ITEM 1. BUSINESS - ------------------
The Company - -----------
Yankee Energy System, Inc. ("Yankee Energy" or the "Company") is a public utility holding company incorporated in Connecticut in 1989. The Company is primarily engaged in the retail distribution of natural gas through its wholly-owned subsidiary, Yankee Gas Services Company ("Yankee Gas"), a Connecticut public service company. Yankee Gas serves approximately 179,000 residential, commercial and industrial customers in 68 cities and towns in Connecticut. The Company is exempt from registration under the Public Utility Holding Company Act of 1935.
The Company has four additional wholly-owned operating subsidiaries which support the Company's core natural gas distribution business or allow the Company to expand its business of providing total energy services: NorConn Properties, Inc. ("NorConn"), which owns the Company's corporate office building and another service building and leases both facilities to Yankee Gas; R. M. Services, Inc. ("RMS") which provides receivables management services to utilities and other businesses. Yankee Energy Financial Services Company ("Yankee Financial"), which provides energy equipment financing; and Yankee Energy Services Company ("YESCo"), whose purpose is to provide a full range of energy-related services for its customers including consulting, fuel procurement management and development for on-site generation and cogeneration systems, as well as technical and operating support and equipment installation for power plants and boilerhouses. YESCo also has three wholly-owned subsidiaries: BVA Cogen, Inc. ("BVA"), a Delaware corporation located in Massachusetts which develops customer-designed cogeneration systems and distributes in the United States the Deutz MWM Gas-Driven Engine/Generator sets used for on-site electric generation and which also provides energy-related services such as feasibility studies, design engineering, turnkey installations and ongoing service contracts; YESCo Energy Consulting Services, Inc., incorporated in November, 1996, which provides energy planning consulting and fuel procurement management services to industrial and commercial energy users; and YESCo Industrial Energy Services, Inc., headquartered in East Granby, Connecticut with several regional field offices, a manufacturers' representative and service company acquired by YESCo in July, 1996, which provides heating, ventilating and air- conditioning services and designs automated temperature control systems for the commercial and industrial market.
The Company may consider or explore opportunities to acquire or invest in other gas distribution companies and/or other energy-related businesses. The Company's overall investment in unregulated businesses is limited to 20% of the Company's total consolidated assets, pursuant to a cap imposed by the Connecticut Department of Public Utility Control ("DPUC") at the time of the Company's formation.
Gas Markets and Competition - ---------------------------
General. Yankee Gas operates the largest natural gas distribution system in Connecticut as measured by number of customers and size of service territory. Total throughput (sales and transportation) for fiscal 1996 was 47.3 billion cubic feet ("Bcf"). In fiscal 1996, gas revenues were comprised of the following: 43% residential; 31% commercial; 24% industrial; and the remaining 2% other. Yankee Gas provides firm gas sales service to customers who require a continuous gas supply throughout the year, such as residential customers who rely on gas for their heating, hot water, and cooking needs. Yankee Gas also provides interruptible gas sales service to certain commercial and industrial customers that have the capability to switch from natural gas to an alternative fuel on short notice. Yankee Gas can interrupt service to these customers during peak demand periods. Yankee Gas offers firm and interruptible transportation services to customers who purchase gas from sources other than Yankee Gas. In addition, Yankee Gas performs gas exchanges, off-system sales and capacity releases to other local gas distribution companies ("LDCs") and marketers to reduce its overall gas expense.
Firm Sales. In fiscal 1996, total firm gas sales of 35.1 Bcf accounted for approximately 74.3% of total gas sales and approximately 88.3% of the Company's operating revenues. Firm gas sales, particularly sales for residential space heating, are highly seasonal. In fiscal 1996, about 62% of total firm sales occurred in the five months from November through March. The following tables set forth certain information with respect to firm sales in fiscal 1996.
Interruptible Sales. In fiscal 1996, total interruptible gas sales of 8.5 Bcf accounted for approximately 18.1% of total gas sales and approximately 9.5% of the Company's operating revenues. The price charged for interruptible sales service is a market price based on the cost of the customer's alternative fuel, which is usually oil. Interruptible sales depend upon the availability of gas supplies and, generally, have provided lower margins than firm sales. Yankee Gas has the authorization from the DPUC to engage in flexible pricing to meet market prices for alternative fuels available to interruptible customers. The following table sets forth certain information with respect to interruptible sales in fiscal 1996.
Transportation Services. Yankee Gas also offers firm and interruptible transportation service to its customers. On April 1, 1996, the DPUC authorized the Connecticut LDCs to provide firm transportation to industrial and commercial customers. These transportation services permit customers who desire to purchase gas from sources other than Yankee Gas to do so, provided they have made all the necessary transportation arrangements with the transmission pipelines to deliver their gas to the Yankee Gas distribution system. Customers can purchase gas directly from producers and suppliers and contract for transportation services rather than purchase gas solely from the local distribution system. Generally, interruptible transportation service is highly sensitive to alternative fuel prices as well as to the availability of interstate pipeline capacity into the region. Under existing tariff structures, the financial condition of the Company is unaffected by customers electing to use transportation service in lieu of making gas purchases from Yankee Gas.
Market Expansion. Yankee Gas has increased efforts to provide additional service throughout its service territory. Yankee Gas concentrates its marketing efforts on increasing the number of residential households using natural gas, increasing the uses of natural gas by existing Yankee Gas customers, and increasing the overall number of both large and small customers through expansion of Yankee Gas' distribution system within its service territory. In the residential market, Yankee Gas focuses marketing efforts on households along Yankee Gas' existing mains because they present opportunities to increase gas sales with little or no capital investment. In the commercial and industrial markets, the Company seeks to expand gas sales by increasing sales to existing customers for both traditional and innovative uses, such as cooling and cogeneration. The Company also emphasizes attracting new commercial and industrial customers within and without its service territory.
The emergence of natural gas vehicles creates a potential new market for the natural gas industry. The establishment of natural gas vehicle fueling stations however is essential to the development of this market. Yankee Gas, in cooperation with various oil companies and gasoline retailers, has opened retail public natural gas vehicle refueling stations in Windsor Locks, Norwalk, and Meriden, Connecticut. Yankee Gas operates two refueling stations for its own fleet of approximately 100 natural gas vehicles. The Company continues to evaluate various options for the establishment and location of additional facilities.
Gas Supply - ----------
In 1992, the FERC issued Order No. 636, which required natural gas pipeline companies to separate or "unbundle" their services. Prior to the issuance of Order No. 636, natural gas pipeline companies sold pipeline services, such as gas purchasing, storage and transportation, as a package. In 1993, the interstate pipeline companies that provided natural gas to Yankee Gas complied with Order No. 636. As a result, Yankee Gas executed contracts with interstate pipeline companies for services to transport gas from production and underground storage areas to Yankee Gas' service territory to replace the traditional merchant services previously provided by the pipeline companies. Yankee Gas concurrently replaced the gas supply traditionally obtained from the pipeline companies' merchant services with firm purchases directly from producers and/or marketing companies. The FERC continues to regulate the rates charged by interstate pipeline companies for transportation and storage of natural gas, but does not regulate the price of natural gas purchased by the Company from producers and marketing companies.
Interstate pipelines delivered over 99.9 percent of Yankee Gas' 1996 fiscal year requirements to its distribution system. Interstate pipeline capacity enabled Yankee Gas to meet its firm customers' requirements with pipeline supplies for more than 98.4 percent of the year.
The following table sets forth sources of fiscal 1996 gas supply (including purchases for storage injections).
Yankee Gas is entitled to purchase 59,000 thousand cubic feet ("Mcf") per day of gas, or about 21.5 Bcf annually, from Alberta Northeast Gas, Limited ("ANE"). Yankee Gas holds a 15.9 percent equity interest in ANE, an entity formed by several utilities in the Northeast to aggregate the purchase of natural gas from Western Canada and to facilitate its sale to LDC owners at the United States-Canadian Border. The sales contracts between Yankee Gas and ANE expire in 2006. The gas purchased from ANE is delivered in the United States by the Iroquois Gas Transmission System, L.P. ("Iroquois") pipeline and the transportation contract between Yankee Gas and Iroquois expires in 2011.
Yankee Gas is also entitled to purchase 9,500 Mcf of gas per day, or about 3.5 Bcf annually, from Boundary Gas, Inc. ("Boundary"). Yankee Gas owns a 10.4 percent equity interest in Boundary, an LDC consortium which imports natural gas from Canada. The sales contract between Yankee Gas and Boundary expires in 2003.
Yankee Gas also holds pipeline transportation and storage service contracts with a number of pipeline companies. Yankee Gas has a transportation contract with Tennessee Gas Pipeline Company ("Tennessee") which provides for 562,794 Mcf of pipeline capacity on an annual basis. This transportation contract expires in 2000, but may be continued on a year-to-year basis after that with the mutual consent of the parties. Another long term transportation contract with Tennessee provides for an annual quantity of 511,000 Mcf and terminates in 2017. Yankee Gas also has a storage contract with Tennessee which provides approximately 1.8 Bcf of storage service on an annual basis. This storage contract expires in 2000. Yankee Gas also has transportation contracts with Algonquin Gas Transmission Company ("Algonquin") which provide for 42.4 Bcf of annual pipeline capacity. These contracts expire in 2012. Texas Eastern Transmission Company ("Texas Eastern") provides 38.7 Bcf of annual pipeline capacity to Yankee Gas pursuant to contracts which expire in 2000-2004. Under other contracts, Texas Eastern provides 1.7 Bcf of annual storage service. Yankee Gas also has transportation contracts with National Fuel Gas Supply Corporation ("National Fuel") which provide 633,480 Mcf of pipeline capacity on an annual basis and expire in 2003. Furthermore, Yankee Gas has transportation contracts with Transcontinental Gas Pipeline Corporation ("Transco") which provide 615,125 Mcf of annual pipeline capacity and expire in 2008. Finally, 4.6 Bcf of annual pipeline capacity is provided to Yankee Gas by CNG Transmission Corporation ("CNGT") pursuant to transportation contracts which expire in 2003-2012. Under other contracts, CNGT provides 1.4 Bcf of annual storage service to Yankee Gas.
Yankee Gas has multiple natural gas purchase agreements with producers and marketers which back Yankee Gas' transportation and storage contracts. These purchase agreements provide a variety of term lengths, pricing provisions and flexibility options to meet Yankee Gas' current and future supply requirements.
In addition to its gas supply contracts, Yankee Gas also participates in the spot market, buying gas supply on an "as available" basis, to the extent such replacement is operationally feasible and economically beneficial.
Yankee Gas does not have sufficient capacity entitlements on the interstate pipelines to serve its firm customers with pipeline-delivered gas at all times. During the winter, therefore, whenever daily firm demand exceeds the amount of gas delivered by the pipelines, service to interruptible customers is interrupted and Yankee Gas supplements pipeline gas with a propane-air mixture produced at facilities within Yankee Gas' service territory. In fiscal 1996, such propane-air comprised less than 0.4 percent of Yankee Gas' total supply. Although Yankee Gas anticipates continued utilization of this relatively expensive supplemental gas, the quantities to be used are substantially decreased from prior periods due to the addition of the ANE supplies transported by Iroquois.
Iroquois Gas Transmission System, L.P. In April 1996, the Company's wholly-owned subsidiary, Housatonic Corporation, sold its entire 10.5 percent interest in Iroquois to three of Iroquois' existing limited partners for a purchase price of approximately $22.2 million. The Company determined that the continued ownership of an interest in an interstate pipeline does not fit the Company's strategic plan to focus more on providing energy distribution services to customers and energy conversion services on customers' premises.
Regulation and Rates - --------------------
Federal Regulation. Although Yankee Gas is not subject to FERC jurisdiction, the FERC does regulate the interstate pipelines serving Yankee Gas' service territory. Yankee Gas, therefore, is directly and substantially affected by the FERC's policies and actions. Accordingly, Yankee Gas closely follows and, when appropriate, participates in proceedings before the FERC.
Connecticut Regulation. Yankee Gas is subject to regulation by the DPUC, which, among other things, has jurisdiction over rates, accounting procedures, certain dispositions of property and plant, mergers and consolidations, issuances of securities, standards of service, management efficiency and construction and operation of distribution, production and storage facilities.
Yankee Gas sells gas to its retail customers under rate schedules filed with and approved by the DPUC. Firm sales rates are subject to monthly adjustments pursuant to a Purchased Gas Adjustment ("PGA") clause approved by the DPUC. The PGA passes through to customers most changes in the cost of gas purchased by Yankee Gas. These adjustments are designed to collect or refund differences in purchased gas costs from the costs included in the base rates. Currently, the DPUC is conducting a review of the Connecticut LDCs' PGA mechanism to determine if any changes are warranted. Hearings have been held but no decision has been rendered; until it is, the Company is unable to determine the impact, if any, of any changes.
Yankee Gas' most recent rate order (effective for service rendered on and after October 1, 1992) allowed a return on equity of 12.43 percent and provided for favorable accounting treatment for environmental cleanup costs, post-retirement benefits and certain other major items.
The DPUC may, after a special public hearing, order an interim rate decrease if it finds that Yankee Gas' return on equity exceeds a reasonable rate of return and rates are more than just, reasonable and adequate as determined by the DPUC. The DPUC also is empowered to grant an interim rate increase under compelling circumstances.
FERC Order No. 636. In implementing Order No. 636, the FERC recognized that the restructuring of the pipelines' traditional services would cause pipelines to incur transition costs in several areas. The FERC has permitted certain transition costs to be recovered by the pipeline companies from their customers.
In July 1994, the DPUC issued an order permitting the recovery of transition costs billed by pipelines under Order No. 636 through various mechanisms authorized by the DPUC. Through September 30, 1996, Yankee Gas has paid approximately $17.3 million of transition costs and an additional $0.7 million are anticipated. To date, Yankee Gas has collected $34.5 million through a combination of gas supplier refunds, deferred gas costs credits and excess interruptible margins. In January 1996, the DPUC approved a joint stipulation and agreement between Yankee Gas and the Connecticut Office of Consumer Counsel which permits Yankee Gas to retain over-collected transition cost credits to offset certain deferred regulatory assets. In exchange, Yankee Gas agreed not to increase its rates prior to October 1, 1998, except in the event of certain circumstances which would adversely affect Yankee Gas' financial condition. If such an event arises, Yankee Gas has the option to apply to the DPUC for a rate increase or to retain up to 80% of any off system sales margin and excess interruptible margin.
In January 1996, the DPUC, in response to Order No. 636, authorized the Connecticut LDCs to offer unbundled firm transportation rates to its commercial and industrial customers. The DPUC's decision permits Yankee Gas to offer a variety of service options to its commercial and industrial firm transportation customers. Yankee Gas implemented new firm transportation rates and services in April 1996. As of September 30, 1996, Yankee Gas had 127 customers under the new firm transportation service. The conversion by existing customers to transportation service will result in decreased revenues for Yankee Gas, as that portion of revenues representing gas costs will be borne directly by the customer who will purchase its own gas directly. Yankee Gas, however, does not expect customer conversions to transportation services to affect its net income. The DPUC's decision did not address Yankee Gas' revenue requirement; Yankee Gas will maintain the existing margin recovery and rates of return established in the last rate case decision issued for Yankee Gas in 1992.
Order No. 636 also authorizes LDCs to make off system sales or to release firm pipeline capacity and Yankee Gas has engaged in these activities to maximize revenues and for effective gas supply planning.
On August 25, 1996, the Company filed an application with the DPUC relating to a Financial and Operation Review (Review) of Yankee Gas. This Review is required to be undertaken by the DPUC under Connecticut State law if the Company has not undergone a rate proceeding within the last four years. Since Yankee Gas' last rate application was approved on August 26, 1992, this Review is necessary to comply with the statute. Hearings have been tentatively scheduled for February 1997. The Company is not able to determine at this time the financial or operational impact of any decisions which may result from the Review, but they are not expected to have a material impact on earnings.
Energy Services - ---------------
The Company has broadened its mission to diversify into energy-related businesses. YESCo is engaged in the business of providing a full range of energy-related services for customers, including consulting, procurement and development for on-site generation and cogeneration systems as well as technical and operating support for power plants and boilerhouses. In fiscal 1996, YESCo began offering consulting services to help commercial and industrial customers solve complex new energy purchasing problems brought about by deregulation of the energy industry. For additional information on YESCo see page 1.
Competition. Yankee Gas' principal competitors are unregulated fuel-oil retailers and regulated electric utilities. Natural gas competes with oil and electricity in many commercial and industrial applications and in residential space and water heating, clothes drying and cooking. Demand for natural gas is affected by the marketing and pricing of competing sources of energy.
Yankee Gas may also face competition from other LDCs. In the past, LDCs did not directly compete with other LDCs for retail customers because the territories they serve are fixed by franchise. However, since 1993, LDCs began marketing efforts within the service territory of other LDCs under blanket certificates granted by the Federal Energy Regulatory Commission ("FERC"). These certificates allow gas to be sold, but not necessarily delivered, in the service territory of another LDC. Within Yankee Gas' service territory, Yankee makes available its transportation services to move other parties' gas through its distribution system. The Company's strategic plan focuses on its core business of gas distribution and expansion of the development of its energy services business through the efforts of its unregulated subsidiary, YESCo, to help customers through changes brought about by deregulation in the natural gas industry.
Federal regulation also permits customers within Yankee Gas' distribution system to connect directly with transmission pipelines and bypass Yankee Gas' distribution system. No interstate pipeline company, however, has physically bypassed Yankee Gas' distribution system to provide retail service to customers in Yankee Gas' service territory. A Connecticut statute currently prohibits an interstate pipeline from bypassing an LDC without the DPUC's prior approval. The Company believes that Yankee Gas is successfully addressing the threat of bypass by its industrial customers by understanding what services they need and executing market-competitive gas service agreements.
Environmental Matters - ---------------------
The Company is subject to federal and state environmental regulation of its operations and properties. Such regulation may result in future environmental liabilities that may include significant expenses incurred to remove, contain or remediate contamination caused by operations of former gas manufacturing plant sites, including coal tar deposits. Coal tar is a by- product of the gas manufacturing process used by Yankee Gas' predecessor companies in the mid-20th century. Those predecessor companies disposed of the coal tar deposits in accordance with the standard operating practices of the time.
Fourteen sites containing coal tar became the property of Yankee Gas at the time of divestiture from its former parent company. Yankee Gas has reported the results of environmental studies conducted at these sites to the Connecticut Department of Environmental Protection ("DEP"). Seven of the fourteen sites are presently listed on the Connecticut Inventory of Hazardous Waste Sites. Inclusion of a site on this list is an indication that remediation may be required in the future.
A program of remediation at two of these properties was conducted during fiscal 1996. In addition, the Company has developed a cost estimate for the remaining sites based on various factors including the probability of clean-up.
Recovery of remediation costs has been specifically allowed by Yankee Gas' 1992 rate case decision. Currently, $325,000 is allowed annually in rates. If costs are expected to exceed $2.5 million on an annual basis, Yankee Gas is required to go to the DPUC for review. The DPUC has stated that "to the extent that coal tar remediation expenses are prudently incurred, they should be allowed as proper operating expenses." The Company recorded a liability of $35 million in fiscal year 1993 for future environmental cleanup.
During fiscal 1996, the Company received funds from certain of its insurance carriers in settlement of certain claims for actual or potential contamination at certain sites that may give rise to environmental liabilities. The terms of the aforementioned settlements are subject to confidentiality provisions in agreements between Yankee Gas and its insurance carriers. Yankee Gas currently is actively pursuing additional claims against some of its insurers.
Franchises - ----------
Yankee Gas and its predecessors in interest have held valid franchises to sell gas in the areas in which Yankee Gas supplies gas service. Such franchises are perpetual but remain subject to the power of alteration, amendment or repeal by the General Assembly of the State of Connecticut, the power of revocation by the DPUC and certain approvals, permits and consents of public authorities and others prescribed by statute. Yankee Gas franchises include, among other rights and powers, the rights and powers to manufacture, generate, purchase, transmit and distribute gas, to sell gas at wholesale to other utility companies and municipalities and to erect and maintain certain facilities on public highways and grounds, all subject to such consents and approvals of public authorities and others as may be required by law. The franchises include the power of eminent domain.
Self-generation and Cogeneration - --------------------------------
With the current industry deregulation, two expanding gas markets in Connecticut and elsewhere are self-generation and cogeneration of electricity. Self-generation is the generation of some or all of a user's electricity requirements, typically for commercial or industrial purposes. Cogeneration involves sequential production of electricity and thermal or mechanical energy.
Under an agreement between Yankee Gas and The Dexter Corporation ("Dexter"), Yankee Gas' largest customer, Dexter has a contract to purchase annually approximately 3.9 Bcf of natural gas sales service for use in its 56-megawatt cogeneration facility for an initial term of 20 years (1989-2009).
Employees - ---------
Yankee Energy and its subsidiaries employ approximately 619 people.
ITEM 2.

ITEM 2. PROPERTIES ----------
Yankee Gas' property consists primarily of its gas distribution facilities including, distribution lines (mains and services), meters, pumps, valves and pressure and flow controllers. Yankee Gas owns various propane facilities with a combined storage capacity equivalent to approximately 238,000 Mcf and seven gas storage holders with a total capacity of approximately 6.4 Bcf. In the opinion of management, Yankee Gas' distribution system is in good condition. Virtually all of the gas properties are subject to the lien of the Yankee Gas first mortgage bond indenture. Yankee Gas also owns service facilities in Meriden, Waterbury, Torrington, Mystic, Bristol, Shelton, Bethel and Danielson, Connecticut.
NorConn owns the Company's headquarters building in Meriden, Connecticut and currently leases it to Yankee Gas. This is the site of the Company's corporate administrative and staff functions including the Customer Service Center. NorConn also owns and leases to Yankee Gas a service building in East Windsor.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS -----------------
Municipal Tax Assessment. In November 1995, Yankee Gas received revised tax bills for the years 1991 through 1994 from the City of Meriden, Connecticut (the "City"). The City is asserting a claim for the payment of approximately $5.0 million of back taxes and interest resulting from a retroactive reassessment and revaluation of Yankee Gas' personal property filings. The City did not locate or identify any property which Yankee Gas omitted from its filings. The tax bills reflect a reassessment of property at higher rates than those previously accepted by the City. Yankee Gas is currently vigorously contesting this retroactive reassessment. On November 17, 1995, Yankee Gas filed a lawsuit in Connecticut Superior Court against the City and certain City officials alleging that the Connecticut state statutes prohibit the City from retroactively reassessing personal property after grand lists are filed and requesting that the City's order to pay additional taxes be invalidated. Although no assurances can be given and no determination can be made at this time as to the outcome of the City's claim or Yankee Gas' lawsuit, the Company does not anticipate that the outcome of this matter will have a material adverse effect on the Company's consolidated results of operations or financial position.
Licensing Issue. In November 1995, The Connecticut Heating and Cooling Contractors Association, Inc. and others filed a class action suit against Yankee Gas and Connecticut's two other LDCs, Connecticut Natural Gas Corporation and The Southern Connecticut Gas Company, claiming the LDCs engaged in unfair trade practices. The action alleges that the LDCs unfairly competed with licensed plumbers and contractors by performing customer service work using customer service employees who did not possess Connecticut state trade licenses. The plaintiffs are seeking injunctive relief and unspecified punitive and actual damages. Yankee Gas is currently vigorously contesting this lawsuit.
The LDCs have asserted that such licenses are not required for this work based on a statutory exemption enacted in 1965 and amended in 1967. However, in a separate proceeding, a Connecticut Superior Court has upheld an administrative ruling against the LDCs' position which was recently affirmed on appeal.
In 1995, the Connecticut General Assembly enacted legislation that established prospectively a separate procedure for State certification of gas service employees. While the ultimate results of the class action suit cannot be determined, management does not expect that it will have a material adverse effect on the Company's consolidated results of operations or financial position.
Other legal proceedings involving the Company and its subsidiaries are litigation incidental to the conduct of the Company's business which, in management's opinion, will not have a material impact on the Company's financial condition or results of operation.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ---------------------------------------------------
There was no matter submitted to a vote of security holders during the fourth quarter of 1996.
EXECUTIVE OFFICERS OF THE COMPANY ---------------------------------
Position and Business Experience Name Age During Past Five Years - ---- --- --------------------------------- Branko Terzic 49 Chairman, President and Chief Executive Officer of the Company and its direct subsidiaries. Mr. Terzic became Chairman in August 1995, Chief Executive Officer in March 1995 and President in September 1994. From June 1993 to September 1994, Mr. Terzic was Managing Director of Arthur Andersen Economic Consulting, Washington, D.C. From October 1990 to May 1993, he served as a Commissioner of the Federal Energy Regulatory Commission.
Charles E. Gooley 43 Executive Vice President of the Company, and its direct subsidiaries, Yankee Gas Services Company, NorConn Properties, Inc., Housatonic Corporation, and Yankee Energy Financial Services Company, since July 1994. Previously, he served as Vice President, General Counsel and Assistant Secretary of the Company from July 1989 to July 1994.
Michael E. Bielonko 44 Vice President of the Company and its direct subsidiaries since July 1989 and Chief Financial Officer since July 1990. From July 1989 to July 1990 and from September 1992 to May 1995, he also served as Treasurer of the Company.
Thomas J. Houde 49 Vice President of the Company and its direct subsidiary, Yankee Gas Services Company, since January 1992. Previously, he served as Director, Corporate Planning, Rates and Economic Analysis of Yankee Gas from March 1990 to December 1991.
Mary J. Healey 45 Vice President, General Counsel and Secretary of the Company and its direct subsidiaries since January 1995. Previously, she served as Secretary and Assistant General Counsel of the Company from January 1992 to January 1995 and as Secretary and Counsel of the Company from July 1989 to January 1992.
Ellen J. Quinn 40 Vice President of the Company and its direct subsidiaries, Yankee Gas Services Company and R.M. Services, Inc., since May 1995. Previously, she served as Director, Corporate and Environmental Planning from October 1992 to May 1995, as Manager, Corporate and Environmental Planning from March 1990 to October 1992.
Steven P. Laden 48 Vice President of the Company and its direct subsidiaries, Yankee Gas Services Company and Yankee Energy Financial Services Company, since July 1996. From October 1991 to July 1996,he served as Vice President of Marketing of Southern Union Company, a company engaged in various aspects of the energy business including the distribution of natural gas in Texas and Missouri.
All executive officers are elected annually by the Company's Board of Directors. There are no family relationships among the executive officers and directors nor are there any arrangements or understandings between any executive officer and any other person pursuant to which the officer was selected.
PART II
ITEM 5.

ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS --------------------------------------
Yankee Energy declared and paid regular quarterly cash dividends in 1996. The dividend paid for the first two quarters of 1996 was $.315 per share and $.325 per share in the last two quarters of 1996. Other information required by this item is incorporated herein by reference to Yankee Energy's 1996 Annual Report to Shareholders ("1996 Annual Report"), on the inside back cover, subsections entitled "Market for Common Stock", and "Dividends".
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA -----------------------
Information required by this item is incorporated herein by reference to the 1996 Annual Report.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS -------------------------------------------------
Information required by this item is incorporated herein by reference to the 1996 Annual Report.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA -------------------------------------------
The Consolidated Financial Statements of Yankee Energy and the Notes thereto, together with the report thereon of the Company's Management and of Arthur Andersen LLP are incorporated herein by reference to the 1996 Annual Report.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE -------------------------------------------------
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY -----------------------------------------------
Information regarding Yankee Energy's directors is incorporated herein by reference to the Company's Proxy Statement for its Annual Meeting of Shareholders to be held on January 31, 1997 (the "1997 Proxy Statement").
Information regarding the Company's executive officers follows Item 4 in Part I of this Form 10-K.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION ----------------------
Information regarding compensation of Yankee Energy's executive officers, except the Report of the Organization and Compensation Committee and the Stock Performance Graph, is incorporated herein by reference to the 1997 Proxy Statement.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -----------------------------------------------
Information regarding the beneficial ownership of shares of Common Stock of the Company by certain persons is incorporated herein by reference to the 1997 Proxy Statement.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ----------------------------------------------
Information regarding certain transactions of the Company is incorporated herein by reference to the 1997 Proxy Statement.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ---------------------------------------------------
(a) 1. Financial Statements:
The following Consolidated Financial Statements of Yankee Energy are incorporated herein by reference to the Company's 1996 Annual Report in response to Item 8 hereof:
(i) Report of Independent Public Accountants
(ii) Consolidated Statements of Income for the years ended September 30, 1996, 1995 and 1994.
(iii) Consolidated Balance Sheets at September 30, 1996 and 1995.
(iv) Consolidated Statements of Cash Flows for the years ended September 30, 1996, 1995 and 1994.
(v) Consolidated Statements of Capitalization at September 30, 1996 and 1995.
(vi) Consolidated Statements of Common Shareholders' Equity for the years ended September 30, 1996, 1995 and 1994.
(vii) Notes to Consolidated Financial Statements
2. Financial Statement Schedules:
The following schedules of the Company are included on the attached pages as indicated: Page ---- Report of Independent Public Accountants on Schedules...S-1
Schedule II Valuation and Qualifying Accounts and Reserves for the years ended September 30, 1996, 1995 and 1994..................S-2
3. Exhibits:
Exhibits for Yankee Energy are listed in the Index to Exhibits........................................E-1
(b)Reports on Form 8-K:
None.
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, thereunto duly authorized.
YANKEE ENERGY SYSTEM, INC. -------------------------- (Registrant)
Date: December 4, 1996 By /s/ Branko Terzic ----------------------- Chairman, President and Chief Executive Officer
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.
Date Title Signature - ---- ----- --------- December 4, 1996 Chairman, President /s/Branko Terzic and Chief Executive Branko Terzic Officer
December 4, 1996 Vice President, /s/Michael E. Bielonko Chief Financial Michael E. Bielonko Officer
December 4, 1996 Controller /s/Nicholas A. Rinaldi Nicholas A. Rinaldi
December 4, 1996 Director /s/Sanford Cloud, Jr. Sanford Cloud, Jr.
December 4, 1996 Director /s/Eileen S. Kraus Eileen S. Kraus
December 4, 1996 Director /s/Frederick M. Lowther Frederick M. Lowther
December 4, 1996 Director /s/Leonard A. O'Connor Leonard A. O'Connor
December 4, 1996 Director /s/Emery G. Olcott Emery G. Olcott
December 4, 1996 Director /s/Nicholas L. Trivisonno Nicholas L. Trivisonno
December 4, 1996 Director /s/Patricia M. Worthy Patricia M. Worthy
ARTHUR ANDERSEN LLP
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders of Yankee Energy System, Inc.:
We have audited, in accordance with generally accepted auditing standards, the financial statements included in Yankee Energy System, Inc.'s (the Company) annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated November 7, 1996. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. The schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
Arthur Andersen LLP Hartford, Connecticut November 7, 1996
INDEX TO FINANCIAL STATEMENT SCHEDULES
SCHEDULE
II Valuation and Qualifying Accounts and Reserves for Years Ended September 30, 1996, 1995 and 1994
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEAR ENDED SEPTEMBER 30, 1996 SCHEDULE II (Thousands of Dollars)
(a) Amounts charged off as uncollectible after deducting customers' deposits and recoveries of accounts previously charged off. (b) Provided to cover claims for injuries to employees, for workmen's compensation, for bodily injury to others and property damage. (c) Principally payments for various injuries and damages and expenses in connection therewith. (d) Provided to cover employee medical claims. (e) Principally payments for various employee medical expenses and expenses in connection therewith.
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEAR ENDED SEPTEMBER 30, 1995 SCHEDULE II (Thousands of Dollars)
(a) Amounts charged off as uncollectible after deducting customers' deposits and recoveries of accounts previously charged off. (b) Provided to cover claims for injuries to employees for workmen's compensation, for bodily injury to others and property damage. (c) Principally payments for various injuries and damages and expenses in connection therewith. (d) Provided to cover employee medical claims. (e) Principally payments for various employee medical expenses and expenses in connection therewith.
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEAR ENDED SEPTEMBER 30, 1994 SCHEDULE II (Thousands of Dollars)
(a) Amounts charged off as uncollectible after deducting customers' deposits and recoveries of accounts previously charged off. (b) Provided to cover claims for injuries to employees for workmen's compensation, for bodily injury to others and property damage. (c) Principally payments for various injuries and damages and expenses in connection therewith. (d) Provided to cover employee medical claims. (e) Principally payments for various employee medical expenses and expenses in connection therewith.
* Filed herewith. + Management contract or compensatory plan.


Item 1. BUSINESS - ------ --------
Technology Funding Secured Investors II (hereinafter referred to as the "Partnership" or the "Registrant") was formed as a California limited partnership on August 31, 1984, and commenced operations on June 4, 1987, with the sale of Units. The business of the Partnership is to provide loans secured by equipment and other assets to new and developing companies and to acquire equity interests in these companies as described in the "Summary of the Offering" and "Business of the Partnership" sections of the Prospectus originally dated June 4, 1987, and in Supplement No. 2 thereto dated February 12, 1988, (the "Supplement"), that forms a part of the Registrant's Form S-1 Registration Statement No. 33-12566 and in the Amended Prospectus dated March 8, 1988, that forms a part of Post- Effective Amendment No. 1 to the Registration Statement as filed with the Securities and Exchange Commission on March 8, 1988, (such Prospectus, as supplemented and amended on March 8, 1988, is hereinafter referred to as the "Prospectus"), which sections are incorporated herein by reference. Additional characteristics of the Partnership's business are discussed in the "Risk Factors" and "Conflicts of Interest" sections of the Prospectus, which sections are also incorporated herein by reference. The Partnership had been inactive until it commenced selling units of limited partnership interest ("Units") on June 4, 1987. The Partnership's Amended and Restated Limited Partnership Agreement ("Partnership Agreement") provides that the Partnership will continue until December 31, 1996, unless further extended. In September of 1996, the General Partners exercised their right and extended the term of the Partnership to December 31, 1998. If the General Partners so determine, the Partnership term can be further extended for an additional two- year period, or the Partnership may be dissolved earlier.
Item 2.

Item 2. PROPERTIES - ------ ----------
The Registrant has no material physical properties.
Item 3.

Item 3. LEGAL PROCEEDINGS - ------ -----------------
Except as disclosed in Note 8 to the financial statements, there are no other material pending legal proceedings to which the Registrant is party or of which any of its property is the subject, other than ordinary routine litigation incidental to the business of the Partnership.
Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------ ---------------------------------------------------
No matter was submitted to a vote of the holders of units of limited partnership interests ("Units") during 1996.
PART II
Item 5.

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER - ------ ------------------------------------------------------------- MATTERS - -------
(a) There is no established public trading market for the Units.
(b) At December 31, 1996, there were 5,214 record holders of Units.
(c) The Registrant, being a partnership, does not pay dividends. Cash distributions, however, may be made to the partners in the Partnership pursuant to the Registrant's Partnership Agreement.
Item 6.

Item 6. SELECTED FINANCIAL DATA - ------ -----------------------
Refer to financial statement notes entitled "Summary of Significant Accounting Policies" and "Allocation of Profits and Losses" for a description of the method of calculation for net realized (loss) income per Unit.
Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION - ------ ----------------------------------------------------------- AND RESULTS OF OPERATIONS - -------------------------
Liquidity and Capital Resources - -------------------------------
In 1996, net cash used by operating activities totaled $1,469,223. The Partnership paid management fees of $165,379 to the Managing General Partner, reimbursed related parties for operating expenses of $1,292,834, and paid affiliated partnerships $2,047 for net loan participations. Other operating expenses of $377,998 were paid, and interest and other income of $323,252 and $4,241, respectively, were received. In addition, the Partnership received collection expense reimbursements of $41,542 from portfolio companies. Distributions declared in 1995 of $466,804 were paid to the Limited and General Partners.
During 1996, the Partnership issued $168,002 in secured notes receivable primarily to a portfolio company in the computers and computer equipment industry. Repayments of secured notes receivable provided cash of $823,522. Proceeds from sales of equity investments and recoveries from investments previously written off totaled $57,574 and $113,214, respectively. The Partnership is a party to litigation, see Note 8 for additional information regarding the future use of Partnership funds and restricted cash as of December 31, 1996.
Cash and cash equivalents at December 31, 1996, were $3,243,908. Operating cash reserves combined with future proceeds from the sales of investments, interest income received from short-term investments, repayments of secured notes receivable, and equity investment sales are expected to be sufficient to fund Partnership operations through the next twelve months.
Results of Operations - ---------------------
1996 compared to 1995 - ---------------------
Net loss in 1996 was $1,624,120 compared to a net income of $1,580,235 in 1995. The change was primarily due to a $2,638,163 decrease in the change in net unrealized fair value of equity investments, a $2,389,795 decrease in net realized gain from sales of equity investments, and a $1,091,165 decrease in secured notes receivable interest income. These changes were mostly offset by a $2,242,556 decrease in realized losses from investment write-downs and a $809,563 decrease in total operating expenses.
During 1996, the decrease in equity investment fair value of $1,033,488 mostly related to portfolio companies in the computer software and systems and industrial/business automation industries. In 1995, the increase in equity investment fair value of $1,604,675 was primarily due to the reversal of unrealized losses, which were realized from investments write-downs for portfolio companies in the medical and retail/consumer products industries.
During 1996, the Partnership realized a gain of $48,824 from sales of Hybridon, Inc., and Allegiant Physicians Services, Inc., stock. In 1995, realized gain totaled $2,438,619, primarily related to sales of Imagine Publishing, Inc., 3Com Corporation, and Datalogix International, Inc.
Secured notes receivable interest income was $138,770 and $1,229,935 for 1996 and 1995, respectively. The higher 1995 balance was primarily due to cash interest payments received from portfolio companies in the computer software and systems, telecommunications, and medical industries which had been on nonaccrual status. At December 31, 1996, the remaining portfolio was on non-accrual status due to uncertainty of the borrowers' financial conditions.
In 1996 and 1995, the Partnership realized losses from investments write-downs of $125,104 and $2,367,660, respectively. The 1996 write-downs related to equity investments in portfolio companies in the computer and computer equipment and telecommunication industries. Write-downs in 1995 primarily related to equity investments in portfolio companies in the medical and retail/consumer products industries.
Total operating expenses were $522,232 and $1,331,795 in 1996 and 1995, respectively. As disclosed in Note 7 to the financial statements, the 1996 operating expenses were reduced by reimbursements of $41,542 for prior period collection expenses. Additionally, as disclosed in Note 3 to the financial statements, the 1995 operating expenses included additional administrative and investor services expenses of $877,965. Had the 1996 reimbursements not been received and the additional expenses in 1995 been recorded in prior years, total operating expenses for 1996 and 1995 would have been $563,774 and $510,515, respectively. The increase was primarily due to higher collection costs as the remaining portfolio requires additional workout efforts to realize maximum value by the Partnership.
The Partnership recorded a secured notes receivable fair value decrease of $67,000 in 1996, compared to an increase of $346,000 in 1995, based upon the level of loan loss reserves deemed adequate by the Managing General Partner at the respective year ends. The 1995 increase was primarily due to the reversal of unrealized losses, which were realized from investment write-downs for a portfolio company in the medical industry.
Given the inherent risk associated with the business of the Partnership, the future performance of portfolio company investments may significantly impact future operations.
1995 compared to 1994 - ---------------------
Net income was $1,580,235 compared to a net loss of $3,747,004 in 1995 and 1994, respectively. The change was primarily due to a $2,825,220 increase in the change in net unrealized fair value of equity investments, and a $2,412,806 increase in net realized gain from sales of equity investments, partially offset by a $742,232 increase in total operating expenses.
In 1995, the increase in equity investment fair value of $1,604,675 was primarily due to the reversal of unrealized losses, which were realized from investments write-downs for portfolio companies in the medical and retail/consumer products industries. In 1994, the decrease of $1,220,545 was mostly due to a net decrease in the fair value of the Partnership's holdings in a portfolio company in the medical industry.
Net realized gain from sales of equity investments totaled $2,438,619 primarily from the sales of Imagine Publishing, Inc., 3Com Corporation, and Datalogix International, Inc. In 1994, the realized gain of $25,813 mostly related to the non- cash exercise of Elantec, Inc., warrants.
Total operating expenses were $1,331,795 and $589,563 in 1995 and 1994, respectively. As discussed in Note 3 to the financial statements, had the additional expenses in 1995 been recorded in prior years and had there been no recovery of prior period costs of approximately $130,000 in 1994, total operating expenses would have been $510,515 and $775,097 for 1995 and 1994, respectively. The decrease was primarily due to lower administrative and investor services, and lending operations and investment management expenses from lower overall portfolio activities.
Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------ -------------------------------------------
The financial statements of the Registrant are set forth in Item 14.
Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING - ------ ----------------------------------------------------------- AND FINANCIAL DISCLOSURE - ------------------------
Registrant has reported no disagreements with its accountants on matters of accounting principles or practices or financial statement disclosure.
PART III
Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------- --------------------------------------------------
As a partnership, the Registrant has no directors or executive officers. Technology Funding Ltd., a California limited partnership ("TFL"), and Technology Funding Inc., a California corporation ("TFI"), and wholly owned subsidiary of TFL, are the General Partners of the Partnership. TFI is the Managing General Partner. Information concerning the ownership of TFL and the business experience of the key officers of TFI and the partners of TFL is incorporated by reference from the sections entitled "Management of the Partnership - The General Partners" and "Management of the Partnership - Key Personnel" in the Prospectus, which are incorporated herein by reference. Changes in this information that have occurred since the date of the Prospectus are included in the parallel sections of the Technology Funding Medical Partners I, L.P. Prospectus, as modified by Cumulative Supplement No. 4 dated January 4, 1995, forming a part of the May 3, 1993, Pre-Effective Amendment No. 3 to the Form N-2 Registration Statement No. 33-54002, dated October 30, 1992, which is incorporated herein by reference.
Item 11.

Item 11. EXECUTIVE COMPENSATION - ------- ----------------------
As a partnership, the Registrant has no officers or directors. In 1996, the Partnership incurred $165,379 in management fees. The management fees are designed to compensate the General Partners for its General Partner Overhead incurred in performing management duties for the Partnership through December 31, 1996. General Partner Overhead includes the General Partners' share of rent and utilities, and certain salaries and benefits paid by the General Partners in performing their obligations to the Partnership.
Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------- --------------------------------------------------------------
Not applicable. No Limited Partner beneficially holds more than 5% of the aggregate number of Units held by all Limited Partners, and neither the General Partners nor any of their officers, directors or partners own any Units. The General Partners control the affairs of the Partnership pursuant to the Partnership Agreement.
Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------- ----------------------------------------------
The Registrant, or its investee companies, have engaged in no transactions with the General Partners or their officers and partners other than as described above, in the notes to the financial statements, or in the Partnership Agreement.
PART IV
Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON - ------- ------------------------------------------------------- FORM 8-K - --------
(a) List of Documents filed as part of this Annual Report on Form 10-K
(1) Financial Statements - the following financial statements are filed as a part of this Report:
Independent Auditors' Report Balance Sheets as of December 31, 1996 and 1995 Statements of Operations for the years ended December 31, 1996, 1995 and 1994 Statements of Partners' Capital for the years ended December 31, 1996, 1995 and 1994 Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994 Notes to Financial Statements
(2) Financial Statement Schedules
All schedules have been omitted because they are not applicable or the required information is included in the financial statements or the notes thereto.
(3) Exhibits
Registrant's Amended and Restated Limited Partnership Agreement (incorporated by reference to Exhibit A to Registrant's Prospectus dated March 8, 1988, included in Registration Statement No. 33-12566 filed pursuant to Rule 424(b) of the General Rules and Regulations under the Securities Act of 1933).
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Registrant during the year ended December 31, 1996.
(c) Financial Data Schedule for the year ended and as of December 31, 1996 (Exhibit 27).
INDEPENDENT AUDITORS' REPORT ----------------------------
The Partners Technology Funding Secured Investors II:
We have audited the accompanying balance sheets of Technology Funding Secured Investors II (a California limited partnership) as of December 31, 1996 and 1995, and the related statements of operations, partners' capital, and cash flows for each of the years in the three-year period ended December 31, 1996. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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. Our procedures included confirmation of certain loans and securities owned, by correspondence with the individual borrowing and investee companies, and a physical examination of securities held by a safeguarding agent as of December 31, 1996 and 1995. 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 Technology Funding Secured Investors II as of December 31, 1996 and 1995, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1996, in conformity with generally accepted accounting principles.
San Francisco, California /S/KPMG Peat Marwick LLP March 27, 1997
BALANCE SHEETS - --------------
See accompanying notes to financial statements.
STATEMENTS OF OPERATIONS - ------------------------
See accompanying notes to financial statements.
STATEMENTS OF PARTNERS' CAPITAL - -------------------------------
See accompanying notes to financial statements.
STATEMENTS OF CASH FLOWS - ------------------------
See accompanying notes to financial statements.
STATEMENTS OF CASH FLOWS (continued) - -----------------------------------
See accompanying notes to financial statements.
NOTES TO FINANCIAL STATEMENTS - -----------------------------
1. Summary of Significant Accounting Policies ------------------------------------------
Organization - ------------
Technology Funding Secured Investors II (the "Partnership") is a limited partnership organized under the laws of the State of California on August 31, 1984. The purpose of the Partnership is to provide secured equipment financing to new and developing companies and to acquire, hold, sell, trade, exchange or otherwise dispose of warrants and/or capital stock acquired by the Partnership in conjunction with these loans. The General Partners are Technology Funding Ltd. ("TFL") and Technology Funding Inc. ("TFI"), a wholly-owned subsidiary of TFL. TFI is the Managing General Partner.
On September 17, 1987, the minimum number of units of limited partnership interest ("Units") required to form the Partnership (4,800) were sold. On March 31, 1989, the offering terminated after 160,000 Units had been sold, generating $40,000,000 in cash from Limited Partners and $40,041 from the General Partners. The Partnership Agreement provides that the Partnership will continue until December 31, 1996, unless further extended. In September of 1996, the General Partners exercised their right and extended the term of the partnership to December 31, 1998. If the General Partners so determine, the Partnership term can be further extended for an additional two-year period, or the Partnership may be dissolved earlier.
Preparation of Financial Statements and Use of Estimates - --------------------------------------------------------
These financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. This required management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The financial statements include marketable and non-marketable investments of $3,268,718 and $5,157,208 (48% and 60% of partners' capital) as of December 31, 1996 and 1995, respectively. For the non-marketable investments, the Managing General Partner has estimated the fair value of such investments in the absence of readily ascertainable market values. Because of the inherent uncertainty of valuation, those estimated values may differ significantly from the values that would have been used had a ready market for investments existed, and the differences could be material. In addition, for certain publicly traded investments that may not be marketable due to selling restrictions, the Managing General Partner has applied an illiquidity discount of up to 33% in determining fair value as discussed below.
Cash and Cash Equivalents - -------------------------
Cash and cash equivalents are principally comprised of cash invested in demand accounts, money market instruments, and commercial paper and are stated at cost plus accrued interest. The Partnership considers all money market and short-term investments with an original maturity of three months or less to be cash equivalents.
Provision for Income Taxes - --------------------------
No provision for income taxes has been made by the Partnership, as the Partnership is not directly subject to taxation. The partners are to report their respective shares of Partnership income or loss on their individual tax returns.
The accompanying financial statements are prepared using generally accepted accounting principles which may not equate to tax accounting. The Partnership's total tax basis in investments was higher than the reported total cost basis of $6,280,407 by $1,490,360 as of December 31, 1996.
Net Realized Income (Loss) Per Unit - -----------------------------------
Net realized income (loss) per Unit is calculated by dividing the weighted average number of Units outstanding for 1996, 1995, and 1994 of 157,128, 158,614 and 159,312, respectively, into total net realized income (loss) allocated to the Limited Partners. The General Partners contributed an amount equal to 0.1% of total Limited Partner Capital Contribution and did not receive Partnership Units.
Investments: - -----------
In accordance with generally accepted accounting principles, the Partnership's method of accounting for investments is the fair value basis used for investment companies. The fair value of Partnership investments is their initial cost basis with changes as noted below:
Secured Notes Receivable, Net -----------------------------
The secured notes receivable portfolio includes accrued interest less the discount related to warrants and the allowance for loan losses. The portfolio approximates fair value through inclusion of an allowance for loan losses. Allowance for loan losses is reviewed quarterly by the Managing General Partner and is adjusted to a level deemed adequate to cover possible losses inherent in notes receivable and unfunded commitments. Notes receivable are placed on nonaccrual status when, in the opinion of the Managing General Partner, the future collectibility of interest or principal is in doubt.
In conjunction with certain secured notes, upon note issuance or restructure, the Partnership receives warrants (to purchase certain types of capital stock) or capital stock of the borrowing company. The cost basis of the warrants and the resulting discount has been estimated by the Managing General Partner to be 1% of the principal balance of the original notes made to the borrowing company. The cost basis of capital stock and the discount are generally based on the valuation set at the latest round of financing. The discount is amortized to interest income on a straight- line basis over the term of the loan. These warrants and capital stock are included in the equity investment portfolio.
Equity Investments ------------------
The fair value for publicly-traded equity investments (marketable equity securities) is based upon the five-day-average closing sales price or bid/ask price that is available on a national securities exchange or over- the-counter market. Certain publicly-traded equity investments may not be marketable due to selling restrictions. For publicly-traded equity investments with selling restrictions, an illiquidity discount of up to 33% is applied when determining fair value; the actual discount percentage is based on the type and length of restrictions. Sales of equity investments are recorded on the trade date. The basis on which cost is determined in computing realized gains or losses is generally specific identification.
Other equity investments, which are not publicly-traded, are generally valued utilizing pricing obtained from the most recent round of third party financings. Valuation is estimated quarterly by the Managing General Partner. Included in equity investments are convertible and subordinated notes receivable as repayment of these notes generally occur through conversion into equity investments.
Equity investments with temporary changes in fair value result in increases or decreases to the unrealized fair value of equity investments. The cost basis does not change. In the case of an other than temporary decline in value below cost basis, an appropriate reduction in the cost basis is recognized as a realized loss. Adjustments to fair value basis are reflected as "Change in net unrealized fair value of equity investments." Cost basis adjustments are reflected as "Realized losses from investment write-downs" on the Statements of Operations.
Non-cash Exercise of Warrants - -----------------------------
Periodically, the Partnership may acquire stock through the non-cash exercise of warrants. Upon the non-cash exercise of warrants, the Partnership recorded net realized gains of $8,497, $83,619, and $25,813, during 1996, 1995, and 1994, respectively, as a result of the underlying stock prices at the date of exercise. These amounts are included in net realized gain from sales of equity investments in the Statements of Operations.
Distributions - -------------
Distributions made to the Limited Partners are made among such partners in the proportion their respective capital accounts bear to the total of all capital accounts of the group. After a reasonable amount of time, unnegotiated distribution checks, if any, are recorded as other liabilities on the Balance Sheets.
Reclassification - ----------------
Certain prior year balances have been reclassified to conform with the 1996 financial statement presentation.
2. Change in Net Unrealized Fair Value of Equity Investments ---------------------------------------------------------
In accordance with the Partnership's accounting policy as stated in Note 1, the Statements of Operations include a line item entitled "Change in net unrealized fair value of equity investments." The table below discloses details of the changes:
3. Related Party Transactions --------------------------
Included in costs and expenses are related party costs as follows:
Management fees, payable quarterly, are equal to one half of one percent of the Partnership's assets under management. Management fees compensate the General Partners solely for General Partner Overhead (as defined in the Partnership Agreement) incurred in supervising the operation, management, and progress of Partnership loans to borrowing companies and its portfolio of warrants and capital stock of borrowing companies, as well as for general administration of the Partnership. Management fees are only paid to the extent that the aggregate amount of all proceeds received by the Partnership (including warrants exercised without cash) from the sale or other disposition of borrowing company equities, plus the aggregate fair market value of any equity securities distributed to the partners, exceeds the total management fee payable.
The Partnership reimburses the Managing General Partner and affiliates for operating expenses incurred in connection with the business of the Partnership. Reimbursable operating expenses include expenses (other than Organizational and Offering and General Partner Overhead) such as investment operations, administrative and investor services and computer services. During late 1995, operating cost allocations to the Partnership were reevaluated. The Managing General Partner determined that it had not fully recovered allocable overhead as permitted by the Partnership Agreement. As a result, the Partnership was charged additional administrative and investor services costs of $877,965, which were not previously recognized by the Partnership. This charge consisted of $56,685, $57,167, and $764,113 related to 1995, 1994, and prior years, respectively. If this charge had been recorded in prior years, total operating expenses would have been $510,515 and $646,730 for 1995 and 1994, respectively. At December 31, 1996 and 1995, expenses due to related parties totaled $42,869 and $872,822, respectively.
Under the terms of a computer support agreement, the Partnership recognized charges from Technology Administrative Management, a division of TFL, for its share of computer support costs. These amounts are included in computer services expense.
Within the normal course of business, the Partnership participates in secured notes receivable issued to non-affiliated borrowing companies by affiliated partnerships which are also managed by the Managing General Partner. The Partnership may also reparticipate such secured notes receivable amongst affiliated partnerships to meet business needs. At December 31, 1996, no amounts were due to or from affiliated partnerships. At December 31, 1995, $2,047 was due to affiliated partnerships. This amount was paid to such affiliated partnerships by the Partnership immediately following the year end.
In order to increase the future investment returns to the Partnership, a portfolio company of the Partnership and affiliated partnerships have entered into a joint venture with the General Partners to perform investment recovery efforts. The General Partners have agreed to waive any "post conversion" profit interest in the Partnership attributable to any such recoveries for a share of the joint venture net profits. The post conversion profit is pursuant to, and as defined in, the profit and loss provisions of the Partnership's Partnership Agreement. The joint venture documents are subject to review by legal counsel for the Partnership to ensure conformity with the terms of the Partnership Agreement.
In 1995 and 1994, TFL had a sublease rental agreement with a Partnership portfolio company in the computers and computer equipment industry. The terms of this agreement were similar to those which would apply to an unrelated party. This agreement was terminated in the fourth quarter of 1995.
4. Distributions -------------
During 1996, distributions of $466,804 ($3 per Unit) declared in 1995 were paid to the Limited and General Partners. As the Partnership has been in its liquidation stage since 1993, future distributions are expected to fluctuate as distributions will be dependent upon loan repayments from borrowing companies and available cash.
5. Allocation of Profits and Losses --------------------------------
Net realized profit of the Partnership is allocated based on the beginning of year partners' capital balances as follows:
(a) first, to those partners with deficit capital account balances in proportion to such deficits until such deficits have been eliminated.
(b) second, to the partners as necessary to offset net realized loss previously allocated to such partners and sales commissions charged to their capital accounts until each partner has been allocated cumulative net realized profit equal to cumulative net realized loss previously allocated to such partner and its share of sales commissions not already offset.
(c) third, 99% to the Limited Partners and 1% to the General Partners until the Limited Partners have been allocated an amount of cumulative net realized profit that would, if distributed at the end of the taxable period, result in a cumulative, compounded annual return to the Limited Partners of 8% of their adjusted capital contributions.
(d) fourth,
(i) 80% to the Limited Partners (ii) 20% to the General Partners.
In no event are the General Partners to be allocated less than 1% of the net realized profit of the Partnership.
Net realized loss of the Partnership is allocated as follows:
(a) to the partners as necessary to offset net realized profit previously allocated to such partners pursuant to (d) above until each partner has been allocated cumulative net realized loss equal to the cumulative net realized profit previously allocated to such partners.
(b) 99% to the Limited Partners and 1% to the General Partners.
Losses in excess of Limited Partner capital accounts are allocated to the General Partners.
Given the inherent risk associated with the business of the Partnership, the future performance of portfolio company investments may significantly impact future operations.
6. Equity Investments ------------------
At December 31, 1996 and 1995, equity investments consisted of:
Marketable Equity Securities - ----------------------------
At December 31, 1996 and 1995, marketable equity securities had aggregate costs of $387,958 and $510,580, respectively, and aggregate fair values of $715,845 and $603,264, respectively. The net unrealized gains at December 31, 1996 and 1995, included gross gains of $339,223 and $237,087, respectively.
Allegiant Physicians Services, Inc. - -----------------------------------
During 1996, the Partnership exercised its option to sell all of its 21,000 common shares to the company for $35,025 resulting in a realized gain of $27,525.
Cyclean, Inc./Cyclean of Los Angeles, LLC - -----------------------------------------
During the second quarter of 1996, the Partnership received 25,495 Series D Preferred shares as a stock dividend while another 112,500 shares were received pursuant to a prior debt restructure. Subsequently, the Managing General Partner determined that the fair value of the Partnership's investment had declined and accordingly, the Partnership recorded a $254,079 decrease in fair value at December 31, 1996.
Hemocleanse, Inc. - -----------------
During 1996, the Partnership recorded a total increase in fair value of $42,650 for its warrant and stock investment, based on the valuation set at the latest round of financing in which third parties participated.
Hybridon, Inc. - --------------
In January of 1996, Hybridon, Inc., completed its initial public offering. The Partnership exercised its warrant holdings without cash and received 2,532 shares of common stock, which were subsequently sold for total proceeds of $22,549. The total realized gain from these transactions was $21,299.
MTI Technology Corporation - --------------------------
During the first quarter of 1996, the Managing General Partner determined that there had been an other than temporary decline in value of the Partnership's investment. As a result, the Partnership realized a loss of $115,104. The Partnership recorded an increase in fair value of $21,200 to reflect the market price of the unrestricted shares at December 31, 1996.
S-TRON - ------
The company was unsuccessful in its efforts to obtain a major government contract; as a result, the company ceased operations during March of 1996. This investment, which had previously been written off, is no longer held by the Partnership.
Wasatch Education Systems Corporation - -------------------------------------
In early 1997, the company entered into a buyout agreement to sell certain assets and liabilities and to grant an exclusive license for a segment of the company's market to management. The company retains the use of the technology for other markets along with certain liabilities and will receive approximately $1.5 million in cash and a royalty stream based on future revenues generated by the new company formed by the former management team. Minimum royalty payments of $500,000 per year for four years must be received in order for the new company to retain exclusivity. Based on terms of the agreement and the near term need to develop a new management team, the Managing General Partner determined that there has been a fair value decline in the Partnership's investment and accordingly, the Partnership recorded a decrease of $1,050,690 at December 31, 1996.
Other Equity Investments - ------------------------
Other changes reflected above generally relate to market value fluctuations or the elimination of a discount relating to selling restrictions for publicly-traded portfolio companies. Celeritek, Inc., Elantec, Inc., and 3Com Corporation are publicly traded companies.
7. Secured Notes Receivable, Net -----------------------------
At December 31, 1996 and 1995, secured notes receivable consisted of:
The 1996 notes are substantially from two portfolio companies (representing 75% and 25% of the notes receivable fair value at December 31, 1996) in the computers and computer equipment and industrial/business automation industries. The notes are secured by specific assets of the borrowing companies. Interest rates at December 31, 1996, ranged from 8% to 15%.
Changes in the allowance for loan losses were as follows:
The provision for loan losses is generally comprised of realized loan losses, net of recognized recoveries, and a change in net unrealized fair value based upon the level of loan loss reserves deemed adequate by the Managing General Partner at the respective year ends.
The allowance for loan losses is adjusted based upon changes to the portfolio size and risk profile. Although the allowance is established by evaluating individual debtor repayment ability, the allowance represents the Managing General Partner's assessment of the portfolio as a whole and is considered adequate at the respective year ends.
Secured notes receivable of $3,880,883 and $4,031,001 at December 31, 1996 and 1995, respectively were on nonaccrual status due to the uncertainty of certain borrowers' financial conditions. The Managing General Partner continues to monitor the progress of these companies and intends to manage these investments to maximize the Partnership's net realizable value. The fair value at December 31, 1996, is based on the Managing General Partner's estimate of collectibility of these notes.
During 1996, in addition to the above note recoveries, the Partnership received reimbursements of $41,542 from portfolio companies primarily for legal, consulting, and other costs incurred in prior periods in the defense of the Partnership's secured note rights through bankruptcy court. The reimbursements were recorded as a reduction to lending operations and investment management expense.
The scheduled principal repayments remaining are:
Secured notes receivable which are due on demand are included as principal repayments in 1997. In addition, the Managing General Partner may at times need to restructure notes by either extending maturity dates or converting notes to equity investments to increase the ultimate collectibility of the Partnership's investments.
8. Litigation and Other Investment Expenses ----------------------------------------
Other investment expenses in 1996 of $201,820 reflect the cost of the following legal actions.
In 1992, the Partnership and a portfolio company in the retail/consumer products industry filed a lawsuit against Quebecor in the Superior Court of Guilford County, North Carolina, claiming that the Partnership had the right to take possession of collateral upon foreclosure on the portfolio company, the price paid was fair and did not interfere with Quebecor's legal rights. Quebecor filed a counter suit claiming otherwise and is seeking relief for $2.6 million, including accrued interest, legal costs and punitive damages. In March of 1997, the Partnership and the portfolio company obtained a favorable judgment in its appeal of a prior trial court ruling that declared the assets of the portfolio company, for a sum not certain, are available to satisfy certain claims of Quebecor. Unless Quebecor is granted the right to appeal this decision to the North Carolina Supreme Court within 30 days, there are no damages to the Partnership. The Managing General Partner believes the Partnership has adequate defenses and no amounts have been provided in the accompanying financial statements for any possible negative outcome for this matter.
In March of 1996, the Partnership filed a lawsuit in the United States District Court, Northern District of California, against Cyclean, Inc. ("Cyclean"), Ecopave, L.P. ("Ecopave"), Ecopave Corp. and Stephen M. Vance ("Vance").
Ecopave was formed by Cyclean, Ecopave Corp. and Vance. Cyclean, without the consent of the Partnership, transferred certain equipment worth approximately $488,000 to Ecopave that is subject to the Partnership's security interest. Cyclean further gave Ecopave a license to use its patented technology. The equipment and intellectual property were security interest on a secured loan extended by the Partnership to Cyclean. The Partnership thus commenced this legal action for patent infringement, seeking to collect approximately $3.5 million of indebtedness owed to the Partnership and affiliated partnerships by Cyclean and the recovery of the equipment from Ecopave. In January of 1997, a counter claim was filed by Ecopave Corp. and Vance against the Partnership which seeks declaration that certain patent rights held by the Partnership as security for the Cyclean debt are invalid as well as asserts a fraud claim. In addition, the counter suit seeks compensatory damages of approximately $5 million and unspecified punitive damages.
As a result of a settlement conference, the above lawsuits have tentatively been resolved for an effective date of April 1, 1997. The Partnership has agreed to indirectly purchase Ecopave Corp. and Vance's ownership interest in Ecopave for $5.5 million; the affiliated partnerships will participate in this purchase. It is anticipated that the settlement of this claim will not result in any material negative impact to the Partnership at December 31, 1996, or the date of settlement as the Managing General Partner believes that the fair value of this additional investment is equal to or greater than the purchase price and improves the Partnership's position to recover its secured notes receivable. The Managing General Partner believes a settlement is the most cost effective resolution of this dispute for the Partnership.
In the event that the aforementioned settlement is not consummated, the above lawsuits will continue to trial. Estimates of possible loss, if any, for the ongoing lawsuits cannot be determined at this time. No amounts have been provided in the accompanying financial statements for any possible negative outcome of this matter. The Managing General Partner believes the Partnership has adequate defenses and intends to pursue this matter vigorously.
At December 31, 1996 and 1995, restricted cash of $642,694 and $50,000, respectively, represented amounts held in escrow accounts pending the outcome of these cases.
9. Cash and Cash Equivalents -------------------------
At December 31, 1996 and 1995, cash and cash equivalents consisted of:
10. Repurchase of Limited Partnership Interests -------------------------------------------
Each June, Limited Partners may tender their Units for repurchase by the Partnership. The price paid for any units tendered is based on the June 30 estimates of fair value for the Partnership. Units repurchased and the amounts paid were: 2,158 Units for $112,216; 1,177 Units for $55,319; and 384 Units for $23,425 in 1996, 1995, and 1994, respectively.
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, thereunto duly authorized.
TECHNOLOGY FUNDING SECURED INVESTORS II
By: TECHNOLOGY FUNDING INC. Managing General Partner
Date: March 27, 1997 By: /s/Debbie A. Wong -------------------------------------- Debbie A. Wong Vice President and Controller
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:
Signature Capacity Date --------- -------- ----
/s/Charles R. Kokesh President, Chief March 27, 1997 - ------------------------ Executive Officer, Charles R. Kokesh Chief Financial Officer and Chairman of Technology Funding Inc. and Managing General Partner of Technology Funding Ltd.
/s/Gregory T. George Group Vice President March 27, 1997 - -------------------------- of Technology Funding Gregory T. George Inc. and a General Partner of Technology Funding Ltd.
The above represents the Board of Directors of Technology Funding Inc. and the General Partners of Technology Funding Ltd.