RAE Systems (RAE)

Note 5. Commitments and Contingencies

Legal Proceedings

A motion was filed on June 17, 2005, by Polimaster Ltd. and Na & SE Trading Co. Limited, for an injunction that would prevent RAE Systems from shipping its Gamma RAE II product and prohibiting RAE from making any additional sales of products in its possession licensed from Polimaster Ltd. and Na & SE Trading Co. Limited, pending resolution of arbitration between the parties. The motion was denied on September 6, 2005. On June 12, 2006, the Company and Polimaster agreed to arbitrate this claim in accordance with the original contract between the parties. The arbitration will be conducted under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. Both parties have agreed to a ten-day arbitration proceeding that is scheduled to start on March 5, 2007. Polimaster’s initial claim is for damages of 13.2 million dollars and an injunction against sales of the Company’s Gamma Rae II and Neutron RAE II products radiation detection products. From initial release of these products through June 30, 2006, the Company shipped approximately 1.9 million dollars of these products. At this time, due to the preliminary and speculative nature of these proceedings, we do not believe an amount of loss, if any, can be reasonably estimated for this matter. We also believe the claim by Polimaster is without merit and we expect to vigorously defend our position.

Notwithstanding the Polimaster proceeding described above, from time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

Operating leases

The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the quarter ended June 30, 2006 and 2005 were $169,000 and $258,000, and for the first six months of 2006 and 2005 were $353,000 and $501,000, respectively. Future minimum lease payments from 2006 (remaining 6 months) through 2011 and beyond excluding the Sunnyvale, California abandoned building lease are $252,000, $223,000, $140,000, $135,000, $115,000 and $82,000, respectively.

In December 2004, the Company purchased the property located at 3775 North First Street in San Jose, California. The lease related to our previous headquarters in Sunnyvale, California was written off as of the second quarter of 2005. The total loss on abandonment of the lease was approximately $2 million. Future discounted lease payments related to the Sunnyvale building have been included in accrued expenses totaling $474,000 and other long term liabilities totaling $1,283,000 at June 30, 2006. Future minimum lease payments for each of the next four years from 2006 (remaining 6 months) through 2009 are $250,000, $528,000, $627,000 and $556,000, respectively. The discount rate used was 4.85%.

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Purchase obligations

The Company has agreements with suppliers and other parties to purchase inventories and other goods and services. The Company estimated its non-cancelable obligations under these agreements in 2006 (remaining 6 months), 2007, 2008, 2009 and 2010, to be approximately $5,934,000, $290,000, $160,000, $43,000 and $3,000 respectively. All non-cancelable obligations related to inventories are expected to be delivered within the next 12 months. The Company periodically reviews the carrying value of its inventories and non-cancelable purchase commitments by evaluating material usage requirements and forecasts and estimates inventory obsolescence, excess quantities and any expected losses on purchase commitments. The Company may record charges to write-down inventory due to excess, obsolete and slow-moving inventory and lower-of-cost or market based on an analysis of the impact of changes in technology, estimates of future sales volumes and market value estimates. There was no loss accrued related to current purchase obligations. However, any additional future write-down of inventories or loss accrued on inventory purchase commitments, if any, due to market conditions, may negatively affect gross margins in future periods.

Guarantees

The Company is permitted under Delaware law and in accordance with its Bylaws to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. As a result of our insurance policy coverage, the Company believes the fair value of these indemnification agreements is minimal.

Note 5. Commitments and Contingencies

Legal Proceedings

From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows. A motion was filed on June 17, 2005, by Polimaster Ltd. and Na & SE Trading Co. Limited, for an injunction that would prevent RAE Systems from shipping its Gamma RAE II product and prohibiting RAE from making any additional sales of products in its possession licensed from Polimaster Ltd. and Na & SE Trading Co. Limited, pending resolution of arbitration between the parties. The motion was denied on September 6, 2005. While this claim may be subject to arbitration in accordance with the original contract between the parties, we do not expect it to have a material effect upon our business or results of operations.

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Operating leases

The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the quarters ended March 31, 2006 and 2005 was $151,000 and $209,000, respectively. Future minimum lease payments for each of the next four years from 2006 through 2009 excluding the Sunnyvale, California abandoned building lease are $244,000, $39,000, $34,000 and $28,000, respectively.

In December 2004, the Company purchased the property located at 3775 North First Street in San Jose, California. The lease related to our previous headquarters in Sunnyvale, California had been written off as of the second quarter of 2005. The total loss on abandonment of the lease was approximately $2 million. Future discounted lease payments related to the Sunnyvale building have been included in accrued expenses totaling $472,000 and other long term liabilities totaling $1,357,000 at March 31, 2006. Future minimum lease payments for each of the next four years from 2006 through 2009 are $372,000, $528,000, $627,000 and $556,000, respectively. The discount rate used was 4.85%.

Purchase obligations

The Company has agreements with suppliers and other parties to purchase inventories and other goods and services. The Company estimated its non-cancelable obligations under these agreements in 2006, 2007, 2008, 2009 and 2010, to be approximately $6,625,000, $297,000, $163,000, $43,000 and $3,000 respectively. All non-cancelable obligations related to inventories are expected to be delivered within the next 12 months. The Company periodically reviews the carrying value of its inventories and non-cancelable purchase commitments by evaluating material usage requirements and forecasts and estimates inventory obsolescence, excess quantities and any expected losses on purchase commitments. The Company may record charges to write-down inventory due to excess, obsolete and slow-moving inventory and lower-of-cost or market based on an analysis of the impact of changes in technology, estimates of future sales volumes and market value estimates. There was no loss accrued related to current purchase obligations. However, any additional future write-down of inventories or loss accrued on inventory purchase commitments, if any, due to market condition, may negatively affect gross margins in future periods.

Guarantees

The Company is permitted under Delaware law and in accordance with its Bylaws to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. As a result of our insurance policy coverage, the Company believes the fair value of these indemnification agreements is minimal.

In the Company’s sales agreements, the Company typically agrees to indemnify its customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle claims or defend lawsuits.

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Note 4. Commitments and Contingencies

Royalty

In June 2004, the Company entered into an agreement with REnex Technologies Ltd. (“REnex”) to develop six prototype RAELink modems for a price of $107,000 and to pay a royalty fee of 7.5% for all products sold for which REnex’s intellectual property is used. As of September 30, 2005, the Company has made a payments to REnex in the amount $124,000 and has accrued an additional $21,000 that will be paid during the fourth quarter of 2005. The Company signed an additional agreement with REnex on August 5, 2005, for the development of a controller, a specialized modem, certain firmware and a network evaluation. The Company expects to pay REnex approximately $157,000 for these developments as well as a royalty of 7% on future products sold as payment for development of the modem. The Company has a 36% interest in REnex and accounts for it under the equity method with effect from January 1, 2002

The Company also has an agreement with Draeger Safety Inc. that requires the Company to pay 7.5% of sales, after selling commissions, for certain consumable items sold by RAE. The Company has paid $12,000 to Draeger Safety, Inc. during 2005 under this agreement.

Litigation

A motion was filed on June 17, 2005, by Polimaster Ltd. and Na & SE Trading Co. Limited, for an injunction that would prevent RAE Systems from shipping its Gamma RAE II product and prohibiting RAE from making any additional sales of products in its possession licensed from Polimaster Ltd. and Na & SE Trading Co. Limited, pending resolution of arbitration between the parties. The motion was denied on September 6, 2005.

The denial of the injunction was related to a May 9, 2005, Polimaster Ltd. complaint filed against the Company in the U.S. District Court for the Northern District of California alleging that the Company had misappropriated and misused technological and proprietary information developed by Polimaster to manufacture the GammaRAE II hand-held radiation detection unit. The complaint stated that Polimaster intends to prosecute its claims against RAE in arbitration, in accordance with the terms of the contracts between the parties. Management will defend the matter vigorously.

From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. On October 5, 2005 the Company was served with a summons related to an ex-employee’s claim for stock options, which the Company intends to oppose. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

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Operating leases

As of May 31, 2005, the majority of the Company’s U.S. operations have been transferred to its new facility in San Jose, California. During the quarter ended June 30, 2005, the Company recorded a one-time charge of $2.0 million for abandonment of the Company’s lease on its former headquarters and U.S. manufacturing site in Sunnyvale, California. The one-time charge of $2.0 million was based on the estimated cash flow to maintain the abandoned facility and rental obligation through the end of the lease term in 2009, discounted at an interest rate of 4.85 percent. Based on broker estimates of current real estate market conditions and other factors, it was considered more likely than not that any potential sublease income would be offset by brokerage, refurbishment and other costs to make the facility ready for a sublease.

Note 4. Commitments and Contingencies

Royalty

In June 2004, the Company entered into an agreement with REnex Technologies Ltd. (“REnex”) to develop six prototype RAELink modems for a price of $95,000 and to pay a royalty fee of 7.5% for all products sold for which REnex’s intellectual property is used. The Company also has two smaller contracts with REnex of $20,000 each for integration of global positioning technologies. As of June 30, 2005, the Company has not made any payments to REnex. However, the Company expects to make a payment against these contracts during the third quarter of 2005. The Company has a 36% interest in REnex and accounts for it under the equity method with effect from January 1, 2002.

Litigation

On May 9, 2005, Polimaster, Ltd. filed a complaint against the Company in the U.S. District Court for the Northern District of California alleging that the Company had misappropriated and misused technological and proprietary information developed by Polimaster to manufacture the GammaRAE II hand-held radiation detection unit. Polimaster, Ltd. is seeking a preliminary injunction against sales of RAE System’s radiation detection equipment pending completion of arbitration. Management believes that Polimaster’s claims are entirely without merit and will defend the matter vigorously. From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

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Operating leases

As of May 31, 2005, the majority of our U.S. operations have been transferred to our new facility in San Jose, California. During the quarter ended June 30, 2005, the Company recorded a one-time charge of $2.0 million for abandonment of the Company’s lease on our former headquarters and U.S. manufacturing site in Sunnyvale, California. The one-time charge of $2.0 million was based on the estimated cash flow to maintain the abandoned facility and rental obligation through the end of the lease term in 2009, discounted at an interest rate of 4.85 percent. Based on broker estimates of current real estate market conditions and other factors, it was considered more likely than not that any potential sublease income would be offset by brokerage, refurbishment and other costs to make the facility ready for a sublease.

Note 4. Commitments and Contingencies

Royalty

Commencing January 1, 2001 and continuing through December 31, 2009, the Company is required to pay Dragerwerk, a German-based competitor, a royalty equal to 7.5% of net sales of certain licensed

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products manufactured or imported for sale by or for the Company in the United States. The royalty relates to U.S. Patent No. 5,654,498 issued August 5, 1997 and entitled “Device for the Selective Detection of a Component in a Gas Mixture.” During the three month periods ended March 31, 2005 and 2004, the Company incurred royalty expense of $12,000 and $10,800, respectively.

Litigation

On May 9, 2005, Polimaster, Ltd. filed a complaint against the Company in the U.S. District Court for the Northern District of California alleging that the Company had misappropriated and misused technological and proprietary information developed by Polimaster to manufacture the GammaRAE II hand-held radiation detection unit. Polimaster, Ltd. is seeking a preliminary injunction against sales of RAE System’s radiation detection equipment pending completion of arbitration. Management believes that Polimaster’s claims are entirely without merit and will defend the matter vigorously. From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

Operating leases

As of May 31, 2005, the majority of our U.S. operations have been transferred from our leased facility in Sunnyvale, CA to our new facility in San Jose, CA. During June, the Company expects to complete the transfer of its operations to the new building and to write-down its lease obligation, estimated at $2.3 million, to its estimated fair market value.

13.    Commitments and Contingencies

Royalty

Commencing January 1, 2001 and continuing through December 31, 2009, the Company is required to pay Dragerwerk, a German-based competitor, a royalty equal to 7.5% of net sales of certain licensed products manufactured or imported for sale by or for the Company in the United States. The royalty relates to U.S. Patent No. 5,654,498 issued August 5, 1997 and entitled “Device for the Selective Detection of a Component in a Gas Mixture.” During the years ended December 31, 2004, 2003, and 2002, the Company incurred royalty expense of $46,000, $60,000, and $51,000, respectively.

Litigation

From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.