UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q/A

(Amendment No. 1)

 

 

Commission file number: 0-17371

 

QUEST RESOURCE CORPORATION
(Exact name of registrant specified in its charter)

 

 

 

 

 

210 Park Avenue, Suite 2750, Oklahoma City, OK 73102

(Address of principal executive offices) (Zip Code)

 

 

 

 

405-600-7704
Registrant’s telephone number, including area code

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o     No þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of May 8, 2008, the issuer had 23,522,859 shares of common stock outstanding.

 

EXPLANATORY NOTE

 

This amended Quarterly Report on Form 10-Q/A for the quarter ended March 31, 2008 includes restated consolidated financial statements as of March 31, 2008 and for the three month periods ended March 31, 2008 and 2007 for Quest Resource Corporation (“QRCP” or the “Company”). The consolidated balance sheet as of December 31, 2007 was restated in our Annual Report on Form 10-K for the year ended December 31, 2008 filed on June 3, 2009 (the “2008 Form 10-K”).

 

Investigation — On August 22, 2008, in connection with an inquiry from the Oklahoma Department of Securities, the boards of directors of QRCP, Quest Energy GP, LLC (“Quest Energy GP”), the general partner of Quest Energy Partners, L.P. (NASDAQ: QELP) (“Quest Energy” or “QELP”), which is a publicly traded limited partnership controlled by QRCP, and Quest Midstream GP, LLC (“Quest Midstream GP”), the general partner of Quest Midstream Partners, L.P. (“Quest Midstream” or “QMLP”), a private limited partnership controlled by QRCP, held a joint working session to address certain unauthorized transfers, repayments and re-transfers of funds (the “Transfers”) to entities controlled by their former chief executive officer, Mr. Jerry D. Cash.

 

A joint special committee comprised of one member designated by each of the boards of directors of QRCP, Quest Energy GP, and Quest Midstream GP was immediately appointed to oversee an independent internal investigation of the Transfers. In connection with this investigation, other errors were identified in prior year financial statements and management and the board of directors concluded that the Company had material weaknesses in its internal control over financial reporting. As of December 31, 2008, these material weaknesses continued to exist.

 

As reported on a Current Report on Form 8-K filed on January 2, 2009, on December 31, 2008, the board of directors of QRCP determined that the audited consolidated financial statements of QRCP as of and for the years ended December 31, 2007, 2006 and 2005 and QRCP’s unaudited consolidated financial statements as of and for the three months ended March 31, 2008 and as of and for the three and six month periods ended June 30, 2008 should no longer be relied upon.

 

Restatement and Reaudit — In October 2008, QRCP’s audit committee engaged a new independent registered public accounting firm to audit the Company’s consolidated financial statements for 2008 and, in January 2009, engaged them to reaudit the Company’s consolidated financial statements as of December 31, 2007 and 2006 and for the years ended December 31, 2007, 2006 and 2005.

 

The restated consolidated financial statements included in this Form 10-Q/A correct errors in a majority of the financial statement line items in the previously issued consolidated financial statements for all periods presented. The most significant errors (by dollar amount) consist of the following:

 

 

 

Although the items listed above comprise the most significant errors (by dollar amount), numerous other errors were identified and restatement adjustments made. The tables below present previously reported stockholders’ equity, major restatement adjustments and restated stockholders’ equity as well as previously reported net loss, major restatement adjustments and restated net loss as of and for the periods indicated (in thousands):

 

 

 

 

 

Reconciliations from amounts previously included in QRCP’s consolidated financial statements to restated amounts on a financial statement line item basis are presented in Note 12 to the accompanying consolidated financial statements.

 

Other Matters — In addition to the items for which QRCP has restated its consolidated financial statements, the Oklahoma Department of Securities has filed a lawsuit alleging:

 

 

 

QRCP experienced significant increased costs in the second half of 2008 and continues to experience such increased costs in the first half of 2009 due to, among other things (as more fully described in our 2008 Form 10-K in Items 1. and 2. “Business and Properties — Recent Developments — Internal Investigation; Restatements and Reaudits”):

 

 

This Amendment No. 1 to the Quarterly Report on Form 10-Q/A restates the Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 in its entirety to reflect the effects of the restatement. However, the Company has not modified nor updated disclosures presented in the Quarterly Report on Form 10-Q for the quarter ended March 31, 2008, except as required to reflect the effects of the matters discussed above. Accordingly, this Amendment No. 1 to the Quarterly Report on Form 10-Q/A does not reflect events occurring after the filing of the Quarterly Report on Form 10-Q for the quarter ended March 31, 2008, initially filed with the SEC on May 12, 2008, or modify or update those disclosures affected by subsequent events or discoveries. Therefore, this Amendment No. 1 to the Quarterly Report on Form 10-Q/A should be read in conjunction with the Company’s Annual Report on 2008 Form 10-K and the others subsequent reports that the Company has filed with the Securities Exchange Commission.

 

The Company has also restated the following items, which were impacted by the adjustments described above:

 

Part I

 

Item 1 — Financial Statements

 

Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Item 3 — Quantitative and Qualitative Disclosures About Market Risk

 

Item 4 — Controls and Procedures

 

In addition, in accordance with applicable SEC rules, this Amendment No. 1 to the Quarterly Report on Form 10-Q/A includes currently-dated certifications from our Chief Executive Officer and President, who is our principal executive officer, and our Chief Financial Officer, who is our principal financial officer, in Exhibits 31.1, 31.2, 32.1 and 32.2.

 

QUEST RESOURCE CORPORATION
FORM 10-Q/A
FOR THE QUARTER ENDED MARCH 31, 2008

TABLE OF CONTENTS

 

 

 

Except as otherwise required by the context, references in this quarterly report to “we,” “our,” “us,” “Quest” or “the Company” refer to Quest Resource Corporation and its subsidiaries: Quest Energy Partners, L.P.; Quest Energy GP, LLC; Quest Cherokee, LLC; Quest Cherokee Oilfield Service, LLC; Quest Midstream Partners, L.P.; Quest Midstream GP, LLC; Bluestem Pipeline, LLC; Quest Transmission Company, LLC; Quest Kansas Pipeline, L.L.C.; Quest Kansas General Partner, L.L.C.; Quest Pipelines (KPC); Quest Oil & Gas, LLC; and Quest Energy Service, LLC. Our operations are primarily conducted through Quest Cherokee, LLC, Quest Cherokee Oilfield Service, LLC, Bluestem Pipeline, LLC and Quest Energy Service, LLC.

 

Our unaudited interim financial statements, including consolidated balance sheets as of March 31, 2008 and December 31, 2007, consolidated statements of operations and consolidated statements of cash flows for the three month period ended March 31, 2008 and the comparable period of 2007, and a consolidated statement of stockholders’ equity for the three month period ended March 31, 2008, are attached hereto as Pages F-1 through F-31 and are incorporated herein by this reference.

 

The financial statements included herein have been prepared internally, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted. However, in our opinion, all adjustments (which include only normal recurring accruals) necessary to fairly present the financial position and results of operations have been made for the periods presented.

 

The financial statements included herein should be read in conjunction with the 2007 financial statements and notes as restated, which have been included in the 2008 Form 10-K.

 

Restatement of Financial Statements: As discussed in the Explanatory Note to this Quarterly Report on Form 10-Q/A the financial statements are being restated to reflect the impact of errors in our previously issued financial statements. See further discussion in Note 12 to the accompanying consolidated financial statements.

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

($ in thousands, except share and per share amounts)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Restated)
($ in thousands, except per share and share amounts)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Restated)
($ in thousands)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 2008
(Restated)
(Amounts subsequent to December 31, 2007 are unaudited)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2008

(Unaudited)

 

 

Nature of Business

 

Quest Resource Corporation (the “Company”) is a Nevada corporation formed in July 1982. Unless the context requires otherwise, references to “we,” “us,” “our,” “QRCP” or the “Company” are intended to mean Quest Resource Corporation and its consolidated subsidiaries.

 

We are an independent energy company with an emphasis on the acquisition, production, transportation, exploration, and development of natural gas (coal bed methane) in the Cherokee Basin of southeastern Kansas and northeastern Oklahoma. Our operations are currently focused on developing coal bed methane gas production through Quest Energy Partners, L.P. (“Quest Energy”) in a fifteen county region that is served by a pipeline network owned through Quest Midstream Partners, L.P. (“Quest Midstream”). Quest Midstream also owns a 1,120-mile interstate natural gas transmission pipeline that runs from Oklahoma to Missouri (the “KPC Pipeline”). In addition, through Quest Oil & Gas, LLC, we have begun developing acreage located in Pennsylvania that is prospective for the Marcellus Shale.

 

We conduct our business through two reportable business segments. These segments and the activities performed to provide services to our customers and create value for our stockholders are as follows:

 

 

Consolidation Policy.  Investee companies in which the Company directly or indirectly owns more than 50% of the outstanding voting securities or those in which the Company has effective control over are generally accounted for under the consolidation method of accounting. Under this method, an Investee company’s balance sheet and results of operations are reflected within the Company’s consolidated financial statements. All significant intercompany accounts and transactions have been eliminated. Minority interests in the net assets and earnings or losses of a consolidated investee are reflected in the caption “Minority interest” in the Company’s consolidated balance sheet and statement of operations. Minority interest adjusts the Company’s consolidated results of operations to reflect only the Company’s share of the earnings or losses of the consolidated investee company. Upon dilution of control below 50% and the loss of effective control, the accounting method is adjusted to the equity or cost method of accounting, as appropriate, for subsequent periods.

 

Financial reporting by the Company’s subsidiaries is consolidated into one set of financial statements with the Company.

 

Misappropriation, Reaudit and Restatement

 

These consolidated financial statements include our restated financial statements as of March 31, 2008 and for the three month periods ended March 31, 2008 and 2007. The consolidated balance sheet as of December 31, 2007 was restated in our 2008 Annual Report on Form 10-K for the year ended December 31, 2008 filed on June 3, 2009.

 

Investigation — On August 22, 2008, in connection with an inquiry from the Oklahoma Department of Securities, the boards of directors of QRCP, Quest Energy GP, LLC (“Quest Energy GP”), the general partner of Quest Energy, and Quest Midstream GP, LLC (“Quest Midstream GP”), the general partner of Quest Midstream, held a joint working session to address certain unauthorized transfers, repayments and re-transfers of funds (the “Transfers”) to entities controlled by their former chief executive officer, Mr. Jerry D. Cash. These transfers totaled approximately $10 million between 2005 and 2008.

 

A joint special committee comprised of one member designated by each of the boards of directors of QRCP, Quest Energy GP, and Quest Midstream GP, was immediately appointed to oversee an independent internal

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

investigation of the Transfers. In connection with this investigation, other errors were identified in prior year financial statements and management and the board of directors concluded that we had material weaknesses in our internal control over financial reporting. As of March 31, and December 31, 2008, these material weaknesses continued to exist.

 

As reported on a Current Report on Form 8-K initially filed on January 2, 2009 on December 31, 2008, the board of directors of QRCP determined that the audited consolidated financial statements of QRCP as of and for the years ended December 31, 2007, 2006 and 2005 and QRCP’s unaudited consolidated financial statements as of and for the three months ended March 31, 2008 and as of and for the three and six months ended June 30, 2008 should no longer be relied upon.

 

The restated consolidated financial statements to which these Notes apply also correct errors in a majority of the financial statement line items found in the previously issued consolidated financial statements for all periods presented. See Note 12 — Restatement.

 

 

Reference is hereby made to the Company’s restated Annual Report on Form 10-K for the year ended December 31, 2008 (the “2008 Form 10-K”), which contains a summary of significant accounting policies followed by the Company in the preparation of its consolidated financial statements. The 2008 Form 10-K includes restated consolidated financial statements and footnotes as of and for the year ended December 31, 2007. These policies were also followed in preparing the consolidated financial statements as of March 31, 2008 and for the three months ended March 31, 2008 and 2007.

 

Use of Estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

 

Estimates made in preparing the consolidated financial statements include, among other things, estimates of the proved oil and gas reserve volumes used in calculating depletion, depreciation and amortization expense; the estimated future cash flows and fair value of properties used in determining the need for any impairment write-down; and the timing and amount of future abandonment costs used in calculating asset retirement obligations. Future changes in the assumptions used could have a significant impact on reported results in future periods.

 

Basis of Accounting

 

The Company’s financial statements are prepared using the accrual method of accounting. Revenues are recognized when earned and expenses when incurred.

 

Revenue Recognition

 

Revenue from the sale of oil and natural gas is recognized when title passes, net of royalties.

 

Cash Equivalents

 

For purposes of the consolidated financial statements, the Company considers investments in all highly liquid instruments with original maturities of three months or less at date of purchase to be cash equivalents.

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Uninsured Cash Balances

 

The Company maintains its cash balances at several financial institutions. Accounts at the institutions are insured by the Federal Deposit Insurance Corporation up to $100,000. The Company’s cash balances typically are in excess of this amount.

 

Restricted Cash

 

Restricted Cash represents cash pledged to support reimbursement obligations under outstanding letters of credit.

 

Accounts Receivable

 

The Company conducts the majority of its operations in the States of Kansas and Oklahoma and operates exclusively in the oil and natural gas industry. The Company’s receivables are generally unsecured; however, the Company has not experienced any significant losses to date. Receivables are recorded at the estimate of amounts due based upon the terms of the related agreements.

 

Management periodically assesses the Company’s accounts receivable and establishes an allowance for estimated uncollectible amounts. Accounts determined to be uncollectible are charged to operations when that determination is made.

 

Inventory

 

Inventory, which is included in current assets, includes tubular goods and other lease and well equipment which we plan to utilize in our ongoing exploration and development activities and is carried at the lower of cost or market using the specific identification method.

 

Concentration of Credit Risk

 

A significant portion of the Company’s liquidity is concentrated in cash and derivative contracts that enable the Company to hedge a portion of its exposure to price volatility from producing oil and natural gas. These arrangements expose the Company to credit risk from its counterparties. The Company’s accounts receivable are primarily from purchasers of oil and natural gas products. Natural gas sales to one purchaser (ONEOK Energy Marketing and Trading Company) accounted for more than 99% of total oil and natural gas revenues for the three months ended March 31, 2008. Natural gas sales to two purchasers (ONEOK and Tenaska Marketing Ventures) accounted for 70% and 30% of total natural gas revenues for the three months ended March 31, 2007.

 

KPC Pipeline’s two primary customers are Kansas Gas Service (KGS) and Missouri Gas Energy (MGE), both of which are served under long-term natural gas transportation contracts representing 59% and 36% of the gas transported, respectively, for the three months ended March 31, 2008.

 

The industry concentration has the potential to impact the Company’s overall exposure to credit risk, either positively or negatively, in that the Company’s customers may be similarly affected by changes in economic, industry or other conditions.

 

Oil and Natural Gas Properties

 

The Company follows the full cost method of accounting for oil and natural gas properties, prescribed by the Securities and Exchange Commission (“SEC”). Under the full cost method, all acquisition, exploration, and development costs are capitalized. The Company capitalizes internal costs including: salaries and related fringe benefits of employees directly engaged in the acquisition, exploration and development of oil and natural gas properties, as well as other directly identifiable general and administrative costs associated with such activities.

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

All capitalized costs of oil and natural gas properties, including the estimated future costs to develop proved reserves, are amortized on the units-of-production method using estimates of proved reserves. The costs of unproved properties are excluded from amortization until the properties are evaluated. The Company reviews all of its unevaluated properties quarterly to determine whether or not and to what extent proved reserves have been assigned to the properties and otherwise if impairment has occurred. Unevaluated properties are assessed individually when individual costs are significant.

 

The Company reviews the carrying value of its oil and natural gas properties under the full-cost accounting rules of the Securities and Exchange Commission on a quarterly basis. This quarterly review is referred to as a ceiling test. Under the ceiling test, capitalized costs, less accumulated amortization and related deferred income taxes, may not exceed an amount equal to the sum of the present value of estimated future net revenues less estimated future expenditures to be incurred in developing and producing the proved reserves, plus the cost of properties not being amortized, less any related income tax effects. In calculating future net revenues, current prices and costs used are those as of the end of the appropriate quarterly period. Two primary factors impacting this test are reserve levels and current prices, and their associated impact on the present value of estimated future net revenues. Revisions to estimates of oil and natural gas reserves and/or an increase or decrease in prices can have a material impact on the present value of estimated future net revenues. Any excess of the net book value, less deferred income taxes, is generally written off as an expense. Under SEC regulations, the excess above the ceiling is not expensed (or is reduced) if, subsequent to the end of the period, but prior to the release of the financial statements, oil and natural gas prices increase sufficiently such that an excess above the ceiling would have been eliminated (or reduced) if the increased prices were used in the calculations. No impairment is reflected in the Company’s financial statements at March 31, 2008 and December 31, 2007.

 

Sales of proved and unproved properties are accounted for as adjustments of capitalized costs with no gain or loss recognized, unless such adjustments would significantly alter the relationship between the capitalized costs and proved reserves of oil and natural gas, in which case the gain or loss is recognized in income.

 

Other Property and Equipment

 

Other property and equipment are stated at cost. Depreciation is calculated using the straight-line method for financial reporting purposes and accelerated methods for income tax purposes.

 

The estimated useful lives are as follows:

 

 

Repairs and maintenance are charged to operations when incurred and improvements and renewals are capitalized.

 

Debt Issue Costs

 

Included in other assets are costs associated with bank credit facilities. The remaining unamortized debt issue costs at March 31, 2008 and December 31, 2007 totaled $8.0 million and $8.4 million, respectively, and are being amortized over the life of the credit facilities.

 

Other Dispositions

 

Upon disposition or retirement of property and equipment other than oil and natural gas properties, the cost and related accumulated depreciation are removed from the accounts and the gain or loss thereon, if any, is credited or charged to income.

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Marketable Securities

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) 115, Accounting for Certain Investments in Debt and Equity Securities, the Company classifies its investment portfolio according to the provisions of SFAS 115 as either held to maturity, trading, or available for sale. At March 31, 2008 and 2007, the Company did not have any investments in its investment portfolio classified as available for sale and held to maturity.

 

Income Taxes

 

The Company accounts for income taxes pursuant to the provisions of the SFAS 109, Accounting for Income Taxes, which requires an asset and liability approach to calculating deferred income taxes. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. The provision for income taxes differ from the amounts currently payable because of temporary differences (primarily intangible drilling costs and the net operating loss carry forward) in the recognition of certain income and expense items for financial reporting and tax reporting purposes.

 

Accounting for Uncertainty in Income Taxes.  In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 is intended to clarify the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes the recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

 

Under FIN 48, evaluation of a tax position is a two-step process. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement.

 

Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met.

 

The adoption of FIN 48 at January 1, 2007 did not have a material effect on the Company’s financial position.

 

Earnings Per Common Share

 

SFAS 128, Earnings Per Share, requires presentation of “basic” and “diluted” earnings per share on the face of the statements of operations for all entities with complex capital structures. Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted earnings per share are excluded from the calculation. See Note 7 — Earnings Per Share, for a reconciliation of the numerator and denominator of the basic and diluted earnings per share computations.

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist of cash, receivables, deposits, derivative contracts, accounts payable, accrued expenses and notes payable. The carrying amount of cash, receivables, deposits, accounts payable

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

and accrued expenses approximates fair value because of the short-term nature of those instruments. The derivative contracts are not designated as hedges, and therefore, are recorded at fair value. The carrying amounts for notes payable approximate fair value due to the variable nature of the interest rates of the notes payable.

 

Stock-Based Compensation

 

Stock Options.  Effective January 1, 2006, the Company adopted SFAS 123 (Revised 2004), Share-Based Payment, which requires that compensation related to all stock-based awards, including stock options, be recognized in the financial statements based on their estimated grant-date fair value. The Company has previously recorded stock compensation pursuant to the intrinsic value method under APB Opinion No. 25, whereby compensation was recorded related to performance share and unrestricted share awards and no compensation was recognized for most stock option awards. The Company used the modified retrospective application method of adopting SFAS 123R, whereby compensation cost and the related tax effect have been recognized in the condensed consolidated financial statements for all relevant periods. The Company has estimated expected forfeitures, as required by SFAS 123R, and the Company is recognizing compensation expense only for those awards expected to vest. Compensation expense is amortized over the estimated service period, which is the shorter of the award’s time vesting period or the derived service period as implied by any accelerated vesting provisions when the common stock price reaches specified levels. All compensation must be recognized by the time the award vests. The cumulative effect of initially adopting SFAS 123R was immaterial.

 

On March 5, 2008, the Company’s board of directors approved the conversion of 140,000 stock options held by certain directors into 70,000 bonus shares. As a result, the Company recognized additional compensation expense of $0.1 million during the three month period ended March 31, 2008.

 

Partnership Unit Awards.  Quest Energy GP, LLC, the general partner of Quest Energy, granted bonus units to certain members of its Board of Directors during the three months ended March 31, 2008. The units are subject to vesting with 25% of the units immediately vested and one-third of the remaining units vesting equally on each of the first three anniversaries of the date of the grant. The fair value of the unit awards granted is recognized over the applicable vesting period as compensation expense. Compensation expense amounts are recognized in general and administrative expenses or capitalized to oil and gas properties. For the three months ended March 31, 2008, Quest Energy did not capitalize any of the value associated with the bonus unit grants. The value of the bonus unit grants included in general and administrative expenses for the three months ended March 31, 2008 was $17,000.

 

Quest Midstream GP, LLC, the general partner of Quest Midstream, granted bonus units to certain employees and certain members of its Board of Directors during the year ended December 31, 2007. The units are subject to a three-year vesting schedule. The fair value of the unit awards granted is recognized over the applicable vesting period as compensation expense. The value of the bonus unit grants included in general and administrative expenses for the three months ended March 31, 2008 was $381,000.

 

Stock Awards.  The Company granted shares of common stock to certain employees in February 2008 and February, March, April, September and December 2007. The shares are subject to three-year and four-year vesting schedules. In March 2008, the Company granted bonus shares to its independent directors in exchange for the cancellation of their unvested stock options. See “— Stock Options” above. The fair value of the stock awards granted is recognized over the applicable vesting period as compensation expense. To the extent the compensation expense relates to employees directly involved in acquisition, exploration and development activities, such amounts are capitalized to oil and gas properties. Amounts not capitalized to oil and gas properties are recognized in general and administrative expenses.

 

Accounting for Derivative Instruments and Hedging Activities

 

The Company uses derivatives to hedge against changes in cash flows related to product price, as opposed to their use for trading purposes. SFAS 133, Accounting for Derivative Instruments and Hedging Activities, requires

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

that all derivatives be recorded on the balance sheet at fair value. None of our derivative instruments have been designated as hedges. Accordingly, we record all derivative instruments in the consolidated balance sheet at fair value with changes in fair value recognized in earnings as they occur. Both realized and unrealized gains and losses associated with derivative financial instruments are currently recognized in other income (expense) as they occur.

 

Asset Retirement Obligations

 

The Company has adopted SFAS 143, Accounting for Asset Retirement Obligations. SFAS 143 requires companies to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement.

 

We own oil and gas properties that require expenditures to plug and abandon the wells when the oil and gas reserves in the wells are depleted. These expenditures are recorded in the period in which the liability is incurred (at the time the wells are drilled or acquired). Asset retirement obligations are recorded as a liability at their estimated present value at the asset’s inception, with the offsetting increase to property cost. Periodic accretion expense of the estimated liability is recorded in the consolidated statements of operations. We have recorded asset retirement obligations relative to the abandonment of our interstate pipeline assets because we believe we have a legal or constructive obligation relative to asset retirements of the interstate pipeline system. We have not recorded an asset retirement obligation relating to our gathering system because we do not have any legal or constructive obligations relative to asset retirements of the gathering system.

 

Recently Issued Accounting Standards

 

The Financial Accounting Standards Board recently issued the following standards which the Company reviewed to determine the potential impact on our financial statements upon adoption.

 

On February 6, 2008, the FASB issued Financial Staff Position FAS 157-2, “Effective Date of FASB Statement No. 157.” This Staff Position delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The delay is intended to allow the FASB and constituents additional time to consider the effect of various implementation issues that have arisen, or that may arise, from the application of SFAS 157.

 

The remainder of SFAS 157 was adopted by us effective for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 did not have an impact on the Company’s financial position, results of operations, or cash flows.

 

In February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, an amendment of FASB SFAS 115. SFAS 159 addresses how companies should measure many financial instruments and certain other items at fair value. The objective is to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with earlier adoption permitted. SFAS 159 had been adopted and did not have a material impact on the Company’s financial position, results of operations, or cash flows.

 

In December 2007, the FASB issued SFAS 141R (revised 2007), “Business Combinations.” Although this statement amends and replaces SFAS 141, it retains the fundamental requirements in SFAS 141 that (i) the purchase method of accounting be used for all business combinations; and (ii) an acquirer be identified for each business combination. SFAS 141R defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date that the acquirer achieves control. This Statement applies to all transactions or other events in which an entity (the acquirer) obtains control of one or more

 

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businesses (the acquiree), including combinations achieved without the transfer of consideration; however, this Statement does not apply to a combination between entities or businesses under common control. Significant provisions of SFAS 141R concern principles and requirements for how an acquirer (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 with early adoption not permitted. Management is assessing the impact of the adoption of SFAS 141R.

 

In December 2007, the FASB issued SFAS 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51”. The objective of this statement is to improve the relevant, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements related to noncontrolling or minority interests. The effective date for this Statement is for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008 with earlier adoption being prohibited. Adoption of this Statement will change the method in which minority interests are reflected on the Company’s consolidated financial statements and will add some additional disclosures related to the reporting of minority interests. Management is assessing the impact of the adoption of SFAS 160.

 

In March 2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities”. The objective of this statement is to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. The effective date for this statement is for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. Management is assessing the impact of the adoption of SFAS 161.

 

 

KPC Pipeline

 

On November 1, 2007, Quest Midstream completed the purchase of the KPC Pipeline pursuant to a Purchase and Sale Agreement, dated as of October 9, 2007, by and among Quest Midstream, Enbridge Midcoast Energy, L.P. and Midcoast Holdings No. One, L.L.C., whereby Quest Midstream purchased all of the membership interests in the two general partners of Enbridge Pipelines (KPC), the owner of the KPC Pipeline for a purchase price of approximately $133 million in cash, subject to adjustment for working capital at closing.

 

The total cost of the acquisition was allocated to the assets acquired and liabilities assumed based on their estimated fair values on the acquisition date. The preliminary allocation was recorded during 2007 before valuation work was completed on contract-based intangibles. After completing valuation work on the acquired intangibles, a final purchase price allocation was recorded in 2008. The following table summarizes the allocation of the purchase price (in thousands):

 

 

Pro Forma Summary Data (unaudited)

 

The following pro forma summary data for the three months ending March 31, 2007 presents the consolidated results of operations as if the KPC Pipeline acquisition made on November 1, 2007 had occurred on January 1, 2007.

 

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisitions been made at January 1, 2007 or of results that may occur in the future.

 

 

Searight

 

Quest Energy purchased certain oil producing properties in Seminole County, Oklahoma from a private company for $9.5 million in a transaction that closed in early February 2008. The properties have estimated proved reserves of 712,000 barrels, all of which are proved developed producing. In addition, Quest Energy entered into crude oil swaps for approximately 80% of the estimated production from the property’s proved developed producing reserves at WTI-NYMEX prices per barrel of oil of approximately $96.00 in 2008, $90.00 in 2009, and $87.50 for 2010. The acquisition was financed with borrowings under Quest Energy’s credit facility.

 

 

The Company has adopted SFAS 143, Accounting for Asset Retirement Obligations. The following table provides a roll forward of the asset retirement obligations for the three months ended March 31, 2008 and 2007:

 

 

 

Long-term debt consists of the following:

 

 

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The aggregate scheduled maturities of notes payable and long-term debt for the period ending December 31, 2013 and thereafter were as follows as of March 31, 2008 (assuming no payments were made on the revolving credit facilities prior to their maturity) (dollars in thousands):

 

 

Credit Facilities

 

The Company and its subsidiaries are parties to three credit facilities. See Note 3 to the consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2007 (the “2007 Form 10-K”) for descriptions of the material terms of the credit facilities.

 

Quest Energy Partners, L.P. and Quest Cherokee, LLC.  Quest Cherokee, LLC is a party to an Amended and Restated Credit Agreement dated as of November 15, 2007 with Royal Bank of Canada, as administrative agent and collateral agent (“RBC”), KeyBank National Association, as documentation agent, and the lenders party thereto. Quest Energy is a guarantor of the credit agreement. As of March 31, 2008, the borrowing base under this credit agreement was $160 million and the amount borrowed under the credit agreement was $123 million. The weighted average interest rate under this credit agreement for the three months ended March 31, 2008 was 6.88%. See Note 11 — Subsequent Events for a description of amendments to this credit agreement.

 

Quest Resource Corporation.  The Company is a party to a Credit Agreement dated as of November 15, 2007 with RBC, as administrative agent and collateral agent, and the lenders party thereto. As of March 31, 2008, the borrowing base under this credit agreement was $50 million and the amount borrowed under the credit agreement was $44 million. The weighted average interest rate under this credit agreement for the three months ended March 31, 2008 was 8.25%.

 

Quest Midstream Partners, L.P. and Bluestem Pipeline, LLC.  Quest Midstream and Bluestem are parties to an Amended and Restated Credit Agreement dated as of November 1, 2007 with RBC, as administrative agent and collateral agent, and the lenders party thereto. As of March 31, 2008, the amount borrowed under the credit agreement was $106 million and the total amount available was $135 million. The weighted average interest rate under this credit agreement for the three months ended March 31, 2008 was 7.23%.

 

Other Long-Term Indebtedness

 

Approximately $488,000 of notes payable to banks and finance companies were outstanding at March 31, 2008 and secured by equipment and vehicles, with payments due in monthly installments through October 2013 with interest rates ranging from 1.9% to 8.9% per annum.

 

 

Oil and Natural Gas Hedging Activities

 

The Company seeks to reduce its exposure to unfavorable changes in oil and natural gas prices, which are subject to significant and often volatile fluctuation, through the use of fixed-price contracts. The fixed-price contracts are comprised of energy swaps and collars. These contracts allow the Company to predict with greater

 

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certainty the effective oil and natural gas prices to be received for hedged production and benefit operating cash flows and earnings when market prices are less than the fixed prices provided in the contracts. However, the Company will not benefit from market prices that are higher than the fixed prices in the contracts for hedged production. Collar structures provide for participation in price increases and decreases to the extent of the ceiling and floor prices provided in those contracts. As of March 31, 2008, fixed-price contracts are in place to hedge 42.9 MMBtu of estimated future natural gas production. Of this total volume, 13.7 MMBtu are hedged for 2008 and 29.2 MMBtu thereafter. As of March 31, 2008, fixed-price contracts are in place to hedge 93,000 Bbls of estimated future oil production. Of this total volume, 27,000 Bbls are hedged for 2008 and 66,000 Bbls thereafter.

 

For energy swap contracts, the Company receives a fixed price for the respective commodity and pays a floating market price, as defined in each contract (generally a regional spot market index or in some cases, NYMEX future prices), to the counterparty. The fixed-price payment and the floating-price payment are netted, resulting in a net amount due to or from the counterparty. Oil and natural gas collars contain a fixed floor price (put) and ceiling price (call) (generally a regional spot market index or in some cases, NYMEX future prices). If the market price of oil or natural gas exceeds the call strike price or falls below the put strike price, then the Company receives the fixed price and pays the market price. If the market price of oil or natural gas is between the call and the put strike price, then no payments are due from either party.

 

The following table summarizes the estimated volumes, fixed prices, fixed-price sales and fair value attributable to the fixed-price contracts as of March 31, 2008.

 

 

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Interest Rate Hedging Activities

 

At March 31, 2008, the Company had no outstanding interest rate cap or swap agreements.

 

Loss from Derivative Financial Instruments

 

Change in derivative fair value in the statements of operations for the three months ended March 31, 2008 and 2007 is comprised of the following:

 

 

Fair Value — The following table sets forth, by level within the fair value hierarchy, our assets and liabilities that were measured at fair value on a recurring basis as of March 31, 2008 (in thousands):

 

 

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Risk management assets and liabilities in the table above represent the current fair value of all open derivative positions, excluding those derivatives designated as “normal purchases normal sales”. We classify all of these derivative instruments as “Derivative financial instrument assets” or “Derivative financial instrument liabilities” in our consolidated balance sheets.

 

In order to determine the fair value amounts presented above, we utilize various factors, including market data and assumptions that market participants would use in pricing assets or liabilities as well as assumptions about the risks inherent in the inputs to the valuation technique. These factors include not only the credit standing of the counterparties involved and the impact of credit enhancements (such as cash deposits, letters of credit and parental guarantees), but also the impact of our nonperformance risk on our liabilities. We utilize observable market data for credit default swaps to assess the impact of non-performance credit risk when evaluating our assets from counterparties.

 

In certain instances, we may utilize internal models to measure the fair value of our derivative instruments. Generally, we use similar models to value similar instruments. Valuation models utilize various inputs which include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, other observable inputs for the assets or liabilities, and market-corroborated inputs, which are inputs derived principally from or corroborated by observable market data by correlation or other means.

 

The following table sets forth a reconciliation of changes in the fair value of risk management assets and liabilities classified as Level 3 in the fair value hierarchy (in thousands):

 

 

Credit Risk

 

Energy swaps and collars and interest rate swaps and caps provide for a net settlement due to or from the respective party as discussed previously. The counterparties to the derivative contracts are financial institutions. Should a counterparty default on a contract, there can be no assurance that we would be able to enter into a new contract with a third party on terms comparable to the original contract. The Company has not experienced non-performance by its counterparties.

 

Cancellation or termination of a fixed-price contract would subject a greater portion of the Company’s oil or natural gas production to market prices, which, in a low price environment, could have an adverse effect on its future operating results. Cancellation or termination of an interest rate swap or cap would subject a greater portion of the Company’s long-term debt to market interest rates, which, in an inflationary environment, could have an adverse effect on its future net income. In addition, the associated carrying value of the derivative contract would be removed from the balance sheet.

 

Market Risk

 

The differential between the floating price paid under each energy swap or collar contract and the price received at the wellhead for our production is termed “basis” and is the result of differences in location, quality,

 

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contract terms, timing and other variables. For instance, some of our fixed price contracts are tied to commodity prices on the New York Mercantile Exchange (“NYMEX”), that is, we receive the fixed price amount stated in the contract and pay to our counterparty the current market price for gas as listed on the NYMEX. However, due to the geographic location of our natural gas assets and the cost of transporting the natural gas to another market, the amount that we receive when we actually sell our natural gas is based on the Southern Star Central TX/KS/OK (“Southern Star”) first of month index, with a small portion being sold based on the daily price on the Southern Star index. The difference between natural gas prices on the NYMEX and the price actually received by the Company is referred to as a basis differential. Typically, the price for natural gas on the Southern Star first of the month index is less than the price on the NYMEX due to the more limited demand for natural gas on the Southern Star first of the month index. The crude oil production for which we have entered into swap agreements is sold at a contract price based on the average daily settling price of NYMEX less $1.10/Bbl, which eliminates our exposure to changing differentials on this production. This contract runs through March 2009 with automatic extensions thereafter unless terminated by either party. Recently, the basis differential has been increasingly volatile and has on occasion resulted in us receiving a net price for our oil and natural gas that is significantly below the price stated in the fixed price contract.

 

The effective price realizations that result from the fixed-price contracts are affected by movements in this basis differential. Basis movements can result from a number of variables, including regional supply and demand factors, changes in the portfolio of the Company’s fixed-price contracts and the composition of its producing property base. Basis movements are generally considerably less than the price movements affecting the underlying commodity, but their effect can be significant. Recently, the basis differential has been increasingly volatile and has on occasion resulted in the Company receiving a net price for its oil and natural gas that is significantly below the price stated in the fixed price contract.

 

Changes in future gains and losses to be realized in oil and natural gas sales upon cash settlements of fixed-price contracts as a result of changes in market prices for oil and natural gas are expected to be offset by changes in the price received for hedged oil and natural gas production.

 

Fair Value of Financial Instruments

 

The Company’s financial instruments consist of cash, receivables, deposits, hedging contracts, accounts payable, accrued expenses and notes payable. The carrying amount of cash, receivables, deposits, accounts payable and accrued expenses approximates fair value because of the short-term nature of those instruments. The derivative contracts are not designated as hedges, and therefore, are recorded at fair value. The carrying amounts for notes payable approximate fair value due to the variable nature of the interest rates of the notes payable.

 

 

SFAS 128 requires a reconciliation of the numerator and denominator of the basic and diluted earnings per share (EPS) computations. The following securities were not included in the calculation of diluted earnings per share because their effect was antidilutive.

 

 

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The following reconciles the components of the EPS computation (dollars in thousands, except per share amounts):

 

 

 

Quest Energy Distributions to Unit Holders

 

Minimum Quarterly Distribution.  Quest Energy will distribute to the holders of its common units and subordinated units on a quarterly basis at least the minimum quarterly distribution of $0.40 per unit, or $1.60 per year, to the extent Quest Energy has sufficient cash from its operations after establishment of cash reserves and payment of fees and expenses, including payments to its general partner. However, there is no guarantee that Quest Energy will pay the minimum quarterly distribution on the units in any quarter. Even if Quest Energy’s cash distribution policy is not modified or revoked, the amount of distributions paid under its policy and the decision to make any distribution is determined by its general partner, taking into consideration the terms of Quest Energy’s partnership agreement. Quest Energy will be prohibited from making any distributions to unitholders if it would cause an event of default, or an event of default is existing, under its credit facility. Please read Note 4 to the consolidated financial statements included in the 2008 Form 10-K for a discussion of the restrictions included in Quest Energy’s credit facility that restrict its ability to make distributions.

 

General Partner Interest and Incentive Distribution Rights.  Initially, Quest Energy’s general partner will be entitled to 2% of all quarterly distributions since inception that Quest Energy makes prior to its liquidation. The 2% general partner interest in the distributions may be reduced if Quest Energy issues additional units in the future and its general partner does not contribute a proportionate amount of capital to Quest Energy to maintain its 2% general partner interest. See Item 5. “Market for Registrant’s Common Equity, Related Unitholder Matters and Issuer Purchases of Equity Securities — Cash Distributions to Unitholders” in Quest Energy’s Annual Report on Form 10-K for the year ended December 31, 2008 for further discussion of its cash distributions.

 

Quest Midstream Distributions to Unit Holders

 

Minimum Quarterly Distribution.  Quest Midstream will distribute to the holders of its common units and subordinated units on a quarterly basis at least the minimum quarterly distribution of $0.425 per unit, or $1.70 per year, plus any arrearages in payment of the minimum quarterly distribution on common units from prior quarters, to the extent Quest Midstream has sufficient cash from its operations after establishment of cash reserves and payment of fees and expenses, including payments to its general partner. However, there is no guarantee that Quest

 

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Midstream will pay the minimum quarterly distribution on the units in any quarter. Even if Quest Midstream’s cash distribution policy is not modified or revoked, the amount of distributions paid under its policy and the decision to make any distribution is determined by its general partner, taking into consideration the terms of Quest Midstream’s partnership agreement. Quest Midstream will be prohibited from making any distributions to unitholders if it would cause an event of default, or an event of default is existing, under its credit facility. Please read Note 4 to the consolidated financial statements included in the 2008 Form 10-K for a discussion of the restrictions included in Quest Midstream’s credit facility that restrict its ability to make distributions.

 

General Partner Interest and Incentive Distribution Rights.  Initially, Quest Midstream’s general partner will be entitled to 2% of all quarterly distributions since inception that Quest Midstream makes prior to its liquidation. The 2% general partner interest in the distributions may be reduced if Quest Midstream issues additional units in the future and its general partner does not contribute a proportionate amount of capital to Quest Midstream to maintain its 2% general partner interest.

 

 

Quest Resource Corporation, Bluestem Pipeline, LLC, STP, Inc., Quest Cherokee, LLC, Quest Energy Service, LLC, Quest Midstream Partners, LP, Quest Midstream GP, LLC, and STP Cherokee, Inc. (now STP Cherokee, LLC) have been named Defendants in a lawsuit filed by Plaintiffs, Eddie R. Hill, et al. in the District Court for Craig County, Oklahoma (Case No. CJ-2003-30). Plaintiffs are royalty owners who are alleging underpayment of royalties owed to them. Plaintiffs also allege, among other things, that Defendants have engaged in self-dealing and breached fiduciary duties owed to Plaintiffs, and that Defendants have acted fraudulently toward the Plaintiffs. Plaintiffs also allege that the gathering fees and related charges should not be deducted in paying royalties. Plaintiffs’ claims relate to a total of 84 wells located in Oklahoma and Kansas. Plaintiffs are seeking unspecified actual and punitive damages. Defendants intend to defend vigorously against Plaintiffs’ claims.

 

STP, Inc., STP Cherokee, Inc. (now STP Cherokee, LLC), Bluestem Pipeline, LLC, Quest Cherokee, LLC, and Quest Energy Service, LLC (improperly named Quest Energy Services, LLC) have been named defendants in a lawsuit by Plaintiffs John C. Kirkpatrick and Suzan M. Kirkpatrick in the District Court for Craig County (Case No. CJ-2005-143). Plaintiffs allege that STP, Inc., et al., sold natural gas from wells owned by the Plaintiffs without providing the requisite notice to Plaintiffs. Plaintiffs further allege that Defendants failed to include deductions on the check stubs of Plaintiffs in violation of state law and that Defendants deducted for items other than compression in violation of the lease terms. Plaintiffs assert claims of actual and constructive fraud and further seek an accounting stating that if Plaintiffs have suffered any damages for failure to properly pay royalties, Plaintiffs have a right to recover those damages. Plaintiffs have not quantified their alleged damages. Discovery is ongoing and Defendants intend to defend vigorously against Plaintiffs’ claims.

 

Quest Cherokee Oilfield Services, LLC has been named in this lawsuit filed by Plaintiffs Segundo Francisco Trigoso and Dana Jara De Trigoso in the District Court of Oklahoma County, Oklahoma (Case No. CJ-2007-11079). Plaintiffs allege that Plaintiff Segundo Trigoso was injured while working for Defendant on September 29, 2006 and that such injuries were intentionally caused by Defendant. Plaintiffs seek unspecified damages for physical injuries, emotional injuries, loss of consortium and pain and suffering. Plaintiffs also seek punitive damages. Defendant intends to defend vigorously against Plaintiffs’ claims.

 

Quest Cherokee and Bluestem were named as defendants in a lawsuit (Case No. 04-C-100-PA) filed by plaintiff Central Natural Resources, Inc. on September 1, 2004 in the District Court of Labette County, Kansas. Central Natural Resources owns the coal underlying numerous tracts of land in Labette County, Kansas. Quest Cherokee has obtained oil and gas leases from the owners of the oil, gas, and minerals other than coal underlying some of that land and has drilled wells that produce coal bed methane gas on that land. Bluestem purchases and gathers the gas produced by Quest Cherokee. Plaintiff alleges that it is entitled to the coal bed methane gas produced and revenues from these leases and that Quest Cherokee is a trespasser. Plaintiff is seeking quiet title and an equitable accounting for the revenues from the coal bed methane gas produced. Plaintiff has alleged that Bluestem

 

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converted the gas and seeks an accounting for all gas purchased by Bluestem from the wells in issue. Quest Cherokee contends it has valid leases with the owners of the coal bed methane gas rights. The issue is whether the coal bed methane gas is owned by the owner of the coal rights or by the owners of the gas rights. If Quest Cherokee prevails on that issue, then the plaintiff’s claims against Bluestem fail. All issues relating to ownership of the coal bed methane gas and damages have been bifurcated. Cross motions for summary judgment on the ownership of the coal bed methane were filed by Quest Cherokee and the plaintiff, with summary judgment being awarded in Quest Cherokee’s favor. The plaintiff has appealed the summary judgment and that appeal is pending. Quest Cherokee and Bluestem intend to defend vigorously against these claims.

 

Quest Cherokee was named as a defendant in a lawsuit (Case No. CJ-06-07) filed by plaintiff Central Natural Resources, Inc. on January 17, 2006, in the District Court of Craig County, Oklahoma. Bluestem is not a party to this lawsuit. Central Natural Resources owns the coal underlying approximately 2,250 acres of land in Craig County, Oklahoma. Quest Cherokee has obtained oil and gas leases from the owners of the oil, gas, and minerals other than coal underlying those lands, and has drilled and completed 20 wells that produce coal bed methane gas on those lands. Plaintiff alleges that it is entitled to the coal bed methane gas produced and revenues from these leases and that Quest Cherokee is a trespasser. Plaintiff seeks to quiet its alleged title to the coal bed methane and an accounting of the revenues from the coal bed methane gas produced by Quest Cherokee. Quest Cherokee contends it has valid leases from the owners of the coal bed methane gas rights. The issue is whether the coal bed methane gas is owned by the owner of the coal rights or by the owners of the gas rights. Quest Cherokee has answered the petition and discovery is ongoing. Quest Cherokee intends to defend vigorously against these claims.

 

Quest Cherokee was named as a defendant in a lawsuit (Case No. 05 CV 41) filed by Labette Energy, LLC in the district court of Labette County, Kansas. Plaintiff claims to own a 3.2 mile gas gathering pipeline in Labette County, Kansas, and that Quest Cherokee used that pipeline without plaintiff’s consent. Plaintiff also contends that the defendants slandered its alleged title to that pipeline and suffered damages from the cancellation of their proposed sale of that pipeline. Plaintiff claims that they were damaged in the amount of $202,375. Discovery in that case is ongoing and Quest Cherokee intend to defend vigorously against the plaintiff’s claims.

 

Quest Cherokee was named as a defendant in a putative class action lawsuit (Case No. 07-1225-MLB) filed by several royalty owners in the U.S. District Court for the District of Kansas. The plaintiffs have not yet filed a motion asking the court to certify the class and the court has not determined that the case may properly proceed as a class action. The case was filed by the named plaintiffs on behalf of a putative class consisting of all Quest Cherokee’s royalty and overriding royalty owners in the Kansas portion of the Cherokee Basin. Plaintiffs contend that Quest Cherokee failed to properly make royalty payments to them and the putative class by, among other things, paying royalties based on reduced volumes instead of volumes measured at the wellheads, by allocating expenses in excess of the actual costs of the services represented, by allocating production costs to the royalty owners, by improperly allocating marketing costs to the royalty owners, and by making the royalty payments after the statutorily proscribed time for doing so without providing the required interest. Quest Cherokee has answered the complaint and denied plaintiffs’ claims. Discovery in that case is ongoing. Quest Cherokee intends to defend vigorously against these claims.

 

Quest Cherokee has been named as a defendant in several lawsuits in which the plaintiff claims that an oil and gas lease owned and operated by Quest Cherokee has either expired by their terms or, for various reasons, have been forfeited by Quest Cherokee. Those lawsuits were originally filed in the district courts of Labette, Montgomery, and Wilson Counties, Kansas. Quest Cherokee has drilled wells on some of the oil and gas leases in issue and some of those oil and gas leases do not have a well located thereon but have been unitized with other oil and gas leases upon which a well has been drilled. The plaintiffs in those cases are generally seeking statutory damages of $100 per lease, attorneys’ fees, and a judicial declaration that Quest Cherokee’s leases have terminated. As of May 7, 2008, the total amount of acreage covered by the leases at issue in these lawsuits was approximately 7,481 acres. Quest Cherokee intends to vigorously defend against those claims.

 

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Quest Cherokee was named in an Order to Show Cause issued by the Kansas Corporation Commission (the “KCC”) (KCC Docket No. 07-CONS-155-CSHO) filed on February 23, 2007. The KCC has ordered Quest Cherokee to demonstrate why it should not be held responsible for plugging 22 abandoned oil wells on a gas lease owned and operated by Quest Cherokee in Wilson County, Kansas. Quest Cherokee denies that it is legally responsible for plugging the wells in issue and intends to vigorously defend against the KCC’s claims.

 

Quest Cherokee was named as a defendant in two lawsuits (Case No. 07-CV-141 and Case No. 08-CV-20) filed in Neosho County District Court by Richard Winder, d/b/a Winder Oil Company. Plaintiff claims to own an oil and gas lease covering lands upon which Quest Cherokee also claims to own an oil and gas lease and upon which Quest Cherokee has drilled two producing wells. Plaintiff claims that his lease is prior and superior to Quest Cherokee’s leases and seeks damages for trespass and conversion. Quest Cherokee contends that plaintiffs leases have expired by their terms and that Quest Cherokee’s leases are valid. Discovery in that case is ongoing. Quest Cherokee intends to vigorously defend against the Plaintiff’s claims.

 

The Company, from time to time, may be subject to legal proceedings and claims that arise in the ordinary course of its business. Although no assurance can be given, management believes, based on its experiences to date, that the ultimate resolution of such items will not have a material adverse impact on the Company’s business, financial position or results of operations. Like other oil and natural gas producers and marketers, the Company’s operations are subject to extensive and rapidly changing federal and state environmental regulations governing air emissions, wastewater discharges, and solid and hazardous waste management activities. Therefore it is extremely difficult to reasonably quantify future environmental related expenditures.

 

 

We divide our operations into two reportable business segments:

 

 

Each segment uses the same accounting policies as those described in the summary of significant accounting policies (see Note 2). Our reportable segments are strategic business units that offer different products and services. Each segment is managed separately because each segment involves different products and marketing strategies. The Company does not allocate income taxes to its operating segments.

 

Operating segment data for the three months ended March 31, 2008 and 2007 follows (in thousands):

 

 

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

 

On April 17, 2008, Quest Energy and Quest Cherokee entered into an amendment to the Amended and Restated Credit Agreement with the Royal Bank of Canada, as administrative agent and collateral agent, Keybank National Association, as documentation agent, and the lenders party thereto (the “Amendment”). The Amendment changed the maturity date from November 15, 2012 to November 15, 2010, and increased the applicable rate at which interest will accrue by 1% to either LIBOR plus a margin ranging from 2.25% to 2.875% (depending on the utilization percentage) or the base rate plus a margin ranging from 1.25% to 1.875% (depending on the utilization percentage). The Amendment also eliminated the “accordion” feature in the credit agreement, which gave Quest Cherokee the option to request an increase in the aggregate revolving commitment from $250 million to $350 million. There was no commitment on the part of the lenders to agree to such a request.

 

 

As reported on a Current Report on Form 8-K filed on January 2, 2009, on December 31, 2008, the board of directors of QRCP determined that the consolidated financial statements of QRCP as of and for the years ended December 31, 2007, 2006 and 2005 and its unaudited consolidated financial statements as of and for the three months ended March 31, 2008 and as of and for the three and six months ended June 30, 2008 should no longer be relied upon as the result of the discovery of the Transfers to entities controlled by QRCP’s former chief executive officer, Mr. Jerry D. Cash. Management identified other errors in these financial statements, as described below, and the board of directors concluded that QRCP had, and as of December 31, 2008 continued to have, material weaknesses in its internal control over financial reporting.

 

The Form 10-Q/A for the three months ended March 31, 2008, to which these consolidated financial statements form a part, includes restated consolidated financial statements for QRCP as of March 31, 2008

 

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and for the three month periods ended March 31, 2008 and March 31, 2007. The financial statements as of December 31, 2007 were restated in the 2008 Form 10-K.

 

Although the items listed below comprise the most significant errors (by dollar amount), numerous other errors were identified and restatement adjustments made. The tables below present previously reported stockholders’ equity, major restatement adjustments and restated stockholders’ equity as well as previously reported net loss, major restatement adjustments and restated net loss as of and for the periods indicated (in thousands):

 

 

 

 

 

The most significant errors (by dollar amount) consist of the following:

 

(A) The Transfers, which were not approved expenditures of QRCP, were not properly accounted for as losses. As a result of these losses not being recorded, cash and accumulated deficit were overstated as of March 31, 2008, and loss from misappropriation of funds was understated for the three months ended March 31, 2007.

 

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

(B) Hedge accounting was inappropriately applied for the Company’s commodity derivative instruments and the valuation of commodity derivative instruments was incorrectly computed. The fair value of the commodity derivative instruments previously reported were over stated by $0.8 million as of March 31, 2008. In addition, we incorrectly presented realized gains and losses related to commodity derivative instruments within oil and gas sales. As a result of these errors, current and long-term derivative financial instrument assets, current and long-term derivative financial instrument liabilities, accumulated other comprehensive income and accumulated deficit were over/(under)stated as of March 31, 2008, and oil and gas sales, gain (loss) from derivative financial instruments were over/(under)stated for the three month periods ended March 31, 2008 and 2007.

 

(C) Errors were identified in the accounting for the formation of Quest Cherokee in December 2003 in which: (i) no value was ascribed to the subsidiary Class A units that were issued to ArcLight Energy Partners Fund I, L.P. in connection with the transaction, (ii) a debt discount (and related accretion) and minority interest were not recorded, (iii) transaction costs were inappropriately capitalized to oil and gas properties, and (iv) subsequent to December 2003, interest expense was improperly stated as a result of these errors. In 2005, the debt relating to this transaction was repaid and the Class A units were repurchased. Due to the errors that existed in the previous accounting, additional errors resulted in 2005 including: (i) a loss on extinguishment of debt was not recorded, and (ii) oil and gas properties, pipeline assets were overstated. Subsequent to the 2005 transaction, depreciation, depletion and amortization expense was also overstated due to these errors.

 

(D) Certain general and administrative expenses unrelated to oil and gas production were inappropriately capitalized to oil and gas properties, and certain operating expenses were inappropriately capitalized to oil and gas properties being amortized. These items resulted in errors in valuation of the full cost pool, oil and gas production expenses and general and administrative expenses. As a result of these errors, oil and gas properties being amortized and accumulated deficit were over/(under)stated as of March 31, 2008, and oil and gas production expenses, general and administrative expenses were over/(under)stated for the three month periods ended March 31, 2008 and 2007.

 

(E) Invoices were not properly accrued resulting in the understatement of accounts payable and numerous other balance sheet and income statement accounts. As a result of these errors, accounts receivable, other current assets, property and equipment, pipeline assets, properties being and not being amortized and accumulated deficit were over/(under)stated as of March 31, 2008, and oil and gas production expenses, pipeline operating expenses and general and administrative expenses were over/(under)stated for the three month periods ended March 31, 2008 and 2007.

 

(F) Capitalized interest was not recorded on pipeline construction. As a result of this error, pipeline assets and accumulated deficit were understated as of March 31, 2008 and interest expense was overstated for the three month periods ended March 31, 2008 and 2007.

 

(G) Errors were identified in stock-based compensation expense, including the use of incorrect grant dates, valuation errors, and incorrect vesting periods. As a result of these errors, additional paid-in capital and accumulated deficit were over/(under)stated as of March 31, 2008, and general and administrative expenses were over/(under)stated for the three month periods ended March 31, 2008 and 2007.

 

(H) As a result of previously discussed errors and an additional error related to the method used in calculating depreciation, depletion and amortization, errors existed in our depreciation, depletion and amortization expense and our accumulated depreciation, depletion and amortization. As a result of these errors, accumulated depreciation, depletion and amortization were over/(under)stated as of March 31, 2008 and depreciation, depletion and amortization expense was over/(under)stated for the three month periods ended March 31, 2008 and 2007.

 

(I) As a result of previously discussed errors relating to oil and gas properties and hedge accounting and errors relating to the treatment of deferred taxes, errors existed in our ceiling test calculations. As a result of

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

these errors, the Company incorrectly recorded a $30.7 million impairment to its oil and gas properties during the year ended December 31, 2006.

 

(J) We identified other errors during the restatement process where the impact on net income was not deemed significant enough to warrant separate disclosure of individual errors. Included in this amount is the minority interest effect of the errors discussed above.

 

Outstanding shares — Errors were identified in the calculation of outstanding shares in all periods as we inappropriately included restricted share grants in our calculation of issued shares when the restrictions lapsed, rather than the date at which the restricted shares were granted. This error did not affect net income, but did impact our issued and outstanding share amounts as well as our weighted average share amounts (in thousands):

 

 

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table outlines the effects of the restatement adjustments on our Consolidated Statement of Operations for the period indicated (in thousands, except share and per share data):

 

 

QUEST RESOURCE CORPORATION AND SUBSIDIARIES

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table outlines the effects of the restatement adjustments on our Consolidated Statement of Cash Flows for the period indicated (in thousands):