. Our California utility pays regular quarterly dividends to Southwest Water. As of December 31, 2002, our utility in California was in compliance with dividend limitations mandated by the California Indenture.

Our New Mexico utility owns and operates a water production and distribution system consisting of well pumping plants, reservoir storage facilities, booster pumping stations, transmission and distribution mains, and service connections to individual customers. We have rights-of-way and easements in our New Mexico service area necessary to provide water and sewer services. At December 31, 2002, our utility in New Mexico owned five wells, approximately 172 miles of transmission and distribution mains and four storage reservoirs with a total capacity of approximately 10,000,000 gallons, and our wells have a total pumping capacity of approximately 9,525 gallons per minute. While facilities we own in New Mexico vary as to age and quality, we believe these facilities are in good condition and are adequate for current and foreseeable operations.

Virtually all of our utility property in New Mexico is subject to the lien of an Indenture of Mortgage and Deed of Trust dated February 14, 1992, as amended (the New Mexico Indenture), securing our New Mexico utility’s First Mortgage Bonds. The New Mexico Indenture contains certain restrictions common to such types of instruments regarding the disposition of such property and includes various covenants and other restrictions, including limitations on the amount of cash dividends that our New Mexico utility may pay to Southwest Water. Our utility in New Mexico pays regular quarterly dividends to Southwest Water. At December 31, 2002, our New Mexico utility was in compliance with dividend limitations mandated by the New Mexico Indenture.

Our Texas utilities own and operate water production and distribution systems consisting of well pumping plants, booster pumping stations, transmission and distribution mains, and service connections to individual customers. We have rights-of-way and easements in our Texas service areas necessary to provide water and wastewater services. At December 31, 2002, the larger of our Texas utilities owned six wells, eight reservoirs and approximately 30 miles of transmission and distribution mains, and its wells have a total pumping capacity of approximately 2,500 gallons per minute. At December 31, 2002, the smaller of our Texas utilities owned two wells, two reservoirs and approximately 14 miles of transmission and distribution mains. The wells owned by this smaller Texas utility have a total pumping capacity of approximately 1,000 gallons per minute.

Wastewater Facilities

Our New Mexico utility owns and operates a sewer collection system consisting of one lift station and approximately 130 miles of interceptor and collector lines. Wastewater is treated at a city-owned facility.

Our Texas utilities own and operate two sewer collection systems, including five lift stations and approximately 44 miles of interceptor and collector lines. In 2002, one of these wastewater treatment facilities was expanded to increase our combined processing capacity from approximately 1,900,000 gallons per day of sewage to over 3,500,000 gallons per day.

Item 3. Legal Proceedings

In September 2002, we were named as a defendant in a lawsuit alleging wrongful death as the result of a chlorine gas leak that occurred in July 2000 at one of the facilities in Mississippi that we operate under an O&M contract. The decedent who was exposed to the gas leak was treated and released from the hospital on the day following the gas leak. He subsequently died eleven months later of causes that we believe are unrelated to the chlorine gas exposure. We deny any wrongdoing and are vigorously defending against the claim. Our umbrella liability insurance carrier is currently absorbing the costs of defense of the lawsuit; however, we cannot predict the outcome of this lawsuit. Based upon information available at this time, however, we do not expect that this action will have a material adverse effect on our financial position, results of operations or cash flows.

We were named as a defendant in three lawsuits filed in 1998 alleging injury and damages as the result of a sewage spill which occurred at an Austin, Texas sewage pumping station operated by us. A cross-complaint was subsequently filed and served on us by the City of Brushy Creek, Texas. In 2001, a settlement was reached with two of the plaintiffs and a third suit was settled in 2002. We expect the cross-complaint to be settled in 2003. Our subsidiary has been defended and indemnified by our insurance carrier and will be required to pay a $10,000 deductible on settlement of each of the claims. We do not believe these actions will have a material adverse effect on our financial position, results of operations or cash flows.

We were named as a defendant in several lawsuits alleging water contamination in the Main Basin. The California Supreme Court (the Court) ruled in February 2002 that the plaintiffs cannot challenge the adequacy of the water quality standards established by the CPUC. However, the plaintiffs may sue and collect damages from our California utility and other regulated water companies if they prove that water delivered did not meet CPUC water quality standards. The Court directed that the cases be sent to the trial court for further proceedings. We believe that our California utility has complied with CPUC water quality standards and are vigorously defending these claims. We have requested defense and indemnification from our liability insurance carriers for these lawsuits. Several of the liability insurance carriers are currently absorbing the costs of defense of the lawsuits. All lawsuits have been consolidated before a single California Superior Court judge. Discovery is underway and we expect, upon completion of that discovery, to obtain orders determining whether the plaintiffs are legally entitled to proceed against us, which plaintiffs may proceed against us and which claims may be prosecuted. We cannot predict the outcome of these lawsuits. Based upon information available at this time, we do not expect that these actions will have a material adverse effect on our financial position, results of operations or cash flows.

Southwest Water and its subsidiaries are the subjects of certain litigation arising from the ordinary course of operations. We believe the ultimate resolution of such matters will not materially affect our financial position, results of operations or cash flows.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 4a. Executive Officers of the Registrant

Our Board of Directors elects the executive officers each year at the first meeting following the Annual Meeting of Stockholders. There are no family relationships among any of the executive officers of Southwest Water, and there are no agreements or understandings between any such officer and another person pursuant to which he or she was elected as an officer. There are no legal proceedings that involve any executive officer of the type requiring disclosure pursuant to the instructions to this item. The executive officers of Southwest Water are as follows:

Name	Age	Position and Offices Currently Held and Business Experience	Date First Elected

Anton C. Garnier	62	Chairman of the Board of Southwest Water Chief Executive Officer and President of Southwest Water	April 1996 January 1968
Peter J. Moerbeek	55	Executive Vice President of Southwest Water President of Southwest Water Services Group Director of Southwest Water President of ECO Director of Suburban and ECO	November 2002 August 2002 April 2001 November 1998 October 1995
Richard J. Shields	45	Chief Financial Officer of Southwest Water Assistant Secretary of Southwest Water Chief Financial Officer of Day Software AG (2001-2002) Chief Financial Officer of Winfire, Inc. (1999-2001) Chief Financial Officer of Frame-n-Lens, Inc. (1996-1999)	October 2002 October 2002
Thomas C. Tekulve	51	Vice President of Finance of Southwest Water Vice President, Chief Financial Officer of Safeguard Health Enterprises, Inc. (1995-1998)	January 1999
Maurice W. Gallarda	49	Vice President New Business Development of Southwest Water Strategic Planning Consultant (1997-1998)	August 1999
Shelley A. Farnham	47	Vice President of Human Resources of Southwest Water Lead Human Resources Consultant, British Petroleum (1995-1998)	July 1998
Robert W. Monette	54	Vice President of Southwest Water President and Director of OpTech President of OpTech (1994-2001)	August 2001 August 2001

PART II

Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters

Market Information

The following table shows the range of market prices of Southwest Water’s common shares. The prices shown reflect the intra-day high and low bid prices for our common stock without retail markup, markdown or commissions and may not necessarily represent actual transactions. The price ranges shown in the table, as well as cash dividends declared in each quarter, reflect a 5% stock dividend on January 1, 2003, a 5% stock dividend on October 1, 2001 and a 5-for-4 stock split in the form of a stock dividend on January 1, 2001. Our common stock is traded on the Nasdaq Stock Market under the symbol SWWC. At December 31, 2002, there were 2,305 stockholders of record.

	2002						2001

	Dividends		Market Price Range				Dividends		Market Price Range

			High		Low				High		Low

1^st Quarter	$	0.053	$	15.43	$	12.80	$	0.050	$	13.33	$	10.71
2^nd Quarter	$	0.053	$	18.19	$	13.56	$	0.050	$	14.29	$	11.24
3^rd Quarter	$	0.053	$	18.10	$	11.24	$	0.050	$	14.88	$	11.48
4^th Quarter	$	0.058	$	14.29	$	12.02	$	0.053	$	15.04	$	12.23

Dividend Policy

Since 1960, our practice has been to pay common stock dividends quarterly in January, April, July and October. The amount and timing of future dividends depends on our growth, results of operations, profitability and financial condition, as well as other factors deemed relevant by our board of directors. Our current quarterly dividend rate is $0.058 per share of common stock.

Item 6. Selected Financial Data

Earnings per common share, cash dividends per common share and basic and diluted weighted average outstanding common shares reflect a 5% stock dividend on January 1, 2003, a 5% stock dividend on October 1, 2001, a 5-for-4 stock split in the form of a stock dividend on January 1, 2001, a 3-for-2 stock split in the form of a stock dividend on October 1, 1999, a 5-for-4 stock split in the form of a stock dividend on October 1, 1998 and a 5% stock dividend on January 1, 1998.

Years Ended December 31,			2002			2001		2000		1999			1998

		(in thousands except per share amounts )
Summary of Operations
Revenues		$	130,800		$	115,547	$	104,741	$	80,849		$	72,146
Operating income		$	10,774		$	11,731	$	11,039	$	8,979		$	7,806
Gain on sales of land		$	119		$	—	$	128	$	2,855		$	110
Other income (a)		$	2,551		$	298	$	161	$	387		$	268
Net income (d), (e)		$	6,002		$	5,451	$	4,839	$	5,430		$	3,110
Net income available for common shares (d), (e)		$	5,975		$	5,424	$	4,812	$	5,403		$	3,083

Common Share Data
Earnings per common share:
	Basic	$	0.61	(b)	$	0.57	$	0.53	$	0.61	(c)	$	0.36
	Diluted	$	0.58	(b)	$	0.55	$	0.52	$	0.59	(c)	$	0.35
Cash dividends per common share		$	0.22		$	0.21	$	0.19	$	0.16		$	0.15

Statistical Data
Capital additions		$	34,602		$	16,589	$	10,768	$	9,509		$	11,921
Total assets		$	268,744		$	225,186	$	196,652	$	142,950		$	129,927
Long-term portion of lines of credit and debt		$	74,880		$	58,063	$	46,351	$	33,454		$	33,400
Stockholders’ equity		$	61,837		$	55,718	$	49,078	$	40,718		$	35,282

See notes (a) – (e) on following page.

Notes to Item 6. Selected Financial Data (in thousands except per share data)

(a)	In 2002, other income includes $1,649 of income before taxes from a settlement with cooperating respondents, as well as a $980 gain before taxes on termination of a pension plan.

(b)	In 2002, includes $0.11 per share of income, net of taxes, from a settlement with cooperating respondents, as well as $0.06 per share gain on termination of a pension plan.

(c)	Includes a $0.18 per share gain, net of taxes, in 1999 on the sale of surplus land formerly used in water utility operations.

(d)	Excludes amortization of goodwill beginning in 2002. The expense for amortization of goodwill was $104 and $63, net of taxes, in 2001 and 2000, respectively. There was no amortization of goodwill in prior years.

(e)	Effective in 2002, we adopted the fair value based method of accounting for our stock options as outlined under SFAS No. 123, Accounting for Stock-Based Compensation. This change was adopted under the retroactive restatement method as defined in SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure. Accordingly, all prior periods presented have been retroactively restated to reflect compensation cost under the fair value based accounting method in SFAS No. 123 for all options granted, modified or settled in fiscal years beginning after December 15, 1994. See Note 11 to the accompanying financial consolidated statements for full disclosures required under SFAS No. 123 and SFAS No. 148. The table below sets forth the effect of the retroactive restatement of prior periods:

		2001		2000		1999		1998

		(in thousands, except per share amounts)
Net Income:
	Restated for adoption of SFAS No. 123	$	5,451	$	4,839	$	5,430	$	3,110
	Previously reported, as adjusted (see below)	$	5,942	$	5,214	$	5,657	$	3,317
Basic Earnings per Common Share:
	Restated for adoption of SFAS No. 123	$	0.57	$	0.53	$	0.61	$	0.36
	Previously reported, as adjusted (see below)	$	0.62	$	0.57	$	0.64	$	0.38
Diluted Earnings per Common Share:
	Restated for adoption of SFAS No. 123	$	0.55	$	0.52	$	0.59	$	0.35
	Previously reported, as adjusted (see below)	$	0.59	$	0.54	$	0.61	$	0.37

The amounts we reported in our previously filed Annual Reports on Forms 10-K included the tax benefit from stock options exercised as a credit to the provision for income taxes. This benefit should have been recorded as an increase to paid-in capital. Accordingly, in the table above, the amounts we previously reported have been adjusted to properly account for this tax benefit. These adjustments which had the effect of reducing net income by $301, $167, $162 and $32 for 2001, 2000, 1999 and 1998, respectively, and reducing both basic and diluted EPS by $0.03, $0.02, $0.02 and $0.00 for each of these respective years compared to the amounts reported in our previously filed Annual Reports on Form 10-K. These non-cash tax adjustments to net income have no effect upon our cash flows ability to pay dividends, current income tax liability or total stockholders’ equity for any of these four years.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

ADJUSTMENTS RELATED TO STOCK OPTION ACCOUNTING

Effective in 2002, we retroactively adopted the fair value based method of accounting for stock options as outlined in SFAS No. 123. Accordingly, all prior periods presented have been restated to reflect compensation cost that would have been recognized under the fair value based accounting method for all options granted, modified or settled in fiscal years beginning after December 15, 1994.

The amounts we previously reported in our Annual Reports on Form 10-K included the tax benefit from stock options exercised as a credit to the provision for income taxes. This benefit for options exercised should have been recorded as an increase to paid-in capital. Accordingly, the amounts previously reported have been adjusted to properly account for this tax benefit. These adjustments had the effect of reducing net income by $301,000, $167,000 and $162,000 for 2001, 2000 and 1999, respectively, and reducing both basic and diluted EPS by $0.03, $0.02 and $0.02 for each of these respective years compared to the amounts previously reported in our Annual Reports on Form 10-K. These non-cash tax adjustments to net income have no effect upon our cash flows, ability to pay dividends, current income tax liability or total stockholders’ equity.

See Note (e) to Item 6. Selected Financial Data, and Notes 2, 11 and 16 to the accompanying consolidated financial statements for more complete disclosure.

RESULTS OF OPERATIONS

Year Ended December 31, 2002 Compared to the Year Ended December 31, 2001

Net Revenues and Operating Income

Services Group

Services Group revenues for 2002 were $78,833,000, an increase of 19% from $66,476,000 in 2001. This increase was due primarily to a) the acquisition of OpTech in August 2001, b) increased construction and O&M revenues and c) the acquisition of Aqua Services in November 2002, offset in part by decreased submetering revenues of 23% primarily as a result of a large construction project completed during 2001 with no similar project in 2002.

Services Group operating income decreased 16% to $1,868,000 in 2002 compared to $2,215,000 in 2001. As a percentage of this group’s revenues, Services Group operating income was 2% and 3% in 2002 and 2001, respectively. Services Group operating income for 2002 reflects decreased operating income from submetering, acquisition integration issues and higher medical and general insurance costs.

Utility Group

Utility Group revenues for 2002 increased to $51,967,000, an increase of $2,896,000, or 6%, from $49,071,000 in 2001. In 2002, water usage increased 6% at our California utility because of hot, dry weather in the third quarter and drought-like conditions throughout much of the year. Water usage increased 3% overall in New Mexico, primarily reflecting a 14% increase in the number of customers, offset in part by reduced water usage per customer during 2002. The effects of a rate increase and an increase in the number of customers at one of our Texas utilities also contributed to the increase in revenues.

For 2002, our Utility Group operating income decreased 4% to $14,137,000 from $14,756,000 in 2001. As a percentage of this group’s revenues, operating income was 27% and 30% in 2002 and 2001, respectively. The decrease in 2002 operating income resulted primarily from the effect of higher water-volume-related expenses incurred at our California utility. In addition, in 2001, our California utility was able to defer recognizing certain costs in the approximate amount of $700,000 until future rate cases through the use of a balancing account. As of November 29, 2001, the CPUC eliminated the use of balancing accounts, which negatively impacted our California utility’s 2002 operating income. This decrease was partially offset by a rate increase at one of our Texas utilities, which positively impacted operating income.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 5% to $18,398,000 during 2002, compared to $17,492,000 for 2001. As a percentage of consolidated revenues, selling, general and administrative expenses were 14% and 15% in 2002 and 2001, respectively. The 2002 increase in selling, general and administrative expenses was primarily attributable to a) the acquisition of OpTech in August 2001, b) the acquisition of Aqua Services in November 2002, c) increases in medical and general insurance costs, d) marketing and new business development expenses and e) an increase in stock-based compensation expense recorded under SFAS No. 123 due to higher fair value for options issued in 2002.

Other Income and Expense

Interest Expense

Total interest expense increased 22% to $4,494,000 during 2002, compared to $3,694,000 in 2001. The increase reflects interest expense on our 20-year convertible subordinate debentures that were issued in July 2001. This increase was partially offset by decreases in the interest expense on our bank lines of credit because we paid down a portion of our line of credit borrowing with the proceeds from the debentures. The interest expense on the bank lines of credit also decreased due to generally lower interest rates in 2002 compared to 2001. The effective interest rates on our indebtedness were approximately 6.8% and 7.4% in 2002 and 2001, respectively. The reduction in capitalized interest during 2002, compared to the prior year, was due primarily to a reduction in company-financed utility projects.

The major components of interest expense for the years ended December 31, 2002 and 2001 are as follows:

	2002			2001

	(in thousands)
Interest expense - convertible subordinate debentures	$	1,358		$	613
Interest expense - bank lines of credit		604			1,240
Interest expense - mortgage bonds and bank term loan		2,245			2,335
Interest expense – other		481			296

Total interest expense before capitalized interest		4,688			4,484
Capitalized interest		(194	)		(790	)

Total interest expense	$	4,494		$	3,694

Water-Related Cost Reimbursement

In the second quarter of 2002, we accrued income for a reimbursement of approximately $1,649,000 for water-quality-related expenses incurred in 2001 and 2000. Additionally, in 2002 we received and will continue to receive reimbursement for a portion of the incremental cost of purchasing water rather than pumping from our closed wells. We bill and collect this reimbursement each month and the amounts are recorded as a reduction against water costs included in direct operating expenses.

Other

In the first quarter of 2002, we recorded a one-time gain on termination of a pension plan of approximately $980,000. This increase in other income was partially offset by amortization of contracts related to the purchase of OpTech in August 2001.

Income Taxes

Our effective tax rate for 2002 was approximately 35% compared to approximately 39% for 2001. Our effective tax rate for 2002 was reduced when we recorded a one-time gain on termination of a pension plan, which is excluded from ordinary taxable income.

Earnings Per Share

Diluted Earnings Per Share (EPS) was $0.58 in 2002, an increase of 5% compared to diluted EPS of $0.55 in 2001 (after adjustment for a 5% stock dividend on January 1, 2003). The water-quality-related cost reimbursement described above contributed $0.11 per share, net of taxes, to diluted EPS in 2002, while the one-time gain on termination of a pension plan in the first quarter of 2002 contributed $0.06, net of taxes, to diluted EPS in 2002.

Year Ended December 31, 2001 Compared to the Year Ended December 31, 2000

Net Revenues and Operating Income

Services Group

Services Group revenues for 2001 were $66,476,000, an increase of 10% from $60,425,000 in 2000. This increase was due primarily to the acquisition of OpTech in August 2001 and increased construction revenues at our submetering company, primarily as a result of a large construction project completed during 2001 with no similar project in 2000. These increases were partially offset by a decrease in revenues due to the benefit in 2000 of a large construction project. There was no comparable project in 2001.

Services Group operating income decreased to $2,215,000 in 2001, a decrease of $648,000, or 23%, compared to 2000. As a percentage of this group’s revenues, Services Group operating income was 3% and 5% in 2001 and 2000, respectively. During 2000, the Services Group had the benefit of a large construction project consisting of a reverse osmosis water treatment plant in El Paso, Texas, and recognized the related revenue and operating income. There was no comparable project in 2001. The decrease in operating income was partially offset because of the acquisition of Master Tek in April 2000 and OpTech in August 2001.

Utility Group

Utility Group revenues for 2001 increased $4,755,000, or 11%, to $49,071,000 from $44,316,000 in 2000. This increase was primarily the result of the acquisition of our Texas utilities in October 2000, coupled with increased water usage at our California utility because of hot, dry weather in the third quarter and drought-like conditions during 2001. Water usage increased 3% overall in New Mexico, primarily reflecting a 14% increase in customers. The effects of a rate increase at one of our Texas utilities also contributed to the increase in revenues.

For 2001, our Utility Group operating income increased 14% to $14,756,000 from $12,938,000 in 2000. As a percentage of this group’s revenues, Utility Group operating income was 30% and 29% in 2001 and 2000, respectively. The increase in 2001 operating income resulted primarily from the acquisition of our Texas utilities in October 2000.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 11% to $17,492,000 during 2001, compared to $15,694,000 for 2000. As a percentage of consolidated revenues, selling, general and administrative expenses were 15% in both 2001 and 2000. Our Services Group selling, general and administrative expenses increased by approximately $909,000 due primarily to the acquisition of our submetering business in April 2000. General and administrative expenses in our Utility Group increased by approximately $411,000, primarily as the result of the acquisition of our Texas utilities in October 2000. General and administrative expenses of the parent company increased by approximately $478,000.

Other Income and Expense

Interest Expense

Total interest expense increased 1% to $3,694,000 during 2001, compared to $3,652,000 in 2000. The increase reflects interest expense on our 20-year convertible subordinate debentures that were issued in July 2001. This increase was partially offset by decreases in the interest expense on our bank lines of credit because we paid down a significant portion of our line of credit borrowing with the proceeds from the debentures. The interest expense on the bank lines of credit also decreased due to generally lower interest rates in 2001, compared to 2000. The effective

interest rates on our indebtedness were approximately 7.4% and 8.7% in 2001 and 2000, respectively. During 2001, we capitalized approximately $790,000 of interest relating to various construction projects at one of our Texas utilities and at our largest Services Group company.

The major components of interest expense for the years ended December 31, 2001 and 2000 are as follows:

	2001			2000

	(in thousands)
Interest expense - convertible subordinate debentures	$	613		$	—
Interest expense - bank lines of credit		1,240			1,379
Interest expense - mortgage bonds		2,335			2,415
Interest expense – other		296			238

Total interest expense before capitalized interest		4,484			4,032
Capitalized interest		(790	)		(380	)

Total interest expense	$	3,694		$	3,652

Income Taxes

Our effective tax rate was approximately 39% for both years ended December 31, 2001 and 2000.

Earnings Per Share

Diluted EPS was $0.55 in 2001, an increase of 6% compared to diluted EPS of $0.52 in 2000 (after adjustment for a 5% stock dividend on January 1, 2003).

FINANCIAL CONDITION

Liquidity and Financial Position

Our liquidity is influenced primarily by cash flows from operations and by capital expenditures at our Utility Group for the addition, replacement and renovation of water and wastewater utility facilities. Our capital resources are used for debt service on our bonds and debentures and are also influenced by investments in new business opportunities, including the acquisition of companies, funding of projects and acquisition of contracts.

As of December 31, 2002, we had a working capital deficit of approximately $1,787,000 with cash and cash-equivalent balances totaling approximately $1,606,000, as well as aggregate lines of credit totaling $24,000,000 consisting of three separate unsecured lines of credit from three commercial banks. One of the lines of credit expires in March 2004, another expires in April 2004 and the remaining line expires in September 2004. As of December 31, 2002, we had approximately $20,158,000 outstanding and approximately $3,842,000 available on these three lines of credit. During 2002, our outstanding line of credit borrowings increased by approximately $4,166,000. We paid for the acquisition of the AquaSource business with approximately $10,317,000 in cash. We paid in full our New Mexico utility Series A First Mortgage Bonds in the amount of $2,000,000, and we purchased certain utility property. These borrowings were offset in part by repayments on our lines of credit with the net proceeds of approximately $9,750,000 from a new bank term loan secured by our Texas utility, the cash received as payment for the El Paso, Texas reverse osmosis plant and from payments received for water-quality-related reimbursements.

On January 8, 2003, we obtained an additional unsecured line of credit facility in the amount of $3,430,000 from one of our commercial banks. This facility was used to issue a $3,430,000 standby letter of credit as collateral for performance under the service contract for the CVWD to design and construct a reverse osmosis water treatment facility and associated wells. This standby letter of credit is in force for the estimated two-year construction period of the project. Upon acceptance of the completed project by the CVWD, the standby letter of credit facility will be terminated.

In addition to our lines of credit, we have excess borrowing capacity under our First Mortgage Bond Indentures of approximately $65,000,000 as of December 31, 2002. However, the additional borrowing available under our current commercial lines of credit is limited by financial covenants that restrict additional borrowing at December

31, 2002 to an amount no greater than the remaining unused credit line amount. Accordingly, borrowings were limited to our unused lines of credit of approximately $3,842,000 at December 31, 2002.

We expect to maintain our lines of credit in the normal course of business. Each of the line of credit agreements contains certain financial covenants. As of December 31, 2002, we were in compliance with all applicable covenants of each of the line of credit agreements.

We periodically use our lines of credit to fund large construction projects and/or acquisitions. Upon completion of these larger transactions, we have historically obtained a permanent funding source and used the proceeds to restore availability under the lines of credit. Of the $24,000,000 total capacity under our lines of credit, we had approximately $3,842,000 in borrowing capacity as of December 31, 2002 as a result of using approximately $10,317,000 in borrowings on our lines of credit to fund the acquisition of Aqua Services in November 2002.

We are currently evaluating our capital structure and potential financing alternatives available to us to provide additional liquidity. These alternatives include increasing the size of our lines of credit, long-term asset-backed financing capacity in our regulated utilities, sale and leaseback of certain fleet assets and administrative office space, and issuance of debt or equity in either public or private offerings. We anticipate that these financing alternatives will enable us to substantially reduce the amounts currently outstanding on our lines of credit. While we believe that there will be investor and lender interest in these financing alternatives, there can be no assurance that we will be able to obtain such funding in 2003.

We anticipate that our available line of credit borrowing capacity and cash flows generated from operations will be sufficient to fund our activities during the next 12 months. If we were unable to renew our existing lines of credit, or if we were unable to execute additional financing alternatives, our capital spending and any future acquisitions would be reduced, eliminated or delayed. While we have the ability to take such actions during 2003, these actions could negatively impact our revenues, revenue growth, and profitability.

During 2002, net cash provided by operations totaled $22,086,000 compared to $4,038,000 in 2001. Increased cash flows from operations were primarily the result of the collection of significant receivables in connection with the completion of a reverse-osmosis water treatment plant constructed by our Services Group and an increase in accounts payable, primarily for construction-related activities. In addition, we recorded approximately $1,649,000 for certain water-quality-related expenses incurred in prior years.

Our investing activities include company-funded acquisitions of plant and equipment as well as acquisitions of operating entities.

Property, Plant and Equipment

During 2002, our additions to property, plant and equipment were $34,602,000 consisting of $13,344,000 in Company-financed additions, $4,278,000 in contributions by CRs, $7,965,000 in developer-paid additions and $9,015,000 in non-cash property contributed by developers. Company-financed capital additions were funded primarily by cash flow from operations and by borrowings on our bank lines of credit. Total additions to property, plant and equipment represented an increase of $18,013,000 compared to 2001.

Additions to property, plant and equipment were primarily utility assets for our Utility Group, including new wells and transmission lines at our New Mexico utility and the construction of a lift station, force main and an elevated storage tank at one of our Texas utilities. In addition, we completed expansion of an office building in Austin, Texas.

Developers made Contributions in Aid of Construction (CIAC), Living Unit Equivalent (LUE) fees and Advances totaling $16,980,000 during 2002, of which $7,965,000 was received in cash and $9,015,000 was received as non-cash contributions of property. We estimate that our total Company-financed capital additions in 2003 will be approximately $14,000,000, primarily for utility plant, and that our cash flows from operations, borrowings on our lines of credit, CIAC, LUE fees and Advances will fund these additions.

Acquisitions

Under the terms of our purchase agreement for Master Tek, the minority owner of Master Tek has the option to require us to purchase his initial 20% minority interest in 5% increments at a price not to exceed $1,000,000 per year over four years. The minority owner exercised this option to sell us 5% of Master Tek stock for which we paid $1,000,000 in cash in April 2002. In February 2003, the minority owner exercised his option to sell us an additional 5% of Master Tek stock for $1,000,000, which we expect to pay in April 2003.

Under the terms of the OpTech purchase agreement, we have the right to acquire the remaining 10% of OpTech after five years based on a formula relating to the profitability of OpTech. In addition, in August 2004 (two years after the effective date of the purchase), the minority owner of OpTech has the option to sell the remaining 10% of OpTech to us using the same profitability formula, which has a minimum purchase price of $1,000,000.

Financing Activities

Our financing activities include net proceeds from the issuance of long-term debt, CIAC, LUE fees, advances and net borrowings on our lines of credit, dividend payments, payments on long-term debt and stock transactions among other items.

On August 9, 2002, we obtained a 10-year $10,000,000 secured bank term loan. The net proceeds of approximately $9,750,000 were used to pay down our bank lines of credit. The term loan bears interest at a rate equal to LIBOR plus 1.75%, with principal payments of $125,000 due quarterly, beginning in November 2002. The note is secured by substantially all of the assets of one of our Texas utilities. We are subject to certain financial covenants under the term loan agreement. As of December 31, 2002, we were in compliance with all applicable covenants under this agreement.

On July 20, 2001, Southwest Water issued $20,000,000 of 6.85% fixed rate convertible subordinate debentures, due July 1, 2021, and received net proceeds of approximately $18,890,000 from the sale after underwriting discounts, commissions and other expenses of the offering. The net proceeds from the sale of these debentures were used to reduce borrowings on our revolving bank lines of credit.

The debentures are convertible into shares of our common stock at a conversion price of $16.197 per share, and are convertible at any time prior to maturity unless previously redeemed. We may redeem the debentures in whole or in part at any time, at a redemption price of 105% at July 1, 2003 and declining 1% annually to par (100% of face value) after June 30, 2008. The issuance costs of the convertible subordinate debentures in the amount of approximately $1,110,000 are being amortized over 20 years. We are subject to certain financial covenants under the terms of the indenture agreement for the convertible subordinate debentures. As of December 31, 2002, we were in compliance with all applicable restrictions.

Contractual Obligations

As of December 31, 2002, the Company’s contractual obligations were due as follows:

	2003		2004		2005		2006		Thereafter

	(in thousands)
Bank lines of credit	$	—	$	20,158	$	—	$	—	$	—
Bank term loan		500		500		500		500		7,875
Economic development revenue bonds		85		90		95		100		2,030
Mortgage bonds		900		900		900		13,500		8,000
Convertible subordinate debentures		—		—		—		—		19,732
Notes payable		484		1,386		1,485		1,592		1,641
Advances for construction		184		184		184		184		6,616
Purchase of 15% interest in majority-owned subsidiary		1,000		1,000		1,000		—		—
Purchase of 10% interest in majority-owned subsidiary		1,000		—		—		—		—
Lease obligations		3,642		3,236		2,630		1,895		2,269

	$	7,795	$	27,454	$	6,794	$	17,771	$	48,163

On January 8, 2003, we obtained an unsecured line of credit facility from a commercial bank used to issue a $3,430,000 standby letter of credit as collateral for performance under a service contract for the CVWD to design and construct a reverse osmosis water treatment facility and associated wells. This standby letter of credit is in force for the estimated two-year construction period of the project. Upon acceptance of the completed project by the CVWD, the standby letter of credit facility will be terminated.

Under this service contract, we will manage both the design and construction of this facility. Upon acceptance by the CVWD, we will also operate the facility for a 20-year period. Subcontractor agreements with an engineering firm and a large construction firm are being used to fulfill significant obligations of this service contract.

This service contract contains certain guarantees to the CVWD related to our performance, including certain liquidated damages in the event of our failure to perform, other than due to uncontrollable circumstances. As part of the financing of this project, the CVWD was successful in the sale of insured municipal bonds. We entered into an agreement with the bond insurer to guarantee our performance under the service contract, subject to certain liability caps in the event of a default. Such liability caps will not exceed an amount equal to $6,000,000 during the two-year construction period of the project, and afterwards, during the 20-year operation of the facility, the liability cap will not exceed an amount equal to $4,000,000 plus an amount equal to the replacement of the actual reverse osmosis unit within the facility.

Critical Accounting Policies

The accounting policies described below are those we consider critical in preparing our consolidated financial statements. Certain of these policies require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of certain contingent assets and liabilities at the date of the consolidated financial statements, as well as amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. See Note 1 to the accompanying consolidated financial statements for a detailed description of our significant accounting policies.

Recognition of Revenues: Revenues for contract operations are billed based on a monthly fee to provide a specific level of service as outlined in each individual contract. We usually bill for additional services provided beyond the scope of the base contract on a time and materials basis as such services are rendered. Revenues for construction projects are recorded using the percentage-of-completion method of accounting.

Revenues for submetering billing and collection services are recognized and billed at the end of the month in which services are performed. Revenues for installation of submetering equipment are accounted for using the percentage-of-completion method.

Water utility revenues are recognized when amounts are billed to customers. An estimated amount for unbilled revenues is also recognized for water used towards the end of the accounting period.

Impairment of Goodwill: We have made acquisitions in the past that resulted in recording goodwill and intangible assets. The balance sheets presented in the consolidated financial statements include the goodwill and intangible customer contracts related to the 2002 acquisition of the contract services business of AquaSource, the goodwill and intangible contract value related to the 2001 acquisition of OpTech, and the goodwill and non-compete agreement related to the 2000 acquisition of Master Tek. In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives are not amortized, but instead are tested for impairment at least annually. For intangible assets with definite useful lives, SFAS No. 142 requires amortization over their estimated useful lives to their estimated residual values. SFAS No. 142 became effective for fiscal years beginning after December 15, 2001. At December 31, 2002, other assets include approximately $20,172,000 of net goodwill, which was no longer subject to amortization beginning in 2002. There was no impairment of goodwill as of December 31, 2002.

Prior to implementation of SFAS No. 142, we recognized approximately $218,000 and $163,000 of goodwill amortization for the years ended December 31, 2001 and 2000, respectively. Beginning in 2002, we no longer recognized such amortization. In addition, under the provisions of SFAS No. 141, Business Combinations, we identified approximately $204,000 of intangible contract costs in connection with our acquisition of AquaSource and approximately $1,100,000 of intangible contract costs in connection with our acquisition of OpTech. We are amortizing the intangible contract costs over a period of four years, which is the average estimated life of the contracts. We do not expect the implementation of SFAS Nos. 141 and 142 to have a material impact on our financial position or results of operations.

Utility Accounting: Our regulated businesses, which include our utilities in California, New Mexico and Texas, are required to be accounted for under the provisions of SFAS No. 71, which specifies certain revenue, expense and balance sheet treatment as required by each state regulatory agency. Each state agency establishes rates which are intended to permit each utility to recover its costs and earn a reasonable rate of return. Each utility may file and process general rate applications on a periodic basis. Since the established rates may be in effect for several years, our utilities attempt to anticipate cost increases and apply for rates sufficient to permit recovery of those cost increases when incurred.

Our Texas and New Mexico utilities have contracted with one of the companies in our Services Group to perform operating services, normal maintenance and construction work, and, in addition, manage capital projects. We believe that these contracts were established utilizing terms and conditions equivalent to prevailing industry rates for similar work performed by our Services Group for non-affiliated entities. In accordance with SFAS No. 71, our Services Group recognizes a profit margin from contract work performed and does not eliminate the intercompany profit on the construction contract work performed when the contract sales price is reasonable and it is probable that the costs and capital will be recoverable through the rate making process. Accordingly, the intercompany profit on such projects has not been eliminated in the accompanying consolidated financial statements.

Balancing Account: Prior to November 29, 2001, the CPUC permitted California water utilities to record the difference between actual and CPUC-adopted water production costs in balancing accounts on the balance sheet, with a corresponding adjustment in the income statement. In 2001, our California utility recorded approximately $700,000 of balancing account benefits in its income statement, and had a total balance of approximately $2,300,000 in deferred costs held on its balance sheet at the end of November 2001. As mentioned above, no such benefits were available in 2002. The disposition of pre-November 29, 2001 balancing accounts became the subject of a CPUC rulemaking. On December 17, 2002, the CPUC issued a decision considered favorable to the water industry that should allow our California utility to recover approximately $2,300,000 that was in its balancing account as of November 29, 2001.

Collectibility of Customer Receivables: We periodically evaluate the collectibility of our customer receivables, and provide an allowance for uncollectible receivables based upon an estimate by management of the amount of receivables that might not be collectible. This estimate is predicated upon a number of factors, including historical receivable write-off experience, a review of customer accounts with past due uncollected balances, probable costs of collection and the general credit worthiness of our customers. During 2002, we provided for an additional $372,000 of bad debt expense and we wrote off approximately $320,000 of uncollectible accounts receivable relating to our Services Group submetering accounts. We believe that our allowance for doubtful accounts is adequate as of December 31, 2002.

Stock-Based Compensation: In 2002, we voluntarily adopted the fair value recognition provisions of SFAS No. 123. SFAS No. 123 requires that we value stock options issued based upon an option pricing model and recognize this value as an expense over the period in which the options vest. In accordance with the provisions of SFAS No. 148, we have elected to recognize stock-based compensation using the retroactive restatement method. Under this change in accounting method, we have restated our consolidated financial statements for all years presented in this Annual Report on Form 10-K and the accompanying consolidated financial statements to reflect stock-based compensation expense under a fair value based accounting method for all options granted, modified or settled in fiscal years beginning after December 15, 1994.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that do not have vesting restrictions and that are fully transferable. In addition, option valuation models require us to make subjective assumptions including the expected future volatility of the stock price. Because the stock options we grant have characteristics that are significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the value of an estimate, in management’s opinion, the existing option valuation models, including Black-Scholes, do not necessarily provide a reliable single measure of the fair value of our employee stock options.

Recent Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires us to record the fair value of an asset retirement obligation as a liability in the period in which we incur a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of the assets. We will also record a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. We were required to and did adopt SFAS No. 143 on January 1, 2003. The adoption of SFAS No. 143 is not expected to have a material effect on our consolidated financial statements.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. The provision of the Statement related to the rescission of Statement No. 4 is applied in fiscal years beginning after May 15, 2002. Earlier application of these provisions is encouraged. The provisions of the Statement related to Statement No. 13 were effective for transactions occurring after May 15, 2002, with early application encouraged. The adoption of SFAS No. 145 is not expected to have a material effect on our consolidated financial statements.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposable activities and nullifies Emerging Issues Task Force (EITF) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The adoption of SFAS No. 146 is not expected to have a material effect on our consolidated financial statements.

In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on our consolidated financial statements. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123. SFAS No. 148 amends FASB No. 123 to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based compensation. In addition, SFAS No. 148 amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements. In 2002, we adopted SFAS No. 123 and the related provisions of SFAS No. 148 using the retroactive restatement method. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in Note 11 to the accompanying consolidated financial statements.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interest in variable interest entities created or obtained after January 31, 2003. For public companies, such as ours, the Interpretation is applied to the enterprise no later than the end of the first annual reporting period beginning after June 15, 2003. The application of this Interpretation is not expected to have a material effect on our Consolidated Financial Statements. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that an entity will consolidate or disclose information about variable interest entities when the Interpretation becomes effective.

In November 2002, the EITF finalized EITF No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. EITF No. 00-21 is required to be adopted for all new revenue arrangements entered into in fiscal years beginning after June 15, 2003 but alternatively would allow us to apply EITF No. 00-21 to existing contracts and record the effect of adoption as the cumulative effect of a change in accounting principle. The adoption of EITF No. 00-21 is not expected to have a material effect on our consolidated financial statements.

Adoption of New Accounting Policy – Stock-Based Compensation

We currently sponsor two stock option plans and, prior to 2002, we accounted for those plans under the recognition and measurement provisions of the Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost was reflected in previously reported results, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2002, we adopted the preferable fair value recognition provisions of SFAS No. 123. Under the retroactive restatement transition method as described in SFAS No. 148, we have recorded compensation costs of $963,000, $765,000, and $598,000 for the years ended December 31, 2002, 2001 and 2000, respectively. The cost recognized is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. The expense for each of the three years ended December 31, 2002, 2001 and 2000 was recorded in the caption selling, general and administrative expenses in the accompanying consolidated financial statements. In accordance with the retroactive restatement transition method of adoption, all periods presented have been restated.

We use the Black-Scholes option-pricing model to determine the fair value of each option grant. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected lives and risk-free interest rates. These assumptions reflect management’s best estimates, but these items involve inherent uncertainties based on market conditions generally outside of our control. As a result, if other assumptions had been used in the current period, stock-based compensation could have been materially impacted. Furthermore, if management uses different assumptions in future periods, stock-based compensation expense could be materially impacted in future years. Refer to Notes 2 and 11 to the accompanying consolidated financial statements.

Selected Risk Factors

Our capital resources may restrict our ability to operate and expand our business

Of the $24,000,000 total capacity under our lines of credit, we had approximately $3,842,000 in available borrowing capacity as of December 31, 2002 as a result of using approximately $10,317,000 in borrowings on our lines of credit to fund the acquisition of Aqua Services in November 2002. In addition to this borrowing capacity we had cash and cash-equivalent balances totaling approximately $1,606,000 as of December 31, 2002.

Our regulated and non-regulated operations are subject to seasonality and weather considerations

Our regulated water utility operations are seasonal. Therefore, the results of operations for one quarter do not indicate results to be expected in another quarter. Rainfall and weather conditions affect our utility operations, with most water consumption occurring during the third quarter of each year when weather tends to be hot and dry. Drought conditions may result in lower revenue due to consumer conservation efforts and a shortage of water supply. Drought conditions may also result in increased water costs to us and adversely affect our profitability. Conversely, unusually wet conditions may result in decreased customer demand, lower revenues and lower profit to our utility operations.

The contract operations business conducted by the subsidiaries in our Services Group can also be seasonal in nature. For example, heavy rainfall limits our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions can result in additional labor and material costs that may not necessarily be recoverable from the various cities under O&M contracts.

Environmental matters

Operations of our utilities in California, New Mexico and Texas fall under the regulatory jurisdiction of the CPUC, the NMPRC and the TCEQ, respectively. The primary responsibility of these regulatory agencies is to ensure an adequate supply of affordable, healthful, potable water to residents of their respective states. Our operations are also subject to water and wastewater pollution standards and water and wastewater quality regulations of the EPA and various state health regulatory agencies. Both the EPA and state health regulatory agencies require periodic testing and sampling of water. Costs associated with the testing of water supplies have increased and are expected to increase further as the regulatory agencies adopt additional monitoring requirements. In November 2001, the EPA announced a decision to lower the arsenic standard in drinking water from 50 parts per billion to 10 parts per billion. Although our utilities meet the current 50 parts per billion standard, our utility in New Mexico does not meet the newly adopted arsenic standard which must be completely met by 2006. Our New Mexico utility anticipates significant capital expenditures will be required in order to comply with the new standard. As discussed in Item 1. Description of Business – Part C. 2) c. Water Quality Regulation, we cannot predict the impact that the change in this standard will have on our water utility operations; however, we do not expect it to have a material adverse impact on our consolidated financial position or operations. We believe that future incremental costs of complying with government regulations, including any capital expenditures, will be recoverable through increased rates and contract operations revenues. However, we cannot assure you that recovery of such costs will be allowed. To date, we have not experienced any material adverse effects upon our financial position, results of operations or cash flows resulting from compliance with government regulations.

As contract operators, the companies in our Services Group do not own any of the water sources or utility facilities that they operate for their clients. Although not the owners, our subsidiaries are responsible for operating these water and wastewater facilities in compliance with all federal, state and local health standards and regulations. Our utility submetering, billing and collection services company does not own or operate any water or other production or treatment facilities.

Increasing costs of producing products and services

The cost of water (whether produced from our own wells or purchased from outside sources), electric power and natural gas represents a substantial portion (approximately 49%, 45% and 47% in 2002, 2001 and 2000, respectively) of the combined operating costs of our water utilities. Purchased water is significantly more expensive than water produced by our utilities. As a result, each utility attempts to produce as much as possible of the water it delivers and to use water purchases only to supplement its own production. Factors such as drought, water contamination issues and customer demand can increase water purchases and the overall cost of water for our utilities. Such factors are not within our control and may decrease our profitability if we are unable to obtain rate increases from a regulatory agency.

Electric power costs in California have increased dramatically in the last two years and may continue to increase in the near term. The cost of natural gas has increased significantly in the United States in recent years. Our response to these increases is to utilize energy-efficient techniques, new and better equipment and seek rate relief from the regulating agencies. We may not, however, have the ability to completely offset the effect of these cost increases. Continued increases in the costs of these services may decrease our profitability. Such factors are not within our control and may decrease our profitability if we are unable to obtain rate increases from regulatory agencies.

Other Risk Factors

For a discussion of other risk factors, see Item 1. Description of Business – Part K. Risk Factors.

Item 7a. Quantitative and Qualitative Disclosures About Market Risk

We have certain indebtedness that is subject to variable interest rates. As a result, Southwest Water’s interest expense is affected by changes in the general level of interest rates. Changes in interest rates affect the interest expense paid on the line of credit borrowings, which is determined based upon an agreed rate formula with the banks. Contractually, the highest interest rates charged on the lines of credit cannot exceed the banks’ prime rate plus one-quarter percent.

Southwest Water is utilizing the favorable low interest rates in the current market. In part to mitigate future market interest rate risk, we completed a $20,000,000, 20-year convertible subordinate debenture offering in July 2001, which bears a fixed interest rate of 6.85% per annum. The proceeds were used to pay down our variable rate indebtedness. Our long-term debentures were sold with a fixed interest rate, and are not subject to market fluctuation of interest rates. Our debentures are convertible into Southwest Water common stock and, at a certain market price, our debentures will become dilutive in our computation of earnings per share.

Item 8. Financial Statements and Supplementary Data

Index to Financial Statements and Financial Statement Schedules

	Page

Independent Auditors’ Report	40
Consolidated Statements of Income-Three Years Ended December 31, 2002	41
Consolidated Balance Sheets-December 31, 2002 and 2001	42
Consolidated Statements of Changes in Stockholders’ Equity-Three Years Ended December 31, 2002	43
Consolidated Statement of Cash Flows-Three Years Ended December 31, 2002	44
Notes to Consolidated Financial Statements	45
Schedule I-Condensed Financial Information of Registrant	70
Schedule II-Valuation and Qualifying Accounts-Three Years Ended December 31, 2002	75

INDEPENDENT AUDITORS’ REPORT

To the Board of Directors and Stockholders of Southwest Water Company:

We have audited the consolidated financial statements of Southwest Water Company and subsidiaries (the Company) as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 consolidated financial position of Southwest Water Company and subsidiaries as of December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

As discussed in Note 1 to the consolidated financial statements, in 2002, the Company changed its method for accounting for the amortization of goodwill.

The Company’s consolidated financial statements for 2001 and 2000 were previously prepared using Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to record stock-based compensation. As more fully described in Note 2 to the consolidated financial statements, the Company adopted SFAS No. 123, “Accounting for Stock-Based Compensation,” to record stock-based compensation. Consequently, the Company’s consolidated financial statements for 2001 and 2000 have been restated in accordance with the retroactive restatement method under SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” an amendment of SFAS No. 123.

/s/ KPMG LLP

Los Angeles, California
March 19, 2003

Southwest Water Company and Subsidiaries

CONSOLIDATED STATEMENTS OF INCOME

		For the Years Ended December 31,

		2002			2001			2000

		(in thousands except per share data)
Revenues:
Service operations		$	78,833		$	66,476		$	60,425
Utility operations			51,967			49,071			44,316

			130,800			115,547			104,741

Expenses:
Operating expenses - services			67,876			57,049			51,258
Operating expenses - utilities			33,752			29,275			26,750
Selling, general and administrative expenses			18,398			17,492			15,694

			120, 026			103,816			93,702

Operating Income			10,774			11,731			11,039
Other Income (Expense):
Interest expense			(4,494	)		(3,694	)		(3,652	)
Interest income			265			655			267
Gain on sales of land			119			—			128
Other			2,551			298			161

			(1,559	)		(2,741	)		(3,096	)

Income Before Income Taxes			9,215			8,990			7,943
Provision for Income Taxes			3,213			3,539			3,104

Net Income			6,002			5,451			4,839
Dividends on Preferred Shares			27			27			27

Net Income Available for Common Shares		$	5,975		$	5,424		$	4,812

Earnings per Common Share:
	Basic	$	0.61		$	0.57		$	0.53
	Diluted	$	0.58		$	0.55		$	0.52

Weighted Average Outstanding Common Shares:
	Basic		9,725			9,549			9,148
	Diluted		10,251			9,913			9,321

See accompanying notes to consolidated financial statements.

Southwest Water Company and Subsidiaries
CONSOLIDATED BALANCE SHEETS

	As of December 31,

	2002		2001

	(in thousands)
Assets
Current Assets:
Cash and cash equivalents	$	1,606	$	789
Customers accounts receivable, less allowance for doubtful accounts ($2,037 in 2002 and $1,667 in 2001)		16,657		21,443
Other current assets		11,573		8,939

		29,836		31,171
Property, Plant and Equipment:
Utility property, plant and equipment—at cost		245,134		218,696
Non-regulated operations property, plant and equipment—at cost		20,753		14,317

		265,887		233,013
Less accumulated depreciation and amortization		61,954		61,889

		203,933		171,124
Other Assets		34,975		22,891

	$	268,744	$	225,186

Liabilities and Stockholders’ Equity
Current Liabilities:
Current portion of long-term debt	$	1,969	$	3,344
Current portion of bank lines of credit		—		2,129
Accounts payable		11,390		6,211
Other current liabilities		18,264		14,627

		31,623		26,311
Other Liabilities and Deferred Credits:
Long-term debt		60,827		50,967
Bank lines of credit		20,158		13,863
Advances for construction		7,352		7,482
Contributions in aid of construction		70,658		53,619
Deferred income taxes		8,411		7,508
Other liabilities and deferred credits		7,878		9,718

Total Liabilities and Deferred Credits		206,907		169,468
Commitments and Contingencies
Stockholders’ Equity:
Preferred stock		513		513
Common stock ($.01 par value – issued 9,759 shares)		98		92
Paid-in capital		42,787		40,521
Retained earnings		18,439		14,592

Total Stockholders’ Equity		61,837		55,718

	$	268,744	$	225,186

See accompanying notes to consolidated financial statements.

Southwest Water Company and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN
STOCKHOLDERS’ EQUITY

	For the Year Ended December 31, 2002, 2001 and 2000

	(in thousands)

	Preferred Stock			Common Stock				Paid-In Capital		Retained Earnings			Total Stockholders’ Equity

				Number of Shares		Amount

Balance at January 1, 2000	$	517			6,447	$	64	$	32,082	$	8,055		$	40,718
Dividend reinvestment and employee stock purchase plans					42		1		528					529
Stock options exercised, net					38		1		44					45
Stock-based compensation									598					598
Excess tax benefits from stock-based compensation									170					170
Stock issued on acquisition					300		3		3,916					3,919
Preferred stock redeemed		(3	)											(3	)
5-for-4 stock split in the form of a stock dividend					1,707		17				(17	)		––
Net income											4,839			4,839
Cash dividends declared											(1,737	)		(1,737	)

Balance at December 31, 2000		514			8,534		86		37,338		11,140			49,078
Dividend reinvestment and employee stock purchase plans					49				635					635
Stock options exercised, net					72		1		161					162
Stock-based compensation									765					765
Excess tax benefits from stock-based compensation									323					323
Stock issued on acquisition					92		1		1,299					1,300
Preferred stock redeemed		(1	)											(1	)
5 percent stock dividend					436		4				(4	)		—
Net income											5,451			5,451
Cash dividends declared											(1,995	)		(1,995	)

Balance at December 31, 2001		513			9,183		92		40,521		14,592			55,718
Dividend reinvestment and employee stock purchase plans					43				627					627
Stock options exercised, net					59		1		386					387
Stock-based compensation									963					963
Excess tax benefits from stock-based compensation									136					136
Debenture conversions					11				154					154
5 percent stock dividend					463		5				(5	)		—
Net income											6,002			6,002
Net income											6,,00336			6,002
Cash dividends declared											(2,150	)		(2,150	)

Balance at December 31, 2002	$	513			9,759	$	98	$	42,787	$	18,439		$	61,837

See accompanying notes to consolidated financial statements.

Southwest Water Company and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS

			For the Years Ended December 31,

			2002			2001			2000

			(in thousands)
Cash Flows From Operating Activities:
Net income			$	6,002		$	5,451		$	4,839
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization				6,380			6,060			5,264
Deferred income taxes				903			1,072			596
Gain on sales of land				(119	)		—			(128	)
Changes in assets and liabilities, net of effects of acquisitions:
		Customers’ accounts receivable		5,984			(3,291	)		(6,415	)
		Other current assets		(597	)		(1,025	)		(3,320	)
		Accounts payable		5,179			2			(433	)
		Other current liabilities		1,324			(1,597	)		740
		Other, net		(2,970	)		(2,634	)		(1,640	)

Net cash provided by (used in) operating activities				22,086			4,038			(497	)

Cash Flows From Investing Activities:
Additions to property, plant and equipment				(25,587	)		(15,008	)		(7,683	)
Purchase of minority interest				(2,000	)		—			—
Acquisition of businesses, net of cash acquired				(10,317	)		(3,276	)		(10,427	)
Proceeds from sales of land				165			—			159
Other investments, net				(833	)		—			—

Net cash used in investing activities				(38,572	)		(18,284	)		(17,951	)

Cash Flows From Financing Activities:
Gross proceeds from issuance of long-term debt				10,000			20,000			—
Contributions in aid of construction and LUE fees				7,965			2,877			1,875
Net borrowings on (repayment of) bank notes payable				4,166			(6,728	)		16,127
Net proceeds from dividend reinvestment, debenture conversion, employee stock purchase and stock option plans				1,168			797			574
Dividends paid				(2,142	)		(1,981	)		(1,646	)
Payments on long-term debt				(3,507	)		(900	)		(900	)
Payments on advances for construction, net				(347	)		(409	)		(349	)

Net cash provided by financing activities				17,303			13,656			15,681

Net increase (decrease) in cash and cash equivalents				817			(590	)		(2,767	)
Cash and cash equivalents at beginning of year				789			1,379			4,146

Cash and cash equivalents at end of year			$	1,606		$	789		$	1,379

Supplemental Disclosure of Cash Flow information Cash paid during the year for:
		Interest	$	5,134		$	4,376		$	3,181

		Income taxes	$	2,335		$	2,502		$	2,070

Non-cash investing and financing activities:
	Purchase of businesses
		Fair value of assets acquired	$	16,781		$	9,764			44,915
		Cash paid		(11,317	)		(3,530	)		(10,880	)
		Notes issued		(1,000	)		(3,000	)		(2,000	)
		Stock issued		––			(1,300	)		(4,000	)

		Liabilities assumed	$	4,464		$	1,934		$	28,035

Non-cash contributions in aid of construction and advances for construction conveyed to Company by developers			$	9,015		$	1,581		$	3,085

See accompanying notes to consolidated financial statements.

Southwest Water Company and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002 and 2001

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business: Southwest Water Company and its subsidiaries (Southwest Water or the Company) provide a broad range of services, including water production and distribution, wastewater collection and treatment, public works services and utility submetering. The Company also provides billing, collection and customer service work as part of its range of services. Southwest Water owns regulated public utilities and also serves cities, utility districts and private companies under contract.

Principles of Consolidation: The consolidated financial statements include the accounts of Southwest Water and its wholly owned and majority-owned subsidiaries, as well as a majority-owned partnership. The principal wholly owned subsidiaries are ECO Resources, Inc. (ECO), Suburban Water Systems (Suburban), New Mexico Utilities, Inc. (NMUI), Aqua Services LP (Aqua Services), and Hornsby Bend Utility Company (Hornsby). The majority-owned subsidiaries are Master Tek International, Inc. (Master Tek), Operations Technologies, Inc. (OpTech) and Windermere Utility Company (Windermere). The majority-owned partnership is Metro H₂O. All significant intercompany transactions have been eliminated, except where permitted by Statement of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Types of Regulation, for intercompany transactions with regulated water utilities.

Regulation: Suburban, NMUI, Windermere and Hornsby conform to the Uniform System of Accounts prescribed by the California Public Utilities Commission (CPUC), the New Mexico Public Regulation Commission (NMPRC) and the Texas Commission on Environmental Quality (TCEQ), formerly the Texas Natural Resource Conservation Commission, respectively. Non-regulated operations consist of the contract water and wastewater management services business and the utility submetering services business conducted by the Company’s subsidiaries, ECO, OpTech, Aqua Services and Master Tek.

Use of Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. The reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period could be affected by changes in such estimates. Actual results may differ from these estimates.

Earnings Per Share: Southwest Water reports earnings per share (EPS) in accordance with SFAS No. 128, Earnings Per Share, by computing basic EPS and diluted EPS. Basic EPS measures the performance of the Company over the reporting period by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS measures the performance of the Company over the reporting period after giving effect to all potentially dilutive common shares that would have been outstanding if the shares had been issued. Stock options and warrants give rise to potentially dilutive common shares. The Company also has convertible subordinate debentures outstanding. When the Company’s common stock reaches a certain market price, the debentures will become common stock equivalents.

Recognition of Revenues: Revenues for contract operations are billed based on a monthly fee to provide a specific level of service as outlined in each individual contract. The Company usually bills for additional services provided beyond the scope of the base contract on a time and materials basis as such services are rendered. Revenues for construction projects are recorded using the percentage-of-completion method of accounting.

Water utility revenues are recognized when amounts are billed to customers. An estimated amount for unbilled revenues is also recognized for water used towards the end of the accounting period.

Other Income: Included in other income on the Company’s consolidated statements of income is the effect of a one-time, non-taxable gain in 2002 of approximately $980,000 resulting from the termination of the Company’s defined

benefit plan as fully disclosed in Note 12 to the consolidated financial statements. Also included in other income are reimbursements of approximately $1,649,000. This was the result of a settlement reached among certain alleged polluters of one of our California utility groundwater sources for water-quality-related expenses incurred in 2001 and 2000.

Cash and Cash Equivalents: Southwest Water considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.

Fair Value of Financial Instruments: The carrying value of financial instruments such as cash and cash equivalents, accounts receivable, accounts payable, and short- and long-term debt approximates fair value. At December 31, 2002, Southwest Water had no derivative financial instruments, financial instruments with off-balance sheet risk or financial instruments with concentrations of credit risks requiring accounting or disclosure under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.

Utility Property, Plant and Equipment: The cost of additions to utility plant includes labor, material and capitalized interest. Interest of approximately $194,000, $790,000 and $380,000 was capitalized in 2002, 2001 and 2000, respectively. The cost of utility plant retired is charged to accumulated depreciation. Depreciation expense on utility plant is recorded using the straight-line method over the useful lives of the assets as prescribed by the CPUC, the NMPRC and the TCEQ, and as permitted by SFAS No. 71. Depreciation expense on average gross depreciable plant was approximately 2.7% in 2002 and 3% in both 2001 and 2000. See further discussion in Note 4 to the consolidated financial statements.

Non-Regulated Operations Property, Plant and Equipment: For book purposes, property, plant and equipment used in submetering services and contract operations are depreciated on the straight-line method over estimated useful lives ranging from three to 30 years.

Goodwill and Intangible Assets: In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, and specifies that identifiable intangible assets acquired in a purchase method business combination must be recognized and reported apart from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives are not amortized, but instead are tested for impairment at least annually. For intangible assets with definite useful lives, SFAS No. 142 requires amortization over their estimated useful lives to their estimated residual values, and requires review for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The Company’s non-compete agreements and other purchased intangible assets are amortized over periods ranging from four to 10 years. SFAS No. 142 became effective for fiscal years beginning after December 15, 2001. The Company performed its transitional analysis for impairment of goodwill under SFAS No. 142 in the first quarter of 2002 and no impairment was identified. The Company will perform an impairment review on an annual basis or when events or circumstances indicate potential impairment. An annual impairment review was performed by the Company on its reporting units as of December 31, 2002 and it was determined that each reporting unit had a fair market value in excess of carrying value. Accordingly, no goodwill impairment has been recorded. Beginning in 2002, goodwill incurred prior to June 2001 in the amount of approximately $2,900,000 is no longer being amortized.

Utility Accounting: Regulatory assets deemed recoverable are recorded by Suburban, NMUI and Windermere and Hornsby as permitted by the CPUC, the NMPRC and the TCEQ, respectively, in accordance with SFAS No. 71. Under prior CPUC procedures (adopted by Suburban in 1991), Suburban recorded the difference between actual water production costs incurred and CPUC-adopted water production costs in balancing accounts in the income statement with a corresponding liability or asset on the balance sheet as permitted by SFAS No. 71. Under previous regulations, the differences recorded would be refunded to or recovered from utility customers through future CPUC-authorized rate adjustments. The CPUC significantly changed this policy by eliminating the use of balancing accounts as of November 29, 2001. In 2002, in place of the balancing account, Suburban began tracking the difference between actual and CPUC-adopted water production cost in a memorandum account. Memorandum accounts are not recorded on Suburban’s books. Instead, costs are being accumulated and Suburban will attempt to recover these costs during its regularly scheduled general rate hearings. As of December 31, 2002 Suburban had a receivable of approximately $2,300,000 in the balancing account. The disposition of the pre-November 29, 2001 balancing accounts became the subject of a CPUC rulemaking when, on December 17, 2002, the CPUC issued a

decision favorable to the water industry that should allow Suburban to recover the $2,300,000 that was in its balancing account prior to November 29, 2001.

Each state agency establishes rates which are intended to permit each utility to recover its costs and earn a reasonable rate of return on capital. Each utility may file and process general rate applications on a periodic basis. Since the established rates may be in effect for several years, utilities attempt to anticipate cost increases and apply for rates sufficient to permit recovery of those cost increases when incurred. Suburban made a rate filing on April 2, 2002 to start a new general rate case, and the rate case proceedings are currently underway. Both the Company and the CPUC staff have testified before an Administrative Law Judge and the judge has rendered a preliminary opinion. That opinion is pending with the CPUC. Suburban anticipates a rate increase in the first half of 2003.

The Company’s New Mexico utility and Texas utilities have contracted with one of the companies in the Services Group to perform operating services, normal maintenance and construction work. The Company believes these contracts were established utilizing terms and conditions equivalent to prevailing industry rates for similar work performed by the Services Group for non-affiliated entities. In accordance with SFAS No. 71, the Services Group recognizes a profit margin from the contract work performed and does not eliminate the intercompany profit on the construction contract work performed when the contract sales price is reasonable and it is probable that the costs and capital will be recoverable through the rate making process. Accordingly, the intercompany profits have not been eliminated in the accompanying consolidated financial statements.

Deferred Costs: Costs incurred to acquire service contracts are capitalized and amortized over the term of each contract. The Company periodically evaluates the profitability of each contract. Any remaining capitalized cost relating to an unprofitable contract is expensed.

Long-Lived Assets: Southwest Water regularly reviews its long-lived assets for impairment. This review includes regulatory assets and assets excluded from rate base by regulators. Potential impairment of assets held for use is determined by comparing the carrying amount of an asset to the future undiscounted cash flows expected to be generated by that asset. If assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying value of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value, less cost to sell. In August 2001, SFAS No. 144 was issued and became effective January 2002. SFAS No. 144 supercedes SFAS No. 121; however, it retains the requirement that long-lived assets be tested for recoverability when events or changes in circumstances indicate carrying amounts may not be recoverable.

Income Taxes: Income taxes are accounted for in accordance with SFAS No. 109, Accounting for Income Taxes, using the asset and liability method. Deferred tax assets and liabilities are recorded in order to recognize future tax effects attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as the recognition of operating losses and tax credit carry-forwards. Deferred tax assets and liabilities are recorded using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that the enactment occurs. The Company files a consolidated U.S. Federal income tax return, which includes all qualifying subsidiaries.

In 1993, under the provisions of SFAS No. 109, Suburban and NMUI recorded additional deferred income taxes, as well as corresponding regulatory assets and regulatory liabilities as permitted by the CPUC and the NMPRC, respectively.

Unamortized investment tax credits have been deferred and are amortized over the estimated productive lives of the related assets as allowed by the CPUC and the NMPRC.

Advances For Construction: Advances for construction represent amounts advanced by developers primarily for water pipeline extensions. Advance contracts issued after June 1982 are refundable to the depositor at a rate of 2-1/2% each year over a 40-year period.

Contributions In Aid of Construction and Living Unit Equivalents: Contributions in Aid of Construction (CIAC) represent contributions in the form of cash, services or property received from developers, governmental agencies, municipalities or individuals for the purpose of constructing utility plant. Living Unit Equivalent (LUE) connection fees are cash contributions received from developers, also for the purpose of constructing utility plant. Depreciation

expense related to utility plant additions from CIAC and LUE fees are charged as a reduction to the respective CIAC and LUE fee accounts instead of as depreciation expense.

Stock-Based Compensation: The Company has two plans which allow for the granting of stock options. As fully disclosed in Note 11, the Company applies FASB No. 123, Accounting for Stock-Based Compensation, in accounting for its stock option grants. Accordingly, compensation expense is recognized for fixed stock options as if the fair value of all stock options as of the grant date were recognized as expense over the vesting period in accordance with SFAS No. 123.

Reclassifications: Certain reclassifications have been made to the prior year consolidated financial statement presentation to conform to the 2002 presentation.

Recent Accounting Policies: In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires the Company to record the fair value of an asset retirement obligation as a liability in the period in which we incur a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of the assets. Southwest Water will also record a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. The Company was required to adopt SFAS No. 143 on January 1, 2003. The adoption of SFAS No. 143 is not expected to have a material effect on the consolidated financial statements.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss as extraordinary. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. The provision of the Statement related to the rescission of Statement No. 4 is applied in fiscal years beginning after May 15, 2002. Earlier application of these provisions is encouraged. The provisions of the Statement related to Statement No. 13 were effective for transactions occurring after May 15, 2002, with early application encouraged. The adoption of SFAS No. 145 is not expected to have a material effect on the Company’s consolidated financial statements.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The adoption of SFAS No. 146 is not expected to have a material effect on the Company’s consolidated financial statements.

In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on Company’s consolidated financial statements. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123. SFAS No. 148 amends FASB No. 123 to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements. In 2002, the Company elected to expense stock-based compensation in accordance with the provisions of SFAS No. 123, and adopted the retroactive restatement provisions of SFAS No. 148, as more fully described in Notes 2 and 11.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interest in variable interest entities created or obtained after January 31, 2003. For public companies, such as ours, the Interpretation is applied to the enterprise no later than the end of the first annual reporting period beginning after June 15, 2003. The application of this Interpretation is not expected to have a material effect on the Company’s consolidated financial statements. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that an entity will consolidate or disclose information about variable interest entities when the Interpretation becomes effective.

In November 2002, the EITF finalized EITF No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. EITF No. 00-21 is required to be adopted for all new revenue arrangements entered into in fiscal years beginning after June 15, 2003, but alternatively would allow the Company to apply EITF No. 00-21 to existing contracts and record the effect of adoption as the cumulative effect of a change in accounting principle. The adoption of EITF No. 00-21 is not expected to have a material effect on the consolidated financial statements.

NOTE 2. CHANGE IN ACCOUNTING METHOD FOR STOCK OPTIONS AND RETROACTIVE RESTATEMENTS

At December 31, 2002, Southwest Water had two stock-based option plans: the Stock Option Plan and the Director Stock Option Plan. Prior to 2002, the Company accounted for these plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and provided pro forma disclosures required under SFAS No. 123, Accounting for Stock Based Compensation. No stock-based compensation cost was reflected in previously reported results, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

Effective in 2002, the Company adopted the fair-value based method of accounting for Company stock options as required under SFAS No. 123. This change was adopted under the retroactive restatement method as defined in SFAS No. 148. Accordingly, all prior periods presented have been retroactively restated to reflect compensation cost under the fair value based accounting method in SFAS No. 123 for all options granted, modified or settled in fiscal years beginning after December 15, 1994. See Note 11 for full disclosures required under SFAS No. 123 and SFAS No. 148. The table below sets forth the effect of the retroactive restatement of prior periods:

		2001		2000		1999

		(in thousands, except per share amounts)
Net Income:
	Restated for adoption of SFAS No. 123	$	5,451	$	4,839	$	5,430
	Previously reported, as adjusted (see below)	$	5,942	$	5,214	$	5,657
Basic Earnings per Common Share:
	Restated for adoption of SFAS No. 123	$	0.57	$	0.53	$	0.61
	Previously reported, as adjusted (see below)	$	0.62	$	0.57	$	0.64
Diluted Earnings per Common Share:
	Restated for adoption of SFAS No. 123	$	0.55	$	0.52	$	0.59
	Previously reported, as adjusted (see below)	$	0.59	$	0.54	$	0.61

The amounts reported by the Company in its previously filed Annual Reports on Form 10-K included the tax benefit from stock options exercised as a credit to the provision for income taxes. This benefit should have been recorded as an increase to paid-in capital. Accordingly, in the table above, the previously reported amounts have been adjusted to properly account for this tax benefit. These adjustments had the effect of reducing net income by $301,000, $167,000 and $162,000 for 2001, 2000 and 1999, respectively, and reducing both basic and diluted EPS by $0.03, $0.02 and $0.02 for each of these respective years compared to the amounts reported in the Company’s previously filed Annual Reports on Form 10-K. These non-cash tax adjustments to net income have no effect upon the Company’s cash flows ability to pay dividends, current income tax liability or total stockholders’ equity for any of these three years.

NOTE 3. OTHER ASSETS

Included in other current assets at December 31, 2002 and 2001 are the following:

	2002		2001

	(in thousands)
Other receivables	$	3,874	$	802
Prepaid expenses		3,246		3,313
Accumulated balancing account receivable		2,329		2,492
Other		2,124		2,332

	$	11,573	$	8,939

Included in other long-term assets at December 31, 2002 and 2001 are the following:

	2002		2001

	(in thousands)
Goodwill, net	$	20,172	$	12,985
Deferred regulatory tax asset		2,177		2,146
Non-compete agreement and purchased contracts, net		2,586		1,733
Other receivables, net		2,233		893
Deferred debt expense, net		1,838		1,709
Investments in joint venture, net		356		355
Other		5,613		3,070

	$	34,975	$	22,891

NOTE 4. UTILITY PROPERTY, PLANT, AND EQUIPMENT

The components of utility property, plant and equipment at December 31, 2002 and 2001 are as follows:

	2002		2001

	(in thousands)
Land and land rights	$	1,131	$	1,118
Source of supply		12,771		11,897
Pumping and purification		18,200		19,140
Transmission and distribution		183,134		159,436
General (including intangibles)		10,046		11,261
Construction work in progress		19,852		15,844

	$	245,134	$	218,696

Suburban has an investment of approximately $699,000 in two mutual water companies, which entitles Suburban to certain water rights. Suburban’s investment in one of these mutual water companies is approximately 32% of the outstanding stock. However, the Company and Suburban do not have significant operating and financial control over either of these mutual water companies. These investments are recorded at cost and are reflected in general utility property. Suburban purchased water from these mutual water companies at a cost of approximately $3,718,000, $3,613,000 and $3,097,000 in 2002, 2001 and 2000, respectively.

At December 31, 2002, substantially all of the Company’s utility plant and equipment was pledged as collateral for the First Mortgage Bonds issued by the Company as more fully described in Note 7.

The Company’s non-regulated operations owned property, plant and equipment of approximately $20,753,000 as of December 31, 2002. The significant components of the Company’s non-regulated plant and equipment were

approximately $4,321,000 of computer and office equipment,$3,330,000 of construction in process, $4,666,000 of machinery and autos, and the remainder in leasehold improvements, buildings, land, and other.

Depreciation expense for utility and non-regulated property, plant and equipment totaled approximately $5,866,000, $5,395,000 and $4,915,000 in 2002, 2001 and 2000, respectively.

NOTE 5. BANK LINES OF CREDIT

At December 31, 2002, Southwest Water had three unsecured lines of credit from three commercial banks with a total borrowing capacity of $24,000,000. One of the lines of credit expires in September 2004, another expires in April 2004 and the remaining line expires in March 2004. The Company expects to maintain bank lines of credit needed in the normal course of business. Under two of the lines of credit, interest is charged at the banks’ prime rates less 1/4%. The Company may borrow funds at a lower interest rate; however, certain minimum borrowing requirements must be maintained for a fixed period of time. Interest charged under the third line of credit is lower than the bank’s prime rate and contains no restrictions as to minimum borrowing or borrowing for a fixed period of time.

Two of the line of credit agreements require a commitment fee of 1/4% per year of the unused portion of the available line of credit, calculated and payable on a quarterly basis. One of the lines of credit requires a monthly commitment fee of $500. Two of the lines of credit require an annual renewal fee, and the third line requires no annual fee. Each of the line of credit agreements, as amended, contains certain financial covenants, and the Company was in compliance with all applicable restrictions at December 31, 2002.

During March 2001, the Company amended its credit agreements and increased its available lines of credit to $30,000,000. The lines were subsequently reduced to $24,000,000 in connection with the convertible debenture offering in July 2001. Of the $24,000,000 total capacity under our lines of credit, the Company had approximately $3,842,000 available borrowing capacity and a working capital deficit of approximately $1,787,000 as of December 31, 2002. As indicated in Note 17, in March 2003, the Company entered into an agreement to amend one of the lines of credit under which the bank increased the line of credit capacity by $4,000,000 through December 31, 2003.

A summary of borrowing on the lines of credit during the years ended December 31, 2002 and 2001 is presented below:

	2002			2001

	(in thousands except percentages)
Bank lines of credit outstanding at December 31	$	20,158		$	15,992
Weighted average interest rate at December 31		2.63	%		4.14	%
Maximum amount of borrowings outstanding at any month end	$	20,212		$	27,716
Weighted average borrowings during the year	$	13,026		$	19,964
Weighted average interest rate during the year		3.40	%		5.28	%

NOTE 6. OTHER LIABILITIES

Included in other current liabilities at December 31, 2002 and 2001 are the following:

	2002		2001

	(in thousands)
Accrued salaries, wages and benefits	$	4,506	$	4,669
Purchased water accrual		2,834		2,105
Franchise and other taxes		1,678		1,263
Deferred revenue and customer deposits		1,509		1,146
Other		7,737		5,444

	$	18,264	$	14,627

Included in other long-term liabilities and deferred credits at December 31, 2002 and 2001 are the following:

	2002		2001

	(in thousands)
Non-compete liability	$	1,470	$	1,680
Regulatory deferred tax liability		1,287		1,687
LUE fees		876		2,973
Minority interest liabilities		561		614
Other		3,684		2,764

	$	7,878	$	9,718

Notes payable were issued in connection with the acquisitions made by the Company in 2001 and 2000, and are payable to the former owners of the acquired entities. In general, these notes bear interest at rates ranging from 5% to 8% per annum, with interest payable either monthly or quarterly and with various contractual principal payments required. At December 31, 2002, principal payments due on the notes payable are approximately $484,000 in 2003, $1,386,000 in 2004, $1,485,000 in 2005, $1,592,000 in 2006 and $1,641,000 thereafter.

The Company has invested $500,000 for a 51% interest in Metro H₂O, a partnership, in order to supply wholesale water and wastewater services to several communities in an area just east of Austin, Texas. During 2001, Metro H₂O entered into a $900,000 loan for the purchase of land. In 2002, a principal payment in the amount of $400,000 was made, reducing the principal balance of the loan to $500,000. This loan is collateralized by the land, and is included in other current liabilities as of December 31, 2002. The land will be utilized for the construction of water wells and a wastewater treatment plant.

NOTE 7. LONG-TERM DEBT

The long-term debt outstanding at December 31, 2002 and 2001 is as follows:

	2002			2001

	(in thousands)
Southwest Water Convertible Subordinate Debentures, due 2021, at 6.85% interest rate, with quarterly interest payments	$	19,732		$	20,000
Windermere 10-year bank term loan, due in quarterly principal payments of $125 plus interest at Libor + 1.75%		9,875			—
Suburban First Mortgage Bond, Series A, due 2006, at 8.93% interest rate, with semi-annual interest payments		4,200			5,100
Suburban First Mortgage Bond, Series B, due 2022, at 9.09% interest rate, with semi-annual interest payments		8,000			8,000
Suburban First Mortgage Bond, Series C, due 2006, at 7.61% interest rate, with semi-annual interest payments		8,000			8,000
NMUI First Mortgage Bond, Series A, due 2002, at 8.86% interest rate, with semi-annual interest payments		—			2,000
NMUI First Mortgage Bond, Series B, due 2006, at 7.64% interest rate, with semi-annual interest payments		4,000			4,000
Economic Development Revenue Bonds, Series 1998A, due 2018, at 5.5% interest rate, with semi-annual interest payments		1,810			—
Economic Development Revenue Bonds, Series 1998A, due 2008, at 6.0% interest rate, with semi-annual interest payments		590			—
Master Tek 10-year note payable dated April 2000, at 8.0% interest rate, due in monthly installments of principal and interest		1,611			1,754
OpTech 5-year notes payable dated August 2001, at 7.5% interest rate, with quarterly interest payments through 2003, followed by quarterly payments of principal and interest		2,820			3,000
Other 7-year notes payable dated December 2001, at 5.0% interest rate, due in monthly installments of principal and interest		2,158			2,457

Long-term debt before current maturities		62,796			54,311
Less current maturities		(1,969	)		(3,344	)

Long-term debt	$	60,827		$	50,967

On July 20, 2001, Southwest Water issued $20,000,000 of 6.85% fixed rate convertible subordinate debentures due July 1, 2021, and received net proceeds of approximately $18,890,000 from the sale after underwriting discounts, commissions and remaining expenses of the offering. The net proceeds from the sale of these debentures were used to reduce borrowings on the Company’s revolving lines of credit. Southwest Water is subject to certain financial covenants under the terms of the indenture agreement for the debentures. As of December 31, 2002, the Company was in compliance with all applicable restrictions. The debentures are convertible into shares of Southwest Water common stock at a conversion price of $16.197 per share. The debentures are convertible at any time prior to maturity unless previously redeemed. The Company may redeem the debentures in whole or in part at any time, at redemption prices from 105% beginning July 1, 2003 and declining 1% annually to par (100% of face value) after June 30, 2008. The issuance costs of the convertible subordinate debentures in the amount of approximately $1,110,000 are being amortized over 20 years.

In August 9, 2002 Windermere obtained a 10-year $10,000,000 secured bank term loan. The net proceeds of approximately $9,750,000 were used to pay down bank lines of credit. The term loan bears interest at a rate equal to

LIBOR plus 1.75%, with principal payments of $125,000 due quarterly, beginning in November 2002. The note is secured by substantially all of the assets of Windermere.

Suburban’s First Mortgage Bond, Series A, requires annual sinking fund payments of $900,000. The bond may be redeemed at the option of the Company at a price of par plus a call premium. Suburban’s First Mortgage Bonds, Series B and C, and NMUI’s First Mortgage Bonds, Series A and B, do not require annual sinking fund payments. These bonds are nonrefundable and may be redeemed at any time by the Company at a price of par plus a call premium. Additional mortgage bonds may be issued subject to the provisions of the existing indentures. Substantially all of the Company’s utility plant is pledged as collateral for these bonds as more fully described in Note 4.

Each indenture limits the amount of cash and property dividends that Suburban and NMUI may pay to the Company. As of December 31, 2002 and 2001, both Suburban and NMUI were in compliance with dividend limitations mandated in the indentures. At December 31, 2002 and 2001, the combined indenture limits for dividends totaled $27,530,000 and $22,957,000, respectively.

In connection with the acquisition of Aqua Services in November 2002, we assumed two Economic Development Revenue Bonds (EDRBs) with principal balances of approximately $1,810,000 and $590,000, respectively. The EDRB in the amount of $1,810,000 is due in 2018, and bears interest at a rate of 6.0%, with annual principal payments beginning in 2009, while the EDRB in the amount of $590,000 is due in 2008, and bears interest at a rate of 5.5%, with annual principal payments until maturity. These revenue bonds are secured by the Keystone, South Dakota wastewater treatment plant.

Annual maturity and sinking fund requirements for all long-term debt are $1,485,000, $1,490,000, and $1,495,000 for the three years ending December 31, 2003, 2004 and 2005, respectively. Annual maturity and sinking fund requirements are $14,100,000 for the year ending December 31, 2006 and include Suburban’s Series A and Series C bonds and NMUI’s Series B bonds which become due in 2006. Maturity and sinking fund requirements are $17,905,000 for the years ended December 31, 2007 and beyond.

NOTE 8. INCOME TAXES

The components of the current and deferred income tax provisions are as follows:

				2002			2001			2000

				(in thousands)
Current tax expense:
			Federal	$	1,993		$	2,012		$	2,166
			State		425			571			498

					2,418			2,583			2,664
Deferred income taxes (benefits):
		Federal			903			1,072			615
	State				—			—			(19	)

					903			1,072			596
Change in regulatory assets and regulatory liabilities, net					(59	)		(67	)		(107	)
Investment tax credit amortization					(49	)		(49	)		(49	)

Provision for income taxes				$	3,213		$	3,539		$	3,104

A reconciliation of the statutory federal income tax rate to the Company’s effective tax rate is as follows:

	2002			2001			2000

Provision computed at statutory rates		34	%		34	%		34	%
State income taxes, net of federal tax benefit		3	%		5	%		5	%
Goodwill amortization and other non-deductible expense		1	%		2	%		1	%
Reversion of pension assets, net		(2	)%		—			—
Investment tax credits		—			(1	)%		(1	)%
Other, net		(1	)%		(1	)%		—

Effective tax rate		35	%		39	%		39	%

Net deferred income tax liabilities consist of the following at December 31, 2002 and 2001:

2002

2001

(in thousands)

Deferred income tax assets:

Contributions in aid of construction and advances for construction

2,512

2,706

Reserves

935

1,234

Investment tax credits

430

455

Stock-based compensation

1,116

846

Pension

—

193

Other

293

185

Total deferred income tax assets

5,286

5,619

Deferred income tax liabilities:

Depreciation

10,690

10,088

Section 1031 like-kind property exchange gain

1,109

1,159

Production cost balancing accounts

896

959

Gains on condemnation of land

554

596

Other

448

325

Total deferred income tax liabilities

13,697

13,127

Net deferred income tax liabilities

8,411

7,508

Based upon the Company’s current and historical pre-tax earnings, management believes it is more likely than not that the Company will realize the benefit of its deferred income tax assets. Management believes the existing net deductible temporary differences will reverse during periods in which the Company generates net taxable income. However, there can be no assurance that the Company will generate any earnings or any specific level of continuing earnings in future years. Management regularly reviews the recoverability of deferred income tax assets and has determined that no valuation allowances were necessary at December 31, 2002 or 2001.

NOTE 9. EARNINGS PER SHARE

The difference between basic and diluted EPS is the effect of stock options that, under the treasury share method, give rise to common stock equivalents. As described in Note 7, the Company issued $20,000,000 of 6.85% fixed-rate convertible subordinate debentures in July 2001. The debentures are convertible at any time prior to maturity, unless previously redeemed, at a conversion price of $16.197. If the market value of the Company’s stock were to exceed the conversion price, the debentures would be considered to be common stock equivalents and would be included in the calculation of diluted EPS after adjusting net income for the after-tax effect of the debenture interest expense.

The following table is a reconciliation of the numerators and denominators used in both basic and diluted EPS calculations:

	Net Income		Dividends on preferred shares			Basic EPS		Effect of Dilutive Options		Diluted EPS

	(in thousands except per share amounts)
2002
Income (numerator)	$	6,002	$	(27	)	$	5,975	$	—	$	5,975
Shares (denominator)							9,725		526		10,251
Per share amount						$	0.61			$	0.58

2001
Income (numerator)	$	5,451	$	(27	)	$	5,424	$	—	$	5,424
Shares (denominator)							9,549		364		9,913
Per share amount						$	0.57			$	0.55

2000
Income (numerator)	$	4,839	$	(27	)	$	4,812	$	—	$	4,812
Shares (denominator)							9,148		173		9,321
Per share amount						$	0.53			$	0.52

Approximately 53,000, 15,000 and 10,000 stock options were excluded from the computation of diluted earnings per share in 2002, 2001 and 2000, respectively, due to their antidilutive effect.

NOTE 10. STOCKHOLDERS’ EQUITY

The Company is currently authorized to issue 25,000,000 common shares at a par value of $.01 per share. The current quarterly cash dividend to common stockholders is $.058 per share. As of December 31, 2002, there were 9,759,165 common shares issued and outstanding after adjustment for a 5% stock dividend (or 463,487 shares) issued to stockholders of record on January 1, 2003. At December 31, 2001, there were 9,183,107 common shares outstanding after adjustment for a 5% stock dividend (or 436,308 shares) issued to stockholders of record on October 1, 2001. As of December 31, 2000, there were 8,533,734 common shares issued and outstanding after adjustment for a 5-for-4 stock split (or 1,707,333 shares) issued in the form of a stock dividend to stockholders of record on January 1, 2001. The weighted average number of outstanding common shares and dividends per common share reflect the stock splits and stock dividends for all periods presented.

On April 6, 1998, the Company adopted a Share Purchase Rights Plan (Rights Plan) to preserve value for the Company’s stockholders. The Rights Plan is designed to deter coercive takeover tactics, to encourage third parties interested in acquiring the Company to negotiate with the Board and to reduce any adverse effects that significant stockholders of the Company may have on the public market for the Company’s common stock. In the event of certain triggering events as specified in the Rights Plan (e.g., accumulation of a significant block of shares by an acquiring person), the stockholders become entitled to purchase additional shares of common stock at a significant discount.

The Company is currently authorized to issue 250,000 preferred shares at a par value of $.01 per share. There were 10,264 Series A preferred shares issued and outstanding at December 31, 2002 and 2001. Series A preferred stockholders are entitled to annual dividends of $2.625 per share. Series A preferred shares may be called by the Company for a price of $52 per share and have preference in liquidation of $50 per share.

Southwest Water has a Dividend Reinvestment and Stock Purchase Plan (DRIP) that allows common stockholders the option of receiving their dividends either in cash or in common stock at a 5% discount from the market value. The DRIP permits optional cash purchases of stock at current market values up to a maximum of $3,000 per stockholder each quarter. As of December 31, 2002, there were 600,000 shares authorized for issuance under the DRIP and 261,242 shares were available for issuance.

NOTE 11. STOCK-BASED PLANS

At December 31, 2002, Southwest Water had three stock-based plans: the Stock Option Plan, the Director Stock Option Plan, and the Employee Stock Purchase Plan. Prior to 2002, the Company elected to follow the accounting provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and to provide the pro forma disclosures required under SFAS No. 123, Accounting for Stock Based Compensation.

In 2002, the Company adopted the fair value recognition provisions of SFAS No. 123, which requires that the Company value stock options issued based upon an option pricing model and recognize this value as an expense over the period in which the options vest. In accordance with the provisions of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of SFAS No. 123, the Company has elected to recognize stock-based compensation using the retroactive restatement method. Under this change in accounting method, the Company has restated its consolidated financial statements for all years presented herein to reflect stock-based compensation expense under a fair value based accounting method for all options granted, modified or settled in fiscal years beginning after December 15, 1994. See Note 2.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that do not have vesting restrictions and that are fully transferable. In addition, option valuation models require the Company to make highly subjective assumptions including the expected future volatility of the stock price. Because the stock options granted by the Company have characteristics that are significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the value of an estimate, in management’s opinion, the existing option valuation models, including Black-Scholes, do not necessarily provide a reliable single measure of the fair value of the Company’s employee stock options.

In the table below, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2002, 2001 and 2000:

	2002			2001			2000

Dividend yield		1.8	%		1.7	%		1.7	%
Expected volatility		27.3	%		26.3	%		27.5	%
Risk free interest rate		4.6	%		4.7	%		6.7	%
Expected life in years		5.6			5.7			5.6

Compensation expense arising from stock option grants as determined using the Black-Scholes fair value option model was approximately $963,000, $765,000 and $598,000 for the years ended December 31, 2002, 2001 and 2000, respectively. All prior periods have been restated to reflect the compensation costs that would have been recognized had the recognition provisions of SFAS No. 123 been applied to all options granted after January 1, 1995. As a result of this change in accounting method, a transition adjustment consisting of a $475,000 decrease in retained earnings and an $814,000 increase in additional paid-in capital has been reflected in the accompanying consolidated statements of stockholders' equity as of January 1, 2000, to reflect the effect on these accounts for periods from January 1, 1995 (the date of initial application of SFAS No. 123) through December 31, 1999.

Stock Option Plan (SOP): In 1988, the stockholders approved the SOP and in 2000, the stockholders approved an amendment to the SOP which increased the number of authorized and available shares for issuance by 937,500, provided for a 150,000 share annual award limit to any one individual, modified the eligibility requirements to include certain consultants to the Company and also extended the future grant date to May 23, 2010. As of December 31, 2002, there were 2,430,880 shares (adjusted for stock splits and stock dividends) authorized for issuance under the SOP and 500,914 shares were available for issuance.

Under the SOP, Southwest Water may grant non-qualified stock options to officers, employees and certain consultants at an exercise price not less than the fair value of the stock on the last trading date preceding the date of grant. The Company also granted non-qualified options to certain non-employee directors of the Company. Options granted subsequent to December 31, 1999 vest equally over a period of five years and expire seven years and one day from the date of grant. Options granted prior to January 1, 2000 expire 10 years and one day from the date of grant.

Options issued under the SOP may be exercised in accordance with the provisions of the Internal Revenue Code concerning stock attestation. Shares attested for purposes of stock options exercised are cancelled. Options are forfeited when they expire or in the event a SOP participant terminates employment with the Company prior to the options vesting.

A summary of the status of the SOP and changes during the years ended as of December 31, 2002, 2001 and 2000 is presented below:

	2002					2001					2000

Fixed Options	Shares			Weighted Average Exercise Price		Shares			Weighted Average Exercise Price		Shares			Weighted Average Exercise Price

Outstanding at beginning of year		1,196,394		$	7.66		1,014,896		$	6.56		887,416		$	5.46
Granted		333,327		$	13.10		280,460		$	10.54		233,868		$	10.10
Exercised		(48,293	)	$	15.70		(93,590	)	$	4.50		(89,919	)	$	4.83
Cancelled		—			—		(5,372	)	$	5.72		(16,469	)	$	6.89

Outstanding at end of year		1,481,428		$	8.91		1,196,394		$	7.66		1,014,896		$	6.56

Options exercisable at year-end		699,071		$	7.48		489,514		$	5.48		415,546		$	4.54

Weighted average fair value of options granted during the year	$	3.86				$	3.12				$	4.14

The following table summarizes information about fixed stock options outstanding at December 31, 2002:

	Options Outstanding						Options Exercisable

Range of Exercise Prices	Number Outstanding at 12/31/02		Weighted Average Remaining Contractual Life in Years		Weighted Average Exercise Price		Number Exercisable at 12/31/02		Weighted Average Exercise Price

$2.00 to $5.00		260,631		2.4	$	2.85		260,631	$	3.71
$5.00 to $10.00		469,335		5.5	$	6.99		312,183	$	6.96
$10.00 to $15.00		746,212		8.1	$	11.64		126,257	$	10.48
$15.00 to $20.00		5,250		9.0	$	16.26		—

$2.00 to $20.00		1,481,428		6.3	$	8.91		699,071	$	7.48

Director Option Plan (DOP): In 1996, the stockholders approved the DOP for non-employee directors, and in 2000, approved an amendment to the DOP, which provided for an increase of 165,375 shares reserved for issuance. As of December 31, 2002, there were 328,166 shares (adjusted for the stock splits and stock dividends) authorized for issuance under the DOP and 159,343 shares were available for issuance.

The DOP provides for an automatic grant of options to purchase 5,000 shares of the Company’s common stock to eligible non-employee directors of the Company on the date of the Company’s Annual Meeting of Stockholders through 2006 at the fair market value of the Company’s stock. New directors are granted an initial option to purchase 5,000 shares of the Company’s common stock upon appointment to the Board of Directors. DOP options granted subsequent to December 31, 1999 vest equally over two years and expire seven years and one day after the date of grant. Options granted prior to January 1, 2000 expire ten years and one day from the date of grant.

A summary of the status of the DOP and changes during the years ended as of December 31, 2002, 2001 and 2000 is presented below:

	2002					2001					2000

Fixed Options	Shares			Weighted Average Exercise Price		Shares			Weighted Average Exercise Price		Shares		Weighted Average Exercise Price

Outstanding at beginning of year		116,001		$	8.92		97,829		$	7.35		56,489	$	6.09
Granted		36,750		$	15.35		32,810		$	12.15		41,340	$	9.07
Exercised		(18,660	)	$	13.01		(14,638	)	$	5.62		—
Cancelled		(5,512	)	$	11.88		—					—

Outstanding at end of year		128,579		$	9.88		116,001		$	8.92		97,829	$	7.35

Options exercisable at year-end		78,179		$	8.62		62,532		$	7.18		46,751	$	5.84

Weighted average fair value of options granted during the year	$	4.50				$	3.58				$	3.72

The following table summarizes information about the director stock options outstanding as of December 31, 2002:

	Options Outstanding						Options Exercisable

Range of Exercise Prices	Number Outstanding at 12/31/02		Weighted Average Remaining Contractual Life in Years		Weighted Average Exercise Price		Number Exercisable at 12/31/02		Weighted Average Exercise Price

$4.00 to $6.00		10,496		4.0	$	4.69		7,693	$	4.72
$6.00 to $9.00		26,024		5.5	$	6.75		32,914	$	7.01
$9.00 to $15.00		60,559		7.6	$	11.04		34,319	$	11.04
$15.00 to $20.00		31,500		9.0	$	15.56		3,253	$	15.56

$4.00 to $20.00		128,579		6.5	$	9.88		78,179	$	8.62

Employee Stock Purchase Plan (ESPP): The Company has a stockholder-approved ESPP that allows eligible employees to purchase common stock through payroll deductions up to 10% of their salary (not to exceed $25,000 per year). The purchase price of the stock is 90% of the lower of the share price as calculated at the beginning and end of each three-month offering period. Under the ESPP, the Company issued 12,761 shares, 13,465 shares and 12,596 shares to employees in 2002, 2001 and 2000, respectively. At December 31, 2002, 854,649 shares (after adjustment for stock splits and stock dividends) were reserved for issuance under the ESPP and 688,296 shares were available for issuance.

NOTE 12. EMPLOYEE PENSION AND OTHER POST-RETIREMENT BENEFIT PLANS

Defined Benefit Plan: Prior to December 30, 1999, Southwest Water had a non-contributory defined benefit pension plan (the Pension Plan) for employees of the parent company, Suburban and NMUI. On August 5, 1999, the Company’s Board of Directors adopted a resolution to terminate the Pension Plan, freeze the assets of the Pension Plan and cease all benefit accruals as of December 30, 1999. In connection with the termination of the Pension Plan, the Company amended the Pension Plan benefit calculation and enhanced its current defined contribution plan, covering employees of the parent company, Suburban and NMUI. The Company applied for an Internal Revenue Service (IRS) determination in April 2000, and received a favorable determination from the IRS in September 2001, thereby permitting the Company to proceed with the Pension Plan termination. In January 2002, the net assets of the Pension Plan were distributed to plan participants as permitted by the Employee Retirement Income Security Act (ERISA) and its related regulations. Following distribution of the plan assets of approximately $14,400,000 to meet the benefit liabilities of the pension plan, and settlement of expenses paid by the Pension Plan in accordance with ERISA and its related regulations, the Pension Plan had excess assets of approximately $1,150,000.

In February 2002, the Company’s Board of Directors approved the transfer of excess assets to a qualified replacement plan. The funds were transferred to the Trustee of the qualified replacement plan in March 2002. Following the transfer of excess assets and payment of applicable excise taxes of approximately $173,000, the Pension Plan was considered settled in the first quarter of 2002 under the guidelines set forth in SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, because all benefit obligations were met and assets have been distributed. The Company no longer has responsibility for the pension benefit obligation. Accordingly, the Company accounted for the plan termination under SFAS No. 88 and recognized a net termination gain of approximately $980,000 as income to the Company in the first quarter of 2002.

Defined Contribution Plans: The Company established a 401(k) profit sharing plan (the ECO Plan) covering employees of its contract operations business. The ECO Plan provides for monthly enrollment by employees after completion of three months of service. Participants may elect to contribute up to 15% of their salary to the ECO Plan. The Company matches a participant’s contribution for an amount up to 50% of the first 4% of the participant’s salary. Company contributions vest immediately. Company contributions to the ECO Plan were approximately $206,000, $212,000 and $181,000 in 2002, 2001 and 2000, respectively. The assets of the ECO Plan are invested at the discretion of the individual employees in mutual funds consisting of stocks, bonds, and money market investments. The ECO Plan does not allow employees to purchase Southwest Water stock.

Effective January 2000, the Company established a 401(k) plan (the Utility Plan) covering employees of the parent company, Suburban, NMUI and Windermere. Employees become eligible for participation on the first of the month following their date of hire. Under the Utility Plan, the Company matches 100% of the first 2% and 50% of the next 4% of the employees’ contributions up to a maximum Company match of 4%. In addition, the Company contributes $250 semi-annually to each eligible employee. The Company contributions vest depending upon an employee’s length of service. Company contributions to the Utility Plan were approximately $395,000, $358,000 and $309,000 in 2002, 2001 and 2000, respectively. The assets of the Utility Plan are invested at the discretion of the individual employees in mutual funds consisting of stocks, bonds, and money market investments. The Utility Plan does not allow employees participating in the Utility Plan to purchase Southwest Water stock. During 2002, the Utility Plan was identified as a qualified replacement plan and amended to permit the excess assets of the Pension Plan to be placed in a suspense account. The amount currently held in the suspense account will be used for company contributions to the Utility Plan as permitted by the IRS, ERISA and the DOL.

In connection with its acquisition of Master Tek, Southwest Water maintained a 401(k) plan for employees of Master Tek. In 2002, the Master Tek Plan was merged into the Utility Plan.

In connection with its acquisition of OpTech, Southwest Water maintained a 401(k) plan for employees of OpTech (the OpTech Plan). Employees become eligible for participation in the OpTech Plan after six months of employment. OpTech matches 20% of the first 5% of the employees’ contributions. OpTech contributions vest depending upon an employee’s length of service. OpTech contributed approximately $11,000 in 2002 and $6,000 for the four months ended December 31, 2001.

Supplemental Executive Retirement Plan (SERP): The Company adopted the SERP effective May 8, 2000. Eligibility to participate in the SERP is determined by Southwest Water’s Board of Directors. Two executive officers of the Company were selected to participate in the SERP. Under the SERP, a vested participant with five to 10 years of service will be eligible for a yearly benefit for his or her lifetime beginning at age 65 equal to: (1) the participant’s average annual compensation multiplied by (2) the applicable compensation percentage, as defined by the SERP, less (3) the social security benefit and less (4) benefits received under the Pension Plan. The Pension Plan was terminated on December 30, 1999. Expenses relating to the SERP were approximately $206,000, $218,000 and $215,000 in 2002, 2001 and 2000, respectively.

NOTE 13. SEGMENT INFORMATION

Under SFAS No. 131, Segment Reporting, Southwest Water has two reportable segments: Services Group and Utility Group operations. The Services Group operates and manages water and wastewater treatment facilities owned by cities, public agencies, municipal utility districts and private entities. Revenue is derived through municipal utility district contracts and operations and maintenance contracts. Also included in the Services Group are construction operations and submetering operations. Utility submetering involves the installation of electronic equipment in various multi-family dwellings to allow an allocation of water, gas and electric usage to each individual residential unit. Revenue is derived through contracts with the dwelling owners.

The Utility Group provides water and wastewater services through regulated utility operations, and derives revenue from the sales of water and wastewater services to the consumer under regulated pricing structures.

Southwest Water’s reportable segments are strategic business units that offer different services. They are managed separately since each business requires different operating and marketing strategies. The Services Group, while subject to certain environmental standards, is not regulated in its pricing, marketing or rates of return. The Utility Group is governed by the regulatory bodies of the respective states and by the federal government. The service areas in which the Utility Group operates constitute monopolies with allowable rates of return determined by state regulatory agencies. The accounting policies of the segments are described in the summary of significant accounting policies in Note 1.

The following table presents information about each reported segment profit or loss and segment assets. These items are the measures reported to the chief operating decision-maker for purposes of making decisions about allocating resources to the segment and assessing its performance.

										Services Group			Utility Group			Total Segment Information			Other			Total Consolidated Information

										(in thousands)
As of December 31, 2002
Total revenues(1)										$	78,833		$	51,967		$	130,800		$	—		$	130,800
Interest income											146			115			261			4			265
Interest expense											410			2,324			2,734			1,760			4,494
Depreciation and amortization											1,624			4,650			6,274			106			6,380
Segment operating profit											1,868			14,137			16,005			(5,231	)		10,774
Income tax provision (benefit)											260			4,185			4,445			(1,232	)		3,213
Gain on sales of land											—			119			119			—			119
Other income (expense)											(95	)		1,635			1,540			1,011			2,551
Other significant non-cash items:
									Non-cash contributions in aid of construction		—			9,015			9,015			—			9,015
								Segment assets			63,706			199,537			263,243			5,501			268,744
							Expenditures for segment assets				3,108			31,399			34,507			95			34,602
As of December 31, 2001
Total revenues(1)										$	66,476		$	49,071		$	115,547		$	—		$	115,547
Interest income											645			—			645			10			655
Interest expense											(169	)		2,539			2,370			1,324			3,694
Depreciation and amortization											1,563			4,438			6,001			59			6,060
Segment operating profit											2,215			14,756			16,971			(5,240	)		11,731
Income tax provision (benefit)											705			3,715			4,420			(881	)		3,539
Other income (expense)											205			4			209			89			298
Other significant non-cash items:
						Non-cash contributions in aid of construction					—			1,581			1,581			—			1,581
					Segment assets						48,355			172,915			221,270			3,916			225,186
				Expenditures from segment assets							3,109			13,419			16,528			61			16,589
As of December 31, 2000
Total revenues(1)										$	60,425		$	44,316		$	104,741		$	—		$	104,741
Interest income											33			69			102			165			267
Interest expense											(90	)		3,136			3,046			606			3,652
Depreciation and amortization											1,193			3,990			5,183			81			5,264
Segment operating profit											2,863			12,938			15,801			(4,762	)		11,039
Income tax provision (benefit)											784			3,130			3,914			(810	)		3,104
Gain on sales of land											—			128			128			—			128
Other income (expense)											(51	)		(6	)		(57	)		218			161
Other significant non-cash items:
			Non-cash contributions in aid of construction								—			3,085			3,085			—			3,085
		Segment assets									29,950			164,351			194,301			2,351			196,652
	Expenditures										1,216			9,470			10,686			82			10,768

(1)	Total revenues include both revenues from external customers and intersegment transactions. Intersegment revenues were $9,470, $5,876 and $5,373 for 2002, 2001 and 2000, respectively. These intersegment revenues are properly included and not eliminated in accordance with SFAS No. 71.

NOTE 14. COMMITMENTS AND CONTINGENCIES

In September 2002, one of the Servicer Group companies was named as a defendant in a lawsuit alleging wrongful death as the result of a chlorine gas leak that occurred in July 2000 at one of the facilities in Mississippi that we operate under an O&M contract. The decedent who was exposed to the gas leak was treated and released from the hospital on the day following the gas leak. He subsequently died eleven months later of causes that we believe are unrelated to the chlorine gas exposure. Southwest Water denies any wrongdoing and is vigorously defending against the claim. The Company’s umbrella liability insurance carrier is currently absorbing the costs of defense of the lawsuit; however, the Company cannot predict the outcome of this lawsuit. Based upon information available at this time, however, this action is not expected to have a material adverse effect on the Company’s financial position, results of operations or cash flows.

The Company was named as a defendant in three lawsuits filed in 1998 alleging injury and damages as the result of a sewage spill which occurred at an Austin, Texas sewage pumping station operated by us. A cross-complaint was subsequently filed and served on us by the City of Brushy Creek, Texas. In 2001, a settlement was reached with two of the plaintiffs and a third suit was settled in 2002. Southwest Water expects the cross-complaint to be settled in 2003. The Company’s subsidiary named in the complaint has been defended and indemnified by the Company’s insurance carrier and will be required to pay a $10,000 deductible on settlement of each of the claims.The Companydoes not believe these actions will have a material adverse effect on its financial position, results of operations or cash flows.

The Company has been named as a defendant in several lawsuits alleging water contamination in the Main Basin. The California Supreme Court (the Court) ruled in February 2002 that the plaintiffs cannot challenge the adequacy of the water quality standards established by the CPUC. However, the plaintiffs may sue and collect damages from the Company’s California utility and other regulated water companies if they prove that water delivered did not meet CPUC water quality standards. The Court directed that the cases be sent to the trial court for further proceedings. Southwest Water believes that its California utility has complied with CPUC water quality standards and the Company is vigorously defending against these claims. The Company has requested defense and indemnification from its liability insurance carriers for these lawsuits. Several of the liability insurance carriers are currently absorbing the costs of defense of the lawsuits. All lawsuits have been consolidated before a single California Superior Court judge. Discovery is underway and Southwest Water expects, upon completion of that discovery, to obtain orders determining whether the plaintiffs are legally entitled to proceed against the Company, which plaintiffs may proceed against the Company and which claims may be prosecuted. Management cannot predict the outcome of these lawsuits. Based upon information available at this time, the Company does not expect that these actions will have a material adverse effect on its financial position, results of operations or cash flows.

Southwest Water and its subsidiaries are also the subjects of other litigation arising from the ordinary course of operations. The Company believes the ultimate resolution of such matters will not materially affect its consolidated financial position, results of operations or cash flow.

The Company leases certain equipment and office facilities under operating leases that expire through 2004. Aggregate rental expense under all operating leases approximated $3,739,000, $2,633,000 and $2,244,000 in 2002, 2001 and 2000, respectively. At December 31, 2002, the future minimum rental commitments under existing non-cancellable operating leases are as follows: 2003 - $3,642,000, 2004 - $3,236,000, 2005 - $2,630,000, 2006 - $1,895,000 and $2,269,000 thereafter.

As part of its contract process, ECO obtains bid bonds which secure, among other things, ECO’s willingness to participate in contract discussions. The bid bonds range in value dependent upon the requirements of the potential client. Upon consummation of the contract, or cancellation of the negotiating process, the bid bond is cancelled and ECO bears no further liability. The aggregate amount of bid bonds outstanding is usually less than $500,000 at any given time. The Company also secures its performance under operating and maintenance contracts with performance and completion bonds obtained from surety companies. The aggregate amount of these bonds at December 31, 2002 was approximately $3,000,000.

On January 8, 2003, the Company obtained an unsecured line of credit facility from a commercial bank used to issue a $3,430,000 standby letter of credit as collateral for performance under a service contract for the Capistrano Valley Water District (CVWD) in San Juan Capistrano, California, to manage the design and construction of a reverse

osmosis water treatment facility and associated wells. This standby letter of credit is in force for the estimated two-year construction period of the project. Upon acceptance of the completed project by the CVWD, the standby letter of credit facility will be terminated.

Upon acceptance by the CVWD, this service contract also includes a 20-year operations contract. Subcontractor agreements with an engineering firm and a large construction firm are being used to fulfill significant obligations of this service contract. During 2002, the Company deferred approximately $832,000 in pre-contract costs and recognized profit under the percentage-of-completion method of accounting.

The service contract contains certain guarantees to CVWD related to the performance of the Company and its affiliate ECO, including certain liquidated damages in the event of failure on the part of the Company to perform not caused by uncontrollable circumstances as defined in the service contract. Among other things, the Company is obligated to produce from the completed plant a specified volume of treated water by December 4, 2004. In the event of a delay beyond this date, not caused by a defined uncontrollable circumstance, specified delay liquidated damages are to be paid to CVWD. To mitigate these issues, the Company has secured from its construction subcontractor both contractual liquidated damage provisions and performance and completion bonds. In addition, the Company may also be liable for liquidated damages relating to any lost payments from an agreement with a state water agency providing financial assistance to CVWD. During the 20-year operation period, the Company has made certain other guarantees to CVWD, including guarantees with respect to the quality and quantity of the finished water and the production efficiency of the facility.

As part of the financing of this project, the CVWD was successful in the sale of insured municipal bonds. The Company entered into an agreement with the bond insurer to guaranty the Company’s performance under the service contract, subject to certain liability caps to the bond insurer in the event of a default. Such liability caps will not exceed an amount equal to $6,000,000 during the construction period of the project, and afterwards, during the 20-year operation of the facility, the liability cap will not exceed an amount equal to $4,000,000 plus an amount no greater than the replacement cost of the actual reverse osmosis filtration unit within the facility estimated to be approximately $1,500,000.

NOTE 15. ACQUISITION OF BUSINESSES

In November 2002, the Company purchased a majority of the contract operations business owned by AquaSource, Inc., a wholly owned subsidiary of DQE, a publicly held investor owned utility. The acquisition extended the Company’s contract operations presence into Colorado and expanded operations in the Texas market. The purchase price consisted of approximately $10,317,000 in cash payments at closing. The acquisition was accounted for using the purchase method of accounting, and the results of Aqua Services’ operations have been consolidated with those of Southwest Water since November 22, 2002, the effective date of the transaction. The purchase price was allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of acquisition. The excess of the purchase price over the net assets acquired is approximately $5,180,000. As required under SFAS No. 141, the Company identified intangible assets and assigned part of the purchase price to such assets. Approximately $204,000 of intangible contract costs have been preliminarily identified and they are being amortized over four years using the straight-line method. The preliminary amount assigned to goodwill of approximately $4,976,000 is reflected in the other assets of Southwest Water as of December 31, 2002. This amount, as finalized, will be reviewed annually for impairment pursuant to SFAS No. 142.

In August 2001, the Company purchased 90% of the outstanding common stock of OpTech for $8,248,000. This acquisition reinforced the Company’s presence in the contract operations industry and extended its client base to the East coast. The purchase price consisted of cash payments of $3,530,000 in August 2001 and $418,000 in January 2002. In addition, the purchase price included 91,981 shares of Southwest Water common stock with a market value of $1,300,000 and promissory notes in the aggregate amount of $3,000,000. Under the terms of the purchase agreement, the Company has the right to acquire the remaining 10% of OpTech after a period of five years based on a formula relating to the profitability of OpTech. After two years, the minority shareholder has the option to sell the remaining 10% of OpTech to the Company using the same formula. The Company also entered into an employment agreement and a non-compete agreement with the owner of the remaining 10% of OpTech. The acquisition was accounted for using the purchase method of accounting, and the results of OpTech’s operations have been consolidated with those of Southwest Water since September 1, 2001, the effective date of the transaction. The purchase price was allocated to the assets acquired and the liabilities assumed based on their estimated fair value at

the date of acquisition. The excess of the purchase price over the net assets acquired is approximately $8,000,000. As required under SFAS No. 141, the Company identified intangible assets and assigned part of the purchase price to such assets. Approximately $1,100,000 of intangible contract costs were identified and they are being amortized over four years using the straight-line method. The remaining goodwill of approximately $6,900,000 is reflected in the other assets of Southwest Water as of December 31, 2002, and will be reviewed annually for impairment pursuant to SFAS No. 142.

In April 2000, the Company purchased 80% of the outstanding common stock of Master Tek for $4,000,000. This acquisition leveraged the Company’s expertise in billing and collection services and extended the Company’s market into the submetering industry. The purchase price consisted of $2,000,000 in cash and a $2,000,000 ten-year promissory note. The purchase agreement provides that the Company has the right to acquire the remaining 20% ownership for a price based on a formula related to the future financial performance of Master Tek over the next seven years. Under the terms of the purchase agreement, the minority owner of Master Tek may require us to purchase his initial 20% minority interest in 5% increments at a price based on a formula but not less than $1,000,000 per year over a four-year period commencing in April 2002. In April 2002, the Company paid $1,000,000 to the minority owner for an additional 5% interest in Master Tek in accordance with the purchase agreement, thereby increasing our ownership to 85%. In February 2003, the minority owner exercised his right to require Southwest Water to purchase an additional 5% interest in Master Tek, which will increase the Company’s ownership to 90%. The Company may be required to purchase the remaining 10% minority interest over the course of the next two years.

The acquisition was accounted for using the purchase method of accounting, and the results of Master Tek’s operations have been consolidated with those of Southwest Water since April 3, 2000, the effective date of the transaction. The purchase price was allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of acquisition. The excess of the purchase price over the net assets acquired is approximately $3,900,000. Beginning at the date of the purchase, the goodwill was being amortized over 15 years using the straight-line method. In accordance with the requirements of SFAS No. 141, the Company was required to identify intangible assets and assign part of the purchase price to such assets, if any. The remaining goodwill of approximately $2,900,000 is reflected in the other assets of Southwest Water as of December 31, 2002, and will be reviewed annually for impairment pursuant to SFAS No. 142.

In February 2000, Suburban purchased the City of West Covina’s water distribution system and facilities for $8,500,000. This acquisition expanded Suburban’s service area in California. The transaction added approximately 7,000 connections to Suburban’s existing customer base. Net proceeds of $3,900,000 from the sale of land completed in 1999 were used to pay a portion of the purchase price in completion of an IRS like-kind exchange. The remaining purchase price was funded by borrowing on the Company’s lines of credit. The acquisition was treated as a purchase for accounting purposes and the results of West Covina’s operations have been consolidated with those of Southwest Water since February 26, 2000, the effective date of the transaction. The excess of cost over assets acquired was allocated to utility plant and certain costs were capitalized as a part of the transaction.

In 1996, the Company acquired a 49% interest in Windermere, and in October 2000, the Company purchased an additional 31% of Windermere from the former majority owner. The Company also purchased 100% of Hornsby. This transaction expanded the Company’s utility operations into the Texas market. The acquisition was accounted for using the purchase method, and the results of Windermere’s and Hornsby’s operations have been consolidated with those of Southwest Water since October 1, 2000, the effective date of the transaction. The purchase was made for $4,000,000 of Southwest Water common stock, and was allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of acquisition. The purchase agreement provides that the Company has the right to acquire the remaining 20% ownership in Windermere at any point in time when the market value of the Company’s stock increases to $18.14 per share (as adjusted for stock splits and dividends), for a purchase price of $6,000,000 payable in Company common stock. The minority owner of Windermere has the right to require the Company to purchase the remaining 20% after October 1, 2005, for $6,000,000 payable in Company common stock, subject to a limitation on the maximum and minimum number of shares issuable.

At December 31, 2002, the gross carrying amount of intangible contract costs was approximately $1,303,000, and accumulated amortization of these contracts was approximately $366,000.

Amortization expense for intangible contract costs for the year ended December 31, 2002 was approximately $275,000. At December 31, 2002, the future estimated amortization expense is as follows: 2003 - $326,000, 2004 - $326,000, 2005 - $234,000, 2006 - $51,000 and none thereafter.

The changes in the carrying amount of goodwill for the year ended December 31, 2002 are as follows:

	Services Group Segment		Utility Group Segment		Totals

	(in thousands)
Balance as of January 1, 2002	$	12,985	$	—	$	12,985
Goodwill acquired during the year		7,187		—		7,187
Impairment losses		—		—		—

Balance as of December 31, 2002	$	20,172	$	—	$	20,172

The following table indicates the impact of goodwill amortization on earnings for the years ended December 31, 2002, 2001 and 2000:

	2002		2001		2000

	(in thousands)
Net income available for common shares, as reported	$	5,975	$	5,424	$	4,812
Add back goodwill amortization (1)		—		140		103

Net income available for common shares, as adjusted	$	5,975	$	5,564	$	4,915

(1) Net of income taxes

There was no goodwill impairment as of December 31, 2002, 2001 and 2000.

NOTE 16. SELECTED QUARTERLY FINANCIAL INFORMATION (Unaudited)

The fluctuations in revenues and operating income among quarters reflect the seasonal nature of the Company’s operations. Earnings per basic and diluted common share reflect a 5% stock dividend on January 1, 2003, a 5% stock dividend on October 1, 2001 and a 5-for-4 stock split in the form of a stock dividend on January 1, 2001. Selected unaudited quarterly consolidated financial information of the Company is presented in the tables below.

2002 Quarters Ended

March 31

June 30

September 30

December 31

(in thousands except per share amounts)

Revenues

28,168

32,746

34,574

35,312

Operating income

1,943

1,893

3,663

3,274

Net income

1,164

1,708

1,720

1,410

Net income available for common shares

1,157

1,701

1,714

1,403

Basic earnings per common share

0.12

0.18

0.14

Diluted earnings per common share

0.11

0.16

0.17

0.14

2001 Quarters Ended		March 31		June 30		September 30		December 31

		(in thousands except per share amounts)
Revenues		$	23,215	$	27,838	$	32,035	$	32,459
Operating income			1,700		2,746		4,295		2,990
Net income:
	Restated for adoption of SFAS No. 123		417		1,532		2,038		1,464
	Previously reported, as adjusted		509		1,607		2,163		1,663
Basic earnings per common share:
	Restated for adoption of SFAS No. 123		0.04		0.17		0.21		0.15
	Previously reported, as adjusted		0.05		0.17		0.23		0.17
Diluted earnings per common share:
	Restated for adoption of SFAS No. 123		0.04		0.16		0.20		0.15
	Previously reported, as adjusted		0.05		0.16		0.22		0.16

See Note 2 for a full discussion of the adjustments to 2002 and 2001 net income and earnings per common share.

NOTE 17. SUBSEQUENT EVENT

On March 17, 2003, the Company entered into an agreement to amend one of its lines of credit under which the bank increased the Company’s line of credit capacity by $4,000,000 through December 31, 2003.

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

PART III

Item 10.

Directors and Executive Officers of the Registrant

Information required by this Item relating to the directors of the Company is set forth in the Company’s definitive Proxy Statement for the Company’s 2003 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission (Commission), under the caption “Governance of the Company,” and is hereby incorporated by reference. In addition, information appearing under the heading “Section 16(a) Beneficial Ownership Reporting Compliance” is contained in the Company’s definitive Proxy Statement, dated on or about April 11, 2003, and is also hereby incorporated by reference.

Item 11.

Executive Compensation

Information required by this Item related to executive compensation is contained in the Company’s definitive Proxy Statement for the Company’s 2003 Annual Meeting of Stockholders, to be filed with the Commission, under the captions “Executive Compensation” and “Director Compensation,” and is hereby incorporated by reference.

Item 12.

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

Information required by this Item with respect to security ownership of certain beneficial owners and management of the Company’s voting securities is set forth in the Company’s definitive Proxy Statement for the Company’s 2003 Annual Meeting of Stockholders, to be filed with the Commission, under the caption “Beneficial Ownership of the Company’s Securities,” and is hereby incorporated by reference.

In addition, information required by this Item is contained in the Company’s definitive Proxy Statement for the Company’s 2003 Annual Meeting of Stockholders to be filed with the Commission, under the caption “Equity Compensation Plan,” and is hereby incorporated by reference.

Item 13.

Certain Relationships and Related Party Transactions

None.

Item 14.

Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Company completed its evaluation.

PART IV

Item 15.

Exhibits, Financial Statement Schedules and Reports on Form 8-K

			Page

(a)(1) The financial statements listed below are filed in Part II of this report:

	Independent Auditors’ Report

	Consolidated Statements of Income - Three Years Ended December 31, 2002

	Consolidated Balance Sheets- December 31, 2002 and 2001

	Consolidated Statements of Changes in Stockholders’ Equity – Three Years Ended December 31, 2002

	Consolidated Statements of Cash Flows - Three Years Ended December 31, 2002

	Notes to Consolidated Financial Statements

(a)(2) The supplementary financial statement schedules required to be filed with this report are as follows:

		Schedule I – Condensed Financial Information of Registrant	70
		Schedule II – Valuation and Qualifying Accounts	75

		Schedules not listed above are omitted because of the absence of conditions under which they are required, or because the information required by such omitted schedules is included in the consolidated financial statements or notes thereto.

(a)(3) Exhibit Index			76

(b)	Reports on Form 8-K:(b)

	There were no reports on Form 8-K filed during the three months ended December 31, 2002.

SOUTHWEST WATER COMPANY
SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT

Statements of Operations

	For the Years Ended December 31,

	2002			2001			2000

	(in thousands)
Revenues	$	—		$	—		$	—
Expenses:
Selling, general and administrative		2,538			1,836			2,092

		2,538			1,836			2,092

Operating Loss		(2,538	)		(1,836	)		(2,092	)
Other Income (Expense):
Interest expense		(1,137	)		(852	)		(800	)
Interest income		4			15			165
Other		1,011			(1	)		218

		(122	)		(838	)		(417	)

Loss Before Income Taxes		(2,660	)		(2,674	)		(2,509	)
Income Tax Benefit		1,246			881			810

Net Loss Before Equity in Net Income of Subsidiaries		(1,414	)		(1,793	)		(1,699	)
Equity in Net Income of Subsidiaries		7,416			7,244			6,538

Net Income	$	6,002		$	5,451		$	4,839

See accompanying notes to condensed financial information of registrant.

SOUTHWEST WATER COMPANY
SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT

Balance Sheets

	As of December 31,

		2002		2001

	(in thousands)
Assets
Current Assets:
Cash and cash equivalents	$	664	$	192
Receivable from subsidiaries, net		10,704		21,545
Other current assets		4,418		1,073

		15,786		22,810
Property, plant and equipment, net		533		547
Investments in subsidiaries and affiliates		77,150		60,261
Deferred income taxes		2,100		2,207
Other assets		2,281		4,740

	$	97,850	$	90,565

Liabilities and Stockholders’ Equity
Current Liabilities:
Other current liabilities	$	3,324	$	4,845

Long-term debt – convertible subordinate debentures		19,732		20,000
Long-term bank lines of credit		11,000		9,663
Other liabilities		1,957		339

Total Liabilities		36,013		34,847
Stockholders’ Equity:
Cumulative preferred stock		513		513
Common stock		98		92
Paid-in capital		42,787		40,521
Retained earnings		18,439		14,592

Total Stockholders’ Equity		61,837		55,718

	$	97,850	$	90,565

See accompanying notes to condensed financial information of registrant.

SOUTHWEST WATER COMPANY
SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT

Statements of Cash Flows

							For the Years Ended December 31,

							2002			2001			2000

							(in thousands)
Cash Flows from Operating Activities:
Net income							$	6,002		$	5,451		$	4,839
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
						Net income from subsidiaries		(7,416	)		(7,244	)		(6,538	)
						Depreciation and amortization		106			59			81
						Deferred income taxes		107			(236	)		(410	)
						Other current assets		(3,345	)		4,507			(3,382	)
						Other current liabilities		(1,521	)		(454	)		2,590
						Other, net		5,936			(1,220	)		(267	)

Net cash provided by (used in) operating activities								(131	)		863			(3,087	)

Cash Flows from Investing Activities:
					Acquisition of businesses			(10,317	)		(3,880	)		(6,980	)
					Purchase of minority interest			(2,000	)		—			—
				Additions to property, plant and equipment				(95	)		(61	)		(82	)
				Dividends received from subsidiaries				2,005			2,793			1,569
				Other investments, net				(188	)		—			—

Net cash used in investing activities								(10,595	)		(1,148	)		(5,493	)

Cash Flows from Financing Activities:
			Net borrowings on (repayments of) bank lines of credit					1,337			(3,188	)		8,042
			Net change in intercompany balances					10,841			(15,277	)		1,655
		Net proceeds from dividend reinvestment, employee stock purchase and stock option plans						1,168			797			574
		Dividends paid						(2,142	)		(1,981	)		(1,646	)
		Conversion of debentures						(268	)		—			—
	Gross proceeds from issuance of debentures							—			20,000			—

Net cash provided by financing activities								10,936			351			8,625

Net increase in cash and cash equivalents								472			66			45
Cash and cash equivalents at beginning of year								192			126			81

Cash and cash equivalents at end of year							$	664		$	192		$	126

See accompanying notes to condensed financial information of registrant.

SOUTHWEST WATER COMPANY
NOTES TO SCHEDULE I CONDENSED FINANCIAL INFORMATION OF REGISTRANT

Basis of Presentation: In accordance with the requirements of Regulation S-X of the Securities and Exchange Commission, the financial statements of the Registrant are condensed and omit many disclosures presented in the consolidated financial statements and the notes thereto.

Long-Term Debt: During 2001, the Registrant issued $20,000,000 in long-term convertible subordinate debentures. The debentures bear a fixed interest rate of 6.85% percent and mature in 2021. The Registrant had outstanding borrowings on long-term bank lines of credit of approximately $11,000,000 and $9,663,000 as of December 31, 2002 and 2001, respectively.

Termination of Defined Benefit Plan:Prior to December 30, 1999, the Registrant had a non-contributory defined benefit pension plan (the Pension Plan) for employees of the parent company, Suburban and NMUI. On August 5, 1999, the Company’s Board of Directors adopted a resolution to terminate the Pension Plan, freeze the assets of the Pension Plan and cease all benefit accruals as of December 30, 1999. In connection with the termination of the Pension Plan, the Company amended the Pension Plan benefit calculation and enhanced its current defined contribution plan, covering employees of the parent company, Suburban and NMUI. The Company applied for an Internal Revenue Service (IRS) determination in April 2000, and received a favorable determination from the IRS in September 2001, thereby permitting the Company to proceed with the Pension Plan termination. In January 2002, the net assets of the Pension Plan were distributed to plan participants as permitted by the Employee Retirement Income Security Act (ERISA) and its related regulations. Following distribution of the plan assets of approximately $14,400,000 to meet the benefit liabilities of the pension plan, and settlement of expenses paid by the Pension Plan in accordance with ERISA and its related regulations, the Pension Plan had excess assets of approximately $1,150,000.

Acquisition of Business: In November 2002, the Company purchased a majority of the contract operations business owned by AquaSource, Inc., a wholly owned subsidiary of DQE, a publicly held investor owned utility. The name of the company was changed to Aqua Services upon closing of the transaction. The purchase price consisted of approximately $10,317,000 in cash payments at closing. The acquisition was accounted for using the purchase method of accounting, and the results of Aqua Services’ operations have been consolidated with those of the Registrant since November 22, 2002, the effective date of the transaction. The purchase price was allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of acquisition. The excess of the purchase price over the net assets acquired is approximately $5,180,000. As required under SFAS No. 141, the Company identified intangible assets and assigned part of the purchase price to such assets. Approximately $204,000 of intangible customer relationships have been preliminarily identified and they are being amortized over four years using the straight-line method. The preliminary amount assigned to goodwill of approximately $4,976,000 is reflected in the other assets of Southwest Water as of December 31, 2002. This amount, as finalized, will be reviewed annually for impairment pursuant to SFAS No. 142.

Adjustment Related to Stock Option Accounting: Effective in 2002, Southwest Water retroactively adopted the fair value based method of accounting for stock options as outlined in SFAS No. 123. Accordingly, all prior periods presented have been restated to reflect compensation cost that would have been recognized under the fair value based accounting method for all options granted, modified or settled in fiscal years beginning after December 15, 1994.

The amounts the Company previously reported in its Annual Reports on Form 10-K included the tax benefit from stock options exercised as a credit to the provision for income taxes. This benefit for options exercised should have been reported as an increase to paid-in capital. Accordingly, the amounts previously reported have been adjusted to properly account for this tax benefit. These adjustments had the effect of reducing net income by $301,000, $167,000 and $162,000 for 2001, 2000 and 1999, respectively, and reducing both basic and diluted EPS by $0.03, $0.02 and $0.02 for each of these respective years compared to the amounts previously reported in the Company's Annual Reports on Form 10-K. These non-cash tax adjustments to net income have no effect upon the Company's cash flows, ability to pay dividends, current income tax liability or total stockholders' equity.

See Notes 2, 11 and 16 to the accompanying consolidated financial statements for more complete disclosure.

Contingencies: Southwest Water is the subject of litigation arising from the ordinary course of operations. The Company believes the ultimate resolution of such matters will not materially affect its financial position, results of operations or cash flow.

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS

	For the Years Ended December 31, 2002, 2001 and 2000

	Balance at Beginning of Year		Provision Charged to Income		Recoveries/ Acquisitions/ Other		Accounts Written off			Balance at End of Year

2002
Allowance for Doubtful Accounts	$	1,667	$	372	$	529	$	(531	)	$	2,037

2001
Allowance for Doubtful Accounts	$	1,468	$	236	$	—	$	(37	)	$	1,667

2000
Allowance for Doubtful Accounts	$	1,202	$	340	$	50	$	(124	)	$	1,468

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
EXHIBIT INDEX

Exhibit No. and Applicable Section of Item 601 of Regulation S-K:

2	Agreement and Plan of Merger of Registrant dated May 25, 1988 (incorporated by reference to Exhibit 2 to Registrant’s Form 10-K Report for the year ended December 31, 1988).

3.1	Registrant’s Restated Certificate of Incorporation dated April 4,1988 (incorporated by reference to Exhibit 3.1 to Registrant’s Form 8-B Report filed with the Commission on July 5, 1988).

3.1B	Certificate of Amendment of Article Four of Articles of Incorporation dated March 30, 1995 (incorporated by reference to Exhibit 3.1B to Registrant’s Form 10-Q Report for the quarter ended March 31, 1995).

3.1C	Certificate of Amendment of Restated Certificate of Incorporation dated June 4, 1998 (incorporated by reference to Appendix A of Registrant’s 1998 Proxy Statement filed with the Commission on April 20, 1998).

3.1D	Certificate of Correction of Amendment of Restated Certificate of Incorporation dated September 14, 1998 (incorporated by reference to Exhibit 3.1D of Registrant’s Form 10-K Report for the year ended December 31, 1999).

3.1E	Certificate of Designation of Series E Convertible Preferred Stock Of Southwest Water Company dated January 12, 2000 (incorporated by reference to Exhibit 3.1E of Registrant’s Form 10-K Report for the year ended December 31, 1999).

3.2	Registrant’s Bylaws as amended April 4, 1988 (incorporated by reference to Exhibit 3.2 to Registrant’s Form 8-B Report filed with the Commission on July 5, 1988).

3.2A	Amendment to Registrant’s Bylaws dated March 15, 1991 (incorporated by reference to Exhibit 3.2A to Registrant’s Form 10-K Report for the year ended December 31, 1990).

3.2B	Amendment to Registrant’s Bylaws dated June 27, 1995 (incorporated by reference to Exhibit 3.2B to Registrant’s Form 10-K Report for the year ended December 31, 1995).

3.2C	Amendment to Registrant’s Bylaws dated December 12, 1996 (incorporated by reference to Exhibit 3.2C to Registrant’s Form 10-K Report for the year ended December 31, 1996).

3.2D	Amended and Restated Bylaws of Southwest Water Company dated May 18, 2001, (incorporated by reference to Exhibit 3.2D to Registrant’s Form 10-K Report for the year ended December 31, 2001).

4.1	Indenture of Mortgage and Deed of Trust between Suburban Water Systems and U.S. Bank National Association, formerly First Trust of California, N.A. dated October 1, 1986 (incorporated by reference to Exhibit 4.3 to Registrant’s Form 10-K Report for the year ended December 31, 1986).

4.1A	First Amendment and Supplement to Indenture of Mortgage and Deed of Trust between Suburban Water Systems and U.S. Bank National Association, formerly First Trust of California, N.A. dated February 7, 1990 (incorporated by reference to Exhibit 4.2A to Registrant’s Form 10-K Report for the year ended December 31, 1989).

4.1B	Second Amendment and Supplement to Indenture of Mortgage and Deed of Trust between Suburban Water Systems and U.S. Bank National Association, formerly First Trust of California, N.A. dated January 24, 1992 (incorporated by reference to Exhibit 4.2B to Registrant’s Form 10-K Report for the year ended December 31, 1991).

4.1C	Third Amendment and Supplement to Indenture of Mortgage dated October 9, 1996, between Suburban Water Systems and U.S. Bank National Association, formerly First Trust of California, N.A. (incorporated by reference to Exhibit 4.2C to Registrant’s Form 10-K Report for the year ended December 31, 1996).

4.2	Bond Purchase Agreement dated October 1, 1986, for Suburban Water Systems (incorporated by reference to Exhibit 4.4 to Registrant’s Form 10-K Report for the year ended December 31, 1986).

4.2A	Bond Purchase Agreement dated February 20, 1992, for Suburban Water Systems (incorporated by reference to Exhibit 4.3A to Registrant’s Form 10-K Report for the year ended December 31,1991).

4.2B	Bond Purchase Agreement dated October 21, 1996, for Suburban Water Systems (incorporated by reference to Exhibit 4.3B to Registrant’s Form 10-K Report for the year ended December 31, 1996).

4.3	Indenture of Mortgage dated February 14, 1992, between New Mexico Utilities, Inc., and Wells Fargo Bank, formerly Sunwest Bank of Albuquerque, N.A. (incorporated by reference to Exhibit 4.4 to Registrant’s Form 10-K Report for the year ended December 31, 1991).

4.3A	First Supplement to Indenture of Mortgage dated May 15, 1992, between New Mexico Utilities, Inc. and Wells Fargo Bank, formerly Sunwest Bank of Albuquerque, N.A. (incorporated by reference to Exhibit 4.4A to Registrant’s Form 10-K Report for the year ended December 31, 1996).

4.3B	Second Amendment and Supplement to Indenture of Mortgage dated October 21, 1996, between New Mexico Utilities, Inc. and Wells Fargo Bank, formerly Sunwest Bank of Albuquerque, N.A. (incorporated by reference to Exhibit 4.4B to Registrant’s Form 10-K Report for the year ended December 31, 1996).

4.4	Bond Purchase Agreement dated March 12, 1992, for New Mexico Utilities, Inc. (incorporated by reference to Exhibit 4.5 to Registrant’s Form 10-K Report for the year ended December 31, 1991).

4.4A	Bond Purchase Agreement dated November 8, 1996, for New Mexico Utilities, Inc. (incorporated by reference to Exhibit 4.5A to Registrant’s Form 10-K Report for the year ended December 31, 1996).

4.5	Article Four of the Restated Certificate of Incorporation of the Registrant as to the rights, preferences, privileges and restrictions of all classes of stock (incorporated by reference to Exhibit 3.1 to Registrant’s form 8-B Report filed with the Commission on July 5, 1988).

4.5A	Registration Statement for the Second Amendment to the Amended and Restated Southwest Water Company Stock Option and Restricted Stock Plan (incorporated by reference to Registrant’s Form S-8 Registration Statement filed with the Commission October 29, 1997).

4.6	Stockholder’s Rights Plan dated April 6, 1998 (incorporated by reference to the Registrant’s Form 8-K Report filed with the Commission April 23, 1998).

4.7	Indenture dated as of July 20, 2001 between the Registrant and Chase Manhattan Bank and Trust Company, National Association (incorporated by reference to Exhibit 4.8 to Registrant’s Form 10-Q Report for the quarter ended June 30, 2001).

4.8	Registration Statement for Southwest Water common stock for Operations Technologies, Inc., dated September 19, 2001 (incorporated by reference to Registrant’s Form S-3 Registration Statement filed with the Commission on September 19, 2001).

4.9	Registration Statement for Southwest Water common stock for the Dividend Reinvestment and Stock Purchase Plan dated September 26, 2001, (incorporated by reference to Registrant’s Form S-3 Registration Statement filed with the Commission on September 26, 2001).

10.1	Amended and Restated Employee Stock Purchase Plan dated May 28, 1998 (incorporated by reference to Appendix B to Registrant’s 1998 Proxy Statement filed with the Commission on April 20, 1998).

10.2	Dividend Reinvestment and Stock Purchase Plan Dated December 1, 1992 (incorporated by reference to Registrant’s Form S-3 Registration Statement filed with the Commission on December 1, 1992).

10.4	Amended and Restated Stock Option and Restricted Stock Option and Restricted Stock Plan dated November 11, 1991, and First Amendment to the Amended and Restated Stock Option and Restricted Stock Plan dated March 21, 1993 (incorporated by reference to Registrant’s Form S-8 Registration Statement filed with the Commission on December 21, 1993).

10.5	Stock Purchase Agreement and First Amendment to Stock Purchase Agreement dated August 13, 1993, between ECO Resources, Inc., and Robert E. Hebert (incorporated by reference to Exhibit 10.11 to Registrant’s Form 10-K Report for the year ended December 31, 1993).

10.6	Utility Employees’ 401(k) Plan dated January 7, 1994 (incorporated by reference to Exhibit 10.13 to Registrant’s Form 10-K Report for the year ended December 31, 1993).

10.6A	First Amendment to Utility Employees’ 401(k) Plan (incorporated by reference to Exhibit 10.8A to Registrant’s Form 10-K Report for the year ended December 31, 1994).

10.6B	Amendment to the 401(k) Retirement Savings Plan of Southwest Water Company dated January 2, 2002, (incorporated by reference to Exhibit 10.6B to Registrant’s Form 10-K Report for the year ended December 31, 2001).

10.7	Tolling Agreement between Suburban Water Systems and Aerojet dated June 20, 2000 (incorporated by reference to Exhibit 10.7 of Registrant’s Form 10-Q Report for the quarter ended June 30, 2000).

10.8	Comprehensive Amendment to the Profit Sharing 401(k) Plan for the Southwest Water Company’s Related Companies dated March 10, 1994 (incorporated by reference to Exhibit 10.14 to Registrant’s Form 10-K Report for the year ended December 31, 1993).

10.8A	First Amendment to the Profit Sharing 401(k) Plan for the Southwest Water Company’s Related Companies (incorporated by reference to Exhibit 10.9A to Registrant’s Form 10-K Report for the year ended December 31, 1994).

10.9	Severance Compensation Agreement between Registrant and certain executive officers approved by the Compensation Committee of the Board of Directors on February 21, 1995 (incorporated by reference to Exhibit 10.11 to Registrant’s Form 10-K Report for the year ended December 31, 1995).

10.9A	Severance Compensation Agreement between Registrant and certain executive officers approved by the Compensation Committee of the Board of Directors on August 5, 1998 (incorporated by reference to Exhibit 10.9A to Registrant’s Form 10-K Report for the year ended December 31, 1998).

10.9B	Severance Compensation Agreement between Registrant and a certain executive officer approved by the Compensation Committee of the Board of Directors on August 31, 2001 (incorporated by reference to Exhibit 10.9B to Registrant’s Form 10-Q Report for the quarter ended June 30, 2002).

10.10	Equity Investment Agreement dated May 23, 1996, between the Registrant and RTNT, Inc., covering Windermere Utility Company, together with two First Refusal Agreements and Call Purchase Agreements between the Registrant and RTNT, Inc. (incorporated by reference to Exhibit 10.12 to Registrant’s Form 10-K Report for the year ended December 31, 1996).

10.11	Credit Agreement between Registrant and Bank of America, N.A. dated July 30, 1999 (incorporated by reference to Exhibit 10.11 to Registrant’s Form 10-K Report for the year ended December 31, 1999).

10.11A	First Amendment to Credit Agreement dated June 30, 2000 between Registrant and Bank of America, N.A. (incorporated by reference to Exhibit 10.11A to Registrant’s Form 10-Q Report for the quarter ended June 30, 2000).

10.11B	Second Amendment to Credit Agreement dated September 29, 2000 between Registrant and Bank of America, N.A. (incorporated by reference to Exhibit 10.11B to Registrant’s Form 10-Q Report for the quarter ended September 30, 2000).

10.11C	Third Amendment to Credit Agreement dated March 9, 2001 between Registrant and Bank of America, N.A. (incorporated by reference to Exhibit 10.11C to Registrant’s Form 10-Q Report for the quarter ended March 31, 2001).

10.11D	Fourth Amendment to Credit Agreement dated July 13, 2001 between Registrant and Bank of America, N.A. (incorporated by reference to Exhibit 10.11D to Registrant’s Form 10-Q Report for the quarter ended June 30, 2001).

10.11E	Fifth Amendment to Credit Agreement dated October 22, 2001 between Registrant and Bank of America, N.A. (incorporated by reference to Exhibit 10.11E to Registrant’s Form 10-Q Report for the quarter ended June 30, 2002).

10.11F	Sixth Amendment to Credit Agreement dated November 9, 2001 between Registrant and Bank of America, N.A. (incorporated by reference to Exhibit 10.11F to Registrant’s Form 10-Q Report for the quarter ended June 30, 2002).

10.11G	Seventh Amendment to Credit Agreement dated November 1, 2002 between Registrant and Bank of America, N.A., filed herewith.

10.11H	Reimbursement Agreement dated January 8, 2003 between Registrant and Bank of America, N.A. filed herewith.

10.11I	Eighth Amendment to Credit Agreement dated March 14, 2003 between Registrant and Bank of America, N.A., filed herewith.

10.12	Credit Agreement between Suburban Water Systems and Bank of America, N.A. dated July 30, 1999 (incorporated by reference to Exhibit 10.12 to Registrant’s Form 10-K Report for the year ended December 31, 1999).

10.12A	First Amendment to Credit Agreement dated March 8, 2000 between Suburban Water Systems and Bank of America, N.A., (incorporated by reference to Exhibit 10.12A to Registrant’s Form 10-K Report for the year ended December 31, 2001).

10.12B	Second Amendment to Credit Agreement dated September 29, 2000 between Suburban Water Systems and Bank of America, N.A. (incorporated by reference to Exhibit 10.12B to Registrant’s Form 10-Q Report for the quarter ended September 30, 2000).

10.12C	Third Amendment to Credit Agreement dated July 13, 2001 between Suburban Water Systems and Bank of America, N.A. (incorporated by reference to Exhibit 10.12C to Registrant’s Form 10-Q Report for the quarter ended June 30, 2001).

10.12D	Fourth Amendment to Credit Agreement dated September 9, 2001 between Suburban Water Systems and Bank of America, N.A. (incorporated by reference to Exhibit 10.12D to Registrant’s Form 10-Q Report for the quarter ended June 30, 2002).

10.12E	Fifth Amendment to Credit Agreement dated November 1, 2002 between Suburban Water Systems and Bank of America, N.A., filed herewith.

10.13	Amended and Restated Credit Agreement between Registrant and Mellon Bank, N.A. dated December 23, 1997 (incorporated by reference to Exhibit 10.13 to Registrant’s Form 10-K Report for the year ended December 31, 1997).

10.13A	First Amendment to the Amended and Restated Credit Agreement between Registrant and Mellon Bank, N.A. dated September 1, 1998 (incorporated by reference to Exhibit 10.13A to Registrant’s Form 10-K for the year ended December 31, 1998).

10.13B	Second Amendment to the Amended and Restated Credit Agreement between Registrant and Mellon Bank, N.A. dated September 29, 1999 (incorporated by reference to Exhibit 10.13B to Registrant’s Form 10-K Report for the year ended December 31, 1999).

10.13C	Third Amendment to the Amended and Restated Credit Agreement dated July 19, 2000 between Registrant and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.13C to Registrant’s Form 10-Q Report for the quarter ended June 30, 2000).

10.13D	Fourth Amendment to the Amended and Restated Credit Agreement dated September 29, 2000 between Registrant and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.13D to Registrant’s Form 10-Q Report for the quarter ended September 30, 2000).

10.13E	Fifth Amendment to the Amended and Restated Credit Agreement dated March 9, 2001 between Registrant and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.13E to Registrant’s Form 10-Q Report for the quarter ended March 31, 2001).

10.13F	Sixth Amendment to the Amended and Restated Credit Agreement dated July 13, 2001 between Registrant and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.13F to Registrant’s Form 10-Q Report for the quarter ended June 30, 2001).

10.13G	Seventh Amendment to the Amended and Restated Credit Agreement dated September 30, 2001 between Registrant and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.13G to Registrant’s Form 10-Q Report for the quarter ended June 30, 2002).

10.13H	Eighth Amendment to the Amended and Restated Credit Agreement dated September 30, 2002 between Registrant and Mellon 1^st Business Bank of California, filed herewith.

10.14	Credit Agreement between Suburban Water Systems and Mellon Bank, N.A. dated December 23, 1997 (incorporated by reference to Exhibit 10.14 to Registrant’s Form 10-K Report for the year ended December 31, 1997).

10.14A	First Amendment to the Credit Agreement between Suburban Water Systems and Mellon Bank, N.A. dated September 1, 1998 (incorporated by reference to Exhibit 10.14A to Registrant’s Form 10-K for the year ended December 31, 1998).

10.14B	Second Amendment to Credit Agreement between Suburban Water Systems and Mellon Bank, N.A. dated September 29, 1999 (incorporated by reference to Exhibit 10.14B to Registrant’s Form 10-K Report for the year ended December 31, 1999).

10.14C	Third Amendment to Credit Agreement dated July 19, 2000 between Suburban Water Systems and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.14C to Registrant’s Form 10-Q Report for the quarter ended June 30, 2000).

10.14D	Fourth Amendment to Credit Agreement dated September 29, 2000 between Suburban Water Systems and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.14D to Registrant’s Form 10-Q Report for the quarter ended September 30, 2000).

10.14E	Fifth Amendment to Credit Agreement dated July 13, 2001 between Suburban Water Systems and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.14E to Registrant’s Form 10-Q Report for the quarter ended June 30, 2001).

10.14F	Sixth Amendment to Credit Agreement dated September 30, 2001 between Suburban Water Systems and Mellon Bank, N.A. (incorporated by reference to Exhibit 10.14F to Registrant’s Form 10-Q Report for the quarter ended June 30, 2002).

10.14G	Seventh Amendment to Credit Agreement dated September 30, 2002 between Suburban Water Systems and Mellon 1^st Business Bank of California, filed herewith.

10.15	Business Loan Agreement dated December 10, 1997 between New Mexico Utilities, Inc. and First Security Bank of New Mexico, N.A. (incorporated by reference to Exhibit 10.15 to Registrant’s Form 10-K Report for the year ended December 31, 1998).

10.15A	Modification Agreement between New Mexico Utilities, Inc. and First Security Bank of New Mexico, N. A. dated April 10, 1999 (incorporated by reference to Exhibit 10.15A to Registrant’s Form 10-Q Report for the quarter ended September 30, 1999).

10.15B	Modification Agreement between New Mexico Utilities, Inc. and First Security Bank of New Mexico, N.A., dated April 10, 2000 (incorporated by reference to Exhibit 10.15B to Registrant’s Form 10-Q Report for the quarter ended March 31, 2000).

10.15C	Business Loan Agreement between New Mexico Utilities, Inc. and Bank of the West dated April 10, 2002 (incorporated by reference to Exhibit 10.15C to Registrant’s Form 10-Q Report for the quarter ended June 30, 2002).

10.16	Agreement Between Suburban Water Systems and The City of West Covina, California for the Acquisition of the City’s Water Utility System dated February 1, 2000 (incorporated by reference to Exhibit 10.16 to Registrant’s Form 10-K for the year ended December 31, 1999).

10.17	IPWC Stockholders Agreement Between Southwest Water Company, Inland Pacific Partners and Inland Pacific Water Company effective January 1, 2000 (incorporated by reference to Exhibit 10.17 to Registrant’s Form 10-K for the year ended December 31, 1999).

10.18	Limited Liability Company Agreement of Inland Pacific Development Company, LLC effective January 1, 2000 (incorporated by reference to Exhibit 10.18 to Registrant’s Form 10-K Report for the year ended December 31, 1999).

10.19	Stock Purchase Agreement between Registrant and Milton R. DiGregorio, Beverly A. DiGregorio, and the Milton R. DiGregorio and Beverly A. DiGregorio 2000 Irrevocable Family Trust dated April 3, 2000 (incorporated by reference to Exhibit 10.19 to Registrant’s Form 10-Q Report for the quarter ended March 31, 2000).

10.20	Merger Agreement and Plan of Reorganization among Registrant, SW Utility Company, RTNT, Inc., Hornsby Bend Utility Company, Inverness Utility Company, Windermere Utility Company, Inc., HB Merger Sub, Inc. and IU Merger Sub, Inc. dated October 1, 2000 (incorporated by reference to Exhibit 10.19 to Registrant’s Form 10-K Report for the year ended December 31, 2000).

10.21	Agreement and Plan of Merger between Registrant and OPT Acquisition Subsidiary, Inc., Operations Technologies, Inc., Operations Technologies Shareholder Trust and Robert W. Monette, dated August 31, 2001, (incorporated by reference to the Registrant’s Form 8-K Report filed with the Commission on September 19, 2001).

10.22	Loan Agreement among Windermere Utility Co., Inc., Registrant and Bank of the West, dated August 9, 2002, filed herewith.

10.23	LLC Purchase Agreement by and among Aqua Source, Inc., DQE, Inc. and Registrant, dated as of September 14, 2002, filed herewith.

10.24	Official Statement for $31,555,000 San Juan Basin Authority Lease Revenue Bonds (Ground Water Recovery Project) Issue of 2002 containing descriptions and summaries of various documents relating to the project, including the Service Contract for the Design, Construction, Financing and Operation of the San Juan Basin Desalter Project by and among ECO Resources, Inc., Registrant, and the Capistrano Valley Water District, Orange County, California, dated as of September 3, 2002, filed herewith.

21.1	Listing of Registrant’s subsidiaries.

23.1	Consent of KPMG LLP.

99.1	Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated March 26, 2003, filed herewith.

99.2	Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated March 26, 2003, filed herewith.

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.

SOUTHWEST WATER COMPANY

By:	/s/ ANTON C. GARNIER

	ANTON C. GARNIER President and Chief Executive Officer (Principal Executive Officer) March 26, 2003

By:	/s/ RICHARD J. SHIELDS

	RICHARD J. SHIELDS Chief Financial Officer (Principal Financial Officer) March 26, 2003

By:	/s/ THOMAS C. TEKULVE

	THOMAS C. TEKULVE Vice President Finance and Treasurer (Principal Accounting Officer) March 26, 2003

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

/s/ JAMES C. CASTLE		/s/ DONOVAN D. HUENNEKENS

JAMES C. CASTLE Director March 26, 2003		DONOVAN D. HUENNEKENS Director March 26, 2003

/s/ H. FREDERICK CHRISTIE		/s/ MAUREEN A. KINDEL

H. FREDERICK CHRISTIE Director March 26, 2003		MAUREEN A. KINDEL Director March 26, 2003

/s/ ANTON C. GARNIER		/s/ PETER J. MOERBEEK

ANTON C. GARNIER Director March 26, 2003		PETER J. MOERBEEK Director March 26, 2003

/s/ LINDA GRIEGO		/s/ RICHARD G. NEWMAN

LINDA GRIEGO Director March 26, 2003		RICHARD G. NEWMAN Director March 26, 2003

EX-10.11(G) 3 dex1011g.txt SEVENTH AMENDMENT TO CREDIT AGREEMENT EXHIBIT 10.11G SEVENTH AMENDMENT TO CREDIT AGREEMENT THIS SEVENTH AMENDMENT TO CREDIT AGREEMENT (the "Amendment"), dated for reference purposes only as of November 1, 2002, is entered into between BANK OF AMERICA, N.A., a national association ("Bank"), and SOUTHWEST WATER COMPANY, a Delaware corporation ("Borrower"). The terms of this Amendment shall be effective for all purposes retroactively to September 30, 2002. RECITAL A. Borrower and Bank have previously entered into that certain Credit Agreement dated as of July 30, 1999, as amended by that certain First Amendment to Credit Agreement dated as of June 30, 2000, that certain Second Amendment to Credit Agreement dated as of September 29, 2000, that certain Third Amendment to Credit Agreement dated as of March 9, 2001, that certain Fourth Amendment to Credit Agreement dated as of July 13, 2001, that certain Fifth Amendment to Credit Agreement dated as of October 22, 2001, and that certain Sixth Amendment to Credit Agreement dated as of November 9, 2001, collectively, the ("Credit Agreement"), pursuant to which Bank has made certain loans and financial accommodations available to Borrower. Terms used herein without definition shall have the meanings ascribed to them in the Credit Agreement. B. Bank and Borrower amend the Credit Agreement under the terms and conditions set forth in this Amendment. Borrower is entering into this Amendment with the understanding and agreement that, except as specifically provided herein, none of Bank's rights or remedies as set forth in the Credit Agreement is being waived or modified by the terms of this Amendment. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants herein contained, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree as follows: 1. Amendments to Credit Agreement. (a) The definition of "Maturity Date" set forth in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "'Maturity Date'": September 30, 2004." (b) Section 6.02(b) of the Credit Agreement is hereby amended and restated in its entirety to read as follows: - 1 - "(b) Consolidated Tangible Net Worth. At any time, permit Consolidated Tangible Net Worth to be less than $54,000,000. 2. Effectiveness of this Amendment. Bank must have received the following items, in form and content acceptable to Bank, before this Amendment is effective and before Bank is required to extend any credit to Borrower as provided for by this Amendment. (a) Amendment. This Amendment fully executed in a sufficient number of counterparts for distribution to Bank and Borrower. (b) Authorizations. Evidence that the execution, delivery and performance by Borrower and each guarantor or subordinating creditor of this Amendment and any instrument or agreement required under this Amendment have been duly authorized. (c) Representations and Warranties. The representations and warranties set forth in the Credit Agreement must be true and correct. 3. Representations and Warranties. Borrower represents and warrants as follows: (a) Authority. Borrower has the requisite corporate power and authority to execute and deliver this Amendment and to perform its obligations hereunder and under the Loan Documents (as amended or modified hereby) to which it is a party. The execution, delivery and performance by the Borrower of this Amendment and the performance by Borrower of each Loan Document (as amended or modified hereby) to which it is a party have been duly approved by all necessary corporate action of Borrower and no other corporate proceedings on the part of Borrower are necessary to consummate such transactions. (b) Enforceability. This Amendment has been duly executed and delivered by Borrower. This Amendment and each Loan Document (as amended or modified hereby) is the legal, valid and binding obligation of Borrower, enforceable against Borrower in accordance with its terms, and is in full force and effect. (c) Representations and Warranties. The representations and warranties contained in each Loan Document (other than any such representations or warranties that, by their terms, are specifically made as of a date other than the date hereof) are correct on and as of the date hereof as though made on and as of the date hereof. (d) No Default. No event has occurred and is continuing that constitutes an Event of Default. 4. Choice of Law. The validity of this Amendment, its construction, interpretation and enforcement, the rights of the parties hereunder, shall be determined under, governed by, and construed in accordance with the internal laws of the State of California governing contracts only to be performed in that State. - 2 - 5. Counterparts. This Amendment may be executed in any number of counterparts and by different parties and separate counterparts, each of which when so executed and delivered, shall be deemed an original, and all of which. when taken together, shall constitute one and the same instrument. Delivery of an executed counterpart of a signature page to this Amendment by telefacsimile shall be effective as delivery of a manually executed counterpart of this Amendment or such Consent. 6. Due Execution. The execution, delivery and performance of this Amendment are within the power of Borrower, have been duly authorized by all necessary corporate action, have received all necessary governmental approval, if any, and do not contravene any law or any contractual restrictions binding on Borrower. 7. Reference to and Effect on the Loan Documents. (a) Upon and after the effectiveness of this Amendment, each reference in the Credit Agreement to "this Agreement", "hereunder", "hereof' or words of like import referring to the Credit Agreement, and each reference in the other Loan Documents to "the Credit Agreement", "thereof" or words of like import referring to the Credit Agreement, shall mean and be a reference to the Credit Agreement as modified and amended hereby. (b) Except as specifically amended above, the Credit Agreement and all other Loan Documents, are and shall continue to be in full force and effect and are hereby in all respects ratified and confirmed and shall constitute the legal, valid, binding and enforceable obligations of Borrower to Bank. (c) The execution, delivery and effectiveness of this Amendment shall not, except as expressly provided herein, operate as a waiver of any right, power or remedy of Bank under any of the Loan Documents, nor constitute a waiver of any provision of any of the Loan Documents. (d) To the extent that any terms and conditions in any of the Loan Documents shall contradict or be in conflict with any terms or conditions of the Credit Agreement, after giving effect to this Amendment, such terms and conditions are hereby deemed modified or amended accordingly to reflect the terms and conditions of the Credit Agreement as modified or amended hereby. 8. Ratification. Borrower hereby restates, ratifies and reaffirms each and every term and condition set forth in the Credit Agreement, as amended hereby, and the Loan Documents effective as of the date hereof. 9. Estoppel. To induce Bank to enter into this Amendment and to continue to make advances to Borrower under the Credit Agreement, Borrower hereby acknowledges and agrees that, after giving effect to this Amendment, as of the date hereof, there exists no Event of Default and no right of offset, defense, counterclaim or objection in favor of Borrower as against Bank with respect to the Obligations. - 3 - IN WITNESS WHEREOF, the parties have entered into this Amendment as of the date first above written. "BANK" "BORROWER" BANK OF AMERICA, N.A. SOUTHWEST WATER COMPANY, a national association a Delaware corporation By: /s/ JAMIE HARNEY By: /s/ RICHARD J. SHIELDS - ---------------------- --------------------------- Name: Jamie Harney Name: Richard J. Shields Title: Vice President Title: Chief Financial Officer By: /s/ THOMAS C. TEKULVE -------------------------- Name: Thomas C. Tekulve Title: Vice President - Finance - 4 - EX-10.11(H) 4 dex1011h.txt REIMBURSEMENT AGREEMENT ================================================================================ EXHIBIT 10.11H REIMBURSEMENT AGREEMENT Dated as of January 8, 2003 By and Between SOUTHWEST WATER COMPANY (the "Borrower") and BANK OF AMERICA, N.A. (the "Bank") ================================================================================ TABLE OF CONTENTS Article I. DEFINITIONS....................................... 1 1.01 Definitions.................................. 1 1.02 Accounting Terms and Determinations.......... 4 Article II. LETTER OF CREDIT.................................. 4 2.01 Issuance of the Letter of Credit............. 4 2.02 Scheduled Termination Date................... 5 2.03 Reimbursement for Draws Upon the Letter of Credit............................. 5 2.04 Obligation to Pay Unconditional.............. 5 Article III. FEES; PAYMENTS; CHANGES IN CIRCUMSTANCES.......... 6 3.01 Letter of Credit Fees........................ 6 3.02 Transaction Fees............................. 7 3.03 Computation of Fees and Interest............. 7 3.04 Payments by the Borrower..................... 7 3.05 Direct Debit................................. 7 3.06 Payment Due on Non-Business Day to be Made on Next Business Day.................... 7 3.07 Increased Costs.............................. 8 Article IV. REPRESENTATIONS AND WARRANTIES.................... 8 4.01 Existence and Power.......................... 8 4.02 Authorization; No Contravention.............. 8 4.03 Authority of Officers........................ 9 4.04 Governmental Approvals....................... 9 4.05 Taxes........................................ 9 4.06 Financial Information........................ 9 4.07 Binding Effect............................... 9 4.08 No Default................................... 10 4.09 Litigation................................... 10 4.10 Compliance with Other Agreements and Applicable Laws.............................. 10 Article V. CONDITIONS........................................ 11 5.01 Conditions Precedent to the Issuance of the Letter of Credit......................... 11 Article VI. AFFIRMATIVE COVENANTS............................. 11 6.01 Credit Agreement Covenants................... 11 6.02 Further Assurances........................... 12 i Article VII. EVENTS OF DEFAULT................................. 12 7.01 Events of Default............................ 12 7.02 Remedies..................................... 14 7.03 Rights Not Exclusive......................... 14 Article VIII. MISCELLANEOUS..................................... 14 8.01 Notices...................................... 14 8.02 Binding Agreement; Third Parties............. 15 8.03 Participations............................... 15 8.04 No Waivers................................... 16 8.05 Payment of Expenses.......................... 16 8.06 Indemnity.................................... 17 8.07 Amendment and Modification of Agreement, Waivers........................... 18 8.08 Severability................................. 19 8.09 Arbitration.................................. 19 8.10 Governing Law................................ 21 8.11 Table of Contents and Captions............... 21 8.12 Counterparts................................. 21 Exhibit A Letter of Credit ii REIMBURSEMENT AGREEMENT This Reimbursement Agreement dated as of January 8, 2003, is entered into by and between SOUTHWEST WATER COMPANY, a Delaware corporation (the "Borrower") and BANK OF AMERICA, N.A., a national banking association organized and existing under the laws of the United States of America (the "Bank"). WHEREAS, pursuant to that certain Service Contract for the Design, Construction, Financing and Operation of the San Juan Basin Desalter Project dated September 3, 2002 (the "Service Contract") between the Capistrano Valley Water District, Orange County, California (the "District") and ECO Resources, Inc., a Texas corporation (the "Company"), the Company has agreed to pay certain daily delay liquidated damages under certain circumstances as set forth in the Service Contract. WHEREAS, the Borrower, the parent corporation of the Company, has entered into that certain Service Contract Guaranty Agreement dated September 3, 2002 (the "Guaranty") pursuant to which Borrower has guaranteed the obligations of the Company to the District under the Service Contract. WHEREAS, to support payment of the liquidated damages under the Services Contract, the Borrower has requested that the Bank issue its irrevocable direct-pay letter of credit, in substantially the form of Exhibit A hereto, for the benefit of the District. NOW, THEREFORE, in consideration of the premises and in order to induce the Bank to issue the Letter of Credit, and intending to be legally bound hereby, the Borrower and the Bank hereby agree as follows: ARTICLE I DEFINITIONS 1.01 Definitions. In addition to the terms defined in the Whereas clauses above and elsewhere in this Agreement, the 1 following terms used in this Agreement and in any exhibits hereto shall, unless the context otherwise requires, have the following meanings: "Agreement" means this Reimbursement Agreement, as it may be amended and supplemented from time to time. "Business Day" means any day other than a Saturday, Sunday, legal holiday or a day on which banking institutions in California are authorized or required to close. "Change of Control" shall have the meaning set forth in the Credit Agreement. "Closing Date" means the date on which all conditions precedent under Paragraph 5.01 have been satisfied or have been waived by the Bank. "Code" means the Internal Revenue Code of 1986, as amended. "Credit Agreement" means that certain Credit Agreement dated as of July 30, 1999, as amended, between the Borrower and the Bank, as the same may be further amended, modified, renewed and restated from time to time. "Default," means an event which with the giving of notice or lapse of time, or both, would constitute an Event of Default. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended, and the rules and regulations issued thereunder as from time to time in effect. "Event of Default" means any of the events specified in Paragraph 7.01. "Governmental Authority" means any government, foreign or domestic, and any political subdivision thereof, any court or any foreign or domestic, federal, state, municipal or other department, commission, board, bureau, agency, public authority or instrumentality. "Governmental Requirement" means any law, ordinance, order, rule or regulation of a Governmental Authority. 2 "Indebtedness" means for any Person calculated on a consolidated basis in accordance with generally accepted accounting principles (a) all indebtedness of such Person for borrowed money or for the deferred purchase price of property; (b) all direct or indirect guaranties of such Person in respect of, and all obligations (contingent or otherwise) of such Person to purchase or otherwise acquire, or otherwise to assure a creditor against loss in respect of, indebtedness of any other Person; and (c) all obligations of such Person as lessee under leases which have been or should be in accordance with generally accepted accounting principles recorded as capital leases. In calculating Indebtedness, no amount shall be included more than once in the aggregate of the above described amounts. "Indemnified Parties" means and includes the Bank, its parent, subsidiaries and affiliated companies, assignees of any of Bank's interests in this Agreement, or any of its affiliates, and officers, directors, employees and agents of each of them. "Letter of Credit" means the letter of credit, substantially in the form of Exhibit A hereto, issued pursuant to Paragraph 2.01(a) and any letter of credit issued in substitution therefor pursuant to the terms of this Agreement, as such Letter of Credit may be amended, renewed or extended from time to time. "Person" means any individual, firm, partnership, joint venture, corporation, association, business enterprise, trust, governmental authority or other entity whether acting in an individual, fiduciary or other capacity. "Plan" means an employee benefit plan or pension plan covered by ERISA. "Prime Rate" means the rate of interest publicly announced from time to time by the Bank, as its prime rate. The Prime Rate is a rate set by the Bank based upon various factors, including the Bank's costs and desired return, general economic conditions and other factors, and is used as a reference point for pricing some loans. The Bank may price loans to its customers at, above or below the Prime Rate. Any change in the Prime Rate shall take effect at the opening of business on the day specified in the public announcement of a change in the Bank's Prime Rate. 3 "Scheduled Termination Date" means the date of termination of the Letter of Credit, being initially January 8, 2004. "Subsidiary" means a corporation of which shares of stock having ordinary voting power (other than stock having such power only by reason of the happening of a contingency) to elect a majority of the board of directors or other managers of such corporation are at the time owned, directly or indirectly through one or more intermediaries, or both, by the Borrower. 1.02 Accounting Terms and Determinations. Unless otherwise specified herein, all accounting terms used herein shall be interpreted, all accounting determinations hereunder shall be made, and all financial statements required to be delivered hereunder shall be prepared in accordance with, generally accepted accounting principles as in effect from time to time and consistently applied. ARTICLE II LETTER OF CREDIT 2.01 Issuance of the Letter of Credit. (a) Subject to the terms and conditions of this Agreement, the Bank hereby agrees on the Closing Date, upon the request of the Borrower evidenced by its execution and delivery of this Agreement, to issue its Letter of Credit in favor of the District for the account of the Borrower. The Letter of Credit shall be in a face amount not exceeding Three Million Four Hundred Thirty Thousand Dollars ($3,430,000). (b) The request for issuance of the Letter of Credit shall constitute a representation and warranty by the Borrower that as of the date of such request the representations and warranties set forth in Article IV are true and correct and that no Default or Event of Default has occurred and is continuing. (c) Subject to the terms and conditions of this Agreement, the Bank hereby agrees, at the request of the Borrower, and subject to the written consent of the District, to amend the Letter of Credit to reflect any reductions in the 4 Stated Amount of the Letter of Credit and/or any assignments of the Service Contract. 2.02 Scheduled Termination Date. The initial Scheduled Termination Date shall be January 8, 2004 and shall be automatically extended each year thereafter for an additional one year unless the Bank gives written notice to the Borrower and the District at least 120 days prior to the then current Scheduled Termination Date of its intention not to extend the Scheduled Termination Date beyond the current Scheduled Termination Date. 2.03 Reimbursement for Draws Upon the Letter of Credit. The Borrower agrees to reimburse the Bank, on each date that any amount drawn upon the Letter of Credit is honored by the Bank, for the amount of such drawing. Any other amount drawn under the Letter of Credit and any amount not paid when due under this Agreement shall bear interest until paid in full at a rate per annum equal to the sum of the Prime Rate plus four percentage points (4%). 2.04 Obligation to Pay Unconditional. (a) The Borrower's obligations to reimburse the Bank as provided herein is absolute, unconditional and irrevocable, and shall be paid strictly in accordance with the terms of this Agreement, under all circumstances whatsoever, including without limitation the following circumstances except as may be the result of the gross negligence or willful misconduct of the Bank: (i) any lack of validity or enforceability of the Letter of Credit or the Service Contract (provided payments are actually made under the Letter of Credit); (ii) any amendment or waiver of or any consent to departure from all or any of such documents; (iii) the existence of any claim, set-off, defense or other right which the Borrower may have at any time against the Company, the District, or any other Person (other than the 5 Bank), whether in connection with this Agreement, the Service Contract or any unrelated transaction; (iv) payment by the Bank under the Letter of Credit against presentation of a sight draft or certificate which complies in all material respects with the terms of the Letter of Credit but does not strictly comply therewith; (v) any demand, statement or any other document presented under the Letter of Credit proving to be forged, fraudulent, invalid or insufficient in any respect or any statement therein being untrue or inaccurate in any respect whatsoever; or (vi) any other circumstance, happening or omission whatsoever which is similar to any of the foregoing. ARTICLE III FEES; PAYMENTS; CHANGES IN CIRCUMSTANCES 3.01 Letter of Credit Fee. The Borrower shall pay to the Bank a letter of credit fee equal to two percent (2%) per annum of the Stated Amount of the Letter of Credit (as defined therein) and as reduced from time to time. The letter of credit fee shall accrue from the Closing Date to the date the Letter of Credit expires and shall be payable quarterly in advance commencing on the date of issuance of the Letter of Credit and quarterly thereafter. 3.02 Transaction Fees. The Borrower shall pay to the Bank: (a) on the date of each drawing under the Letter of Credit, a transaction fee in amount equal to Two Hundred Fifty Dollars ($250) and, if required, a wire transfer fee of Thirty-Five Dollars ($35.00); and (b) on the date of any amendment to or transfer of the Letter of Credit, an amendment or transfer fee in an amount 6 equal to Two Thousand Five Hundred Dollars ($2,500.00). 3.03 Computation of Fees and Interest. All computations of fees and interest under this Agreement shall be made on the basis of a three hundred sixty (360) day year and actual days elapsed (which results in a higher interest and higher fees than if a three hundred sixty-five (365) day year were used). Interest shall accrue during each period during which interest is computed from but excluding the first day thereof to and including the last day thereof. 3.04 Payments by the Borrower. (a) On the date of the Bank's honoring of each drawing under the Letter of Credit, the Borrower shall before 5:00 p.m. (California time) make an amount equal to the amount of such drawing available to the Bank by payment in immediately available funds. (b) Any payment received after 5:00 p.m. (California time) shall be deemed to have been received on the next Business Day. 3.05 Direct Debit (a) The Borrower agrees that interest and principal payments and any fees will be deducted automatically on the due date from the Borrower's account number 14599-07501, or such other of the Borrower's account with the Bank as designated in writing by the Borrower. The Bank shall promptly, upon receipt of notice from the District of a drawing under the Letter of Credit, notify the Borrower of the amount of such drawing and any fees incurred in connection therewith. (b) The Borrower will maintain sufficient funds in the account on the dates the Bank enters debits authorized by this Agreement to cover each debit. If there are insufficient funds in the account on the date the Bank enters any debit authorized by this Agreement, the debit will be reversed. 3.06 Payment Due on Non-Business Day to be Made on Next Business Day. If any sum becomes payable pursuant to this Agreement on a day which is not a Business Day, the date for payment thereof shall be extended, without penalty, to the next 7 succeeding Business Day, and such extended time shall be included in the computation of interest and fees. 3.07 Increased Costs. If after the date hereof any change in any law or regulation or in the interpretation thereof by any court or administrative or Governmental Authority charged with the administration thereof shall either (i) impose, modify or deem applicable any reserve, special deposit, assessment or insurance fee or similar requirement against letters of credit issued by the Bank or (ii) impose on the Bank any other condition relating to this Agreement or the Letter of Credit or affect the calculations relating to the Bank's capitalization, and the result of any event referred to in clause (i) or (ii) shall be to increase the cost to the Bank of issuing or maintaining the Letter of Credit or funding amounts drawn thereunder, then, upon demand by the Bank, the Borrower shall immediately pay to the Bank, from time to time as specified by the Bank, additional amounts which shall be sufficient to compensate the Bank for such increased cost from the date of such change, together with interest on each such amount from the date demanded until payment in full thereof at the Prime Rate plus two percent (2%). A certificate setting forth with reasonable explanations such increased cost incurred by the Bank as a result of any event mentioned in clause (i) or (ii) of this paragraph, submitted by the Bank to the Borrower, shall be conclusive, absent manifest error, as to the amount thereof. ARTICLE IV REPRESENTATIONS AND WARRANTIES The Borrower represents and warrants that: 4.01 Existence and Power. The Borrower is a corporation duly formed and existing under the law of the State of Delaware and has all governmental licenses, authorizations, consents and approvals required to carry on its business as now conducted. 4.02 Authorization; No Contravention. The execution and delivery and performance by the Borrower of this Agreement, the Guaranty and the other related documents to which it is a party is within the Borrower's powers, has been duly authorized by all necessary action and does not contravene, or constitute a 8 default under, any provision of applicable law or regulation or of its organizational papers or of any agreement, judgment, injunction, order, decree or other instrument binding upon the Borrower in any material respect or result in the creation or imposition of any lien or encumbrance on any asset of the Borrower. 4.03 Authority of Officers. The officers of the Borrower who will execute this Agreement and who have executed all other documents, instruments and agreements required to be delivered or contemplated hereunder or under the Service Contract are or will be duly authorized to execute the same. 4.04 Governmental Approvals. No order, permission, consent, approval, license or authorization by registration or filing with, or exemption by, any Governmental Authority is required by the Borrower to authorize, or is required by any Borrower in connection with, the execution, delivery and performance by the Borrower of this Agreement or under any document required under the Service Contract to which it is a party or the taking by the Borrower of any action hereby or thereby contemplated, except as have been granted and which are in full force and effect. 4.05 Taxes. The Borrower and each of its Subsidiaries has filed all tax returns and reports required to be filed and has paid all taxes shown to be due and payable on such returns and has paid all tax assessments, fees and other governmental charges upon it or its properties, income or assets otherwise due and payable except those presently payable without penalty or interest and further except those which are being contested in good faith by appropriate proceedings diligently conducted, and for which adequate reserves have been set aside in accordance with generally accepted accounting principles. 4.06 Financial Information. The financial statements of the Borrower and its consolidated Subsidiaries dated as of September 30, 2002, and the information and other data furnished by the Borrower to the Bank fairly and accurately reflect the financial condition of the Borrower and its consolidated Subsidiaries as of the date and for the periods indicated therein and have been prepared in conformity with generally accepted accounting principles. 4.07 Binding Effect. This Agreement constitutes valid and 9 binding agreement of Borrower, enforceable against Borrower in accordance with its terms, subject to the effect of applicable bankruptcy and other similar laws affecting the rights of creditors generally and the effect of equitable principles whether applied in an action at law or a suit in equity. 4.08 No Default. No material Default or any Event of Default has occurred and is continuing or would result from the obligations incurred by the Borrower hereunder or by the actions contemplated hereby. 4.09 Litigation. There are no suits, proceedings, claims or disputes pending or, to the knowledge of the Borrower, threatened against or affecting the Borrower or its property, the adverse determination of which might in any material respect affect the Borrower's financial condition or operations or impair the Borrower's ability to perform its obligations hereunder, under the Service Contract or under any instrument or agreement required hereunder or thereunder. 4.10 Compliance with Other Agreements and Applicable Laws. Neither Borrower nor any of the its Subsidiaries is in default in any material respect under, or in violation in any material respect of any of the terms of, any agreement, contract, instrument, lease or other commitment (including, but not limited to any such agreement involving the debts or investments of Borrower or liens upon its assets) to which it is a party or by which it or any of its assets are bound and Borrower and each of its Subsidiaries is in compliance in all material respects with all applicable provisions of laws, rules, regulations, licenses, permits, approvals, and orders of any Governmental Authority. The representations and warranties contained in this Article IV shall be deemed to be made by the Borrower on the date of execution of this Agreement. 10 ARTICLE V CONDITIONS 5.01 Conditions Precedent to the Issuance of the Letter of Credit. The obligation of the Bank to issue the Letter of Credit is subject to the condition precedent that on or before the Closing Date the Bank shall have received the following, in form and detail satisfactory to the Bank: (a) evidence that the execution, delivery and performance by the Borrower of this Agreement and any instrument or agreement required under this Agreement have been duly authorized; (b) certificate of good standing from the Borrower from its state of incorporation, certified as of a recent date by the Secretary of State of its state of incorporation; (c) copy of the executed Service Contract and all other documents executed or delivered in connection therewith as Bank may reasonably require; (d) the fees required by Paragraph 3.01; (e) such other evidence, documents, instruments, approvals or opinions as the Bank may reasonably request to establish the due execution of the transactions contemplated by this Agreement. ARTICLE VI AFFIRMATIVE COVENANTS The Borrower covenants and agrees, that as long as the Letter of Credit is outstanding and until the full and final payment of all indebtedness of the Borrower incurred hereunder, unless the Bank shall otherwise consent in writing: 6.01 Creditor Agreement Covenants. Borrower agrees to perform each and every covenant contained in Sections 6.01 and 6.02, inclusive, of the Credit Agreement. The above referenced covenants are hereby incorporated by reference into this 11 Agreement as in effect on the date hereof and as such covenants may be further amended, modified, waived, or in any way changed; provided, however, if the Credit Agreement is terminated for any reason, Borrower will still comply with the above-referenced covenants as they exist on the date of termination, unless otherwise agreed to in writing by the Bank. 6.02 Further Assurances. The Borrower will execute and deliver to the Bank all such documents, instruments and agreements (other than as specifically required by this Agreement) and do all such other acts and things as may be reasonably requisite to enable the Bank to exercise and enforce its rights hereunder. ARTICLE VII EVENTS OF DEFAULT 7.01 Events of Default. The following events shall constitute "Events of Default"; (a) Non-Payment. The Borrower shall fail to pay within three (3) days of the date when due any amount of principal, interest, fee or other amount payable by it hereunder; (b) Representation or Warranties. Any representation or warranty made by the Borrower in this Agreement or which is contained in any certificate, financial statement or other document delivered at any time pursuant hereto or in connection with any transaction contemplated hereby shall prove to have been incorrect in any material respect when made or deemed to be made; (c) Other Defaults. The Borrower shall fail to observe or perform any material term, provision, covenant, agreement or obligation contained in this Agreement not specifically mentioned in this Paragraph 7.01 and, with respect to any such default which by its nature can be cured, such default shall continue for a period of twenty (20) days from its occurrence; (d) Voluntary Bankruptcy; Insolvency. The Borrower shall (i) suspend or discontinue its business, or (ii) make an 12 assignment for the benefit of creditors, or (iii) generally not be paying its debts as such debts become due, or (iv) admit in writing its inability to pay its debts as they become due, or (v) file a voluntary petition in bankruptcy, or (vi) become insolvent (however such insolvency shall be evidenced), or (vii) file any petition or answer seeking for itself any bankruptcy reorganization, arrangement, composition, readjustment of debt, liquidation or dissolution or similar relief under any present or future statute, law or regulation of any jurisdiction, or (viii) petition or apply to any tribunal for any receiver, custodian or trustee for any substantial part of its property; (e) Involuntary Proceedings. An involuntary case or other proceeding shall be commenced against the Borrower seeking liquidation, reorganization or other relief with respect to it or its debts under any bankruptcy, insolvency or other similar law now or hereafter in effect or seeking the appointment of a trustee, receiver, liquidator, custodian or other similar official of it or any substantial part of its property, and such involuntary case or other proceeding shall remain undismissed and unstayed for a period of sixty (60) days; (f) Judgments. Any judgment or decree is issued in an amount exceeding Two Hundred Fifty Thousand Dollars ($250,000) not covered by insurance against the Borrower or against any of its property; (g) ERISA. Any Plan termination or any full or partial withdrawal from a Plan or Plans shall occur which could result in a material liability of the Borrower to the Pension Benefit Guaranty Corporation; (h) Material Adverse Change. A material adverse change occurs in the Borrower's financial condition, properties or prospects, or ability to repay any obligations hereunder; (i) Other Bank Agreements. The Borrower fails to meet the material conditions of, or fails to perform any material obligation under any other agreement the Borrower has with the Bank or any affiliate of the Bank and, with respect to any such default which by its nature can be cured, such default shall continue for a period of twenty (20) days from its occurrence; 13 (j) Termination of Credit Agreement. The Credit Agreement is terminated, cancelled or no longer in effect for any reason; or (k) Change of Control. A Change of Control shall have occurred. 7.02 Remedies. If any Event of Default shall have occurred: (a) The obligation of the Bank to issue, extend, amend or renew the Letter of Credit, if the Letter of Credit has not yet been issued, extended, amended or renewed, shall terminate; and/or (b) The Bank may declare all amounts due hereunder (together with accrued interest thereon) to be, and such amounts shall thereupon become, due and payable without presentment, demand, protest or notice of any kind, all of which are hereby waived by the Borrower; and/or (c) The Borrower will at the request of the Bank immediately pay to the Bank an amount equal to the aggregate amount which could be drawn under the Letter of Credit to be held by the Bank in a cash collateral account as security for the Indebtedness hereunder and the Borrower agree that such funds may be applied against the Indebtedness hereunder as the same becomes due and payable; and/or (d) The Bank may exercise all rights and remedies available to it by law or in equity. 7.03 Rights Not Exclusive. The rights provided for in this Article are cumulative and are not exclusive of any other rights, powers, privileges or remedies provided by law or in equity. ARTICLE VIII MISCELLANEOUS 8.01 Notices. All notices, requests and other communications to any party hereunder shall be in writing 14 (including cable or telex) and shall be given to such party at its address or facsimile number set forth below or such other address or facsimile number as such party may hereafter specify by notice to the Bank and the Borrower: If to the Borrower: Southwest Water Company 225 North Barranca Avenue, Suite 200 West Covina, California 91791-1605 Attn: Thomas C. Tekulve Vice President, Finance If to the Bank: Bank of America, N.A. 675 Anton Boulevard, 2nd Floor Costa Mesa, California 92626 Attn: Jamie Harney Vice President Each such notice, request or other communication shall be effective when received at the addresses specified in this Paragraph. 8.02 Binding Agreement; Third Parties. (a) This Agreement shall be binding upon and inure to the benefit of the Borrower and the Bank and their respective successors and assigns, provided that the Borrower may not assign or transfer any of its rights under this Agreement without the prior written consent of the Bank, which consent shall not be unreasonably withheld or delayed. (b) This Agreement shall not be construed so as to confer any right or benefit upon any Person other than the parties to this Agreement and their respective successors and assigns. 8.03 Participations. The Bank may at any time sell, assign, grant participations in, or otherwise transfer to any other Person (each a "Participant") all or part of the obligations of the Borrower under this Agreement. The Borrower agrees that each such disposition will give rise to a direct 15 obligation of the Borrower to the Participant. The Borrower authorizes the Bank and each Participant, upon the occurrence of an Event of Default, to proceed directly by right of setoff, banker's lien, or otherwise, against any assets of the Borrower which may be in the hands of the Bank or such Participant, respectively. The Borrower authorizes the Bank to disclose to any prospective Participant and any Participant any and all information in the Bank's possession concerning the Borrower, this Agreement. 8.04 No Waivers. No failure or delay by the Bank in exercising any right, power or privilege hereunder shall operate as a waiver thereof nor shall any single or partial exercise thereof preclude any other or further exercise thereof or the exercise of any other right, power or privilege. The rights and remedies herein provided shall be cumulative and not exclusive of any rights or remedies provided by law. 8.05 Payment of Expenses. (a) The Borrower agrees: (i) to pay or reimburse the Bank for all of its reasonable out-of-pocket costs, attorneys' fees and expenses (including, without limitation, allocated costs of in-house counsel) incurred in connection with the preparation, review and execution of, and any amendment, supplement or modification to, this Agreement, the Letter of Credit, and any other document prepared in connection herewith or therewith and the consummation of the transactions contemplated hereby and thereby; (ii) to pay the Bank's reasonable costs and expenses incurred in connection with the administration of this Agreement, including title insurance, recording and escrow charges, fees for appraisal, audit charges, and any other reasonable fees and costs for services, regardless of whether such services are furnished by the Bank's employees or agents or independent contractors. 16 (iii) to pay or reimburse the Bank for all reasonable costs and out-of-pocket expenses incurred in connection with the enforcement or preservation of any rights under this Agreement, the Letter of Credit, and any other document prepared in accordance herewith or therewith or any refinancing or restructuring of this Agreement or such other documents in the nature of a "work-out", including, out-of-pocket fees and disbursements of counsel to the Bank (including without limitation, allocated out-of-pocket costs of in-house counsel), and including any costs and attorneys fees incurred in any arbitration proceeding. (b) The obligations of the Borrower in this paragraph shall survive repayment of all disbursements made under the Letter of Credit and all other amounts payable hereunder. (c) In the event that any party hereto shall incur legal fees and costs in connection with the actual or threatened breach of any provision hereof, or to enforce any right or remedy hereunder, such party shall be entitled to recover such fees and costs from the breaching party. In the event that an action or arbitration proceeding is brought in connection with this Agreement the prevailing party shall be entitled to recover from the losing party in addition to any money judgment or other relief, such actual attorney's fees (including allocated costs of staff counsel), disbursements and costs as may be incurred by the prevailing party instituting or defending such litigation or arbitration, together with such reasonable costs and expenses as may be allowed by the court or arbitrator. In the event that any case is commenced by or against the Borrower under the Bankruptcy Code (Title 11, United States Code) or any similar or successor statute, the Bank is entitled to recover costs and reasonable attorneys' fees (including allocated costs of in-house counsel) incurred by the Bank related to the preservation, protection or enforcement of any rights of the Bank in such case. 8.06 Indemnity. (a) The Borrower agrees to indemnify and hold the Indemnified Parties harmless from and against all liabilities, 17 claims, actions, damages, costs and expenses (including all legal fees and expenses of counsel to the Indemnified Parties) arising out of or resulting from the Indemnified Parties' performance of any act permitted under this Agreement (excluding gross negligence or willful misconduct of any Indemnified Party); or breach of any representation or warranty made or given by the Borrower or any obligation of Borrower contained in this Agreement; or any claim or cause of action of any kind by any party that the Indemnified Parties are liable for any act or omission committed or made by the Borrower or any other person or entity (except the Bank) in connection with the ownership, operation or development of the Project, whether on account of any theory of derivative liability, comparative negligence or otherwise. Upon demand by the Indemnified Parties, Borrower shall defend any action or proceeding brought against the Indemnified Parties arising out of or alleging any claim or cause of action covered by this indemnity, all at Borrower's own cost and by counsel to be approved by the Indemnified Parties in the exercise of their reasonable judgment. In the alternative, the Indemnified Parties may elect to conduct its own defense, and Borrower shall pay the reasonable expenses thereof. The provisions of this paragraph shall survive the termination of this Agreement. (b) The Borrower agrees to save, indemnify and hold harmless the Indemnified Parties from and against any and all losses, claims, damages and liabilities (including liabilities for penalties) resulting from any litigation brought in connection with the issuance or sale of the Bonds, unless such liability shall be due to gross negligence or willful misconduct on the part of any Indemnified Party. (c) The Indemnified Parties shall not in any way be responsible for performance by the Trustee or any paying agent for the Bonds of its obligations to the Borrower, nor for the form, sufficiency, correctness, genuineness, authority of person signing, falsification or legal effect of any documents called for under the Letter of Credit if such documents on their face appear to be in order. 8.07 Amendment and Modification of Agreement, Waivers. No modification or waiver of any provision of this Agreement or any other document, instrument or agreement required, referred to or contemplated hereunder, nor consent to any departure by the 18 Borrower, or the Bank therefrom shall in any event be effective unless the same shall be in writing and then such waiver or consent shall be effective only in the specific instance and for the purpose for which given. No notice to or demand on either party in any case shall entitle such party to any other or further notice or demand in the same, similar or other circumstances. 8.08 Severability. In case any one or more of the provisions contained in this Agreement or any document, instrument, or agreement required hereunder should be declared invalid, illegal or unenforceable in any respect, the validity, legality and enforceability of the remaining provisions contained herein or therein shall not in any way be affected or impaired thereby. 8.09 Arbitration. (a) This paragraph concerns the resolution of any controversies or claims between the Borrower and the Bank, whether arising in contract, tort or by statute, including but not limited to controversies or claims that arise out of or relate to: (i) this Agreement (including any renewals, extensions or modifications); or (ii) any document related to this Agreement (collectively a "Claim"). (b) At the request of the Borrower or the Bank, any Claim shall be resolved by binding arbitration in accordance with the Federal Arbitration Act (Title 9, U. S. Code) (the "Act"). The Act will apply even though this Agreement provides that it is governed by the law of a specified state. (c) Arbitration proceedings will be determined in accordance with the Act, the rules and procedures for the arbitration of financial services disputes of JAMS/Endispute, LLC, a Delaware limited liability company or any successor thereof ("JAMS"), and the terms of this paragraph. In the event of any inconsistency, the terms of this paragraph shall control. (d) The arbitration shall be administered by JAMS and conducted in any U. S. state where real or tangible personal property collateral for this credit is located or if there is no such collateral, in California. All Claims shall be determined by one arbitrator; however, if Claims exceed Five Million 19 Dollars ($5,000,000), upon the request of any party, the Claims shall be decided by three arbitrators. All arbitration hearings shall commence within ninety (90) days of the demand for arbitration and close within ninety (90) days of commencement and the award of the arbitrator(s) shall be issued within thirty (30) days of the close of the hearing. However, the arbitrator(s), upon a showing of good cause, may extend the commencement of the hearing for up to an additional sixty (60) days. The arbitrator(s) shall provide a concise written statement of reasons for the award. The arbitration award may be submitted to any court having jurisdiction to be confirmed and enforced. (e) The arbitrator(s) will have the authority to decide whether any Claim is barred by the statute of limitations and, if so, to dismiss the arbitration on that basis. For purposes of the application of the statute of limitations, the service on JAMS under applicable JAMS rules of a notice of Claim is the equivalent of the filing of a lawsuit. Any dispute concerning this arbitration provision or whether a Claim is arbitrable shall be determined by the arbitrator(s). The arbitrator(s) shall have the power to award legal fees pursuant to the terms of this Agreement. (f) This paragraph does not limit the right of the Borrower or the Bank to: (i) exercise self-help remedies, such as but not limited to, setoff; (ii) initiate judicial or nonjudicial foreclosure against any real or personal property collateral; (iii) exercise any judicial or power of sale rights, or (iv) act in a court of law to obtain an interim remedy, such as but not limited to, injunctive relief, writ of possession or appointment of a receiver, or additional or supplementary remedies. (g) The procedure described above will not apply if the Claim, at the time of the proposed submission to arbitration, arises from or relates to an obligation to the Bank secured by real property located in California. In this case, both the Borrower and the Bank must consent to submission of the Claim to arbitration. If both parties do not consent to arbitration, the Claim will be resolved as follows: The Borrower and the Bank will designate a referee (or a panel of referees) selected under the auspices of JAMS in the same manner as 20 arbitrators are selected in JAMS administered proceedings. The designated referee(s) will be appointed by a court as provided in California Code of Civil Procedure Section 638 and the following related sections. The referee (or the presiding referee of the panel) will be an active attorney or a retired judge. The award that results from the decision of the referee(s) will be entered as a judgment in the court that appointed the referee, in accordance with the provisions of California Code of Civil Procedure Sections 644 and 645. (h) The filing of a court action is not intended to constitute a waiver of the right of the Borrower or the Bank, including the suing party, thereafter to require submittal of the Claim to arbitration. (i) By agreeing to binding arbitration, the parties irrevocably and voluntarily waive any right they may have to a trial by jury in respect of any Claim. Furthermore, without intending in any way to limit this Agreement to arbitrate, to the extent any Claim is not arbitrated, the parties irrevocably and voluntarily waive any right they may have to a trial by jury in respect of such Claim. This provision is a material inducement for the parties entering into this Agreement. 8.10 Governing Law. This Agreement and the rights and obligations of the parties under this Agreement shall be governed by, and construed and interpreted in accordance with, the laws of the State of California. 8.11 Table of Contents and Captions. The table of contents and captions contained in this Agreement are for convenience of reference only and shall not limit or define the provisions of this Agreement or affect the interpretation or construction thereof. 8.12 Counterparts. This Agreement may be signed in any number of counterparts, each of which shall be an original with the same effect as if the signatures thereto and hereto were upon the same instrument. [INTENTIONALLY LEFT BLANK] 21 IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed and delivered by their proper and duly authorized officers as of the day and year first above written. BANK: BANK OF AMERICA, N.A. By: /s/ JAMIE HARNEY -------------------- Name: Jamie Harney Title: Vice President BORROWER: SOUTHWEST WATER COMPANY By: /s/ THOMAS C. TEKULVE ------------------------- Name: Thomas C. Tekulve Title: Vice President - Finance By: /s/ RICHARD J. SHIELDS -------------------------- Name: Richard J. Shields Title: Chief Financial Officer 22 EX-10.11(I) 5 dex1011i.txt EIGHTH AMENDMENT TO CREDIT AGREEMENT Exhibit 10.11 I EIGHTH AMENDMENT TO CREDIT AGREEMENT THIS EIGHTH AMENDMENT TO CREDIT AGREEMENT (the "Amendment"), dated for reference purposes only as of March 14, 2003, is entered into between BANK OF AMERICA, N.A., a national association ("Bank"), and SOUTHWEST WATER COMPANY, a Delaware corporation ("Borrower"). RECITALS A. Borrower and Bank have previously entered into that certain Credit Agreement dated as of July 30, 1999, as amended by that certain First Amendment to Credit Agreement dated as of June 30, 2000, that certain Second Amendment to Credit Agreement dated as of September 29, 2000, that certain Third Amendment to Credit Agreement dated as of March 9, 2001, that certain Fourth Amendment to Credit Agreement dated as of July 13, 2001, that certain Fifth Amendment to Credit Agreement dated as of October 22, 2001, that certain Sixth Amendment to Credit Agreement dated as of November 9, 2001, and that certain Seventh Amendment to Credit Agreement dated as of November 1, 2002, (collectively, the "Credit Agreement"), pursuant to which Bank has made certain loans and financial accommodations available to Borrower. Terms used herein without definition shall have the meanings ascribed to them in the Credit Agreement. B. Bank and Borrower wish to amend the Credit Agreement under the terms and conditions set forth in this Amendment. Borrower is entering into this Amendment with the understanding and agreement that, except as specifically provided herein, none of Bank's rights or remedies as set forth in the Credit Agreement is being waived or modified by the terms of this Amendment. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants herein contained, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree as follows: 1. Amendments to Credit Agreement. (a) The definition of "Revolving Commitment" set forth in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "`Revolving Commitment': The amount of $10,000,000 from the date hereof to December 31, 2003, and $6,000,000 thereafter as such amount may be reduced pursuant to Section 2.01 (c)." 1 (b) Section 6.02 (a) of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "(a) Leverage Ratio. Permit the ratio of the amount of Consolidated Liabilities less the outstanding principal amount of the Debentures to Consolidated Tangible Net Worth to be more than 2.10:1.00 between the date hereof and December 31, 2003, and 2.00:1.00 thereafter." (c) Section 6.02 (f) of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "Debt. Create, incur, assume or permit to exist, or permit any Subsidiary to create, incur, assume or permit to exist, any indebtedness or liabilities resulting from borrowings, loans or advances, whether matured or unmatured, liquidated or unliquidated, joint or several, secured or unsecured, except for (i) Debt incurred pursuant to the Agreement and the other Loan Documents, (ii) Debt incurred pursuant to the Suburban Loan Documents; (iii) Debts, revolving lines of credit and lease obligations of Borrower existing as of, and disclosed to Bank prior to, the date of the Agreement (including $6,000,000 of unsecured debt of the Borrower to Mellon, $4,000,000 of unsecured debt of Suburban to Mellon, and $4,000,000 of unsecured debt of NMUI to First Security Bank (or successors), (iv) secured indebtedness for purchase money financing of equipment which is permitted under Section 6.02 (e)(iii) not to exceed an aggregate of $500,000, (v) unsecured funded bank debt not to exceed aggregate of $28,000,000 between the date hereof and December 31, 2003, and $24,000,000 thereafter (including, without limitation, unsecured funded bank debt incurred pursuant to the Loan Documents and the Suburban Loan Documents and unsecured funded bank debt to Mellon as described in clause (iii) above), (vi) Debt incurred pursuant to the Debentures not to exceed $20,000,000, (vii) secured term Debt incurred by Windermere Utility Company not to exceed $10,000,000 and Borrower's guaranty of such Debt, (viii) obligations owing to Bank by Borrower in respect of a standby letter of credit issued for the benefit of Capistrano Valley Water District, and (ix) intercompany Debt between Borrower and its majority-owned Subsidiaries." 2. Effectiveness of this Amendment. Bank must have received the following items, in form and content acceptable to Bank, before this Amendment is effective and before Bank is required to extend any credit to Borrower as provided for by this Amendment. (a) Amendment. This Amendment fully executed in a sufficient number of counterparts for distribution to Bank and Borrower. (b) Amendment Fee. Receipt by Bank of the amendment fee set forth in Paragraph 3 below. 2 (c) Note. The Fifth Amended and Restated Revolving Note, the form of which is attached hereto as Exhibit A, fully executed by the Borrower. (d) Authorizations. Evidence that the execution, delivery and performance by Borrower and each guarantor or subordinating creditor of this Amendment and any instrument or agreement required under this Amendment have been duly authorized. (e) Representations and Warranties. The representations and warranties set forth in the Credit Agreement must be true and correct. (f) Other Required Documentation. All other documents and legal matters in connection with the transactions contemplated by this Amendment shall have been delivered or executed or recorded and shall be in form and substance satisfactory to Bank. 3. Amendment Fee. Borrower shall pay to Bank an amendment fee in the amount of _________ for the processing and approval of this Amendment, which fee will be fully earned on the date of this Amendment. 4. Representations and Warranties. The Borrower represents and warrants as follows: (a) Authority. The Borrower has the requisite corporate power and authority to execute and deliver this Amendment and to perform its obligations hereunder and under the Loan Documents (as amended or modified hereby) to which it is a party. The execution, delivery and performance by the Borrower of this Amendment and the performance by Borrower of each Loan Document (as amended or modified hereby) to which it is a party have been duly approved by all necessary corporate action of Borrower and no other corporate proceedings on the part of Borrower are necessary to consummate such transactions. (b) Enforceability. This Amendment has been duly executed and delivered by the Borrower. This Amendment and each Loan Document (as amended or modified hereby) is the legal, valid and binding obligation of Borrower, enforceable against Borrower in accordance with its terms, and is in full force and effect. (c) Representations and Warranties. The representations and warranties contained in each Loan Document (other than any such representations or warranties that, by their terms, are specifically made as of a date other than the date hereof) are correct on and as of the date hereof as though made on and as of the date hereof. (d) No Default. No event has occurred and is continuing that constitutes an Event of Default. 5. Choice of Law. The validity of this Amendment, its construction, interpretation and enforcement, the rights of the parties hereunder, shall be determined under, governed by, and construed in accordance with the internal laws of the State of California governing contracts only to be performed in that State. 3 6. Counterparts. This Amendment may be executed in any number of counterparts and by different parties in separate counterparts, each of which when so executed and delivered, shall be deemed an original, and all of which, when taken together, shall constitute one and the same instrument. Delivery of an executed counterpart of a signature page to this Amendment by telefacsimile shall be effective as delivery of a manually executed counterpart of this Amendment. 7. Due Execution. The execution, delivery and performance of this Amendment are within the power of Borrower, have been duly authorized by all necessary corporate action, have received all necessary governmental approvals, if any, and do not contravene any law or any contractual restrictions binding on Borrower. 8. Reference to and Effect on the Loan Documents. (a) Upon and after the effectiveness of this Amendment, each reference in the Credit Agreement to "this Agreement", "hereunder", "hereof" or words of like import referring to the Credit Agreement, and each reference in the other Loan Documents to "the Credit Agreement", "thereof" or words of like import referring to the Credit Agreement, shall mean and be a reference to the Credit Agreement as modified and amended hereby. (b) Except as specifically amended above, the Credit Agreement and all other Loan Documents, are and shall continue to be in full force and effect and are hereby in all respects ratified and confirmed and shall constitute the legal, valid, binding and enforceable obligations of Borrower to Bank. (c) The execution, delivery and effectiveness of this Amendment shall not, except as expressly provided herein, operate as a waiver of any right, power or remedy of Bank under any of the Loan Documents, nor constitute a waiver of any provision of any of the Loan Documents. (d) To the extent that any terms and conditions in any of the Loan Documents shall contradict or be in conflict with any terms or conditions of the Credit Agreement, after giving effect to this Amendment, such terms and conditions are hereby deemed modified or amended accordingly to reflect the terms and conditions of the Credit Agreement as modified or amended hereby. 9. Ratification. Borrower hereby restates, ratifies and reaffirms each and every term and condition set forth in the Credit Agreement, as amended hereby, and the Loan Documents effective as of the date hereof. 10. Estoppel. To induce Bank to enter into this Amendment and to continue to make advances to Borrower under the Credit Agreement, Borrower hereby acknowledges and agrees that, after giving effect to this Amendment, as of the date hereof, there exists no Event of Default and no right of offset, defense, counterclaim or objection in favor of Borrower as against Bank with respect to the Obligations. 4 (SIGNATURES ON NEXT PAGE) IN WITNESS WHEREOF, the parties have entered into this Amendment as of the date first above written. "Bank" "Borrower" BANK OF AMERICA, N.A. SOUTHWEST WATER COMPANY, a national association a Delaware corporation By: /s/ JAMIE HARNEY By: /s/ THOMAS C. TEKULVE - --------------------- -------------------------- Name: Jamie Harney Name: Thomas C. Tekulve Title: Vice President Title: Vice President - Finance By: /s/ ANTON C. GARNIER ------------------------- Name: Anton C. Garnier Title: President 5 FIFTH AMENDED AND RESTATED REVOLVING NOTE $10,000,000 Costa Mesa, California March 14, 2003 FOR VALUE RECEIVED, the undersigned SOUTHWEST WATER COMPANY, a Delaware corporation ("Borrower") promises to pay to the order of BANK OF AMERICA, N.A. ("Bank") at its office at 675 Anton Blvd., Costa Mesa, California, or at such other place as the holder hereof may designate, in lawful money of the United States of America and in immediately available funds, the principal sum of Ten Million Dollars ($10,000,000), or so much thereof as may be advanced and be outstanding, with interest thereon, to be computed on each advance from the date of its disbursement (computed on the basis of a 360-day year and actual days elapsed, which results in more interest than if a 365-day year were used) at a rate per annum equal to the applicable IBOR Rate plus the Applicable Margin or Prime Rate plus the Applicable Margin. When interest is determined in relation to the Prime Rate, each change in the rate of interest hereunder shall become effective on the opening of business on the day specified in the public announcement of a change in Bank's Prime Rate. With respect to each IBOR option selected hereunder, Bank is hereby authorized to note the date, principal amount, interest rate and applicable IBOR Rate Term thereto and any payments made thereon on Bank's books and records (either manually or by electronic entry) and/or on any schedule attached to this Note, which notations shall be prima facie evidence of the accuracy of the information noted. This Note amends, restates in its entirety, and replaces that certain Fourth Amended and Restated Revolving Note dated as of September 30, 2001 in the original amount of Six Million Dollars ($6,000,000), made by Borrower payable to the order of Bank, pursuant to that certain Credit Agreement (as defined in Section D below). A. DEFINITIONS: As used herein, the following terms shall have the meanings set forth after each: 1. "Applicable Margin" means the following amounts per annum, based upon the Leverage Ratio as set forth in the certificate received pursuant to Section 6.01 (a) (iv) of the Credit Agreement ("Compliance Certificate"):

During the period from the date of this Note to the date on which the Bank receives the first Compliance Certificate after the date of this Note, the Applicable Margin shall be based on a pricing level 1 set forth in the above table. Thereafter, the Applicable Margin shall be in effect from the date the most recent Compliance Certificate is received by the Bank, provided however, that if the * Less than **** Greater than or equal to Exhibit A 1 Borrower fails to timely deliver the next certificate, the Applicable Margin from the date such Compliance Certificate was due shall be that indicated for the pricing level 3 set forth in the above table, and thereafter, the pricing level indicated by such Compliance Certificate when received. 2. "Business Day" means any day except a Saturday, Sunday or any other day designated as a holiday under Federal or California statute or regulation, or for amounts bearing interest at an offshore rate, a Business Day is any day except a Saturday, Sunday or any other day designated as a holiday under Federal or California statute or regulation on which Bank is open for business in California and dealing in offshore dollars. 3. "IBOR Rate Portion" means a portion of the principal amount outstanding under this Note which is bearing interest at a rate related to IBOR. No IBOR Rate Portion shall be less than Two Hundred Fifty Thousand Dollars ($250,000). 4. "IBOR Rate Term" means a period commencing on a Business Day and continuing for no shorter than one (1) month and no longer than six (6) months, as designated by Borrower, during which all or a portion of the outstanding principal balance of this Note bears interest determined in relation to Bank's IBOR; provided however, that no IBOR Rate Term shall extend beyond the scheduled maturity date hereof. The last day of the interest period will be determined by Bank using the offshore dollar inter-bank market. If any IBOR Rate Term would end on a day which is not a Business Day, then such IBOR Rate Term shall be extended to the next succeeding Business Day. 5. "IBOR Rate" means the interest rate determined by the following formula, rounded upward, if necessary, to the nearest 1/100 of one percent. (All amounts in the calculation will be determined by Bank as of the first day of the interest period.) IBOR Rate = IBOR Base Rate ----------------------------------------------------- (1.00 - Reserve Percentage) (a) "IBOR Base Rate" means the interest rate at which Bank's Grand Cayman Branch, Grand Cayman, British West Indies, would offer U.S. dollar deposits for the applicable interest period to other major banks in the offshore dollar inter-bank market. (b) "Reserve Percentage" means the total of the maximum reserve percentages for determining the reserves to be maintained by member banks of the Federal Reserve System for Eurocurrency Liabilities, as defined in Federal Reserve Board Regulation D, rounded upward to the nearest 1/100 of one percent. The percentage will be expressed as a decimal, and will include, but not be limited to, marginal, emergency, supplemental, special, and other reserve percentages. 6. "Prime Rate" means the rate of interest publicly announced from time to time by Bank in San Francisco, California, as its Prime Rate. The Prime Rate is set by Bank based on various factors, including Bank's costs and desired return, Exhibit A 2 general economic conditions and other factors, and is used as a reference point for pricing some loans. Bank may price loans to its customers at, above or below the Prime Rate. B. INTEREST: 1. Payment of Interest. Interest accrued on this Note shall be payable on the first day of each month, commencing April 1, 2003. 2. Selection of Interest Rate Options. At any time any portion of this Note bears interest determined in relation to Bank's IBOR, it may be continued by Borrower at the end of the IBOR Rate Term applicable thereto so that all or a portion thereof bears interest determined in relation to the Prime Rate or in relation to Bank's IBOR for a new IBOR Rate Term designated by Borrower. At any time any portion of this Note bears interest determined in relation to the Prime Rate, Borrower may convert all or a portion thereof so that it bears interest determined in relation to Bank's IBOR for an IBOR Rate Term designated by Borrower. At the time each advance is requested hereunder or Borrower wishes to select the IBOR option for all or a portion of the outstanding principal balance hereof, and at the end of each IBOR Rate Term, Borrower shall give Bank notice specifying (a) the interest rate option selected by Borrower, (b) the principal amount subject thereto, and (c) if the IBOR option is selected, the length of the applicable IBOR Rate Term. Any such notice may be given by telephone so long as, with respect to each IBOR selection, such notice is given to Bank prior to 10:00 a.m., California time, on the first day of the IBOR Rate Term. For each IBOR option requested hereunder, Bank will quote the applicable IBOR Rate to Borrower at approximately 10:00 a.m., California time, on the first day of the IBOR Rate Term. If Borrower does not immediately accept the rate quoted by Bank, any subsequent acceptance by Borrower shall be subject to a re-determination by Bank of the applicable IBOR Rate; provided however, that if Borrower fails to accept any such rate by 11:00 a.m., California time, on the Business Day such quotation is given, then the quoted rate shall expire and Bank shall have no obligation to permit a IBOR option to be selected on such day. If no specific designation of interest is made at the time any advance is requested hereunder or at the end of any IBOR Rate Term, Borrower shall be deemed to have made a Prime Rate interest selection for such advance or the principal amount to which such IBOR Rate Term applied. 3. Additional IBOR Provisions. (a) If Bank at any time shall determine that for any reason adequate and reasonable means do not exist for ascertaining Bank's IBOR, then Bank shall promptly give notice thereof to Borrower. If such notice is given and until such notice has been withdrawn by Bank, than (i) no new IBOR option may be selected by Borrower, and (ii) any portion of the outstanding principal balance hereof which bears interest determined in relation to Bank's IBOR, subsequent to the end of the IBOR Rate Term applicable thereto, shall bear interest determined in relation to the Prime Rate. (b) If any law, treaty, rule, regulation or determination of a court or governmental authority or any change therein or in the interpretation or application thereof (each, a "Change in Law") shall make it unlawful for Bank (i) Exhibit A 3 to make IBOR options available hereunder, or (ii) to maintain interest rates based on Bank's IBOR, then in the former event, any obligation of Bank to make available such unlawful IBOR options shall immediately be cancelled, and in the latter event, any such unlawful IBOR-based interest rates then outstanding shall be converted, at Bank's option, so that interest on the portion of the outstanding principal balance subject thereto is determined in relation to the Prime Rate; provided however, that if any such Change in Law shall permit any IBOR-based interest rates to remain in effect until the expiration of the IBOR Rate Term applicable thereto, then such permitted IBOR-based interest rates shall continue in effect until the expiration of such IBOR Rate Term. Upon the occurrence of any of the foregoing events, Borrower shall pay to Bank immediately upon demand such amounts as may be necessary to compensate Bank for any fines, fees, charges, penalties or other costs incurred or payable by Bank as a result thereof and which are attributable to any IBOR options made available to Borrower hereunder, and any reasonable allocation made by Bank among its operations shall be conclusive and binding upon Borrower. (c) If any Change in Law or compliance by Bank with any request or directive (whether or not having the force of law) from any central bank or other governmental authority shall: (i) subject Bank to any tax, duty or other charge with respect to any IBOR options, or change the basis of taxation of payments to Bank of principal, interest, fees or any other amount payable hereunder (except for changes in the rate of tax on the overall net income of Bank); or (ii) impose, modify or hold applicable any reserve, special deposit, compulsory loan or similar requirement against assets held by, deposits or other liabilities in or for the account of advances or loans by, or any other acquisition of funds by any office of Bank; or (iii) impose on Bank any other condition; and the result of any of the foregoing is to increase the cost to Bank of making, renewing or maintaining any IBOR options hereunder and/or to reduce any amount receivable by Bank in connection therewith, then in any such case, Borrower shall pay to Bank immediately upon demand such amounts as may be necessary to compensate Bank for any additional costs incurred by Bank and/or reductions in amounts received by Bank which are attributable to such IBOR options. In determining which costs incurred by Bank and/or reductions in amounts received by Bank are attributable to any IBOR options made available to Borrower hereunder, any reasonable allocation made by Bank among its operations shall be conclusive and binding upon Borrower. 4. Default Interest. During the continuance of an Event of Default, the outstanding principal balance of this Note shall bear interest until paid in full at an increased rate per annum (computed on the basis of a 360-day year and actual days elapsed, which Exhibit A 4 results in more interest than if a 365-day year were used) equal to two percent (2%) above the rate of interest from time to time applicable to this Note. C. BORROWING AND REPAYMENT: 1. Borrowing and Repayment. Borrower may from time to time during the term of this Note borrow, partially or wholly repay its outstanding borrowings, and re-borrow, subject to all of the limitations, terms and conditions of this Note and of any document executed in connection with or governing this Note; provided however, that the total outstanding borrowings under this Note shall not at any time exceed the principal amount stated above. The unpaid principal balance of this obligation at any time shall be the total amounts advanced hereunder by the holder hereof less the amount of principal payments made hereon by or for Borrower, which balance may be endorsed hereon from time to time by the holder. The outstanding principal balance of this Note shall be due and payable in full on the "Maturity Date" (as defined in the Credit Agreement). 2. Advances. Advances hereunder, to the total amount of the principal sum stated above, may be made by the holder at the oral or written request of (a) Thomas C. Tekulve, Doug Hansen, Leslie-Ward Cline, any one acting alone, who are authorized to request advances and direct the disposition of any advances until written notice of the revocation of such authority is received by the holder at the office designated above, or (b) any person, with respect to advances deposited to the credit of any account of Borrower with the holder, which advances, when so deposited, shall be conclusively presumed to have been made to or for the benefit of Borrower regardless of the fact that persons other than those authorized to request advances may have authority to draw against such account. The holder shall have no obligation to determine whether any person requesting an advance is or has been authorized by Borrower. 3. Application of Payments. Each payment made on this Note shall be credited first, to any interest then due and second, to the outstanding principal balance hereof. Unless instructed otherwise by Borrower, all payments credited to principal shall be applied first, to the outstanding principal balance of this Note which bears interest determined in relation to the Prime Rate, if any, and second, to the outstanding principal balance of this Note which bears interest determined in relation to Bank's IBOR, with such payments applied to the oldest IBOR Rate Term first. 4. Prepayment. (a) Prime Rate. Borrower may prepay principal on any portion of this Note which bears interest determined in relation to the Prime Rate at any time, in any amount and without penalty. (b) IBOR. Each prepayment of an IBOR Rate Portion, whether voluntary, by reason of acceleration or otherwise, will be accompanied by the amount of accrued interest on the amount prepaid, and a prepayment fee as described below. A "prepayment" is a payment of an amount on a date earlier than the scheduled payment date for such amount as required by this Agreement. The prepayment fee shall be equal to the amount (if any) by which: Exhibit A 5 (i) the additional interest which would have been payable during the interest period on the amount prepaid had it not been prepaid, exceeds (ii) the interest which would have been recoverable by Bank by placing the amount prepaid on deposit in the domestic certificate of deposit market, the eurodollar deposit market, or other appropriate money market selected by Bank for a period starting on the date on which it was prepaid and ending on the last day of the interest period for such Portion (or the scheduled payment date for the amount prepaid, if earlier). Bank will have no obligation to accept an election of an IBOR Rate Portion if any of the following described events has occurred and is continuing: (i) Dollar deposits in the principal amount, and for periods equal to the IBOR Rate Term, of an IBOR Rate Portion are not available in the offshore dollar inter-bank market; or (ii) the IBOR Rate does not accurately reflect the cost of an IBOR Rate Portion. Borrower acknowledges that prepayment of such amount may result in Bank incurring additional costs, expenses and/or liabilities, and that it is difficult to ascertain the full extent of such costs, expenses and/or liabilities. Borrower, therefore, agrees to pay the above-described prepayment fee and agrees that said amount represents a reasonable estimate of the prepayment costs, expenses and/or liabilities of Bank. If Borrower fails to pay any prepayment fee when due, the amount of such prepayment fee shall thereafter bear interest until paid at a rate per annum two percent (2%) above the Prime Rate in effect from time to time (computed on the basis of a 360-day year, actual days elapsed). D. EVENTS OF DEFAULT: This Note is made pursuant to and is subject to the terms and conditions of that certain Credit Agreement between Borrower and Bank dated as of July 30, 1999, as amended from time to time, including, without limitation, those terms relating to arbitration of Disputes (the "Credit Agreement"). Any default in the payment or performance of any obligation under this Note, or any defined event of default under the Credit Agreement, shall constitute an "Event of Default" under this Note. E. MISCELLANEOUS: 1. Remedies. Upon the occurrence of any Event of Default, the holder of this Note, at the holder's option, without notice upon the occurrence of an Event of Default pursuant to Section 7.01(g) of the Credit Agreement, and with notice upon the occurrence of any other Event of Default, may declare all sums of principal and interest outstanding hereunder to be immediately due and payable without presentment, demand, protest or notice of dishonor, all of which are expressly waived by Borrower, and the obligation, if any, of the holder to extend any further credit hereunder shall immediately cease and terminate. Borrower shall pay to the holder immediately upon demand the full amount of all payments, advances, charges, costs and expenses, including reasonable attorneys' fees (to include outside counsel fees and all allocated costs of the holder's in-house counsel), incurred by the holder in connection with the Exhibit A 6 enforcement of the holder's rights and/or the collection of any amounts which become due to the holder under this Note, and the prosecution or defense of any action in any way related to this Note, including without limitation, any action for declaratory relief, and including any of the foregoing incurred in connection with any bankruptcy proceeding relating to Borrower. 2. Obligations Joint and Several. Should more than one person or entity sign this Note as a Borrower, the obligations of each such Borrower shall be joint and several. 3. Governing Law. This Note shall be governed by and construed in accordance with the laws of the State of California, except to the extent Bank has greater rights or remedies under Federal law, whether as a national bank or otherwise, in which case such choice of California law shall not be deemed to deprive Bank of any such rights and remedies as may be available under Federal law. 4. Defined Terms. All capitalized terms not herein defined shall have the meanings given to them in the Credit Agreement. "Borrower" SOUTHWEST WATER COMPANY, a Delaware corporation By:__________________________ Title: ____________________ By:__________________________ Title:_______________________ Exhibit A 7 EX-10.12(E) 6 dex1012e.txt FIFTH AMENDMENT TO CREDIT AGREEMENT EXHIBIT 10.12E FIFTH AMENDMENT TO CREDIT AGREEMENT THIS FIFTH AMENDMENT TO CREDIT AGREEMENT (the "Amendment"), dated for reference purposes only as of November 1, 2002, is entered into between BANK OF AMERICA, N.A., a national association ("Bank"), and SUBURBAN WATER SYSTEMS, a California corporation ("Borrower"). The terms of this Amendment shall be effective for all purposes retroactively to September 30, 2002. A. Borrower and Bank have previously entered into that certain Credit Agreement dated as of July 30, 1999, as amended by that certain First Amendment to Credit Agreement dated as of March 8, 2000, by that certain Second Amendment to Credit Agreement dated as of September 29, 2000, by that certain Third Amendment to Credit Agreement dated as of July 13, 2001 and by that certain Fourth Amendment to Credit Agreement dated as of November 9, 2001 (collectively, the "Credit Agreement"), pursuant to which Bank has made certain loans and financial accommodations available to Borrower. Terms used herein without definition shall have the meanings ascribed to them in the Credit Agreement. B. Bank and Borrower amend the Credit Agreement under the terms and conditions set forth in this Amendment. Borrower is entering into this Amendment with the understanding and agreement that, except as specifically provided herein, none of Bank's rights or remedies as set forth in the Credit Agreement is being waived or modified by the terms of this Amendment. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants herein contained, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree as follows: 1. Amendments to Credit Agreement. (a) The definition of "Maturity Date" set forth in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "'Maturity Date': September 30, 2004." (b) Section 6.02(c) of the Agreement is amended in its entirety to read as follows: "(c) Consolidated Tangible Net Worth of Southwest. At any time, permit Consolidated Tangible Net Worth of Southwest to be less than $54,000,000." - 1 - 2. Effectiveness of this Amendment. Bank must have received the following items, in form and content acceptable to Bank, before this Amendment is effective and before Bank is required to extend any credit to Borrower as provided for by this Amendment. (a) Amendment. This Amendment fully executed in a sufficient number of counterparts for distribution to Bank and Borrower. (b) Authorizations. Evidence that the execution, delivery and performance by Borrower and each guarantor or subordinating creditor of this Amendment and any instrument or agreement required under this Amendment have been duly authorized. (c) Representations and Warranties. The representations and warranties set forth in the Credit Agreement must be true and correct. (d) Other Required Documentation. All other documents and legal matters in connection with the transactions contemplated by this Amendment shall have been delivered or executed or recorded and shall be in form and substance satisfactory to Bank. 3. Representations and Warranties. Borrower represents and warrants as follows: (a) Authority. Borrower has the requisite corporate power and authority to execute and deliver this Amendment and to perform its obligations hereunder and under the Loan Documents (as amended or modified hereby) to which it is a party. The execution, delivery and performance by the Borrower of this Amendment and the performance by Borrower of each Loan Document (as amended or modified hereby) to which it is a party have been duly approved by all necessary corporate action of Borrower and no other corporate proceedings on the part of Borrower are necessary to consummate such transactions. (b) Enforceability. This Amendment has been duly executed and delivered by Borrower. This Amendment and each Loan Document (as amended or modified hereby) is the legal, valid and binding obligation of Borrower, enforceable against Borrower in accordance with its terms, and is in full force and effect. (c) Representations and Warranties. The representations and warranties contained in each Loan Document (other than any such representations or warranties that, by their terms, are specifically made as of a date other than the date hereof) are correct on and as of the date hereof as though made on and as of the date hereof. (d) No Default. No event has occurred and is continuing that constitutes an Event of Default. 4. Choice of Law. The validity of this Amendment, its construction, interpretation and enforcement, the rights of the parties hereunder, shall be determined under, - 2 - governed by, and construed in accordance with the internal laws of the State of California governing contracts only to be performed in that State. 5. Counterparts. This Amendment may be executed in any number of counterparts and by different parties and separate counterparts, each of which when so executed and delivered, shall be deemed an original, and all of which, when taken together, shall constitute one and the same instrument. Delivery of an executed counterpart of a signature page to this Amendment or the Consent by telefacsimile shall be effective as delivery of a manually executed counterpart of this Amendment or such Consent. 6. Due Execution. The execution, delivery and performance of this Amendment are within the power of Borrower, have been duly authorized by all necessary corporate action, have received all necessary governmental approval, if any, and do not contravene any law or any contractual restrictions binding on Borrower. 7. Reference to and Effect on the Loan Documents. (a) Upon and after the effectiveness of this Amendment, each reference in the Credit Agreement to "this Agreement", "hereunder", "hereof" or words of like import referring to the Credit Agreement, and each reference in the other Loan Documents to "the Credit Agreement", "thereof" or words of like import referring to the Credit Agreement, shall mean and be a reference to the Credit Agreement as modified and amended hereby. (b) Except as specifically amended above, the Credit Agreement and all other Loan Documents, are and shall continue to be in full force and effect and are hereby in all respects ratified and confirmed and shall constitute the legal, valid, binding and enforceable obligations of Borrower to Bank. (c) The execution, delivery and effectiveness of this Amendment shall not, except as expressly provided herein, operate as a waiver of any right, power or remedy of Bank under any of the Loan Documents, nor constitute a waiver of any provision of any of the Loan Documents. (d) To the extent that any terms and conditions in any of the Loan Documents shall contradict or be in conflict with any terms or conditions of the Credit Agreement, after giving effect to this Amendment, such terms and conditions are hereby deemed modified or amended accordingly to reflect the terms and conditions of the Credit Agreement as modified or amended hereby. 8. Ratification. Borrower hereby restates, ratifies and reaffirms each and every term and condition set forth in the Credit Agreement, as amended hereby, and the Loan Documents effective as of the date hereof. 9. Estoppel. To induce Bank to enter into this Amendment and to continue to make advances to Borrower under the Credit Agreement, Borrower hereby acknowledges and agrees that, after giving effect to this Amendment, as of the date hereof, there exists no Event of - 3 - Default and no right of offset, defense, counterclaim or objection in favor of Borrower as against Bank with respect to the Obligations. IN WITNESS WHEREOF, the parties have entered into this Amendment as of the date first above written. "BANK" "BORROWER" BANK OF AMERICA, N.A. SUBURBAN WATER SYSTEMS, a national association a California corporation By: /s/ JAMIE HARNEY By: /s/ DANIEL N. EVANS - ---------------------- ------------------------ Name: Jamie Harney Name: Daniel N. Evans Title: Vice President Title: V.P. Finance and CFO By: /s/ PETER J. MOERBEEK -------------------------- Name: Peter J. Moerbeek Title: Secretary (Acknowledgement on Next Page) - 4 - ACKNOWLEDGEMENT Dated as of September 30, 2002 The undersigned SOUTHWEST WATER COMPANY, a Delaware corporation ("Southwest"), in consideration of the continued extension of credit to SUBURBAN WATER SYSTEMS, a California corporation by BANK OF AMERICA, N.A. ("BofA"), hereby acknowledges and agrees to the foregoing Fifth Amendment to Credit Agreement (the "Amendment") and hereby confirms and agrees that its Continuing Guaranty dated July 30, 1999 (the "Guaranty") in favor of BofA remains in full force and effect, and restates, ratifies and reaffirms each and every term and condition set forth in the Guaranty. Although BofA has informed Southwest of the matters set forth above, and Southwest has acknowledged the same, Southwest understands and agrees that BofA has no duty under the Credit Agreement, the Guaranty or any other agreement with Southwest to so notify Southwest or to seek such an acknowledgement, and nothing contained herein is intended to or shall create such a duty as to any advances or transaction hereafter. SOUTHWEST WATER COMPANY, a Delaware corporation By: /s/ THOMAS C. TEKULVE - -------------------------- Name: Thomas C. Tekulve Title: Vice President - Finance By: /s/ RICHARD J. SHIELDS - --------------------------- Name: Richard J. Shields Title: Chief Financial Officer - 5 - EX-10.13(H) 7 dex1013h.txt EIGHTH AMENDMENT TO AMENDED AND RESTATED CREDIT AGREEMENT EXHIBIT 10.13H EIGHTH AMENDMENT TO AMENDED AND RESTATED CREDIT AGREEMENT THIS EIGHTH AMENDMENT TO AMENDED AND RESTATED CREDIT AGREEMENT (the "Agreement"), dated as of September 30, 2002, is entered into between MELLON 1ST BUSINESS BANK, a California corporation ("Bank"), and SOUTHWEST WATER COMPANY, a Delaware corporation ("Borrower"). RECITALS A. Borrower and Bank have previously entered into that certain Amended and Restated Credit Agreement dated as of December 23, 1997, as amended by that certain First Amendment to Amended and Restated Credit Agreement dated as of September 1, 1998, that certain Second Amendment to Amended and Restated Credit Agreement dated as of July 19, 2000, that certain Fourth Amendment to Amended and Restated Credit Agreement dated as of September 29, 2000, that certain Fifth Amendment to Amended and Restated Credit Agreement dated as of March 9, 2001, that certain Sixth Amendment to Amended and Restated Credit Agreement dated as of July 13, 2001, and that certain Seventh Amendment to Amended and Restated Credit Agreement dated as of September 30, 2001 (collectively, the "Credit Agreement"), pursuant to which Bank has made certain loans and financial accommodations available to Borrower. Terms used herein without definition shall have the meanings ascribed to them in the Credit Agreement. B. Bank and Borrower amend the Credit Agreement under the terms and conditions set forth in this Amendment. Borrower is entering into this Amendment the understanding and agreement that, except as specifically provided herein, none of Bank's rights or remedies as set forth in the Credit Agreement is being waived or modified by the terms of this Amendment. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants herein contained, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree as follows: 1. Amendments to Credit Agreement. (a) The definition of "Maturity Date" set forth in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "'Maturity Date': March 31, 2004." 2. Effectiveness of this Amendment. Bank must have received the following items, in form and content acceptable to Bank, before this Amendment is effective and before Bank is required to extend any credit to Borrower as provided for by this Amendment. (a) Amendment. This Amendment fully executed in a sufficient number of counterparts for distribution to Bank and Borrower. (b) Authorizations. Evidence that the execution, delivery and performance by Borrower and each guarantor or subordinating creditor of this Amendment and any instrument or agreement required under this Amendment have been duly authorized. (c) Representations and Warranties. The representations and warranties contained in each Loan Document (other than any such representations or warranties that, by their terms are specifically made as of a date other than the date hereof) are correct on and as of the date hereof as though made on and as of the date hereof. 3. Representations and Warranties. The Borrower represents and warrants as follows: (a) Authority. The Borrower has the requisite corporate power and authority to execute and deliver this Amendment and to perform its obligations hereunder and under the Loan Documents (as amended or modified hereby) to which it is a party. The execution, delivery and performance by the Borrower of this Amendment and the performance by Borrower of each Loan Document (as amended or modified hereby) to which it is a party have been duly approved by all necessary corporate action of Borrower and no other corporate proceedings on the part of Borrower are necessary to consummate such transactions. (b) Enforceability. This Amendment has been duly executed and delivered by the Borrower. The Amendment and each Loan Document (as amended or modified hereby) is the legal, valid and binding obligation of Borrower, enforceable against Borrower in accordance with its terms, and is in full force and effect. (c) Representations and Warranties. The representations and warranties contained in each Loan Document (other than any such representations or warranties that, by their terms, and specifically made as of a date other than the date hereof) are correct on and as of the date hereof as though made on and as of the date hereof. (d) No Default. No event has occurred and is continuing that constitutes an Event of Default. 4. Choice of Law. The validity of this Amendment, its construction, interpretation and enforcement, the rights of the parties hereunder, shall be determined under, governed by, and construed in accordance with the internal laws of the state of California governing contracts only to be performed in that State. 5. Counterparts. This Amendment may be executed in any number of counterparts and by different parties and separate counterparts, each of which when so executed and delivered, shall be deemed an original, and all of which, when taken together, shall constitute one and the same instrument. Delivery of an executed counterpart of a signature page to this Amendment by telefacsimile shall be effective as delivery of a manually executed counterpart of this Amendment or such Consent. 6. Due Execution. The execution, delivery and performance of this Amendment are within the power of Borrower, have been duly authorized by all necessary corporate action, have received all necessary governmental approval, if any, and do not contravene any law or any contractual restrictions binding on Borrower. 7. Reference to and Effect on the Loan Documents. (a) Upon and after the effectiveness of this Amendment, each reference in the Credit Agreement to "this Agreement", "hereunder", "hereof" or words of like import referring to the credit Agreement, and each reference in the other Loan Documents to "the Credit Agreement", "thereof" or words of like import referring to the Credit Agreement, shall mean and be a reference to the Credit Agreement as modified and amended hereby. (b) Except as specifically amended above, the Credit Agreement and all other Loan Documents are and shall continue to be in full force and effect and are hereby in all respects ratified and confirmed and shall constitute the legal, valid, binding and enforceable obligations of Borrower to Bank. (c) The execution, delivery and effectiveness of this Amendment shall not, except as expressly provided herein, operate as a waiver of any right, power or remedy of Bank under any of the Loan Documents, nor constitute a waiver of any provision of any of the Loan Documents. (d) To the extent that any terms and conditions in any of he loan Documents shall contradict or be in conflict with any terms or conditions of the Credit Agreement, after giving effect to this amendment, such terms and conditions are hereby deemed modified or amended accordingly to reflect the terms and conditions of the Credit Agreement as modified or amended hereby. 8. Ratification. Borrower hereby restates, ratifies and reaafirms each and every term and condition set forth in the Credit Agreement, as amended hereby, and the Loan Documents effective as of the date hereof. 9. Estoppel. To induce Bank to enter into this Amendment and to continue to make advances to borrower under the Credit Agreement, Borrower hereby acknowledges and agrees that, after giving effect to this Amendment, as of the date hereof, there exists no Event of Default and no right of offset, defense, counterclaim or objection in favor of Borrower as against Bank with respect to the Obligations. IN WITNESS WHEREOF, the parties have entered into this Amendment as of the date first above written. "Bank" "Borrower" MELLON 1ST BUSINESS BANK, SOUTHWEST WATER COMPANY, A California Corporation a Delaware Corporation By: /s/ JOHN CARLSON By: /s/ RICHARD J. SHIELDS - ------------------------- ------------------------------ Name: John Carlson Name: Richard J. Shields Title: Vice President Title: Chief Financial Officer By: /s/ F. D. HARE By: /s/ THOMAS C. TEKULVE - ----------------------- ----------------------------- Name: F. D. Hare Name: Thomas C. Tekulve Name: EVP and CEO Title: Vice President - Finance EX-10.14(G) 8 dex1014g.txt SEVENTH AMENDMENT TO CREDIT AGREEMENT EXHIBIT 10.14G SEVENTH AMENDMENT TO CREDIT AGREEMENT THIS SEVENTH AMENDMENT TO CREDIT AGREEMENT (the "Agreement"), dated as of September 30, 2002, is entered into between MELLON 1ST BUSINESS BANK, a California corporation ("Bank"), and SUBURBAN WATER SYSTEMS, a California corporation ("Borrower"). RECITALS A. Borrower and Bank have previously entered into that certain Credit Agreement dated as of December 23, 1997, as amended by that certain First Amendment to Credit Agreement dated as of September 1, 1998, that certain Second Amendment to Credit Agreement dated as of July 19, 2000, that certain Fourth Amendment to Credit Agreement dated as of September 29, 2000, that certain Fifth Amendment to Credit Agreement dated as of March 9, 2001, and that certain Sixth Amendment to Credit Agreement dated as of July 13, 2001 (collectively, the "Credit Agreement"), pursuant to which Bank has made certain loans and financial accommodations available to Borrower. Terms used herein without definition shall have the meanings ascribed to them in the Credit Agreement. B. Bank and Borrower amend the Credit Agreement under the terms and conditions set forth in this Amendment. Borrower is entering into this Amendment the understanding and agreement that, except as specifically provided herein, none of Bank's rights or remedies as set forth in the Credit Agreement is being waived or modified by the terms of this Amendment. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants herein contained, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereby agree as follows: 1. Amendments to Credit Agreement. (a) The definition of "Maturity Date" set forth in Section 1.01 of the Credit Agreement is hereby amended and restated in its entirety to read as follows: "'Maturity Date': March 31, 2004." 2. Effectiveness of this Amendment. Bank must have received the following items, in form and content acceptable to Bank, before this Amendment is effective and before Bank is required to extend any credit to Borrower as provided for by this Amendment. (a) Amendment. This Amendment fully executed in a sufficient number of counterparts for distribution to Bank and Borrower. 1 (b) Authorizations. Evidence that the execution, delivery and performance by Borrower and each guarantor or subordinating creditor of this Amendment and any instrument or agreement required under this Amendment have been duly authorized. (c) Representations and Warranties. The representations and warranties contained in each Loan Document (other than any such representations or warranties that, by their terms are specifically made as of a date other than the date hereof) are correct on and as of the date hereof as though made on and as of the date hereof. (d) Other Required Documentation. All other documents and legal matters in connection with the transactions contemplated by this Amendment shall have been delivered or executed or recorded and shall be in form and substance satisfactory to Bank. 3. Representations and Warranties. The Borrower represents and warrants as follows: (a) Authority. The Borrower has the requisite corporate power and authority to execute and deliver this Amendment and to perform its obligations hereunder and under the Loan Documents (as amended or modified hereby) to which it is a party. The execution, delivery and performance by the Borrower of this Amendment and the performance by Borrower of each Loan Document (as amended or modified hereby) to which it is a party have been duly approved by all necessary corporate action of Borrower and no other corporate proceedings on the part of Borrower are necessary to consummate such transactions. (b) Enforceability. This Amendment has been duly executed and delivered by the Borrower. The Amendment and each Loan Document (as amended or modified hereby) is the legal, valid and binding obligation of Borrower, enforceable against Borrower in accordance with its terms, and is in full force and effect. (c) Representations and Warranties. The representations and warranties contained in each Loan Document (other than any such representations or warranties that, by their terms, and specifically made as of a date other than the date hereof) are correct on and as of the date hereof as though made on and as of the date hereof. (d) No Default. No event has occurred and is continuing that constitutes an Event of Default. 2 4. Choice of Law. The validity of this Amendment, its construction, interpretation and enforcement, the rights of the parties hereunder, shall be determined under, governed by, and construed in accordance with the internal laws of the state of California governing contracts only to be performed in that State. 5. Counterparts. This Amendment may be executed in any number of counterparts and by different parties and separate counterparts, each of which when so executed and delivered, shall be deemed an original, and all of which, when taken together, shall constitute one and the same instrument. Delivery of an executed counterpart of a signature page to this Amendment by telefacsimile shall be effective as delivery of a manually executed counterpart of this Amendment or such Consent. 6. Due Execution. The execution, delivery and performance of this Amendment are within the power of Borrower, have been duly authorized by all necessary corporate action, have received all necessary governmental approval, if any, and do not contravene any law or any contractual restrictions binding on Borrower. 7. Reference to and Effect on the Loan Documents. (a) Upon and after the effectiveness of this Amendment, each reference in the Credit Agreement to "this Agreement", "hereunder", "hereof" or words of like import referring to the credit Agreement, and each reference in the other Loan Documents to "the Credit Agreement", "thereof" or words of like import referring to the Credit Agreement, shall mean and be a reference to the Credit Agreement as modified and amended hereby. (b) Except as specifically amended above, the Credit Agreement and all other Loan Documents are and shall continue to be in full force and effect and are hereby in all respects ratified and confirmed and shall constitute the legal, valid, binding and enforceable obligations of Borrower to Bank. (c) The execution, delivery and effectiveness of this Amendment shall not, except as expressly provided herein, operate as a waiver of any right, power or remedy of Bank under any of the Loan Documents, nor constitute a waiver of any provision of any of the Loan Documents. (d) To the extent that any terms and conditions in any of he loan Documents shall contradict or be in conflict with any terms or conditions of the Credit Agreement, after giving effect to this amendment, such terms and conditions are hereby deemed modified or amended accordingly to reflect the terms and conditions of the Credit Agreement as modified or amended hereby. 8. Ratification. Borrower hereby restates, ratifies and reaafirms each and every term and condition set forth in the Credit Agreement, as amended hereby, and the Loan Documents effective as of the date hereof. 3 9. Estoppel. To induce Bank to enter into this Amendment and to continue to make advances to borrower under the Credit Agreement, Borrower hereby acknowledges and agrees that, after giving effect to this Amendment, as of the date hereof, there exists no Event of Default and no right of offset, defense, counterclaim or objection in favor of Borrower as against Bank with respect to the Obligations. IN WITNESS WHEREOF, the parties have entered into this Amendment as of the date first above written. "BANK" "BORROWER" MELLON 1ST BUSINESS BANK, SUBURBAN WATER SYSTEMS, A California Corporation a Delaware Corporation By: /s/ JOHN CARLSON By: /s/ DANIEL N. EVANS - ------------------------- --------------------------- Name: John Carlson Name: Daniel N. Evans Title: Vice President Title: VP Finance and CFO By: /s/ F. D. HARE By: /s/ PETER J. MOERBEEK - ----------------------- ----------------------------- Name: F. D. Hare Name: Peter J. Moerbeek Title: EVP and CEO Title: Secretary 4 ACKNOWLEDGEMENT Dated as of September 30, 2002 The undersigned and SOUTHWEST WATER COMPANY, A Delaware corporation ("Southwest"), in consideration of the continued extension of credit to SUBURBAN WATER SYSTEMS, a California corporation by MELLON 1ST BUSINESS BANK, a California Corporation ("Mellon"), hereby acknowledges and agrees to the foregoing Seventh Amendment to Credit Agreement (the "Amendment") and hereby confirms and agrees that this Guarantee dated December 23, 1997 in favor of Mellon is, and shall continue to be, in full force and effect and is hereby ratified and confirmed in all respects except that, upon the effectiveness, of, and on and after the date of the Amendment, each reference in the Guarantee to the Credit Agreement (as defined in the Amendment), "thereunder", "thereof" or words of like import referring to the "Credit Agreement", shall mean and be a reference to the Credit Agreement as amended or modified by the Amendment. Although Mellon has informed Southwest of the matters set forth above, and Southwest has acknowledged the same, Southwest understands and agrees that Mellon has no duty under the Credit Agreement, Guarantee or any other agreement with Southwest to so notify Southwest or to seek such an acknowledgement, and nothing contained herein is intended to or shall create such a duty as to any advances or transaction hereafter. SOUTHWEST WATER COMPANY, a Delaware Corporation By: /s/ THOMAS C. TEKULVE - ------------------------------ Name: Thomas C. Tekulve Title: Vice President - Finance By: /s/ RICHARD J. SHEILDS - ------------------------------- Name: Richard J. Shields Title: Chief Financial Officer 5 EX-10.22 9 dex1022.txt LOAN AGREEMENT EXHIBIT 10.22 LOAN AGREEMENT THIS LOAN AGREEMENT (the "Agreement") is made and entered into as of August 9, 2002, by and between WINDERMERE UTILILTY CO., INC., a Texas corporation (the "Borrower"), SOUTHWEST WATER COMPANY, a Delaware corporation (the "Guarantor") and BANK OF THE WEST (the "Lender"). W I T N E S S E T H: THAT, in consideration of the mutual covenants, agreements and undertakings herein contained, the parties hereto agree as follows: 1. Definitions: Unless a particular word or phrase is otherwise defined or the context otherwise requires, capitalized words and phrases used in Loan Documents have the meanings provided below (such meanings to be applicable to both the singular and plural forms of these words): Accounts, Account Debtor, Equipment, Inventory and General Intangibles shall have the respective meanings assigned to them in the Texas Business and Commerce Code in force on the date the document using such term was executed. Adjusted LIBOR shall mean the sum of the LIBOR plus one and three-fourths percent (1-3/4%). Affiliate shall mean any Person controlling, controlled by, or under common control with any other Person. For purposes of this definition, "control" (including "controlled by" and "under common control with") means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of such Person, whether through the ownership of voting securities or otherwise. If any Person shall own, directly or indirectly, twenty percent (20%) or more of the indicia of equity rights (whether outstanding capital stock, partnership interests or otherwise) of another Person, such Person shall be deemed to be an Affiliate. Agreement shall mean this Loan Agreement. Annual Audited Financial Statements shall mean consolidated financial statements, including all notes thereto, which statements shall include a balance sheet as of the end of such fiscal year and an income statement and a statement of changes in cash flows for such fiscal year, all setting forth in comparative form the corresponding figures from the previous fiscal year, all prepared in conformity with Generally Accepted Accounting Principles and accompanied by a report and opinion of independent certified public accountants qualified to practice before the SEC, which shall state that such financial statements, in the opinion of such accountants, present fairly the financial position of such Person as of the date thereof and the results of its operations for the period covered thereby in conformity with Generally Accepted Accounting Principles. Annual Unaudited Financial Statements shall mean annual financial statements, which shall include a balance sheet as of the end of such fiscal year and an income statement and a statement of changes in cash flows for such fiscal year, all setting forth in comparative form the corresponding figures from the previous fiscal year, all prepared in conformity with Generally Accepted Accounting Principles, which agree, on a consolidating basis, with the Annual Audited Financial Statements of the Guarantor. Capital Expenditures shall mean all expenditures which, in accordance with Generally Accepted Accounting Principles, would be capitalized, excluding those specifically financed by the Lender. Chapter 303 shall mean Chapter 303 of the Texas Finance Code, as in effect on the date the document using such term was executed (unless otherwise provided in such document). Code shall mean the Internal Revenue Code of 1986, as amended, as now or hereafter in effect, together with all regulations, rulings and interpretations thereof or thereunder by the Internal Revenue Service. Collateral shall mean all Property, tangible or intangible, real, personal or mixed, now or hereafter subject to the Security Documents, or intended so to be. Coverage Ratio shall mean the ratio of (a) the sum of net income after taxes, plus depreciation and amortization, less dividends to (b) the prior year's current maturities of long-term debt, all as determined in accordance with Generally Accepted Accounting Principles. Debt to Worth Ratio shall mean the ratio of (a) total liabilities, less contributions in aid of construction, living unit equivalents and inter-company debt which is subordinated in payment to the Loan to (b) net worth, being total assets minus total liabilities, as determined in accordance with Generally Accepted Accounting Principles. ERISA shall mean the Employee Retirement Income Security Act of 1974, as amended from time to time, and all rules, regulations, rulings and interpretations adopted by the Internal Revenue Service or the Department of Labor thereunder. Event of Default shall mean any of the events specified as a default in any Loan Document, including without limitation any of the events described in Section 7.1 of this Agreement, provided there has been satisfied any requirement in connection with such event for the giving of notice, or the lapse of time, or the happening of any further condition, event or act, and Default shall mean any of such events, whether or not any such requirement has been satisfied. Generally Accepted Accounting Principles shall mean, as to a particular Person, such accounting practice as, in the opinion of the independent accounts of recognized national standing regularly retained by such Person and acceptable to the Lender, conforms at the time to Generally Accepted Accounting Principles, consistently applied. Generally Accepted Accounting Principles means those principles and practices (1) which are recognized as such by the Financial Accounting Standards Board, (2) which are applied for all periods after the date hereof in a manner consistent with the manner in which such principles and practices were applied to the most recent audited financial statements of the relevant Person furnished to the Lender, and (3) which are consistently applied for all periods after the date hereof so as to reflect properly the financial condition, and results of operations and changes in cash flow, of such Person. Any accounting terms used in this Agreement but not defined herein shall have the same meaning as promulgated by the Financial Accounting Standards Board. Highest Lawful Rate shall mean the maximum nonusurious rate of interest permitted to be charged, contracted for, received or collected by applicable federal or Texas law (whichever shall permit the higher lawful rate) from time to time in effect. At all times, if any, as Chapter 303 shall establish the Highest Lawful Rate, the Highest Lawful Rate shall be the "indicated rate ceiling" (as defined in Chapter 303) from time to time in effect. If the obligation is an open-end account, the Lender may from time to time, as to then-current and future balances, implement any other ceiling under Chapter 303 and/or revise the index, formula, or provision of law used to compute the rate on such obligation, if and to the extent permitted by, and in the manner provided in, Chapter 303. Indebtedness shall mean and include (1) all items which in accordance with Generally Accepted Accounting Principles would be included on the liability side of a balance sheet on the date as of which Indebtedness is to be determined (excluding capital stock, surplus, surplus reserves, and deferred credits), (2) all guaranties, endorsements, and other contingent obligations respecting any obligations to purchase or otherwise acquire, Indebtedness of others, (3) all Indebtedness secured by any Lien existing on any interest of the Person respecting which Indebtedness is being determined in Property owned subject to such Lien whether or not the Indebtedness secured thereby shall have been assumed, and (4) capital leases; provided, that such term shall not mean or include any Indebtedness in respect of which monies sufficient to pay and discharge the same in full (either on the expressed date of maturity thereof or on such earlier date as such Indebtedness may be duly called for redemption and payment) have been deposited with a depository, agency, or trustee acceptable to the Lender in trust for the payment thereof. Interest Period shall mean a one (1) month, three (3) month of six (6) month period chosen by the Borrower and specified in each Rate Request. Investment shall mean the purchase or other acquisition of any securities or Indebtedness of, or the making of any loan, advance, transfer of Property, or capital contribution to, or the incurring of any liability, contingently or otherwise, respecting the Indebtedness of, any Person. LIBOR shall mean the London Interbank Offered Rate as quoted under the title "Money Rates" in the Wall Street Journal issue published on or nearest to the date said rate is to be determined for any pertinent Interest Period, adjusted upward to the nearest hundredth of one percent to compensate for any reserve requirements (including any basic, supplemental, marginal and emergency reserves under regulations of any governmental authority) actually required to be maintained by the Lender. In the event The Wall Street Journal ceases or fails to publish LIBOR for any reason, then the Lender shall determine LIBOR by reference to other recognized sources of market information. Lien shall mean any mortgage, pledge, charge, encumbrance, security interest, collateral assignment, or other lien or restriction of any kind, whether based on common law, constitutional provision, statute, or contract, and shall include reservations, exceptions, encroachments, easements, rights of way, covenants, conditions, restrictions, leases, and other title exceptions. Loan shall mean all indebtedness for money borrowed from the Lender by the Borrower, together with all other liabilities of the Borrower under the Loan Documents, whether now existing or hereafter arising. Loan Documents shall mean this Agreement, the Note, all Security Documents, all instruments, certificates, and agreements now or hereafter executed or delivered to the Lender pursuant to any of the foregoing, and all amendments, modifications, renewals, extensions, increases, and rearrangements of, and substitutions for, any of the foregoing. Material shall mean an expected result or impact with a value of greater than $250,000.00, as to the Borrower, or $500,000.00 as to the Guarantor. Note shall mean the Promissory Note described in Section 2.1 hereof. Parties shall mean all Persons other than the Lender executing any Loan Document. Permitted Investment Securities shall mean: (1) readily marketable securities issued or fully guaranteed by the United States of American; (2) commercial paper rated "Prime 1" by Moody's Investor Service, Inc., or A-1 by Standard and Poor's Borrower with maturities of not more than one hundred eighty (180) days; (3) mutual funds acceptable to the Lender; (4) certificates of deposit or repurchase contracts with financial institutions acceptable to the Lender on terms satisfactory to the Lender, all of the foregoing not having a maturity of more than one (1) year from the date of issuance thereof; and (5) readily marketable securities received in settlement of liabilities created in the ordinary course of business. Person shall mean any individual, business entity, trust, unincorporated organization, governmental authority, or any other form of entity. Plan shall mean any plan subject to Title IV of ERISA and maintained for employees of the Borrower or of any member of a "controlled group of corporations", as such term is defined in the Code, of which the Borrower is a part, or any such plan to which the Borrower is required to contribute on behalf of its employees. Property shall mean any interest in any kind of property or asset, whether real, personal or mixed, tangible or intangible. Quarterly Unaudited Financial Statements shall mean quarterly financial statements which statements shall include a balance sheet as of the end of such period and an income statement for such period, and for the fiscal year to date, subject to normal end of period adjustments, all setting forth in comparative form the corresponding figures for the corresponding month of the preceding year, prepared in accordance with Generally Accepted Accounting Principles and certified by the president or chief financial officer of such Person as being true and correct and fairly reflecting the financial position of such Person as of the date thereof and the results of its operations for the period covered thereby. Rate Request shall mean a choice of interest rate made by the Borrower pursuant to this Agreement. Security Documents shall mean this Agreement, the security agreement, and any and all other agreements, mortgages, security agreements, pledges, guaranties, assignments of income, assignments of contract rights, subordination agreements, undertakings, and other instruments and financing statements now or hereafter executed and delivered by any Person (other than solely by the Lender and/or any other creditor participating in the Loan or any collateral or security therefor) in connection with, or as security for the payment or performance of, the Note, or any Indebtedness. Subsidiary shall mean, as to a particular parent business entity, any business entity of which fifty percent (50%) or more of the indicia of equity rights (whether outstanding capital stock or otherwise) is at the time directly or indirectly owned by such parent business entity, or by one or more of its Affiliates. 2. The Loan. 2.1 Description of the Loan. Subject to the terms and conditions of this Agreement and in reliance upon the representations and warranties made by the Borrower and the Guarantor, the Lender agrees to (a) make available to the Borrower a $10,000,000.00 term loan, as evidenced by the Promissory Note (the "Note") in substantially the form attached hereto as Exhibit "A". The Loan is secured, in part, by the Borrower's Accounts, Equipment, Inventory and General Intangibles, and the Borrower's real property located in Travis County, Texas, together with all improvements, fixtures, equipment and other appurtenances attached thereto. 2.2 Rates of Interest on the Note. From the date of this Agreement until maturity, interest shall accrue on the Note at a rate (or rates) per annum equal to a fixed rate equal to Adjusted LIBOR for the pertinent Interest Period. Each determination of the rate of interest made by the Lender in accordance with this Agreement shall be conclusive except in the case of manifest error. Each Rate Request shall include the following information: 1. The amount of the Loan to be subject to the Rate Request; 2. The Borrower's choice of the Interest Period; and 3. Any other information required under the other provisions of this Agreement. Each Rate Request shall be made by telephone or in writing not later than 12:00 noon, local time, in Albuquerque, New Mexico, three (3) business days prior to the date the Borrower desires for the rate to be changed under this Agreement. In the event the Rate Request is made by telephone, written confirmation of such Rate Request must be sent to the Lender within five (5) business days following such Rate Request. If the Borrower makes no interest rate choice by the end of any Interest Period, the Borrower shall be deemed to have made a Rate Request for the same Interest Period as previously in effect until such time as said Interest Period ends (or the Note matures). The Borrower and the Lender contemplate that different rate options may be in effect simultaneously under the Note. Any Rate Request shall be subject to the following special provisions: (a) interest shall commence on the date specified in the Rate Request and shall remain in effect for the Interest Period specified in the pertinent Rate Request, or until maturity, whichever is earlier; (b) if any Interest Period would otherwise expire on a day which is not a banking day in Albuquerque, New Mexico, such Interest Period shall expire on the next succeeding banking day; (c) no Interest Period shall extend beyond the scheduled maturity of the Note; and (d) no more than ten (10) Interest Periods shall be in existence under this Agreement at any time. 2.3 Fees and Deposit. The Borrower shall pay the Lender a fee of $100,000.00 (1.00%) for the Loan at funding, and an annual fee of $12,000.00, commencing on August 9, 2003 and continuing annually through and including August 9, 2011. Furthermore, the Borrower shall deposit $100,000.00 (the "Deposit") at funding, which Deposit shall be applied toward the cost of the interest rate swap described in Section 5.13 of this Agreement, or, at the Borrower's option, refunded to the Borrower after the interest rate swap agreement is executed. If the Borrower fails to enter into said interest rate swap by December 15, 2002, the Lender shall be entitled to retain the Deposit as an additional fee for the Loan. 3. Conditions. 3.1 Funding. The obligation of the Lender to fund the proceeds of the Loan to the Borrower is subject to the receipt by the Lender of each of the following, in form and substance satisfactory to the Lender: (a) The Note; (b) Appropriate certificates from the Borrower and the Guarantor which evidence the authority of the officers and agents of the Borrower and the Guarantor to execute the Loan Documents, together with copies of appropriate organizational documents for said entities; (c) The Security Documents; (d) Policies of insurance reflecting the insurance required by Section 5.6 hereof; (e) Satisfaction of the requirements described in commitment letter from the Lender to the Borrower dated on or about May 31, 2002; (f) An opinion from the Borrower's counsel in form and substance acceptable to the Lender; (g) Evidence satisfactory to the Lender as to the priority of the security interests created by the Security Documents, and to the further condition that, at the time of the initial advance of funds, all legal matters incident to the transactions herein contemplated shall be satisfactory to counsel for the Lender; (h) A business valuation prepared by an appraiser acceptable to the Lender showing that the market value of the Borrower is not less than $13,333,333.33; and (i) A Phase I Environmental Site Assessment in form and substance acceptable to the Lender that concludes that no impairments exist or are likely to exist. 4. Representations and Warranties. To induce the Lender to enter into this Agreement and to make the Loan, the Parties represent and warrant as follows: 4.1 Organization. Windermere Utility Co., Inc. expressly represents and warrants to the Lender that it is a corporation duly organized and existing under the laws of the State of Texas; that it possesses full power and authority to own its property and to conduct its business as presently proposed to be conducted; that the execution and delivery of this Agreement and the Loan Documents and the performance of the obligations hereunder will not contravene any provisions of its articles of incorporation; and that the president, vice president or other agent executing this Agreement and the Loan Documents is expressly authorized to execute this Agreement and the Loan Documents by resolution of the Board of Directors of the Borrower. 4.2 Financial Statements. The financial statements delivered to the Lender fairly present, in accordance with Generally Accepted Accounting Principles, the results of operations of the Borrower and the Guarantor at the dates and for the periods indicated. No Material adverse change has occurred in the Property, liabilities, and financial condition of, and no significant adverse change has occurred in the business of affairs of, the Borrower or the Guarantor since the dates of such financial statements. The Borrower is not subject to any instrument or agreement materially and adversely affecting its financial condition, business, or affairs. 4.3 Enforceable Obligations; Authorization. The Loan Documents are legal, valid, and binding obligations of the Parties thereto, enforceable in accordance with their respective terms, except as may be limited by bankruptcy, insolvency, and other similar laws affecting creditors' rights generally and by general equitable principles. The execution, delivery, and performance of the Loan Documents have all been duly authorized by all necessary action of the Parties. 4.4 Other Debt. None of the Parties are in default in the payment of any other Indebtedness or under any Material agreement, mortgage, deed of trust, security agreement or lease. Except as previously disclosed in writing to the Lender, none of the Parties have any Indebtedness for borrowed money. 4.5 Litigation. Except as previously disclosed in writing to the Lender and for matters in which less than $100,000.00 are in controversy, there is no litigation or administrative proceeding pending or, to the knowledge of the parties, threatened against, nor any outstanding judgment, order or decree affecting, the Parties or any of the Property owned by the Parties. 4.6 Title. The Borrower has good and marketable title to all of its assets, free and clear of any Lien except for property tax liens which are not delinquent and mechanics' liens which are not Material or are bonded or otherwise secured to the reasonable satisfaction of the Lender. 4.7 Taxes. The Parties have filed all tax returns required to have been filed and paid all taxes due, except those for which extensions have been obtained and those which are being contested in good faith and for which reserves deemed adequate by the Lender have been established therefor. None of the Parties are aware of any pending investigation by any taxing authority which in the event of an adverse determination would have a Material adverse impact upon the financial condition or the business prospects of the Parties. 4.8 Subsidiaries. The Borrower has no Subsidiaries. 4.9 ERISA. No reportable Event (as defined in Section 4043(b) of ERISA) has occurred with respect to any Plan. Each Plan complies with all applicable provisions of ERISA, and the Borrower has filed all reports required by ERISA and the Code to be filed with respect to each Plan. The Borrower has no knowledge of any Event which could result in a liability of the Borrower to the Pension Benefit Guaranty Corporation. The Borrower has met all requirements with respect to funding any Plan proposed by ERISA or the Code. Since the effective date of Title IV of ERISA, there have not been any nor are there any Events or conditions now existing that would permit any Plan to be terminated under circumstances which would cause the lien provided under Section 4068 of ERISA to attach to any assets of the Borrower. The value of the Plan's benefits guaranteed under Title IV of ERISA on the date hereof does not exceed the value of such Plan's assets allocable to such benefits as of the date of this Agreement and shall not be permitted to do so hereafter. 4.10 Representations by Others. All written statements made by the Parties or in connection with any Loan Document shall constitute representations and warranties of the Parties hereunder. 4.11 Survival of Representations, etc. All written representations and warranties made by the Parties shall survive the delivery of the Note to the Lender and the making of the Loan, and no investigation at any time made by or on behalf of the Lender shall diminish the Lender's rights to rely thereon. 5. Affirmative Covenants. The Parties covenant and agree with the Lender that prior to (a) the termination of this Agreement, (b) the payment in full of the Loan and (c) the termination of all obligations, if any, of the Lender to advance monies to or on behalf of the Borrower, the Parties will do, and if necessary cause to be done, each and all of the following: 5.1 Taxes, Existence, Regulations, Property, etc. At all times (a) pay when due all taxes and governmental charges of every kind upon the Parties or against the income, profits, or Property of the Parties, unless and only to the extent that the same shall be contested in good faith and reserves deemed adequate by the Lender have been established therefor; (b) do all things necessary to preserve the existence, qualifications, rights, and franchises of the Borrower in all states where such qualification is necessary or desirable; (c) comply with all applicable legal requirements in respect of the conduct of the business and the ownership of the Property of the Parties; and (d) cause the Property of the Parties to be protected, maintained, and kept in good repair and make all replacements and additions to the Property as may be reasonably necessary to conduct the business properly and efficiently. 5.2 Financial Statements and Information. Furnish, or cause to be furnished, to the Lender each of the following in form, substance and detail satisfactory to the Lender: (a) as soon as available and in any event within one hundred five (105) days after the end of each fiscal year, Annual Unaudited Financial Statements of the Borrower; (b) as soon as available and in any event within forty-five (45) days after the end of each calendar quarter, Quarterly Unaudited Financial Statements of the Borrower; (c) within ten (10) days of the date due, copies of the Guarantor's 10Q statements for the most recent period; and (d) as soon as available and in any event within one hundred five (105) days after the end of each fiscal year, Annual Audited Financial Statements of the Guarantor. 5.3 Inspection. Permit the Lender and the Lender's designated agent to inspect the Borrower's assets, examine the Borrower's files, books and records and make and take away copies thereof, and discuss the Borrower's affairs with the Borrower's officers and accountants, all at such times and intervals and to such extent as the Lender may reasonably desire. The Lender shall not disclose any confidential information gained from any such inspection except to the Lender's directors, officers, employees, attorneys, accountants and regulators or as otherwise necessary in the Lender's ordinary course of business. 5.4 Further Assurances. Promptly execute and deliver any and all other and further instruments which may be reasonably requested by the Lender to cure any defect in the execution and delivery of any Loan Document or more fully to describe significant aspects of the Parties' agreements set forth in the Loan Documents or so intended to be. 5.5 Books and Records. Maintain books of record and account in accordance with Generally Accepted Accounting Principles. 5.6 Insurance. Maintain insurance with such insurers, on the Parties' assets, in an amount of not less than $10,000,000.00 and against such risks as are reasonably satisfactory to the Lender and furnish the Lender satisfactory evidence thereof promptly upon request. These insurance provisions are cumulative of the insurance provisions of the Security Documents. The Borrower shall cause the Lender to be named as a beneficiary and/or loss payee as to hazard insurance (as required by the Lender) of such insurance and shall provide the Lender with copies of the insurance certificate of the insured that the insurance required by this Section may not be non-renewed without thirty (30) days' prior written notice to the Lender. 5.7 Debt to worth Ratio. Cause the Borrower to maintain at all times a Debt to Worth Ratio of not more than 2.2 to 1.0, as determined as of the last day of each fiscal year. 5.8 Coverage Ratio. Cause the Borrower to maintain at all times a Coverage Ratio of not less than 1.3 to 1.0, as determined as of the last day of each fiscal year. 5.9 Pay Indebtedness. Pay, renew or extend the principal and interest on all Material Indebtedness owed by the Parties as the same shall become due and payable. 5.10 ERISA. At all times cause the Borrower to immediately upon acquiring knowledge of any Reportable Event (as defined in Section 4043(b) of ERISA) or of any "prohibited transaction", as such term is defined in the Code, in connection with the Plan, furnish the Lender a statement executed by the president or chief financial officer of the Borrower setting forth the details thereof and the action which the Borrower proposes to take with respect thereto and, when known, any action taken by the Internal Revenue Service or the Department of Labor with respect thereto. 5.11 Subordination of Indebtedness to Affiliates. Cause all Affiliates of the Borrower, including the Guarantor, to subordinate the payment of any Indebtedness owed by the Borrower to such Affiliates to the payment of the Loan, in form and substance satisfactory to the Lender. The Borrower shall provide the Lender with copies of all notes or other agreements which evidence or secure any such Indebtedness. However, the Lender consents to the application of the Loan proceeds to the Borrower's current Indebtedness to Affiliates. 5.12 Notice of Certain Matters. Notify the Lender immediately upon acquiring knowledge of the occurrence of any of the following: (a) the institution or threatened institution of any lawsuit or administrative proceedings affecting the Borrower or the Guarantor excluding tort claims fully covered by insurance or litigation with an aggregate claim not in excess of $100,000.00, as to Borrower, and $250,000.00 as to the Guarantor; (b) the occurrence of any Material adverse change in the assets, liabilities or financial condition of, or any significant adverse change has occurred in the business or affairs of, the Borrower or the Guarantor; (c) the occurrence of any Event of Default or any Default. 5.13 Interest Rate Swap. Cause the Borrower to enter into an interest rate swap agreement with the Lender or its Affiliate by December 15, 2002 in a minimum amount of $5,000,000.00 and for a minimum term of five (5) years; provided, however, the Lender's sole remedy for a default under this Section 5.13 shall be to retain the Deposit described in Section 2.3 of this Agreement. 6. Negative Comments. The Parties covenant and agree with the Lender that prior to (i) the termination of this Agreement, (ii) the payment in full of the Loan and (iii) the termination of all obligations, if any, of the Lender to advance monies to or on behalf of the Borrower, or either of them, the Borrower will not, without the prior written consent of the Lender, do or allow to be done any of the following: 6.1 Mergers, Consolidation, and Dispositions and Acquisitions of Assets. In any single transaction or series of transactions with an aggregate value of greater than $500,000.00, directly or indirectly: (a) liquidate or dissolve; (b) be a party to any merger or consolidation; (c) sell, convey, or lease all or any substantial part of its Property, except for sale of inventory in the ordinary course of business; or (d) acquire all or substantially all of the Property of any Person. 6.2 Redemption, Dividends and Distributions. At any time (a) redeem or otherwise acquire, directly or indirectly, any of its equity capital; (b) pay any dividends in excess of fifty percent (50%) of the Borrower's net income, after tax, during any fiscal year; and (c) make any other distribution of any Property or cash to shareholders as such, except for the application of the Loan proceeds to pay Indebtedness owed to Affiliates as described in Section 5.11 of this Agreement. 6.3 Nature of Business; Management. Change the nature of its business or enter into any business which is substantially different from the business in which it is presently engaged or permit any substantial change in its executive management. 6.4 Books and Records. Change the method by which the Borrower maintains its books and records, except as required by Generally Accepted Accounting Principles. 6.5 Change in Ownership. Allow a change in ownership of twenty-five percent (25%) or more of the common stock of the Borrower during the term of the Loan. 7. EVENTS OF DEFAULT AND REMEDIES. 7.1 Events of Default. If any of the following events shall occur, then the Lender may do any or all of the following subject to the express notice and cure rights described in the Note: (1) declare the Loan to be immediately due and payable, together with all accrued interest thereon, without notice of any kind, notice of acceleration or of intention to accelerate, presentment and demand or protest, all of which are hereby expressly waived (except for the express notice and cure rights described in the Note); (2) terminate all commitments to advance funds to the Borrower; (3) accelerate the maturity of the Loan to a date as early as the date of the notice; (4) exercise its rights of offset against each Account and all other Property of the Borrower in the possession of the Lender, which right is hereby granted by the Borrower to the Lender; and (5) exercise any and all other rights pursuant to the Loan Documents: (a) The Borrower fails to pay or prepay any principal of or interest on the Loan or any commitment fee or any other obligation hereunder within five (5) days of the date due; or (b) The Borrower (i) fails to pay at maturity, or within any applicable period of grace, any principal or interest on any other borrowed money obligation or if the holder of such other obligation declares, or may declare, such obligation due prior to its stated maturity because of a default thereunder; or shall fail to observe or perform any Material term, covenant or agreement contained in any agreement or obligation by which the Borrower is bound, or (ii) is in default under or in violation of any agreement or obligation by which the Borrower is bound; or (c) Any representation or warranty made by the Parties herein or otherwise in connection with this Agreement proves to have been incorrect, false or misleading in any significant respect when made; or (d) The Parties violate any covenant, agreement, or condition contained in this Agreement or the other Loan Documents and such violation is not cured within the express notice and cure period described in the Note (or a cure commenced within such period and diligently pursued to completion where the cure reasonably required more than fifteen (15) days); or (e) A final and nonappealable judgment, or final and nonappealable judgments in the aggregate, for the payment of money in excess of $500,000.00 is rendered against the Borrower and the same shall remain undischarged for a period of thirty (30) days during which execution shall not be effectively stayed; or (f) The Borrower or any other Person claims, or any court finds or rules, that the Lender does not have a valid Lien as provided for herein on any Material security which may have been provided by the Borrower, or such other Person; or (g) The Borrower sells, encumbers, or abandons (except as otherwise expressly permitted by the Loan Documents) any significant portion of the Property now or hereafter subject to any of the Security Documents; or any levy, seizure or attachment is made thereof or thereon; or such Property is lost, stolen, substantially damaged or destroyed, and such loss or damage is not reimbursed by adequate insurance proceeds; or (h) Any order is entered in any proceeding against the Borrower decreeing the dissolution, liquidation or split-up of the Borrower, and such order remains in effect for twenty (20) days; or (i) The Borrower makes an assignment for the benefit of creditors or becomes insolvent or fails generally to pay its debts as they become due, or petitions or applies to any tribunal for the appointment of a trustee, custodian, receiver, (or other similar official) of the Borrower or of all or any substantial part of the Property of the Borrower or commences a voluntary case or any other proceedings relating to the Borrower under any bankruptcy, reorganization, compromise arrangement, insolvency, readjustment of debt, dissolution, or liquidation or similar law (herein called the "bankruptcy law") of any jurisdiction; or (j) Any such petition or application is filed, or any such proceedings are commenced, against the Borrower and the Borrower by any act or omission indicates its approval, consent, or acquiescence, or an order for relief is entered in an involuntary case under the federal bankruptcy laws as now or hereafter constituted, or an order, judgment or decree is entered appointing any such trustee, custodian, receiver, liquidator, or similar official or adjudicating the Borrower bankrupt or insolvent, or approving the petition in any such proceedings, and such order, judgment, or decree remains in effect for twenty (20) days; or (k) A Material adverse change occurs in the Property, liabilities or financial condition of, or any significant adverse change in the business or affairs of, the Parties (or any of them); or (l) The Parties conceal, remove, or permit to be concealed or removed, any part of their Property, with intent to hinder, delay or defraud their creditors or any of them, or makes or suffers a transfer of any of their Property which may be fraudulent under any bankruptcy, fraudulent conveyance or similar law; or shall have made any transfer of their Property to or for the benefit of a creditor at a time when other creditors similarly situated have not been paid. 7.2 Other Remedies. In addition to and cumulative of any rights or remedies provided for in this Agreement or any of the other Loan Documents, upon the occurrence of any of the events described in Section 7.1 hereof, the Lender may at any time proceed to protect and enforce its rights hereunder, by any appropriate proceedings, and the Liens evidenced by the Security Documents shall be subject to foreclosure in any manner provided for therein or provided for by law as the Lender may elect. The Lender may also proceed either by the specific performance of any covenant or agreement contained in this Agreement or the other Loan Documents or to enforce the payment of the Loan or to enforce any other legal or equitable right provided under this Agreement or the other Loan Documents, or otherwise existing under any law in favor of the holders of Indebtedness. 7.3 Remedies Cumulative. No remedy, right or power of the Lender is intended to be exclusive of any other remedy, right or power, and each and every remedy, right and power shall be cumulative and in addition to every other remedy, right and power given hereunder or now or hereafter existing at law or in equity or by statute or otherwise. 8. Miscellaneous. 8.1 No Waiver. No failure to exercise and no delay on the part of the Lender in exercising any power or right in connection herewith or under any other Loan Document shall operate as a waiver, nor shall any single or partial exercise of any such right or power, preclude any other or further exercise thereof or the exercise of any other right or power. No course of dealing between the Borrower and the Lender shall operate as a waiver of any right of the Lender. No modification or waiver of any provision of this Agreement or any other Loan Document shall be effective unless the same shall be in writing and signed by the Person against whom enforcement thereof is to be sought. 8.2 Governing Law. Unless otherwise specified therein, each Loan Document shall be governed by and construed in accordance with the laws of the State of Texas and The United States of America. The Parties hereby irrevocably agree that any legal proceeding against the Lender arising out of or in connection with this Agreement or the other Loan Documents shall be brought in the District Courts of Travis County, Texas, or in the United States District Court for the Western District of Texas, Austin Division. 8.3 Usury Not Intended; Refund of Any Excess Payments. It is the intent of the Parties in the execution and performance of this Agreement to contract in strict compliance with the usury laws of the State of Texas and The United States of America from time to time in effect. In furtherance thereof, the Lender and the Parties stipulate and agree that none of the terms and provisions contained in this Agreement or the other Loan Documents shall ever be construed to create a contract to pay for the use, forbearance, or detention of money with interest at a rate in excess of the Highest Lawful Rate and that for purposes hereof "interest" shall include the aggregate of all charges which constitute interest under such laws that are contracted for, reserved, taken, charged, or received under this Agreement. In determining whether or not the interest paid or payable, under any specific contingency, exceeds the Highest Lawful Rate, the Parties and the Lender shall, to the maximum extent permitted under applicable law, (a) treat all advances as but a single extension of credit (and the Parties and the Lender agree that such is the case and that provision herein for multiple advances is for convenience only), (b) characterize any nonprincipal payment as an expense, fee, or premium rather than as interest, (c) exclude voluntary prepayments and the effects thereof, and (d) "spread" the total amount of interest throughout the entire contemplated term of the Loan. The provisions of this paragraph shall control over all other provisions of the Loan Documents which may be in apparent conflict herewith. 8.4 Expenses. Any provision to the contrary notwithstanding, and whether or not the transactions contemplated by this Agreement shall be consummated, the Parties shall pay on demand all reasonable out-of-pocket expenses (including, without limitation, the fees and expenses of counsel for the Lender) in connection with the negotiation, preparation, execution, filing, recording, refiling, re-recording, modification, supplementing, and waiver of the Loan Documents and the making and collection of the Loan. The obligations of the Parties under this and the following section shall survive the termination of this Agreement and/or the payment of the Loan. 8.5 Indemnification. The Borrower agrees to indemnify, defend, and hold the Lender harmless from and against any and all loss, liability, obligation, damage, penalty, judgment, claim, deficiency, and expense (including interest, penalties, attorneys' fees, and amounts paid in settlement) to which the Lender may become subject arising out of or based upon the Loan Documents or the Loan, excluding those to the extent caused by the Lender's own acts or omissions. 8.6 Entire Agreement. This Agreement and the Loan Documents embody the entire Agreement and understanding between the Parties and the Lender relating to the subject matter hereof and supersedes all prior proposals, negotiations, agreements, and understandings relating to such subject matter. The Parties certify that they are not relying on any representation, warranty, covenant, or agreement except for those set forth in this Agreement and the other Loan Documents. All written representations made by the Parties to the Lender respecting the subject matter hereof shall survive the execution of this Agreement. 8.7 Severability. If any provision of any Loan Document shall be invalid, illegal, or unenforceable in any respect under any applicable law, the validity, legality, and enforceability of the remaining provisions shall not be affected or impaired thereby. 8.8 Loan Agreement Controls. If there are any conflicts or inconsistencies among this Agreement and any of the other Loan Documents, this Agreement shall prevail and control. 8.9 Commitment. The Lender has no commitment to lend sums to the Borrower other than as specifically set forth herein. 8.10 Notices. All notices, demands and requests made under any provision of this Agreement shall be in writing and shall be deemed to have been properly delivered as of the time of delivery if personally delivered, the date of receipt or refusal indicated on the return receipt, if sent by United States certified mail, return receipt requested, and postage prepaid, or one (1) business day after the time of delivery to Federal Express (or comparable express delivery system) if sent by such method with all costs prepaid. All notices, demands and requests shall be addressed to the Lender at 500 Marquette NW, 14th Floor, Albuquerque, New Mexico 87102, Attention: Elizabeth Allbright, to the Borrower at 2700 Pecan Street West, Suite 423, Pflugerville, Texas 78660, Attention: William Jasura, Chief Financial Officer, or to such other address that either the Lender or the Borrower may designate to the other by written notice sent in the manner required hereby. 8.11 Sale or Assignment. The Lender reserves the right, in its sole discretion, without notice to the Borrower, or any of the other Parties, to sell participants or assign its interest, or both, in all or any part of the Loan evidenced by this Agreement, or the other Loan Documents. No such sale or assignment shall relieve the Lender of any obligation of the Lender under the Loan Documents. BANK OF THE WEST By: /s/ ELIZABETH R. ALLBRIGHT ------------------------------ Name: Elisabeth R. Allbright Title: Vice President WINDERMERE UTILITY CO., INC. a Texas Corporation By: /s/ MICHAEL O. QUINN ------------------------ Name: Michael O. Quinn Title: President SOUTHWEST WATER COMPANY, a Delaware corporation By: /s/ THOMAS C. TEKULVE ------------------------- Name: Thomas C. Tekulve Title: Vice President Finance and Treasurer ATTACHMENTS: Exhibit A - Note PROMISSORY NOTE $10,000,000.00 August 9, 2002 For value received, WINDERMERE UTILITY CO., INC., a Texas corporation (the "Makers," whether one or more), promise to pay to the order of BANK OF THE WEST (the "Lender"), at 500 Marquette NW, 14th Floor, Albuquerque, New Mexico 87102, or such other location as the Lender designates to the makers in writing, the principal sum of TEN MILLION AND NO/100 DOLLARS ($10,000,000.00), or the outstanding principal amount advanced hereunder, whichever is less, in legal and lawful money of the United States of America, with interest thereon as hereinafter specified. TERMS OF PAYMENT: Principal shall be due and payable in quarterly installments of $125,000.00 each, commencing on November 9, 2002 and continuing thereafter on February 9, May 9, August 9 and November 9 of each year until August 9, 2012 (the "Maturity Date"), when the entire amount hereof, principal and interest then remaining unpaid, shall be then due and payable. Interest, computed upon the unpaid principal balance hereof, shall be due and payable quarterly as it accrues, on the same dates as, but in addition to, said payments of principal; interest being calculated on the unpaid principal to the date each payment is received and the payment made credited first to the discharge of the interest accrued and the balance to the reduction of the principal. PAYMENT ON NON-BUSINESS DAYS: If any payment hereunder falls due on a Saturday, Sunday or public holiday on which commercial banks in Albuquerque, New Mexico are permitted or required by law to be closed, the time for such payment shall be extended to the next day on which the Lender is open for business, and such extension of time shall be included in the calculation of interest accruing and payable hereunder. LATE PAYMENT CHARGE: The Makers agree to pay to the Lender a late payment service charge in an amount equal to five percent (5%) of any regularly scheduled principal and accrued interest installment which is not received by the Lender within fifteen (15) days after the installment is due; provided however, such late payment service charge shall not apply to the principal and interest installment due on the Maturity Date. RATE OF INTEREST: Prior to maturity (whether by acceleration or otherwise) interest on the outstanding and unpaid principal balance hereof shall be computed in accordance with the specific provisions of the Loan Agreement dated of even date herewith between the Makers and the Lender (the "Loan Agreement"). INTEREST AFTER DEFAULT: Upon default, including failure to pay upon final maturity, the Lender, at its option, may, if permitted under applicable law, increase the variable interest rate on this Note to six percent (6.00%) over the Adjusted LIBOR, as defined in the Loan Agreement (the "Past Due Rate"). The interest rate will not exceed the Maximum Lawful Rate permitted by applicable law. Prior to maturity, the Past Due Rate shall not be charged on any balance owed under the Note after the Borrower successfully cures any default in accordance with the express notice and cure rights described in this Note. As used herein, the term "Maximum Lawful Rate" shall mean the greater of (i) the highest non-usurious rate of interest permitted by applicable United States law, or (ii) a rate per annum equal to the applicable weekly ceiling described in Chapter 303 of the Texas Finance Code, as amended, as such weekly ceiling is in effect from time to time, but in no event greater than twenty-eight percent (28.00%) per annum. Unless precluded by law, changes in the Maximum Lawful Rate created by statute or governmental action during the term of this Note shall be immediately applicable to this Note on the effective date of such changes. If the applicable law ceases to provide for a Maximum Lawful Rate, the Maximum Lawful Rate shall be equal to eighteen percent (18%) per annum. PREPAYMENT: Prior to August 9, 2007, the Borrower shall only have the right to prepay this Note upon payment of a prepayment premium to the Lender on the date of the prepayment. The prepayment premium shall be equal to two percent (2.00%) of the unpaid principal balance of this Note if made prior to August 9, 2005 and one percent (1.00%) of the unpaid principal balance of this Note if made between August 9, 2005 and August 9, 2007. At any other time, the Makers reserve the right to prepay this Note or any portion hereof without penalty or premium; however, all prepayments must be made at the end of the applicable Interest Period (as defined in the Loan Agreement). Interest shall be calculated on the unpaid principal to the date of any prepayment and any such prepayment shall be applied first toward the payment of accrued interest and next to the principal installments of this Note in the direct order of maturity beginning with the earliest date. SECURITY FOR PAYMENT: Payment of this Note is secured by, and this Note is entitled to the benefits of, all security agreements, assignments, deeds of trust, mortgages and lien instruments executed by the Makers (or any of them), or other similar instruments, guaranties, endorsements or other agreements, executed by any other person or entity (the "Collateral Agreements," whether one or more) to secure, guarantee or otherwise provide for the payment hereof, in favor of or for the benefit of the Lender, including any previously executed and any now or hereafter executed. Without limiting the foregoing, the Collateral Agreements include (i) a Deed of Trust, Security Agreement and Financing Statement dated of even date herewith executed by the Makers to Meade Bauer, Trustee for the benefit of the Lender, which instrument covers certain real property (the "Real Property") located in Travis and Williamson Counties, Texas, and (ii) a security agreement dated of even date herewith executed by the Makers, as debtor, in favor of the Lender, as secured party, covering certain collateral as more particularly described therein. USE OF PROCEEDS: This Note represents funds advanced and to be advanced to the Makers at the Makers' special instance and request, the receipt of a portion which is hereby acknowledged, which funds are to refinance certain improvements on the Real Property pursuant to the terms of the Loan Agreement. REPRESENTATIONS AND WARRANTIES: WINDERMERE UTILITY CO., INC. expressly represents and warrants to the Lender that it is a corporation duly organized and existing in good standing under the laws of the State of Texas; that it possesses full power and authority to conduct its business as now conducted and as presently proposed to be conducted; that the execution and delivery of this Note will not contravene any provisions of its articles of incorporation or by-laws; that the officer executing this Note is the legally elected, qualified and acting officer of said corporation and is expressly authorized to execute this Note by resolution of the board of directors of said corporation. LIMITATION OF INTEREST: All agreements and transactions among the Makers and the Lender, whether now existing or hereafter arising, whether contained herein or in any other instrument, and whether written or oral, are hereby expressly limited so that in no contingency or event whatsoever, whether by reason of acceleration of the maturity hereof, late payment, prepayment, or otherwise, shall the amount of interest contracted for, charged or received by the Lender from the Makers for the use, forbearance, or detention of the principal indebtedness or interest hereof, which remains unpaid from time to time, exceed the Maximum Lawful Rate, it particularly being the intention of the parties hereto to conform strictly to the applicable usury laws of the State of Texas (or applicable United States law to the extent that it permits the Lender to contract for, charge or receive a greater amount of interest than under Texas law). Any interest payable hereunder or under any other instrument relating to the indebtedness evidenced hereby that is in excess of the Maximum Lawful Rate, shall, in the event of acceleration of maturity, late payment, prepayment, or otherwise, be applied to a reduction of the unpaid indebtedness hereunder and not to the payment of interest, or if such excessive interest exceeds the unpaid balance of such unpaid indebtedness, such excess shall be refunded to the Makers. To the extent not prohibited by applicable law, determination of the Maximum Lawful Rate shall at all times be made by amortizing, prorating, allocating and spreading in equal parts during the full term of this loan, all interest at any time contracted for, charged or received from the Makers in connection with this loan, so that the actual rate of interest on account of such indebtedness is uniform throughout the term thereof. SUCCESSORS AND ASSIGNS: As used herein, the term "Lender" shall include the successors and assigns of the Lender and any subsequent owner and holder of this Note, and the term "Makers" shall include co-makers, endorsers, guarantors, sureties and their respective successors and assigns. DEFAULT AND COLLECTION: Subject to the express notice and cure rights described in this Note, it is expressly provided that, upon default in the punctual payment of this Note, or any part hereof, principal or interest, as the same shall become due and payable, or if the Lender deems itself insecure, either because the prospect of timely payment of this Note becomes impaired, or because the prospect of timely performance of any of the Collateral Agreements becomes impaired, at the option of the Lender, the entire indebtedness evidenced hereby shall be matured, and in the event default is made in the prompt payment of this Note when due or declared due, and the same is placed in the hands of an attorney for collection, or suit is brought on the same, or the same is collected through probate, bankruptcy or other judicial proceedings, then the Makers jointly and severally agree and promise to pay all reasonable attorney's fees, court costs and collection costs incurred by the Lender. NOTICE AND CURE RIGHTS: In the event of any default under the Collateral Agreements or this Note, or if the Lender deems itself insecure, the Makers shall be entitled to receive written notice of any such default and a period of fifteen (15) days after such notice is sent by the Lender within which to cure such default prior to the Lender being entitled to exercise any remedy which may arise due to the occurrence of such default, other than the right to withhold making further advances of funds during the period any such default remains uncured. However, nothing herein shall obligate the Lender to give the Makers more than one (1) notice of default during any ninety (90) day period. WAIVERS AND CONSENTS: Except for the express notice and cure provisions contained in this Note, each of the Makers waives presentment for payment, notice of intent to accelerate, notice of acceleration, protest and notice of protest, dishonor and diligence in collecting and the bringing of suit against any other party, and agrees to all renewals, extensions, partial payments, releases and substitutions of security, in whole or in part, with or without notice, before or after maturity. The Lender may remedy any default, without waiving the same, or may waive any default without waiving any prior to subsequent default. GOVERNING LAWS AND VENUE: This Note is governed by and is to be construed and enforced in accordance with the laws of the State of Texas and of the United States. The Makers agree and consent to the jurisdiction of the District Courts of Travis County, Texas, and of the United States District Court for the Western District of Texas (Austin Division) and acknowledge that such courts shall constitute proper and convenient forums for the resolution of any actions among the Makers and the Lender with respect to the subject matter hereof, and agree that such courts shall be the exclusive forums for the resolution of any actions among the Makers and the Lender with respect to the subject matter hereof. WINDERMERE UTILITY CO., INC., a Texas corporation By: /s/ MICHAEL O. QUINN ------------------------ Name: Michael O. Quinn Title: President EX-10.23 10 dex1023.txt LLC PURCHASE AGREEMENT EXHIBIT 10.23 LLC PURCHASE AGREEMENT by and among AQUASOURCE, INC. and DQE, INC., on the one hand, and SOUTHWEST WATER COMPANY, on the other hand Dated as of September 14, 2002 TABLE OF CONTENTS ARTICLE I PURCHASE AND SALE OF MEMBERSHIP INTERESTS.............................................................. 7 Section 1.1 Sale and Transfer of Membership Interests................................................... 7 Section 1.2 The Purchase Price.......................................................................... 7 Section 1.3 Certain Liabilities, Accounts Receivable and Accounts Payable............................... 8 Section 1.4 Ongoing Revenues Statement.................................................................. 9 Section 1.5 Closing Statements and Payments............................................................. 9 ARTICLE II THE CLOSING...........................................................................................10 Section 2.1 Closing.....................................................................................10 Section 2.2 Closing Transactions........................................................................10 ARTICLE III REPRESENTATIONS AND WARRANTIES OF THE SELLER.........................................................11 Section 3.1 Organization and Qualification..............................................................11 Section 3.2 Subsidiaries................................................................................12 Section 3.3 Ownership and Possession of Membership Interests; Capitalization; Ownership and Possession of Integrated Assets................................................................12 Section 3.4 Authority; Non-Contravention; Statutory Approvals; Compliance...............................13 Section 3.5 Financial Statements........................................................................14 Section 3.6 Absence of Certain Changes or Events........................................................15 Section 3.7 Litigation..................................................................................15 Section 3.8 Tax Matters.................................................................................15 Section 3.9 Employee Benefits; ERISA....................................................................16 Section 3.10 Labor and Employee Relations...............................................................18 Section 3.11 Environmental Matters......................................................................19 Section 3.12 No Breaches or Defaults....................................................................20 Section 3.13 Insurance..................................................................................21 Section 3.14 Brokers or Finders.........................................................................21 Section 3.15 Competing Lines of Business................................................................21 Section 3.16 Limitation on Representations and Warranties...............................................21 ARTICLE IV REPRESENTATIONS AND WARRANTIES OF THE BUYER...........................................................21 Section 4.1 Organization and Qualification..............................................................21 Section 4.2 Authority; Non-Contravention; Statutory Approvals; Compliance...............................22 Section 4.3 Litigation..................................................................................23 Section 4.4 Investigation by the Buyer; the Seller's Liability..........................................24 Section 4.5 Acquisition of Membership Interests for Investment; Ability to Evaluate and Bear Risk..................................................................................25 Section 4.6 Financing...................................................................................25 Section 4.7 Brokers or Finders..........................................................................25 ARTICLE V CONDUCT OF BUSINESS PENDING THE CLOSING................................................................25 Section 5.1 Covenants of the Seller.....................................................................25 Section 5.2 Covenants of the Buyer......................................................................27 Section 5.3 Mutual Covenants of the Parties.............................................................28

i ARTICLE VI ADDITIONAL AGREEMENTS.................................................................................29 Section 6.1 Access to Company Information...............................................................29 Section 6.2 Regulatory Matters..........................................................................30 Section 6.3 Consents....................................................................................30 Section 6.4 Directors' and Officers' Indemnification....................................................31 Section 6.5 Public Announcements........................................................................32 Section 6.6 Workforce Matters...........................................................................32 Section 6.7 Seller Plans................................................................................34 Section 6.8 Tax Treatment...............................................................................35 Section 6.9 Tax Indemnity and Tax Returns...............................................................35 Section 6.10 Transfer Taxes.............................................................................37 Section 6.11 Financial Information......................................................................38 Section 6.12 Transition Services........................................................................38 Section 6.13 Update of the Seller Disclosure Schedule...................................................39 Section 6.14 AquaSource Name............................................................................39 Section 6.15 Officer and Director Resignations..........................................................39 Section 6.16 Non-Competition Covenants..................................................................39 Section 6.17 Enforcement of Other Covenants.............................................................42 Section 6.18 Surety Bonds...............................................................................42 Section 6.19 Further Assurances.........................................................................43 ARTICLE VII CONDITIONS...........................................................................................43 Section 7.1 Conditions to Each Party's Obligation to Effect the Closing.................................43 Section 7.2 Conditions to Obligation of the Buyer to Effect the Closing.................................45 Section 7.3 Conditions to Obligation of the Seller to Effect the Closing................................46 ARTICLE VIII TERMINATION.........................................................................................47 Section 8.1 Termination.................................................................................47 Section 8.2 Effect of Termination.......................................................................49 ARTICLE IX INDEMNIFICATION.......................................................................................49 Section 9.1 Indemnification Obligations.................................................................49 Section 9.2 Certain Definitions.........................................................................50 Section 9.3 Limitations on Indemnification..............................................................51 Section 9.4 Defense of Claims...........................................................................54 Section 9.5 Certain Covenants in Respect of Excluded Assets.............................................58 ARTICLE X GENERAL PROVISIONS.....................................................................................58 Section 10.1 Survival of Obligations....................................................................58 Section 10.2 Amendment and Modification.................................................................58 Section 10.3 Extension; Waiver..........................................................................58 Section 10.4 Expenses...................................................................................59 Section 10.5 Notices....................................................................................59 Section 10.6 Entire Agreement; No Third Party Beneficiaries.............................................60 Section 10.7 Severability...............................................................................60 Section 10.8 Governing Law..............................................................................61 Section 10.9 Venue......................................................................................61 Section 10.10 Waiver of Jury Trial and Certain Damages..................................................61 Section 10.11 Assignment................................................................................61 Section 10.12 Interpretation............................................................................62

ii Section 10.13 No Specific Enforcement...................................................................62 Section 10.14 Counterparts; Effect......................................................................62

iii INDEX OF PRINCIPAL TERMS
Term Page 90 Day Ongoing Revenues..........................................................................................9 Actual Cost.....................................................................................................40 Affected Employees..............................................................................................34 Affiliate.......................................................................................................43 Agreement........................................................................................................7 Assumed Defense.................................................................................................60 Audit...........................................................................................................39 Business Employees..............................................................................................17 Buyer............................................................................................................7 Buyer Disclosure Schedule.......................................................................................22 Buyer Indemnifiable Loss........................................................................................52 Buyer Indemnified Liabilities...................................................................................52 Buyer Indemnitee................................................................................................52 Buyer Material Adverse Effect...................................................................................23 Buyer Required Consents.........................................................................................23 Buyer Required Statutory Approvals..............................................................................24 Buyer Subsidiary................................................................................................23 Closing.........................................................................................................10 Closing Date....................................................................................................10 COBRA...........................................................................................................35 Code............................................................................................................18 Company..........................................................................................................7 Company Financial Statements....................................................................................15 Company Indemnified Parties.....................................................................................32 Company Indemnified Party.......................................................................................32 Company Material Adverse Effect.................................................................................12 Company Subsidiary..............................................................................................12 Confidential Information........................................................................................43 Confidentiality Agreement.......................................................................................31 Contracts.......................................................................................................21 Covered Excluded Assets.........................................................................................60 December 31, 2001 Balance Sheet.................................................................................15 Deficiency......................................................................................................10 Designated Employees............................................................................................44 Direct Claim....................................................................................................59 DQE..............................................................................................................7 Encumbrances....................................................................................................11 Environmental Laws..............................................................................................21 Environmental Whitepaper........................................................................................20 ERISA...........................................................................................................17 ERISA Affiliate.................................................................................................17 Estimated Closing Statement......................................................................................9
iv
Term Page Excepted Liabilities............................................................................................53 Excess..........................................................................................................10 Excluded Assets.................................................................................................29 Final Closing Statement..........................................................................................9 Final Order.....................................................................................................46 Governmental Authority..........................................................................................14 Hazardous Substances............................................................................................21 Hiring Conditions...............................................................................................34 Indemnifiable Loss..............................................................................................52 Indemnity Basket................................................................................................54 Indemnity Cap...................................................................................................54 Indemnity Period................................................................................................52 Initial Termination Date........................................................................................50 Integrated Assets...............................................................................................13 June 30, 2002 Balance Sheet.....................................................................................15 knowledge.......................................................................................................12 Membership Interests.............................................................................................7 Net Accounts Receivable..........................................................................................8 Notified Persons................................................................................................60 Other Unbilled Revenue...........................................................................................8 Party at Fault..................................................................................................51 Pending Litigation Matter.......................................................................................60 Permitted Encumbrances..........................................................................................11 Person..........................................................................................................12 Pre-Closing APs..................................................................................................9 Prohibited Activity.............................................................................................42 Purchase Price...................................................................................................7 Qualifying Offer................................................................................................34 Representatives.................................................................................................25 Retention Agreements............................................................................................19 Revenue Statement................................................................................................9 Securities Act..................................................................................................11 Seller...........................................................................................................7 Seller Disclosure Schedule......................................................................................11 Seller Indemnifiable Loss.......................................................................................52 Seller Indemnified Liabilities..................................................................................53 Seller Indemnitee...............................................................................................52 Seller Plans....................................................................................................17 Seller Required Consents........................................................................................14 Seller Required Statutory Approvals.............................................................................14 Services I.......................................................................................................7 Services II......................................................................................................7 Services, LP.....................................................................................................7 Severance Obligations...........................................................................................34
v
Term Page Severance Policy................................................................................................34 Straddle Period.................................................................................................38 Subsidiary......................................................................................................12 Tax.............................................................................................................17 Tax Claim.......................................................................................................38 Tax Return......................................................................................................17 Third Party Claim...............................................................................................57 Unbilled Active Work Order Revenue...............................................................................8 Violation.......................................................................................................14
vi LLC PURCHASE AGREEMENT This LLC Purchase Agreement, dated as of September 14, 2002 (this "Agreement"), is entered into by and among AquaSource, Inc., a Delaware corporation (the "Seller"), and DQE, Inc., a Pennsylvania corporation ("DQE"), on the one hand, and Southwest Water Company, a Delaware corporation (the "Buyer"), on the other hand. WHEREAS, the Seller owns all of the issued and outstanding membership interest (the "Membership Interests") of AquaSource Services I, LLC, a Delaware limited liability company ("Services I"); WHEREAS, Services I and its Subsidiaries (as defined in Section 3.2), AquaSource Services II, LLC, a Delaware limited liability company ("Services II"), and AquaSource Services, LP, a Texas limited partnership ("Services, LP"), together with the Company Subsidiaries (as defined in Section 3.2), are collectively referred to in this Agreement as the "Company"; and WHEREAS, each of the Boards of Directors of the Buyer and the Seller and DQE, as applicable, has approved, and deems it advisable and in the best interests of its respective shareholders to consummate, the acquisition of the Company by the Buyer, which acquisition is to be effected by the purchase of all of the Membership Interests by the Buyer upon the terms and subject to the conditions set forth herein; NOW, THEREFORE, in consideration of the premises and the representations, warranties, covenants and agreements contained herein, the parties hereto, intending to be legally bound hereby, agree as follows: ARTICLE I PURCHASE AND SALE OF MEMBERSHIP INTERESTS Section 1.1 Sale and Transfer of Membership Interests. Subject to the terms and conditions of this Agreement, on the Closing Date (as defined in Section 2.1), the Seller agrees to sell, convey, assign, transfer and deliver to the Buyer, and the Buyer agrees to purchase and accept from the Seller, all of the Seller's rights, title and interest in and to the Membership Interests. Section 1.2 The Purchase Price. Subject to the terms and conditions of this Agreement, in consideration of the aforesaid sale, conveyance, assignment, transfer and delivery to the Buyer of the Membership Interests, the Buyer shall pay to the Seller the following amounts (together, the "Purchase Price") pursuant to the provisions of this Section 1.2: (a) $7,500,000 in cash at Closing; (b) An amount of cash equal to ninety percent (90%) of the Net Accounts Receivable at Closing. For purposes of this Agreement, "Net Accounts 7 Receivable" shall mean the aggregate amount of the Company's outstanding accounts receivable as of the Closing Date, calculated in accordance with existing practices and procedures used by the Company, minus the amount of any allowance for doubtful accounts attributable to such accounts receivable then included on the books of the Company, provided that the amount of any such allowance for doubtful accounts shall be calculated by taking the aggregate amount of all accounts receivable then included on the books of the Company that have aged more than 120 days, multiplying such aggregate amount by a factor of 0.08, and then adding to the resulting product the amount of $450,000; (c) An amount of cash equal to fifty percent (50%) of the Unbilled Active Work Order Revenue at Closing. For purposes of this Agreement, "Unbilled Active Work Order Revenue" shall mean the aggregate amount of the Company's unbilled revenue attributable to active work orders of the Company for work or services not then fully completed and shall be calculated by determining the number of such active work orders in accordance with existing practices and procedures used by the Company and multiplying such number by $288.29; and (d) An amount of cash equal to one hundred percent (100%) of the Other Unbilled Revenue at Closing. For purposes of this Agreement, "Other Unbilled Revenue" shall mean the aggregate amount of the Company's unbilled revenue attributable to any source other than active work orders of the Company for work or services not then fully completed, including, but not limited to, revenue attributable to base fees, retainer fees or similar fees and revenue attributable to work or services that have been fully completed, and shall be calculated in accordance with existing practices and procedures used by the Company. Section 1.3 Certain Liabilities, Accounts Receivable and Accounts Payable. (a) Consistent with the June 30, 2002 Balance Sheet (as defined in Section 3.5), but subject to agreements in Section 1.3(b) below regarding Pre-Closing APs (as defined in Section 1.3(b)), the Seller agrees that at Closing the Company will have no accounts payable, no cash and no intercompany receivables or payables. However, the Buyer agrees that it will assume vacation accruals, but expressly not accrued payroll for any employees, through the Closing Date for employees who accept the Company's Qualifying Offer made pursuant to Section 6.6(a) below. Additionally, the Keystone, South Dakota, industrial revenue bond obligation will remain an obligation of the Company after the Closing. (b) The Seller or DQE will pay, in the ordinary course and consistent with past practice, all of the Company's accounts payable for obligations incurred prior to Closing ("Pre-Closing APs") that are received in the ordinary course of business prior to the Closing. The Buyer will forward to the Seller all Pre-Closing APs received by the Company in the ordinary course of business during the thirty (30) day period commencing on the Closing Date, and Seller will pay such Pre-Closing APs. All Pre-Closing APs received by the Company after such thirty (30) day period will be paid 8 by the Buyer, but all amounts so paid will each be a Buyer Indemnifiable Loss (as defined in Section 9.1) in accordance with the terms of Article IX. Section 1.4 Ongoing Revenues Statement. On the Closing Date, the earned revenues of the Company for the ninety (90) day period prior to the Closing Date for ongoing customer relations and customer contracts (the "90 Day Ongoing Revenues") must total at least $3,750,000. At the same time that the Seller prepares and delivers to the Buyer the Final Closing Statement (as defined below), the Seller will prepare and deliver to the Buyer a statement (the "Revenue Statement") showing the calculation and amount of the 90 Day Ongoing Revenues. Such calculation will be performed according to the methods and procedures historically used by the Company for calculating earned revenues. Together with the Revenue Statement, the Seller will provide to the Buyer copies of the worksheets and other documentation showing in reasonable detail how the 90 Day Ongoing Revenues were calculated. In the event that the 90 Day Ongoing Revenues are less than $3,750,000, then together with delivery of the Revenue Statement, the Seller will make a payment to Buyer in the amount of $.45 for each $1 by which the 90 Day Ongoing Revenues are less than $3,750,000. Section 1.5 Closing Statements and Payments. (a) At least ten (10) calendar days prior to the Closing Date, the Seller shall prepare and deliver to the Buyer in good faith its estimate of the Purchase Price as calculated pursuant to Section 1.2 (the "Estimated Closing Statement"). For the avoidance of doubt, at the Closing, the Buyer shall pay to the Seller the Purchase Price as reflected on the Estimated Closing Statement. (b) Within fifteen (15) calendar days following the Closing Date, the Seller shall prepare and deliver to the Buyer in good faith a Final Closing Statement setting forth the Purchase Price as calculated pursuant to Section 1.2 (the "Final Closing Statement"). Within fifteen (15) calendar days following the Buyer's receipt of the Final Closing Statement and the Revenue Statement, the Buyer may object in good faith to the Final Closing Statement and/or the Revenue Statement in writing. In the event of any such objection, the Buyer and the Seller shall attempt to resolve their differences by negotiation. If such parties are unable to do so within thirty (30) calendar days following the Seller's receipt of the Buyer's objection, the Seller and the Buyer shall appoint a nationally recognized accounting firm mutually acceptable to each of the Seller and the Buyer, which shall, at the Seller's and the Buyer's joint expense, review the Final Closing Statement and the Revenue Statement, as applicable, and determine the Purchase Price and the 90 Day Ongoing Revenues, as applicable, within thirty (30) calendar days of such appointment. The Seller and the Buyer shall be entitled to make a written submission to such accounting firm setting forth their respective positions and proposed Purchase Price and amount of 90 Day Ongoing Revenues, as applicable. In addition, the Seller and the Buyer agree to cooperate with such accounting firm and provide it with such information as it reasonably requests to enable it to make such determination. The finding of such accounting firm shall be binding on the parties hereto but is expressly limited to (i) a determination of the Purchase Price that neither exceeds the Seller's proposed Purchase Price nor is less than the Buyer's proposed Purchase Price, and (ii) a 9 determination of the amount of 90 Day Ongoing Revenues that neither exceeds the Seller's proposed amount of such revenues nor is less than the Buyer's proposed amount of such revenues, as applicable. Upon determination by agreement of the Seller and the Buyer or by binding determination of said accounting firm of the Purchase Price or the amount of the 90 Day Ongoing Revenues, as applicable, (i) if the Purchase Price or the amount of the 90 Day Ongoing Revenues, as applicable, that is finally agreed upon or determined exceeds the Purchase Price or the amount of the 90 Day Ongoing Revenues, as applicable, that was reflected on the Estimated Closing Statement or the Revenue Statement, as applicable (such excess amount, the "Deficiency"), the Buyer shall pay to the Seller an amount of cash equal to the Deficiency, or (ii) if the Purchase Price or the amount of the 90 Day Ongoing Revenues, as applicable, that was reflected on the Estimated Closing Statement or the Revenue Statement, as applicable, exceeds the Purchase Price that is finally agreed upon or determined (such excess amount, the "Excess"), the Seller shall pay to the Buyer an amount of cash equal to the Excess. Any amount of cash in respect of any Deficiency or Excess owed hereunder shall be paid to the party owed the same by the party owing the same by wire transfer in immediately available funds to an account designed by the party owed the same no later than five (5) business days following the determination by agreement of the Seller and the Buyer or by binding determination of said accounting firm of the Purchase Price. ARTICLE II THE CLOSING Section 2.1 Closing. The consummation of the sale and transfer of the Membership Interests by the Seller to the Buyer (the "Closing") shall take place at the Washington, D.C. office of Skadden, Arps, Slate, Meagher & Flom LLP at 10:00 a.m., local time, on the fifth business day immediately following the date on which the last of the conditions set forth in Article VII hereof is fulfilled or waived, or at such other time, date and place as the Seller and the Buyer shall mutually agree (the "Closing Date"). Section 2.2 Closing Transactions. At the Closing: (a) The Seller shall deliver to the Buyer (i) free and clear of any liens, claims, security interests and other encumbrances of any nature whatsoever (collectively, "Encumbrances"), except for those Encumbrances arising pursuant to restrictions on the transfer of securities imposed under the Securities Act of 1933, as amended (the "Securities Act") or any applicable state securities laws and those Encumbrances created by this Agreement or the Buyer (collectively, "Permitted Encumbrances"), certificates representing the Membership Interests, each such certificate to be duly and validly endorsed in favor of the Buyer or accompanied by a separate instrument of assignment sufficient to vest in the Buyer good title to the Membership Interests and (ii) such other documents as are required to be delivered by the Seller to the Buyer pursuant hereto; and (b) The Buyer shall deliver to the Seller (i) the portion of the Purchase Price to be paid at the Closing, by wire transfer in immediately available funds 10 to an account designated by the Seller prior to the Closing, and (ii) such other documents as are required to be delivered by the Buyer to the Seller pursuant hereto. ARTICLE III REPRESENTATIONS AND WARRANTIES OF THE SELLER The Seller and, only where specifically noted, DQE, represent and warrant to the Buyer as follows, provided, however, that notwithstanding any other provision of this Agreement to the contrary, the Seller and DQE make no representations or warranties with respect to any of the Excluded Assets (as defined in Section 5.3) and all representations and warranties of the Seller and, as applicable, DQE, contained herein expressly exclude such Excluded Assets and shall not be read or deemed to be a representation or warranty regarding any Excluded Asset, consequently, as used in this Article III, the terms "Company", "Company Subsidiary" and "Company Subsidiaries" shall not be read or deemed to include the Excluded Assets. Section 3.1 Organization and Qualification. (a) Except as set forth in Section 3.1(a) of the schedule delivered by the Seller to the Buyer on the date hereof and attached to this Agreement (the "Seller Disclosure Schedule"), (i) the Seller is a corporation duly organized, validly existing and in good standing under the laws of Delaware, and (ii) Services I, Services II, Services, LP and each Company Subsidiary is a limited liability company, limited partnership or corporation duly organized, validly existing and in good standing under the laws of its jurisdiction of incorporation or organization, has all requisite power and authority to own, lease and operate its assets and properties to the extent owned, leased and operated and to carry on its business as it is now being conducted and is duly qualified to do business in each jurisdiction in which the nature of its business or the ownership or leasing of its assets and properties makes such qualification necessary other than in such jurisdictions where the failure to be in good standing or be so qualified neither is having nor is reasonably likely to have a Company Material Adverse Effect (as defined in Section 3.1(b)). True and correct copies of the articles of incorporation and by-laws (or equivalent documents) of Services I, Services II, Services, LP and each Company Subsidiary have been delivered to the Buyer. (b) As used in this Agreement, the term "Company Material Adverse Effect" shall mean any material adverse effect on the business, assets, financial condition or results of operations of the Company, taken as a whole; provided, however, that the term "Company Material Adverse Effect" shall not include (i) any such effect resulting from any change in law, rule, or regulation of any Governmental Authority (as defined in Section 3.4(c)) that applies generally to similarly situated Persons (as defined in Section 3.1(c)) or (ii) effects relating to or resulting from general changes in the industries in which the Company operates its assets or conducts its businesses. (c) As used in this Agreement, (i) the term "knowledge" when referring to the knowledge of the Seller shall mean the knowledge, after reasonable inquiry of employees who are reasonably likely to have the relevant information, of the 11 executive officers of the Seller identified by name and/or title in Section 3.1(c) of the Seller Disclosure Schedule, and (ii) the term "Person" shall mean any natural person, corporation, general or limited partnership, limited liability company, joint venture, trust, association or entity of any kind. Section 3.2 Subsidiaries. Section 3.2 of the Seller Disclosure Schedule sets forth a complete list, as of the date hereof, of all of the Company Subsidiaries and their respective jurisdictions of incorporation or organization. Except as set forth in Section 3.2 of the Seller Disclosure Schedule, all of the issued and outstanding capital stock or other ownership interests of each Company Subsidiary are owned, directly or indirectly, by Services, LP free and clear of any Encumbrances, except for Permitted Encumbrances. As used in this Agreement, the term "Subsidiary" of a Person shall mean any corporation or other entity (including partnerships and other business associations) of which at least a majority of the voting power represented by the outstanding capital stock or other voting securities or interests having voting power under ordinary circumstances to elect directors or similar members of the governing body of such corporation or entity (or, if there are no such voting interests, 50% or more of the equity interests in such corporation or entity) shall at the time be held, directly or indirectly, by such Person. The term "Company Subsidiary" shall mean a Subsidiary of Services, LP. Section 3.3 Ownership and Possession of Membership Interests; Capitalization; Ownership and Possession of Integrated Assets. As of the date hereof, (i) the Seller owns beneficially and of record all of the Membership Interests of Services I free and clear of any Encumbrances, except for Permitted Encumbrances; (ii) Services I owns beneficially and of record all of the membership interests of Services II free and clear of any Encumbrances, except for Permitted Encumbrances; (iii) Services I and Services II, collectively, own beneficially and of record all of the partnership interests of Services, LP free and clear of any Encumbrances, except for Permitted Encumbrances, and (iv) except as set forth on Section 3.2 of the Seller Disclosure Schedule, Services, LP owns beneficially and of record all of the ownership interests of the Company Subsidiaries free and clear of any Encumbrances, except for Permitted Encumbrances. Other than as set forth in the immediately preceding sentence, there are no member, partner or equity interests in the Services I, Services II, Services, LP or any Company Subsidiary outstanding. There are no options, warrants, calls, rights, commitments or agreements of any character to which DQE, the Seller, Services I, Services II, Services, LP or any Company Subsidiary is a party or by which it is bound obligating DQE, the Seller, Services I, Services II, Services, LP or any Company Subsidiary to issue, deliver or sell, or cause to be issued, delivered or sold, additional membership, partnership or equity interests of Services I, Services II, Services, LP or any Company Subsidiary or obligating DQE, the Seller, Services I, Services II, Services, LP or any Company Subsidiary to grant, extend or enter into any option, warrant, call, right, commitment or agreement in respect of membership, partnership or equity interests of Services I, Services II, Services, LP or any Company Subsidiary. All of the assets listed on Section 3.3 of the Seller Disclosure Schedule (the "Integrated Assets") are owned, directly or indirectly, by the Seller free and clear of any Encumbrances, except for Permitted Encumbrances. The assets of the Company, together with the Integrated Assets, 12 constitute substantially all of the assets used in the ordinary course of business of the Company as it is currently being conducted. Section 3.4 Authority; Non-Contravention; Statutory Approvals; Compliance. (a) Authority. The Seller and DQE have all requisite corporate power and authority to enter into this Agreement and, subject to the receipt of the applicable Seller Required Statutory Approvals (as defined in Section 3.4(c)) and the applicable Seller Required Consents (as defined in Section 3.4(b)), to consummate the transactions contemplated hereby. The execution and delivery of this Agreement and the consummation by the Seller and DQE of the transactions contemplated hereby have been duly authorized by all necessary corporate action on the part of the Seller and DQE. No vote of, or consent by, the holders of any class or series of stock issued by the Seller or DQE is necessary to authorize the execution and delivery by the Seller and DQE of this Agreement or the consummation by it of the transactions contemplated hereby. This Agreement has been duly executed and delivered by the Seller and DQE and, assuming the due authorization, execution and delivery hereof by the Buyer, constitutes the valid and binding obligation of each of the Seller and DQE enforceable against it in accordance with its terms, subject to, to the extent applicable, bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles. (b) Non-Contravention. Except as set forth in Section 3.4(b)(i) of the Seller Disclosure Schedule, the execution and delivery of this Agreement by the Seller and DQE does not, and the consummation of the transactions contemplated hereby will not, violate or result in a breach of any provision of, constitute a default (with or without notice or lapse of time or both) under, result in the termination or modification of, accelerate the performance required by, result in a right of termination, cancellation or acceleration of any obligation or the loss of a benefit under, or result in the creation of any Encumbrance, except for Permitted Encumbrances, upon any of the properties or assets of the Company (any such violation, breach, default, right of termination, modification, cancellation or acceleration, loss or creation, is referred to herein as a "Violation" with respect to DQE (in respect of the Company), the Seller (in respect of the Company) and the Company, and such term when used in Article IV has a correlative meaning with respect to the Buyer and the Buyer Subsidiaries) pursuant to any provisions of (i) the articles of incorporation, by-laws or similar governing documents of the Seller, Services I, Services II, Services, LP or any Company Subsidiary, (ii) subject to obtaining the Seller Required Statutory Approvals, any statute, law, ordinance, rule, regulation, judgment, decree, order, injunction, writ, permit or license of any Governmental Authority applicable to DQE (in respect of the Company), the Seller (in respect of the Company) or the Company or any of their respective properties or assets, or (iii) subject to obtaining the third-party consents set forth in Section 3.4(b)(iii) of the Seller Disclosure Schedule (the "Seller Required Consents"), any note, bond, mortgage, indenture, deed of trust, license, franchise, permit, concession, contract, lease or other instrument, obligation or agreement of any kind to which Services I, Services II, Services, LP or any Company Subsidiary is a party or by which they or any of their 13 respective properties or assets may be bound or affected, except in the case of clause (ii) or (iii) for any such Violation which neither is having nor is reasonably likely to have a Company Material Adverse Effect. (c) Statutory Approvals. Except as described in Section 3.4(c) of the Seller Disclosure Schedule (the "Seller Required Statutory Approvals"), no declaration, filing or registration with, or notice to or authorization, consent or approval of, any court, federal, state, local or foreign governmental or regulatory body (including a national securities exchange or other self-regulatory body) or authority (each, a "Governmental Authority") is necessary for the execution and delivery of this Agreement by DQE or the Seller or the consummation by the Seller of the transactions contemplated hereby, except those which the failure to obtain neither is having nor is reasonably likely to result in a Company Material Adverse Effect (it being understood that references in this Agreement to "obtaining" such Seller Required Statutory Approvals shall mean making such declarations, filings or registrations; giving such notices; obtaining such authorizations, consents or approvals; and having such waiting periods expire as are necessary to avoid a violation of law). (d) Compliance. Except as set forth in Section 3.4(d)(i), Section 3.7, Section 3.10(a) or Section 3.11 of the Seller Disclosure Schedule, the Company is not in violation of, has not been given notice of and is not currently being charged with any violation of, and, to the knowledge of the Seller, is not under investigation with respect to any violation of any law, statute, order, rule, regulation, ordinance or judgment of any Governmental Authority, except for possible violations which neither are having nor are reasonably likely to have a Company Material Adverse Effect. Except as set forth in Section 3.4(d)(ii) or Section 3.12 of the Seller Disclosure Schedule, to the knowledge of the Seller, Services I, Services II, Services, LP and each Company Subsidiary has all permits, licenses, franchises and other governmental authorizations, consents and approvals necessary to conduct their businesses as conducted since July 1, 2001, except those that the absence of which neither are having nor are reasonably likely to have a Company Material Adverse Effect. Except as set forth in Section 3.4(d)(iii) of the Seller Disclosure Schedule, neither Services I, Services II, Services, LP nor any Company Subsidiary is in breach or violation of any term or provision of their respective articles of incorporation or by-laws. Section 3.5 Financial Statements. True and complete copies of the Company Financial Statements (as defined below) are set forth in Section 3.5 of the Seller Disclosure Schedule. The Company Financial Statements have been prepared from, are in accordance with, and accurately reflect the books and records of the Company, comply in all material respects with applicable accounting requirements, have been prepared in accordance with GAAP applied on a consistent basis during the period involved (except as may be stated in the notes thereto) and fairly present the consolidated financial position and the consolidated results of operations and cash flows (and changes in financial position, if any) of the Company as of the time and for the period referred to therein. As used in this Agreement, the term "Company Financial Statements" shall mean the consolidated balance sheet of the Company as at December 31, 2001 (the "December 31, 2001 Balance Sheet") and as at June 30, 2002 (the "June 30, 2002 14 Balance Sheet"), in each case together with the consolidated statements of income, shareholders' equity and cash flows for the twelve (12) and six (6) month periods, respectively, then ended. The Company Financial Statements are not audited and reflect only the Company, including the related assets and liabilities, contemplated to be transferred to the Buyer pursuant to this Agreement. Section 3.6 Absence of Certain Changes or Events. Except as set forth in Section 3.6 of the Seller Disclosure Schedule, since December 31, 2001, the Company has conducted its business only in the ordinary course of business consistent with past practice and there has not been any development or combination of developments affecting the Company, of which the Seller has knowledge, that is having or is reasonably likely to have a Company Material Adverse Effect. Section 3.7 Litigation. Except as set forth in Section 3.7, Section 3.8(a), Section 3.9(i), Section 3.10(a) or Section 3.11 of the Seller Disclosure Schedule, (a) there are no claims, suits, actions or proceedings before any court, governmental department, commission, agency, instrumentality or authority or any arbitrator pending or, to the knowledge of the Seller, threatened, nor are there, to the knowledge of the Seller, any investigations or reviews by any court, governmental department, commission, agency, instrumentality or authority or any arbitrator pending or threatened against, relating to or affecting the Services I, Services II, Services, LP or any Company Subsidiary, and (b) there are no judgments, decrees, injunctions, rules or orders of any court, governmental department, commission, agency, instrumentality or authority or any arbitrator applicable to Services I, Services II, Services, LP or any Company Subsidiary, except, in the case of clause (a) and clause (b), for such that are not having nor are reasonably likely to have a Company Material Adverse Effect. Section 3.8 Tax Matters. (a) Except as set forth in Section 3.8(a) of the Seller Disclosure Schedule: (i) Services I, Services II, Services, LP and each Company Subsidiary has timely filed (or has had filed on its behalf) with appropriate taxing authorities all material Tax Returns required to be filed by it or, for periods during which Services I, Services II or Services, LP is a member, the affiliated group filing a consolidated federal income tax return the common parent of which is DQE on or prior to the date hereof, such Tax Returns (as defined in Section 3.8(b)) are correct, complete and accurate in all material respects, and all material Taxes (as defined in Section 3.8(b)) owed by Services I, Services II, Services, LP and each Company Subsidiary (whether or not shown on any Tax Return) have been paid; (ii) all material Tax withholding and deposit requirements imposed on or with respect to Services I, Services II, Services, LP and each Company Subsidiary (including any withholding with respect to wages or other amounts paid to employees) have been satisfied in full in all material respects; (iii) there are no liens for Taxes upon any property or assets of the Company, except for liens for Taxes not yet due and payable; (iv) there are no outstanding requests, agreements, consents or waivers to extend the statutory period of limitations applicable to the assessment or collection of any Taxes or deficiencies against the Company; (v) neither Services I, Services II, Services, LP nor any Company Subsidiary has been a member of any affiliated group filing a 15 consolidated federal income Tax Return (other than a group the common parent of which is the Seller or DQE); (vi) each of Services I and Services II is, and has been at all times during its existence, properly disregarded as an entity separate from its owner for federal income Tax purposes pursuant to Treasury Regulation Section 301.7701-3(b)(ii) and has not at any time during its existence made any election pursuant to Treasury Regulation Section 301.7701-3(c) to be classified as an association taxable as a corporation for federal income tax purposes; (vii) Services, LP has properly made an election pursuant to Treasury Regulation Section 301.7701-3(c) to be classified as an association taxable as a corporation for federal income Tax purposes; (viii) no claim has ever been asserted in writing by any Tax authority in a jurisdiction where Services I, Services II, Services, LP, or any Company Subsidiary does not file Tax Returns that Services I, Services II, Services, LP, or any Company Subsidiary is or may be subject to taxation by such jurisdiction; (ix) Services II is not, and has never been at any time during its existence, a limited liability company or corporation that does business in the state of Texas, organized in the state of Texas, or authorized to do business in the state of Texas, as set forth in Section 171.001 of the Texas Tax Code or any other applicable Texas statute, regulation, or pronouncement; and (x) neither Services I, Services II, Services, LP nor any Company Subsidiary is a party to any agreement, contract, arrangement or plan that has resulted or would result, separately or in the aggregate, in the payment of (A) any "excess parachute payment" within the meaning of Section 280G of the Tax Code (or any corresponding provision of state, local or foreign Tax law) or (B) any amount that will not be fully deductible as a result of Section 162(m) of the Tax Code (or any corresponding provision of state, local or foreign Tax law). (b) As used in this Agreement: (i) the term "Tax" includes all federal, state, local and foreign income, profits, franchise, gross receipts, environmental, customs duty, capital stock, severance, stamp, payroll, sales, employment, unemployment, disability, use, property, withholding, excise, production, value added, occupancy and other taxes, duties or assessments of any nature whatsoever, together with all interest, penalties and additions imposed with respect thereto; and (ii) the term "Tax Return" includes all returns and reports (including elections, declarations, disclosures, Schedules, estimates and information returns) required to be supplied to a Tax authority relating to Taxes. Section 3.9 Employee Benefits; ERISA. (a) Seller Plans. Section 3.9(a) of the Seller Disclosure Schedule contains a list of each employee benefit plan, program, agreement or arrangement (including without limitation any employee benefit plan within the meaning of Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA")), in each case, that is sponsored, maintained or contributed to or required to be contributed to by the Seller, DQE or by any trade or business, whether or not incorporated that together with the Company, the Seller or DQE would be deemed a "single employer" within the meaning of Section 4001(b) of ERISA (an "ERISA Affiliate"), or to which the Seller, DQE or an ERISA Affiliate is a party, for the benefit of any employee or former employee of the Company, the Seller or any affiliate of the Seller whose employment is (in the case of current employees) or was (in the case of former employees) principally 16 attributable to the businesses carried on by or in respect of the Company (such individuals, the "Business Employees," and such plans, programs, agreements or arrangements, collectively, the "Seller Plans"). The Company does not sponsor, maintain, contribute to, and is not a party to, or within the last six (6) years preceding the Closing has not sponsored, maintained, or contributed to, been required to contribute to, or been a party to, any Seller Plans or any other employee benefit plan within the meaning of Section 3(3) of ERISA. (b) Information Regarding Affected Employees. On even date herewith, the Seller has delivered to the Buyer a schedule containing the work location and wage or salary information for each of the Affected Employees (as defined in Section 6.6), which information is true and correct as of the date of this Agreement. (c) Absence of Liability. Except as set forth in Section 3.9(c) of the Seller Disclosure Schedule, no liability under Title IV of ERISA has been incurred by the Company or any ERISA Affiliate with respect to a Seller Plan that has not been satisfied in full, and, to the knowledge of the Seller, no condition exists that presents a material risk to the Company of incurring any such liability, other than liability for premiums due the Pension Benefit Guaranty Corporation (which premiums have been paid when due). (d) Multiemployer Plan. Except as set forth in Section 3.9(d) of the Seller Disclosure Schedule, no Seller Plan is a "multiemployer plan," as defined in Section 4001(a)(3) of ERISA, nor is any Seller Plan a plan described in Section 4063(a) of ERISA. (e) No Violations. Except as set forth in Section 3.9(e) of the Seller Disclosure Schedule, each Seller Plan has been operated and administered in all material respects in accordance with its terms and applicable law, including without limitation ERISA and the Internal Revenue Code of 1986, as amended (the "Code"), and there have been no prohibited transactions (within the meaning of Section 4975 of ERISA and Section 406 of ERISA) involving any Seller Plan for which the Buyer would have any liability. (f) Section 401(a) Qualification. Each Seller Plan "intended" or "designed" to be "qualified" within the meaning of Section 401(a) of the Code has received or timely applied for a current determination letter from the Internal Revenue Service to the effect that it is so qualified and any distribution to an Affected Employee (as defined in Section 6.6(a)) from each such plan will be eligible for treatment as an eligible rollover distribution within the meaning of Section 402(c)(4) of the Code. (g) Post-Employment Benefits. Except as set forth in Section 3.9(g) of the Seller Disclosure Schedule, no Seller Plan provides medical, surgical, hospitalization, death or similar benefits (whether or not insured) for Business Employees for periods extending beyond their respective dates of retirement or other termination of service, other than (i) coverage mandated by applicable law, (ii) death benefits under any 17 "pension plan," or (iii) benefits the full cost of which is borne by the Business Employee (or his beneficiary). (h) Effect of Change of Control. Except to the extent that the Company expressly assumes Severance Obligations (as defined in Section 6.6(b)) or obligations under the Retention Agreements (as defined in Section 3.10(b)), no liability will be incurred by the Company for severance pay or acceleration of compensation or benefits as a result of the transactions contemplated by this Agreement. (i) Claims. Except as set forth in Section 3.9(i) of the Seller Disclosure Schedule, there are no pending, or to the knowledge of the Seller threatened, material claims by or on behalf of any Seller Plan, by any Business Employee or Business Employee beneficiary covered under any such Seller Plan, or otherwise involving any such Seller Plan (other than routine claims for benefits), and there are no pending or, to the knowledge of the Seller, threatened audits, investigations, enforcement actions, or other similar proceedings conducted by any state or federal agency involving any Seller Plan. Section 3.10 Labor and Employee Relations. (a) As of the date hereof, except as disclosed in Section 3.10(a) of the Seller Disclosure Schedule, neither Services I, Services II, Services, LP nor any Company Subsidiary is a party to any collective bargaining agreement or other labor agreement with any union or labor organization. Except as disclosed in Section 3.10(a) of the Seller Disclosure Schedule or except to the extent not reasonably likely to have a Company Material Adverse Effect, (i) there is no strike, lockout, slowdown or work stoppage pending or, to the knowledge of the Seller or DQE, threatened against or involving the Company, and (ii) there is no proceeding, claim, suit, action or governmental investigation pending or, to the knowledge of the Seller or DQE, threatened in respect of which any director, officer, employee or agent of the Company is or may be entitled to claim indemnification from Services I, Services II, or Services, LP or any Company Subsidiary pursuant to their articles of incorporation, by-laws or any indemnification agreement. (b) Except as set forth in Section 3.10(b) of the Seller Disclosure Schedule, prior to the Closing, Services I, Services II, Services, LP and any Company Subsidiary did not have any employees, and on the Closing Date will not have any obligation to persons who provided services to the Company prior to the Closing in any capacity for DQE or the Seller, including employees, consultants, independent contractors, subcontractors, officers or directors of DQE or the Seller. Effective after the Closing, Services I, Services II, Services, LP and the Company Subsidiaries will have only such obligations to the employees that they hire that arise out of services provided by such employees commencing after the Closing which obligations will include the Severance Obligations (as defined in Section 6.6(b)), and obligations under the Retention Agreements (as defined below). The term "Retention Agreements" shall mean (i) the Retention Agreement between Bryan S. Chapline and the Seller dated June 6, 2002, and 18 (ii) the Retention Agreement between Randolph S. Jones and the Seller dated February 14, 2002. (c) Section 3.10(c) of the Seller Disclosure Schedule lists all agreements between DQE, the Seller or the Company and the Designated Employees (as defined in Section 6.17) that include covenants not to compete. Section 3.11 Environmental Matters. (a) Except as set forth in Section 3.11 of the Seller Disclosure Schedule and except for those matters disclosed in the "Environmental White Paper" relating to the Company delivered by the Seller to the Buyer on even date herewith (the "Environmental Whitepaper"): (i) To the knowledge of the Seller, each of Services I, Services II, Services, LP and each Company Subsidiary is in compliance with all applicable Environmental Laws (as defined in Section 3.11(b)(i)), including, but not limited to, possessing all permits and other governmental authorizations required for their operations under applicable Environmental Laws, except for such noncompliance that neither is having nor is reasonably likely to have, individually or in the aggregate, a Company Material Adverse Effect. (ii) (A) To the knowledge of the Seller, there is no pending or threatened claim, notice of violation, lawsuit, demand, action, or administrative proceeding against the Seller (in respect of the Company), DQE (in respect of the Company), Services I, Services II, Services, LP or any Company Subsidiary under or pursuant to any Environmental Law that is having or is reasonably likely to have, individually or in the aggregate, a Company Material Adverse Effect; (B) neither the Seller (in respect of the Company), DQE (in respect of the Company), Services I, Services II, Services, LP nor any Company Subsidiary is subject to any administrative or judicial consent order or decree in connection with any Environmental Laws or the release or threat of release of Hazardous Substances (as defined in Section 3.11(b)(ii)) that is having or is reasonably likely to have, individually or in the aggregate, a Company Material Adverse Effect; and (C) neither the Seller (in respect of the Company), DQE (in respect of the Company), Services I, Services II, Services, LP nor any Company Subsidiary has received written notice from any Person, including but not limited to any Governmental Authority, alleging that the Seller (in respect of the Company), DQE (in respect of the Company), Services I, Services II, Services, LP or any Company Subsidiary is in violation or potentially in violation of any applicable Environmental Law or otherwise may be liable under any applicable Environmental Law, which violation or liability is unresolved and which have or may, individually or in the aggregate, have or may have a Company Material Adverse Effect. 19 (iii) To the knowledge of the Seller, with respect to the real property that was formerly or is currently owned or leased by the Seller (in respect of the Company), DQE (in respect of the Company), Services I, Services II, Services, LP or any Company Subsidiary, there have been no releases or threats of releases of Hazardous Substances on or underneath or from any of such real property that, individually or in the aggregate, have or would be reasonably likely to result in a Company Material Adverse Effect. (b) For purposes of this Agreement: (i) "Environmental Laws" shall mean all federal, state and local laws, common law, regulations, codes, policies, guidance documents, rules and ordinances relating to occupational health and safety, or pollution or protection of the environment, including, without limitation, laws (such as the Comprehensive Environmental Response Compensation and Liability Act, 42 U.S.C. Section 9601 et seq. (CERCLA)) relating to releases or threatened releases of Hazardous Substances into the environment (including, without limitation, ambient air, surface water, groundwater, land, surface and subsurface strata). (ii) "Hazardous Substances" shall mean any chemicals, materials or substances defined as or included in the definition of "hazardous substances", "hazardous wastes", "hazardous materials", "hazardous constituents", "restricted hazardous materials", "extremely hazardous substances", "toxic substances", "contaminants", "pollutants", "toxic pollutants", or words of similar meaning and regulatory effect under any applicable Environmental Law including, without limitation, petroleum and asbestos. (c) The representations and warranties set forth in this Section 3.11 are the sole and exclusive representations and warranties relating to environmental matters made by the Seller in this Agreement. Section 3.12 No Breaches or Defaults. Except as disclosed on Section 3.7 or Section 3.12 of the Seller Disclosure Schedule, the Company is not in breach or violation of or in default in the performance or observance of any term or provision of, and no event has occurred which, with the lapse of time or action by a third party, could result in a default by the Company under, nor, to the knowledge of the Seller, is any third party in breach or default in any material respect under, any Contract (as defined below), except, in any such case, for such breaches and defaults by the Company as to which requisite waivers or consents have been or will be obtained prior to the Closing Date and for such breaches and defaults that are not having nor are reasonably likely to have a Company Material Adverse Effect. The term "Contracts" means all written notes, bonds, mortgages, indentures, deeds of trust, licenses, franchises, permits, contracts, leases or other instruments, obligations or agreements of any kind to which Services I, Services II, Services, LP or any Company Subsidiary is a party or by which their properties or assets 20 may be bound, provided, however, that for purposes of this Section 3.12, Contracts shall not include Seller Plans or agreements, if any, with any Governmental Authority regarding compliance with Environmental Laws. Section 3.13 Insurance. Section 3.13 of the Seller Disclosure Schedule describes the fire and casualty, general liability, business interruption, product liability, pollution and sprinkler and water damage insurance policies maintained by the Seller or DQE on behalf of the Company as well as a description of any self-insurance arrangement by or affecting the Company, including any reserves thereunder. To the knowledge of the Seller, all of such policies are in full force and effect, all premiums with respect thereto are currently paid and neither the Seller nor DQE has received any notice of cancellation or termination with respect to any such insurance policy. Section 3.14 Brokers or Finders. The Seller has not entered into any agreement or arrangement entitling any agent, broker, investment banker, financial advisor or other firm or Person to any broker's or finder's fee or any other commission or similar fee in connection with any of the transactions contemplated by this Agreement, except Lehman Brothers, whose fees and expenses will be paid by the Seller in accordance with the Seller's agreements with such firm. Section 3.15 Competing Lines of Business. Except as set forth in Section 3.15 of the Seller Disclosure Schedule, to the knowledge of the Seller, neither DQE, the Seller nor any Subsidiary of the Seller is, or owns, indirectly or directly, any interest in any other business which is a competitor of the Company. Section 3.16 Limitation on Representations and Warranties. Except for the representations and warranties contained in this Article III, neither the Seller, DQE nor any other Person or entity acting on behalf of the Seller or DQE makes any representation or warranty, express or implied, concerning the Membership Interests or the business, assets, or liabilities of the Company or any other matter. In addition, notwithstanding any other provision of this Agreement to the contrary, neither the Seller nor DQE makes any representations or warranties with respect to any of the Excluded Assets. ARTICLE IV REPRESENTATIONS AND WARRANTIES OF THE BUYER The Buyer represents and warrants to the Seller as follows: Section 4.1 Organization and Qualification. Except as set forth in Section 4.1 of the Schedule delivered by the Buyer to the Seller on the date hereof and attached to this Agreement (the "Buyer Disclosure Schedule") the Buyer is a corporation duly organized, validly existing and in good standing under the laws of its jurisdiction of incorporation or organization, has all requisite power and authority to own, lease and operate its assets and properties to the extent owned, leased and operated and to carry on its business as it is now being conducted and is duly qualified to do business in each jurisdiction in which the nature of its business or the ownership or leasing of its assets 21 and properties makes such qualification necessary other than in such jurisdictions where the failure to be in good standing or be so qualified is not reasonably likely, individually or in the aggregate, to have a Buyer Material Adverse Effect (as defined below). As used in this Agreement, the term "Buyer Material Adverse Effect" shall mean any material adverse effect on the ability of the Buyer to consummate the transactions contemplated by this Agreement and to perform its obligations hereunder; provided, however, that any such effect resulting from any change in law, rule, or regulation of any Governmental Authority that applies generally to similarly situated Persons shall not be included in the term "Buyer Material Adverse Effect." The term "Buyer Subsidiary" shall mean a Subsidiary of the Buyer. Section 4.2 Authority; Non-Contravention; Statutory Approvals; Compliance. (a) Authority. The Buyer has all requisite corporate power and authority to enter into this Agreement and, subject to the receipt of the applicable Buyer Required Statutory Approvals (as defined in Section 4.2(c)) and applicable Buyer Required Consents (as defined in Section 4.2(b)), to consummate the transactions contemplated hereby. The execution and delivery of this Agreement and the consummation by the Buyer of the transactions contemplated hereby have been duly authorized by all necessary corporate action on the part of the Buyer. No vote of, or consent by, the holders of any class or series of stock issued by the Buyer is necessary to authorize the execution and delivery by the Buyer of this Agreement or the consummation by it of the transactions contemplated hereby. This Agreement has been duly executed and delivered by the Buyer and, assuming the due authorization, execution and delivery hereof by the Seller and DQE, constitutes the valid and binding obligation of the Buyer enforceable against it in accordance with its terms, subject to, to the extent applicable, bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium and similar laws of general applicability relating to or affecting creditors' rights and to general equity principles. (b) Non-Contravention. Except as set forth in Section 4.2(b)(i) of the Buyer Disclosure Schedule, the execution and delivery of this Agreement by the Buyer does not, and the consummation of the transactions contemplated hereby will not, result in a Violation pursuant to any provisions of (i) the certificate of incorporation, by-laws or similar governing documents of the Buyer or any of the Buyer Subsidiaries, (ii) subject to obtaining the Buyer Required Statutory Approvals, any statute, law, ordinance, rule, regulation, judgment, decree, order, injunction, writ, permit or license of any Governmental Authority applicable to the Buyer or any of the Buyer Subsidiaries or any of its or their respective properties or assets, or (iii) subject to obtaining the third-party consents set forth in Section 4.2(b)(iii) of the Buyer Disclosure Schedule (the "Buyer Required Consents"), any note, bond, mortgage, indenture, deed of trust, license, franchise, permit, concession, contract, lease or other instrument, obligation or agreement of any kind to which the Buyer or any of the Buyer Subsidiaries is a party or by which they or any of their respective properties or assets may be bound or affected, except in the case of clause (ii) or (iii) for any such Violation which is not reasonably likely to have a Buyer Material Adverse Effect. 22 (c) Statutory Approvals. Except as described in Section 4.2(c) of the Buyer Disclosure Schedule (the "Buyer Required Statutory Approvals"), no declaration, filing or registration with, or notice to or authorization, consent or approval of, any Governmental Authority is necessary for the execution and delivery of this Agreement by the Buyer or the consummation by the Buyer of the transactions contemplated hereby, except those which the failure to obtain is not reasonably likely to have a Buyer Material Adverse Effect (it being understood that references in this Agreement to "obtaining" such Buyer Required Statutory Approvals shall mean making such declarations, filings or registrations; giving such notices; obtaining such authorizations, consents or approvals; and having such waiting periods expire as are necessary to avoid a violation of law). (d) Compliance. Except as set forth in Section 4.2(d)(i) or Section 4.3 of the Buyer Disclosure Schedule, neither the Buyer nor any of the Buyer Subsidiaries is under investigation with respect to any violation of, or has been given notice of or been charged with any violation of, any law, statute, order, rule, regulation, ordinance or judgment of any Governmental Authority, except for possible violations which are not reasonably likely to have a Buyer Material Adverse Effect. Except as set forth in Section 4.2(d)(ii) of the Buyer Disclosure Schedule or as disclosed in the Buyer SEC Reports filed prior to the date hereof, the Buyer and the Buyer Subsidiaries have all permits, licenses, franchises and other governmental authorizations, consents and approvals necessary to conduct their businesses as presently conducted except those that the absence of which is not reasonably likely to have a Buyer Material Adverse Effect. Except as set forth in Section 4.2(d)(iii) of the Buyer Disclosure Schedule, neither the Buyer nor any Buyer Subsidiary is in breach or violation of or in default in the performance or observance of any term or provision of, and no event has occurred which, with lapse of time or action by a third party, could result in a default by the Buyer or any Buyer Subsidiary under (i) their respective certificates of incorporation or by-laws or (ii) any contract, commitment, agreement, indenture, mortgage, loan agreement, note, lease, bond, license, approval or other instrument to which they are a party or by which the Buyer or any Buyer Subsidiary is bound or to which any of their property is subject, except for possible violations, breaches or defaults which are not reasonably likely to have a Buyer Material Adverse Effect. Section 4.3 Litigation. Except as set forth in Section 4.3 of the Buyer Disclosure Schedule, (a) there are no claims, suits, actions or proceedings by any court, governmental department, commission, agency, instrumentality or authority or any arbitrator, pending or, to the knowledge of the Buyer, threatened, nor are there, to the knowledge of the Buyer, any investigations or reviews by any court, governmental department, commission, agency, instrumentality or authority or any arbitrator pending or threatened against, relating to or affecting the Buyer or any Buyer Subsidiary which are reasonably likely to have a Buyer Material Adverse Effect, and (b) there are no judgments, decrees, injunctions, rules or orders of any court, governmental department, commission, agency, instrumentality or authority or any arbitrator applicable to the Buyer or any Buyer Subsidiaries except for such that are not reasonably likely to have a Buyer Material Adverse Effect. 23 Section 4.4 Investigation by the Buyer; the Seller's Liability. The Buyer has conducted its own independent investigation, review and analysis of the business, operations, assets, liabilities, results of operations, financial condition, software, technology and prospects of the Company, which investigation, review and analysis was done by the Buyer and its affiliates and, to the extent the Buyer deemed appropriate, by the officers, directors, employees, accountants, counsel, investment bankers, financial advisors and other representatives (collectively, "Representatives") of Buyer. The Buyer acknowledges that it and its Representatives have been provided adequate access to the personnel, properties, premises and records of the Company for such purpose. In entering into this Agreement, the Buyer acknowledges that it has relied solely upon the aforementioned investigation, review and analysis and not on any factual representations of the Seller, DQE or the Seller's or DQE's Representatives (except the specific representations and warranties of the Seller and, as applicable, DQE set forth in Article III of this Agreement), and the Buyer: (a) acknowledges, except for the specific representations and warranties of the Seller and, as applicable, DQE set forth in Article III of this Agreement, that none of the Seller, Services I, Services II, Services, LP, or any Company Subsidiary or any of their respective directors, officers, shareholders, employees, affiliates, controlling Persons, agents, advisors or Representatives makes or has made any representation or warranty, either express or implied, as to the accuracy or completeness of any of the information (including in materials furnished in the Seller's data room, in presentations by the Seller's management, on site visits or otherwise) provided or made available to the Buyer or its directors, officers, employees, affiliates, controlling Persons, agents or Representatives, and (b) agrees, to the fullest extent permitted by law, that none of the Seller, Services I, Services II, Services, LP, or any Company Subsidiary or any of their respective directors, officers, employees, shareholders, affiliates, controlling Persons, agents, advisors or Representatives shall have any liability or responsibility whatsoever to the Buyer or its directors, officers, employees, affiliates, controlling Persons, agents or Representatives on any basis (including in contract or tort, under federal or state securities laws or otherwise) based upon any information provided or made available, or statements made (including in materials furnished in the Seller's data room, in presentations by the Seller's management, on site visits or otherwise) to the Buyer or its directors, officers, employees, affiliates, controlling Persons, advisors, agents or Representatives (or any omissions therefrom), including in respect of the specific representations and warranties of the Seller and, as applicable, DQE set forth in Article III of this Agreement. For the avoidance of doubt, the foregoing limitations, representations and warranties, acknowledgments and agreements of the Buyer set forth in this Section 4.4 shall not modify, limit or effect in any way the specific representations and warranties of the Seller and, as applicable, DQE set forth in Article III of this Agreement, and shall not apply to or limit the Seller's and DQE's indemnification obligations contained in Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. 24 Section 4.5 Acquisition of Membership Interests for Investment; Ability to Evaluate and Bear Risk. (a) The Buyer is acquiring the Membership Interests for investment and not with a view toward, or for sale in connection with, any distribution thereof, nor with any present intention of distributing or selling the Membership Interests. The Buyer acknowledges that the Membership Interests have not been registered under the Securities Act and agrees that the Membership Interests may not be sold, transferred, offered for sale, pledged, hypothecated or otherwise disposed of without registration under the Securities Act and any applicable state securities laws, except pursuant to an exemption from such registration under the Securities Act and any applicable state securities laws. (b) The Buyer is able to bear the economic risk of holding the Membership Interests for an indefinite period, and has knowledge and experience in financial and business matters such that it is capable of evaluating the risks of the investment in the Membership Interests. Section 4.6 Financing. The Buyer has or will have available, prior to the Closing, sufficient cash in immediately available funds to pay the Purchase Price pursuant to Article I hereof and to consummate the transactions contemplated hereby. Section 4.7 Brokers or Finders. The Buyer has not entered into any agreement or arrangement entitling any agent, broker, investment banker, financial advisor or other firm or Person to any broker's or finder's fee or any other commission or similar fee in connection with any of the transactions contemplated by this Agreement, except API, whose fees and expenses will be paid by the Buyer in accordance with the Buyer's agreement with such firm. ARTICLE V CONDUCT OF BUSINESS PENDING THE CLOSING Section 5.1 Covenants of the Seller. As used in this Section 5.1, the terms "Company", "Company Subsidiary" and "Company Subsidiaries", and any reference to their assets, shall not be read or deemed to include the Excluded Assets. After the date hereof and prior to the Closing or earlier termination of this Agreement, the Seller agrees that, except as set forth in Section 5.1 of the Seller Disclosure Schedule and except (i) as expressly contemplated in or permitted by this Agreement or (ii) to the extent the Buyer shall otherwise consent in writing, which decision regarding consent shall be made as soon as reasonably practical, and which consent shall not be unreasonably withheld, conditioned or delayed: (a) the business of the Company shall be conducted in the ordinary and usual course in substantially the same manner as heretofore conducted and, to the extent consistent therewith, the Company shall use its commercially reasonable efforts to preserve its business organization intact and maintain its existing relations and 25 goodwill with customers, suppliers, creditors, regulators, lessors, employees and business associates; (b) neither Services I, Services II, Services, LP nor any Company Subsidiary shall (i) amend its certificate of formation, operating agreement or other operating documents; (ii) issue any new membership or other ownership interests; (iii) declare, set aside or pay any dividend payable in cash, stock or property in respect of any of its membership or other ownership interests; or (iv) repurchase, redeem or otherwise acquire any of its membership or other ownership interests or any securities convertible into or exchangeable or exercisable for any of its membership or other ownership interests; (c) neither Services I, Services II nor Services, LP nor any Company Subsidiary shall (i) issue, sell, pledge, dispose of or encumber any equity interests of, or securities convertible into or exchangeable or exercisable for, or options, warrants, calls, commitments or rights of any kind to acquire, any of its equity interests; or (ii) make any commitments for, make or authorize any capital expenditures (other than (A) capital expenditures not in excess of $150,000 in the aggregate incurred in connection with the repair or replacement of facilities destroyed or damaged due to casualty or accident (to the extent not covered by insurance), (B) as required by law or by any consent agreement with a Governmental Authority by which the Company, or its assets, is bound, or (C) in amounts less than $150,000 in the aggregate); (d) the Company shall not terminate, establish, adopt, enter into, make any new grants or awards of stock-based or membership-based compensation or other benefits under, amend or otherwise modify any Seller Plan or increase the salary, wage, bonus or other compensation of any directors, officers or employees except (i) for grants or awards to directors, officers and employees under existing Seller Plans in such amounts and on such terms as are consistent with past practice, (ii) in the normal and usual course of business (which shall include normal periodic performance reviews and related plans and the provision of individual Seller Plans consistent with past practice for newly hired or appointed officers and employees), or (iii) for actions necessary to satisfy existing contractual obligations under Seller Plans existing as of the date hereof; provided, however, that the Seller shall have satisfied its obligations with respect to the Seller Plans under this provision if DQE maintains the Seller Plans in such a manner as to comply with this provision; (e) the Seller, on behalf of the Company, shall maintain insurance in such amounts and against such risks and losses as are consistent with the insurance heretofore maintained by the Seller or DQE on behalf of the Company; provided, however, that the Seller shall have satisfied its obligations under this provision if DQE maintains such insurance on behalf of the Seller; (f) the Seller shall promptly provide the Buyer with copies of all filings made by the Seller or the Company with, and inform the Buyer of any communications received from, any state or federal court, administrative agency, 26 commission or other Governmental Authority in connection with this Agreement and the transactions contemplated hereby; (g) the Seller shall, and shall cause the Company to, use all commercially reasonable efforts to promptly obtain all of the Seller Required Consents and the Seller Required Statutory Approvals. The Seller shall promptly notify the Buyer of any failure or prospective failure to obtain any such consents or approvals and shall provide copies of all of the Seller Required Consents and the Seller Required Statutory Approvals obtained by the Seller and the Company to the Buyer; (h) The Seller will promptly notify the Buyer in writing if the Seller becomes aware of any fact or condition that causes or constitutes a breach of any of the Seller's representations or warranties, or that would constitute a breach of any such representation or warranty had such representation or warranty been made as of the time of the occurrence or discovery of such fact or condition or if such representation or warranty were not qualified by the term Company Material Adverse Effect. The Seller will promptly notify the Buyer of the occurrence of any breach of any covenant of Seller in this Agreement, or of the occurrence or any event that may make the satisfaction of the conditions in Sections 7.1 and 7.2 impossible or unlikely; and (i) the Seller shall not, and the Seller shall not permit the Company to, willfully take any action that would or is reasonably likely to result in a breach of any provision of this Agreement or in any of its representations and warranties set forth in this Agreement being untrue on and as of the Closing Date or to unduly delay the Closing. Section 5.2 Covenants of the Buyer. After the date hereof and prior to the Closing Date or earlier termination of this Agreement, the Buyer agrees, as to itself and to each of the Buyer Subsidiaries, as follows except as expressly contemplated or permitted in this Agreement or to the extent the Seller shall otherwise consent in writing, which decision regarding consent shall be made as soon as reasonably practical, and which consent shall not be unreasonably withheld, conditioned or delayed: (a) the Buyer shall promptly provide the Seller with copies of all filings made by the Buyer or any of the Buyer Subsidiaries with, and inform the Seller of any communications received from, any state or federal court, administrative agency, commission or other Governmental Authority in connection with this Agreement and the transactions contemplated hereby; (b) the Buyer shall, and shall cause the Buyer Subsidiaries to, use all commercially reasonable efforts to promptly obtain all of the Buyer Required Consents and the Buyer Required Statutory Approvals. The Buyer shall promptly notify the Seller of any failure or prospective failure to obtain any such consents or approvals and, if requested by the Seller, shall provide copies of all of the Buyer Required Consents and the Buyer Required Statutory Approvals obtained by the Buyer to the Seller; 27 (c) the Buyer will promptly notify the Seller in writing if the Buyer becomes aware of any fact or condition that causes or constitutes a breach of any of the Buyer's representations or warranties, or that would constitute a breach of any such representation or warranty had such representation or warranty been made as of the time of the occurrence or discovery of such fact or condition or if such representation or warranty were not qualified by the term Buyer Material Adverse Effect. The Buyer will promptly notify the Seller of the occurrence of any breach of any covenant of the Buyer in this Agreement, or of the occurrence of any event that may make the satisfaction of the conditions in Sections 7.1 and 7.3 impossible or unlikely; and (d) the Buyer shall not, and the Buyer shall not permit any of the Buyer Subsidiaries to, willfully take any action that would or is reasonably likely to result in a material breach of any provision of this Agreement or in any of its representations and warranties set forth in this Agreement being untrue on and as of the Closing Date or to unduly delay the Closing. Section 5.3 Mutual Covenants of the Parties. (a) Notwithstanding any other provision of this Agreement to the contrary, the Seller and the Buyer expressly agree that prior to the Closing, the Seller shall cause any and all of Services I's, Services II's, Services, LP's and the Company Subsidiaries' right, title and interest in and to all of those assets set forth on Section 5.3 of the Seller Disclosure Schedule (collectively, the "Excluded Assets") to be assigned and transferred, without any warranty of title, condition or otherwise, and all such Excluded Assets to be delivered, by Services I, Services II, Services, LP, and the Company Subsidiaries, as applicable, to the Seller or such third party as the Seller may designate, and all of the obligations and liabilities of Services I, Services II, Services, LP or any Company Subsidiary in respect of any such Excluded Assets to be assumed by the Seller or such third party, as the case may be. For the avoidance of doubt, liabilities and obligations of DQE, the Seller or the Company relating to the Excluded Assets shall be Buyer Indemnifiable Losses and subject to the Seller's and DQE's indemnification obligations under Article IX. (b) Notwithstanding any other provision of this Agreement to the contrary, the Seller and the Buyer expressly agree that prior to the Closing, the Seller shall cause any and all of the Seller's and any Subsidiary of the Seller's right, title and interest in and to the Integrated Assets to be assigned and transferred free and clear of all Encumbrances (other than Permitted Encumbrances), but without any other warranty of condition or otherwise, and all such Integrated Assets to be delivered, by the Seller or any Subsidiary of the Seller, as applicable, to the Company, and all of the performance obligations of DQE, the Seller, any Subsidiary of the Seller and the Company which arise after the Closing and relate to the contracts included among the Integrated Assets listed on Section 3.3 of the Seller Disclosure Schedule and all liabilities of the Seller, any Subsidiary of DQE, the Seller, any Subsidiary of the Seller and the Company, direct or indirect, known or unknown, absolute or contingent, which arise after the Closing and relate to the Integrated Assets listed on Section 3.3 of the Seller Disclosure Schedule, provided, however, that the provisions of this Section 5.3(b) shall not limit the 28 representations and warranties of the Seller set forth in the last sentence of Section 3.3 or the Seller's and DQE's indemnification obligations under Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. For avoidance of doubt, liabilities and obligations of DQE, the Seller, any Subsidiary of the Seller or the Company relating to the Integrated Assets which arise prior to the Closing shall be Buyer Indemnifiable Losses and subject to the Seller's and DQE's indemnification obligations under Article IX, and liabilities and obligations of DQE, the Seller, any Subsidiary of the Seller or the Company relating to the Integrated Assets which arise after the Closing and are not a breach of a representation or warranty made by the Seller in respect of any such Integrated Asset shall be Seller Indemnifiable Losses and subject to the Buyer's indemnification obligations under Article IX recognizing that all such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. (c) The parties agree that the Buyer shall not be responsible for any, and the Seller agrees to pay for all, costs or expenses associated with assigning and transferring the Excluded Assets and the Integrated Assets, as contemplated by Section 5.3. ARTICLE VI ADDITIONAL AGREEMENTS Section 6.1 Access to Company Information. Upon reasonable notice, the Seller shall, and shall cause Services I, Services II or Services, LP, and each Company Subsidiary, to, afford to the Representatives of the Buyer reasonable access, during normal business hours throughout the period prior to the Closing Date, to all of the Company's properties, books, contracts, commitments and records (including, but not limited to, Tax Returns) and the Affected Employees and, during such period, the Seller shall, and shall cause Services I, Services II or Services, LP, and each Company Subsidiary, to, furnish promptly to the Buyer and its Representatives, (i) access to each report, Schedule and other document filed or received by the Seller (with respect to the Company) or the Company pursuant to the requirements of federal or state securities laws or filed with or sent to any federal or state regulatory agency or commission and (ii) access to all information concerning the Integrated Assets and the Company and its respective directors and officers and such other matters as may be reasonably requested by the Buyer or its Representatives in connection with any filings, applications or approvals required or contemplated by this Agreement or for any other reason related to the transactions contemplated by this Agreement; provided, however, that (i) any such access shall be granted only in such a manner as not to interfere unreasonably with the Seller's business operations in respect of the Company or otherwise, (ii) upon being granted such access, the Buyer shall not interfere with the Seller's business operations in respect of the Company or otherwise, (iii) in granting any such access the Seller, Services I, Services II, Services, LP and the Company Subsidiaries shall not be required to take any action that would constitute a waiver of any legal privilege, including the attorney-client privilege, the work product privilege and the self critical investigation privilege, (iv) in granting any such access, the Seller, Services I, Services II, Services, LP and the Company Subsidiaries shall not be required to provide the Buyer with access to any 29 information which the Seller, Services I, Services II, Services, LP or any Company Subsidiary is under a legal or contractual obligation to withhold from disclosure, and (v) in granting such access, the Seller, Services I, Services II, Services, LP and the Company Subsidiaries shall not be required to provide the Buyer with access to any information that relates exclusively to the Excluded Assets, provided that, in all cases, the Seller shall be entitled to redact information relating to the Excluded Assets from any information to which the Buyer is granted access. The Buyer shall, and shall cause its Subsidiaries and Representatives to, hold in strict confidence all documents and information concerning the Seller or the Company furnished or made available to it in connection with the transactions contemplated by this Agreement in accordance with the Confidentiality Agreement, dated January 5, 2001, entered into by and among the Seller, DQE and the Buyer (as amended on April 12, 2002, the "Confidentiality Agreement"); provided, however, that the Buyer shall not be in breach of the Confidentiality Agreement if, following the Closing, it uses Proprietary Information (as defined in the Confidentiality Agreement) that is or was developed for, used by, or otherwise related to the operations of the Company; provided, further, that notwithstanding the foregoing, in no event shall the Buyer or any Buyer Subsidiary (including after the Closing, the Company) directly disclose any such Proprietary Information in any manner that is inconsistent with paragraph (iv) of the Acknowledgment and Amendment to the Confidentiality Agreement dated April 12, 2002 (except for disclosures made after the Closing to either Robert Haas or Violet Vela Divin but, in either case, only if such person shall have been hired by the Company and except for disclosures of (i) employee information related to Affected Employees, (ii) purchase contracts for goods and services of the Company that were in effect prior to the Closing, (iii) work orders of the Company relating to the balance sheet of the Company at the Closing, and (iv) such other information the disclosure of which is approved by the Seller and DQE). Section 6.2 Regulatory Matters. The Seller and the Buyer shall cooperate and use all commercially reasonable efforts to promptly prepare and file all necessary documentation, to effect all necessary applications, notices, petitions, filings and other documents, and to use all commercially reasonable efforts to obtain all necessary permits, consents, approvals and authorizations of all Governmental Authorities necessary or advisable to obtain the Seller Required Statutory Approvals and the Buyer Required Statutory Approvals; provided, however, that the Seller and the Buyer shall cooperate to prepare and file any such applications, notices, petitions, filings and other documents timely in order to obtain all such approvals on or before the Initial Termination Date (as defined in Section 8.1(c)) and shall thereafter cooperate to diligently prosecute all such applications, notices, petitions, filings and other documents. The Buyer shall not be required to dispose of or change any portion of its existing business or to incur any other burden expense to obtain a Seller Required Statutory Approval and the Seller shall not be required to dispose of or change any portion of its existing business or to incur any other burden expense to obtain a Buyer Required Statutory Approval. The Buyer shall be precluded from including in any application for regulatory approval contingencies relating to rate treatment of acquisition premiums. Section 6.3 Consents. The Seller and the Buyer agree to use all commercially reasonable efforts to obtain the Seller Required Consents and the Buyer 30 Required Consents, respectively, and to cooperate with each other in connection with the foregoing. The Buyer shall not be required to dispose of or change any portion of its existing business or to incur any other burden expense to obtain a Seller Required Consent and the Seller shall not be required to dispose of or change any portion of its existing business or to incur any other burden expense to obtain a Buyer Required Consent. Section 6.4 Directors' and Officers' Indemnification. (a) Indemnification. To the fullest extent permitted by law, from and after the Closing Date, all rights to indemnification existing immediately prior to the Closing in favor of the current and former employees, agents, directors or officers of Services I, Services II, Services, LP and each Company Subsidiary (each, a "Company Indemnified Party" and, collectively, the "Company Indemnified Parties") with respect to their activities as such prior to or on the Closing Date, as provided in Services I's, Services II's, Services, LP's and each Company Subsidiary's respective certificates of formation, operating agreement, or other organizational documents in effect on the date of such activities or otherwise in effect on the date hereof, shall survive the Closing and shall continue in full force and effect for a period of not less than six (6) years from the Closing Date, provided that, in the event any claim or claims are asserted or made within such six (6) year period, all such rights to indemnification in respect of any claim or claims shall continue until final disposition of such claim or claims. For the avoidance of doubt, liabilities and obligations of the Company to Company Indemnified Parties resulting from the rights to indemnification contemplated by this Section 6.4 and attributable to pre-Closing activities shall be Buyer Indemnifiable Losses and subject to the Seller's and DQE's indemnification obligations under Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. (b) Insurance. For a period of six (6) years after the Closing Date, DQE or the Seller shall maintain policies of directors' and officers' liability insurance for those Persons covered by such policies maintained by the Seller or DQE on behalf of the Company immediately prior to the Closing in respect of pre-Closing acts or omissions on terms no less favorable than the terms of such current insurance coverage. (c) Successors. In the event that after the Closing Date, Services I, Services II, Services, LP or any Company Subsidiary or any of their respective successors or assigns (i) consolidates with or merges into any other Person or entity and shall not be the continuing or surviving corporation or entity of such consolidation or merger or (ii) transfers all or substantially all of its properties and assets to any Person or entity, then and in either such case, proper provisions shall be made so that the successors and assigns of Services I, Services II, Services, LP or any such Company Subsidiary, as the case may be, shall assume the obligations set forth in this Section 6.4. (d) Benefit. The provisions of this Section 6.4 are intended to be for the benefit of, and shall be enforceable by, each Company Indemnified Party, his or her heirs and his or her representatives. 31 Section 6.5 Public Announcements. Except as may be required by law, applicable rules and regulations, or by obligations pursuant to any listing agreement with or rules of any national securities exchange, DQE, the Seller and the Buyer shall consult with each other prior to issuing any press releases or otherwise making public announcements with respect to this Agreement and the transactions contemplated hereby and shall keep the terms of this Agreement confidential prior to Closing and shall not make any disclosure of this Agreement to any Person. The Seller and the Buyer shall consult with each other concerning the means by which the Company's employees, customers, suppliers and other Persons dealing with the Company will be informed of the transaction contemplated by this Agreement and representatives of the Buyer shall have the right to be present for any such communication at any general meeting of the employees. Section 6.6 Workforce Matters. (a) Prior to the Closing, the Buyer shall make a "qualifying offer" of employment as that term is defined in the AquaSource Severance Policy dated January 1, 2002 (the "Severance Policy" and, such qualifying offer, a "Qualifying Offer") to each of the employees of the Seller identified in Section 6.6(a) of the Seller Disclosure Schedule (such individuals, the "Affected Employees"). The Qualifying Offers shall be subject to Closing and contingent on the Affected Employee satisfying the Buyer's drug testing policy and other requirements imposed by applicable law, such as the Immigration Reform and Control Act of 1986, as applicable (the "Hiring Conditions"). Subject to Closing and satisfaction of the applicable Hiring Conditions, such Qualifying Offers shall be accepted or rejected by the Affected Employees prior to the Closing Date, to be effective immediately after the Closing. In connection with the hiring process for Affected Employees, the Buyer shall comply with applicable laws pertaining to labor and employment, including, without limitation, Title VII of the Civil Rights Act of 1964, as amended, the Age Discrimination in Employment Act, the Americans With Disabilities Act, the Rehabilitation Act and comparable state and local laws. (b) Effective immediately after the Closing, the Company shall assume, and continue in effect for a period of not less than twelve (12) months from the Closing Date, the Severance Policy for the benefit of all Affected Employees who have accepted Qualifying Offers and satisfied the Hiring Conditions (the "Severance Obligations"), except that for purposes of the assumption, all references in the Severance Policy to "AquaSource" shall be to the Company, and all references to "any DQE Subsidiary" shall be to any Buyer Subsidiary. If any Affected Employee does not accept a Qualifying Offer or does not satisfy the Hiring Conditions, then the Buyer shall have no further obligation to such Affected Employee or to the Seller or DQE with regard to such Affected Employee. For the avoidance of doubt, liabilities and obligations in respect of Affected Employees who do not accept a Qualifying Offer or satisfy the applicable Hiring Conditions shall be Buyer Indemnifiable Losses and subject to the Seller's and DQE's indemnification obligations under Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. As between the Seller and the Buyer, neither the Seller nor DQE shall be obligated to provide any severance or separation pay benefits to any 32 Affected Employee who has accepted a Qualifying Offer and satisfied the Hiring Conditions on account of any termination of such Affected Employee's employment after the Closing. Pursuant to Section 10 of the Retention Agreements, effective upon the Closing, the Company hereby assumes and agrees to perform the Seller's obligations under the Retention Agreements in the same manner and to the same extent that the Seller would be required to perform, had such succession not taken place. In addition, effective upon the Closing, (i) DQE and the Seller hereby assign to the Company those agreements set forth in Section 3.10(c) of the Seller Disclosure Schedule and (ii) the Company hereby assumes and agrees to perform the Seller's or DQE's obligations which arise after the Closing under those agreements set forth in Section 3.10(c) of the Seller Disclosure Schedule, provided, however, that DQE and the Seller retain sufficient rights under such agreements necessary to satisfy their respective obligations contemplated by the last sentence of Section 6.17(a). For the avoidance of doubt, liabilities and obligations of DQE, the Seller or the Company which arise after the Closing under the Retention Agreement and those agreements set forth in Section 3.10(c) of the Seller Disclosure Schedule shall be Seller Indemnifiable Losses and subject to the Seller's indemnification obligations under Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. (c) The Buyer shall be responsible for providing any continuation coverage required under the Consolidated Omnibus Budget Reconciliation Act of 1985, as amended ("COBRA") in respect of Affected Employees who experience a qualifying event (within the meaning of COBRA) after the Closing, except for those Affected Employees who do not accept a Qualifying Offer or who do not satisfy the Hiring Conditions. The Buyer shall not have any further responsibility for compliance with the continuation coverage requirements under COBRA with respect to any other employees of the Seller or DQE. The Seller shall be responsible for providing continuation coverage required under COBRA in respect of Affected Employees who experience a qualifying event (within the meaning of COBRA) before the Closing Date and in respect of Affected Employees who do not accept a Qualifying Offer or who do not satisfy the Hiring Conditions. (d) The Seller shall be responsible for any notices required to be given under, or otherwise comply with, the WARN Act or similar statutes or regulations of any jurisdiction relating to any "plant closing" or "mass layoff" or similar triggering event ordered by DQE or the Seller with respect to the Affected Employees prior to or on the Closing Date. The Buyer shall be responsible for any notices required to be given under, or otherwise comply with, the WARN Act or similar statutes or regulations of any jurisdiction relating to any "plant closing" or "mass layoff" or similar triggering event ordered by the Buyer or any Buyer Subsidiary after the Closing with respect to the Affected Employees who have accepted a Qualifying Offer and satisfied the Hiring Conditions. For the avoidance of doubt, for purposes here, the parties intend for the "effective date" within the meaning of the WARN Act to refer to and mean the Closing Date. To the extent possible, the Buyer and the Seller agree to treat the Buyer as a "successor employer" and the Seller or one or more of its affiliates as a "predecessor employer" within the meaning of Sections 3121(a)(1) and 3306(b)(1) of the Code, with 33 respect to Affected Employees, for purposes of Taxes imposed under the United States Federal Unemployment Tax or the United States Federal Insurance Contributions Act. Provided that the Buyer fully performs its obligations to make Qualifying Offers and to employ Affected Employees who accept such Qualifying Offers pursuant to this Section 6.6, the Seller and DQE shall, jointly and severally, indemnify and hold harmless the Buyer against any liabilities related to any WARN Act obligations arising from the transactions contemplated hereby attributable to the actions of the Seller or DQE. (e) The Buyer expressly agrees that (i) from the date hereof until the first anniversary of the Closing Date, it will not directly or indirectly solicit for employment, other than through solicitations made to the general public, any of those persons listed on Section 6.6(e) of the Seller Disclosure Schedule, and from the Closing Date until the first anniversary of the Closing Date, it will cause the Company not to directly or indirectly solicit for employment, other than through solicitations made to the general public, those persons listed on Section 6.6(e) of the Seller Disclosure Schedule and (ii) from the date hereof until the first anniversary of the Closing Date, it will not employ any of those persons listed on Section 6.6(e) of the Seller Disclosure Schedule, unless it shall have first given notice to the Seller of its intent to make an offer of employment to any such persons, and, from the Closing Date until the first anniversary of the Closing Date, it will cause the Company not to employ any of those persons listed on Section 6.6(e) of the Seller Disclosure Schedule, unless it shall have first given notice to the Seller of its intent to make an offer of employment to any such persons. Section 6.7 Seller Plans. (a) Continued Employment; Service Credit. The Buyer does not, indirectly or directly, assume or otherwise take responsibility for contribution to benefits under, COBRA continuation coverage under, or the administration, maintenance, or sponsorship of, any Seller Plan other than the Severance Obligations and the Retention Agreements, nor shall there be any transfer of assets or liabilities of any Seller Plan to any plan, program or arrangement maintained by the Buyer or any of its affiliates. For the avoidance of doubt, liabilities and obligations of the Seller Plans (other than the Severance Obligations and the Retention Agreements) shall be Buyer Indemnifiable Losses and subject to the Seller's and DQE's indemnification obligations under Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. However, if any Affected Employee becomes a participant in any employee benefit plan, practice or policy of the Buyer or any of its affiliates to the extent reasonably permitted by applicable law and existing insurance contracts, such Affected Employee shall be given credit under such plan for all service prior to the Closing Date with the Company, any of its affiliates, any ERISA Affiliate or any predecessor employer to the extent such credit was given by the Company, any of its affiliates, any ERISA Affiliate or any predecessor employer under a Seller Plan, and for all service with the Buyer or any of its affiliates on and after the Closing Date but prior to the time such employee becomes such a participant, for purposes of determining eligibility, vesting, benefit accrual and for all other purposes for which such service is either taken into account or recognized; provided, however, such service need not be credited to the extent it would result in a duplication of benefits, 34 including for purposes of benefit accrual under defined benefit plans. Further, the Buyer shall, and shall cause its affiliates to, to the extent reasonably permitted by applicable law and existing insurance contracts, (i) waive all limitations as to preexisting conditions exclusions and waiting periods with respect to participation and coverage requirements applicable to each Affected Employee under any welfare plan or welfare benefit plan in which the Affected Employee participates on or after the Closing Date, except to the extent of limitations or waiting periods that are already in effect with respect to the Affected Employee as of the Closing Date under the Seller Plans and that have not been satisfied as of the Closing Date and (ii) credit each Affected Employee for any co-payments and deductibles paid prior to the Closing Date in satisfying any applicable deductible or out-of-pocket requirements for the year in which the Closing Date occurs under any welfare plan or welfare benefit plan in which the Affected Employee participates on or after the Closing Date. The parties acknowledge that the welfare plans which the Buyer will make available to the Affected Employees will provide benefits substantially similar to those provided by the welfare plans of the Buyer and the Buyer Subsidiaries for their current employees. As of the Closing, the Company and its affiliates shall cease to provide coverage and benefits for Affected Employees and their dependents and beneficiaries under any benefit plan maintained by the Seller or DQE or any of their respective affiliates, except as required by applicable law. The provisions of this Section 6.7 shall not create or modify any Seller Plan (other than the Severance Obligations) or employee benefit plans or agreements of the Buyer. (b) Continuation of Agreements. The Buyer shall, and shall cause the Company to, assume and honor the obligations arising under the Severance Obligations and the Retention Agreements according to the terms thereof. Section 6.8 Tax Treatment. Neither the Seller nor the Buyer shall make or file any election under Section 338 of the Code (or any similar provision of the law of any state or other taxing jurisdiction) with respect to the purchase of the Membership Interests (or the acquisition of shares in any Company Subsidiary) in connection with the transactions contemplated by this Agreement. For purposes of all Tax Returns and other applicable filings, the Buyer and the Seller will each report the transactions contemplated hereby as a purchase and sale, respectively, of the Membership Interests. Section 6.9 Tax Indemnity and Tax Returns. Notwithstanding any other provision of this Agreement to the contrary, the Seller and DQE shall, jointly and severally, indemnify, defend and hold harmless each Buyer Indemnitee (as defined in Section 9.1(a)), and the Buyer shall indemnify, defend and hold harmless each Seller Indemnitee (as defined in Section 9.1(b)) from and against any and all of the liabilities of the Seller and DQE, and the Buyer, respectively, as set forth below: (a) The Seller and DQE shall be liable for, shall pay to the appropriate Tax authorities (or shall pay to the Company as a reimbursement of Taxes paid to the appropriate Tax authorities for a Straddle Period (as defined below) Tax Return), and shall indemnify and hold the Buyer and the Company harmless against, all Taxes of the Company that relate to (i) the taxable periods ending before or on the Closing Date (other than Taxes attributable to transactions not in the ordinary course of 35 business occurring after the Closing which are effectuated or initiated by the Buyer), (ii) any taxable period that includes but does not end on the Closing Date (a "Straddle Period"), but only to the extent that such Taxes relate to the portion of such Straddle Period up to and including the Closing Date, and (iii) any liability for Taxes of the consolidated group of which DQE or the Seller is the common parent arising under Treasury Regulations section 1.1502-6 (or any similar provision of state, local or foreign law), as a transferor or successor, by contract or otherwise. The Seller shall be entitled to all Tax refunds (including interest) attributable to the taxable periods for which it is liable. (b) The Buyer shall be liable for, shall pay to the appropriate Tax authorities, and shall indemnify and hold the Seller and DQE harmless against all Taxes of the Company that relate to (i) the taxable periods that begin after the Closing Date (including, for this purpose, any Taxes attributable to transactions not in the ordinary course of business occurring after the Closing which are effectuated or initiated by the Buyer) and (ii) the portion of any Straddle Period commencing with the first day after the Closing Date. The Buyer shall be entitled to any Tax refund (including interest) attributable to the taxable periods for which it is so liable. (c) The obligations of the parties to indemnify each other pursuant to this Section 6.9 shall continue until the statutory period of limitations (taking into account any extensions or waivers thereof) for the assessment of Taxes, covered by this Section 6.9, has expired. Any payment due to an indemnified party pursuant to this Section 6.9 shall be paid promptly by the indemnifying party upon receipt of written notice and, for further clarification, shall not be subject to, or included in, the Indemnity Basket (as defined in Section 9.3(b)) or the Indemnity Cap (as defined in Section 9.3(b)). (d) No party shall take any action the purpose and intent of which is to prejudice the defense of any claim subject to indemnification hereunder or to induce a third party to assert a claim subject to indemnification hereunder. (e) After the Closing, each of the Seller and the Buyer shall notify the chief tax officer of the other party in writing (including by telecopier) within ten (10) days of the receipt of any written notice of any pending or threatened Audit (as defined below) which, if determined adversely, could be grounds for indemnification under this Section 6.9 (a "Tax Claim"); provided, however, that any failure to give such notice shall not affect the rights of the parties hereunder unless and to the extent such failure materially and adversely affects the indemnifying party's right to participate in and defend such Tax Claim. The Seller shall have the right at its expense to participate in and control the conduct of any Tax Claim of or attributable to the Company relating to taxable periods ending on or before the Closing Date and to employ counsel of its own choice at its expense; provided, however, that the Seller shall not settle any such Tax Claim or make or agree to any adjustment in any manner without the consent of the Buyer, which consent shall not be unreasonably withheld, conditioned or delayed; and provided, further, that the Buyer shall have the right to participate in (but not to control) such Tax Claim. If the Seller fails to participate in any Tax Claim of the Company relating to taxable periods ending on or before the Closing Date for which notice was 36 provided pursuant to this Section 6.9(e), the Buyer may defend and settle such Tax Claim in such manner as it may deem appropriate in its sole discretion. Except as set forth above in the first sentence of this Section 6.9(e), the Buyer shall control the conduct of any Tax Claim of the Company relating to any taxable period ending after the Closing Date and may defend and settle such Tax Claim in such manner as it may deem appropriate in its sole discretion. The term "Audit" means any audit, assessment of Taxes, reassessment of Taxes, or other examination by any Governmental Authority or any judicial or administrative proceedings or appeal of such proceedings. (f) All indemnity payments made by DQE or the Seller to the Buyer, or by the Buyer to the Seller, pursuant to this Agreement shall, to the maximum extent permitted under the Code (or other applicable Tax law), be treated for all Tax purposes as adjustments to the consideration paid with respect to the Membership Interests. (g) The Seller shall prepare and file, or cause to be prepared and filed, when due all Tax Returns that are required to be filed by or with respect to the Company for taxable years or periods ending on or before the Closing Date. The Buyer shall prepare and file, or cause to be prepared and filed, when due all Tax Returns that are required to be filed by or with respect to the Company for taxable years or periods ending after the Closing Date. Any Tax Return required to be filed by the Buyer relating to any Straddle Period shall be prepared based on past practice and submitted (with copies of any relevant Schedules, work papers and other documentation then available) to the Seller for the Seller's approval not less than thirty (30) days prior to the due date for the filing of such Tax Return, which approval shall not be unreasonably withheld. The Seller and the Buyer shall make available all books and records and cooperate with each other as reasonably necessary for the preparation and filing of any Tax Returns relating to the Company. (h) Except as otherwise provided in this Agreement, any tax sharing agreement between DQE and/or the Seller (including any of its Subsidiaries) and the Company will be terminated with respect to the Company as of the Closing Date, and the Company shall not have any obligation after the Closing Date to make any payment under any such tax sharing agreement. Section 6.10 Transfer Taxes. Notwithstanding any other provision of this Agreement to the contrary, the Buyer shall pay (a) all transfer (including real property transfer and documentary transfer) Taxes and fees imposed with respect to the transactions contemplated hereby and (b) all sales, use, gains (including state and local transfer gains), excise and other transfer or similar Taxes imposed with respect to the transactions contemplated hereby; provided, however, that the Buyer shall not be responsible for any, and the Seller shall pay all, costs, fees or Taxes imposed in respect of the transfer of the Excluded Assets and the Integrated Assets, as contemplated by Section 5.3 of this Agreement. The Seller shall execute and deliver to the Buyer, and the Buyer shall execute and deliver to the Seller at the Closing any certificates or other documents as the requesting party may reasonably request in order to perfect any exemption from 37 any such transfer, documentary, sales, use, gains, excise or other Taxes, or to otherwise comply with any applicable reporting requirements with respect to any such Taxes. Section 6.11 Financial Information. (a) After the Closing, upon reasonable written notice, the Buyer and the Seller shall furnish or cause to be furnished to each other and their respective accountants, counsel and other Representatives, during normal business hours, such information (including records pertinent to the Company) as is reasonably necessary for financial reporting and accounting matters of the party to whom information is furnished. (b) At the Closing, all books and records of the Company, including all financial and accounting information and all of the books, records, files and other information maintained with respect to the business of the Company, will be either delivered to Buyer or made available for pickup by Buyer. The Buyer shall retain all such books and records of the Company for such period after the Closing Date as Buyer may determine, provided that before disposing of such books or records, the Buyer shall give notice of its intent to do so to the Seller and give the Seller an opportunity for thirty (30) days after such notice to remove and retain all or any part of such books or records as the Seller may select. (c) Without limiting the generality of the provisions of Section 6.16(b) below, any information provided by the Buyer to the Seller under the provisions of this Section 6.11 shall be Confidential Information of the Company (as defined in Section 6.16(b)). Section 6.12 Transition Services. Except as agreed to in writing by the Seller and the Buyer, all data processing, accounting, insurance, banking, personnel, legal, communications and other products and services provided to the Company by the Seller or any affiliate of the Seller, including any agreements or understandings (written or oral) with respect thereto, shall terminate simultaneously with the Closing without any further action or liability on the part of the parties thereto. Notwithstanding the foregoing, in the absence of a written agreement, at the Buyer's request, the Seller shall provide, for a period of six (6) months after the Closing, services (similar to those contemplated by the preceding sentence as shall be mutually agreed to by the parties) to the Company, which services, at the Buyer's request, shall be provided at a price for such services that is equal to DQE's or the Seller's Actual Cost (as defined below) for such services, as the case may be, to be paid on a monthly basis by the Buyer to DQE or the Seller. The term "Actual Cost" shall mean the sum of (A) the reasonable costs or expenses actually incurred by the Seller or DQE attributable to the provision of transition services to the Buyer, including (i) the reasonable salary and benefits for personnel performing transition services for those hours when such personnel are performing transition services, (ii) reasonable payments to temporary contract employees for, or related to, transition services, and (iii) reasonable payments to vendors and other third parties for, or related to, transition services, and (B) costs of the Seller or DQE, including all overheads, that cannot be specifically identified with a particular service or product provided to the Buyer but that are reasonably allocable to the products or services 38 rendered by the Seller or DQE. At the request of the Buyer prior to Closing, the Seller and the Buyer will cooperate to negotiate reasonable and mutually acceptable terms upon which specific transition services will be provided after the Closing. In addition, at the request of the Buyer prior to the Closing, the Seller and the Buyer will cooperate to negotiate reasonable and mutually acceptable terms pursuant to which the Seller, to the extent it retains, following the Closing, an ownership or leasehold interest in the office building located in the Brittmoore-Tanner Industrial Park, shall lease to the Company for a period of one (1) year following the Closing Date (or such shorter period of time in the event that the Seller's ownership or leasehold interest shall expire or terminate prior to the conclusion of such one year period) such space in said office building that is substantially equivalent to the space that the Company is using in said building on the date hereof at a monthly rent payment equal to the Seller's actual costs in respect of such space. Section 6.13 Update of the Seller Disclosure Schedule. The Seller may from time to time prior to or on the Closing Date by notice in accordance with this Agreement supplement or amend the Seller Disclosure Schedule, including one or more supplements or amendments thereto, to promptly disclose any fact, event or circumstance that has arisen, occurred or changed since the date of this Agreement. Notwithstanding any other provision hereof to the contrary, the Seller Disclosure Schedule and the representations and warranties made by the Seller and DQE shall be deemed for all purposes to include and reflect such supplements and amendments as of the date hereof and at all times thereafter, including the Closing Date. Section 6.14 AquaSource Name. The Seller agrees that on the Closing Date, and continuing until the sixth month anniversary of Closing Date, it shall grant to Buyer the non-exclusive, fully-paid license to use the name "AquaSource" or any derivations thereof that may have been used by the Company on the date hereof anywhere in the United States of America. Section 6.15 Officer and Director Resignations. At the Closing, the Seller will cause each officer and director of the Company to resign, or the Seller shall remove each such officer and director, from such position as an officer and/or director. Section 6.16 Non-Competition Covenants. (a) Prohibited Activities. Each of the Seller and DQE agree that effective upon the Closing it will not, for a period of five (5) years following the Closing Date, directly or indirectly, either in its own capacity or as a partner, agent, consultant, through an Affiliate (as defined in Section 6.16(c)), or otherwise, or by means of any corporate device, do any of the following, such activity constituting a "Prohibited Activity": (i) engage in any business identical to or which competes with the business providing water and wastewater services for municipal utility districts and municipalities, as such business was conducted by the Company during the period commencing on January 1, 2001 and continuing through the Closing Date, within 100 miles of the 39 downtown business districts of the cities of Houston, Texas and Denver, Colorado, or engage in any business which would require use, directly or indirectly, of the Company's trade secrets or the Company's confidential or privileged information; provided, however, that the limitations provided for in this Section 6.16(a)(i) shall not apply to the Seller or DQE with regard to those systems within 100 miles of the downtown business district of the city of Houston, Texas listed on Exhibit 6.16(a)(i); (ii) solicit, induce, recruit or encourage any of Company's employees, consultants or independent contractors, to leave their employment or terminate their relationship with the Company, provided, however, that neither the Seller nor DQE shall be in violation of this Section 6.16(a)(ii) by continuing to utilize those consultants and independent contractors listed on Exhibit 6.16(a)(ii) or those consultants and independent contractors who, on the date of this Agreement, are performing services for DQE, the Seller or Subsidiaries of the Seller (other than the Company); or (iii) solicit any person or entity which is, or which has been within one (1) year prior to the date of solicitation, a customer of the Company for the purpose of selling to such customer services or products which are in direct competition with the services or products offered by the Company prior to the Closing. (b) The Seller and DQE recognize and acknowledge that it and its Affiliates had in the past, currently have, and in the future will have, access to Confidential Information of the Company (as defined in this Section 6.16(b)). The Seller and DQE agree that from the Closing Date until April 12, 2005 neither the Seller nor any of its Affiliates will disclose such Confidential Information to any person, firm, corporation, association or other entity for any purpose whatsoever, unless (i) such Confidential Information becomes known to the public generally through no fault of the Seller, or (ii) disclosure is required by law or the order of any governmental authority, provided, that prior to disclosing any Confidential Information pursuant to this clause (ii) the Seller shall, if possible, give prior written notice thereof to the Buyer and provide the Buyer with the opportunity to contest such disclosure. In the event of a breach or threatened breach by the Seller or any of its Affiliates of the provisions of this Section 6.16(b), the Buyer shall be entitled to an injunction restraining the Seller or any of its Affiliates from disclosing, in whole or in part, such Confidential Information. Nothing herein shall be construed as prohibiting the Buyer from pursuing any other available remedy for such breach or threatened breach, including the recovery of damages. For purposes of this Section 6.16(b), "Confidential Information" shall mean all information of the Company which is not generally known in the industries in which the Company is engaged during the period commencing on January 1, 2001 and continuing through the Closing Date, about the Company's business, products, processes and services, including, without limitation, information relating to research, development, inventions, computer program designs, flow charts, source and object codes, products and services under development, pricing and pricing strategies, marketing and selling strategies, servicing, 40 purchasing, accounting, engineering, costs and costing strategies, sources of supply, customer lists, customer requirements, business methods or practices, training and training programs, proprietary information, trade secrets, confidential information supplied from outside sources, and related documentation, provided that, notwithstanding any other provision of this Section 6.16(b), neither DQE nor the Seller shall be in violation of this Section 6.6(b) by using information that is or was developed for, used by, or otherwise related to the operations of DQE, the Seller or any of their Affiliates other than the Company. (c) Reasonable Restraint. The Seller and DQE acknowledge that the covenants in this Section 6.16 impose a reasonable restraint on the Seller and DQE in light of the activities and business of the Buyer and the Company on the date of the execution of this Agreement and the current plans of the Buyer and the Company. The Seller and DQE further acknowledge that the covenants in this Section 6.16 contain limitations as to time, geographic area and scope of activity to be restrained that are reasonable and do not impose a greater restraint than is necessary to protect the good will or other business interests of the Buyer and the Company. (d) Affiliate. For purposes of this Section 6.16, the term "Affiliate" shall mean a Person that directly or indirectly controls, or is controlled by or under common control with the Seller or DQE; provided, that, this Section 6.16 shall not apply to any Person who has ceased to be an Affiliate for any reason. Control including the terms "controlled by" and "under common control with," with respect to any entity includes officers, directors, and 10% or greater owners, and other individuals or entities with the power to direct or cause the direction of the management and policies of such entity, directly or indirectly, whether through ownership of voting securities or by contract or otherwise. (e) Equitable Relief. Because of the difficulty of measuring economic losses to the Buyer or the Company as a result of a breach of the covenants in this Section 6.16, and because of the immediate and irreparable damage that could be caused to the Buyer or the Company for which they would have no other adequate remedy, the Seller and DQE agree that the covenants in this Section 6.16 may be enforced by Buyer or the Company by injunctions, restraining orders and other equitable actions. (f) Severability; Reformation; Survival. The covenants in this Section 6.16 are severable and separate, and the unenforceability of any specific covenant shall not affect the continuing validity and enforceability of any other covenant. In the event that any court of competent jurisdiction shall determine that the scope, time or territorial restrictions set forth in this Section 6.16 are unreasonable, then it is the intention of the parties that such restrictions be enforced to the fullest extent which the court deems reasonable and this Agreement shall thereby be reformed. The covenants in this Section 6.16 shall survive the Closing. (g) Material Covenants. The Seller and DQE acknowledge that their agreement with the covenants in this Section 6.16 are material conditions to Buyer's 41 agreement to execute and deliver this Agreement and to consummate the transactions contemplated hereby, are essential elements of this Agreement and without the agreement of Seller and DQE to comply with such covenants, Buyer would not have agreed to purchase the Membership Interests pursuant to this Agreement. (h) Independent Covenants. All of the covenants in this Section 6.16 shall be construed as an agreement independent of any other provision in this Agreement, and the existence of any claim or cause of action of Seller or DQE against Buyer, whether predicated on this Agreement or otherwise, shall not constitute a defense to the enforcement by Buyer of such covenants. It is specifically agreed that the respective periods during which the covenants of the Seller or DQE made in this Section 6.16 shall survive and shall be computed by excluding from such computation any time during which Seller or DQE is in violation of any provision of this Section 6.16. The covenants contained in this Section 6.16 shall not be affected by any breach of any other provision of this Agreement by any party hereto. Section 6.17 Enforcement of Other Covenants. (a) The Buyer may attempt to negotiate agreements with Bryan K. Chapline, Kenneth W. Lindsey, James L. Coursey, Robert G. Haas, and Randolph S. Jones (the "Designated Employees"), which agreements will become effective only upon the Closing and will include covenants not to compete, on terms mutually acceptable to the Buyer and each Designated Employee. Prior to and after the Closing, the Seller shall cooperate with the Buyer and use all actions reasonably necessary to enforce the "Covenants Against Competition" set forth in the agreements listed in Section 3.10(c) of the Seller Disclosure Schedule, including by seeking legal damages and/or injunctions or other equitable relief. The Seller and DQE shall, prior to the Closing and for a period of one (1) year after the Closing, cooperate with the Buyer and the Company and use all actions reasonably necessary to enforce David Beyer's existing covenants not to compete for the benefit of the Company. (b) The Buyer shall reimburse the Seller or DQE, as applicable, for any reasonable costs and expenses, including reasonable legal fees, incurred by the Seller or DQE, as applicable, after the Closing in complying with their respective obligations set forth in Section 6.17(a). Section 6.18 Surety Bonds. (a) After the Closing, the Buyer shall, and shall cause the Company to, use all commercially reasonable efforts to recover and replace those surety bonds listed in Exhibit 6.18(a) and to have such surety bonds returned to Seller within ninety (90) calendar days of the Closing Date. (b) The Buyer expressly acknowledges that, after the Closing, the Seller and/or DQE may cancel those surety bonds listed in Exhibit 6.18(b) without notice to the Buyer, subject to the terms of the bond documents. 42 (c) After the Closing, the Buyer shall, and shall cause the Company to, use all commercially reasonable efforts to replace the Seller as guarantor under that certain Marshall Office Park II Lease Agreement between MOPII, B1, LLC and AquaSource Services, LP, dated November 13, 2001. Section 6.19 Further Assurances. Each party will, and will cause its Subsidiaries to, execute such further documents or instruments and take such further actions as may reasonably be requested by any other party in order to consummate the transaction contemplated hereby in accordance with the terms hereof or otherwise perform those obligations required hereunder. In the event that any asset reflected in the Company Financial Statements to be conveyed, assigned, transferred and delivered hereunder to the Company shall not have been so conveyed, assigned, transferred and delivered to the Company at the Closing, the Seller shall as promptly as practicable after the Closing Date convey, assign, transfer and deliver such asset to the Company at which time the Buyer shall cause the Company to assume all liabilities and obligations, and be entitled to all benefits, associated therewith that are due, or received, after (but not before) such assignment, transfer and delivery and such asset shall thereafter be deemed to be an Integrated Asset for all other purposes under this Agreement, including Article IX, except that they shall be deemed to have been included among the Integrated Assets as of the date of such assignment and transfer. ARTICLE VII CONDITIONS Section 7.1 Conditions to Each Party's Obligation to Effect the Closing. The respective obligations of each party to effect the Closing shall be subject to the satisfaction on or prior to the Closing Date of the following conditions, except, to the extent permitted by applicable law, that such conditions may be waived in writing pursuant to Section 10.3 of this Agreement: (a) No Injunction. No temporary restraining order or preliminary or permanent injunction or other order by any federal or state court preventing consummation of the transactions contemplated hereby shall have been issued and be continuing in effect, and the transactions contemplated hereby shall not have been prohibited under any applicable federal or state law or regulation. (b) Statutory Approvals. The Seller Required Statutory Approvals and the Buyer Required Statutory Approvals shall have been obtained at or prior to the Closing Date, such approvals shall have become Final Orders (as defined below) and such Final Orders shall not, individually or in the aggregate, impose terms or conditions (other than the preclusion of recovery of an acquisition premium) which would have a material adverse effect on the business, operations, properties, assets, financial condition, or results of operations of the Company and the Buyer and their respective Subsidiaries taken as a whole. A "Final Order" means action by the relevant regulatory authority which has not been reversed, stayed, enjoined, set aside, annulled or suspended, with respect to which any waiting period prescribed by law before the transactions contemplated hereby may be consummated has expired, and as to which all 43 conditions to the consummation of such transactions prescribed by law, regulation or order have been satisfied. (c) Assignment, Transfer and Delivery of Excluded Assets and Assumption of Related Liabilities. All of Services I's, Services II's, Services, LP's and the Company Subsidiaries' right, title and interest in and to the Excluded Assets shall have been assigned and transferred, and all such Excluded Assets shall have been delivered, to the Seller or such third party as the Seller may designate, and the Seller or such third party, as the case may be, shall have assumed all of the obligations and liabilities of Services I, Services II, Services, LP and the Company Subsidiaries in respect of such Excluded Assets, as contemplated by Section 5.3(a) of this Agreement; provided, however, that if any such assignment, transfer or delivery requires the approval or consent of any third party which shall not have been obtained, the parties shall use commercially reasonable efforts, at the Seller's expense, to secure such consent or otherwise effect such assignment, transfer and delivery following the Closing and the Seller shall fully indemnify the Buyer and the Company for and against any consequences of the failure to secure such consent prior to the Closing. For the avoidance of doubt, liabilities and obligations of DQE, the Seller or the Company relating to the Excluded Assets shall be Buyer Indemnifiable Losses and subject to the Seller's and DQE's indemnification obligations under Article IX. (d) Assignment, Transfer and Delivery of Integrated Assets and Assumption of Related Liabilities. All of the Seller's and any Subsidiary of the Seller's right, title and interest in and to the Integrated Assets shall have been assigned and transferred, and all such Integrated Assets shall have been delivered, to the Company, and the Company shall have assumed all of the performance obligations of DQE, the Seller, any Subsidiary of the Seller and the Company which arise after the Closing and relate to the contracts included among the Integrated Assets listed on Section 3.3 of the Seller Disclosure Schedule and all liabilities of DQE, the Seller, any Subsidiary of the Seller and the Company, direct or indirect, known or unknown, absolute or contingent, which arise after the Closing and relate to the Integrated Assets listed on Section 3.3 of the Seller Disclosure Schedule, as contemplated by Section 5.3(b) of this Agreement; provided, however, that if any such assignment, transfer or delivery requires the approval or consent of any third party which shall not have been obtained, the parties shall use commercially reasonable efforts, at the Seller's expense, to secure such consent or otherwise effect such assignment, transfer and delivery following the Closing and the Seller shall fully indemnify the Buyer and the Company for and against any consequences of the failure to secure such consent prior to the Closing. For avoidance of doubt, liabilities and obligations of DQE, the Seller, any Subsidiary of the Seller or the Company relating to the Integrated Assets which arise prior to the Closing shall be Buyer Indemnifiable Losses and subject to the Seller's and DQE's indemnification obligations under Article IX, and liabilities and obligations of DQE, the Seller, any Subsidiary of the Seller or the Company relating to the Integrated Assets which arise after the Closing shall be Seller Indemnifiable Losses and subject to the Buyer's indemnification obligations under Article IX, recognizing that all such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. 44 Section 7.2 Conditions to Obligation of the Buyer to Effect the Closing. The obligation of the Buyer to effect the Closing shall be further subject to the satisfaction, on or prior to the Closing Date, of the following conditions, except as may be waived by the Buyer in writing pursuant to Section 9.3: (a) Performance of Obligations of the Seller. The Seller (and/or DQE or the Company) will have performed in all material respects its agreements and covenants contained in or contemplated by this Agreement which are required to be performed by it at or prior to the Closing. (b) Representations and Warranties of the Seller. The representations and warranties of the Seller (and DQE in Section 3.4) set forth in this Agreement shall be true and correct (i) on and as of the date hereof and (ii) on and as of the Closing Date with the same effect as though such representations and warranties had been made on and as of the Closing Date (except for representations and warranties that expressly speak only as of a specific date or time which need only be true and correct as of such date or time provided that the Seller's representations and warranties in Section 3.3 shall be true and correct on and as of the Closing Date) except in each of cases (i) and (ii) for such failures of representations or warranties to be true and correct (without giving effect to any materiality qualification or standard contained in any such representations and warranties) which, individually or in the aggregate, would not result in a Company Material Adverse Effect. (c) Closing Certificates of the Seller. The Buyer shall have received a certificate signed by a duly authorized officer on behalf of the Seller and DQE, dated the Closing Date, to the effect that the conditions set forth in Section 7.2(a) and Section 7.2(b) have been satisfied. (d) Company Material Adverse Effect. No Company Material Adverse Effect shall have occurred and there shall exist no facts or circumstances that, individually or in the aggregate, are reasonably likely to have a Company Material Adverse Effect. For the purpose of this Section 7.2(d): (w) events, facts or circumstances need not constitute, or be likely to constitute, a breach of a representation or warranty in order to have, or be reasonably likely to have, a Company Material Adverse Effect, (x) no materiality or knowledge qualification or standard contained in the representations and warranties shall be taken into account in determining whether or not events, facts or circumstances, have, or are reasonably likely to have a Company Material Adverse Effect, (y) if a Designated Employee is subject to a "Covenant Against Competition" with the Seller, and such Designated Employee's employment with the Seller is terminated prior to the Closing, then such termination of employment or any impact on the Company resulting therefrom will not constitute a Company Material Adverse Effect so long as the Seller and DQE are complying with their obligations to use all actions reasonably necessary actions to enforce the "Covenants Against Competition" set forth in the agreements listed in Section 3.10(c) of the Seller Disclosure Schedule, as contemplated by Section 6.17(a) of this Agreement, and (z) the inability of the Company to own or operate its assets in materially the same manner as such assets are owned or operated by the Company on the date hereof resulting specifically from any change in 45 law, rule or regulation of any Governmental Authority, which change is made specifically in order to enhance or protect the safety and security of water and wastewater systems in light of concerns arising due to national or international occurrences, and which change applies generally to parties providing water and wastewater services for municipal utility districts and/or municipalities, will be taken into account in determining whether or not there is, or there is reasonably likely to be, a Company Material Adverse Effect. (e) The Seller Required Consents. The Seller Required Consents, the failure of which to obtain would have a Company Material Adverse Effect, shall have been obtained. (f) Additional Documents. Each of the following documents shall have been delivered to the Buyer: (i) A certified copy of resolutions of the Seller's Board of Directors, and of DQE's Board of Directors, as applicable, authorizing the transactions contemplated by this Agreement, and the authority of the parties acting on behalf of the Seller to execute and deliver documents in connection therewith; (ii) Certificates of Good Standing and Existence (or the equivalent) with respect to Services I, Services II, Services, LP and each Company Subsidiary, dated no earlier than five (5) business days prior to the Closing Date; and (iii) Such additional documents as the Buyer may reasonably request for the purpose of facilitating or in connection with the Closing of the transactions contemplated by this Agreement. Section 7.3 Conditions to Obligation of the Seller to Effect the Closing. The obligation of the Seller to effect the Closing shall be further subject to the satisfaction, on or prior to the Closing Date, of the following conditions, except as may be waived by the Seller in writing pursuant to Section 9.3: (a) Performance of Obligations of the Buyer. The Buyer (and/or its appropriate Subsidiaries) will have performed in all material respects its agreements and covenants contained in or contemplated by this Agreement which are required to be performed by it at or prior to the Closing Date. (b) Representations and Warranties. The representations and warranties of the Buyer set forth in this Agreement shall be true and correct (i) on and as of the date hereof and (ii) on and as of the Closing Date with the same effect as though such representations and warranties had been made on and as of the Closing Date (except for representations and warranties that expressly speak only as of a specific date or time which need only be true and correct as of such date or time) except in each of cases (i) and (ii) for such failures of representations or warranties to be true and correct (without giving effect to any materiality qualification or standard contained in any such 46 representations and warranties) which, individually or in the aggregate, would not result in a Buyer Material Adverse Effect. (c) Closing Certificates. The Seller shall have received a certificate signed by a duly authorized officer of the Buyer, dated the Closing Date, to the effect that, to the best of such officer's knowledge, the conditions set forth in Section 7.3(a) and Section 7.3(b) have been satisfied. (d) Buyer Material Adverse Effect. No Buyer Material Adverse Effect shall have occurred and there shall exist no fact or circumstance that would result in a Buyer Material Adverse Effect. (e) Buyer Required Consents. The Buyer Required Consents, the failure of which to obtain would have a Buyer Material Adverse Effect, shall have been obtained. (f) Additional Documents. Each of the following documents shall have been delivered to the Seller: (i) A certified copy of resolutions of the Buyer's Board of Directors authorizing the transactions contemplated by this Agreement, and the authority of the parties acting on behalf of the Buyer to execute and deliver documents in connection therewith; (ii) Certificate of Good Standing and Existence (or the equivalent) with respect to the Buyer, dated no earlier than five (5) business days prior to the Closing Date; and (iii) Such additional document as the Buyer may reasonably request for the purpose of facilitating or in connection with the Closing of the transactions contemplated by this Agreement. ARTICLE VIII TERMINATION Section 8.1 Termination. This Agreement may be terminated at any time prior to the Closing Date: (a) by mutual written consent of the Seller and the Buyer; (b) by the Buyer or the Seller, if any state or federal law, order, rule or regulation is adopted or issued, which has the effect, as supported by the written opinion of outside counsel for such party, of prohibiting the Closing, or by the Buyer or the Seller, if any court of competent jurisdiction in the United States or any state shall have issued an order, judgment or decree permanently restraining, enjoining or otherwise prohibiting the Closing, and, in either case, if such order, rule, regulation, judgment or decree shall have become final and nonappealable; 47 (c) by the Buyer or the Seller, by written notice to the other party, if the Closing shall not have occurred on or before sixty (60) days after the date hereof (the "Initial Termination Date"); provided, however, that the right to terminate the Agreement under this Section 8.1(c) shall not be available to any party whose failure, or whose Affiliate's failure, to fulfill any obligation under this Agreement shall have proximately contributed to the failure of the Closing to occur on or before such date; and provided, further, that if on the Initial Termination Date the conditions to the Closing set forth in Sections 7.1(b), 7.2(e) and/or 7.3(e) shall not have been fulfilled but all other conditions to the Closing shall be fulfilled or shall be capable of being fulfilled, then the Initial Termination Date shall be extended to one hundred twenty (120) days after the date hereof; (d) by the Buyer if, at the Closing, any breach or breaches of any of the Seller's representations or warranties, covenants or agreements result, or are reasonably likely to result, individually or in the aggregate, in a Company Material Adverse Effect and such breach or breaches shall not have been cured by the Seller or in respect of which the Seller shall not have agreed to indemnify the Buyer (pursuant to which indemnity agreement, all Indemnifiable Losses relating to, resulting from or arising out of such breach or breaches shall be Buyer Indemnifiable Losses subject to the Seller's indemnification obligations under Article IX but shall not be limited by, or taken into account in determining whether Buyer Indemnifiable Losses exceed, the Indemnity Cap or be limited by the Indemnity Period). For the avoidance of doubt, if at the Closing there are any breaches of the Seller's representations and warranties that do not result, or are not reasonably likely to result, individually or in the aggregate, in a Company Material Adverse Effect, then following the Closing all Indemnifiable losses relating to, resulting from or arising out of such breaches, to the extent uncured by the Seller, shall be Buyer Indemnifiable Losses subject to the Seller's indemnification obligations under Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. (e) by the Seller if, at the Closing any breach or breaches of any of the Buyer's representations or warranties, covenants or agreements result, or are reasonably like to result, individually or in the aggregate, in a Buyer Material Adverse Effect and such breach or breaches shall not have been cured by the Buyer or in respect of which the Buyer shall not have agreed to indemnity the Seller (pursuant to which indemnity agreement all Indemnifiable Losses relating to, resulting from or arising out of such breach or breaches shall be Seller Indemnifiable Losses, subject to the Buyer's indemnification obligations under Article IX but shall not be limited by, or taken into account in determining whether Seller Indemnifiable Losses exceed, the Indemnity Cap or be limited by the Indemnity Period). For the avoidance of doubt, if at the Closing there are any breaches of the Buyer's representations and warranties that do not result, or are not reasonably likely to result, individually or in the aggregate, in a Buyer Material Adverse Effect, then following the Closing all Indemnifiable Losses relating to, resulting from or arising out of such breaches, to the extent uncured by the Buyer, shall be Seller Indemnifiable Losses subject to the Buyer's indemnification obligations under Article IX, recognizing that such indemnification obligations are always subject to the limitations and restrictions contained in Articles IX and X. 48 (f) by the Buyer if one or more supplements to or amendments of any sections of the Seller Disclosure Schedule made by the Seller pursuant to Section 6.13, individually or in the aggregate, materially and adversely affects the benefits to be obtained by the Buyer under this Agreement. Section 8.2 Effect of Termination. In the event of termination of this Agreement by either the Seller or the Buyer pursuant to Section 8.1 there shall be no liability on the part of either the Seller or the Buyer or their respective officers or directors hereunder, except that: (a) in the event of fraud or willful breach of this Agreement by one party (the "Party at Fault"), or in the event of the failure of a condition to a party's obligation to effect the Closing that results from the other party's (also the "Party at Fault") willful breach of its obligations under this Agreement, then the party who is not the Party at Fault shall have the right to terminate this Agreement and pursue all available legal remedies against the Party at Fault, which right shall survive termination unimpaired, and in addition to the foregoing, upon such termination, the Party at Fault shall pay the party who is not the Party at Fault the sum of one million dollars ($1,000,000). (b) Sections 8.2, 10.2, 10.4, 10.5, 10.8, 10.9, 10.10, 10.11, 10.12 and 10.13, and the agreement contained in the last sentence of Section 6.1 shall survive the termination. ARTICLE IX INDEMNIFICATION Section 9.1 Indemnification Obligations. (a) Subject to the limitations set forth in Sections 9.3 and 9.4 hereof, the Seller and DQE shall, jointly and severally, indemnify, defend and hold harmless the Buyer, the Buyer Subsidiaries (including, after the Closing, the Company), and its and their officers, directors, employees, shareholders, affiliates and agents (each, a "Buyer Indemnitee") from and against any and all Indemnifiable Losses (as defined below) asserted against or suffered by any Buyer Indemnitee (each, a "Buyer Indemnifiable Loss") and for which a Buyer Indemnitee makes a claim during the Indemnity Period (as defined below) in any way relating to, resulting from or arising out of (i) any breach by the Seller of the representations and warranties contained in Article III hereof, and (ii) the Buyer Indemnified Liabilities (as defined below). (b) Subject to the limitations set forth in Sections 9.3 and 9.4 hereof, the Buyer shall, jointly and severally, indemnify, defend and hold harmless the Seller, DQE, its and their Subsidiaries, officers, directors, employees, shareholders, affiliates and agents (each, a "Seller Indemnitee") from and against any and all Indemnifiable Losses asserted against or suffered by any Seller Indemnitee (each, a "Seller Indemnifiable Loss") during the Indemnity Period in any way relating to, resulting from or arising out of (i) any breach by the Buyer of the representations and 49 warranties contained in Article IV hereof, and (ii) the Seller Indemnified Liabilities (as defined below). Section 9.2 Certain Definitions. As used in this Agreement: (a) the term "Indemnity Period" shall mean the period of time commencing with the Closing Date and continuing until the second (2nd) anniversary of the Closing Date; (b) the term "Indemnifiable Loss" shall mean any claim, demand, suit, loss, liability, damage (including, but not limited to, diminution in value, if proven, and, in respect of liabilities of obligations relating to certain Contracts contemplated by Section 9.2(c)(ii), proven damages resulting from performance of the subject Contract), obligation, payment, fine, penalty, cost or expense (including, without limitation, the cost and expense of any action, suit, proceeding, assessment, judgment, settlement or compromise relating thereto and reasonable attorneys' fees and reasonable disbursements in connection therewith); (c) the term "Buyer Indemnified Liabilities" shall mean: (i) all litigation or other legal proceedings (including any settlements or judgments in respect thereof), existing or threatened, that are set forth in Section 3.7 of the Seller Disclosure Schedule and all other litigation or other legal proceedings (including any settlements or judgments in respect thereof) that involve the Company and are based on facts or circumstances arising, existing or occurring prior to the Closing, (ii) any liabilities or obligations that relate to the Excluded Assets, (iii) any liabilities or obligations that relate to the Integrated Assets, and, in any case of this (iii), that relate to, result from, arose during, or are attributable to events, facts, circumstances or conditions in existence prior to the Closing or which occurred prior to the Closing, (iv) any liabilities or obligations relating to any Contracts with annualized revenues or liabilities in excess of $25,000 individually that are not disclosed on Section 9.2 of the Seller Disclosure Schedule or otherwise reflected in the Company Financial Statements, (v) any other liabilities, obligations or other Indemnifiable Losses of Services I, Services II, Services, LP or the Company Subsidiaries except for Excepted Liabilities (as defined in Section 9.2(d)), in any case of this (v) that relate to, result from, arose during, or are attributable to events, facts, circumstances or conditions in existence prior to the Closing or which occurred prior to the Closing, and in any case for each (i), (ii), (iii), (iv) and (v) above whether direct or indirect, known or unknown, absolute or contingent, and regardless of whether or not such liability, obligation or other Indemnifiable Loss is asserted against or suffered by a Buyer Indemnitee before or after the Closing, regardless of whether such liability, obligation or other Indemnifiable Loss results from a breach of any of Seller's representations or warranties and without regard to any materiality, knowledge or other qualifier contained in any such representatives or warranties; provided, however, that Buyer Indemnified Liabilities shall exclude any liability or obligation or other Indemnifiable Loss that is an Excepted Liability, including Excepted Liabilities that are disclosed in any Section of the Seller Disclosure Schedule that are expressly designated, by agreement of the parties, as Excepted Liabilities on such Seller Disclosure Schedule, but, subject to the provisions of Section 9.2(d), Buyer Indemnified Liabilities shall 50 expressly include any liability or obligation or other Indemnifiable Loss disclosed on the Seller Disclosure Schedule that is not designated an Excepted Liability; and the term "Seller Indemnified Liabilities" shall mean: (x) any liabilities or obligations of Services I, Services II, Services, LP or the Company Subsidiaries that are neither Buyer Indemnified Liabilities nor otherwise covered by DQE's and the Seller's indemnity obligations in Section 9.1(a), and any liabilities that relate to or arise by virtue of the Buyer's ownership of the Company that are not Buyer Indemnified Liabilities, in either case whether direct or indirect, known or unknown, absolute or contingent, that relate to, result from, arise during, or are attributable to, events, facts, circumstances or conditions in existence after (but not before) the Closing or which occur after the Closing, and (y) any liabilities or obligations or other Indemnifiable Losses that relate to the Excepted Liabilities and any liabilities or obligations that arise after the Closing and relate to the Integrated Assets, the Retention Agreements and those agreements set forth in Section 3.10(c) of the Seller Disclosure Schedule; (d) the term "Excepted Liabilities" shall mean (i) any liabilities or obligations of Services I, Services II, Services, LP or the Company Subsidiaries that arise out of any of the following liabilities or obligations incurred by Services I, Services II, Services, LP or the Company Subsidiaries, as the case may be: (1) any liability or obligation of Services I, Services II, Services, LP or the Company Subsidiaries, that is allocable to the right of Services I, Services II, Services, LP or the Company Subsidiaries, as the case may be, to receive property, services or other benefits on or after the Closing Date under a contract or agreement entered into on or after the Closing Date, and (2) any liability or obligation of Services I, Services II, Services, LP or the Company Subsidiaries to make any expenditure or to perform any obligation that is due after (but not before) the Closing under any Contract disclosed on Schedule 9.2 of the Seller Disclosure Schedule, any Contracts not disclosed on Schedule 9.2 of the Seller Disclosure Schedule but having annualized revenues or liabilities that are equal to or less than $25,000 individually, or any Contract otherwise reflected in the Company Financial Statements or to make any expenditure to perform any obligation that is due after (but not before) the Closing pursuant to any order, rule or regulation of any Governmental Authority by which Services I, Services II, Services, LP or the Company Subsidiaries, or any of their assets, is bound, as listed in the Seller Disclosure Schedule, (ii) those liabilities or obligations which arise after the Closing and that are disclosed on any Section of the Seller Disclosure Schedule and expressly designated on such Section of the Seller Disclosure Schedule, by agreement of the parties, as Excepted Liabilities, and (iii) the liabilities of the Company reflected on the June 30, 2002 Balance Sheet (but excluding any liability for Pre-Closing APs), the liabilities of the Company for vacation accruals for employees who accept Qualifying Offers, and the liabilities of the Company with respect to the Keystone, South Dakota industrial revenue bond. Section 9.3 Limitations on Indemnification. (a) Notwithstanding any other provision of this Agreement to the contrary, the parties' obligations pursuant to this Article IX are, and at all times shall be, subject to the limitations set forth in this Section 9.3. The parties shall not be required to indemnify, defend or hold harmless any Buyer Indemnitee or Seller Indemnitee, as the 51 case may be, until the aggregate dollar amount of the Buyer Indemnifiable Losses or Seller Indemnifiable Losses, as the case may be determined taking into account all Indemnifiable Losses (except for Indemnified Losses to which the Indemnity Cap does not apply) asserted against or suffered by the Buyer Indemnitees or the Seller Indemnitees, as the case may be, exceeds the Indemnity Basket (as defined in Section 9.3(b)), following which the indemnifying party shall indemnify, defend and hold harmless the Buyer Indemnitees or the Seller Indemnitees, as the case may be, only to the extent that the aggregate amount of Buyer Indemnifiable Losses or the Seller Indemnifiable Losses, as the case may be, exceeds the Indemnity Basket. In addition, the Seller's and DQE's liability, taken together, for Buyer Indemnifiable Losses and the Buyer's liability for Seller Indemnifiable Losses, in either case, as contemplated by this Article IX shall in no event exceed an aggregate amount of dollars equal to the Indemnity Cap (as defined in Section 9.3(b)). (b) As used in this Agreement, (i) the term "Indemnity Basket" shall mean Two Hundred Thousand Dollars ($200,000), and (ii) the term "Indemnity Cap shall mean Four Million, Two Hundred, Twenty-Five Thousand Dollars ($4,250,000). Notwithstanding any other provision of this Agreement to the contrary, the Seller's and DQE's liability for the following Buyer Indemnifiable Losses shall not be limited by, nor taken into account in determining whether Buyer Indemnifiable Losses exceed the Indemnity Cap, shall not be limited by the requirement to make a claim during the Indemnity Period and shall not be limited by any requirement to meet or exceed the Indemnity Basket: Buyer Indemnifiable Losses relating to (i) Excluded Assets, (ii) any and all liabilities and obligations of the Seller or the Subsidiaries of the Seller (other than any liabilities or obligations of the Seller (in respect of the Company), Services I, Services II, Services, LP or any Company Subsidiary), (iii) indemnity obligations of the Seller in respect of Taxes, as set forth in Section 6.9, (iv) litigation or other legal proceedings (including any settlements or judgments in respect thereof), existing or threatened, that are set forth in Section 3.7 of the Seller Disclosure Schedule and all other litigation or other legal proceedings (including any settlements or judgments in respect thereof), that involve the Company and are based on facts or circumstances arising, existing or occurring prior to the Closing, including any claims that were brought or could have been brought in the litigation captioned Edward Wallace, et al v. AquaSource, Inc., et al (Case No. 2001-05987), filed in the 270th Judicial District Court of Harris County, Texas, (v) any indemnity given pursuant to the first sentence of Section 8.1(d) and (vi) any fraud committed by DQE, the Seller, Services I, Services II, Services, LP or any Company Subsidiary (provided that the foregoing reference to Services I, Services II, Services, LP or any Company Subsidiary refers to fraud committed prior to the Closing Date); in addition, the Buyer's liability for the following Seller Indemnifiable Losses shall not be limited by, nor taken into account in determining whether Seller Indemnifiable Losses exceed the Indemnity Cap, shall not be limited by the requirement to make a claim during the Indemnity Period, and shall not be limited by any requirement to meet or exceed the Indemnity Basket: Seller Indemnifiable Losses relating to (x) indemnity obligations of the Buyer in respect of Taxes, as set forth in Section 6.9, (y) any indemnity given pursuant to the first sentence of Section 8.1(e), and (z) any fraud committed by the Buyer, any Buyer Subsidiary, Services I, Services II, Services, LP or any Company Subsidiary (provided that the foregoing reference to Services I, Services II, 52 Services, LP or any Company Subsidiary refers to fraud committed on or after the Closing Date). (c) For the avoidance of doubt, if at any time during the Indemnity Period, the amount of the Seller's and DQE's aggregate dollar amount of liability for Buyer Indemnifiable Losses, taking into account all liability for Buyer Indemnifiable Losses incurred by the Seller and DQE since the Closing Date (other than those Buyer Indemnifiable Losses that are not limited by the Indemnity Cap as contemplated by Section 9.3(b)), equals the Indemnity Cap, then the Seller shall have no further obligation whatsoever to indemnify, defend or hold harmless any Buyer Indemnitee in respect of any Buyer Indemnifiable Losses that are subject to the Indemnity Cap; similarly, if at any time during the Indemnity Period, the amount of the Buyer's aggregate liability for Seller Indemnifiable Losses, taking into account all liability for Seller Indemnifiable Losses incurred by the Buyer since the Closing Date (other than those Seller Indemnifiable Losses that are not limited by the Indemnity Cap as contemplated by Section 9.3(b)), equals the Indemnity Cap, then the Buyer shall have no further obligation whatsoever to indemnify, defend or hold harmless any Seller Indemnitee in respect of any Seller Indemnifiable Losses that are subject to the Indemnity Cap. (d) Notwithstanding any other provision of this Agreement to the contrary, any Buyer Indemnitee or Seller Indemnitee shall use commercially reasonable efforts to mitigate all losses, damages and the like relating to a claim under these indemnification provisions, including availing itself of any defenses, limitations, rights of contribution, claims against third Persons and other rights at law or equity. The Buyer Indemnitee's or Seller Indemnitee's, as the case may be, commercially reasonable efforts shall include the reasonable expenditure of money to mitigate or otherwise reduce or eliminate any loss or expenses for which indemnification would otherwise be due, and the indemnifying party shall, to the extent that Buyer Indemnifiable Losses or Seller Indemnifiable Losses, as the case may be, exceed the Indemnity Basket, reimburse the Buyer Indemnitee or Seller Indemnitee, as the case may be, for its reasonable expenditures (except for any portion of the wages, salary, benefits, overhead or other costs attributable to Buyer Indemnitee or Seller Indemnitee, as the case may be, and its officers, directors, employees and agents) in undertaking the mitigation and, subject to Section 9.3(b) shall, to such extent, take such expenses into account in calculating the aggregate amount of the Seller's and DQE's liability for the Buyer Indemnifiable Losses or the Buyer's liability for the Seller Indemnifiable Losses, as the case may be. Notwithstanding any other provision of this Agreement to the contrary, any Buyer Indemnifiable Loss or Seller Indemnifiable Loss shall be net of (i) the dollar amount of any insurance or other proceeds actually received by the Buyer Indemnitee or any of its affiliates with respect to the Buyer Indemnifiable Loss or by the Seller or DQE or any of their affiliates with respect to the Seller Indemnifiable Loss, and (ii) income tax benefits to the Buyer Indemnitee, to the extent realized by the Buyer Indemnitee, or to the Seller Indemnitee, to the extent recognized by the Seller Indemnitee. Any Person seeking indemnity hereunder shall, to the extent they have the right to do so under an insurance policy, use commercially reasonable efforts to seek coverage (including both costs of 53 defense and indemnity) under applicable insurance policies with respect to any such Buyer Indemnifiable Loss or Seller Indemnifiable Loss, as the case may be. (e) Notwithstanding any other provision of this Agreement to the contrary, (i) except to the extent otherwise provided in Article VIII, the rights and remedies of the parties under this Article IX are exclusive and in lieu of any and all other rights and remedies which the parties may have under this Agreement for monetary relief with respect to (A) any breach by the parties of their respective representations and warranties and (B) the Indemnified Liabilities, and (ii) except in the case of fraud, no party (nor any Buyer Indemnitee or Seller Indemnitee) shall be entitled to recover from any other party for any liabilities, damages, obligations, payments, losses, costs, or expenses under this Agreement any amount in excess of the actual compensatory damages, court costs and reasonable attorneys' and other advisor fees suffered by such party (or Buyer Indemnitee or Seller Indemnitee, as the case may be). Each party waives any right to recover incidental, special, exemplary and consequential damages arising in connection with or with respect to this Agreement (except in the case of fraud). Section 9.4 Defense of Claims. The parties agree that the provisions set forth below in (a), (b) and (c) shall not apply to claims made in respect of Excluded Assets or in respect of any litigation or other legal proceedings (including any settlements or judgments in request thereof) contemplated by Section 9.2(c)(i), but that such provisions shall apply to all other claims under this Article IX. (a) (i) If any Buyer Indemnitee receives notice of the assertion or commencement of any claim, action or proceeding made or brought by any Person who is neither a party to this Agreement nor an affiliate of a party to this Agreement (a "Third Party Claim") with respect to which indemnification is to be sought from the Seller and DQE, the Buyer Indemnitee shall give the Seller and DQE reasonably prompt written notice thereof, but in any event such notice shall not be given later than forty-five (45) calendar days after the Buyer Indemnitee's receipt of written notice of such Third Party Claim, provided, that the failure to give such notice within such time period shall not relieve the Seller or DQE of any liability except to the extent the Seller or DQE is prejudiced by such failure. To the extent known, such written notice shall describe the nature of the Third Party Claim in reasonable detail and shall indicate the estimated amount, if practicable, of the Buyer Indemnifiable Loss that has been or may be sustained by the Buyer Indemnitee. The Seller and DQE will have the right to participate in or, by giving written notice to the Buyer Indemnitee, to elect to assume the defense of any Third Party Claim by the Seller's own counsel, the cost for which shall be borne by the Seller and DQE to the extent that Buyer Indemnifiable Losses exceed the Indemnity Basket and shall, to such extent, be taken into account in calculating the aggregate amount of the Seller's and DQE's liability for Buyer Indemnifiable Losses under the Indemnity Cap. The Buyer Indemnitee shall cooperate in good faith in such defense at such Buyer Indemnitee's own expense. If the Seller and DQE elect not to assume the defense of any Third Party Claim, the Buyer Indemnitee may compromise or settle such Third Party Claim over the objection of the Seller and DQE, which settlement or compromise shall 54 conclusively establish the Seller's and DQE's liability pursuant to this Agreement. (ii) If any Seller Indemnitee receives notice of the assertion or commencement of a Third Party Claim with respect to which indemnification is to be sought from the Buyer, the Seller Indemnitee shall give the Buyer reasonably prompt written notice thereof, but in any event such notice shall not be given later than forty-five (45) calendar days after the Seller Indemnitee's receipt of written notice of such Third Party Claim, provided, that the failure to give such notice within such time period shall not relieve the Buyer of any liability except to the extent the buyer is prejudiced by such failure. To the extent known, such written notice shall describe the nature of the Third Party Claim in reasonable detail and shall indicate the estimated amount, if practicable, of the Seller Indemnifiable Loss that has been or may be sustained by the Seller Indemnitee. The Buyer will have the right to participate in or, by giving written notice to the Seller Indemnitee, to elect to assume the defense of any Third Party Claim by the Buyer's own counsel, the cost for which shall be borne by the Buyer to the extent that Seller Indemnifiable Losses exceed the Indemnity Basket and shall, to such extent, be taken into account in calculating the aggregate amount of the Buyer's liability for Seller Indemnifiable Losses under the Indemnity Cap. The Seller Indemnitee shall cooperate in good faith in such defense at such Seller Indemnitee's own expense. If the Buyer elects not to assume the defense of any Third Party Claim, the Seller Indemnitee may compromise or settle such Third Party Claim over the objection of the Buyer, which settlement or compromise shall conclusively establish the Buyer's liability pursuant to this Agreement. (b) (i) If, after a Buyer Indemnitee provides written notice to the Seller and DQE of any Third Party Claims, the Buyer Indemnitee receives written notice from the Seller or DQE that the Seller or DQE has elected to assume the defense of such Third Party Claim, the Seller and DQE will not be liable for any legal expenses subsequently incurred by the Buyer Indemnitee in connection with the defense thereof. Without the prior written consent of the Buyer Indemnitee, the Seller and DQE shall not enter into any settlement of any Third Party Claim that would lead to liability or create any financial or other obligation on the part of the Buyer Indemnitee for which the Buyer Indemnitee is not entitled to indemnification hereunder. If a firm offer is made to settle a Third Party Claim without leading to liability or the creation of a financial or other obligation on the part of the Buyer Indemnitee for which the Buyer Indemnitee is not entitled to indemnification hereunder and the Seller and DQE desire to accept and agree to such offer, the Seller and DQE shall give written notice to the Buyer Indemnitee to that effect. If the Buyer Indemnitee fails to consent to such firm offer within thirty (30) calendar days after its receipt of such notice, the Seller and DQE shall be relieved of their obligations to defend such Third Party Claim and the Buyer Indemnitee may contest or defend such Third Party Claim. In such 55 event, the maximum liability of the Seller and DQE as to such Third Party Claim will be the amount of such settlement offer plus reasonable costs and expenses paid or incurred by the Buyer Indemnitee up to the date of said notice, at all time subject to the additional limitations on the Seller's and DQE's liability contained in this Article IX. (ii) If, after a Seller Indemnitee provides written notice to the Buyer of any Third Party Claims, the Seller Indemnitee receives written notice from the Buyer that the Buyer has elected to assume the defense of such Third Party Claim, the Buyer will not be liable for any legal expenses subsequently incurred by the Seller Indemnitee in connection with the defense thereof. Without the prior written consent of the Seller Indemnitee, the Buyer shall not enter into any settlement of any Third Party Claim that would lead to liability or create any financial or other obligation on the part of the Seller Indemnitee for which the Seller Indemnitee is not entitled to indemnification hereunder. If a firm offer is made to settle a Third Party Claim without leading to liability or the creation of a financial or other obligation on the part of the Seller Indemnitee for which the Seller Indemnitee is not entitled to indemnification hereunder and the Buyer desires to accept and agree to such offer, the Buyer shall give written notice to the Seller Indemnitee to that effect. If the Seller Indemnitee fails to consent to such firm offer within thirty (30) calendar days after its receipt of such notice, the Buyer shall be relieved of its obligation to defend such Third Party Claim and the Seller Indemnitee may contest or defend such Third Party Claim. In such event, the maximum liability of the Buyer as to such Third Party Claim will be the amount of such settlement offer plus reasonable costs and expenses paid or incurred by the Seller Indemnitee up to the date of said notice, at all time subject to the additional limitations on the Buyer's liability contained in this Article IX. (c) (i) Any claim that does not result from a Third Party Claim (a "Direct Claim") by a Buyer Indemnitee on account of a Buyer Indemnifiable Loss shall be asserted by giving the Seller and DQE reasonably prompt written notice thereof after the Buyer Indemnitee becomes aware of such Direct Claim, stating, to the extent known, the nature of such claim in reasonable detail and indicating the estimated amount, if practicable, but in any event such notice shall not be given later than forty-five (45) calendar days after the Buyer Indemnitee becomes aware of such Direct Claim, provided, that the failure to give such notice within such time period shall not relieve the Seller or DQE of any liability except to the extent the Seller or DQE is prejudiced by such failure, and the Seller and DQE shall have a period of thirty (30) calendar days from receipt of such notice within which to respond to such Direct Claim. If the Seller or DQE does not respond within such thirty (30) calendar day period, the Seller and DQE shall be deemed to have accepted, and shall be liable for, such claim. If the Seller and DQE reject such claim, the Buyer Indemnitee will be free to seek enforcement of its right to indemnification under this Agreement. (ii) Any Direct Claim by a Seller Indemnitee on account of a Seller Indemnifiable Loss shall be asserted by giving the Buyer reasonably 56 prompt written notice thereof after the Seller Indemnitee becomes aware of such Direct Claim, stating, to the extent known, the nature of such claim in reasonable detail and indicating the estimated amount, if practicable, but in any event such notice shall not be given later than forty-five (45) calendar days after the Seller Indemnitee becomes aware of such Direct Claim, provided, that the failure to give such notice within such time period shall not relieve the Seller or DQE of any liability except to the extent the Seller or the Buyer is prejudiced by such failure, and the Buyer shall have a period of thirty (30) calendar days from receipt of such notice within which to respond to such Direct Claim. If the Buyer does not respond within such thirty (30) calendar day period, the Buyer shall be deemed to have accepted, and shall be liable for, such claim. If the Buyer rejects such claim, the Seller Indemnitee will be free to seek enforcement of its right to indemnification under this Agreement. (d) If the amount of any Buyer Indemnifiable Loss or Seller Indemnifiable Loss, as the case may be, at any time subsequent to the making of an indemnity payment in respect thereof, is reduced by recovery, settlement or otherwise under or pursuant to any insurance coverage, or pursuant to any claim, recovery, settlement or payment by, from or against any other entity, the amount of such reduction, less any costs, expenses or premiums incurred in connection therewith (together with interest thereon from the date of payment thereof at the publicly announced prime rate then in effect of The Chase Manhattan Bank) shall promptly be repaid by the Buyer Indemnitee to the Seller and DQE or by the Seller Indemnitee to the Buyer, as the case may be. (e) With respect to those pending litigation matters set forth in Schedule 3.7 of the Seller Disclosure Schedule (each a "Pending Litigation Matter"), the parties agree as follows: DQE and/or the Seller will defend, continue to defend or assume the defense of each Pending Litigation Matter on and after the Closing Date (each such defense, an "Assumed Defense"). The Buyer agrees to cooperate, and to cause its Subsidiaries, officers, directors and employees to cooperate, fully in connection with such Pending Litigation Matters, including, but not limited to, providing access to personnel and records. The Seller or DQE shall reimburse the Buyer, and its Subsidiaries for any out of pocket expenses (e.g. travel, lodging, meals and related expenses) incurred by them in cooperation with the Seller or DQE as contemplated by this Section 9.4(e); provided, however, that the Seller and DQE shall not reimburse the Buyer or its Subsidiaries, and the Buyer and its Subsidiaries shall not be entitled to reimbursement, for any portion of the wages, salary, benefits, overhead or other costs, attributable to the officers, directors and employees of the Buyer or its Subsidiaries whose cooperation may be required by this Section 9.4(e). Notwithstanding any other provision of this Agreement to the contrary and for the avoidance of doubt, (i) the defense of any Pending Litigation Matter, shall not be the responsibility of the Buyer on and after the Closing Date, except for the obligations in respect thereof set forth in this Section 9.4(e) and (ii) the obligations set forth in this Section 9.4(e) in no way limit or reduce the Seller's and DQE's indemnity obligation, in respect of any Pending Litigation Matter or otherwise. 57 Section 9.5 Certain Covenants in Respect of Excluded Assets. The parties agree that the Seller may deliver such notices to such persons as it deems advisable in respect of the assignment and transfer of the Excluded Assets (such persons to whom such notice is delivered, "Notified Persons" and such Excluded Assets in respect of which such notices are delivered, "Covered Excluded Assets"); provided, however, that any such notices must (i) include the name and contact information of the transferee or assignee and (ii) be sent to Notified Persons by Certified U.S. mail. The Seller shall provide the Buyer with a list of Notified Persons and Covered Excluded Assets, which list may be updated from time to time to reflect additional notices delivered. For a period of five years from the Closing Date, the Buyer shall, and shall cause the Company to, deliver to the Seller and DQE, in such a manner so as not to prejudice the Seller or DQE, notices of any claims received by the Buyer or the Company and brought by the Notified Persons in respect of the Covered Excluded Assets; provided, however, that the Seller or DQE shall bear the burden of proof in respect of any such prejudice. ARTICLE X GENERAL PROVISIONS Section 10.1 Survival of Obligations. The representations and warranties of the parties contained in this Agreement shall survive the Closing until the second (2nd) anniversary of the Closing Date. None of the covenants, obligations or agreements of the parties contained in this Agreement or in any instrument, certificate, opinion or other writing provided for herein, shall survive the Closing of this transaction; provided, however, that, notwithstanding the foregoing, the covenants of DQE, the Seller and the Buyer, as applicable, contained in Sections 1.1, 1.2, 1.3, 1.4, 1.5, 6.4, 6.5, 6.6, 6.7, 6.8, 6.9, 6.10, 6.11, 6.12, 6.14, 6.15, 6.16, 6.17, 6.18 and 6.19, the last sentence of Section 6.1 and all of Articles II, V, IX and X shall survive the Closing of this transaction. Section 10.2 Amendment and Modification. This Agreement may be amended, modified and supplemented in any and all respects, but only by a written instrument signed by all of the parties to this Agreement expressly stating that such instrument is intended to amend, modify or supplement this Agreement. Section 10.3 Extension; Waiver. Any failure of any of the parties to comply with any obligation, covenant, agreement or condition herein, and any inaccuracies in the representations and warranties contained herein or in any document delivered pursuant hereto, and any time for the performance of any of the obligations or other acts of a party hereto, may be waived or extended, as the case may be, but only pursuant to a written instrument signed by all parties entitled to the benefits thereof; provided, however, that any such waiver or extension of such obligation, covenant, agreement or condition, or inaccuracy, shall not operate as a waiver of, or estoppel with respect to, any subsequent failure to comply therewith. The failure of any party to this Agreement to assert any of its rights under this Agreement or otherwise shall not constitute a waiver of such rights. 58 Section 10.4 Expenses. Unless otherwise provided in this Agreement, all costs and expenses incurred in connection with this Agreement and the transactions contemplated hereby shall be paid by the party incurring such expenses. Section 10.5 Notices. All notices and other communications hereunder shall be in writing and shall be deemed given (a) when delivered personally, (b) when sent by reputable overnight courier service, or (c) when telecopied (which is confirmed by copy sent within one (1) business day by a reputable overnight courier service) to the parties at the following addresses (or at such other address for a party as shall be specified by like notice): (i) If to the Seller, to AquaSource, Inc. c/o DQE, Inc. 411 Seventh Avenue Pittsburgh, Pennsylvania 15219 Telecopier No.: 412-393-1071 Telephone No.: 412-393-1143 Attention: David R. High, Esq. with a copy to Skadden, Arps, Slate, Meagher & Flom LLP 1440 New York Avenue, N.W. Washington, D.C. 20005 Telecopier No.: (202) 393-5760 Telephone No.: (202) 371-7000 Attention: Erica Ward, Esq. (ii) if to DQE, to DQE, Inc. 411 Seventh Avenue Pittsburgh, Pennsylvania 15219 Telecopier No.: 412-393-1071 Telephone No.: 412-393-1143 Attention: David R. High, Esq. 59 with a copy to Skadden, Arps, Slate, Meagher & Flom LLP 1440 New York Avenue, N.W. Washington, D.C. 20005 Telecopier No.: (202) 393-5760 Telephone No.: (202) 371-7000 Attention: Erica Ward, Esq. and (iii) if to the Buyer, to Southwest Water Company 225 North Barranca Ave., Suite 200 West Covina, California 91791-1605 Attention: Peter J. Moerbeek with a copy to Jenkens & Gilchrist, LLP 12100 Wilshire Blvd., 15th Floor Los Angeles, CA 90025 Telecopier No.: (310) 820-8859 Telephone No.: (310) 422-8885 Attention: John F. Cermak, Jr., Esq. Section 10.6 Entire Agreement; No Third Party Beneficiaries. This Agreement, including the Schedules attached hereto, and the Confidentiality Agreement (a) constitute the entire agreement and supersede all prior agreements and understandings, both written and oral, among DQE, the Seller and the Buyer with respect to the subject matter hereof and thereof, and (b) are not intended to confer any rights or remedies hereunder upon any Person other than the parties hereto and thereto, the Company Indemnified Parties to the extent set forth in Section 6.4 and the Buyer Indemnitees and the Seller Indemnitees to the extent set forth in Article IX. Section 10.7 Severability. Any term or provision of this Agreement that is held by a court of competent jurisdiction or other authority to be invalid, void or unenforceable in any situation in any jurisdiction shall not affect the validity or enforceability of the remaining terms and provisions hereof or the validity or enforceability of the offending term or provision in any other situation or in any other jurisdiction. If the final judgment of a court of competent jurisdiction or other authority declares that any term or provision hereof is invalid, void or unenforceable, the parties agree that the court making such determination shall have the power to reduce the scope, duration, area or applicability of the term or provision, to delete specific words or phrases, or to replace any invalid, void or unenforceable term or provision with a term or 60 provision that is valid and enforceable and that comes closest to expressing the intention of the invalid or unenforceable term or provision. Section 10.8 Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the Commonwealth of Pennsylvania without giving effect to the principles of conflicts of law thereof. Section 10.9 Venue. EACH OF THE PARTIES HERETO (A) CONSENTS TO SUBMIT ITSELF TO THE EXCLUSIVE PERSONAL JURISDICTION OF ANY FEDERAL OR STATE COURT LOCATED IN OR FOR DENVER, CO IN THE EVENT ANY DISPUTE ARISES OUT OF THIS AGREEMENT, (B) AGREES THAT IT SHALL NOT ATTEMPT TO DENY OR DEFEAT SUCH PERSONAL JURISDICTION BY MOTION OR OTHER REQUEST FOR LEAVE FROM ANY SUCH COURT, PROVIDED, HOWEVER, THAT IN THE EVENT THAT ANY SUCH COURT REFUSES JURISDICTION IN RESPECT OF SUCH ACTION, THEN EACH OF THE PARTIES (X) CONSENTS TO SUBMIT ITSELF TO THE EXCLUSIVE PERSONAL JURISDICTION OF ANY FEDERAL OR STATE COURT LOCATED IN OR FOR PITTSBURGH, PA OR WEST COVINA, CA, (Y) AGREES THAT IT SHALL NOT ATTEMPT TO DENY OR DEFEAT SUCH PERSONAL JURISDICTION BY MOTION OR OTHER REQUEST FOR LEAVE FROM ANY SUCH COURT AND (C) AGREES THAT IT SHALL NOT BRING ANY ACTION RELATING TO THIS AGREEMENT IN ANY COURT OTHER THAN A FEDERAL OR STATE COURT SITTING IN OR FOR DENVER, CO, PITTSBURGH, PA OR WEST COVINA, CA AS CONTEMPLATED BY THIS SECTION 10.9. Section 10.10 Waiver of Jury Trial and Certain Damages. EACH PARTY TO THIS AGREEMENT WAIVES, TO THE FULLEST EXTENT PERMITTED BY APPLICABLE LAW, (A) ANY RIGHT IT MAY HAVE TO A TRIAL BY JURY IN RESPECT OF ANY ACTION, SUIT OR PROCEEDING ARISING OUT OF OR RELATING TO THIS AGREEMENT AND (B) ANY RIGHT IT MAY HAVE TO RECEIVE DAMAGES FROM THE OTHER PARTY BASED ON ANY THEORY OF LIABILITY FOR ANY SPECIAL, INDIRECT, CONSEQUENTIAL (INCLUDING LOST PROFITS) OR PUNITIVE DAMAGES (EXCEPT IN THE CASE OF FRAUD). The parties agree that (i) the aggregate liability of the Seller and DQE arising out of or relating to this Agreement or the transactions contemplated herein shall in no event exceed the Purchase Price (except in the case of Buyer Indemnifiable Losses specifically listed in Section 9.3(b) of this Agreement) and (ii) the aggregate liability of the Buyer arising out of or relating to this Agreement or the transactions contemplated herein shall in no event exceed the Purchase Price (except in the case of Seller Indemnifiable Losses specifically listed in Section 9.3(b) of this Agreement). Section 10.11 Assignment. Neither this Agreement nor any of the rights, interests or obligations hereunder shall be assigned by any party hereto (whether by operation of law or otherwise) without the prior written consent of the Buyer and the Seller; provided, however, that the Seller may assign this Agreement, without the consent of the Buyer, to the Seller's successor as a result of a change in control of the Seller, a 61 consolidation of the Seller with or into another entity, a sale of all or substantially all of the assets of the Seller, or a merger of the Seller with or into another entity, in any case whether or not the Seller is the surviving entity. Section 10.12 Interpretation. When a reference is made in this Agreement to Articles or Sections, such reference shall be to an Article or Section of this Agreement, respectively, unless otherwise indicated. The table of contents and headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. Whenever the words "include," "includes" or "including" are used in this Agreement, they shall be deemed to be followed by the words "without limitation." Section 10.13 No Specific Enforcement. Except with respect to the obligations set forth in the last sentence of Section 6.1 and all of Sections 1.2, 1.3, 1.4, 1.5, 6.4, 6.5, 6.6, 6.7, 6.8, 6.9, 6.10, 6.11, 6.12, 6.14, 6.15, 6.16, 6.17, 6.18, 6.19, 8.1, 8.2, 10.1, 10.4, 10.7, 10.8, 10.9, 10.10 and 10.11 and all of Article V and Article IX, the parties agree that in the event of a breach of this Agreement, the parties shall not be entitled to specific performance of the terms hereof. Section 10.14 Counterparts; Effect. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original, but all of which shall constitute one and the same agreement. SIGNATURES FOLLOW ON NEXT PAGE 62 IN WITNESS WHEREOF, each of the Seller, DQE and the Buyer have caused this Agreement to be signed by their respective officers thereunto duly authorized as of the date first written above. AQUASOURCE, INC. By: /s/ FRANK A HOFFMAN ------------------- Name: Frank A. Hoffman Title: President DQE, INC. By: /s/ FRANK A. HOFFMAN -------------------- Name: Frank A. Hoffman Title: Executive Vice President SOUTHWEST WATER COMPANY By: /s/ PETER J. MOERBEEK --------------------- Name: Peter J. Moerbeek Title: Chief Financial Officer 63 EX-10.24 11 dex1024.txt OFFICIAL STATEMENT EXHIBIT 10.24 NEW ISSUE-BOOK-ENTRY ONLY RATING: Standard & Poor's: "AAA" (Ambac Insured) (See "RATING" herein) In the opinion of Stradling Yocca Carlson & Rauth, a Professional Corporation, Newport Beach, California, Bond Counsel, under existing statutes, regulations, rulings and judicial decisions, and assuming certain representations and compliance with certain covenants and requirements described herein, interest (and original issue discount) on the Bonds is excluded from gross income for federal income tax purposes and is not an item of tax preference for purposes of calculating the federal alternative minimum tax imposed on individuals and corporations. In the further opinion of Bond Counsel, interest on the Bonds is exempt from State of California personal income tax. In addition, the difference between the issue price of a Bond (the first price at which a substantial amount of the Bonds of a maturity is to be sold to the public) and the stated redemption price at maturity with respect to the Bond constitutes original issue discount. See "TAX MATTERS" herein with respect to certain tax consequences with respect to the Bonds. $31,555,000 SAN JUAN BASIN AUTHORITY LEASE REVENUE BONDS (GROUND WATER RECOVERY PROJECT) ISSUE OF 2002 Dated: Date of Delivery Due: December 1, as shown on the inside front cover This cover page contains certain information for general reference only. It is not a summary of the issue. Investors are advised to read the entire Official Statement to obtain information essential to making an informed decision. Capitalized undefined terms used in this cover page shall have the meanings given such terms herein. The Bonds are issuable as fully registered bonds and when initially issued will be registered in the name of Cede & Co., as nominee of The Depository Trust Company, New York, New York ("DTC"). Purchases of the Bonds will be made in book-entry form only, in denominations of $5,000 or any integral multiple thereof, through brokers and dealers who are, or who act through, DTC Participants. Beneficial owners of the Bonds will not be entitled to receive physical delivery of bond certificates so long as DTC or a successor securities depository acts as the securities depository with respect to the Bonds. So long as DTC or its nominee is the registered owner of the Bonds, reference herein to Bondowners or registered owners shall mean Cede & Co., as aforesaid, and payments of principal of and interest on the Bonds will be made directly to DTC by BNY Western Trust Company, as Trustee. Disbursement of such payments to DTC Participants is the responsibility of DTC and disbursement of such payments to the Beneficial Owners is the responsibility of DTC Participants. Interest on the Bonds is payable on June 1 and December 1 of each year, commencing June 1, 2003. See "DESCRIPTION OF THE BONDS--General Terms" herein. The Bonds are subject to extraordinary, optional and mandatory redemption prior to maturity as described herein. See "DESCRIPTION OF BONDS--Redemption" herein. Proceeds of the Bonds are to be applied to (i) finance and reimburse the costs of the design, development, acquisition and construction of a groundwater recovery plant and related improvements and facilities, (ii) fund a debt service reserve fund securing the Bonds, (iii) fund capitalized interest through June 1, 2004, and (iv) pay certain costs of issuance of the Bonds. See "DESCRIPTION OF BONDS--Sources and Uses of Funds" and "THE PROJECT" herein. Payment of the principal of and interest on the Bonds when due will be insured by a financial guaranty insurance policy to be issued by AMBAC simultaneously with the delivery of the Bonds. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Financial Guaranty Insurance Policy" herein. The Bonds are special, limited obligations of the San Juan Basin Authority (the "Authority") payable solely from the Trust Estate, including Lease Payments to be made by the Capistrano Valley Water District (the "Water District") to the Authority solely from Revenues of the Water District pledged to the payment of the Lease Payments pursuant to the Lease Agreement, dated as of December 1, 2002 (the "Lease Agreement"), between the Water District and the Authority. Pursuant to the Trust Agreement, dated as of December 1, 2002 (the "Trust Agreement"), among the Water District, the Authority and the Trustee, the Authority has assigned all of its rights, title and interest (other than certain Additional Payments) in the Lease Agreement to the Trustee for the benefit of the Bondowners. The Lease Agreement provides that, except with respect to certain rights of the Water District to terminate the Lease Agreement early as permitted thereunder, the obligation of the Water District to make the Lease Payments is absolute and unconditional and the Water District will not discontinue or suspend any Lease Payments required to be made by it thereunder when due until such time as the Lease Payments are paid in full. For the circumstances under which the Water District may terminate the Lease Agreement and the consequences thereof, see "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease" herein. The Property subject to the Lease Agreement and the improvements thereon and the Water System are not pledged or available to the Trustee or the Bondowners in the event of termination of the Lease Agreement, default in the payment of Lease Payments or otherwise, and no default under Lease Agreement will result in the loss of the Property or the improvements thereon, the Water System or other assets of the Water District. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease" and "--Limited Recourse on Default" herein. The obligation of the Water District to make the Lease Payments and other payments required to be made by it under the Lease Agreement is a special obligation of the Water District payable, in the manner provided in the Lease Agreement, solely from Revenues, and does not constitute a debt of the Water District in contravention of any constitutional or statutory debt limitation or restriction. Except for the pledge of Revenues pursuant to the Lease Agreement, neither the faith and credit nor the taxing power of the Water District or the City of San Juan Capistrano (the "City") is pledged to the payment of the Lease Payments (and the merger of the Water District into the City, which is expected to occur in early 2003, will not affect this limitation). UNDER CERTAIN CIRCUMSTANCES DESCRIBED HEREIN, THE WATER DISTRICT HAS THE RIGHT TO TERMINATE THE LEASE AGREEMENT. IN SUCH EVENT, THE WATER DISTRICT WILL HAVE NO FURTHER OBLIGATION TO MAKE ANY LEASE PAYMENTS UNDER THE LEASE AGREEMENT AND THE TRUSTEE WILL HAVE NO FURTHER RIGHTS OR RECOURSE WITH RESPECT TO THE PROPERTY OR THE IMPROVEMENTS THEREON. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease" and "DESCRIPTION OF BONDS--Redemption--Extraordinary Redemption" herein. THE BONDS DO NOT CONSTITUTE A CHARGE AGAINST THE GENERAL CREDIT OF THE AUTHORITY AND ARE NOT SECURED BY A LEGAL OR EQUITABLE PLEDGE OF, OR CHARGE OR LIEN UPON, ANY PROPERTY OF THE AUTHORITY OR ANY OF ITS INCOME OR RECEIPTS EXCEPT THE FUNDS AND SECURITY PROVIDED UNDER THE TRUST AGREEMENT. NEITHER THE FAITH AND CREDIT NOR THE TAXING POWER OF THE STATE OF CALIFORNIA OR ANY PUBLIC AGENCY THEREOF OR ANY MEMBER OF THE AUTHORITY IS PLEDGED TO THE PAYMENT OF THE PRINCIPAL OF, PREMIUM, IF ANY, OR INTEREST ON, THE BONDS. SEE "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS" HEREIN. ---------- MATURITY SCHEDULE - See Inside Front Cover ---------- The Bonds will be offered when, as and if issued and received by the Underwriter, subject to the approval of validity by Stradling Yocca Carlson & Rauth, a Professional Corporation, Newport Beach, California, Bond Counsel, and to certain other conditions. Certain legal matters in connection with the Bonds will be passed upon for the Underwriter by Orrick, Herrington & Sutcliffe LLP; for the City and the Water District by John R. Shaw, Esq., San Juan Capistrano, California, City Attorney and General Counsel to the Water District, and by Hawkins, Delafield & Wood, New York, New York, Special Counsel to the City and the Water District; and for the Authority by Stradling Yocca Carlson & Rauth, a Professional Corporation, Newport Beach, California. It is expected that the Bonds will be available for delivery through DTC in New York, New York, on or about January 8, 2003. LEHMAN BROTHERS December 11, 2002 MATURITY SCHEDULE $16,290,000 Serial Bonds
MATURITY PRINCIPAL INTEREST MATURITY PRINCIPAL INTEREST (DECEMBER 1) AMOUNT RATE YIELD CUSIP NO. (DECEMBER 1) AMOUNT RATE YIELD CUSIP NO. - ------------ --------- -------- ----- --------- ------------ ----------- -------- ----- --------- 2005 $ 755,000 3.000% 1.700% 798250AA4 2013 $ 990,000 5.000% 3.930% 798250AJ5* 2006 780,000 3.000 2.100 798250AB2 2014 1,040,000 5.250 4.050 798250AK2* 2007 805,000 3.000 2.500 798250AC0 2015 1,095,000 5.250 4.180 798250AL0* 2008 825,000 3.000 2.850 798250AD8 2016 1,150,000 5.250 4.280 798250AM8* 2009 850,000 4.000 3.160 798250AE6 2017 1,210,000 5.250 4.380 798250AN6* 2010 885,000 4.000 3.410 798250AF3 2018 1,275,000 5.250 4.460 798250AP1* 2011 920,000 3.600 3.630 798250AG1 2019 1,340,000 5.250 4.520 798250AQ9* 2012 955,000 3.700 3.730 798250AH9 2020 1,415,000 5.250 4.580 798250AR7*
$3,045,000 5.000% Term Bond due December 1, 2022 Price 101.792 CUSIP 798250A S5* $12,220,000 5.000% Term Bond due December 1, 2034 Price 100.538 CUSIP 798250AT3* - ---------- *Indicates pricing to call at par on December 1, 2012. No broker, dealer, salesperson or other person has been authorized by the City of San Juan Capistrano (the "City"), the Capistrano Valley Water District (the "Water District"), the San Juan Basin Authority (the "Authority") or the Underwriter to give any information or to make any representations other than those contained herein and, if given or made, such other information or representation must not be relied upon as having been authorized by the City, the Water District, the Authority or the Underwriter. This Official Statement does not constitute an offer to sell or the solicitation of an offer to buy, nor shall there be any sale of the Bonds by a person in any jurisdiction in which it is unlawful for such person to make such offer, solicitation or sale. This Official Statement is not to be construed as a contract with the purchasers of the Bonds. Certain statements contained in this Official Statement reflect not historical facts but forecasts and "forward-looking" statements. In this respect, the words "estimate," "project," "anticipate," "expect," "intend," "believe" and similar expressions are intended to identify forward-looking statements. All projections, forecasts, assumptions, expressions of opinions, estimates and other forward-looking statements, are not to be construed as representations of fact and are qualified in their entirety by the cautionary statements set forth in this Official Statement. The forward-looking statements are not guarantees of future performance. Actual results may vary materially from what is contained in a forward-looking statement. The Authority and the Water District assume no obligation to provide public updates of forward-looking statements. The Underwriter has provided the following sentence for inclusion in this Official Statement. The Underwriter has reviewed the information in this Official Statement in accordance with, and as part of, its responsibilities to investors under the federal securities laws as applied to the facts and circumstances of this transaction, but the Underwriter does not guarantee the accuracy or completeness of such information. The information set forth herein has been obtained from the Authority, the Water District and from other sources and is believed to be reliable but is not guaranteed as to accuracy or completeness. The information and expressions of opinions herein are subject to change without notice and neither the delivery of this Official Statement nor any sale made hereunder shall, under any circumstances, create any implication that there has been no change in the affairs of the Water District since the date hereof. This Official Statement is submitted in connection with the sale of Bonds referred to herein and may not be reproduced or used, in whole or in part, for any other purpose, unless authorized in writing by the Water District. All summaries of the documents and laws are made subject to the provisions thereof and do not purport to be complete statements of any or all such provisions. IN CONNECTION WITH THIS OFFERING OF THE BONDS, THE UNDERWRITER MAY OVER-ALLOT OR EFFECT TRANSACTIONS THAT STABILIZE OR MAINTAIN THE MARKET PRICE OF SUCH BONDS AT A LEVEL ABOVE THAT WHICH MIGHT OTHERWISE PREVAIL IN THE OPEN MARKET. SUCH STABILIZING, IF COMMENCED, MAY BE DISCONTINUED AT ANY TIME. THE UNDERWRITER MAY OFFER AND SELL BONDS TO CERTAIN DEALERS, INSTITUTIONAL INVESTORS AND OTHERS AT PRICES LOWER THAN THE PUBLIC OFFERING PRICES STATED ON THE COVER PAGE HEREOF AND SUCH PUBLIC OFFERING PRICES MAY BE CHANGED FROM TIME TO TIME BY THE UNDERWRITER. SAN JUAN BASIN AUTHORITY BOARD OF DIRECTORS John Schatz, President Jack Foley, Director Diane Bathgate, Director Richard Gardner, Director OFFICERS Don Martinson, Administrator and Secretary SPECIAL SERVICES CITY ATTORNEY AND GENERAL COUNSEL TO WATER DISTRICT John R. Shaw, Esq. San Juan Capistrano, California Special Counsel to Water District and City Hawkins, Delafield & Wood New York, New York BOND COUNSEL AND AUTHORITY COUNSEL Stradling Yocca Carlson & Rauth, a Professional Corporation Newport Beach, California FINANCIAL ADVISOR Fieldman, Rolapp & Associates Irvine, California TRUSTEE BNY Western Trust Company Los Angeles, California TABLE OF CONTENTS
PAGE INTRODUCTORY STATEMENT........................................................................................ 1 DESCRIPTION OF BONDS.......................................................................................... 5 General Terms........................................................................................ 5 Redemption........................................................................................... 5 Transfer and Exchange................................................................................ 7 Sources and Uses of Funds............................................................................ 8 Debt Service Schedule................................................................................ 9 SOURCES OF PAYMENT AND SECURITY FOR THE BONDS................................................................. 9 Source of Payment.................................................................................... 9 Lease Payments.......................................................................................10 Water District Right to Terminate Lease..............................................................11 Service Contract Letter of Credit....................................................................15 Additional Payments..................................................................................16 Limited Recourse on Default..........................................................................16 Pledge of Revenues...................................................................................17 Revenue Fund.........................................................................................18 Additional Obligations; Parity Obligations...........................................................19 Rate Covenant; Impact of Proposition 218.............................................................19 Lease Revenue Bonds Rate Stabilization Reserve; Impact of Proposition 218............................19 Debt Service Reserve Account.........................................................................20 Financial Guaranty Insurance Policy..................................................................20 Insurance and Indemnity Agreement and Insurance Agreement Guaranty...................................23 THE PROJECT...................................................................................................26 Overview.............................................................................................26 Agreement with Metropolitan Water District of Southern California....................................28 Project Water Rights and Implementation Agreement....................................................29 Liquidated Damages under the Service Contract........................................................29 The Company..........................................................................................31 Independent Engineer's Report........................................................................32 THE AUTHORITY.................................................................................................34 THE WATER DISTRICT............................................................................................34 Introduction.........................................................................................34 Governance and Management............................................................................35 Merger...............................................................................................35 Service Area; Overview of Water System Facilities....................................................36 Sources of Water Supply..............................................................................36 Service Connection Information.......................................................................39 Largest Customers....................................................................................39 Rates and Charges; Collection........................................................................40 Proposition 218......................................................................................42 Projected Water Usage................................................................................45 Regulatory Requirements..............................................................................45 WATER DISTRICT FINANCIAL INFORMATION..........................................................................46 Outstanding Indebtedness.............................................................................46
-i- TABLE OF CONTENTS (continued)
PAGE Historic Operating Results...........................................................................47 Management Discussion and Analysis...................................................................48 Projected Operating Results..........................................................................49 Water System Insurance...............................................................................51 Employee Benefits....................................................................................51 California Electricity Market........................................................................51 Security of the System...............................................................................53 Investment of Water District Funds...................................................................54 TAX MATTERS...................................................................................................55 INDEPENDENT ACCOUNTANTS.......................................................................................56 RATING........................................................................................................56 CERTAIN LEGAL MATTERS.........................................................................................57 LITIGATION....................................................................................................57 UNDERWRITING..................................................................................................57 CONTINUING DISCLOSURE.........................................................................................57 AVAILABILITY OF DOCUMENTS.....................................................................................58 MISCELLANEOUS.................................................................................................58 APPENDIX A - FINANCIAL STATEMENTS OF THE WATER DISTRICT......................................................A-l APPENDIX B - BOOK-ENTRY-ONLY SYSTEM..........................................................................B-l APPENDIX C - DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS..................C-l APPENDIX D - SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT...........................................D-l APPENDIX E - FORM OF CONTINUING DISCLOSURE AGREEMENT.........................................................E-l APPENDIX F - PROPOSED FORM OF BOND COUNSEL OPINION...........................................................F-l APPENDIX G - INDEPENDENT ENGINEER'S REPORT...................................................................G-l APPENDIX H - SPECIMEN FINANCIAL GUARANTY INSURANCE POLICY....................................................H-l APPENDIX I - GENERAL INFORMATION CONCERNING THE CITY OF SAN JUAN CAPISTRANO..................................I-1 APPENDIX J - CERTAIN INFORMATION CONCERNING THE SERVICE CONTRACT LETTER OF CREDIT PROVIDER...................J-l
-ii- OFFICIAL STATEMENT $31,555,000 SAN JUAN BASIN AUTHORITY LEASE REVENUE BONDS (GROUND WATER RECOVERY PROJECT) ISSUE OF 2002 INTRODUCTORY STATEMENT The following introductory statement is subject in all respects to the more complete information set forth in this Official Statement, including the cover page and appendices (the "Official Statement"). The descriptions and summaries of various documents hereinafter set forth do not purport to be comprehensive or definitive and are qualified in their entirety by reference to each document. Capitalized terms used in the body of this Official Statement and not otherwise defined therein shall have the meanings given to such terms in the definitional sections included in Appendix C--"DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS" and Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT," attached hereto. This Official Statement is provided to furnish information in connection with the offering of $31,555,000 aggregate principal amount of San Juan Basin Authority Lease Revenue Bonds (Ground Water Recovery Project) Issue of 2002 (the "Bonds"). The Bonds are being issued under the Trust Agreement, dated as of December 1, 2002 (the "Trust Agreement"), among the Capistrano Valley Water District (the "Water District"), the San Juan Basin Authority (the "Authority"), and BNY Western Trust Company, Los Angeles, California, as trustee (the "Trustee"), pursuant to the provisions of the Joint Exercise of Powers Act (commencing with Section 6500), comprising Article 1, Article 2 and Article 4 of Division 7 of Title 1 of the California Government Code. The Bonds are special, limited obligations of the Authority payable solely from the Trust Estate, including certain lease payments (the "Lease Payments") to be made by the Water District to the Authority solely from Revenues of the Water District pledged to the payment of the Lease Payments pursuant to the Lease Agreement, dated as of December 1, 2002 (the "Lease Agreement"), between the Water District and the Authority. The Water District (formerly known as the Orange County Waterworks District No. 4) was formed to serve the San Juan Capistrano area in 1930 and is currently existing pursuant to the California Water Code (the "Water Code"). The Water District was governed by the Board of Supervisors (the "Board of Supervisors") of the County of Orange, California (the "County") until 1970 when the district became a subsidiary district of the City of San Juan Capistrano (the "City"). At that time, the City Council of the City became the governing board of the Water District pursuant to the Water Code. For more complete information regarding the Water District, including certain financial information, see "THE WATER DISTRICT" and "WATER DISTRICT FINANCIAL INFORMATION." The Water District intends to formally merge into the City in early 2003 pursuant to a formal reorganization process that has been instituted with the County of Orange Local Agency Formation Commission ("LAFCO"). See "THE WATER DISTRICT--Merger." The Bonds are issuable as fully registered bonds and when initially issued will be registered in the name of Cede & Co., as nominee of The Depository Trust Company, New York, New York ("DTC"). Purchases of the Bonds will be made in book-entry form only, in denominations of $5,000 or any integral multiple thereof, through brokers and dealers who are, or who act through, DTC participants. See Appendix B--"BOOK-ENTRY-ONLY SYSTEM." Interest on the Bonds is payable on June 1 and December 1 of each year, commencing June 1, 2003. The Bonds are subject to extraordinary, optional and mandatory redemption prior to maturity as described herein. See "DESCRIPTION OF BONDS--General Terms" and "--Redemption." The proceeds of the Bonds are to be applied to (i) finance and reimburse the costs of the design, development, acquisition and construction of a groundwater recovery plant (the "Groundwater Recovery Plant") and related offsite improvements and facilities (together with the Groundwater Recovery Plant and as further defined in the Trust Agreement, the "Service Contract Project Improvements"), (ii) fund a debt service reserve fund securing the Bonds, (iii) fund capitalized interest through June 1, 2004, and (iv) pay certain costs of issuance of the Bonds. See "DESCRIPTION OF BONDS--Sources and Uses of Funds" and "THE PROJECT." Pursuant to the Service Contract for the Design, Construction, Financing and Operation of the San Juan Basin Desalter Project, dated September 3, 2002 (the "Service Contract"), between the Water District and Eco Resources, Inc. (the "Company"), the Company has agreed to design and construct the Service Contract Project Improvements. For information regarding the Company, see "THE PROJECT--The Company." Under the Service Contract, the Company is required to complete the Service Contract Project Improvements for a fixed price of $25,030,607 and by a date certain of September 1, 2004, as such date may be extended upon the occurrence of an Uncontrollable Circumstance, Water District requested changes or District Fault, and once completed, operate such Service Contract Project Improvements, subject to the conditions and performance guarantees set forth in the Service Contract. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT" for a summary of certain provisions of the Service Contract. However, in the Insurance Agreement (see "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Insurance and Indemnity Agreement and Insurance Agreement Guaranty), the Company will agree for the benefit of the Bond Insurer that within six months after the date the Bonds are issued, the Company will assign all of its rights in and to, and delegate all of its obligations under, the Service Contract to a wholly owned subsidiary of the Company that satisfies certain corporate separation requirements set forth in the Insurance Agreement (the "SPE"), and will cause the SPE to assume all of the obligations of the Company under the Service Contract. Upon the effectiveness of such assignment, the Company will be released from all of its obligations under the Service Contract and the Insurance Agreement; provided that the Service Contract Guaranty Agreement and the Insurance Agreement Guaranty will extend to such obligations of the SPE following such assignment. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Insurance and Indemnity Agreement and Insurance Agreement Guaranty--Assignment of Company Rights and Obligations." The Company will simultaneously enter into a management and administrative services agreement with the SPE for a term equal to the term of the Service Contract, whereby the Company will provide certain management and administrative services necessary to support the SPE's performance of its obligations under the Service Contract, including the construction and operation of the Service Contract Project Improvements. Accordingly, as used in this Official Statement, the term "DB/Operator" shall mean the Company before such assignment, and shall mean the SPE thereafter. The Service Contract continues in effect for 20 years following the provisional acceptance of the Service Contract Project Improvements under the Service Contract (as further defined in the Service Contract, "Provisional Acceptance") (or, if Provisional Acceptance is not certified by the DB/Operator, the Acceptance Date), subject to renewal and earlier termination as set forth in the Service Contract, including certain buy-out rights of the Water District. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Breach, Default, Remedies and Termination." See also "DESCRIPTION OF BONDS--Redemption--Extraordinary Redemption." The full and prompt performance and observance of each and all of the amounts payable by, and the covenants and agreements of, the DB/Operator pursuant to the terms of the Service Contract will be guaranteed by Southwest Water Company, a Delaware corporation and the parent corporation of the Company (the "Guarantor"), pursuant to a Service Contract Guaranty Agreement, dated as of September 3, 2002 (the "Service Contract Guaranty Agreement"), provided by the Guarantor in favor of the Water District. 2 PSOMAS, a California corporation, has been retained as the Independent Engineer with respect to the design, development, acquisition and construction of the Service Contract Project Improvements (the "Project"), and has prepared an updated report dated December 6, 2002, attached hereto as Appendix G (the "Independent Engineer's Report"), evaluating the Project and the capability of the Project participants to successfully complete the design, construction and operation of the Project. Under the Service Contact, the DB/Operator is required to design, engineer, construct, operate and maintain the Service Contract Project Improvements to be capable of processing 5.14 million gallons of groundwater per day and the Water District has the right to demand the production and delivery of up to 5,231 acre-feet of treated water on an annual basis, subject to the Water District supplying sufficient groundwater to enable the DB/Operator to produce such amount of treated water within the parameters of the DB/Operator's performance guarantees under the Service Contract. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Performance." Pursuant to the Project Implementation Agreement (San Juan Basin Desalter Project), effective as of October 15, 2002 (the "Implementation Agreement"), by and between the Authority and the Water District, the Authority has allocated 5,800 acre-feet per year of the Authority's existing rights to groundwater from the San Juan Creek to the Project, which is expected to be sufficient to enable the DB/Operator to produce the Water District's expected demand of 4,800 acre-feet of treated water on an annual basis but not the full 5,231 acre-feet of treated water provided for under the Service Contract. Accordingly, to the extent additional treated water is needed, it may be necessary for the Water District to allocate a portion of its existing groundwater rights to the Project. See "THE PROJECT--Project Water Rights and Implementation Agreement" and "THE WATER DISTRICT--Sources of Water Supply." Once constructed and fully operational, it is anticipated that the Project will supply approximately one-half of the Water District's annual water supply requirements and, therefore, assist the Water District in meeting its goal of securing fifty-percent of its annual water supply from local groundwater sources. In addition, based on current projections, the development of local groundwater sources in connection with the operation of the Groundwater Recovery Plant is anticipated to significantly reduce or eliminate the need for the Water District to acquire additional import capacity and the related infrastructure costs associated with such additional capacity as well as reduce the Water District's need for additional storage. See "THE PROJECT--Overview." Furthermore, the Water District anticipates that the costs associated with the financing of the Project and the operations of such improvements will be offset in part by certain grant credits or payments from the Metropolitan Water District of Southern California ("MWD"). See "THE PROJECT--Agreement with Metropolitan Water District of Southern California." Other benefits of the Project include a reduction of the Water District's dependence on imported water, enhanced system reliability and reduced exposure to the rising cost of imported water. Accordingly, the Water District has determined that the Water District's objectives justify the Project even though the costs associated with the financing of the Project and the operations of such improvements may not be fully offset solely by the credits from MWD. See "THE PROJECT." The City will enter into a Property Lease, dated as of December 1, 2002 (the "Property Lease"), by and between the Authority and the City pursuant to which it will lease to the Authority various real property sites located in San Juan Capistrano, California, on which a portion of the Service Contract Project Improvements are to be constructed (the "Property"). The Authority will then sublease the Property and the improvements to be constructed thereon to the Water District pursuant to the Lease Agreement. The Lease Agreement will obligate the Water District to make the Lease Payments to the Authority. Pursuant to the Trust Agreement, the Authority will assign all of its rights, title and interest (other than certain Additional Payments) in the Lease Agreement and the Property Lease (for so long as any Bond is Outstanding) to the Trustee for the benefit of the Bondowners. The Lease Agreement provides that, except with respect to certain rights of the Water District to terminate the Lease Agreement early as permitted thereunder, the obligation of the Water District to make the Lease Payments is absolute and unconditional and the Water District will not discontinue or suspend any Lease Payments required to 3 be made by it thereunder when due until such time as the Lease Payments are paid in full. For the circumstances under which the Water District may terminate the Lease Agreement and the consequences thereof, see "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease" and "DESCRIPTION OF BONDS--Redemption--Extraordinary Redemption." None of the Property subject to the Lease Agreement or the improvements thereon or the Water System are pledged or available to the Trustee or the Bondowners in the event of termination of the Lease Agreement, default in the payment of Lease Payments or otherwise, and no default under Lease Agreement will result in the loss of the Property or the improvements thereon, the Water System or other assets of the Water District. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease" and "--Limited Recourse on Default." The obligation of the Water District to make the Lease Payments and other payments required to be made by it under the Lease Agreement is a special obligation of the Water District payable, in the manner provided in the Lease Agreement, solely from Revenues, and does not constitute a debt of the Water District in contravention of any constitutional or statutory debt limitation or restriction. Except for the pledge of Revenues pursuant to the Lease Agreement, neither the faith and credit nor the taxing power of the Water District or the City is pledged to the payment of the Lease Payments (and the merger of the Water District into the City, which is expected to occur in early 2003, will not affect this limitation). UNDER CERTAIN CIRCUMSTANCES DESCRIBED HEREIN, THE WATER DISTRICT HAS THE RIGHT TO TERMINATE THE LEASE AGREEMENT. IN SUCH EVENT, THE WATER DISTRICT WILL HAVE NO FURTHER OBLIGATION TO MAKE ANY LEASE PAYMENTS UNDER THE LEASE AGREEMENT AND THE TRUSTEE WILL HAVE NO FURTHER RIGHTS OR RECOURSE WITH RESPECT TO THE PROPERTY OR THE IMPROVEMENTS THEREON. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease" and "DESCRIPTION OF BONDS--Redemption--Extraordinary Redemption." THE BONDS DO NOT CONSTITUTE A CHARGE AGAINST THE GENERAL CREDIT OF THE AUTHORITY AND ARE NOT SECURED BY A LEGAL OR EQUITABLE PLEDGE OF, OR CHARGE OR LIEN UPON, ANY PROPERTY OF THE AUTHORITY OR ANY OF ITS INCOME OR RECEIPTS EXCEPT THE FUNDS AND SECURITY PROVIDED UNDER THE TRUST AGREEMENT. NEITHER THE FAITH AND CREDIT NOR THE TAXING POWER OF THE STATE OF CALIFORNIA OR ANY PUBLIC AGENCY THEREOF OR ANY MEMBER OF THE AUTHORITY IS PLEDGED TO THE PAYMENT OF THE PRINCIPAL OF, PREMIUM, IF ANY, OR INTEREST ON, THE BONDS. The payment of principal of and interest on the Bonds when due will be guaranteed by a financial guaranty insurance policy (the "Policy") to be issued by Ambac Assurance Corporation (the "Bond Insurer") simultaneously with the delivery of the Bonds. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Financial Guaranty Insurance Policy" and Appendix H--"SPECIMEN FINANCIAL GUARANTY INSURANCE POLICY." This Official Statement contains forward-looking statements within the meaning of the federal securities laws. Such statements are based on currently available information, expectations, estimates, assumptions, projections and general economic conditions. Such words as expects, intends, plans, believes, estimates, anticipates or variations of such words or similar expressions are intended to identify forward-looking statements. The forward-looking statements are not guarantees of future performance. Actual results may vary materially from what is contained in a forward-looking statement. The Authority and the Water District assume no obligation to provide public updates of forward-looking statements. The brief descriptions of the Bonds, the Trust Agreement, the Property Lease, the Lease Agreement, the Service Contract, the Implementation Agreement, the Continuing Disclosure Agreement, the Insurance Agreement, and other documents, statutes, reports and instruments included in this Official 4 Statement do not purport to be complete, comprehensive or definitive. All references to the Trust Agreement, the Property Lease, the Lease Agreement, the Service Contract, the Implementation Agreement, the Continuing Disclosure Agreement, the Insurance Agreement, and any other documents, statutes, reports and instruments, are qualified in their entirety by reference to such document, statute, report or instrument, and all references to the Bonds are qualified in their entirety by reference to the form thereof set forth in the Trust Agreement. Copies of the documents are on file and available for inspection at the office of the Trustee at 700 South Flower Street, Suite 500, Los Angeles, California. DESCRIPTION OF BONDS GENERAL TERMS The Bonds will be dated as of the date of delivery, will bear interest from such date at the rates per annum, payable semi-annually on June 1 and December 1 of each year, commencing June 1, 2003 (each an "Interest Payment Date"), and will mature in the principal amounts in each year (subject to prior redemption), as set forth on the inside front cover page hereof. Interest will be calculated on the basis of a 360 day year of twelve 30 day months. Beneficial ownership of the Bonds may be purchased in denominations of $5,000 or any integral multiple thereof. Interest on the Bonds will be payable from the preceding Interest Payment Date to which interest was paid, provided, that Bonds registered on or prior to May 15, 2003, will have interest payable with respect thereto from the date of delivery of the Bonds, and Bonds registered after the fifteenth day of the calendar month preceding an Interest Payment Date (each, a "Record Date") and on or prior to an Interest Payment Date will have interest payable with respect thereto from such Interest Payment Date. The Bonds are issued only in fully registered form and, when issued, will be registered in the name of Cede & Co., as registered owner and nominee of DTC. DTC will act as securities depository for the Bonds. Purchasers will not receive physical certificates representing their interest in the Bonds purchased. While the Bonds are subject to the book-entry system, payments of principal of and interest on the Bonds will be made by the Trustee to DTC, which in turn is obligated to remit such principal and interest to its DTC participants for subsequent disbursement to beneficial owners of the Bonds. See Appendix B--"BOOK-ENTRY-ONLY SYSTEM." REDEMPTION Extraordinary Redemption. The Bonds are subject to redemption in whole or in part, without premium, on any date, in the principal amount thereof to be redeemed, together with accrued interest to the date fixed for redemption, upon the occurrence of (i) a termination of the Lease Agreement prior to the end of its term pursuant to the Lease Agreement (see Appendix C--"DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS--LEASE AGREEMENT--AGREEMENT OF LEASE; TERM OF LEASE; LEASE PAYMENTS--Term" and "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease"), or (ii) damage, destruction or condemnation of the Service Contract Project Improvements, or any portion thereof, which results in Net Insurance Proceeds, to the extent required or permitted by the Lease Agreement to be applied to prepayment of Lease Payments (see Appendix C--"DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS--LEASE AGREEMENT--INSURANCE CONDEMNATION" and "--LEASE AGREEMENT--DAMAGE, DESTRUCTION AND EMINENT DOMAIN; USE OF NET PROCEEDS"). 5 Optional Redemption. The Bonds maturing on December 1, 2013 are subject to optional redemption prior to maturity, at the option of the Water District, as a whole or in part on any date on or after December 1, 2012 from available funds in the Redemption Account, at a redemption price equal to the principal amount to be redeemed plus accrued interest to the redemption date. Mandatory Term Bond Redemption. The Bonds maturing on December 1, 2022 are subject to mandatory redemption, by lot, in the principal amounts hereinafter set forth, without premium, on December 1 of each year, commencing on December 1, 2021, from the principal portion of the Lease Payments required to be on deposit in the Debt Service Payment Account on the Lease Payment Date immediately prior to December 1 of each of the years and in the amounts as follows: Year Principal Amount ---- ---------------- 2021 $ 1,485,000 2022 1,560,000 The Bonds maturing on December 1, 2034 are subject to mandatory redemption, by lot, in the principal amounts hereinafter set forth, without premium, on December 1 of each year, commencing on December 1, 2023, from the principal portion of the Lease Payments required to be on deposit in the Debt Service Payment Account on the Lease Payment Date immediately prior to December 1 of each of the years and in the amounts as follows: Year Principal Amount ---- ---------------- 2023 $ 1,640,000 2024 1,720,000 2025 705,000 2026 740,000 2027 775,000 2028 815,000 2029 855,000 2030 900,000 2031 945,000 2032 990,000 2033 1,040,000 2034 1,095,000 Mandatory Redemption from Unexpended Proceeds. The Bonds are subject to redemption, in whole or in part, without premium, on any date, in the principal amount thereof to be redeemed, together with accrued interest to the date fixed for redemption, from unexpended proceeds of the Bonds, if any, remaining in the Project Account of the Project Trust Fund following Acceptance of the Service Contract Project Improvements under the Service Contract. Selection of Bonds to be Redeemed. If less than all of the Bonds of a single maturity will be called for redemption, the particular Bonds or portions thereof to be redeemed will be selected by the Trustee by lot in any manner which the Trustee in its sole discretion will deem appropriate and fair. The portion of any Bond of a denomination of more than $5,000 to be redeemed will be in the principal amount of $5,000 or an integral multiple thereof, and, in selecting portions of such Bonds for redemption, the Trustee will treat each such Bond as representing that number of Bonds of $5,000 denomination which is obtained by dividing the principal amount of such Bond to be redeemed in part by $5,000. Unless the Water District directs the Trustee in writing as to any other method of redemption, whenever provisions are made for the redemption of Bonds in part, the Bonds to be redeemed will be redeemed from each maturity, with the mandatory redemption schedule set forth above to be adjusted accordingly. 6 Notice of Redemption. When redemption of Bonds is required, the Trustee will, at the expense of the Water District, give notice of the redemption of such Bonds, the redemption date and the place or places where amounts due upon such redemption will be payable and, if less than all of the Bonds are to be redeemed, the letters and numbers of such Bonds so to be redeemed, and, in the case of Bonds to be redeemed in part only, such notice will also specify the respective portions of the principal amount thereof to be redeemed. Such notice will further state that on such date there will become due and payable upon each Bond to be redeemed the principal amount to be redeemed, together with interest accrued to the redemption date, and that from and after such date interest on the principal amount redeemed will cease to accrue and be payable. The Trustee will mail a copy of such notice, postage prepaid, first class United States mail, not less than 30 days and not more than 60 days before the redemption date, to the Bondowners of any Bonds or portions of Bonds which are to be redeemed, at their addresses as the same appear upon the registry books, but neither the failure of a Bondowners to receive such notice nor any immaterial defect therein will affect the validity of the proceedings for the redemption of Bonds. Effect of Redemption. Notice having been given and payment having been provided for, the Bonds or portions thereof so called for redemption will become due and payable on the redemption date so designated at the principal amount to be redeemed plus interest accrued and unpaid to the redemption date, and, upon presentation and surrender thereof at the office specified in such notice, such Bonds, or portions thereof, the principal amount and interest will be paid as provided in the Trust Agreement. If, on the redemption date, moneys for the redemption of all the Bonds or portions thereof to be redeemed together with interest to the redemption date will be held by the Trustee so as to be available therefor on said date; and if notice of redemption will have been given to the Bondowners as provided in the Trust Agreement, then from and after the redemption date interest on the Bonds or portions thereof so called for redemption will cease to accrue and become payable. TRANSFER AND EXCHANGE The following provisions regarding the transfer and exchange of the Bonds apply only during any period in which the Bonds are not subject to the book-entry system. While the Bonds are subject to the book-entry system, their transfer and exchange will be effected through DTC and the DTC Participants and will be subject to the procedures, rules and requirements established by DTC. See Appendix B--"BOOK-ENTRY-ONLY SYSTEM." Upon surrender of a Bond at the corporate trust office of the Trustee with a written instrument of transfer satisfactory to the Trustee, duly executed by the Bondowner or his duly authorized attorney, a Bond may be transferred or exchanged by the Bondowner thereof, but only in the manner, subject to the limitations and upon payment of the charges provided in the Trust Agreement. The Trustee will not be required to transfer or exchange any Bonds selected for redemption or within the 15 days before the selection of Bonds for redemption. 7 SOURCES AND USES OF FUNDS The proceeds of the Bonds are to be applied as follows: PROCEEDS: Principal Amount $ 31,555,000.00 Net Original Issue Premium 960,274.40 Total Available Funds $ 32,515,274.40 ================ USES: Deposit to Project Account $ 24,825,783.83 Deposit to Reserve Account/(1)/ 2,252,537.50 Deposit to Debt Service Payment Account/(2)/ 2,086,216.95 Costs of Issuance/(3)/ 3,350,736.12 Total Amount Applied $ 32,515,274.40 ================ - ---------- /(1)/ The amount on deposit in the Reserve Account equals the Reserve Requirement as defined in the Trust Agreement. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Debt Service Reserve Account." /(2)/ Represents capitalized interest on the Bonds in an amount expected to fund interest through June 1, 2004. /(3)/ Includes legal fees, financial advisor fees, rating agency fees, printing costs, the underwriter's discount (see "UNDERWRITING"), premium for the Policy and other expenses. [Remainder of page intentionally left blank.] 8 DEBT SERVICE SCHEDULE The following table shows the debt service requirements for the Bonds. YEAR ENDING (DECEMBER 31) INTEREST PRINCIPAL TOTAL DEBT SERVICE - ------------- --------------- ------------- ------------------ 2003 $ 1,339,658.20 $ -- $ 1,339,658.20 2004 1,493,117.50 -- 1,493,117.50 2005 1,493,117.50 755,000 2,248,117.50 2006 1,470,467.50 780,000 2,250,467.50 2007 1,447,067.50 805,000 2,252,067.50 2008 1,422,917.50 825,000 2,247,917.50 2009 1,398,167.50 850,000 2,248,167.50 2010 1,364,167.50 885,000 2,249,167.50 2011 1,328,767.50 920,000 2,248,767.50 2012 1,295,647.50 955,000 2,250,647.50 2013 1,260,312.50 990,000 2,250,312.50 2014 1,210,812.50 1,040,000 2,250,812.50 2015 1,156,212.50 1,095,000 2,251,212.50 2016 1,098,725.00 1,150,000 2,248,725.00 2017 1,038,350.00 1,210,000 2,248,350.00 2018 974,825.00 1,275,000 2,249,825.00 2019 907,887.50 1,340,000 2,247,887.50 2020 837,537.50 1,415,000 2,252,537.50 2021 763,250.00 1,485,000 2,248,250.00 2022 689,000.00 1,560,000 2,249,000.00 2023 611,000.00 1,640,000 2,251,000.00 2024 529,000.00 1,720,000 2,249,000.00 2025 443,000.00 705,000 1,148,000.00 2026 407,750.00 740,000 1,147,750.00 2027 370,750.00 775,000 1,145,750.00 2028 332,000.00 815,000 1,147,000.00 2029 291,250.00 855,000 1,146,250.00 2030 248,500.00 900,000 1,148,500.00 2031 203,500.00 945,000 1,148,500.00 2032 156,250.00 990,000 1,146,250.00 2033 106,750.00 1,040,000 1,146,750.00 2034 54,750.00 1,095,000 1,149,750.00 SOURCES OF PAYMENT AND SECURITY FOR THE BONDS SOURCE OF PAYMENT The Bonds are special, limited obligations of the Authority payable solely from the Trust Estate. The Bonds do not constitute a charge against the general credit of the Authority and are not secured by a legal or equitable pledge of, or charge or lien upon, any property of the Authority or any of its income or receipts except the funds and security provided under the Trust Agreement. Neither the faith and credit nor the taxing power of the State of California or any public agency thereof or any member of the Authority is pledged to the payment of the principal of, premium, if any, or interest on, the Bonds. 9 The Trust Estate is defined in the Trust Agreement to mean all right, title and interest of the Trustee in and to the Trustee benefit provisions under the Service Contract described under the heading entitled "--Water District Right to Terminate Lease--Bond Insurer Notice and Cure Provisions," all amounts received by the Trustee for the account of the Water District pursuant to or with respect to the Service Contract Letter of Credit (see "--Service Contract Letter of Credit" below) and the Lease Agreement including, without limitation, the Lease Payments and all amounts from time to time deposited in the funds, accounts and subaccounts created pursuant to the Trust Agreement, including all investments and investment earnings thereon, excluding, however, all moneys deposited or required to be deposited in the Rebate Fund. LEASE PAYMENTS The Water District is obligated to make the Lease Payments to the Authority solely from Revenues of the Water District pledged to the payment of the Lease Payments pursuant to the Lease Agreement. Pursuant to the Trust Agreement, the Authority has assigned all of its rights, title and interest (other than certain Additional Payments) in the Lease Agreement, including its right to receive the Lease Payments, and the right to exercise any remedies provided therein in the event of a default by the Water District thereunder, to the Trustee for the benefit of the Bondowners. Pursuant to the Lease Agreement, the Authority directs the Water District, and the Water District agrees, to pay to the Trustee all Lease Payments or prepayments thereof payable by the Water District under the Lease Agreement. None of the Property subject to the Lease Agreement or the improvements thereon or the Water System are pledged or available to the Trustee or the Bondowners in the event of termination of the Lease Agreement, default in the payment of Lease Payments or otherwise, and no default under Lease Agreement will result in the loss of the Property or the improvements thereon, the Water System or other assets of the Water District. See "--Water District Right to Terminate Lease" and "--Limited Recourse on Default" below. Notwithstanding any dispute between the Authority and the Water District, the Water District agrees in the Lease Agreement to make all Lease Payments when due and not to withhold any Lease Payment pending the final resolution of such dispute. The Lease Agreement provides that, except with respect to certain rights of the Water District to terminate the Lease Agreement early (See "--Water District Right to Terminate Lease" immediately below), the obligation of the Water District to make the Lease Payments is absolute and unconditional until such time as the Lease Payments are paid in full (or provision for the payment thereof is made pursuant to the Lease Agreement), the Water District will not discontinue or suspend any Lease Payments or Additional Payments required to be made by it under the Lease Agreement when due, whether or not the Water System or any part thereof is operating or operable or its use is suspended, interfered with, reduced or curtailed or terminated in whole or in part, and such payments will not be subject to reduction whether by offset or otherwise and will not be conditional upon the performance or nonperformance by any party of any agreement for any cause whatsoever. In the event the Water District should fail to make any Lease Payment required by the Lease Agreement, or any portion of any such Lease Payment, the Lease Agreement provides that the Lease Payment or portion in default will continue as an obligation of the Water District until the amount in default is fully paid, and that the Water District agrees to pay the same with interest thereon, to the extent permitted by law, from the date such amount was originally payable at the rate equal to the highest stated interest rate on any of the Bonds as stated in the Trust Agreement. The obligation of the Water District to make the Lease Payments and other payments required to be made by the Water District under the Lease Agreement is a special obligation of the Water District payable, in the manner provided in the Lease Agreement, solely from Revenues. Except for the pledge of Revenues pursuant to the Lease Agreement, neither the faith and credit nor the taxing power of the Water District or the City is pledged to the payment of the Lease Payments (and the merger of the Water District into the City, which is expected to occur in early 2003, will not affect this limitation). See "--Pledge of Revenues" below. UNDER CERTAIN CIRCUMSTANCES DESCRIBED HEREIN, THE WATER 10 DISTRICT HAS THE RIGHT TO TERMINATE THE LEASE AGREEMENT. IN SUCH EVENT, THE WATER DISTRICT WILL HAVE NO FURTHER OBLIGATION TO MAKE ANY LEASE PAYMENTS UNDER THE LEASE AGREEMENT AND THE TRUSTEE WILL HAVE NO FURTHER RIGHTS OR RECOURSE WITH RESPECT TO THE PROPERTY OR THE IMPROVEMENTS THEREON. See "--Water District Right to Terminate Lease" immediately below and "DESCRIPTION OF BONDS--Redemption-- Extraordinary Redemption." WATER DISTRICT RIGHT TO TERMINATE LEASE Water District Right to Terminate Lease as a Result of DB/Operator Default under Service Contract; Water District Lockout. Under the Service Contract, the DB/Operator is required to complete the Service Contract Project Improvements for a fixed price of $25,030,607 and by the Scheduled Acceptance Date, September 1, 2004, as such date may be extended upon the occurrence of an Uncontrollable Circumstance, Water District requested changes or District Fault, and once completed, operate such Service Contract Project Improvements, subject to the conditions and performance guarantees set forth in the Service Contract. The DB/Operator's obligations under the Service Contract are described in Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT." In the event certain events of default by the DB/Operator under the Service Contract occur that continue beyond any applicable cure period, the Water District has the right, subject to the limitations in the Service Contract described below, to terminate the Lease Agreement. The Water District has the right to terminate the Lease Agreement in the event it exercises its right to terminate the Service Contract (i) without any requirement of having given notice previously or of providing any further or additional cure opportunity, in the event the DB/Operator fails to achieve satisfaction of all of the Acceptance Date Conditions specified in the Service Contract (see Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Provisional Acceptance, Acceptance and Final Completion of the Project--Acceptance Date Conditions") by the end of the Extension Period, March 2, 2006, as such date may be extended by the occurrence of Uncontrollable Circumstances, Water District requested changes or District Fault, or (ii) subject to the notice and cure provisions described below, in the event any Payment/Performance Default (defined below) by the DB/Operator occurs. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Breach, Default, Remedies and Termination." For information regarding the allocation of the days to remedy any failure to achieve Provisional Acceptance on or before the Scheduled Acceptance Date during the Extension Period between the DB/Operator and the Bond Insurer pursuant to the Insurance Agreement, see also "--Insurance and Indemnity Agreement and Insurance Agreement Guaranty." If the Water District exercises its right to so terminate the Lease Agreement, the Lease Agreement will terminate, the Trustee will have no further rights or recourse with respect to the Property or the improvements thereon and the Water District will have no further obligation to make any Lease Payments under the Lease Agreement. See "DESCRIPTION OF BONDS--Redemption--Extraordinary Redemption." In the event of a Payment/Performance Default, however, the DB/Operator and the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) will have a reasonable period of time (which shall not in any event exceed 120 days plus an additional 120 to 350 days, for a maximum combined total of 470 days) to cure such default (so long as they diligently carry out such cure and satisfy certain other requirements (see "--Bond Insurer Notice and Cure Provisions--Continuing Performance Obligations; Obligation to Pay Liquidated Damages" below)), during which time the Water District, subject to certain conditions, is obligated to continue to make the Lease Payments. See "--DB/Operator Notice and Cure Provisions" and "--Bond Insurer Notice and Cure Provisions" below. For information regarding the Bond Insurer's right to pursue certain cure rights during the DB/Operator's cure period and the tolling of all cure periods during certain bankruptcy or similar proceedings pursuant to the Insurance Agreement, see also "--Insurance and Indemnity Agreement and Insurance Agreement Guaranty." Furthermore, pursuant to the Lease Agreement, the Property Lease and the Insurance Agreement (see "--Insurance and Indemnity Agreement and Insurance Agreement Guaranty" below), the Water District, the 11 Authority and the City will agree that upon the occurrence of a termination of the Lease Agreement as a result of a termination of the Service Contract caused by a Payment/Performance Default by the DB/Operator (a "Termination Event"), the Water District will not have the right to construct, operate or otherwise use (except for maintenance by the Water District, the Authority or the City) the Project for a three-year period from the date of such Termination Event (the "Lock-out Period"), except with the prior written approval of the Bond Insurer. In addition, the Water District will agree that, to the extent permitted by law, it will not develop or construct Alternative Facilities during any cure period following an event of default under the Service Contract or during any Lock-out Period, if applicable, without the prior written consent of the Bond Insurer. The Lease Agreement does not terminate on expiration of the Service Contract at the end of its term or as a result of a buy-out of the Service Contract by the Water District. See Appendix C--"DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS--LEASE AGREEMENT--AGREEMENT OF LEASE; TERM OF LEASE; LEASE PAYMENTS--Term." The term "Alternative Facilities" is defined in the Lease Agreement to mean any new water storage and production facilities that would in the aggregate supply more than three million gallons per day of potable water; provided, however, that Alternative Facilities shall not include any wells that exist on the date of issuance of the Bonds, any facilities for the importation or transmission of local water sources delivered by wholesale water agencies to the Water District or other generation, storage and production sources developed by the Water District in the course of its ongoing program to develop local water supply infrastructure, including without limitation for reclaimed water, prior to any event of default under the Service Contract and not in view of the termination of the Lease Agreement." Under the Service Contract, a "Payment/Performance Default" occurs if the DB/Operator fails, refuses or otherwise defaults in its duty (i) to pay any amount required to be paid to the Water District under the Service Contract within 60 days following the due date for such payment, or (ii) to perform any material obligation under the Service Contract (unless such default is excused by an Uncontrollable Circumstance or District Fault as and to the extent provided in the Service Contract). See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Breach, Default, Remedies and Termination." DB/Operator Notice and Cure Provisions. No Payment/Performance Default under the Service Contract will constitute an event of default giving the Water District the right to terminate the Service Contract, and, as a result, the Lease Agreement, unless (y) the Water District has given prior written notice to the DB/Operator stating that in its opinion a specified Payment/Performance Default in the DB/Operator's duty to pay or perform exists which gives the Water District a right to terminate the Service Contract for cause, and describing the Payment/Performance Default in reasonable detail; and (z) the DB/Operator neither challenged in an appropriate forum the Water District's conclusion that such a failure or refusal to perform has occurred or constitutes a material breach of the Service Contract, nor initiated within a reasonable time (in any event not more than 30 days from the initial default notice) and continued with due diligence to carry out to completion all actions reasonably necessary to correct the default and prevent its recurrence; except that if the DB/Operator will have initiated within such reasonable time and continued with due diligence to carry out to completion all such actions, the Payment/Performance Default will not constitute such an event of default during such period of time (in any event not more than 120 days from the initial default notice) as the DB/Operator continues with due diligence to carry out to completion all such actions. For information regarding the Bond Insurer's right to pursue certain cure rights during the DB/Operator's cure period and the tolling of all cure periods during certain bankruptcy or similar proceedings pursuant to the Insurance Agreement, see also "--Insurance and Indemnity Agreement and Insurance Agreement Guaranty." 12 Bond Insurer Notice and Cure Provisions. The Service Contract provides that, during the Lease Term, the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) will be entitled to the protections set forth below if the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) has (i) provided the Water District with an address for notices under the Service Contract, (ii) acknowledged the Water District's rights with respect to the DB/Operator, the Trustee and the Project, and (iii) paid any non-performance liquidated damages to the Water District which are due and owing by the DB/Operator. For a discussion of certain of such non-performance liquidated damages, see "THE PROJECT--Liquidated Damages under the Service Contract." Default Notice. During the Lease Term, should any event of default by the DB/Operator under the Service Contract occur, the Water District is required to mail or deliver to the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) a duplicate copy of any and all notices in writing that the Water District may from time to time give to or serve upon the DB/Operator pursuant to the provisions of the Service Contract. The Service Contract provides that any such notice will set forth the nature of the event of default and the actions required to cure such event of default. The Service Contract provides that each such notice will be mailed or delivered to the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) at or as near as possible to the time such notices are given to or served upon the DB/Operator by the Water District if required to be so served or at the earliest opportunity if such notice is not required to be given to the DB/Operator. No notice by the Water District to the DB/Operator will be deemed to be given to the DB/Operator unless and until a copy thereof has been mailed or delivered to the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy). Bond Insurer Right of Cure for Payment/Performance Defaults. If a default by the DB/Operator occurs under the Service Contract which, with the giving of notice or the passage of time, may lead to a Payment/Performance Default, and the DB/Operator has failed to cure such default on or before the expiration of any applicable period of cure for such a default as described above under the heading entitled "--DB/Operator Notice and Cure Provisions," the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) will have 120 days after the later of the expiration of the DB/Operator's cure period with respect to such Payment/Performance Default, or the date of the Bond Insurer's (or the Trustee's if the Bond Insurer is in default under the Policy) receipt of written notice of the occurrence of the Payment/Performance Default from the Water District, and an additional 230 day period of time after the expiration of such 120 day period within which to remedy such default; provided that the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) will (i) have fully cured any default in the payment of any monetary obligations of the DB/Operator under the Service Contract within such 120 day period and will continue to pay current such monetary obligations as and when they are due, (ii) will have commenced action to cure any nonmonetary default within such 120 day period, and (iii) will thereafter diligently prosecute such action or proceeding to completion by no later than 350 days of the Bond Insurer's (or the Trustee's if the Bond Insurer is in default under the Policy) receipt of such notice from the Water District. For information regarding the Bond Insurer's right to pursue certain cure rights during the DB/Operator's cure period and the tolling of all cure periods during certain bankruptcy or similar proceedings pursuant to the Insurance Agreement, see also "--Insurance and Indemnity Agreement and Insurance Agreement Guaranty." The Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) will be entitled to cure certain other defaults that do not in and of themselves give rise to a Termination Event. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Breach, Default, Remedies and Termination." The Service Contract provides that all rights of the Water District during the term of the Lease Agreement to terminate the Service Contract as a result of the occurrence of any event of default by the DB/Operator thereunder will be subject to and conditioned upon the Water District having first given to the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) written notice of such default as specified in the Service Contract and the Bond Insurer (or the Trustee if the Bond Insurer is in default 13 under the Policy) having failed to act within the time specified in the Service Contract for the Bond Insurer (or, if applicable, the Trustee) to cure such default. Assignment. During any cure period described under the heading entitled "--Bond Insurer Right of Cure for Payment/Performance Defaults" above, the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) will have the right to assign (and the DB/Operator in such circumstances agrees to the assignment of) the DB/Operator's rights and obligations under the Service Contract to any replacement operator recognized as competent in the water treatment industry and as being technically and financially capable of carrying out both the DB/Operator's obligations under the Service Contract and the Guarantor's obligations under the Service Contract Guaranty Agreement for the remaining term of the Service Contract. Any such replacement operator will be subject to the approval of the Water District, which approval will be based on the standards set forth in the preceding sentence and will not unreasonably be withheld. No such assignment will take place unless and until the replacement operator has executed and delivered to the Water District an agreement acknowledging and confirming its assumption of all of the DB/Operator's obligations under the Service Contract, together with all authorizing documentation. The Water District has agreed to fully cooperate with the Bond Insurer, as requested by the Bond Insurer, in all reasonable respects to assist the Bond Insurer in identifying and engaging a replacement operator pursuant to the Service Contract. New Agreement Upon Rejection in Bankruptcy. The Service Contract provides that if the Service Contract is rejected or disaffirmed by or on behalf of the DB/Operator in a proceeding under the Bankruptcy Code or other insolvency law then, unless the Service Contract has theretofore been terminated, on written request of the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) made at any time within 60 days after the date on which notice of such rejection or disaffirmance is given, the Water District will enter into a new agreement with respect to the Project with a designee of the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) meeting the requirements described under the heading entitled "--Assignment" above for a replacement operator. The Service Contract provides that a new agreement will be effective as of the effective date of such rejection or disaffirmance of the Service Contract, for the term of the Service Contract remaining as of the effective date of such rejection or disaffirmance, and upon the same executory terms, covenants, conditions and agreements as are contained in the Service Contract; provided, however, that the Water District will not be so obligated unless (i) such designee will execute and deliver such new agreement within 20 days after the later of the date on which the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) gives the Water District notice of its election to do so or the date on which the Water District tenders such new agreement to such designee for execution, and (ii) the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) or its designee will pay to the Water District at the time of the execution and delivery of such new agreement all expenses, including reasonable attorney's fees, incurred by the Water District in connection with the termination of the Service Contract and the execution and delivery of such new agreement. Continuing Performance Obligations; Obligation to Pay Liquidated Damages. The Service Contract provides that the rights of the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) to cure an event of default by the DB/Operator and to appoint a replacement operator will not relieve the DB/Operator or any such replacement operator from its continuing obligation to perform under the Service Contract, and that the Bond Insurer's (or the Trustee's if the Bond Insurer is in default under the Policy) cure and notice rights are subject to the timely payment and performance by the Bond Insurer (or the Trustee if the Bond Insurer is in default under the Policy) or another entity as arranged for by the Bond Insurer (or the Trustee, as applicable), on behalf of the DB/Operator, of all non-performance liquidated damages and other obligations which are to be performed or paid by the DB/Operator to the Water District under the Service Contact and which remain unperformed or unpaid as of the due date. For a discussion of certain of such non-performance liquidated damages, see "THE PROJECT--Liquidated Damages under the Service Contract." 14 SERVICE CONTRACT LETTER OF CREDIT The Service Contract provides that, in the event that Provisional Acceptance of the Service Contract Project Improvements under the Service Contract (or, if Provisional Acceptance is not certified by the DB/Operator, Acceptance) occurs subsequent to December 4, 2004, the DB/Operator will pay to the Water District daily delay liquidated damages for each day that the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the DB/Operator, the Acceptance Date) falls after December 4, 2004 in an amount equal to the Lease Payments (including payments with respect to both interest and principal) accrued by the Water District on a daily basis, up to the end of the Extension Period and thereafter until any termination of the Service Contract for an event of default by the DB/Operator under the Service Contract. The Service Contract provides that the accrual of such Lease Payments will be determined on the basis of the amount of the Lease Payments actually payable under the Lease Agreement, whether such payments are in fact made by the Water District directly or from proceeds of the Bonds borrowed in order to capitalize interest. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Provisional Acceptance, Acceptance and Final completion of the Project--Daily Liquidated Damages." See also Section 7.3 of the Independent Engineer's Report entitled "--Service Contract" attached hereto as Appendix G. The Service Contract provides that such damages will be payable on the first day of each month and the date of termination of the Service Contract (if the Service Contract is terminated by the Water District on account of default by the DB/Operator). The Service Contract provides that such liquidated damages will be secured by an irrevocable direct pay letter of credit in a stated amount of $3,430,000, equal to daily accrued debt service on the Bonds for a period of 547 days, issued by a United States bank whose long-term debt is rated "A" or better by either Moody's Investors Service ("Moody's") or Standard & Poor's Credit Markets Services, a Division of The McGraw-Hill Companies ("Standard & Poor's"), and which maintains a banking office in the State (the "Service Contract Letter of Credit"). Notwithstanding any provision of the Service Contract to the contrary, pursuant to the Insurance Agreement, from and after the assignment of the Service Contract and the Insurance Agreement by the Company to the SPE, the Service Contract Letter of Credit (and any replacements thereof) will secure the obligations of the Guarantor under the Service Contract Guaranty Agreement (including the guaranty of the Company's obligations to pay daily delay liquidated damages to the Water District in accordance with the Service Contract) to guarantee the Company's performance of the Contract Services (as defined in the Service Contract) rather than directly securing the obligations of the Company under the Service Contract. The Service Contract Letter of Credit will be initially provided by Bank of America, N.A. (the "Service Contract Letter of Credit Provider"). For information regarding the Service Contract Letter of Credit Provider, see Appendix J--"CERTAIN INFORMATION CONCERNING THE SERVICE CONTRACT LETTER OF CREDIT PROVIDER." The Service Contract Letter of Credit will be for a term of one year, will be continuously renewed, extended or replaced so that it remains in effect until thirty days after the date that the Water District states in writing that the Water District and the Independent Engineer concur with the DB/Operator's certification that Acceptance has occurred under the Service Contract. THE SERVICE CONTRACT LETTER OF CREDIT WILL BE ISSUED TO THE WATER DISTRICT. HOWEVER, UNDER THE TRUST AGREEMENT, THE WATER DISTRICT WILL COVENANT TO TRANSFER TO THE TRUSTEE, FOR DEPOSIT INTO THE DEBT SERVICE PAYMENT ACCOUNT ESTABLISHED UNDER THE TRUST AGREEMENT, NO LATER THAN THREE BUSINESS DAYS FOLLOWING RECEIPT THEREOF BY THE WATER DISTRICT, ALL PROCEEDS OF ANY DRAWING ON THE SERVICE CONTRACT LETTER OF CREDIT RECEIVED BY THE WATER DISTRICT. The DB/Operator may reduce and replace the Service Contract Letter of Credit on the sixth and twelve month anniversary dates of the Scheduled Acceptance Date by an amount equal to all daily delay liquidated damages that the DB/Operator then shall have previously paid to the Water District. 15 ADDITIONAL PAYMENTS The Lease Agreement provides that, in addition to the Lease Payments, the Water District will also pay such amounts ("Additional Payments") as are required for the payment of all administrative costs of the Authority relating to the Property, including, without limitation, all expenses including usual and ordinary legal fees and expenses, assessments, compensation and indemnification of the Authority and the Trustee, any amounts required to be rebated to the federal government in order to comply with the provisions of Section 148 of the Internal Revenue Code of 1986, as amended, any amounts required to be paid to the Trustee to replenish the Reserve Account to the Reserve Requirement, fees under any Alternative Reserve Account Security, taxes of any sort whatsoever payable by the Authority as a result of its lease of the Property or undertaking of the transactions contemplated in the Lease Agreement or in the Trust Agreement, fees of auditors, accountants, attorneys or engineers, insurance premiums required by the Lease Agreement, certain repair and maintenance costs, taxes and assessments and utility charges required by the Lease Agreement and all other necessary administrative costs of the Authority or charges required to be paid by it in order to comply with the terms of the Bonds or of the Trust Agreement or to indemnify the Trustee and its officers and directors. All such Additional Payments are to be paid when due directly by the Water District to the respective parties to whom such Additional Payments are owing. LIMITED RECOURSE ON DEFAULT The Lease Agreement provides that whenever any Event of Default under the Lease Agreement by the Water District will have happened and be continuing, it will be lawful for the Authority to exercise (subject to the restrictions described below) any and all remedies available pursuant to law or equity or granted pursuant to the Lease Agreement, and, in each and every such case during the continuance of such an Event of Default, the Authority may, with the consent of the Bond Insurer, and will, at the direction of the Bond Insurer, declare the entire principal amount of the unpaid Lease Payments and the accrued interest thereon to be due and payable immediately, and upon any such declaration the same will become immediately due and payable, anything contained in the Lease Agreement to the contrary notwithstanding. However, the Water District has no ability to accelerate Revenues, and the amount of Revenues pledged to the payment of the Lease Payments on a basis that is senior to certain other obligations of the Water District is subject to certain annual dollar limitations. See "--Pledge of Revenues" below. Furthermore, the Lease Agreement provides that none of the Authority, the Trustee, the Bond Insurer, or the Bondowners have the right under the Lease Agreement to re-enter or re-let the Property or the improvements thereon under any circumstances, and neither the Authority nor the Trustee has a security interest in or mortgage on or other recourse to the Property subject to the Lease Agreement or the improvements thereon, the Water System or other assets of the Water District and no default under Lease Agreement will result in the loss of the Property or the improvements thereon, the Water System, or other assets of the Water District. The Lease Agreement also provides that if at any time after the entire principal amount of the unpaid Lease Payments and the accrued interest thereon will have been so declared due and payable and before any judgment or decree for the payment of the moneys due will have been obtained or entered the Water District will deposit with the Authority a sum sufficient to pay the unpaid principal amount of the Lease Payments due prior to such declaration and the accrued interest thereon, with interest on such overdue installments, at the rate or rates applicable to the remaining unpaid principal balance of the Lease Payments, and the reasonable expenses of the Authority, and any and all other defaults known to the Authority (other than in the payment of the entire principal amount of the unpaid Lease Payments and the accrued interest thereon due and payable solely by reason of such declaration) will have been made good or cured to the satisfaction of the Authority or provision deemed by the Authority to be adequate will have been made therefor, then and in every such case the Authority, by written notice to the Water District may rescind and annul such declaration and its consequences; but no such rescission and annulment will extend to or will affect any subsequent default or will impair or exhaust any right or 16 power consequent thereon. The Lease Agreement provides that upon the occurrence and continuance of any such Event of Default, so long as the Bond Insurer is not in default under the Policy, the Bond Insurer will be entitled to control and direct the enforcement of all rights and remedies granted to the Authority or the Trustee under the Lease Agreement or otherwise available to the Authority or the Trustee, including, without limitation (i) the right to accelerate the portion of each Lease Payment designated as and representing the principal of the Bonds, and (ii) the right to annul any declaration of acceleration, and the Bond Insurer will also be entitled to approve all waivers of Events of Default. PLEDGE OF REVENUES Pursuant to the Lease Agreement, the Water District has unconditionally pledged the Revenues of the Water District to the payment of the Lease Payments. Furthermore, subject to the Maintenance and Operation Cap described below, the Water District agrees in the Lease Agreement that such pledge is senior to its pledge of net revenues to the payment of the installment payments of interest and principal (the "Installment Payments") scheduled to be paid by the Water District under and pursuant to the Installment Purchase Agreement, dated as of March 1, 2002 (the "Installment Purchase Agreement"), by and between the Water District and the San Juan Capistrano Public Financing Authority. See "WATER DISTRICT FINANCIAL INFORMATION--Outstanding Indebtedness." The Water District entered into the Installment Purchase Agreement in connection with the execution and delivery of $8,525,000 aggregate principal amount of revenue certificates of participation executed and delivered on April 3, 2002 (the "2002 Certificates of Participation"). Pursuant to the Installment Purchase Agreement, the Revenues of the Water District are pledged to pay the Installment Payments net of operation and maintenance costs, defined in the Installment Purchase Agreement to include, in part, annual costs not to exceed (i) $2,750,000 for project lease payments, including principal and interest components for the Groundwater Recovery Plant; plus (ii) $1,100,000 for other capital and operations costs of the Groundwater Recovery Plant, increasing by 85% of CPI annually; plus (iii) $1,200,000 for electricity costs of the Groundwater Recovery Plant, provided that (i), (ii) and (iii) above may be increased due to currently unforeseeable cost increases which are out of the control of the Water District and of the owner, operator and lenders with respect to the Groundwater Recovery Plant (the limitations relating to project lease payments as further defined in the Lease Agreement, the "Maintenance and Operation Cap"). The Lease Agreement provides that the Lease Payments are, and are deemed to be, for all purposes of the Installment Purchase Agreement, the project lease payments included in operation and maintenance costs under the Installment Purchase Agreement and constitute Maintenance and Operation Costs for purposes of the Lease Agreement, and, as such, are payable, to the extent the Lease Payments due in such year do not exceed the dollar limitations under the Maintenance and Operation Cap described above, from Revenues on a senior lien basis to the Installment Payments. To the extent the Lease Payments due in any one year exceed the dollar limitations under the Maintenance and Operation Cap described above due to the acceleration of such payments or otherwise, the Lease Agreement provides that such payments would be payable from Net Revenues on a parity lien basis to the Installment Payments. See also "--Limited Recourse on Default" above and "--Additional Obligations; Parity Obligations" below. The Water District has covenanted in the Lease Agreement not to make any changes in the Installment Purchase Agreement or otherwise that would impair the priority of the pledge of the Revenues of the Water District to the payment of the Lease Payments and that such priority will survive any payment or defeasance of the Installment Purchase Agreement or the 2002 Certificates of Participation. "Revenues" is defined in the Lease Agreement to mean all income, rents, rates, fees, charges and other moneys derived from the ownership or operation of the Water System, including, without limiting the generality of the foregoing, (i) all income, rents, rates, fees, charges, business interruption insurance proceeds or other moneys derived by the Water District from the sale, furnishing and supplying of the water or other services, facilities, and commodities sold, furnished or supplied through the facilities of or 17 in the conduct or operation of the business of the Water System; (ii) the earnings on and income derived from the investment of amounts described in clause (i) above and from Water District reserves; and (iii) the proceeds derived by the Water District directly or indirectly from the sale, lease or other disposition of a part of the Water System; and (iv) payments under the Metropolitan Agreement; but excluding (a) customers' deposits or any other deposits or advances subject to refund until such deposits or advances have become the property of the Water District; and (b) any proceeds of taxes or assessments restricted by law to be used by the Water District to pay bonds or other obligations heretofore or hereafter issued. Revenues also include all amounts transferred from the Lease Revenue Bonds Rate Stabilization Reserve to the Revenue Fund of the Water District during any Fiscal Year in accordance with the Lease Agreement. For information regarding the Lease Revenue Bonds Rate Stabilization Reserve, see "--Lease Revenue Bonds Rate Stabilization Reserve; Impact of Proposition 218" below. For information regarding the Water District, including certain financial information, see "THE WATER DISTRICT" and "WATER DISTRICT FINANCIAL INFORMATION." "Net Revenues" is defined in the Lease Agreement to mean the amounts of Revenues of the Water System remaining after payment therefrom of the Maintenance and Operation Costs. "Maintenance and Operation Costs" is defined in the Lease Agreement to mean costs spent or incurred for operation and maintenance of the Water System calculated in accordance with generally accepted accounting principles, including (among other things) the reasonable expenses of management and repair and other expenses necessary to maintain and preserve the Water System in good repair and working order, and also all costs of water purchased or otherwise acquired for delivery by the Water System (including the Lease Payments, any Parity Obligations, and any interim or renewed arrangement for water purchase or acquisition); but excluding in all cases depreciation, replacement and obsolescence charges or reserves therefor and amortization of intangibles or other bookkeeping entries of a similar nature and any amounts transferred to the Lease Revenue Bonds Rate Stabilization Reserve. For information regarding certain rights of the Water District to receive grant credits or payments from MWD in connection with the development of the Project, see "THE PROJECT--Agreement with Metropolitan Water District of Southern California." See also "THE PROJECT--Liquidated Damages under the Service Contract" for information regarding the obligation of the DB/Operator to pay certain non-performance liquidated damages to the Water District. REVENUE FUND The Water District accounts for its water operations through an enterprise fund currently identified as the Unrestricted Fund of the Water District (the "Revenue Fund"). The Revenue Fund is held separate and apart from other funds of the Water District. The Revenue Fund is invested in accordance with the Water District's investment policy. See "WATER DISTRICT FINANCIAL INFORMATION--Investment of Water District Funds." The Water District agrees and covenants under the Lease Agreement that all Revenues will be deposited in the Revenue Fund. The Lease Agreement provides that the Water District will transfer moneys from the Revenue Fund to pay Maintenance and Operation Costs, including the Lease Payments in accordance with the Lease Agreement and lease payments securing Parity Obligations, if any, and that any Revenues in excess of the amounts budgeted, as required, for the payment of the Lease Payments and Maintenance and Operation Costs will constitute surplus revenues in the Revenue Fund and that such surplus revenues may be used for (i) payment of the Installment Payments, (ii) extensions and betterments of the Water System or (iii) any lawful purpose of the Water District. 18 ADDITIONAL OBLIGATIONS; PARITY OBLIGATIONS The Water District covenants in the Lease Agreement that no additional bonds, notes or obligations will be issued by the Water District which will have any priority in payment of principal or interest out of the Revenues over the Lease Payments. The Water District further covenants in the Lease Agreement that, except for obligations issued to prepay the Lease Payments, it will issue obligations payable from Revenues on a parity basis with the Lease Payments ("Parity Obligations") only provided that certain conditions are met, including the requirements (i) that the Revenues as shown by the books of the Water District for the twelve calendar months ending prior to the incurring of such additional obligations will have amounted to at least the sum of (x) one hundred percent of Maintenance and Operation Costs, including without limitation the Lease Payments, for such twelve calendar month period, plus (y) the amount by which the amount on deposit on the Lease Revenue Bonds Rate Stabilization Reserve on the date prior to the first day of such twelve calendar month period was less than twenty-five percent of Maximum Annual Debt Service, and (ii) that the estimated Revenues for the twelve calendar months following the date of incurring such Parity Obligations will be at least equal to one hundred percent of all Maintenance and Operation Costs, including without limitation the Lease Payments projected to be paid in the next succeeding Fiscal Year and payments on Parity Obligations to be outstanding immediately after the incurring of such Parity Obligations, and the Additional Payments paid in the prior Fiscal Year as of the date of incurring of such Parity Obligation. Nothing in the Lease Agreement precludes the Water District from issuing obligations which are subordinate to the payment of the Lease Payments. See Appendix C--"DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS--LEASE AGREEMENT--AGREEMENT OF LEASE; TERM OF LEASE; LEASE PAYMENTS--Limits on Additional Debt" and "--LEASE AGREEMENT--AGREEMENT OF LEASE; TERM OF LEASE; LEASE PAYMENTS--No Priority for Additional Obligations." "Maximum Annual Debt Service" is defined in the Trust Agreement to mean, as of the date of any calculation, the maximum amount of principal, interest and mandatory sinking fund deposits required to be paid with respect to the Bonds in the current or any future Bond Year. RATE COVENANT; IMPACT OF PROPOSITION 218 To the maximum extent permitted by law, the Water District has covenanted in the Lease Agreement to fix, prescribe and collect rates and charges for water service which will be at least sufficient to yield Revenues during each Fiscal Year equal to one hundred percent of Maintenance and Operation Costs paid in the immediately preceding Fiscal Year, provided that such costs will include the Lease Payments payable in such Fiscal Year, plus Additional Payments payable in such Fiscal Year, plus the amount by which the amount on deposit in the Lease Revenue Bonds Rate Stabilization Reserve on the last day of the immediately preceding Fiscal Year was less than twenty-five percent of Maximum Annual Debt Service as of such day. The Water District may make adjustments from time to time in such rates and charges and may make such classification thereof as it deems necessary, but will not reduce the rates and charges then in effect unless the Revenues from such reduced rates and charges will at all times be sufficient to meet the requirements of the rate covenant. For information on the possible limitation on the Water District's ability to comply with the rate covenant as a consequence of Proposition 218, see "THE WATER DISTRICT--Proposition 218." LEASE REVENUE BONDS RATE STABILIZATION RESERVE; IMPACT OF PROPOSITION 218 The Lease Agreement provides that the Water District is required to establish, hold and fund, so long as any Bonds remain outstanding, a Lease Revenue Bonds Rate Stabilization Reserve in an amount equal to 25% of Maximum Annual Debt Service (the "Rate Stabilization Requirement"), and that Water District will withdraw all or any portion of the amounts on deposit in the Lease Revenue Bonds Rate 19 Stabilization Reserve and transfer such amounts to the Revenue Fund to the extent amounts in the Revenue Fund are not sufficient to pay Maintenance and Operation Costs. The Water District may also withdraw all or any portion of the amounts on deposit in the Lease Revenue Bonds Rate Stabilization Reserve and transfer such amounts to the Revenue Fund to the extent the Water District needs to increase Revenues to meet its rate covenant described under the heading entitled "--Rate Covenant; Impact of Proposition 218" immediately above. Under the Lease Agreement, amounts so withdrawn are treated as Revenues. The Water District may expend amounts in the Lease Revenue Bonds Rate Stabilization Reserve for any purpose permitted by law. The Rate Stabilization Requirement is in addition to amounts required to be maintained in the rate stabilization reserve established in connection with the 2002 Certificates of Participation. For information on the possible limitation on the Water District's ability to establish rates and charges at levels which would permit deposits to a rate stabilization fund as a consequence of Proposition 218, see "THE WATER DISTRICT--Proposition 218." DEBT SERVICE RESERVE ACCOUNT A portion of the proceeds of the Bonds will be deposited in the Reserve Account in an amount equal to the Reserve Requirement. See "DESCRIPTION OF BONDS--Sources and Uses of Funds." The Reserve Requirement is defined in the Trust Agreement to be, as of any date of calculation, an amount equal to the lesser of (i) Maximum Annual Debt Service; (ii) 10% of the proceeds of the Bonds; or (iii) 125% of Average Annual Debt Service. The Trust Agreement provides that the Reserve Requirement may be recalculated at any time upon the request of the Water District, and that the Trustee will maintain the Reserve Account thereafter at a level equal to the recalculated Reserve Requirement. The Authority reserves the right to substitute, at any time and from time to time, one or more letters of credit, Alternative Reserve Account Security, bond insurance policies or other form of guaranty, in any case approved in writing by the Bond Insurer from a financial institution the long-term unsecured obligations of which are rated to the Bond Insurer's satisfaction in substitution for or in place of all or any portion of the Reserve Requirement, under the terms of which the Trustee is unconditionally entitled to draw amounts when required for the purposes thereof. See Appendix C--"DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS--TRUST AGREEMENT-- ESTABLISHMENT AND ADMINISTRATION OF FUNDS AND ACCOUNTS--Reserve Account." FINANCIAL GUARANTY INSURANCE POLICY Payment of the principal of and interest on the Bonds when due will be insured by a financial guaranty insurance policy to be issued simultaneously with the delivery of the Bonds by the Bond Insurer. The following information has been furnished by the Bond Insurer for use in this Official Statement. Such information has not been independently confirmed or verified by the Authority or the Water District. No representation is made herein as to the accuracy or adequacy of such information or as to the absence of material adverse changes in such information subsequent to the date hereof. Reference is made to Appendix H for a specimen of the financial guaranty insurance policy. Payment Pursuant to Financial Guaranty Insurance Policy. Ambac Assurance Corporation (the "Bond Insurer") has made a commitment to issue a financial guaranty insurance policy (the "Policy") relating to the Bonds effective as of the date of issuance of the Bonds. Under the terms of the Policy, the Bond Insurer will pay to The Bank of New York, in New York, New York or any successor thereto (the "Insurance Trustee") that portion of the principal of and interest on the Bonds which shall become Due for Payment but shall be unpaid by reason of Nonpayment by the Authority (as such terms are defined in the Policy). The Bond Insurer will make such payments to the Insurance Trustee on the later of the date on which such principal and interest becomes Due for Payment or within one business day following the 20 date on which the Bond Insurer shall have received notice of Nonpayment from the Trustee. The insurance will extend for the term of the Bonds and, once issued, cannot be canceled by the Bond Insurer. The Policy will insure payment only on stated maturity dates and on mandatory sinking fund installment dates, in the case of principal, and on stated dates for payment, in the case of interest. If the Bonds become subject to mandatory redemption and insufficient funds are available for redemption of all outstanding Bonds, the Bond Insurer will remain obligated to pay principal of and interest on outstanding Bonds on the originally scheduled interest and principal payment dates including mandatory sinking fund redemption dates. In the event of any acceleration of the principal of the Bonds, the insured payments will be made at such times and in such amounts as would have been made had there not been an acceleration. In the event the Trustee has notice that any payment of principal of or interest on a Bond which has become Due for Payment and which is made to a Bondowner by or on behalf of the Authority has been deemed a preferential transfer and theretofore recovered from its registered owner pursuant to the United States Bankruptcy Code in accordance with a final, nonappealable order of a court of competent jurisdiction, such registered owner will be entitled to payment from the Bond Insurer to the extent of such recovery if sufficient funds are not otherwise available. The Policy does not insure any risk other than Nonpayment, as defined in the Policy. Specifically, the Policy does not cover: 1. payment on acceleration, as a result of a call for redemption (other than mandatory sinking fund redemption) or as a result of any other advancement of maturity. 2. payment of any redemption, prepayment or acceleration premium. 3. nonpayment of principal or interest caused by the insolvency or negligence of any Trustee, Paying Agent or Bond Registrar, if any. If it becomes necessary to call upon the Policy, payment of principal requires surrender of Bonds to the Insurance Trustee together with an appropriate instrument of assignment so as to permit ownership of such Bonds to be registered in the name of the Bond Insurer to the extent of the payment under the Policy. Payment of interest pursuant to the Policy requires proof of Bondowner entitlement to interest payments and an appropriate assignment of the Bondowner's right to payment to the Bond Insurer. Upon payment of the insurance benefits, the Bond Insurer will become the owner of the Bond, appurtenant coupon, if any, or right to payment of principal or interest on such Bond and will be fully subrogated to the surrendering Bondowner's rights to payment. In the event that the Bond Insurer were to become insolvent, any claims arising under the Policy would be excluded from coverage by the California Insurance Guaranty Association, established pursuant to the laws of the State of California. Ambac Assurance Corporation. The Bond Insurer is a Wisconsin-domiciled stock insurance corporation regulated by the Office of the Commissioner of Insurance of the State of Wisconsin and licensed to do business in 50 states, the District of Columbia, the Territory of Guam and the Commonwealth of Puerto Rico, with admitted assets of approximately $5,802,000,000 (unaudited) and statutory capital of approximately $3,564,000,000 (unaudited) as of September 30, 2002. Statutory capital consists of the Bond Insurer's policyholders' surplus and statutory contingency reserve. Standard & Poor's Credit Markets Services, a Division of The McGraw-Hill Companies, Moody's Investors Service and Fitch, Inc. have each assigned a triple-A financial strength rating to the Bond Insurer. 21 The Bond Insurer has obtained a ruling from the Internal Revenue Service to the effect that the insuring of an obligation by the Bond Insurer will not affect the treatment for federal income tax purposes of interest on such obligation and that insurance proceeds representing maturing interest paid by the Bond Insurer under policy provisions substantially identical to those contained in its financial guaranty insurance policy shall be treated for federal income tax purposes in the same manner as if such payments were made by the Authority. The Bond Insurer makes no representation regarding the Bonds or the advisability of investing in the Bonds and makes no representation regarding, nor has it participated in the preparation of, the Official Statement other than the information supplied by the Bond Insurer and presented under the heading "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Financial Guaranty Insurance Policy" and in Appendix H--"SPECIMEN FINANCIAL GUARANTY INSURANCE POLICY." Available Information. The parent company of the Bond Insurer, Ambac Financial Group, Inc. (the "Parent Company"), is subject to the informational requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and in accordance therewith files reports, proxy statements and other information with the Securities and Exchange Commission (the "SEC"). These reports, proxy statements and other information can be read and copied at the SEC's public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. The SEC maintains an internet site at http://www.sec.gov that contains reports, proxy and information statements and other information regarding companies that file electronically with the SEC, including the Parent Company. These reports, proxy statements and other information can also be read at the offices of the New York Stock Exchange, Inc. (the "NYSE"), 20 Broad Street, New York, New York 10005. Copies of the Bond Insurer's financial statements prepared in accordance with statutory accounting standards are available from the Bond Insurer. The address of the Bond Insurer's administrative offices and its telephone number are One State Street Plaza, 19th Floor, New York, New York 10004 and (212) 668-0340. Incorporation of Certain Documents by Reference. The following documents filed by the Parent Company with the SEC (File No. 1-10777) are incorporated by reference in this Official Statement: 1) The Parent Company's Current Report on Form 8-K dated January 23, 2002 and filed on January 25, 2002; 2) The Parent Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001 and filed on March 26, 2002; 3) The Parent Company's Current Report on Form 8-K dated April 17, 2002 and filed on April 18, 2002; 4) The Parent Company's Quarterly Report on Form 10-Q for the fiscal quarterly period ended March 31, 2002 and filed on May 13, 2002; 5) The Parent Company's Current Report on Form 8-K dated July 17, 2002 and filed on July 19, 2002; 6) The Parent Company's Current Report on Form 8-K dated August 14, 2002 and filed on August 14, 2002; 22 7) The Parent Company's Quarterly Report on Form 10-Q for the fiscal quarterly period ended June 30,2002 and filed on August 14,2002; 8) The Parent Company's Current Report on Form 8-K dated October 16, 2002 and filed on October 17,2002; 9) The Parent Company's Quarterly Report on Form 10-Q for the fiscal quarterly period ended September 30,2002 and filed on November 14, 2002; and 10) The Parent Company's Current Report on Form 8-K dated November 18, 2002 and filed on November 20,2002. All documents subsequently filed by the Parent Company pursuant to the requirements of the Exchange Act after the date of this Official Statement will be available for inspection in the same manner as described in "--Available Information" above. INSURANCE AND INDEMNITY AGREEMENT AND INSURANCE AGREEMENT GUARANTY The Bond Insurer, the Water District and the Company will enter into an Insurance and Indemnity Agreement, to be dated as of the date of delivery of the Bonds (the "Insurance Agreement"), initially among the Bond Insurer, the Water District and the Company (and after the assignment of the Service Contract by the Company to the SPE, among the Bond Insurer, the Water District and the SPE), pursuant to which the Water District and the DB/Operator (subject to the applicable Liability Caps described below) will have separate obligations to reimburse the Bond Insurer for certain payments of principal and interest on the outstanding Bonds made by the Bond Insurer under the Policy and certain expenses that the Bond Insurer incurs. DB/Operator Payment and Reimbursement Obligations. In the Insurance Agreement, the DB/Operator (subject to the Liability Caps described below) will agree to reimburse the Bond Insurer for certain expenses in connection with (i) the enforcement, defense or preservation of any of the rights of the Bond Insurer, the Bondowners or the Trustee under certain agreements, (ii) the cure of an event of default caused by DB/Operator under the Service Contract and (iii) any amendment, waiver or other action requested by the DB/Operator with respect to, or related to, certain agreements. The Insurance Agreement will provide that, if the Service Contract is terminated as a result of a Termination Event, the DB/Operator (subject to the Liability Caps set forth below) will reimburse the Bond Insurer for certain payments of principal or interest on the outstanding Bonds made by the Bond Insurer under the Policy to the extent that Lease Payments are not available to fund such payments as a result of a Termination Event. Water District Payment and Reimbursement Obligations. In the Insurance Agreement, the Water District will agree to reimburse the Bond Insurer for certain expenses in connection with (i) the enforcement, defense or preservation of any rights under certain agreements, or (ii) any amendment, waiver or other action requested by the Water District with respect to, or related to, certain agreements. Unless a Termination Event will have occurred, the Insurance Agreement will require the Water District to reimburse the Bond Insurer for any payment of principal or interest on the outstanding Bonds made by the Bond Insurer under the Policy which relates to a payment obligation on the Bonds occurring prior to a Termination Event. Upon and after a Termination Event, the Water District will have no further obligation to make, and no liability to reimburse the Bond Insurer for the amount of, any Lease Payments (except those that were accrued prior to such Termination Event), and the Bond Insurer will have no recourse to the Water District therefor. After a merger of the Water District into the City, the City's 23 financial obligations under the Insurance Agreement (as successor to the Water District) will be limited to the amounts from time to time on deposit in the Revenue Fund which will become the City's "Water Enterprise Fund," and the Bond Insurer will have no recourse to the City (as successor to the Water District) for amounts in excess thereof. Assignment of Company Rights and Obligations. In the Insurance Agreement, the Company will agree for the benefit of the Bond Insurer that within six months after the date the Bonds are issued, the Company will assign all of its rights in and to, and delegate all of its obligations under, the Service Contract and the Insurance Agreement to the SPE, a wholly owned subsidiary of the Company that satisfies certain corporate separation requirements set forth in the Insurance Agreement, and will cause the SPE to assume all of the obligations of the Company under the Service Contract and the Insurance Agreement; provided that the Insurance Agreement Guaranty and the Service Contract Guaranty Agreement will extend to such obligations of the SPE following such assignment. Upon the effectiveness of such assignment, the Company will be released from all of its obligations under the Service Contract and the Insurance Agreement. In the Insurance Agreement, if such assignment has not occurred (and certain related requirements have not been met) within six months after the date the Bonds are issued, then the Company will pay to the Water District certain liquidated damages for each month after the six-month anniversary of the date the Bonds are issued that such assignment has not occurred. In the Insurance Agreement, the Bond Insurer will be granted (subject to the terms and conditions of the Service Contract) the right: (i) to cure certain events of default caused by the DB/Operator under the Service Contract (as further described in "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease--Bond Insurer Notice and Cure Provisions") and (ii) to assign the DB/Operator's rights and obligations under the Service Contract to a replacement operator (as further described in "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease--Bond Insurer Notice and Cure Provisions--Assignment"). The Water District will agree in the Insurance Agreement to fully cooperate with the Bond Insurer in all reasonable respects to assist the Bond Insurer in identifying and engaging a replacement operator under the Service Contract. Insurance Agreement Guaranty. As security for the performance of DB/Operator's obligations under the Insurance Agreement, the Company will cause the Guarantor to enter into a Guaranty Agreement, to be dated as of the date of delivery of the Bonds (the "Insurance Agreement Guaranty"), between the Guarantor and the Bond Insurer. Pursuant to the Insurance Agreement Guaranty, the Guarantor, subject to the applicable Liability Caps described below, will during the term of the Insurance Agreement Guaranty guarantee to the Bond Insurer (i) the payment when due of the payments required to be made by the DB/Operator under the Insurance Agreement to, or for the account of, the Bond Insurer, and (ii) the performance of the DB/Operator pursuant to the terms of the Insurance Agreement (the "DB/Operator Obligations"). The Insurance Agreement Guaranty will terminate upon the earlier to occur of the following: (a) all of the DB/Operator Obligations have been fully paid and performed; or (b) the voluntary or involuntary insolvency, bankruptcy or reorganization of the Guarantor, or other similar proceedings against the Guarantor. Other Covenants and Security for the Bond Insurer. As further security for the performance of DB/Operator's obligations under the Insurance Agreement, the Company will grant to the Bond Insurer a security interest in the interest of the DB/Operator in the Service Contract and certain contracts entered into in connection therewith. Pursuant to the Lease Agreement and the Insurance Agreement, the Authority and the City will agree that upon the occurrence of a termination of the Lease Agreement as a result of a Termination Event, the Water District will not have the right to construct, operate or otherwise use (except for maintenance by the Water District, the Authority or the City) the Project for the Lock-out Period, except 24 with the prior written approval of the Bond Insurer. In addition, the Water District will agree that, to the extent permitted by law, it will not develop or construct Alternative Facilities during any cure period following an event of default under the Service Contract or during any Lock-out Period, if applicable, without the prior written consent of the Bond Insurer. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease." The Insurance Agreement will provide that, in connection with certain events of default under the Service Contract, the Bond Insurer rather than the DB/Operator will have control during certain cure periods, as follows. Prior to Acceptance under the Service Contract, if an event of default occurs under the Service Contract due to a failure to achieve Provisional Acceptance by the Scheduled Acceptance Date, then the DB/Operator will have the first 274 days of the 547-day Extension Period allowed for the remedy thereof and the Bond Insurer, with the cooperation of the District, will have the remaining 273 days for the remedy thereof (unless during the first 274 days of such 547-day Extension Period there shall also have occurred a voluntary or involuntary bankruptcy of the Guarantor, the Company or the SPE, in which case the DB/Operator shall instead have only the first 122 days of such 547-day Extension Period, or such greater number of days out of the first 274 days as shall have already passed at the time the bankruptcy occurs, and the Bond Insurer, with the cooperation of the District, shall have the remaining days). In addition, after the Acceptance under the Service Contract, if an event of default under the Service Contract occurs and is continuing for which there is a cure period and at the same time a voluntary or involuntary bankruptcy of the Guarantor, the Company or the SPE has occurred and is continuing, the Bond Insurer will grant the DB/Operator 30 days to make a proposal to remedy such default, which the Bond Insurer may accept or reject in its discretion, but the Bond Insurer shall nevertheless have the ability to pursue all of its cure rights under the Service Contract during the applicable cure period. Absent the occurrence and continuation of a voluntary or involuntary bankruptcy of the Guarantor, the Company or the SPE, the cure rights shall be as otherwise provided in the Service Contract. For information regarding the Scheduled Acceptance Date, Provisional Acceptance and the Extension Period, see Appendix D "SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT." In addition, the Insurance Agreement will provide that prior to the time the SPE becomes the DB/Operator, all cure periods under the Service Contract will be tolled in the event of a voluntary or involuntary insolvency, bankruptcy or reorganization of the Company or any of its affiliates (or other similar proceedings against the Company or any of its affiliates) pursuant to which there is a stay affecting the rights of the Water District, the Trustee or the Bond Insurer under any of the Insurance Agreement, the Insurance Agreement Guaranty, the Service Contract Letter of Credit, the construction performance bond required under the Service Contract, the Policy, the Property Lease, the Lease Agreement, the Service Contract, the Bonds, the Trust Agreement or the Service Contract Guaranty Agreement, until such time as one of the following has occurred: (a) the stay has been lifted; or (b) the SPE has become the DB/Operator. Liability Caps. The Insurance Agreement and the Insurance Agreement Guaranty will provide that the maximum aggregate personal liability of the DB/Operator, the Guarantor, and their respective affiliates, collectively, to the Bond Insurer relating to any event occurring prior to the Acceptance Date (as defined in the Service Contract) under the Insurance Agreement, the Insurance Agreement Guaranty, certain other agreements or otherwise in connection with the foregoing or the Project (the "Construction Period Liability Cap"), will not exceed an amount equal to: (i) $6,000,000, less (ii) the amount then available to be drawn under the Service Contract Letter of Credit (see "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Service Contract Letter of Credit"), and less (iii) all amounts drawn under the Service Contract Letter of Credit. 25 The Insurance Agreement and the Insurance Agreement Guaranty will further provide that the maximum aggregate personal liability of the DB/Operator, the Guarantor and their respective affiliates, collectively, to the Bond Insurer relating to any event occurring on or after the Acceptance Date (as defined in the Service Contract) under the Insurance Agreement, the Insurance Agreement Guaranty, certain other agreements or otherwise in connection with the foregoing or the Project (the "Operation Period Liability Cap" and together with the Construction Period Liability Cap, each a "Liability Cap"), will not exceed an amount equal to: (i) $4,000,000, plus (ii) an amount equal to the reasonable actual costs incurred by, or on behalf of, the Bond Insurer following an event of default by the DB/Operator under the Service Contract to replace the portion of the Service Contract Project Improvements comprising the reverse osmosis unit (as more specifically defined in the Insurance Agreement). Trustee and Bondowners Not Entitled to Benefit. The DB/Operator's obligations under the Insurance Agreement will be solely for the benefit of the Bond Insurer (and, to a limited extent, the Water District), and the Water District's obligations under the Insurance Agreement will be solely for the benefit of the Bond Insurer. Similarly, the Guarantor's obligations under the Insurance Agreement Guaranty will be solely for the benefit of the Bond Insurer. Neither the Trustee nor the Bondowners will have any interest in or rights under or rights to enforce the Insurance Agreement or the Insurance Agreement Guaranty. THE PROJECT OVERVIEW The Project consists of the design, development, acquisition and construction of the Groundwater Recovery Plant and related offsite improvements and facilities. The Groundwater Recovery Plant is expected to consist primarily of two reverse osmosis treatment trains within an enclosed building; three iron/manganese filters, two desanders, and two cartridge filters; bulk chemical storage tanks within a semi-enclosed building; an approximately 85,000-gallon bolted steel tank for iron/manganese filter backwash water supply; two degasifiers; an approximately 30,000-gallon clearwell tank, a finished water pumping station and an approximately 225,000-gallon bolted steel tank for spent backwash water recovery. For a site plan diagram, see Section III of the Independent Engineer's Report entitled "PROJECT SITE" attached hereto as Appendix G. The related offsite improvements and facilities are anticipated to include eight, or possibly nine, well sites, a pipeline to collect well water and convey it to the Groundwater Recovery Plant, a booster pumping station and a pipeline to convey the treated water from the Groundwater Recovery Plant to the Water System, and a pipeline to convey the reverse osmosis concentrate discharge from the Groundwater Recovery Plant to an ocean outfall. For well collection system schematics and a treated water and disposal pipeline schematic, see Section III of the Independent Engineer's Report entitled "PROJECT SITE" attached hereto as Appendix G. The Groundwater Recovery Plant will be located on property adjacent to Descanso Veterans Park on Paseo Adelanto in San Juan Capistrano, California. In addition, the eight, or possible nine, well sites, the pipeline and the booster pumping station will be constructed at various locations within the boundaries of the City. The purpose of the Project is to extract brackish groundwater, which in its natural state is unsuitable to use as drinking water due to high concentrations of solids and other impurities, from multiple well sites, to treat that groundwater, to blend the finished water to be compatible with the other water sources available to the Water District and to pump the finished water into the Water System. The treatment of the brackish groundwater will consist of three processes: (i) pretreatment to remove sand, iron, and manganese from the well water flowing into the Groundwater Recovery Plant; (ii) desalting the pretreated water using reverse osmosis to reduce total dissolved solids; and (iii) post-treatment to meet drinking water quality regulations including control of the product water corrosiveness. Reverse osmosis is a high-pressure process, developed over thirty years ago, that forces water through a thin membrane to filter out minerals and contaminates, including salts and other materials. For a process flow diagram, see 26 Section II of the Independent Engineer's Report entitled "PROCESS TECHNOLOGY" attached hereto as Appendix G. In an effort to increase system reliability to its customers, the Water District has identified two goals: (i) securing fifty-percent of its annual water supply from local groundwater sources; and (ii) maintaining emergency storage sufficient to supply five average days of water demand in the event of an emergency. With respect to the Water District's source of annual water supply, the Water District currently imports approximately 85% to 90% of its water from MWD. See "THE WATER DISTRICT--Sources of Water Supply." Although the delivery of water to Southern California has been reliable in the past, approximately sixteen million Southern Californians rely on MWD for water, and MWD faces the potential for decreased deliveries from both its imported water sources, the Colorado River and the State Water Project. Furthermore, to meet the Water District's ultimate demand in absence of the Project, the Water District has projected that it would need to acquire additional water import capacity rights and construct or expand pipelines to manage such additional import water capacity. With respect to emergency storage, it is estimated that the Water District will be able to provide over 60% of average daily water demand between the Water District's existing wells and the Project compared to its current ability to only provide approximately 11% of average daily water demand from the Water District's existing wells. Once constructed and fully operational, it is anticipated that the Project will supply approximately one-half of the Water District's annual water supply requirements and, therefore, assist the Water District in meeting its goal of securing fifty-percent of its annual water supply from local groundwater sources. In addition, based on current projections, the development of local groundwater sources in connection with the operation of the Groundwater Recovery Plant is anticipated to significantly reduce or eliminate the need for the Water District to acquire additional import capacity and the related costs of infrastructure improvements necessary to manage such additional import water capacity as well as to significantly reduce the need for additional emergency storage. The Water District also anticipates, based upon current information, that the costs associated with the financing of the Project and the operations of such improvements will be offset by certain grant credits or payments from MWD and increased water rates. See "--Agreement with Metropolitan Water District of Southern California" below. For a comparison of alternate wholesale water rates, see Section 8.3 of the Independent Engineer's Report entitled "--Project Cost Projections" attached hereto as Appendix G. See also the information included in Table No. 9 below and under the caption "THE WATER DISTRICT--Rates and Charges; Collection" for projected costs of the Service Contract Project Improvements and projected increases in water rates. Other benefits the development of the Project are projected to provide the Water District include a reduction of the Water District's dependence on imported water in the event of the reduction of imported water during a drought, enhanced system reliability in the event of a loss of imported water due to transmission main outages, and reduced exposure to MWD's rising cost of water. Accordingly, the Water District has determined that the Water District's objectives justify the Project even though the costs associated with the financing of the Project and the operations of such improvements may not be fully offset solely by the credits or payments from MWD. As with any major construction effort, construction of the Service Contract Project Improvements will involve many risks, including shortages of materials and labor, work stoppages, labor relations disputes, weather interference, engineering, environmental, permitting or geological problems and unanticipated cost increases for reasons beyond the control of the contractors, the occurrence of which could give rise to delays, cost overruns or performance deficiencies, or otherwise adversely affect the design, construction or operation of the Service Contract Project Improvements. See Appendix G-- "INDEPENDENT ENGINEER'S REPORT" for the Independent Engineer's Report evaluating the Project and the capability of the Project participants to successfully complete the design, construction and operation of the Project. For information regarding the right of the Water District to terminate the Lease Agreement in the event it exercises its right to terminate the Service Contract in the event the 27 DB/Operator defaults under the Service Contract, see "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Water District Right to Terminate Lease." AGREEMENT WITH METROPOLITAN WATER DISTRICT OF SOUTHERN CALIFORNIA In connection with the development of the Groundwater Recovery Plant, the Water District has been assigned the rights to receive certain credits or payments from MWD pursuant to the 1998 San Juan Basin Desalter Project Agreement between MWD, the Municipal Water District of Orange County ("MWDOC") and the Authority, effective as of December 4, 1998, as amended and supplemented by that certain First Amendment thereto, dated as of October 15, 2002, by and among MWD, MWDOC, the Authority and the Water District (collectively, the "Metropolitan Agreement"). The Metropolitan Agreement provides that MWD will make a financial contribution to the Project in a dollar amount per acre-foot of recovered groundwater produced based on an established water right equal to the sum of the project unit cost and deferred cost as set forth in the Metropolitan Agreement minus MWD's prevailing full service treated water rate; provided, that the financial contribution is capped at $250 per acre-foot and is limited to up to 5,760 acre-feet in any one fiscal year. MWD's water supply and demand projections indicate that supplemental sources of water must be developed to meet future requirements, and MWD has determined to take necessary steps to provide economical, high quality water supplies in the years ahead. Accordingly, MWD, in accordance with its Groundwater Recovery Program, has decided to assist with the cost of treating the degraded groundwater in the area of the Project. It is anticipated that the Project will increase domestic and municipal production by producing approximately 4,800 acre-feet of finished water per year. See "THE PROJECT--Overview." This production rate is based upon eighty percent of the maximum capacity of the Groundwater Recovery Plant. Since the projected cost to produce each acre-foot of recovered groundwater at the Groundwater Recovery Plant is expected to exceed the projected cost of MWD's prevailing full service treated water rate, it is expected that the Water District will receive the full $250 MWD contribution per acre-foot of groundwater produced at the Groundwater Recovery Plant under the Metropolitan Agreement. See "--Independent Engineer's Report" below and Section X of the Independent Engineer's Report entitled "CONCLUSIONS," attached hereto as Appendix G, for the Independent Engineer's conclusions with respect to the MWD contribution. The Metropolitan Agreement provides that the financial contribution will continue for twenty years from the date of the initial production of recovered groundwater. However, the Metropolitan Agreement will automatically terminate if (i) payments are not required to be made by MWD for a five consecutive-year period subsequent to the initiation of operations at the Groundwater Recovery Plant, (ii) construction of the Groundwater Recovery Plant has not commenced by December 4, 2002, (iii) no recovered groundwater is produced by December 4, 2004, or (iv) in the event of a material breach by any party to the Metropolitan Agreement other than MWD. Accordingly, if the Groundwater Recovery Plant does not produce finished water for a five consecutive-year period subsequent to the initiation of operations and, as a result, MWD is not obligated to make any contributions under the Metropolitan Agreement for such period, the Metropolitan Agreement will terminate. Construction of the Groundwater Recovery Plant commenced on November 25, 2002. For information regarding the obligation of the DB/Operator to pay liquidated damages in connection with certain terminations of the Metropolitan Agreement or certain losses of credits or payments from MWD under the Metropolitan Agreement, see "--Liquidated Damages under the Service Contract--Liquidated Damages with respect to the Metropolitan Agreement" below. For the Independent Engineer's conclusions regarding the reasonableness of the construction schedule to complete the Project within the parameters of the Metropolitan Agreement, see "--Independent Engineer's Report" below and Section IV of the Independent Engineer's Report entitled "ENGINEERING, PROCUREMENT AND CONSTRUCTION" attached hereto as Appendix G. 28 PROJECT WATER RIGHTS AND IMPLEMENTATION AGREEMENT Under the Service Contract, the DB/Operator is required to design, engineer, construct, operate and maintain the Service Contract Project Improvements to be capable of processing 5.14 million gallons of groundwater per day and the Water District has the right to demand the production and delivery of up to 5,231 acre-feet of treated water on an annual basis, subject to the Water District supplying sufficient groundwater to enable the DB/Operator to produce such amount of treated water within the parameters of the DB/Operator's performance guarantees under the Service Contract. Pursuant to the Implementation Agreement, the Authority has allocated 5,800 acre-feet per year of the Authority's existing rights to groundwater from the San Juan Creek, which is located within the San Juan Basin, to the Project. (For a discussion of the San Juan Basin, see Section 3.3.3 of the Independent Engineer's Report entitled "--Groundwater Basins" attached hereto as Appendix G.) It is expected that the Water District will demand approximately 4,800 acre-feet of treated water be produced on an annual basis pursuant to the Service Contract and the allocation of 5,800 acre-feet of groundwater per year under the Implementation Agreement is expected to be sufficient to enable the DB/Operator to produce the 4,800 acre-feet of treated water on an annual basis. However, the allocation of 5,800 acre-feet of groundwater under the Implementation Agreement probably will not be sufficient to produce the full 5,231 acre-feet of treated water provided for under the Service Contact. Accordingly, to the extent the Water District demands additional treated water, it may be necessary for the Water District to allocate a portion of its existing groundwater rights to the Project. See "THE WATER DISTRICT--Sources of Water Supply." Similarly, to the extent the DB/Operator desires to provide surplus water in order to mitigate any treated water delivery shortfalls (see Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Performance--Water Delivery Guarantee") and the 5,800 acre-feet of groundwater per year allocated under the Implementation Agreement is insufficient, it would also be necessary for the Water District to so allocate such other water rights to the Project. LIQUIDATED DAMAGES UNDER THE SERVICE CONTRACT Under certain circumstances the DB/Operator is obligated to pay certain non-performance liquidated damages to the Water District pursuant to the Service Contract. Certain of these non-performance liquidated damages are described below. Liquidated Damages Relating to the Metropolitan Agreement. Under the Metropolitan Agreement, MWD has agreed to make a financial contribution to the Project, subject to certain terms and conditions. See "--Agreement with Metropolitan Water District of Southern California" above. Under certain circumstances the DB/Operator is obligated to pay liquidated damages to the Water District with respect to the Metropolitan Agreement pursuant to the Service Contract. The Service Contract provides that in the event (i) the Metropolitan Agreement terminates because no recovered groundwater is produced at the Groundwater Recovery Plant by December 4, 2004, or the financial contribution payments are not required to be made by MWD under the Metropolitan Agreement for a five consecutive-year period subsequent to the initiation of operations at the Groundwater Recovery Plant, and (ii) such termination is the result of a failure to commence construction on or before December 4,2002, or a failure to produce recovered groundwater that, in either case, is not caused by the occurrence of an Uncontrollable Circumstance, Water District requested changes or District Fault under the Service Contract, the DB/Operator is required to pay the Water District for each Fiscal Year during the term of the Service Contract, as liquidated damages for such failure, an amount, calculated in accordance with the Service Contract, intended to equal the lost credits or payments from MWD under the Metropolitan Agreement. For information regarding the credits or payments from MWD under the Metropolitan Agreement, see "--Agreement with Metropolitan Water District of Southern California" above. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Provisional Acceptance, Acceptance and Final Completion of the Project--Effect of Unexcused Delay -Metropolitan Agreement." 29 Furthermore, except with respect to certain delays in achieving Acceptance of the Service Contract Project Improvements under the Service Contract, the DB/Operator has agreed under the Service Contract to perform all of the Water District's obligations under the Metropolitan Agreement. In the event the Metropolitan Agreement is terminated due to a failure of the DB/Operator to comply with such obligations, and such failure is not caused by an Uncontrollable Circumstance, Water District-directed Change Order or District Fault, the DB/Operator has agreed in the Service Contract to pay the Water District liquidated damages in the amounts described above for each remaining Contract Year or portion thereof during the term of the Service Contract. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Operation and Management--Compliance with Metropolitan Agreement." Daily Delay Liquidated Damages. In addition, the Service Contract provides that, in the event that Provisional Acceptance of the Service Contract Project Improvements under the Service Contract (or, if Provisional Acceptance is not certified by the DB/Operator, Acceptance) occurs subsequent to December 4, 2004, or a later date if the DB/Operator's design and construction work is delayed as a result of an Uncontrollable Circumstance, Water District requested changes or District Fault, the DB/Operator will pay to the Water District daily delay liquidated damages for each day that the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the DB/Operator, the Acceptance Date) falls after December 4, 2004, in an amount equal to the Lease Payments (including payments with respect to both interest and principal) accrued by the Water District on a daily basis, up to the end of the Extension Period and thereafter until any termination of the Service Contract for an event of default by the DB/Operator under the Service Contract. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT--Provisional Acceptance, Acceptance and Final Completion of the Project--Daily Liquidated Damages." The Service Contract provides that such damages will be payable on the first day of each month and, upon any such termination, on the date of termination, and will be secured by the Service Contract Letter of Credit. THE SERVICE CONTRACT LETTER OF CREDIT WILL BE ISSUED TO THE WATER DISTRICT. HOWEVER, UNDER THE TRUST AGREEMENT, THE WATER DISTRICT WILL COVENANT TO TRANSFER TO THE TRUSTEE, FOR DEPOSIT INTO THE DEBT SERVICE PAYMENT ACCOUNT ESTABLISHED UNDER THE TRUST AGREEMENT, NO LATER THAN THREE BUSINESS DAYS FOLLOWING RECEIPT THEREOF BY THE WATER DISTRICT, ALL PROCEEDS OF ANY DRAWING ON THE SERVICE CONTRACT LETTER OF CREDIT RECEIVED BY THE WATER DISTRICT. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Service Contract Letter of Credit." Delivery Shortfall Liquidated Damages. Under certain circumstances described below the DB/Operator is obligated to pay liquidated damages to the Water District with respect to finished water delivery shortfalls pursuant to the Service Contract. The Service Contract provides that if, in any Contract Year, (i) the cumulative amount of any finished water delivery shortfalls under the Water Delivery Guarantee (defined below) exceeds (ii) the cumulative amount of any permissible surplus finished water deliveries pursuant to the Service Contract, the DB/Operator is obligated to pay liquidated damages to the Water District, for each acre foot of such finished water delivery shortfalls. The amount of such liquidated damages is equal to the sum of (x) MWD's prevailing full service treated water rate (expressed in dollars per acre foot) plus, (y) MWD's financial contribution under the Metropolitan Agreement with respect to such Contract Year (expressed in dollars per acre foot), plus (z) the administrative and operation and maintenance charge (expressed in dollars per acre foot) imposed by MWDOC on the Water District with respect to such Contract Year (exclusive of any elements thereof which are attributable to services provided by MWDOC which are substantially different in scope or quantity than the services historically provided by MWDOC to the Water District prior to the Contract Date); provided, however, that the amount described in item (y) above will not be payable if the Metropolitan Agreement has been terminated as the result of a failure to timely commence construction or a failure to timely produce recovered groundwater that is caused by the occurrence of an Uncontrollable Circumstance, Water District requested changes or District Fault under the Service Contract as described 30 under the heading entitled "--Liquidated Damages Relating to the Metropolitan Agreement" above and the DB/Operator has paid liquidated damages as a result thereof. In order to give the DB/Operator an opportunity to mitigate any daily delivery shortfalls occurring in a Contract Year, the Service Contract provides that the DB/Operator may, during the months of April through November, deliver finished water to the Water District on any day in a volume up to 5% more (or up to 9% more, subject to Water District approval) than the Firm Daily Water Demand Volume (defined below) established by the Water District with respect to such day, but subject to a maximum overall limit of 5,231 acre feet per Contract Year. Moreover, the DB/Operator has the right under the Service Contract to apply surplus water deliveries achieved in the first 60 days of any Contract Year against finished water delivery shortfalls occurring in the last 60 days of the preceding Contract Year, so as to reduce any liquidated damages that may be payable as described above. The DB/Operator is not permitted to deliver finished water in excess of the Firm Daily Water Demand Volume during the months of December, January, February and March and is not be entitled to any additional compensation for any such surplus daily deliveries under the Service Contract. See "--Project Water Rights and Implementation Agreement" for information regarding the allocation of groundwater rights to the Project. The term "Water Delivery Guarantee" is defined in the Service Contract to mean the requirement that, except to the extent excused by Uncontrollable Circumstances or District Fault and with respect to certain adjustments permitted under the Service Contract, including adjustments for scheduled and unscheduled maintenance, repair and replacement, the DB/Operator operate the Project so as to deliver finished water to the Water District each day during the operation period in volumes at least equal to the Firm Daily Water Demand Volume established under the Service Contract with respect to such day. The term "Firm Daily Water Demand Volume" is defined in the Service Contract to mean the volume of finished water demanded by the Water District based on the flow rates specified in the "day-before" firm finished water demand schedules furnished by the Water District as adjusted by any "day-of" modifications thereto made by the Water District pursuant to the Service Contract. Other Performance Guarantees. The DB/Operator has made certain other guarantees under the Service Contract with respect to the Project, including guarantees with respect to the quality of the finished water and the production efficiency of the Service Contract Project Improvements, and has agreed to certain non-performance penalties with respect to such other guarantees. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT-- Performance." THE COMPANY The Company, ECO Resources, Inc., a Texas corporation, is headquartered in the Houston suburb of Sugar Land, Texas and is led by president and chief executive officer, Peter J. Moerbeek. The Company manages, operates and maintains utility systems offering water production, water distribution, sewage treatment, wastewater collection, and storm water collection along with other services. The Company, established in 1973, has provided a full range of services to the water industry since its inception, and currently provides such services to more than 200 cities, municipal utility districts and large companies throughout the southern and western United States. For an evaluation of the capability of the Company to successfully complete the design, construction and operation of the Project, see Appendix G--"INDEPENDENT ENGINEER'S REPORT." In the Insurance Agreement, the Company will agree for the benefit of the Bond Insurer that within six months after the date the Bonds are issued, the Company will assign all of its rights in and to, and delegate all of its obligations under, the Service Contract and the Insurance Agreement to the SPE, a wholly owned subsidiary of the Company that satisfies certain corporate separation requirements set 31 forth in the Insurance Agreement, and will cause the SPE to assume all of the obligations of the Company under the Service Contract and the Insurance Agreement; provided that the Insurance Agreement Guaranty and the Service Contract Guaranty Agreement will extend to such obligations of the SPE following such assignment. Upon the effectiveness of such assignment, the Company will be released from all of its obligations under the Service Contract and the Insurance Agreement. The Company will, simultaneously with the assignment to the SPE, enter into a management and administrative services agreement with the SPE for a term equal to the term of the Service Contract, whereby the Company will provide certain management and administrative services necessary to support the SPE's performance of its obligations under the Service Contract, including the construction and operation of the Service Contract Project Improvements. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Insurance and Indemnity Agreement and Insurance Agreement Guaranty--Assignment of Company Rights and Obligations." The Guarantor, Southwest Water Company, is a Delaware corporation and the corporate parent of the Company. The Guarantor was founded in West Covina, California in 1954. The Guarantor's experience in building, owning, and operating water utility systems is broad and includes five substantial water utility systems; two in California, one in New Mexico and two in Texas. Southwest Water Company, through its subsidiaries, the Company and Suburban Water Systems, has financed, built and operated over $100 million of water/wastewater systems throughout the southwestern United States. For more information regarding the Guarantor, see Appendix G--"INDEPENDENT ENGINEER'S REPORT." INDEPENDENT ENGINEER'S REPORT PSOMAS (the "Independent Engineer") has prepared an updated report dated December 6, 2002, attached hereto as Appendix G (the "Independent Engineer's Report"). The Independent Engineer's Report should be read in its entirety for an understanding of the Independent Engineer's conclusions concerning the Project. Based upon the analysis and the conclusions presented in the Independent Engineer's Report, the Independent Engineer is of the following opinions: 1. All of the Project Participants (as defined in the Independent Engineer's Report) have the relevant experience and financial capability to successfully complete the design, construction and operation of the Project within the parameters of the Service Contract. 2. The brackish water treatment process proposed for the Project will produce the quality and quantity of water required by the Service Contract. 3. The site on which the Groundwater Recovery Plant is to be located is adequate in size and location and from an infrastructure and geotechnical perspective is adequate for construction and operation of the Groundwater Recovery Plant. The sites for the wells do not meet the new requirements that the California Department of Health Services is enforcing, but these new requirements should not significantly increase the capital and operating costs of the Project. 4. There is sufficient unappropriated water within the San Juan Basin to provide an adequate source of feed water for the Project for the Operation Period of the Service Contract and beyond for the full term of the Bonds. 5. The environmental site assessments have been accomplished in a manner consistent with industry standards, using appropriate industry protocols. The adopted Mitigated Negative 32 Declaration for the Project does not impose any conditions which are not common to normal construction activities and should not cause any significant delay or increased cost to the Project. 6. Based upon the Service Contract parameters, the preliminary design, and the proposed equipment list, the Project will operate and provide water which meets federal, state and local drinking water standards ("Finished Water") within the Service Contract parameters for the Operation Period of the Service Contract and beyond for the full term of the Bonds. 7. The construction of the Project is similar to other projects constructed by ARB, Inc. (the general contractor for the Project) and the construction of the Project can be accomplished within the scope of the Service Contract, by the Scheduled Acceptance Date and within the Fixed Design/Build Price included in the Service Contract. 8. The Acceptance Test is sufficient to predict that the Project will perform reliably for the Operation Period of the Service Contract and beyond for the full term of the Bonds. This opinion is based upon the assumption that the required preventative and scheduled maintenance is performed in accordance with industry standards. 9. The operation and maintenance requirements of the Project under the Service Contract are adequate for the full term of the Bonds. The operating costs included in the Service Contract are reasonable, and the variable replacement cost for membranes will not have a significant cost impact to the annual operating costs. The only other variables are labor and chemicals and experience indicates that any variation in these costs should be minor. 10. All of the required permits and easements to begin construction were obtained prior to the commencement of construction, which occurred on November 25, 2002. The remainder of the permits and easements to complete construction will be acquired on a sequential basis prior to the construction of the various components of the Project. These outstanding permits and easements are identified and expected to be obtained in time to prevent any delay to construction of the Project. The operating permits required to comply with the Finished Water date of December 4, 2004, under the Metropolitan Agreement are identified and scheduled to be obtained in sufficient time to support the completion of the Project. Based upon a review of the preliminary construction schedule for the Project, there is sufficient time to obtain these permits prior to the December 4, 2004 MWD Finished Water date. 11. The safety plan is adequate and is in compliance with industry requirements and the California Occupational Safety and Health Act. 12. The security plan is adequate and is in compliance with all regulatory agencies on the local and state level. 13. Based upon a review of the Project Agreements (as defined in the Independent Engineer's Report), the terms of the Project Agreements will allow the DB/Operator to meet its obligations under the Service Contract. 14. The preliminary construction schedule is reasonable and includes sufficient contingency in the activity durations in order to complete the Project within the parameters of the Metropolitan Agreement and the Service Contract. 33 15. The Project can be constructed for the Fixed Design/Build Price included in the Service Contract and the construction milestone payment schedule is reasonable. 16. The operations cost included in the Service Contract is sufficient to operate and maintain the Project for the Operation Period of the Service Contract. See Section IX of the Independent Engineer's Report entitled "ASSUMPTIONS AND CONSIDERATIONS USED" and Section X of the Independent Engineer's Report entitled "CONCLUSIONS" attached hereto as Appendix G. No assurance can be given that the assumptions on which the foregoing opinions were based will prove correct or that actual results of any matters covered by the Independent Engineer's Report will not be materially different than the projections and opinions set forth above or otherwise contained in the Independent Engineer's Report. THE AUTHORITY The Authority is a public entity organized pursuant to a Joint Exercise of Powers Agreement Creating the San Juan Basin Authority, dated as of November 22, 1971, by and between the South Coast Water District ("SCWD"), the Moulton Niguel Water District ("MNWD"), the Water District and the Santa Margarita Water District ("SMWD"), as amended effective September 1, 1987 by Addendum No. 1 to the Joint Exercise of Powers Agreement and Addendum No. 3 dated as of September 1, 2002, pursuant to the provisions of the Joint Exercise of Powers Act contained in Chapter 5 of Division 7 of Title 1 (commencing with Section 6500) of the California Government Code. The Authority presently has no outstanding debt other than the Bonds, but does participate in activities relating to the funding of water system facilities and water conservation projects necessary to conserve and make water resources available to the areas within the San Juan Creek Watershed serviced by the members of the Authority and may incur debts, liabilities and other obligations unrelated to the Bonds. Since the Authority is engaged in operations and other transactions besides the issuance of the Bonds, should the Authority become the subject of a bankruptcy case, there could be adverse effects on the holders of the Bonds that could result in delays or reductions in payments to the holders of the Bonds. THE WATER DISTRICT INTRODUCTION The Water District, formerly known as the Orange County Waterworks District No. 4, is a water district formed in 1930 pursuant to the Water Code, Section 55000 et seq., to serve the San Juan Capistrano area. The Water District was originally governed by the Board of Supervisors of the County until 1970 when the Water District became a subsidiary water district of the City. On June 15, 1982, the Board of Supervisors adopted Resolution No. 82-6-15-2 changing the name of Water District to its current name. The Water District still operates under the provisions of the Water Code but is now governed by a Board of Directors comprised of the five-member City Council of the City (the "Board of Directors"). On July 1, 1997, the Water District entered into an operations and maintenance agreement (the "Operations and Maintenance Agreement") with the City wherein the City assumed the daily operational and maintenance management functions of the Water District. Subsequently, all Water District employees became full-time employees of the City. The Water District has the power under the Water Code to, among other things, provide water service within its boundaries. 34 GOVERNANCE AND MANAGEMENT The Water District is governed by a five-member Board of Directors. Pursuant to the Water Code, the City Council of the City (a five-member elected body) sits as the Board of Directors of the Water District. The members of the Board, their occupations, and the expiration date of their terms are as follows: Name and Office Expiration of Term Occupation - --------------- ------------------ -------------------------- Diane Bathgate November 2006 Urban Planner/Consultant Joe Soto November 2004 Environmental Consultant Wyatt Hart November 2006 Parole Board Member David Swerdlin November 2006 Consultant John S.Gelff November 2004 Strategic Planner/Educator Under the Operations and Maintenance Agreement, the Water District is operated by the City's Public Works Department. Management of the Water District is delegated to the City Manager and General Manager of the Water District, George Scarborough, the City Administrative Services Director, Cindy Russell, and other staff of the City. The background of the key management personnel are set forth below. George Scarborough, City Manager and General Manager of the Water District. Mr. Scarborough was employed by the City in 1988 as Assistant City Manager and appointed as City Manager in 1992. Mr. Scarborough is responsible for the day-to-day management of all functions of the Water District. Prior to working for the City, Mr. Scarborough was employed as City Manager of the City of Los Altos Hills and Greenfield, California. Mr. Scarborough is a member of the International City Manger's Association. Cindy Russell, City Administrative Services Director. Ms. Russell was employed by the City in 1986. Ms. Russell is responsible for planning, coordinating and administering the administrative, financial and business operations of the Water District under the general direction of the General Manager. Prior to working for the City, Ms. Russell worked for a public accounting firm providing municipal audits. Ms. Russell is a member of the California Society of Municipal Finance Officers, Government Finance Officers of the United States and Canada and the California Municipal Treasurer's Association. In addition, the Water District operations include approximately twenty-five other full-time positions, including 6 customer service positions and nineteen regular maintenance and operations positions. There are two union represented employees groups. The general classified employees are represented by the San Juan Capistrano Employees Association and their current contract expires on June 30,2004. Employees considered to be in middle management are represented by the San Juan Capistrano Management Employees Association and their current contract expires on June 30, 2003. Executives are not represented by a labor union. MERGER In 1996, the City filed a reorganization application with LAFCO for the purpose of formally merging the Water District with the City. As of the date of this Official Statement, LAFCO has finalized its review of the final condition of approval. The City anticipates that it will authorize LAFCO to file a Notice of Completion with the State of California in the month of January, 2003, after which the Water District will become officially merged with the City. After completion of the merger, the City will assume all rights and obligations of the Water District subject to the same limitations applicable to the 35 Water District. For general information regarding the City, see Appendix I--"GENERAL INFORMATION CONCERNING THE CITY OF SAN JUAN CAPISTRANO." SERVICE AREA; OVERVIEW OF WATER SYSTEM FACILITIES The Water District is located in Orange County, California, midway between Los Angeles and San Diego, approximately 1 mile east of Dana Point Harbor, and serves an area of approximately 18 square miles, the majority of which is within the incorporated boundaries of the City. For general information regarding the City, see Appendix I--"GENERAL INFORMATION CONCERNING THE CITY OF SAN JUAN CAPISTRANO." The remaining portion of the Water District, approximately 3% of the service area or 1,000 connections, falls within the neighboring city of Dana Point. The approximate boundaries of the Water District are the City of Dana Point to the south; the City of Mission Viejo to the north; the City of Laguna Niguel to the west; and Rancho Mission Viejo to the east. The Water District provides water service for residential, commercial, industrial, agricultural and municipal customers. During the 1970's and 1980's, the Water District underwent gradual residential development and is currently almost completely developed. The Water District currently serves a population of approximately 35,500, and expects its service area population to grow to approximately 41,725 (expected to be reached in 2020) and then stabilize. The total number of active accounts is 10,622. The majority of the service area consists of residential land use (42%) and open space (46%). Strip commercial development is typical along Camino Capistrano, Ortega Highway, the central downtown area and in isolated pockets along Rancho Viejo Road. This makes up about three percent of the Water District's total service area. Other land uses include agriculture (5%) and public/institutional (2%). Elevations within the Water District vary between 15 feet and 880 feet above mean sea level. Because of the uneven terrain, the three creeks that cross the service area, and scattered development, the existing water distribution system is very complex. The Water District currently serves seven distinct pressure zones defined by reservoirs, and 26 sub-pressure zones served through pressure regulating stations and hydropneumatic systems. The Water District's system consists of approximately 174 miles of pipeline, 11 reservoirs with an aggregate storage capacity equal to approximately 14.95 million gallons, 10 booster stations to lift water from lower pressure zones to higher pressure zones for distribution and storage and to pressurize hydropneumatic systems, and five sources of water supply. For information regarding the Water District's sources of water supply, see "--Sources of Water Supply" immediately below. SOURCES OF WATER SUPPLY Capacity Rights. The Water District utilized local groundwater as its sole source of supply until 1965 when imported water became available. Presently, the Water District primarily relies upon imported water purchased from MWD through MWDOC. Of the approximately 3.3 billion gallons of water the Water District delivered to its customers in Fiscal Year 2001-02, 90.8% was surface water purchased from MWD through MWDOC. The remaining water was supplied from local groundwater sources. The total capacity available through imported sources is currently 21.9 cubic feet per second ("cfs"). Of this, up to 15 cfs may be supplied through the Allen McCollugh Pipeline at the Eastern Transmission Main turnout, referred to as the Master Meter. This turnout is situated in the north central area of the Water District at Camino Capistrano, north of Avery Parkway. It is the main source of water to the service area. In addition, 4.9 cfs is available through a connection to the South County Pipeline through turnout SC-04, located in the eastern portion of the Water District, near Ortega Highway and Avenue La 36 Pata. The Water District leased these capacity rights pursuant to an interim license and lease of capacity agreement, entered into on October 22, 1992, with MWDOC. In Fiscal Year 1994-95, the Water District negotiated a lump sum payment of $456,126 with MWDOC to complete the purchase of such capacity rights. The capacity rights are being amortized over 60 years. Lastly, 2 cfs is available through a leased interconnection with MWDOC at Del Obispo Street. This connection is used to maintain pressures in the southern portion of the 250 pressure zone during high demand periods. The remaining water needs are currently supplied from wells that pump groundwater from the San Juan Basin. The Water District currently operates two domestic wells (Rosenbaum Well No. 1 and North Area Well) and two non-domestic wells (Mission Street and Hollywood Wells) with a total capacity of approximately 3.2 cfs. For information regarding additional groundwater rights allocated to the Project in connection with the development of the Project by the Water District, see "THE PROJECT--Project Water Rights and Implementation Agreement" above and "--Future Water Supply" below. Although there are a number of private water companies currently operating small farming or ranching enterprises within the Water District's boundaries, these private water companies have water rights that are subordinate to the Water District's and thus do not represent competition for Water District resources. The table that follows summarizes water sources generally used by the Water District to supply water to its customers: TABLE NO. 1 CAPISTRANO VALLEY WATER DISTRICT WATER SOURCES
Capacity Source Name Location (Supply Points) Rights Area Served - ----------- --------------------- --------------------------- ---------------- --------------- Imported Allen McCollugh Camino Capistrano North of 15.0 cfs Entire District Pipeline-Master Meter Avery Parkway (CM-100) Imported South County Pipeline Ortega Highway at Avenue La 4.9 cfs Entire District (SC-04) Pata Imported Del Obispo Connection Del Obispo Street 2.0 cfs (leased) Entire District Groundwater Rosenbaum Well No. 1 Rancho Viejo Road South of 1.0 cfs Entire District Village Road Groundwater North Area Well North Open Space Area of 0.5 cfs Entire District Camino Capistrano Groundwater Mission Street Well Mission Street East of Lobo 1.0 cfs Entire District Groundwater Hollywood Well Avenue De La Vista North of 0.7 cfs Entire District Mission Street
- ---------- Source: The Water District. In addition, the Water District maintains two interconnections with its neighboring agencies, SCWD and the City of San Clemente, which are used only in emergency situations. 37 Historic Water Deliveries. Over the past five full Fiscal Years (Fiscal Year 1997-98 through Fiscal Year 2001-02), the Water District has delivered to its customers, on average, 3.0 billion gallons, or 9,236 acre-feet of water per year. The following table summarizes historic water deliveries in acre-feet for Fiscal Years 1992-93 through 2001-2002. TABLE NO. 2 CAPISTRANO VALLEY WATER DISTRICT HISTORIC WATER DELIVERIES (in acre-feet) Fiscal Year Imported Water Total Water Ending June 30, Delivered Groundwater Delivered Delivered --------------- -------------- --------------------- ----------- 1993 5,797 1,830 7,627 1994 5,884 1,634 7,518 1995 5,746 1,371 7,117 1996 6,695 1,418 8,113 1997 7,229 1,433 8,662 1998 6,808 1,220 8,028 1999 7,401 1,276 8,677 2000 8,761 1,177 9,938 2001 8,004 1,689 9,693 2002 8,946 898* 9,844 - ---------- *The Water District has primarily been utilizing wells located in the Trabuco Creek sub-basin as its source of groundwater which produced less water in Fiscal Year ended June 30, 2002 due to drought conditions. The alluvial aquifer system in the Trabuco Creek sub-basin is narrower and thinner than the aquifer along San Juan Creek which is where the wells for the Project will be located. See Section 3.3.3 of the Independent Engineer's Report entitled "--Groundwater Basins" attached hereto as Appendix G. Source: The Water District. FUTURE WATER SUPPLY. Domestic Water Master Plan. The Water District's Domestic Water Master Plan, dated May, 1999 (the "Domestic Master Plan"), provides for the local distribution of potable water. The primary function of the Domestic Master Plan is to identify the facilities that will allow for adequate storage and fire flow, and increase system reliability, and a key component of the plan is the Groundwater Recovery Plant. Once constructed and fully operational, it is anticipated that the Groundwater Recovery Plant will supply approximately one-half of the Water District's annual water supply requirements, assist the Water District in meeting its goal of securing fifty-percent of its annual water supply from local groundwater sources, and eliminate the need to increase the Water District's import capacity and will avoid the cost of additional capacity from suppliers. Additionally, the development of local groundwater sources from the operation of the Groundwater Recovery Plant is expected to significantly reduce the need to provide additional emergency reservoir storage. See "THE PROJECT--Overview." See Table No. 7 below entitled "Projected Water Usage" for a comparison of groundwater and imported water. The projected costs of obtaining water through the Groundwater Recovery Plant are included in Table No. 9 below entitled "Projected Operating Results", as Operating Expenses. For further information regarding the Groundwater Recovery Plant, see "THE PROJECT." Non-Domestic Water Master Plan. The Water District's Non-Domestic Water Master Plan (the "Non-Domestic Master Plan") provides for local distribution and increased supply of non-potable water. In order to expand the non-domestic system to meet projected demand, the Water District expects to maximize its groundwater supply and add reclaimed water. The Water District has water rights to 1,825 38 acre feet per year of non-potable to be shared between the City and the Water District for the non-domestic system. The Non-Domestic Master Plan provides for three new non-potable well sites in the San Juan Basin area to bring additional water to the Water District's system. The Non-Domestic Master Plan also provides for the construction of new treatment facilities at the Southeast Regional Reclamation Authority's Jay R. Latham Wastewater Treatment Plant. These new facilities would be required to produce high quality reclaimed water, and comply with the Title 22 Wastewater Reclamation Criteria set forth by the State Department of Health Services. The Non-Domestic Master Plan also recommends that the Water District pursue the purchase of excess reclaimed water either from MNWD or SMWD in order to increase the Water District's supply of reclaimed water on an interim basis or as an emergency inter-tie. South Orange County Reliability Study. The Water District is participating in the South Orange County Reliability Study being conducted by MWDOC. The purpose of the study is to develop alternatives to improve water reliability in the event of emergency, drought and increased water demand. The emergencies considered by the study include certain failures in the Deimer filtration plant or at any of the pipelines, pump stations, or reservoirs in the system. In such event, each water agency in the South Orange County area and the Water District would have to rely on its own capacity. The study seeks to investigate regional joint projects which could provide water during a lack of local capacity. In the event of drought, MWD would reduce its allocation to MWDOC, and MWDOC would in turn reduce its allocation to the Water District. The goal of the reliability study is to develop concepts for projects such as groundwater banking, or desalinization that would reduce the impact of a MWD drought reduction. Increases in water demand have an impact on the reliability of the system under any conditions. The study analyzes increased demand and attempts to more accurately project increases. SERVICE CONNECTION INFORMATION The following table represents a summary of average service connections to the Water System for Fiscal Years 1997-98 through 2001-02. TABLE NO. 3 CAPISTRANO VALLEY WATER DISTRICT SERVICE CONNECTIONS Fiscal Year Ending June 30, Service Connections Percent Increase - --------------- ------------------- ---------------- 1998 10,110 1.6% 1999 10,463 3.5 2000 10,582 1.1 2001 10,622 0.4 2002 10,777 1.5 - ---------- Source: The Water District. LARGEST CUSTOMERS The Water District provides metered water service to all of its customers. The Water District estimates approximately 65% of water provided within the Water District is consumed by single family residences and reports that the largest water bills are paid by golf courses, parks, commercial and governmental or institutional properties. The Water District's top ten users for Fiscal Year ended June 30,2002, are as follows: 39 TABLE NO. 4 CAPISTRANO VALLEY WATER DISTRICT TEN LARGEST USERS (FISCAL YEAR ENDED JUNE 30, 2002) Customer Name Annual Dollars Activity % of Total - ---------------------------- -------------- ---------------- ---------- Marbella Golf & Country Club $ 164,440 Golf Course 2.6% City of San Juan Capistrano 162,544 Landscaping 2.5 Capo Villas III HOA 135,310 HOA - Condos 2.1 Village San Juan HOA 74,228 HOA - Various 1.2 San Juan Hills Estates HOA 69,686 HOA - SFR 1.1 San Juan Mobile Estates 39,296 Mobile Home Park 0.6 Casitas De Alipax HOA 38,748 HOA - Condos 0.6 EI Nido 24,891 Mobile Home Park 0.4 Rancho Del Avion 24,420 Mobile Home Park 0.4 Capistrano Valley Mobile Estates 20,380 Mobile Home Park 0.3 - ---------- Source: The Water District. RATES AND CHARGES; COLLECTION Rates and Charges. The Water District's rates and charges are approved by the Board of Directors of the Water District from time to time and are not subject to the approval of the voters or any outside governmental agency or body. See, however, the caption "--Proposition 218" below for a discussion of an enacted state initiative which could affect the ability of the Board of Directors to increase rates and charges. The Water District's rates and charges generally consist of a commodity charge and a monthly service charge. The commodity charge is based on volume of water consumed. Billing is in hundred cubic feet ("ccf"). The commodity rates are based on customer classes and a three-tiered allocation system. In general, each customer class is allocated water based on a combination of an indoor allocation and an outdoor allocation of water. The indoor allocation is applied equally to each month whereas the outdoor allocation is calculated each monthly billing period based upon local weather data for the actual days in the billing period. Use above the combined indoor and outdoor allocation is penalized by a higher commodity rate. Customers are charged one commodity rate up to their allocated volume, a second rate for water use above their allocated volume up to twice such allocation, and a third rate for water use above twice their allocation. The monthly service charge is a fixed charge billed to cover the costs of meter reading, billing, postage and some of the fixed costs of production and fire protection. For budgeting purposes, the Water District generally sets rates to cover operating expenses and to finance general administrative expenses, capital projects, and debt service. The Water District staff provide estimates of revenues and expenditures for operations for the upcoming Fiscal Year in June to the Board of Directors of the Water District. The Board of Directors conducts public meetings and makes such revisions as it deems desirable, adopting the proposed budgets for the following Fiscal Year effective as of July 1 of such Fiscal Year. The Board of Directors adopted its operating budget for Fiscal Year 2002-03 on June 18,2002. The Water District's budget is prepared on a cash basis. The average monthly bill for Fiscal Year 2001-02 for all sizes of single family homes was $40.96. The table below lists the percentage rate increases approved by the Board of Directors of the Water District over the last four Fiscal Years and for Fiscal Year 2002-03 for single family residences. 40 TABLE NO. 5 CAPISTRANO VALLEY WATER DISTRICT WATER SYSTEM RATES AND CHARGES-SINGLE FAMILY RESIDENCES Fiscal Year Ending Tier l Tier 2 Tier 3 Service Percent June 30, (per ccf) (per ccf) (per ccf) Charge Increase - ------------------ --------- --------- --------- ------- -------- 1999 $ 1.23 $ 1.55 $ 2.59 $ 6.15 -- 2000 1.24 1.57 2.62 6.21 1.0% 2001 1.25 1.59 2.65 6.27 1.0 2002 1.33 1.70 2.82 6.67 6.3 2003* 1.41 1.81 3.00 7.09 6.3 - ---------- * Fiscal Year 2002-03 water rates and charges were approved by the Board on October 1,2001. Source: The Water District. On December 17, 1999, the Water District adopted a 20-year rate plan to finance the Domestic Master Plan. This rate plan provides for rates to increase by approximately 1% in each Fiscal Year from Fiscal Year 2002-2003 through Fiscal Year 2019-2020. In addition, on October 2, 2001, the Water District adopted a five-year rate plan to provide for rate increases necessary to meet operation and maintenance expenses. The new rate plan further increased rates as of October 2, 2001 by 5.3% and by another 5.3% on July 1, 2002. The plan also provides for an increase of 2.25% each July 1st from Fiscal Year 2003-04 through Fiscal Year 2005-06. It is expected that the Groundwater Recovery Plant will commence operations by December 4, 2004. It is expected that the costs associated with the Groundwater Recovery Plant will require an additional rate increase at the inception of plant operations. The projected rate increase is estimated to be approximately 14 to 15%. See also "--Sources of Water Supply--Future Water Supply--Domestic Water Master Plan" above. See Table 6 below "Comparative Rates" for a comparison of water rates charged in surrounding areas effective as of October 1,2002. [Remainder of page intentionally left blank.] 41 TABLE NO. 6 CAPISTRANO VALLEY WATER DISTRICT COMPARATIVE RATES* $ per 20ccf of Agencies Water Service Provider Average Usage - ------------------- -------------------------------- -------------- City of Irvine Irvine Ranch Water District $ 19.98 Laguna Niguel Moulton Niguel Water District 20.00 Lake Forest El Toro Water District 30.50 San Juan Capistrano Capistrano Valley Water District 35.29 Mission Viejo Santa Margarita Water District 35.86 Costa Mesa Mesa Consolidated Water District 40.20 Trabuco Canyon (Unincorporated) Trabuco Canyon Water District 48.05 San Clemente City of San Clemente 50.88 Laguna Beach Laguna Beach Water District 57.50 Dana Point South Coast Water District 61.72 - ---------- * Higher of two seasonal rates quoted, if applicable. Sources: Municipal Water District of Orange County. Collection. All customers are billed monthly during the year. Payments are due and payable on the date rendered and become delinquent at the next scheduled read date, approximately 30 days thereafter. The late charge assessed is 8%. If not paid within 45 days, service may discontinued. A reconnection charge, payment for deposit, equal to twice the average monthly bill, and the entire bill must be paid in full before service will be re-established. The rate of delinquencies has remained consistent for several years. Bad debt write-offs for unpaid closing bills is approximately 0.25% of total revenue. Over the last five years, 96% of all customers have paid on time with four percent receiving a late charge delinquent notice and 0.47% experiencing water service shut-off prior to collection. PROPOSITION 218 Impact of Proposition 218 on Water Service Rates and Charges. On November 5, 1996, the voters of the State approved Proposition 218, the so-called "Right to Vote on Taxes Act." Proposition 218 added Articles XIIIC and XIID to the State Constitution, which contain a number of provisions affecting the ability of local governments to levy and collect both existing and future taxes, assessments, fees and charges. Article XIIID conditions the imposition or increase of any "fee" or "charge" upon there being no written majority protest after a required public hearing and, for fees and charges other than for sewer, water or refuse collection services, voter approval. Article XIIID defines "fee" or "charge" to mean levies (other than ad valorem or special taxes or assessments) imposed by a local government upon a parcel or upon a person as an incident of the ownership or tenancy of real property, including a user fee or charge for a "property-related service." One of the requirements of Article XIIID is that before a property related fee or charge may be imposed or increased, a public hearing upon the proposed fee or charge must be held and mailed notice sent to the record owner of each identified parcel of land upon which the fee or charge is proposed for imposition. In the public hearing if written protests of the proposed fee or charge are presented by a majority of the owners of affected identified parcel(s), an agency may not impose the fee or charge. The Water District's water charges have two components, a base fee based on meter size and a commodity charge based on the volume of water consumed. In July 1997, the Attorney General of the State of California issued an opinion to the effect that Article XIIID does not apply to water fees or 42 charges which are based on the volume of consumption. In an intermediate appellate court decision issued in 2000, it was held that water service fees and charges, where based primarily on consumption were not "fees" or "charges" within the meaning of Article XIIID; in that case, the charge had two components, a base charge and a variable charge based upon consumption. The California State Supreme Court denied review of the case and has not otherwise considered the issue directly. The Water District is of the view that the water and capacity fees and charges are not subject to Article XIID. In addition, by July 1, 1997, under Article XIIID, all property-related fees and charges, including those which have been in existence since prior to the passage of Proposition 218 in November 1996, had to have met the following substantive standards: (1) Revenues derived from the fee or charge cannot exceed the funds required to provide the property-related service. (2) Revenues derived from the fee or charge must not be used for any purpose other than that for which the fee or charge was imposed. (3) The amount of a fee or charge imposed upon any parcel or person as an incident of property ownership must not exceed the proportional cost of the service attributable to the parcel. (4) No fee or charge may be imposed for a service unless that service is actually used by, or immediately available to, the owner of the property in question. Fees or charges based on potential or future use of a service are not permitted. Standby charges, whether characterized as charges or assessments, must be classified as assessments and cannot be imposed without compliance with Section 4 of Article XIIID (relating to assessments). (5) No fee or charge may be imposed for general governmental services including, but not limited to, police, fire, ambulance or library services where the service is available to the public at large in substantially the same manner as it is to property owners. Even though the Water District believes that its water rates and capacity charges are not subject to Article XIIID, the Water District believes that they comply with the foregoing standards; provided, that it is unclear whether under the foregoing standards rates and charges may be established at levels which would permit deposits to a rate stabilization fund or maintenance of uncommitted cash reserves. Article XIIIC removes limitations on the initiative power in matters of local taxes, assessments, fees and charges. Consequently, the voters of the Water District could, by future initiative, repeal, reduce or prohibit the future imposition or increase of any local tax, assessment, fee or charge. "Assessment," "fee" and "charge" are not defined in Article XIIIC and it is unclear whether the definitions of such terms contained in Article XIIID (which are generally property-related as described above) are so limited under Article XIIIC. No assurance can be given that the voters of the Water District will not, in the future, approve initiatives which repeal, reduce or prohibit the future imposition or increase of assessments, fees or charges, including the Water District's water service fees and charges, which are the primary sources of Revenues pledged to the payment of the Lease Payments securing the Bonds. The interpretation and application of Proposition 218 will ultimately be determined by the courts or through implementing legislation with respect to a number of the matters discussed above, and it is not possible at this time to predict with certainty the outcome of such determination or the nature or scope of any such legislation. 43 Effect of Proposition 218 and of Possible General Limitations on Enforcement Remedies. The ability of the Water District to comply with its covenants under the Lease Agreement and to generate Revenues sufficient to pay the Lease Payments thereunder, and ultimately the payment of the principal of and interest on the Bonds, may be adversely affected by actions and events outside of the control of the Water District and may be adversely affected by actions taken (or not taken) under Article XIIIC or Article XIIID by voters, property owners, taxpayers or payers of assessments, fees and charges. Furthermore, any remedies available to the owners of the Bonds upon the occurrence of an event of default under the Trust Agreement are in many respects dependent upon judicial actions which are often subject to discretion and delay and could prove both expensive and time consuming to obtain. In addition to the possible limitations on the ability of the Water District to comply with its covenants under the Lease Agreement, the rights and obligations under the Bonds, the Trust Agreement, the Lease Agreement and the Property Lease may be subject to bankruptcy, insolvency, reorganization, arrangement, fraudulent conveyance, moratorium and other laws relating to or affecting creditors' rights, to the application of equitable principles, to the exercise of judicial discretion in appropriate cases and to limitations on legal remedies against public entities in the State of California. Based on the foregoing, in the event the Water District fails to comply with its covenants under the Lease Agreement, including its covenants to generate sufficient Revenues, as a consequence of the application of Article XIIIC and Article XIIID, or to pay the Lease Payments thereunder, and thus ultimately effect the payment of principal or interest on the Bonds, there can be no assurance that available remedies will be adequate to fully protect the interests of the holders of the Bonds. None of the Property subject to the Lease Agreement or the improvements thereon or the Water System are pledged or available to the Trustee or the Bondowners in the event of termination of the Lease Agreement, default in the payment of Lease Payments or otherwise, and no default under Lease Agreement will result in the loss of the Property or the improvements thereon, the Water System or other assets of the Water District. For information regarding other limitations on available remedies in the event of a default under the Lease Agreement, see "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Limited Recourse on Default." Future Initiatives. Article XIIIC and Article XIIID were each adopted as measures that qualified for the ballot pursuant to the State's initiative process. From time to time, other initiative measures could be adopted, which may place further limitations on the ability of the Water District to increase revenues or to increase appropriations which may affect the Water District's Revenues or water rights or its ability to expend its Revenues. [Remainder of page intentionally left blank.] 44 PROJECTED WATER USAGE The following table lists the Water District's estimated water deliveries for the current and the next four Fiscal Years. TABLE NO. 7 CAPISTRANO VALLEY WATER DISTRICT PROJECTED WATER USAGE (ACRE-FEET) Fiscal Year Ending June 30, Groundwater Imported Water Total Water Usage - --------------- ----------- -------------- ----------------- 2002 898 8,946 9,844 2003 911 9,080 9,991 2004 1,400 8,740 10,140 2005 3,800 6,492 10,292 2006 6,200 4,246 10,446 - ---------- Source: The Water District. REGULATORY REQUIREMENTS Federal Requirements. The Water District is subject to regulations imposed by the federal Safe Drinking Water Act, as amended (the "Act"), which is administered by the Environmental Protection Agency ("EPA"). In 1986, the United States Congress passed amendments to the Act, wherein 83 potential contaminants of potable water were to be regulated by no later than 1989, with 25 new contaminants to be added, prioritized and regulated every three years thereafter. In 1996, the Act was amended again, reducing the number to five new regulated contaminants every five years. The 1996 amendments also require that each regulation be reviewed every six years to determine if a revision is warranted. In addition to setting maximum levels for contaminants, the Act also allows regulations to require water treatment plants to meet defined "Treatment Techniques." Other new regulations that are currently proposed impact water treatment are the Arsenic, Radon, Sulfate, Groundwater and Filter Backwash Rules. It is anticipated that new regulated contaminants, plus the continued revision of current regulations, will impact treatment costs and possibly require advance treatment processes. The fiscal impact of these proposed regulations is unknown to the Water District. State Regulations. As an operator of a municipal water system, the Water District is responsible for complying with various state requirements, including: operational requirements; design and construction standards for dams and reservoirs, distribution systems and pipelines; requirements for control of cryptosporidium and other water safety issues; and training and other requirements for water treatment and distribution operators. Failure to meet these standards may subject the Water District to civil or criminal sanctions. Water District Compliance. The Water District believes its water is currently meeting or exceeding all present and proposed Federal and State water quality standards. The Water District does not expect water quality in its groundwater basin to diminish. The Water District cannot, however, predict whether future Federal and State water quality standards may result in a need for additional or enhanced treatment facilities. 45 WATER DISTRICT FINANCIAL INFORMATION OUTSTANDING INDEBTEDNESS Water District Indebtedness. The Water District entered into the Installment Purchase Agreement in connection with the execution and delivery of the 2002 Certificates of Participation in aggregate principal amount of $8,525,000. The Water District agrees in the Lease Agreement that its pledged of the Revenues to the payment of the Lease Payments is, subject to the limitations described above under the caption entitled "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Pledge of Revenues," senior to its pledge of net revenues to the payment of the Installment Payments scheduled to be paid by the Water District under and pursuant to the Installment Purchase Agreement. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Lease Payments" and "--Pledge of Revenues." The Installment Agreement provides that the Installment Payments be made by the Water District according to the following schedule: Annual Period (December 31) Principal Interest Total - ------------- ----------- -------------- --------------- 2002 $ 220,000 $ 246,299.43 $ 466,299.43 2003 315,000 364,853.76 679,853.76 2004 320,000 353,828.76 673,828.76 2005 330,000 342,628.76 672,628.76 2006 340,000 331,078.76 671,078.76 2007 350,000 319,178.76 669,178.76 2008 360,000 306,928.76 666,928.76 2009 370,000 293,428.76 663,428.76 2010 385,000 278,998.76 663,998.76 2011 400,000 263,213.76 663,213.76 2012 415,000 246,713.76 661,713.76 2013 435,000 229,076.26 664,076.26 2014 455,000 209,936.26 664,936.26 2015 475,000 189,461.26 664,461.26 2016 495,000 167,492.50 662,492.50 2017 520,000 143,732.50 663,732.50 2018 545,000 118,382.50 663,382.50 2019 570,000 91,132.50 661,132.50 2020 595,000 62,632.50 657,632.50 2021 630,000 32,287.50 662,287.50 ----------- -------------- --------------- Totals $ 8,525,000 $ 4,591,285.81 $ 13,116,285.81 In addition, the Water District currently has one series of general obligation bonds outstanding, which are not payable from Revenues. See Appendix A--"FINANCIAL STATEMENTS OF THE WATER DISTRICT." Future Water District Indebtedness. The Water District's Domestic Master Plan provides for $27 million in improvements to the Water System as well as an allocation $13.2 million for replacement projects. These improvements and replacements are projected to be funded through a combination of developer impact fees, property taxes and financing. Developer Fees relating to these projects are anticipated to be approximately $13.2 million. Property taxes are projected at $15 million. This leaves $12 million to be financed by the Water District through water rates. The Water District issued the first series of debt in April 2002 resulting in net proceeds of $7.75 million. In addition, the Water District currently anticipates incurring approximately $2.7 million in debt in Fiscal Year 2007-08, and $2 million 46 in Fiscal Year 2010-11 to finance the completion of capital facilities under the Domestic Master Plan. Such debt would be on a parity with the 2002 Certificates of Participation and, to the extent the Lease Payments required under the Lease Agreement exceed the Maintenance and Operation Cap, on a parity with the Lease Payments. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS--Lease Payments" and "--Pledge of Revenues." It is possible that the Water District could issue more or less debt than currently anticipated. HISTORIC OPERATING RESULTS The following table sets forth a summary of Water System operating results of the Water District for the last five Fiscal Years. The information set forth in the table has been derived by the Water District from its audited financial statements for such Fiscal Years 1997-98 through 2000-01 and its unaudited financial statements for Fiscal Year 2001-02, but excludes certain non-cash items and certain other adjustments. Copies of the audited financial statements of the Water District for Fiscal Years ended June 30, 2001 and 2000, including the unqualified opinion letters of Moreland & Associates, Inc. (the "Auditor") are included as Appendix A hereto. The following summary for the Fiscal Years ended June 30 for the years indicated is qualified in its entirety by reference to such statements for such years, including the notes thereto. See also "--Management Discussion and Analysis" below for managements' analysis of Table No. 8. The Auditor has not reviewed the information set forth in the following table. [Remainder of page intentionally left blank.] 47 TABLE NO. 8 CAPISTRANO VALLEY WATER DISTRICT HISTORICAL REVENUES AND EXPENDITURES
Fiscal Year Ended June 30, 1998/(1)/ 1999/(1)/ 2000/(1)/ 2001/(1)/ 2002/(2)/ ------------ ------------ ------------ ------------ ------------ OPERATING REVENUES Charges for Services/(3)/ $ 5,200,256 $ 5,705,782 $ 6,360,246 $ 5,923,062 $ 6,625,573 Development Service Charges/(4)/ 28,316 10,667 40,945 61,068 13,995 Other Income/(5)/ 139,541 99,932 321,444 8,097 156,684 ------------ ------------ ----------- ------------ ------------ Total Operating Revenues $ 5,368,113 $ 5,816,381 $ 6,722,635 $ 5,992,227 $ 6,796,252 OPERATING EXPENSES Total Operation and Maintenance Expenses/(6)/ $ 6,496,935 $ 7,337,488 $ 7,736,030 $ 8,228,985 $ 8,151,971 Net Water System Revenues (1,128,822) (1,521,107) (1,013,395) (2,236,758) (1,355,719) Non-Operating Revenues/(7)/ 1,078,961 1,167,743 2,143,592 1,918,579 963,146 Depreciation on Contributed Assets 178,753 178,753 178,825 177,252 177,252 Net Revenues $ 128,892 $ (174,611) $ 1,309,022 $ (140,927) $ (215,321)
- ---------- /(1)/ Derived from Water District's audited financial statements. /(2)/ Derived from Water District's unaudited financial statements for Fiscal Year 2001-02. /(3)/ Includes revenue from water sales, customer service charges, sewer collection fees, late payments and bad check charges. /(4)/ Includes turn on/off charges and meter installation. /(5)/ Includes bad debt, other revenues. /(6)/ Includes water purchase and production, water operation and maintenance, general and administrative, amortization and other expenses. /(7)/ Includes investment income, capital improvement fees, property taxes, grant revenues and gain on sale of property, less interest expense and loss on joint venture. Source: The Water District. MANAGEMENT DISCUSSION AND ANALYSIS The following discussion relates to certain information shown in Table No. 8. Charges for Services. Except for Fiscal Year 2000-01, water sale revenues have increased annually from 1998 due to higher demand as a result of drought conditions in the area and rate increases which began in December 1999. In Fiscal Year 1999-00, water sales increased dramatically due to unusually hot weather. In Fiscal Year 2000-01, although still very little rainfall, the weather was unusually cool and water sales declined. Normal weather patterns brought usage back up in 2002. Other Operating Revenues. Development related revenues fluctuate with development. Other income, which includes various reimbursements was unusually high in Fiscal Year 1999-00 due to a release of funds held as part of the Orange County bankruptcy. In 2002, a MWD rebate increased other income. 48 Operating Expenses. Operating Expenses have increased more than the average of 3.5% from Fiscal Year 1997-98 to Fiscal Year 2001-02 primarily due to an increase in water purchases, increased power costs and increased staff costs. The Water District is in the fourth year of a drought. This year being the driest year on record for the area. With the severe drop in rainfall, the Water District has increased its import from 84% to 91% in the last five years. This has resulted in additional cost above normal increases of $255,000. In June 2000, San Diego Gas and Electric increased the cost of power within the Water District by 75%. This resulted in an increase in power costs of approximately $250,000. In November 2001, these rates were reduced, however the Water District's power costs are still $150,000 than previously anticipated. See also "--California Electricity Market" below. In Fiscal Year 2000-01, the Water District added two new employees for a total of $150,000 to provide administrative and engineering support to the Water System. Non-Operating Revenues. Property taxes have increased consistently each year, while development revenues are tied to the housing market. Fiscal Years 1999-00 and 2000-01 included property sales and large fees from a 150 home development. PROJECTED OPERATING RESULTS Estimated projected operating results (on a cash basis) for the Water District for the current and next four Fiscal Years are set forth below. Certain assumptions have been made by the Water District in the development of the projections. Many of these assumptions are reflected in the footnotes accompanying the projections. While the Water District believes its assumptions are reasonable, there can be no assurance that the assumed conditions will in fact occur. The forecasts constitute forward looking statements and are subject to the cautions described on the inside cover page of this Official Statement. The Water District's projections may be affected (favorably or unfavorably) by unforeseen future events. Therefore, the results projected below are not to be construed as representations of fact nor a guarantee of future performance. [Remainder of page intentionally left blank.] 49 TABLE NO. 9 CAPISTRANO VALLEY WATER DISTRICT PROJECTED OPERATING RESULTS FISCAL YEARS 2002-03 THROUGH 2006-07
Fiscal Year Ending June 30, 2003/(1)/ 2004/(2)/ 2005/(2)/ 2006/(2)/ 2007/(2)/ -------------- ------------ ------------- ------------- ------------- OPERATING REVENUES: Water Commodity/Service Charge/(3)/ $ 7,066,764 $ 7,405,880 $ 8,856,656 $ 9,281,665 $ 9,515,099 Sewer Service Charge 102,973 104,518 106,085 107,677 109,292 Other 29,300 29,740 30,186 30,638 31,098 Development Service Charge/(4)/ 23,775 60,222 60,316 60,412 60,509 Other Income/(5)/ 4,000 4,060 4,121 4,183 4,245 -------------- ------------ ------------- ------------- ------------- Total Revenues 7,226,812 7,604,419 9,057,364 9,484,575 9,720,243 OPERATING EXPENSES: Total Operations and Maintenance Expenses/(6)/ 7,792,914 8,065,666 9,408,468 9,725,339 10,031,597 Plus Operating Depreciation/(7)/ 833,114 862,273 892,453 923,688 956,017 -------------- ------------ ------------- ------------- ------------- Net Water System Revenues 267,012 401,026 541,349 682,925 644,663 NON-OPERATING REVENUES: Developer Revenues 380,111 387,713 395,467 403,377 411,444 Property Taxes/(8)/ 586,924 550,000 561,000 572,220 583,664 Interest Rentals 76,025 77,165 78,323 79,498 80,690 Other/(9)/ (42,794) 3,553 3,606 3,660 3,715 -------------- ------------ ------------- ------------- ------------- Total Non-Operating Revenues/(10)/ 1,000,266 1,018,431 1,038,396 1,058,754 1,079,514 Net Revenues Available for Debt Service 1,267,278 1,419,458 1,579,745 1,741,679 1,724,177 Debt Service on 2002 Certificates of Participation (559,071) (644,708) (638,596) (637,221) (635,496) Net Revenues Available after Debt Service $ 708,207 $ 774,750 $ 941,149 $ 1,104,458 $ 1,088,681 ============== ============ ============= ============= ============= Debt Service Coverage Ratio 227% 220% 247% 273% 271%
- ---------- /(1)/ Derived from Water District's Fiscal Year 2002-03 Adopted Budget. /(2)/ Charges for service based on 1.5% annual growth and rate schedule adopted October 2, 2001. See "THE WATER DISTRICT--Rates and charges; Collection." Non-operating revenues increased by 2.0%. Expenses inflated by 3.5%. /(3)/ Fiscal Years 2004-05 through 2006-07 include additional amounts related to the proposed Groundwater Recovery Plant. /(4)/ Includes turn on/off charges and meter installation. /(5)/ Includes bad debt and other revenues. /(6)/ Includes water purchase and production, water operation and maintenance, general and administrative, and amortization other expenses. Also, Fiscal Year 2004-05 through Fiscal Year 2006-07 include additional expenses related to the Groundwater Recovery Plant. The Groundwater Recovery Plant costs include the Lease Payments under the Lease Agreement. /(7)/ Assumes 3.5% rate of growth in operating depreciation. /(8)/ Fiscal Year 2002-03 includes voter approved property tax revenue to pay debt services and expenses on general existing obligation bonds. /(9)/ Fiscal Year 2002-03 includes debt service and expenses on existing general obligation bonds. /(10)/ Includes investment income, capital improvement fees, property taxes, grant revenues and gain on sale of property, less interest expense and loss on joint venture. Source: The Water District. 50 WATER SYSTEM INSURANCE The City is a member of the California Joint Powers Insurance Authority (the "JPIA"). Under the Water District's contractual agreement for maintenance and operations, the Water District falls under the City's coverage through the JPIA. General Liability protection for each member is $50,000,000 per occurrence and $50,000,000 annual aggregate. Property insurance coverage is $100,000,000. The insurance coverage is an all-risk property protection program of the JPIA. Blanket employee dishonesty and public official bonds are also provided through the JPIA. These coverages extend to the Water District operations as well. Worker's Compensation Insurance is carried by the State Compensation Fund for work-related injuries. During the past three Fiscal Years none of the above programs have had settlements or judgments that exceeded pooled or insured coverage. There have been no significant reductions in pooled or insured liability coverage from coverage in the prior year. The Lease Agreement requires that the Water District procure and maintain insurance on the Project with responsible insurers at reasonable cost in such amount and against such risks (including damage to or destruction of the Service Contract Project Improvements) as are usually covered in connection with facilities similar to the Service Contract Project Improvements, but not less than the lesser of the full replacement cost or the principal amount of Bonds then outstanding, so long as such insurance is available from reputable insurance companies. See Appendix C--"DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS--LEASE AGREEMENT--INSURANCE AND CONDEMNATION--Insurance." EMPLOYEE BENEFITS On July 1, 1997, the Water District entered into an operations and maintenance agreement with the City wherein the City assumed the daily operational and maintenance management functions of the Water District. Subsequently, all Water District employees became full-time employees of the City. All full-time employees of the City, including those serving the Water District, are eligible to participation in the Orange County Employees Retirement System ("OCERS"). OCERS provides retirement, regular disability, and survivor benefits for miscellaneous and safety group employees. All benefits vest after five years. The benefit provisions and all other requirements are established by State statutes. The payroll charged to the Water District for employees covered by OCERS for the year ended June 30, 2002, was $1,515,882. Total payroll was $6,013,990. Employees are required to contribute approximately 7% of their annual salary to OCERS. The City pays its portion, the employee portion for management and executive employees, and up to 5.6% of the employees portion for classified employees. CALIFORNIA ELECTRICITY MARKET General. Beginning in the Spring of 2000, the California energy market experienced a severe imbalance between the supply of, and the demand for, electricity causing the wholesale price of electricity to increase dramatically. Due to a combination of mild weather, reduced natural gas prices, conservation efforts, delays in power plant shutdowns for scheduled maintenance and the introduction of a number of new power plants, the price of electricity in California has stabilized since June, 2001. The imbalance of supply and demand had its most significant impact on the short-term or spot market for the purchase of electricity and so has had a material, adverse effect on the three major California investor-owned electric utilities, Pacific Gas and Electric Company ("PG&E"), Southern California Edison Company ("SCE") and San Diego Gas and Electric Company ("SDG&E" and collectively with PG&E and SCE the "California IOUs") which had to purchase their electric requirements in excess of their own generation capacity as a result of the California electric industry deregulation plan. As a result of the situation, the California IOUs experienced severe financial difficulties, the California Department of Water Resources ("DWR") has become a substantial supplier of electricity to the retail customers of the California IOUs, state legislation has been enacted to stabilize the bills of SDG&E customers, the rates of PG&E and SCE 51 customers have been substantially increased by the California Public Utilities Commission (the "CPUC"), the Federal Regulatory Energy Commission ("FERC") has instituted price caps on the price of wholesale electric energy and proceedings with respect to potential refunds on wholesale power purchases, and a State agency has been created to increase electric generation and transmission facilities serving California, including State-owned facilities. To pay the costs of DWR's purchases of electricity, the State has extended unsecured loans from the State General Fund. The State has also authorized the issuance of up to $13.4 billion of revenue bonds by DWR to reimburse such expenditures and to provide funds for additional electricity purchases. The California IOUs are net buyers of electricity. Following the deregulation of the California energy markets under Assembly Bill 1980 (Chapter 854 of the Laws of 1996) ("AB 1890"), the California IOUs were purchasing electricity at fluctuating short-term and spot wholesale prices while the retail prices that they could charge their residential and small business customers were capped at specified levels. During portions of 2000 and 2001, the market price of electricity in California significantly exceeded such capped prices. Under this structure, the creditworthiness of PG&E and SCE deteriorated to the point they could no longer purchase electricity, and ultimately defaulted on many of their obligations. Because the creditworthiness of the California Independent System Operator Corporation (the "ISO"), the Independent System Operator for the California IOU's transmission facilities under AB 1890, and the California Power Exchange Corporation (the "PX"), the clearinghouse for electric energy sales and purchases under AB 1890, were directly tied to that of the California IOUs, the ISO suffered a substantial downgrade of its creditworthiness and the PX ultimately filed for bankruptcy protection. In April 2001, PG&E filed for voluntary protection under Chapter 11 of the federal Bankruptcy Code and those proceedings are ongoing. Bankruptcies involving large and complex organizations may take several years to reach conclusion. The potential for SCE to declare bankruptcy subsided following an October 2001 settlement reached with the CPUC that permits SCE to recover from its customers a substantial portion of its accumulated debts. In January 2001, California Governor Gray Davis proclaimed a state of emergency to exist in California and ordered the California Department of Water Resources to purchase electric power as necessary to assist in mitigating the effects of the emergency. DWR's commitments for electric power purchases through January 31, 2002 aggregated approximately $14 billion. DWR has announced plans to issue approximately $12 billion of revenue bonds to fund its very substantial power purchase program and to reimburse the State's General Fund for previous purchases. The revenue bonds are to be repaid from a dedicated revenue stream derived from retail end use customer payments for DWR electricity. DWR sold $4.25 billion of the tax-exempt bonds on October 23, 2002, $6.3 billion of tax-exempt bonds on November 5, 2002, and $700 million of taxable bonds on November 7, 2002. A number of lawsuits have been filed concerning various aspects of the recent and current energy situation. In addition, state and federal authorities are conducting investigations and other proceedings concerning various aspects of the energy situation. These include, for example, disputes over rates set by the CPUC, investigations by FERC and the California Senate Select Committee to Investigate Price Manipulation of the Wholesale Energy Markets into alleged overcharging for the sale of electricity (including sales by municipal utilities), responsibility for electricity and natural gas purchases made by the California IOUs and the ISO and antitrust and fraud claims against various parties. As a result of DWR executing numerous long-term agreements to purchase electricity and other factors, the volatility of the cost of electricity for California IOU customers has been reduced because smaller amounts of power are now being purchased from the short-term market. In addition, certain conservation measures during the height of the electricity crisis in California were successful. However, some of the applications to build additional power plants have been withdrawn. Many power plant developers are experiencing financial difficulties and are reviewing the timing and economic feasibility of building additional power plants in California. In addition, progress on new transmission line projects 52 within California has been slow. As a result of the foregoing, no assurance can be given that measures undertaken during the last two years, together with measures to be taken in the future, will be sufficient to prevent similar or other energy problems from occurring again in California. Effect on the Water District. The Water District is supplied with electricity and gas by a California IOU, SCE. To date, the Water District has not experienced any significant power shortages, and there has not been any disruption in service by the Water District. Further, the Water District currently has sufficient self-generating resources to provide water and wastewater services to domestic customers in the event of the occurrence of more significant power shortages. However, power outages may cause difficulties in receiving an adequate water supply and thus increase the cost of water. Moreover, the operation of the Groundwater Recovery Plant will significantly increase the Water District's electricity needs, although the DB/Operator (during the term of the Service Contract) has guaranteed that electricity usage and demand will not exceed certain levels and has agreed, subject to certain limitations, to pay or credit to the Water District the cost of any usage in excess of such level. See Appendix D--"SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT-- Operation and Management--Electricity Supply, Payment and Utilization." No assurance is given that any future significant reduction or loss of power would not materially adversely affect the operations of the Water District. Energy costs account for approximately 4.0% of the Water District's total budget and are incurred to pump both groundwater and imported water supplies to various pumping elevations located throughout the Water District. The Water District's energy costs were $491,887.05 in Fiscal Year 2000-2001 and $259,030.45 in Fiscal Year 2001-2002, and the Water District estimates its energy costs will total approximately $300,000 in Fiscal Year 2002-2003. The Water District has adopted average water rate increases for domestic and industrial customers of approximately 1% for Fiscal Year ending June 30, 2002 to fund increased electric energy and natural gas costs. The Water District believes that anticipated increased energy costs will not materially adversely affect the Water District's financial condition. However, the Water District cannot guarantee that prices for electricity or gas will not increase more than anticipated which could materially adversely affect the Water District's financial condition or that additional increases in water rates or other charges imposed by the Water District will not be proposed. Such increases in water rates and such other charges, however, are not subject to approval by any public agency other than the Water District or the customers of the Water District. SECURITY OF THE SYSTEM Military conflicts and terrorist activities may adversely impact the operations and finances of the Water District. On September 11, 2001, terrorist attacks occurred in New York City and Washington D.C. and resulted in significant damage and casualties. The Water District is unable to determine the precise effect of such events, if any, on, among other things, the Water District's current and future budgets, revenues, available reserves and additional safety and security expenditures. MWD has reported that it has increased ground and air patrols of the Colorado River Aqueduct. In addition, MWD has increased the frequency of monitoring and testing at all treatment plants in addition to various sites along the Colorado River Aqueduct. Although MWD has constructed redundant systems and other safeguards, no assurance can be given that a terrorist attack against MWD's facilities would not impair MWD's ability to deliver water to its customers through the Colorado River Aqueduct or the State Water Project. The Water District's system is subject to safety and security inspections on a continuing basis as part of the Water District's normal operations and additional security measures have recently been implemented. The Water District's drinking water distribution system is a closed system with no open storage facilities and water from Vail Lake is taken only when available. Water storage reservoirs are 53 fenced, locked and equipped with intrusion alarms to notify operating personnel if unauthorized access is attempted at a reservoir or other facility. Facilities are patrolled by Water District staff on a regular basis to prevent intruders. The Water District believes that these safety and security measures are adequate to address potential threats to the system. However, the Water District does not guarantee that such safety and security measures will be adequate in the event that terrorist activities are directed against the system. See "--Water System Insurance" herein. For information regarding the security plan for the Service Contract Project Improvements, see Section 6.3 of the Independent Engineer's Report entitled "-- Security Plan" attached hereto as Appendix G. INVESTMENT OF WATER DISTRICT FUNDS All funds held by the Water District are invested in accordance with the Water District's investment policy (the "Investment Policy"). The primary objectives of the Investment Policy, in priority, are safety of principal, liquidity, and yield. The comprehensive Investment Policy was first adopted by the Water District in March, 1997, last amended in May, 1997, and, as required by California law, last approved on October 1, 2002. The Water District has covenanted in the Installment Purchase Agreement to invest amounts held in the Revenue Fund in certain Permitted Investments defined to mean any of the following which at the time are legal investments under the laws of the State of California: (i) cash, or direct obligations of (including obligations issued or held in book-entry form on the books of) the Department of the Treasury of the United States of America, (ii) obligations of any of the following federal agencies which obligations represent the full faith and credit of the United States of America, including the Export-Import Bank; Farm Credit System Financial Assistance Corporation; Farmers Home Administration; General Services Administration; United States Maritime Administration; Small Business Administration; Government National Mortgage Association (GNMA); United States Department of Housing & Urban Development (PHA's); and Federal Housing Administration; (iii) senior debt obligations rated "AAA" by Standard & Poor's and "Aaa" by Moody's issued by the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation and senior debt obligations of other government sponsored agencies approved by the Insurer; (iv) U.S. dollar denominated deposit accounts, federal funds and banker's acceptances with domestic commercial banks (including the Trustee or any of its affiliates) which have a rating on their short-term certificates of deposit on the date of purchase of "A-l" or "A-1+" or "P-1+" by Standard & Poor's and "P-l" by Moody's and maturing no more than 360 days after the date of purchase. (Ratings on holding companies are not considered as the rating of the bank); (v) commercial paper which is rated at the time of purchase in the single highest classification, "A-1+" by Standard & Poor's and "P-l" by Moody's and which matures not more than 270 days after the date of purchase; (vi) investments in a money market fund rated "AAAm" or "AAAm-G" or better by Standard & Poor's; (vii) pre-refunded Municipal Obligations defined as follows: any bonds or other obligations of any state of the United States of America or of any agency, instrumentality or local governmental unit of any such state which are not callable at the option of the obligor 54 prior to maturity or as to which irrevocable instructions have been given by the obligor to call on the date specified in the notice; and (a) which are rated, based on an irrevocable escrow account or fund (the "escrow"), in the highest rating category of Standard & Poor's and Moody's or any successors thereto; or (b) (i) which are fully secured as to principal and interest and redemption premium, if any, by an escrow consisting only of cash or the other obligations described in paragraph (i) above, which escrow may be applied only to the payment of such principal of and interest and redemption premium, if any, on such bonds or other obligations on the maturity date or dates thereof or the specified redemption date or dates pursuant to such irrevocable instructions, as appropriate, and (ii) which escrow is sufficient, as verified by a nationally recognized independent certified public accountant, to pay principal of and interest and redemption premium, if any, on the bonds or other obligations described in this paragraph on the maturity date or dates specified in the irrevocable instructions referred to above, as appropriate; (viii) investment agreements approved in writing by the municipal bond insurer of the 2002 Certificates of Participation with notice to Moody's and Standard & Poor's; (ix) other forms of investments (including repurchase agreements) approved in writing by the municipal bond insurer of the 2002 Certificates of Participation with notice to Moody's and Standard & Poor's; and (x) the State of California Local Agency Investment Fund. All investments, including the Permitted Investments and those authorized by law from time to time for investments by public agencies, contain a certain degree of risk. Such risks include, but are not limited to, a lower rate of return than expected and loss or delayed receipt of principal. See the audited financial statements of the Water District for a description of the Water District's investments at June 30, 2001 which are attached hereto as Appendix A. The Water District's Investment Policy may be changed at any time by the Board of Directors (subject to the State law provisions relating to authorized investments) and as the California Government Code is amended. There can be no assurance, therefore, that the State law and/or the Investment Policy will not be amended in the future to allow for investments which are currently not permitted under State law or the Investment Policy or that the objectives of the Water District with respect to investments or its investment holdings at any point in time will not change. TAX MATTERS In the opinion of Stradling Yocca Carlson & Rauth, a Professional Corporation, Newport Beach, California, Bond Counsel, under existing statutes, regulations, rulings and judicial decisions, interest on the Bonds is excluded from gross income for federal income tax purposes, and is not an item of tax preference for purposes of calculating the federal alternative minimum tax imposed on individuals and corporations. In the further opinion of Bond Counsel, interest on the Bonds is exempt from State of California personal income tax. Bond Counsel notes that, with respect to corporations, interest on the Bonds may be included as an adjustment in the calculation of alternative minimum taxable income which may affect the alternative minimum tax liability of corporations. In addition, the difference between the issue price of a Bond (the first price at which a substantial amount of the Bonds of a maturity is to be sold to the public) and the stated redemption price at maturity with respect to the Bond constitutes original issue discount. Original issue discount accrues under a constant yield method, and original issue discount will accrue to a Bondowner before receipt of cash 55 attributable to such excludable income. The amount of original issue discount deemed received by a Bondowner will increase the Bondowner's basis in the applicable Bond. The amount of original issue discount that accrues to the owner of the Bond is excluded from gross income of such owner for federal income tax purposes, is not an item of tax preference for purposes of the federal alternative minimum tax imposed on individuals and corporations, and is exempt from State of California personal income tax. Bond Counsel's opinion as to the exclusion from gross income of interest on the Bonds (and original issue discount) is based upon certain representations of fact and certifications made by the Water District and others and is subject to the condition that the Water District complies with all requirements of the Internal Revenue Code of 1986, as amended (the "Code"), that must be satisfied subsequent to the issuance of the Bonds to assure that interest on the Bonds (and original issue discount) will not become includable in gross income for federal income tax purposes. Failure to comply with such requirements of the Code might cause the interest on the Bonds (and original issue discount) to be included in gross income for federal income tax purposes retroactive to the date of issuance of the Bonds. The Water District has covenanted to comply with all such requirements. Bond Counsel's opinions may be affected by actions taken (or not taken) or events occurring (or not occurring) after the date hereof. Bond Counsel has not undertaken to determine, or to inform any person, whether any such actions or events are taken or do occur. The Trust Agreement and the Tax Certificate relating to the Bonds permit certain actions to be taken or to be omitted if a favorable opinion of Bond Counsel is provided with respect thereto. Bond Counsel expresses no opinion as to the exclusion from gross income of interest on the Bonds (and original issue discount) for federal income tax purposes with respect to any Bond if any such action is taken or omitted based upon the advice of counsel other than Stradling Yocca Carlson & Rauth. Although Bond Counsel has rendered an opinion that interest (and original issue discount) on the Bonds is excluded from gross income for federal income tax purposes provided that the Water District continues to comply with certain requirements of the Code, the ownership of the Bonds and the accrual or receipt of interest (and original issue discount) with respect to the Bonds may otherwise affect the tax liability of certain persons. Bond Counsel expresses no opinion regarding any such tax consequences. Accordingly, before purchasing any of the Bonds, all potential purchasers should consult their tax advisors with respect to collateral tax consequences relating to the Bonds. A copy of the proposed form of opinion of Bond Counsel is attached hereto as Appendix F. INDEPENDENT ACCOUNTANTS The financial statements of the Water District for the Fiscal Years ended June 30, 2001 and 2000, attached hereto as Appendix A to this Official Statement have been audited by Moreland & Associates, Inc., independent auditors, as set forth in their report, dated November 2, 2001. RATING Standard & Poor's has assigned a rating of "AAA" to the Bonds based upon the issuance of the Policy by the Bond Insurer. Such rating reflects only the views of such organization and any desired explanation of the significance of such rating should be obtained from such rating agency, at the following addressee: Standard & Poor's Ratings Group, 25 Broadway, New York, New York 10004. Such rating is not a recommendation to buy, sell or hold the Bonds. Generally, a rating agency bases its rating on the information and materials furnished to it and on investigations, studies and assumptions of its own. There is no assurance that such rating will continue for any given period of time or that such rating will not be revised downward or withdrawn entirely by the rating agency, if in the judgment of such rating agency, circumstances warrant. Any such downward revision or withdrawal of such rating may have an adverse effect on the market price or marketability of the Bonds. 56 CERTAIN LEGAL MATTERS The validity of the Bonds and certain other legal matters are subject to the approving opinion of Stradling Yocca Carlson & Rauth, a Professional Corporation, Newport Beach, California, Bond Counsel. The form of opinion Bond Counsel proposes to render is attached as Appendix F. Certain other legal matters will be passed upon for the Authority by Stradling Yocca Carlson & Rauth, a Professional Corporation, Newport Beach, California; for the Water District and the City by John R. Shaw, Esq., San Juan Capistrano, California, City Attorney and General Counsel to the Water District, and by Hawkins, Delafield & Wood, New York, New York, Special Counsel to the City and the Water District; and for the Underwriter by its counsel, Orrick, Herrington & Sutcliffe LLP. LITIGATION To the knowledge of their respective officers, there is no controversy of any nature now pending or threatened against the Authority, the Water District or the City which seeks to restrain or enjoin the sale, issuance, execution or delivery of the Bonds or which in any way contests or affects the validity or enforceability of the Bonds or any proceedings of the Authority, the Water District or the City taken with respect to the issuance, delivery or sale thereof, or the pledge or application of any moneys or security provided for the payment of the Bonds, the use of the Bond proceeds or the existence or powers of the Authority, the Water District or the City relating to the issuance and delivery of the Bonds. There is no litigation pending concerning the corporate existence of the Authority, the Water District or the City, or the title of their officers to their respective offices, and there is no litigation pending against the Water District which would have a material adverse effect upon the operations of the Water District or the Revenues of the Water District. Except as provided below, there is no controversy or litigation of any nature now pending against either the Company or the Guarantor or, to the knowledge of any of their respective officers, threatened, wherein an unfavorable decision, ruling or finding is reasonably likely and would materially adversely affect the operations or financial conditions of the Company or the Guarantor. The Company recently received notice of a wrongful death claim filed against it for $60 million in connection with the death of a 52-year old man, which death is alleged to be from chlorine gas exposure. The Company denies any responsibility therefor, and the Company's insurer has assumed responsibility for defending the claim. The Company believes that any direct exposure it may have in respect of this claim would be immaterial to its operations or financial condition. UNDERWRITING The Bonds are to be purchased by Lehman Brothers Inc., as Underwriter, at a price which includes an underwriter's discount of $946,169.36. The Underwriter is committed to purchase all the Bonds if any are purchased. The Underwriter may offer and sell the Bonds to certain dealers (including depositing the Bonds into investment trusts) and others at prices lower than the offering prices stated on the inside cover page of this Official Statement. After the initial public offering, the public offering prices of the Bonds may be changed from time to time by the Underwriter. CONTINUING DISCLOSURE The Authority has determined that no financial or operating data concerning the Authority is material to an evaluation of the offering of the Bonds or to any decision to purchase, hold or sell the Bonds and the Authority will not provide any such information. The Water District has undertaken all responsibilities for any continuing disclosure to Bondowners as described below, and the Authority will have no liability to the Bondowners of the Bonds or any other person with respect to Securities and Exchange Commission Rule 15c2-12 under the Securities Exchange Act of 1934 ("Rule 15c2-12"). 57 The Water District has agreed to provide, or cause to be provided, to each nationally recognized municipal securities information repository and any public or private repository or entity designated by the State as a state repository for purposes of Rule 15c2-12 certain annual financial information and operating data and, in a timely manner, notice of certain material events. For a complete listing of items of information which will be provided in the Annual Report, see Appendix E--"FORM OF CONTINUING DISCLOSURE AGREEMENT." Such information is to be provided by the Water District not later than nine (9) months after the end of the Water District's Fiscal Year (which currently would be April 1), commencing with the report for the 2001-02 Fiscal Year. The Annual Report will be filed by the Trustee, acting as Dissemination Agent, on behalf of the Water District with each Nationally Recognized Municipal Securities Information Repository and with each State Repository, if any. These covenants have been made in order to assist the Underwriter in complying with Rule 15c2-12. The Water District has never failed to comply in all material respects with any previous undertakings with regard to said Rule to provide annual reports or notices of material events. AVAILABILITY OF DOCUMENTS Copies of the Official Statement, the Service Contract, the Trust Agreement, the Lease Agreement, the Property Lease, the Continuing Disclosure Agreements, the Water District's audited financial statements and additional information relating to the Water District and the Bonds will be available, upon written request, from the office of the Administrative Services Director, 32400 Paseo Adelanto, San Juan Capistrano, California 92675. MISCELLANEOUS The purpose of this Official Statement is to supply information to prospective buyers of the Bonds. References are made herein to certain documents and reports that are brief summaries thereof that do not purport to be complete or definitive, and reference is made to such documents and reports for full and complete statement of the contents thereof. [Remainder of page intentionally left blank.] 58 Any statements in this Official Statement involving matters of opinion, whether or not expressly so stated, are intended as such and not as representations of fact. This Official Statement is not to be construed as a contract or agreement between the Water District or the Authority and the purchasers or holders of any of the Bonds. The preparation and distribution of this Official Statement have been authorized by the Water District and the Authority. SAN JUAN BASIN AUTHORITY By: /s/ John Schatz ---------------------------------- President, Board of Directors CAPISTRANO VALLEY WATER DISTRICT By: /s/ Diane Bathgate ---------------------------------- Chairperson, Board of Directors 59 (This Page Intentionally Left Blank) APPENDIX A FINANCIAL STATEMENTS OF THE WATER DISTRICT (This Page Intentionally Left Blank) CAPISTRANO VALLEY WATER DISTRICT ANNUAL FINANCIAL REPORT JUNE 30, 2001 AND 2000 (This Page Intentionally Left Blank) CAPISTRANO VALLEY WATER DISTRICT Annual Financial Report June 30, 2001 and 2000 TABLE OF CONTENTS PAGE ---- Independent Auditors' Report 1 Balance Sheets 2 Statements of Revenues, Expenses and Changes in Retained Earnings 4 Statements of Cash Flows 5 Notes to Financial Statements 6 (This Page Intentionally Left Blank) [LETTER HEAD OF MORELAND & ASSOCIATES, INC.] November 2, 2001 The Board of Directors of the Capistrano Valley Water District Independent Auditors' Report We have audited the accompanying balance sheets of the Capistrano Valley Water District (District), a component unit of the City of San Juan Capistrano, as of June 30, 2001 and 2000, and the related statements of revenues, expenses and changes in retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the District's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 financial statements referred to above present fairly, in all material respects, the financial position of the Capistrano Valley Water District as of June 30, 2001 and 2000, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Moreland & Associates, Inc. 1 CAPISTRANO VALLEY WATER DISTRICT Balance Sheets June 30, 2001 and 2000
2001 2000 ------------ ------------ ASSETS Current Assets: Cash and investments (Note 2) $ 843,537 $ 2,794,613 Customer receivables 979,880 896,615 Property taxes receivable 7,513 9,260 Grant receivables 43,344 43,344 Other receivables 186,462 243,203 Inventory 116,842 99,695 Due from other agencies (Note 6) 97,500 97,500 Prepaid insurance 11,999 ------------ ------------ Total Current Assets 2,275,078 4,196,229 ------------ ------------ Restricted Assets (Note 2) Debt Service: Cash and investments 142,117 37,000 Cash in County Treasury 110,389 121,412 ------------ ------------ Total Restricted Assets 252,506 158,412 ------------ ------------ Noncurrent Assets: Due from other agencies (Note 6) 370,411 343,533 Investment in joint venture (Note 8) 181,868 198,634 ------------ ------------ Total Noncurrent Assets 552,279 542,167 ------------ ------------ Utility Plant in Service (Note 3): Land 151,732 233,651 Distribution system 33,590,640 32,387,807 Equipment 959,577 Construction in progress 3,309,690 2,460,526 ------------ ------------ 37,052,062 36,041,561 Less accumulated depreciation 11,713,083 11,769,992 ------------ ------------ Net Utility Plant in Service 25,338,979 24,271,569 ------------ ------------ Other Assets: Capacity rights, net of accumulated amortization (Note 10) 539,982 551,034 ------------ ------------ Total Assets $ 28,958,824 $ 29,719,411 ============ ============
(Continued) See Accompanying Notes to Financial Statements. 2 CAPISTRANO VALLEY WATER DISTRICT Balance Sheets (Continued) June 30, 2001 and 2000
2001 2000 --------------- --------------- LIABILITIES AND FUND EQUITY Current Liabilities Payable from Current Assets: Accounts payable and accrued liabilities $ 547,529 $ 742,960 Due to City of San Juan Capistrano (Note 12) 172,347 172,027 Other liabilities 27,448 28,698 --------------- --------------- Total Current Liabilities Payable from Current Assets 747,324 943,685 --------------- --------------- Current Liabilities Payable from Restricted Assets: Current portion of bonds payable (Note 4) 150,000 145,000 Accrued interest payable 4,519 7,840 --------------- --------------- Total Current Liabilities Payable from Restricted Assets 154,519 152,840 --------------- --------------- Total Current Liabilities 901,843 1,096,525 Long-Term Liabilities, Net of Current Portion: General obligation bonds payable (Note 4) 45,000 195,000 --------------- --------------- Total Liabilities 946,843 1,291,525 --------------- --------------- Fund Equity: Contributed capital, net (Note 11 ) 8,240,871 8,418,122 --------------- --------------- Retained earnings (Note 7): Reserved for debt service 97,987 5,572 Unreserved 19,673,123 20,004,192 --------------- --------------- Total Retained Earnings 19,771,110 20,009,764 --------------- --------------- Total Fund Equity 28,011,981 28,427,886 --------------- --------------- Total Liabilities and Fund Equity $ 28,958,824 $ 29,719,411 =============== ===============
3 CAPISTRANO VALLEY WATER DISTRICT Statements of Revenues, Expenses and Changes in Retained Earnings For the Years Ended June 30, 2001 and 2000
2001 2000 ------------ ------------ Operating Revenues: Water sales $ 4,838,737 5,313,543 Customer service charges 981,966 945,686 Development service charges 61,068 40,945 Sewer collection fees 102,359 101,017 Other 8,097 321,444 ------------ ------------ Total Operating Revenues 5,992,227 6,722,635 ------------ ------------ Operating Expenses: Water purchase and production 3,617,196 3,944,555 Water operations and maintenance 3,402,729 2,590,719 General and administrative 381,900 353,967 Depreciation (Note 3) 804,941 824,969 Amortization 11,054 11,053 Other expense 11,165 10,767 ------------ ------------ Total Operating Expenses 8,228,985 7,736,030 ------------ ------------ Operating Loss (2,236,758) (1,013,395) ------------ ------------ Non Operating Revenues (Expenses): Investment income 196,588 219,376 Capital improvement fees 998,423 1,223,111 Property taxes 663,845 670,813 Grant revenues 993 Gain on sale of property 86,581 58,288 Interest expense (Note 4) (10,092) (18,523) Loss on investment in joint venture (Note 8) (16,766) (10,466) ------------ ------------ Total Nonoperating Revenues 1,918,579 2,143,592 ------------ ------------ Net Income (Loss) (318,179) 1,130,197 Depreciation on Contributed Assets (Note 11) 177,252 178,825 ------------ ------------ Increase (Decrease) in Retained Earnings (140,927) 1,309,022 Retained Earnings, Beginning of Period 20,009,764 18,700,742 Residual Equity Transfer (97,727) ------------ ------------ Retained Earnings, End of Period $ 19,771,110 $ 20,009,764 ============ ============
See Accompanying Notes to Financial Statements. 4 CAPISTRANO VALLEY WATER DISTRICT Statements of Cash Flows Years Ended June 30, 2001 and 2000
2001 2000 ------------ ------------ Cash Flows from Operating Activities: Operating loss $ (2,236,758) $ (1,013,395) Adjustments to reconcile operating loss to net cash provided (used) by operating activities: Depreciation and amortization 815,995 836,022 (Increase) decrease customer receivables (83,265) (91,289) (Increase) decrease other receivables 58,488 (134,296) (Increase) decrease inventory (17,147) (9,198) (Increase) decrease other assets 11,999 (6,699) (Increase) decrease due from other agencies (26,878) 125,953 Increase (decrease) in deferred revenues (213,214) Increase (decrease) accounts payable and accrued liabilities (195,431) 240,609 Increase (decrease) other liabilities (1,250) 6,100 ------------ ------------ Net Cash Provided (Used) by Operating Activities (1,674,247) (259,407) ------------ ------------ Cash Flows from Noncapital and Related Financing Activities: Increase in amounts due to City of San Juan Capistrano (Note 12) 320 5,188 Property taxes 665,590 670,813 Grant revenues 993 ------------ ------------ Net Cash Provided by Noncapital and Related Financing Activities 665,910 676,994 ------------ ------------ Cash Flows from Capital and Related Financing Activities: Interest and fiscal agent payments on long-term borrowings (13,413) (22,482) Principal payments on long-term borrowing (145,000) (183,000) Acquisition of property, plant and equipment (2,051,997) (1,719,473) Proceeds from sale of property 166,754 58,288 Capital improvement fees 998,423 1,223,111 ------------ ------------ Net Cash (Used) by Capital and Related Financing Activities (1,045,233) (643,556) ------------ ------------ Cash Flows from Investing Activities: Interest payments received 196,588 219,376 ------------ ------------ Net (Decrease) in Cash and Cash Equivalents (1,856,982) (6,593) Cash and Cash Equivalents, July 1 2,953,025 2,959,618 ------------ ------------ Cash and Cash Equivalents, June 30 $ 1,096,043 $ 2,953,025 ============ ============
The District had a noncash loss from an investment in the San Juan Basin Authority joint venture in an amount of $16,766 and $10,466 in the years ended June 30, 2001 and June 30, 2000, respectively, primarily due to depreciation. Equipment with a net book value of $97,727 was transferred to the City of San Juan Capistrano. See Accompanying Notes to Financial Statements. 5 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements June 30, 2001 and 2000 1. REPORTING ENTITY AND SIGNIFICANT ACCOUNTING POLICIES: a. Reporting Entity: The Capistrano Valley Water District (the District) was formerly known as the Orange County Waterworks District No. 4 which was formed to serve the San Juan Capistrano area in 1930. The District was governed by the Orange County Board of Supervisors until 1970, when the District became a subsidiary district of the City of San Juan Capistrano. In July 1997, the District's operations were merged with the City of San Juan Capistrano. The employees of the District were transferred to the City and all services are provided to the District through a contractual agreement. The District still operates under the provisions of the California Water Code by which it was formed, but is now governed by a Board of Directors comprised of the five-member San Juan Capistrano City Council. The District also has a five-member Advisory Commission which makes recommendations to the Board of Directors on items such as the District's Budget. For financial reporting purposes, the District is included as a component unit of the City of San Juan Capistrano. The District provides water service for the City of San Juan Capistrano. Water is provided for residential, commercial, industrial, and agricultural uses, and also for fire fighting purposes. b. Basis of Accounting: The District operates and reports as an enterprise fund utilizing the accrual method of accounting. Revenues are recognized when earned and expenses are recognized when incurred. c. Investments: Effective July 1, 1997, the District adopted the provisions of Governmental Accounting Standards Board (GASB) Statement No. 31, "Accounting and Financial Reporting for Certain Investments and External Pools," which require governmental entities to report certain investments at fair value (quoted market price or the best available estimate thereof) in the balance sheet and recognize the corresponding change in the fair value of investments in the year in which the change occurred. In accordance with GASB Statement No. 31, the District has stated investments at fair value. d. Cash Equivalents: For purposes of the statement of cash flows, the District considers all highly liquid investments (including restricted assets) to be cash equivalents. 6 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 e. Customer Receivables: The allowance for doubtful accounts is based upon collection experience with the customers. There were no allowances for doubtful accounts required at June 30, 2001 and June 30, 2000. Charges to bad debt expense were $8,277 and $8,542 for the years ended June 30, 2001 and June 30, 2000, respectively. f. Inventory: Inventory, which consists principally of water meters and spare parts, is stated at the lower of cost or market. g. Utility Plant in Service and Depreciation: Property, plant and equipment are stated at cost. Cost includes materials, direct labor, and such indirect items as engineering and supervision, employee fringe benefits and interest during construction on borrowed funds related to plant under construction. Contributed facilities are recorded at the estimated cost of construction and/or the face amount of construction bonding secured by the developers. Depreciation is recorded on the straight-line basis over the estimated useful lives of the related assets, which range from 3-60 years. h. Contributed Capital: Contributed capital is recorded for assets donated to the District funded by developers or governmental grants received for capital outlay in accordance with GASB Statement No. 33, effective July 1, 2000. Depreciation is charged to operations and later reclassified to contributed capital. i. Grant Accounting: Grants receivable and revenue are recorded when they are earned. This occurs after the District has incurred an expense reimbursable through a grant. Accordingly, when the District receives money in advance of grant expenses it records deferred grant revenue. j. Property Tax Calendar: Property taxes are levied by the County of Orange on assessed valuations each January 1 and become a lien on the property assessed on that date. Taxes on the secured rolls are payable in two installments each November 1 and March 1 and become delinquent on December 10 and April 10, respectively. Taxes on unsecured property are assessed 7 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 taxes are collected by the County of Orange Tax Collector and are apportioned to participating agencies in accordance with a prearranged schedule of apportionments. k. Insurance: The District insurance coverage is provided in conjunction with the City of San Juan Capistrano. Information related to the insurance program can be found in the notes to the general purpose financial statements of the City of San Juan Capistrano. l. Estimates: The preparation of financial statements in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ from those estimates. 2. CASH AND INVESTMENTS Cash and investments at June 30, 2001 and 2000 are reported in the accompanying balance sheet as follows: June 30, 2001 June 30, 2000 ------------- ------------- Cash and investments $ 843,537 $ 2,794,613 Restricted Assets: Debt service - Cash and investments 142,117 37,000 Cash in County Treasury 110,389 121,412 ------------- ------------- Total $ 1,096,043 $ 2,953,025 ============= ============= Authorized Investments: Under provisions of the District's Investment Policy, and in accordance with Section 53601 of the California Government Code, the District may invest in the following types of investments: Securities of the U.S. Government, or its agencies California Local Agency Investment Fund demand deposits (LAIF) Repurchase Agreements up to a one year term with certain collateral requirements Taxable or tax-exempt warrants, notes, bonds or similar evidences of indebtedness of the State of California Classification of Deposits and Investments By Credit Risk: 8 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 Classification of Deposits and Investments By Credit Risk: Deposits and investments are classified into three categories of credit risk. These categories are as follows: Deposits: Category 1 - Deposits which are insured by the Federal Deposit Insurance Corporation (FDIC). Category 2 - Deposits which are collateralized. The California Government Code requires California banks and savings and loan associations to secure the District's deposits by pledging government securities with a value of 110% of the District's deposits. California law also allows financial institutions to secure District deposits by pledging first deed mortgage notes having a value of 150% of the District's total deposits. The District Treasurer may waive the collateral requirement for deposits which are fully insured up to $100,000 by the FDIC. The collateral for deposits in federal and state chartered banks is held in safekeeping by an authorized Agent of Depository recognized by the State of California Department of Banking. The collateral for deposits with savings and loan associations is generally held in safekeeping by the Federal Home Loan Bank in San Francisco, California as a third-party trustee. These securities are physically held in an undivided pool for all California public agency depositors. Under government Code Section 53655, the placement of securities by a bank or savings and loan association with an "Agent of Depository" has the effect of perfecting the security interest in the name of the local government agency. Accordingly, all collateral held by California Agents of Depository are considered to be held for, and in the name of, the local governmental agency. Category 3 - Deposits which are uninsured or uncollateralized. Investments: Category 1 - Investments which are insured by the Securities Investors Protection Corporation (SIPC), or investments which are held in definitive (i.e. physical) form by the District or the District's agent in the District's name, or investments acquired through the federal reserve book-entry system where the financial institution or broker/dealer associated with the purchases is separated from the custodial safekeeping agent on the same investments and where the investments are recorded on the books and records of the financial institution or broker/dealer in the name of the District. 9 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 Category 2 - Investments which are uninsured, 1) where the investments are acquired through a financial institution's investment or trading department, but are held in the same financial institution's trust department and are recorded in the District's name in the trust department's systems and records. Category 3 - Investments which are uninsured, 1) where the investments are acquired through a financial institution's investment department but are held for custodial purposes in the same financial institution's safekeeping department, or 2) where the investments are acquired through a financial institution's trust department, and held for custodial safekeeping by the same trust department, or 3) where investments are not held in the District's name in the systems are records of the financial institution. The District had $985,654 of cash and investments pooled with the City of San Juan Capistrano's cash and investments. The information required by Governmental Accounting Standards Board Statement No. 3 for the pooled cash and investments is available in the City of San Juan Capistrano's financial statements. The District's cash of $110,389 held by the Orange County Treasurer is not required to be categorized. 3. CHANGES IN UTILITY PLANT IN SERVICE: A summary of the changes in property, plant and equipment for the years ended June 30, 2001 follows:
Balance Balance July 1, 2000 Additions Deletions June 30, 2001 -------------- ------------- ------------- ------------- Land $ 233,651 $ (81,919) $ 151,732 Distribution system 32,387,807 $ 1,202,833 33,590,640 Equipment 959,577 (959,577) Construction in progress 2,460,526 2,051,998 (1,202,834) 3,309,690 -------------- ------------- ------------- ------------- 36,041,561 3,254,831 (2,244,330) 37,052,062 Less Accumulated Depreciation (11,769,992) (804,941) 861,850 (11,713,083) -------------- ------------- ------------- ------------- Net Property, Plant and Equipment $ 24,271,569 $ 2,449,890 $ 1,382,480 $ 25,338,979 ============= ============= ============= =============
10 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 4. BONDS PAYABLE: Bonds payable at June 30, 2001 and 2000 consisted of the following:
2001 2000 ----------- ---------- 1961 General Obligation Bonds The District issued $2,800,000 of general obligation bonds on October 1, 1961, with interest rates ranging from 4.50% to 5%. Bond principal payments of $10,000 to $130,000 are due on July 1 of each year from 1963 through 2001. Interest is payable semi-annually on January 1 and July 1. $ 105,000 $ 210,000 1972 General Obligation Bonds The District issued $700,000 of general obligation bonds on August 1, 1972, with interest rates ranging from 5.60% to 7%. Bond principal payments of $5,000 to $45,000 are due on August 1 of each year from 1973 through 2002. Interest is payable semi-annually on February 1 and August 1. 90,000 130,000 ----------- ---------- Total Bonds Payable 195,000 340,000 Less Current Portion 150,000 145,000 ----------- ---------- Long-Term Bonds Payable $ 45,000 $ 195,000 =========== ==========
The future debt service payments on long-term debt are as follows: Year Ending June 30, Principal Interest Total ----------- ----------- ----------- ----------- 2002 $ 150,000 $ 6,244 $ 156,244 2003 45,000 1,294 46,294 ----------- ----------- ----------- $ 195,000 $ 7,538 $ 202,538 =========== =========== =========== 5. ORANGE COUNTY EMPLOYEES' RETIREMENT SYSTEM: Effective July 1, 1997, employees of the District were transferred to the City of San Juan Capistrano. All District employees eligible to participate in the Orange County Retirement Plan prior to July 1, 1997 are eligible to participate in the City of San Juan Capistrano's retirement plan with the Orange County Employees Retirement System (OCERS). Additional information on OCERS can be obtained from the City of San Juan Capistrano's financial statements. 11 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 6. DUE FROM OTHER AGENCIES: The District has entered into a Cooperation Agreement with the City of San Juan Capistrano Redevelopment Agency (the "Agency") whereby the District has deferred receipt of site development fees from developers in the redevelopment project area and has requested that developers pay the Agency those fees. The deferred fees plus accrued interest will be repaid to the District beginning July 1, 1994 at the rate of $97,500 a year (principal) for 10 years. At the end of that period a balloon payment will be due for the balance. The interest rate is to be adjusted annually based on the District's rate of return on invested funds during the previous year. The receivable at June 30, 2001 of $467,911 includes $134,419 of accrued interest. 7. RESERVES OF RETAINED EARNINGS: In accordance with the covenants and requirements of the District's long-term debt agreements, a portion of retained earnings has been reserved for future repayment of principal and interest. The reserve at June 30, 2001 and 2000 was calculated as follows: 2001 2000 ----------- ----------- Restricted assets - debt service $ 252,506 $ 158,412 Less current liabilities payable from restricted assets - debt service 154,519 152,840 ----------- ----------- Reserved for debt service $ 97,987 $ 5,572 =========== =========== 8. INVESTMENT IN SAN JUAN BASIN AUTHORITY: On November 22, 1972, the Capistrano Valley Water District, the Capistrano Beach County Water District and the Santa Margarita Water District established the San Juan Basin Authority (the Authority), a separate legal entity, whose function is to plan, acquire, construct, maintain, repair, operate, and control facilities to supply the inhabitants and lands within each of the member agencies boundaries with water and provide for the development and conservation of water supplies. The Moulton Niguel Water District was subsequently admitted as a member in September 1987. In 1989, the Capistrano Beach County Water District withdrew from the Authority and the Trabuco Canyon Water District was subsequently admitted as a member. The Authority's governing board consists of one member from each District. The District's ownership percentage in the joint venture varies by fund and project. For the general fund, the District has a twenty-five percent ownership, and of the five Authority projects, the District has a fifty percent ownership in two projects and a twenty-five percent ownership in two projects, and no interest in the other project. 12 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 The District paid the Authority $65,234 and $46,553 for operations and maintenance for the years ended June 30, 2001 and 2000, respectively. The District's investment in the Authority has been recorded utilizing the equity method of accounting. Audited financial information of the Authority is available at the District's administrative office. 9. COMMITMENTS AND CONTINGENCIES: When it is probable that claim liability has been incurred at year-end, and the amount of the loss can be reasonably estimated, the District records the estimated loss, net of any insurance coverage. At June 30, 2001 in the opinion of the Districts management there were no material unrecorded claims. Under the terms of the District's grants from the Federal Emergency Management Agency (FEMA), final inspections and audits by the State of California Office of Emergency Services (OES) are required prior to final approval and release of funds. The final determination of the amounts to be reimbursed will be based upon these inspections and audits, therefore actual amounts received could differ from the recorded amounts. District management believes that disallowances, if any, would be immaterial. 10. CAPACITY RIGHTS: Lease of Capacity Rights in Allen-McColloch Pipeline: On October 22, 1992, the District entered into an interim license and lease of capacity agreement with the Municipal Water District of Orange County (MWDOC) to lease capacity rights for delivery of water. In fiscal year 1995, the District negotiated a payment plan with MWDOC to complete the purchase of rights to 4.9 CFS capacity, and as of June 30, 2001, the District has paid a total of $456,126. The District is amortizing the capacity rights over 60 years. At June 30, 2001 the remaining unamortized capacity rights amounted to $357,109. South County Pipeline: During 1993, the District entered into the South County Pipeline Service Connection Agreement (agreement) with Santa Margarita Water District, which provides a service connection and rights to capacity in the South County Pipeline. As part of the agreement, the District agreed to pay a share of the costs of constructing a Regulating Reservoir and 13 CAPISTRANO VALLEY WATER DISTRICT Notes to Financial Statements (Continued) June 30, 2001 and 2000 other required capital improvements. The District's share of the costs totaled $207,025, which did not result in any ownership rights in the underlying asset. The total amount has been capitalized as capacity rights on the accompanying balance sheet, and is to be amortized over the estimated useful life of the improvements. The District is amortizing the capacity rights over a period of 60 years. At June 30, 2001, the remaining unamortized capacity rights amounted to $182,873. 11. CONTRIBUTED CAPITAL: Changes in contributed capital were as follows: For the For the Year Ended Year Ended June 30, 2001 June 30, 2000 ------------- ------------- Balance - Beginning of Year $ 8,418,122 $ 8,596,947 Depreciation on contributed assets (177,252) (178,825) ------------- ------------- $ 8,240,870 $ 8,418,122 Balance - End of Year ============= ============= 12. DUE TO CITY OF SAN JUAN CAPISTRANO: The District collects sewer charges on behalf of the City of San Juan Capistrano. The sewer charges collected but not paid to the City amounted to $172,347 and $172,027 at June 30, 2001 and June 30, 2000, respectively. 14 APPENDIX B BOOK-ENTRY-ONLY SYSTEM The following information has been provided by DTC for use in securities offering documents, and neither the Authority nor the Water District takes any responsibility for the accuracy or completeness thereof. Neither the Authority nor the Water District can give any assurances that DTC, DTC Participants or Indirect Participants will distribute to the Beneficial Owners either (a) payments of interest, principal or premium, if any, with respect to the Bonds or (b) certificates representing ownership interest in or other confirmation of ownership interest in the Bonds, or that they will so do on a timely basis or that DTC, DTC Participants or DTC Indirect Participants will act in the manner described in this Official Statement. The current "Rules" applicable to DTC are on file with the Securities and Exchange Commission and the current "Procedures" of DTC to be followed in dealing with DTC Participants are on file with DTC. The Depository Trust Company ("DTC"), New York, NY, will act as securities depository for the Bonds. The Bonds will be issued as fully-registered securities registered in the name of Cede & Co. (DTC's partnership nominee) or such other name as may be requested by an authorized representative of DTC. One fully-registered Bond certificate will be issued for each maturity of the Bonds, each in the aggregate principal amount of such maturity, and will be deposited with DTC. DTC, the world's largest depository, is a limited-purpose trust company organized under the New York Banking Law, a "banking organization" within the meaning of the New York Banking Law, a member of the Federal Reserve System, a "clearing corporation" within the meaning of the New York Uniform Commercial Code, and a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934. DTC holds and provides asset servicing for over 2 million issues of U.S. and non-U.S. equity issues, corporate and municipal debt issues, and money market instruments from over 85 countries that DTC's participants ("Direct Participants") deposit with DTC. DTC also facilitates the post-trade settlement among Direct Participants of sales and other securities transactions in deposited securities, through electronic computerized book-entry transfers and pledges between Direct Participants' accounts. This eliminates the need for physical movement of securities certificates. Direct Participants include both U.S. and non-U.S. securities brokers and dealers, banks, trust companies, clearing corporations, and certain other organizations. DTC is a wholly owned subsidiary of The Depository Trust & Clearing Corporation ("DTCC"). DTCC, in turn, is owned by a number of Direct Participants of DTC and Members of the National Securities Clearing Corporation, Government Securities Clearing Corporation, MBS Clearing Corporation, and Emerging Markets Clearing Corporation, (NSCC, GSCC, MBSCC, and EMCC, also subsidiaries of DTCC), as well as by the New York Stock Exchange, Inc., the American Stock Exchange LLC, and the National Association of Securities Dealers, Inc. Access to the DTC system is also available to others such as both U.S. and non-U.S. securities brokers and dealers, banks, trust companies, and clearing corporations that clear through or maintain a custodial relationship with a Direct Participant, either directly or indirectly ("Indirect Participants"). DTC has Standard & Poor's highest rating: AAA. The DTC Rules applicable to its Participants are on file with the Securities and Exchange Commission. More information about DTC can be found at www.dtcc.com. Purchases of Bonds under the DTC system must be made by or through Direct Participants, which will receive a credit for the Bonds on DTC's records. The ownership interest of each actual purchaser of each Bond ("Beneficial Owner") is in turn to be recorded on the Direct and Indirect Participants' records. Beneficial Owners will not receive written confirmation from DTC of their purchase. Beneficial Owners are, however, expected to receive written confirmations providing details of the transaction, as well as periodic statements of their holdings, from the Direct or Indirect Participant B-l through which the Beneficial Owner entered into the transaction. Transfers of ownership interests in the Bonds are to be accomplished by entries made on the books of Direct and Indirect Participants acting on behalf of Beneficial Owners. Beneficial Owners will not receive certificates representing their ownership interests in Bonds, except in the event that use of the book-entry system for the Bonds is discontinued. To facilitate subsequent transfers, all Bonds deposited by Direct Participants with DTC are registered in the name of DTC's partnership nominee, Cede & Co., or such other name as may be requested by an authorized representative of DTC. The deposit of Bonds with DTC and their registration in the name of Cede & Co. or such other DTC nominee do not effect any change in beneficial ownership. DTC has no knowledge of the actual Beneficial Owners of the Bonds; DTC's records reflect only the identity of the Direct Participants to whose accounts such Bonds are credited, which may or may not be the Beneficial Owners. The Direct and Indirect Participants will remain responsible for keeping account of their holdings on behalf of their customers. Conveyance of notices and other communications by DTC to Direct Participants, by Direct Participants to Indirect Participants, and by Direct Participants and Indirect Participants to Beneficial Owners will be governed by arrangements among them, subject to any statutory or regulatory requirements as may be in effect from time to time. Beneficial Owners of Bonds may wish to take certain steps to augment the transmission to them of notices of significant events with respect to the Bonds, such as redemptions, tenders, defaults, and proposed amendments to the Bond documents. For example, Beneficial Owners of Bonds may wish to ascertain that the nominee holding the Bonds for their benefit has agreed to obtain and transmit notices to Beneficial Owners. In the alternative, Beneficial Owners may wish to provide their names and addresses to the registrar and request that copies of notices be provided directly to them. Redemption notices shall be sent to DTC. If less than all of the Bonds within an issue are being redeemed, DTC's practice is to determine by lot the amount of the interest of each Direct Participant in such issue to be redeemed. Neither DTC nor Cede & Co. (nor any other DTC nominee) will consent or vote with respect to Bonds unless authorized by a Direct Participant in accordance with DTC's Procedures. Under its usual procedures, DTC mails an Omnibus Proxy to the Authority as soon as possible after the record date. The Omnibus Proxy assigns Cede & Co.'s consenting or voting rights to those Direct Participants to whose accounts Bonds are credited on the record date (identified in a listing attached to the Omnibus Proxy). Redemption proceeds, distributions, and dividend payments on the Bonds will be made to Cede & Co., or such other nominee as may be requested by an authorized representative of DTC. DTC's practice is to credit Direct Participants' accounts upon DTC's receipt of funds and corresponding detail information from the Authority or the Trustee, on payable date in accordance with their respective holdings shown on DTC's records. Payments by Participants to Beneficial Owners will be governed by standing instructions and customary practices, as is the case with securities held for the accounts of customers in bearer form or registered in "street name," and will be the responsibility of such Participant and not of DTC nor its nominee, the Trustee, the Water District or the Authority, subject to any statutory or regulatory requirements as may be in effect from time to time. Payment of redemption proceeds, distributions, and dividend payments to Cede & Co. (or such other nominee as may be requested by an authorized representative of DTC) is the responsibility of the Authority or the Trustee, disbursement of such payments to Direct Participants will be the responsibility of DTC, and disbursement of such payments to the Beneficial Owners will be the responsibility of Direct and Indirect Participants. B-2 DTC may discontinue providing its services as depository with respect to the Bonds at any time by giving reasonable notice to the Authority or the Trustee. Under such circumstances, in the event that a successor depository is not obtained, Bond certificates are required to be printed and delivered. The Authority may decide to discontinue use of the system of book-entry transfers through DTC (or a successor securities depository). In that event, Bond certificates will be printed and delivered. The information in this section concerning DTC and DTC's book-entry system has been obtained from sources that the Authority and the Water District believe to be reliable, but neither the Authority nor the Water District takes any responsibility for the accuracy thereof. B-3 (This Page Intentionally left Blank) APPENDIX C DEFINITIONS AND SUMMARY OF CERTAIN PROVISIONS OF PRINCIPAL FINANCING DOCUMENTS The following is a brief summary of certain provisions of the legal documents related to the Bonds which are not described in the Official Statement to which this Appendix is attached. This summary is not intended to be definitive and is qualified in its entirety by reference to the Lease and the Trust Agreement for the complete terms thereof. Copies of the Lease and the Trust Agreement are available upon request from the Authority. DEFINITIONS The following are summaries of definitions of certain terms used in this Summary of Principal Financing Documents. All capitalized terms not defined herein or elsewhere in the Official Statement have the meanings set forth in the Lease or the Trust Agreement. "Acceptance" means acceptance of the Service Contract Project Improvements by the Water District pursuant to the terms of the Service Contract. "Additional Payments" means any amounts payable by the Water District under the terms of the Lease Agreement, other than the Lease Payments. "Alternative Facilities" shall mean any new water storage and production facilities that would in aggregate supply more than 3.0 MGD of potable water. Alternative Facilities shall not include any wells existing on the Closing Date, any facilities for the importation or transmission of local water sources delivered by wholesale water agencies to the Water District, or other generation, storage and production sources developed by the District in the course of its ongoing program to develop local water supply infrastructure, including without limitation for reclaimed water, prior to an event of default under the Service Contract and not in view of a Lease Termination. "Alternative Reserve Account Security" means one or more letters of credit, surety bonds or bond insurance policies, for the benefit of the Trustee in substitution for or in place of all or any portion of the Reserve Requirement. "Annual Debt Service" means, for each Bond Year, the sum of (a) the interest payable on the Outstanding Bonds in such Bond Year, assuming that any Outstanding term Bonds are redeemed from mandatory sinking fund payments as scheduled and (b) the principal amount of the Outstanding Bonds scheduled to be paid or redeemed in such Bond Year. "Authority" means the San Juan Basin Authority, a joint exercise of powers authority organized and existing pursuant to Chapter 5, Division 7, Title 1 of the Government Code of the State. "Authorized Representative of the Authority" means the Chairman or Executive Director of the Authority and any person or persons designated by the Chairman or Executive Director of the Authority and authorized to act on behalf of the Authority as certified by a written certificate signed C-l on behalf of the Authority by the Chairman or Executive Director of the Authority and containing the specimen signature of each such person. "Authorized Representative of the City" means the City Manager of the City, the Public Works Director of the City or any person or persons designated by the City Manager and authorized to act on behalf of the City by a written certificate signed on behalf of the City by the City Manager and containing the specimen signature of each such person. "Authorized Representative of the Water District" means the General Manager of the Water District or Administrative Services Director of the Water District, City Public Works Director or any person or persons designated by the General Manager and authorized to act on behalf of the Water District by a written certificate signed on behalf of the Water District by the General Manager and containing the specimen signature of each such person. "Average Annual Debt Service" means the amount determined by dividing the sum of all Annual Debt Service amounts due in each of the Bond Years following the date of such calculation by the number of such Bond Years. "Board of Directors" means the Board of Directors of the Water District. "Bond" or "Bonds" means any of the San Juan Basin Authority, Lease Revenue Bonds (Ground Water Recovery Project), Issue of 2002 issued pursuant to the Trust Agreement. "Bond Counsel" means a firm of nationally-recognized firm of attorneys experienced in the issuance of tax-exempt obligations the interest on which is excludable from gross income under Section 103 of the Code. "Bond Insurer" means Ambac Assurance Corporation, a Wisconsin stock insurance corporation or any successor thereto. "Bondowner" or "Owner of Bonds" or "Owner" means the registered owner of any Bond or Bonds. "Bond Purchase Agreement" means the Bond Purchase Agreement by and among the Authority, the Water District and Lehman Brothers relating to the sale of the Bonds. "Bond Year" means the twelve month period which commences on November 2 in every year and ends on November 1 of the succeeding year. The first Bond Year shall commence on the Delivery Date and end on November 1, 2003. "Business Day" means any day other than (i) a Saturday or Sunday or legal holiday or a day on which banking institutions in the city in which the principal office of the Trustee is located are authorized to close or (ii) a day on which the New York Stock Exchange is closed. "Certificate of Authorized Representative of the Authority" means a certificate executed by an Authorized Representative of the Authority. "Certificate of Authorized Representative of the Water District" means a certificate executed by an Authorized Representative of the Water District. C-2 "City" means the City of San Juan Capistrano, California. "Closing Date" means the date on which the Bonds are delivered to the initial purchaser thereof. "Code" means the Internal Revenue Code of 1986, as amended and the United States Treasury Regulations proposed or in effect with respect thereto. "Company" means ECO Resources, Inc., a Texas corporation, and any successor thereto under the terms of the Service Contract. "Costs of Issuance" means all expenses and costs of the Authority or the Water District incident to the performance of its obligations in connection with the authorization, execution, sale and delivery of the Bonds, including, but not limited to, printing costs, initial Trustee fees and expenses and fees and expenses of its counsel, fees and expenses of consultants and fees and expenses of bond counsel to the Authority or the Water District, credit enhancement fees and bond insurance costs. "Costs of Issuance Account" means the account by that name established pursuant to the Trust Agreement. "CPI" means Consumer Price Index, as published by U.S. Department of Commerce, Bureau of Economic Analysis. "DTC" means The Depository Trust Company, New York, New York, and its successors and assigns. "Debt Service Payment Account" means the Debt Service Payment Account established in the Trust Agreement. "Delivery Date" means the date of the initial issuance of the Bonds. "Depository" means (a) initially, DTC, and (b) any other securities depository acting as Depository pursuant to the Trust Agreement. "End of Term" shall have the meaning ascribed thereto in the Lease. "Events of Default" means events of default as set forth in the Lease. "Fiscal Year" means the twelve month fiscal period of the Water District which commences on July 1 in every year and ends on June 30 of the succeeding year. "GAAP" means generally accepted accounting principles. "Independent Counsel" means an attorney duly admitted to the practice of law before the highest court of the state in which such attorney maintains an office and who is not an employee or officer of the Authority, the Trustee or the Water District. "Independent Engineer" means the engineer so designated from time to time pursuant to the terms of the Service Contract. C-3 "Insurance Policy" means the financial guaranty insurance policy issued by the Bond Insurer insuring the payment when due of the principal of and interest on the Bonds as provided therein. "Interest Payment Date" means June 1 and December 1 of each year commencing June 1, 2003. "Investment Securities" means and includes any of the following securities, if and to the extent the same are at the time legal for investment of Authority funds (the Trustee is entitled to rely upon investment direction of the Water District as a determination that such investment is a legal investment): A. For all purposes including defeasance investments. (1) Cash (insured at all times by the Federal Deposit Insurance Corporation), (2) Direct obligations of (including obligations issued or held in book entry form on the books of the Department of the Treasury of the United States of America, or (3) Senior debt obligations of other Government Sponsored Agencies approved by the Bond Insurer. B. For all purposes other than defeasance investments in refunding escrow accounts. (1) Obligations of any of the following federal agencies which obligations represent the full faith and credit of the United States of America, including: .Export-Import Bank .Rural Economic Community Development Administration .U.S. Maritime Administration .Small Business Administration .U.S. Department of Housing & Urban Development (PHAs) .Federal Housing Administration .Federal Financing Bank (2) Direct obligations of any of the following federal agencies which obligations are not fully guaranteed by the full faith and credit of the United States of America: .Senior debt obligations issued by the Federal National Mortgage Association (FNMA) or Federal Home Loan Mortgage Corporation (FHLMC). .Obligations of the Resolution Funding Corporation (REFCORP) .Senior debt obligations of the Federal Home Loan Bank System .Senior debt obligations of other Government Sponsored Agencies approved by the Bond Insurer (3) U.S. dollar denominated deposit accounts, federal funds and bankers' acceptances with domestic commercial banks which have a rating on their short term certificates of deposit on the date of purchase of "P-l" by Moody's and "A-l" or "A-1+" by S&P and maturing not C-4 more than 360 calendar days after the date of purchase. (Ratings on holding companies are not considered as the rating of the bank); (4) Commercial paper which is rated at the time of purchase in the single highest classification, "P-l" by Moody's and "A-1+" by S&P and which matures not more than 270 calendar days after the date of purchase; (5) Investments in a money market fund rated "AAAm" or "AAAm-G" or better by S&P including funds for which the Trustee or an affiliate provides investment advice or other services; (6) Pre-refunded Municipal Obligations defined as follows: any bonds or other obligations of any state of the United States of America or of any agency, instrumentality or local governmental unit of any such state which are not callable at the option of the obligor prior to maturity or as to which irrevocable instructions have been given by the obligor to call on the date specified in the notice; and (A) which are rated, based on an irrevocable escrow account or fund (the "escrow"), in the highest rating category of Moody's or S&P or any successors thereto; or (B) (i) which are fully secured as to principal and interest and redemption premium, if any, by an escrow consisting only of cash or obligations described in paragraph A(2) above, which escrow may be applied only to the payment of such principal of and interest and redemption premium, if any, on such bonds or other obligations on the maturity date or dates thereof or the specified redemption date or dates pursuant to such irrevocable instructions, as appropriate, and (ii) which escrow is sufficient, as verified by a nationally recognized independent certified public accountant, to pay principal of and interest and redemption premium, if any, on the bonds or other obligations described in this paragraph on the maturity date or dates specified in the irrevocable instructions referred to above, as appropriate; (7) Municipal obligations rated "Aaa/AAA" or general obligations of States with a rating of "A2/A" or higher by both Moody's and S&P. (8) Investment agreements approved in writing by the Bond Insurer (supported by appropriate opinions of counsel); and (9) Other forms of investments (including repurchase agreements) approved in writing by the Bond Insurer. C. The value of the above investments shall be determined as follows: (a) For the purpose of determining the amount in any fund, all Permitted Investments credited to such fund shall be valued at fair market value. The Trustee shall determine the fair market value based on accepted industry standards and from accepted industry providers. Accepted industry providers shall include but are not limited to pricing services provided by Financial Times Interactive Data Corporation, Merrill Lynch, Salomon Smith Barney, Bear Stearns, or Lehman Brothers. (b) As to certificates of deposit and bankers' acceptances: the face amount thereof, plus, accrued interest thereon; and C-5 (c) As to any investment not specified above: the value thereof established by prior agreement among the Authority, the Trustee, and the Bond Insurer. "Joint Exercise of Powers Agreement" means that certain Joint Exercise of Powers Agreement entered into by and among the Capistrano Beach County Water District, the Santa Margarita Water District, and Orange County Water District No. 4 dated as of November 22, 1971, as amended effective September 1, 1987 by Addendum No. 1 to the Joint Exercise of Powers Agreement and Addendum No. 3 dated as of September 1, 2002. "Lease" or "Lease Agreement" means the Lease Agreement, between the Water District and the Authority, as amended and supplemented from time to time in accordance with its terms. "Lease Payment" means the amount to be paid by the Water District for the lease of the Project corresponding to the Lease Payment Date set forth in the Lease. "Lease Payment Date" means the 15th day of the month preceding each Interest Payment Date (or if the 15th day of the month is not a Business Day, on the next succeeding Business Day). "Lease Revenue Bonds Rate Stabilization Reserve" means the fund by that name established pursuant to the Lease. "Lease Term" means the period during which the Lease Agreement is in effect as specified in the Lease Agreement. "Lease Termination" means any Termination of the Lease pursuant to the terms of the Lease controlling termination upon the occurrence of an event of default under the Service Contract. "Letter of Credit" means the Service Contract Letter of Credit (as defined in the Service Contract). "Letter of Credit Provider" means, initially, Bank of America, N.A. "Lock-out Period" shall mean a three-year period from the date of a Termination Event. "Maintenance and Operation Costs" means costs spent or incurred for operation and maintenance of the Water System calculated in accordance with generally accepted accounting principles, including (among other things) the reasonable expenses of management and repair and other expenses necessary to maintain and preserve the Water System in good repair and working order, and also means all costs of water purchased or otherwise acquired for delivery by the Water System (including the Lease Payments, any Parity Obligations and any interim or renewed arrangement for water purchase or acquisition); but excluding in all cases depreciation, replacement and obsolescence charges or reserves therefor and amortization of intangibles or other bookkeeping entries of a similar nature and any amounts transferred to the Lease Revenue Bonds Rate Stabilization Reserve. "Maintenance and Operation Cap" means annual costs not to exceed $2,750,000 for Lease Payments, as such costs may be increased due to currently unforeseeable cost increases which are out of the control of the Water District and of the owner, operator and lenders with respect to the Ground Water Recovery Plant. C-6 "Manager" means the General Manager of the Water District, or any other person designated by the General Manager to act on behalf of the General Manager. "Maximum Annual Debt Service" means, as of the date of any calculation, the maximum amount of principal, interest and mandatory sinking fund deposits required to be paid with respect to the Bonds in the current or any future Bond Year. "Metropolitan Water Agreement" means that certain 1998 San Juan Basin DeSalter Agreement between the Metropolitan Water District of Southern California ("MWD"), the Municipal Water District of Orange County ("MWDOC"), and the San Juan Basin Authority dated December 4, 1998, as amended effective October 15, 2002 by that certain First Amendment thereto by and between MWD, MWDOC, the Authority and the Water District. "Moody's" means Moody's Investors Service, a municipal bond rating service with offices in New York, New York. "Net Insurance Proceeds" means any insurance or condemnation proceeds paid with respect to the Property and the Service Contract Project Improvements and remaining after payment therefrom of all expenses incurred in the collection thereof. "Net Revenues" means the amounts of Revenues of the Water System remaining after payment therefrom of the Maintenance and Operation Costs. "Operating Lease" means that certain Operating Lease of even date with the Lease by and between the Water District and the Authority. "Original Proceeds" means proceeds from the sale of the Bonds. "Original Purchaser" means the first purchaser of the Bonds upon their delivery by the Trustee. "Outstanding," when used with reference to Bonds, means, as of any date, Bonds theretofore or thereupon being issued under the Trust Agreement, except: (a) Bonds canceled or delivered for cancellation by the Trustee on or prior to such date (but excluding Bonds paid by the Bond Insurer); (b) Bonds (or portions of Bonds) defeased as provided in the Trust Agreement; and (c) Bonds in lieu of or in substitution for which other Bonds shall have been issued pursuant to the Trust Agreement. "Parity Obligations" means any obligations secured on a parity with the Lease Payments which are incurred in accordance with the Lease. "Permitted Encumbrances" means as of any particular time: (1) liens for general ad valorem taxes and assessments, if any, not then delinquent, or which the Water District may, pursuant to the Trust Agreement, permit to remain unpaid; (2) the Trust Agreement as it may be amended from time to time; (3) the Lease Agreement and the Property Lease as they may be amended from time to time; (4) any right or claim of any mechanic, laborer, materialman, supplier or vendor filed or perfected in C-7 the manner prescribed by law to the extent permitted under the Lease; (5) easements, rights of way, mineral rights, drilling rights and other rights, reservations, covenants, conditions or restrictions which exist of record as of the Closing Date and which the Water District certifies in writing on the Closing Date will not materially impair the use of the Project; (6) easements, rights of way, mineral rights, drilling rights and other rights, reservations, covenants, conditions or restrictions established following the Closing Date, to which the Authority and the Water District consent in writing and which the Water District certifies will not materially impair the use of the Project or real property substituted for the Project, as the case may be; and (7) liens created in connection with the issuance of Parity Obligations. "Project" means, collectively, the Property and the Service Contract Project Improvements thereon, and any and all additions or modifications thereto made as provided in the Lease. "Project Account" means the account by that name established pursuant to the Trust Agreement. "Project Trust Fund" means the fund so designated which is established in the Trust Agreement. "Property" means the real property described from time to time in the Lease. "Property Lease" means the Property Lease between the City, as lessor, and the Authority, as lessee, as amended and supplemented from time to time in accordance with its terms. "Purchase Option Price" means the amount to be paid pursuant to the Lease Agreement, as the same may be amended, less the amount of any funds held by the Trustee which are available for redemption of the Bonds plus interest on such principal to the redemption date and premium, if any. "Rating Agencies" means Moody's and S&P, any successors thereto or any other nationally recognized rating service to the extent such rating agencies are maintaining a rating in connection with the Bonds as requested by or on behalf of the Water District. "Rebatable Arbitrage" shall have the meaning attributed to such term in the Trust Agreement. "Rebate Fund" means the account so designated established pursuant to the Trust Agreement. "Rebate Regulations" means the Regulations issued under Section 148(f) of the Code. "Record Date" means the fifteenth day of the calendar month preceding an Interest Payment Date. "Redemption Account" means the Redemption Account established in the Trust Agreement. "Requisition" means the Requisition as set out in either Exhibit C or Exhibit D attached to the Trust Agreement, as applicable. "Reserve Account" means the Reserve Account established in the Trust Agreement. C-8 "Reserve Requirement" means, as of any date of calculation, an amount equal to the lesser of (i) Maximum Annual Debt Service; (ii) 10% of the proceeds of the Bonds; or (iii) 125% of Average Annual Debt Service. "Revenue Fund" means the enterprise fund of the Water District currently identified as the "Water Enterprise Fund" of the Water District, any successor fund or funds, and such other funds as the Board of Directors shall establish as a part of the Revenue Fund which shall constitute the Revenue Fund maintained pursuant to the Lease Agreement and the "Revenue Fund" maintained pursuant to the Series 2002 Installment Purchase Agreement. "Revenues" means all income, rents, rates, fees, charges and other moneys derived from the ownership or operation of the Water System, including, without limiting the generality of the foregoing, (1) all income, rents, rates, fees, charges, business interruption insurance proceeds or other moneys derived by the Water District from the sale, furnishing and supplying of the water or other services, facilities, and commodities sold, furnished or supplied through the facilities of or in the conduct or operation of the business of the Water System; (2) the earnings on and income derived from the investment of amounts described in clause (1) above and from Water District reserves; (3) the proceeds derived by the Water District directly or indirectly from the sale, lease or other disposition of a part of the Water System; and (4) payments under Metropolitan Water Agreement; but excluding (a) customers' deposits or any other deposits or advances subject to refund until such deposits or advances have become the property of the Water District; (b) any proceeds of taxes or assessments restricted by law to be used by the Water District to pay bonds or other obligations theretofore or thereafter issued. Revenues shall also include all amounts transferred from the Lease Revenue Bonds Rate Stabilization Reserve to the Revenue Fund during any Fiscal Year in accordance with the Lease Agreement. "S&P" or "Standard & Poor's" means Standard & Poor's Ratings Group, a municipal bond rating service with offices in New York, New York. "Series 2002 Certificates of Participation" means the San Juan Capistrano Public Financing Authority Revenue Certificates of Participation, Series 2002, executed and delivered on April 3, 2002 in the aggregate principal amount of $8,525,000. C-9 "Series 2002 Installment Payments" means the installment payments of interest and principal scheduled to be paid by the Water District under and pursuant to the Series 2002 Installment Purchase Agreement, and any amendments thereto. "Series 2002 Installment Purchase Agreement" means that certain Installment Purchase Agreement by and between the Water District and the San Juan Capistrano Public Financing Authority, dated as of March 1, 2002. "Service Contract" means that certain service contract by and between the Water District and the Company, for the design, construction and operation of the Project dated as of September 3, 2002. "Service Contract Project Improvements" means those certain Project Improvements, Project Structures and Project Equipment (as defined in the Service Contract) each to be completed and located on the Sites (as defined in the Service Contract) pursuant to the terms of the Service Contract. "State" means the State of California. "Supplemental Trust Agreement" means any agreement supplemental or amendatory of the Trust Agreement. "Tax Certificate" means the certificate by that name to be executed by the Authority and the Water District on the Delivery Date to establish certain facts and expectations and which contains certain covenants relevant to compliance with the Code. "Term" means the duration of the Lease Agreement pursuant to the provisions in the Lease. "Transaction Documents" means, collectively, the Lease, the Trust Agreement, the Property Lease, the Service Contract and the Insurance and Indemnity Agreement. "Trust Agreement" means the Trust Agreement relating to the San Juan Basin Authority, Lease Revenue Bonds (Ground Water Recovery Project) Issue of 2002, dated as of December 1, 2002 entered into by and among the Water District, the Authority and the Trustee and any and all Supplemental Trust Agreements. "Trust Estate" means all right, title and interest of the Trustee in and to the Trustee benefit provisions pursuant to Section 13.3 of the Service Contract, all amounts received by the Trustee for the account of the Water District pursuant to or with respect to the Letter of Credit and the Lease Agreement including, without limitation, the Lease Payments and all amounts from time to time deposited in the funds, accounts and subaccounts created pursuant to the Trust Agreement, including all investments and investment earnings thereon, excluding, however, all moneys deposited or required to be deposited in the Rebate Fund. "Trustee" means BNY Western Trust Company, a banking corporation, duly organized and existing under and by virtue of the laws of the State of California having a corporate trust office in Los Angeles, California, or such other offices as the Trustee may designate. "Water District" means Capistrano Valley Water District, a county water district duly organized and existing under and by virtue of the laws of the State, and its successors and assigns, including any successor by merger to all of its rights and obligations. C-10 "Water System" means the entire water system of the Water District, including, without limitation, all real property and buildings, and including all improvements, works or facilities assessed, controlled or operated by the Water District to provide water, as such improvements, works or facilities now exist, together with all improvements and extensions to said water system later acquired, constructed or organized. LEASE AGREEMENT REPRESENTATIONS, COVENANTS AND WARRANTIES Representations, Covenants and Warranties of the Water District. The Water District represents, covenants and warrants to the Authority as follows: (a) Due Organization and Existence. The Water District is a county water district duly organized and existing under and by virtue of the laws of the State, with the power and authority to own, lease and acquire real and personal property and equipment and to incur the obligations under the Lease Agreement. (b) Authorization; Enforceability. The laws of the State authorize the Water District to enter into the Lease Agreement and to enter into the transactions contemplated by and to carry out its obligations under the Lease Agreement, and the Water District has duly authorized and executed the Lease Agreement. The Lease Agreement constitutes the legal, valid and binding obligation of the Water District, enforceable in accordance with its terms, except to the extent limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws or equitable principles affecting the rights of creditors generally. (c) No Conflicts or Default; No Liens or Encumbrances. Neither the execution and delivery of the Lease Agreement, nor the fulfillment of or compliance with the terms and conditions of the Lease Agreement, nor the consummation of the transactions contemplated thereby, conflicts with or results in a breach of the terms, conditions or provisions of any restriction or any agreement or instrument to which the Water District is now a party or by which the Water District is bound, or constitutes a default under any of the foregoing, or results in the creation or imposition of any lien, charge or encumbrance whatsoever upon any of the property or assets of the Water District or upon the Project, except for Permitted Encumbrances. (d) Execution and Delivery. The Water District has duly authorized and executed the Lease Agreement in accordance with the laws of the State. (e) No Consent Required. There is no consent, approval, authorization or other order of, or filing with, or certification by, any regulatory authority having jurisdiction over the Water District required for the consummation by the Water District of the transactions contemplated by the Lease Agreement. (f) No Litigation. There is no action, suit, proceeding, inquiry or investigation, at law or in equity, before or by any court, governmental agency, public office or body, pending or threatened against the Water District affecting the existence of the Water District or the titles of its officers to their respective offices or seeking to prohibit, restrain or enjoin the Water District's covenants to make Lease Payments or in any way contesting or affecting the validity or C-ll enforceability of the Lease Agreement or contesting the powers of the Water District or its authority to enter into, adopt or perform its obligations under the Lease Agreement or any amendment or supplement thereto, wherein an unfavorable decision, ruling or finding would materially adversely affect the Lease Agreement, or in which a final adverse decision could materially adversely affect the operations of the Water District. (g) Indemnification of Authority. To the extent permitted by law, the Water District covenants to defend, indemnify and hold harmless the Authority and its assigns (including specifically the Trustee), directors and employees (collectively, the "Indemnified Party") against any and all losses, claims, damages or liabilities, joint or several, including fees and expenses incurred in connection therewith, to which such Indemnified Party may become subject under any statute or at law or in equity or otherwise in connection with the transactions contemplated by the Lease Agreement or the Trust Agreement, and shall reimburse any such Indemnified Party for any legal expenses reasonably incurred by it in connection with defending any actions, insofar as such losses, claims, damages, liabilities or actions arise out of the transactions contemplated by the Lease Agreement, the Trust Agreement or the Property Lease. In particular, without limitation, to the extent permitted by law, the Water District shall agree to indemnify and save the Indemnified Party harmless from and against all claims, losses and damages, including legal fees and expenses, to the extent arising out of (i) the use, maintenance, condition or management of, or from any work or thing done on, the Project by the Water District, (ii) any breach or default on the part of the Water District in the performance of any of its obligations under the Lease Agreement or the Trust Agreement, (iii) any act of negligence of the Water District or of any of its agents, contractors, servants, employees or licensees with respect to the Project, (iv) any act of negligence of any assignee or sublessee of the Water District with respect to the Project or (v) the acceptance of, and performance of the duties of the Trustee under the Trust Agreement. No indemnification is made under this Section or elsewhere in the Lease Agreement for claims, losses or damages, including legal fees and expenses arising out of the willful misconduct, negligent acts or omissions, or breach of duty under the Lease Agreement, the Property Lease or the Trust Agreement by the Authority, its officers, directors, agents, employees, successors or assigns (including specifically the Trustee). (h) General Tax and Arbitrage Covenant. The Water District covenants that, notwithstanding any other provision of the Lease Agreement, it shall not take any action, or fail to take any action, if any such action or failure to take action would adversely affect the exclusion from gross income of interest with respect to the Bonds under Section 103 of the Internal Revenue Code of 1986, as amended (the "Code"). The Water District shall not, directly or indirectly, use or permit the use of proceeds of the Bonds or the Service Contract Project Improvements, or any portion thereof, by any person other than a governmental unit (as such term is used in Section 141 of the Code), in such manner or to such extent as would result in the loss of exclusion from gross income for federal income tax purposes of interest on the Bonds. The Water District shall not take any action, or fail to take any action, if any such action or failure to take action would cause the Bonds to be "private activity bonds" within the meaning of Section 141 of the Code, and in furtherance thereof, shall not make any use of the proceeds of the Bonds or the Service Contract Project Improvements, or any portion thereof, or any other funds of the Water District, that would cause the Bonds to be "private activity bonds" within the meaning of Section 141 of the Code. To that end, so long as any Bonds are outstanding, the Water District, with respect to such proceeds and the Service Contract Project Improvements and such other funds, will comply with applicable requirements of the Code and all regulations of the United States Department C-12 of the Treasury issued thereunder and under Section 103 of the Code, to the extent such requirements are, at the time, applicable and in effect. The Water District shall not, directly or indirectly, use or permit the use of any proceeds of any Bonds, or of the Service Contract Project Improvements, or other funds of the Water District, or take or omit to take any action, that would cause the Bonds to be "arbitrage bonds" within the meaning of Section 148 of the Code. To that end, the Water District shall comply with all requirements of Section 148 of the Code and all regulations of the United States Department of the Treasury issued thereunder to the extent such requirements are, at the time, in effect and applicable to the Bonds. The Water District shall not make any use of the proceeds of the Bonds or any other funds of the Water District, or take or omit to take any other action, that would cause the Bonds to be "federally guaranteed" within the meaning of Section 149(b) of the Code. (i) The Lease Payments as due and payable pursuant to Exhibit A to the Lease, do not in any year exceed the Maintenance and Operations Cap and, except as Lease Payments exceed the Maintenance and Operations Cap in any year due to acceleration thereof, shall constitute Maintenance and Operations Costs. Representations, Covenants and Warranties of the Authority. The Authority represents, covenants and warrants to the Water District as follows: (a) Due Organization and Existence: Enforceability. The Authority is a joint powers authority, duly organized, existing and in good standing under and by virtue of the laws of the State, has the power to enter into the Lease Agreement, the Property Lease and the Trust Agreement; is possessed of full power to own and hold real and personal property, and to lease and sell the same; and has duly authorized the execution and delivery of the Lease Agreement, the Property Lease and the Trust Agreement. The Lease Agreement, the Property Lease and the Trust Agreement constitute the legal, valid and binding obligations of the Authority, enforceable in accordance with their respective terms, except to the extent limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws or equitable principles affecting the rights of creditors generally. (b) No Encumbrances. The Authority will not pledge the Lease Payments or Additional Payments or other amounts derived from the Project or from its other rights under the Lease Agreement or the Property Lease, except for Permitted Encumbrances and except as provided under the terms of the Lease Agreement and the Trust Agreement. (c) No Conflicts or Defaults: No Liens or Encumbrances. Neither the execution and delivery of the Lease Agreement, the Property Lease or the Trust Agreement nor the fulfillment of or compliance with the terms and conditions thereof, nor the consummation of the transactions contemplated thereby, conflicts with or results in a breach of the terms, conditions or provisions of the Joint Exercise of Powers Agreement of the Authority or any restriction or any agreement or instrument to which the Authority is now a party or by which the Authority is bound, or constitutes a default under any of the foregoing, or results in the creation or imposition of any lien, charge or encumbrance whatsoever upon any of the property or assets of the Authority or upon the Project, except for Permitted Encumbrances. C-13 (d) No Consent Required. There is no consent, approval, authorization or other order of, or filing with, or certification by, any regulatory authority having jurisdiction over the Authority required for the consummation by the Authority of the transactions contemplated by the Lease Agreement, the Trust Agreement or the Property Lease. (e) No Litigation. There is no action, suit, proceeding, inquiry or investigation, at law or in equity, before or by any court, governmental agency, public office or body, pending or threatened against the Authority affecting the existence of the Authority or the titles of its officers to their respective offices or seeking to prohibit, restrain or enjoin the Authority's receipt of, or assignment to the Trustee of, Lease Payments or in any way contesting or affecting the validity or enforceability of the Lease Agreement, the Trust Agreement or the Property Lease or contesting the powers of the Authority or its authority to enter into, adopt or perform its obligations under the Lease Agreement, the Trust Agreement or the Property Lease or any amendment or supplement thereto, wherein an unfavorable decision, ruling or finding would materially adversely affect the Lease Agreement, the Trust Agreement or the Property Lease, or in which a final adverse decision could materially adversely affect the operations of the Authority. (f) Execution and Delivery. The Authority has duly authorized and executed the Lease Agreement, the Property Lease and the Trust Agreement in accordance with the Constitution and laws of the State. (g) General Tax and Arbitrage Covenant. The Authority covenants that, notwithstanding any other provision of the Lease Agreement, it will make no use of the proceeds of the Bonds or of any other amounts or property, regardless of the source, or take any action or refrain from taking any action that may cause the obligations of the Water District under the Lease Agreement to be "arbitrage bonds" subject to federal income taxation by reason of Section 148 of the Code. In addition, the Authority covenants that it will not make any use of the proceeds of the obligations provided in the Lease Agreement or in the Trust Agreement or of any other funds of the Water District or the Authority or take or omit to take any other action that would cause such obligations to be "private activity bonds" within the meaning of Section 141 of the Code, or "federally guaranteed" within the meaning of Section 149(b) of the Code. To that end, so long as necessary to maintain the exclusion from gross income for federal income tax purposes of the interest portion of the Lease Payments, the Authority will comply with all requirements of such Sections and all regulations of the United States Department of the Treasury issued thereunder and under Section 103 of the Code, to the extent that such requirements are, at the time, applicable and in effect. (h) Maintenance of Corporate Existence. To the extent permitted by law, the Authority agrees that during the Term it will maintain its existence as a public entity, will not dissolve or otherwise dispose of all or substantially all of its assets. ACQUISITION AND CONSTRUCTION OF THE SERVICE CONTRACT PROJECT IMPROVEMENTS Deposit of Bond Proceeds. On the Closing Date, the Authority agrees to deposit to the Project Account of the Project Trust Fund created under the Trust Agreement the proceeds of the Authority's sale of the Bonds in the amount specified in the Trust Agreement. C-14 Acquisition and Construction of the Service Contract Project Improvements. The Water District agrees, as agent for the Authority, to exercise its rights pursuant to the terms of the Service Contract as may be reasonably necessary to cause the Service Contract Project Improvements to be acquired, constructed, delivered and installed with the proceeds of Bonds made available by the Trustee, pursuant to the Lease Agreement, and the Authority shall have no responsibility with respect thereto. Further Assurances and Corrective Instruments. The Authority and the Water District agree that they will, from time to time, execute, acknowledge and deliver, or cause to be executed, acknowledged and delivered, such supplements and such further instruments as may reasonably be required for correcting any inadequate or incorrect description of the Property leased or intended so to be or for carrying out the expressed intention of the Lease Agreement. AGREEMENT OF LEASE; TERM OF LEASE; LEASE PAYMENTS Lease. The Authority leases the Property to the Water District upon the terms and conditions set forth in the Lease Agreement. Term. The Term of the Lease Agreement shall commence on the Closing Date and shall end on December 1, 2035, unless extended pursuant to the Lease Agreement (as so extended the "End of Term"), or unless terminated prior thereto upon the earlier of the following events: (a) Payment of All Lease Payments. The payment by the Water District of all Lease Payments and any Additional Payments required under the Lease Agreement; or (b) Prepayment. The optional prepayment of all Lease Payments in accordance with the Lease Agreement and the payment of all Additional Payments due through such prepayment date; or (c) Extraordinary Termination. The exercise by the Water District of its right to terminate the Lease Agreement upon the occurrence of one or more of the conditions therefor as described in the Lease Agreement. Extension of Lease Term. If on December 1, 2035 the Bonds shall not be fully paid, then the Term shall be extended until all Bonds shall be fully paid, except that the Term shall in no event be extended beyond December 1, 2045. Lease Payments. (a) Time and Amount. Subject to the provisions of the Lease Agreement (regarding prepayment of Lease Payments) and subject to the provisions of the Lease Agreement (regarding termination of the Lease Agreement), the Water District agrees to pay to the Authority, its successors and assigns, as annual rental for the use and possession of the Project, the Lease Payments to be due and payable in arrears on the days specified in the Lease Agreement or if such a day is not a Business Day then on the next preceding Business Day (each such day a "Lease Payment Date"). (b) Priority Payment. The Water District unconditionally pledges the Revenues to the payment of the Lease Payments on a senior basis to its pledge of Net Revenues to the payment of the Series 2002 Installment Payments up to the Maintenance and Operation Cap and C-15 unconditionally pledges Net Revenues to the payment of Lease Payments on a parity to its pledge of Net Revenues to the payment of the Series 2002 Installment Payments. The Water District covenants to make no changes in the Series 2002 Installment Purchase Agreement or otherwise that impairs the priority of such pledge and such priority shall survive any partial payment or defeasance of the Series 2002 Installment Purchase Agreement or Series 2002 Certificates of Participation. (c) Credits. Any amount held in the Debt Service Payment Account on any Lease Payment Date (other than amounts required for payment of past due principal or interest with respect to any Bonds that have matured or been called for redemption and have not been presented for payment or amounts which have been paid with respect to a prior Lease Payment Date but not yet distributed to Bond Owners) shall be credited toward the Lease Payment then due and payable. No Lease Payment need be made on any Lease Payment Date if the amounts then held in the Debt Service Payment Account (other than those amounts excluded under the prior sentence) are at least equal to the cumulative total of Lease Payments then required to be paid. (d) Rate on Overdue Payments. In the event the Water District should fail to make any Lease Payment required by the Lease Agreement, or any portion of any such Lease Payment, the Lease Payment or portion in default shall continue as an obligation of the Water District until the amount in default shall have been fully paid, and the Water District agrees to pay the same with interest thereon, to the extent permitted by law, from the date such amount was originally payable at the rate equal to the highest stated interest rate on any of the Bonds as stated in the Trust Agreement. No Withholding. Notwithstanding any dispute between the Authority and the Water District, the Water District shall make all Lease Payments when due and shall not withhold any Lease Payment pending the final resolution of such dispute. Obligation Absolute. Except as permitted pursuant to the Lease Agreement, the obligation of the Water District to make the Lease Payments is absolute and unconditional and until such time as the Lease Payments shall have been paid in full (or provision for the payment thereof shall have been made pursuant to the Lease Agreement), the Water District will not discontinue or suspend any Lease Payments or Additional Payments required to be made by it under the Lease Agreement when due, whether or not the Water System or any part thereof is operating or operable or its use is suspended, interfered with, reduced or curtailed or terminated in whole or in part, and such payments shall not be subject to reduction whether by offset or otherwise and shall not be conditional upon the performance or nonperformance by any party of any agreement for any cause whatsoever. Budget and Appropriation. The Water District covenants to take such action as may be necessary to include all Lease Payments and Additional Payments due under the Lease Agreement in its proposed annual budget and its final adopted annual budget and to make the necessary appropriations for any amount of Lease Payments and Additional Payments to be paid therefor. Revenue Fund. The Water District agrees to maintain the Revenue Fund held by the Treasurer of the Water District (the "Treasurer"). All Revenues shall be deposited with the Treasurer and credited to the Revenue Fund. The Water District shall transfer moneys from the Revenue Fund to pay Maintenance and Operation Costs, including without limitation the Lease Payments in accordance with the Lease Agreement and lease payments securing Parity Obligations, if any. Any Revenues in excess of the amounts budgeted, as required, for the payment of the Lease Payments and Maintenance and Operation Costs shall constitute surplus revenues in the Revenue Fund. After all C-16 covenants contained in the Lease Agreement have been duly performed each year, and provided that there are no amounts then owing to Authority or the Trustee by the Water District, such surplus revenues may be used for: (1) payment of Series 2002 Installment Payments, (2) extensions and betterments of the Water System; or (3) any lawful purpose of the Water District. Rates and Charges. The Water District shall, to the maximum extent permitted by law, fix, prescribe and collect rates and charges for water service which will be at least sufficient to yield during each Fiscal Year Revenues equal to one hundred percent (100%) of Maintenance and Operation Costs paid in the immediately preceding Fiscal Year, provided that such costs shall include the Lease Payments payable in such Fiscal Year, plus Additional Payments payable in such Fiscal Year, plus the amount by which the amount on deposit in the Lease Revenue Bonds Rate Stabilization Reserve on the last day of the immediately preceding Fiscal Year was less than twenty-five percent (25%) of Maximum Annual Debt Service as of such day. The Water District may make adjustments from time to time in such rates and charges and may make such classification thereof as it deems necessary, but shall not reduce the rates and charges then in effect unless the Revenues from such reduced rates and charges will at all times be sufficient to meet the requirements of this rate covenant. No Priority for Additional Obligations. The Water District covenants that no additional bonds, notes or obligations shall be issued or incurred by the Water District which will have any priority in payment out of the Revenues over the Lease Payments. Limits on Additional Debt. The Water District covenants that, except for obligations issued to prepay all or a portion of the Lease Payments, it will issue obligations payable from Revenues on a parity basis with the Lease Payments only if the Water District delivers to the Trustee prior to the issuance of any Parity Obligations a certificate certifying that all of the following additional conditions are met: (a) The Water District is not in default under the terms of the Lease Agreement; and (b) the Revenues as shown by the books of the District for the twelve (12) calendar months ending prior to the incurring of such additional obligations shall have amounted to at least the sum of (x) one hundred percent (100%) of Maintenance and Operation Costs, including without limitation Lease Payments, for such twelve (12) calendar month period, plus (y) the amount by which the amount on deposit on the Lease Revenue Bonds Rate Stabilization Reserve on the date prior to the first day of such twelve (12) calendar month period was less than twenty-five percent (25%) of Maximum Annual Debt Service; for purposes of preparing the certificate or certificates described above, the Water District may rely upon financial statements prepared by the Water District, which have not been subject to audit by an Independent Certified Public Accountant if audited financial statements for the Fiscal Year or period are not available; (c) the estimated Revenues for the twelve (12) calendar months following the date of incurring such Parity Obligations will be at least equal to one hundred percent (100%) of all Maintenance and Operation Costs, including without limitation Lease Payments projected to be paid in the next succeeding Fiscal Year and payments in the next succeeding Fiscal Year on Parity Obligations to be outstanding immediately after the incurring of such Parity Obligations, and the Additional Payments paid in the prior Fiscal Year as of the date of incurring of such Parity Obligations; C-17 (d) the amount on deposit in the Lease Revenue Bonds Rate Stabilization Reserve on the date of incurring such Parity Obligations will, after giving effect to additional deposits in connection therewith, be at least equal to twenty-five percent (25%) of the sum of (i) Maximum Annual Debt Service, (ii) the maximum annual lease payment for such Parity Obligations, and (iii) the Additional Payments paid in the prior Fiscal Year as of the date of incurring of such Parity Obligations; and (e) for so long as the Series 2002 Certificates of Participation are outstanding, the Lease Payments plus lease payments securing all Parity Obligations, including without limitation the Parity Obligations proposed to be issued, do not in the aggregate exceed the Maintenance and Operation Cap. For purposes of the computations to be made as described in (b) above, the determination of the Revenues: (i) may take into account any increases in rates and charges which relate to the Water System and shall take into account any reduction in such rates and charges, which will be effective prior to or at the time of incurring such proposed additional obligations; (ii) may take into account an allowance for any estimated increase in such Revenues from any revenue producing additions to or improvements or extensions of the Water System to be made with the proceeds of such additional obligations or with the proceeds of obligations previously issued, as shown by a certificate of the Water District; and (iii) for the period contemplated by (c) above, Maintenance and Operation Costs of the Water System shall be deemed to be the same as for the period for which a calculation is done pursuant to (b) above, but adjusted, if deemed necessary by the Water District, for any increased Maintenance and Operation Costs of the Water System which are, in the judgment of the Water District, essential to maintaining and operating the Water System. Nothing in the Lease Agreement shall preclude the Water District from issuing obligations which are subordinate to the payment of the Lease Payments. In the event the additional indebtedness bears interest at a variable rate, for purposes of the rate covenant and determining compliance with the tests for issuance of additional indebtedness under the Lease Agreement, debt service payable on variable rate additional indebtedness shall be computed assuming such additional indebtedness bears interest at the rate quoted in The Bond Buyer 25 Revenue Bond Index for the last week of the month preceding the date when the Water District incurs such additional indebtedness, as published in The Bond Buyer, plus one-half of one percent (0.50%), or if such index is no longer published, another similar index to be selected by the Authority, or if the Authority fails to select a replacement index, an interest rate equal to eighty percent (80%) of the yield for outstanding United States Treasury bonds having a maturity equivalent to that of the additional indebtedness proposed to be incurred, or if there are no such Treasury bonds having equivalent maturities, eighty percent (80%) of the lowest prevailing prime rate of any of the five largest commercial banks in the United States ranked by assets. Assignment of Lease Payments. Certain of the Authority's rights under the Lease Agreement, including the right to receive and enforce payment of the Lease Payments to be made by the Water District under the Lease Agreement, have been absolutely assigned by the Authority to the C-18 Trustee, subject to certain exceptions, pursuant to the Trust Agreement, to which assignments the Water District consents. The Authority directs the Water District, and the Water District agrees, to pay to the Trustee at the Trustee's corporate trust office, or to the Trustee at such other place as the Trustee shall direct in writing, all Lease Payments or prepayments thereof payable by the Water District under the Lease Agreement. The Authority will not assign or pledge the Lease Payments or other amounts derived from the Project or from its other rights under the Lease Agreement except as provided under the terms of the Lease Agreement and the Trust Agreement, or its duties and obligations except as provided under the Trust Agreement. Use and Possession. The total Lease Payments and Additional Payments due in any Fiscal Year shall be for the use and possession of the Project for such Fiscal Year. During the Term of the Lease Agreement, the Water District shall be entitled to the exclusive use of the Project subject only to the Permitted Encumbrances. Additional Payments. In addition to the Lease Payments, the Water District shall also pay such amounts ("Additional Payments") as shall be required for the payment of all administrative costs of the Authority relating to the Project, including without limitation all expenses including usual and ordinary legal fees and expenses, assessments, compensation and indemnification of the Authority and the Trustee, any amounts required to be rebated to the federal government in order to comply with the provisions of Section 148 of the Code, any amounts required to be paid to the Trustee to replenish the Reserve Account to the Reserve Requirement pursuant to the Trust Agreement, fees under any Alternative Reserve Account Security instruments, taxes of any sort whatsoever payable by the Authority as a result of its lease of the Project or undertaking of the transactions contemplated in the Lease Agreement or in the Trust Agreement, fees of auditors, accountants, attorneys or engineers, insurance premiums or other items required by the Lease Agreement and all other necessary administrative costs of the Authority or charges required to be paid by it in order to comply with the terms of the Bonds or of the Trust Agreement or to pay or indemnify the Trustee and its officers and directors. All such Additional Payments to be paid under the Lease Agreement shall be paid when due directly by the Water District to the respective parties to whom such Additional Payments are owing. Net-Net-Net Lease. The Lease Agreement shall be deemed and construed to be a "net-net-net lease" and the Water District agrees that the Lease Payments shall be an absolute net return to the Authority, free and clear of any expenses, charges or set-offs whatsoever, except as expressly provided therein. Lease Revenue Bonds Rate Stabilization Reserve. There is established a special fund designated as the "Lease Revenue Bonds Rate Stabilization Reserve" to be held by the Water District which fund the Water District agrees and covenants to hold separate and apart from other funds so long as any Bonds remain outstanding. The Water District is required to fund the Lease Revenue Bonds Rate Stabilization Reserve in an amount equal to 25% of Maximum Annual Debt Service (the "Rate Stabilization Requirement"). Money transferred by the Water District to the Lease Revenue Bonds Rate Stabilization Reserve shall be held in the Lease Revenue Bonds Rate Stabilization Reserve and applied in accordance with the Lease Agreement. The Water District shall withdraw all or any portion of the amounts on deposit in the Lease Revenue Bonds Rate Stabilization Reserve and transfer such amounts to the Revenue Fund for application in accordance with the Lease Agreement to the extent amounts in the Revenue Fund are not sufficient to pay Maintenance and Operation Costs. The Water District may expend amounts in the Lease Revenue Bonds Rate Stabilization Reserve for any purpose permitted by law. The Rate Stabilization Requirement is in addition to C-19 amounts required to be maintained in the separate rate stabilization reserve established in connection with the Series 2002 Certificates of Participation and amounts in the Lease Revenue Bonds Rate Stabilization Reserve are not available to make payments relative to the Series 2002 Certificates of Participation. Termination of Lease Agreement Prior to End of Term. (a) Termination of Lease Agreement for Failure to Achieve Acceptance. The Water District shall have the right to terminate the Lease in the event the Water District exercises its right to terminate the Service Contract, provided that the Water District shall have no right to terminate the Lease if and after the Water District exercises any of its buy-out rights under the Service Contract. (b) Termination of Lease Agreement Upon an Event of Default by the Company. The Water District shall have the right to terminate the Lease Agreement in the event the Water District exercises its right, subject to applicable notice and cure provisions set forth in the Service Contract, to terminate the Service Contract upon the occurrence of an Event of Default (as defined in the Service Contract) by the Company under Section 13.2(B)(2) of the Service Contract, provided that the Water District shall have no right to terminate the Lease if and after the Water District exercises any of its buy-out rights under the Service Contract. (c) Trustee Benefit Rights. The Water District and the Authority acknowledge the rights of the Trustee as assignee of all rights of the Authority pursuant to the Trust Agreement and rights of Trustee and Bond Insurer to notice and rights to cure under the Service Contract. (d) Obligations Not Conditioned on Service Contract. Except as provided in (a) and (b) above, the Water District and Authority acknowledge the Water District's obligations under the Lease Agreement are not conditioned or affected by the Service Contract or the performance by any party of its obligations thereunder, including, without limitation, termination of the Service Contract pursuant to any circumstance other than as described in (a) or (b) above. (e) Lock-out Provisions of Insurance and Indemnity Agreement. The Water District and the Authority accept and agree to be bound by the lockout provisions of the Insurance and Indemnity Agreement affecting the rights of the Water District, City and Authority in the event of a termination of the Lease Agreement pursuant thereto, subject to the express terms of the Insurance and Indemnity Agreement. To the extent permitted by law, the District shall not develop or construct Alternative Facilities during any cure period following an Event of Default, including any Lock-out Period, if applicable, without the prior written consent of the Bond Insurer. INSURANCE AND CONDEMNATION Insurance. The Water District will procure and maintain insurance on the Project with responsible insurers at reasonable cost in such amount and against such risks (including damage to or destruction of the Service Contract Project Improvements) as are usually covered in connection with facilities similar to the Service Contract Project Improvements, but not less than the lesser of the full replacement cost or the principal amount of Bonds then outstanding, so long as such insurance is available from reputable insurance companies. C-20 In the event of any damage to or destruction of the Project caused by the perils covered by such insurance, the Net Insurance Proceeds thereof shall be applied in accordance the Lease Agreement. The Water District shall provide adequate reserves to cover the amount of any deductible provisions of the insurance required to be maintained pursuant to the Lease Agreement. Cooperation. The Authority shall cooperate fully with the Water District at the expense of the Water District in filing any proof of loss with respect to any insurance policy maintained and in the prosecution or defense of any prospective or pending condemnation proceeding with respect to the Project or any portion thereof. DAMAGE, DESTRUCTION AND EMINENT DOMAIN; USE OF NET PROCEEDS Application of Net Insurance Proceeds. (a) Deposit in Insurance and Condemnation Account. The Water District and/or the Authority shall transfer to the Trustee any Net Insurance Proceeds received by the Water District and/or Authority in respect of any insurance required by the Lease Agreement or in the event of any taking by eminent domain or condemnation with respect to the Project, for deposit in the Insurance and Condemnation Account by the Trustee in accordance with the Trust Agreement. (b) Disbursement for Replacement or Repair of the Project. Upon receipt of the certification described in paragraph (i) below and the requisition described in paragraph (ii) below, the parties agree that the Trustee shall disburse moneys in the Insurance and Condemnation Account to the person, firm or corporation named in the requisition. (i) Certification. The Authorized Representative of the Water District must provide to the Authority and the Trustee a certificate stating that the Net Insurance Proceeds available for such purpose, together with other funds, if any, supplied by the Water District for such purpose in its sole and absolute discretion, are sufficient to restore the Project to a value greater than or equal to the value thereof prior to the insured event, and (ii) Requisition. An Authorized Representative of the Water District must state with respect to each payment to be made (1) the requisition number, (2) the name and address of the person, firm or corporation to whom payment is due, (3) the amount to be paid and (4) that each obligation mentioned therein has been properly incurred, is a proper charge against the Insurance and Condemnation Account, has not been the basis of any previous withdrawal therefrom, and specifying in reasonable detail the nature of the obligation. Any balance of the Net Insurance Proceeds remaining after such replacement or repair has been completed as evidenced by a certificate of the Water District shall be disbursed as provided in subsection (c) below. In the event and to the extent the requirements of subsections (b)(i) and (b)(ii) above are satisfied, the Water District shall begin such reconstruction, repair or replacement promptly after such damage or destruction shall occur, and shall continue and properly complete such reconstruction, repair or replacement as expeditiously as possible, and shall pay out of such Net C-21 Insurance Proceeds and funds provided by it (if any) in its sole discretion all costs and expenses in connection with such reconstruction, repair or replacement so that the same shall be completed and the Project shall be free and clear of all claims and liens except as provided in the Lease Agreement. (c) Disbursement for Prepayment. If the Authorized Representative of the Water District notifies the Trustee in writing of the Water District's determination that the certification provided in the Lease Agreement cannot be made or replacement or repair of any portion of the Project is not economically feasible or in the best interest of the Water District, Net Insurance Proceeds will be applied to the prepayment of Lease Payments, provided that if available Net Insurance Proceeds exceed the amount necessary to prepay enough Lease Payments and any other amounts due or to become due under the Lease Agreement or the Trust Agreement such that the value of the remaining portion of the Project is equal to or greater than the value of such portion of the Project prior to the insured event, excess proceeds shall be available to be expended by the Water District for any lawful purpose. Eminent Domain Proceeds. If all or any part of the Service Contract Project Improvements shall be taken by eminent domain proceedings rendering the Project substantially unavailable for use by the Water District, the Net Insurance Proceeds thereof shall be applied by the Water District to the prepayment of Lease Payments as provided in Article X and to such other fund or account as may be appropriate and used for the retirement of Bonds. COVENANTS WITH RESPECT TO THE PROJECT Use of the Project. The Water District represents and warrants that it has an immediate need for all of the Project, which need is not expected to be temporary or to diminish in the foreseeable future. Leasehold Interest in the Project. (a) Authority Holds Leasehold Interest During Term. During the Term, the Authority shall hold a leasehold interest in the Project pursuant to the Property Lease. The Authority shall take any and all actions reasonably required, including but not limited to executing and filing any and all documents, reasonably required to maintain and evidence the Authority's leasehold interest in the Project at all times during the Term. (b) Leasehold Interest Transferred to Authority at End of Term. Upon the expiration of the Term as provided in the Lease Agreement, the Water District's leasehold interest in the Project pursuant to the Lease shall terminate, provided that, concurrent with such termination, the leasehold interest of the Water District pursuant to the terms of the Operating Lease shall become effective without the necessity of any additional document of transfer. Option to Prepay Lease Payments. The Water District may exercise an option to prepay all or a portion of the Lease Payments in accordance with the Lease Agreement and, by prepaying Lease Payments in the amounts necessary to cause the termination of the Term as provided in the Lease Agreement (the "Purchase Option Price"), terminate the Authority's leasehold interest in the Property under the Property Lease. Quiet Enjoyment. Subject only to Permitted Encumbrances, during the Term the Authority shall provide the Water District with quiet use and enjoyment of the Project, and the Water District C-22 shall during such Term peaceably and quietly have and hold and enjoy the Project, without suit, trouble or hindrance from the Authority, or any person or entity claiming under or through the Authority except as expressly set forth in the Lease Agreement. The Authority will, at the request of the Water District, join in any legal action in which the Water District asserts its right to such possession and enjoyment to the extent the Authority may lawfully do so. Notwithstanding the foregoing, the Authority shall have the right of access to the Project as provided in the Lease Agreement. Installation of Water District's Personal Property. The Water District may at any time and from time to time, in its sole discretion and at its own expense, install or permit to be installed items of equipment or other personal property in or upon any portion of the Project. All such items shall remain the sole personal property of the Water District, regardless of the manner in which the same may be affixed to such portion of the Project, in which neither the Authority nor the Trustee shall have any interest, and may be modified or removed by the Water District at any time; provided that the Water District shall repair and restore any and all damage to such portion of the Project resulting from the installation, modification or removal of any such items of equipment. Nothing in the Lease Agreement shall prevent the Water District from purchasing items to be installed, provided that no lien or security interest attaching to such items shall attach to any part of the Project. Access to the Project. The Water District agrees that the Authority and the Authority's successors or assigns shall have (1) the right at all reasonable times to enter upon the Project or any portion thereof to examine and inspect the Project, and (2) such rights of access to the Project as may be reasonably necessary to cause the proper maintenance of the Project in the event of failure by the Water District to perform its obligations under the Lease Agreement. Maintenance, Utilities, Taxes and Assessments. (a) Maintenance; Repair and Replacement. Throughout the Term of the Lease Agreement, as part of the consideration for the rental of the Project, all repair and maintenance of the Project shall be the responsibility of the Water District, and the Water District shall pay for or otherwise arrange for the payment of the cost of the repair and replacement of the Project resulting from ordinary wear and tear or want of care on the part of the Water District or any sublessee thereof. The Water District shall provide or cause to be provided all security service, custodial service, power, gas, telephone, light, heating and water, and all other public utility services for the Project. In exchange for the Lease Payments provided for in the Lease Agreement, the Authority agrees to provide only the Project. (b) Tax and Assessments; Utility Charges. The Water District shall also pay or cause to be paid all taxes and assessments, including but not limited to utility charges of any type or nature charged to the Authority or the Water District or levied, assessed or charged against any portion of the Project (excluding the Property, with respect to which the City shall pay or cause to be paid such amounts pursuant to the Property Lease) or the respective interests or estates therein; provided that with respect to special assessments or other governmental charges that may lawfully be paid in installments over a period of years, the Water District shall be obligated to pay only such installments as are required to be paid during the Term of the Lease Agreement as and when the same become due. (c) Contests. The Water District may, at its expense and in its name, in good faith contest any such taxes, assessments, utility and other charges and, in the event of any such C-23 contest, may permit the taxes, assessments or other charges so contested to remain unpaid during the period of such contest and any appeal therefrom; provided that prior to such nonpayment it shall furnish the Authority and the Trustee with the opinion of an Independent Counsel to the effect that, by nonpayment of any such items, the interest of the Authority in such portion of the Project will not be materially endangered and that the Project will not be subject to loss or forfeiture or lien. Otherwise, the Water District shall promptly pay such taxes, assessments or charges or make provisions for the payment thereof in form satisfactory to the Authority. The Authority will cooperate fully in such contest, upon the request and at the expense of the Water District. Modification of the Project. (a) Additions, Modifications and Improvements. Subject only to applicable restrictions and conditions of the Service Contract, and provided the Bond Insurer's prior written consent shall be required if to do so would (i) render available funds insufficient to complete the Project, or (ii) require additional time to complete the Project, the Water District shall, at its own expense, have the right to make additions, modifications or improvements to any portion of the Project if such additions, modifications or improvements are necessary or beneficial for the use of such portion of the Project. Such additions, modifications and improvements shall not in any way damage any portion of the Project or cause them to be used for purposes other than those authorized under the provisions of state and federal law or in any way which would impair the exclusion from gross income for federal income tax purposes of the interest portion of the Lease Payments; and the Project, upon completion of any additions, modifications and improvements made pursuant to the Lease Agreement, shall be of a value which is not less than the value of the Project immediately prior to the making of such additions, modifications or improvements. (b) No Liens. The Water District will not create, will use its best efforts to prevent the creation of, and will remove any mortgage or lien upon the Water System or any property essential to the proper operation of the Water System or to the maintenance of the Revenues, provided that, notwithstanding the foregoing, the Water District may encumber the Water System with mechanic's or materialman's liens, in connection with provision of administration buildings and operational facilities, or with the prior written consent of the Bond Insurer; and provided further, that the foregoing covenant shall not affect the Authority's right to issue Parity Obligations in accordance with the Trust Agreement and this Lease Agreement. Except for Permitted Encumbrances, the Water District will not permit any mechanic's or other lien to be established or remain against the Project for labor or materials furnished in connection with any additions, modifications or improvements made by the Water District pursuant to the Section; provided that if any such lien is established and the Water District shall first notify or cause to be notified the Authority of the Water District's intention to do so, the Water District may in good faith contest any lien filed or established against the Project, and in such event may permit the items so contested to remain undischarged and unsatisfied during the period of such contest and any appeal therefrom and shall provide the Authority with full security against any loss or forfeiture which might arise from the nonpayment of any such lien, in form satisfactory to the Trustee of the Authority. The Authority will cooperate fully in any such contest, upon the request and at the expense of the Water District. Liens. Except as permitted by the Lease Agreement, the Water District shall not, directly or indirectly, create, incur, assume or suffer to exist any mortgage, pledge, liens, charges, encumbrances or claims, as applicable, on or with respect to the Project, other than Permitted Encumbrances and other than the respective rights of the Authority and the Water District as provided in the Lease Agreement, except with the prior written consent of the Bond Insurer. Except as expressly provided C-24 in the Lease Agreement, the Water District shall promptly, at its own expense, take such action as may be necessary to duly discharge or remove any such mortgage, pledge, lien, charge, encumbrance or claim, for which it is responsible, if the same shall arise at any time; provided that the Water District may contest such lien or claim if it desires to do so, so long as such contest will not materially, adversely affect the rights of the Water District to the Project or the payment of Lease Payments under the Lease Agreement. The Water District shall reimburse the Authority for any expense incurred by it in order to discharge or remove any such mortgage, pledge, lien, charge, encumbrance or claim. Authority's Disclaimer of Warranties. THE AUTHORITY OR TRUSTEE MAKES NO WARRANTY OR REPRESENTATION, EITHER EXPRESS OR IMPLIED, AS TO THE VALUE, DESIGN, CONDITION, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OR FITNESS FOR THE USE CONTEMPLATED BY THE WATER DISTRICT OF THE PROJECT OR PORTION THEREOF. In no event shall the Authority or Trustee be liable for incidental, indirect, special or consequential damages, in connection with or arising out of the Lease Agreement, the Property Lease, or the Trust Agreement for the existence, furnishing, functioning or Water District's use and possession of the Project. Water District's Right to Enforce Warranties of Manufacturers, Vendors or Contractors. The Authority irrevocably appoints the Water District its agent and attorney-in-fact during the Term, so long as the Water District shall not be in default under, to assert from time to time whatever claims and rights, including without limitation, warranty claims, claims for indemnification and claims for breach of any representations, with respect to the Project or the improvements to the Project which the Authority may have against any manufacturer, vendor or contractor, or any agents thereof. The Water District's sole remedy for the breach of any such warranty, indemnification or representation shall be against the manufacturer, vendor or contractor with respect thereto, and not against the Authority, nor shall such matter have any effect whatsoever on the rights and obligations of the Authority with respect to the Lease Agreement, including the right to receive full and timely Lease Payments and to cause the Water District to make all other payments due under the Lease Agreement. The Water District shall be entitled to retain any and all amounts recovered as a result of the assertion of any such claims and rights. The Authority shall, upon the Water District's request and at the Water District's expense, do all things and take all such actions as the Water District may request in connection with the assertion of any such claims and rights. The Water District expressly acknowledges that neither the Authority nor the Trustee makes, or has made, any representation or warranty whatsoever as to the existence or availability of such warranties of the manufacturer, vendor or contractor with respect to any of the improvements on the Project. Reconstruction; Application of Net Insurance Proceeds. If any useful portion of the Service Contract Project Improvements shall be destroyed or is damaged by fire or other casualty, or title to, or the temporary use of, such portion shall be taken under the exercise of the power of eminent domain, the Water District shall, as expeditiously as possible, continuously and diligently prosecute or cause to be prosecuted the repair, reconstruction, restoration or replacement thereof, unless it is determined under the provisions of the Lease Agreement that such repair, reconstruction, restoration or replacement is not to be undertaken. Against Encumbrances. The Water District will not make any pledge of or place any lien on the Net Revenues except as provided in the Lease Agreement. The Water District may expend at any C-25 time, or from time to time, general fund revenues or may issue evidences of indebtedness or incur other obligations for any lawful purpose which are payable from and secured by a pledge of and lien on general fund revenues. Against Sale or Other Disposition of Project. The Water District will not enter into any agreement or lease which impairs the operation of the Project or any part thereof necessary to secure adequate water services for the community. Any real or personal property which has become nonoperative or which is not needed for the efficient and proper operation of the improvements on the Project, or any material or equipment which has become worn out, may be sold if such sale will not impair the ability of the Water District to pay Lease Payments and if the proceeds of such sale are deposited in the Lease Payment Fund. Payment of Claims. The Water District will pay and discharge any and all lawful claims for labor, materials or supplies which, if unpaid, might become a lien on the Net Revenues or the funds or accounts created under the Lease Agreement or on any funds in the hands of the Water District pledged to pay the Bonds prior or superior to the lien of the Trust Agreement or which might impair the security of the Bonds. Notwithstanding the foregoing, the Water District may pledge, encumber or otherwise secure its obligations with the Net Revenues; provided, that in all instances any such pledge, lien or security is wholly subordinate and junior to the obligations of the Water District contained in the Trust Agreement and the Lease Agreement. Compliance with Lease. The Water District will neither take nor omit to take any action under any contract if the effect of such act or failure to act would in any manner impair or adversely affect the ability of the Water District to pay Lease Payments; and the Water District will comply with, keep, observe and perform all agreements, conditions, covenants and terms, express or implied, required to be performed by it contained in all other contracts affecting or involving the Project, to the extent that the Water District is a party thereto. Compliance with Governmental Regulations. The Water District will duly observe and comply with all valid regulations and requirements of any governmental authority relative to the operation of the improvements on the Project, or any part thereof, but the Water District shall not be required to comply with any regulations or requirements so long as the validity or application thereof shall be contested in good faith. ASSIGNMENT, SUBLEASING AND AMENDMENT Assignment by the Authority. Except as provided in the Lease Agreement and in the Trust Agreement, the Authority will not assign the Lease Agreement, or any right, title or interest of the Authority in and to the Lease Agreement, to any other person, firm or corporation so as to impair or violate the representations, covenants and warranties contained in the Lease Agreement. Assignment and Subleasing by the Water District. (a) Assignment. The Lease Agreement may not be assigned by the Water District unless the Water District receives (i) prior written consent of the Bond Insurer, which consent shall not be unreasonably withheld, and (ii) an opinion of Bond Counsel, stating that such assignment does not adversely affect the exclusion from gross income for federal income tax purposes or from State of California personal income taxes of the interest portion of Lease Payments. In the event that the Lease Agreement is assigned by the Water District, the obligation to make Lease C-26 Payments and perform the other covenants of the Water District under the Lease Agreement shall remain the obligation of the Water District. (b) Sublease. The Water District may sublease any portion of the Project, with the prior written consent of the Authority and Bond Insurer, which consent shall not be unreasonably withheld, subject to all of the following conditions: (i) The Lease Agreement and the obligation of the Water District to make Lease Payments and perform the other covenants of the Water District under the Lease Agreement shall remain obligations of the Water District; (ii) The Water District shall, within 30 days after the delivery thereof, furnish or cause to be furnished to the Authority, the Bond Insurer and the Trustee a true and complete copy of such sublease; (iii) No sublease by the Water District shall cause the Project to be used for a purpose other than a governmental or proprietary function authorized under the provisions of the laws of the State; and (iv) No sublease shall cause the interest portion of Lease Payments, or any of them to become subject to federal income taxes or State of California personal income taxes. Amendments and Modifications. The terms of the Lease Agreement shall not be waived, altered, modified, supplemented or amended in any manner whatsoever except by written instrument signed by the Authority and the Water District, with the written consent of the Bond Insurer and the Trustee subject to the same conditions for amendment and modification of the Trust Agreement as set forth in the Trust Agreement. EVENTS OF DEFAULT AND REMEDIES Events of Default Defined. The following shall be "Events of Default" under the Lease Agreement and the terms "Events of Default" and "default" mean, whenever they are used in the Lease Agreement, any one or more of the following events: (a) Payment Default. Failure by the Water District to pay any Lease Payment or Additional Payment required to be paid under the Lease Agreement on the date such payment is due under the Lease Agreement. (b) Covenant Default. Failure by the Water District to observe and perform any warranty, covenant, condition or agreement on its part to be observed or performed or otherwise with respect to the Lease Agreement or in the Property Lease, other than as referred to in clause (a) above, for a period of 30 days after written notice specifying such failure and requesting that it be remedied has been given to the Water District by the Authority or the Trustee; provided, however, if the failure stated in the notice cannot be corrected within the applicable period, then no Event of Default shall have occurred, for a period of 90 days after such applicable period so long as corrective action is instituted by the Water District within the applicable period and diligently pursued until the default is corrected. Notwithstanding the foregoing, an Event of Default will have occurred concurrent with the failure by the Water District to observe or perform any warranty, covenant, condition or agreement on its part to be observed or performed pursuant to the Lease provisions relating to C-27 assignment of Lease Payments, Lease Termination, maintaining insurance, liens with respect to the Project and covenants against encumbrance, sale or disposal of the Project. (c) Bankruptcy or Insolvency. The filing by the Water District of a case in bankruptcy, or the subjection of any right or interest of the Water District under the Lease Agreement to any execution, garnishment or attachment, or adjudication of the Water District as a bankrupt, or assignment by the Water District for the benefit of creditors, or the entry by the Water District into an agreement of composition with creditors, or the approval by a court of competent jurisdiction of a petition applicable to the Water District in any proceedings instituted under the provisions of the federal bankruptcy code, as amended, or under any similar act which may thereafter be enacted. (d) Breach of Representation. A material breach of any representation of the Water District or the Authority under the Lease, for a period of 30 days after written notice specifying such failure and requesting that it be remedied has been given to the Water District by the Authority, the Trustee or the Bond Insurer. Remedies on Default. Whenever any Event of Default referred to in the Lease Agreement shall have happened and be continuing, it shall be lawful for the Authority to exercise any and all remedies available pursuant to law or equity or granted pursuant to the Lease Agreement, and, in each and every such case during the continuance of an Event of Default, the Authority may, with the consent of the Bond Insurer, and by notice in writing to the Water District and shall, at the direction of the Bond Insurer, declare the entire principal amount of the unpaid Lease Payments and the accrued interest thereon to be due and payable immediately, and upon any such declaration the same shall become immediately due and payable, anything contained in the Lease Agreement to the contrary notwithstanding. This section, however, is subject to the condition that if at any time after the entire principal amount of the unpaid Lease Payments and the accrued interest thereon shall have been so declared due and payable and before any judgment or decree for the payment of the moneys due shall have been obtained or entered the Water District shall deposit with the Authority a sum sufficient to pay the unpaid principal amount of the Lease Payments due prior to such declaration and the accrued interest thereon, with interest on such overdue installments, at the rate or rates applicable to the remaining unpaid principal balance of the Lease Payments, and the reasonable expenses of the Authority, and any and all other defaults known to the Authority (other than in the payment of the entire principal amount of the unpaid Lease Payments and the accrued interest thereon due and payable solely by reason of such declaration) shall have been made good or cured to the satisfaction of the Authority or provision deemed by the Authority to be adequate shall have been made therefor, then and in every such case the Authority, by written notice to the Water District may rescind and annul such declaration and its consequences; but no such rescission and annulment shall extend to or shall affect any subsequent default or shall impair or exhaust any right or power consequent thereon. Anything in the Lease Agreement to the contrary notwithstanding, upon the occurrence and continuance of an Event of Default as defined in the Lease Agreement, so long as the Bond Insurer is not in default under the Bond Insurance Policy, the Bond Insurer shall be entitled to control and direct the enforcement of all rights and remedies granted to the Authority or the Trustee under the Lease Agreement or otherwise available to the Authority or the Trustee, including, without limitation: (i) the right to accelerate the portion of each Lease Payment designated as and representing the principal of the Bonds as described in the Lease Agreement and (ii) the right to annul any declaration of acceleration, and the Bond Insurer shall also be entitled to approve all waivers of Events of Default. C-28 Notwithstanding anything to the contrary contained in the Lease Agreement or any of the Transaction Documents, none of the Authority, the Trustee, the Bond Insurer, or the Bondholders shall have the right under the Lease Agreement to re-enter or re-let the Project under any circumstances unless otherwise permitted under the Transaction Documents. Application of Funds Upon Acceleration. Upon the date of the declaration of acceleration as provided in the Lease Agreement, all Revenues thereafter received by the Water District shall be applied in the following order -- First, to the payment, without preference or priority, and in the event of any insufficiency of such Revenues ratably without any discrimination or preference, of the fees, costs and expenses of the Authority and Trustee, if any, in carrying out the provisions of this article, including reasonable compensation to their respective accountants and counsel and any other fees, costs and expenses of the Trustee then owing for Trustee's services under the Lease Agreement or under the Trust Agreement, including the reasonable fees and expenses of its counsel and accountants; and Second, to the payment of the Maintenance and Operation Costs including without limitation the entire principal amount of the unpaid Lease Payments and lease payments securing Parity Obligations, if any, and the accrued interest thereon, with interest on the overdue installments at the rate or rates of interest applicable to the Lease Payments and such lease payments securing Parity Obligations if paid in accordance with their respective terms, provided that, to the extent Lease Payments and lease payments securing Parity Obligations exceed in any year the Maintenance and Operation Cap due to acceleration, Revenues shall be applied to pay Lease Payments and lease payments securing Parity Obligations on a parity basis with Series 2002 Installment Payments. Other Remedies of the Authority. The Authority shall have the right (a) by mandamus or other action or proceeding or suit at law or in equity to enforce its rights against the Water District or any director, officer or employee thereof, and to compel the Water District or any such director, officer or employee to perform and carry out its or his duties under the agreements and covenants required to be performed by it or him contained in the Lease Agreement; (b) by suit in equity to enjoin any acts or things which are unlawful or violate the rights of the Authority; or (c) by suit in equity upon the happening of an Event of Default to require the Water District and its directors, officers and employees to account as the trustee of an express trust. Notwithstanding anything contained in the Lease Agreement, the Authority shall have no security interest in or mortgage on the Project, the Water System or other assets of the Water District and no default under the Lease Agreement shall result in the loss of the Project, the Water System, or other assets of the Water District. C-29 No Remedy Exclusive. Subject to the express limitation on remedies described in the Lease Agreement, no remedy conferred therein upon or reserved to the Authority is intended to be exclusive and every such remedy shall be cumulative and shall be in addition to every other remedy given under the Lease Agreement or now or thereafter existing at law or in equity. No delay or omission to exercise any right or power accruing upon any default shall impair any such right or power or shall be construed to be a waiver thereof, but any such right and power may be exercised from time to time and as often as may be deemed expedient. In order to entitle the Authority to exercise any remedy reserved to it in the Lease Agreement it shall not be necessary to give any notice, other than such notice as may be required in the Lease Agreement or by law. Agreement to Pay Attorneys Fees and Expenses. In the event either party to the Lease Agreement should default under any of the provisions thereof and the nondefaulting party should commence legal action or arbitration for the collection of moneys or the enforcement of performance or observance of any obligation or agreement on the part of the defaulting party contained therein, the defaulting party agrees that it will pay on demand to the nondefaulting party the reasonable attorneys fees, court costs and legal expenses incurred by the nondefaulting party in such action or arbitration after payment of all fees and expenses of the Trustee. No Additional Waiver Implied by One Waiver. In the event any agreement contained in the Lease Agreement should be breached by either party and thereafter waived by the other party, such waiver shall be limited to the particular breach so waived and shall not be deemed to waive any other breach thereunder. Trustee to Exercise Rights. Such rights and remedies as are given to the Authority under the Lease Agreement have been assigned by the Authority to the Trustee, to which assignment the Water District consents. Such rights and remedies shall be exercised by the Trustee subject to the terms of the Trust Agreement and the Lease Agreement. MISCELLANEOUS Liability of Water District Limited. Except for the pledge of Revenues pursuant to the terms of the Lease Agreement, neither the faith and credit nor the taxing power of the Water District is pledged to the payment of Lease Payments under the Lease Agreement. Nevertheless, the Water District may, but shall not be required to, advance for any of the purposes of the Lease Agreement any funds of the Water District which may be made available to it for such purposes. The obligation of the Water District to make Lease Payments is a special obligation of the Water District payable solely from the Revenues which are irrevocably pledged, subject to the Lease Agreement. Waiver of Personal Liability. No member, officer, agent or employee of the Water District or the Water District shall be individually or personally liable for the payment of Lease Payments under the Lease Agreement or be subject to any personal liability or accountability by reason of the issuance thereof; but nothing in the Lease Agreement contained shall relieve any such member, officer, agent or employee from the performance of any official duty provided by law or by the Trust Agreement. Applicable Law. The Lease Agreement shall be governed by and construed in accordance with the laws of the State. C-30 TRUST AGREEMENT ASSIGNMENT; DECLARATION OF TRUST; REPRESENTATIONS AND RECITALS Assignment of Lease Agreement. The Authority absolutely assigns all of its rights, title and interest in the Lease Agreement to the Trustee for the benefit of the Bondowners, and the Authority retains no right, title or interest therein (other than its right to certain Additional Payments under the Lease Agreement). The Water District consents to such assignment. Assignment of Property Lease. The Authority absolutely assigns, for so long as any Bond is Outstanding, all of its rights, title and interest in the Property Lease to the Trustee for the benefit of the Bondowners, and the Authority retains no right, title or interest therein (other than such right, title and interest as may exist from and after the payment in full, or defeasance pursuant to the Trust Agreement, of the Bonds). The Water District consents to such assignment. Declaration of Trust by Trustee. The Trustee declares that it holds and will hold the Trust Estate upon the trusts set forth in the Trust Agreement and for the use and benefit of the Bondowners. Deposit of Moneys. In order to induce the Water District to proceed with the lease of the Project from the Authority and to assure the Water District that the funding of the Service Contract Project Improvements will be paid as contemplated by the Lease Agreement, the Authority has executed the Lease Agreement and caused the Trustee to authenticate and deliver the Bonds and from the proceeds of the sale of the Bonds, the Trustee shall deposit into the various accounts in the Project Trust Fund the amounts provided for in the Trust Agreement. BONDS, TERMS AND PROVISIONS Payments from Trust Estate Only; Distribution of Trust Estate. (a) All amounts payable by the Trustee with respect to the Bonds pursuant to the Trust Agreement shall be paid only from the income of and proceeds from the Trust Estate and only to the extent that the Trustee shall have actually received sufficient income or proceeds from the Trust Estate to make such payments in accordance with the terms of the Trust Agreement. Each Bondowner agrees to look solely to the income of and the proceeds from the Trust Estate to the extent available for distribution to such holder as provided in the Trust Agreement, and each Bondowner agrees that the Trustee is not personally liable to any Bondowner for any amounts payable under the Trust Agreement or subject to any liability under the Trust Agreement except liability under the Trust Agreement as a result of negligence or willful misconduct by the Trustee. (b) So long as the Bonds shall be Outstanding, all amounts of Lease Payments (including without limitation prepayments), Additional Payments, payments received by the Trustee pursuant to or with respect to the Letter of Credit, indemnity payments and other payments of any kind constituting a part of the Trust Estate payable to the Trustee, shall be paid directly to the Trustee for distribution, in accordance with the Trust Agreement, to or for the Bondowners. C-31 Negotiability, Transfer and Registry. (a) Each Bond shall be transferable only upon the books of the Trustee which shall be kept for that purpose at the corporate trust office of the Trustee, by the Bondowner in person or by his attorney duly authorized in writing, upon surrender thereof together with a written instrument of transfer satisfactory to the Trustee duly executed by the Bondowner or his duly authorized attorney. Upon the transfer of any such Bond the Trustee shall deliver in the name of the transferee a new Bond or Bonds of the same aggregate principal amount and maturity and interest rate as the surrendered Bond. (b) The Trustee may deem and treat the person in whose name any Bond shall be registered upon the books of the Trustee as the absolute owner of such Bond, whether such Bond shall be overdue or not, for the purpose of receiving payment of, or on account of, the principal, if any, of and interest with respect to such Bond and for all other purposes; and all such payments so made to any such Bondowner or upon his order shall be valid and effectual to satisfy and discharge the liability upon such Bond to the extent of the sum or sums so paid; and the Trustee shall not be affected by any notice to the contrary. Regulations with Respect to Exchanges and Transfers. In all cases in which the privilege of exchanging Bonds or transferring Bonds is exercised, the Trustee shall authenticate and deliver Bonds in accordance with the provisions of the Trust Agreement. All Bonds surrendered in any such exchanges or transfers shall forthwith be canceled by the Trustee pursuant to the Trust Agreement. For every such exchange or transfer of Bonds, except an exchange of a temporary Bond for a definitive Bond, the Trustee may make a charge sufficient to reimburse it for any tax, fee or other governmental charge required to be paid with respect to such exchange or transfer. The cost of printing any new Bonds and any services rendered or any expenses incurred by the Trustee in connection with any exchange or transfer shall be paid by the Water District (except governmental taxes and charges and the costs of replacing lost, stolen or mutilated Bonds which shall be paid by the Owner). The Trustee shall not be required to transfer or exchange any Bonds selected for redemption or within the 15 days before the selection of Bonds for redemption. Bonds Mutilated, Destroyed, Stolen or Lost. In case any Bond shall become mutilated or be destroyed, stolen or lost, the Trustee shall authenticate and deliver a new Bond of like maturity and principal amount as the Bond so mutilated, destroyed, stolen or lost, in exchange and substitution for such mutilated Bond, upon surrender and cancellation of such mutilated Bond, or in lieu of and substitution for the Bond, destroyed, stolen or lost, upon receipt by the Trustee of evidence satisfactory to the Trustee that such Bond has been destroyed, stolen or lost and proof of ownership thereof, and upon furnishing the Trustee with indemnity satisfactory to the Trustee and complying with such other regulations as the Trustee may prescribe and paying such expenses as the Trustee may incur. All Bonds so surrendered to the Trustee shall be canceled by it pursuant to the Trust Agreement. Any such new Bonds issued pursuant to the Section in substitution for Bonds mutilated or alleged to be destroyed, stolen or lost shall be equally secured by and entitled to equal and proportionate benefits of, with all other Bonds delivered under the Trust Agreement, any moneys or securities held by the Trustee for the benefit of the Bondowners. Temporary Bonds. Until the definitive Bonds are prepared, the Trustee may authenticate and deliver, in the same manner as is provided for the Trust Agreement, in lieu of definitive Bonds, one or more temporary Bonds substantially of the tenor of the definitive Bonds in lieu of which such temporary Bond or Bonds are issued, in any authorized denomination, and with such omissions, C-32 insertions and variations as may be appropriate to temporary Bonds. The Trustee at the expense of the Water District shall authenticate and, upon the surrender of such temporary Bonds and the cancellation of such surrendered temporary Bonds, shall, without charge to the Owners thereof, in exchange therefor, deliver definitive Bonds, of the same aggregate principal amount and maturity as the temporary Bonds. ESTABLISHMENT AND ADMINISTRATION OF FUNDS AND ACCOUNTS Establishment of Project Trust Fund. There is established with the Trustee a special trust fund to be designated as the "Project Trust Fund"; which shall be held in trust by the Trustee for the benefit of the Bondholders pending application of the funds on deposit therein as provided in the Trust Agreement. The Trustee shall keep the Project Trust Fund separate and apart from all other funds and moneys held by it. Within the Project Trust Fund there are established the following accounts (the "Accounts"): (i) Debt Service Payment Account, and a Capitalized Interest Subaccount therein; (ii) Reserve Account; (iii) Costs of Issuance Account; (iv) Project Account; (vi) Redemption Account; and (vii) Insurance and Condemnation Account. There is established by the Trust Agreement with the Trustee a special trust fund to be designated as the "Rebate Fund", which the Trustee shall maintain and manage pursuant to the provisions of the Trust Agreement. Project Account. (a) There shall be credited to the Project Account any funds from time to time deposited with Trustee for such purpose. The Trustee shall keep the Project Account separate and apart from all other funds and accounts held by it and shall administer the Project Account as provided in the Trust Agreement and the Lease Agreement. (b) Except as provided in the Trust Agreement, the Trustee shall disburse funds from the Project Account in the manner and at the times described in the Trust Agreement. The Trustee shall disburse funds from the Costs of Issuance Account upon receipt by the Trustee of an executed Requisition; additionally, the Trustee shall transfer all amounts on deposit in the Costs of Issuance Account on August 1, 2003 to the Project Account and thereafter, upon receipt of a Requisition of the Water District, the Trustee shall pay Costs of Issuance from the Project Account. (c) Upon receipt by the Trustee of a Requisition of the Water District that the Service Contract Project Improvements have been completed and that all costs thereof and Cost of Issuance have been paid any amounts then remaining in the Project Account not encumbered or needed to pay costs of the Service Contract Project Improvements and Cost of Issuance, as evidenced by a certificate of a Requisition of Water District, shall be deposited by Trustee in the Rebate Fund if the Water District has notified the Trustee such funds are needed to pay arbitrage rebate payments to the federal government and the balance shall be deposited in the Debt Service Payment Fund and be applied from time to time on behalf of the Water District as a credit against the next subsequent Lease Payments. In no event will amounts in the Project Account after the date three years from the Delivery Date be invested at a yield in excess of the yield on the Bonds within the meaning of Section 148 of the Code and the regulations thereunder. C-33 Debt Service Payment Account. (a) In addition to the moneys required to be deposited in the Debt Service Payment Account pursuant to the Trust Agreement, all Lease Payments received by the Trustee shall be deposited by the Trustee in the Debt Service Payment Account immediately upon their receipt. On or about October 1 of each year the Trustee shall give written notice to the Water District of the amount of Lease Payments for the next following Bond Year. The Trustee shall pay from the Debt Service Payment Account on each Interest Payment Date, the amount required for the interest payable on such date and the amount required for the principal payable, if any, on such date. Such amounts shall be applied by the Trustee on the due dates thereof. The Trustee shall apply amounts on deposit in the Capitalized Interest Subaccount to the payment of interest on the Bonds as it becomes due and payable prior to the application of any other amounts in the Debt Service Payment Account therefor. (b) Upon receipt of any proceeds of a draw on the Letter of Credit, the Trustee shall promptly deposit all such amounts in the Debt Service Payment Account. The Trustee shall thereafter apply such amounts received, together with interest earnings thereon, to pay, on the next succeeding Interest Payment Date, interest and principal, if any, then due and payable on the Bonds. The Trustee shall notify the Water District and the Bond Insurer that Lease Payments next coming due are permitted to be reduced by such draw amounts received, together with interest earning thereon. The Water District shall not have any liability to any party for any failure to direct the Trustee to draw on the Letter of Credit or for any delay in so drawing. (c) The Trustee shall also transfer to the Redemption Account from the Debt Service Payment Account any amount available therein to pay principal, premium, if any, and the accrued interest on the Bonds redeemed pursuant to the Trust Agreement. Reserve Account. (a) The Reserve Requirement shall be maintained by the Trustee in the Reserve Account until the Lease Payments are paid in full pursuant to the terms of the Lease Agreement, or the Bonds have been redeemed in full, or the Trust Agreement is terminated. The Reserve Requirement may be recalculated at any time upon the request of the Water District, and the Trustee shall maintain the Reserve Account thereafter at a level equal to the recalculated Reserve Requirement. The Trustee shall apply moneys in the Reserve Account as provided in the Trust Agreement. The Trustee shall value the investments of monies in the Reserve Account pursuant to the Trust Agreement. (b) If on any Interest Payment Date the amount in the Debt Service Payment Account shall be less than the amount required for the interest payable with respect to the Bonds on said date, the Trustee shall withdraw from the Reserve Account and deposit in the Debt Service Payment Account the amount necessary to make good the deficiency. Any amounts transferred from the Reserve Account pursuant to this subsection (b) shall not be considered payment in full or in part of any Lease Payment and shall, upon receipt of the delinquent Lease Payment, be repaid from such Lease Payment to the Reserve Account. (c) If on an Interest Payment Date the amount in the Debt Service Payment Account shall be less than the amount required for the principal payable with respect to the Bonds on such date, the Trustee shall withdraw from the Reserve Account and deposit in the Debt Service C-34 Payment Account the amount necessary to make good the deficiency. Any amounts transferred from the Reserve Account pursuant to this subsection (c) shall not be considered payment in full or in part of a Lease Payment and shall, upon receipt of the delinquent Lease Payment, be repaid from such Lease Payment to the Reserve Account. (d) Whenever the amount in the Reserve Account, together with the amount in the Debt Service Payment Account, is sufficient to pay in full all Outstanding Bonds in accordance with their terms, the funds on deposit in said Reserve Account shall be transferred to the Debt Service Payment Account and applied to the payment of Bonds. Any provision of the Trust Agreement to the contrary notwithstanding, so long as there shall be held in the Debt Service Payment Account an amount sufficient to pay in full all Outstanding Bonds in accordance with their terms, no deposits shall be required to be made into the Reserve Account. (e) Moneys in the Reserve Account shall be used solely for the purpose of: (i) making up deficiencies in the Debt Service Payment Account as provided in the Trust Agreement; or (ii) making up deficiencies in the Debt Service Payment Account as provided in the Trust Agreement; (iii) providing for the payment of the final Lease Payment in which event the Trustee shall transfer all amounts on deposit in the Reserve Account to the Debt Service Payment Account to be applied as a credit against said final Lease Payment; or (iv) providing for the redemption in full of all Outstanding Bonds as provided in the Trust Agreement. (f) If ten (10) days prior to any Lease Payment Date the amount on deposit in the Reserve Account is less than the Reserve Requirement, the Trustee shall notify the Authority and the Water District and the Water District shall include the amount necessary to meet the Reserve Requirement with its Lease Payment on such Lease Payment Date as an Additional Payment. (g) The Authority reserves the right to substitute, at any time and from time to time, one or more letters of credit, Alternative Reserve Account Security, bond insurance policies or other form of guaranty, in any case approved in writing by the Bond Insurer from a financial institution the long-term unsecured obligations of which are rated to the Bond Insurer's satisfaction in substitution for or in place of all or any portion of the Reserve Requirement, under the terms of which the Trustee is unconditionally entitled to draw amounts when required for the purposes thereof. Upon deposit by the Authority with the Trustee of any such letter of credit, surety bond, bond insurance policy or other form of guaranty, the Trustee shall withdraw from the Reserve Account and transfer to the Water District an amount equal to the principal amount of such letter of credit, Alternative Reserve Account Security, bond insurance policy or other form of guaranty. If and to the extent that the Reserve Account has been funded with a combination of cash (or Investment Securities) and a Alternative Reserve Account Security, then all such cash (or Investment Securities) shall be completely used before any demand is made on such Alternative Reserve Account Security, and replenishment of the Alternative Reserve Account Security shall be made prior to any replenishment of any such cash (or Investment Securities). If the Reserve Fund is C-35 funded, in whole or in part, with more than one Alternative Reserve Account Security, then any draws made against such Alternative Reserve Account Security shall be made pro-rata. Redemption Account. (a) The Trustee shall apply moneys in the Redemption Account as provided in the Trust Agreement. Amounts in the Redemption Account shall be applied to the redemption of Bonds in accordance with the Trust Agreement. Interest on Bonds so redeemed shall be paid from the Debt Service Payment Account, except to the extent Net Insurance Proceeds are used to pay such interest, and all expenses in connection with such redemption shall be paid by the Water District as Additional Payments. (b) The Trustee shall deposit in the Redemption Account as received, all moneys, if any, paid to it by the Water District for prepayment of Lease Payments pursuant to the Lease Agreement. All of said moneys shall be set aside in the Redemption Account for the purpose of redeeming the Bonds in advance of their maturity and shall be applied on or after the date of redemption designated pursuant to the Trust Agreement to the payment of principal, redemption premium, if any, and accrued interest, if any, with respect to the Bonds to be redeemed upon presentation and surrender of such Bonds. Insurance and Condemnation Account. Subject to the provisions of the Lease Agreement, the proceeds of insurance maintained pursuant to the Lease Agreement against physical loss of or damage to the Project or any portion thereof shall be deposited in the Insurance and Condemnation Account immediately upon receipt and applied as provided in Article VI of the Lease Agreement. Deposits of Money; Payment Procedure. (a) All moneys required to be held by the Trustee under the provisions of the Trust Agreement shall be deposited with the Trustee. All moneys deposited under the provisions of the Trust Agreement with the Trustee shall be held in trust and applied only in accordance with the provisions of the Trust Agreement, and the Project Trust Fund shall be a trust fund for the purposes thereof. (b) All moneys deposited with the Trustee shall be credited to the particular account to which such moneys belong. Investment of Certain Accounts and Subaccounts. Subject to the requirements of the Trust Agreement, all moneys in the funds, accounts and subaccounts held by the Trustee under the Trust Agreement shall be invested as follows: (a) Moneys held in the Debt Service Payment Account and the Reserve Account shall be invested and reinvested by the Trustee pursuant to the Section. Moneys held in the Insurance and Condemnation Account may be invested and reinvested in Investment Securities which mature not later than such times as shall be necessary to provide moneys when needed for payments to be made from such Account. Moneys in the Redemption Account shall be invested only in Investment Securities which have a maturity no longer than 30 days. The Trustee shall make all such investments of moneys held by it in accordance with written instructions received from an Authorized Representative of the Water District at least two Business Days in advance of the investment. The Authorized Representative of the Water District may instruct the Trustee in making C-36 any investment in any Investment Securities with moneys in any Account established under the Trust Agreement, to combine such moneys with moneys in any other Account, but solely for purposes of making such investment in such Investment Securities. In the absence of instructions from the Water District, the Trustee shall invest solely in Investment Securities set forth in (B)(5) of the definition thereof and shall provide notice to the Water District of such investment by means of its customary statements; provided, however, the Trustee shall incur no liability for its failure to so notify the Water District. Absent negligence or willful misconduct on its part, the Trustee shall have no liability or responsibility for any loss resulting from any investment made in accordance with the provisions of the Trust Agreement. The Trustee shall have no obligation to pay additional interest or maximize investment income on any funds held by it and neither the Authority, nor the Bond Owners shall have any claim of any kind against the Trustee in connection with such Investments. (b) Any income or interest earned by the Debt Service Payment Account due to the investment thereof shall be retained in the Debt Service Payment Account and applied as a credit against the Lease Payments due on the next occurring Lease Payment Date and deemed to be the payment of the interest portion thereof to the extent thereof and then to principal, provided that all income or interest earned by the Capitalized Interest Subaccount of the Debt Service Payment Account shall be transferred to the Project Account on or before each June 2 and December 2, until Acceptance, and shall thereafter be applied as provided in the first sentence of this subsection (b). (c) Any income or interest earned by the Reserve Account due to the investment thereof shall be paid into the Project Account until Acceptance and shall thereafter be paid into the Debt Service Payment Account to the extent that it would cause the amount in the Reserve Account to exceed the Reserve Requirement. Such amount shall be applied as a credit against the Lease Payments due on the next occurring Lease Payment Date and deemed to be the payment of the interest portion thereof to the extent thereof and then to principal. (d) Moneys held in the Project Account shall be invested and reinvested by the Trustee in Investment Securities maturing as required to make timely Project payments pursuant to the Service Contract. Any income or interest earned by the Project Account due to the investment thereof shall be retained in the Project Account and used for purposes of the Project Account until Acceptance, and after Acceptance shall be transferred to the Debt Service Payment Account. (e) Nothing in the Trust Agreement shall prevent any Investment Securities acquired as investments of funds held thereunder from being issued or held in book-entry form on the books of the Department of the Treasury of the United States of America. (f) The Trustee or an affiliate may act as principal or agent in the acquisition or disposition of an investment and shall be entitled to its customary fees therefor pursuant to a prior written fee agreement with the Authority and the Water District. (g) If at any time after investment therein an investment ceases to meet the criteria set forth in the definition of Investment Securities as determined by a valuation of such investment and such obligation, aggregated with other non-conforming investments, exceeds ten percent (10%) of invested funds, such investment shall be sold or liquidated unless otherwise approved by the Water District and the Bond Insurer. (h) Investments (except investment agreements) in Trust Agreement funds and accounts and subaccounts shall be valued by the Trustee as frequently as deemed necessary by the C-37 Authority, but not less often than semi-annually nor more often than monthly, at the fair market value thereof, exclusive of accrued interest. Deficiencies in the amount on deposit in any fund or account resulting from a decline in market value shall be restored not later than the next succeeding semiannual valuation date which is at least six months after the valuation date. Investments purchased with funds on deposit in the Reserve Account shall have an average aggregate weighted term to maturity not greater than five years. The Trustee shall terminate any repurchase agreement upon a failure of the counterparty thereto to maintain the requisite collateral percentage after the restoration period and, if not paid by the counterparty in federal funds against transfer of the repo securities, liquidate the collateral. The Trustee shall give notice to any provider of an investment agreement in accordance with the terms of the investment agreement so as to receive funds thereunder with no penalty or premium paid. The Trustee shall, upon actual knowledge of the withdrawal or suspension of either of the ratings of an investment agreement provider or a drop in the ratings thereon below "A," so notify the Authority and, if so directed by the Authority, shall demand further collateralization of the agreement or liquidation thereof. The Water District acknowledges that to the extent regulations of the Comptroller of the Currency or other applicable regulatory entity grant the Water District the right to receive brokerage confirmations of security transactions as they occur, the Water District will not receive such confirmations to the extent permitted by law. The Trustee will furnish the Water District periodic cash transaction statements which the Trustee may make any investments under the Trust Agreement through its own bond or investment department or trust investment department, or those of its parent or any affiliate. The Trustee or any of its affiliates may act as sponsor, advisor or manager in connection with any investments made by the Trustee under the Trust Agreement. Valuation and Sale of Investments. Obligations purchased as an investment of moneys in any fund, account or subaccount created under the provisions of the Trust Agreement shall be deemed at all times to be a part of such fund, account or subaccount and any profit realized from the liquidation of such investment shall be credited to, and any loss resulting from the liquidation of such investment shall be charged to, the computation of net interest earned on the moneys and investments of such fund, account or subaccount. The value of the above investments shall be determined as provided in "Value" below. "Value," which shall be determined as of the 10th day of March and September of each year unless otherwise directed in writing by the Authority, means that the value of any investments shall be calculated as follows: (a) as to investments the bid and asked prices of which are published on a regular basis in The Wall Street Journal (or, if not there, then in The New York Times): the average of the bid and asked prices for such investments so published on or most recently prior to such time of determination; (b) as to investments the bid and asked prices of which are not published on a regular basis in The Wall Street Journal or The New York Times: the average bid price at such time of determination for such investments by any two nationally recognized government securities C-38 dealers (selected by the Trustee in its absolute discretion) at the time making a market in such investments or the bid price published by a nationally recognized pricing service; (c) as to certificates of deposit and bankers acceptances: the face amount thereof, plus accrued interest; (d) as to any investment not specified above: the value thereof established by prior agreement between the Authority, the Trustee and the Water District; and (e) alternatively, by any reasonable method used by the Trustee and approved by the Water District, including without limitation, computer pricing services. Except as otherwise provided in the Trust Agreement, the Trustee shall sell or present for redemption or transfer as provided in the next sentence any obligation so purchased as an investment whenever it shall be requested in writing by an Authorized Representative of the Water District so to do or whenever it shall be necessary in order to provide moneys to meet any payment or transfer from any fund, account or subaccount held by it. In lieu of such sale or presentment for redemption, the Trustee may, in making the payment or transfer from any fund, account or subaccount mentioned in the preceding sentence, transfer such investment obligations or interest appertaining thereto if such investment obligations shall mature or be collectable at or prior to the time the proceeds thereof shall be needed and such transfer of investment obligations may be made in book entry form. Absent bad faith or willful misconduct or negligence on its part, the Trustee shall not be liable or responsible for making or liquidating any such investment in the manner provided above or for any loss resulting from any such investment. Costs of Issuance Account. The Trustee shall deposit to the Costs of Issuance Account the amount required under the Trust Agreement. Moneys on deposit in the Costs of Issuance Account shall be applied to pay Costs of Issuance upon submission of a written request from an Authorized Representative of the Authority to the Trustee stating that the amount is justly due and owing, has not been the subject of any other written request which has been paid by the Trustee and is a proper Costs of Issuance. Any moneys remaining in the Costs of Issuance Account on May 1, 2003 shall be transferred to the Project Account. Rebate Fund. (a) Establishment. The Trustee shall establish a special fund designated the "Rebate Fund" (the "Rebate Fund"). All amounts at any time on deposit in the Rebate Fund shall be held by the Trustee in trust, to the extent required to satisfy the requirement to make rebate payments to the United States pursuant to Section 148 of the Code and the Treasury Regulations promulgated thereunder. Such amounts shall be free and clear of any lien under the Trust Agreement and shall be governed by the Trust Agreement and by the Tax Certificate executed by the Water District and Authority. The Trustee shall have no independent responsibility to, or liability resulting from its failure to, enforce compliance by the Authority with the Rebate Requirement. All money at any time deposited in the Rebate Fund shall be held by the Trustee in trust for payment to the United States Treasury. All amounts on deposit in the Rebate Fund for the Bonds shall be governed by the Trust Agreement and the Tax Certificate for the Bonds, unless and to the extent that the Authority delivers to the Trustee an opinion of Bond Counsel that the exclusion from gross income for federal income tax purposes of interest on the Bonds will not be adversely affected if such requirements are not satisfied. C-39 (b) Deficiencies in the Rebate Fund. In the event that, prior to the time of any payment required to be made from the Rebate Fund, the amount in the Rebate Fund is not sufficient to make such payment when such payment is due, the Authority shall calculate or cause to be calculated the amount of such deficiency and deposit an amount received from any legally available source equal to such deficiency prior to the time such payment is due. (c) Disposition of Unexpended Moneys. Any moneys remaining in the Rebate Fund after redemption and payment of the Bonds and the payments described in the Trust Agreement being made may be withdrawn by the Authority and utilized in any lawful manner by the Authority. (d) Record Keeping. The Authority shall retain records of all determinations made under the Trust Agreement until six years after the complete retirement of the Bonds. (e) Survival of Defeasance. Notwithstanding anything in the Trust Agreement to the contrary, the obligation to comply with the requirements of the Trust Agreement shall survive the payment in full or defeasance of the Bonds. COVENANTS, EVENTS OF DEFAULT, REMEDIES OF BONDOWNERS AND LIMITATIONS OF LIABILITY Trustee to Enforce Lease Agreement and Property Lease. The Trustee covenants and agrees with the Bondowners and the Bond Insurer, subject to the provisions of the Trust Agreement to exercise the rights assigned to it under the Lease Agreement and the Property Lease as assignee of the Authority, and to enforce the Property Lease against the City as provided therein and the Lease Agreement against the Water District as provided under the Trust Agreement, all subject to the provisions of the Trust Agreement. Against Amendment or Termination of Property Lease. The Authority and the Water District covenant and agree not to amend the Property Lease in a manner that is adverse to the Bond Insurer, or to terminate the Property Lease, without the prior written consent of the Bond Insurer, so long as the Insurance Policy is still in effect and the Bond Insurer is not in default thereunder. Notice of Non-Payment. In the event of delinquency in the payment of Lease Payments due by the Water District pursuant to the Lease Agreement, the Trustee shall promptly give written notice of the delinquency and the amount thereof to the Water District and the Company. Assignment of Rights. Pursuant to the Trust Agreement, the Authority has transferred, assigned and set over to the Trustee all of the Authority's rights in and to the Property Lease and the Lease Agreement including without limitation all of the Authority's right to receive Lease Payments from the Water District under the Lease Agreement, its right to receive the proceeds of insurance or of an eminent domain award on the Service Contract Project Improvements, its right to pursue the remedies to which it is entitled in the event of default by the Water District under the Lease Agreement (a "Lease Default Event"), its right to enforce payment of such Lease Payments when due, or otherwise protect its interests and enforce its rights under the Lease Agreement. C-40 Events of Default. The following events shall be Events of Default under the Trust Agreement: (a) Default in the due and punctual payment of the principal on any Bonds when and as the same shall become due and payable, whether at maturity as therein expressed, by proceedings for redemption, by acceleration, or otherwise. (b) Default in the due and punctual payment of any installment of interest on any Bonds when and as the same shall become due and payable. (c) Default by the Authority in the observance of any of the other covenants, agreements or conditions on its part in the Trust Agreement or in the Bonds contained, if such default shall have continued for a period of thirty (30) days after written notice thereof, specifying such default and requiring the same to be remedied, shall have been given to the Authority by the Trustee; provided, however, that if in the reasonable opinion of the Authority the default stated in the notice can be corrected, but not within such thirty (30) day period, such default shall not constitute an Event of Default under the Trust Agreement if the Authority shall commence to cure such default within such thirty (30) day period and thereafter diligently and in good faith cure such failure in a reasonable period of time (provided that in the event such breach is not cured within 60 days, the Water District shall obtain the prior written consent of the Bond Insurer to pursue the same to completion beyond the grace period provided herein). (d) The occurrence and continuation of a Lease Default Event. (e) Notwithstanding the foregoing, no effect shall be given to payments made under the Insurance Policy in determining whether an Event of Default exists under Section 5.04 of the Trust Agreement. Any reorganization or liquidation plan with respect to the Water District (excepting only a merger of the Water District with the City, as to which none of the Bond Insurer, the Authority or the Trustee have any approval or consent rights) must be acceptable to the Bond Insurer. In the event of any reorganization or liquidation, the Bond Insurer shall have the right to vote on behalf of all Owners who hold Bond Insurer-insured Bonds absent a default by the Bond Insurer under the applicable Insurance Policy insuring such Bonds. Anything in the Trust Agreement to the contrary notwithstanding, upon the occurrence and continuance of an Event of Default as defined in the Trust Agreement, the Bond Insurer shall be entitled to control and direct the enforcement of all rights and remedies granted to the Owners or the Trustee for the benefit of the Owners under the Trust Agreement or otherwise available to the Owners or Trustee, including, without limitation: (i) the right to accelerate the principal of the Bonds as described in the Trust Agreement, and (ii) the right to annul any declaration of acceleration. The Bond Insurer shall also be entitled to approve all waivers of Events of Default. Upon the occurrence of an Event of Default, the Trustee may, with the consent of the Bond Insurer, and shall, at the direction of the Bond Insurer or 60% of the Owners with the consent of the Bond Insurer, by written notice to the Authority and Water District and the Bond Insurer, declare the principal of the Bonds to be immediately due and payable, whereupon that portion of the principal of the Bonds thereby coming due and the interest thereon accrued to the date of payment shall, without C-41 further action, become and be immediately due and payable, anything in the Trust Agreement or in the Bonds to the contrary notwithstanding. Application of Funds. All moneys received by the Trustee pursuant to any right given or action taken under the provisions of the Lease Agreement shall be applied by the Trustee in the order following upon presentation of the several Bonds, and the stamping thereon of the payment if only partially paid, or upon the surrender thereof if fully paid - First, to the payment of the costs and expenses of the Trustee and of the Bondowners in declaring such Event of Default, including reasonable compensation to its or their agents, attorneys, consultants and counsel and any fees and expenses due or owing the Trustee; Second, to the payment of the whole amount then owing and unpaid with respect to the Bonds for principal and interest and in case such moneys shall be insufficient to pay in full the whole amount so owing and unpaid with respect to the Bonds, then to the payment of such principal and interest without preference or priority of principal over interest, or of interest over principal, or of any installment over any other installment of interest, ratably to the aggregate of such principal and interest. Institution of Legal Proceedings. If one or more Events of Default shall happen and be continuing, the Trustee in its discretion may, and upon the written request of the Owners of a majority in principal amount of the Bonds then Outstanding, and upon being indemnified to its satisfaction therefor, shall, proceed to protect or enforce its rights or the rights of the Owners of Bonds as provided in the Lease Agreement or in the Trust Agreement. Non-Waiver. Nothing in the Trust Agreement or in the Bonds, shall affect or impair the obligation of Water District to pay or prepay the Lease Payments in accordance with and subject to the terms and provisions of the Lease Agreement, or affect or impair the right of action, which is also absolute and unconditional, of the Bondowners to institute suit to enforce and collect such payment. No delay or omission of the Trustee or of any Bondowners to institute suit to enforce and collect such payment and no delay or omission of the Trustee or of any Bondowner of any of the Bonds to exercise any right or power arising upon the happening of any Event of Default shall impair any such right or power or shall be construed to be a waiver of any such Event of Default or an acquiescence therein, and every power and remedy given by the Trust Agreement to the Trustee or to the Bondowner may be exercised from time to time and as often as shall be deemed expedient by the Trustee or the Bondowner. Remedies Not Exclusive. No remedy in the Trust Agreement conferred upon or reserved to the Trustee or the Bondowners is intended to be exclusive of any other remedy, and every such remedy shall be cumulative and shall be in addition to every other remedy given under the Trust Agreement or now or thereafter existing, at law or in equity or by statute or otherwise. Power of Trustee to Control Proceedings. Except as provided in the Trust Agreement, in the event that the Trustee, upon the happening of an Event of Default, shall have taken any action, by judicial proceedings or otherwise, pursuant to its duties thereunder, whether upon its own discretion or upon the request of the Bondowners of a majority in principal amount of the Bonds then Outstanding, it shall have full power, in the exercise of its discretion for the best interests of the Owners of the Bonds, with respect to the continuance, discontinuance, withdrawal, compromise, settlement or other disposal of such action; provided, however, that the Trustee shall not discontinue, C-42 withdraw, compromise or settle, or otherwise dispose of any litigation pending at law or in equity, without the consent of a majority in aggregate principal amount of the Bonds Outstanding. Limitation on Bondowners' Right to Sue. Except as provided in the Trust Agreement, no Bondowner shall have the right to institute any suit, action or proceeding at law or in equity, for any remedy under or upon the Trust Agreement, unless (a) such Bondowner shall have previously given to the Trustee written notice of the occurrence of an Event of Default; (b) the Bondowners of at least twenty-five percent (25%) in aggregate principal amount of all the Bonds then Outstanding shall have made written request upon the Trustee to exercise the powers granted to the Trustee as assignee of the Authority or to institute such action, suit or proceeding in its own name; (c) said Bondowner shall have tendered to the Trustee reasonable indemnity against the costs, expenses and liabilities to be incurred in compliance with such request; and (d) the Trustee shall have refused or omitted to comply with such request for a period of sixty (60) days after such written request shall have been received by, and said tender of indemnity shall have been made to, the Trustee. Such notification, request, tender of indemnity and refusal or omission are declared, in every case, to be conditions precedent to the exercise by any Bondowner of any remedy thereunder; it being understood and intended that no one or more Bondowners shall have any right in any manner whatever by his or their action to enforce any right under the Trust Agreement, except in the manner provided in the Trust Agreement, and that all proceedings at law or in equity with respect to an Event of Default shall be instituted, had and maintained in the manner therein provided and for the equal benefit of all Bondowners of the Outstanding Bonds. The right of any Bondowner of any Bond to receive payment of said Bondowner's interest in the Lease Payments as the same become due, or to institute suit for the enforcement of such payment, shall not be impaired or affected without the consent of such Bondowner, notwithstanding the foregoing provisions of the Trust Agreement. Amendment of Lease Agreement. The terms of the Lease Agreement shall not be waived, altered, modified, supplemented or amended in any manner whatsoever except by written instrument signed by the Authority and the Water District, with the written consent of the Bond Insurer and the Trustee subject to the same conditions as set forth in the Trust Agreement. Reconstruction; Application of Insurance Proceeds. If any useful portion of the Service Contract Project Improvements shall be destroyed or is damaged by fire or other casualty, or title to, or the temporary use of, such portion shall be taken under the exercise of the power of eminent domain, the Water District shall as expeditiously as possible, continuously and diligently prosecute or cause to be prosecuted the repair, reconstruction, restoration or replacement thereof, unless it is determined under the provisions of the Lease Agreement that such repair, reconstruction, restoration or replacement is not to be undertaken. The proceeds of any insurance paid on account of such damage or destruction, shall be held by the Trustee in the Insurance and Condemnation Account and made available for, and to the extent necessary be applied to, the cost of such repair, reconstruction, restoration or replacement. Such moneys deposited in the Insurance and Condemnation Account shall be applied and paid out by the Trustee as provided in the Lease Agreement. Pending such application, such proceeds shall be invested, upon direction of an Authorized Representative of the Water District, by the Trustee in Investment Securities which mature not later than such times as shall be necessary to provide moneys when needed to pay such cost of repair, reconstruction, restoration or replacement. The interest, as well as the gain, if any, on such investments shall remain a part of any such Insurance and Condemnation Account to be applied as provided in the Trust C-43 Agreement. The proceeds of any insurance not applied within six months after receipt thereof by Trustee to repairing, reconstructing, restoring or replacing damaged or destroyed property, or in respect of which notice in writing of intention to apply the same to the work of repairing, reconstruction, restoring or replacing the property damaged or destroyed shall not have been given to the Trustee by Water District within such six months, or which Water District shall at any time notify the Trustee are not to be so applied, shall be deposited in the Redemption Account and applied to the redemption of Bonds pursuant to the Trust Agreement. After the completion of any repair, reconstruction, restoration, any remaining insurance proceeds shall be deposited in the Redemption Account and applied to the redemption of Bonds pursuant to the Trust Agreement. Accounts and Reports. (a) The Trustee shall keep proper books of record and account in which complete and correct entries shall be made of its transactions relating to each fund and account established under the Trust Agreement and the principal amount of the Bonds and which shall at all reasonable times upon reasonable prior notice be subject to the inspection of the Water District and Bondowners. (b) The Trustee shall provide the Water District, promptly after the end of each calendar month a statement of its transactions during such month relating to each fund, account or subaccount held by it under the Trust Agreement. No Obligation by the Water District to Bondowners. Except for the payment of Lease Payments when due in accordance with the Lease Agreement and any other payment due and owing by the Water District under the Lease Agreement and the performance of the other covenants and agreements of the Water District contained in the Lease Agreement or under the Trust Agreement, the Water District shall have no obligation or liability to any of the other parties or to the Bondowners with respect to the Trust Agreement or the terms, execution, delivery or transfer of the Bonds, or the distribution of Lease Payments to the Bondowners by the Trustee. No Obligation with Respect to Performance by Trustee. The Water District or the Authority shall not have any obligation or liability to any of the other parties or to the Bondowners with respect to the performance by the Trustee of any duty imposed upon it under the Trust Agreement. No Liability to Bondowners for Payment. Except as provided in the Trust Agreement, neither the Trustee nor the Authority shall have any obligation or liability to the Bondowners with respect to the payment of the Lease Payments by the Water District when due, or with respect to the performance by the Water District of any other covenant by it in the Lease Agreement. Possession and Enjoyment. So long as no Lease Termination shall have occurred, from and after the acquisition, construction and installation by the Water District of the Service Contract Project Improvements in accordance with the terms of the Lease Agreement, the Water District shall during such Lease Term peaceably and quietly have and hold and enjoy the Project, without suit, trouble or hindrance from the Trustee, except as expressly set forth in the Lease Agreement. The Trustee will, at the written request of the Water District and at the Water District's cost, join in any legal action in which the Water District asserts its right to such possession and enjoyment, to the extent Trustee lawfully may do so; provided, however, the Trustee may decline to join in such action if it believes it will be exposed to liability for which it has not been satisfactorily indemnified against. C-44 Tax Covenants. Notwithstanding any other provision of the Trust Agreement, absent an opinion of Bond Counsel that the exclusion from gross income of interest on the Bonds will not be adversely affected for federal income tax purposes, the Authority and the Water District covenant to comply with all applicable requirements of the Code necessary to preserve such exclusion from gross income and specifically covenant, without limiting the generality of the foregoing, as follows: (a) Private Activity. The Authority and the Water District will not take or omit to take any action or make any use of the proceeds of the Bonds, the Service Contract Project Improvements or of any other moneys or property which would cause the Bonds to be "private activity bonds" within the meaning of Section 141 of the Code. (b) Arbitrage. The Authority and the Water District will make no use of the proceeds of the Bonds, the Project or of any other amounts or property, regardless of the sources, or take or omit to take any action which would cause the Bonds to be "arbitrage bonds" within the meaning of Section 148 of the Code; (c) Federal Guarantee. The Authority and the Water District will make no use of the proceeds of the Bonds, the Project, or take or omit to take any action that would cause the Bonds to be "federally guaranteed" within the meaning of Section 149(b) of the Code; (d) Information Reporting. The Authority and the Water District will take or cause to be taken all necessary action to comply with the informational reporting requirement of Section 149(e) of the Code; (e) Hedge Bonds. The Authority and the Water District will make no use of the proceeds of the Bonds, the Project, or any other amounts or property, regardless of the source, or take or omit to take any action that would cause the Bonds to be considered "hedge bonds" within the meaning of Section 149(g) of the Code unless the Authority and the Water District take all necessary action to assure compliance with the requirements of Section 149(g) of the Code to maintain the exclusion from gross income of interest on the Bonds for federal income tax purposes; and (f) Miscellaneous. The Authority and the Water District will take no action inconsistent with their expectations stated in the Tax Certificate and will comply with the covenants and requirements stated therein and incorporated by reference in the Trust Agreement. Parity Obligations. Neither the Authority nor the Water District shall issue or incur evidences of indebtedness or other obligations payable from the Lease Payments having any priority in payment over the Bonds. The Water District may at any time issue obligations secured on a parity with the Lease Payments which are incurred in accordance with the Lease Agreement. Continuing Disclosure. The Water District covenants and agrees that it will comply with and carry out all of the provisions of the Continuing Disclosure Agreement dated the date of issuance of the Bonds. Notwithstanding any other provision of the Trust Agreement, failure of the Water District to comply with the Continuing Disclosure Agreement shall not be considered an Event of Default; however, any participating underwriter, holder or beneficial owner of the Bonds may take such actions as may be necessary and appropriate to compel performance, including seeking mandate or specific performance by court order. C-45 CONCERNING THE TRUSTEE Employment of Trustee. The Authority, pursuant to the Trust Agreement, appoints BNY Western Trust Company as Trustee. The Trustee will, prior to an Event of Default, and after the curing of all Events of Default which may have occurred, perform such duties and only such duties as are specifically set forth in the Trust Agreement, and no implied covenants or obligations shall be read into the Trust Agreement against the Trustee. The Trustee shall, during the existence of any Event of Default (which has not been cured in accordance with the Trust Agreement), exercise such of the rights and powers vested in it by the Trust Agreement, and use the same degree of care and skill in their exercise, as a prudent person would exercise or use under the circumstances in the conduct of such person's own affairs. Trustee Acceptance of Duties. The Trustee shall signify its acceptance of the duties and obligations imposed upon it by executing and delivering the Trust Agreement; and by executing such acceptance the Trustee shall be deemed to have accepted such duties and obligations with respect to all the Bonds thereafter delivered, but only, however, upon the terms and conditions set forth therein. Evidence on Which Trustee May Act. (a) The Trustee, upon receipt of any notice, resolution, request, consent, order, certificate, report, opinion, bond, or other paper or document furnished to it pursuant to any provision of the Trust Agreement, shall examine such instrument to determine whether it conforms to the requirements thereof and shall not be liable for acting upon any such instrument believed by it to be genuine and to have been signed or presented by the proper party or parties. The Trustee may consult with counsel, who may or may not be counsel to the Water District, and the opinion of such counsel shall be full and complete authorization and protection in respect of any action taken or suffered by it thereunder in good faith and in accordance therewith. The Trustee may rely on and shall not be liable for acting upon the written instructions of the Authority and the Water District and such employees and representatives of the Water District as the Water District may thereinafter designate in writing. (b) Whenever the Trustee shall deem it necessary or desirable that a matter be proved or established prior to taking or suffering any action under the Trust Agreement, such matter (unless other evidence in respect thereof be therein specifically prescribed) may be deemed to be conclusively proved and established by a certificate of an Authorized Representative of the Water District, and such certificate shall be full warrant for any action taken or suffered in good faith under the provisions and terms of the Trust Agreement; but in its discretion the Trustee may in lieu thereof accept other evidence of such fact or matter or may require such further or additional evidence as to it may seem reasonable. (c) Except as otherwise expressly provided in the Trust Agreement, any request, order, notice or other direction required or permitted to be furnished pursuant to any provision thereof by the Authority or the Water District to the Trustee shall be sufficiently executed in the name of the Authority or the Water District by an Authorized Representative of the Authority or the Water District, as appropriate. (d) Notwithstanding any other provision of the Trust Agreement, in determining whether the rights of the Bondholders will be adversely affected by any action taken pursuant to the C-46 terms and provisions of the Trust Agreement, the Trustee shall consider the effect on the Bondholders as if there were no Insurance Policy. Obligations of Trustee. Upon receipt of written notice of the termination of the Lease Agreement, the Trustee shall at the written request of the Water District convey any right, title or interest in the Project created by the Trust Agreement free and clear of all liens thereon which Trustee may have. Compensation. The Water District has agreed in the Lease Agreement to pay to the Trustee compensation for all services rendered under the Trust Agreement and also all expenses, charges, counsel fees and other disbursements, including those of its attorneys, agents, and employees, incurred in and about the performance of its powers and duties under the Trust Agreement, at the rates and charges specified in a separate written fee agreement among the Authority, the Water District and the Trustee. The Water District shall reimburse the Trustee for any advances of its own funds to make payments for which the Water District and Authority is obligated under the Trust Agreement, with interest at the maximum rate allowed by law. Resignation of Trustee. The Trustee may at any time resign and be discharged of the duties and obligations created by the Trust Agreement by giving not less than 60 day's written notice to the Water District, the Bond Insurer, and the Bondowners, specifying the date when such resignation shall take effect, and such resignation shall take effect upon the day specified in such notice unless previously a successor shall have been appointed by the Water District and the Authority or the Bondowners as provided in the Trust Agreement, in which event such resignation shall take effect immediately on the appointment of such successor; provided that in the event the Water District and the Authority are unable to appoint a successor on or before the date specified, the resigning Trustee shall continue to serve under the Trust Agreement until a successor is appointed pursuant to the Trust Agreement. Removal of Trustee. The Trustee may be removed upon 60 days' written notice by an instrument or concurrent instruments in writing, filed with the Trustee, and signed by the Owners of a majority in principal amount of the Bonds then Outstanding or their attorneys-in-fact duly authorized. The Trustee may be removed at any time, at the request of the Bond Insurer, for any breach of the trust set forth in the Trust Agreement. Appointment of Successor Trustee. (a) In case at any time the Trustee shall resign or shall be removed or shall become incapable of acting, or shall be adjudged as bankrupt or insolvent, or if a receiver, liquidator or conservator of the Trustee, or of its property, shall be appointed, or if any public officer shall take charge or control of the Trustee or of its property or affairs, a successor may be appointed by the Authority and the Water District. (b) If in a proper case no appointment of a successor Trustee shall be made pursuant to the foregoing provisions of the Section within 45 days after the Trustee shall have given to the Water District and Bond Insurer written notice as provided in the Trust Agreement or after a vacancy in the office of the Trustee shall have occurred by reason of its inability to act, the Trustee may petition at the expense of the Water District a court to appoint a successor Trustee. C-47 (c) Any Trustee appointed under the provisions of the Trust Agreement in succession to the Trustee shall be a commercial bank or trust company or national banking association, having capital stock and surplus aggregating at least $75,000,000, acceptable to the Bond Insurer, and authorized to exercise trust powers. (d) Notwithstanding any other provision of the Trust Agreement, no removal, resignation or termination of the Trustee shall take effect until a successor shall be appointed. Transfer of Rights and Project to Successor Trustee. Any successor Trustee appointed under the Trust Agreement shall execute, acknowledge and deliver to its predecessor Trustee an instrument accepting such appointment, and thereupon such successor Trustee, without any further act, deed or conveyance, shall become fully vested with all moneys, estates, properties, rights, powers, duties and obligations of such predecessor Trustee, with like effect as if originally named as Trustee; but the Trustee ceasing to act shall nevertheless, on the written request of the successor Trustee, execute, acknowledge and deliver such instrument of conveyance and further assurance and do such other things as may reasonably be required for more fully and certainly vesting and confirming in such successor Trustee all the right, title and interest of the predecessor Trustee in and to any property held by it under the Trust Agreement, and shall pay over, assign and deliver to the successor Trustee any money or other property subject to the trusts and conditions set forth in the Trust Agreement. Should any deed, conveyance or instrument in writing from the Water District or the Authority be required by such successor Trustee for more fully and certainly vesting in and confirming to such successor Trustee any such estates, rights, power and duties, any and all such deeds, conveyances and instruments in writing shall, on request, and so far as may be authorized by law, be executed, acknowledged and delivered by the Water District or the Authority. Merger or Consolidation. Any company into which the Trustee may be merged or converted or with which it may be consolidated or any company resulting from any merger, conversion or consolidation to which it shall be a party or any company to which the Trustee may sell or transfer all or substantially all of its corporate trust business, provided such company shall be a bank or trustee company organized under the laws of any state of the United States or a national banking association, shall meet the other requirements of the Trust Agreement, and shall be authorized by law to perform all the duties imposed upon it by the Trust Agreement, shall be the successor to the Trustee without the execution or filing of any paper or the performance of any further act. Adoption of Authorized Signature. In case any of the Bonds contemplated to be delivered under the Trust Agreement shall have been executed but not delivered, any successor Trustee may adopt the authorized signature of any predecessor Trustee so authenticating such Bonds and deliver such Bonds so executed; and in case any of the said Bonds shall not have been executed, any successor Trustee may authenticate such Bonds in the name of the successor Trustee, and in all such cases such authentication shall have the full force which it is anywhere in said Bonds or provided that the authentication of the Trustee shall have. Liability of the Trustee. The recitals, statements and representations by the Water District or the Authority contained in the Trust Agreement or in the Bonds shall be taken and construed as made by and on the part of the Water District and Authority and not by the Trustee and the Trustee does not assume, and shall not have, any responsibility or obligations for the correctness of any thereof. The Trustee may execute any of the trusts or powers of the Trust Agreement and perform the duties required of it under the Trust Agreement either directly or by or through attorneys or agents C-48 and shall be entitled to advice of counsel concerning all matters of trust and its duties under the Trust Agreement and shall be absolutely protected in relying thereon. The Trustee shall not be responsible for the misconduct of such persons selected by it with reasonable care. No provision in the Trust Agreement shall require the Trustee to risk or expend its own funds or otherwise incur any financial liability in the performance of any of its duties under the Trust Agreement if it shall have reasonable grounds for believing that repayment of such funds or adequate indemnity against such risk or liability is not assured to it. The Trustee shall not be liable in connection with the performance of its duties under the Trust Agreement except for its own negligence or willful misconduct. In accepting the trust created by the Trust Agreement, the Trustee acts solely as Trustee for the Owners and not in its individual capacity and all persons, including without limitation the Owners and the Water District or the Authority, having any claim against the Trustee arising from the Trust Agreement shall look only to the funds and accounts held by the Trustee under the Trust Agreement for payment except as otherwise provided therein. Under no circumstances shall the Trustee be liable in its individual capacity for the obligations evidenced by the Bonds. The Trustee makes no representation or warranty, express or implied as to the title, value, design, compliance with specifications or legal requirements, quality, durability, operation, condition, merchantability or fitness for any particular purpose or fitness for the use contemplated by the Water District or the Authority of the Project. In no event shall the Trustee be liable for incidental, indirect, special or consequential damages in connection with or arising from the Lease Agreement or the Trust Agreement for the existence, furnishing or use of the Service Contract Project Improvements. The Trustee shall not be responsible for the sufficiency or enforceability of the Property Lease or the Lease Agreement or the assignment under the Trust Agreement of its rights to receive Lease Payments. The Trustee shall not be deemed to have knowledge of any Event of Default under the Trust Agreement or under the Lease Agreement unless and until it shall have actual knowledge thereof. The Trustee shall not be accountable for the use or application by the Water District or the Authority or any other party of any funds which the Trustee has released under the Trust Agreement. The Trustee shall not be responsible for accounting for, or paying to, any party to this transaction, including but not limited to the Water District, the Authority, and the Bondowners, any return on or benefit from funds held for payment of unredeemed Bonds or outstanding checks and no calculation of the same shall affect, or result in any offset against, fees due to the Trustee under the Trust Agreement. The Trustee's rights to immunities and protection from liability under the Trust Agreement and its rights to payment of its fees and expenses shall survive its resignation or removal and the final payment or the defeasance of the Bonds (or the discharge of the Bonds or the defeasance of the lien of the Trust Agreement). C-49 All indemnification and releases from liability granted to the Trustee in the Trust Agreement or in the Lease Agreement shall extend to the directors, officers, employees, attorneys and agents of the Trustee. The Trustee shall have no responsibility, opinion, or liability with respect to any information, statement or recital in any offering memorandum or other disclosure material prepared or distributed with respect to the issuance of the Bonds except for information provided by the Trustee. Before taking any action under the Trust Agreement at the request of Owners, the Trustee may require that a satisfactory indemnity bond be furnished by the Owners for the reimbursement of all expenses to which it may be put and to protect it against all liability, except liability which is adjudicated to have resulted from its negligence or willful misconduct in connection with any action so taken. AMENDMENTS Mailing. Any provision in the Trust Agreement for the mailing of a notice or other paper to Bondowners shall be fully complied with if it is mailed first class United States mail, postage prepaid only (i) to each Owner of Bonds then Outstanding at his address, if any, appearing upon the registry books of the Trustee, and (ii) to the Trustee. Powers of Amendment. The Trust Agreement and the rights and obligations provided may be modified or amended at any time by a Supplemental Trust Agreement, entered into among the Trustee, the Authority and the Water District but without the consent of any Bondowners, but only (a) to cure any ambiguity, supply any omission, or cure or correct any defect or inconsistent provision in the Trust Agreement, (b) to insert such provisions clarifying matters or questions arising under the Trust Agreement as are necessary or desirable and are not contrary to or inconsistent with the Trust Agreement as theretofore in effect, (c) to provide for the authorization, execution and delivery of Parity Obligations, or (d) in regard to matters arising under the Trust Agreement or thereunder, as the parties may deem necessary or desirable which shall not in the opinion of Bond Counsel which may be supported by a certificate of an independent financial consultant materially adversely affect the interest of the Bondowners or the Bond Insurer. Any other modification or amendment of the Trust Agreement and of the rights and obligations of the Trustee or of the Owners of the Bonds under the Trust Agreement, in any particular, may be made by a Supplemental Trust Agreement, entered into among the Trustee, the Authority and the Water District with the written consent, given as provided in the Trust Agreement, of the Owners of at least sixty percent (60%) in principal amount of the Bonds Outstanding at the time such consent is given. No such modification or amendment shall permit a change in the terms of redemption or maturity of the principal with respect to any Outstanding Bonds or of any installment of interest with respect thereto or a reduction in the principal amount or the redemption price with respect thereto or in the rate of interest with respect thereto or which will have an adverse effect on the security interest of the Owner without the consent of the Owner of such Bond, or shall reduce the percentages or otherwise affect the classes of Bonds the consent of the Owners of which is required to effect any such modification or amendment, or shall change or modify any of the rights or obligations of the Trustee without the written assent of the Trustee. The Trustee may in its discretion determine whether or not, in accordance with the foregoing powers of amendment, Bonds of any particular maturity would be affected by any modification or amendment of the Trust Agreement, and any such determination shall be binding and conclusive on the Authority, the Water District and all Owners of Bonds. The Trustee may obtain an opinion of counsel that any such Supplemental Trust Agreement entered into by the Authority, the C-50 Water District and the Trustee complies with the provisions of the Trust Agreement and the Trustee may conclusively rely upon such opinion. The Authority shall be provided with a full original transcript of all proceedings relating to the execution of any amendatory or Supplemental Trust Agreement or Lease Agreement. Any provision of the Trust Agreement expressly recognizing or granting rights in or to Bond Insurer may not be amended in any manner which affects the rights of Bond Insurer under the Trust Agreement without the prior written consent of Bond Insurer. Consent of Bondowners. The Trustee, the Authority and the Water District may at any time enter into a Supplemental Trust Agreement making a modification or amendment permitted by the provisions of the Trust Agreement to take effect when and as provided in the Trust Agreement. A copy of such Supplemental Trust Agreement (or brief summary thereof), together with a request to Bondowners to approve the same shall be mailed to each Bondowner (but failure to mail such copy and request shall not affect the validity of the Supplemental Trust Agreement when consented to as provided in the Trust Agreement). Such Supplemental Trust Agreement shall not be effective unless and until (i) there shall have been filed with the Trustee (a) the written consents of Owners of the percentage of Outstanding Bonds specified in the Trust Agreement and (b) an opinion of Bond Counsel stating that such Supplemental Trust Agreement has been duly and lawfully entered into by the parties thereto and filed with the Water District and the Trustee in accordance with the provisions of the Trust Agreement, is authorized or permitted by the Trust Agreement, and is valid and binding upon the parties thereto in accordance with its terms. Each such consent shall be effective only if accompanied by proof of the Owner, at the date of such consent, of the Bonds with respect to which such consent is given, which proof shall be such as is permitted by the Trust Agreement. The request for consent of Bondowners pursuant to the Trust Agreement may provide a date by which such consents must be received to be effective. A certificate or certificates executed by the Trustee and filed with the Water District stating that it has examined such proof and that such proof is sufficient in accordance with the Trust Agreement shall be conclusive that the consents have been given by the Owners of the Bonds described in such certificate or certificates of the Trustee. Any such consent shall be binding upon the holder of the Bonds giving such consent and, anything in the Trust Agreement to the contrary notwithstanding, upon any subsequent Owner of such Bonds and of any Bonds issued in exchange therefor (whether or not such subsequent Owner thereof has notice thereof) unless such consent is revoked in writing by the Owner of such Bonds giving such consent or a subsequent Owner thereof by filing with the Trustee, prior to the time when the written statement of the Trustee provided for in the Trust Agreement is filed. Such revocation and, if such Bonds are held by the signer of such revocation, proof of ownership shall be evidenced in the manner permitted by the Trust Agreement. The fact that a consent has not been revoked may likewise be proved by a certificate of the Trustee filed with the Water District to the effect that no revocation thereof is on file with the Trustee. At any time after the Owners of the required percentage of Bonds shall have filed their consents to the Supplemental Trust Agreement, the Trustee shall make and file with the Water District a written statement that the Owners of such required percentage of Bonds have filed such consents. Such written statements shall be conclusive that such consents have been so filed. At any time thereafter notice, stating in substance that the Supplemental Trust Agreement (which may be referred to as a Supplemental Trust Agreement entered into by the parties thereto on a stated date, a copy of which is on file with the Trustee) has been consented to by the Owners of the required percentages of Bonds and will be effective as provided in the Trust Agreement, may be given to Bondowners by the Water District or the Trustee at the direction of the Water District, by mailing such notice pursuant to the Trust Agreement to Bondowners (but failure to receive such notice shall not prevent such Supplemental Trust Agreement from becoming effective and binding as in the Section provided). The Water District shall file with the Trustee proof of the mailing of such notice. A record, consisting of the certificates or statements required or permitted by the Trust C-51 Agreement to be made by the Trustee, shall be proof of the matters therein stated. Such Supplemental Trust Agreement making such amendment or modification shall be deemed conclusively binding upon the Water District, the Trustee, the Authority and the Owners of all Bonds at the expiration of 40 days after the filing with the Trustee of the proof of the mailing of such last mentioned notice, except in the event of a final decree of a court of competent jurisdiction setting aside such Supplemental Trust Agreement in a legal action or equitable proceeding for such purpose commenced within such 40 day period; provided, however, that the Trustee, the Authority or the Water District during such 40 day period and any such further period during which any such action or proceeding may be pending shall be entitled in their absolute discretion to take such action, or to refrain from taking such action, with respect to such Supplemental Trust Agreement as they may deem expedient. Unless otherwise provided in the Trust Agreement, Bond Insurer's consent shall be required in addition to Owner consent, when required, for the following purposes: (i) execution and delivery of any supplemental Trust Agreement or any amendment, supplement or change to or modification of the Lease Agreement; (ii) removal of the Trustee or selection and appointment of any successor trustee; and (iii) initiation or approval of any action not described in (i) or (ii) above which requires Owner consent. Modifications by Unanimous Consent. The terms and provisions of the Trust Agreement and the rights and obligations of the Trustee and of the Owners of the Bonds under the Trust Agreement may be modified or amended in any respect upon entering into by the parties of a Supplemental Trust Agreement with the unanimous consent of the Owners of all the Bonds then Outstanding and the Bond Insurer, such consent to be given as provided in the Trust Agreement except that no notice to Bondowners by mailing shall be provided and to the extent any such Supplemental Trust Agreement alters the rights and obligations of the Trustee the Trustee's approval shall be required. Exclusion of Bonds. Bonds owned or held by or for the account of the Water District shall not be deemed Outstanding for the purpose of consent or other action or any calculation of Outstanding Bonds provided for in the Trust Agreement, and the Water District shall not be entitled with respect to such Bonds to give any consent or take any other action provided for in the Trust Agreement. At the time of any consent or other action taken under the Trust Agreement, the Water District shall furnish the Trustee a Certificate of Authorized Representative of the Water District, upon which the Trustee may rely, describing all Bonds so to be excluded. Notation on Bonds. Bonds issued after the effective date of any action taken as provided in the Trust Agreement provided may, and if the Water District so determines shall, bear a notation by endorsement or otherwise in form approved by the Water District and the Trustee as to such action, and in that case upon demand of the Owner of any Bond Outstanding at such effective date and presentation of the Bond or Bonds for the purpose at the principal corporate trust office of the Trustee or upon any transfer or exchange of any Bond Outstanding at such effective date, suitable notation shall be made on such Bond or upon any Bonds issued upon any such transfer or exchange by the Trustee as to any such action. If the Water District and the Trustee shall so determine, new Bonds so modified as in the opinion of the Trustee and the Water District may be necessary to conform to such action shall be prepared, issued, and upon demand of the Owner of any Bond then Outstanding shall be exchanged, without cost to such Bondowner, for Bonds of the same maturity then Outstanding, upon surrender of such Bonds. C-52 MISCELLANEOUS Defeasance. (a) Outstanding Bonds shall be paid and discharged in any one or more of the following ways - (i) by paying or causing to be paid the principal of and interest with respect to said Outstanding Bonds, as and when the same become due and payable; or (ii) by depositing with the Trustee, in trust, cash or Investment Securities of the type set forth in part (A) of the definition thereof in such amount, including without limitation cash or Investment Securities of the type set forth in part (A) of the definition thereof then on deposit in the Debt Service Payment Account and Reserve Account applicable to the Outstanding Bonds, together with the interest to accrue with respect thereto, as will be sufficient, as shown on a certificate of a nationally recognized certified public accountant or firm of certified public accountants, to pay and discharge the Outstanding Bonds to be paid and discharged (including all principal, interest and premium, if any) at or before their respective maturity dates. In the event of a refunding, the Water District shall cause to be delivered (i) a report of an independent firm of nationally recognized certified public accountants ("Accountant") verifying the sufficiency of the escrow established to pay the Bonds in full and (ii) an opinion of nationally recognized Bond Counsel to the effect that the Bonds are no longer "Outstanding" under the Trust Agreement, each of which shall be addressed to the Water District, the Trustee, the Authority and the Bond Insurer. Notwithstanding that any Bonds shall not have been surrendered for payment, all obligations of Authority, the Trustee and the Water District under the Trust Agreement with respect to those Bonds paid, as provided in the above subsections, and the trust created by the Trust Agreement shall cease and terminate, except only the obligation of the Trustee to pay or cause to be paid to the Owner of the Bonds not so surrendered and paid all sums due thereon, to transfer title to the Water District as provided in the Lease Agreement, and the obligation of Water District to cause rebates pursuant to the Trust Agreement and the obligation of the Trustee to make transfers and exchanges of Bonds pursuant to the Trust Agreement. Notice of defeasance of the Bonds and the obligations under the Trust Agreement shall be given by the Trustee in the manner provided in the Trust Agreement. The fees and charges of the Trustee (including reasonable counsel fees and expenses) must be paid in order to effect such discharge. The satisfaction and discharge of the Trust Agreement shall be without prejudice of the rights, if any, of the Trustee to charge and be reimbursed by the Water District for any expenditures which it may thereafter incur in connection therewith. Any funds held by the Trustee, at the time of one of the events described above, shall have occurred, which are not required for the payment to be made to Owners, or for payments to be made to the Trustee by the Water District, or for payment to the United States under the Trust Agreement, shall be paid over to the Water District. (b) Anything in the Trust Agreement to the contrary notwithstanding, any moneys held by the Trustee in trust for the payment of any of the Bonds which remain unclaimed for two years after the date when such Bonds have become due and payable, either at their stated maturity dates or by call for earlier redemption, if such moneys were held by the Trustee at such date, C-53 or for two years after the date of deposit of such moneys if deposited with the Trustee after the said date when such Bonds became due and payable, shall be repaid by the Trustee to the Water District, as its absolute property and free from trust, and the Trustee shall thereupon be released and discharged with respect thereto and the Bondowners shall look only to the Water District for the payment of such Bonds. (c) Notwithstanding anything in the Trust Agreement to the contrary, in the event that the principal and/or interest due on the Bonds shall be paid by Bond Insurer pursuant to the Insurance Policy, the Bonds shall remain Outstanding for all purposes, not be defeased or otherwise satisfied and not be considered paid by the Water District or the Authority, and the assignment and pledge of the Trust Estate and all covenants, agreements and other obligations of the Water District and the Authority to the registered owners shall continue to exist and shall run to the benefit of the Bond Insurer and the Bond Insurer shall be subrogated to the rights of such registered owners. Evidence of Signatures of Bondowners and Ownership of Bonds. (a) Any request, consent, revocation of consent or other instrument which the Trust Agreement may require or permit to be signed and executed by the Bondowners may be in one or more instruments of similar tenor, and shall be signed or executed by such Bondowners in person or by their attorneys appointed in writing. Proof of (i) the execution of any such instrument, or of an instrument appointing any such attorney, or (ii) the ownership by any person of the Bonds, shall be sufficient for any purpose under the Trust Agreement (except as otherwise therein expressly provided) if made in the following manner, or in any other manner satisfactory to the Trustee, which may nevertheless in its discretion require further or other proof in cases where it deems the same desirable: the fact and date of the execution by any Bondowner or his attorney of such instruments may be proved by a guaranty of the signature thereon by a commercial bank or trust company or member firm of the New York Stock Exchange or by the certificate of any notary public or other officer authorized to take acknowledgments of deeds, that the person signing such request or other instrument acknowledged to him the execution thereof, or by an affidavit of a witness of such execution, duly sworn to before such notary public or other officer. Where such execution is by an officer of a corporation or association or a member of a partnership, on behalf of such corporation, association or partnership, such signature guaranty, certificate or affidavit shall also constitute sufficient proof of his authority. (b) The ownership of Bonds and the amount, numbers and other identification, and date of owning the same shall be proved by the registry books of the Trustee. Moneys Held for Particular Bonds. The amounts held by the Trustee for the payment of the interest, principal or premium due on any date with respect to particular Bonds shall, on and after such date and pending such payment, be set aside on its books and held in trust by it for the Owners of the Bonds entitled thereto. Preservation and Inspection of Documents. All documents received by the Trustee under the provisions of the Trust Agreement shall be retained in its possession and shall be subject at all reasonable times to the inspection of the Water District, the Authority, the Bond Insurer or any Bondowner and their agents and representatives, any of whom may make copies thereof. Severability of Invalid Provisions. If any one or more of the covenants or agreements provided in the Trust Agreement should be contrary to law, then such covenant or covenants or C-54 agreement or agreements shall be deemed severable from the remaining covenants and agreements, and shall in no way affect the validity of the other provisions thereof. Recording and Filing. The Water District shall be responsible for the recording and filing of the Property Lease, Lease Agreement and financing statements (or continuation statements in connection therewith) or of any supplemental instruments or documents of further assurance as may be required by law in order to perfect the security interests created by the Property Lease or the Lease Agreement. The Water District and the Authority shall take such further actions as may be necessary to effectuate the transactions contemplated by the Trust Agreement, the Property Lease and the Lease Agreement. Payment Procedure Pursuant to the Insurance Policy. As long as the Insurance Policy shall be in full force and effect, the Authority and the Trustee agree to comply with the following provisions: (a) At least one (1) day prior to all Interest Payment Dates the Trustee will determine whether there will be sufficient funds in the funds and accounts established under the Trust Agreement for such purpose to pay the principal of or interest on the Bonds on such Interest Payment Date. If the Trustee determines that there will be insufficient funds in such Funds or Accounts, the Trustee shall so notify the Bond Insurer. Such notice shall specify the amount of the anticipated deficiency as to principal or interest, or both. If the Trustee has not so notified the Bond Insurer at least one (1) day prior to the Interest Payment Date, the Bond Insurer will make payments of principal or interest due on the Bonds on or before the first (1st) day next following the date on which the Bond Insurer shall have received notice of nonpayment from the Trustee. (b) The Trustee shall, after giving notice to the Bond Insurer as provided in (a) above, make available to the Bond Insurer and, at the Bond Insurer's direction, to The Bank of New York, in New York, New York, as insurance trustee for Ambac Assurance or any successor insurance trustee (the "Insurance Trustee"), the registration books of the Authority maintained by the Trustee and all records relating to the Funds and Accounts maintained under the Trust Agreement. (c) The Trustee shall provide the Bond Insurer and the Insurance Trustee with a list of registered owners of Bonds entitled to receive principal or interest payments from the Bond Insurer under the terms of the Insurance Policy, and shall make arrangements with the Insurance Trustee (i) to mail checks or drafts to the registered owners of Bonds entitled to receive full or partial interest payments from the Bond Insurer and (ii) to pay principal upon Bonds surrendered to the Insurance Trustee by the registered owners of Bonds entitled to receive full or partial payments from the Bond Insurer. (d) The Trustee shall, at the time it provides notice to the Bond Insurer pursuant to (a) above, notify registered owners of Bonds entitled to receive the payment of principal or interest thereon from the Bond Insurer (i) as to the fact of such entitlement, (ii) that the Bond Insurer will remit to them all or a part of the interest payments next coming due upon proof of Owner entitlement to interest payments and delivery to the Insurance Trustee, in form satisfactory to the Insurance Trustee, of an appropriate assignment of the registered owner's right to payment, (iii) that should they be entitled to receive full payment of principal from the Bond Insurer, they must surrender their Bonds (along with an appropriate instrument of assignment in form satisfactory to the Insurance Trustee to permit ownership of such Bonds to be registered in the name of the Bond Insurer for payment to the Insurance Trustee, and not the Trustee, and (iv) that should they be entitled to receive C-55 partial payment of principal from the Bond Insurer they must surrender their Bonds for payment thereon first to the Trustee who shall note on such Bonds the portion of the principal paid by the Trustee and then, along with an appropriate instrument of assignment in form satisfactory to the Insurance Trustee, to the Insurance Trustee, which will then pay the unpaid portion of principal. (e) In the event the Trustee has notice any payment of principal of or interest on Bonds which has become due for payment and which is made to an Owner by or on behalf of the Authority has been deemed a preferential transfer and theretofore recovered from its registered owner pursuant to the United States Bankruptcy Code by a trustee in bankruptcy in accordance with the final, nonappealable order of a court having competent jurisdiction, the Trustee shall, at the time the Bond Insurer is notified pursuant to (a) above, notify all registered owners that in the event that any registered owner's payment is so recovered, such registered owner will be entitled to payment from the Bond Insurer to the extent of such recovery if sufficient funds are not otherwise available, and the Trustee shall furnish to the Bond Insurer its records evidencing the payments of principal of and interest on the Bonds which have been made by the Trustee and subsequently recovered form the registered owners and the dates on which such payments were made. (f) In addition to those rights granted the Bond Insurer under the Trust Agreement, the Bond Insurer shall, to the extent it makes payment of principal of or interest on Bonds, become subrogated to the rights of the recipients of such payments in accordance with the terms of the Insurance Policy, and to evidence such subrogation (i) in the case of subrogation as to claims for past due interest, the Trustee shall note the Bond Insurer's rights as subrogee on the registration books of the Authority maintained by the Trustee upon receipt from the Bond Insurer of proof of the payment of interest thereon to the registered owners of the Bonds and (ii) in the case of subrogation as to claims for past due principal, the Trustee shall note the Bond Insurer's rights as subrogee on the registration books of the Authority maintained by the Trustee upon surrender of the Bonds by the registered owners thereof together with proof of the payment of principal thereof. (g) In connection with the issuance of additional Bonds, the Authority shall deliver to the Bond Insurer a copy of the disclosure document, if any, circulated with respect to such additional Bonds. (h) Copies of any amendments made to the documents executed in connection with the issuance of the Bonds which are consented to by the Bond Insurer shall be sent to S&P. (i) The Bond Insurer shall receive notice of the resignation or removal of the Trustee and the appointment of a successor thereto. (j) The Bond Insurer shall receive copies of all notices required to be delivered to the Owners of the Bonds and, on an annual basis, copies of the Water District's audited financial statements and Annual Budget. Bond Insurer as Third Party Beneficiary. To the extent that the Trust Agreement confers upon or gives or grants to the Bond Insurer any right, remedy or claim under or by reason of the Trust Agreement, the Bond Insurer is explicitly recognized as being a third-party beneficiary under the Trust Agreement and may enforce any such right, remedy or claim conferred, given or granted under the Trust Agreement. C-56 APPENDIX D SUMMARY OF CERTAIN PROVISIONS OF THE SERVICE CONTRACT Set forth below is a summary of the Service Contract between the Capistrano Valley Water District (the "District") and ECO Resources, Inc. (the "Company") for the design construction, financing and operation of the San Juan Basin Desalter Project (the "Service Contract"). This summary is in all respects subject to and qualified in its entirety by reference to the Service Contract itself, copies of which are available at the offices of the Capistrano Valley Water District. Capitalized terms used but not defined in this Appendix D or elsewhere in the Official Statement shall have the respective meanings set forth in the Service Contract. CERTAIN DEFINITIONS "Applicable Law" means (1) any federal, state or local law, code, regulation, consent order or agreement; (2) any formally adopted and generally applicable rule, requirement, determination, standard, policy, implementation schedule or order of any Governmental Body having appropriate jurisdiction; (3) any established interpretation of law or regulation utilized by an appropriate Governmental Body if such interpretation is documented by such regulatory body and generally applicable; and (4) any Governmental Approval, in each case having the force of law and applicable from time to time to (a) the siting, permitting, design, acquisition, construction, equipping, financing, ownership, possession, start-up, testing, operation, maintenance, repair, replacement or management of water treatment systems, including the Project; (b) the delivery, treatment, storage or supply of water; (c) the transfer, handling, transportation or disposal of Plant By-Products; or (d) any other transaction or matter contemplated by the Service Contract (including, without limitation, any of the foregoing which pertain to water treatment, waste disposal, health, safety, fire, environmental protection, labor relations, building codes, the payment of prevailing or minimum wages and non-discrimination). Applicable Law shall be deemed to include the requirements contained in the final mitigated negative declaration approved by the District in connection with the Project. "Bankruptcy Code" means the United States Bankruptcy Code, 11 U.S.C. 101 et seq., as amended from time to time and any successor statute thereto. "Bankruptcy Code" shall also include (1) any similar state law relating to bankruptcy, insolvency, the rights and remedies of creditors, the appointment of receivers or the liquidation of companies and estates that are unable to pay their debts when due, and (2) in the event the Guarantor is incorporated or otherwise organized under the laws of a jurisdiction other than the United States, any similar insolvency or bankruptcy code applicable under the laws of such juris diction. "Change in Law" means any of the following acts, events or circumstances to the extent that compliance therewith materially increases the cost of performing or materially increases the scope of the party's obligations under the Service Contract: (a) the adoption, amendment, promulgation, issuance, modification, repeal or written change in administrative or judicial interpretation of any Applicable Law on or after the Contract Date, unless such Applicable Law was on or prior to the Contract Date duly adopted, promulgated, issued or otherwise officially modified or changed in interpretation, in each case in final form, to become effective without any further action by any Governmental Body; (b) the order or judgment of any Governmental Body issued on or after the Contract Date (unless such order or judgment is issued to enforce compliance with Applicable Law which was effective as of the Contract Date) to the extent such order or judgment is not the result of willful or negligent action, error or omission or lack of reasonable diligence of the Company or of the District, whichever is asserting the occurrence of a Change in Law; provided, however, that the contesting in good faith or the failure in good faith to contest any such order or judgment shall not constitute or be construed as such a willful or negligent action, error or omission or lack of reasonable diligence; (c) except with respect to any Governmental Approval required for the construction of the Project as provided within (b) below pertaining to exclusions from "Change in Law", the denial of an application for, a delay D-l in the review, issuance or renewal of, or the suspension, termination or interruption of any Governmental Approvals, or the imposition of a term, condition or requirement which is more stringent or burdensome than the Contract Standards in connection with the issuance, renewal or failure of issuance or renewal of, any Governmental Approval to the extent that such occurrence is not the result of willful or negligent action, error or omission or a lack of reasonable diligence of the Company or of the District, whichever is asserting the occurrence of a Change in Law; provided, however, that the contesting in good faith or the failure in good faith to contest any such occurrence shall not be construed as such a willful or negligent action or lack of reasonable diligence; and (d) any requirements in the mitigated negative declaration finally approved by the District in connection with the Project which are materially more burdensome or costly than the requirements contained in the mitigated negative declaration approved by the District on July 17, 2001. It is specifically understood, however, that none of the following shall constitute a "Change in Law": (a) a change in the nature or severity of the actions typically taken by a Governmental Body to enforce compliance with Applicable Law which was effective as of the Contract Date; (b) acts, events and circumstances with respect to which the Company has assumed the permitting risk relating to the Project; (c) any event that affects generally applicable working conditions or standards that is not specific to the water treatment industry or to the Project, and that does not require a Capital Modification, other than changes in federal or State OSHA regulations or minimum wage requirements; and (d) as and to the extent provided in the Service Contract, the establishment by a Governmental Body of a minimum staffing level for the Project. "Change Order" means a written order to the Company issued and signed by the District after the Contract Date requiring a change in the Design/Build Work which is District-directed and not due to an Uncontrollable Circumstance. "Construction Date" means the first date on which all of the Construction Date Conditions shall be satisfied or waived, as agreed to in writing by the parties pursuant to the Service Contract. "Contract Date" means September 3, 2002. "Contract Standards" means the standards, terms, conditions, methods, techniques and practices imposed or required by: (1) Applicable Law; (2) the Design Requirements; (3) the Performance Guarantees; (4) Good Engineering and Construction Practice; (5) Good Industry Practice; (6) the Quality Management Plan; (7) the Operation and Maintenance Manual; (8) applicable equipment manufacturers' specifications; (9) applicable Insurance Requirements, and (10) any other standard, term, condition or requirement specifically provided in the Service Contract to be observed by the Company. "Contract Year" means the District's fiscal year commencing on July 1 in any year and ending on June 30 of the following year; provided, however, that the first Contract Year shall commence on the Acceptance Date and shall end on the following June 30, and the last Contract Year shall commence on July 1 prior to the date the Service Contract expires or is terminated, whichever is appropriate, and shall end on the last day of the Term of the Service Contract or the effective date of any termination, whichever is appropriate. Any computation made on the basis of a Contract Year shall be adjusted on a pro rata basis to take into account any Contract Year of less than 365 or 366 days, whichever is applicable. "Design/Build Work" means the employment and furnishing of all labor, materials, equipment, supplies, tools, scaffolding, transportation, Utilities, insurance, temporary facilities and other things and services of every kind whatsoever necessary for the full performance and completion of the Company's design, engineering, construction, financing, start-up, shakedown, Acceptance Testing, obtaining Governmental Approvals and related obligations with D-2 respect to the construction of the Project during the Development Period and the Construction Period under the Service Contract, including all conpleted structures, assemblies, fabrications, acquisitions and installations, all commissioning and testing, and all of the Company's administrative, accounting, record-keeping, notification and similar responsibilities of every kind whatsoever under the Service Contract pertaining to such obligations. A reference to Design/Build Work shall mean any part and all of the Design/Build Work unless the context otherwise requires, and shall include all Extra Design/Build Work authorized by Change Order. "Development Period" means the period from and including the Contract Date to the Construction Date. "District Fault" means any breach (including the untruth or breach of any District representation or warranty set forth in the Service Contract), failure, non-performance or non-compliance by the District under the Service Contract with respect to its obligations and responsibilities under the Service Contract to the extent not attributable to any Uncontrollable Circumstance or Company Fault, and which materially and adversely affects the Company's rights, obligations or ability or costs to perform under the Service Contract. "Extension Period" means the period commencing on the day after the Scheduled Acceptance Date and ending 547 days following the Scheduled Acceptance Date, or in the event of one or more delays caused by Uncontrollable Circumstances, District-requested Change Orders or District Fault occurring during such period, the date determined by adding to such 547-day period the aggregate number of days of delay caused by such Uncontrollable Circumstances, District-requested Change Orders, or District Fault. "Finished Water" means Raw Water which has been treated at the Plant in accordance with the Service Contract and delivered by the Company to the Finished Water Transmission Line. "Hazardous Material" means any waste, substance, object or material deemed hazardous under Applicable Law including, without limitation, "hazardous substances" as defined under CERCLA and "hazardous waste" as defined under RCRA. "Operation Period" means the period from and including the Provisional Acceptance Date, to and including the last day of the Term. "Pre-Existing Environmental Condition" means, and is limited to, (1) the presence anywhere in, on or under the Project on the Contract Date, if not disclosed to the Company as of the Contract Date, of underground storage tanks (for the storage of chemicals or petroleum products), and (2) the presence anywhere in, on or under the Project, whether or not disclosed to the Company as of the Contract Date, of Hazardous Materials. "Project Equipment" means all manufactured equipment, property or assets, whether or not constituting personal property or fixtures, constituting part of the Project Improvements including tanks (other than concrete basins, and metal tanks that exceed 500 gallons capacity), pumps, membrane systems, and water processing and treatment equipment; instrumentation and control systems; remote monitoring and communications systems; filtration, disinfection, corrosion control and water treatment systems; and chemical mixing, metering, storage, handling and feed systems. Appendix 1 to the Service Contract generally lists the types of equipment that are expected to be installed in the Project and to constitute "Project Equipment". "Project Improvements" means the Plant, the Wells, the Raw Water Transmission Line, the Booster Pumping Station, the Finished Water Transmission Line, the Concentrate Disposal Line, and any Capital Modifications made thereto from time to time. After Acceptance, the Booster Pumping Station shall become part of the Water System, and shall not be considered part of the Project Improvements. "Project Structures" means all structures, buildings, concrete basins and metal tanks exceeding 500 gallons in capacity, piping and other buried infrastructure, other than Project Equipment, constituting part of the Project Improvements. Appendix 1 to the Service Contract generally lists the types of structures that are expected to be installed in the Project and to constitute "Project Structures". D-3 "Specified Site Conditions" means, and is limited to: (1) the presence at the Project of subsurface structures, materials or conditions having historical, archaeological, religious or similar significance; (2) the presence at the Project of functioning subsurface structures used by Utility providers on, underneath, near or adjacent to the Project if not disclosed to the Company as of the Contract Date; (3) the presence at the Project of any habitat of an endangered or protected species as provided in Applicable Law. "Uncontrollable Circumstance" means any act, event or condition that is beyond the reasonable control of the party relying thereon as justification for not performing an obligation or complying with any condition required of such party under the Service Contract, and that materially interferes with or materially increases the costs of performing its obligations under the Service Contract (other than payment obligations) to the extent that such act, event or condition is not the result of the willful or negligent act, error or omission, failure to exercise reasonable diligence, or breach of the Service Contract on the part of such party. (i) Inclusions. Subject to the foregoing, Uncontrollable Circumstances shall include, and shall not be limited to, the following: (a) a Change in Law, except as provided in (l) and (m) of item 2 below; (b) the existence of a Pre-Existing Environmental Condition; (c) the existence of a Specified Site Condition; (d) the treatment of Raw Water having parameters which are outside the range established by the Design Raw Water Quality Parameters; (e) contamination of the Project from groundwater, soil or airborne Hazardous Material migrating from sources outside of the Project and not caused by Company Fault; (f) naturally occurring events (except weather conditions normal for the Service Area) such as landslides, underground movement, earthquakes, fires, tornadoes, hurricanes, floods, lightning, epidemics and other acts of God; (g) explosion, sabotage or similar occurrence, acts of a declared or undeclared public enemy, extortion, war, blockade or insurrection, riot or civil disturbance; (h) labor disputes, except labor disputes involving employees of the Company, its Affiliates, or Subcontractors which affect the performance of the Contract Services; (i) the failure of any Subcontractor (other than the Company, the Guarantor or any Affiliate of either) to furnish services, materials, chemicals or equipment on the dates agreed to, but only if such failure is the result of an event which would constitute an Uncontrollable Circumstance if it affected the Company directly, and the Company is not able after exercising all reasonable efforts to timely obtain substitutes; (j) the failure of any appropriate Governmental Body or private utility having operational jurisdiction in the area in which the Project is located to provide and maintain Utilities to the Project which are required for the performance of the Service Contract, except as provided in paragraph (h) of item (2) below; (k) the absence of ownership rights by the District or the City in the Sites, notwithstanding the representation of the District with respect thereto in the Service Contract; (1) except as provided in (k) of item 2 below, the existence of any right, restriction, servitude, license, easement, right of way, limitation, qualification, exception, adverse claim, Encumbrance D-4 or Lien on the Sites which either is unrecorded or not listed as an exception on the Preliminary Title Reports and which materially and adversely affects the performance of the Contract Services; (m) the preemption, confiscation, diversion, destruction or other interference in possession or performance of materials or services by a Governmental Body in connection with a public emergency or any condemnation or other taking by eminent domain of any material portion of the Project; (n) a violation of Applicable Law by a person other than the affected party or its Subcontractors; (o) any Legal Proceeding described the Service Contract, or any order or decree issued by a court of competent jurisdiction or other Governmental Body which delays or prevents the construction or operation of the Project, where such order or decree is not caused by Company Fault; (p) with respect to the Company, any District Fault or District-requested Change Orders not due to Company Fault; and (q) with respect to the District, any Company Fault. (ii) Exclusions. It is specifically understood that, without limitation, none of the following acts, events or circumstances shall constitute Uncontrollable Circumstances: (a) any act, event or circumstance that would not have occurred if the affected party had complied with its obligations under the Service Contract; (b) changes in interest rates, inflation rates, wage rates, insurance premiums, commodity prices, currency values, exchange rates or other general economic conditions; (c) changes in the financial condition of the District, the Company, the Guarantor, or their Affiliates or Subcontractors affecting the ability to perform their respective obligations; (d) the consequences of error, neglect or omissions by the Company, the Guarantor, any Subcontractor, any of their Affiliates or any other person in the performance of the Contract Services; (e) union or labor work rules, requirements or demands which have the effect of increasing the number of employees employed at the Project or otherwise increasing the cost to the Company of performing the Contract Services; (f) any and all surface, subsurface and other conditions affecting the Sites, which may increase cost of performing or cause delay in the performance of the Design/Build Work, including particularly any subsurface geotechnical conditions, except those constituting Pre-Existing Environmental Conditions and Specified Site Conditions; (g) mechanical failure of equipment to the extent not resulting from a condition that is listed in the "Inclusions" Section of this definition; (h) power outages not caused by third-party Utilities or other Uncontrollable Circumstances; (i) weather conditions normal for the Service Area; (j) the existence of any recorded right, restriction, servitude, license, easement, right of way, limitation, qualification, exception, adverse claim, Encumbrance or Lien appearing as an exception on the Preliminary Title Reports; D-5 (k) failure of the Company to obtain easements, rights of way or encroachment permits for certain segments of the Sites as indicated in the Service Contract. (1) failure of the Company to secure any patent or other intellectual property right which is or may be necessary for the performance of the Contract Services; (m) a Change in Law pertaining to Taxes (except a Change in Law which imposes a Tax on the private provision of water treatment services, or the imposition of a Tax on building materials used in the construction of the Project); (n) any Change in Law regarding the quality of Finished Water (including the issuance of any Governmental Approval, the enactment of any statute, or the promulgation of any regulation) the terms and conditions of which do not impose more stringent or burdensome requirements on the Company than are imposed by the Contract Standards; or (o) except as set forth in the Service Contract, any failure or delay in obtaining the Construction Governmental Approvals or the CADHS Approval, or the imposition of any term or condition by a Governmental Body in connection therewith, which is more burdensome or imposes costs greater than those assumed by the Company in entering into the Service Contract. TERM Initial Term. The Service Contract commenced upon execution and delivery of the Service Contract (the "Contract Date"), and shall continue in effect for 20 years following the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the Company, the Acceptance Date). District Renewal Option. The Service Contract may be renewed or extended by mutual agreement of the parties. OWNERSHIP Project Ownership. The Sites, and all Project Improvements other than the Plant, shall be owned by the District or the City at all times. The Plant Site shall be leased to the Authority pursuant to the Property Lease and the Plant shall be owned by the Authority, subject to the District's rights provided in the Lease Agreement. DESIGN AND CONSTRUCTION OF THE PROJECT Commencement of Design/Build Work. On the Construction Date, the Construction Period shall commence and the Company shall promptly proceed to undertake, perform and complete the Design/Build Work in accordance with the Contract Standards. The time for completion of the Company's performance of the Design/Build Work shall be computed from the Construction Date. The Company's failure to achieve Provisional Acceptance on or before December 4, 2004 shall result in the assessment of delay liquidated damages described below. Title and Risk of Loss. Title to the structures, improvements, fixtures, machinery, equipment and materials constituting the Project shall be in the Authority, subject to the terms and conditions of the Property Lease and the Lease Agreement. The Company shall bear all risk of loss concerning such structures, improvements, fixtures, machinery, equipment and materials until Acceptance has occurred, regardless of the extent to which the loss was insured or the availability of insurance proceeds. Elements of the Design/Build Work. In performing the Design/Build Work generally, the Company shall, in accordance with the Contract Standards and without limitation, as and to the extent applicable: (1) prepare and excavate the Sites; (2) demolish and remove any existing improvements; (3) re-route or replace any underground Utilities; (4) obtain Governmental Approvals; (5) remove from the Sites and dispose of any demolition or construction debris resulting from the Design/Build Work and any unused soil excavated therefrom; (6) design and D-6 construct the Project; (7) conduct start up operations; and (8) conduct the Acceptance Tests, all so that the Project is suitable and adequate for the purposes thereof. Warranties. The Company warrants to the District and the Trustee that the structures, improvements, fixtures, machinery, equipment and materials incorporated in the Project, and in all Capital Modifications that are undertaken or made by the Company or its Subcontractor, will be new, of recent manufacture, of good quality, free from faults and defects, suitable for its intended purpose and in conformity with the Contract Standards. The Company shall, for the protection of the District and the Trustee, obtain from all Subcontractors, vendors, suppliers and other persons from which the Company procures structures, improvements, fixtures, machinery, equipment and materials such warranties and guarantees as are normally provided with respect thereto, each of which shall be assigned to the District to the full extent of the terms thereof. No such warranty or guarantee shall relieve the Company of any of its obligations under the Service Contract, and no failure of any warranted structures, improvements, fixtures, machinery, equipment or material shall be the cause for any increase in the Service Fee or n on-performance of the Contract Services unless such failure is itself attributable to an Uncontrollable Circumstance or District Fault. Payment of Costs. The Company shall pay directly all costs and expenses incurred in the performance of the Design/Build Work of any kind or nature whatsoever, including all costs of permitting (regardless of permittee); regulatory compliance and Legal Proceedings brought against the Company; obtaining and maintaining the Security Instruments; payments due under the construction contract, subcontracts with Subcontractors or otherwise for all labor and materials; legal, financial, engineering, architectural and other professional services of the Company; sales, use and similar taxes on building supplies, materials and equipment; general supervision by the Company of all Design/Build Work; Company preparation of schedules, budgets and reports; keeping all construction accounts and cost records; and all other costs required to achieve Acceptance. The Company shall pay prevailing wages with respect to the construction portion of the Design/Build Work in accordance with Section 1720 et seq. of the California Labor Code. Company Design. The Company shall have the sole and exclusive responsibility and liability for the design, construction and performance of the Project, notwithstanding the Contract Standards or the fact that the RFP for the Contract Services included certain minimum conceptual design criteria for the Design/Build Work and certain performance standards that the Project would be required to meet. The Company shall indemnify, defend and hold harmless the District and the District Indemnitees from any Loss-and-Expense arising out of the design, construction or performance of the Project. Compliance with Applicable Law. In designing, constructing, starting up and testing the Project, the Company shall comply with Applicable Law, including all applicable Governmental Approvals, shall construct and operate all equipment and systems comprising the Project in accordance with the Contract Standards and applicable equipment manufacturer's specifications and recommendations, and shall observe the same safety standards as are set forth with respect to the operation of the Project. Construction Practice. The Company shall perform the Design/Build Work in accordance with the Contract Standards and shall have exclusive responsibility for all construction means, methods, techniques, sequences, and procedures necessary or desirable for the correct, prompt, and orderly prosecution and completion of the Design/Build Work as required by the Service Contract. The Company shall provide, without limitation, the following: temporary power and light; temporary offices and construction trailers; required design certifications; required approvals; weather protection; Sites clean-up and housekeeping; construction trade management; temporary parking; vehicle traffic; safety and first aid facilities; correction of or compensation for defective work or equipment; Subcontractors' insurance; storage areas; workshops and warehouses; temporary fire protection; Sites security; temporary Utilities; potable water; sanitary services; Subcontractor and vendor qualification; receipt and unloading of delivered materials and equipment; erection rigging; temporary supports; and construction coordination. Independent Engineer. The Company shall cooperate with any Independent Engineer designated by the Trustee on behalf of the bondholders to assist it in connection with the oversight of the design and construction of the Project and the disbursement of Bond proceeds. D-7 Change Orders and Extra Design/Build Work. The District may issue Change Orders pertaining to any and all aspects of the Design/Build Work at any time and for any reason whatsoever, whether and however such Change Orders revise the Service Contract, add Extra Design/Build Work or omit Design/Build Work or affect the Scheduled Acceptance Date. Change Orders shall pertain only to District-directed modifications. The Company shall not commence performance of any Extra Design/Build Work without a Change Order authorized by the District. The Company shall be entitled to additional compensation for Extra Design/Build Work unless required by reason of any Company Fault. The Fixed Design/Build Price shall be changed if and to the extent that any Change Order, whether for omitted Design/Build Work or otherwise, results in any change in the Company's cost of the Design/Build Work. PROVISIONAL ACCEPTANCE, ACCEPTANCE AND FINAL COMPLETION OF THE PROJECT Relation of Acceptance to Metropolitan Agreement. The achievement of Provisional Acceptance, Acceptance and Final Completion are independent measures of performance by the Company. Provisional Acceptance, Acceptance and Final Completion may occur on the same or on different dates, as the facts may warrant. Provisional Acceptance and Acceptance shall be determined without regard to any provision of the Metropolitan Agreement. The Company shall have the right to seek to avoid the termination by Metropolitan of the Metropolitan Agreement by producing Allowable Yield, notwithstanding the requirements relating to Provisional Acceptance and Acceptance. Substantial Completion. The Company shall not be permitted to conduct the Acceptance Tests until Substantial Completion has occurred. Substantial Completion shall occur only when all of the following conditions have been satisfied, unless waived by the District: (i) construction of the Project Improvements in accordance with the Contract Standards has been substantially completed; (ii) both water treatment process trains are fully operational; (iii) a preliminary or temporary certificate of occupancy has been issued for the Project, if required by Applicable Law; (iv) the Company is authorized by all appropriate Governmental Bodies to perform the procedures necessary to achieve Acceptance and to conduct the Acceptance Tests under Applicable Law, and such authorization has not been withdrawn, revoked, superseded, suspended, or materially impaired or amended; (v) all Utilities specified or required under the Service Contract to be arranged for by the Company are connected and functioning properly; (vi) the Company has delivered to the District written certification from the manufacturers of the reverse osmosis system and the iron/manganese filters (and from the Company for all other equipment) that such equipment has been properly installed and tested in accordance with the manufacturers' recommendations and requirements; (vii) the Company has submitted to the District and the District has reviewed and approved the plan for Acceptance Testing; (viii) if required by Applicable Law, the CADHS has approved the plan for Acceptance Testing and has issued a notice of permission to conduct the Acceptance Tests; and (ix) the Company has submitted written certification that all of the foregoing conditions have been satisfied. Pre-Acceptance Test Raw Water Quality Analysis . The Company shall begin to conduct a pre-Acceptance Test Raw Water quality analysis at least 120 days before the earlier of the Scheduled Acceptance Date or the date upon which the Company plans to begin Acceptance Testing, and complete such analysis and deliver a final report with respect thereto to the District and the Independent Engineer within 30 days thereafter. The pre-Acceptance Test Raw Water quality analysis is to be conducted by the Company for purposes of determining whether the actual quality of the Raw Water from the Wells is within the Design Raw Water Quality Parameters as set forth in the Service Contract. If the pre-Acceptance Test Raw Water quality analysis results indicate that the Raw Water which was subject to the analysis is not within the Design Raw Water Quality Parameters, the Company shall provide to the District and the Independent Engineer, within 15 days after delivery of its final report, an assessment as to the potential impact of such non-conformity on the Acceptance Test, Design/Build Price, the Service Fee, Acceptance, and the Performance Guarantees, together with a discussion of possible Uncontrollable Circumstance mitigating measures. Acceptance Date Conditions. The following conditions shall constitute the "Acceptance Date Conditions," each of which must be satisfied in all material respects by the Company in order for the Acceptance Date to occur, and each of which must be and remain satisfied as of the Acceptance Date: (i) each of the Construction Date D-8 Conditions shall be and remain satisfied as of the Acceptance Date; (ii) the Company shall demonstrate that Substantial Completion has occurred; (iii) CADHS has issued the CADHS Approval, and it is lawful to introduce Finished Water into the Water System; (iv) all other applicable Governmental Approvals required under Applicable Law which are necessary for the continued routine operation of the Project shall have been duly obtained by the Company and shall be in full force and effect; (v) the Company shall have completed all required Acceptance Tests and such tests shall have demonstrated that the Project has met the Acceptance Test Procedures and Standards; and (vi) there shall be no Event of Default by the Company under the Service Contract or by the Guarantor under the Service Contract Guaranty Agreement, or event which with the giving of notice or the passage of time would constitute an Event of Default by the Company under the Service Contract or an Event of Default by the Guarantor under the Service Contract Guaranty Agreement. Provisional Acceptance. The Company shall have the right, following the conduct of the Acceptance Tests and the delivery of the Acceptance Test report, to certify Acceptance on a provisional basis. In order to certify Acceptance on a provisional basis, the Company shall deliver a written certification to the District and the Independent Engineer that, in the good faith judgment of the Company based on all information available to it at the time of the certification, all of the Acceptance Date Conditions have occurred. The date upon which the Company's provisional Acceptance certification is delivered is referred to as the "Provisional Acceptance Date," and thereupon "Provisional Acceptance" shall be deemed to have occurred. Upon the occurrence of Provisional Acceptance, the Operation Period shall commence and all of the Operation Period rights and obligations of the parties shall apply on a permanent basis (including the Performance Guarantees of the Company, the Service Fee payment obligations of the District, and the obligation of the Company to pay liquidated damages for any failure to meet the Performance Guarantees). The Initial Term of the Service Contract shall commence on the Provisional Acceptance Date, and thereafter the parties shall be bound as if Acceptance had permanently occurred, unless the District disputes the Company's Provisional Acceptance certification. Daily Liquidated Damages. In the event that Provisional Acceptance (or, if Provisional Acceptance is not certified by the Company, Acceptance) occurs prior to December 4, 2004, the Company shall have no obligation to pay delay liquidated damages. The Company shall, however, following the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the Company, the Acceptance Date), be responsible for all performance-related damages and liquidated damages provided for in the Service Contract during the Operation Period. In the event that Provisional Acceptance (or, if Provisional Acceptance is not certified by the Company, Acceptance) occurs subsequent to December 4, 2004, the Company shall pay to the District daily delay liquidated damages for each day that the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the Company, the Acceptance Date) falls after December 4, 2004 in an amount equal to the Lease Payments (including payments with respect to both interest and principal) accrued by the District on a daily basis, up to the end of the Extension Period and thereafter until any termination of the Service Contract for an Event of Default by the Company. The accrual of such Lease Payments shall be determined on the basis of the amount of the Lease Payments actually payable to the Issuer under the Lease Agreement, whether such payments are in fact made by the District directly or from proceeds of the Bonds borrowed in order to capitalize interest. Such damages shall be payable on the first day of each month and, upon any such termination, the date of termination, and shall be secured by the Service Contract Letter of Credit. Concurrence or Disagreement With Test Results. If the District states in writing that the District and the Independent Engineer concur with the Company's certification of Provisional Acceptance, the Project shall be deemed to have achieved Acceptance and the Acceptance Date shall be deemed to have been established on a permanent basis as of the Provisional Acceptance Date. The District may determine at any time within 60 days of the Company's certification of Provisional Acceptance that it does not concur with the Company's certification. In the event of any such non-concurrence by the District, either party may elect to refer the dispute to Non-Binding Mediation for resolution. In the event that the Mediator fails to issue a decision within 60 days, then either party may initiate judicial proceedings. The parties acknowledge and agree that any decision rendered by the Mediator as to whether Acceptance has occurred shall be non-binding. Acceptance shall not be deemed to have been achieved unless the Acceptance Test, conducted in a D-9 unified and continuous manner as provided in the Acceptance Test plan, demonstrates that all of the Acceptance Test Procedures and Standards have been met. No disagreement as to the achievement of Acceptance shall prevent the Company from operating the Project so as to produce Allowable Yield and avoid the automatic termination of the Metropolitan Agreement. Scheduled Acceptance Date. The Scheduled Acceptance Date shall be September 1, 2004. In the event one or more delays in the Design/Build Work caused by Uncontrollable Circumstances, District-requested Change Orders or District Fault occur during the Construction Period, the Scheduled Acceptance Date shall not be September 1, 2004, but shall be the date determined by adding to September 1, 2004 the aggregate number of days of delay in the performance of the Design/Build Work by the Company caused by such Uncontrollable Circumstances, District-requested Change Orders, and District Fault. In the event of any such adjustment, delay liquidated damages payable by the Company, if any, shall be payable from the adjusted Scheduled Acceptance Date and not from September 1, 2004. Effect of Unexcused Delay - Metropolitan Agreement. The Company acknowledges that the Final GRP Contribution payment required to be made by Metropolitan under the Metropolitan Agreement to the District constitutes a material inducement for the District to undertake the Project through the Service Contract, and that the Metropolitan Agreement is subject to automatic termination if construction has not commenced by December 4, 2002 or if no Allowable Yield is produced by December 4, 2004. In the event (1) the Metropolitan Agreement terminates under paragraphs (b) or (c) of Section 9.4 thereof, and (2) such termination is the result of a failure to commence construction or a failure to produce Allowable Yield that is not caused by the occurrence of an Uncontrollable Circumstance or District Fault, the Company shall pay the District for each Contract Year during the Term of the Service Contract, as liquidated damages for such failure, an amount calculated as follows: LD = AWD x FC where, AWD = The total number of acre feet of Finished Water actually demanded by the District in such Contract Year pursuant to its demand rights. FC = The amount, expressed in dollars per acre foot, which the Final GRP Contribution would have been in such Contract Year had the Metropolitan Agreement not been terminated. The liquidated damages shall be applied as a credit to reduce the Service Fee payment due in the applicable Contract Year, and shall be paid in cash to the extent it exceeds such Service Fee payment. Effect of Unexcused Delay - Extension Period. If Acceptance shall not have occurred on or before the Scheduled Acceptance Date, the Company shall be entitled to continue to seek to achieve Acceptance during the Extension Period. If, as of the last day of the Extension Period, the Acceptance Tests have not been conducted or have failed to demonstrate that Acceptance has been achieved, an Event of Default by the Company will be deemed to have occurred notwithstanding any absence of notice, further cure opportunity or other procedural rights accorded the Company, and the District shall thereupon have the right to terminate the Service Contract for cause upon written notice to the Company and the Trustee. Final Completion. The Company shall achieve Final Completion within 180 days after the Acceptance Date. "Final Completion" shall occur when all of the following conditions have been satisfied: (i) a certificate of occupancy has been issued for the Project, if required; (ii) the Acceptance Test has been conducted, the Acceptance Test Procedures and Standards have been achieved, and Acceptance has occurred; (iii) all applicable Design/Build Work (including all items on the Final Punch List and all clean up and removal of construction materials and demolition debris) is complete and in all respects is in compliance with the Service Contract, and there are no D-10 outstanding legally valid "stop notices"; (iv) the District has approved in writing, such approval not to be unreasonably withheld, the certification by the Company that all Design/Build Work pertaining to the Project has been completed to the level reasonably required under Good Engineering and Construction Practice and under Applicable Law in order to conduct the Acceptance Tests, and that such Design/Build Work is in all respects in compliance with the Design Requirements; (v) the Company has delivered to the District the final Operation and Maintenance Manual; (vi) the Company has submitted to the District certificates of insurance for all Required Operation Period Insurance; (vii) the Company has furnished to the District all Deliverable Material required to be delivered prior to Acceptance; (viii) the Company shall have delivered to the District a final and complete reproducible set of record drawings and shall certify that the Project was constructed in accordance with the Design Requirements, including any Change Orders; and (ix) the Company shall be in possession of, and shall have delivered to the District, copies of the warranties of machinery, equipment, fixtures and rolling stock constituting a part of the Project, together with copies of all related operating manuals supplied by the equipment supplier. DESIGN/BUILD PRICE; PAYMENT OF THE DESIGN/BUILD PRICE Design/Build Price Generally. The District shall pay the Company the Design/Build Price for the Design/Build Work. Payments shall be made on a milestone basis from the proceeds of the Bonds held by the Trustee based on requisitions for payment submitted by the Company to the Trustee and approved by the Independent Engineer. The Fixed Design/Build Price shall be the sum of the Fixed Design/Build Price and the Fixed Design/Build Price Adjustments. Fixed Design/Build Price. The Fixed Design/Build Price is $25,030,607; provided, however, that in the event the District makes an election to require the use of pile driving for the construction of the Plant foundation, the Fixed Design/Build Price shall be $24,190,607. Fixed Design/Build Price Adjustments. The following items shall constitute the Fixed Design/Build Price Adjustments: (i) an adjustment for the cost of any Change Orders issued by the District, it being agreed by the parties that only the District is entitled to issue Change Orders; (ii) an adjustment for the cost of any modifications to the Design/Build Work required by Uncontrollable Circumstances; and (3) an adjustment for certain San Diego Gas and Electric interconnection costs. In the event the cost paid by the Company on an upfront basis for interconnecting with the San Diego Gas and Electric utility system for the supply of electric power to the Project exceeds $50,000, there shall be a Fixed Design/Build Price Adjustment equal to (1) 25% of the amount of such excess over $50,000 and under $100,000; and (2) 50% of the amount of such excess over $100,000. There shall be no-mark-up by the Company on San Diego Gas and Electric's interconnection cost. If the cost of the San Diego Gas and Electric interconnection is in part or in whole paid over time through electric rates, the District shall pay such electric rates, and the Company shall reimburse the District (on a reasonably estimated one-time basis) with respect to such electric rates so as to bear the same portion of the cost of the interconnection that it would have borne had the cost been paid on an upfront basis. The Company agrees that the Design/Build Price shall be the Company's entire compensation and reimbursement for the performance of the Design/Build Work, including obtaining all Utilities that the Company will require to perform the Design/Build Work, starting up the Project, and operating the Project during the Acceptance Test. In no event shall the Company be entitled to any payment for Design/Build Work costs in excess of the Design/Build Price notwithstanding any cost overruns the Company may incur. The Company shall finance and pay for any such excess costs in any manner it chooses without reimbursement from or other claim upon the District or the Trustee. Payment of the Design/Build Price. The milestone payment schedule of the Service Contract sets forth the milestone payments to be made with respect to the Design/Build Work, and the sum of all such milestone payments equals the Fixed Design/Build Price. Following the Construction Date, the Company shall be entitled to submit Requisitions on a monthly basis and receive from the Trustee on behalf of the District the milestone payments against the Fixed Design/Build Price, which: (1) shall be made only upon achievement of the milestone required to be achieved as the basis for such payment as set forth in the milestone payment schedule, as achievement shall be determined and certified to the Trustee by the Independent Engineer; and (2) shall be subject to the conditions of payment set forth in the Service Contract. D-ll Retainage. Each progress payment will be subject to a 10% retainage holdback. Interest earned on the retainage holdback shall remain in the Trustee's construction fund for disbursement in accordance with the Trust Agreement and the Service Contract. The Trustee shall release to the Company the accumulated funds (without interest) so retained with respect to the Design/Build Work upon receipt of (1) certification from the Company and confirmation by the Independent Engineer that Final Completion of the Design/Build Work has occurred and (2) the Trustee's receipt of written concurrence from the District that Final Completion of the Design/Build Work has occurred. Permissible Withholdings. The Trustee may disapprove and withhold and retain all or any portion of any payment requested in any Requisition in an amount equal to the sum of: (1) any amounts which are permitted under the Service Contract to be withheld from any payment requested in any Requisition; (2) any delay liquidated damages payable; (3) any indemnification or other amounts which are due and owing to the Trustee or the District under any provision of the Service Contract; provided, however, that the Trustee shall not disapprove, withhold or retain any amounts in respect of funds owed to the District by the Company unless the District made a written request therefor to the Trustee and has submitted to the Trustee reasonably detailed documentation evidencing the District's immediate entitlement to the funds that the District has requested the Trustee to disapprove, withhold and retain and the basis for such entitlement; (4) any deductions which are required by Applicable Law; (5) an amount equal to the cost to the District of performing any work in the event of a failure by the Company or any Subcontractor to timely perform its obligations under the warranties given; (6) any payments with respect to which the Design/Build Work covered by such Requisition (or any previous Requisition) does not comply with the Service Contract; (7) any payments for Design/Build Work with respect to which any person has recorded a Lien or Encumbrance resulting from the acts or omissions of the Company in performing the Design/Build Work, where such Lien or Encumbrance remains unreleased, unbonded or undischarged; and (8) all requisitioned payments, if an Event of Default of the Company has occurred. OPERATION AND MANAGEMENT Operation and Management Responsibility. Commencing on the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the Company, Acceptance), the Company shall operate and manage the Project on a 24-hour per day, 7-day per week basis, and shall treat Raw Water, produce and supply Finished Water, transport and dispose of Plant By-Products and operating wastes, provide all information necessary to secure Governmental Approvals, and otherwise operate and manage the Project so as to comply with the Contract Standards applicable to such activities, each of the plans pertaining thereto set forth in the Appendices to the Service Contract, and the other terms and conditions of the Service Contract. District Obligations. The District, in addition to the obligations it has accepted elsewhere in the Service Contract, shall: (1) make available to the Company upon request all information relating to the Project which is in the possession of the District and material to the Company's performance of the Contract Services; (2) grant and assure the Company access to the Project for the performance of its obligations under the Service Contract; (3) maintain and repair in good working order all Water System assets which are not included in the Project (including, after Acceptance, the Booster Pumping Station); and (4) pay the Service Fee and any other amounts due the Company in accordance with the terms and conditions of the Service Contract. Electricity Supply, Payment and Utilization. The District shall have the exclusive right to arrange for the supply of electricity to the Project, and to negotiate and establish electric rates with the supplier. The Company shall cooperate with and assist the District in making such arrangements, and the District shall give reasonable consideration to any requests and recommendations made by the Company as to the terms and conditions of electricity supply. The District shall pay all electricity bills. The Company guarantees that electricity usage and demand shall not exceed the levels established under the Guaranteed Maximum Electricity Utilization. In the event that electricity usage or demand exceeds such levels for reasons other than Uncontrollable Circumstances or District Fault, the Company shall pay or credit to the District an amount equal to the portion of the electric bill paid by the District which is attributable to such excess; provided, however that the Company shall have no obligation to make such payment or credit if and to the extent that such payment would not reduce the Effective Rate for Finished Water. In the event that electricity usage or demand is less than the levels established under the Guaranteed Maximum Electricity Utilization, the District shall pay the Company the electricity savings element of the Service Fee; provided, however, that the District shall be obligated to pay such electricity savings element only if and to the D-12 extent that the savings shall reduce the Effective Rate for Finished Water. The Company shall operate the Project in a manner which minimizes, to the maximum extent reasonably practicable in light of its obligation to provide the Contract Services, charges to the District for electricity use, demand, transmission and distribution. Compliance with Metropolitan Agreement. The Company shall perform all of the District's obligations under the Metropolitan Agreement, including the reporting obligations of the District, notwithstanding the fact that the Company is not a party to the Metropolitan Agreement. In the event the Metropolitan Agreement is terminated due to a failure of the Company to comply with its obligations under the Service Contract, and such failure is not caused by an Uncontrollable Circumstance, District-directed Change Order or District Fault, the Company shall pay the District for each remaining Contract Year or portion thereof during the Term of the Service Contract, liquidated damages in the amounts specified in the Service Contract. The District shall not amend the Metropolitan Agreement in a manner that materially and adversely affects the Company without the consent of the Company. In the event Metropolitan agrees to amendments to or interpretations of the Metropolitan Agreement that are favorable to the District, or agrees to reinstate the Metropolitan Agreement following its termination, or agrees to forebear in the enforcement of any of the terms thereof, the Company shall have the benefit of any such amendment, interpretation, reinstatement or forebearance with respect to its obligations under the Service Contract. Compliance with Applicable Law. The Company shall perform the Contract Services in accordance with Applicable Law, and shall cause all Subcontractors to comply with Applicable Law. The Company shall comply with the terms of all Governmental Approvals and other Applicable Law pertaining to the Project, Raw Water and Finished Water, notwithstanding the fact that the Company may not be a permittee or co-permittee to some of the Governmental Approvals. The Company shall perform and provide all sampling, laboratory testing and analyses, and quality assurance and quality control procedures and programs required by the Contract Standards. All testing laboratories shall be CADHS and EPA, as applicable, certified for the applicable test. All sampling and test data shall be available for review by, and reported to, the District. The Company explicitly assumes the risk of incorrect sampling, testing and laboratory work and any consequences thereof or actions taken or corrections needed based thereon, whether such work is performed by itself or third parties, both as to failures to detect and as to false detections. The Company shall permit the District, at the District's expense, to perform any testing, sampling or analytical procedure it deems appropriate, using the Project or otherwise. In connection with any actual or alleged event of non-compliance with Applicable Law, the Company shall, in addition to any other duties which Applicable Law may impose: (1) fully and promptly respond to all inquiries, investigations, inspections, and examinations undertaken by any Governmental Body; (2) attend all meetings and hearings required by any Governmental Body; (3) provide all corrective action plans, reports, submittals and documentation required by any Governmental Body; (4) in conjunction with the District, communicate in a timely and effective manner with the general public as to the nature of the event, the impact on the public, and the nature and timetable for the planned remediation measures; and (5) immediately upon receipt thereof, provide the District with a true, correct and complete copy of any written notice of violation or non-compliance with Applicable Law, and true and accurate transcripts of any verbal notice of non-compliance with Applicable Law, issued or given by any Governmental Body. The Company shall furnish the District with an immediate written notice describing the occurrence of any event or the existence of any circumstance which does or may result in any such notice of violation or non-compliance to the extent the Company has knowledge of any such event or circumstance, and of any Legal Proceeding alleging such non-compliance. Except to the extent excused by Uncontrollable Circumstances or District Fault, in the event that the Company or any Subcontractor fails at any time to comply with Applicable Law with respect to the Project, Raw Water, Finished Water, air emissions, odor, Residuals or other environmental or operating conditions, the Company shall, without limiting any other remedy available to the District upon such an occurrence and notwithstanding any other provision of the Service Contract: (1) immediately correct such failure and resume compliance with Applicable Law; (2) bear all Loss-and-Expense of the Company and indemnify and hold harmless the District from any Loss and Expense resulting therefrom; (3) pay or reimburse the District for any resulting damages, fines, assessments, levies, impositions, penalties or other charges; (4) make all Capital Modifications and changes in D-13 operating and management practices which are necessary to assure that the failure of compliance with Applicable Law will not recur; and (5) comply with any corrective action plan filed with or mandated by any Governmental Body in order to remedy a failure of the Company to comply with Applicable Law. The Company shall keep the Project neat, clean and litter-free at all times, ensure that the operation of the Project does not create any odor, litter, noise, fugitive dust, vector, excessive light or other adverse environmental effects constituting, with respect to each of the foregoing, a nuisance condition under Applicable Law. Should any such nuisance condition occur which is not caused by Uncontrollable Circumstances, the Company shall immediately remedy the condition, pay any fines or penalties relating thereto, make all Capital Modifications and changes in operating and management practices necessary to prevent a recurrence of the nuisance condition, and indemnify and hold harmless the District from any Loss-and Expense relating thereto. Operating Governmental Approvals. The Company shall make all filings, applications and reports necessary to obtain and maintain all Governmental Approvals required to be made, obtained or maintained by or in the name of the Company or the District under Applicable Law in order to operate the Project. With respect to Governmental Approvals which are required to be obtained in the name of the District, the Company shall: (1) prepare the application and develop and furnish all necessary supporting material; (2) supply all data and information which may be required; (3) familiarize itself with the terms and conditions of such Governmental Approvals; (4) attend all required meetings and hearings; and (5) take all other action necessary in obtaining, maintaining, renewing, extending and complying with the terms of such Governmental Approvals. Except as set forth elsewhere in the Service Contract, permit and filing fees required in order to obtain and maintain Governmental Approvals for the Contract Services shall be paid by the Company, regardless of the identity of the applicant, except Governmental Approvals required in connection with an Uncontrollable Circumstance. The Company shall agree to be named as a co-permittee on any Governmental Approval if so required by the issuing Governmental Body. The Company shall not knowingly disadvantage the District in any application, data submittal or other communication with any Governmental Body regarding Governmental Approvals. The final terms and conditions of any Governmental Approval shall be subject to the District's approval. All data, information and action required to be supplied or taken in connection with the Governmental Approvals required for the Contract Services shall be supplied and taken on a timely basis considering the requirements of Applicable Law and the responsibilities of the District as the beneficial owner of the Project and primary permittee. The data and information supplied by the Company to the District and all regulatory agencies in connection therewith shall be correct and complete in all material respects, and shall be submitted in draft form to the District sufficiently in advance to allow full and meaningful review and comment by the District. To the extent that a Change in Law subsequent to the Contract Date requires additional information or data to be supplied for Governmental Approvals, the Company shall be reimbursed for the reasonable additional costs incurred by the Company to collect, develop and provide such data. The Company shall be responsible for any schedule and cost consequences which may result from the submission of materially incorrect or incomplete information. The District reserves the right to reject, modify, alter, amend, delete or supplement any information supplied by the Company in connection with the Governmental Approvals required for the Contract Services. The District shall pay the costs of collecting, developing and providing any additional data and information which must be supplied to a Governmental Body for a Governmental Approval as the result of any Change in Law. The Company shall report to the District, immediately upon obtaining knowledge thereof, all violations of the terms and conditions of any Governmental Approval or Applicable Law pertaining to the Project. The unexcused failure of the Company to comply with any Governmental Approval shall constitute a breach of the Service Contract as well as an event of non-compliance with the Governmental Approval and shall, with respect to unexcused failures to comply with water quality standards, obligate the Company to pay liquidated damages as and to the extent provided in the Service Contract. PERFORMANCE Water System. The Company acknowledges that the Project will constitute a primary component of the Water System and that the District, in meeting the water supply requirements of the Service Area, is providing an essential public service, and in complying with Applicable Law, will rely on the performance by the Company of its obligations under the Service Contract. D-14 Except for the property and facilities delineated in the Service Contract as being subject to the management responsibility of the Company, the District has and shall retain full management responsibility for the Water System. The Company shall manage the Project in a manner which serves and complements the requirements of the Water System and in accordance herewith, and agrees that no provision of the Service Contract shall confer upon the Company any right the exercise of which may adversely affect the Water System or the ability of the District to operate the Water System in a manner which serves the water needs of the Service Area in compliance with Applicable Law. Water Treatment Guarantee. Except to the extent relieved by Uncontrollable Circumstances or District Fault, the Company shall operate the Project on a continuous 24-hour per day, 7-day per week basis so as to treat Raw Water and to produce and distribute Finished Water to the Water System in compliance with the requirements of Applicable Law. In addition to its obligations to comply with the Finished Water requirements imposed by Applicable Law and except to the extent relieved for Uncontrollable Circumstances or District Fault, the Company shall treat Raw Water and produce and distribute Finished Water in compliance with the contract requirements set forth in the Service Contract (the "Enhanced Standards"), except that with respect to the certain Enhanced Standards relating to flavor and aroma, the Company shall be obligated only to use its best reasonable efforts to achieve such Enhanced Standards. Except to the extent relieved for Uncontrollable Circumstances or District Fault, the Company shall pay liquidated damages in the amounts set forth in the Service Contract (which amounts shall not be subject to escalation) for the Company's failure to comply with certain Water Treatment Guarantee parameters. These liquidated damages have been established to address minor, occasional exceedences of the applicable regulatory standards and the Enhanced Standards. Major or repeated unexcused failures of compliance with the Water Treatment Guarantee are not intended to be events of non-compliance as to which liquidated damages apply, but instead shall be deemed to be breaches of the Service Contract, as to which the District may seek actual damages and exercise its other remedies under the Service Contract. The District shall have no right of termination except pursuant to an Event of Default by the Company upon the occurrence of a material breach. If any such unexcused failure by the Company to comply with the Water Treatment Guarantee results in a requirement that a "boil water" or other public notice be issued, or results in a significant regulatory enforcement action by a Governmental Body, the nature and extent of the unexcused non-compliance and of the resulting public notice or regulatory enforcement action shall be taken into account in determining the level of actual damages and establishing any other remedies which are appropriate to the breach. The Water Treatment Guarantee shall apply, except to the extent excused by Uncontrollable Circumstances or District Fault, (1) without any allowance for scheduled or unscheduled downtime or Plant maintenance, repair or replacement, which the Company acknowledges has been factored into the Water Treatment Guarantee, and (2) so long as the actual Raw Water supply conditions are in conformity with the Design Raw Water Quality Parameters. In the event and for any period during which the actual Raw Water supply conditions are not in conformity with the Design Raw Water Quality Parameters, the Company shall use its best reasonable efforts to comply with the Water Treatment Guarantee during the period of non-conformity. In the event that any Finished Water supplied to the Water System fails to comply with the Water Treatment Guarantee and the Service Contract, except to the extent such failure of compliance is caused by an Uncontrollable Circumstance or District Fault, the Company shall indemnify, defend and hold harmless the District and the District Indemnities from the Loss-and-Expense of any tort, environmental, contract or other liability resulting in any Legal Proceeding originated by any third party arising from the supply of such non-complying Finished Water. This indemnity shall extend to any liability resulting from property loss or damage or death or personal injury suffered or alleged to be suffered by any person from exposure to or as a result of using or consuming such non-complying Finished Water based on any theory of recovery, including theories of product liability, toxic tort or environirental impairment. The Loss-and-Expense to which the indemnity extends shall not be construed to constitute consequential or other damages, as to which both parties have waived any rights of recovery. The parties acknowledge that a Change in Law may affect Finished Water standards or impose more stringent requirements relating to equipment or processes than those established as of December 31, 2001. In the D-15 event a Change in Law occurs, the Company shall not be entitled to performance relief or additional compensation unless: (1) such Change in Law imposes a regulatory standard or operating requirement with respect to any particular Finished Water characteristic or parameter which is more stringent or burdensome to comply with than the Contract Standards applicable to such characteristic or parameter, or requires equipment or processes not then in place or practiced at the Project; and (2) the Company is unable, after taking all reasonable mitigation measures required under the Service Contract with respect to such a Change in Law, to avoid the necessity for such performance relief or additional compensation. Water Delivery Guarantee. Except with respect to permitted scheduled and unscheduled Plant downtime and except as the Company's obligations may be limited upon the occurrence of an Uncontrollable Circumstance or District Fault, the District shall have the right throughout the Operation Period to demand the delivery of Finished Water to the Finished Water Transmission Line at Flow Rates of 5.14, 2.57 or 0 MGD reflecting two-train or single train operation, or full shut down. The Company shall use its best efforts, within the physical capacity of the Plant, to meet the District's demand for the delivery of Finished Water in accordance with the provisions of the Service Contract. The "Firm Daily Water Demand Volume", for purposes of the Service Contract, shall be the volume of Finished Water demanded by the District based on the Flow Rates specified in the "day-before" firm Finished Water demand schedules furnished by the District, as adjusted by any "day-of" modifications thereto. Except to the extent excused by Uncontrollable Circumstances or District Fault and except as adjusted pursuant to the Service Contract, the Company shall operate the Project so as to deliver Finished Water to the District each day during the Operation Period in volumes at least equal to the Firm Daily Water Demand Volume with respect to such day (the "Water Delivery Guarantee"). The Company may not deliver Finished Water to the District on any day during the months of December, January, February and March, in a volume which is greater than the Firm Daily Water Demand Volume established by the District with respect to such day. The Company may, however, during the months of April through November, deliver Finished Water to the District on any day in a volume up to 5% more (or up to 9% more, subject to District approval) than the Firm Daily Water Demand Volume established by the District with respect to such day, but subject to a maximum overall limit of 5,231 acre feet per Contract Year. The purpose of the Company's surplus delivery rights is to give the Company an opportunity to mitigate any daily delivery shortfalls occurring in a Contract Year. The Company shall not be entitled to any additional compensation for any such surplus daily deliveries. The Company shall have the right to apply surplus water deliveries achieved in the first 60 days of any Contract Year against Finished Water delivery shortfalls occurring in the last 60 days of the preceding Contract Year, so as to reduce any liquidated damages that may be payable pursuant to the Water Delivery Guarantee. If, in any Contract Year, (1) the cumulative amount of any Finished Water delivery shortfalls under the Water Delivery Guarantee exceeds (2) the cumulative amount of any permissible surplus Finished Water deliveries, the Company shall pay liquidated damages to the District, for each acre foot of such Finished Water delivery shortfalls, in an amount equal to the sum of (1) Metropolitan's Prevailing Full Service Treated Water Rate (expressed in dollars per acre foot) plus, (2) the Final GRP Contribution with respect to such Contract Year (expressed in dollars per acre foot), plus (3) the administrative and operation and maintenance charge (expressed in dollars per acre foot) imposed by MWDOC on the District with respect to such Contract Year (exclusive of any elements thereof which are attributable to services provided by MWDOC which are substantially different in scope or quantity than the services historically provided by MWDOC to the District prior to the Contract Date); provided, however, that the amount described in item (2) shall not be payable if the Metropolitan Agreement has been terminated and the Company has paid liquidated damages as a result. Extraordinary Flow Rate Change. The District shall have the right at any time during which the Plant is not shut down for scheduled or unscheduled maintenance, repair or replacement and for any emergency or other reasonable purpose to require the Company to change the Flow Rate upon 60 minutes notice, notwithstanding the four-hour notice requirement for Flow Rate changes provided elsewhere in the Service Contract. The District also shall have the right to require the Company during any shutdown to resume normal operations as expeditiously as practicable for any such purpose. Any such extraordinary Flow Rate change or resumption of operations required shall be considered an Uncontrollable Circumstance. Notwithstanding the foregoing, the Company shall use its best reasonable efforts to comply with the Hydraulic Transients Guarantee. D-16 Plant Shutdowns. The Company shall be permitted to schedule downtime for Plant maintenance, repair or replacement as follows: (1) Winter Months. In each of the months of December, January, February and March, the Company may schedule 2 days of no Finished Water production. In addition, in the months of January, February and March, the Company may schedule 7 days of Finished Water production of not more than 2.57 MGD. For each successive day on which the Company schedules no Finished Water production, the Company shall operate the Plant at a Flow Rate of 5.14 MGD (or such lesser volume as may be requested by the District) for two days in succession thereafter before scheduling additional downtime. For each successive day on which the Company schedules at a Flow Rate of not more than 2.57 MGD of Finished Water production, the Company shall operate the Plant at a Flow Rate of 5.14 MGD (or such lesser volume as may be requested by the District) for one day in succession thereafter before scheduling additional downtime. (2) Summer Months. In the period from April 1 through November 30, the Company may schedule 12 days of no Finished Water production. There shall be no more than 1.5 days of such scheduled downtime per month during such eight month period. Scheduled downtime shall not overlap successive months. The Company shall also be entitled to take 3 days in each Contract Year on which no Finished Water is produced, and shut down the Plant in order to conduct unscheduled maintenance, repair and replacement work, without restriction as to the month in which such days are taken. The Company shall use its best efforts to minimize the duration of such unscheduled periods of downtime, and any adverse effect on the District's water supply to its customers. On any day on which the Plant is shut, the District shall not have the right to demand Finished Water. The Company acknowledges that operating conditions in the Water System as a whole may require the immediate curtailment or cessation of delivery of Finished Water from the Plant. The Company shall curtail or cease supplying Finished Water at the Finished Water Pumping Station immediately upon receipt by the Company's Contract Representative or the Facilities Manager of such a directive by the District's Contract Representative, and the issuance of any such directive shall constitute an Uncontrollable Circumstance. The Company shall resume operations of the Plant within 24 hours of receipt by the Company of a written resumption directive issued by the District's Contract Representative. No District Obligation to Demand Water. The District shall have the right, but not the obligation, during the Operation Period to demand Finished Water. The District shall pay the Service Fee irrespective of the volume of Finished Water actually demanded by the District, but shall not be liable in damages or otherwise for any failure to demand Finished Water. Insufficiency of Wellfield Supply of Raw Water. In the event that at any time during the Term the eight Wells originally installed by the Company, when designed, constructed, operated and maintained by the Company in accordance with the Contract Standards, do not produce a supply of Raw Water sufficient to enable the Company to meet the Water Delivery Guarantee, the Company shall design, drill, construct, install and operate additional Wells in the Wellfield as required to provide an adequate supply of Raw Water. If a ninth or further additional Wells are required, the District shall bear all of the capital and additional operating, maintenance, repair and replacement costs of such ninth and additional Wells and related pipelines required to connect the Well to the existing Wellfield. The District shall pay the electricity bills incurred from the operation of all such additional wells, as provided and subject to the limitations set forth in the Service Contract. The Company shall be relieved of its obligation to comply with the Water Delivery Guarantee to the extent of such Raw Water supply insufficiency, pending the completion of the additionally required Wells. The District shall have the right to direct the Company to design, drill, construct, install and operate such additional Wells to remedy any such insufficiency, or to modify the Water Delivery Guarantee to account for such insufficiency. The Company shall mitigate, to the maximum extent practicable, any such additional costs to be borne by the District in the event that groundwater supplies thereafter increase to a level sufficient to permit the discontinuance of the operation of some or all of such additional Wells. Production Efficiency Guarantee. Except to the extent excused by Uncontrollable Circumstances or District Fault, the Company shall operate the Project to achieve a Raw Water to Finished Water production efficiency of no less than 80% of the Raw Water volumes over the course of each Contract Year following the Acceptance Date. D-17 Hydraulic Transients Guarantee. Except to the extent relieved for Uncontrollable Circumstances or District Fault, the Company shall operate the Project so as to avoid the occurrence of sudden, significant changes in the Flow Rate and pressure of Finished Water delivered to the Water System. District Remedies for Non-Compliance with Performance Guarantees. If the Company fails to comply with any Performance Guarantee and is not excused from performance as a result of an Uncontrollable Circumstance or District Fault, the Company shall, without relief under any other Performance Guarantee, and in addition to any other remedy provided herein, allowed by Applicable Law or required by a Governmental Body: (1) promptly notify the District within 24 hours of the Company's having knowledge of any such non-compliance; (2) promptly provide the District within 24 hours with copies of any notices sent to or received from the EPA, the CADHS or any other Governmental Body having regulatory jurisdiction with respect to any violations of Applicable Law; (3) pay liquidated damages in the amounts provided for herein; (4) pay (directly, if levied against the Company and through the indemnification provisions of the Service Contract if levied against the District) any other resulting damages, fines, levies, assessments, impositions, penalties or other charges resulting therefrom; (5) take any action (including, without limitation, making all repairs, replacements, Capital Modifications and operating and management practices changes) necessary, in light of the nature, extent and repetitiveness of such non-compliance, in order to comply with such Performance Guarantee, to continue or resume performance of the Contract Services and eliminate the cause of, and to assure that such non-compliance will not recur; (6) promptly prepare all public notifications required by Applicable Law, and submit such notifications for publication; and (7) assist the District with all public relations matters necessary to adequately address any public concern caused by such non-compliance, including, but not limited to, preparation of press releases, attendance at press conferences, and participation in public information sessions and meetings. Releases, Leaks and Spills. The Company shall operate the Project in such a manner that Raw Water, Finished Water or Plant By-Products will not contaminate, or be released, leak or spill on or into the environment other than as permitted by the Contract Standards. The Company, after first notifying the District, shall be responsible for fulfilling all notification of and reporting requirements established by Applicable Law related to any unauthorized release into the environment from or in connection with its operation and management of the Project. The Company shall coordinate with the District in identifying the source of any unauthorized release and cooperate with the District and all appropriate Governmental Bodies in effectuating the prompt remediation thereof. The Company shall, in the most expeditious manner possible under the circumstances, cause any waste or material released without authorization to be cleaned up, removed from the Project or other point of release, and transported to and discharged or disposed of at a landfill or other disposal site which constitutes an Acceptable Disposal Site, and perform all necessary remediation measures. All costs associated with the identification, testing, cleanup, removal, transportation and disposal of such waste or material and performing necessary remediation measures shall be borne by the Company, except to the extent the release of the waste or material resulted from an Uncontrollable Circumstance or District Fault, in which case the appropriate portion of such costs shall be borne by the District. Pre-Existing Environmental Conditions. The Company shall operate and manage the Project so as not to aggravate the effect of any Pre-Existing Environmental Condition. If at any time a Pre-Existing Environmental Condition is determined to exist which requires an action under Applicable Law, then the District shall within 60 days after written notice from any Governmental Body or the Company of the presence or existence thereof, or within 60 days after the District's obtaining actual knowledge thereof, commence and diligently prosecute such actions as may be necessary to dispose of, remediate or otherwise correct the Pre-Existing Environmental Condition or otherwise make the Pre-Existing Environmental Condition comply with Applicable Law. The District shall have the right to contest any determination of a Pre-Existing Environmental Condition and shall not be required to take any action so long as: (1) the District is contesting any determination of a Pre-Existing Environmental Condition in good faith by appropriate proceedings conducted with due diligence; (2) the District indemnifies the Company in connection therewith; and (3) Applicable Law permits continued operation of the Project pending resolution of the contest, so that the Company shall have no liability as a result of the failure of the District to dispose of, remediate or otherwise correct such Pre-Existing Environmental Condition during the period of contest. Notwithstanding the foregoing, to the extent that a Pre-Existing Environmental Condition is discovered which causes imminent and substantial danger to human health and safety and adversely impacts the operation of the Plant, the District shall promptly take all necessary action to dispose of, remediate or otherwise mitigate such imminent condition. Any such Pre-Existing Environmental Condition or imminent Pre-Existing Environmental Condition shall constitute an Uncontrollable Circumstance which relieves Company of its obligations to perform under the Service Contract. D-18 Company Disposal of Residuals. The Company shall locate an Acceptable Disposal Site and make all necessary arrangements with the owner or operator thereof for the disposal of all Residuals during the Term of the Service Contract. The Company shall store Residuals at the Plant in an enclosed building in accordance with the Design Requirements. The Company shall operate the Plant and treat Raw Water so as to minimize the production of Residuals and comply with the Performance Guarantees. The Company shall transport all Residuals to an Acceptable Disposal Site in a safe and environmentally sound manner and in accordance with Applicable Law. In the event of a release, spill, leak or loss of Residuals during transfer or transit, the Company shall immediately arrange for the clean-up of the material and transportation to a Acceptable Disposal Site, and pay any resulting fines, assessments, penalties or damages resulting therefrom. The Company shall indemnify, defend and hold and harmless the District in accordance with the Service Contract, from all Loss-and-Expense that may result from the generation, processing, transportation or disposal of Residuals. Company Disposal of Brine. The District shall pay a one-time fee of $599,640 to the Santa Margarita Water District for the purchase of the right to discharge up to 1.2 MGD of Brine concentrate, which Brine concentrate shall consist solely of reverse osmosis concentrate, into the Southeast Regional Reclamation Authority's ocean outfall. The parties acknowledge that the Project includes the construction and maintenance of discharge pipes connecting the Plant and such ocean outfall. In the event such ocean outfall becomes unavailable or restricted in use for the disposal of brine concentrate for any reason other than Company Fault, such unavailability or restriction shall constitute an Uncontrollable Circumstance, and the District shall pay the cost of providing an alternate disposal method and the Company shall be relieved of the Performance Guarantees until the alternate disposal method becomes available. The Company shall, at its own cost and expense, treat and dispose of all Brine produced at the Plant during the Term of the Service Contract through such ocean outfall, and shall bear all risk and expense associated with the siting, permitting, design, construction, and operation of any pipelines and other assets necessary for the conveyance of the Brine to the ocean outfall; provided, however, that if the Company is operating the Plant in compliance with the Production Efficiency Guarantee, the District will pay any additional charges that are imposed by the Santa Margarita Water District as a result of the discharge of excessively concentrated or voluminous Brine to the ocean outfall which is attributable to the treatment of Raw Water having parameters which are outside the Design Raw Water Quality Parameters. Notwithstanding the foregoing, the Company shall not produce more than 1.2 million gallons of Brine for every 5.14 million gallons of Finished Water delivered to the District. The Company shall operate the Plant and treat Raw Water so as to minimize the production of Brine and comply with the Performance Guarantees. Compliance Failures and Liquidated Damages. The Company shall perform the Contract Services in accordance with the Contract Standards. Except to the extent the Company is relieved for Uncontrollable Circumstances or District Fault, the Service Fee shall be reduced by the amounts provided below for the Company's failures of compliance indicated with the following: (1) failure to report any exceedence as required by the Contract Standards; (2) failure to calibrate or verify calibration of flow meters in accordance with the manufacturer's specifications or, if not specified in the manufacturers specifications, semi-annually; (3) failure to respond to a written request for information related to the Service Contract made by the Contract Administrator and designated as a "priority request" within 3 business days; (4) failure to provide any plan, proposal, report or other deliverable required with respect to Uncontrollable Circumstances or any regulatory matter by the deadline agreed upon by the parties with respect thereto; (5) failure to keep monthly maintenance logs as required by the Service Contract; (6) failure of Company staff to attend District meetings as reasonably requested, with adequate advance notice from the District; (7) failure to provide any reports required within 7 days of the due date; (8) failure to maintain proper certification as required by CADHS; (9) failure to maintain adequate quantities of chemicals at the Sites which leads to a violation of a Performance Guarantee; (10) failure to respond to alarms at the Plant; and (11) failure to properly sample, test or report the results thereof as required by Applicable Law. If the Company fails to comply with any of its performance obligations as set forth above, the District, within 30 days of its discovery of such violation, shall notify the Company in writing of its alleged failure to perform. The Company shall have the right to cure any violation described in items (2), (4), (8) and (9) above within 15 days of receipts of the District's notice of violation; any other such violation shall not be subject to cure. D-19 The Company shall pay to the District, as liquidated damages, the following amounts (which amounts shall not be subject to escalation): (1) Nothing for the first failure to perform in any Contract Year. (2) $250 for the second failure to perform in any Contract Year. (3) $500 for the third failure to perform in any Contract Year. (4) $1,000 for the fourth failure to perform in any Contract Year. (5) $3,000 for the fifth failure to perform in any Contract Year. (6) $5,000 for the sixth failure to perform in any Contract Year. (7) $7,000 for each of the seventh and any subsequent failure to perform in any Contract Year. The Company shall have the right to contest the occurrence of any alleged violation or alleged failure to cure, and the Company shall have no obligation to pay such contested amounts until the contest is resolved. MAINTENANCE, REPAIR AND REPLACEMENT Ordinary Maintenance. The Company shall perform all normal and ordinary maintenance of the machinery, equipment structures, improvements and all other property constituting the Project, shall keep the Project in good working order, condition and repair, in a neat and orderly condition and in accordance with the Contract Standards, and shall maintain the aesthetic quality of the Project as originally constructed and in accordance with the Design Requirements. The Company shall provide or make provisions for all labor, materials, supplies, equipment, spare parts, Consumables and services which are necessary for the normal and ordinary maintenance of the Project and shall conduct predictive, preventive and corrective maintenance of the Project as required by the Contract Standards. The Company shall keep maintenance logs for the Project in accordance with the Contract Standards. The Company, in accordance with the Contract Standards, shall keep the grounds of the Sites in a neat and orderly condition (including the cleanup of litter and debris on a daily basis or more frequently as required). The Company shall also maintain and repair all Sites signage, fencing and other security systems. In addition, the Company shall provide all landscaping services for the Sites. Major, Maintenance, Repair and Replacement. The Company shall perform all major maintenance, repairs and replacement of the machinery, equipment, structures, improvements and all other property constituting the Project during the Term of the Service Contract required under the Contract Standards, including membrane replacement and all other maintenance, repair and replacement which may be characterized as "major" or "capital" in nature. The District's approval for any such maintenance, repair or replacement shall not be required unless it constitutes a Capital Modification, other than a Small Scale Capital Modification, in which event the District shall have the approval rights set forth in the Service Contract. The obligations of the Company are intended to assure that the machinery, equipment, structures and improvements constituting the Project are properly and regularly maintained in order to preserve their reliability and in a way such that when the Project is returned to the District at the end of the Term it is in a condition which does not require the District to undertake a significant overhaul or immediate replacements in order to continue to provide water treatment and delivery services. The Company shall prepare and submit to the District within 90 days before each of the fourth, ninth, fourteenth and nineteenth anniversaries of the Acceptance Date, a five-year forecast of the major repair and replacement activities that the Company believes needs to be performed at the Project during such five-year period to keep the Project in good working condition and repair so as to be able to properly perform the Contract Services. To the extent any repair or replacement is required as a result of Uncontrollable Circumstances or District Fault, the District shall pay the costs thereof. Replacements Constituting Capital Modifications. The Company shall bear the cost and expense of all maintenance, repairs and replacements required under this Article, including the cost and expense of any maintenance, repair or replacement that may constitute a Capital Modification, unless otherwise provided in the Service Contract. Project Evaluations. The Independent Evaluator shall, within 180 days following the Acceptance Date, photograph and prepare an itemized inventory of all property constituting the Project and having an installed cost greater than $1,000, including records of assets originally installed, manufacturer, identification number and original cost data (the "Baseline Project Record"). The Baseline Project Record shall be prepared in accordance with the Service Contract, shall distinguish Project Equipment and Project Structures, and shall reflect, based on the Fixed D-20 Design/Build Price and the Design Requirements, the condition, functionality, value and useful life of the Project as originally constructed by the Company under the Service Contract. Final Evaluations of the Project. Not later than six months following the sixteenth anniversary of the Acceptance Date, the Independent Evaluator shall conduct a final evaluation of the Project in accordance with the protocol established in the Service Contract and shall utilize standard utility property evaluation methods. In connection with the final asset evaluation, the Company shall furnish the District and the Independent Evaluator with the Baseline Project Record prepared pursuant to the Service Contract and all data base information developed in connection with the implementation of the Company's computerized maintenance management system. The evaluation of the Project Structures shall determine and establish the physical condition of the Project Structures. The evaluation of the Project Equipment shall determine and establish the weighted average useful life of the Project Equipment as of the date of evaluation (expressed as a single number of years, carried to one decimal place), taking into account the performance capability and value of each piece of Project Equipment. The final evaluation shall exclude the value of any Capital Modifications to the extent paid for by the District, directly or indirectly, other than those made on account of Uncontrollable Circumstances or District Fault. The Independent Evaluator shall also conduct such a final evaluation not later than six months prior to the Termination Date resulting from the expiration of the Service Contract. The Contract Year 16 evaluation shall be for the informational purposes of the parties only. The Contract Year 20 evaluation shall be used for the purpose of determining compliance with the Company's obligations under the Service Contract. Required Condition of Project Structures Upon Return to the District. The Project Structures shall be returned to the District in good condition, working order and repair as when new, with ordinary wear and tear excepted as determined in light of the Company's maintenance, repair and replacement obligations. At the end of the Initial Term, each individual Project Structure listed in the Baseline Project Record must have a functionality and structural integrity rating of at least "3" (as described in the Service Contract). In the event the final audit establishes a functionality and structural integrity rating deficiency, the Company shall, at the election of the Company, either remedy the deficiency or make a cash payment to the District sufficient to enable the District to remedy the deficiency. Required Condition of Project Equipment Upon Return to the District. The Project Equipment shall be returned to the District in a condition and state of repair such that, in the aggregate, the weighted average useful life of the Project Equipment at the end of the Initial Term is equal to or greater than (1) 3 years, in the case of Project Equipment having an installed cost of $2,500 or greater, and (2) 2 years, in the case of Project Equipment having an installed cost of between $1,000 and $2,500. There shall be no weighted average useful life requirement with respect to Project Equipment having an installed cost of less than $1,000. In the event the final audit establishes a maintenance, repair and replacement weighted average useful life deficiency, the Company shall, at the election of the Company, either remedy the deficiency or make a cash payment to the District sufficient to enable the District to remedy the deficiency. In the event that Capital Modifications constituting Project Structures are made during the Term, such assets shall be returned to the District on the Termination Date in good condition, working order and repair, with ordinary wear and tear excepted as determined in light of the Company's maintenance, repair and replacement obligations. In the event that Capital Modifications constituting Project Equipment are made during the Term and are paid for by the District, such Capital Modifications shall be disregarded in preparing the final evaluation of the Plant. The weighted average useful life of all such assets as an aggregate which are paid for by the District, however, shall be separately determined in the final asset evaluation, and shall be equal to or greater than the weighted average useful life for Project Equipment. Reasonable conventions may be adopted in the weighting analysis to take account of the varying dates of installation. Capital Modifications and other maintenance, repairs and replacements paid for by the Company, including computer and other replacement systems installed based on advances in technology, shall be included in the final asset evaluation, and their remaining useful life included in such final evaluation. The expense of the Independent Evaluator for all services performed pursuant hereto shall be borne by the District. The determination by the Independent Evaluator as to any matter arising with respect to the final evaluation of the Project which is in dispute between the District and the Company and which involves amounts less than $250,000 (as adjusted annually from the Contract Date based on the Adjustment Factor) shall be final and D-21 binding upon the parties; for disputes involving amounts greater than $250,000, the Independent Evaluator's determination shall be advisory only, and any such dispute shall be handled as provided in the Service Contract. Loss, Damage or Destruction to the Project. The Company shall use care and diligence, and shall take all appropriate precautions, to protect the Project from loss, damage or destruction. The Company shall promptly report to the District and the insurers, upon obtaining knowledge thereof, any damage or destruction to the Project and as soon as practicable thereafter shall submit a full report to the District. The Company shall also submit to the District within 24 hours of receipt copies of all accident and other reports filed with, or given to the Company by, any insurance company, adjuster or Governmental Body. The parties shall cooperate so as to promptly commence and proceed with due diligence to complete the repair, replacement and restoration of the Project to at least the character or condition thereof existing immediately prior to the loss, damage or destruction, in accordance with the Service Contract. The District shall have the right to monitor, review and inspect the performance of any repair, replacement and restoration work by the Company as if such work constituted part of the Project as originally constructed. To the extent that any repair, replacement or restoration costs incurred can be recovered from any insurer or from another third-party, each party shall assist each other in exercising such rights as it may have to effect such recovery. Each party shall provide each other with copies of all relevant documentation at no cost to the other party, and shall cooperate with and assist the other party upon request by participating in conferences, negotiations and litigation regarding insurance claims. The District shall provide all funds necessary to pay the costs of repairing, replacing and restoring the Project and all insurance proceeds and recoveries from third parties resulting from damage to or the loss or destruction of the Project shall be for the account of the District; provided, however, that such costs not covered by insurance proceeds or third-party payments shall be borne by the Company to the extent the loss, damage or destruction was not caused by Uncontrollable Circumstances or District Fault. The Company shall promptly repair or replace all Municipal Property and all private property damaged by the Company or any officer, director, employee, representative or agent of the Company in connection with the performance of, or the failure to perform, the Contract Services, except (1) to the extent any such damage was caused by Uncontrollable Circumstances or District Fault, or (2) for reasonable wear and tear resulting from heavy construction activities prior to the Acceptance Date to Del Obispo Road and the City parking lot resulting from the performance of the Design/Build Work. The repair and replacements shall restore the damaged property, to the maximum extent reasonably practicable, to its character and condition existing immediately prior to the damage. CAPITAL MODIFICATIONS District Approval. The District shall have the right, in its sole discretion, to approve all Capital Modifications; provided, however, that the Company may implement Small Scale Capital Modifications without District approval, if the requirements of the Service Contract are complied with. All Capital Modifications shall be made and implemented in accordance with this Article. The District shall have the express right to condition its approval of Capital Modifications upon the sharing of net cost savings expected to result therefrom. In the event any Capital Modification is made, the Company shall bear the cost and expense thereof and all related operation, maintenance, repair and replacement costs, unless the Capital Modification is directed by the District (other than as part of an enforcement action taken in response to a breach hereof) or is necessitated by District Fault or is necessary to address an Uncontrollable Circumstance. Capital Modifications at Company Request. The Company shall give the District written notice of, and reasonable opportunity to review and comment upon, any Capital Modification proposed to be made at the Company's request, whether before or after Acceptance. The notice shall contain sufficient information for the District to determine that the Capital Modification: (1) does not diminish the capacity of the Project to be operated so as to meet the Contract Standards; (2) does not impair the quality, integrity, durability and reliability of the Project; (3) is reasonably necessary or is advantageous for the Company to fulfill its obligations under the Service Contract; and (4) is feasible. The Company shall not be entitled to any adjustment in the terms of the Service D-22 Contract as a result of any such Capital Modification unless approved by the District or made a condition of approval by the District in its sole discretion. Capital Modifications Due To Uncontrollable Circumstances. Upon the occurrence of an Uncontrollable Circumstance, the District shall promptly proceed, subject to the terms, conditions and procedures set forth in the Service Contract, to make or cause to be made all Capital Modifications reasonably necessary to address the Uncontrollable Circumstance. The Company shall consult with the District concerning possible means of addressing and mitigating the effect of any Uncontrollable Circumstance, and the Company and the District shall cooperate in order to minimize any delay, lessen any additional cost and modify the Project so as to permit the Company to continue providing the Contract Services in light of such Uncontrollable Circumstance. The design and construction costs of any such Capital Modification, and any related operation, maintenance, repair and replacement costs, shall be borne by the District except to the extent provided in the Service Contract pertaining to cost sharing. The District shall pay the Capital Modification costs and any such related operation, maintenance, repair and replacement costs for which it is responsible in the manner established in accordance with the procedures set forth in the Service Contract. Capital Modifications at District Direction. The District shall have the right to make Capital Modifications at any time and for any reason whatsoever, whether and however the exercise of such rights affects the Service Contract so long as the Company's rights are protected as provided in the Service Contract. The design and construction costs of any such Capital Modification made at the District's direction, and any related operation, maintenance, repair and replacement costs, shall be borne by the District, through District financing and through an adjustment to the Service Fee. The Company shall have no responsibility for any such costs unless the Company agrees in its sole discretion to participate in the financing thereof upon terms and conditions acceptable to the Company. The District shall have no obligation to direct the Company to make any Capital Modification. District Financing. The District shall provide financing for any Capital Modification for which it is financially responsible under the Service Contract, and shall make the proceeds of the financing available to the Company to pay the negotiated price on the milestone schedule and subject to any retainage negotiated by the parties. The District in its sole discretion may voluntarily, if requested by the Company, provide financing for the Capital Modifications for which the Company is financially responsible under the Service Contract, on terms and conditions established by the District in its sole discretion. Company Financing. The District may request the Company to finance all or any portion of the cost of any Capital Modification. The terms and conditions of any such financing and its impact on the Service Contract shall include, but are not limited to, any District right to refinance any such Company financing and any reimbursement due the Company with respect to the unamortized principal amount of such financing if the Service Contract is terminated prior to the end of its scheduled Term. If the Company agrees to provide financing for any Capital Modifications and assigns the Service Contract as security therefor, the loan documents related to such financing may require that all or a portion of each Service Fee payment be paid to a trustee or paying agent, either on a regular basis or upon the occurrence of certain stated events. In such a case, upon being notified in writing of such requirement by the Company, the District shall make payment as required therein and the Company shall, as between it and the District, accept any payment made to such trustee or paying agent as required therein as payment to the Company. Company Non-Impairment Rights. No Capital Modification, other than a Company-requested Capital Modification, shall be made that materially impairs any right, materially impairs the ability to perform, imposes any material additional obligation or liability, or materially increases the costs of the Company under the Service Contract, including operating, maintenance, repair and replacement costs related to such Capital Modification. Any Capital Modification undertaken by the District which violates the Company's rights under the Service Contract shall relieve the Company from its Performance Guarantee and indemnity obligations under the Service Contract to the extent such obligation is affected by the unauthorized Capital Modification. SERVICE FEE Service Fee. From and after the Acceptance Date, the District shall pay the Service Fee to the Company as compensation for the Company's performing the Operation Services under the Service Contract. D-23 Service Fee Formula. The annual Service Fee shall be calculated in accordance with the following formula: SF = BOC + EI where, SF = Service Fee BOC = Base Operating Charge EI = Extraordinary Items Charge or Credit Base Operating Charge. The Base Operating Charge shall be calculated in accordance with the following formulas: BOC = FC + VC FC = OMC + LC + RC VC = DAE + ESE where, BOC = Base Operating Charge FC = Fixed Component OMC = Operation and Maintenance Component LC = Labor Component RC = Replacement Component VC = Variable Component DAE1 = First Water Demand Adjustment Element DAE2 = Second Water Demand Adjustment Element ESE = Electricity Savings Element Adjustment Factor. The "Adjustment Factor" for purposes of the Service Contract, when used with respect to the second and each subsequent Contract Year, shall be determined as follows: AFn = 1 + {(0.90) X [(CPI-Un-1 - CPI-Un-2) ? CPI-Un-2]} where, AFn = The Adjustment Factor for Contract Year "n" CPI-Un-1 = The average of the 12 month CPI-U values occurring in the Contract Year preceding the Contract Year with respect to which a calculation is to be made. CPI-Un-2 = The average of the 12 month CPI-U value occurring in the Contract Year two years preceding the Contract Year with respect to which a calculation is to be made. Fixed Component. The Fixed Component of the Base Operating Charge shall be the sum of: (1) the Operation and Maintenance Component, (2) the Labor Component, and (3) the Replacement Component. The Fixed Component of the Base Operating Charge represents compensation for the District's right to demand the production and delivery of up to 4,800 acre feet of Finished Water per Contract Year. The Company shall be compensated for the production and delivery of Finished Water in volumes in excess of 4,800 acre feet per Contract Year through the Variable Component of the Base Operating Charge. The Operation and Maintenance Component. The Operation and Maintenance Component for the Contract Year ending on June 30, 2003 shall be $611,400. The Operation and Maintenance Component for each subsequent Contract Year shall be determined by multiplying (1) the Operation and Maintenance Component for the previous Contract Year, times (2) the Adjustment Factor. The Labor Component. The Labor Component for the Contract Year ending on June 30, 2003 shall be $170,600. The Labor Component for each subsequent Contract Year shall be determined by multiplying (1) the Labor Component for the previous Contract Year, times (2) the Adjustment Factor. D-24 The Replacement Component. The Replacement Component for the Contract Year ending on June 30, 2003 shall be $312,900. The Replacement Component for each subsequent Contract Year shall be determined by multiplying (1) the Replacement Component for the previous Contract Year, times (2) the Adjustment Factor. Variable Component. The Variable Component of the Base Operating Charge shall be the sum of: (1) the First Water Demand Adjustment Element, (2) the Second Water Demand Adjustment Element and (3) the Electricity Savings Element. First Water Demand Adjustment Element. In the event that the District's demand for Finished Water in any Contract Year is greater that 4,800 acre feet and less than 5,231 acre feet, the District shall pay the Company as the First Water Demand Adjustment Element an amount equal to the product of: (1) $151 per acre foot of Finished Water (for the Contract Year ending June 30, 2003 and adjusted annually thereafter based on the Adjustment Factor), and (2) the difference between the volume of Finished Water delivered to the District by the Company (measured in acre feet of Finished Water) and 4,800 acre feet. Second Water Demand Adjustment Element. If the District requests, and the Company supplies at its election, more than 5,231 acre-feet of Finished Water in any Contract Year, the District shall pay to the Company as the Second Water Demand Adjustment Element an amount equal to the product of: (1) $228 per acre-foot of Finished Water (for the Contract Year ending June 30, 2003 and adjusted annually thereafter based on the Adjustment Factor), and (2) the difference between the volume of Finished Water delivered to the District by the Company (measured in acre-feet of Finished Water) and 5,231 acre-feet. Electricity Savings Element. The Electricity Savings Element in a Contract Year, if payable, shall be the sum of (1) the Electricity Consumption Savings and (2) the Electricity Demand Savings. If the annual electricity consumption for the Project in a Contract Year is greater than the Guaranteed Maximum Electricity Consumption applicable for that Contract Year, or the average monthly electricity demand for the Project for the Contract Year is greater than the Guaranteed Maximum Electricity Demand applicable for that Contract Year, then the Electricity Savings Element for that Contract Year shall be equal to zero. If the annual electricity consumption for the Project in a Contract Year is less than 95% of the Guaranteed Maximum Electricity Consumption applicable for that Contract Year, and the average monthly electricity demand for the Project for the Contract Year is less than or equal to the Guaranteed Maximum Electricity Demand for the Contract Year, then the Company shall be entitled to an incentive payment (i.e., the Electricity Consumption Savings) equal to 50% of the product of: (1) twelve; (2) the average "generation charges" representing the total cost of electricity (i.e., all charges based upon kilowatt hours consumed, including any directly related prorated charges, including, but not limited to, transmission charges, deregulation fees and taxes) for the Contract Year, measured in dollars per kilowatt hour consumed ($/kWh); and (3) the difference between (a) 95% of the Guaranteed Maximum Electricity Consumption and (b) the actual annual electricity consumed, measured in kilowatt hours, for the Project in the Contract Year. If the average monthly electricity demand for the Project in a Contract Year is less than the 95% of the Guaranteed Maximum Electricity Demand applicable for that Contract Year, and the annual electricity consumption for the Project for the Contract Year is less than or equal to the Guaranteed Maximum Electricity Consumption for the Contract Year, then the Company shall be entitled to an incentive payment (i.e., the Electricity Demand Savings) equal to 50% of the product of: (1) twelve; (2) the average "demand charges" (i.e., all charges based upon monthly kilowatt demand, including any directly related prorated changes and taxes) for the Contract Year, measured in dollars per kilowatt demanded ($/kW); and (3) the difference between (a) 95% of the Guaranteed Maximum Electricity Demand and (b) the actual average monthly demand for the Project in the Contract Year. The Electricity Savings Element shall not be paid to the Company for electricity consumption or demand savings generated by District actions or initiatives. Extraordinary Items Charge or Credit. The Extraordinary Items component of the Service Fee, which may be a charge or a credit, shall be equal to the sum of: (1) the amounts payable by the District for increased operation, maintenance or other costs incurred on account of the occurrence of an Uncontrollable Circumstance which is chargeable to the District under the Service Contract, net of any operation, maintenance or other cost savings achieved by the Company in mitigating the effects of the occurrence of such an Uncontrollable Circumstance; plus (2) the adjustments to the Service Fee resulting from any Capital Modifications the costs of which are payable by the District, or the benefits of which accrue to the District, under the provisions of the Service Contract; minus (3) any liquidated damages or Service Fee reductions due to Company non-performance specifically provided for under any D-25 other provision hereof; plus or minus (4) any other increase or reduction in the Service Fee provided for under any other Article of the Service Contract. Tax Exemption Of Managed Assets. It is the intent of the parties that the Managed Assets shall continue to be municipally owned property and not subject to real property or possessory interest taxation. If (1) the Company has exercised due diligence and taken all steps necessary to obtain all such tax exemptions on a timely basis, and (2) the Company is nonetheless required to pay any real property or possessory interest tax on account of the Project, the Company shall be entitled to recover the amount paid as a Reimbursable Cost. Sales And Business Taxes. In its performance of the Contract Services, the Company acknowledges that (1) construction materials and supplies initially acquired by the Company or any Subcontractor in connection with the Project Improvements or any Capital Modification, and operating supplies relating to the performance of the Management Services, are subject to State sales tax, and (2) the Company is subject to the City's "business tax". The Company further acknowledges that these taxes have been priced into the Design/Build Price and the Service Fee, and agrees to pay all such taxes without reimbursement from the District. Compliance With Internal Revenue Service Rev. Proc. 97-13. Any provision of the Service Contract to the contrary notwithstanding, the District and the Company agree that the District shall be under no obligation to, and shall not, pay compensation for services to the Company for any Contract Year, to the extent that such payment would result in less than 80% of the Company's compensation for services for such Contract Year being based on a periodic fixed fee or would result in any portion of the Company's compensation being based on net profit, as such terms are defined in Rev. Proc. 97-13. The District and the Company further agree that any such payment or portion thereof that is not made by virtue of the preceding sentence shall be paid to the Company, with interest at the Prime Rate, during the next annual period in wnich such payment will not result in less than 80% of the Company's compensation being based on a periodic fixed fee or in which such payment will be based on net profit, all as defined by Rev. Proc. 97-13. It is the intent of the District and the Company that the Service Contract shall be construed and applied so as to constitute a management contract that does not result in private business use of property financed by the District within the meaning and intent of Rev. Proc. 97-13. BREACH, DEFAULT, REMEDIES AND TERMINATION Remedies For Breach. The parties agree that, except as otherwise provided with respect to termination rights, in the event that either party breaches the Service Contract, the other party may exercise any legal rights it may have under the Service Contract, under the Security Instruments and under Applicable Law to recover damages or to secure specific performance, and that such rights to recover damages and to secure specific performance shall ordinarily constitute adequate remedies for any such breach. Neither party shall have the right to terminate the Service Contract for cause except upon the occurrence of an Event of Default. Notwithstanding any other provision hereof, in the event either party breaches the Service Contract, the other party shall be entitled to all available legal or equitable remedies as provided in and within the meaning of Section 5956.6 of the Government Code. Event of Default by the Company Not Requiring Previous Notice or Cure Opportunity for Termination. In the event the Company fails to achieve Acceptance by the last day of the Extension Period, an Event of Default by the Company shall be deemed to have occurred, on the basis of which the District, by notice to the Company, may terminate the Service Contract without any requirement of having given notice previously or of providing any further or additional cure opportunity. Events of Default by the Company Requiring Previous Notice and Cure Opportunity for Termination. It shall be an Event of Default by the Company upon which the District may terminate the Service Contract, by notice to the Company, if: (i) Any representation or warranty of the Company under the Service Contract or the Guarantor under the Service Contract Guaranty Agreement was false or inaccurate in any material respect when made, and the legality of the Service Contract or the Service Contract Guaranty Agreement or the ability of the Company to carry out its obligations under the Service Contract or the ability of the Guarantor to carry out its obligations thereunder is thereby materially and adversely affected; or D-26 (ii) The Company fails, refuses or otherwise defaults in its duty (a) to pay any amount required to be paid to the District under the Service Contract within 60 days following the due date for such payment, or (b) to perform any material obligation under the Service Contract (unless such default is excused by an Uncontrollable Circumstance or District Fault as and to the extent provided herein); or (iii) The insolvency of the Company or the Guarantor as determined under the Bankruptcy Code; or (iv) The filing by the Company or the Guarantor of a petition of voluntary bankruptcy under the Bankruptcy Code; the consenting of the Company or the Guarantor to the filing of any bankruptcy or reorganization petition against the Company or the Guarantor under the Bankruptcy Code; or the filing by the Company or the Guarantor of a petition to reorganize the Company or the Guarantor pursuant to the Bankruptcy Code; or (v) The issuance of an order of a court of competent jurisdiction appointing a receiver, liquidator, custodian or trustee of the Company or the Guarantor or of a major part of the Company's or the Guarantor's property, respectively, or the filing against the Company or the Guarantor of a petition to reorganize the Company or the Guarantor pursuant to the Bankruptcy Code, which order shall not have been discharged or which filing shall not have been dismissed within 90 days after such issuance or filing, respectively. No such default shall constitute an Event of Default giving the District the right to terminate the Service Contract for cause unless, (1) the District has given prior written notice to the Company stating that in its opinion a specified default in its duty to pay or perform exists which gives the District a right to terminate the Service Contract for cause, and describing the default in reasonable detail; and (2) the Company neither challenged in an appropriate forum the District's conclusion that such a failure or refusal to perform has occurred or constitutes a material breach of the Service Contract, nor initiated within a reasonable time (in any event not more than 30 days from the initial default notice) and continued with due diligence to carry out to completion all actions reasonably necessary to correct the default and prevent its recurrence; except that if the Company shall have initiated within such reasonable time and continued with due diligence to carry out to completion all such actions, the default shall not constitute an Event of Default during such period of time (in any event not more than 120 days from the initial default notice) as the Company shall continue with due diligence to carry out to completion all such actions. The right of termination provided the District upon an Event of Default by the Company is not exclusive. If the Service Contract is terminated by the District for an Event of Default by the Company, the District shall have the right to pursue a cause of action for actual damages and to exercise all other remedies which are available to it under the Service Contract, under the Security Instruments and under Applicable Law. Protection of Trustee. During the Lease Term, the Trustee, as assignee of the rights of the Issuer under the Lease Agreement, shall be entitled to the protections set forth in the Service Contract if the Trustee has (1) provided the District with the Trustee's address for notices under the Service Contract, (2) acknowledged the District's rights with respect to the Company, the Trustee and the Project as provided under the Service Contract, and (3) paid any non-performance liquidated damages to the District which are due and owing by the Company. The Trustee shall be protected as described below, until such time as the Lease Agreement expires or has been terminated: (1) The District shall not consent to any amendment or modification of the Service Contract (including any amendment or modification effectuated through non-binding mediation or arbitration) which materially aid adversely affects the rights and interests of the Trustee without the prior written consent of the Trustee, such written consent to be submitted by the Company. (2) Notwithstanding any Event of Default by the Company under the Service Contract, the District shall have no right to terminate the Service Contract unless prior to such termination (a) the Event of Default shall be continuing, (b) the District shall have given the Trustee written notice of such Event of Default, and (c) the Trustee shall have failed to remedy such Event of Default or to take such other actions as set forth in and within the time specified by the Service Contract. D-27 During the Lease Term, should any Event of Default by the Company under the Service Contract occur, the District shall mail or deliver to the Trustee a duplicate copy of any and all notices in writing that the District may from time to time give to or serve upon the Company pursuant to the provisions of the Service Contract. Any such notice shall set forth the nature of the Event of Default and the actions required to cure such Event of Default. Each such notice shall be mailed or delivered to the Trustee at or as near as possible to the time such notices are given to or served upon the Company by the District if required to be so served or at the earliest opportunity if such notice is not required to be given to the Company. No notice by the District to the Company shall be deemed to be given to the Company unless and until a copy thereof shall have been mailed or delivered to the Trustee. If an Event of Default by the Company occurs which does not require notice or cure opportunity under the Service Contract, the Trustee shall have no right of cure thereafter, the parties agreeing that the 547 day Extension Period following the Scheduled Acceptance Date constitutes a reasonable and sufficient period of cure to remedy any failure to achieve Provisional Acceptance on or before the Scheduled Acceptance Date. Any rights of the Trustee with respect to the Company and its performance during the Construction Period shall be provided for in the Company Financing Support Agreements, the terms and conditions of which shall be consistent with the Service Contract and shall not materially and adversely affect the District's rights under the Service Contract. If a default by the Company occurs under the Service Contract which, with the giving of notice or the passage of time, may lead to an Event of Default by the Company under the Service Contract, and the Company shall have failed to cure such default on or before the expiration of any applicable period of cure provided in the Service Contract, the Trustee shall have 120 days after the later of the expiration of the Company's cure period with respect to such default, or the date of the Trustee's receipt of written notice of the occurrence of an Event of Default from the District, and an additional 230 day period of time after the expiration of such 120 day period within which to remedy such default; provided that the Trustee shall (1) have fully cured any default in the payment of any monetary obligations of the Company under the Service Contract within such 120 day period and shall continue to pay current such monetary obligations as and when they are due, (2) shall have commenced action to cure any nonmonetary default within such 120 day period, and (3) shall thereafter diligently prosecute such action or proceeding to completion by no later than 350 days after the Trustee's receipt of such notice from the District. All rights of the District during the Lease Term to terminate the Service Contract as a result of the occurrence of any Event of Default by the Company shall be subject to and conditioned upon the District having first given to the Trustee written notice of such default and the Trustee having failed to act within the time specified, or such longer time as extended by the Service Contract. During any Trustee cure period described in the Service Contract, the Trustee shall have the right to assign (and the Company in such circumstances agrees to the assignment of) the Company's rights and obligations under the Service Contract to any replacement operator recognized as competent in the water treatment industry and as being technically and financially capable of carrying out both the Company's obligations under the Service Contract and the Guarantor's obligations under the Service Contract Guaranty Agreement for the remaining Term. Any such replacement operator shall be subject to the approval of the District, which approval shall be based on the standards set forth in the preceding sentence and shall not unreasonably be withheld. No such assignment shall take place unless and until the replacement operator has executed and delivered to the District an agreement acknowledging and confirming its assumption of all of the Company's obligations under the Service Contract, together with all authorizing documentation. All of the rights of the District with respect to the Project, the Company and the Trustee set forth in the Service Contract shall be fully preserved with respect to the Project, any replacement operator and the Trustee on any such conveyance, assignment and assumption. If the Service Contract shall have been rejected or disaffirmed by or on behalf of the Company in a proceeding under the Bankruptcy Code or other insolvency law then, unless the Service Contract has theretofore been terminated due to an Event of Default by the Company, on written request of the Trustee made at any time within 60 days after the date on which notice of such rejection or disaffirmance shall have been given, the District shall enter into a new agreement with respect to the Project with a designee of the Trustee meeting the requirements of the Service Contract for a replacement operator. The new agreement shall be effective as of the effective date of such rejection or disaffirmance of the Service Contract, for the Term of the Service Contract remaining as of the effective date of such rejection or disaffirmance, upon the same executory terms, covenants, conditions and agreements as are contained in the Service Contract; provided, however, that the District shall not be so obligated unless (a) such designee shall execute and deliver such new agreement within 20 days after the later of the date on D-28 which the Trustee shall have given the District notice of its election to do so or the date on which the District shall tender such new agreement to such designee for execution, and (b) the Trustee or its designee shall pay to the District at the time of the execution and delivery of such new agreement all expenses, including reasonable attorney's fees, incurred by the District in connection with the termination of the Service Contract and the execution and delivery of such new agreement. The Trustee's cure right period provided under the Service Contract shall continue in effect with respect to such new agreement and the expiration of such cure right period shall be determined by reference to the date on which such cure right period commenced with respect to the Service Contract. Notwithstanding the foregoing, the District shall have no obligation to deliver physical possession of the Project to any such designee until and unless the District shall have obtained physical possession thereof. The rights of the Trustee to cure an Event of Default by the Company and to appoint a replacement operator shall not relieve the Company or any such replacement operator from its continuing obligation to perform the Contract Services. The Trustee's rights shall be subject to the timely payment and performance by the Trustee or another entity as arranged for by the Trustee, on behalf of the Company, of all non performance damages and other obligations which are to be performed or paid by the Company to the District and which remain unperformed or unpaid as of the due date. Bond Insurer Cure Rights. At all times during which a policy of municipal bond insurance is in effect as contemplated by the Service Contract and the Bond Insurer is not in default under such policy, the Bond Insurer, and not the Trustee, shall have the rights and obligations given the Trustee under the Service Contract. Events Of Default By The District. Each of the following shall constitute an Event of Default by the District upon which the Company, by notice to the District, may terminate the Service Contract: (i) Any representation or warranty of the District under the Service Contract was false or inaccurate in any material respect when made, and the legality of the Service Contract or the ability of the District to carry out its obligations under the Service Contract is thereby adversely affected; (ii) The failure, refusal or other default by the District in its duty: (1) to pay the amount required to be paid to the Company under the Service Contract within 60 days following the due date for such payment; or (2) to perform any other material obligation under the Service Contract (unless such default is excused by an Uncontrollable Circumstance or Company Fault); or (iii) The authorized filing by the District of a petition seeking relief under the Bankruptcy Code, as applicable to political subdivisions which are insolvent or unable to meet their obligations as they mature; provided that the appointment of a financial control or oversight board by the State for the District shall not in and of itself constitute an Event of Default. No such default shall constitute an Event of Default giving the Company the right to terminate the Service Contract for cause unless: (i) The Company has given prior written notice to the District stating that a specified default which gives the Company a right to terminate the Service Contract for cause has occurred, and describing the default in reasonable detail; and (ii) The District has neither challenged in an appropriate forum the Company's conclusion that such failure or refusal to perform has occurred or constitutes a material breach of the Service Contract nor corrected or diligently taken steps to correct such default within a reasonable period of time but not more than 30 (thirty) days from the date of the notice (but if the District shall have diligently taken steps to correct such default within a reasonable period of time, the same shall not constitute an Event of Default for as long (but in any event not more than 120 days from the initial default notice) as the District is diligently continuing to take such steps to correct such default). Other Remedies Upon District Event of Default-Prior to Tenth Anniversary of Acceptance Date. The right of termination provided under the Service Contract upon an Event of Default by the District is not exclusive. If the D-29 Service Contract is terminated by the Company for an Event of Default by the District prior to the tenth anniversary of the Acceptance Date, the Company shall have the right to pursue a cause of action for actual damages and to exercise all other remedies which are available to it under the Service Contract and under Applicable Law. Other Remedies Upon District Event of Default - After Tenth Anniversary of Acceptance Date. If the Service Contract is terminated by the Company for cause as a result of an Event of Default by the District after the tenth anniversary of the Acceptance Date, the District shall pay the Company, as liquidated damages upon any such termination, the same amount that would be payable upon a District buy-out during the Operation Period, as set forth in the table below, based on the date the Event of Default by the District occurs, which amount shall be interpolated appropriately if the Event of Default occurs between the two-year anniversary dates set forth in such table. District Termination Right Relating To Certain Principal Agreements. The District shall have the right, at any time on or before December 31, 2002, to terminate the Service Contract upon written notice to the Company in the event that the District determines, in its sole discretion, that it will be unable to achieve (1) modification of the Metropolitan Agreement to the effect described in the Service Contract, or (2) agreement with the San Juan Basin Authority to the effect described in the Service Contract. All obligations of the parties under the Service Contract shall terminate on the effective date of any such termination. If the District exercises its termination right under after October 15, 2002, the District shall pay the Company an amount equal to the sum of (1) the amount of the first installment of the Transaction Cost Reimbursement Payment made by the Company to the District; plus (2) subject to Cost Substantiation, an amount equal to 100% of the reasonable costs incurred directly by the Company and any expenses paid or incurred to third parties from the Contract Date to the Termination Date which are directly related to the performance of the Design/Build Work, not to exceed the Design/Build Price. District Buy-Out Right For Significant Uncontrollable Circumstances During The Construction Period. In the event an Uncontrollable Circumstance causes a total constructive loss of the Project, or in the event an Uncontrollable Circumstance causes an extraordinary increase in District costs relating to the Project, in either case due to events occurring during the Construction Period, the District shall have the right to terminate the Service Contract upon payment to the Company of the Construction Period buy-out fee set forth below. A "total constructive loss" for this purpose shall be deemed to have occurred: (1) if so determined by the property insurance carrier; or (2) if re-construction cannot reasonably be expected to commence within six months following the occurrence of the Uncontrollable Circumstance. "An extraordinary increase" in District costs shall be deemed to have occurred for this purpose if the increase in the Effective Rate for Finished Water in the first full Contract Year which would reasonably be expected to result from an Uncontrollable Circumstance occurring during the Construction Period would cause an increase of more than 20% in the Effective Rate for Finished Water which would reasonably expected to be payable in such first full Contract Year had no such Uncontrollable Circumstance occurred. Promptly following receipt of the District's termination notice, the Company shall prepare and deliver to the District an invoice for the Construction Period buy-out-fee payable, including all required Cost Substantiation. The District shall pay the invoice within 30 days following receipt thereof. The Construction Period buy-out fee shall be an amount equal to the sum of (1) subject to Cost Substantiation, an amount equal to 100% of the reasonable costs incurred directly by the Company and any expenses paid or incurred to third parties from the Contract Date to the Termination Date (including reasonable demobilization costs for work required of the Company upon termination) which are directly related to the performance of the Design/Build Work, not to exceed the Design/Build Price; plus (2), an amount equal to 10% of the amount described in item (1) above (but not less than $250,000 nor more than $2,000,000). The District shall have no obligation to pay the buy-out fee provided for under the Service Contract except concurrently with the surrender of possession and control by the Company of the Project to the District. The Company agrees that the buy-out fee shall fully and adequately compensate the Company and all Subcontractors for all foregone potential profits, Loss-and-Expense, and charges of any kind whatsoever (whether foreseen or unforeseen), including initial transition and mobilization costs and demobilization, and other similar wind-down costs, attributable to the termination of the Company's right to perform the Service Contract. D-30 District Buy-Out Rights During The Operation Period. The District shall have the right, on the tenth, twelfth, fourteenth, sixteenth and eighteenth anniversaries of the Acceptance Date, exercisable in its sole discretion and without cause, to terminate the Service Contract upon 60 days prior written notice to the Company. If the District exercises this right to terminate the Service Contract, the District shall pay the Company a buy-out fee in the amount stated in the table below, which amounts shall not be escalated. Promptly following receipt of the District's termination notice, the Company shall prepare and deliver to the District an invoice for the buy-out-fee payable, including all required Cost Substantiation. The District shall pay the invoice within 30 days following receipt thereof. - -------------------------------------------------------------------------------- Buy-Out-Date Buy-Out Fee - -------------------------------------------------------------------------------- Tenth Anniversary $ 1,000,000 - -------------------------------------------------------------------------------- Twelfth Anniversary 800,000 - -------------------------------------------------------------------------------- Fourteenth Anniversary 600,000 - -------------------------------------------------------------------------------- Sixteenth Anniversary 400,000 - -------------------------------------------------------------------------------- Eighteenth Anniversary 200,000 - -------------------------------------------------------------------------------- If the Company has provided financing for any Capital Modifications, the unamortized value thereof based on the financing methodology approved by the District at the time the financing was effectuated shall also be included in the buy-out fee. Significant Uncontrollable Circumstances Buy-Out Right and Fee. In the event an Uncontrollable Circumstance causes a total constructive loss of the Project, or in the event an Uncontrollable Circumstance causes an extraordinary increase in District costs, relating to the Project, in either case due to events occurring during the Operation Period, the District shall have the right to terminate the Service Contract upon payment to the Company of the buy-out fee set forth below. A "total constructive loss" for this purpose shall be deemed to have occurred: (1) if so determined by the casualty insurance carrier; or (2) if the Project is substantially inoperable for a period of at least six months following the occurrence of the Uncontrollable Circumstance. "An extraordinary increase" in District costs shall be deemed to have occurred for this purpose if the increase in the Effective Rate for Finished Water in the full Contract Year following the Contract Year in which the Uncontrollable Circumstance occurred which would reasonably be expected to result from such occurrence would cause an increase of more than 20% in the Effective Rate for Finished Water which would reasonably be expected to be payable in such following Contract Year had no Uncontrollable Circumstance occurred. Promptly following receipt of the District's termination notice, the Company shall prepare and deliver to the District an invoice for the buy-out-fee payable, including all required Cost Substantiation. The District shall pay the invoice within 30 days following receipt thereof. The buy-out fee payable by the District to the Company upon the occurrence of the Uncontrollable Circumstances described above shall be an amount equal to (1) if termination occurs on or before the tenth anniversary of the Provisional Acceptance Date, $2,000,000 or (2) if termination occurs after the tenth anniversary of the Provisional Acceptance Date, $1,000,000, reduced by 1/120 of such amount for each month which has elapsed following the tenth anniversary of the Provisional Acceptance Date to and including the month in which the Termination Date occurs. Upon any such termination, the Company shall also be paid all amounts due for the Contract Services to be paid as part of the Service Fee but not yet paid as of the date of termination. The District shall have no obligation to pay the applicable termination fee except concurrently with the surrender of possession and control by the Company of the Project to the District. The Company agrees that the applicable buy-out fee shall fully and adequately compensate the Company and all Subcontractors for all foregone potential profits, Loss-and-Expense, and charges of any kind whatsoever D-31 (whether foreseen or unforeseen), including initial transition and mobilization costs and demobilization, employee transition and other similar wind-down costs, attributable to the termination of the Company's right to perform the Service Contract. Except as otherwise provided in the Service Contract with respect to survival of certain provisions upon termination hereof, upon and at all times after any termination of the Service Contract resulting from the District's exercise of its buy-out rights under the Service Contract, the Company shall be fully and forever released and discharged of and from all liability and obligations to the District, the Issuer, the Trustee and the bondholders arising from or related to the Project, the Service Contract, the Bonds and any and all other Transaction Documents. Company Payment of Certain Costs. If termination is pursuant to a Company Event of Default, or upon the expiration of the Service Contract, the Company shall be obligated to pay the costs and expenses of undertaking its obligations upon termination. If the Company fails to comply with any of its obligations upon termination, the District may perform such obligation and the Company shall pay on demand all reasonable costs thereof subject to Cost Substantiation. District Payment of Certain Costs. If termination is for the convenience of the District or due to a District Event of Default, the District shall pay to the Company within 45 days of the date of the Company's invoice supported by Cost Substantiation all reasonable costs and expenses incurred by the Company in satisfying its obligations upon termination. Exit Test. The Company, at the request of the District and after reasonable notice to the Company, shall perform the exit test of the Project for compliance with the Exit Test Procedures and Standards in the first 90 days of the 180-day period preceding the end of the Term hereof. If such test shows that the Project is operating out of compliance with the Exit Test Procedures and Standards, then within 30 days of such test results, the Company shall submit to the District a plan for remediation and retesting. The District shall have 30 days to approve such plan, which approval shall not be unreasonably withheld. The Company shall make all repairs, replacements, renewals and operating changes and take all other actions which may be necessary to enable the Project to meet the Exit Test Procedures and Standards. The Project shall then be re-tested to demonstrate that the necessary corrective action has been taken and the Project is in compliance with the Exit Test Procedures and Standards. No such testing or retesting shall relieve the Company of its obligations under the Service Contract during the performance of the test or retest. Forum For Dispute Resolution. It is the express intention of the parties that all Legal Proceedings related to the Service Contract or to the Project or to any rights or any relationship between the parties arising therefrom shall be solely and exclusively initiated and maintained in courts of the State located in Orange County. The Company and the District each irrevocably consents to the jurisdiction of such courts in any such Legal Proceeding, waives any objection it may have to the laying of the jurisdiction of any such Legal Proceeding, and waives its right to a trial by jury. Non-Binding Mediation. Either party may request Non-Binding Mediation of any dispute arising under the Service Contract, whether technical or otherwise. The non-requesting party may decline the request in its sole discretion. If there is concurrence that any particular matter shall be mediated, the provisions of the Service Contract relating to Non-Binding Mediation shall apply. The costs of such Non-Binding Mediation shall be divided equally between the District and the Company. The Mediator shall be a professional engineer, attorney or other professional mutually acceptable to the parties who has no current or past on-going relationship to either party. The Mediator shall have full discretion as to the conduct of the mediation. Each party shall participate in the Mediator's program to resolve the dispute until and unless the parties reach agreement with respect to the disputed matter or one party determines in its sole discretion that its interests are not being served by the mediation. Mediation is intended to assist the parties in resolving disputes over the correct interpretation of the Service Contract. No Mediator shall be empowered to render a binding decision. None of the provisions summarized in this paragraph shall operate to limit, interfere with or delay the right of either party to commence judicial Legal Proceedings upon a breach of the Service Contract by the other party, whether in lieu of, concurrently with, or at the conclusion of any Non-Binding Mediation. D-32 Arbitration. To the extent that the Non-Binding Mediation fails to resolve any dispute between the parties, and upon mutual agreement of the parties, the District and the Company may agree to binding arbitration of any dispute which arises under the Service Contract. Such arbitration shall be governed and conducted pursuant to the provisions of Section 1281 et seq. of the California Code of Civil Procedure. None of the provisions summarized in this paragraph shall operate to limit, interfere with or delay the right of either party to commence judicial Legal Proceedings upon a breach of the Service Contract by the other party. INSURANCE, UNCONTROLLABLE CIRCUMSTANCES AND INDEMNIFICATION Insurance. At all times during the Term of the Service Contract, the Company shall obtain and maintain the Required Insurance and shall pay all premiums with respect thereto as the same become due and payable. All insurance shall be obtained and maintained from financially sound and generally recognized responsible insurance companies meeting the qualifications of the Service Contract. The insurers shall be selected by the Company and authorized to write such insurance in the State. The insurance coverage may be written with deductible amounts within the limits allowed in the Service Contract, and the Company shall be responsible for any deductible amounts. The Company shall also be responsible for all self insured retentions contained in its insurance coverages, as well as any excluded losses if such losses are within the liability of the Company under the Service Contract. All policies evidencing such insurance shall provide for: (1) payment of the losses to the District, and to the Company as their respective interests may appear; and (2) at least 30 days prior written notice of the cancellation thereof to the Company and the District. All policies of insurance shall be primary insurance without any right of contribution from other insurance carried by the District. If the Company fails to pay any premium for Required Insurance, or if any insurer cancels any Required Insurance policy and the Company fails to obtain replacement coverage so that the Required Insurance is maintained on a continuous basis, then, at the District's election (but without any obligation to do so), the District, following 7 days notice to the Company, may pay such premium or procure similar insurance coverage from another company or companies and upon such payment by the District the amount thereof shall be immediately reimbursable to the District by the Company. The Company shall not perform Design/Build Work during any period when any policy of Required Construction Period Insurance is not in effect. The Company shall comply with all applicable Required Insurance and take all steps necessary to assure the Project remains continuously insured in accordance with the requirements of the Service Contract during the Term. The failure of the Company to obtain and maintain any Required Insurance shall not relieve the Company of its liability for any losses intended to be insured thereby. Should any failure to provide continuous insurance coverage occur, the Company shall indemnify and hold harmless the District from and against any Loss and Expense arising out of such failure. The purchase of insurance to satisfy the Company's obligations shall not be a satisfaction of any Company liability under the Service Contract or in any way limit, modify or satisfy the Company's indemnity obligations under the Service Contract. Uncontrollable Circumstances. Except as expressly provided under the Service Contract, neither party to the Service Contract shall be liable to the other for any loss, damage, delay, default or failure to perform any obligation to the extent it results from an Uncontrollable Circumstance. The parties agree that the relief for an Uncontrollable Circumstance described in the Service Contract shall apply to all obligations in the Service Contract, except to the extent specifically provided otherwise, notwithstanding that such relief is specifically mentioned with respect to certain obligations in the Service Contract but not other obligations. The occurrence of an Uncontrollable Circumstance shall not excuse or delay the performance of a party's obligation to pay monies previously accrued and owing under the Service Contract, or to perform any obligation under the Service Contract not affected by the occurrence of the Uncontrollable Circumstances. The District shall pay the Service Fee during the continuance of any Uncontrollable Circumstance, adjusted to account for any cost reductions achieved through Company mitigation measures required by the Service Contract, as well as for any cost increases to which the Company is entitled under the Service Contract. A Contract Administration Memorandum shall be prepared to confirm and evidence the terms and conditions of the relief given to the Company on account of any Uncontrollable Circumstances. If and to the extent that Uncontrollable Circumstances interfere with, delay or increase the cost of the Company's performance of the Contract Services in accordance herewith, the Company shall be entitled to an increase in the Design/Build Price and the Service Fee, and an extension of the Scheduled Acceptance Date, all as applicable, which properly reflects the interference with performance, the amount of the increased cost, or the time D-33 lost as a result thereof, and the Company shall perform all other Contract Services. The Scheduled Acceptance Date shall be extended only to the extent that the Uncontrollable Circumstance affects the critical path of the Design/Build Work. The proceeds of any Required Insurance available to meet any such increased cost shall be applied to such purpose prior to any determination of cost increase payable by the District with respect to Uncontrollable Circumstance. In particular, the Company shall apply the proceeds of Required Insurance maintained by the Company for builder's risk to the reconstruction of the Project should an insured event under such builder's risk insurance cause property damage prior to Acceptance. To the extent there is any cost reduction achieved through the mitigating measures undertaken by the Company pursuant to the Service Contract upon the occurrence of an Uncontrollable Circumstance, the parties shall agree to the amount of the cost reduction and such cost reduction shall be reflected in a reduction of the amount by which the Design/Build Price or the Service Fee would have otherwise been increased or shall serve to reduce the Design/Build Price or the Service Fee to reflect such mitigation measures, as applicable. In the event that the Company believes it is entitled to any Design/Build Price, Service Fee or schedule relief on account of any Uncontrollable Circumstance, it shall furnish the District written notice of the specific relief requested and detailing the event giving rise to the claim within 30 days after the giving of notice delivered with respect to the occurrence of an Uncontrollable Circumstance, or if the specific relief cannot reasonably be ascertained and such event detailed, within such 30-day period, then within such longer period with which it is reasonably possible to detail the event and ascertain such relief. Within 30 days after receipt of such a timely submission from the Company the District shall issue a written determination as to the extent, if any, it concurs with the Company claim for performance, price or schedule relief, and the reasons therefor. The Company acknowledges that its failure to give timely notice pertaining to an Uncontrollable Circumstance may adversely affect the District. Share of Costs of Uncontrollable Circumstances. The Company shall bear the costs which result from the occurrence of an uninsured Uncontrollable Circumstance (except any Change in Law made by the District) to the extent of the first 5% of the costs necessitated by Uncontrollable Circumstances up to an aggregate of $12,500 per Contract Year, as adjusted annually by the Adjustment Factor, and an aggregate of $250,000 over the Initial Term of the Service Contract, as adjusted annually by the Adjustment Factor. Any costs occurring over future Contract Years as the result of an Uncontrollable Circumstance occurring in a prior Contract Year shall be treated as Uncontrollable Circumstance costs occurring in such future Contract Year. The Company's share of such net costs shall be paid as a lump sum within 60 days of the end of each Contract Year, unless otherwise agreed by the parties. The Company's obligation to bear the expense of any deductibles applicable on claims made with respect to any Required Insurance provided by the Company is an independent obligation, but the amount of any such expense shall be credited against the Company's obligation to share in the costs of Uncontrollable Circumstances if the event to which the Required Insurance responded was an Uncontrollable Circumstance. Either party's acceptance of any performance, price or schedule relief shall be construed as a release of the other party for that portion of the Loss-and-Expense resulting from, or otherwise attributable to, the event giving rise to the relief claimed. Indemnification By The Company. The Company shall indemnify, defend and hold harmless the District, and its elected officials, appointed officers, employees, representatives, agents and contractors (each, a "District Indemnitee") and the Trustee and its officers, employees, representatives, agents and contractors ("Trustee Indemnitee"), from and against (and pay the full amount of) any and all Loss-and-Expense incurred by a District Indemnitee or a Trustee Indemnitee to third parties arising from or in connection with (or alleged to arise from on in connection with): (1) any failure by the Company to perform its obligations under the Service Contract; or (2) the negligence or willful misconduct of the Company or any of its officers, directors, employees, agents, representatives or Subcontractors in connection with the Service Contract. The Company shall also indemnify the District as and to the extent provided elsewhere in the Service Contract. The Company's indemnity obligations under the Service Contract shall not be limited by any coverage exclusions or other provisions in any insurance policy maintained by the Company which is intended to respond to such events. The Company shall not, however, be required to reimburse or indemnify any District Indemnitee or Trustee Indemnitee for any Loss-and-Expense to the extent caused by the negligence or willful misconduct of any District Indemnitee or Trustee Indemnitee to the extent attributable to any Uncontrollable Circumstance. A District Indemnitee or Trustee Indemnitee shall promptly notify the Company of the assertion of any claim against it for which it is entitled to be indemnified under the Service Contract, and the Company shall have the right to assume the defense of the claim in any Legal Proceeding and to approve any settlement of the claim. These indemnification provisions are for the protection of the District D-34 Indemnitee and the Trustee Indemnitee only and shall not establish, of themselves, any liability to third parties. The indemnification provisions of the Service Contract shall survive termination of the Service Contract. Indemnification By The District. The District shall indemnify, defend and hold harmless the Company, and its elected officials, appointed officers, employees, representatives, agents and contractors (each, a "Company Indemnitee"), from and against (and pay the full amount of) any and all Loss-and-Expense incurred by a Company Indemnitee to third parties arising from or in connection with (or alleged to arise from on in connection with): (1) any failure by the District to perform its obligations under the Service Contract; or (2) the negligence or willful misconduct of the District or any of its officers, directors, employees, agents, representatives or subcontractors in connection with the Service Contract. The District shall also indemnify the Company as and to the extent provided elsewhere in the Service Contract. The District's indemnity obligations under the Service Contract shall not be limited by any coverage exclusions or other provisions in any insurance policy maintained by the District which is intended to respond to such events. The District shall not, however, be required to reimburse or indemnify any Company Indemnitee for any Loss-and-Expense to the extent caused by the negligence or willful misconduct of any Company Indemnitee or to the extent attributable to any Uncontrollable Circumstance. A Company Indemnitee shall promptly notify the District of the assertion of any claim against it for which it is entitled to be indemnified under the Service Contract, and the District shall have the right to assume the defense of the claim in any Legal Proceeding and to approve any settlement of the claim. These indemnification provisions are for the protection of the Company Indemnitee only and shall not establish, of themselves, any liability to third parties. The indemnification provisions of the Service Contract shall survive termination of the Service Contract. SECURITY FOR PERFORMANCE Service Contract Guaranty Agreement. The Company shall cause the Service Contract Guaranty Agreement to be provided and maintained by the Guarantor during the Term in the form attached to the Service Contract as a Transaction Form. Construction Performance and Payment Bonds. On or before the Construction Date, and on or before the date of any Capital Modification (in excess of $100,000) undertaken by the Company, the Company shall provide the Construction Performance Bond and the Payment Bond, each in an amount equal to the portion of the Fixed Design/Build Price relating to the construction work (plus a reasonable amount to be determined by the parties for any estimated Fixed Design/Build Price Adjustments), as financial security for the faithful performance and payment of its Construction Period obligations and Capital Modification obligations under the Service Contract. The Construction Performance Bond and the Payment Bond shall be substantially in the form set forth in the Transaction Forms and shall be issued by a surety company: (1) approved by the District having a rating of "A" in the latest revision of the A.M. Best Company's Insurance Report; (2) be listed in the United States Treasury Department's Circular 570, "Companies Holding Certificates of Authority as Acceptable Sureties on Federal Bonds and as Acceptable Reinsurance Companies"; and (3) holding a certificate of authority to transact surety business in the State issued by the Director of the Department of Insurance. The Construction Performance Bond and the Payment Bond shall remain open until Acceptance of the Project. Service Contract Letter Of Credit. On or before the Bond Issuance Date, the Company shall provide further security to the District for the performance of its obligations under the Service Contract to achieve Acceptance through an irrevocable direct pay letter of credit issued by a United States bank whose long-term debt is rated "A" or better by either Rating Service and which maintains a banking office in the State (the "Service Contract Letter of Credit"). The Service Contract Letter of Credit shall be in a stated amount equal to daily accrued debt service on the Bonds for a period of 547 days, shall be for a term of one year, shall be continuously renewed, extended or replaced so that it remains in effect until 30 days after the date that the District states in writing that the District and the Independent Engineer concur with the Company's certification that Acceptance has occurred, and shall be issued substantially in the form set forth in the Transaction Forms. The stated amount of the Service Contract Letter of Credit shall in no way limit the amount of damages to which the District may be entitled for any Company failure to achieve Acceptance. The Company shall have the right to reduce and replace the stated amount of the Service Contract Letter of Credit on the 6 month and 12-month anniversary dates of the Scheduled Acceptance Date by an amount equal to the sum of all daily delay liquidated damage payments, if any, which the Company has previously paid to the District. The Service Contract Letter of Credit shall be surrendered by the City D-35 for cancellation by the Company on the date that the District states in writing that the District and the Independent Engineer concur with the Company's certification that Acceptance has occurred. The Service Contract Letter of Credit shall authorize the District to draw the full stated amount thereof: (1) in the event that any required renewal, extension or replacement thereof is not made earlier than the date which is 30 days prior to its expiration date, or (2) upon certain events of bankruptcy or insolvency of the Company or the Guarantor described in the drawing certificate attached thereto. The proceeds of any such drawings shall be held by the District as cash collateral to secure the performance of the Contract Services and, in the event of a material breach of the Service Contract following any such drawing, may be retained by the District as payment of damages resulting therefrom. The Service Contract Letter of Credit shall also authorize the District to draw an amount representing delay liquidated damages due the District. The cost and expense of obtaining and maintaining the Security Instruments required under the Service Contract as security for the performance of the Company's obligations under the Service Contract shall be borne by the Company without reimbursement from the District. D-36 APPENDIX E FORM OF CONTINUING DISCLOSURE AGREEMENT CONTINUING DISCLOSURE AGREEMENT THIS CONTINUING DISCLOSURE AGREEMENT (this "Disclosure Agreement"), dated as of January ___, 2003, is by and between BNY WESTERN TRUST COMPANY, a state banking company duly organized and validly existing under the laws of the State of California, as Trustee (the "Trustee"), and the CAPISTRANO VALLEY WATER DISTRICT, a county water district organized and existing under and by virtue of the laws of the State of California (the "Water District"). W I T N E S S E T H : WHEREAS, the Water District has caused to be executed and delivered San Juan Basin Authority Lease Revenue Bonds (Ground Water Recovery Project) Issue of 2002 (the "Bonds"), evidencing principal in the aggregate amount of $31,555,000, pursuant to a Trust Agreement, dated as of the date hereof (the "Trust Agreement"), by and among the Trustee, the San Juan Basin Authority and the Water District; and WHEREAS, this Disclosure Agreement is being executed and delivered by the Water District and the Trustee for the benefit of the holders and beneficial owners of the Bonds and in order to assist the underwriters of the Bonds in complying with S.E.C. Rule 15c2-12(b)(5); NOW, THEREFORE, for and in consideration of the mutual promises and covenants herein contained, the parties hereto agree as follows: Section 1. Definitions. In addition to the definitions set forth in the Trust Agreement, which apply to any capitalized term used in this Disclosure Agreement unless otherwise defined in this Section, the following capitalized terms shall have the following meanings: "Annual Report" means any Annual Report provided by the Water District pursuant to, and as described in, Sections 2 and 3 hereof. "Disclosure Representative" means the General Manager of the Water District and the Administrative Services Director of the Water District, or such other officer or employee of the Water District as the Water District shall designate in writing to the Trustee from time to time. "Dissemination Agent" means the Trustee, acting in its capacity as Dissemination Agent hereunder, or any successor Dissemination Agent designated in writing by the Water District and which has filed with the Trustee a written acceptance of such designation. "Listed Events" means any of the events listed in subsection (a) of Section 4 hereof. "National Repository" means any Nationally Recognized Municipal Securities Information Repository for purposes of the Rule. "Official Statement" means the Official Statement, dated December 11, 2002, relating to the Bonds. "Participating Underwriter" means any of the original underwriters of the Bonds required to comply with the Rule in connection with the offering of the Bonds. "Repository" means each National Repository and each State Repository. E-l "Rule" means Rule 15c2-12(b)(5) adopted by the Securities and Exchange Commission under the Securities Exchange Act of 1934, as the same may be amended from time to time. "State Repository" means any public or private repository or entity designated by the State of California as a state repository for the purpose of the Rule and recognized by the Securities and Exchange Commission. As of the date of this Disclosure Agreement, there is no State Repository. Section 2. Provision of Annual Reports, (a) The Water District shall, or shall cause the Dissemination Agent to, not later than the date that is nine months after the end of the Water District's fiscal year (which date currently would be April 1), commencing with the report for the 2001-02 Fiscal Year, provide to each Repository an Annual Report which is consistent with the requirements of Section 3 hereof. The Annual Report may be submitted as a single document or as separate documents comprising a package, and may include by reference other information as provided in Section 3 hereof; provided that the audited financial statements of the Water District may be submitted separately from the balance of the Annual Report, and later than the date required above for the filing of the Annual Report if not available by that date. If the Water District's fiscal year changes, it shall give notice of such change in the same manner as for a Listed Event under subsection (f) of Section 4 hereof. (b) Not later than 15 business days prior to the date specified in subsection (a) of this Section for the providing of the Annual Report to the Repositories, the Water District shall provide the Annual Report to the Dissemination Agent and the Trustee (if the Trustee is not the Dissemination Agent). If by such date, the Trustee has not received a copy of the Annual Report, the Trustee shall contact the Water District and the Dissemination Agent to determine if the Water District is in compliance with the first sentence of this subsection (b). (c) If the Trustee is unable to confirm that an Annual Report has been provided to Repositories by the date required in subsection (a) of this Section, the Trustee shall send a notice to the Municipal Securities Rulemaking Board and each State Repository, if any, in substantially the form attached as Exhibit A. (d) The Dissemination Agent shall: (i) determine each year prior to the date for providing the Annual Report the name and address of each National Repository and each State Repository, if any; and (ii) file a report with the Water District and (if the Dissemination Agent is not the Trustee) the Trustee certifying that the Annual Report has been provided pursuant to this Disclosure Agreement, stating the date it was provided and listing all the Repositories to which it was provided. Section 3. Content of Annual Reports. The Water District's Annual Report shall contain or incorporate by reference the following: (a) Audited financial statements prepared in accordance with generally accepted accounting principles as promulgated to apply to governmental entities from time to time by the Governmental Accounting Standards Board. If the Water District's audited financial statements are not available by the time the Annual Report is required to be filed pursuant to subsection (a) of Section 2 hereof, the Annual Report shall contain unaudited financial statements in a format similar to the financial statements contained in the Official Statement, and the audited financial statements shall be filed in the same manner as the Annual Report when they become available. E-2 (b) The following information with respect to the Bonds: (i) The Outstanding principal of the Bonds as of the January 1 next preceding the date of such Annual Report and the principal amount of any Parity Obligations outstanding as of the January 1 next preceding the date of such Annual Report. (ii) The balance in the Reserve Fund, and a statement of the Reserve Requirement, as of the January 1 next preceding the date of such Annual Report. (iii) The outstanding principal evidenced by the San Juan Capistrano Public Financing Authority Revenue Certificates of Participation, Series 2002, preceding the date of such Annual Report and the principal amount of any obligations on a parity to such certificates of participation outstanding as of the January 1 next preceding the date of such Annual Report. (c) A summary report showing in reasonable detail Revenues, Maintenance and Operation Costs, Net Revenues and Debt Service for the Fiscal Year ended the immediately preceding June 30, which report shall be substantially in the form of Table 9 in the Official Statement. (d) An update of the information contained in Tables 1, 2, 3, 4, 5, 6, and 7 in the Official Statement for the Fiscal Year ended the immediately preceding June 30. (e) Prior to Acceptance (as defined in the Service Contract), an update of the completion of the milestones set forth in Appendix 21 of the Service Contract for the Design, Construction, Financing and Operation of the San Juan Basin Desalter Project, dated September 3,2002 (the "Service Contract"), between the Water District and Eco Resources, Inc. (f) In addition to any of the information expressly required to be provided under subsections (a), (b), (c), (d) and (e) of this Section, the Water District shall provide such further information, if any, as may be necessary to make the specifically required statements, in the light of the circumstances under which they are made, not misleading. Any or all of the items listed above may be included by specific reference to other documents, including official statements of debt issues of the Water District or related public entities, which have been submitted to each of the Repositories or the Securities and Exchange Commission. If the document included by reference is a final official statement, it must be available from the Municipal Securities Rulemakmg Board. The Water District shall clearly identify each such other document so included by reference. Section 4. Reporting of Significant Events, (a) Pursuant to the provisions of this Section, the Water District shall give, or cause to be given, notice of the occurrence of any of the following events with respect to the Bonds, if material: (1) Principal and interest payment delinquencies. (2) Non-payment related defaults. (3) Unscheduled draws on debt service reserves reflecting financial difficulties. (4) Unscheduled draws on credit enhancements reflecting financial difficulties. (5) Substitution of credit or liquidity providers, or their failure to perform. E-3 (6) Adverse tax opinions or events affecting the tax-exempt status of the security. (7) Modifications to rights of security holders. (8) Contingent or unscheduled Bond calls. (9) Defeasances. (10) Release, substitution, or sale of property securing repayment of the securities. (11) Rating changes. (b) The Trustee shall, within one business day of obtaining actual knowledge of the occurrence of any of the Listed Events, contact the Disclosure Representative, inform such person of the event, and request that the Water District promptly notify the Trustee in writing whether or not to report the event pursuant to subsection (f) of this Section. (c) Whenever the Water District obtains knowledge of the occurrence of a Listed Event, whether because of a notice from the Trustee pursuant to subsection (b) of this Section or otherwise, the Water District shall as soon as possible determine if such event would be material under applicable Federal securities law. (d) If the Water District has determined that knowledge of the occurrence of a Listed Event would be material under applicable Federal securities law, the Water District shall promptly notify the Trustee in writing. Such notice shall instruct the Trustee to report the occurrence pursuant to subsection (f) of this Section. (e) If in response to a request under subsection (b) of this Section, the Water District determines that the Listed Event would not be material under applicable Federal securities law, the Water District shall so notify the Trustee in writing and instruct the Trustee not to report the occurrence pursuant to subsection (f) of this Section. (f) If the Trustee has been instructed by the Water District to report the occurrence of a Listed Event, the Trustee shall file a notice of such occurrence with the Municipal Securities Rulemaking Board and each State Repository. Notwithstanding the foregoing, notice of Listed Events described in paragraphs (8) and (9) of subsection (a) of this Section need not be given under this subsection any earlier than the notice (if any) of the underlying event is given to holders of affected Bonds pursuant to the Trust Agreement. Section 5. Termination of Reporting Obligation. The Water District's obligations under this Disclosure Agreement shall terminate upon the legal defeasance, prior redemption or payment in full of all of the Bonds. If such termination occurs prior to the final maturity of the Bonds, the Water District shall give notice of such termination in the same manner as for a Listed Event under subsection (f) of Section 4 hereof. Section 6. Dissemination Agent. The Water District may, from time to time, appoint or engage a Dissemination Agent to assist it in carrying out its obligations under this Disclosure Agreement, and may discharge any such Dissemination Agent, with or without appointing a successor Dissemination Agent. If at any time there is not any other designated Dissemination Agent, the Trustee shall be the Dissemination Agent; provided it shall receive written notice of such designation at the time of such designation. Section 7. Amendment; Waiver. Notwithstanding any other provision of this Disclosure Agreement, the Water District and the Trustee may amend this Disclosure Agreement (and the Trustee E-4 shall agree to any amendment so requested by the Water District), and any provision of this Disclosure Agreement may be waived, provided that the following conditions are satisfied: (a) if the amendment or waiver relates to the provisions of subsection (a) of Section 2 hereof, Section 3 hereof or subsection (a) of Section 4 hereof, it may only be made in connection with a change in circumstances that arises from a change in legal requirements, change in law, or change in the identity, nature or status of an obligated person with respect to the Bonds, or type of business conducted; (b) the undertakings herein, as proposed to be amended or waived, would, in the opinion of nationally recognized bond counsel, have complied with the requirements of the Rule at the time of the primary offering of the Bonds, after taking into account any amendments or interpretations of the Rule, as well as any change in circumstances; and (c) the proposed amendment or waiver (i) is approved by holders of the Bonds in the manner provided in the Trust Agreement for amendments to the Trust Agreement with the consent of holders, or (ii) does not, in the opinion of the Trustee or nationally recognized bond counsel, materially impair the interests of holders. If the annual financial information or operating data to be provided in the Annual Report is amended pursuant to the provisions hereof, the annual financial information containing the amended operating data or financial information shall explain, in narrative form, the reasons for the amendment and the impact of the change in the type of operating data or financial information being provided. If an amendment is made to the undertaking specifying the accounting principles to be followed in preparing financial statements, the annual financial information for the year in which the change is made shall present a comparison between the financial statements or information prepared on the basis of the new accounting principles and those prepared on the basis of the former accounting principles. The comparison shall include a qualitative discussion of the differences in the accounting principles and the impact of the change in the accounting principles on the presentation of the financial information, in order to provide information to investors to enable them to evaluate the ability of the Water District to meet its obligations. To the extent reasonably feasible, the comparison shall be quantitative. A notice of the change in the accounting principles shall be sent to the Repositories. Section 8. Additional Information. Nothing in this Disclosure Agreement shall be deemed to prevent the Water District from disseminating any other information, using the means of dissemination set forth in this Disclosure Agreement or any other means of communication, or including any other information in any Annual Report or notice of occurrence of a Listed Event, in addition to that which is required by this Disclosure Agreement. If the Water District chooses to include any information in any Annual Report or notice of occurrence of a Listed Event in addition to that which is specifically required by this Disclosure Agreement, the Water District shall have no obligation under this Disclosure Agreement to update such information or include it in any future Annual Report or notice of occurrence of a Listed Event. Section 9. Default. In the event of a failure of the Water District, the Trustee or the Dissemination Agent to comply with any provision of this Disclosure Agreement, the Trustee may (and, at the written direction of any Participating Underwriter or the holders of at least 25% of the aggregate amount of Outstanding principal of Bonds, shall), or any holder or beneficial owner of the Bonds may, take such actions as may be necessary and appropriate, including seeking mandate or specific performance by court order, to cause the Water District, Trustee or the Dissemination Agent, as the case may be, to comply with its obligations under this Disclosure Agreement. A default under this Disclosure Agreement shall not be deemed an Event of Default under the Trust Agreement, and the sole remedy under this Disclosure Agreement in the event of any failure of the Water District, the Trustee or the E-5 Dissemination Agent to comply with this Disclosure Agreement shall be an action to compel performance. Section 10. Duties, Immunities and Liabilities of Trustee and Dissemination Agent. Article VIII of the Trust Agreement is hereby made applicable to this Disclosure Agreement as if this Disclosure Agreement were (solely for this purpose) contained in the Trust Agreement. Neither the Trustee nor the Dissemination Agent shall be responsible for the form or content of any Annual Report or notice of Listed Event. The Dissemination Agent shall receive reasonable compensation for its services provided under this Disclosure Agreement. The Dissemination Agent (if other than the Trustee or the Trustee in its capacity as Dissemination Agent) shall have only such duties as are specifically set forth in this Disclosure Agreement, and the Water District agrees to indemnify and save the Dissemination Agent, its officers, directors, employees and agents, harmless against any loss, expense and liabilities which it may incur arising out of or in the exercise or performance of its powers and duties hereunder, including the costs and expenses (including attorneys fees) of defending against any claim of liability, but excluding liabilities due to the Dissemination Agent's negligence or willful misconduct. The obligations of the Water District under this Section shall survive resignation or removal of the Dissemination Agent and payment of the Bonds. SECTION 11. BENEFICIARIES. This Disclosure Agreement shall inure solely to the benefit of the Water District, the Trustee, the Dissemination Agent, the Participating Underwriter and holders and beneficial owners from time to time of the Bonds, and shall create no rights in any other person or entity. SECTION 12. COUNTERPARTS. This Disclosure Agreement may be executed in several counterparts, each of which shall be an original and all of which shall constitute but one and the same Instrument. IN WITNESS WHEREOF, the parties hereto have executed this Disclosure Agreement as of the date first above written. CAPISTRANO VALLEY WATER DISTRICT By: ------------------------------ BNY WESTERN TRUST COMPANY, AS TRUSTEE By: ------------------------------ Authorized Signatory E-6 EXHIBIT A NOTICE TO MUNICIPAL SECURITIES RULEMAKING BOARD OF FAILURE TO FILE ANNUAL REPORT Name of Issuer: Capistrano Valley Water District Name of Issue: San Juan Basin Authority Lease Revenue Bonds (Ground Water Recovery Project) Issue of 2002 Date of Issuance: January _, 2003 NOTICE IS HEREBY GIVEN that the Capistrano Valley Water District (the "Water District") has not provided an Annual Report with respect to the above-named Bonds as required by Section 6.09 of the Trust Agreement, dated as of December 1, 2002, by and among BNY Western Trust Company, as Trustee, the San Juan Basin Authority and the Water District. [The Water District anticipates that the Annual Report will be filed by___________________.] Dated: ---------------- BNY Western Trust Company, as Trustee, on behalf of the Capistrano Valley Water District cc: Capistrano Valley Water District E-7 (This Page Intentionally Left Blank) APPENDIX F PROPOSED FORM OF BOND COUNSEL OPINION [Closing Date] San Juan Basin Authority San Juan Capistrano, California Re: $31,555,000 San Juan Basin Authority Lease Revenue Bonds (Ground Water Recovery Project) Issue of 2002 Members of the Authority: We have acted as bond counsel to the San Juan Basin Authority (the "Authority") in connection with the issuance by the Authority of $31,555,000 San Juan Basin Authority Lease Revenue Bonds (Ground Water Recovery Project) Issue of 2002 (the "Bonds"), pursuant to the provisions of Article 4 (commencing with Section 6584) of Chapter 5 of Division 7 of Title 1 of the California Government Code (the "Bond Law"), and pursuant to a Trust Agreement dated as of December 1, 2002 (the "Trust Agreement"), by and among the Authority, the Capistrano Valley Water District (the "Water District") and BNY Western Trust Company, as Trustee. The Bonds will be principally secured by lease payments to be made by the Water District pursuant to a Lease Agreement dated as of December 1, 2002 (the "Lease"), by and between the Authority and the Water District. We have examined the law and such certified proceedings and other documents as we deem necessary to render this opinion. This opinion is based on current statutory and constitutional law and published court decisions as of the date hereof. Capitalized terms used herein and not otherwise defined shall have the meaning ascribed thereto in the Trust Agreement. As to questions of fact material to our opinion, we have relied upon representations of the Authority contained in the Trust Agreement and in the certified proceedings and certifications of public officials and others furnished to us, without undertaking to verify the same by independent investigation. Based upon the foregoing we are of the opinion, under existing law, as follows: 1. The Authority is a joint exercise of powers authority duly organized and validly existing under the laws of the State of California with the full power to enter into the Trust Agreement and the Lease, to perform the agreements on its part contained therein and to issue the Bonds. 2. The Trust Agreement, the Lease and the Property Lease have each been duly approved by the Authority and constitute the valid and binding obligations of the Authority enforceable against the Authority in accordance with their respective terms. The Trust Agreement F-l San Juan Basin Authority [Closing Date] Page Two creates a valid express and irrevocable trust of the Trust Estate, subject to the provisions of the Trust Agreement permitting the application thereof for the purposes and subject to the terms and conditions set forth in the Trust Agreement. 3. The Bonds have been duly authorized and issued by the Authority and are valid and binding special obligations of the Authority, payable solely from the Trust Estate. 4. The Lease has been duly approved by the Water District, constitutes the valid and binding obligation of the Water District enforceable against the Water District in accordance with its terms and creates a valid pledge of Revenues pursuant to the terms thereof. Except for the pledge of Revenues to the payment of Lease Payments pursuant to the terms of the Lease, neither the faith and credit nor the taxing power of the Water District, the City of San Juan Capistrano, the State of California or any political subdivision thereof is pledged to the payment of Lease Payments. 5. Under existing statutes, regulations, rulings and judicial decisions, interest on the Bonds is excluded from gross income for federal income tax purposes and is not an item of tax preference for purposes of calculating the federal alternative minimum tax imposed on individuals and corporations; however, it should be noted that, with respect to corporations, such interest may be included as an adjustment in the calculation of alternative minimum taxable income, which may affect the alternative minimum tax liability of corporations. 6. Interest on the Bonds is exempt from State of California personal income tax. 7. The difference between the issue price of a Bond (the first price at which a substantial amount of the Bonds of a maturity is to be sold to the public) and the stated redemption price at maturity with respect to such Bonds constitutes original issue discount. Original issue discount accrues under a constant yield method, and original issue discount will accrue to a Bondowner before receipt of cash attributable to such excludable income. The amount of original issue discount deemed received by a Bondowner will increase the Bondowner's basis in the applicable Bond. Original issue discount that accrues to the Bondowner is excluded from the gross income of such owner for federal income tax purposes, is not an item of tax preference for purposes of the federal alternative minimum tax imposed on individuals and corporations, and is exempt from State of California personal income tax. 8. The amount by which a Bondowner's original basis for determining loss on sale or exchange in the applicable Bond (generally, the purchase price) exceeds the amount payable on maturity (or on an earlier call date) constitutes amortizable Bond premium, which must be amortized under Section 171 of the Code; such amortizable Bond premium reduces the Bondowner's basis in the applicable Bond (and the amount of tax-exempt interest received), and is not deductible for federal income tax purposes. The basis reduction as a result of the amortization of Bond premium may result in a Bondowner realizing a taxable gain when a Bond is sold by the owner for an amount equal to or less (under certain circumstances) than the original cost of the Bond to the owner. Purchasers of the Bonds should consult their own tax advisors as to the treatment, computation and collateral consequences of amortizable Bond premium. F-2 San Juan Basin Authority [Closing Date] Page Three The opinions expressed herein may be affected by actions taken (or not taken) or events occurring (or not occurring) after the date hereof. We have not undertaken to determine, or to inform any person, whether any such actions or events are taken or do occur. In rendering this opinion, we have relied upon certain representations of fact and certifications made by the Authority, the Water District, the initial purchaser of the Bonds and others. We have not undertaken to verify through independent investigation the accuracy of the representations and certifications relied upon by us. The Trust Agreement, the Lease and the Tax Certificate relating to the Bonds permit certain actions to be taken or to be omitted if a favorable opinion of Bond Counsel is provided with respect thereto. No opinion is expressed herein as to the exclusion from gross income of interest (and original issue discount) for federal income tax purposes with respect to any Bond if any such action is taken or omitted based upon the advice of counsel other than ourselves. Other than as expressly stated herein, we express no opinion regarding tax consequences with respect to the Bonds. The opinions expressed herein as to the exclusion from gross income of interest (and original issue discount) on the Bonds are based upon certain representations of fact and certifications made by the Authority, the Water District and others and are subject to the condition that the Authority and the Water District comply with all requirements of the Internal Revenue Code of 1986, as amended (the "Code"), that must be satisfied subsequent to the issuance of the Bonds to assure that such interest (and original issue discount) will not become includable in gross income for federal income tax purposes. Failure to comply with such requirements of the Code might cause interest (and original issue discount) on the Bonds to be included in gross income for federal income tax purposes retroactive to the date of issuance of the Bonds. The Authority and the Water District have covenanted to comply with all such requirements. With respect to the opinions expressed herein, the rights and obligations under the Trust Agreement, the Lease and the Bonds are subject to bankruptcy, insolvency, fraudulent conveyance or transfer, moratorium and other laws affecting the enforcement of creditors' rights, to the application of equitable principles if equitable remedies are sought, to the exercise of judicial discretion in appropriate cases and to the limitations on legal remedies against public agencies in the State of California. We have not made or undertaken to make an investigation of the state of title to any of the real property described in the Lease or of the accuracy or sufficiency of the description of such property contained therein, and we express no opinion with respect to such matters. We express no opinion herein as to the accuracy, completeness or sufficiency of the Official Statement relating to the Bonds or other offering material relating to the Bonds, and purchasers of the Bonds should not assume that we have reviewed the Official Statement. Respectfully submitted, F-3 (This Page Intentionally Left Blank) APPENDIX G INDEPENDENT ENGINEER'S REPORT (This Page Intentionally Left Blank) Updated Independent Engineer's Report CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT DECEMBER 6, 2002 Prepared by: PSOMAS 3187 Red Hill Avenue, Suite 250 Costa Mesa, CA 92626 (714) 751-7373 [SEAL] /s/Michael D. Swan --------------------------- Michael D. Swan P.E. 25737 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page intentionally left blank PSOMAS 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT TABLE OF CONTENTS I. PROJECT PARTICIPANTS................................................... 1 1.1 Introduction..................................................... 1 1.2 Capistrano Valley Water District................................. 3 1.3 Independent Engineer............................................. 3 1.4 Design-Build, and Operate Team................................... 4 1.4.1 Southwest Water Company.................................... 4 1.4.2 ECO Resources, Inc......................................... 5 1.4.3 Boyle Engineering ......................................... 6 1.4.4 Osmonics .................................................. 6 1.4.5 ARB, Inc .................................................. 7 II. PROCESS TECHNOLOGY..................................................... 11 2.1 Process.......................................................... 11 2.1.1 Pre-treatment ............................................. 11 2.1.2 Desalting.................................................. 12 2.1.3 Post-treatment ............................................ 12 Figure 2.1 Process Legend and Block Flow Diagram......... ....... 14 III. PROJECT SITE........................................................... 15 3.1 Site Description................................................. 15 3.2 Offsite Facilities............................................... 15 3.3 Site Conditions.................................................. 16 3.3.1 RO Facility ............................................... 16 3.3.2 Well Sites, Pump Station and Pipelines..................... 17 3.3.3 Groundwater Basins......................................... 18 3.3.4 California Environmental Quality Act Mitigation............ 19 Figure 3.1 WTP Site Layout....................................... 21 Figure 3.2 Well Collection System Schematic Alignment............ 23 Figure 3.3 Treated Water and RO Disposal Pipelines............... 27 PSOMAS 12/6/2002 2SOU170100 i INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT TABLE OF CONTENTS (CONTINUED) IV. ENGINEERING, PROCUREMENT AND CONSTRUCTION...............................29 4.1 Conceptual Design Parameters......................................29 4.2 Engineering Design................................................30 4.3 Major Equipment-Well Sites........................................31 4.4 Major Equipment-Pre-treatment.....................................32 4.5 Major Equipment-Reverse Osmosis...................................32 4.6 Major Equipment-Post-treatment....................................33 4.7 Contractor's Scope of Work........................................33 4.8 Acceptance Test/Provisional Acceptance............................35 V. OPERATION AND MAINTENANCE...............................................37 5.1 Proposed Operation of the Facility................................37 5.2 Maintenance Management............................................38 VI. ENVIRONMENTAL AND REGULATORY REQUIREMENTS...............................41 6.1 Major Permitting and Regulatory Requirements......................41 6.1.1 Construction Permit.........................................41 6.1.2 Operation Permit ...........................................41 6.2 Safety Plan.......................................................42 6.3 Security Plan.....................................................43 VII. RELEVANT PROJECT CONTRACTS/AGREEMENTS...................................45 7.1 Project Implementation Agreement..................................45 7.2 Metropolitan Water District of Southern California Project Agreement.................................................45 7.3 Service Contract................................. ................47 7.3.1 Construction ...............................................47 7.3.2 Acceptance Testing and Requirements.........................47 7.3.3 MWD Agreement ..............................................50 7.3.4 Operation ..................................................50 7.3.5 Performance Guarantees......................................50 PSOMAS 12/6/2002 2SOU170100 ii INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT TABLE OF CONTENTS (CONTINUED) 7.3.6 District's Remedies for Non-compliance with Performance Guarantees..................................................52 7.3.7 Releases, Leaks and Spills..................................52 7.4 Service Contract Guaranty Agreement...............................52 7.5 Property Lease....................................................53 7.6 Lease Agreement...................................................53 7.7 Trust Agreement...................................................54 7.8 Osmonics Contract.................................................55 7.9 Agreement for Construction - ARB,Inc..............................55 VIII. PROJECT SCHEDULE AND COSTS..............................................57 8.1 Engineering, Procurement, Construction Schedule and Costs.........57 8.1.1 Construction Schedule.......................................57 8.1.2 Construction Costs..........................................58 8.2 Operations and Maintenance Costs..................................59 8.2.1 Base Operating Charge.......................................60 8.2.2 Extraordinary Items Charge or Credit........................60 8.2.3 Adjustment Factor ..........................................60 8.3 Project Cost Projections..........................................61 8.4 Project Cost Projection Schedule..................................62 IX. ASSUMPTIONS AND CONSIDERATIONS USED.....................................67 9.1 Assumptions.......................................................67 X. CONCLUSIONS.............................................................69 10.1 Conclusions.......................................................69 PSOMAS 12/6/2002 2SOU170100 iii INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page intentionally left blank PSOMAS 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT I. PROJECT PARTICIPANTS 1.1 INTRODUCTION The Capistrano Valley Water District (District) selected ECO Resources, Inc. (ECO) to assemble and lead a multi-disciplined team to design, construct, and operate a brackish groundwater treatment facility, raw water supply well sites (well sites), and raw water supply and concentrate discharge pipelines (pipelines), (collectively known as the Project) for the construction and twenty-year Operation Period of the Service Contract, which includes options to extend. The Project will be funded by tax-exempt governmental purpose bonds (Bonds) with a thirty-two year final maturity. Once constructed, the Project will supply nearly one-half of the District's annual water supply requirements and assist the District in meeting its goal of securing fifty-percent of its annual supply from local groundwater sources. The Service Contract provides for ECO to design, construct, and operate a 5.14-million gallon per day (MGD) brackish groundwater treatment facility utilizing the reverse osmosis (RO) process, related well sites and pipelines in the City of San Juan Capistrano, California (City) for the District. The total Project includes wells, distribution pipelines from the wells to the RO Facility, a pump station and pipeline to convey the treated water to the District's water collection system, facilities to convey the process concentrate to the South East Regional Reclamation Authority (SERRA) Ocean Outfall, and construction of the Strawberry Hill Booster Pumping Station to connect the District's 350 water distribution pressure zone with the 425 pressure zone. As further described in Section IV of this Report, the RO Facility includes: the de-sanding equipment, iron and manganese filters, RO units, backwash tanks and equipment, degasifiers and related piping, equipment, pumps and buildings. Pursuant to the terms and conditions contained in the Insurance and Indemnity Agreement, ECO will agree that within six months after the date the Bonds are issued, ECO will, for the benefit of the Bond Insurer, assign all of its rights in and to, and delegate all of its obligations under, the Service Contract and the Insurance and Indemnity Agreement to a wholly owned subsidiary of ECO that satisfies certain corporate separation requirements set forth in the Insurance and Indemnity Agreement (Special Purpose Entity or SPE) and shall cause the SPE to assume all of the obligations of ECO under the Service Contract and Insurance and Indemnity Agreement. Upon such assignment, ECO will be released from all of its obligations under the Service Contract and the Insurance and Indemnity Agreement, and the Insurance and Indemnity Agreement Guaranty will extend to such obligations of the SPE following such assignment. In the Insurance and Indemnity Agreement, the Bond Insurer and the District consent to such assignment. ECO will simultaneously enter into a management and administrative services agreement (A&A Agreement) with the SPE for a term equal to the term of the Service Contract, whereby ECO will provide management and administrative services necessary to support the SPE's performance of its obligations under the Service Contract, including the construction and operation of the Service Contract Project Improvements. Accordingly, as used in this Report, the term PSOMAS Page 1 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT "DB/Operator" shall mean ECO before such assignment and shall mean the SPE thereafter. The DB/Operator is required to furnish up to 5,231 acre-feet of treated water to the District on an annual basis. The fixed annual fee (Service Fee) however, is based upon a projected demand of 4,800 acre-feet per year (AFY). The District will have no obligation to demand water from the DB/Operator but will be required to pay the Service Fee and Lease Payments regardless of the amount of water demanded. If the District demands treated water in excess of 4,800 AFY, the DB/Operator will be paid on a unit basis for each acre-foot of water demanded above 4,800 AFY. The Metropolitan Water District of Southern California (MWD), which supplies the remainder of the District's requirements, entered into an agreement in December 1998 with the Municipal Water District of Orange County (MWDOC) and the San Juan Basin Authority (Authority) under MWD's Groundwater Recovery Program (GRP). The GRP, as an incentive to develop alternative water sources for the Southern California area, will provide a subsidy in the amount up to $250 per AFY for alternative sources of domestic potable water./1/ There is an Implementation Agreement, approved October 15, 2002, between the Authority and the District to delegate and assign the obligation to develop the proposed San Juan Basin Desalter Project (Project) and subsequent ownership of the Project to the Authority, subject to an operating lease with the District. The Implementation Agreement establishes that the District is allocated the right to extract approximately 5,800 AFY of groundwater to be used in the production of 4,800 AFY of Finished Water. Under the Implementation Agreement, the right to the MWD GRP annual subsidy of up to $250 per acre-foot of treated potable groundwater produced is irrevocably committed to the Project, if specific performance requirements relating to the construction start date and the production of Finished Water are obtained. Refer to Section VII of this Report for further discussion of the MWD performance requirements. The District's Domestic Water Master Plan (Domestic Master Plan), dated May 1999 provides for the local distribution of potable water. The primary function of the Domestic Master Plan is to identify the facilities that will provide adequate supply, storage, fire flow and increase system reliability, and a key component of the Domestic Master Plan is the Project. Once constructed and fully operational, it is anticipated that the Project will supply a minimum of 4,800 AFY, which is approximately one-half of the District's annual water supply requirement from local groundwater sources. This will reduce the need to rely on additional imported water capacity and avoid the cost associated with the imported water. Additionally, the development of local groundwater sources in connection with the operation of the Project will eliminate the need for additional operational and emergency storage. The additional storage requirement is estimated, by the District, at 41-million gallons (MG). The District estimates the present value savings at $21-million with the implementation of this Project. /1/ Capistrano Valley Water District, as a member of the San Juan Basin Authority, will be implementing the Agreement. PSOMAS Page 2 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT The capitalized undefined terms used herein have the same meaning as set forth in the Service Contract, the Lease Agreement, and the Trust Agreement, which terms are summarized in the Official Statement relating to the Bonds. 1.2 CAPISTRANO VALLEY WATER DISTRICT The District was formed in 1930 and was under the control of the Orange County Board of Supervisors until 1970, at which time it became a subsidiary district of the City. In 1997, an Operations and Maintenance Agreement was approved whereby the District is operated by the City's Public Works Department. The District services an area of approximately 18 square miles, mostly within the incorporated boundaries of San Juan Capistrano, which primarily consists of residential and open space land use. Strip commercial developments make up approximately three percent of the total service area. The service area population is projected to increase from approximately 35,500 at present to 41,725 by 2020. Elevations within the District vary from 15 feet to 880 feet above mean sea level. The District water system consists of 7 distinct pressure zones defined by reservoirs, and 26 sub-pressure zones served through pressure regulating stations and hydro pneumatic systems. The system contains 174 miles of pipelines, 11 reservoirs, 10 booster pump stations and approximately 10,777 active water services. 1.3 INDEPENDENT ENGINEER The Trustee, on behalf of the bondholders, has retained PSOMAS, a California Corporation, to prepare this Independent Engineer's Report. In addition, PSOMAS will assist in connection with oversight of the design and construction of the Project and the disbursement of Bond proceeds. In the performance of these services, PSOMAS will: review and monitor construction progress; review proposed changes to Design Requirements; review project plans, drawings and specifications for compliance with Design Requirements; monitor the Acceptance Tests undertaken by the DB/Operator and review the DB/Operator's certified Acceptance Test Report to determine compliance with the Service Contract; review the DB/Operator's milestone payment requests and perform other such duties as may be specifically conferred on the Independent Engineer. Founded in 1946 by George Psomas, PSOMAS has grown into a full-service consulting engineering firm with approximately 450 employees in eight offices throughout California and one office in Salt Lake City, Utah. PSOMAS is a leading employee-owned consulting engineering firm offering services in water and natural resources, land development, public works, survey and information systems to public and private sector clients. The firm is currently ranked 134 on Engineering News Record's Top Engineering Firms. Relevant to this Project, PSOMAS' annual revenues in water resources are over $15 million. PSOMAS also has extensive expertise in the planning, design, construction management and operation of well fields, water treatment and distribution systems similar to those PSOMAS Page 3 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT proposed for the Project. Key personnel at PSOMAS were involved in the design and project management for the RO desalination plant located in Oceanside, California. PSOMAS, as the Authority's District Engineer, has been involved from the outset in the planning and investigation of beneficial use of the San Juan Basin to reduce reliance on imported water supplies. The Project is a result of those studies and PSOMAS' efforts to help obtain the necessary water rights. 1.4 DESIGN-BUILD, AND OPERATE (DBO) TEAM 1.4.1 SOUTHWEST WATER COMPANY Southwest Water Company (Southwest Water), the corporate parent of ECO, is the project guarantor for all of the DB/Operator's responsibilities under the Service Contract. Southwest Water was incorporated in West Covina, California in 1954. Southwest Water's experience to build, own, and operate is very extensive and includes five water utility systems; two in California, one in New Mexico and two combined water/wastewater systems in Texas. Southwest Water has, through its subsidiaries ECO, New Mexico Utilities and Suburban Water Systems, financed, built and operated over $100-million of water/wastewater systems throughout the southwestern United States. Examples of related experience are listed below: . Suburban Water Systems has served over 30,000 customers in the San Jose Hills District of the greater Los Angeles area for several decades. The San Jose Hills District builds, owns and operates tens of millions of dollars of infrastructure in order to pump, store and distribute water to its clients. . Suburban Water Systems has served over 35,000 customers in the La Mirada District of Los Angeles County for several decades. Like its sister system, San Jose Hills, La Mirada has funded, built and operated a full service water system to bring the highest quality water to its customers. . New Mexico Utilities provides full service water production, storage and distribution to approximately eight thousand customers in the fast-growing region of Albuquerque, New Mexico. . Windermere Utilities, Texas is a water/wastewater system jointly owned by Southwest Water and RTNT, Inc. and has been operated by ECO since 1996. This is a combined water and wastewater system, with secondary treatment of wastewater via activated sludge and all phases of potable water supply. Southwest Water's investment and ECO's operating capabilities brought the system into full compliance within three months of start. . Hornsby Bend Utilities, Texas is a combined water and wastewater system, with secondary treatment of wastewater via activated sludge and all phases of potable water supply. PSOMAS Page 4 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 1.4.2 ECO RESOURCES, INC. ECO, established in 1973, is the initial prime contractor for the team and will be responsible to the District for all other team members until the Service Contract is assigned to the SPE. All team members will function as sub-consultants/subcontractors to ECO until the Service Contract is assigned to the SPE. ECO is headquartered in the Houston suburb of Sugar Land, Texas and is led by president and CEO, Peter J. Moerbeek. ECO manages, operates and maintains utility systems offering water production, water distribution, sewage treatment, wastewater collection, and storm water collection along with many other services. ECO serves more than 200 cities, municipal utility districts and large companies throughout the southern and western United States. ECO has been providing a full range of services to the water industry since its inception. ECO's water/wastewater services, which serves a population in excess of 650,000, includes: . 214 water production plants operating at 282 MGD, . 3,155 miles of water distribution with 200,000 connections, . 2,146 miles of wastewater collection with 122,152 connections, and . 332 lift stations. Specific water, wastewater and RO projects include: -------------------------------------------------------------------- YEAR LOCATION/AGENCY CAPACITY PURPOSE -------------------------------------------------------------------- 2002 Torrance, 4 MGD RO facility for Total California/Water Dissolved Solids (TDS) Reclamation District removal -------------------------------------------------------------------- 2001 El Paso, Texas 4 MGD, RO facility for TDS expandable removal to 8 MGD -------------------------------------------------------------------- 1995 Taft, California 1.5 MGD Two wastewater treatment plants -------------------------------------------------------------------- 1995 Barstow, California 4 MGD Wastewater treatment plant -------------------------------------------------------------------- In addition to the above specific examples, ECO has provided water and wastewater design, build and operate services to over 70 municipal utility districts similar to the District. PSOMAS Page 5 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 1.4.3 BOYLE ENGINEERING Boyle Engineering, the engineer for the Project, is an independent, employee-owned company that was established over 60 years ago and maintains offices in 20 cities with more than 500 employees. The current president and CEO is Dan Boyd who has been associated with the firm for 30 years. Boyle has grown to service a diversified array of projects and infrastructure needs including water system development. In addition to conventional water treatment capabilities, Boyle is recognized nationally as a leader in the field of innovative water treatment technology, including membrane processes, ion exchange and specialized filtration. Membrane process expertise includes experience in microfiltration (MF), nanofiltration (NF), low-pressure RO, brackish water RO, electro-dialysis reversal (EDR), and seawater RO applications. Services provided include project conceptualization, pilot testing, design and start-up. Relevant recent RO design projects, similar in design to the Project, which Boyle Engineering has completed include: -------------------------------------------------------------------- YEAR LOCATION/AGENCY CAPACITY PURPOSE -------------------------------------------------------------------- 2002 Orange County, 4 MGD RO facility for color California/Irvine removal Ranch Water District -------------------------------------------------------------------- 2002 City of Albuquerque, 300 gallons Electro-dialysis for New Mexico/ per minute TDS and arsenic Metropolitan (gpm) reduction Detention Center Treatment Plant -------------------------------------------------------------------- 2002 Seymour, Texas 3 MGD RO facility for TDS, hardness and nitrate reduction -------------------------------------------------------------------- 2000 San Diego, 4 MGD RO facility for TDS California/ expandable reduction Sweetwater to 8 MGD Authority -------------------------------------------------------------------- 1996 Las Animas, Texas 1 MGD RO facility for TDS, expandable hardness and sulfate to 1.5 MGD reduction -------------------------------------------------------------------- 1.4.4 OSMONICS Osmonics, the preferred RO membrane provider for the facility, is one of the pioneering companies in the application of membrane technology to municipal drinking water treatment. Osmonics has a long history of developing innovative PSOMAS Page 6 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT water treatment technologies. Osmonics is a charter member of the American Water Works Association and has extensive experience in treating water from well fields, surface water, brackish water and seawater. Osmonics is a public company, trading on the New York Stock Exchange, which was founded in 1969 to expand membrane technology in the industrial/municipal marketplace and currently has total annual sales of $200 million. Osmonics has several production facilities, including a facility located in northern San Diego County. In the past five years, Osmonics installed RO/NF membranes in 25 facilities for a total of 46.3 MGD in the United States. These facilities ranged in size from 0.2 to 6.0 MGD. A representative list of recent Osmonics RO and NF membrane and disinfectant water treatment experience in municipal projects, similar to the Project, includes: -------------------------------------------------------------------- YEAR LOCATION/AGENCY CAPACITY PURPOSE -------------------------------------------------------------------- 2002 Ottawa, Illinois 4 MGD Radium reduction -------------------------------------------------------------------- 2001 Texas/Brazos River Authority, 6 MGD TDS reduction -------------------------------------------------------------------- 2001 Passcagola, Mississippi 2 MGD Color reduction -------------------------------------------------------------------- 2001 Chelsea, Michigan 1 MGD Hardness reduction -------------------------------------------------------------------- 1999- Abilene, Texas/Coca-Cola 1.5 MGD TDS reduction 2001 Enterprises -------------------------------------------------------------------- 2000 Horizon City, Texas 4.25 MGD TDS reduction -------------------------------------------------------------------- 1997 Clifton, Colorado 2.4 MGD Sulfate and TDS reduction -------------------------------------------------------------------- 1.4.5 ARB, INC. ARB, Inc. (ARB), established in 1946, is a union contractor with excellent long-term relationships with local Labor Unions and State Building Trades. ARB is signatory to collective bargaining agreements with all major trade unions throughout California and the Western States. ARB's construction volume exceeded $340 million in 2001 and $163 million in 2000. ARB's bonding capacity is $350 million. ARB's work includes water/wastewater, civil/concrete, underground and above ground piping, and power plant construction throughout the State of California. PSOMAS Page 7 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Their experience includes performing site work, foundations, underground and above ground piping, mechanical and RO equipment installation and pre-engineered building installation for the Pre-treatment and Zero Discharge facility at the La Paloma Power Plant in Bakersfield, California. Major equipment installation for this facility included: multi media filters, activated carbon filters, clarifiers, tankage, chemical storage and injection systems, compressors, RO filtration, evaporators, mixers, blowers and clean-in-place systems. Relevant water/wastewater treatment plant and major piping projects ARB is constructing or has completed within the past ten years include:
YEAR LOCATION/AGENCY CAPACITY PURPOSE - ------------ ------------------------- -------------------------- ----------------------------------------- 2002-2004 City of Ventura, CA 10 MGD Rehabilitation of existing wastewater treatment plant 2001 City of Whittier, CA 10 MGD Water reservoir and pump station 2001 Laguna Niguel, CA/ 55,700 lineal feet of 6, Recycled water distribution system Moulton Niguel Water 8, and 12-inch diameter District pipeline 2000-2002 Bakersfield, CA/Pacific 6,700 gpm Raw Water RO Raw water treatment for use and discharge Gas and Electric Co. treatment facility at the La Paloma Power Plant. 1995-1996 Wilmington, CA/Air 500 gpm RO treatment RO water treatment system for a Hydrogen Products & Chemical Co. facility Reformer.
Analysis: As discussed above, Southwest Water has been a major player in the water treatment industry for almost 50 years. Through its wholly owned subsidiaries, Southwest Water's experience in DBO encompasses three utility systems and two combined water/wastewater systems serving over 70,000 customers in California, Texas and New Mexico. Southwest Water, through its subsidiary ECO, has been involved in a Design, Build, Operate and Finance (DBOF) desalter facility in El Paso, Texas, which was financed, constructed and is presently being successfully operated. ECO has also successfully completed the desalter facility in Torrance, California, assisted in obtaining the operating permit and is presently successfully operating the facility. Boyle Engineering is recognized nationwide as being in the forefront of new technologies involving both salt water and brackish groundwater desalination. The design and process, which Boyle has prepared for the Project, is proven and modified to meet the parameters of the Project. Based upon previous RO facilities similar in process and size to the PSOMAS Page 8 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Project, which Boyle has designed, and the conservative assumptions Boyle has used for the design of the Project, the design is sufficient to meet the requirements for providing water, which meets federal, state and local drinking water standards (Finished Water). Since 1969, Osmonics has been a pioneer in the application of membrane technology to the water treatment industry. As membrane replacement will be a major operating cost, the proposed agreement that Osmonics is negotiating with the DB/Operator will provide an approximately 4% savings in the annual operating costs if membrane replacement life increases by 20%, and an approximately 5% increase in annual operating costs if the membrane replacement life decreases by 50%. Osmonics has extensive experience in designing membranes for similar-sized facilities and for many different parameters of Raw Water. ARB is a heavy construction contractor established in 1946 and has extensive experience in the successful construction of water/wastewater and piping facilities similar to and greater in size than the Project. ARB has RO desalination experience relating to the La Paloma Pre-treatment and Zero Discharge facility, in which they were responsible for the civil and site work, mechanical equipment installation, piping, and tankage. ARB will be the General Contractor for the Project and self perform all the work except electrical, instrumentation, well drilling, pile driving and field erected tanks. ARB has the financial and bonding capability and sufficient water treatment construction experience to complete the Project within the parameters of the Service Contract. CONCLUSION: PSOMAS is of the opinion that all of the Project Participants have the relevant experience and financial capability to successfully complete the design, construction and operation of the Project within the parameters of the Service Contract. PSOMAS Page 9 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 10 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT II PROCESS TECHNOLOGY 2.1 PROCESS It is planned that the Project will extract brackish groundwater from eight well sites and pump that groundwater to the RO Facility. In its natural state the groundwater is unsuitable to use as drinking water due to high concentrations of solids and other impurities. The RO Facility will remove these solids and impurities, blend the permeate to be compatible with the MWD water, and pump this Finished Water into the existing District distribution system. The blended Finished Water will be comparable to the District's MWD water and will meet all federal, state and local drinking water standards. The cornerstone of the Project's treatment technology is based on the RO technology, developed over thirty years ago, a high-pressure process that forces water through a thin membrane to filter out minerals and contaminates, including salts, and other materials. The RO membrane is similar to a microscopic strainer that essentially allows only water molecules to pass through. In practice the feed water is pumped into a closed vessel where it is pressurized against the membrane. As a portion of the water passes through the membrane, the remaining feed water increases in solid/salt content. At the same time a portion of this feed water is discharged without passing through the membrane. Without this controlled discharge, the pressurized feed water would continue to increase in solid/salt concentration, creating problems such as precipitation of super-saturated solids/salts and increased pressure across the membranes. Based upon the design pressure, the Total Dissolved Solids (TDS) of the Raw Water, and the membrane design, the amount of feed water to be discharged to waste in the brine stream is approximately twenty percent. As indicated by the Process Flow Diagram (PFD) following this section, the treatment process will consist of the following three processes: . Pretreatment to remove sand, iron (Fe), and manganese (Mn) from the well water flowing into the RO Facility; . Desalting the pretreated water using the RO process to reduce the TDS; and . Post-treatment to meet drinking water quality regulations including control of the product water corrosiveness. 2.1.1 PRE-TREATMENT The pretreatment process will consist of three steps: DE-SANDING At the RO Facility, the water will be de-sanded using an inline screening device with screens specifically designed to remove particles less than 100 microns in size. Two de-sanding units will be installed to provide redundancy and increase reliability. The PSOMAS Page 11 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT sand removed from the water accumulates in the de-sander and is periodically removed and transported to a landfill. Fe/Mn REMOVAL After the sand is removed, the water proceeds to the iron and manganese filters where the dissolved iron and manganese in the groundwater is removed by the greensand filtration/precipitation process, which has been utilized for decades for iron and manganese removal. Upon contact with an oxidizing agent (potassium permanganate and sodium hypochlorite) the electrical charge of the Fe/Mn increases and results in the formation of iron and manganese solids, which are filtered from the water. The filters are backwashed periodically, (once per day per filter) and the backwash water with the diluted Fe/Mn solids is pumped to the spent backwash recovery tank and then the suspended Fe/Mn solids are pumped to the adjacent, existing sewer collection system. CHEMICAL ADDITION After removal of Fe/Mn the filtrate is injected with sodium bisulfate, sulfuric acid, if required, and scale inhibitor. This process eliminates the potential for calcium carbonate, barium sulfate and silicate scale formation on the RO membranes. 2.1.2 DESALTING (RO) Following the injection of the acid (if used), scale inhibitor and sodium bisulfate, the RO feed water will flow into the RO membranes. The saline feed water is forced through the semi-permeable membranes in a closed vessel at high pressure (between 225 to 375 pounds per square inch (psi)) and the salts are deposited on the front of the membrane. To prevent salt concentration build up, a portion of the feed water is discharged to the waste stream (concentrate) without passing through the membrane. This waste stream, brine concentrate, is discharged directly to the outfall. In order to meet the required drinking water standards for TDS, two stages in series are utilized in the RO process. (The first stage permeate water becomes the feed water for the second stage.) After treatment by the second stage, the permeate is then pumped to the post-treatment process. 2.1.3 POST-TREATMENT Post-treatment will consist of degasification, blending the RO permeate with pretreated well water and chemical addition. The RO permeate flows into the top of the degasifier and flows downward through plastic packing material designed to break the water stream into a multitude of smaller streams. Air is injected into the bottom of the tower and flows upward through the streams of water removing carbon dioxide. The degasified water then flows into a sump at the bottom of the degasifier where it is blended with the pretreated well water. Chemicals are then added to make the permeate compatible with the water within the District's system and the Finished Water is pumped into the distribution system as it is produced. PSOMAS Page 12 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Analysis: The RO technology utilized for the design of the project has been commercially available since the 1970's and has been utilized in the treatment of brackish ground water in over twenty-five (25) facilities of similar size within the United States. The RO technology proposed for this Project is commercially demonstrated and is similar in design to other brackish water desalination plants CONCLUSION: PSOMAS is of the opinion that the brackish water treatment process proposed will produce the quality and quantity of water required by the Service Contract. PSOMAS Page 13 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT [GRAPHIC APPEARS HERE] Figure 2.1 Process Legend and Block Flow Diagram PSOMAS Page 14 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT III. PROJECT SITE 3.1 SITE DESCRIPTION The site for the RO Facility is approximately a 1.2-acre "L-shaped" parcel located adjacent to 32400 Paseo Adelanto in San Juan Capistrano, California. This property is owned by the City of San Juan Capistrano. A pre-school, through a licensing agreement with the City, a parking lot, and the District's storage area, presently utilize the site. Relocation of the pre-school has been negotiated and agreed upon by all parties. The site is adjacent to Descanso Veterans Park. A site plan is attached following this section. A review of the Geo-technical report prepared by Geomatrix Consultants, Inc., dated January 2002, indicates that the closest active earthquake fault is the Newport/Inglewood fault, 8 kilometers from the Project. Additional faults in the vicinity are the Palo Verde fault at 33 kilometers, Whittier fault at 42 kilometers, Elsinore fault at 32 kilometers, and Chino fault at 35 kilometers. The report states that, "The possibility of a fault rupture at the site is considered remote." The Geo-technical report indicates that due to the gradation of the soil (clay silts, sandy silts, and poorly graded sands), the RO Facility site is susceptible to liquefaction. Liquefaction occurs in sandy/granular soils with a high groundwater table and poor gradation and during an earthquake results in the displacement of the liquid in the voids between the granular members and allows the material to settle. This situation is very common along the coast of California. The possibility of liquefaction occurring during a seismic event has been considered and mitigated by the foundation design. This design, which consists of either drilled piles thirty and thirty-six inches in diameter and up to fifty feet below ground level or driven piles, at the District's option, has proven to be effective against the impacts of liquefaction through its use for many years. The Service Contract states that the District shall undertake and complete any environmental remediation of the sites, which may be required during the Development Period. The Phase 1 Environmental Report and the mitigated negative declarations with respect to the sites, prepared by the District, identified no hazardous material. The discovery of Hazardous Materials on the site after the Construction Date shall be treated as an Uncontrollable Circumstance (UCC) governed by the terms of the Service Contract. See the discussion in the Service Contract for remedies pertaining to a UCC. 3.2 OFFSITE FACILITIES The offsite facilities will consist of the following: . Eight, or possibly nine, well sites, all located in the San Juan Basin. The number will be determined based upon obtaining flow information after the initial eight wells are developed. If a ninth or additional wells are required, the cost of developing, operating and maintaining the additional wells will be the responsibility of the District. Some of the proposed new wells are to be constructed on existing wells sites and all existing wells will be abandoned in accordance with applicable standards. PSOMAS Page 15 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT . A pipeline, varying in diameter from eight to sixteen inches, to collect the Raw Water from the well sites and convey it to the RO Facility. . A pump station and a sixteen-inch pipeline to convey the Finished Water from the RO Facility to the connection with the District's system in the 350-distribution pressure zone. The RO Facility will also furnish Finished Water via a separate connection to the 250-pressure zone. The Finished Water will be pumped to the distribution system as it is produced. . An eight-inch pipeline to convey the RO concentrate discharge from the RO Facility to the Chiquita Land Outfall. The DB/Operator will pay a one-time fee of $599,640 to the Santa Margarita Water District (SMWD) for the purchase of capacity rights, on behalf of the District, to discharge up to 1.2 MGD of brine concentrate into the SMWD Chiquita Land Outfall, process the brine concentrate through the SERRA Wastewater Treatment Plant, then discharge the concentrate through the SERRA Ocean Outfall. In the event that the outfall becomes unavailable or restricted in use for brine disposal, for any reason other than the fault of the DB/Operator, it becomes an UCC and the District will pay the cost of an alternate disposal method and the DB/Operator shall be relieved of any Performance Guarantees. If the DB/Operator is operating the RO Facility in compliance with the Production Efficiency Guarantee, the District will pay any additional charges imposed by SMWD as a result of the discharge of excessively concentrated or voluminous brine to the Chiquita Land Outfall, which is attributable to the treatment of Raw Water having parameters outside the Design Raw Water Quality Parameters specified in the Service Contract. The RO feed pumps will provide the pressure necessary to convey the concentrate from the RO Facility to the outfall. . The Strawberry Hill Booster Pumping Station will include two 40-horsepower, turbine pumps located in either an underground vault or an aboveground pump house. The Booster Pumping Station will lift the treated water from the 350 Hydraulic Grade Line (HGL) pressure zone to the 425 HGL pressure zone. This Booster Pumping Station will have a programmable logic control and a radio transmitter unit for communication with the District's existing Supervisory Control and Data Acquisition (SCADA) system. The responsibility for operating and maintaining this pump station will, upon completion, be transferred to the District. 3.3 SITE CONDITIONS In order to construct the Project, the following site conditions will be addressed by the DB/Operator: 3.3.1 RO FACILITY . Demolition of the pre-school. . Encroachment onto the existing parking lot for Descanso Veteran's Park: A minimum amount of parking will be at the RO Facility. The majority of the PSOMAS Page 16 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT parking facility for the park will relocate to the City Hall parking lot, approximately 100 yards to the north. This relocation requires that the DB/Operator provide a direct, protected access to the park from the parking lot. This cost has been included in the design and cost of the Project. . An existing 18-inch sewer line is located approximately 6 to 8 feet north of the proposed south property line for the RO Facility. This line will remain and accept the sanitary flow and iron and manganese sludge from the RO Facility. . Siting of elements within the RO Facility will have to take into account the location of the sewer line. . Utilization of land already owned by the City. . The project must comply with the City's noise ordinance, which states that, "The noise level must be reduced to 45 db inside the nearest home, four feet from the wall with the windows closed." 3.3.2 WELL SITES, PUMP STATION AND PIPELINES . Property utilized for the well sites is under public ownership or dedicated right-of-way. . Wells must be a minimum of 800-feet apart. . A fifty-foot separation must be maintained from wells to sewer lines. . The California Department of Health Services (CADHS) will allow the well sites to be situated adjacent to San Juan Creek, but requires that groundwater from the wells can not be influenced by surface water flowing in the creek. CADHS recently stated that it is currently enforcing new standards, in whereby the wells have to be a minimum distance of two hundred feet from the Creek to be considered to have no surface water influence. In addition, California has passed a statewide law, effective January 1, 2003. This law states that the owner or operator of a well must have control of any percolation at that well site for a radius of 50 feet from the wellhead. If the above parameters are not met, CADHS can require that all the Raw Water processed through the RO Facility be treated to full surface water standards, which would cause both a capital cost and operating cost impact to the Project. Although these requirements are UCC's to the DB/Operator, negotiations are underway with CADHS to allow the well sites to remain as they are now situated and formulate and employ an enhanced monitoring plan to verify that there is no surface water influence on the Raw Water that is being treated. If, the enhanced monitoring plan is not acceptable to CADHS, the Project will require a larger chlorine contact tank to allow for increased disinfectant of the treated water. Preliminary estimates of this higher degree of disinfectant are increased capital cost of approximately $250,000 and PSOMAS Page 17 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT increased operations cost of approximately $30,000 per year. These increases equate to approximately one percent (1%) of the Capital Improvement Budget and approximately three percent (3%) annually to the Operations and Maintenance Budget . The preferred location of the Strawberry Hill Booster Pumping Station described in Appendix 1 to the Service Contract is within a proposed subdivision development on land not currently owned by the City. The City is negotiating with the developer to acquire a location for the pump station. If the City is not successful on obtaining a pump site within the development a preferred alternative site in a location adjacent to the development but within existing City right-of-way has been identified. However, this decision is not on the critical path for the start-up of the Project and alternatives are available if and when timing does become critical. . Although the majority of the pipeline alignments are located within existing right-of-way, there are a total of five segments, which will require easements from private parties and four segments which require encroachment permits from Caltrans, Southern California Regional Rail Authority (SCRRA), or the County of Orange. Obtaining these easements and encroachment permits is the responsibility of the DB/Operator. The easements, from a total of three or possibly four property owners, and the encroachment permits are identified and under the process of negotiation and procurement. Obtaining the remainder of the required easements and encroachment permits are normal construction related activities. . Nationwide permit required from Corps of Engineers for creek crossings. It is assumed that the California Department of Fish and Game will not be involved, as the creek crossings will be bored. . Corrosive soil dictates that PVC pipe and lined and coated cast iron fittings be utilized. CONCLUSION: PSOMAS is of the opinion that the site on which the RO Facility is to be located is adequate in size and location and from an infrastructure and geotechnical perspective is adequate for construction and operation of the RO Facility. The sites for the wells do not meet the new requirements that CADHS is enforcing, but these new requirements should not significantly increase the capital and operating costs of the Project. 3.3.3 GROUNDWATER BASINS The San Juan Creek watershed covers more than 111,000 acres draining the western slope of the Santa Ana Mountains through San Juan, Horno, Trabuco and Oso Creeks (DWR, 1972). Surface flow occurs primarily in the winter and spring and recharges the alluvial sediments that comprise the groundwater basin. PSOMAS Page 18 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Unconsolidated alluvial deposits of silt, sand and gravel along San Juan and Trabuco Creeks form the local groundwater basin. Surface flows will percolate into the granular sediment and recharge groundwater. Finer grained sediment at the bottom of Oso and Horno Creeks provides less opportunity for deep percolation until the flow reaches the Trabuco or San Juan Creek channels, respectively. Horno Creek drains an urban area dominated by residential development, a golf course and Capistrano Formation siltstone. Urban runoff from this area follows the original natural channel to approximately Interstate 5, where engineered channels follow the original path to San Juan Creek. The Trabuco Creek sub-basin represents a small part of the much larger San Juan Creek Basin. The alluvial aquifer system in the Trabuco Creek sub-basin is narrower and thinner than the aquifer along San Juan Creek, and represents only about 14 percent of the total Basin storage capacity. The District has primarily been using the Trabuco sub-basin for the production of potable water. As explained above due to the geotechnical condition of this Basin, the water production has averaged 1400 AFY for the past ten years. Last year, which was one of the driest years on record, this production was reduced to about 900 AF. The San Juan Basin is substantially larger and has a different configuration than the Trabuco sub-basin, therefore providing a higher proportional yield. The November 1998 Stetson/Boyle Report entitled "Availability of Unappropriated Water - San Juan Creek Basin" indicates that 11,100 AFY could be reliably extracted by the Project in addition to existing (historic) pumping with this amount increasing to over 14,000 AFY at build-out of the tributary area. All of the well sites for the Project are located within the San Juan Basin. CONCLUSION: PSOMAS is of the opinion that there is sufficient unappropriated water within the San Juan Basin to provide an adequate source of Raw Water for the Project for the Operation Period of the Service Contract and beyond for the full term of the Bonds. 3.3.4 CALIFORNIA ENVIRONMENTAL QUALITY ACT (CEQA) MITIGATION The Authority passed and adopted Resolution 95-8-1 approving a Mitigated Negative Declaration for the Project. This Mitigated Negative Declaration was determined after a supporting Expanded Initial Study was prepared, publicly reviewed, all comments addressed and responded to and the Expanded Initial Study was revised to include all pertinent comments. The Final Mitigated Negative Declaration specified certain mitigation measures, which have to be implemented by the DB/Operator and the Authority in order to comply with the Mitigated Negative Declaration. These mitigation measures are detailed in Resolution 95-8-1 and the Service Contract. PSOMAS Page 19 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Analysis: An analysis of the sites required for the Project indicates that there are no apparent environmental or site construction concerns that would prevent the successful completion of the Project. In addition, provisions within the Service Contract allocate costs arising from undetermined site constraints. Furthermore, the required pipeline easements or encroachment permits have been identified and are being negotiated. It is anticipated that these easements will be obtained in due course during the construction period so that there should be no delay to the construction. If timing does become critical, rerouting of the pipeline would be an option. All geo-technical and subsurface restraints known at this time have been considered during the design and have been mitigated through the foundation design for the RO Facility. The foundation design is, of necessity, a conservative design and there are sufficient safety factors incorporated in the design to compensate for unknown subsurface circumstances. A review of the conditions indicated in the Mitigated Negative Declaration determined that it does not impose any conditions that are not common to normal construction activities and the Mitigated Negative Declaration conditions should not cause any delay or cost increase to the Project. CONCLUSION: PSOMAS is of the opinion that the environmental site assessments have been accomplished in a manner consistent with industry standards, using appropriate industry protocols. The adopted Mitigated Negative Declaration for the Project does not impose any conditions that are not common to normal construction activities and should not cause any significant delay or increased cost to the Project. PSOMAS Page 20 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT [GRAPHIC APPEARS HERE] Figure 3.1 WTP Site Layout PSOMAS Page 21 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 22 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT [GRAPHIC APPEARS HERE] Figure 3.2 Well Collection System Schematic Alignment PSOMAS Page 23 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 24 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT [GRAPHIC APPEARS HERE] Figure 3.2 (continued) Well Collection System Schematic Alignment PSOMAS Page 25 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 26 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT [GRAPHIC APPEARS HERE] Figure 3.3 Treated Water and RO Disposal Pipelines PSOMAS Page 27 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 28 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT IV. ENGINEERING, PROCUREMENT AND CONSTRUCTION 4.1 CONCEPTUAL DESIGN PARAMETERS The design of the Project is based upon the Raw Water quality defined in the Service Contract. The Raw Water quality design data indicates insignificant concentrations of organic compounds. The design TDS for the Raw Water is significant at 1705 mg/L. Specifically, the design values for iron, manganese and barium are significant but the greensand filtration/precipitation process has proven very effective in removing these constituents, which otherwise could cause scaling and fouling of the membranes, as has been successfully accomplished in other facilities. Extensive studies of available data and negotiations have occurred between the District, Boyle Engineering and the DB/Operator to arrive at the values for these parameters. The values have been obtained from existing wells in the vicinity of the proposed new wells. The worst-case scenario of values was determined and the design of the RO Facility is sufficiently conservative to provide Finished Water within the parameters of the Service Contract. The Water Treatment Guarantee shall apply only if the actual Raw Water supply is within the parameters of the Service Contract. The DB/Operator operation requirements are based upon Raw Water quality not to exceed the base values indicated in the Service Contract. If the actual Raw Water quality exceeds these parameters, the DB/Operator shall provide to the District, within thirty days, an assessment as to the potential impact of such non-conformity on the Design/Build Price, the Service Fee, Acceptance and Performance Guarantees, together with a discussion of possible UCC mitigating measures. To confirm the effectiveness of the RO Facility process for removal of TDS, iron and manganese and to determine that the Finished Water will attain the standards for water produced by the MWD Diemer Filtration Plant (alternative source) for flavor, color and aroma, a small-scale pilot plant (2 gpm) has been constructed and operated at the site of an existing well. The entire treatment train proposed for construction at the RO Facility has been tested, including a functioning model of the Chemical Feeds; Greensand Filter; Reverse Osmosis; and Air Stripping. The pilot plant was operated for a minimum of five days, eight to ten hours per day. During operation of the pilot plant, samples were taken of the following: 1) Raw Water, 2) Filtrate from the Fe/Mn filter, 3) RO Permeate, 4) RO Concentrate and 5) Finished Water. These samples were then tested in accordance with the Service Contract. The results of the Pilot Test indicated that the Raw Water quality was within the specifications of the Service Contract and that the Finished Water should attain the standards for water produced by the MWD Diemer Filtration Plant. Since the TDS goal, per the Service Contract, for the treated water delivered to the system is less than 500 mg/L, it will not be necessary to desalt all of the water. It is expected that the product water will consist of an approximate blend of 75% RO permeate and 25% pretreated well water. The blended Finished Water will meet all requirements for federal, state, and local drinking water standards. The RO concentrate water (residual brine water) will be discharged at the maximum rate of 1.2 MGD through the SERRA Ocean Outfall into the Pacific Ocean. The brine concentrate water quality is indicated as within the parameters of SERRA's current PSOMAS Page 29 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT National Pollution Discharge Elimination System (NPDES) discharge permit and amending the permit will not be required. 4.2 ENGINEERING DESIGN The treatment process will include the following steps: . Pre-treatment, which includes sand removal, iron and manganese removal utilizing the greensand process, and chemical addition. . Desalting of approximately 75% of the pretreated water using RO, with 25% of the pretreated water used for blending. . Degasification of the RO permeate water. . Blending of 25% of the pretreated, but not desalted water, with the permeate water. . Post-treatment of the blended water to meet drinking water quality regulations and to control the Finished Water corrosiveness. Due to the District's NPDES permit requiring that all test/development water discharged from the wells be treated, all such well water will be conveyed through the collection pipeline to the RO Facility. At the RO Facility, the water will be de-sanded using two in-line-screening devices designed to remove particles less than 100 microns in size. The accumulated sand removed from the water is hauled to a landfill. The two screening devices increase reliability and provide redundancy. The greensand treatment process, which has been in use for decades, will be used for removal of the iron and manganese. In order to meet the iron and manganese limits in the product water of 0.1 mg/L and 0.025 mg/L respectively, the process will use potassium permanganate and sodium hypochlorite to process all the well water with the resulting formation of iron and manganese solids, which can then be filtered from the water. The greensand process will result in approximately 145,000 gallons per day (gpd) of spent backwash water. This backwash water will be pumped to a recovery tank where the inert solids will drop out and the sludge will then be disposed of in the existing sewer line. The clarified water from the recovery tank will be recycled to the greensand filters for re-treatment, which reduces the amount of well water required. Recognizing that there can be significant iron and manganese concentrations in the well water, and that the quality can vary during the pumping cycle, the filter size has been based on a conservative design. Sodium bisulfate and scale inhibitor will be added to the RO feed water from the greensand filters to neutralize the oxidizing agents used in the greensand process and prevent damage to the RO membranes. PSOMAS Page 30 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Following the injection of scale inhibitor and sodium bicarbonate, the feed water will flow into the RO membranes. Two streams will emanate from the RO process: 1) permeate (desalted water), and 2) brine concentrate. The RO process parameters include: . Two RO package units, which bolt directly to the foundation. Each package unit has two stages in series and the RO package units are in parallel. Permeate from the first stage RO package unit becomes the feed water for the second stage RO package unit. Each RO package unit has a permeate capacity of approximately 2.57 MGD. The first stage of each package unit has an average capacity of 13-gpd/square foot (sf) of membrane area and the second stage has an average capacity of 12-gpd/sf of membrane area. . Approximately eighty percent of the pretreated water processed through the RO package units goes to the District's distribution system and twenty percent is discharged to the outfall as brine concentrate water. . 150-psi feed water pump discharge pressure. . Concentrate discharged directly into the outfall. It is also proposed to install energy recovery devices on the concentrate from the second RO stage in order to use the energy in the water to assist the electric motors driving the RO feed water pumps. Post-treatment will consist of degasification, blending of the RO permeate with the bypass well water and chemical addition. Permeate enters the top of the degasifier and flows downward. Air is injected from the bottom and flows upward stripping the carbon dioxide and reducing the pH of the water. The degasified permeate then flows into a 30,000-gallon sump where the bypass water is blended and caustic soda is added to adjust the ph so that the resulting Finished Water is non-corrosive. The Finished Water is then pumped directly from the sump into the District's distribution system. The Finished Water is primarily designed to supply the needs of the 250 and 350 HGL pressure zones. These zones have a storage capacity of 1.6 MG with an additional 3 MG planned for the 250 zone. Utilizing the existing and planned storage capability accommodates the District's peaking requirements and allows the plant to operate at a constant rate. 4.3 MAJOR EQUIPMENT - WELL SITES There will be a total of eight well sites developed for supply of Raw Water to the RO Facility. These sites will range in depth from 130 feet to 160 feet. Each well site will have a production capacity of 500 to 1,000 gpm. PSOMAS Page 31 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Each well site will have a vertical turbine pump, a 50 to 60 horsepower fixed speed motor, and associated piping. The equipment will be contained in an enclosed thirteen feet by twenty-four feet masonry building. 4.4 MAJOR EQUIPMENT - PRE-TREATMENT The major equipment in the pretreatment process includes the iron and manganese filters. These filters consist of three dual cell filters with the following characteristics: . Twelve feet diameter by forty-seven feet long. . 375 square feet (sf) of filter area per filter, 187.5 sf per cell. . 1,500 gpm/sf of filter area. . 4 to 6-gpm/sf initial backwash rate. . 10-gpm/sf final backwash rate. Also included in the major equipment for the pre-treatment process are: . 30 feet diameter by 16 feet tall, 85,000-gallon bolted steel backwash water supply tank with three 25 horsepower fixed-speed pumps. . 40 feet diameter by 24 feet tall, 225,000-gallon bolted steel spent backwash water recovery tank with three 5 horsepower fixed-speed pumps. . Two cartridge filters. . Chemical Feed systems. a. 4,000-gallon sodium bisulfate storage tank, three feed pumps. b. 1,000-gallon scale inhibitor storage tank, two feed pumps. c. 4,000-gallon sodium hypochlorite storage tank, four feed pumps. d. 4,000-gallon caustic soda storage tank, two feed pumps. e. 2,000-gallon ammonia storage tank, two feed pumps. f. Potassium permanganate mixing tank with mixer, two feed pumps. 4.5 MAJOR EQUIPMENT - REVERSE OSMOSIS The major equipment for the RO desalination process consists of the following: . Two trains of RO package units consisting of two RO stages in series, 68 pressure vessels each with 7 membranes per vessel. PSOMAS Page 32 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT . Two 200 horsepower VFD equipped feed water pumps. One pump for each of the RO trains. . One RO membrane clean-in-place system for both trains. 4.6 MAJOR EQUIPMENT - POST-TREATMENT The major equipment for the post-treatment process includes the following: . Two degasifiers with clear well. Each degasifier has the following parameters: a. RO permeate flow is 2800 gpm. b. Packing depth is 7 feet. c. Volume of packing is 830 cubic feet. d. Air to water ratio is 25:1. . Two 10 horsepower fixed-speed blowers. . Two 125 horsepower VFD equipped product water pumps, one 125 horsepower fixed speed product water pump, two 60 horsepower VFD equipped product water pumps and one 60 horsepower fixed speed product water pump. Analysis: The design is conservative and proven in numerous similar brackish water RO facilities constructed and operating within the United States. The design is predicated on the worst-case scenario of the indicated parameters. Boyle Engineering has indicated that in addition to assuming the worst-case scenario, there is a 25% redundancy factor included in the design. CONCLUSION: PSOMAS is of the opinion that, based upon the Service Contract parameters, the preliminary design, and the proposed equipment list the Project will operate and provide Finished Water within the Service Contract parameters for the Operation Period of the Service Contract and beyond for the full term of the Bonds. 4.7 CONTRACTOR'S SCOPE OF WORK The contractor, ARB, will be responsible for constructing the RO Facility, drilling and construction of new well sites, construction of the well water conveyance pipeline, construction of the RO concentrate pipeline, construction of the product water pipeline, construction of the booster pump station, and associated controls and power systems. The RO Facility construction consists of removal of existing facilities, rerouting of existing utilities, grading, access road, parking lot, an RO building with two RO package units, a PSOMAS Page 33 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT chemical building, a backwash supply tank, a backwash recovery tank, three iron/manganese filters, two sand filters, two cartridge filters, backwash pumps, process feed pumps, product water pumps, two degasifiers, 30,000-gallon clearwell, fencing, associated piping and control systems. Originally, the building foundations were designed to be mat foundations. Additional soil information has determined that the foundations will be either drilled or driven piles with grade beams. There are a total of eight well sites, which are required in order to provide sufficient feed water (Raw Water) to the RO Facility. Each well site requires drilling of a new well. Each well site will consist of well casing, vertical turbine pump, electrical gear, controls, remote monitoring, associated piping, and a thirteen-foot by twenty-four-foot pump house. There are six existing wells which are no longer in use or are substandard and will require abandonment in accordance with State of California standards. Six of the well sites are located on the west side of the Interstate 5 Freeway and south of the RO Facility. The seventh well site is located adjacent to the RO Facility. The eighth well site is north of the RO Facility and east of the Interstate 5 Freeway. If a ninth or further additional wells are required, the District will bear all of the capital, operation, maintenance, repair and replacement costs of such ninth and additional wells and related pipelines required for connection of the additional wells to the existing well field. The feed water pipeline from the south well sites to the RO Facility will be a sixteen-inch line from the RO Facility to the west side of Trabuco Creek and connects to an existing conveyance line. The feed water pipeline from the eighth well site will be an eight-inch line jacked under Interstate 5 Freeway then proceeding to the RO Facility. The RO brine concentrate disposal pipeline is an eight-inch line from the RO Facility to the connection with the Chiquita Land Outfall southeast of the RO Facility. The Finished Water line is a sixteen-inch line proceeding north from the RO Facility, to the connection with the District's 350 HGL pressure zone. Another Finished Water line proceeds to the north and connects with the 250 HGL pressure zone. Analysis: Based upon a review of the preliminary design, ARB's scope of work included in their Guaranteed Maximum Cost contract price is in accordance with the preliminary design requirements and the Scheduled Acceptance Date should be obtainable. ARB has extensive experience in the construction of water and wastewater treatment plants and pipelines as well as being the contractor for the La Paloma Pre-treatment and Zero Discharge RO Facility. CONCLUSION: The construction of the Project is similar to other projects constructed by ARB and PSOMAS is of the opinion that the construction of the Project can be accomplished within the scope of the Service Contract, by the Scheduled Acceptance Date and within the Fixed Design/Build Price included in the Service Contract. PSOMAS Page 34 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 4.8 ACCEPTANCE TEST/PROVISIONAL ACCEPTANCE During the six-day Acceptance Test, specified in the Service Contract, each train of the RO and iron/manganese filter systems will be operated sequentially, each at 2.57 MGD. Operation of each half at 2.57 MGD shall constitute acceptable demonstration of the Projects capability to produce 5.14 MGD of Finished Water. The Acceptance test shall be conducted for a minimum of six days with a minimum of two days continuous operation of each of the two RO trains. During the Acceptance Test, the project improvements must also successfully demonstrate the following: 1. Manual shutdown and start-up of the project improvements as a functioning train. 2. Automatic shutdown of the project improvements as a functioning train. 3. Operation of each train (RO package unit and Fe/Mn filter) to produce the quantity and quality of Finished Water as stated above. During the Acceptance Test, the Finished Water will be regularly monitored and sampled according to the Service Contract for compliance with the Water Treatment Guarantee. An outside laboratory certified for water analyses by the State will analyze the samples. During the Acceptance Test, the Project will discharge brine into the Chiquita Land Outfall, the Finished Water will be discharged into the San Juan Creek, and the iron and manganese waste will be discharged into the sewer system. One hundred and eighty (180) days prior to performing the Acceptance Test, the DB/Operator shall prepare and submit to the District and PSOMAS as the Independent Engineer, for review and approval, a detailed Acceptance Test plan. This plan shall conform to all the requirements of the Service Contract. The District and PSOMAS shall have thirty days to approve the plan, but the Acceptance Test cannot take place until the DB/Operator has addressed all comments by the District or Independent Engineer. Following the completion of the Acceptance Tests, the DB/Operator shall have the right to certify Acceptance on a provisional basis. In order to certify Acceptance on a provisional basis, the DB/Operator will deliver written certification to the District and PSOMAS, that in the good faith judgment of the DB/Operator and based upon all information available at the time of the certification, all of the Acceptance Date Conditions have occurred. The date upon which the DB/Operator's provisional Acceptance certification is delivered is referred to as the "Provisional Acceptance Date" and thereupon "Provisional Acceptance" shall be deemed to have occurred. Upon the occurrence of Provisional Acceptance, the Operation Period will commence and all Operation Period rights and obligations of the parties shall apply. The initial term of the Service Contract will commence on the Provisional Acceptance Date, and thereafter the parties shall be bound as if Acceptance had permanently occurred, except as provided in the Service Contract in the event the District disputes the DB/Operator's Provisional Acceptance certification. PSOMAS Page 35 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT CONCLUSION: PSOMAS is of the opinion that the Acceptance Test is sufficient to predict that the Project will perform reliably for the Operation Period of the Service Contract and beyond for the full term of the Bonds. This opinion is based upon the assumption that the required preventative and scheduled maintenance is performed in accordance with industry standards. PSOMAS Page 36 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT V. OPERATION AND MAINTENANCE 5.1 PROPOSED OPERATION OF THE FACILITY Pursuant to the A & A Agreement, ECO brings a variety of techniques and procedures to enhance water treatment efficiencies in process control and management. Their approach is to separate the individual processes and analyze each process to ensure that all areas are maintained at the level of operations required. The individual processes as determined for the Service Contract Project Improvements are as follows: . Production wells. . Sand removal. . Iron and Manganese removal via "greensand" filters. . RO treatment. . Brine Discharge. . Adjustment of the RO product water by degasification, chemical addition and disinfection. . Sampling/analyses/reporting. . Discharge of Finished Water into the District system. In that an RO system requires a fairly sophisticated level of technology, process control becomes the utmost importance. Since it is essential that accurate data be collected on an ongoing basis, several systems have been included in the instrumentation and control network to provide "on-line" information to the operator. The collection of on-time data is essential in aiding the operators to vary the process to compensate for fluctuations in the water quality and to maximize the efficiency of the Project. In order to provide ongoing monitoring and control of the process, the wells, RO Facility and the Booster Pumping Station will be provided with instrumentation and remote control equipment. A Supervisory Control and Data Acquisition (SCADA) System will be provided at the RO Facility control room. The SCADA System will be interfaced with all process control and instrumentation equipment at the wells and the RO Facility. The SCADA System will incorporate redundancy to meet all requirements of the California Department of Health Services. The Booster Pumping Station will be incorporated with the existing District SCADA System. The RO Facility SCADA System will interface with the District's existing SCADA System using compatible licensed radio. The SCADA System PSOMAS Page 37 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT will be implemented with report generation coordinated with the District requirements. In addition, an Un-interruptible Power Supply (UPS) will be provided for the SCADA System in the event there is a power outage. The control system will provide reliable control and information transfer within the RO Facility along with remote locations including the District's headquarters and the well sites. This system will provide complete automation of the filtration and auxiliary facilities. The control system will monitor RO Facility operations and automatic shutdown will be initiated when certain conditions exist. The DB/Operator will assign a Manager of the Project and Operation Services who is trained, experienced, and proficient in the management and operations of similar projects as the Facilities Manager for this Project. The Facilities Manager will be assisted by a full-time Project Operator who will have an Operator's Certificate as required by CADHS. Both the Operator and the Facility Manager will have the responsibility, twenty-four hours a day, seven days a week, to respond to all call-outs within two hours or less. Telemetry and automatic alarm paging are the traditional methods of off-hours coverage. This will be enhanced with the Osmonics RO system capability to be remotely monitored and evaluated via a laptop computer over a phone line. 5.2 MAINTENANCE MANAGEMENT The DB/Operator's commitment to the District is to properly maintain the Project and at the end of the Service Contract term provide the District with a system in good working order and a useful life in excess of the standards as defined in the Service Contract between the DB/Operator and the District. The goal of ECO's preventative and corrective computerized maintenance management plan is to prevent and correct equipment deficiencies while minimizing breakdowns and extending service life. The plan incorporates all Project components, along with inspection and maintenance frequencies, inspection and maintenance techniques, and the method of record keeping for each piece of equipment. Periodic scheduled, specific maintenance procedures are performed on all plant equipment and tracked via a computerized system that minimizes human error. The computerized Preventive Maintenance Tracking Program tracks both scheduled and unscheduled preventative and corrective maintenance and repair. The program also tracks maintenance, labor, and spare parts inventory, prints work orders and tracks work order history. All completed maintenance for each piece of equipment is normally kept on a computer disc and backed-up with a hard copy placed in the maintenance file created for each piece of equipment. This file contains information on all preventative maintenance completed including the date work was accomplished, supplies and parts utilized, and the technician who performed the work. Maintenance reporting is performed through daily and weekly inspection reports and work orders. A weekly summary Preventative Maintenance Report outlines all inspection reports and preventative maintenance performed, lists scheduled work not completed, and lists corrective maintenance PSOMAS Page 38 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT scheduled for the following week. The following schedule is normally adhered to for correcting deficiencies: . Emergency repairs are completed within eight hours, . Urgent repairs are completed within three days, and . Routine service completed within thirty days. Longevity of the Project is of primary concern and importance and the critical areas are the RO membranes and wells. The other systems tend to fall within two categories. The first is large equipment for which operating and maintenance standards have been well established over a long period of use. The second category is smaller and more specialized pieces of equipment, which are typically covered by specialized contract maintenance firms. The life span of RO membranes is dependent upon the Raw Water influent quality, pretreatment techniques and membrane design. Although the influent water quality is susceptible to fluctuations during the life of the Project, the DB/Operator in conjunction with Osmonics has been able to establish lifetime replacement pricing for the membranes with an average membrane life of four years. Osmonics has agreed to pricing that, if the replacement life of the membranes is five years or greater, then the savings will be approximately 4% of the annual operating costs. If the replacement life of the membranes is two years, then the pricing is such that the annual operating costs will increase by approximately 5%. Cartridge filters will be replaced much more frequently and the pattern will be established early on in the contract. Although the average life of wells is approximately forty years, the DB/Operator has assumed that one well will require complete replacement within the life of this Contract. Also included are the costs for well pulling, videos and overhauling vertical turbine pumps on a five-year basis. Other capital equipment scheduled for replacement every five years includes: vehicles, computer systems, office furniture, tools and safety equipment, and personnel replacement costs. CONCLUSION: The operation and maintenance requirements of the Project, under the Service Contract are adequate for the full term of the Bonds. PSOMAS is of the opinion that the operating costs included in the Service Contract are reasonable, and the variable replacement cost for the membranes will not have a significant cost impact to the annual operating costs. The only other variables are labor and chemicals and experience indicates that any variation in these costs should be minor. PSOMAS Page 39 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 40 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT VI. ENVIRONMENTAL AND REGULATORY REQUIREMENTS 6.1 MAJOR PERMITTING AND REGULATORY REQUIREMENTS The DB/Operator, as the prime contractor and operator of the Project, will be responsible for implementation of mitigation measures incorporated in the 1995 Expanded Initial Study/Mitigated Negative Declaration for the San Juan Basin Groundwater Management and Facility Plan. Biological and Archeological studies performed in January 2001 indicate that the RO Facility site and well sites do not require mitigation for archeological, suitable habitat for endangered species, and sensitive plant species. The pipeline routing could require mitigation measures. These mitigation measures could include: rerouting of the pipeline(s), relocation of the well sites, and other mitigation measures. These mitigation measures would constitute an UCC in accordance with the Service Contract. 6.1.1 CONSTRUCTION PERMIT Permits required prior to construction of the Project include: . Air Quality Management District (AQMD) - Permit to operate Portable/Fixed Generator . County of Orange - Pipeline Crossing Encroachment Permit . California Occupational Safety and Health Act (CAL-OSHA) - Title 24 Excavation Permit . City of San Juan Capistrano - Grading permit, Architectural review, CEQA mitigation. . Southern California Regional Rail Authority/Metrolink Railroad - Licenses required for boring under Right-of-Way . California Department of Transportation (Caltrans) - Encroachment permit required for crossing under the Interstate 5 Freeway . Orange County Flood Control District - Permit to construct on easement . Orange County Fire Authority Approval 6.1.2 OPERATION PERMIT Permits to operate the Project during the Acceptance Testing and to provide Finished Water to the District's distribution system include: . Southeast Regional Reclamation Authority/Regional Water Quality Control Board (SERRA/RWQCB) - Brine Discharge permit, Well Flushing Discharge permit and Well Development Water Discharge Permit PSOMAS Page 41 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT . Orange County Health Department (OCHD) - Well Development Permit . California Department of Health Services (CADHS) - Permit to operate the facility Analysis: The CADHS permit, which is required in order to supply Finished Water to the District system, will not be issued on a final basis until after review of the Acceptance Test results. The quality that the Finished Water has to obtain is specified in the Service Contract and those specifications were determined in accordance with CADHS standards. If the Finished Water produced by the Project is within the specifications contained in the Service Contract, there is no technical reason that CADHS would not issue the operating permit. Based upon the dates for start of construction and provision of the Finished Water, the required permits have been identified and there is sufficient time to procure all the necessary permits without delay to the Project. The permits to be issued by SERRA, RWQCB, and CADHS are required to produce Finished Water and provide it to the District distribution system. Based on the preliminary construction schedule these permits are not required until August 2004, but if delayed, it is possible that the MWD GRP Agreement Date of December 4, 2004, for Delivery of Finished Water may be jeopardized. CONCLUSION: The required permits and easements to begin construction were obtained prior to the commencement of construction, which occurred on November 25, 2002. The remainder of the permits and easements to complete construction will be acquired on a sequential basis prior to the construction of the various components of the Project. These outstanding permits and easements are identified and expected to be obtained in time to prevent any delay to construction of the Project. The operating permits required to comply with the Finished Water date of December 4, 2004, are identified and scheduled to be obtained in sufficient time to support the completion of the Project. Based upon a review of the preliminary construction schedule for the Project, there is sufficient time to obtain these permits prior to the December 4, 2004 MWD Finished Water date. 6.2 SAFETY PLAN ECO has an exemplary safety record, receiving awards from the California Water Environment Association. Implementation of a safety program will be the responsibility of the Regional Safety Officer. OSHA compliance will be part of the comprehensive safety and training program and will be appropriately administered based on the level of involvement of operations. In addition to OSHA health and safety training, additional safety training, including CPR, will be conducted. Use of classroom exercises, discussions, hands-on practice along with instructor/student guides, and support media PSOMAS Page 42 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT will help to enable each staff member with the proper support and training. More specific information is included in the ECO Safety Manual, dated January 1997, and copies of this information will be distributed to each staff member. Any operation and maintenance personnel that will be involved with hazardous materials handling or hazardous waste site operations will receive special training that will include: . Confined Spaces, . Chlorine Safety, . Hazardous Gases and Detectors, . Hazardous Material Response Team Training, and . Hazardous Communications Standard (right-to-know). Policies and procedures regarding safety will be welcomed by peer evaluators such as insurance carriers and regulatory bodies to ensure proper safety compliance. Weekly safety meetings will be held to update employees on current safety practices as well as address any current safety practices with hands-on training. The Regional Safety Officer will review and edit the current Safety Manual to assure all aspects of training are administered to the employees. In addition to the safety compliance, training and procedures, there are the physical precautions of the site to safeguard. Appropriate signage and fencing will be placed around the building and well sites. Channels will include plates or grating covers to form walkways and all mechanical equipment will be supplied with shaft guards and other safety devices will be replaced if they are removed for any reason. Extinguishers, such as the multi-purpose ABC dry chemical type, will be strategically located throughout the plant along with first aid kits. All personnel are required to comply with the established procedures as mentioned above and good housekeeping and record-keeping practices will be enforced. A hazardous materials plan will include a program that will address the special handling of hazardous materials in compliance with OSHA standards. CONCLUSION: PSOMAS is of the opinion that the safety plan is adequate and is in compliance with industry requirements and CAL-OSHA. 6.3 SECURITY PLAN The security plan is designed to address the specific needs of the operations. Some of the issues are addressed by design (lighting, fencing, well enclosures, landscaping, etc.) and some by operations (graffiti control, water quality monitoring, local safety authority coordination, etc.). In addition to the design and operations, coordination with local authorities (city, police, fire) will also be implemented, if needed, to maintain security for both the operation at the sites and for the community at-large. Further security plans include personnel that will be equipped to handle unusual emergency situations such as earthquakes, the potential release of hazardous materials, flooding, sudden storms, power loss, and other critical conditions. PSOMAS Page 43 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Management and technical staff will: . Evaluate existing emergency response plans, . Complete, update, or prepare these plans as necessary, . Develop contingency or fall-back plans, and . Train employees on implementation of the plans. CONCLUSION: PSOMAS is of the opinion that the security plan is adequate and is in compliance with all regulatory agencies on the local and state level. PSOMAS Page 44 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT VII. RELEVANT PROJECT CONTRACTS/AGREEMENTS (PROJECT AGREEMENTS) The Project Agreements, discussed in this Section, are established for the design, construction and operation of the San Juan Basin Project, a 5.14 MGD brackish well water RO Facility, well sites, feed water, distribution, and disposal pipe lines and related items. The Project will be financed with tax-exempt governmental purpose bonds. Specifically, the bonds will be Lease Revenue Bonds issued by the Authority under the terms and conditions contained in the Trust Agreement dated as of December 1, 2002, by and among the Authority, the District and BNY Western Trust Company as Trustee. The City will lease, under the Property Lease dated as of December 1, 2002, by and between the City and the Authority, various real property sites on which portions of the Service Contract Project Improvements are to be constructed, to the Authority. The Authority will then lease, under the Lease Agreement dated December 1, 2002, by and between the Authority and the District, the to-be-constructed Project to the District. The District is a subsidiary district of the City and the Lease Payments are primarily secured by water revenues of the District. Lease Payments, from the Lease Agreement, will be assigned to a Trustee for the benefit of the bondholders. The Authority will hold title to the Project during the term of the Lease. 7.1 PROJECT IMPLEMENTATION AGREEMENT The Implementation Agreement is entered into between the Authority and the City acting as the governing body for the District for the purpose of complying with sections of previous agreements. The Implementation Agreement specifies that the District and City's allocated interest in the Project's water rights shall be in the amount of 5,800 acre-feet per year. The Agreement also specifies that since the District is the only Authority member participating in the Project, major decisions and approvals concerning the Project shall be made by the District in consultation with the Authority. The Authority will also take no action which would impair the Project's ability to extract up to 5,800 acre-feet per year or impair the MWD Agreement between MWD, MWDOC and the Authority. The subsidy described in the MWD Agreement will be irrevocably committed to the Project and the Authority will not exercise its right to terminate the MWD Agreement without the prior written consent of the District. 7.2 METROPOLITAN WATER DISTRICT OF SOUTHERN CALIFORNIA PROJECT AGREEMENT This review is based upon the 1998 San Juan Basin Project Agreement between MWD, MWDOC and the Authority, dated December 4, 1998 and the First Amendment dated October 15, 2002. MWDOC, a Metropolitan Water District member agency, and the Authority have determined that it would be more costly to develop its groundwater sources than to PSOMAS Page 45 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT purchase an equivalent amount of MWD treated water from MWDOC. Consequently, MWD, MWDOC and the Authority have determined that it would be mutually beneficial for the Authority to increase production from the Lower San Juan Basin by treating the groundwater through developing and operating a new treatment facility. Accordingly, MWD, in accordance with its GRP, desires to assist MWDOC and the Authority with the cost of treating the degraded groundwater in excess of the cost of treated Full Service water from MWD. This GRP assistance is equal to the sum of the Project unit cost and deferred cost minus the MWD cost for treated water, but is capped at $250 per acre-foot produced annually by the facility. The Project will increase domestic and municipal production by producing a minimum of 4,800 acre-feet of Finished Water per year from the Lower San Juan Basin. The First Amendment to this Project Agreement restates that under the MWD Agreement the Authority is the sole owner of all Project facilities and is solely responsible for development of the Project. The District, as agent for the Authority, will agree to cause the Service Contract Project Improvements to be acquired, constructed, delivered, and installed and the Authority will have no responsibility with respect to the acquisition, construction, delivery and installation of the Service Contract Project Improvements. The District will operate the Project as the contracted operator of the Authority during the term of the Lease Agreement and pursuant to the Project Lease and Implementation Agreement. The Implementation Agreement transfers the responsibility for developing, operating and maintaining the Project from the Authority to the District. The MWD Agreement further defines those costs, under the Service Contract, which can be used in calculating the fixed cost and subsequently the Final GRP contribution, capped at $250 per acre-foot. Amortization of the capital costs and operating costs indicate, as shown in Section 8.2, Operating and Maintenance Costs and Section 8.3 Amortized Costs, that the full GRP of $250 per acre-foot per year will be required for the full term of the Contract. The MWD Agreement will automatically terminate if either of the following schedule parameters are not met: Per the Agreement: . Construction of the Project must commence no later than December 4, 2002, and . Allowable yield must be produced by the Project no later than December 4, 2004. If construction has commenced previous to December 4, 2002, MWD will consider a request from the District and MWDOC to amend the agreement to provide additional time for commencement of production of Allowable Yield, if the December 4, 2004 date for production of Finished Water is not met. PSOMAS Page 46 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 7.3 SERVICE CONTRACT The Service Contract for the Design, Construction, and Operation of the San Juan Basin Desalter Project, dated as of September 3, 2002, between the District and ECO provides for the design, construction and operation of the Project for a term of twenty years following the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the DB/Operator, the Acceptance Date). 7.3.1 CONSTRUCTION COMMENCEMENT OF CONSTRUCTION On the Construction Date, the DB/Operator will commence construction of the Project on a design/build basis and shall undertake to perform the work in accordance with the Contract Standards. To the extent that any design/build work is not in accordance with the Contract Standards, the DB/Operator has an obligation to rebuild, repair, and/or replace such work so that it complies with the Contract Standards. In performing the design/build work, the DB/Operator shall perform the work so that the Project is suitable and adequate for the production of Finished Water in accordance with the MWD Agreement (as described below). DESIGN/BUILD PRICE The District shall pay the DB/Operator the Design/Build Price for the design/build work on a milestone basis as set forth in the Service Contract. The Design/Build Price is the sum of the Fixed Design/Build Price and the Fixed Design/Build Price Adjustments. The Fixed Design/Build Price is $25,030,670. The Fixed Design/Build Price Adjustments are based upon change orders issued by the District, UCCs and adjustments caused by certain San Diego Gas and Electric Company interconnection costs. The District is currently negotiating with DB/Operator for a modification to the Design/Build Work which would modify the Plant foundation construction method and would result in a reduction of the Fixed Design/Build Price from $25,030,607 to $24,190,607. No assurances can be made, however, that such negotiations will be successful and that the Modification to the Design/Build Work and corresponding Fixed Design/Build Price reduction will occur. 7.3.2 ACCEPTANCE TESTING AND REQUIREMENTS Achievement of Provisional Acceptance, Acceptance and Final Completion (as each is described below) are independent measures of the DB/Operator's performance. PSOMAS Page 47 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT SUBSTANTIAL COMPLETION Prior to conducting the tests necessary for Acceptance to be achieved ("Acceptance Tests"), the DB/Operator shall have obtained Substantial Completion, which includes each of the following: . Construction of the Project improvements in accordance with the Contract Standards has been substantially completed; . Both water treatment trains are operational; . A preliminary or temporary certificate of occupancy has been issued (if required by applicable law); . The DB/Operator is authorized by all appropriate governmental agencies (including CADHS) to perform the procedures necessary to achieve Acceptance and conduct Acceptance Testing; . Utilities required are connected and fully functional; . The DB/Operator has delivered to the District written certifications from the equipment manufacturers that all major items of equipment have been tested and are fully functional; . The District has approved the DB/Operator's plan for Acceptance Testing; and . The DB/Operator has submitted certification that all the foregoing requirements have been satisfied. PRE-ACCEPTANCE TEST RAW WATER QUALITY ANALYSIS The DB/Operator shall begin to conduct a pre-acceptance test Raw Water quality analysis at least 120 days prior to the earlier of September 1, 2004, as such date may be extended for UCCs (the "Scheduled Acceptance Date") or the date upon which the DB/Operator plans to begin Acceptance Testing. Such pre-acceptance test will be conducted to determine that the Raw Water quality is within the design Raw Water parameters set forth in the Service Contract. If this test determines that the Raw Water quality is outside the parameters, the DB/Operator shall, within 30 days, provide an assessment of the potential impact of the non-conformity with a discussion of possible UCC mitigating measures. ACCEPTANCE TESTING; ACCEPTANCE DATE CONDITIONS The DB/Operator shall conduct the Acceptance Test in accordance with the Service Contract and the Acceptance Test Plan. The following conditions must occur in order for the Acceptance Date to occur: PSOMAS Page 48 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT . Each of the conditions for the commencement of construction shall be and remain satisfied as of the Acceptance Date; . Substantial Completion shall have occurred; . CADHS has issued its approval and it is lawful to introduce Finished Water into the District's water system; . All governmental approvals required under applicable law shall have been obtained; . The DB/Operator shall have completed all required Acceptance Tests and shall have demonstrated satisfaction of the Acceptance Test Procedures and Standards; and . There shall be no event of default by the DB/Operator under the Service Contract or by the Guarantor under the Service Contract Guaranty. PROVISIONAL ACCEPTANCE The DB/Operator can certify Provisional Acceptance after completion of the Acceptance Test, upon written certification to the District that in its judgment all the Acceptance Date conditions have been met. Within 30 days of Provisional Acceptance, the DB/Operator shall furnish the District with a written report describing and certifying the Acceptance Test conducted and the results. The District has 60 days to notify the DB/Operator if it concurs that the Acceptance Date conditions have been met. If the District concurs, the Acceptance Date will be deemed to have been met on a permanent basis as of the date of Provisional Acceptance. If the District disagrees and does not concur with the certification of Provisional Acceptance, either party can refer the dispute to non-binding mediation. If either party so elects, judicial proceedings can be initiated 120 days after the Districts disagreement with the Provisional Acceptance. The DB/Operator shall achieve Provisional Acceptance on or before December 4, 2004. If the DB/Operator does not achieve Provisional Acceptance on or before such date, the DB/Operator shall pay the District liquidated damages in an amount equal to the Lease Payments (including payments with respect to both interest and principal) accrued by the District on a daily basis, up to the end of the Extension Period and thereafter until any termination of the Service Contract for an event of default by the DB/Operator. Provisional Acceptance and Acceptance shall be determined without regard to the MWD Agreement. The DB/Operator has the right to avoid termination of the MWD Agreement through production of Allowable Yield, without regard to the requirements as to Provisional Acceptance and Acceptance. PSOMAS Page 49 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 7.3.3 MWD AGREEMENT MWD, which supplies imported water for the remainder of the District's water requirements, entered into an agreement with the Authority to provide to the Authority an annual subsidy of up to $250 per acre-foot of treated groundwater produced in order to encourage the use of local supplies and attempt to equate the costs of supply from groundwater to MWD imported water. The Authority has irrevocably assigned the rights to this subsidy to the District. In order to receive this subsidy, the Project must begin construction by December 2002 and supply treated groundwater to the District's distribution system by December 2004. In the event that the MWD Agreement is terminated as a result of failure to commence construction or deliver Finished Water by the dates in the MWD Agreement and the failure is not due to District Fault or UCCs, the DB/Operator shall pay the District for each contract year during the term of the Service Contract an amount equal to the number of acre-feet of Finished Water actually demanded by the District multiplied by the amount of the Final GRP contribution that the District would have received, if the MWD Agreement had not been canceled. These liquidated damages shall be applied as a credit against the Service Fee payment. In the event that the DB/Operator fails to achieve Acceptance by the Scheduled Acceptance Date or during the extension period, an event of default will be deemed to have occurred and the District shall have the right to terminate the Service Contract. 7.3.4 OPERATION Upon occurrence of Provisional Acceptance, the Operation Period shall commence and all Operation Period rights and obligations of all parties shall apply on a permanent basis. Commencing on the Provisional Acceptance Date (or, if Provisional Acceptance is not certified by the DB/Operator, the Acceptance Date) the DB/Operator shall operate and manage the Project on a 24-hour, 7-day per week basis and shall treat Raw Water, produce and supply Finished Water, dispose of plant by-products, secure government approvals and manage the Project to comply with the Contract Standards. The operation services must be performed in compliance with applicable law, the operation and maintenance manual prepared by ECO for the Project and ECO's computerized maintenance management system. 7.3.5 PERFORMANCE GUARANTEES WATER TREATMENT GUARANTEE The DB/Operator must operate the Project so as to treat Raw Water and to produce and distribute Finished Water to the District's water system in compliance with the requirements of applicable law and the requirements set forth in the Service Contract. PSOMAS Page 50 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Except to the extent relived for UCCs or District Fault, the DB/Operator shall pay the District liquidated damages in the amounts set forth in the Service Contract for failure to comply with the Water Treatment Guarantee. The liquidated damages set forth in the Service Contract are as follows: . $100 per day per Contract Year for Violation Number 1. . $200 per day per Contract Year for Violation Number 2. . $400 per day per Contract Year for Violation Number 3. These liquidated damages are established to address minor, occasional exceedences. Major or repeated unexcused failures of compliance with the Water Treatment Guarantee are not intended to be events of non-compliance to which liquidated damages would apply, but are deemed to be breaches of the Service Contract for which the District may seek actual damages and exercise its other remedies under the Service Contract. WATER DELIVERY GUARANTEE The DB/Operator must use its best efforts, within the physical capacity of the Plant, to meet the District's demand for the delivery of Finished Water in accordance with the Service Contract. Subject to certain exceptions if, in any Contract Year, the DB/Operator fails to meet such Water Delivery Guarantee, the cumulative amount of acre-feet shortfall minus the permissible surplus deliveries will be subject to liquidated damages. The liquidated damages for each acre-foot shortfall is equal to the sum of: (1) MWD's Prevailing Full Service Water Rate (expressed in dollars per acre-foot) plus, (2) the final GRP Contribution for that Contract Year (expressed in dollars per acre-foot), plus, (3) the administrative, operation and maintenance charged imposed by MWDOC (expressed in dollars per acre-foot). PRODUCTION EFFICIENCY GUARANTEE Except to the extent caused by UCCs or District Fault, the DB/Operator must operate the Project to achieve a Raw Water to Finished Water production efficiency of no less than 80% of the Raw Water volumes over the course of each Contract Year following the Acceptance date. HYDRAULIC TRANSMISSIONS GUARANTEE Except to the extent caused by UCCs or District Fault, the DB/Operator shall operate the Project so as to avoid the occurrence of sudden, significant changes in the flow rate and pressure of Finished Water delivered to the District's water system. PSOMAS Page 51 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 7.3.6 DISTRICT'S REMEDIES FOR NON-COMPLIANCE WITH PERFORMANCE GUARANTEES If the DB/Operator fails to comply with any Performance Guarantee and is not excused from performance as a result of an UCC or District Fault, the DB/Operator shall, without relief under any other Performance Guarantee, or in addition to any other remedy provided in the Service Contract, allowed by applicable law or required by a governmental body: . Promptly notify the District of such non-compliance; . Promptly provide to the District copies of any notices sent to governmental bodies; . Pay liquidated damages in the amounts provided in the Service Contract; . Pay any other resulting fines, damages, etc.; . Take any actions necessary to comply with the Performance Guarantees; . Promptly prepare all public notifications required by applicable law and submit such notifications for publication; and . Assist the District with all public relations matters necessary to adequately address any public concern caused by such non-compliance. 7.3.7 RELEASES, LEAKS AND SPILLS The DB/Operator shall operate the Project in such a manner that Raw Water, Finished Water or plant by-products will not contaminate, or be released, leak or spill on or into the environment. All costs associated with the identification, testing, cleanup, removal, etc. of any waste or material released, leaked or spilled from the Project and the costs of performing any necessary remediation measures shall be born by the DB/Operator (unless caused by an UCC or District Fault). 7.4 SERVICE CONTRACT GUARANTY AGREEMENT The Guarantor, Southwest Water, absolutely, irrevocably and unconditionally guarantees to the District the full and prompt performance of each and all the obligations including the payment when due of each and all payments to be credited or paid by the DB/Operator under the Service Contract. The Guaranty Agreement specifically agrees that the District can proceed first and directly against the Guarantor for any payments or obligations that the DB/Operator fails to pay without exhausting its remedies against the DB/Operator. The District and Guarantor acknowledge that no security for the Obligations of the Guarantor has been granted to the District as of the date of this Agreement, but the PSOMAS Page 52 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT security shall be granted to the District subsequent to the Contract Date as set forth in the Service Contract. The Service Contract Guaranty Agreement shall remain in effect until all of the Obligations of the DB/Operator have been fully paid and performed. The Service Contract Guaranty shall be effective irrespective as to when the Construction Date occurs. 7.5 PROPERTY LEASE The City and the Authority entered into the "Property Lease" Agreement, whereby the City will lease the various real property sites required for the Project on which the Service Contract Project Improvements are to be constructed to the Authority. The Authority will then lease the sites and the to be constructed Project Improvements to the District, pursuant to the terms of the "Lease" Agreement, discussed below, in order to obtain funds to finance the design, construction and installation of the Project as described in the Service Contract. The term of the Property Lease shall commence as of the Delivery Date for the Bonds and will remain in effect until October 1, 2057. 7.6 LEASE AGREEMENT Under the Lease Agreement, the Authority will sublease the Property to the District. The Lease Agreement will, subject to the terms thereof, obligate the District to make the Lease Payments to the Authority in an amount equal to the principal and interest on the Bonds. On the Closing Date the Authority agrees to deposit to the Project Account of the Project Trust Fund created under the Trust Agreement a portion of the proceeds of the Authority's sale of the Bonds. These funds will be utilized for the construction of the Project. The Lease Agreement provides for the design, construction and Acceptance of the Project by the District through the DB/Operator in accordance with the Service Contract, the use of Bond funds to reimburse the Design-Build price, on a milestone basis, to the DB/Operator, the lease of a portion of the RO Facility site and the RO Facility and related facilities by the District and the payment of the Lease Payments to the Trustee in an amount equal to the debt service on the Bonds. The Lease Agreement terminates upon the payment of all the outstanding Bonds or the termination of the Service Contract as a result of Default by the DB/Operator (subject to Trustee and Insurer cure rights in accordance with the Service Contract). Upon termination of the Lease Agreement, the title to the Project will revert to the Authority, subject to the District's rights pursuant to the Operating Lease Agreement. The Lease Payments and other payments required to be made under the Lease Agreement are a special obligation of the District payable solely from Revenues and do not constitute a debt of the District in contravention of any constitutional or statutory debt limitation or restriction. Except for the pledge of Revenues, neither the faith and credit nor the taxing power of the District is pledged to the payment of the Lease Payments. The Property, PSOMAS Page 53 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT subject to the Lease Agreement, improvements thereon and other assets of the District are not pledged or available to the Trustee or Bondholders in the event of termination of the Lease Agreement or default in Lease Payments and no default will result in loss of the property, improvements thereon or other assets of the District. The Lease Agreement specifies that, except with respect to certain rights of the District to terminate the Lease Agreement early, the obligation of the District is absolute and unconditional and the District will not discontinue or suspend any Lease Payments required to be made until such time as the Lease Payments are paid in full. The District covenants that it will not issue or incur any additional bonds, notes or obligations, which will have a priority in payment out of Revenues over the Lease Payments. Pursuant to the Trust Agreement, the Authority will assign all of its rights, title, and interest in the Lease Agreement to the Trustee for the benefit of Bondholders. 7.7 TRUST AGREEMENT The Trust Agreement relating to the San Juan Basin Authority Lease Revenue Bonds Issue of 2002 is entered into between the District, the Authority, and BNY Western Trust Company (Trustee). This Agreement is entered into for the purpose of holding the Trust Estate for the use and benefit of the Bondholders. The Bonds shall be issued on a conduit basis by the Authority and are secured solely by the Trust Estate pledged under this Trust Agreement. The Trust Estate consists principally of (1) all amounts received by the Trustee for account of the District in connection with the Service Contract Letter of Credit, and the Lease Agreement, including without limitation, the Lease Payments, (2) all right, title and interest in the Trustee benefit provisions pursuant to the Service Contract, and (3) the amounts held in funds and accounts under the Trust Agreement pending disbursement. The Authority assigns all its rights, title and interest in the Lease Agreement to the Trustee and retains no right, title, or interest therein. Pursuant to the Service Contract, the DB/Operator will provide the Service Contract Letter of Credit with the District as beneficiary. However, under the Trust Agreement, the District will covenant to transfer to the Trustee for deposit into the Debt Service Payment Account established under the Trust Agreement, all proceeds of any drawing on the Service Contract Letter of Credit received by the District. The Bonds are special obligations of the Authority and are secured by an irrevocable pledge of, and are payable as to principal and interest from the Trust Estate. In order to provide funds to construct the Service Contract Project Improvements, the Authority has caused the Trustee to authenticate and deliver the Bonds and from the proceeds of the sale of the Bonds, the Trustee shall deposit the amounts provided into the various funds of the Project Trust Fund. So long as the Lease Agreement is in effect, all of the Lease Payments, made by the District constituting a part of the Trust Estate payable to the Trustee, shall be paid directly to the Trustee for distribution, in accordance with the Trust Agreement to the Bondholders. PSOMAS Page 54 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 7.8 OSMONICS CONTRACT This review of the Osmonics scope and pricing is based upon a preliminary proposal dated June 22, 2001 and the Osmonics letter dated November 1, 2002. All comments pertain to a review of the preliminary proposal and the referenced letter. Osmonics is to furnish the two Cartridge Filters, three RO High Pressure Pumps, including a spare pump and can, two RO trains, including housings, membranes, energy recovery booster, and the RO electrical panel, the Chemical Injection Pump System, Chemical Feed Systems and the membrane cleaning system. Per the Osmonics letter dated November 1, 2002, Osmonics has agreed to a variable pricing structure for membrane replacement. If the replacement life of the membranes increases by 20%, then the annual savings in operating costs is approximately 4%. If the membrane replacement life decreases by 50%, then the annual operating costs increase by approximately 5%. There is no change in the membrane replacement pricing if the replacement life of the membranes is four years. 7.9 AGREEMENT FOR CONSTRUCTION - ARB, INC. This review of the Construction Agreement between ECO Resources, Inc. and ARB is based upon the undated and unsigned draft received December 6, 2002, scheduled for execution on December 8, 2002. The DB/Operator has retained ARB to furnish all construction services that the DB/Operator is required to perform under the Service Contract for a Guaranteed Maximum Price of Sixteen Million Five Hundred Thousand Dollars ($16,500,000)(GMP). The GMP includes all costs of labor, supervision, tools, equipment, supplies, materials, services, allowances, overhead, profits, fees, taxes and other costs and expenses related to construction of the Project. The GMP is based upon the scope of work described in the Contract Documents, including the Project Design, as described in the Service Contract. The work includes the following Project Elements as described in the Service Contract: . Plant . Project Structures . Project Equipment . Additional Assets . Project Wells . Project Pipelines . Raw Water Transmission Line PSOMAS Page 55 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT . Booster Pumping Station . Finished Water Transmission Line . Concentrate Disposal Line . Abandonment of the Existing Wells. The contractor shall not be entitled to an adjustment in the GMP for costs of any DB/Operator generated changes up to 1% of the GMP. The contractor shall not be entitled to change in the GMP or contract time due to a differing site condition except to the extent that the DB/Operator is entitled to an adjustment in its compensation or time for performance under the Service Contract. The contractor is responsible for obtaining the construction related permits. The contractor acknowledges that it is entering into the Agreement on the basis of conceptual plans prepared by Boyle Engineering and with knowledge of the District's requirements for the design and construction of the Project as set forth in the Service Contract. The Construction Agreement also includes specific dates upon which the contractor will achieve Substantial Completion of the Work and Project Acceptance. The contractor will be responsible for paying the DB/Operator the following liquidated damages for each calendar day that expires after the date for Substantial Completion and for each calendar day that expires after the date for Acceptance until the foregoing events are achieved. 1 to 30 days $2,000 per day 31 to 60 days 3,000 per day 61 and beyond 4,000 per day The Construction Agreement indicates that the rights, duties and obligations of the DB/Operator and the contractor with regard to UCCs shall be the same as those between the District and the DB/Operator as set forth in the Service Contract. The contractor will be compensated monthly based upon the Project Schedule and the agreed Schedule of Values included in the Construction Agreement. Each invoice is subject to ten percent (10%) retention, which retention shall be reduced to five percent (5%) upon achievement of Substantial Completion. The balance of the retention shall be paid upon Final Completion. The contractor will secure completion of the Contract by furnishing performance and payment bonds in the full amount of the Contract Price. These bonds shall remain in effect for one year after the date of Acceptance and shall be issued by surety insurers having an AM Best rating of "A" or better. The contractor will also Warranty his work for one (1) year after Acceptance. CONCLUSION: PSOMAS is of the opinion that based upon a review of the Project Agreements, the terms of the Project Agreements will allow the DB/Operator to meet its obligations under the Service Contract. PSOMAS Page 56 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT VIII. PROJECT SCHEDULE AND COSTS 8.1 ENGINEERING, PROCUREMENT, CONSTRUCTION SCHEDULE AND COSTS 8.1.1 CONSTRUCTION SCHEDULE These construction milestones are predicated on the executed Service Contract and construction start no later that December 4, 2002. Start dates, completion dates and duration of activities were obtained from the preliminary schedule dated October 25, 2002, which has been included in the Agreement for Construction. This schedule is subject to change based upon final design, the start of procurement for major equipment items and the Financing Date. The schedule indicates that the geo-technical surveys started January 2002 and completed July 3, 2002. The design survey is scheduled to start October 28, 2002, and completed November 15, 2002. The demolition plan started October 28, 2002, and the demolition permit was acquired November 22, 2002. The foundation design, grading plan, plant layout, equipment and mechanical layout, and the building plan started November 18, 2002 and scheduled completion is February 6, 2003. Permit acquisition for the RO Facility will start December 18, 2002 and complete February 13, 2003. The design for the offsite pipelines, wells and Booster Pumping Station is scheduled to start December 9, 2002, and complete January 16, 2003. The permit acquisition for the offsite facilities is scheduled to start January 17, 2003 and complete April 10, 2003. The procurement activities for the RO trains, Fe/Mn filters, sand separators, chemical feed equipment, miscellaneous process tanks and pumps, pre-fabricated buildings, and well pumps and motors will take place between January 10, 2003 and March 14, 2003. Fabrication and delivery of the above equipment will complete starting April 10, 2003 and ending September 23, 2003. Mobilization, demolition and civil site work commenced November 25, 2002, and will complete May 22, 2003. Foundation construction is scheduled to start April 11, 2003 with the completion scheduled for October 7, 2003. Pre-fabricated building installation is scheduled for August 5, 2003 through December 16, 2003. Fe/Mn equipment installation is scheduled for September 24, 2003, RO equipment installation is scheduled for September 10, 2003, pipeline construction is scheduled for April 11, 2003, and well drilling is scheduled to start April 11, 2003. Acceptance Testing and permitting is scheduled to start May 11, 2004 and be completed August 18, 2004. Provisional Acceptance is scheduled for August 19, 2004. Analysis: If the DB/Operator has not received Acceptance/Provisional Acceptance by the Service Contract Scheduled Date of September 1, 2004 or as adjusted by approved changes or UCCs, the Extension Period of 547 days is in effect. Liquidated damages equal to the Lease Payments (including payments with respect to both interest and principal) are payable from December 5, 2004, if Acceptance has not been achieved by December 4, PSOMAS Page 57 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 2004. These liquidated damages are in addition to the liquidated damages assessed due to cancellation of the MWD GRP contribution not caused by UCCS or District Fault. CONCLUSION: PSOMAS is of the opinion that the preliminary construction schedule is reasonable and includes sufficient contingency in the activity durations in order to complete the Project within the parameters of the MWD Agreement and the Service Contract. 8.1.2 CONSTRUCTION COSTS The Service Contract dated September 2002 states the Fixed Design-Build Price for the Engineering, Procurement and Construction as $25,030,607. This price is estimated based upon the use of drilled pile foundations. This amount is payable based upon the following Milestone Payment Schedule. The DB/Operator is entitled to monthly payments based upon completions of the indicated milestones as shown below: PROJECT MILESTONES PROJECT DRAWS Construction Date $ 2,971,966 Construction Date plus 30 Days $ 163,660 Construction Date plus 60 Days $ 163,660 Begin Foundation $ 773,300 Begin Well Drilling $ 490,980 33% Completion of Well Casings $ 490,980 67% Completion of Well Casings $ 490,980 Completion of Well Casings $ 490,980 Begin Pipeline Work $ 309,596 33% Complete Pipeline Work $ 354,596 67% Complete Pipeline Work $ 354,596 Complete Pipeline Work $ 354,596 Complete Foundation $ 1,691,152 Issue PO for Fe/Mn Filters $ 436,426 Issue PO for RO Equipment $ 763,746 Begin Bore $ 545,533 50% Bore Completion $ 545,533 Completion of Bore $ 545,533 Begin Creek Crossing $ 360,052 50% Completion of Creek Crossing $ 370,962 Completion of Creek Crossing $ 360,052 Begin Steel Framing $ 360,052 Complete Steel Framing $ 731,014 Delivery of Fe/Mn Filters $ 1,636,599 PSOMAS Page 58 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT Delivery of Backwash Tank Steel $ 818,300 Delivery of RO Equipment $ 2,045,749 60 Days after Delivery Fe/Mn Filters $ 545,533 60 Days After Delivery of Backwash Steel $ 272,767 60 Days After Delivery RO Equipment $ 681,916 Connection into SCRA $ 1,091,066 Completion of Strawberry Hill Pump Sta. $ 545,533 Test Pumping of Wells $ 545,533 Install Chemical Feed System $ 1,091,066 Completion of Well Enclosures $ 272,767 Install SCADA at Wells $ 272,767 Install SCADA at RO Building $ 545,533 Delivery of Chemicals at RO Plant $ 545,533 ------------ Total $ 25,030,607 ------------ The District is currently negotiating with DB/Operator for a modification to the Design/Build Work which would modify the Plant foundation construction method and would result in a reduction of the Fixed Design/Build Price from $25,030,607 to $24,190,607. No assurances can be made, however, that such negotiations will be successful and that the modification to the Design/Build Work and corresponding Fixed Design/Build Price reduction will occur. CONCLUSION: PSOMAS is of the opinion that the Project can be constructed for the Fixed Design/Build Price included in the Service Contract and the construction milestone payment schedule is reasonable. 8.2 OPERATIONS AND MAINTENANCE COSTS The District has entered into the Service Contract with the DB/Operator, whereby the DB/Operator will manage the design and construction of the Project for which they will be reimbursed out of bond proceeds. Upon acceptance of the Project, the DB/Operator will receive the Service Fee in return for operational services over the twenty-year period. Following Acceptance of the Project, the DB/Operator will be paid the Service Fee in accordance with the following formula: Service Fee = Base Operating Charge +/- Extraordinary Items Charge/Credit PSOMAS Page 59 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 8.2.1 BASE OPERATING CHARGE The Base Operating Charge is calculated by adding the Fixed Component and the Variable Component. The Fixed Component is the sum of the Operations and Maintenance Component ($611,400), the Labor Component ($170,600), and the Replacement Component ($312,900) for a total for the first contract year of $1,094,900. The Fixed Component will be adjusted in the second and each subsequent contract year in accordance with the Adjustment Factor, discussed below. The Variable Component consists of the First Water Demand Adjustment Element, the Second Water Demand Adjustment Element, and the Electrical Savings Element. The First Water Demand Adjustment Element is based upon the District's annual demand of Finished Water in an amount greater than 4,800 AFY but less than 5,231 AFY. This amount is $151 per acre-foot for every acre-foot greater than 4,800 AFY. The Second Water Demand Adjustment Element is based upon the District's annual demand of Finished Water in an amount greater than 5,231 AFY. This amount is $228 per acre-foot greater than 5,231 AFY. The Electrical Savings Element will be a charge or credit determined on the basis of the DB/Operator's use of electrical power in accordance with the threshold limits specified in the Service Contract. 8.2.2 EXTRAORDINARY ITEMS CHARGE OR CREDIT The Extraordinary Items component of the Service Fee, which may be a charge or credit, will be equal to the sum of: (1) the amounts payable by the District for increased operation, maintenance or other costs incurred on account of the occurrence of an UCC; plus (2) the adjustments to the Service Fee resulting from any Capital Modifications the costs of which are payable by the District, or the benefits of which accrue to the District, under the provisions of the Service Contract; minus (3) any liquidated damages or Service Fee reductions due to the DB/Operator's non-performance specifically provided for under any other provision of the Service Contract; plus or minus (4) any other increase or reduction in the Service Fee provided for under the Service Contract. 8.2.3 ADJUSTMENT FACTOR The Service Fee will be adjusted in the second and each subsequent contract year in accordance with the Adjustment Factor determined as follows: AF//n// = 1 + {(0.90) x [(CPI-U//n// - 1 - CPI-U//n//- 2)/CPI-U//n// - 2]} Where, AF//n// = The Adjustment Factor for Contract Year "n". PSOMAS Page 60 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT CPI - U//n// - 1 = the average of the 12 month CPI -U values occurring in the Contract Year preceding the Contract Year with respect to which the calculation is to be made. CPI - U//n// - 2 = The average of the 12 month CPI -U value occurring in the Contract Year two years preceding the Contract Year with respect to which the calculation is to be made. CONCLUSION: PSOMAS is of the opinion that the Operations Cost included in the Service Contract is sufficient to operate and maintain the Project for the Operation Period of the Service Contract. 8.3 PROJECT COST PROJECTIONS The total projected costs over the Operation Period of the Service Contract period, plus an additional period to and beyond the thirty-two year Bond term for comparison with assumed MWD imported water rates, are shown on the spreadsheet attached hereto. The costs have been projected on the basis of 4,800 AFY and 5,231 AFY of Finished Water. The 4,800 AFY is the Guaranteed Delivery Rate and the 5,231 AFY rate is the conservative maximum capability of the distribution system per the Service Contract. For estimating purposes, the CPI-U (Los Angeles, Riverside and Orange County) has been assumed to increase at 3 percent per year for the entire 33-year analysis period. The rate used as per the Service Contract was 90 percent of that rate, or approximately 2.7 percent. Although the Service Contract expires in 20 years from Acceptance, it was assumed that it would be extended at the same terms and rates for analysis purposes. The projected cost per acre-foot at 4,800 AFY varies from $931, for the first full year of operation, to $1,231 in year-twenty, the last year of the MWD GRP contribution. The cost per acre-foot at 5,231 AFY varies from $887, in the first full year of operation to $1184, in year-twenty. As indicated above, none of the rates met the initial goal of $681 ($431 plus the GRP of $250) per acre-foot escalated for the twenty-year Service Contract period. However, the value of a local treated water resource in terms of reliability, operational flexibility, avoided costs for additional storage and the ability to avoid future MWD rate increases and charges for growth make the Project scenario attractive to the District. It should be noted that in 2036, the first year following bond retirement, the estimated cost of the Project water is within a few percentage points of projected MWD imported water rates. PSOMAS Page 61 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT PROJECT COST PROJECTION SCHEDULE CAPISTRANO VALLEY WATER DISTRICT PHASE 1 - DESALTER PROJECT 4,800 AFY
FISCAL YEAR 2003 2004 2005 2006 2007 2008 2009 2010 - ----------------------------------------------------------------------------------------------------------------------------------- Water Quantity (AFY) 0 0 2,400 4,800 4,800 4,800 4,800 4,800 ANNUAL COSTS O & M Component 611,400 627,908 644,861 662,273 680,154 698,518 717,378 736,747 Labor Component 170,600 175,206 179,937 184,795 189,785 194,909 200,171 205,576 Replacement Component 312,900 321,348 330,025 338,935 348,087 357,485 367,137 377,050 Annual Service Payment 1,094,900 1,124,462 1,154,823 1,186,003 1,218,025 1,250,912 1,284,686 1,319,373 Power Cost 1,031,250 1,059,094 1,087,689 1,117,057 1,147,217 1,178,192 1,210,003 1,242,674 --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Operational Cost NA NA 1,121,256 2,303,060 2,365,243 2,429,104 2,494,690 2,562,046 Net Debt Service Rqmt. NA NA 1,511,017 2,164,267 2,159,142 2,161,342 2,156,573 2,154,836 --------- --------- --------- --------- --------- --------- Total Annual Cost NA NA 2,632,273 4,467,327 4,524,385 4,590,446 4,651,263 4,716,882 Unit Cost per AF NA NA 1,097 931 943 956 969 983 MWD Subsidy (20 yr. @ 250/AF) NA NA 600,000 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 Unit Cost per AF NA NA 250 250 250 250 250 250 --------- --------- --------- --------- --------- --------- --------- --------- Net Annual Cost NA NA 2,032,273 3,267,327 3,324,385 3,390,446 3,451,263 3,516,882 Unit Cost per AF NA NA 847 681 693 706 719 733 UNIT COSTS O & M Component 134 138 142 146 149 153 Labor Component 37 38 40 41 42 43 Replacement Component 69 71 73 74 76 79 Power 227 233 239 245 252 259 Unit Cost per AF 467 480 493 506 520 534 - ----------------------------------------------------------------------------------------------------------------------------------- RATE COMPARISONS (PER AF) Annual Cost NA NA 1,097 931 943 956 969 983 MWD Subsidy Available NA NA 250 250 250 250 250 250 Net Annual Cost NA NA 847 681 693 706 719 733 Comparison Wholesale Rate 431 443 455 467 479 492 506 519 - ----------------------------------------------------------------------------------------------------------------------------------- FISCAL YEAR 2011 2012 2013 2014 2015 2016 2017 2018 2019 - ----------------------------------------------------------------------------------------------------------------------------------- Water Quantity (AFY) 4,800 4,800 4,800 4,800 4,800 4,800 4,800 4,800 4,800 ANNUAL COSTS O & M Component 756,639 777,069 798,050 819,597 841,726 864,453 887,793 911,763 936,381 Labor Component 211,126 216,827 222,681 228,694 234,868 241,210 247,722 254,411 261,280 Replacement Component 387,230 397,685 408,423 419,450 430,775 442,406 454,351 466,619 479,217 Annual Service Payment 1,354,996 1,391,581 1,429,154 1,467,741 1,507,370 1,548,069 1,589,867 1,632,793 1,676,878 Power Cost 1,276,226 1,310,684 1,346,072 1,382,416 1,419,742 1,458,075 1,497,443 1,537,874 1,579,396 --------- --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Operational Cost 2,631,222 2,702,265 2,775,226 2,850,157 2,927,111 3,006,143 3,087,309 3,170,666 3,256,274 Net Debt Service Rqmt. 2,155,867 2,154,536 2,150,842 2,149,029 2,148,801 2,150,483 2,148,939 2,144,170 2,143,479 --------- --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Cost 4,787,089 4,856,801 4,926,068 4,999,186 5,075,912 5,156,626 5,236,248 5,314,836 5,399,753 Unit Cost per AF 997 1,012 1,026 1,041 1,057 1,074 1,091 1,107 1,125 MWD Subsidy (20 yr. @ 250/AF) 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 Unit Cost per AF 250 250 250 250 250 250 250 250 250 --------- --------- --------- --------- --------- --------- --------- --------- --------- Net Annual Cost 3,587,089 3,656,801 3,726,068 3,799,186 3,875,912 3,956,626 4,036,248 4,114,836 4,199,753 Unit Cost per AF 747 762 776 791 807 824 841 857 875 UNIT COSTS O & M Component 158 162 166 171 175 180 185 190 195 Labor Component 44 45 46 48 49 50 52 53 54 Replacement Component 81 83 85 87 90 92 95 97 100 Power 266 273 280 288 296 304 312 320 329 Unit Cost per AF 548 563 578 594 610 626 643 661 678 - ----------------------------------------------------------------------------------------------------------------------------------- RATE COMPARISONS (PER AF) Annual Cost 997 1,012 1,026 1,041 1,057 1,074 1,091 1,107 1,125 MWD Subsidy Available 250 250 250 250 250 250 250 250 250 Net Annual Cost 747 762 776 791 807 824 841 857 875 Comparison Wholesale Rate 533 548 563 578 593 609 626 643 660 - -----------------------------------------------------------------------------------------------------------------------------------
Notes: 1. O&M Costs per Service Contract between CVWD and ECO Resources, Inc. dated September 3, 2002. 2. Annual Cost Escalation based on 90% of assumed 3% CPI increase, or 0.27% per year. 3. Costs for first two years (in italics) only used for escalation purposes, as first fiscal year of operation is 2005. 4. Net Debt Service from DBC Finance run dated September 10, 2002. 5. Power Costs based on Guaranteed Maximum Electricity Utilization (Appendix 10 of Service Contract) and $0.125 per Kwh in FY 2003 escalated per Note 2. 6. ECO Contract expires after 20 years but extension is assumed using same operating cost parameters to end of bond term and beyond to determine water rate comparison to and beyond bond retirement. 7. Assumed first FY of operation (2005) generates 2,400 AF and Total Annual Cost is equal to half of normal full-year Fixed O&M and Power Cost plus first six months of debt service not funded by capitalized interest. 8. Since Met Subsidy runs out half way through 2025 (20 years), comparison rate is figured with $125/AF subsidy -vs- $250/AF and comparison is skewed. PSOMAS Page 62 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT PROJECT COST PROJECTION SCHEDULE CAPISTRANO VALLEY WATER DISTRICT PHASE 1 - DESALTER PROJECT 4,800 AFY
FISCAL YEAR 2020 2021 2022 2023 2024 2025 - ---------------------------------------------------------------------------------------------------------- Water Quantity (AFY) 4,800 4,800 4,800 4,800 4,800 4,800 ANNUAL COSTS O & M Component 961,663 987,628 1,014,294 1,041,680 1,069,805 1,098,690 Labor Component 268,335 275,580 283,020 290,662 298,510 306,569 Replacement Component 492,156 505,445 519,092 533,107 547,501 562,283 Annual Service Payment 1,722,154 1,768,652 1,816,406 1,865,449 1,915,816 1,967,543 Power Cost 1,622,040 1,665,835 1,710,812 1,757,004 1,804,443 1,853,163 --------- --------- --------- --------- --------- --------- Total Annual Operational Cost 3,344,194 3,434,487 3,527,218 3,622,453 3,720,259 3,820,706 Net Debt Service Rqmt 2,141,855 2,141,854 2,138,355 2,141,104 2,134,979 2,086,684 --------- --------- --------- --------- --------- --------- Total Annual Cost 5,486,049 5,576,341 5,665,573 5,763,557 5,855,238 5,907,390 Unit Cost per AF 1,143 1,162 1,180 1,201 1,220 1,231 MWD Subsidy (20 yr. @ 250/AF) 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 600,000 Unit Cost per AF 250 250 250 250 250 250 --------- --------- --------- --------- --------- --------- Net Annual Cost 4,286,049 4,376,341 4,465,573 4,563,557 4,655,238 5,307,390 Unit Cost per AF 893 912 930 951 970 1,106 UNIT COSTS O & M Component 200 206 211 217 223 229 Labor Component 56 57 59 61 62 64 Replacement Component 103 105 108 111 114 117 Power 338 347 356 366 376 386 Unit Cost per AF 697 716 735 755 775 796 - ---------------------------------------------------------------------------------------------------------- RATE COMPARISONS (PER AF) Annual Cost 1,143 1,162 1,180 1,201 1,220 1,231 MWD Subsidy Available 250 250 250 250 250 125 Net Annual Cost 893 912 930 951 970 1,106 Comparison Wholesale Rate 678 696 715 734 754 775 - ---------------------------------------------------------------------------------------------------------- FISCAL YEAR 2026 2027 2028 2029 2030 2031 - ---------------------------------------------------------------------------------------------------------- Water Quantity (AFY) 4,800 4,800 4,800 4,800 4,800 4,800 ANNUAL COSTS O & M Component 1,128,355 1,158,820 1,190,108 1,222,241 1,255,242 1,289,133 Labor Component 314,847 323,348 332,078 341,044 350,252 359,709 Replacement Component 577,465 593,057 609,069 625,514 642,403 659,748 Annual Service Payment 2,020,667 2,075,225 2,131,256 2,188,800 2,247,897 2,308,590 Power Cost 1,903,199 1,954,585 2,007,359 2,061,558 2,117,220 2,174,385 --------- --------- --------- --------- --------- --------- Total Annual Operational Cost 3,923,865 4,029,810 4,138,615 4,250,357 4,365,117 4,482,975 Net Debt Service Rqmt 947,013 945,389 942,013 941,763 944,389 939,889 --------- --------- --------- --------- --------- --------- Total Annual Cost 4,870,878 4,975,199 5,080,628 5,192,120 5,309,506 5,422,864 Unit Cost per AF 1,015 1,036 1,058 1,082 1,106 1,130 MWD Subsidy (20 yr. @ 250/AF) 0 0 0 0 0 0 Unit Cost per AF 0 0 0 0 0 0 --------- --------- --------- --------- --------- --------- Net Annual Cost 4,870,878 4,975,199 5,080,628 5,192,120 5,309,506 5,422,864 Unit Cost per AF 1,015 1,036 1,058 1,082 1,106 1,130 UNIT COSTS O & M Component 235 241 248 255 262 269 Labor Component 66 67 69 71 73 75 Replacement Component 120 124 127 130 134 137 Power 396 407 418 429 441 453 Unit Cost per AF 817 840 862 885 909 934 - --------------------------------------------------------------------------------------------------------- RATE COMPARISONS (PER AF) Annual Cost 1,015 1,036 1,058 1,082 1,106 1,130 MWD Subsidy Available 0 0 0 0 0 0 Net Annual Cost 1,015 1,036 1,058 1,082 1,106 1,130 Comparison Wholesale Rate 795 817 839 862 885 909 - --------------------------------------------------------------------------------------------------------- FISCAL YEAR 2032 2033 2034 2035 2036 - ---------------------------------------------------------------------------------------------------------- Water Quantity (AFY) 4,800 4,800 4,800 4,800 4,800 ANNUAL COSTS O & M Component 1,323,940 1,359,686 1,396,398 1,434,101 1,472,821 Labor Component 369,421 379,396 389,639 400,160 410,964 Replacement Component 677,561 695,855 714,643 733,939 753,755 Annual Service Payment 2,370,922 2,434,937 2,500,680 2,568,199 2,637,540 Power Cost 2,233,093 2,293,387 2,355,308 2,418,901 2,484,212 --------- --------- --------- --------- --------- Total Annual Operational Cost 4,604,015 4,728,324 4,855,989 4,987,100 5,121,752 Net Debt Service Rqmt 958,569 964,388 964,139 (117,399) 0 --------- --------- --------- --------- --------- Total Annual Cost 5,562,584 5,692,712 5,820,128 4,869,701 5,121,752 Unit Cost per AF 1,159 1,186 1,213 1,015 1,067 MWD Subsidy (20 yr. @ 250/AF) 0 0 0 0 0 Unit Cost per AF 0 0 0 0 0 --------- --------- --------- --------- --------- Net Annual Cost 5,562,584 5,692,712 5,820,128 4,869,701 5,121,752 Unit Cost per AF 1,159 1,186 1,213 1,015 1,067 UNIT COSTS O & M Component 276 283 291 299 307 Labor Component 77 79 81 83 86 Replacement Component 141 145 149 153 157 Power 465 478 491 504 518 Unit Cost per AF 959 985 1,012 1,039 1,067 - --------------------------------------------------------------------------------------------------------- RATE COMPARISONS (PER AF) Annual Cost 1,159 1,186 1,213 1,015 1,067 MWD Subsidy Available 0 0 0 0 0 Net Annual Cost 1,159 1,186 1,213 1,015 1,067 Comparison Wholesale Rate 933 958 984 1,011 1,038 - ---------------------------------------------------------------------------------------------------------
Notes: 1. O&M Costs per Service Contract between CVWD and ECO Resources, Inc. dated September 3, 2002. 2. Annual Cost Escalation based on 9 3. Costs for first two years (in italics) only used for escalation purposes, as first fiscal year of operation is 2005. 4. Net Debt Service from DBC Finance run dated September 10, 2002. 5. Power Costs based on Guaranteed Maximum Electricity Utilization (Appendix 10 of Service Contract) and $0.125 per Kwh in FY 2003 escalated per Note 2. 6. ECO Contract expires after 20 years but extension is assumed using same operating cost parameters to end of bond term and beyond to determine water rate comparison to and beyond bond retirement. 7. Assumed first FY of operation (2005) generates 2,400 AF and Total Annual Cost is equal to half of normal full-year Fixed O&M and Power Cost plus first six months of debt service not funded by capitalized interest. 8. Since Met Subsidy runs out half way through 2025 (20 years), comparison rate is figured with $125/AF subsidy -vs- $250/AF and comparison is skewed. PSOMAS Page 63 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT PROJECT COST PROJECTION SCHEDULE CAPISTRANO VALLEY WATER DISTRICT PHASE 1 - DESALTER PROJECT 5,231 AFY
FISCAL YEAR 2003 2004 2005 2006 2007 2008 2009 2010 - ---------------------------------------------------------------------------------------------------------------------------------- Water Quantity (AFY) 0 0 2,400 5,231 5,231 5,231 5,231 5,231 ANNUAL COSTS O & M Component 611,400 627,908 644,861 662,273 680,154 698,518 717,378 736,747 Labor Component 170,600 175,206 179,937 184,795 189,785 194,909 200,171 205,576 Replacement Component 312,900 321,348 330,025 338,935 348,087 357,485 367,137 377,050 First Demand Adj. Element 65,081 66,838 68,643 70,496 72,400 74,354 76,362 78,424 --------- --------- --------- --------- --------- --------- --------- --------- Annual Service Payment 1,159,981 1,191,300 1,154,823 1,256,499 1,290,425 1,325,266 1,361,048 1,397,797 Power Cost 1,126,000 1,156,402 1,187,625 1,219,691 1,252,622 1,286,443 1,321,177 1,356,849 --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Operational Cost NA NA 1,121,256 2,476,190 2,543,047 2,611,709 2,682,225 2,754,646 Net Debt Service Rqmt. NA NA 1,511,017 2,164,267 2,159,142 2,161,342 2,156,573 2,154,836 --------- --------- --------- --------- --------- --------- Total Annual Cost NA NA 2,632,273 4,640,457 4,702,189 4,773,051 4,838,798 4,909,482 Unit Cost per AF NA NA 1,097 887 899 912 925 939 MWD Subsidy (20 yr @ 250/AF) NA NA 600,000 1,307,750 1,307,750 1,307,750 1,307,750 1,307,750 Unit Cost per AF NA NA 250 250 250 250 250 250 --------- --------- --------- --------- --------- --------- --------- --------- Net Annual Cost NA NA 2,032,273 3,332,707 3,394,439 3,465,301 3,531,048 3,601,732 Unit Cost per AFY NA NA 847 637 649 662 675 689 UNIT COSTS O & M Component 134 127 130 134 137 141 Labor Component 37 35 36 37 38 39 Replacement Component 69 65 67 68 70 72 First Demand Adj. Element 0 13 14 14 15 15 Power 227 233 239 246 253 259 Unit Cost per AF 468 473 486 499 513 527 - ---------------------------------------------------------------------------------------------------------------------------------- RATE COMPARISONS (AFY) Annual Cost NA NA 1,097 887 899 912 925 939 MWD Subsidy Available NA NA 250 250 250 250 250 250 Net Annual Cost NA NA 847 637 649 662 675 689 Comparison Wholesale Rate 431 443 455 467 479 492 506 519 - ----------------------------------------------------------------------------------------------------------------------------- FISCAL YEAR 2011 2012 2013 2014 2015 2016 2017 2018 2019 - ------------------------------------------------------------------------------------------------------------------------------------ Water Quantity (AFY) 5,231 5,231 5,231 5,231 5,231 5,231 5,231 5,231 5,231 ANNUAL COSTS O & M Component 756,639 777,069 798,050 819,597 841,726 864,453 887,793 911,763 936,381 Labor Component 211,126 216,827 222,681 228,694 234,868 241,210 247,722 254,411 261,280 Replacement Component 387,230 397,685 408,423 419,450 430,775 442,406 454,351 466,619 479,217 First Demand Adj. Element 80,541 82,716 84,949 87,243 89,598 92,017 94,502 97,053 99,674 --------- --------- --------- -------- -------- --------- --------- --------- --------- Annual Service Payment 1,435,537 1,474,297 1,514,103 1,554,983 1,596,968 1,640,086 1,684,368 1,729,846 1,776,552 Power Cost 1,393,484 1,431,108 1,469,748 1,509,431 1,550,186 1,592,041 1,635,026 1,679,171 1,724,509 --------- --------- --------- -------- -------- --------- --------- --------- --------- Total Annual Operational Cost 2,829,021 2,905,405 2,983,850 3,064,414 3,147,154 3,232,127 3,319,394 3,409,018 3,501,061 Net Debt Service Rqmt. 2,155,867 2,154,536 2,150,842 2,149,029 2,148,801 2,150,483 2,148,939 2,144,170 2,143,479 --------- --------- --------- -------- -------- --------- --------- --------- --------- Total Annual Cost 4,984,888 5,059,941 5,134,692 5,213,443 5,295,955 5,382,610 5,468,333 5,553,188 5,644,540 Unit Cost per AF 953 967 982 997 1,012 1,029 1,045 1,062 1,079 MWD Subsidy (20 yr @ 250/AF) 1,307,750 1,307,750 1,307,750 1,307,750 1,307,750 1,307,750 1,307,750 1,307,750 1,307,750 Unit Cost per AF 250 250 250 250 250 250 250 250 250 --------- --------- --------- -------- -------- --------- --------- --------- --------- Net Annual Cost 3,677,138 3,752,191 3,826,942 3,905,693 3,988,205 4,074,860 4,160,583 4,245,438 4,336,790 Unit Cost per AFY 703 717 732 747 762 779 795 812 829 Unit Costs O & M Component 145 149 153 157 161 165 170 174 179 Labor Component 40 41 43 44 45 46 47 49 50 Replacement Component 74 76 78 80 82 85 87 89 92 First Demand Adj. Element 15 16 16 17 17 18 18 19 19 Power 266 274 281 289 296 304 313 321 330 Unit Cost per AF 541 555 570 586 602 618 635 652 669 - ------------------------------------------------------------------------------------------------------------------------------------ RATE COMPARISONS (PER AFY) Annual Cost 953 967 982 997 1,012 1,029 1,045 1,062 1,079 MWD Subsidy Available 250 250 250 250 250 250 250 250 250 Net Annual Cost 703 717 732 747 762 779 795 812 829 Comparison Wholesale Rate 533 548 563 578 593 609 626 643 660 - ------------------------------------------------------------------------------------------------------------------------------------
Notes: 1. O&M Costs per Service Contract between CVWD and ECO Resources, Inc. dated September 3, 2002. 2. Annual Cost Escalation based on 90% of assumed 3% CPI increase, or 0.27% per year. 3. Costs for first two years (in italics) only used for escalation purposes, as first fiscal year of operation is 2005. 4. Net Debt Service from DBC Finance run dated September 10, 2002. 5. Power Costs based on Guaranteed Maximum Electricity Utilization (Appendix 10 of Service Contract) and $0.125 per Kwh in FY 2003 escalated per Note 2. 6. ECO Contract expires after 20 years but extension is assumed using same operating cost parameters to end of bond term and beyond to determine water rate comparison to and beyond bond retirement. 7. Assumed first FY of operation (2005) generates 2,400 AF and Total Annual Cost is equal to half of normal full-year Fixed O&M and Power Cost plus first six months of debt service not funded by capitalized interest. 8. Since Met Subsidy runs out half way through 2025 (20 years), comparison rate is figured with $125/AF subsidy -vs- $250/AF and comparison is skewed. PSOMAS Page 64 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT PROJECT COST PROJECTION SCHEDULE CAPISTRANO VALLEY WATER DISTRICT PHASE 1 - DESALTER PROJECT 5,231 AFY
FISCAL YEAR 2020 2021 2022 2023 2024 2025 2026 2027 - ------------------------------------------------------------------------------------------------------------------------ Water Quantity (AFY) 5,231 5,231 5,231 5,231 5,231 5,231 5,231 5,231 ANNUAL COSTS O & M Component 961,663 987,628 1,014,294 1,041,680 1,069,805 1,098,690 1,128,355 1,158,820 Labor Component 268,335 275,580 283,020 290,662 298,510 306,569 314,847 323,348 Replacement Component 492,156 505,445 519,092 533,107 547,501 562,283 577,465 593,057 First Demand Adj. Element 102,365 105,129 107,967 110,883 113,876 116,951 120,109 123,352 --------- --------- --------- --------- --------- --------- --------- --------- Annual Service Payment 1,824,519 1,873,781 1,924,373 1,976,331 2,029,692 2,084,494 2,140,775 2,198,576 Power Cost 1,771,071 1,818,890 1,868,000 1,918,436 1,970,234 2,023,430 2,078,062 2,134,170 --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Operational Cost 3,595,590 3,692,671 3,792,373 3,894,767 3,999,926 4,107,924 4,218,838 4,332,746 Net Debt Service Rqmt. 2,141,855 2,141,854 2,138,355 2,141,104 2,134,979 2,086,684 947,013 945,389 --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Cost 5,737,445 5,834,525 5,930,728 6,035,871 6,134,905 6,194,608 5,165,851 5,278,135 Unit Cost per AF 1,097 1,115 1,134 1,154 1,173 1,184 988 1,009 MWD Subsidy (20 yr @ 250/AF) 1,307,750 1,307,750 1,307,750 1,307,750 1,307,750 653,875 0 0 Unit Cost per AF 250 250 250 250 250 250 0 0 --------- --------- --------- --------- --------- --------- --------- --------- Net Annual Cost 4,429,695 4,526,775 4,622,978 4,728,121 4,827,155 5,540,733 5,165,851 5,278,135 Unit Cost per AFY 847 865 884 904 923 1,059 988 1,009 UNIT COSTS O & M Component 184 189 194 199 205 210 216 222 Labor Component 51 53 54 56 57 59 60 62 Replacement Component 94 97 99 102 105 107 110 113 First Demand Adj. Element 20 20 21 21 22 22 23 24 Power 339 348 357 367 377 387 397 408 Unit Cost per AF 687 706 725 745 765 785 807 828 - ------------------------------------------------------------------------------------------------------------------------ RATE COMPARISONS (AFY) Annual Cost 1,097 1,115 1,134 1,154 1,173 1,184 988 1,009 MWD Subsidy Available 250 250 250 250 250 125 0 0 Net Annual Cost 847 865 884 904 923 1,059 988 1,009 Comparison Wholesale Rate 678 696 715 734 754 775 795 817 - ------------------------------------------------------------------------------------------------------------------------ FISCAL YEAR 2028 2029 2030 2031 2032 2033 2034 2035 2036 - ------------------------------------------------------------------------------------------------------------------------------------ Water Quantity (AFY) 5,231 5,231 5,231 5,231 5,231 5,231 5,231 5,231 5,231 ANNUAL COSTS O & M Component 1,190,108 1,222,241 1,255,242 1,289,133 1,323,940 1,359,686 1,396,398 1,434,101 1,472,821 Labor Component 332,078 341,044 350,252 359,709 369,421 379,396 389,639 400,160 410,964 Replacement Component 609,069 625,514 642,403 659,748 677,561 695,855 714,643 733,939 753,755 First Demand Adj. Element 126,682 130,103 133,615 137,223 140,928 144,733 148,641 152,654 156,776 --------- --------- --------- --------- --------- --------- --------- --------- --------- Annual Service Payment 2,257,938 2,318,902 2,381,512 2,445,813 2,511,850 2,579,670 2,649,321 2,720,853 2,794,316 Power Cost 2,191,793 2,250,971 2,311,747 2,374,165 2,438,267 2,504,100 2,571,711 2,641,147 2,712,458 --------- --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Operational Cost 4,449,730 4,569,873 4,693,260 4,819,978 4,950,117 5,083,770 5,221,032 5,362,000 5,506,774 Net Debt Service Rqmt. 942,013 941,763 944,389 939,889 958,569 964,388 964,139 (117,399) 0 --------- --------- --------- --------- --------- --------- --------- --------- --------- Total Annual Cost 5,391,743 5,511,636 5,637,649 5,759,867 5,908,686 6,048,158 6,185,171 5,244,601 5,506,774 Unit Cost per AF 1,031 1,054 1,078 1,101 1,130 1,156 1,182 1,003 1,053 MWD Subsidy (20 yr @ 250/AF) 0 0 0 0 0 0 0 0 0 Unit Cost per AF 0 0 0 0 0 0 0 0 0 --------- --------- --------- --------- --------- --------- --------- --------- --------- Net Annual Cost 5,391,743 5,511,636 5,637,649 5,759,867 5,908,686 6,048,158 6,185,171 5,244,601 5,506,774 Unit Cost per AF 1,031 1,054 1,078 1,101 1,130 1,156 1,182 1,003 1,053 UNIT COSTS O & M Component 228 234 240 246 253 260 267 274 282 Labor Component 63 65 67 69 71 73 74 76 79 Replacement Component 116 120 123 126 130 133 137 140 144 First Demand Adj. Element 24 25 26 26 27 28 28 29 30 Power 419 430 442 454 466 479 492 505 519 Unit Cost per AFY 851 874 897 921 946 972 998 1,025 1,053 - ------------------------------------------------------------------------------------------------------------------------------------ RATE COMPARISONS (AFY) Annual Cost 1,031 1,054 1,078 1,101 1,130 1,156 1,182 1,003 1,053 MWD Subsidy Available 0 0 0 0 0 0 0 0 0 Net Annual Cost 1,031 1,054 1,078 1,101 1,130 1,156 1,182 1,003 1,053 Comparison Wholesale Rate 839 862 885 909 933 958 984 1,011 1,038 - ------------------------------------------------------------------------------------------------------------------------------------
Notes: 1. O&M Costs per Service Contract between CVWD and ECO Resources, Inc. dated September 3, 2002. 2. Annual Cost Escalation based on 9. 3. Costs for first two years (in italics) only used for escalation purposes, as first fiscal year of operation is 2005. 4. Net Debt Service from DBC Finance run dated September 10, 2002. 5. Power Costs based on Guaranteed Maximum Electricity Utilization (Appendix 10 of Service Contract) and $0.125 per Kwh in FY 2003 escalated per Note 2. 6. ECO Contract expires after 20 years but extension is assumed using same operating cost parameters to end of bond term and beyond to determine water rate comparison to and beyond bond retirement. 7. Assumed first FY of operation (2005) generates 2,400 AF and Total Annual Cost is equal to half of normal full-year Fixed O&M and Power Cost plus first six months of debt service not funded by capitalized interest. 8. Since Met Subsidy runs out half way through 2025 (20 years), comparison rate is figured with $125/AF subsidy -vs- $250/AF and comparison is skewed. PSOMAS Page 65 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 66 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT IX. ASSUMPTIONS AND CONSIDERATIONS USED 9.1 ASSUMPTIONS This report has been prepared with written and verbal information received from the ECO Team and the District. A complete review of the executed Project Agreements is the basis for the Report. Also reviewed was the unexecuted Construction Agreement between ECO and ARB and the unexecuted Osmonics purchase order and clarification letter. This written information was modified during conversations with Boyle Engineering who provided the revised Conceptual Design Drawings, dated March 11, 2002, for review of the Project. Additional information, which provided the basis for evaluation of the design, construction operations and maintenance costs, was received from ECO, the District, ARB, Osmonics and Boyle Engineering in April, June, July, September, October and December 2002 and incorporated in this report. A copy of the executed Service Contract was furnished to PSOMAS in September 2002 and incorporated into the Report. An investigation was made to determine the capabilities of ARB as to their construction and financial capabilities as well as their reputation. This investigation included contacting the California Contractors State License Board, interviewing ARB over the phone, and verifying ARB's bonding capabilities and rating with the bonding company. The observations contained in this report were gained through utilizing the above information, interpreting this information and arriving at the conclusions, recommendations and evaluating the feasibility according to Standard and Poor's Rating Group criteria, dated September 1997. In providing this opinion of probable design, construction and operation feasibility, it is understood that PSOMAS does not have control over costs of labor, equipment, materials or the construction schedule and the operations of the Project. The opinion as to the feasibility of the Project contained herein is based on PSOMAS' qualifications and experience. Actual estimates and costs may vary due to many circumstances, but not limited to, changes in availability, cost of materials, variation in feed water quality, methods and/or timing of construction and operations and inflation. PSOMAS has made certain assumptions with respect to conditions, which may occur in the future. While these assumptions appear to be reasonable for the purpose of this report, they are dependent upon future events that may differ from those assumed. In addition, certain information used and relied upon herein was provided by sources believed to be reliable. It is believed that the use of such information and sources is reasonable for the purpose of this report; however, some assumptions may vary significantly due to unanticipated events and circumstances. This report summarizes the information available and analysis through the date of the executed Service Contract, thus changed conditions occurring after the date of this report could affect the material presented. PSOMAS Page 67 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT This page left intentionally blank PSOMAS Page 68 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT X. CONCLUSIONS 10.1 CONCLUSIONS Based upon the analysis and the conclusions presented in the Report, PSOMAS is of the opinion that: 1. All of the Project Participants have the relevant experience and financial capability to successfully complete the design, construction and operation of the Project within the parameters of the Service Contract. 2. The brackish groundwater treatment process proposed for this Project will produce the quality and quantity of water required by the Service Contract. 3. The site on which the RO Facility is to be located is adequate in size and location and from an infrastructure and geotechnical perspective is adequate for construction and operation of the RO Facility. The sites for the wells do not meet the new requirements that CADHS is enforcing, but these new requirements should not significantly increase the capital and operating costs of the Project. 4. There is sufficient unappropriated water within the San Juan Basin to provide an adequate source of Raw Water for the Project for the Operation Period of the Service Contract and beyond for the full term of the Bonds. 5. The environmental site assessments have been accomplished in a manner consistent with industry standards, using appropriate industry protocols. The adopted Mitigated Negative Declaration for the Project does not impose any conditions that are not common to normal construction activities and should not cause any significant delay or increased cost to the Project. 6. Based upon the Service Contract parameters, the preliminary design, and the proposed equipment list, the Project will operate and provide Finished Water within the Service Contract parameters for the Operation Period of the Service Contract and beyond for the full term of the Bonds. 7. The construction of the Project is similar to other projects constructed by ARB and the construction of the Project can be accomplished within the scope of the Service Contract, by the Scheduled Acceptance Date and within the Fixed Design/Build Price included in the Service Contract. 8. The Acceptance Test is sufficient to predict that the Project will perform reliably for the Operation Period of the Service Contract and beyond for the full term of the Bonds. This opinion is based upon the assumption that the required preventative and scheduled maintenance is performed in accordance with industry standards. PSOMAS Page 69 12/6/2002 2SOU170100 INDEPENDENT ENGINEER'S REPORT CAPISTRANO VALLEY WATER DISTRICT PHASE 1 DESALTER PROJECT 9. The operation and maintenance requirements of the Project, under the Service Contract are adequate for the full term of the Bonds. The operating costs included in the Service Contract are reasonable, and the variable replacement cost for membranes will not have a significant cost impact to the annual operating costs. The only other variables are labor and chemicals and experience indicates that any variation in these costs should be minor. 10. All of the required permits and easements to begin construction were obtained prior to the commencement of construction, which occurred on November 25, 2002. The remainder of the permits and easements to complete construction will be acquired on a sequential basis prior to the construction of the various components of the Project. These outstanding permits and easements are identified and expected to be obtained in time to prevent any delay to construction of the Project. The operating permits required to comply with the Finished Water date of December 4, 2004, are identified and scheduled to be obtained in sufficient time to support the completion of the Project. Based upon a review of the preliminary construction schedule for the Project, there is sufficient time to obtain these permits prior to the December 4, 2004 MWD Finished Water date. 11. The safety plan is adequate and is in compliance with industry requirements and CAL-OSHA. 12. The security plan is adequate and is in compliance with all regulatory agencies on the local and state level. 13. Based upon a review of the Project Agreements, the terms of the Project Agreements will allow the DB/Operator to meet its obligations under the Service Contract. 14. The preliminary construction schedule is reasonable and includes sufficient contingency in the activity durations in order to complete the Project within the parameters of the MWD Agreement and the Service Contract. 15. The Project can be constructed for the Fixed Design/Build Price included in the Service Contract and the construction milestone payment schedule is reasonable. 16. The Operations Cost included in the Service Contract is sufficient to operate and maintain the Project for the Operation Period of the Service Contract. PSOMAS Page 70 12/6/2002 2SOU170100 APPENDIX H SPECIMEN FINANCIAL GUARANTY INSURANCE POLICY H-l (This Page Intentionally Left Blank) [LETTER HEAD OF AMBAC] FINANCIAL QUARANTY INSURANCE POLICY Obligor: Policy Number: Obligations: Premium: Ambac Assurance Corporation (Ambac), a Wisconsin stock insurance corporation, in consideration of the payment of the premium and subject to the terms of this Policy, hereby agrees to pay to The Bank of New York, as trustee, or its successor (the "Insurance Trustee"), for the benefit of the Holders, that portion of the principal of and interest on the above-described obligations (the "Obligations") which shall become Due for Payment but shall be unpaid by reason of Nonpayment by the Obligator. Ambac will make such payments to the Insurance Trustee within one (1) business day following written notification to Ambac of Nonpayment. Upon a Holder's presentation and surrender to the Insurance Trustee of such unpaid Obligations or related coupons, uncanceled and in bearer form and free of any adverse claim, the Insurance Trustee will disburse to the Holder the amount of principal and interest which is then Due for Payment but is unpaid. Upon such disbursement, Ambac shall become the owner of the surrendered Obligations and/or coupons and shall be fully subrogated to all of the Holder's rights to payment, thereon. In cases where the Obligations are issued in registered form, the Insurance Trustee shall disburse principal to a Holder only upon presentation and surrender to the Insurance Trustee of the unpaid Obligation, uncanceled and free of any adverse claim, together with an instrument of assignment, in form satisfactory to Ambac and the Insurance Trustee duly executed by the Holder or such Holder's duly authorized representative, so as to permit ownership of such Obligation to be registered in the name of Ambac or its nominee. The Insurance Trustee shall disburse interest to a Holder of a registered Obligation only upon presentation to the Insurance Trustee of proof that the claimant is the person entitled to the payment of interest on the Obligtion and delivery to the Insurance Trustee of an instrument of assignment, in form satisfactory to Ambac and the Insurance Trustee, duly executed by the Holder or such Holder's duly authorized representative, transferring to Ambac all rights under such Obligation to receive the interest in respect of which the insurance disbursement was made . Ambac shall be subrogated to all of the Holders' rights to paypment on registered Obligations to the extent of any insurance disbursements so made. In the event that a trustee or paying agent for the Obligations has notice that any payment of principal of or interest on an Obligation which has become Due for Payment and which is made to a Holder by or on behalf of the Obligor has been deemed a preferential transfer and theretofore recovered from the Holder pursuant to the United States Bankruptcy Code in accordance with a final, nonappealable order of a court of competent jurisdiction, such Holder will be entitled to payment from Ambac to the extent of such recovery if sufficient Funds are not otherwise available. As used herein, the term "Holder" means any person other than (i) the Obligor or (ii) any person whose obligations constitute the underlying security or source of payment for the Obligations who, at the time of Nonpayment, is the owner of an Obligation or of a coupon relating to an Obligation. As used herein, "Due for Payment", when referring to the principal of Obligations, is when the scheduled maturity date or mandatory redemption date for the application of a required sinking fund installment has been reached and does not refer to any earlier date on which payment is due by reason of call for redemption (other than by application of required sinking fund installments), acceleration or other advancement of maturity; and, when referring to interest on the Obligations, is when the scheduled date for payment of interest has been reached. As used herein, "Nonpayment" means the failure of the Obligor to have provided sufficient funds to the trustee or paying agent for payment in full of all principal of and interest on the Obligations which are Due for Payment. This Polfcy is noncancelable. The premium on this Policy is not refundable for any reason, including payment of the Obligations prior to maturity. This Policy does not insure against loss of any prepayment or other acceleration payment which at any time may become due in respect of any Obligation, other than at the sole option of Ambac, nor against any risk other than Nonpayment. In witness whereof, Ambac has caused this Policy to be affixed with a facsimile of its corporate seal and to be signed by its duly authorized officers in facsimile ro become effective as its original seal and signatures and binding upon Ambac by virtue of the countersignature of its duly authorized representative. /s/ [ILLEGIBLE] [SEAL OF AMBAC ASSURANCE CORPORATION] /S/ [ILLEGIBLE] President Secretary Effective Date: Authorized Representative THE BANK OF NEW YORK acknowledges that it has agreed to perform the duties ofInsurance Trustee under this Policy Form No.: 2B-0012(1/01) /s/ [ILLEGIBLE] Authorized Officer of Insurance Trustee [LETTER HEAD OF AMBAC] Endorsement Policy for: Attached to and forming part of Policy No.: Effective Date of Endorsemen In the event that Ambac Assurance Corporation were to become insolvent, any claims arising under the Policy would be excluded from coverage by the California Insurance Guaranty Association, established pursuant to the laws of the State of California. Nothing herein contained shall be held to vary, after, waive or extend any of the terms, conditions provisions, agreements or limitations of the above mentioned Policy other than as above stated. In Witness Whereof, Ambac has caused this Endorsement to be affixed with a facsimile of its corporate seal and to be signed by its duly authorized officers in facsimile to become effective as its original seal and signatures and binding upon Ambac by virtue of the countersignature of its duly authorized representative. Ambac Assurance Corporation President [SEAL OF AMBAC ASSURANCE CORPORATION] Secretary Form No.: 2B-0015(7/97) Authorized Representative APPENDIX I GENERAL INFORMATION CONCERNING THE CITY OF SAN JUAN CAPISTRANO The following information concerning the City of San Juan Capistrano (the "City") and surrounding areas is provided as supplementary information only, and it should not be inferred from the inclusion of this information in this Official Statement that the principal of or interest on the Bonds is payable from any funds, taxes or other revenues of the City. The Bonds are payable from the Revenues of the Water District and other security described herein. See "SOURCES OF PAYMENT AND SECURITY FOR THE BONDS" herein. LOCATION The City encompasses 17.4 square miles and is located at the southern end of the County. It is approximately 55.3 miles southeast of downtown Los Angeles and 24.7 miles south of Santa Ana, the county seat. Neighboring communities include the cities of Dana Point, Laguna Niguel, Mission Viejo and San Clemente. GOVERNMENT The City is a general law city and was incorporated in 1928. The City has a Council-Manager form of municipal government. The City Council appoints the City Manager who is responsible for the day-to-day administration of city business and the coordination of all city departments. The City Council is composed of five members elected bi-annually at large to four-year alternating terms. The Mayor is selected by the City Council from among its members. Under the 2002-03 fiscal year budget, the City employed a staff of approximately 68 classified employees and 16 exempt employees, including 25 full-time positions which cover the operations of the Water District. COMMUNITY SERVICES AND FACILITIES The City provides a full range of municipal services, including street maintenance, public improvements, recreation, golf, water, sewer, storm drainage, planning and general administrative services. The City contracts with the Orange County Sheriffs Department to provide on-site and localized police services. The Orange County Fire Authority provides fire prevention/suppression and emergency services to the City. TRANSPORTATION The City is within minutes of the San Diego Freeway (Interstate 5), the San Joaquin Hills Transportation Corridor (State Route 73) and the Ortega Highway (State Route 74). Air cargo and passenger flight services are provided at the John Wayne Airport, 21.1 miles northwest of the City, Ontario International Airport, 55.4 miles northeast of the City, Los Angeles International Airport, 59.2 miles northwest of the City, and Long Beach Municipal Airport, 39.6 miles northwest of the City. Commercial and passenger rail services are provided by Union Pacific, Southern Pacific, Atchison, Topeka and Santa Fe Railway Co., and Amtrak lines. Trucking services are provided through numerous common and contract carriers. I-1 UTILITIES Additionally, other utility services are provided to City residents and business by: San Diego Gas & Electric (electric), Southern California Gas Company (gas), Pacific Bell (telephone) and Cox Communications (cable television). POPULATION The historic population of the City, the County of Orange (the "County") and the State of California (the "State") is shown below. CITY OF SAN JUAN CAPISTRANO, COUNTY OF ORANGE AND STATE OF CALIFORNIA POPULATION ESTIMATES Year City of San Juan Capistrano County of Orange State of California -------- ----------------------------- ------------------ --------------------- 1998 31,212 2,744,549 33,225,655 1999 32,253 2,788,767 33,765,185 2000 32,495 2,828,351 34,336,091 2001 34,100 2,910,000 34,758,000 2002 34,708 2,939,547 35,037,000 - ---------- Note: Years 1998 and 1999 population estimates were calculated with 1990 U.S. Census data and Years 2000 and 2001 population estimates were calculated with 2000 U.S. Census data. Source: California State Department of Finance, Historical City/County Population Estimates 1997-2000, with 1990 Census Counts and E-5 City County Population and Housing Estimates, 2000, 2001 and 2002. I-2 EMPLOYMENT The following table shows industry employment figures for the Orange County Primary Metropolitan Statistical Area ("PMSA"), which includes the City for calendar years 1996 through 2001. These figures are county-wide statistics and may not necessarily accurately reflect employment trends in the City. ORANGE COUNTY PRIMARY PMSA ANNUAL AVERAGE INDUSTRY EMPLOYMENT/(1)/
Industry 1997 1998 1999 2000 2001 ------------------------ --------- --------- --------- --------- --------- Agriculture 6,900 6,600 7,000 7,600 7,100 Mining 900 900 700 600 600 Construction 58,100 65,500 73,800 77,600 80,400 Manufacturing 222,400 231,700 229,400 230,500 225,200 Transportation & Public 44,400 46,300 48,600 50,900 52,300 Utilities Wholesale Trade 93,800 98,300 99,900 100,200 101,800 Retail Trade 216,000 224,200 231,600 239,500 247,200 Finance, Insurance & Real 92,900 100,400 104,200 105,800 111,800 Estate Services 372,700 395,600 415,900 437,100 448,300 Government 132,700 136,400 141,10 146,600 150,900 Total, All Industries 1,240,800 1,305,800 1,352,100 1,396,500 1,425,400
- ---------- Note: The "Total, All Industries" data is not directly comparable to the employment data found herein. /(1)/ Employment is reported by place of work; it does not include persons involved in labor-management disputes. Figures are rounded to the nearest hundred. Columns may not add to totals due to rounding. Source: State of California, Employment Development Department, Orange PMSA Annual Average Labor Force and Industry Employment, March 2001 Benchmark. I-3 The following summarizes the civilian labor force, civilian employment and civilian employment figures over the period from 1996 through 2001 in the City, the County and the State. CITY OF SAN JUAN CAPISTRANO, COUNTY OF ORANGE, STATE OF CALIFORNIA AND UNITED STATES LABOR FORCE, EMPLOYMENT AND UNEMPLOYMENT YEARLY AVERAGE
Civilian Labor Civilian Civilian Civilian Unemployment Year and Area Force Employment/(1)/ Unemployment/(2)/ Rate/(3)/ - -------------------------------- -------------- --------------- ----------------- --------------------- 1997 San Juan Capistrano 14,150 13,800 350 2.5% Orange County 1,385,100 1,339,900 45,200 3.3% California 15,947,200 14,942,500 1,004,700 6.3% United States/(4)/ 136,297,000 129,558,000 6,739,000 4.9% 1998 San Juan Capistrano 14,670 14,350 320 2.2% Orange County 1,435,100 1,393,700 41,400 2.9% California 16,336,500 15,367,500 969,000 5.9% United States/(4)/ 137,673,400 131,463,000 6,210,000 4.5% 1999 San Juan Capistrano 15,050 14,750 300 2.0% Orange County 1,471,700 1,432,700 39,000 2.6% California 16,596,500 15,731,700 864,800 5.2% United States/(4)/ 139,368,000 135,208,000 5,655,000 4.2% 2000 San Juan Capistrano 15,460 15,160 300 1.9% Orange County 1,511,000 1,472,700 38,300 2.5% California 17,090,800 16,245,600 845,200 4.9% United States/(5)/ 140,863,000 135,208,000 5,655,000 4.0% 2001 San Juan Capistrano 15,710 15,350 360 2.3% Orange County 1,537,100 1,490,800 46,300 3.0% California 17,362,300 16,435,200 927,100 5.3% United States/(5)/ 141,815,000 135,073,000 6,742,000 4.8%
- ---------- /(1)/ Includes persons involved in labor-management trade disputes. /(2)/ Includes all persons without jobs who are actively seeking work. /(3)/ The unemployment rate is computed from unrounded data; therefore, it may differ from rates computed from rounded figures in this table. /(4)/ Not strictly comparable with data for prior years. /(5)/ Beginning in January 2000, data are not strictly comparable with data for 1999 and earlier years because of the revisions in the population controls used in the household survey. Source: California Employment Development Department, based on March 2001 benchmark and U.S. Department of Labor, Bureau of Labor Statistics. I-4 The principal employers within the City and the number of employees are shown in the table below. CITY OF SAN JUAN CAPISTRANO PRINCIPAL EMPLOYERS Company Employees ---------------------------------- --------- Capistrano Unified School District 854/(1)/ Fluidmaster Inc. 593 Endevco 370 Nichols Institute 228 Costco 150 St. Margarets School 150 Brown Bag Sandwich Co. 150 Capistrano Ford 124 Marbella Country Club 130 Barwick Automotive 105 - ---------- /(1)/ Approximate. Source: City of San Juan Capistrano, Business Licenses. CONSTRUCTION ACTIVITY The following table summarizes the construction activity in the City from fiscal years 1991-92 through 2001-02. CITY OF SAN JUAN CAPISTRANO CONSTRUCTION ACTIVITY 1991-92 THROUGH 2001-02
Commercial Industrial Construction Residential Construction Other Additions, Pool, etc. Total Construction ------------------------- ------------------------ --------------------------- ------------------------ Fiscal No. of No. of No. of No. of Year Permits Value Permits Value Permits Value Permits Value - ------- ---------- ---------- ------- ---------- ------- ---------- ------- ---------- 1991-92 20 1,175,200 23 10,780,190 971 11,163,734 1,014 23,119,124 1992-93 -- -- 109 25,029,624 1,100 9,714,771 1,209 34,744,395 1993-94 -- -- 132 27,549,466 1,608 7,359,554 1,740 34,909,020 1994-95 8 5,412,942 54 12,129,332 1,773 7,123,740 1,835 24,660,014 1995-96 4 2,963,073 301 44,366,564 2,000 7,953,877 2,305 55,283,514 1996-97 6 6,011,129 242 72,774,016 2,273 11,232,244 2,521 90,017,389 1997-98 8 12,526,482 225 64,614,579 3,058 13,827,688 3,291 90,968,749 1998-99 5 9,196,957 43 19,540,542 2,503 17,261,728 2,551 45,999,227 1999-00 21 16,330,908 68 23,814,142 2,281 24,541,816 2,370 64,686,866 2000-01 18 17,940,896 80 21,014,262 2,821 15,160,060 2,919 54,115,218 2001-02 17 15,535,452 84 21,317,874 2,688 13,503,079 2,789 50,356,405
- ---------- Source: City of San Juan Capistrano. I-5 RETAIL SALES TAX The table below shows retail sales in the City for 1997 through 2001. CITY OF SAN JUAN CAPISTRANO TAXABLE RETAIL SALES DATA (000'S OMITTED) 1997 THROUGH 2001
1997 1998 1999 2000 2001/(1)/ ---------- ---------- ---------- ---------- ---------- Apparel Stores $ 14,507 $ 12,969 $ 11,252 $ 11,500 $ 8,178 General Merchandise Stores 54,745 62,171 70,192 75,976 47,736 Food Stores 12,944 12,843 13,566 13,823 9,755 Eating and Drinking Places 30,872 32,426 35,575 36,576 28,164 Home Furnishings and Appliances 4,204 4,080 5,795 7,224 6,812 Building Materials and Farm Implements 20,593 24,031 26,247 30,684 23,912 Auto Dealers and Auto Supplies 112,136 146,626 174,507 197,865 167,235 Service Stations 20,019 18,611 20,792 23,393 18,201 Other Retail Stores 33,220 33,284 36,192 39,225 37,341 Total Retail Outlets $ 330,240 $ 347,041 $ 394,118 $ 436,266 350,334 All Other Outlets 61,077 87,165 112,624 111,743 72,010 Total All Outlets $ 364,317 $ 434,206 $ 506,742 $ 405,577 $ 419,334
- ---------- (1) First three quarters of data through September 30, 2001. Source: California State Board of Equalization. The table below shows sales tax revenues for the City for the last five years. CITY OF SAN JUAN CAPISTRANO SALES TAX REVENUES FOR THE FISCAL YEARS ENDED JUNE 30, 1998 THROUGH JUNE 30, 2002 Fiscal Year Sales Tax Revenues ----------- ------------------ 1998 $ 4,540,151 1999 5,270,098 2000 6,002,209 2001 6,050,832 2002 6,731,799 - ---------- Source: City of San Juan Capistrano. I-6 EFFECTIVE BUYING INCOME "Effective Buying Income" is defined as personal income less personal tax and nontax payments, a number often referred to as "disposable" or "after-tax" income. Personal income is the aggregate of wages and salaries, other than labor-related income (such as employer contributions to private pension funds), proprietor's income, rental income (which includes imputed rental income of owner-occupants of non-farm dwellings), dividends paid by corporations, interest income from all sources and transfer payments (such as pensions and welfare assistance). Deducted from this total are personal taxes (federal, state and local, nontax payments, fines, fees, penalties, etc.) and personal contributions to social insurance. According to U.S. government definitions, the resultant figure is commonly known as "disposable personal income." The following table summarizes the Effective Buying Income for the County and the State for the period 1997 through 2001. COUNTY OF ORANGE AND STATE OF CALIFORNIA EFFECTIVE BUYING INCOME/(1)/
Median Total Per Capita Household Percent of Effective Buying Effective Effective Households Income/(2)/ Buying Income Buying Income over $50,000 ---------------- ------------- ------------- ------------ 1997 Orange County $ 48,027,189 $ 17,767 $ 42,715 40.3% California 524,439,600 15,797 36,483 33.5% 1998 Orange County $ 50,605,637 $ 18,290 $ 45,176 43.4% California 551,999,317 16,299 37,091 34.6% 1999 Orange County $ 55,179,528 $ 19,614 $ 48,773 48.7% California 590,376,663 17,245 39,492 38.3% 2000 Orange County $ 62,330,828 $ 21,650 $ 55,262 55.1% California 652,190,282 19,081 44,464 44.3% 2001 Orange County $ 62,568,674 $ 21,329 $ 53,277 53.6% California 650,521,407 18,652 43,532 41.9%
- ---------- /(1)/ Not comparable with prior years. Effective Buying Income is now based on money income (which does not take into account sale of property, taxes and social security paid, receipt of food stamps, etc.) versus personal income. /(2)/ Dollars in thousands. Source: "Survey of Buying Power," Sales & Marketing Management Magazine, dated 1998, 1999, 2000, 2001 and 2002. I-7 PROPERTY TAX REVENUES The total assessed valuation of the property within the City for the fiscal year 2000-01 was $3,304,879,224. The City receives funds annually from the State based upon a percentage of property taxes collected within the County computed on the City's respective assessed valuation, and a statutory system of annual appropriations. The table below presents the assessed valuation of property within the City for the past five fiscal years. CITY OF SAN JUAN CAPISTRANO ASSESSED VALUATIONS
Total Before Rdv. Total After Year Local Secured Utility Unsecured Rdv. Increment Increment Rdv.Increment - ------- --------------- ----------- ------------ --------------- ------------- ---------------- 1996-97 $ 2,296,959,931 $ 2,211,204 $ 80,270,800 $ 2,379,441,935 $ 212,192,178 $ 2,167,249,757 1997-98 2,351,160,574 2,324,688 129,852,260 2,483,337,522 214,171,599 2,269,165,923 1998-99 2,609,193,397 2,830,043 101,826,323 2,713,849,763 242,272,325 2,471,577,438 1999-00 2,916,901,599 2,990,383 116,406,815 3,036,298,797 305,562,109 2,730,736,688 2000-01 3,178,944,644 3,032,066 122,902,514 3,304,879,224 352,669,360 2,952,209,864
- ---------- Source: California Municipal Statistics, Inc. The table below presents the City's property tax collection experience for the last five fiscal years. CITY OF SAN JUAN CAPISTRANO PROPERTY TAX LEVIES AND COLLECTIONS LAST FIVE FISCAL YEARS Secured Amount Delinquent Percentage Delinquent Fiscal Year Tax Charge June 30 June 30 - ----------- ----------- ----------------- --------------------- 1997-1998 $ 3,917,258 $ 98,795 2.5% 1998-1999 4,115,991 99,729 2.4 1999-2000 4,530,247 76,674 1.69 2000-2001 4,373,519 90,005 2.1 2001-2002 4,569,291 78,632 1.7 - ---------- Source: City of San Juan Capistrano. EDUCATION Public educational instruction from kindergarten through 12th grade is provided by the Capistrano Unified School District. There are numerous private schools in the City. There are 22 community colleges, colleges, universities and graduate schools within 30 minutes commuting distance from the City in the Orange County Metropolitan Area. I-8 APPENDIX J CERTAIN INFORMATION CONCERNING THE SERVICE CONTRACT LETTER OF CREDIT PROVIDER Bank of America, N.A. (the "Service Contract Letter of Credit Provider"), is a national banking association organized under the laws of the United States, and its principal executive offices are located in Charlotte, North Carolina. The Service Contract Letter of Credit Provider is a wholly owned indirect subsidiary of Bank of America Corporation and is engaged in general consumer banking, commercial banking and trust business, offering a wide range of commercial, corporate, international, financial market, retail and fiduciary banking services. As of September 30, 2002, the Service Contract Letter of Credit Provider had consolidated assets of $576 billion, consolidated deposits of $394 billion and stockholder's equity of $50 billion based on regulatory accounting principles. Bank of America Corporation is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, with its principal executive offices located in Charlotte, North Carolina. Additional information regarding Bank of America Corporation is set forth in its Annual Report on Form 10-K for the fiscal year ended December 31, 2001, together with any subsequent documents it filed with the Securities and Exchange Commission (the "Commission) pursuant to the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Service Contract Letter of Credit has been issued by the Service Contract Letter of Credit Provider. Moody's Investors Service, Inc. ("Moody's") currently rates the Service Contract Letter of Credit Provider's long-term certificates of deposit as "Aal" and short-term certificates of deposit as "P-l". Standard & Poor's Rating Services ("Standard & Poor's") rates the Service Contract Letter of Credit Provider's long-term certificates of deposit as "AA-" and its short-term certificates of deposit as "A-1+". Fitch, Inc. ("Fitch") rates long-term certificates of deposit of the Service Contract Letter of Credit Provider as "AA" and short-term certificates of deposit as "F-1+." Further information with respect to such ratings may be obtained from Moody's, Standard & Poor's and Fitch, respectively. No assurances can be given that the current ratings of the Service Contract Letter of Credit Provider's instruments will be maintained. The Service Contract Letter of Credit Provider will provide copies of the most recent Bank of America Corporation Annual Report on Form 10-K, any subsequent reports on Form 10-Q, and any required reports on Form 8-K (in each case as filed with the Commission pursuant to the Exchange Act), and the most recent publicly available portions of the quarterly Call Reports of the Service Contract Letter of Credit Provider delivered to the Comptroller of the Currency, without charge, to each person to whom this document is delivered, on the written request of such person. Written requests should be directed to: Bank of America Corporate Communications 100 North Tryon Street 18th Floor Charlotte, North Carolina 28255 Attention: Corporate Communications PAYMENTS OF DAILY DELAY LIQUIDATED DAMAGES DUE FROM THE COMPANY UNDER THE SERVICE CONTRACT WILL BE PAYABLE FROM DRAWINGS UNDER THE SERVICE CONTRACT LETTER OF CREDIT. ALTHOUGH THE SERVICE CONTRACT LETTER OF CREDIT IS A BINDING OBLIGATION OF THE SERVICE CONTRACT LETTER OF CREDIT PROVIDER, THE BONDS ARE NOT DEPOSITS OR OBLIGATIONS OF BANK OF AMERICA CORPORATION OR ANY OF ITS AFFILIATED BANKS AND ARE NOT GUARANTEED BY ANY OF THESE ENTITIES. THE BONDS ARE NOT INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION OR ANY OTHER GOVERNMENTAL AGENCY AND ARE SUBJECT J-l TO CERTAIN INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED. The information contained in this Appendix J relates to and has been obtained from the Service Contract Letter of Credit Provider. The information concerning Bank of America Corporation and the Service Contract Letter of Credit Provider contained herein is furnished solely to provide limited introductory information regarding Bank of America Corporation and the Service Contract Letter of Credit Provider and does not purport to be comprehensive. Such information is qualified in its entirety by the detailed information appearing in the documents and financial statements referenced above. The delivery hereof shall not create any implication that there has been no change in the affairs of Bank of America Corporation or the Service Contract Letter of Credit Provider since the date hereof, or that the information contained or refereed to in this Appendix J is correct as of any time subsequent to its date. J-2 EX-21.1 12 dex211.txt SUBSIDIARIES OF REGISTRANT EXHIBIT 21.1 SOUTHWEST WATER COMPANY SUBSIDIARIES OF THE REGISTRANT As of March 27, 2003
Jurisdiction of Name of Subsidiary Tax payer EIN Incorporation Parent - ---------------------------------------------------------------------------------------------------------------- Suburban Water Systems 95-1371870 California Southwest Water Company Water Suppliers Mobile Communication Service 95-2394217 California Suburban Water Systems New Mexico Utilities 85-0205040 New Mexico Southwest Water Company ECO Resources, Inc. 74-1800544 Texas Southwest Water Company Southwest Environmental Labs 76-0155825 Texas ECO Resources, Inc. Wastewater Rehabilitation, Inc. 74-2894610 Texas Southwest Water Company SW Utility Company 76-0332193 Texas Southwest Water Company Southwest Resource Management 95-4169558 Delaware Southwest Water Company SOCI, Inc. (1) 95-4107357 Delaware Southwest Water Company SW Operating Services Co. (1) 95-4107349 Delaware Southwest Water Company Inland Pacific Water Company Pending Delaware Southwest Water Company Master Tek, International, Inc. 84-1022702 Colorado Southwest Water Company Windermere Utility Company 74-2371831 Texas Southwest Water Company Hornsby Bend Utility Company 74-2385749 Texas Southwest Water Company Operations Technologies, Inc. 58-2206883 Georgia Southwest Water Company Aqua Services LP 76-0550054 Texas Southwest Water Company METRO-H2O Utilities, Inc. 91-2118765 Texas Southwest Water Company
All above listed subsidiaries have been included in the Registrant's consolidated financial statements. (1) Inactive EX-23.1 13 dex231.txt CONSENT OF KPMG LLP Exhibit 23.1 The Board of Directors Southwest Water Company: We consent to incorporation by reference in the registration statements on Form S-3 and S-8 (Nos. 33-21154, 333-77881, 333-35252, 333-63196, 333-69662 and 333-70194, 33-28918, 33-28919, 33-73174, 333-18513 and 333-38935) of Southwest Water Company of our report dated March 19, 2003 relating to the consolidated balance sheets of Southwest Water Company and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity and cash flows and related schedules for each of the years in the three-year period ended December 31, 2002, which report appears in the December 31, 2002 annual report on Form 10-K of Southwest Water Company. Our report refers to a change in accounting for goodwill and other intangible assets in 2002 and adoption of SFAS No. 123 "Accounting for Stock-Based Compensation" in 2002 which resulted in the restatement of the Company's consolidated financial statements for 2001 and 2000 in accordance with the retroactive restatement method under SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure", an amendment of SFAS No. 123. /s/ KPMG LLP Los Angeles, California March 27, 2003 EX-99.1 14 dex991.txt CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 EXHIBIT 99.1 I, Anton C. Garnier, President and Chief Executive Officer, certify that: 1. I have reviewed this annual report on Form 10-K of Southwest Water Company; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5) The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and The registrant's other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Dated: March 26, 2003 /s/ ANTON C. GARNIER -------------------- Anton C. Garnier Chief Executive Officer EX-99.2 15 dex992.txt CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 EXHIBIT 99.2 I, Richard J. Shields, certify that: 1. I have reviewed this annual report on Form 10-K of Southwest Water Company 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and The registrant's other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Dated: March 26, 2003 /s/ RICHARD J. SHIELDS ---------------------- Richard J. 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