10-Q 1 form10q.txt FORM 10-Q ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 Commission File Number: 0-30162 FRONTLINE CAPITAL GROUP (Exact name of registrant as specified in its charter)

405 Lexington Avenue, New York, NY 10174 ------------------------------------ ----- (Address of principal executive office) (Zip Code) (212) 931-8000 -------------- (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 preceding 12 months (or for such shorter period that the registrant was required to file such reports) Yes X No __, and (2) has been subject to such filings for the past 90 days, Yes X No __. The registrant has only one class of common stock, issued at $.01 par value per share with 37,344,039 shares outstanding as of August 13, 2002. ================================================================================ FRONTLINE CAPITAL GROUP AND SUBSIDIARIES QUARTERLY REPORT FOR THE THREE MONTHS ENDED JUNE 30, 2002 TABLE OF CONTENTS

2 PART 1 - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS FRONTLINE CAPITAL GROUP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

See accompanying notes to consolidated financial statements. 3 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) (UNAUDITED)

See accompanying notes to consolidated financial statements. 4 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)

See accompanying notes to consolidated financial statements. 5 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) 1. DESCRIPTION OF THE COMPANY FrontLine Capital Group ("FrontLine" or the "Company") is a holding company, with two distinct operating segments: one holds FrontLine's interest in HQ Global Workplaces, Inc., a company in the officing solutions market (see Note 3 for further discussion), and its predecessor companies ("HQ" or the "HQ Global Segment"), and the other consists of FrontLine (parent company) ("FrontLine Parent") and its interests in a group of companies (the "Parent and Other Interests Segment") that provide a range of services. In October 2000, FrontLine announced that it would focus its resources and capital on the businesses within its existing portfolio and cease pursuing new investment activities. FRONTLINE BANKRUPTCY On June 12, 2002, Frontline filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). The Company remains in possession of its assets and properties, and continues to operate its business and manage its property as a debtor-in-possession under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the United States Bankruptcy Code. The Company anticipates proposing a plan of reorganization in accordance with the federal bankruptcy laws as administered by the Bankruptcy Court. Confirmation of a plan of reorganization could materially change the amounts currently recorded in the financial statements. The financial statements do not give effect to any adjustment to the carrying value of assets, or amounts and classifications of liabilities that might be necessary as a consequence of this matter. The Company has the exclusive right to propose a plan of reorganization during the 120-day period following June 12, 2002, which may be extended by the Bankruptcy Court. HQ GLOBAL BANKRUPTCY On March 13, 2002, HQ Global and certain of its affiliates (collectively, the "Debtors") filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware (the "Court") and received a commitment for $30.0 million in debtor-in-possession financing (see Note 5). The Debtors will continue to operate their business and manage their properties as debtors-in-possession during the Chapter 11 proceeding. The Debtors have the exclusive right to propose a plan of reorganization until November 13, 2002, which period may be extended further by the Court. The debtors are obligated under their debtor-in-possession financing facility to file with the Court, no later than September 9, 2002, a plan of reorganization in a form acceptable to the "Requisite Lenders" under the facility. The Debtors anticipate proposing a plan of reorganization in accordance with the federal bankruptcy laws as administered by the Court. Confirmation of a plan of reorganization could materially change the amounts currently recorded in the financial statements. The financial statements do not give effect to any adjustment to the carrying value of assets, or amounts and classifications of liabilities that might be necessary as a consequence of this matter. 6 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) NOTES PAYABLE, CREDIT FACILITIES AND PREFERRED STOCK DEFAULTS As of June 30, 2002, the Company has not paid certain principal and interest due on the FrontLine Bank Credit Facility and both the FrontLine Bank Credit Facility (see Note 5) and the Credit Facilities with Reckson Operating Partnership, L.P. ("Reckson") (see Note 1) are in default. Additionally, the Company did not pay the dividend that became payable on December 31, 2001 or any subsequent dividend for the Redeemable Preferred Stock, and is in default under that agreement (see Note 6). The accompanying consolidated financial statements have been prepared on a going concern basis of accounting and do not reflect any adjustments that might result should the Company be unable to continue as a going concern. The Company's inability to repay or refinance its indebtedness when due, and pay dividends on its redeemable preferred stock, its recent losses from operations and the related Chapter 11 proceedings of FrontLine and HQ raise concern about its ability to continue as a going concern. The appropriateness of using the going concern basis is dependent upon, among other things (i) confirmation of plans of reorganization for FrontLine and HQ under the Bankruptcy Code, (ii) the ability to achieve profitable operations after such confirmations and (iii) the ability to generate sufficient cash from operations and through asset sales to meet its obligations. DELISTING BY NASDAQ In March 2002, the Company's stock was delisted by Nasdaq as a direct result of the HQ bankruptcy filing. The Company's common stock currently trades on the OTC Bulletin Board under the symbol FLCGQ. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying consolidated financial statements present the consolidated financial position of the Company and its majority-owned subsidiaries. The financial position, results of operations and cash flows of the HQ Global Segment are presented in Note 3. The financial position, results of operations and cash flows of the Parent and Other Interests Segment are summarized in Note 4. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (substantially consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six-month period ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and notes thereto included in the Company's annual report on Form 10-K (the "Form 10-K") for the year ended December 31, 2001. 7 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) The accompanying unaudited financial statements have been presented in accordance with Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code ("SOP 90-7"). In accordance with SOP 90-7, no interest has been accrued on unsecured debt, no dividends on preferred stock have been accrued, unamortized premiums and debt issuance costs relating to unsecured debt have been expensed, costs relating to the bankruptcy proceeding and interest earned on accumulating cash resulting from the bankruptcy proceeding and interest earned on accumulating cash resulting from the bankruptcy proceeding have been reported as reorganization items in the accompanying statement of operations, and liabilities subject to compromise have been separately reported in the accompanying balance sheet. ACCOUNTING FOR OWNERSHIP INTERESTS The interests that FrontLine owns are accounted for under one of three methods: consolidation, equity method and cost method. The applicable accounting method is generally determined based on the Company's voting interest and rights in each investee. Consolidation. Where the Company directly or indirectly owns more than 50% of the outstanding voting securities of an entity or controls the board of directors, the consolidation method of accounting is applied. Under this method, an entity's results of operations are reflected within the Company's Consolidated Statements of Operations. Participation of other (non-FrontLine) shareholders in the earnings or losses of a consolidated entity is reflected in the caption "Minority interest" in the Consolidated Statements of Operations. Minority interest adjusts the consolidated net results of operations to reflect only the Company's share of the earnings or losses of the consolidated entity. Equity Method. Investees whose results are not consolidated, but over whom the Company exercises significant influence, have been accounted for under the equity method of accounting. Under the equity method of accounting, an investee's accounts are not reflected within the Company's Consolidated Statements of Operations; however, FrontLine's share of the earnings or losses of the investee is reflected in the caption "Equity in net loss and impairment of unconsolidated companies." Cost Method. Investees not accounted for under either the consolidation or the equity method of accounting, which are generally those in which the Company has less than a 20% interest in the voting securities of the investee, are accounted for under the cost method of accounting. Under this method, the Company's share of the earnings or losses of such companies is not included in the Consolidated Statements of Operations. CASH AND CASH EQUIVALENTS The Company considers highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. MARKETABLE EQUITY SECURITIES Available-for-sale marketable equity securities are reported at fair market value, with the resulting net unrealized gain or loss reported within shareholders' equity. 8 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) RECEIVABLES HQ licenses office space and provides support services to clients in various industries, ranging in size from small entrepreneurial entities to local offices of international corporations. HQ's facilities included in continuing operations are primarily located in the United States, which limits its exposure to certain economic risks based upon local economic conditions. HQ performs credit evaluations of its clients to the extent deemed necessary and generally requires approximately two months' charges as a service retainer. HQ records an allowance for doubtful accounts which reflects management's estimate of the risk of uncollectible accounts receivable. PROPERTY AND EQUIPMENT Property and equipment consists primarily of property and equipment owned by HQ, and is stated at cost less accumulated depreciation and amortization. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets which range from three to seven years. Leasehold improvements are amortized over the lesser of the term of the related lease or the estimated useful lives of the assets. As of June 30, 2002 and December 31, 2001, the related accumulated depreciation and amortization was $95.9 million and $77.6 million, respectively. DEFERRED FINANCING COSTS The Company amortizes deferred financing costs over the term of the related debt. As of June 30, 2002 and December 31, 2001, accumulated amortization was $17.8 million and $16.0 million, respectively. Amortization of deferred financing costs is included as a component of interest expense in the accompanying consolidated statement of operations. IMPAIRMENTS OF OWNERSHIP INTERESTS AND ADVANCES TO UNCONSOLIDATED COMPANIES The Company continually evaluates the carrying value of its ownership interests in and advances to each of its investments in unconsolidated companies for possible impairment based on achievement of business plan objectives and milestones, the value of each ownership interest in the unconsolidated company relative to carrying value, the financial condition and prospects of the company and other relevant factors. The fair value of the Company's ownership interests in and advances to privately held companies is generally determined based on the value at which independent third parties have invested or have committed to invest in the companies. The Company recorded a $25.7 million charge during the year ended December 31, 2000 to recognize impairment charges to reduce the carrying value of its investments in certain unconsolidated companies. In recognition of continuing difficult capital market conditions and operating performance of these ownership interests, the Company recorded an additional $32.9 million during the year ended December 31, 2001. Of the $32.9 million recorded, $20.0 million related to Reckson Strategic Venture Partners, LLC ("Reckson Strategic")(see Note 4 for further discussion). During the six months ended June 30, 2002, the Company determined that no additional impairment was necessary. These charges are included in "Equity in net loss and impairment of unconsolidated companies" in the accompanying Consolidated Statements of Operations. 9 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) IMPAIRMENTS OF LONG-LIVED ASSETS The Company reviews long-lived assets, including intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated fair value of the asset or business center. In preparing these estimates, HQ must make a number of assumptions concerning occupancy rates, rates which will be charged to clients for workstations and services, and rates of growth of rent expense and other operating expenses. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets. Impairment charges are recorded as a permanent reduction in the carrying amount of the related asset. Based on the trend of operating losses as well as HQ's inability to remain in compliance with its debt arrangements, HQ determined that the carrying value of its intangible assets was impaired at September 30, 2001. Therefore, in the third quarter of 2001, the Company recognized an impairment charge of approximately $294.1 million, representing the amount by which the carrying amount of the intangible assets exceeded their estimated fair value. As a result of continuing operating losses, the Company further revised its projected cash flows during the fourth quarter of 2001, resulting in an additional impairment charge of $241.4 million. As of June 30, 2002, the Company determined that no additional impairment was necessary. Management believes that assumptions made in estimating fair values were reasonable, but actual fair values may differ significantly from these estimates. RECENT PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board ("FASB") issued Statements of Financial Accounting Standards ("FAS") No. 141, Business Combinations, ("FAS 141"), and No. 142, Goodwill and Other Intangible Assets, ("FAS 142"), effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized, but will be subject to annual impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives. As a result of impairment charges recorded in the third and fourth quarters of 2001, the Company does not have any recorded goodwill or indefinite lives of intangible assets at June 30, 2002. Accordingly, adoption of FAS 142 did not have an impact on the Company's financial condition or results of operations. Intangible assets with a carrying value of approximately $16.8 million at December 31, 2001 will continue to be amortized. The FASB has also recently issued FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("FAS 144"), which was adopted by the Company on January 1, 2002. The FASB's new rules on asset impairment supersede FAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of ("FAS 121"). FAS 144 retains the requirements of FAS 121 to (a) recognize an impairment loss only if the carrying amount of a long-lived asset is not recoverable from its undiscounted cash flows and (b) measure an impairment loss as the difference between the carrying amount and fair value of the asset, but removes goodwill from its scope. This aspect of FAS 144 will primarily impact the accounting for intangible assets subject to amortization, property and equipment, and certain other long-lived assets. The adoption of this statement did not have a material effect on the results of operations or the financial position of the Company. 10 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) REVENUE RECOGNITION The Company's operating revenues for all periods presented were attributable to HQ. Revenues from workstations and business services are recognized as the related services are provided. Workstation revenues consist of office and related furniture rental, parking and storage. Business services consist of (1) technology services comprised of Internet, videoconferencing and telecommunications services and (2) other business services which include charges to clients that do not require offices on a full-time basis, conference and training room usage, catering, copies, management and franchise fees. INCOME TAXES The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. This method also requires the recognition of future tax benefits such as net operating loss carry forwards, to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. The result a valuation allowance is recognized if it is more likely than not that some portion of the deferred asset will not be recognized. At June 30, 2002 and December 31, 2001, all of HQ and FrontLine Parent's deferred tax assets have been fully reserved due to the uncertainty as to whether these assets will provide benefit in future years. COMPREHENSIVE LOSS Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions, events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. During the three months ended June 30, 2001, the difference between net loss of $39,072,000 and total comprehensive loss of $39,090,000 was due to $296,000 of unrealized losses arising from foreign currency translation and $278,000 of unrealized gains on "available-for-sale" marketable securities. During the six months ended June 30, 2001, the difference between net loss of $69,288,000 and comprehensive loss of $72,387,000 was due to $3,011,000 of unrealized losses arising from foreign currency translation and $88,000 of unrealized losses on "available-for-sale" marketable securities. There were no differences between net loss and comprehensive loss for the 2002 periods. SEGMENT REPORTING The segment information required by SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information," relating to the HQ Segment and the Parent and Other Interests Segment is presented in Notes 3 and 4, respectively. 11 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) Each of the segments has a FrontLine senior professional assigned for purposes of monitoring performance and carrying out operating activity. These professionals report directly to the Chief Executive Officer and Treasurer, who along with the Board of Directors have been identified as the Chief Operating Decision Makers ("CODM") because of their final authority over resource allocation decisions and performance assessment. FrontLine's governance and control rights are generally exercised through Board of Directors seats and through representation on the executive committees of its investee entities. FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" requires the Company to disclose the estimated fair values of its financial instrument assets and liabilities. The carrying amounts approximate fair value for cash and cash equivalents, accounts receivable and accounts payable because of the short maturity of those instruments. Other than as disclosed in Notes 5 and 11, the estimated fair values of the Company's long-term debt approximate the recorded balances. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES The Company adopted the provisions of SFAS No. 133 ("SFAS 133") "Accounting for Derivatives and Hedging Activities," as amended, effective January 1, 2001. SFAS 133 requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. HQ enters into contracts that establish a cap and a floor interest rate on notional amounts to hedge the interest rate risk on its floating-rate debt. The Company's policy is that it will not speculate in hedging activities. The adopting of FAS 133 as of January 2001 was not material to the Company's results of operations. There were no derivatives outstanding at June 30, 2002. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The most significant assumptions and estimates relate to the lives and recoverability of long-lived assets. Actual results could differ from those estimates. RECLASSIFICATIONS Certain prior period amounts and segment disclosures have been reclassified to conform to the current period presentation. 12 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) 3. INTEREST IN HQ GLOBAL AND PREDECESSOR ENTITIES OVERVIEW HQ is a provider of flexible officing solutions. HQ provides a complete outsourced office solution through furnished and equipped individual offices and multi-office suites available on short notice with flexible contracts. HQ also provides business support and information services, including telecommunications; broadband Internet access; mail room and reception services; high-speed copying, faxing and printing services; secretarial, desktop publishing and IT support services and various size conference facilities, with multi-media presentation and, in certain cases, video teleconferencing capabilities. HQ also provides similar services for those businesses and individuals that do not require offices on a full-time basis. As of June 30, 2002, HQ owned, operated, or franchised 357 business centers, which are included in continuing operations and are primarily located in the United States. There were 19 business centers operating at June 30, 2002 that were held for sale and included in discontinued operations or in the process of being closed. HQ's wholly-owned subsidiary is also the franchisor of 45 domestic and 33 international business centers for unrelated franchisees. Excluding franchised centers, HQ owned and operated 279 business centers as of June 30, 2002. 2000 TRANSACTIONS In connection with the completion of its step acquisition of VANTAS which began in 1999, in the first quarter of 2000 the Company paid approximately $43.3 million in cash and issued 1,294,103 shares of its common stock to other VANTAS stockholders pursuant to the terms of stock purchase agreements thereby increasing its ownership interest in VANTAS to approximately 84% on a basic basis and 76% on a diluted basis. On June 1, 2000, VANTAS merged with HQ Global Workplaces, Inc. ("Old HQ"), in a two-step merger, and HQ Global also acquired two other entities involved in the executive office suites business outside the United States (the "HQ Merger"). As a result of the HQ Merger, the combined company, under the name HQ Global Workplaces, Inc., became a wholly-owned subsidiary of a newly-formed parent corporation, HQ Global Holdings, Inc. ("HQ Global"). The HQ Merger was financed through a combination of debt and HQ Global preferred stock and warrants. To effectuate the HQ Merger, FrontLine contributed approximately $17 million in cash and its ownership interest in VANTAS. The costs of the HQ Merger have been allocated to the respective assets acquired and liabilities assumed, with the remainder recorded as goodwill, based on preliminary estimates of fair values as follows (in thousands): Working capital ................................... $ 7,840 Property and equipment ............................ 107,047 Goodwill .......................................... 407,441 Favorable acquired business center operating leases 25,690 Other assets ...................................... 32,504 Other liabilities ................................. (45,080) Notes payable ..................................... (138,693) --------- Total .......................................... $ 396,749 ========= 13 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) The estimates of fair value were determined by HQ Global's management based on information provided by the management of the acquired entities. The above purchase price allocation has been revised from the original allocation as estimated amounts have been finalized. OWNERSHIP BY FRONTLINE To facilitate HQ Global obtaining amendments to certain debt covenants, on June 29, 2001, FrontLine invested an additional $15.0 million into HQ Global via the acquisition of a new subordinated series of preferred stock and common stock warrants. As of June 30, 2002, FrontLine's ownership interest was approximately 57% on a basic basis. Although FrontLine's percentage ownership may vary depending on the actual preferred stock conversion price, on a fully-diluted basis, assuming the outstanding preferred stock converted at the HQ Merger conversion price, and including certain warrants to purchase HQ Global stock, FrontLine would own approximately 38% of the common stock of HQ Global. An HQ Global shareholder has a put option ("Put Option") to require the Company to purchase all of its interest any time between January 8, 2002 and January 8, 2005, at the then determined fair value of the interest. The Company has entered into a stockholders agreement (the "HQ Stockholders Agreement") with certain of the stockholders of HQ Global which provides them with rights to put up to approximately 3.1 million shares of HQ Global (the "HQ Shares") to the Company during the two years subsequent to the HQ Merger if HQ Global has not completed an initial public offering of its shares. On February 25, 2002, such stockholders irrevocably waived their Put Rights. DISCONTINUED OPERATIONS In December 2001, HQ's Board of Directors approved a plan to dispose of HQ's business in Europe. The planned disposition of the businesses in Europe represents the disposal of a business segment under Accounting Principles Board ("APB") Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions ("APB 30"). As a result of this transaction, the consolidated financial statements have been reclassified to present the European businesses as a discontinued operation. On June 24, 2002, HQ sold certain assets of the discontinued operations in the United Kingdom for cash proceeds of $15.5 million. Of this amount, $11.5 million was repatriated to the United States. This transaction resulted in a gain of $5.4 million, representing the excess of the proceeds over the previously estimated net realizable value of the assets. The gain of $5.4 million is included in income from discontinued operations for the three and six months ended June 30, 2002. There were no income taxes related to this transaction. Excluding this transaction, loss from discontinued operations was $2.5 million and $2.4 million for the three and six months ended June 31, 2002, respectively. FINANCIAL STATEMENTS The following statements present the portion of the Company's financial position, results of operations and cash flows represented by HQ Global and predecessor entities as of and for the periods indicated. 14 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) HQ GLOBAL AND PREDECESSOR ENTITIES BALANCE SHEETS (IN THOUSANDS)

15 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) HQ GLOBAL AND PREDECESSOR ENTITIES STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

16 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) HQ GLOBAL AND PREDECESSOR STATEMENTS OF CASH FLOWS (IN THOUSANDS)

17 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) 4. OTHER OWNERSHIP INTERESTS The Company's ownership interests in its investees are classified according to the applicable accounting method utilized at June 30, 2002 and December 31, 2001. The carrying value of equity method investments represents the Company's acquisition costs less any impairment charges and the Company's share of such investees' losses. The carrying value of cost method investments represents the Company's acquisition costs less any impairment charges in such investees. The Company's ownership interests in and advances to investees as of June 30, 2002, are as follows (in thousands):

The following details the Company's equity in net loss and impairment of unconsolidated companies (in thousands):

EMPLOYEE MATTERS On December 20, 2000, the Company sold its interest in EmployeeMatters, Inc. ("EmployeeMatters") to Intuit, Inc. ("Intuit") for 556,027 shares of Intuit common stock. The fair value of such stock on the closing date of the sale was $21.3 million. As a result of the sale, the Company recorded a gain of $8.3 million, net of $0.7 million of expenses and other related charges, in the fourth quarter of the year ended December 31, 2000. Included in the above Intuit shares are 23,072 shares that were held in escrow in order to collateralize certain indemnification obligations of the Company. On December 31, 2001, Intuit shares were released from escrow. SALE OF INTUIT During the three months ended March 31, 2001, the Company sold all shares of Intuit not held in escrow at a realized gain of $0.5 million. On January 9, 2002, the Company sold all 23,072 shares of Intuit, which were released from escrow at December 31, 2001. 18 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) RECKSON STRATEGIC Reckson Strategic Venture Partners, LLC ("Reckson Strategic") invests in operating companies with experienced management teams in real estate and real estate related market sectors which are in the early stages of their growth cycle or offer unique circumstances for attractive investments, as well as platforms for future growth. Through RSVP Holdings, LLC ("Holdings"), the Company is a managing member and 100% owner of the common equity of Reckson Strategic. New World Realty, LLC, an entity owned by two individuals (the "RSVP Managing Directors") retained by Holdings, acts as a managing member of Holdings, and has a carried interest which provides for the RSVP Managing Directors to receive a share in the profits of Reckson Strategic after the Company, UBS Real Estate Securities, Inc. ("UBS Real Estate"), formerly Paine Webber Real Estate Securities, Inc., and Stratum Realty Fund, L.P. ("Stratum") have received certain minimum returns and a return of capital. UBS Real Estate and Stratum are non-managing members and preferred equity owners who have committed $150 million and $50 million, respectively, in capital and share in profits and losses of Reckson Strategic with the Company, subject to a maximum internal rate of return of 16% of invested capital. The carrying values of the Company's investment in Reckson Strategic, which is accounted for under the equity method, were $12.3 million and $13.4 million as of June 30, 2002 and December 31, 2001, respectively. FINANCIAL STATEMENTS The following statements present the portion of the Company's financial position, results of operations and cash flows represented by FrontLine Parent and other interests as of and for the periods indicated. 19 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) FRONTLINE PARENT AND OTHER INTERESTS BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

20 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) FRONTLINE PARENT AND OTHER INTERESTS STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

21 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) FRONTLINE PARENT AND OTHER INTERESTS STATEMENTS OF CASH FLOWS (IN THOUSANDS)

22 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) 5. NOTES PAYABLE HQ DEBTOR-IN-POSSESSION FACILITY In connection with HQ's bankruptcy filing (See Note 1), HQ received a commitment for a $30.0 million facility, with borrowings permitted for up to nine months in accordance with certain operating and liquidity covenants. Any borrowings, of which there have been none, will incur interest at prime plus 3%. HQ CREDIT FACILITY HQ has a credit facility (the "HQ Credit Facility") with certain lending institutions, which, as amended and restated as of June 29, 2001, provides for borrowings of up to $219.4 million under four term loans (the "Term Loans") and for borrowings or letters of credit of up to an additional $55.6 million under two revolving loan commitments (the "Revolver Loans"). Availabilities under the Revolver Loans are formula based. As of June 30, 2002, there was $188.7 million in outstanding borrowings under the Term Loans and $35.6 million in borrowings outstanding under the Revolver Loans. As of June 30, 2002, HQ had letters of credit outstanding in the aggregate amount of $23.1 million for landlord security deposits. Such letters of credit are collateralized by $0.8 million in cash and $19.9 million of Revolver Loans. The Term Loans are repayable in various quarterly installments through November 2005. Additional annual principal payments of 75% of excess cash flow as defined are required. Pursuant to such requirement, HQ made an accelerated principal payment of $15.1 million during the six-month period ended June 30, 2001, based on cash flows for the year ended December 31, 2000. Any outstanding borrowings under the two Revolver Loans are due on November 6, 2003 and May 31, 2005, respectively. Borrowings under the HQ Credit Facility bear interest ranging from LIBOR (one-month LIBOR was approximately 1.84% at June 30, 2002) plus 3.25% to 4.0% for one, three or nine-month periods at the election of HQ or prime (4.75% at June 30, 2002) plus 2.25% to 3.00%. The weighted average interest rate on borrowings under the Term Loans and the Revolver Loans at June 30, 2002, were approximately 5.9% and 6.0%, respectively. HQ pays a commitment fee of 1/2 of 1.0% per annum on the unused portion of the HQ Credit Facility. HQ's lending institutions have an assignment of leases and rents associated with HQ's business centers and certain preferred security interests to collateralize the borrowings under the HQ Credit Facility. The stated maturities of borrowings outstanding under the HQ Credit Facility subsequent to June 30, 2002 are as follows (in thousands): TWELVE MONTHS ENDED JUNE 30, AMOUNT --------------------------- -------- 2003 and arrears........... $ 43,572 2004....................... 51,262 2005....................... 65,561 2006....................... 63,870 -------- Total...................... $224,265 ======== 23 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) MEZZANINE LOAN On May 31, 2000, HQ entered into a Senior Subordinated Credit Facility (the "Bridge Loan") in the amount of $125.0 million. The Bridge Loan carried an interest rate of LIBOR plus 6.5% and was to mature on May 31, 2007. On August 11, 2000, HQ replaced the Bridge Loan with a $125.0 million Note and Warrant Purchase Agreement (the "Mezzanine Loan"). The Mezzanine Loan bears interest at 13.5% per annum and matures on May 31, 2007. The entire balance was outstanding at June 30, 2002 and December 31, 2001. In connection with the Mezzanine Loan, the Mezzanine Loan lenders received 503,545 Series A Warrants and 227,163 Series B Warrants to purchase common stock. The fair value of the Series A Warrants to purchase Common Stock issued to the lenders was recorded as debt issuance costs and is being amortized over the terms of the related loan resulting in an effective interest rate of 15.6%. No value will be assigned to the Series B Warrants. EVENTS OF DEFAULT AND COMPLIANCE WITH COVENANTS The HQ Credit Facility and Mezzanine Loan contain certain covenants, including a defined maximum ratio of consolidated indebtedness to consolidated earnings before interest, income taxes, depreciation and amortization. In addition, there are other covenants pertaining to financial ratios and limitations on capital expenditures. Also, the HQ Credit Facility and Mezzanine Loan prohibit the declaration or payment of dividends by HQ Global or any of its subsidiaries, except for the payment of dividends in kind on its preferred stock. In addition to not complying with certain financial covenants, in September 2001, HQ defaulted on its principle payments due under the HQ Credit Facility and, in February 2002, commenced defaulting on interest payments. As a result of entering into forbearance agreements, additional borrowings under the HQ Credit Facility were permitted from September 30, 2001 to February 14, 2002. Due to these defaults, outstanding borrowings are reflected as a current liability as of June 30, 2002 and December 31, 2001. HQ also defaulted on the September 30, 2001 interest payment on the Mezzanine Loan but did enter into a forbearance agreement that expired February 14, 2002. As a result of this default and non-compliance with financial covenants, the Mezzanine Loan has been classified as a current liability as of June 30, 2002 and December 31, 2001. FRONTLINE BANK CREDIT FACILITY On September 11, 2000, FrontLine entered into a $25.0 million line of credit agreement (the "FrontLine Bank Credit Facility"). Borrowings under the FrontLine Bank Credit Facility are secured by a 20.51% common ownership interest in shares of HQ Global and bear interest, at the election of FrontLine, at the Prime rate plus 5%. Any outstanding borrowings under the FrontLine Bank Credit Facility were originally due on March 11, 2001. In January 2001, FrontLine exercised its option to extend the maturity date until June 11, 2001. In May 2001, the Company further extended the maturity date to September 11, 2001. In September 2001, the Company further extended the maturity date to October 25, 2001. Since the entire outstanding balance of $25.0 million and accrued interest was not repaid at this time, FrontLine became in default. Such amount is classified as current in the accompanying Consolidated Balance Sheet. The weighted average interest rate of the outstanding borrowings at such date was 7.66%. The carrying value of FrontLine's borrowings under the FrontLine Bank Credit Facility approximates its fair value as of June 30, 2002. 24 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) The restructuring of the Company's indebtedness may result in significant dilution to holders of the Company's common stock or the elimination of their interest. 6. REDEEMABLE PREFERRED STOCK On December 13, 2000, FrontLine obtained a $25.0 million preferred equity facility (the "Preferred Equity Facility") with a major financial institution. At the inception of the Preferred Equity Facility, the Company drew $15.0 million, for net proceeds of $13.9 million; the remaining amount was drawn by FrontLine during the three months ended March 31, 2001, for net proceeds of $10.0 million. The Preferred Equity Facility is comprised of a series of redeemable convertible preferred securities (the "Series B Preferred Stock"). The holders have consent rights for certain significant transactions, including the incurrence of additional debt by the Company or HQ, the issuance of equity securities senior to, or on a parity with, the Series B Preferred Stock or the issuance by HQ of preferred stock. These securities also contain certain covenants relating to HQ. In addition, the securities include a redemption premium of 27.5%. Since the securities were not redeemed prior to December 13, 2001, the securities (including the amount of the redemption premium) have become convertible at the holder's option into FrontLine common stock at the initial rate of $13.3875 per share, the preferred stock has become a voting security on an "as-converted" basis, and quarterly dividends have become payable from the date of initial issuance at the annual rate of 9.25%. Securities have a mandatory redemption requirement at a 27.5% premium, which has been triggered as a result of uncured events of default. Accordingly, the securities are classified as "Redeemable convertible preferred stock" in the accompanying consolidated balance sheet at June 30, 2002. The initial net proceeds of the securities are being accreted to the mandatory redemption price of 127.5% of face value over the five-year period through the mandatory redemption date. At June 30, 2002, the Company did not pay the dividend that was payable at that time and accordingly is in default. The Company is in arrears with regard to the payment of dividends on its Series A and Series B Preferred Stock. 7. SHAREHOLDERS' EQUITY During the three months ended March 31, 2000, the Company completed preferred stock offerings of 26,000 shares of 8.875% Convertible Cumulative Preferred Stock (the "Series A Preferred Stock") at a price of $1,000 per share with net proceeds of $24.6 million. These shares are convertible into the Company's common stock at a price of $70.48. The Company did not declare or pay the quarterly dividend due on these shares commencing with the payment that was due on November 6, 2001. Accordingly, future dividends will accrue at a higher rate of 10.875%. Since dividend distributions are in arrears for more than two quarterly periods, then the holders of such shares are entitled to elect two additional members to the Company's Board of Directors. In connection with the HQ Merger, the Company entered into a stockholders agreement (the "HQ Stockholders Agreement") with certain of the stockholders of HQ Global which provide them with rights to put up to approximately 3.1 million shares of HQ Global (the "HQ Shares") to the Company during the two years subsequent to the HQ Merger if HQ Global did not complete an initial public offering of its shares. On February 25, 2002, such stockholders irrevocably waived their Put Rights. 25 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) 8. LONG-TERM INCENTIVE PLAN In March 2000, the Compensation Committee of the Board of Directors adopted a long-term incentive plan (the "LTIP"). The terms of the LTIP are described in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. In April 2000, FrontLine paid advances aggregating $2.8 million on future payments under the long-term incentive plan to its four executive officers at that date. During the three months ended September 30, 2001, $1.8 million of these advances were forgiven as a result of the termination of three of these executives. Including related income tax accruals, the resulting expenses relating to the forgiveness of the advances to these three executives was $2.8 million in the twelve months ended December 31, 2001, respectively. The Company is continuing to amortize the remaining $1.0 million and related tax payments through April 2007, the end of the required service period, for the remaining executive officer who is still Write off of employed with the Company. During the three and six months ended June 30, 2002, $0.1 million and s $0.1 million, respectively, of amortization related to the LTIP was recorded. 9. REORGANIZATION COSTS HQ In the first quarter of 2002, HQ recorded $3.7 million of professional costs associated with the Chapter 11 proceeding and a $6.2 million non-cash charge associated with the write-off of deferred financing costs associated with the Mezzanine Loan. In the second quarter of 2002, HQ recorded $4.4 million of professional costs associated with the Chapter 11 proceeding. The following table summarizes the accrued charges related to reorganization (in thousands): WRITE OFF OF DEFERRED FINANCING PROFESSIONAL COSTS COST NON-CASH TOTAL ------------ --------- ------- First quarter 2002 charge 3,689 6,163 9,852 Non-cash reduction -- (6,163) (6,163) Second quarter 2002 charge 4,387 -- 4,387 Cash expenditures (2,941) -- (2,941) ------- ------- ------- Balance at June 30,2002 $ 5,135 $ -- $ 5,135 ======= ======= ======= FRONTLINE FrontLine has incurred approximately $0.1 million of reorganization costs, all of which were paid previous to June 30, 2002. 26 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) 10. RESTRUCTURING HQ In the second quarter of 2001, HQ initiated a restructuring program to close certain of its business centers and eliminate certain other business center and corporate positions. This restructuring program resulted in a charge of $11.3 million in the third quarter of 2001 consisting of employee severance and HQ's estimate of future lease payments it would be required to make following closure of the centers. Subsequent to the initiation of the plan, HQ has filed bankruptcy and has revised its estimates of severance and lease costs based on the expected costs of buying out its lease obligations resulting in a reduction of accrued restructuring costs of $3.2 million in the fourth quarter of 2001. In the fourth quarter of 2001, HQ expanded its restructuring program to include the closure of additional business centers resulting in an additional restructuring charge of $49.4 million consisting primarily of HQ's estimate of the future lease payments it will be required to make following closure of these centers. Restructuring costs also include $5.7 million of professional costs associated with this restructuring and HQ's Chapter 11 proceeding (See Note 1). In the second quarter of 2002, HQ recorded a restructuring charge of $7.2 million related to additional planned center closures. During the six months ended June 30, 2002, various landlords drew down $4.8 million of Letters of credit, which reduced the estimated liability related to center closures. Also, $0.4 million in cash was paid to reduce the estimated liability related to center closures. The following table summarizes the accrued charges related to restructuring (in thousands):

The total restructuring program is expected to result in a net reduction of approximately 411 employees. At June 30, 2002, the program had resulted in a reduction of 402 employees. Severance costs are expected to be paid in 2002, while the lease costs are expected to be paid in 2002 and future years. FRONTLINE On October 18, 2000, FrontLine announced a restructuring of its strategic plan. In connection with the Restructuring, FrontLine terminated approximately 90% of its headquarters personnel, which has occurred during a transition period through the first quarter of 2002. As a result of this Restructuring, FrontLine has recognized cash and non-cash restructuring charges of $0.1 and $0.3 million during the three-month and six-month periods ended June 30, 2002, respectively. 27 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) The restructuring costs recognized during 2002 consist principally of $0.3 million of professional fees and other expenses. 11. TRANSACTIONS WITH RELATED PARTIES HQ believes that the terms and pricing of each of the following transactions with related parties are similar to those negotiated at arms length. Certain officers and members of HQ's Board of Directors are also officers and/or on the board of directors of FrontLine, Reckson Associates Realty Corp. ("Reckson Associates"), Equity Office Properties ("EOP") or CarrAmerica. HQ is a tenant under several leases with Reckson Associates and affiliates. For the six months ended June 30, 2002, HQ made payments of $1.5 million for rent, construction and other charges under such leases. HQ is a tenant under several leases with EOP and affiliates of EOP, which are affiliated with EOP Operating Limited Partnership, a purchaser of HQ's Series A Preferred Stock in conjunction with the HQ Merger. For the six months ended June 30, 2002, HQ made payments of $7.6 million for rent and other charges under such leases. HQ is a tenant under several leases with CarrAmerica and affiliates of CarrAmerica, who received shares of HQ's Voting Common Stock and Nonvoting Common Stock in conjunction with the HQ Merger. For the six months ended June 30, 2002, HQ made payments of $1.5 million for rent and other charges under such leases. FRONTLINE The Company has a credit facility with Reckson Operating Partnership, L.P. ("Reckson") in the amount of $100 million (the "FrontLine Facility"). Reckson has advanced the Company $93.4 million at June 30, 2002 under the FrontLine Facility. Additionally, Reckson Strategic has a $100 million commitment from Reckson to fund its investment activities (the "Reckson Strategic Facility"). Draws on the Reckson Strategic Facility occur either in the form of loans to FrontLine (the "Reckson Strategic Facility" and, collectively with the FrontLine Facility, the "Credit Facilities") under terms similar to the FrontLine Facility or whereby Reckson makes direct investments with Reckson Strategic in joint ventures. As of June 30, 2002, Reckson has advanced FrontLine $49.3 million under the Reckson Strategic Facility. The aggregate principal amount outstanding and due Reckson at December 31, 2001 under both credit facilities was $142.7 million. Interest accrued on these facilities at June 30, 2002, was $46.7 million. Both of the FrontLine and Reckson Strategic Facilities expire in June 2003. Currently, the Company has an outstanding letter of credit in the amount of $0.2 million. 28 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) On March 28, 2001, the Company's Board of Directors approved amendments to the Credit Facilities pursuant to which (i) interest is payable only at maturity and (ii) Reckson may transfer all or any portion of its rights or obligations under the Credit Facilities to its affiliates. In addition, the Reckson Strategic Facility was amended to increase the amount available thereunder to up to $110 million. Reckson has advanced approximately $59.8 million under the Reckson Strategic Facility to fund additional Reckson Strategic-controlled joint ventures through June 30, 2002. There is no remaining availability under the Credit Facilities. At June 30, 2002, as a result of the Company's failure to pay the principal and interest due upon maturity on the FrontLine Bank Credit Facility, an event of default has occurred upon the Credit Facilities with Reckson. As a result of the default under the Credit Facilities, interest borrowings currently bear interest at 14.62% per annum. The Company is entitled to a cumulative annual management fee of $2 million with respect to Reckson Strategic, of which $1.5 million is subordinate to UBS Real Estate receiving an annual minimum rate of return of 16% and a return of its capital. The non-subordinated portion of the fee for each of the three months ended March 31, 2002 and 2001 was $0.1 million and each of the six months ended June 30, 2002 and 2001 was $0.2 million. 12. CONTINGENCIES Reference is made to the lawsuit captioned OmniOffices, Inc. et al. v. Joseph Kaidanow et al. set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. In connection with such litigation, on September 12, 2001, without holding oral argument, the Court denied Plaintiffs' motion for summary judgment, but granted the Defendants' cross-motion for summary judgment. Plaintiffs and the directors of old HQ filed a Notice of Appeal in October 2001. On February 15, 2002, the D.C. Circuit announced that oral argument was scheduled for January 16, 2003. In March 2002, the D.C. Circuit referred the appeal to its Appellate Mediation Program. On April 24, 2002, HQ filed a notice of bankruptcy stay in respect of its March 13, 2002 Chapter 11 filing. HQ informed the D.C. Circuit that the appeal was stayed as to HQ pursuant to the automatic stay provisions of the U.S. Bankruptcy Code. Reference is made to the lawsuit captioned Joseph Kaidanow and Robert Arcoro v. CarrAmerica Realty Corporation, HQ Global Workplaces, Inc., Thomas A. Carr, Philip L. Hawkins, C. Ronald Blankenship, Oliver T. Carr, and Gary Kusin set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. In connection with such litigation, on March 8, 2002, Plaintiffs filed a motion for leave to amend their complaint to add, inter alia, a breach of warrant agreements claim against HQ and other claims against FrontLine. On March 15, 2002, HQ filed a notice of bankruptcy stay, stemming from its March 13, 2002 voluntary petition for Chapter 11 bankruptcy protection in the United States Bankruptcy Court for the District of Delaware (the "Delaware Bankruptcy Court"). HQ informed the Court that the consolidated action was stayed as to HQ pursuant to the automatic stay provisions of the Bankruptcy Code. Co-defendent CarrAmerica Realty Corporation filed a motion requesting that, in light of HQ's bankruptcy, the consolidated motion be stayed as to all defendants. At a status conference held on March 25, 2002, the Vice Chancellor ordered the parties to work out a scheduling order for the briefing of the motion regarding the stay of the proceedings. A hearing on this motion is scheduled for September 9, 2002. The former director co-defendants in the consolidated action separately filed an adversary proceeding in the Delaware Bankruptcy Court seeking to stay the consolidated action as to the former directors. After a hearing on June 25, 2002, the Delaware Bankruptcy Court denied the requested relief. On or about October 3, 2001, Burgess Services, LLC ("Burgess Services"), Dominion Venture Group, LLC ("Dominion Venture Group") and certain affiliated parties commenced an action in Oklahoma State Court against Reckson Strategic Venture Partners, LLP ("RSVP"), Reckson Associates Realty Corp. ("Reckson"), and RAP-Dominion LLC ("RAP-Dominion"), a joint venture through which RSVP and Reckson invested in a venture with certain of the plaintiffs. On April 10, 2002, the litigation was settled without liability on the part of the Company or the defendant. In connection with the settlement, the joint venture will be terminated. As a result of this settlement, the Company determined that no further impairment was necessary on its carrying value in its investment in Reckson Strategic. 29 FRONTLINE CAPITAL GROUP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2002 (UNAUDITED) In April 2000, the Company entered into an office lease which expires in December, 2010. In January, 2001, the Company assigned the lease to HQ. The lease assignment did not relieve the Company of its payment obligations under the terms of its lease. On March 13, 2002, HQ commenced its bankruptcy cases by filing voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. On or about April 22, 2002, the landlord filed a Motion For Order Compelling Debtor HQ Global Workplaces, Inc. To Elect Whether To Assume Or Reject Unexpired Leases Of Non-Residential Real Property and Granting It Other Related Relief. On or about May 8, 2002, HQ filed an objection to the motion. Pursuant to an order dated April 9, 2002, the bankruptcy court in HQ's bankruptcy cases approved the debtors' rejection of the leases with the landlord. The debtors and landlord subsequently entered into a stipulation and agreed order resolving the landlord's motion, which was approved by the bankruptcy court on June 10, 2002. The landlord may seek to recover any further damages from FrontLine. The schedules, as amended, filed in FrontLine's bankruptcy case indicate that the landlord may hold a general, unsecured, non-priority claim against the Company for an unknown amount. This claim is scheduled as contingent, unliquidated and disputed. By order dated July 29, 2002, September 30, 2002 was established as the deadline for filing general claims in FrontLine's bankruptcy case. The Company also has potential liability under its indemnification of CarrAmerica for liabilities of Carr America under its guarantees relating to five HQ leases. In conjunction with the HQ Merger, FrontLine agreed to indemnify CarrAmerica for its guarantees of certain HQ leases. At December 31, 2001, HQ had $1.4 million in outstanding letters of credit associated with these 5 leases. Of the $57.6 million HQ restructuring charge recorded in 2001, a $2.3 million accrual applicable to this lease was recorded as an estimate for the cost of terminating these leases. As of December 31, 2001, the remaining lease commitments in excess of the existing letter of credit was $25.4 million. In addition to the cases set forth above, the Company and its investee entities are party to claims and administrative proceedings arising in the ordinary course of business or which are otherwise subject to indemnification, some of which are expected to be covered by liability insurance (subject to policy deductibles and limitations of liability) and all of which, including the cases discussed above, collectively are not expected to have a material adverse effect on the Company's financial position or results of operations. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the accompanying financial statements of FrontLine Capital Group (the "Company" or "FrontLine") and related notes thereto. The Company considers certain statements set forth in this Quarterly Report Form 10-Q to be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, with respect to the Company's expectations for future periods. Certain forward-looking statements involve certain risks and uncertainties. Although the Company believes that the expectations reflected in such forward-looking statements are based on reasonable assumptions, the actual results may differ materially from those set forth in the forward-looking statements and the Company can give no assurance that such expectations will be achieved. Certain factors that might cause the results of the Company to differ materially from those indicated by such forward-looking statements include, among other factors, an inability to extend and/or amend the terms of the Company's outstanding indebtedness and HQ Global Holdings Inc. ("HQ" or the "HQ Global Segment") indebtedness on terms that are favorable to the Company and its common stockholders, results of any recapitalization of HQ and its bankruptcy, negative changes in the officing solutions industry or the Internet-related businesses in which the unconsolidated companies in which we invest operate, a continued downturn in general economic conditions, increases in interest rates, a lack of capital availability, ability to satisfy financial covenants, competition, reduced demand or decreases in rental rates for executive office suites and other real estate-related risks such as the timely completion of projects under development, our inability to complete future strategic transactions, costs incurred in connection with strategic transactions and our dependence upon our key personnel and the key personnel of HQ and other risks detailed in FrontLine's reports and other filings made with the Securities and Exchange Commission. Consequently, such forward-looking statements should be regarded solely as reflections of the Company's current operating and development plans and estimates. These plans and estimates are subject to revision from time to time as additional information becomes available, and actual results may differ from those indicated in the referenced statements. 30 OVERVIEW AND BACKGROUND FrontLine is a holding company, with two distinct operating segments: one holds FrontLine's interest in HQ Global Workplaces, Inc., a company in the officing solutions market, and its predecessor companies ("HQ" or the "HQ Global Segment"), the other consists of FrontLine (parent company) ("FrontLine Parent") and its interests in a group of companies (the "Parent and Other Interests Segment") that provided a range of services. In October 2000, FrontLine announced that it would focus its resources and capital on the businesses within its existing portfolio and cease pursuing new investment activities. In conjunction with the Restructuring, FrontLine re-evaluated the carrying values of its investments and recorded aggregate impairment charges of $57.7 million through the year ended December 31, 2001 in order to reduce the carrying value of these investments to fair value. No subsequent impairment charges have been recorded. EFFECT OF VARIOUS ACCOUNTING METHODS ON RESULTS OF OPERATIONS The interests that FrontLine owns in its investee entities have historically been accounted for under one of three methods: consolidation, equity method and cost method. The applicable accounting method is generally determined based on the Company's voting interest and rights in each investee. Consolidation. Where the Company directly or indirectly owns more than 50% of the outstanding voting securities of an entity or controls the board of directors, the consolidation method of accounting is applied. Under this method, an entity's results of operations are reflected within the Company's Consolidated Statements of Operations. The entities whose results are consolidated by the Company are comprised of VANTAS Incorporated ("VANTAS") and effective with the June 1, 2000 merger (the "HQ Merger") of VANTAS with HQ Global Workplaces, Inc. ("Old HQ"), HQ Global. The entity representative of Old HQ and its predecessors, such as VANTAS, is referred to herein as HQ. (See Note 3 to the accompanying consolidated financial statements for further discussion). Participation of other shareholders in the earnings or losses of the consolidated entities is reflected in the caption "Minority interest" in the Consolidated Statements of Operations. Minority interest adjusts the consolidated net results of operations to reflect only the Company's share of the earnings or losses of the consolidated entities. To understand the Company's results of operations and financial position without the effect of the consolidation of HQ, Note 4 to the accompanying consolidated financial statements presents the balance sheets, statements of operations and cash flows of the Company without the consolidation of FrontLine's ownership interest in HQ. Equity Method. Investees whose results are not consolidated, but over whom the Company exercises significant influence, have been accounted for under the equity method of accounting. Cost Method. Investees not accounted for under either the consolidation or the equity method of accounting are accounted for under the cost method of accounting. Under this method, the Company's share of the earnings or losses of these companies is not included in the Consolidated Statements of Operations. Impairment charges recognized on cost method investments are included in "Equity in net loss and impairment of unconsolidated companies" in the accompanying Consolidated Statements of Operations. 31 RESULTS OF OPERATIONS The reportable segments in FrontLine's financial statements are the HQ Segment and the Parent and Other Interests Segment. The following discussion should be read in conjunction with the accompanying consolidated financial statements and notes thereto. HQ All of FrontLine's operating revenues and operating expenses for the three and six months ended June 30, 2002 and 2001 were attributable to HQ. The following is a discussion of HQ's results of operations for such periods. RESULTS OF CONTINUING OPERATIONS THREE MONTHS ENDED JUNE 30, 2002 AND 2001 Revenues. Total business center revenues for the three-month period ended June 30, 2002 were $83.5 million, representing a decrease in 2002 of $39.7 million, or 32.2%, compared to 2001. Business centers with three months of activity for both periods under comparison ("Same Centers") had revenues for the three-month period ended June 30, 2002 and 2001 of $82.4 million and $107.3 million, respectively, representing a decrease in 2002 of $24.9 million, or 23.2%, compared with 2001. The decrease in revenues in 2002 is attributable to a general decline in business performance. Reflective of the challenging macro-economic environment experienced throughout 2001 and into 2002, business centers experienced reduced demand and downward pricing pressure. Business centers that were closed subsequent to April 1, 2001 ("Closed Centers") had revenues for the three-month period ended June 30, 2002 and 2001 of $1.1 million and $15.9 million, respectively. Subsequent to April 1, 2001, the Company has ceased operations in approximately 75 business centers. Expenses. Total business center expenses for the three-month period ended June 30, 2002 were $74.4 million, representing a decrease of $26.6 million, or 26.3%, from the three-month period ended June 30, 2001. Business centers with three months of activity for both periods under comparison ("Same Centers") had expenses for the three-month period ended June 30, 2002 and 2001 of $72.6 million and $83.1 million, respectively, representing a decrease in 2002 of $10.5 million, or 12.6%, compared with 2001. The decrease is attributable to reduced bad debt expense, center general and administrative costs, as well as lower technology and business service expenses associated with the decline in related revenue, offset by certain normal lease increases. Business centers that were closed subsequent to April 1, 2001 ("Closed Centers") had expenses for the three-month period ended June 30, 2002 and 2001 of $1.8 million and $17.9 million, respectively. Business Center Operating Income ("BCOI"). For the three-month period ended June 30, 2002, BCOI was $9.1 million as compared with $22.1 million for three-month period ended June 30, 2001. The BCOI as a percentage of total revenues ("BCOI Margin") was 10.9% for the period ended June 30, 2002 as compared to 18.0% for 2001. The decrease in BCOI Margin is primarily attributable to lower revenues. 32 Same Center BCOI was $9.8 million and $24.2 million for the three-month periods ended June 30, 2002 and 2001, respectively, representing a decrease in 2002 of $14.4 million from 2001. The BCOI Margin from Same Centers for the three-month period ended June 30, 2002 was 11.9% as compared with 22.6% in the corresponding period in 2001. Closed Center BCOI was negative $0.7 million and negative $2.1 million for the three-month periods ended June 30, 2002 and 2001, respectively. Corporate General and Administrative Expenses. For the three- month periods ended June 30, 2002 and 2001, corporate general and administrative expenses were $9.5 million and $16.8 million, respectively. The three months ended June 30, 2001, contains $2.6 million of non-recurring expenses, consisting of costs associated with an abandoned merger and obtaining amendments to debt covenants. Excluding these charges, such expenses were 11.3% and 11.5%, respectively, of total revenue. Reorganization Charges. For the three-month periods ended June 30, 2002 and 2001, reorganization charges associated with HQ's bankruptcy filing were $4.4 million and zero, respectively. For the period ended June 30, 2002, reorganization charges consisted of professional fees. Restructuring Charges. For the three months ended June 30, 2002 and 2001, restructuring charges were $7.2 million and $11.3 million, respectively. For the periods ended June 30, 2002 and 2001, restructuring charges consist of center closure and employee severance costs. Depreciation and Amortization. For the three-month periods ended June 30, 2002 and 2001, depreciation and amortization expenses were $10.6 million and $18.2 million, respectively. The decrease in depreciation and amortization is attributable to the reduced carrying value of intangible and fixed assets due to impairment charges recorded in the second half of fiscal 2001. Interest Expense. For the three-month periods ended June 30, 2002 and 2001, net interest expense was $5.1 million and $10.5 million, respectively. The decrease in interest expense is due to ceasing to accrue interest on the Mezzanine Loan after March 13, 2002, the date of HQ's bankruptcy filing, and lower interest rates. Minority Interest. Minority interest was allocated income for the three-month period ended June 30, 2001 of $10.5 million. Subsequently, minority interest was eliminated due to the losses HQ incurred. DISCONTINUED OPERATIONS Income From Discontinued Operations. For the three-month period ended June 30, 2002, income from discontinued operations was $2.9 million, as compared to a loss of $0.5 million for the three-month period ended June 30, 2001. The period ended June 30, 2002 includes a gain of $5.4 million, resulting from the sale of certain assets of the discontinued operation in the United Kingdom for an amount in excess of their previously estimated net realizable values. Excluding this gain, loss from discontinued operations was $2.5 million for the three month ended June 30, 2002. 33 RESULTS OF CONTINUING OPERATIONS SIX MONTHS ENDED JUNE 30, 2002, COMPARED WITH SIX MONTHS ENDED JUNE 30, 2001 REVENUES. Total business center revenues for the six months ended June 30, 2002 were $172.0 million, representing a decrease of $88.5 million, or 34.0%, from the six months ended June 30, 2001. Business centers with six months of activity for both periods under comparison ("Same Centers") had revenues for the six months ended June 30, 2002 and 2001 of $165.2 million and $222.8 million, respectively, representing a decrease in 2002 of $57.6 million, or 25.9%, compared with 2001. The decrease in revenues in 2002 is attributable to a general decline in business performance. Reflective of the challenging macro-economic environment experienced throughout 2001 and into 2002, business centers experienced reduced demand and downward pricing pressure. Business centers that were closed subsequent to January 1, 2001 ("Closed Centers") had revenues for the six months ended June 30, 2002 and 2001 of $4.0 million and $36.6 million, respectively. Business centers opened subsequent to January 1, 2001 ("Development Centers") had revenues for the six months ended June 30, 2002 and 2001 of $2.8 million and $1.1 million, respectively. EXPENSES. Total business center expenses for the six months ended June 30, 2002 were $153.2 million, representing a decrease of $47.8 million, or 23.8%, from the six months ended June 30, 2001. Business centers with six months of activity for both periods under comparison ("Same Centers") had expenses for the six months ended June 30, 2002 and 2001 of $144.5 million and $163.1 million, respectively, representing a decrease in 2002 of $18.6 million, or 11.4%, compared with 2001. The decrease is attributable to reduced bad debt expense, center general and administrative costs, as well as lower technology and business service expenses associated with the decline in related revenue, offset by certain normal lease increases. Business centers that were closed subsequent to January 1, 2001 ("Closed Centers") had expenses for the six months ended June 30, 2002 and 2001 of $6.0 million and $36.2 million, respectively. Business centers opened subsequent to January 1, 2001 ("Development Centers") had expenses for the six months ended June 30, 2002 and 2001 of $2.8 million and $1.7 million, respectively. Business Center Operating Income ("BCOI"). For the six months ended June 30, 2002, BCOI was $18.8 million as compared with $59.5 million for 2001. The BCOI as a percentage of total revenues ("BCOI Margin") was 10.9% for the six months ended June 30, 2002 as compared to 22.8% for 2001. The decrease in BCOI Margin can be primarily attributed to lower revenues. Same Center BCOI was $20.8 million and $59.8 million for the six months ended June 30, 2002 and 2001, respectively, representing a decrease in 2002 of $39.0 million from 2001. The BCOI Margin from Same Centers for the six months ended June 30, 2002 was 12.6% as compared with 26.8% in the corresponding six months in 2001. Development Center BCOI was zero and negative $0.6 million for the six monthss ended June 30, 2002 and 2001, respectively. 34 Closed Center BCOI was negative $2.0 million and positive $0.4 million for the six months ended June 30, 2002 and 2001, respectively. Corporate General and Administrative Expenses. For the six months ended June 30, 2002 and 2001, corporate general and administrative expenses were $20.5 million and $32.9 million, respectively. The six months ended June 30, 2001 contain $2.6 million of non-recurring expenses. Excluding these charges, corporate general and administrative expenses were 11.9% and 11.5%, respectively, of total revenue. Reorganization Charges. For the six months ended June 30, 2002 and 2001, reorganization charges associated with HQ's bankruptcy filing were $14.2 million and zero, respectively. For the six months ended June 30, 2002, reorganization charges consisted of professional fees of $8.1 million and a write-off of $6.1 million of deferred financing costs associated with the Company's Mezzanine Loan. Restructuring Charges. For the six months ended June 30, 2002 and 2001, restructuring charges were $7.2 million and $11.3 million, respectively. The charges related to center closure and employee severance costs. Deprecation and Amoritization. For the six months ended June 30, 2002 and 2001, depreciation and amortization expenses were $21.3 million and $36.2 million, respectively. The decrease in depreciation and amortization is attributable to the reduced carrying value of intangible and fixed assets due to impairment charges recorded in the second half of fiscal 2001. Interest Expense. For the six months ended June 30, 2002 and 2001, net interest expense was $13.9 million and $23.3 million, respectively. The decrease in interest expense is due to ceasing to accrue interest on the Mezzanine Loan after March 13, 2002, the date of HQ's bankruptcy filing, and lower interest rates. Minority Interest. Minority interest was allocated income for the six month period ended June 30, 2001 of $9.0 million. Subsequently, minority interest was eliminated due to the losses HQ incurred. DISCONTINUED OPERATIONS Income (Loss) from Discontinued Operations. For the six months ended June 30, 2002, income from discontinued operations was $3.0 million, as compared to $0.7 million for the six months ended June 30, 2001. The period ended June 30, 2002 includes a gain of $5.4 million, resulting from the sale of certain assets of the discontinued operation in the United Kingdom for an amount in excess of their previously estimated net realizable values. Excluding this gain, loss from discontinued operations was $2.4 million for the six months ended June 30, 2002. PARENT AND OTHER INTERESTS THREE AND SIX MONTHS ENDED JUNE 30, 2002 AND 2001 As a result of the Restructuring discussed above, FrontLine has changed from a company which invested in early stage companies which leveraged the Internet into one which is focused on highlighting the value of HQ. The restructuring costs recognized in the three and six month periods ended June 30, 2002 were $0.1 million and $0.3 million, respectively, and consisted principally of professional fees and other expenses. 35 FrontLine's general and administrative expenses were $0.4 million and $1.0 million during the three and six months period ended June 30, 2002, respectively, compared with $0.7 million and $2.6 million for the corresponding periods in 2001 reflecting the planned reduction in workforce and the resulting lower recurring general and administrative expenses in connection with the Restructuring. A significant portion of FrontLine's net loss is derived from companies in which it held minority ownership interests. The equity in net loss and impairment of unconsolidated companies decreased $0.4 million and $10.0 million for the three and six month periods ended June 30, 2002, respectively, as compared with the corresponding period in 2001. The equity in net loss and impairment of unconsolidated companies in the 2002 quarter consisted of $1.0 million of equity in net loss of unconsolidated companies. The impairment charges in 2001 were determined in recognition of specific unfavorable developments affecting these companies as well as the continuing difficult market conditions experienced during such period. The loss for 2001 was comprised of $9.4 million of impairment charges reflecting the estimated decreases in the fair values of certain of the Company's investments and $2.5 million of equity in net loss, both partially offset by a $0.5 million gain on the sale of the stock received as consideration for the December 2000 sale of EmployeeMatters, Inc (see Note 4). Dividends on, and accretion of, preferred stock of $0.7 million and $1.4 million in the three and six month period respectively, ended June 30, 2002 represents dividends on FrontLine's 8.875% Series A Convertible Cumulative Preferred Stock (the "Series A Stock"), which was issued in the first quarter of 2000 and accretion of FrontLine's Series B Convertible Cumulative Preferred Stock which was issued in the fourth quarter of 2000. Such amount in the three and six month period ended June 30, 2001 of $1.0 million and $3.9 million, respectively, represents dividends on the Series A Stock and accretion of the Series B Stock. LIQUIDITY AND CAPITAL RESOURCES HQ On March 13, 2002, HQ filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware (the "Court"). HQ continues to operate and manage their properties as debtors-in-possesssion during the Chapter 11 proceeding. HQ anticipates proposing a plan of reorganization in accordance with the federal bankruptcy laws as administered by the Court. In connection with HQ's bankruptcy proceeding, HQ received a commitment for a $30.0 million credit facility ("Debtor-in-Possession Facility"), with borrowings permitted through December 31, 2002 for up to nine months in accordance with certain operating and liquidity covenants. Any borrowings, of which there have been none, will incur interest at Prime plus 3.0%. There can be no assurance as to HQ's ability to execute its business plan and meet its obligations with respect to its Debtor-in-Possession Facility. The availability of additional capital and the ultimate recapitalization of HQ to permit it to confirm a plan of reorganization and emerge from bankruptcy protection is subject to numerous factors, including some that are beyond HQ's control. In the event HQ is unable to access additional capital or secure a confirmed plan of reorganization, no assurance can be given that HQ will be able to meet its future cash requirements. FRONTLINE On June 12, 2002, FrontLine filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). The Company remains in possession of its assets and properties, and continues to operate its business and manage its property as a debtor-in-possession under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the United States Bankruptcy Code. 36 The Company anticipates proposing a plan of reorganization in accordance with the federal bankruptcy laws as administered by the Bankruptcy Court. Confirmation of a Plan of reorganization could materially change the amounts currently recorded in the financial statements. The financial statements do not give effect to any adjustment to the carrying value of assets, or amounts and classifications of liabilities that might be necessary as a consequence of this matter. Historically, FrontLine has funded operations and investing activities through a combination of borrowings under various credit facilities, issuances of the Company's equity securities and sales of assets. Since the Restructuring, FrontLine's cash requirements have been substantially reduced. As of June 30, 2002, there is no remaining availability under any FrontLine credit facility. The Company has a credit facility with Reckson in the amount of $100 million (the "FrontLine Facility"). Additionally, Reckson Strategic has a $100 million facility (the "Reckson Strategic Facility") with Reckson to fund Reckson Strategic investments. Note 10 to the consolidated financial statements summarizes the terms of the FrontLine Facility and Reckson Strategic Facility (collectively, the "Credit Facilities"). The Company had $93.4 million outstanding under the FrontLine Facility at June 30, 2002, and due to outstanding letters of credit and accrued interest, has no remaining availability. The Company had $49.3 million outstanding under the Reckson Strategic Facility at June 30, 2002. These borrowings were utilized to fund Reckson Strategic investments and its general operations. As long as there are outstanding amounts under the Credit Facilities, the Company is prohibited from paying dividends on shares of its common stock or, subject to certain exceptions, incurring additional debt. The Credit Facilities are subject to certain other covenants and prohibit advances thereunder to the extent the advances could, in Reckson's determination, endanger the status of Reckson Associates as a REIT. Under the Credit Facilities, additional indebtedness may be incurred by the Company's subsidiaries. The Credit Facilities also contain covenants prohibiting the Company from entering into any merger, consolidation or similar transaction and from selling all or any substantial part of its assets, or allowing any subsidiary to do so, unless approved by the lender. The Credit Facilities also provide for defaults thereunder in the event debt is accelerated under another of FrontLine's financing agreements. On March 28, 2001, the Company's Board of Directors approved amendments to the Credit Facilities pursuant to which (i) interest is payable only at maturity and (ii) Reckson may transfer all or any portion of its rights or obligations under the Credit Facilities to its affiliates. These changes were requested by Reckson as a result of changes in REIT tax laws. In addition, the Reckson Strategic Facility was amended to increase the amount available thereunder to up to $110 million (from $100 million). On September 11, 2000, FrontLine amended its $25.0 million credit agreement (the "FrontLine Bank Credit Facility"). Borrowings under the FrontLine Bank Credit Facility are secured by a 20.51% common ownership interest in HQ and bear interest at the Prime rate plus 2%. Any outstanding borrowings under the FrontLine Bank Credit Facility were due on October 25, 2001, as a result of various extensions exercised by FrontLine in May 2001. At September 30, 2001, FrontLine had fully borrowed the FrontLine Bank Credit Facility. The FrontLine Bank Credit Facility provides for a default thereunder in the event debt is accelerated under another of FrontLine's financing agreements or if there is a default under certain HQ financing agreements. The FrontLine Bank Credit Facility contains, among others, covenants relating to the financial ratios of HQ and covenants prohibiting the Company from (i) transferring, conveying, disposing of, pledging or granting a security interest in any of the collateral previously pledged under the FrontLine Bank Credit Facility, (ii) terminating, amending or modifying any organizational or other governing documents of the Company or HQ without first obtaining the lender's prior written consent, (iii) violating certain specified financial ratios, (iv) exceeding $25,000,000 of new indebtedness, and (v) declaring or paying cash dividends on any class of the Company's stock. Subsequent to December 31, 2001, the Company has not repaid the principal or paid any interest applicable to this period and accordingly is at the forbearance of the bank. There is no remaining availability under the Credit Facilities. As a result of the Company's failure to pay the principal and interest upon maturity on the FrontLine Bank Credit Facility, an event of default has occurred under the credit facilities with Reckson. 37 During the three months ended March 31, 2000, the Company completed preferred stock offerings of 26,000 shares of Series A Preferred Stock at a price of $1,000 per share with net proceeds of $24.6 million. These shares are convertible into the Company's common stock at a price of $70.48. The Company did not declare or pay the quarterly dividend due on these shares commencing with the payment that was due on November 6, 2001. Accordingly, future dividends will accrue at a higher rate of 10.875%. Since dividend distributions are in arrears for more than two quarterly periods, then the holders of such shares are entitled to elect two additional members to the Company's Board of Directors. While the Company's $25 million of Series B Preferred Stock is outstanding, the holders have consent rights for certain significant transactions, including the incurrence of additional debt by the Company or HQ, the issuance of equity securities senior to, or on a parity with, the Series B Preferred Stock or the issuance by HQ of preferred stock. These securities also contain certain covenants relating to HQ. In addition, the securities include a redemption premium of 27.5%. Since securities were not redeemed prior to December 13, 2001, the securities (including the amount of the redemption premium) have become convertible at the holder's option into FrontLine common stock at the initial rate of $13.3875 per share, the preferred stock has become a voting security on an "as-converted" basis, and quarterly dividends have become payable from the date of initial issuance at the annual rate of 9.25%. In addition, since the Company did not pay the dividend on the Series B Preferred Stock in December 2001, the holders of such stock have the right to vote on an "as converted" basis on any matters that holders of common stock are permitted to vote upon and to elect two members to the Company's Board of Directors. Securities have a mandatory redemption requirement at a 27.5% premium, which has been triggered as a result of uncured events of default. In addition, the consent of two-thirds of the holders of the Company's Series A Preferred Stock is necessary in order to issue any equity securities ranking senior to the Series A Preferred Stock. The Company is also prohibited from paying dividends on its common stock unless full distributions have been paid on both the Series A Preferred Stock and Series B Preferred Stock. The Company is in arrears with regard to the payment of dividends on its Series A and Series B Preferred Stock. Currently, the Company has a short-term letter of credit in the amount of $0.2 million, which is being utilized as a security deposit. The Company has entered into a stockholders agreement (the "HQ Stockholders Agreement") with certain of the stockholders of HQ Global which provides them with rights to put up to approximately 3.1 million shares of HQ Global (the "HQ Shares") to the Company during the two years subsequent to the HQ Merger if HQ Global has not completed an initial public offering of its shares. On February 25, 2002, such stockholders irrevocably waived their Put Rights. FrontLine's operations do not require significant capital expenditures. There were no significant capital expenditure commitments as of June 30, 2002. There can be no assurance as to the Company's ability to execute its business plan and to meet its obligations with respect to its credit facilities. If additional funds are raised through the issuance of equity securities, existing shareholders may experience significant dilution. The availability of additional capital is subject to numerous factors including some that are beyond the Company's control. In the event the company is unable to access additional capital, no assurance can be given that it will be able to meet its future cash requirements. 38 The Company has formed a committee of its Board of Directors, comprised solely of the independent directors of the Board, in order to address conflicts that may arise in connection with the Company's credit facilities with Reckson Operating Partnership. The committee has retained legal counsel in connection with its responsibilities. In March 2002, the Company's stock was delisted by Nasdaq as a direct result of the HQ bankruptcy filing. The Company's common stock currently trades on the OTC Bulletin Board under the symbol FLCGQ. INFLATION HQ Certain of HQ's leases include increases in annual rent based on changes in the consumer price index or similar inflation indices. HQ's contracts with clients generally range from six to twelve months in duration. Accordingly, HQ may have the ability to pass on any inflation related increased costs at the time of renewal of such contracts. FrontLine Management believes that inflation did not have a significant effect on its results of operations during any of the periods presented. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK HQ The primary market risk facing HQ is interest rate risk on the HQ Credit Facility. HQ mitigates this risk by entering into hedging instruments on a portion of its outstanding balances. In addition, HQ may elect to enter into LIBOR contracts on portions of the HQ Credit Facility, which locks in the interest rate on those portions for 30, 60 or 90-day periods. The HQ Credit Facility bears interest ranging from either 3.25% to 4.00% over applicable LIBOR, or alternatively 2.25% to 3.00% over prime, generally at HQ's election. As of June 30, 2002, HQ had hedged the interest rates on approximately $103.5 million of the HQ Credit Facility using various instruments with various expiration dates through September 30, 2002. These instruments lock in the maximum underlying three-month LIBOR at levels between 7.93% and 9.00%. An increase in interest rates will have a negative impact on the net income of HQ due to the variable interest component of the HQ Credit Facility. Based on current interest rate levels, a 10% increase in underlying interest rates will have a 4.4% increase in interest expense, ignoring the short-term impact of remaining terms under current LIBOR hedge contracts. Following the HQ Merger, HQ is conducting more of its operations in foreign currencies, primarily the British Pound. Due to the nature of foreign currency markets, there is potential risk for foreign currency losses as well as gains. Currently, HQ has not hedged its foreign currency risk. 39 HQ has not, and does not plan to, enter into any derivative financial instruments for trading or speculative purposes. As of June 30, 2002, HQ had no other material exposure to market risk. FRONTLINE Interest Rate Risk FrontLine faces interest rate risk on its Credit Facilities and the FrontLine Bank credit Facility. The Company has not hedged interest rate risk using financial instruments. The Credit Facilities bear interest at the greater of the prime rate plus 2% or 12% (with interest on balances outstanding more than one year increasing by 4% of the previous year's rate). The FrontLine Bank Credit Facility bears interest at LIBOR plus 5% for one, two, three or six-month interest periods as elected by FrontLine. The rates of interest on the Credit Facilities and the FrontLine Bank Credit Facility will be influenced by changes in the prime rate and LIBOR. A significant increase in interest rates may have a negative impact on the financial results of the Company due to the variable interest rate (in excess of 12%) under the Credit facilities. The following table sets forth FrontLine's obaigations with respect to the Credit Facilities and the FrontLine Bank Credit Facility, principal cash flows by scheduled maturity, weighted average interest rates and estimated fair market value at June 30, 2002 (in thousands, except rates).

Equity Market Risk FrontLine faces equity market risk in its ownership interests in its unconsolidated companies. During the fourth quarter of the year ended December 31, 2000 and the first quarter of 2001, FrontLine recognized impairment charges to reflect decreased valuations for certain of its investments as a result of unfavorable market conditions and other factors (see Note 4 to the accompanying consolidated financial statements for further discussion). As a result of such impairment charges, along with the recognition of FrontLine's equity in the net losses of certain ownership interests, the carrying value of FrontLine's ownership interests in and advances to unconsolidated companies, at June 30, 2002 was $12.3 million, approximately 5% of total assets, thereby mitigating FrontLine's future equity market risk related to these interests. PART II. OTHER INFORMATION Item 1. Legal Proceedings Reference is made to the lawsuit captioned OmniOffices, Inc. et al. v. Joseph Kaidanow et al. set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. In connection with such litigation, on September 12, 2001, without holding oral argument, the Court denied Plaintiffs' motion for summary judgment, but granted the Defendants' cross-motion for summary judgment. Plaintiffs and the directors of old HQ filed a Notice of Appeal in October 2001. On February 15, 2002, the D.C. Circuit announced that oral argument was scheduled for January 16, 2003. In March 2002, the D.C. Circuit referred the appeal to its Appellate Mediation Program. On April 24, 2002, HQ filed a notice of bankruptcy stay in respect of its March 13, 2002 Chapter 11 filing. HQ informed the D.C. Circuit that the appeal was stayed as to HQ pursuant to the automatic stay provisions of the U.S. Bankruptcy Code. 40 Reference is made to the lawsuit captioned Joseph Kaidanow and Robert Arcoro v. CarrAmerica Realty Corporation, HQ Global Workplaces, Inc., Thomas A. Carr, Philip L. Hawkins, C. Ronald Blankenship, Oliver T. Carr, and Gary Kusin set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. In connection with such litigation, on March 8, 2002, Plaintiffs filed a motion for leave to amend their complaint to add, inter alia, a breach of warrant agreements claim against HQ and other claims against FrontLine. On March 15, 2002, HQ filed a notice of bankruptcy stay, stemming from its March 13, 2002 voluntary petition for Chapter 11 bankruptcy protection in the United States Bankruptcy Court for the District of Delaware (the "Delaware Bankruptcy Court"). HQ informed the Court that the consolidated action was stayed as to HQ pursuant to the automatic stay provisions of the Bankruptcy Code. Co-defendent CarrAmerica Realty Corporation filed a motion requesting that, in light of HQ's bankruptcy, the consolidated motion be stayed as to all defendants. At a status conference held on March 25, 2002, the Vice Chancellor ordered the parties to work out a scheduling order for the briefing of the motion regarding the stay of the proceedings. A hearing on this motion is scheduled for September 9, 2002. The former director co-defendants in the consolidated action separately filed an adversary proceeding in the Delaware Bankruptcy Court seeking to stay the consolidated action as to the former directors. After a hearing on June 25, 2002, the Delaware Bankruptcy Court denied the requested relief. On or about October 3, 2001, Burgess Services, LLC ("Burgess Services"), Dominion Venture Group, LLC ("Dominion Venture Group") and certain affiliated parties commenced an action in Oklahoma State Court against Reckson Strategic Venture Partners, LLP ("RSVP"), Reckson Associates Realty Corp. ("Reckson"), and RAP-Dominion LLC ("RAP-Dominion"), a joint venture through which RSVP and Reckson invested in a venture with certain of the plaintiffs. On April 10, 2002, the litigation was settled without liability on the part of the Company or the defendant. In connection with the settlement, the joint venture will be terminated. As a result of this settlement, the Company determined that no further impairment was necessary on its carrying value in its investment in Reckson Strategic. In April 2000, the Company entered into an office lease which expires in December, 2010. In January, 2001, the Company assigned the lease to HQ. The lease assignment did not relieve the Company of its payment obligations under the terms of its lease. On March 13, 2002, HQ commenced its bankruptcy cases by filing voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. On or about April 22, 2002, the landlord filed a Motion For Order Compelling Debtor HQ Global Workplaces, Inc. To Elect Whether To Assume Or Reject Unexpired Leases Of Non-Residential Real Property and Granting It Other Related Relief. On or about May 8, 2002, HQ filed an objection to the motion. Pursuant to an order dated April 9, 2002, the bankruptcy court in HQ's bankruptcy cases approved the debtors' rejection of the leases with the landlord. The debtors and landlord subsequently entered into a stipulation and agreed order resolving the landlord's motion, which was approved by the bankruptcy court on June 10, 2002. The landlord may seek to recover any further damages from FrontLine. The schedules, as amended, filed in FrontLine's bankruptcy case indicate that the landlord may hold a general, unsecured, non-priority claim against the Company for an unknown amount. This claim is scheduled as contingent, unliquidated and disputed. By order dated July 29, 2002, September 30, 2002 was established as the deadline for filing general claims in FrontLine's bankruptcy case. The Company also has potential liability under its indemnification of CarrAmerica for liabilities of Carr America under its guarantees relating to five HQ leases. In conjunction with the HQ Merger, FrontLine agreed to indemnify CarrAmerica for its guarantees of certain HQ leases. At December 31, 2001, HQ had $1.4 million in outstanding letters of credit associated with these 5 leases. Of the $57.6 million HQ restructuring charge recorded in 2001, a $2.3 million accrual applicable to this lease was recorded as an estimate for the cost of terminating these leases. As of December 31, 2001, the remaining lease commitments in excess of the existing letter of credit was $25.4 million. Item 2. Changes in Securities and Use of Proceeds Item 3. Defaults Upon Senior Securities (i) HQ. HQ has received notice from the lenders under its senior credit agreement (the "Credit Agreement") that it is in default with respect to certain of its covenant and payment obligations under such agreement. On September 30, 2001, HQ elected not to make the principal amortization payment of $4.1 million due and payable under the Credit Agreement. On November 1, 2001, HQ entered into a forbearance agreement (the "Agreement"), effective as of October 1, 2001, with the lenders party to the Credit Agreement, wherein the lenders have agreed for a certain period of time to forbear from the enforcement of their remedies under the Credit Agreement with respect to HQ's default. For additional information regarding this matter, see "Note 5 -Notes Payable" to the Company's financial statements included elsewhere in this report, which note is incorporated by reference into this item. 41 On September 30, 2001, HQ elected not to make the interest payment due and payable with respect to its $125 million senior subordinated credit facility (the "Mezzanine Loan") in the amount of $4.2 million. For additional information regarding this matter, see "Note 5 - Notes Payable" to the Company's financial statements included elsewhere in this report, which note is incorporated by reference into this item. (ii) FrontLine. The Company failed to repay the $25 million of principal and $0.2 million of interest due under the Company's $25 million secured credit facility, which matured on October 25, 2001. The Company is currently in negotiations to further extend the maturity of this facility. For additional information regarding this matter see "Note 5 - Notes Payable" to the Company's financial statements included elsewhere in this report, which note is incorporated by reference into this item. As a result of the Company's failure to pay the principal and interest under the senior facility when due, an event of default has occurred under the Company's credit facilities with Reckson Operating Partnership, L.P. For additional information regarding this matter, see "Note 11 - Transactions with Related Parties" to the Company's financial statements included elsewhere in this report, which note is incorporated by reference into this item. On February 6, 2002, the Company elected not to make the dividend payment due on the Company's Series A convertible cumulative preferred stock in the aggregate amount of $0.6 million. As a result of the failure to make the dividend payment, dividends on the Series A preferred stock will accrue quarterly at the rate of 10.875%. If dividends are in arrears for more than two quarterly periods, the holders of the Series A preferred stock will be entitled to elect two additional members to the Company's Board of Directors. Dividends on the Company's Series A preferred stock are cumulative, and therefore, all accrued and unpaid dividends on the Company's Series A preferred stock must be paid in full prior to commencing the payment of cash dividends on the Company's common stock. Item 4. Submission of Matters to a Vote of Securities Holders--None Item 5. Other Information--None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 99.1 Certification of Scott H. Rechler, President and Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Sectin 906 of the Sarbanes-Oxley Act of 2002 99.2 Certification of James D. Burnham, Chief Financial Officer and Treasurer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) During the three months ended June 30, 2002, the Registrant filed the following reports: On April 30, 2002, the Registrant filed an amendment to its Annual Report on Form 10-K/A to report the information required by Items 10 to 13 of Form 10-K. On May 15, 2002, the Registrant submitted a Quarterly Report on Form 10-Q to report financial results for the quarter ended March 31, 2002. On June 26, 2002, the Registrant submitted a Current Report on Form 8-K to report the Registrant's filing a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. 42 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FRONTLINE CAPITAL GROUP By: \s\ Scott H. Rechler ------------------------------------------------------- Scott H. Rechler, President and Chief Executive Officer (Principal Executive Officer) By: \s\ James D. Burnham ------------------------------------------------------- James D. Burnham, Chief Financial Officer and Treasurer (Chief Accounting Officer) 43

FRONTLINE CAPITAL GROUP 10-Q