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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 29, 1999
REGISTRATION NO. 333-68995
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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PRE-EFFECTIVE AMENDMENT NO. 1
TO
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
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MEGO MORTGAGE CORPORATION
(Exact name of Registrant as specified in its charter)
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DELAWARE 6162 88-0286042
(State or other jurisdiction of (Primary standard industrial (I.R.S. employer
incorporation or organization) classification code number) identification number)
</TABLE>
1000 PARKWOOD CIRCLE, SUITE 600
ATLANTA, GEORGIA 30339
(770) 952-6700
(Address, including zip code, and telephone number, including area code, of
Registrant's principal executive offices)
---------------------
J. RICHARD WALKER
1000 PARKWOOD CIRCLE, SUITE 600
ATLANTA, GEORGIA 30339
(770) 952-6700
(Name, address, including zip code, and telephone number, including area code,
of agent for service)
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COPIES TO:
JOHN D. CAPERS, JR.
KING & SPALDING
191 PEACHTREE STREET
ATLANTA, GEORGIA 30303-1763
(404) 572-4600
Approximate date of commencement of proposed sale to the public: As soon
as practicable after the effective date of this Registration Statement.
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box: [X]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier registration statement for the same
offering. [ ] __________
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ] __________
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [ ]
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THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933, AS AMENDED OR UNTIL THIS REGISTRATION STATEMENT
SHALL BECOME EFFECTIVE ON SUCH DATE AS THE SECURITIES AND EXCHANGE COMMISSION,
ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE.
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MEGO MORTGAGE CORPORATION
1000 PARKWOOD CIRCLE
SUITE 600
ATLANTA, GEORGIA 30339
(770) 952-6700
70,688,838 SHARES OF COMMON STOCK, PAR VALUE $.01 PER SHARE
This prospectus describes Mego Mortgage Corporation and the sale of shares of
our common stock that:
- are owned by certain of our stockholders or
- may be acquired by certain of our stockholders, if they convert their
shares of our Series A convertible preferred stock into shares of our
common stock or
- may be acquired by certain of our optionholders upon exercise of their
options to purchase common stock.
We will not receive any of the proceeds from the sale of these shares of common
stock. The holders of the common stock will determine if, and when, these shares
will be sold and will receive the proceeds from these sales.
We are a specialized consumer finance company that funds, purchases, makes and
sells consumer loans secured by deeds of trust on one-to-four family residences.
These loans primarily are used to purchase one-to-four family residences,
refinance existing mortgages, consolidate debt and/or finance home improvements.
THIS INVESTMENT INVOLVES A HIGH DEGREE OF RISK. SEE "RISK FACTORS"
BEGINNING ON PAGE 14.
The common stock is traded on the Nasdaq Stock Market under the symbol
"MMGC."
Closing sale price on January 28, 1999: $0.50
Neither the Securities and Exchange Commission nor any state securities
commission has approved the securities offered by this prospectus. These
organizations have not determined if this prospectus is truthful or complete. It
is illegal for any person to tell you otherwise.
This prospectus is dated February 2, 1999.
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TABLE OF CONTENTS
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PAGE
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Prospectus Summary.............. 5
Risk Factors.................... 14
Significant Deterioration in
Our Financial Condition Due
to Losses in Fiscal 1998... 14
Risks Associated with
Implementing Our New
Strategic Plan............. 15
Risks Associated with New
Management Team............ 16
Liquidity Risks............... 16
Performance of Future
Acquisitions............... 18
Risks Associated with Mortgage
Backed Securities.......... 18
Risks from the Sale of
Servicing Rights........... 20
Interest Rate Risks........... 21
Risk of Variations in
Quarterly Operating
Results.................... 22
Risks Associated with
Delinquencies and Defaults
on Loans................... 22
Risks Associated with Title I
Loans Backing Our Mortgage
Related Securities......... 23
Risks Associated with Existing
Equity + Loans............. 23
Litigation; Risk of Claims.... 24
Concentration of Operations... 24
Competition................... 24
Volatility of Stock Price..... 25
Risk of Failing to Comply with
the Listing Requirements of
the Nasdaq Stock Market.... 26
Factors Inhibiting Takeover;
Effect of Change of
Control.................... 26
Legislative and Regulatory
Risks...................... 26
Environmental Risks........... 27
Year 2000..................... 27
Shares Eligible for Future
Sale....................... 28
Use of Proceeds................. 29
Dividend Policy................. 29
Price Range of Common Stock..... 29
Capitalization.................. 30
Selected Financial Data......... 31
</TABLE>
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Management's Discussion and
Analysis of Financial
Condition and Results of
Operations.................... 34
General....................... 34
Securitization Transactions... 35
Results of Operations......... 42
Liquidity and Capital
Resources.................. 58
Quantitative and Qualitative
Disclosure About Market
Risk....................... 61
Effects of Changing Prices and
Inflation.................. 62
Recent Accounting
Pronouncements............. 62
Impact of Year 2000 Issue..... 64
Special Cautionary Notice
Regarding Forward-Looking
Statements................. 66
The Recapitalization............ 67
General....................... 67
Private Placements............ 67
Exchange Offer................ 68
Management.................... 68
Transactions with Strategic
Partners................... 68
Business........................ 70
General....................... 70
Strategic Initiatives......... 72
Mortgage Industry............. 73
Company Loan Products......... 74
Lending Operations............ 75
Loan Processing and
Underwriting............... 79
Quality Control............... 81
Technology Systems............ 82
Loan Servicing................ 82
Sale of Loans................. 85
Competition................... 86
Government Regulation......... 88
Seasonality................... 89
Employees..................... 89
Properties.................... 89
Legal Proceedings............. 89
Recent Developments........... 90
Management...................... 92
Directors and Executive
Officers................... 92
Executive Compensation........ 94
Employment Agreements......... 96
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Company Stock Option Plans.... 97
Compensation Committee
Interlocks and Insider
Participation.............. 98
Principal Stockholders.......... 99
Selling Stockholders............ 101
Certain Transactions............ 103
Relationship with Greenwich... 103
Tax Sharing and Indemnity
Agreement.................. 103
Management Services Agreement
with PEC................... 103
Sub-Servicing Agreement with
PEC........................ 104
Funding and Guarantees by Mego
Financial.................. 104
Relationships with FBR........ 105
The Recapitalization.......... 105
Description of Notes............ 106
General....................... 106
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Registration Rights........... 106
Description of Capital Stock.... 107
General....................... 107
Common Stock.................. 107
Preferred Stock............... 107
Certain Provisions of Delaware
Law........................ 108
Certain Charter and Bylaw
Provisions................. 108
Registration Rights........... 109
Transfer Agent................ 109
Shares Eligible for Future
Sale.......................... 110
Plan of Distribution............ 111
Where You Can Find More
Information................... 112
Legal Matters................... 112
Experts......................... 112
Index to Financial Statements... F-1
</TABLE>
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PROSPECTUS SUMMARY
Because this is a summary, it does not contain all the information that may
be important to you. You should read the entire prospectus carefully before you
purchase shares of our common stock. Unless otherwise indicated, all information
in this prospectus gives effect to a 1,600-for-1 stock split that occurred in
October 1996.
THE COMPANY
Mego Mortgage Corporation is a specialized consumer finance company that
funds, purchases, makes and sells consumer loans secured by deeds of trust on
one-to-four family residences. Historically, we have retained the right to
service a substantial portion of the loans we have sold. Our borrowers generally
do not qualify for traditional "A" credit mortgage loans. Typically, their
credit histories, income or other factors do not conform to the lending criteria
of government-chartered agencies that traditional lenders rely on in evaluating
whether to make loans to potential borrowers.
Our loan products are:
- First mortgage loans and home equity loans (which we call "Home Equity
loans") that typically are secured by first liens, and in some cases by
second liens, on the borrowers' residence. In making Home Equity loans,
we rely primarily on the appraised values of the borrowers' residences.
We determine the loan amount based on the appraised values and the
creditworthiness of the borrowers. These loans generally are used to
purchase residences and refinance existing mortgages.
- High loan-to-value loans (which we call "Equity + loans") that are based
on the borrowers' credit. These loans typically are secured by second
liens on the borrowers' primary residences. The initial amount of an
Equity + loan, when added to other outstanding senior or secured debt on
the residences, resulted in a combined loan-to-value ratio that averaged
112% during fiscal 1997 and 1998. The loan-to-value ratio on these loans
may be as high as 125%. These loans generally are used to consolidate
debt and make home improvements.
Our loans are produced by our wholesale and retail divisions.
<TABLE>
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WHOLESALE DIVISION RETAIL DIVISION
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<S> <C> <C> <C>
- - underwrites and funds loans - makes loans directly to
originated by a network of pre- consumers charging loan fees to
approved mortgage brokers the borrowers that should
offset our total cost of making
the loans
- - purchases closed loans,
historically at a premium (100%
or more of the loans' principal
amount), from a nationwide
network of independent mortgage
bankers and other qualified
financial intermediaries
</TABLE>
5
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Since we made our first loan in March 1994, we have substantially changed
our business strategy. In addition, we have made further substantial changes in
our business strategy since consummation of a recapitalization in July 1998,
which is described below. The timeline below summarizes the changes in our
business.
TIME PERIOD ACTION
From March 1994 through
May 1996 We purchased home improvement contracts and
closed loans insured under the Title I credit
insurance program of the Federal Housing
Administration ("Title I loans") from mortgage
bankers and home improvement contractors.
May 1996 We began purchasing Equity + loans from mortgage
bankers.
March 1996 through August
1997 We sold substantially all of the loans we
purchased in securitization transactions. These
securitization transactions resulted in
substantial negative cash flow, because the cash
proceeds from the sale of the loans were
substantially less than our total cost of
producing the loans sold.
September 1997 We established a retail division that began
making Equity + loans directly to consumers.
December 1997 We began making Home Equity loans, through our
retail division, directly to consumers.
Through our wholesale division, we began funding
Equity + and Home Equity loans originated by
brokers.
January through June 1998 We substantially reduced our loan production
(fundings and purchases) because our warehouse
lender stopped making advances on our warehouse
line of credit after we violated certain
borrowing agreements with our warehouse lender.
We had used these advances to fund new loan
production. We funded and purchased $68.8
million of loans from January through June 1998
as compared to $312.0 million of loans in
January through June 1997.
We implemented cost savings primarily through a
32% personnel reduction initiated in January
1998. We closed our dealer division, which
traditionally had purchased Title I and Equity +
loans from our network of home improvement
contractors.
We substantially increased the sale of our loan
portfolio to generate cash to repay outstanding
indebtedness under our warehouse line, to pay
general and administrative expenses for
personnel retention and to maintain
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our systems while we explored alternatives for
raising new capital.
May 1998 Our independent auditors expressed substantial
doubt about our ability to continue as a going
concern.
July 1, 1998 We completed a recapitalization (described
below), which raised approximately $84.5 million
in additional equity.
By using the $50.0 million in cash proceeds from
the recapitalization, we began to increase the
funding and purchase of mortgage loans. We
produced $1.7 million of mortgage loans in July
and August 1998.
September 1998 A liquidity shortage and a focus by the buyers
of asset backed bonds on U.S. treasury
securities impacted the specialty finance
industry.
October 1998 We adjusted our strategic initiatives (described
below), which are designed to return us to a
positive cash flow position and to
profitability.
We produced $1.1 million of mortgage loans in
October.
THE RECAPITALIZATION
We have historically operated on a negative cash flow basis, funding the
deficits principally from borrowings. In addition, during fiscal 1998 we were
required to write down the value of our mortgage related securities, which
resulted in substantial losses. These losses caused us to violate certain
covenants contained in agreements with our lenders, restricting our ability to
borrow money to fund new loans prior to their sale. Beginning in January 1998,
these events caused us to reduce substantially our loan production, liquidate
our loan portfolio, reduce our borrowings and seek additional capital to
continue in operation. On July 1, 1998, we completed our recapitalization, as
described below.
Private Placements - We sold an aggregate of 25,000 shares of
Series A convertible preferred stock for a
price of $1,000 per share.
- We sold 16.67 million shares of common stock
for a price of $1.50 per share.
- We issued $41.5 million principal amount of
new 12 1/2% subordinated notes (the "Current
Notes") and 37,500 shares of Series A
convertible preferred stock in exchange for
$79.0 million principal amount of 12 1/2%
subordinated notes sold in November 1996 and
October 1997 (collectively, the "Old Notes").
We purchased all of the Old Notes still
outstanding after the recapitalization for
cash in September and October 1998.
- We issued 1.6 million shares of common stock
to the placement agent as part of its fee.
- These private placements raised approximately
$84.5 million of additional equity.
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Use of Proceeds - We used $5.1 million to pay interest on our
Old Notes.
- We used $2.4 million to pay off our warehouse
line of credit, which we had used to fund
loans prior to their sale.
- We used $1.6 million to pay loan and
management fees and other miscellaneous
charges due to Mego Financial Corp., our
former parent ("Mego Financial")
- We used $428,000 to pay a portion of the costs
of the recapitalization.
- We used the balance to fund and purchase loans
and for other general corporate purposes.
Management Changes - Four of the five members of our board of
directors resigned from the board and Champ
Meyercord was elected our Chairman and Chief
Executive Officer.
- Purchasers of the shares of preferred stock
and common stock in the recapitalization,
including the strategic partners described
below, exercised their rights to have three
new directors elected to the board.
Transactions with Strategic
Partners As part of the recapitalization:
- Sovereign Bancorp, Inc. ("Sovereign Bancorp")
and City National Bank of West Virginia ("City
National Bank"), a wholly owned subsidiary of
City Holding Company, each purchased 10,000
shares of Series A convertible preferred stock
at a price of $1,000 per share
- Sovereign Bancorp agreed to provide us up to
$90.0 million in borrowings (the "Sovereign
Warehouse Line")
- Sovereign Bancorp agreed to purchase up to
$100.0 million of our loans per quarter at
specified prices through September 2001
- City National Bank purchased our existing
mortgage servicing rights
- City Mortgage Services, a division of City
National Bank, agreed to service all of our
mortgage loans held for sale and loans sold by
us on a servicing retained basis
- Sovereign Bancorp and City National Bank were
each granted an option which expires in
December 2000 to purchase 6.67 million shares
of common stock at a price of $1.50 per share
- Sovereign Bancorp and City National Bank were
each granted a right of first refusal to
purchase a controlling voting interest or a
majority of our assets if the board of
directors determines to sell us
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- City National Bank has appointed, and
Sovereign Bancorp has the right to appoint,
one member to the board of directors. Each has
the right to appoint an additional member to
the board of directors if they exercise their
option to purchase shares of common stock
For more details on, and a description of, the recapitalization, see "The
Recapitalization" beginning on page 66.
STRATEGIC INITIATIVES
Our strategic initiatives have been substantially impacted by recent events
in the capital markets and their effect on the specialty finance industry. There
has been a significant reduction in the number of institutions willing to
provide warehouse facilities to mortgage lenders producing home equity and high
loan-to-value loans. Additionally, there has been a reduction in the number of
buyers of senior interests issued in securitization transactions backed by home
equity and high loan-to-value loans, and a concurrent increase in the yield (and
a reduction in the price) demanded by such buyers on the senior interests they
purchase. Finally, the number of institutional investors acquiring loans similar
to the loans we produce has declined, along with the premiums, if any, these
investors are willing to pay for these loans. These events have substantially
reduced the liquidity available to companies in our business to make new loans.
With these events in mind, we have redefined our strategic initiatives.
OUR PRIMARY FOCUS WILL BE IN PRODUCING HOME EQUITY LOANS. We anticipate
reducing our reliance on high loan-to-value loans and significantly increasing
the percentage and amount of our business devoted to the production of Home
Equity loans by expanding our network of mortgage brokers and bankers and
acquiring other mortgage lending companies that produce Home Equity loans. We
will produce Home Equity loans solely for sale for cash, generally at premiums
to their principal amounts, to institutional purchasers in the secondary market
without recourse for credit losses or risk of prepayment. Based on our
experience in the industry, we believe that currently there are more buyers for
Home Equity loans than for high loan-to-value loans.
DUAL PRODUCTION PLATFORMS SHOULD LOWER OUR TOTAL LOAN PRODUCTION COSTS.
While pursuing our mortgage broker and banker wholesale loan programs, we intend
to pursue loan production on a retail (direct-to-consumer) basis. Although a
retail loan platform is relatively expensive, we expect it to produce loans at a
lower cost than our wholesale platform. When we make a loan directly to a
consumer, we typically receive loan fees and we avoid any premium due when we
purchase a loan from our network of mortgage bankers. We expect our dual loan
production platform strategy to lower our overall cost of producing mortgage
loans and improve our cash flow.
WE INTEND TO INCREASE PRODUCTION BY ACQUIRING OTHER MORTGAGE LENDING
COMPANIES. We intend to increase our loan production significantly by acquiring
companies that produce mortgage loans. Because we raised cash in the
recapitalization, we expect the current lack of liquidity available to companies
in our industry to create opportunities for us in this area.
SELLING LOANS FOR CASH WILL BE OUR PRIMARY METHOD OF LOAN DISPOSITION. We
intend to sell substantially all of the loans we produce for cash to
institutional purchasers in the secondary market as our primary loan disposition
strategy. We expect this method of
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loan sales to generate positive cash flow, because Home Equity and Equity +
loans can generally be sold for more than their principal amount. To this end,
we are expanding the number of institutions with which we have loan purchase and
sale relationships. We do not anticipate selling our loans in securitization
transactions. Securitization transactions typically result in substantial
negative cash flow, because the initial cash proceeds to us are substantially
less than our total cost of producing the loans sold.
WE INTEND TO CONTINUE TO IMPLEMENT COST SAVING MEASURES. We are continuing
an internal restructuring, which has resulted in a reduction of our workforce
from a peak of 475 employees in January 1998 to 134 employees as of August 31,
1998 and 56 employees as of January 1, 1999. This reduction and other cost
saving measures we have taken have significantly reduced our monthly recurring
general and administrative expenses from approximately $2.7 million in June 1998
(the month prior to completion of the recapitalization) to approximately $1.0 in
December 1998. In addition, we have reduced by $4.7 million the annual interest
expense on our outstanding subordinated notes by issuing 37,500 shares of
preferred stock and $41.5 million principal amount of Current Notes in exchange
for $79.0 million principal amount of Old Notes.
RISK FACTORS
The purchase of shares of our common stock is a high-risk investment. You
should carefully consider all of the matters described in this prospectus under
"Risk Factors" beginning on page 14.
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SUMMARY FINANCIAL DATA
You should read the summary financial information set forth below in
conjunction with our audited financial statements and related notes and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" beginning on page 34 of this prospectus. During the last eight
months of fiscal 1998, our operations consisted principally of: (1) liquidating
for cash our portfolio of loans to pay down our outstanding indebtedness; (2)
paying general and administrative expenses to maintain our systems and retain
the personnel necessary to resume operations while exploring alternative sources
of new capital; and (3) designing and beginning the implementation of our
strategic initiatives. Results for the three months ended November 30, 1998 are
not necessarily indicative of the results for the entire year. Due to recent
substantial changes to our business and operating strategy, we believe that our
historical financial and operating data are not likely to be indicative of our
future performance and our results of operation for fiscal 1998 are not
comparable to fiscal 1997.
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THREE MONTHS
ENDED
FISCAL YEAR ENDED AUGUST 31, NOVEMBER 30,
------------------------------------------------------- -------------------------
1994 1995 1996 1997 1998 1997 1998
------- ------- ------- ----------- ----------- ----------- -----------
(THOUSANDS OF DOLLARS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Revenues:
Gain (loss) on sale of
loans................... $ 579 $12,233 $16,539 $ 45,123 $ (26,578) $ 3,721 $ 172
Net unrealized gain (loss)
on mortgage related
securities(1)........... -- -- 2,697 3,518 (70,024) (13,108) 270
Loan servicing income,
net..................... -- 873 3,348 3,036 999 1,194 240
Interest revenue, net of
interest expense of
$107, $468, $1,116,
$6,374, $13,162, $3,086
and $1,764.............. 172 473 988 3,133 1,624 1,210 (162)
------- ------- ------- ----------- ----------- ----------- -----------
Total revenues (losses)..... 751 13,579 23,572 54,810 (93,979) (6,983) 520
------- ------- ------- ----------- ----------- ----------- -----------
Total expenses.............. 2,262 7,660 12,417 31,000 32,010 11,865 4,482
------- ------- ------- ----------- ----------- ----------- -----------
Income (loss) before income
taxes(2).................. (1,511) 5,919 11,155 23,810 (125,989) (18,848) (3,962)
Income tax expense
(benefit)(2).............. -- 2,277 4,235 9,062 (6,334) -- (1,468)
------- ------- ------- ----------- ----------- ----------- -----------
Net income (loss)(2)........ $(1,511) $ 3,642 $ 6,920 $ 14,748 $ (119,655) $ (18,848) $ (2,494)
======= ======= ======= =========== =========== =========== ===========
Net income (loss) per
share(3):
Basic..................... $ 1.25 $ (7.72) $ (1.53) $ (0.08)
=========== =========== =========== ===========
Diluted................... $ 1.25 $ (7.72) $ (1.53) $ (0.08)
=========== =========== =========== ===========
Weighted-average number of
common shares(3).......... 11,802,192 15,502,926 12,300,000 30,566,666
=========== =========== =========== ===========
Weighted-average number of
common shares and assumed
conversions(3)............ 11,802,192 15,502,926 12,300,000 30,566,666
=========== =========== =========== ===========
</TABLE>
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AS OF
AS OF AUGUST 31, NOVEMBER 30,
----------------------------------------------- ------------
1994 1995 1996 1997 1998 1998
------ ------- ------- -------- ------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C> <C>
STATEMENT OF FINANCIAL CONDITION
DATA:
Cash and cash equivalents....... $ 824 $ 752 $ 443 $ 6,104 $36,404(4) $ 30,010(4)
Loans held for sale, net........ 1,463 3,676 4,610 9,523 10,975(5) 18,883(5)
Mortgage related
securities(1)................. -- -- 22,944 106,299 34,830 34,927
Excess servicing rights(1)...... 904 14,483 12,121 -- -- --
Mortgage servicing rights....... -- 1,076 3,827 9,507 83 --
Total assets.................... 5,122 24,081 50,606 156,554 104,535 107,840
Allowance for credit losses on
loans sold with recourse...... 66 886 920 7,014 2,472 2,476
Subordinated debt(6)............ -- -- -- 40,000 42,693 41,801
Total liabilities............... 983 13,300 32,905 103,447 77,941 83,740
Stockholders' equity............ 4,139 10,781 17,701 53,107 26,594 24,100
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS
ENDED
FISCAL YEAR ENDED AUGUST 31, NOVEMBER 30,
------------------------------------------------- ------------------
1994 1995 1996 1997 1998 1997 1998
------ ------- -------- -------- -------- -------- -------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C> <C> <C>
OPERATING DATA:
Loan production............. $8,164 $87,751 $139,367 $526,917 $338,942 $199,861 $16,518
Weighted-average interest
rate on loan production... 14.18% 14.55% 14.03% 13.92% 13.89% 13.99% 10.92%
Loans in servicing portfolio
(end of period):
Company-owned(7).......... 1,471 3,720 4,698 9,563 12,450(5) 53,241 21,003
Securitized............... 6,555 88,566 209,491 618,505 18,772 714,106 --
------ ------- -------- -------- -------- -------- -------
Total servicing
portfolio............. $8,026 $92,286 $214,189 $628,068 $ 31,222 $767,347 $21,003
====== ======= ======== ======== ======== ======== =======
Cash used in operations..... $4,402 $ 3,619 $ 12,440 $ 72,438 $ 39,723 $ 59,445 $20,161
====== ======= ======== ======== ======== ======== =======
</TABLE>
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(1) Mortgage related securities are junior subordinated interests retained by us
in pools of mortgage loans sold by us in securitization transactions. SFAS
No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities," required us, as of January 1, 1997, to
reclassify our excess servicing rights (junior subordinated interests
retained by us in pools of mortgage loans sold in transactions similar to a
securitization) to mortgage related securities. The fair value (the dollar
amount on our balance sheet) of our mortgage related securities was written
down from $106.3 million at the end of fiscal 1997 to $34.8 million at the
end of fiscal 1998. For additional details concerning the sale of loans in
securitization transactions and the fair value of our mortgage related
securities, see "Management's Discussion and Analysis of Financial Condition
and Results of Operations" beginning on page 34 of this prospectus and Notes
2, 4 and 17 to our financial statements located later in this prospectus.
(2) Our results of operations were included in the consolidated federal income
tax returns filed by Mego Financial Corporation ("Mego Financial"), our
former parent, through September 2, 1997, the date the shares of our common
stock owned by Mego Financial were distributed by Mego Financial to its
shareholders in a tax-free spin-off. Mego Financial charged us an amount
equal to the taxes we would have paid if we had filed a separate return. For
more details on this and other transactions with Mego Financial and its
affiliates, see "Certain Transactions" beginning on page 102 of this
prospectus.
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(3) Earnings per share for the fiscal years ended August 31, 1994, 1995 and 1996
are not presented because, during these fiscal years, we were a wholly-owned
subsidiary of Mego Financial.
(4) As part of the recapitalization, we sold an aggregate of $50.0 million of
common stock and Series A convertible preferred stock for cash. For more
details, see "The Recapitalization" beginning on page 66 of this prospectus.
(5) Loans held for sale, net includes a valuation reserve which reflects our
best estimate of the amount we expect to receive on the sale of these loans.
(6) We sold $40.0 million principal amount of Old Notes in November 1996 and an
additional $40.0 million principal amount of Old Notes in October 1997. As
part of the recapitalization, we issued $37.5 million of Series A
convertible preferred stock and $41.5 million principal amount of Current
Notes in exchange for $79.0 million principal amount of Old Notes. We
purchased all of the Old Notes still outstanding after the recapitalization
in September and October 1998, including premiums and accrued and unpaid
interest.
(7) Excludes approximately $9.4 million and $2.6 million of Equity + loans to be
repurchased at August 31, 1998 and November 30, 1998, respectively. We
repurchased a majority of these loans prior to November 30, 1998. The amount
on our balance sheet as of August 31, 1998 is the amount we expect to
receive on the sale of these loans. For additional details, see Note 3 to
our financial statements located later in this prospectus.
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RISK FACTORS
The purchase of common stock involves, among other things, your evaluation
of our business strategy and the significant risks and other factors that will
affect whether we will be successful. As a result, we cannot guarantee that we
will achieve our objectives. You should carefully consider the risk factors we
discuss below, along with all of the other information included in this
prospectus, before you decide to purchase shares of our common stock.
Some of the information in this prospectus may contain forward-looking
statements. Such statements can be identified by the use of forward-looking
terminology such as "may," "will," "expect," "anticipate," "estimate,"
"continue" or other similar words. These statements discuss future expectations,
contain projections of results of operations or of financial condition or state
other "forward-looking" information. When considering such forward-looking
statements, you should keep in mind the risk factors and other cautionary
statements in this prospectus. The risk factors noted in this section and other
factors noted throughout this prospectus, including certain risks and
uncertainties, could cause our actual results to differ materially from those
contained in any forward-looking statement.
SIGNIFICANT DETERIORATION IN OUR FINANCIAL CONDITION DUE TO LOSSES IN FISCAL
1998
We generated a $119.7 million net loss in fiscal 1998 compared to a net
profit of $14.7 million in fiscal 1997 and $6.9 million in fiscal 1996. Our
fiscal 1998 loss primarily resulted from:
(1) writing down the fair value of our mortgage related securities
from $106.3 million at the end of fiscal 1997 to $34.8 million at the end
of fiscal 1998;
(2) substantially reducing loan production;
(3) liquidating our loan portfolio; and
(4) spending significant amounts on general and administrative
expenses to:
(a) maintain our systems;
(b) retain our personnel;
(c) design and implement a new strategic plan; and
(d) explore alternative capital-raising transactions.
In fiscal 1997, we made ordinary course adjustments to the value of our mortgage
related securities based on certain assumptions with respect to prepayment
rates, delinquency rates, default rates and credit losses on the loans backing
the securities. During fiscal 1998, we experienced substantially higher
prepayment rates, delinquency rates, default rates and credit losses than we had
assumed at the end of fiscal 1997. As a result, during fiscal 1998 we
substantially increased our assumptions on prepayment rates, delinquency rates,
default rates and credit losses on the remaining loans backing our mortgage
related securities and we made corresponding writedowns to the value of our
mortgage related securities throughout fiscal 1998. We had produced the Equity +
and Title I loans that backed these securities in prior periods and sold them in
securitization transactions. For additional information on our mortgage related
securities, see "Management's Discussion and
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Analysis of Financial Condition and Results of Operations" and Notes 2, 4, and
17 to our financial statements included later in this prospectus.
The $119.7 million net loss in fiscal 1998 reduced our stockholders' equity
at the end of fiscal 1998 to $26.6 million, despite an $84.5 million addition to
stockholders' equity in July 1998 as a result of the recapitalization.
Stockholders' equity was $53.1 million at the end of fiscal 1997 and $17.7
million at the end of fiscal 1996. In May 1998, our independent auditors,
revised their report on our fiscal 1997 financial statements to include an
explanatory paragraph related to their substantial doubt that we could continue
as a going concern. We cannot guarantee that our results of operations and
financial condition will not continue to decline.
RISKS ASSOCIATED WITH IMPLEMENTING OUR NEW STRATEGIC PLAN
Since February 1998, our business strategy has been substantially revised.
Our new business strategy has three main components:
(1) focusing on producing Home Equity loans and reducing our historical
focus on the production of Equity + loans;
(2) increasing loan production by acquiring other mortgage lending
companies; and
(3) selling loans produced by us for cash to institutional purchasers in a
secondary market instead of selling loans in securitization transactions.
During the three months ended August 31, 1998, we produced only $1.9
million principal amount of mortgage loans. During the three months ended
November 30, 1998, we produced only $16.5 million principal amount of mortgage
loans. Our ability to increase loan production will depend on many factors,
including our ability to:
- successfully acquire and integrate the operations of other mortgage
lending companies
- offer attractive loan products to prospective borrowers
- successfully market our loan products
- establish, maintain and expand relationships with mortgage brokers and
bankers
- obtain and maintain increasingly larger lines of credit to fund loans
prior to their sale
- access capital markets
- attract and retain qualified funding, quality control and other personnel
You should consider our future prospects in light of the risks, delays,
expenses and difficulties frequently encountered by an early-stage business in a
highly-regulated, competitive environment. We cannot guarantee that we will
implement successfully our new business strategy, develop our current operations
in a timely or effective manner, or generate significant revenues, positive cash
flow or profits.
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RISKS ASSOCIATED WITH NEW MANAGEMENT TEAM
We have only recently assembled our management team and the management
control structure is still in its formative stages. We cannot guarantee that the
new management team will be able to operate effectively or implement
successfully our new strategic plan. The new management team's ability to manage
our growth as we implement our strategic initiatives depends upon many factors,
including their ability to:
(1) maintain appropriate procedures, policies and systems to ensure that
our loans perform at least in accordance with industry standards;
(2) satisfy our need for additional financing on reasonable terms;
(3) manage the costs associated with expanding our infrastructure,
including systems, personnel and facilities; and
(4) operate profitably and on a cash flow positive basis.
If management cannot execute successfully our new business strategy, it
will have a material adverse effect on our financial condition, results of
operations and cash flow.
Our expansion and development largely will be dependent upon the continued
services of the senior members of our new management team: Champ Meyercord, our
Chief Executive Officer, Wm. Paul Ralser, our President and Chief Operating
Officer, and J. Richard Walker, our Executive Vice President and Chief Financial
Officer. The loss of the services of Messrs. Meyercord, Ralser or Walker for any
reason could have a material adverse effect on us. In addition, our future
success will require us to recruit and retain additional key personnel,
including additional sales and marketing personnel. We do not maintain key
person life insurance on any members of senior management.
LIQUIDITY RISKS
Our business operations require continued access to adequate cash to fund,
purchase and make mortgage loans, to pay interest on, and repay, our debts and
to pay general and administrative expenses. Specialty finance companies similar
to us currently are experiencing a liquidity shortage. This liquidity shortage,
among other things, has reduced the availability of warehouse credit lines to
finance first mortgage loans, home equity loans and high loan-to-value loans
prior to their sale. We are currently dependent on the Sovereign Warehouse Line
to fund, purchase and make mortgage loans before we sell them. If we
successfully increase loan production, we will need increasingly larger amounts
of cash for our operations.
Risks Related to the Sale of Loans
We historically have principally relied on selling loans in securitization
transactions to generate cash. As a major part of our strategic initiatives, we
intend to generate positive cash flow mainly by selling loans to institutional
purchasers in the secondary market. Under the terms of the Flow Purchase
Agreement with Sovereign Bancorp (the "Flow Purchase Agreement"), we have agreed
to sell, and Sovereign Bancorp has agreed to buy, up to $100.0 million of our
mortgage loans per quarter through September 2001. Sovereign Bancorp also has a
right of first refusal to buy the balance of our loans, subject to our mutual
agreement as to the purchase terms. The right of first refusal could make it
more difficult for us to sell our loans to others if Sovereign Bancorp decides
not to acquire some
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of our loans or if we cannot negotiate mutually acceptable terms for the
purchase of our loans.
The value of, and markets for, selling our loans are dependent on, among
other things:
(1) the willingness of banks, thrifts and other institutional purchasers to
acquire Home Equity and Equity + loans;
(2) the premiums over the principal amount of these loans that
institutional purchasers are willing to pay; and
(3) the resale market for our loans.
The markets also are affected by more general factors, including general
economic conditions, interest rates and government regulations. These factors
currently affect, and may continue to affect, our ability to sell loans in the
secondary market for acceptable prices within reasonable time frames. A
reduction in the secondary market for first mortgage loans, home equity loans
and high loan-to-value loans would hurt our ability to sell loans in the
secondary market as well as our liquidity and future loan production. We cannot
predict whether the liquidity of the secondary market will continue to diminish
in the future.
Risks Associated with the Need For Alternative Financing
If the amounts available under the Sovereign Warehouse Line to fund our
loan production prior to its sale are insufficient to enable us to produce the
volume of loans necessary for us to operate profitably or on a positive cash
flow basis, we will have to seek out other sources of liquidity. This may
include additional warehouse financing and debt and/or equity securities
offerings. The Sovereign Warehouse Line terminates at the end of August 1999 and
is renewable, at Sovereign's option, in six-month intervals for up to five
years. Sovereign Bancorp may terminate the Sovereign Warehouse Line if we do not
sell them $100.0 million of loans in each fiscal quarter beginning with the
calendar quarter ending March 31, 1999. If that happens, we cannot guarantee
that additional financing will be available on favorable terms, or at all. If we
are not successful in maintaining or replacing existing financing or obtaining
additional financing, we would have to reduce our activities. For additional
details about our liquidity, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources" and Notes 9 and 15 to our financial statements located later in this
prospectus.
Except for certain financial covenants in a pledge and security agreement
entered into in April 1997, we are currently complying with the Sovereign
Warehouse Line, the indenture governing the New Notes and agreements with our
other lenders. Before the recapitalization, we were in violation of our
warehouse agreement, the indenture governing the Old Notes and agreements with
our other lenders. If we breach or violate any covenant or condition contained
in our borrowing arrangements, we might be unable to obtain funding for our
operations which would have a material adverse effect on us.
Some of our borrowing arrangements limit the amount of advances that can be
made to us. These limitations are based on the value of, and the delinquency
experience relating to, our mortgage related securities pledged to the lender. A
decrease in the value of the pledged securities would reduce the amount of funds
that we can borrow under the facilities, requiring us to pay down the loans.
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Risk of Violation of Representations Made to Loan Purchasers
We make representations and warranties to the purchasers of our mortgage
loans regarding compliance with laws, regulations and program standards and the
accuracy of information. Under certain circumstances we could become liable for
damages or be required to repurchase a loan if there has been a breach of these
representations or warranties. We generally receive similar representations and
warranties from our loan sources. If these representations and warranties are
breached, we would be subject to the risk that a loan source will not have the
financial capacity to repurchase loans or that a loan source will not otherwise
respond to our demands. We cannot guarantee that we will not experience losses
due to breaches of representations and warranties in the future.
PERFORMANCE OF FUTURE ACQUISITIONS
As part of our business strategy, we intend to acquire other mortgage
lending companies. By acquiring other mortgage lending companies, we believe we
can expand our loan production, while avoiding the time and expense required to
build new mortgage loan production platforms. The value of these companies
generally will be in their ability to immediately produce mortgage loans at a
low cost. This type of value will typically be a substantial portion of the
assets acquired and it is classified under generally accepted accounting
principles as an intangible. Generally acceptable accounting principles require
us to amortize (write off) expenses related to goodwill and other intangible
assets that we acquire. This will reduce our earnings. Future acquisitions may
also result in dilutive issuances of equity securities and our incurrence of
additional debt. All of these factors could have a material adverse effect on
our financial condition, results of operations and cash flows.
Future acquisitions would involve numerous additional risks, including:
- difficulties in the integration of the acquired company's operations,
services, products and personnel
- entry into markets in which we have little or no direct prior experience
- the potential loss of the acquired company's key employees
Mortgage lending companies that we acquire in the future may not perform in
accordance with our expectations. We cannot predict whether we will identify
acquisition opportunities, whether we can negotiate acquisitions on favorable
terms or whether any acquisition will result in profitable operations in the
future or be successfully integrated with our existing business.
Acquisitions in which all or a portion of the purchase price is in shares
of common stock would require, in certain cases, the written consent of each of
City National Bank and Sovereign Bancorp. We cannot guarantee that we would be
able to obtain any such consent.
RISKS ASSOCIATED WITH MORTGAGE BACKED SECURITIES
Risks Related to our Junior Interest
We historically have sold the greater portion of our Equity + and Title I
loans in securitization transactions. As a result, we are at risk because these
loans back our mortgage related securities. In a securitization transaction, the
cash flow from the
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mortgage loans backing the securitization, principal and interest is first paid
to the owners of the senior interests according to a pre-established schedule of
required interest and principal payments. Payment of cash flow to our mortgage
related securities is junior to the scheduled principal and interest payments to
the senior interests.
If the borrowers do not make their payments on the loans backing a
securitization or if the payments are insufficient to make required principal
and interest payments on the senior interests, the amounts that would be paid to
us will be used to cover the shortfall. This would reduce or in some cases
eliminate the stream of revenues that would have been paid to us on our mortgage
related securities. If payments received from the loans backing a securitization
are less than the amounts we anticipated at the time we sold the loans in a
securitization transaction, we may be required to write down the fair value of
our mortgage related securities retained in that securitization. This would
result in a charge to earnings. We cannot guarantee that estimates of future
losses on loans backing our mortgage related securities will be adequate in the
future.
Risk of Write Down of the Value of Mortgage Backed Securities due to Poor
Performance of Mortgage Loans
As noted above under "-- Significant Deterioration in our Financial
Condition Due to Losses in Fiscal 1998," we had to write down the fair value of
our mortgage related securities during fiscal 1998. This write down resulted
from unexpectedly high rates of prepayments, delinquencies, default, and credit
losses. As a result, we substantially increased the anticipated prepayment
rates, delinquency rates, default rates and credit losses on the mortgage loans
backing our mortgage related securities. The new assumptions significantly
decreased the cash flow we expected to receive on these securities in the
future, which required us to reduce the fair value of our mortgage related
securities to $34.8 million on August 31, 1998 compared to $106.3 million on
August 31, 1997.
In the future, we may have to make additional reductions in the carrying
value of our mortgage related securities. We cannot guarantee that the
prepayment rate, delinquency rate, default rate, and credit losses on the
mortgage loans backing the securities will not increase above the levels we
currently anticipate. If we have to further write down these securities' value,
we may incur losses in the quarter when we write them down. We may then violate
the net worth covenants in our borrowing agreements. Any of these events could
have a material adverse effect on our financial condition and operations. For
additional details concerning the valuation of our mortgage backed securities,
see "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Securitization Transactions" and Notes 2, 4 and 17 to our
financial statements located later in this prospectus.
Risks Related to Over-Collateralization
As part of the sale of loans in securitization transactions, we are
required to establish over-collateralization and/or build over-collateralization
levels by retaining distributions of excess cash flow otherwise payable to us on
our mortgage related securities. Excess cash flow results from the positive
difference between the higher interest rate paid by our borrowers on the
mortgage loans sold in the securitization and the lower yield paid to the owners
of the senior interests in the trust established to own the loans sold by us.
Over-collateralization serves as credit enhancement for the owners of the senior
interests and is available to absorb losses realized on loans backing the
securitization. Were it not for these over-collateralization requirements, we
would be able to use the excess cash flow
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in our operations. Because of those requirements, if borrowers default on
principal and interest payments on their loans, the securitization trust holding
the mortgages would have to use part of the over-collateralization to pay the
owners of the senior interests. This could delay, reduce or eliminate the excess
cash flow otherwise payable to us on our mortgage related securities.
Risk Related to Interest Rate Spread
During fiscal 1997, we sold $398.4 million principal amount of mortgage
loans, that had a weighted-average interest rate of 14.0%, in securitization
transactions. The $390.1 million principal amount of senior interests sold to
institutional investors as part of these securitizations had an initial
weighted-average interest rate of 6.88%. The $8.3 million difference between the
amount of mortgage loans sold and the amount of senior interests sold creates
the initial over-collateralization. The 7.1% difference between the interest
paid by the borrowers and the interest paid to the owners of the senior
interests (the "spread") declines over time primarily because of payoffs
(including defaults) of the loans backing the securitization. The initial spread
would be equal to 7.1% times $390.1 million, or $27.7 million annually plus
interest at 14.0% on the $8.3 million principal amount of loans in the
over-collateralization account. We use the spread and the cash flow from the
loans in an initial over-collateralization to reduce the principal balances of
the senior interests or fund the additional over-collateralization.
The initial over-collateralization and retained amounts are determined by
the entity that, as a condition to obtaining insurance, issues any guarantee of
the related senior interests and/or by the rating agencies as a condition to
obtaining the desired rating on the senior interests. If we use the spread and
the cash flow from the loans in an initial over-collateralization in this
manner, we will continue to be subject to the risks of faster than anticipated
rates of voluntary prepayments, delinquencies, defaults and credit losses on
foreclosure on the mortgage loans backing our mortgage related securities that
we sold in prior securitizations.
In addition, using the spread to fund reserves delays or in some cases
eliminates cash distributions that we would be entitled to receive on our
mortgage related securities. For a detailed explanation of excess cash flow,
mortgage related securities and securitization transactions, see "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Securitization Transactions" located later in this prospectus.
Risks Related to Loan Repurchases
We agree to repurchase or replace loans that do not conform to our
representations and warranties at the time we sell the loans. If we were
required to repurchase or replace loans, we cannot guarantee that the loans
repurchased or replaced repurchased could be sold at a price equal to our total
cost of acquisition. For additional details, see "Business -- Loan Servicing"
and "-- Sale of Loans" and Note 2 to our financial statements located later in
this prospectus.
RISKS FROM THE SALE OF SERVICING RIGHTS
We historically have sold substantially all of our mortgage loans with
servicing retained. This means that we retained the right to service the loans.
As part of the recapitalization, we sold our existing mortgage loan servicing
rights, including the right to
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service all of the mortgage loans backing our mortgage related securities, to
City Mortgage Services. To the extent that City Mortgage Services is ineffective
in servicing these loans, we would experience increased delinquencies, defaults
and credit losses, which would have an adverse effect on us. Consequences could
include the additional write downs of the fair value of our mortgage related
securities and a restriction on our ability to access capital markets for our
future financing requirements.
The delinquency and default rates on the mortgage loans backing our
mortgage related securities has increased significantly since we sold the
servicing rights on these loans to City Mortgage Services. In the past, this
increase in delinquencies and defaults has caused us to write down the fair
value of these securities. We cannot guarantee that City Mortgage Services will
perform up to industry standards, which could result in the adverse consequences
described above. If City Mortgage Services does not perform well, we have the
right to terminate City Mortgage Services. However, we would have to find a new
servicer for these loans after such a termination. We might be unable to find an
appropriate servicer or, if identified, we may not be able to hire such servicer
on favorable terms.
INTEREST RATE RISKS
Changes in interest rates affect our business by decreasing the demand for
loans during periods of higher interest rates and increasing prepayment rates
during periods of lower interest rates. The profits we realize from loans are,
in part, a function of the difference between the fixed long term interest rates
we charge to borrowers and the adjustable short term interest rates we pay on
the Sovereign Warehouse Line, which we use to fund loans until we sell them.
Generally, short-term rates are lower than long-term rates. We benefit from
the positive interest rate differential during the time we own the loans pending
their sale. During the period from 1994 to the present, the interest rate
differential was high. Interest rates are not predictable or controllable, and
we cannot predict whether the positive interest rate differential will continue
in the future. A change in the differential could have a material adverse effect
on our financial position, results of operations and cash flows.
Changes in interest rates during the period between the establishment of
the borrowers' interest rate on a loan and the sale of the loan affect the
revenues we realize. As part of our loan production process, we issue loan
commitments (sometimes referred to as "interest rate locks") for periods of up
to 30 days to mortgage bankers and brokers. The period of time between the
closing of a loan and the sale of the loan generally ranges from 10 to 90 days.
Increases in interest rates during these periods will result in lower gains (or
even losses) on loan sales than would be recorded if interest rates had remained
stable or had declined. We intend to expand our loan production, increase the
amount of our borrowings under the warehouse lines of credit and increase the
amount of loans held for sale, which will increase our exposure to the risk of
interest rate increases.
Increases in interest rates also may require us to write down the fair
value of our mortgage related securities, which could have a material adverse
effect on our financial condition, results of operations, and cash flows. This
interest rate is the rate we believe would be used by a third party in
determining the value of our mortgage related securities. At the end of fiscal
1998, we were using a 16.0% rate and at the end of fiscal 1997 we were using a
12.0% rate. Increasing the rate at which we discount to present value the cash
flow we expect to receive on our mortgage related securities reduces their fair
value.
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Decreases in interest rates may result in increased prepayment rates which may
require us to write down the fair value of our mortgage related securities. For
additional details on the risks to the fair value of our mortgage related
securities, see "-- Increased Prepayments and Other Factors May Adversely Affect
Valuation of Mortgage Related Securities" located earlier in this section of
this prospectus.
RISK OF VARIATIONS IN QUARTERLY OPERATING RESULTS
Several factors affecting our business can cause significant variation in
our quarterly operating results. Variations in the volume of our production,
differences between our costs of borrowings and the average interest rates paid
by our borrowers, our inability to complete scheduled loan sale transactions and
the condition of the mortgage loan industry and the specialty finance industry
can result in significant increases or decreases in our revenues from quarter to
quarter. A delay in closing a particular loan sale transaction during a
particular quarter would postpone recognition of revenues and gain or loss on
the sale of those loans. In addition, unanticipated delays in closing a
particular loan sale transaction would also increase our exposure to interest
rate fluctuations by lengthening the period during which our variable rate
borrowings under the Sovereign Warehouse Agreement are outstanding. If we were
unable to sell a sufficient number of loans at a premium in a particular
reporting period, our revenues for that period would decline, resulting in lower
net income and possibly a net loss for that period. This could have a material
adverse effect on our financial condition and results of operations. See
"Management's Discussion and Analysis of Financial Condition, Results of
Operations -- Liquidity and Capital Resources" located later in this prospectus.
RISKS ASSOCIATED WITH DELINQUENCIES AND DEFAULTS ON LOANS
Potential loan delinquencies and defaults by our borrowers expose us to
risks of loss and reduced net earnings. During economic slowdowns or recessions,
loan delinquencies, defaults and credit losses generally increase. In addition,
significant declines in market values of residences securing the loans reduce
homeowners' equity in their homes. The limited borrowing power of our customers
also increases the likelihood of delinquencies, defaults and credit losses on
foreclosure. For Home Equity loans, we rely primarily on the appraised value of
the borrower's home and for Equity + loans we rely on the creditworthiness of
the borrower. We determine the amount of a loan based on the loan-to-value ratio
and the borrower's creditworthiness. After a default by a borrower, we, or the
servicer of the mortgage loan, evaluates the cost effectiveness of foreclosing
on the property. Such default may cause us to charge our allowances for credit
losses on loans held for sale, except to the extent that FHA insurance proceeds
are available. If we must take losses on a loan backing our mortgage related
securities or loans that exceed our allowances, our financial position, results
of operations and cash flows could suffer.
Many of our borrowers have limited access to consumer financing for a
variety of reasons, including insufficient home equity value and unfavorable
past credit histories. We are subject to various risks associated with these
borrowers, including, but not limited to, the risk that borrowers will not pay
interest and principal due, and that the value received from the sale of the
borrower's residence in a foreclosure will not be sufficient to repay the
borrower's obligation to us.
The risks associated with the our business increase during an economic
downturn or recession. These periods also may be accompanied by decreased demand
for consumer
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credit and declining real estate values. Any material decline in real estate
values reduces the ability of borrowers to use the value of their homes to
support borrowings and increases the loan-to-value ratios of our loans and the
loans backing our mortgage related securities. This weakens collateral values
and the amount, if any, obtained upon foreclosures.
The frequency and severity of losses generally increases during economic
downturns or recessions. Because our borrowers generally do not satisfy criteria
of government agencies that traditional lenders rely on in evaluating whether to
make loans to potential borrowers, these borrowers do not qualify for
traditional "A" credit loans. The actual rate of delinquencies, foreclosures and
credit losses on these loans are often higher under adverse economic conditions
than those currently experienced in the mortgage loan industry in general
because of the lower credit quality of the borrower. Any sustained period of
increased delinquencies, foreclosures and losses could hurt our financial
condition, results of operations and cash flows.
RISKS ASSOCIATED WITH TITLE I LOANS BACKING OUR MORTGAGE RELATED SECURITIES
At the end of our 1998 fiscal year, the Title I loans sold in
securitization transactions backed $10.7 million (representing 30.6%) of the
$34.8 million aggregate fair value of our mortgaged related securities. During
the period in which these Title I loans back our mortgage related securities, we
bear the risk of delinquencies, defaults and credit losses on these loans except
to the limited amount of FHA insurance remaining.
We have exhausted our reserves with respect to substantially all of the
Title I loans which back our mortgage related securities, and the remaining
pools of Title I loans backing our mortgage related securities have been
performing poorly. In addition, if the prepayment rates, delinquencies and
credit losses on the Title I loans backing our mortgage related securities
increase beyond the levels we have anticipated, we will need to further write
down the value of our Title I mortgage related securities.
RISKS ASSOCIATED WITH EXISTING EQUITY + LOANS
During fiscal 1997, 81.4% of the loans we produced were Equity + loans and,
during fiscal 1998, 91.6% of the loans we produced were Equity + loans. Their
weighted-average loan-to-value ratio was 112.0% for both of these periods. In
almost all cases, the value of the residences that secure these loans will not
be sufficient to cover the principal amount of the loans in the event of
defaults. During the three months ended November 30, 1997 and 1998, 93.9% and
29.7%, respectively, of the loans we produced were Equity + loans.
We historically sold a substantial portion of our Equity + loans in
securitization transactions. At the end of fiscal 1998, $24.1 million
(representing 69.4%) of our mortgage related securities were backed by Equity +
loans.
We bear the risk of delinquencies and defaults with respect to the entire
principal amount of, and interest on, these loans. Delinquencies, defaults and
credit losses on these loans in excess of the levels we anticipated in
determining the fair value of our mortgage related securities at the end of
fiscal 1998 would require us to further write down the fair value of these
securities. A write down would adversely affect our financial condition, results
of operations and cash flows. To the extent that borrowers with high
loan-to-value ratios default on their loan obligations, we are unlikely to use
foreclosure as a means to mitigate our losses. As of August 31, 1998, 9.7% of
the principal amount of the Equity +
23
<PAGE> 25
loans backing our mortgage related securities were more than 30 days
contractually past due. We will apply these losses to our allowances for
possible credit losses. If the credit losses exceeded this allowance, we would
be required to record additional provisions for losses on loans held for sale,
which would have a material adverse effect on our financial condition and
results of operations.
LITIGATION; RISK OF CLAIMS
In the ordinary course of business, we are subject to claims made by
borrowers and private investors from, among other things, losses allegedly
incurred as a result of potentially breaches of fiduciary obligations and
misrepresentations, errors and omissions of our employees, officers and agents.
Industry participants are frequently named as defendants in litigation involving
alleged violations of federal and state consumer lending laws because of the
consumer-oriented nature of the industry and uncertainties with respect to the
application of various laws and regulations. Pending claims and any claims made
in the future may result in legal expenses or liabilities which could have a
material adverse effect on our financial condition, results of operations and
cash flows. For details about pending litigation, see "Business -- Legal
Proceedings" located later in this prospectus.
CONCENTRATION OF OPERATIONS
The residences securing our loans have historically been concentrated in
California and Florida. We expect this trend to continue. As of August 31, 1998,
loans backed by residences in Florida and California represented a substantial
portion of the loans securing our mortgage backed securities. Consequently, our
financial condition, results of operations and cash flows are dependent upon
general trends in the California and Florida economies and their residential
real estate markets. Residential real estate market declines may adversely
reduce the value of the residences that are the collateral for our loans.
In addition, California and Florida historically have been vulnerable to
certain natural disaster risks, such as earthquakes, floods, hurricanes, fires
and erosion-caused mudslides, which are not typically covered by standard
borrower's hazard insurance policies. Uninsured disasters will adversely impact
borrowers' ability to repay our loans. The existence of adverse economic
conditions or the occurrence of such natural disasters in California or Florida
could have a material adverse effect on our financial condition, results of
operations and cash flows.
COMPETITION
We face intense competition in producing and selling Home Equity loans and
Equity + loans. Our competitors include other consumer finance companies,
mortgage banking companies, commercial banks, credit unions, thrifts, credit
card issuers and insurance finance companies. Many of these competitors are
substantially larger than we are. In addition, our competitors may have more
capital and other resources and a lower cost of capital than we do. In addition,
we may face competition from government-sponsored entities which have entered
the market for non-conforming mortgage loans. Existing mortgage loan purchase
programs may be expanded by the Federal National Mortgage Association ("FNMA"),
the Federal Home Loan Mortgage Corporation ("FHLMC"), or the Government National
Mortgage Association ("GNMA") to include non-conforming mortgages, particularly
loans similar to our Home Equity loans. Entries of government-
24
<PAGE> 26
sponsored entities into the non-conforming loan market may reduce the interest
rate borrowers are willing to pay on our mortgage loans and may reduce or
eliminate premiums on their sale.
Industry participants compete for business in many ways. Some provide
borrowers more convenience in obtaining a loan, some have better customer
service and others have strong marketing and distribution channels. This
industry has a relatively low barrier to entry, which permits new competitors to
enter the broker-sourced loan market quickly. This may lower the rates we can
charge borrowers, potentially lowering gains on future loan sales. If any of our
competitors significantly expand their activities in our markets, such action
could have a material adverse effect on us.
Changes in interest rates and general economic conditions may also affect
our competition. During periods of increasing interest rates, competitors who
have locked in low borrowing costs may have a competitive advantage. During
periods of declining rates, competitors have solicited, and may in the future
solicit, our customers to refinance their loans. To the extent these
solicitations are successful, the prepayment rates on the loans backing our
mortgage related securities may increase beyond the levels currently anticipated
which may result in a write down in the fair value of these securities.
We depend on mortgage brokers and bankers for substantially all of our
mortgage loan production. These mortgage brokers and bankers generally deal with
multiple lenders for each prospective borrower. Our competitors also attempt to
establish relationships with these entities, none of which are contractually or
otherwise obligated to deal exclusively, or to continue to do business, with us.
In addition, we expect the volume of broker and mortgage banker-sourced loans
funded and purchased by us to increase significantly. Our future operating and
financial results may be more susceptible to fluctuations in the volume and cost
of our broker and mortgage banker-sourced loans from, among other things,
competition from other purchasers of these loans.
As we expand our retail, broker and mortgage banker-sourced loan production
into new geographic markets, we will face competition from lenders with
established positions in these markets. We cannot predict whether we will be
able to compete successfully with those established lenders.
VOLATILITY OF STOCK PRICE
The price of our common stock has experienced significant volatility since
our initial public offering in November 1996. The market price of our common
stock has ranged from a high of $15.75 per share to a low of $0.375 per share
through January 28, 1999. As of January 28, 1999, the last sale price of our
common stock as reported on the Nasdaq National Market System was $0.50 per
share. The stock market recently has experienced extreme price and volume
fluctuations which may be unrelated to the operating performance of particular
companies. Market conditions in the specialty finance industry and factors such
as legislative and regulatory changes, announcements of new products and
services by us, our competitors or third parties, and changes in earnings
estimates by analysts may have a significant effect on the price of our common
stock.
25
<PAGE> 27
RISK OF FAILING TO COMPLY WITH THE LISTING REQUIREMENTS OF THE NASDAQ STOCK
MARKET
The Nasdaq Stock Market requires that all listed companies maintain certain
levels with respect to each of the following:
- net tangible assets
- number of publicly held shares
- value of capital stock traded in the Nasdaq Stock Market
- bid price
- number of stockholders
- number of market makers
If we fail to comply with any of these requirements, the Nasdaq Stock Market
could delist our shares of common stock. If the Nasdaq Stock Market delisted our
common stock, we cannot guarantee that there would be a market for you to trade
in the common stock.
FACTORS INHIBITING TAKEOVER; EFFECT OF CHANGE OF CONTROL
Sovereign Bancorp and City Holding Company each has a right of first
refusal to acquire us if our board of directors decides to offer us for sale. In
addition, the change of control provisions of the New Notes, as well as the
change in for sale control provisions of certain of our other credit
arrangements and employment agreements with our senior executives, could inhibit
a takeover attempt by a third party.
Certain provisions of our Certificate of Incorporation and Bylaws may
delay, defer or prevent a takeover attempt by a third party. Our Certificate of
Incorporation authorizes the board of directors to determine the rights,
preferences, privileges and restrictions of unissued series of preferred stock
and to fix the number of shares and designation of any series of preferred stock
without any vote or action by our stockholders. The issuance of preferred stock
may have the effect of delaying, deferring or preventing a change of control,
since the terms of the preferred stock that might be issued could potentially
prohibit or otherwise restrict our ability to consummate any merger,
reorganization, sale of substantially all of our assets, liquidation or other
extraordinary corporate transaction without the approval of the holders of the
outstanding shares of the preferred stock. Other provisions of our Certificate
of Incorporation and Bylaws provide that special meetings of the stockholders
may be called only by the board of directors or upon the written demand of the
holders of not less than 30% of the votes entitled to be cast at a special
meeting.
LEGISLATIVE AND REGULATORY RISKS
Our business is subject to extensive regulation, supervision and licensing
by federal, state and local governmental authorities. These rules and
regulations, among other things, impose licensing obligations on us, establish
eligibility criteria for mortgage loans, prohibit discrimination, provide for
inspections and appraisals of properties, govern credit reports on loan
applicants, regulate assessment, collection, foreclosure and claims handling,
investment and interest payments on escrow balances and payment features,
mandate disclosures and notices to borrowers and, in some cases, fix maximum
interest rates, fees and mortgage loan amounts. If we do not comply with these
requirements, many of which are highly technical, we could lose our approved
status, our servicing contracts could be terminated or suspended without
compensation to the servicer, we could face demands for indemnification or
mortgage loan repurchases, we may suffer the exercise of certain rights
26
<PAGE> 28
of rescission for mortgage loans by our borrowers, and we may be subject to
class action lawsuits and administrative enforcement actions. For a discussion
of pending litigation see "Business -- Legal Proceedings" located later in this
prospectus.
The Internal Revenue Service is considering a rule that would require
lenders to "flag" all of their high loan-to-value loans and to inform consumers
that some portion of their interest payments on high loan-to-value loans are not
tax-deductible. The adoption of this change could have an adverse affect on our
Equity + loan production. In addition, Congress is considering a recommendation
of the National Bankruptcy Review Commission that, if adopted, would treat in a
consumer bankruptcy proceeding the portion of a second mortgage loan that
exceeds the value of a house as unsecured debt. Adoption of these or more
restrictive laws, rules and regulations would have an adverse effect on our
financial condition, results of operations and cash flows. For more details, see
"Business -- Government Regulation" located later in this prospectus.
Members of Congress and government officials periodically have suggested
the elimination of the mortgage interest as a deduction for federal income tax
purposes in certain situations, based on, among other things, borrower income,
type of loan or the principal amount of the loan. Because many of our loans are
used by borrowers to consolidate consumer debt, make home improvements or for
other consumer needs, the reduction or elimination of these tax benefits could
substantially reduce the demand for the type of loans that we offer.
ENVIRONMENTAL RISKS
In the course of our business, we have acquired, and may acquire in the
future, residences that are the collateral or security for loans that are in
default. There is a risk that hazardous substances or waste, contaminants,
pollutants or their sources could be discovered on-site after these residences
are acquired by us. In that event, we may be required by law to remove the
substances from the residences at our cost and expense. We cannot guarantee
that: (1) the cost of removal would not substantially exceed the value of the
residence that is the collateral or security for a loan; (2) we would have
adequate remedies against the prior owner or other responsible parties; or (3)
we would be able to sell the residence prior to or following the removal.
YEAR 2000
The Company has begun to make inquiry of substantially all of its strategic
partners, vendors and third party entities with which it has material
relationships, and has begun to compile data related to their Year 2000 plans.
The Company's reliance upon certain third parties, vendors and strategic
partners for loan servicing, investor reporting, document custody and other
functions, means that their failure to adequately address the Year 2000 issue
could have a material adverse impact on the Company's operations and financial
results. The Company has received assurances from its two major strategic
partners, City National Bank and Sovereign Bancorp, that they have implemented
plans to address the Year 2000 issue. The Company has not evaluated these plans
or assurances for their accuracy and adequacy, or developed contingency plans in
the event of their failure. The Company has not yet received a significant
number of responses from its vendors or other third parties, and therefore
potential risks related to their failure to address Year 2000 issues are not
known at this time.
27
<PAGE> 29
SHARES ELIGIBLE FOR FUTURE SALE
The sale of substantial amounts of our common stock into the market or the
prospects of a sale could have a material and adverse effect on the market price
of our common stock. As of January 28, 1999, there were 30,566,660 shares of
common stock outstanding. The 70,688,838 shares of common stock being offered by
the selling stockholders listed in this prospectus will be immediately eligible
for sale in the public market, without restriction, beginning on the date of
this prospectus. In addition, Sovereign Bancorp and City National Bank each have
the option to purchase 6,666,667 million shares of common stock, subject to
adjustment, at an exercise price of $1.50 per share which, if exercised in full,
would add 13,333,334 shares of common stock to the number of shares of common
stock outstanding. In addition, options to purchase 4,818,591 shares of the
common stock at an exercise price of $1.50 per share were granted to Champ
Meyercord, our Chief Executive Officer, as part of his employment agreement. Our
stock option plans authorize the granting of options to purchase an aggregate of
2,010,000 shares of common stock, of which options to purchase 1,200,000 shares
of common stock were granted prior to this offering.
28
<PAGE> 30
USE OF PROCEEDS
All of the proceeds from the sale of the shares of common stock that may be
sold using this prospectus will be received by the selling stockholders. The
Company will not receive any of the proceeds from the sale of these shares of
common stock.
DIVIDEND POLICY
The Company has never paid cash dividends on its common stock, and the
board of directors currently intends to retain any earnings for use in the
Company's business for the foreseeable future. Any future payment of dividends
will depend on the Company's financial condition, results of operations, cash
requirements and other factors that the board of directors believes are
important.
PRICE RANGE OF COMMON STOCK
The Company completed its initial public offering on November 19, 1996 and,
since that date, the common stock has traded on the Nasdaq Stock Market under
the symbol "MMGC." The following table sets forth the high and low sales prices
of the common stock as reported on the Nasdaq National Market for the periods
indicated.
<TABLE>
<CAPTION>
HIGH LOW
-------- --------
<S> <C> <C>
FISCAL YEAR 1997:
First Quarter (November 19, 1996 to November 30, 1996)... $12.00 $10.75
Second Quarter........................................... 15.75 10.125
Third Quarter............................................ 14.625 8.00
Fourth Quarter........................................... 13.50 9.00
FISCAL YEAR 1998:
First Quarter............................................ 15.00 9.5625
Second Quarter........................................... 10.25 3.00
Third Quarter............................................ 3.375 1.875
Fourth Quarter........................................... 2.0625 1.00
FISCAL YEAR 1999:
First Quarter............................................ 1.53125 0.375
Second Quarter (through January 28, 1999)................ 0.813 0.375
</TABLE>
As of January 28, 1999, there were 1,838 holders of record of the Company's
common stock.
29
<PAGE> 31
CAPITALIZATION
The following table sets forth the capitalization of the Company at August
31, 1998. This table should be read in conjunction with the financial
statements, the related notes, and the other financial information appearing
elsewhere in this prospectus.
<TABLE>
<CAPTION>
AUGUST 31, 1998 NOVEMBER 30, 1998
---------------------- -----------------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Debt:
Revolving lines of credit................. $ 14,576 $ 29,432
Other notes and contracts payable......... 1,769 1,626
12 1/2% Senior Subordinated Notes due
2001("Old Notes")(1)................... 1,193 --
12 1/2% Subordinated Notes due 2001
("Current Notes")...................... 41,500 41,801
-------- --------
Total debt........................ 59,038 72,859
-------- --------
Stockholders' equity:
Preferred Stock, par value $.01 per share;
5,000,000 shares authorized; 62,500
shares issued and outstanding.......... 1 1
Common Stock, par value $.01 per share;
50,000,000 shares authorized;
30,566,667 shares issued and
outstanding as of August 31, 1998 and
30,566,660 shares issued and
outstanding as of November 30, 1998;
shares issued and outstanding as
adjusted(2)............................ 306 306
Additional paid-in capital................ 122,143 122,143
Accumulated deficit....................... (95,856) (98,350)
-------- --------
Total stockholders' equity........ 26,594 24,100
-------- --------
Total capitalization.............. $ 85,632 $ 96,959
======== ========
</TABLE>
- -------------------------
(1) As of October 31, 1998, the Company had completed the repurchase of all the
outstanding Old Notes.
(2) Does not include: (1) 10,000 shares of common stock reserved for issuance
upon the exercise of stock options granted and available to be granted under
the Company's 1996 Employee Stock Option Plan; (2) 2,000,000 shares of
common stock reserved for issuance upon the exercise of stock options
granted and available to be granted under the Company's 1997 Stock Option
Plan; and (3) an aggregate of approximately 4,818,591 shares of common stock
reserved for issuance upon the exercise of stock options granted to
management. For details on the Company's stock option plans, see
"Management -- Company Stock Option Plans" located later in this prospectus.
30
<PAGE> 32
SELECTED FINANCIAL DATA
The selected financial data set forth below has been derived from our
audited financial statements. The financial data as of August 31, 1997 and 1998
and for each of the three years in the period ended August 31, 1998 have been
derived from financial statements audited by the Company's independent auditors,
whose report for the year ended August 31, 1997 included an explanatory
paragraph related to their substantial doubt about our ability to continue as a
going concern. The Company's financial statements are included elsewhere in this
prospectus. The financial data as of August 31, 1994, 1995 and 1996 and for the
years ended August 31, 1994 and 1995 have been derived from audited financial
statements not included herein. The income statement data for the three months
ended November 30, 1997 and 1998 and the balance sheet data as of November 30,
1998 have been derived from unaudited interim financial statements contained
elsewhere herein, which in the opinion of management, include all adjustments
(consisting of only normal recurring adjustments) necessary for a fair
presentation of the information set forth therein. Results for the three months
ended November 30, 1998 are not necessarily indicative of the results for the
entire year. We have reclassified certain items to conform to prior years. You
should read the selected financial information set forth below in conjunction
with the financial statements, the related notes, and "Management's Discussion
and Analysis of Financial Condition and Results of Operations" appearing
elsewhere in this prospectus. However, due to recent substantial changes to our
business and operating strategy, we believe that our historical financial and
operating data are not likely to be indicative of our future performance and our
results of operation for fiscal 1998 are not comparable to fiscal 1997.
<TABLE>
<CAPTION>
THREE MONTHS
FISCAL YEAR ENDED AUGUST 31, ENDED NOVEMBER 30,
------------------------------------------------------- -------------------------
1994 1995 1996 1997 1998 1997 1998
------- ------- ------- ----------- ----------- ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
Gain (loss) on sale of
loans.................... $ 579 $12,233 $16,539 $ 45,123 $ (26,578) $ 3,721 $ 172
Net unrealized gain (loss)
on mortgage related
securities(1)............ -- -- 2,697 3,518 (70,024) (13,108) 270
Loan servicing income,
net...................... -- 873 3,348 3,036 999 1,194 240
Interest income, net of
interest expense of $107,
$468, $1,116, $6,374,
$13,162, $3,086 and
$1,764................... 172 473 988 3,133 1,624 1,210 (162)
------- ------- ------- ----------- ----------- ----------- -----------
Total revenues
(losses)........... 751 13,579 23,572 54,810 (93,979) (6,983) 520
------- ------- ------- ----------- ----------- ----------- -----------
Expenses:
Provision for credit
losses, net.............. 96 864 55 6,300 (3,198) 1,590 43
Depreciation and
amortization............. 136 403 394 672 1,013 208 215
Other interest............. 22 187 167 245 439 77 42
General and administrative:
Payroll and benefits..... 975 3,611 6,328 13,052 18,582 5,686 1,979
Commissions and
selling(2)............. 13 552 -- -- -- -- --
Credit reports........... 13 133 367 1,387 510 272 17
Rent and lease
expenses............... 85 249 338 1,199 1,616 321 359
Professional services.... 548 1,043 1,771 2,271 4,783 1,516 964
Sub-servicing fees....... 13 232 709 1,874 2,160 661 22
Other services........... 128 340 665 1,352 2,068 399 --
Travel................... 261 107 677 1,005 1,159 367 109
FHA insurance premiums... 11 231 572 558 430 106 82
</TABLE>
31
<PAGE> 33
<TABLE>
<CAPTION>
THREE MONTHS
FISCAL YEAR ENDED AUGUST 31, ENDED NOVEMBER 30,
------------------------------------------------------- -------------------------
1994 1995 1996 1997 1998 1997 1998
------- ------- ------- ----------- ----------- ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
Other.................... (39) (292) 374 1,085 2,448 662 650
------- ------- ------- ----------- ----------- ----------- -----------
Total costs and
expenses........... 2,262 7,660 12,417 31,000 32,010 11,865 4,482
------- ------- ------- ----------- ----------- ----------- -----------
Income (loss) before income
taxes(3)................... (1,511) 5,919 11,155 23,810 (125,989) (18,848) (3,962)
Income tax expense
(benefit)(3)............... -- 2,277 4,235 9,062 (6,334) -- (1,468)
------- ------- ------- ----------- ----------- ----------- -----------
Net income (loss)(3)......... $(1,511) $ 3,642 $ 6,920 $ 14,748 $ (119,655) $ (18,848) $ (2,494)
======= ======= ======= =========== =========== =========== ===========
Net income (loss) per
share(4):
Basic...................... $ 1.25 $ (7.72) $ (1.53) $ (0.08)
=========== =========== =========== ===========
Diluted.................... $ 1.25 $ (7.72) $ (1.53) $ (0.08)
=========== =========== =========== ===========
Weighted-average number of
common shares(4)........... 11,802,192 15,502,926 12,300,000 30,566,666
=========== =========== =========== ===========
Weighted-average number of
common shares and assumed
conversions(4)............. 11,802,192 15,502,926 12,300,000 30,566,666
=========== =========== =========== ===========
</TABLE>
<TABLE>
<CAPTION>
AS OF
AS OF AUGUST 31, NOVEMBER 30,
------------------------------------------------- ------------
1994 1995 1996 1997 1998 1998
------ ------- ------- -------- --------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C> <C>
STATEMENT OF FINANCIAL CONDITION DATA:
Cash and cash equivalents.................... $ 824 $ 752 $ 443 $ 6,104 $ 36,404(5) $ 30,010(5)
Loans held for sale, net..................... 1,463 3,676 4,610 9,523 10,975(6) 18,883(6)
Mortgage related securities(1)............... -- -- 22,944 106,299 34,830 34,927
Excess servicing rights(1)................... 904 14,483 12,121 -- -- --
Mortgage servicing rights.................... -- 1,076 3,827 9,507 83 --
Total assets................................. 5,122 24,081 50,606 156,554 104,535 107,840
Allowance for credit losses on loans sold
with recourse.............................. 66 886 920 7,014 2,472 2,476
Subordinated debt(7)......................... -- -- -- 40,000 42,693 41,801
Total liabilities............................ 983 13,300 32,905 103,447 77,941 83,740
Stockholders' equity......................... 4,139 10,781 17,701 53,107 26,594 24,100
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS
ENDED
FISCAL YEAR ENDED AUGUST 31, NOVEMBER 30,
------------------------------------------------- ------------------
1994 1995 1996 1997 1998 1997 1998
------ ------- -------- -------- -------- -------- -------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C> <C> <C>
OPERATING DATA:
Loan production........................ $8,164 $87,751 $139,367 $526,917 $338,942 $199,861 $16,518
Weighted-average interest rate on loan
production........................... 14.18% 14.55% 14.03% 13.92% 13.89% 13.99% 10.92%
Loans in servicing portfolio (end of
period):
Company-owned:
Equity +........................... $ -- $ -- $ 922 $ 8,661 $ 8,217 $ 51,325 $18,404
Title I............................ 1,471 3,720 3,776 902 4,233 1,916 2,599
------ ------- -------- -------- -------- -------- -------
Total Company-owned(8)......... 1,471 3,720 4,698 9,563 12,450(6) 53,241 21,003
</TABLE>
32
<PAGE> 34
<TABLE>
<CAPTION>
THREE MONTHS
ENDED
FISCAL YEAR ENDED AUGUST 31, NOVEMBER 30,
------------------------------------------------- ------------------
1994 1995 1996 1997 1998 1997 1998
------ ------- -------- -------- -------- -------- -------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C> <C> <C>
Securitized:
Equity +........................... -- -- 10,501 363,961 -- 462,078 --
Title I............................ 6,555 88,566 198,990 254,544 18,772 252,028 --
------ ------- -------- -------- -------- -------- -------
Total securitized.............. 6,555 88,566 209,491 618,505 18,772 714,106 --
------ ------- -------- -------- -------- -------- -------
Total servicing portfolio...... $8,026 $92,286 $214,189 $628,068 $ 31,222 $767,347 $21,003
====== ======= ======== ======== ======== ======== =======
Cash used in operations................ $4,402 $ 3,619 $ 12,440 $ 72,438 $ 39,723 $ 59,445 $20,161
====== ======= ======== ======== ======== ======== =======
</TABLE>
- ---------------
(1) Mortgage related securities are junior subordinated interests retained by
the Company in pools of mortgage loans sold by the Company in securitization
transactions. SFAS No. 125, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities," required the Company,
as of January 1, 1997, to reclassify excess servicing rights (junior
subordinate interests retained by the Company in pools of mortgage loans
sold in transactions similar to a securitization) to mortgage related
securities. The fair value (the dollar amount on the Company's balance
sheet) of the Company's mortgage related securities was written down from
$106.3 million at the end of fiscal 1997 to $34.8 million at the end of
fiscal 1998. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and Notes 2, 4 and 17 to the Company's
financial statements located later in this prospectus.
(2) For fiscal 1996, 1997, 1998 and the three months ended November 30, 1997,
commissions and selling expenses of $2.0 million, $2.8 million, $2.0 million
and $690,000 respectively, have been reclassified into its functional
classifications within general and administrative expenses.
(3) The results of the Company's operations were included in the consolidated
federal income tax returns filed by Mego Financial through September 2,
1997, the date the shares of common stock of the Company were distributed by
Mego Financial to its shareholders in a tax free spin-off. For more details
on this and other transactions with Mego Financial and its affiliates, see
"Certain Transactions" located later in this prospectus.
(4) Earnings per share for the fiscal years ended August 31, 1994, 1995 and 1996
are not presented because, during these years, the Company was a wholly
owned subsidiary of Mego Financial.
(5) As part of the recapitalization, the Company sold an aggregate of $50.0
million of common stock and Series A convertible preferred stock. For more
details, see "The Recapitalization" located later in this prospectus.
(6) Loans held for sale, net includes a valuation reserve which reflects the
Company's best estimate of the amount that the Company expects to receive on
the sale of these loans.
(7) The Company sold $40.0 million principal amount of Old Notes in November
1996 and an additional $40.0 million principal amount of Old Notes in
October 1997. As part of the recapitalization, the Company issued $37.5
million of Series A convertible preferred stock and $41.5 million principal
amount of Current Notes in exchange for $79.0 million of Old Notes. The
Company purchased all of the Old Notes remaining outstanding as of October
1998.
(8) Excludes approximately $9.4 million and $2.6 million of Equity + loans to be
repurchased on August 31, 1998 and November 30, 1998, respectively. The
majority of these loans have been repurchased prior to November 30, 1998.
The amount on the Company's balance sheet as of August 31, 1998 is the
amount the Company expected to receive on the sale of these loans. For
additional details, see Note 3 to the Company's financial statements located
later in this prospectus.
33
<PAGE> 35
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The purpose of Management's Discussion and Analysis of Financial Conditions
and Results of Operations is to provide a detailed explanation of the Company's
financial performance in fiscal 1996, 1997 and 1998 and the quarters ended
November 30, 1997 and 1998, the factors that had a significant impact on the
Company's performance in those periods and a description of any trends affecting
financial performance during the periods discussed. We also describe the
Company's liquidity situation at the end of the quarter ended November 30, 1998,
including the amount that the Company owed to its lenders on that date, and the
additional amounts, if any, available to be borrowed by the Company. In
addition, we describe the major changes to the balance sheet. This information
is the primary basis for our belief that we have enough cash and borrowing
ability to carry out our business plan for fiscal 1999. You should read this
section in conjunction with the Company's financial statements, including the
notes to the financial statements, located later in this prospectus.
During the last eight months of fiscal 1998 and the three months ended
November 30, 1998, the Company's operations consisted principally of:
(1) liquidating its portfolio of loans to repay outstanding debt;
(2) maintaining its systems and retaining personnel necessary to resume
operations while exploring alternatives to locate new capital; and
(3) designing and beginning to implement its strategic initiatives.
Due to recent substantial changes to the Company's business and operating
strategy, we believe that the Company's historical financial and operating data
are not likely to be indicative of the Company's future performance and the
Company's results of operation for fiscal 1998 are not comparable to fiscal
1997.
GENERAL
The Company substantially expanded its operations during fiscal 1996 and
1997 and the first four months of fiscal 1998. During these periods the
Company's loan production was $139.4 million (fiscal 1996), $526.9 million
(fiscal 1997) and $268.5 million (first four months of fiscal 1998). As it
expanded its business, the Company's general and administrative expenses
increased from $11.8 million in fiscal 1996 to $23.8 million in fiscal 1997 and
$13.8 million in the first four months of fiscal 1998.
During these periods, a substantial majority of the Company's loan
production was sold in securitization transactions. The sale of loans by the
Company in securitization transactions, as described below, typically results in
substantial negative cash flow, because the cash proceeds from the sale of loans
in a securitization transaction is substantially less the Company's total cost
of producing the loans sold. The combination of negative cash flow from the sale
of loans in securitization transactions and increases in general and
administrative expenses caused the Company, historically, to operate on a
substantial negative cash flow basis. The Company's negative cash flow from
operations was $12.4 million for fiscal 1996, $72.4 million for fiscal 1997 and
$49.7 million for the first four months of fiscal 1998.
34
<PAGE> 36
As a result of a $11.7 million loss in the first quarter of fiscal 1998 and
continuing cash flow deficits, the Company violated certain provisions of its
warehouse line. In February 1998, the warehouse lender requested that the
Company repay a significant portion of the principal balance of the line or be
declared in default. Since a default on the warehouse line would have triggered,
among other things, a default on the Company's $80 million principal amount of
outstanding Old Notes, the Company agreed to reduce the outstanding balance of
the warehouse line from $55.0 million periodically. The Company repaid the
balance on June 29, 1998.
To generate cash to reduce the outstanding balance of the warehouse line
and continue to operate, the Company began to liquidate, through sales for cash,
its mortgage loan portfolio and the warehouse lender refused to make further
advances under the line. In addition, because the Company's old warehouse line
was used to fund loans produced by the Company prior to their sale, the Company
substantially curtailed its loan production beginning in January 1998. The cash
received from the Company's sale of loans from its loan portfolio was used to
pay down the old warehouse line and other Company borrowings and to pay
substantial general and administrative expenses to retain personnel and maintain
the Company's operations while it sought to locate new capital.
On July 1, 1998, the Company completed the recapitalization. As part of the
recapitalization, the Company received $50.0 million in proceeds from the
private placement of approximately 16.67 million shares of common stock at a
price of $1.50 per share and 25,000 shares of Series A convertible preferred
stock at a price of $1,000 per share. In addition, the Company issued $37.5
million of Series A convertible preferred stock and $41.5 million principal
amount of Current Notes in exchange for approximately $79.0 million principal
amount of Old Notes. The recapitalization resulted in approximately $84.5
million of new equity. For more information on the recapitalization, see "The
Recapitalization" located later in this prospectus.
SECURITIZATION TRANSACTIONS
Securitization transactions historically had been the main source of the
Company's revenue and income. In a securitization transaction, a specific group
of the Company's mortgage loans having similar characteristics, loan type
(Equity + or Title I) and loan amounts are pooled for sale. By selling loans in
a securitization transaction, the Company could sell a very large group of loans
at one time. The Company sold an average of $79.7 million of mortgage loans in
each of the five securitizations completed in fiscal 1997. However, the sale of
loans in a securitization transaction generates a significant cash flow deficit,
because the cash received by the Company from the sale of the loans is
significantly less than the Company's total cost of producing the loans sold.
The purchaser of the loans in a securitization transaction is a special
trust created:
(1) to purchase and hold title to the loans;
(2) to sell debt securities or ownership interests backed by the cash flow
to be received on the loans owned by the trust, i.e., the principal and interest
payments from the Company's borrowers; and
(3) to distribute payments over time to the holders of securities issued by
the trust.
Once the trust purchases the loans from the Company, it generally has no
recourse against the Company other than for breaches of certain representations
and warranties
35
<PAGE> 37
made by the Company at the time the loans were sold. Likewise, after the trust
purchases the loans from the Company, creditors of the Company have no recourse
against the loans in the event the Company experiences financial difficulties.
The trust purchases the loans from the Company with money it obtains by selling
the securities.
The trust sells both senior "rated" securities and issues an unrated
subordinate residual security to the Company. Only qualified institutional
investors, such as insurance companies, banks and thrifts, can purchase the
senior securities sold by the trust.
Because the Company's Equity + loans are not insured and its Title I loans
have only limited FHA insurance, the trust, as the owner of these mortgage
loans, has credit risk. If the borrowers default on their loans, the trust (as
the owner of the loans) typically will lose its entire investment (except to the
extent of the limited FHA insurance on Title I loans). As a result of these
potential losses, the purchasers of the trust's senior securities are willing to
buy the securities only if they receive additional assurance that they will get
paid. This assurance is provided by a rating from the national rating agencies,
such as Standard & Poor's and Moody's.
As a general matter, the more predictable the cash flow to the senior
securities, the higher the rating on the senior securities and the lower the
yield that will be demanded by purchasers of the senior securities relative to
prevailing market yields. The lower the yield paid to the senior security
holders, the greater the positive spread (the "spread") between the interest
paid by the Company's borrowers on the mortgage loans in the trust and (i) the
interest costs of the senior securities sold and (ii) fees paid to the trustee
and the servicer for servicing the mortgage loans. In general, the greater the
spread, the greater the amount of cash flow in excess of the principal and
interest payments to the senior security holders the Company anticipates it will
receive on the mortgage related securities issued to the Company in the
securitization, and the greater their fair value. During fiscal 1997, the
Company sold $398.4 million principal amount of loans in securitization
transactions that had a weighted-average interest rate of 14.0% and in which the
senior securities sold had an initial weighted-average yield of 6.88%.
In order for the senior securities to gain a sufficiently high rating to
attract investors, the rating agencies require that the trust create various
forms of credit enhancement to increase the likelihood that the loans in the
trust will generate sufficient cash flow to pay the interest and principal
payments on the senior securities. Credit enhancement may be achieved in several
ways. The trust may purchase the loans the Company sells in the securitization
transaction for a combination of cash and by issuing the Company a subordinated
residual interest in the securitization. The security issued by the trust to the
Company receives cash flow only after required payments of interest and
principal have been made to the senior security holders, and absorbs any losses
from defaults or foreclosures on the loans in the trust. The junior subordinated
interests issued to the Company in securitization transactions are called
mortgage related securities. Another credit enhancement is a "guaranty," a form
of insurance issued by an insurance company. While some of the Company's
securitizations have included guaranty insurance, the Company has always
received a subordinate mortgage related security and has provided
over-collateralization as credit enhancement in order to achieve acceptable
ratings.
Credit enhancement may also be achieved through "over-collateralization."
National rating agencies will give higher ratings if the senior securities
receive assurance that they will be paid. This is achieved by requiring an
initial level of over-collateralization and by building more
over-collateralization through the trust's retaining cash flow (from the
36
<PAGE> 38
spread) that would otherwise be paid to the Company on its mortgage related
securities. The initial over-collateralization is created by having the
principal amount of loans sold to the trust be greater than the principal amount
(and cash proceeds from the sale) of senior interests sold. In the five
securitization transactions during fiscal 1997, the trusts purchased $398.4
million principal amount of loans from the Company, but the trusts sold only
$379.2 principal amount of senior securities.
As borrowers make their monthly mortgage loan payments to the servicer of
the loans in the trust, the payments are remitted by the servicer to a trustee
that collects these payments and make payments of interest and principal to the
holders of the senior securities pursuant to a pre-established schedule. The
priority of the payments is determined by the terms of an indenture.
The mortgage related securities owned by the Company, while offering the
potential of a substantially higher yield than the senior securities, have very
high credit risk. The Company's mortgage related securities absorb all losses
caused by defaults on the mortgage loans backing the securitization. The
Company's mortgage related securities are highly speculative and are subject to
the special risks which are described in more detail under "Risk Factors"
earlier in this prospectus.
Sample Securitization Transaction
In order to make the concept of negative cash flow that results from the
sale of mortgage loans in a securitization transaction more understandable, the
Company has provided the following example.
THE EXAMPLE BELOW ILLUSTRATES THE MECHANICS OF A SECURITIZATION AND THE
RESULTING NEGATIVE CASH FLOW BUT DOES NOT REFLECT (1) AN ACTUAL SALE OF MORTGAGE
LOANS BY THE COMPANY IN A SECURITIZATION TRANSACTION OR (2) THE ACTUAL AMOUNT OF
NEGATIVE CASH FLOW FROM THE DISPOSITION OF LOANS IN THIS MANNER. ACTUAL RESULTS
WILL BE MATERIALLY DIFFERENT FROM THE EXAMPLE.
This example is based on five general assumptions:
(1) mortgage bankers originated $100.0 million of mortgage loans having a
weighted average interest rate of 13.98%;
(2) the Company purchased the loans from mortgage bankers for a premium of
$4.0 million (the mortgage bankers received an aggregate of $104.0 million for
the loans);
(3) the Company sells the loans to the securitization trust for $97.0
million in cash, the trust sells $97.0 million of senior securities having a
weighted average interest rate of 6.88% and issues a subordinate mortgage
related security to the Company;
(4) the securitization process costs $1.0 million in fees and costs paid to
investment bankers, attorneys, accountants and others; and
(5) Standard & Poor's and Moody's require (A) an initial level of "over-
collateralization" of 3% ($3.0 million) of the original amount of loans sold in
the securitization and (B) that the level of over-collateralization must reach
6% of the original principal amount of loans ($6.0 million) before the cash flow
will be paid by the trustee to the holder of the subordinate mortgage related
security.
37
<PAGE> 39
In this example, the sale of this pool of $100.0 million of mortgage loans
would result in negative cash flow of $8.0 million. The negative cash flow
results from the following factors:
- $104.0 million, representing the total cost of producing the loans sold
in the securitization minus
- $97.0 million is received by the trust from the sale of the senior
securities, all of which is paid to the Company, minus
- $1.0 million of fees and expenses.
The $3.0 million difference between the $100.0 million of mortgage loans
purchased by the trust and the $97.0 million of senior securities sold by the
trust creates the 3.0% initial over-collateralization. The senior securities
have the "protection" or credit enhancement of the cash flow, principal and
interest received on the $3.0 million of loans plus the spread initially equal
to $7.4 million per year. The spread represents 7.1% (the difference between
13.98%, the interest paid by the borrower on the loans in the trust, and 6.88%,
the interest paid by the trust on the senior securities) on the $97.0 million of
loans plus 13.98% on the $3.0 million of loans in the over-collateralization
account. The trustee would retain the spread until the over-collateralization
reaches $6.0 million.
After the required level of over-collateralization is achieved, the trustee
pays all of the cash flow, after the payment of interest and principal to the
senior interest, to the Company's mortgage related securities. Loan
delinquencies and defaults reduce this over-collateralization. If the amount in
the account falls below 6.0% of the amount of loans sold to the trust, the
trustee stops the payment of cash to the Company's mortgage related securities
and retains it until the 6.0% level is again achieved.
Accounting for a Securitization Transaction
Under generally accepted accounting principles, the sale of mortgage loans
by the Company in securitization transactions requires the Company to recognize
revenue on the completion of the securitization transaction based on the
discounted present value of the estimated future cash flow stream ("gain on sale
accounting") to be received by the Company on its mortgage related securities.
As described in more detail later in this "Management's Discussion and Analysis
of Financial Condition and Results of Operation," the Company determines the
fair value of each of its mortgage related securities using prepayment,
delinquency, default and credit loss assumptions on the mortgage loans backing
each of its mortgage related securities that the Company believes to be
appropriate for the particular mortgage loans. The anticipated cash to be
received by the Company's mortgage related securities from the mortgage loans is
discounted to present value to establish the fair value of the mortgage related
securities shown on the Company's balance sheet.
Accounting for specialty finance companies that sell assets in
securitization transactions is particularly complex. The most complex item is
the source of the Company revenues. The Company gets its revenues from the
following items:
- Gain (loss) on the sale of loans;
- Unrealized gain (loss) on mortgage related securities retained in
securitization transactions;
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<PAGE> 40
- Interest income, net; and
- Loan servicing income, net.
Gain (Loss) on the Sale of Loans. Historically, the most significant
portion of the Company's revenues comes from Gain (loss) on the sale of loans.
One component is the Gain (loss) resulting from the sale of loans in
securitization transactions. Refer to the example the Company used earlier,
where the sale of $100.0 million of our loans in the securitization transaction
resulted in negative cash flow of $8.0 million. Assume the mortgage related
security issued by the trust to the seller of the loans from that securitization
had a fair value of $18.0 million (see discussion on "gain on sale" accounting
above). The seller then would have received a total of $115.0 million from the
securitization, consisting of $97.0 million in cash and a mortgage related
security having a fair value of $18.0 million. The total cost of the loans sold
in the securitization were $105.0 million, consisting of the total cost of
producing the loans of $104.0 million and $1.0 million in fees and expenses for
the securitization. In this example, the revenues recorded from this
securitization would be $10.0 million. This amount is divided between two
revenue items, Gain (loss) on sale of loans and Net unrealized gain (loss) on
mortgage related securities. The division of the revenues between these two
items is determined by allocating the total revenues of $10.0 million,
proportionately between the cash proceeds from the sale of the loans, in this
case $97.0 million (allocated to revenues from "Gain (Loss) on the Sale of
Loans"), and the fair value of the mortgage related security issued by the trust
to the seller of the loans in the securitization, in this case $18.0 million
(allocated to revenues from "Unrealized gain (loss) on mortgage related
securities").
Another component represents the gain (loss) on the sale of loans for cash.
It is equal to the Company's total cost (expense) of producing loans including
any premiums paid when the Company purchases loans from its network of mortgage
bankers, minus the amount received by the Company at the time the loans are sold
for cash to an institutional purchaser. For example, if the Company purchased a
$100,000 principal balance loan from a mortgage banker for $104,000 and sold
that loan to an institutional purchaser for $107,000, the Company would
recognize $3,000 of revenue from gain on the sale of loans.
Unrealized Gain (Loss) on Mortgage Related Securities Retained in
Securitization Transactions. Revenues from "Unrealized gain (loss) on mortgage
related securities" results from the allocation of total revenues from the sale
of mortgage loans in securitization transactions described immediately above and
from two other sources. Revenues from the amortization on the Company's mortgage
related securities generally is equal to the amount of cash flow received on the
Company's mortgage related securities. In addition, Unrealized gain (loss) on
mortgage related securities generates negative revenues equal to (i) the write
down, if any, of the fair value of the Company's mortgage related securities;
and (ii) positive revenues from the write up, if any, of those securities.
Interest Income, Net. Interest income, net, is the interest received by
the Company on its portfolio of mortgage loans prior to their sale plus
accretion interest on its mortgage related securities minus the Company's
interest expense on its borrowings including its subordinated debt, warehouse
line of credit and other borrowings.
Loan Servicing Income, Net. "Loan servicing income, net", are the fees
paid to the Company for servicing loans owned by the Company or loans sold with
servicing retained. The prepayment penalties, if any, received from the
Company's borrowers who repay their
39
<PAGE> 41
loans prior to their scheduled maturity date are included in Loan servicing
income, net. As discussed earlier in this prospectus, the Company historically
retained the servicing on a substantial majority of loans it sold. The Company
uses "net" as a part of the revenues from loan servicing because, under
generally accepted accounting principles, the amount of servicing fees earned is
reduced by the amortization of the Company's servicing rights. The Company
values the anticipated servicing fees the Company will receive for servicing a
loan from inception until its anticipated maturity and discounts the anticipated
cash flow to its present value similar to the way the Company determines the
fair value of its mortgage related securities. Historically, the Company's fee
for servicing a loan was 1% of the loan's outstanding principal balance. The
fair value of the anticipated cash flow is recorded on the Company's balance
sheet as "Mortgage servicing rights." As servicing revenues are received, the
discounted present value of the future cash flow is reduced. The amount of the
reduction is the "amortization." Revenue from mortgage servicing rights will not
be significant in the future, because the Company sold all of its servicing
rights to City Mortgage Servicing as part of the recapitalization.
Revision of Assumptions
As described immediately above, the most significant source of the
Company's revenues and income historically has resulted from the sale of loans
produced by the Company and sold in securitization transactions and the fair
value of the mortgage related security issued to the Company by the trusts. The
Company explained earlier in this prospectus under "Risk Factors" that it
projects the anticipated cash flow to be received from the loans backing its
mortgage related securities based on assumptions of voluntary prepayment speeds
and losses. When prepayments, delinquencies, default and credit losses on the
mortgage loans backing the Company's mortgage related securities exceed the
Company's assumptions, the Company is required to modify its assumptions as to
the prepayments, delinquencies, defaults and credit loss rates on the mortgage
loans backing its mortgage related securities. This generally reduces the
anticipated cash flow to be received from the mortgage loans and results in a
write down in the fair value of the particular mortgage related securities. The
amount of the writedown is treated as negative revenues from Unrealized gain
(loss) on mortgage related securities.
The fair value of the Company's mortgage related securities are affected
by, among other things, changes in market interest rates and prepayment and loss
experiences of these and similar securities. The Company estimates the fair
value of its mortgage related securities using prepayment and credit loss
assumptions on the mortgage loans backing these securities that the Company
believes to be appropriate for the characteristics (weighted-average interest
rate, weighted-average maturity date, etc.) of the mortgage loans backing each
particular securitization. The Company discounts the projected cash flow at the
rate it believes an independent third-party purchaser would require as a rate of
return.
During the fiscal year ended August 31, 1998, the Company experienced
prepayment activity and delinquencies with respect to its securitized Equity +
loans, which substantially exceeded the levels that had been assumed for the
applicable time frame. As a result of this increase, the Company adjusted the
assumptions previously utilized in calculating the carrying value of its
mortgage related securities. The application of these revised assumptions to the
Company's portfolio of Equity + and Title I loans backing its mortgage related
securities caused the Company to adjust the carrying value of these securities
by approximately $72.1 million during fiscal 1998. The changes in prepayment
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<PAGE> 42
and credit loss assumptions also caused the Company to write down the fair value
of its mortgage servicing rights by $1.1 million during fiscal 1998. As
discussed earlier in this prospectus, the fair value of the Company's mortgage
related securities and the fair value of its mortgage servicing rights are
determined in a similar manner.
The Company has revised its assumptions based on information from a variety
of sources including, among other things, the Company's experience with its own
portfolio of loans, pertinent information from a variety of market sources and
consultations with its financial advisors. However, the Company has not obtained
an independent evaluation of the assumptions utilized in calculating the
carrying value of its mortgage related securities for any period subsequent to
August 31, 1997. To the Company's knowledge, there is no active market for the
sale of these securities. During the year ended August 31, 1998, negative
adjustments of approximately $72.1 million were recognized. See Note 4 to the
Company's financial statements included later in this prospectus.
Although the Company believes that it has made reasonable estimates of the
prepayment and default rates in determining the fair value of the Company's
mortgage related securities, the rate of prepayments and defaults utilized are
estimates, and actual experience will vary from these estimates and such
variances may be material. There can be no assurance that the revised prepayment
and loss assumptions used to determine the fair value of the Company's mortgage
related securities and mortgage servicing rights will remain appropriate for the
life of the loans backing such securities. If actual loan prepayments or credit
losses vary from the Company's estimates, the fair value of the Company's
mortgage related securities and mortgage servicing rights, if any, may have to
be further adjusted through a charge or credit to earnings.
The Company's revised prepayment assumptions used for Title I loans at
August 31, 1998 reflect an annualized rate of 23.0% for the life of the
portfolio. Actual annualized prepayment rates of the Title I loans backing the
Company's mortgage related securities were 22.5% for the fiscal year ended
August 31, 1998 and 22.7% for the six months ended August 31, 1998. These
revised loss assumptions for Title I loans at August 31, 1998 are based on a
historical "migration" analysis of delinquent loans that the Company anticipates
will become "defaulted loans." The new assumed default rate and the restricted
rates are shown below in the following model and historical default rates:
<TABLE>
<CAPTION>
HISTORICAL DEFAULT RATES
FOR THE PERIODS ENDED AUGUST 31, 1998
NEW ASSUMED ---------------------------------------
DELINQUENCY (DAYS) STATUS DEFAULT RATES 12 MONTHS 6 MONTHS 3 MONTHS
- ------------------------- ------------- ----------- ---------- ----------
<S> <C> <C> <C> <C>
31 - 60....................... 5% 1.51% 1.69% 2.64%
61 - 90....................... 20-25 21.80 24.80 29.55
91 - 120...................... 50 43.02 46.43 54.78
121 - 150..................... 80 55.90 55.55 63.28
151 - 180..................... 95 59.25 59.85 68.34
Over 180...................... 100 100 100 100
</TABLE>
The Company assumes that a defaulted Title I loan will result in loss of
95.0% of the loan balance and that all Title I insurance has been exhausted. On
a cumulative basis, the new assumptions anticipate aggregate losses of 11.9% of
the original principal balance of Title I loans.
The prepayment assumptions for Equity + loans were also increased at the
end of fiscal 1998 to reflect an annualized prepayment rate of 4.5% in the first
month following the completion of the securitization with the annualized rate
increases in level monthly
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<PAGE> 43
increments so that by the 18th month the annualized prepayment rate is 18.75%.
The annualized prepayment rate is maintained at that level through the 36th
month at which time it is assumed to decline in level monthly increments to
15.25% by the 43rd month, and is maintained at 15.25% for the remaining life of
the portfolio. The weighted-average annualized prepayment speed for the loans
backing the Company's mortgage related securities was 17.4% during fiscal 1998
and 4.1% during fiscal 1997.
The loss assumptions for the Equity + loans backing the Company's mortgage
related securities have also been increased to reflect losses commencing in the
second month following a securitization and building in level monthly increments
until a 4.25% annualized loss rate is reached in the 15th month. The annualized
loss rate is maintained at that level through the 43rd month at which time it is
assumed to decline in level monthly increments to 4.0% at month 48 and is
maintained for the life of the portfolio. On a cumulative basis this model
assumes aggregate losses of approximately 16% of the initial principal balance
of Equity + loans backing the Company's mortgage related securities. The actual
losses on Equity + loans backing the Company's mortgage related securities
during fiscal 1998 were approximately 2.5% of the original principal balance.
The Company utilizes a 16% discount rate at August 31, 1998 to discount to
their present sale of the cash flow streams to be received by the Company on its
mortgage related securities. During fiscal 1996 and 1997, the Company used an
annual weighted-average discount rate of 12% for Title I and Equity + loans and
generally utilized annual prepayment assumptions ranging from 1% to 15%, annual
estimated losses of up to 1.75% on Equity + loans resulting in an aggregate loss
of 15%, and estimated losses on Title I loans based on the then current
migration analysis and assuming recoveries of 20% after exhaustion of insured
reserves.
We believe that due to recent substantial changes to the Company's business
and operating strategy, the Company's historical financial and operating data is
not likely to be indicative of the Company's future performance.
RESULTS OF OPERATIONS
Three Months Ended November 30, 1998 Compared to Three Months Ended November
30, 1997
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<PAGE> 44
Loan Production
The following table sets forth certain data regarding loans produced,
securitized, and serviced by the Company during the three months ended November
30, 1997 and 1998:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30,
-----------------------------------
1997 1998
---------------- ---------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Principal balance of loans produced:
Wholesale (includes Bankers/Brokers):
Title I................................. $ 4,902 2.5% $ 4 0.0%
Equity + loans.......................... 178,757 89.4 2,942 17.8
Home Equity............................. -- -- 11,584 70.2
-------- ----- ------- -----
Total Wholesale.................... 183,659 91.9 14,530 88.0
-------- ----- ------- -----
Dealers(1):
Title I................................. 7,201 3.6 -- --
Equity + loans.......................... 8,754 4.4 -- --
-------- ----- ------- -----
Total Dealers...................... 15,955 8.0 -- --
-------- ----- ------- -----
Retail:
Equity + loans.......................... 247 0.1 1,965 11.9
Home Equity............................. -- -- 23 0.1
-------- ----- ------- -----
Total Retail....................... 247 0.1 1,988 12.0
-------- ----- ------- -----
Total Principal Amount of Loans
Produced........................ $199,861 100.0% $16,518 100.0%
======== ===== ======= =====
NUMBER OF LOANS PRODUCED:
Wholesale (includes Bankers/Brokers):
Title I................................. 225 3.3% 1 0.4%
Equity + loans.......................... 5,440 80.6 85 32.7
Home Equity............................. -- -- 111 42.7
-------- ----- ------- -----
Total Wholesale.................... 5,665 83.9 197 75.8
-------- ----- ------- -----
Dealers(1):
Title I................................. 587 8.7 -- --
Equity + loans.......................... 489 7.3 -- --
-------- ----- ------- -----
Total Dealers...................... 1,076 16.0 -- --
-------- ----- ------- -----
Retail:
Equity + loans.......................... 8 0.1 62 23.8
Home Equity............................. -- -- 1 0.4
-------- ----- ------- -----
Total Retail....................... -- 0.1 63 24.2
-------- ----- ------- -----
Total Number of Loans Produced..... 6,749 100.0% 260 100.0%
======== ===== ======= =====
</TABLE>
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<PAGE> 45
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30,
-----------------------------------
1997 1998
---------------- ---------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
LOANS SERVICED AT END OF PERIOD (INCLUDING
LOANS SECURITIZED, SOLD TO INVESTORS
SERVICING RETAINED AND HELD FOR SALE):
Title I.................................... $253,944 33.1% $ 2,599 12.4%
Conventional (Equity + and Home Equity
loans).................................. 513,403 66.9 18,404 87.6
-------- ----- ------- -----
Total Loans Serviced at End of
Period(2)....................... $767,347 100.0% $21,003 100.0%
======== ===== ======= =====
</TABLE>
- -------------------------
(1) The Company closed its dealer division, which purchased loans from home
improvement contractors, in February 1998.
(2) Exludes approximately $2.6 million of loans to be repurchased at November
30, 1998.
Loan Sales
The following table sets forth the principal balance of loans sold or
securitized and related gain on sale data for the three months ended November
30, 1997 and 1998:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
-----------------------
1997 1998
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Principal Amount of Loans Sold:
Title I.................................................. $ 11,075 $ 810
Equity +................................................. 144,782 7,652
Home Equity.............................................. -- 24
--------- -------
Total............................................ $ 155,857 $ 8,486
========= =======
Gain on sale of loans $ 3,721 $ 172
========= =======
Net unrealized (loss) gain on mortgage related
securities(1) $ (13,108) $ 270
========= =======
</TABLE>
44
<PAGE> 46
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
-----------------------
1997 1998
(DOLLARS IN THOUSANDS)
<S> <C> <C>
PRINCIPAL AMOUNT OF LOANS SOLD(2):
Title I.................................................. $ 11,075 $ 810
Equity +................................................. 106,421 12,143
Home Equity.............................................. -- 24
--------- -------
Total............................................ $ 117,496 $12,977
========= =======
Gain on sale of loans(3) $ 2,790 $ 172
========= =======
Gain on sale of loans as a percentage of principal balance
of loans sold(3)......................................... 2.4% 2.0%
========= =======
Gain on sale of loans plus net unrealized loss on mortgage
related securities as a percentage of principal balance
of loans sold(3)......................................... (8.8)% 5.2%
========= =======
</TABLE>
- -------------------------
(1) The loss for the three months ended November 30, 1997 was a result of the
application of a negative adjustment to the carrying value of mortgage
related securities of $14.1 million during that period. No such adjustment
has been made to the carrying value of mortgage related securities during
the three months ended November 30, 1998.
(2) Excludes $38.4 million of loans sold with servicing released during the
three months ended November 30, 1997. Includes approximately $4.5 million
principal amount of repurchased loans sold in the three months ended
November 30, 1998.
(2) Excludes gain on sale of $931,000 relating to whole loan sales of $38.4
million of loans sold with servicing released during the three months ended
November 30, 1997.
The percentage of gain on sale of loans can vary for several reasons,
including the relative amounts of Equity +, Home Equity and Title I Loans, each
of which type of loan has different (i) estimated prepayment rates, (ii)
weighted-average interest rates, (iii) weighted-average maturities and (iv)
estimated future default rates. Typically, the gain on sale of loans through
securitizations is higher than on whole loan sales.
As the holder of residual securities issued in securitizations, the Company
is entitled to receive certain excess cash flows. These excess cash flows are
calculated as the difference between (a) principal and interest paid by
borrowers and (b) the sum of (i) pass-through interest and principal to be paid
to the holders of the regular securities and interest only securities, (ii)
trustee fees, (iii) third-party credit enhancement fees, (iv) servicing fees and
(v) estimated loan pool losses. The Company's right to receive the excess cash
flows is subject to the satisfaction of certain reserve or
over-collateralization requirements that are specific to each securitization and
are used as a means of credit enhancement.
45
<PAGE> 47
Loan Delinquencies
The following table sets forth the Title I, Equity + and Home Equity Loan
delinquencies and Title I insurance claims experience of loans serviced by the
Company as of the dates indicated:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
1998 1998
---------- ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Delinquency period(1)
31-60 days past due................................... 7.69% 4.86%
61-90 days past due................................... 2.16 1.50
91 days and over past due............................. 24.95 11.38
Total past due.......................................... 34.88 17.74
91 days and over past due, net of claims filed(2)..... 7.56 --
Outstanding claims filed with HUD(3)(4)................. 17.39 18.06
Outstanding number of Title I insurance claims.......... 207 160
Total servicing portfolio............................... $ 31,222 $21,003
Title I Loans serviced.................................. 23,005 2,599
Conventional Loans serviced (Equity + and Home Equity
loans)................................................ 8,217 18,404
Aggregate losses on liquidated loans (twelve and three
months ended, respectively)(5)........................ $ 1,368.0 $ 47.9
</TABLE>
- -------------------------
(1) Represents the dollar amount of delinquent loans as a percentage of the
total dollar amount of loans serviced by the Company (including loans owned
by the Company) as of the dates indicated.
(2) Represents the dollar amount of delinquent loans net of delinquent Title I
Loans for which claims have been filed with HUD and payment is pending as a
percentage of the total dollar amount of total loans serviced by the Company
(including loans owned by the Company) as of the dates indicated.
(3) Represents the dollar amount of delinquent Title I Loans for which claims
have been filed with HUD and payment is pending as a percentage of total
dollar amount of total loans serviced by the Company (including loans owned
by the Company) as of the dates indicated.
(4) If all claims filed with HUD had been processed as of November 30, 1998, the
amount of FHA insurance available for serviced Title I Loans would have been
reduced to $8.8 million.
(5) On Title I Loans, a loss is recognized upon receipt of payment of a claim or
final rejection thereof. Claims paid in a period may relate to a claim filed
in an earlier period. Since the company commenced its Title I lending
operations in March 1994, there has been no final rejection of a claim by
the FHA. Aggregate losses on liquidated Title I Loans related to 1,326 Title
I insurance claims made by the Company, as servicer, since commencing
operation through November 30, 1998. Losses on Title I Loans liquidated will
increase as the balance of the claims are processed by HUD. The Company has
received an average payment from HUD equal
46
<PAGE> 48
to 90% of the outstanding principal balance of such Title I Loans, plus
appropriate interest and costs.
The Company reduced substantially its loan production after January 1, 1998
as compared to the first four months of fiscal 1998. In the last eight months of
fiscal 1998, the Company focused on (1) liquidating its loan portfolio for cash
to reduce its indebtedness while it explored alternatives to raise new capital
and (2) initiating new strategic initiatives to return the Company to
profitability. As a result, the Company does not believe that its results for
the three months ended November 30, 1998 are comparable to the Company's results
for the three months ended November 30, 1997.
The Company produced $199.9 million of loans during the three months ended
November 30, 1997 compared to $16.5 million of loans during the three months
ended November 30, 1998, a decrease of 91.7%. The decrease is a result of the
reduction in the Company's business while the Company has sought to pursue its
new strategic initiatives. The $16.5 million of loans produced during the three
months ended November 30, 1998 represents an increase of $14.6 million over the
fourth quarter of fiscal 1998.
Net Revenues. Net revenues (losses) increased $7.5 million to revenues of
$520,000 during the three months ended November 30, 1998 from losses of $7.0
million during the three months ended November 30, 1997. The loss for the three
months ended November 30, 1997 was primarily the result of a negative valuation
adjustment on the carrying value of the Company's mortgage related securities.
No valuation adjustments were recorded in the three months ended November 30,
1998.
Gain on sale of loans decreased $3.5 million to $172,000 during the three
months ended November 30, 1998 from $3.7 million during the three months ended
November 30, 1997. The decrease was primarily the result of a lower volume of
loans sold in the three months ended November 30, 1998 of $8.5 million compared
to $155.9 million in the three months ended November 30, 1997.
Net unrealized gain (loss) on mortgage related securities increased $13.4
million to a gain of $270,000 during the three months ended November 30, 1998
from a loss of $13.1 million during the three months ended November 30, 1997.
The increase was the result of a $14.1 million downward valuation adjustment
relating to the Company's mortgage backed securities during the three months
ended November 30, 1997. No valuation adjustments were recorded in the three
months ended November 30, 1998.
Loan servicing income, net, decreased $954,000 to $240,000 during the three
months ended November 30, 1998 from $1.2 million during the three months ended
November 30, 1997. The decrease was primarily the result of the decrease in the
Company's servicing portfolio to $21.0 million at November 30, 1998 from $767.3
million at November 30, 1997 due to the sale of the Company's servicing rights
to City Mortgage Services, Inc. ("City Mortgage Services") during the fourth
quarter of fiscal 1998.
Interest income on loans held for sale and mortgage related securities, net
of interest expense, decreased $1.4 million to an expense of $162,000 during the
three months ended November 30, 1998 from income of $1.2 million during the
three months ended November 30, 1997. The decrease was primarily the result of
the decrease in the average size of the portfolio of loans held for sale to
$14.9 million for the three months ended November 30, 1998 from $32.6 million
for the three months ended November 30, 1997.
47
<PAGE> 49
Provision for Credit Losses. The net provision for credit losses decreased
$1.5 million to $43,000 for the three months ended November 30, 1998 from $1.6
million for the three months ended November 30, 1997. The decrease was primarily
due to a lower level of loans sold with recourse in the three months ended
November 30, 1998 compared to November 30, 1997. No allowance for credit losses
on loans sold with recourse is established on loans sold through
securitizations, as the Company has no recourse obligation under those
securitization agreements for credit losses and estimated credit losses on loans
sold through securitizations are considered in the Company's valuation of its
residual interest securities. The provision for credit losses is based upon
periodic analysis of the portfolio, economic conditions and trends, historical
credit loss experience, borrowers' ability to repay, collateral values, and
estimated FHA insurance recoveries on Title I loans produced and sold.
Total General and Administrative Expenses. Total general and
administrative expenses decreased $5.8 million to $4.2 million during the three
months ended November 30, 1998 compared to $10.0 million during the three months
ended November 30, 1997. The decrease was primarily a result of decreased
payroll and benefits expenses as a result of the Company's downsizing since
January 1998, decreased professional services expenses due to lower legal and
consulting fees, decreased loan servicing expenses due to a decrease in loans
serviced due to the sale of the Company's servicing rights to City Mortgage
Services during fiscal 1998 and lower travel and entertainment expenses due to
the reduction in the Company's business.
Payroll and benefits expense decreased $3.7 million to $2.0 million during
the three months ended November 30, 1998 from $5.7 million during the three
months ended November 30, 1997 primarily due to a decreased number of employees.
The number of employees decreased to 63 at November 30, 1998 from 459 at
November 30, 1997 due to a reduction in the Company's business during fiscal
1998.
Supplies and postage expense decreased $295,000 to $71,000 during the three
months ended November 30, 1998 from $366,000 during the three months ended
November 30, 1997 primarily due to mass mailing expenses in the three months
ended November 30, 1997 in connection with the Company's marketing plans which
were not present in the three months ended November 30, 1998.
Professional services decreased $552,000 to $964,000 during the three
months ended November 30, 1998 from $1.5 million for the three months ended
November 30, 1997 due to lower legal expenses and reduced usage of outside
consultants.
Insurance expenses decreased $184,000 to $185,000 during the three months
ended November 30, 1998 from $369,000 for the three months ended November 30,
1997 primarily due to lower FHA insurance expenses due to a lower level of loans
insured under FHA in the three months ended November 30, 1998.
Sub-servicing fees paid to third parties (Mego Financial in the three
months ended November 30, 1997 and City Mortgage Services in the three months
ended November 30, 1998) to service the Company's portfolio of loans held for
sale decreased $639,000 to $22,000 for the three months ended November 30, 1998
from $661,000 for the three months ended November 30, 1997 due primarily to the
sale of the Company's servicing rights to City Mortgage Services in the fourth
quarter of fiscal 1998.
48
<PAGE> 50
Travel and entertainment expenses decreased $360,000 to $109,000 during the
three months ended November 30, 1998 from $469,000 during the three months ended
November 30, 1997 due primarily to the reduction in the Company's business.
Loss before Income Taxes. Loss before income taxes was $4.0 million for
the three months ended November 30, 1998 compared to $18.8 million for the three
months ended November 30, 1997. The provision for income taxes decreased to an
income tax benefit of $1.5 million for the three months ended November 30, 1998
while no such income tax benefit was provided for in the restated three months
ended November 30, 1997.
As a result of the foregoing, the Company incurred a net loss of $2.5
million for the three months ended November 30, 1998 compared to a net loss of
$18.8 million for the three months ended November 30, 1997.
Fiscal 1998 Compared to Fiscal 1997
As previously discussed, the Company reduced substantially its loan
production after January 1, 1998 as compared to the first four months of fiscal
1998. In the last eight months of fiscal 1998, the Company focused on (1)
liquidating its loan portfolio for cash to reduce its indebtedness while it
explored alternatives to raise new capital and (2) initiating new strategic
initiatives to return the Company to profitability. As a result, the Company
does not believe that its results for fiscal 1998 are comparable to the
Company's results for fiscal 1997.
The Company produced $338.9 million of loans during fiscal 1998 compared to
$526.9 million of loans during fiscal 1997, a decrease of 35.7%. The decrease is
due to a substantial reduction in the Company's loan production after January
1998 caused by the Company's inability to obtain funds to produce loans due to
its violation of covenants contained in the old warehouse line.
The Company's loan production by month during fiscal 1997 and 1998 is
illustrated in the chart below.
[Chart reflecting monthly loan production in fiscal 1997 and fiscal 1998 (in
millions of dollars) as follows:]
<TABLE>
<CAPTION>
fiscal year 1997 fiscal year 1998
<S> <C> <C>
September $13.6 $62.5
October $24.0 $71.2
November $24.9 $66.2
December $32.7 $68.6
January $34.5 $34.2
February $44.0 $24.5
March $52.9 $ 7.9
April $59.5 $ 1.4
May $61.6 $ 0.5
June $59.5 $ 0.2
July $55.4 $ 1.0
August $64.3 $ 0.6
</TABLE>
49
<PAGE> 51
Net Revenues. Net revenues were negative $94.0 million during fiscal 1998
compared with positive $54.8 million during fiscal 1997. The Company's revenues
are determined largely by special accounting requirements that required the
Company in fiscal 1997 to recognize significant revenue on loans sold in
securitization transactions ("gain on sale") even though these transactions
generated negative cash flow.
We have separated below the following four components of the Company's
revenues in fiscal 1998 and compared them to the same four components of revenue
in fiscal 1997:
1. Revenues from gain (loss) on sale of loans
- in securitization transactions
- for cash
2. Revenues from net unrealized gain (loss) on mortgage related securities
3. Loan servicing income, net
4. Revenues from net interest income
Revenues from Gain (loss) on sale of loans in fiscal 1998 were a negative
$26.6 million compared to a positive $45.1 million in fiscal 1997. The table
below shows the principal components of Gain (loss) on sale of loans in each of
these periods.
<TABLE>
<CAPTION>
COMPONENTS
OF GAIN (LOSS)
ON THE SALE OF LOANS
-------------------------
FISCAL 1997 FISCAL 1998
----------- -----------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Gain (loss) on the sale of loans in securitization
transactions........................................... 62,014 (6,187)
Gain on the sale of loans for cash....................... 833 11,775
Mark-to-market adjustment to loans held for sale......... -- (13,674)
Write off of loan origination costs...................... (12,573) (12,541)
Write off of commitment fee.............................. -- (2,849)
Amortization of commitment fee........................... (817) (734)
Write off of placement fee............................... (4,129) (1,153)
Interest expense......................................... (205) --
Write off of servicing................................... -- (1,215)
-------- ---------
Total.......................................... 45,123 (26,578)
======== =========
</TABLE>
Revenues from gain on the sale of loans in securitization transactions in
fiscal 1997 of $62.0 million resulted from the allocation of 79.4% of the $78.2
million total revenues earned by the Company on loans sold in these
transactions. The $16.2 million balance of these revenues was allocated to Net
unrealized gain (loss) on mortgage related securities. In fiscal 1997, the
Company sold $398.4 million principal amount of loans in securitization
transactions, with a total cost of production of $20.0 million. This includes
premiums of $18.4 million (3.5% of the principal amount of the Company's loans
produced) paid to the Company's network of mortgage bankers for closed loans. In
fiscal 1998, only $90.5 million principal amount of loans were sold in
securitization transactions. The substantially lower amount of loans sold in
securitization transactions in fiscal 1998 and the lower revenues
50
<PAGE> 52
from these transactions resulted from the continuing cash flow deficits of the
Company. These deficits were principally due to substantial increases in the
Company's loan production in fiscal 1997, the sale of these loans in
securitization transactions and a major increase in general and administrative
expenses.
Revenues from gain on the sale of loans for cash were $11.8 million in
fiscal 1998 compared to $833,000 in fiscal 1997. In fiscal 1998, the Company
sold $160.1 million principal amount of loans for cash as part of its plan to
continue operating while it was exploring alternatives for locating new capital.
The Company's total cost of producing these loans was $15.0 million in fiscal
1998 compared to $20.0 million in fiscal 1997 (representing 12.5% of the $160.1
million of the amount of loans sold for cash in that period). In fiscal 1997,
revenues from the sale of $99.0 million principal amount of loans for cash were
$833,000. The Company believes that its loan sales for cash in fiscal 1998 may
have been adversely impacted by the market's knowledge that the Company was
liquidating its loan portfolio to pay down the Company's lenders. The Company's
revenues from gain (loss) on the sale of loans for cash in fiscal 1998 were also
impacted by a lower of cost or market write down of $13.7 million of the
Company's $21.9 million principal amount of loans in its portfolio at the end of
fiscal 1998. The loans in the Company's portfolio at August 31, 1998 primarily
had document deficiencies or the borrowers were delinquent in their loan
payments. The lower of cost or market adjustment is based on the Company's
estimate of the proceeds to be received when these loans are sold. The Company
believes that liquidity shortage in the specialty finance industry may have also
hurt the market value of these loans.
As part of the recapitalization, the Company terminated its Master
Warehouse Agreement with Greenwich Capital Markets. This termination resulted in
negative revenues of $4.0 million from gain (loss) on sale of loans due to the
write off of a $2.85 million commitment fee. Negative revenues of $1.2 million
also resulted from payments to Greenwich Capital Markets in connection with
their sale of the Company's loans. For additional details, see "Certain
Transactions" located later in this prospectus.
Revenues from Net unrealized gain (loss) on mortgage related securities
were negative $70.0 million in fiscal 1998 compared to a positive $3.5 million
in fiscal 1997. Substantially all of fiscal 1998's negative revenues resulted
from a write down of $73.0 million in the fair value of the Company's mortgage
related securities. The write down was required because prepayment, delinquency,
default and credit loss rates on the Equity + and Title I loans backing these
securities substantially exceeded the assumptions the Company used to value its
mortgage related securities at the end of fiscal 1997. These loans were produced
by the Company in prior periods. Additionally, in response to recent adverse
changes in the liquidity and market value of these and other similar asset
backed residual interests, the Company increased the rate used to discount to
present value the anticipated cash flow to be received on its mortgage related
securities from 12% at the end of fiscal 1997 to 16% at the end of fiscal 1998.
The positive revenues of $3.5 million from Net unrealized gain (loss) on
mortgage related securities recorded in fiscal 1997 resulted from a write up of
$2.0 million in the fair value of the Company's mortgage related securities and
favorable cash flow from the Company's mortgage related securities.
In August 1998, the Company pooled approximately $90.5 million of loans
with approximately $239.6 million of loans from a second party to create a home
loan owner trust securitization. The Company was issued a residual interest
mortgage related security
51
<PAGE> 53
in this securitization calculated on the pro rata share of the Company loans
originated in the total pool. This residual interest mortgage related security
will be owned two-thirds by the Company and one-third by Greenwich Capital
Markets. Cash flow on the Company's residual interest mortgage related security
will be subordinated to recovery by Greenwich of: (1) premium paid for in the
acquisition of the pool; (2) upfront overcollaterization of 1.25% of the total
pool; (3) Greenwich's underwriting fee and (4) transaction costs. The total of
these recoveries will accrue interest at a 12% per annum rate until recovered.
The target overcollaterization level of 6% must be achieved prior to recovery by
Greenwich. See "Certain Transactions -- Relationship With Greenwich."
Loan servicing income, net, decreased from $3.0 million in fiscal 1997 to
$1.0 million in fiscal 1998. The decrease was a result of negative revenues of
$1.1 million from a write down in the fair value of the Company's mortgage
servicing rights in the third quarter of fiscal 1998 due to an increase in the
Company assumptions of prepayment, delinquency, default and credit loss rates on
the loans in the Company's servicing portfolio, which reduced the discounted
present value of the Company's anticipated servicing revenues on those loans. In
addition, in fiscal 1998 the Company had negative loan servicing revenues of
$703,000 from the loss on the sale of the Company's servicing rights to City
Mortgage Services as part of the recapitalization.
Revenues from net interest income decreased from $3.1 million in fiscal
1997 to $1.6 million in fiscal 1998. The table below shows the amount of the
Company's interest income and interest expense for fiscal 1997 and 1998.
<TABLE>
<CAPTION>
NET INTEREST INCOME
-------------------------
FISCAL 1997 FISCAL 1998
----------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Interest Income:
Short-term investments and accretion on mortgage related
securities........................................... $ 7,353 8,964
Loans held in portfolio pending sale.................... 2,038 5,492
Cash.................................................... 116 330
-------- --------
Total Interest Income........................... $ 9,507 $ 14,786
======== ========
Interest Expense:
Subordinated debt....................................... $ 4,266 $ 8,839
Old warehouse line...................................... 1,805 3,961
Other borrowings........................................ 303 362
-------- --------
Total Interest Expense.................................. $ 6,374 13,162
-------- --------
Net Interest Income............................. $ 3,133 $ 1,624
======== ========
</TABLE>
Interest income increased from $9.5 million in fiscal 1997 to $14.8 million
in fiscal 1998. The increase was due to the sale of the Company's 1998 loan
production in cash transactions over a period of time, compared to the sale of
fiscal 1997 loan production in quarterly securitization transactions. In
addition, the Company earned approximately $304,600 in interest in fiscal 1998
from the short-term investment of $50.0 million in proceeds from the
recapitalization.
Interest expense in fiscal 1998 was substantially higher than interest
expense in fiscal 1997 due primarily to additional interest expense of $3.5
million on the Company's subordinated debt as a result of the October 1997 sale
of $40.0 million principal amount of
52
<PAGE> 54
12 1/2% subordinated notes. In addition, the Company borrowed an aggregate of
$15.0 million secured by certain of its mortgage related securities in the first
quarter of fiscal 1998. The principal amount of these borrowings were
outstanding for all of fiscal 1998 and for only a portion of fiscal 1997.
Provision for Credit Losses. The net provision for credit losses decreased
$9.5 million to income of $3.2 million for fiscal 1998 from losses of $6.3
million for fiscal 1997. The decrease in the provision for credit losses was due
to the decrease in the volume of loans produced and the ratio of Equity + loans
to Title I loans produced during fiscal 1998 compared to fiscal 1997. An
allowance for credit losses is not established on loans sold in securitization
transactions, because the Company typically does not have recourse obligations
for these losses. Estimated credit losses on loans sold in securitization
transactions are considered in the Company's determination of the fair value of
its mortgage related securities. The provision for credit losses is based upon
periodic analysis of the portfolio, economic conditions and trends, historical
credit loss experience, borrowers' ability to repay, collateral values, and
estimated FHA insurance recoveries on Title I loans originated and sold.
Total General and Administrative Expenses. Total general and
administrative expenses increased $10.0 million, or 42.0%, to $33.8 million
during fiscal 1998 from $23.8 million during fiscal 1997. The increase was
primarily a result of increased costs of professional services due to:
(1) increased outside legal and audit expenses associated with
additional securities filings;
(2) the recapitalization;
(3) amendments to existing debt agreements;
(4) increased loan servicing expenses due to an increase in loans
serviced; and
(5) increased payroll and benefits related to the hiring of additional
personnel to support the Company's expansion in the first quarter of fiscal
1998.
The substantial individual changes in general and administrative expenses
are discussed in more detail below.
Payroll and benefits expense increased $5.5 million, or 42.4%, to $18.6
million during fiscal 1998 from $13.1 million during fiscal 1997 primarily due
to an increased number of employees prior to January 1998 and expenses
associated with the reduction in the Company's workforce. Although the number of
employees decreased to 134 at August 31, 1998 from 405 at August 31, 1997, the
average number of employees employed was higher during fiscal 1998 than fiscal
1997.
Credit reports expense decreased $877,000, or 63.2%, to $510,000 during
fiscal 1998 from $1.4 million for fiscal 1997 due to the decrease in loan
production during the second half of fiscal 1998.
Rent and lease expenses increased $417,000, or 34.8%, to $1.6 million for
fiscal 1998 from $1.2 million for fiscal 1997 due to annual escalation in rent
and expiration of tenant discounts the Company enjoyed in fiscal 1997 for office
space at the Company's corporate offices.
53
<PAGE> 55
Professional services increased $2.5 million, or 110.6%, to $4.8 million
for fiscal 1998 from $2.3 million for fiscal 1997 due to increased outside legal
and audit expenses associated with the Company's private placement of $40.0
million principal amount of Old Notes in fiscal 1997, additional securities
filings, amendments to existing debt agreements and higher consulting and
management services expenses. A substantial portion of the increase in
professional services was due to actions taken by the Company subsequent to
January 1, 1998 as a result of its adverse financial position and the
recapitalization.
Sub-servicing fees increased $286,000, or 15.3%, to $2.2 million for fiscal
1998 from $1.9 million for fiscal 1997 due primarily to a larger average loan
servicing portfolio, partially offset by a lower sub-servicing rate paid to the
sub-servicer in the latter part of fiscal 1998.
Other services increased $716,000, or 53.0%, to $2.1 million for fiscal
1998 from $1.4 million for fiscal 1997, due to higher telephone and overnight
mailing expenses.
FHA insurance expense decreased $128,000, or 22.9%, to $430,000 during
fiscal 1998 from $558,000 during fiscal 1997 due to decreased production of
insured Title I loans.
Other general and administrative expenses increased $1.3 million, or
125.6%, to $2.4 million during fiscal 1998 from $1.1 million during fiscal 1997
due primarily to increased expenses related to the expansion of facilities
related to the Company's business expansion at the beginning of fiscal 1998.
The Company had a $126.0 million loss before income taxes for fiscal 1998
compared to income of $23.8 million for fiscal 1997. An income tax expense of
$9.1 million was provided for in fiscal 1997 while an income tax benefit of $6.3
million has been provided for in fiscal 1998.
As a result of the above, the Company incurred a net loss of $119.7 million
for fiscal 1998 compared to net income of $14.7 million for fiscal 1997.
Fiscal 1997 Compared to Fiscal 1996
The Company produced $526.9 million principal amount of loans during fiscal
1997 compared to $139.4 million of loans during fiscal 1996. The increase is a
result of the overall growth in the Company's business, including an increase in
the number of active mortgage bankers that sold the Company closed Equity +, and
to a lesser extent, Title I loans and home improvement contractors ("dealers")
that sold the Company closed Title I loans and an increase in the number of
states served. At August 31, 1996 and 1997, the Company's network consisted of
the following:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
AUGUST 31,
----------------------
1996 1997
---- ----
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Active mortgage bankers................................ 310 694
Active dealers......................................... 435 670
</TABLE>
54
<PAGE> 56
The following table describes the types of loans produced by the Company
during fiscal 1996 and 1997:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
AUGUST 31,
------------------------
1996 1997
-------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Equity + loans....................................... $ 11,582 $428,832
Title I loans........................................ 127,785 98,085
-------- --------
Total...................................... $139,367 $526,917
======== ========
</TABLE>
The following table sets forth certain data regarding loans produced by the
Company during fiscal 1996 and 1997:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
--------------------------------------
1996 1997
----------------- -----------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
PRINCIPAL AMOUNT OF LOANS PRODUCED:
Mortgage bankers:
Title I............................ $ 82,596 59.3% $ 50,815 9.7%
Equity +........................... 11,582 8.3 409,603 77.7
-------- ----- -------- -----
Total mortgage bankers........ 94,178 67.6 460,418 87.4
-------- ----- -------- -----
Dealers:
Title I............................ 45,189 32.4 47,270 9.0
Equity +........................... -- -- 19,229 3.6
-------- ----- -------- -----
Total dealers................. 45,189 32.4 66,499 12.6
-------- ----- -------- -----
Total principal amount of
loans produced............. $139,367 100.0% $526,917 100.0%
======== ===== ======== =====
NUMBER OF LOANS PRODUCED:
Mortgage bankers:
Title I............................ 4,382 50.9% 2,445 12.0%
Equity +........................... 392 4.6 12,831 62.7
-------- ----- -------- -----
Total mortgage bankers........ 4,774 55.5 15,276 74.7
-------- ----- -------- -----
Dealers:
Title I............................ 3,836 44.5 3,893 19.0
Equity +........................... -- -- 1,296 6.3
-------- ----- -------- -----
Total dealers................. 3,836 44.5 5,189 25.3
-------- ----- -------- -----
Total number of loans
produced................... 8,610 100.0% 20,465 100.0%
======== ===== ======== =====
</TABLE>
Net Revenues. Net revenues increased $31.2 million, or 132.5%, to $54.8
million for fiscal 1997 from $23.6 million for fiscal 1996. The increase was
primarily the result of the increased volume of loans produced and the principal
amount of loans sold.
Gain on sale of loans and net unrealized gain on mortgage related
securities together increased $29.4 million, or 152.9%, to $48.6 million during
fiscal 1997 from $19.2 million during fiscal 1996. The increase was primarily
due to increases in the principal amount of loans sold in securitization and
similar transactions of $521.6 million during fiscal 1997 compared to $137.9
million during fiscal 1996.
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<PAGE> 57
The following table sets forth the principal balance of loans sold or
securitized and related gain on sale data for fiscal 1996 and 1997:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
----------------------------
1996 1997
---------- ----------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
LOANS SOLD IN SECURITIZATION TRANSACTIONS:
Principal amount of loans sold:
Title I............................................ $127,414 $ 62,097
Equity +........................................... 10,494 360,411
-------- --------
Total principal amount..................... $137,908 $422,508
======== ========
Gain on sale of loans................................ $ 16,539 $ 41,132
======== ========
Net unrealized gain on mortgage related securities... $ 2,697 $ 3,524
======== ========
Gain on sale of loans as a percentage of principal
balance of loans sold.............................. 12.0% 9.7%
======== ========
Gain on sale of loans plus net unrealized gain on
mortgage related securities as a percentage of
principal balance of loans sold.................... 13.9% 10.6%
======== ========
LOANS SOLD FOR CASH WITH SERVICING RELEASED TO FNMA
AND OTHERS:
Principal amount of loans sold:
Title I............................................ $ -- $ 39,810
Equity +........................................... -- 59,189
-------- --------
Total principal amount..................... $ -- $ 98,999
======== ========
Gain on sale of loans................................ $ -- $ 3,991
======== ========
Net unrealized loss on mortgage related securities... $ -- $ (6)
======== ========
Gain on sale of loans as a percentage of principal
balance of loans sold.............................. 0.0% 4.0%
======== ========
Gain on sale of loans plus net unrealized loss on
mortgage related securities as a percentage of
principal balance of loans sold.................... 0.0% 4.0%
======== ========
LOANS SERVICED AT END OF YEAR:
Title I............................................ $202,766 $255,446
Equity +........................................... 11,423 372,622
-------- --------
Total servicing portfolio at end of
period.................................. $214,189 $628,068
======== ========
</TABLE>
For additional details on gain on the sale of Loans sold in securitization
transactions, see Note 2 to the Company's financial statements located later in
this prospectus.
Loan servicing income, net decreased $312,000, or 9.3%, to $3.0 million
during fiscal 1997 from $3.3 million during fiscal 1996. The decrease was
primarily the result of the reclassification of net revenue in compliance with
SFAS No. 125 and increased interest advances and reduced servicing fees related
to $34.0 million in delinquent loans serviced by the Company at August 31, 1997
compared to $16.2 million at August 31, 1996.
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<PAGE> 58
Interest income on loans held for sale and mortgage related securities, net
of interest expense, increased $2.1 million, or 217.1%, to $3.1 million during
fiscal 1997 from $988,000 during fiscal 1996. The increase was primarily the
result of the increase in the average principal amount of the Company-owned
loans held for sale and the increased mortgage related securities portfolio.
Provision for Credit Losses. The net provision for credit losses increased
$6.2 million to $6.3 million for fiscal 1997 from $55,000 for fiscal 1996. The
increase in the provision was directly related to the increase in the volume of
loans produced and the increased ratio of Equity + loans to Title I loans
produced during fiscal 1997 compared to fiscal 1996. No allowance for credit
losses on loans sold with recourse is established on loans sold through in
securitization and similar transactions. The Company has no recourse obligation
for credit losses on loans sold. Estimated credit losses on loans sold are
considered in the Company's valuation of its mortgage related securities. The
provision for credit losses is based upon periodic analysis of the portfolio,
economic conditions and trends, historical credit loss experience, borrowers'
ability to repay, collateral values, and estimated FHA insurance recoveries on
Title I loans produced and sold in securitization and similar transactions. For
details on mortgage related securities, see Notes 2 and 4 to the Company's
financial statements located later in this prospectus.
Total General and Administrative Expenses. Total general and
administrative expenses increased $12.0 million, or 101.5%, to $23.8 million
during fiscal 1997 compared to $11.8 million during fiscal 1996. The increase
was primarily a result of increased credit reports expense due to increased loan
production volume, increased rent and lease expense due to facilities expansion,
increased loan servicing expenses due to an increase in loans serviced, and
increased payroll related to the hiring of additional underwriting, loan
processing, administrative, loan quality control and other personnel as a result
of the expansion of the Company's business.
Payroll and benefits expense increased $6.7 million, or 106.3%, to $13.1
million during fiscal 1997 from $6.3 million during fiscal 1996 primarily due to
an increased number of employees. The number of employees increased to 405 at
August 31, 1997 from 170 at August 31, 1996 due to increased staff necessary to
support the business expansion and maintain quality control.
Credit reports expense increased $1.0 million, or 277.9%, to $1.4 million
during fiscal 1997 from $367,000 during fiscal 1996 primarily due to increased
loan origination volume to $526.9 million during fiscal 1997 from $139.4 million
during fiscal 1996.
Rent and lease expenses increased $861,000, or 254.7%, to $1.2 million
during fiscal 1997 from $338,000 during fiscal 1996 primarily due to increased
expansion costs for the corporate headquarters and additional branch offices.
Professional services fees increased $500,000, or 28.2%, to $2.3 million
during fiscal 1997 from $1.8 million during fiscal 1996 primarily due to
increased audit and legal fees attributable to continued growth.
Sub-servicing fees paid increased $1.2 million, or 164.3%, to $1.9 million
during fiscal 1997 from $709,000 during fiscal 1996 due primarily to a larger
loan servicing portfolio.
Other services increased $687,000, or 103.3%, to $1.4 million during fiscal
1997 from $665,000 during fiscal 1996. These expenses represent executive,
accounting, legal,
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<PAGE> 59
management information, data processing, human resources and advertising
services provided and promotional materials.
Travel expenses increased $328,000, or 48.4%, to $1.0 million during fiscal
1997 from $677,000 during fiscal 1996 due to increased travel needed to support
the Company's business expansion.
Other general and administrative expenses increased $711,000, or 190.1%, to
$1.1 million during fiscal 1997 from $374,000 during fiscal 1996 due primarily
to increased expenses related to the ongoing expansion of facilities.
Income before income taxes increased $12.7 million, or 113.4%, to $23.8
million for fiscal 1997 from $11.2 million for fiscal 1996. The provision for
income taxes increased to $9.1 million for fiscal 1997 compared to $4.2 million
for fiscal 1996.
As a result of the foregoing, the Company's net income increased $7.8
million, or 113.1%, to $14.7 million for fiscal year 1997 from $6.9 million for
fiscal 1996.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity Sources
The Company currently has four significant sources of financing and
liquidity:
(1) the balance of the proceeds from the sale of Preferred Stock and common
stock in the recapitalization;
(2) the new Sovereign Warehouse Line of $90.0 million;
(3) the Flow Purchase Agreement; and
(4) sales of loans in the institutional whole loan market
Certain material covenant restrictions exist in the Indenture governing the
Current Notes. These covenants include limitations on the Company's ability to
incur certain types of additional indebtedness, grant liens on its assets and to
enter into extraordinary corporate transactions. The Company may not incur this
additional indebtedness if, on the date of such incurrence and after giving
effect thereto, the Consolidated Leverage Ratio (as defined therein) would
exceed 1.5:1, subject to certain exceptions. At November 30, 1998, the
Consolidated Leverage Ratio was 2.0:1 and the Company could not incur any
additional indebtedness other than permitted indebtedness.
The Sovereign Warehouse Line was originally scheduled to terminate on
December 29, 1998 and is renewable, at Sovereign's option, in six-month
intervals for up to five years. During December 1998, the Sovereign Warehouse
Line was extended through August 1999. The Sovereign Warehouse Line may be
increased with certain consents and contains pricing/fees which vary by product
and the dollar amount outstanding. The Sovereign Warehouse Line is to be secured
by specific loans held for sale and includes certain material covenants
including maintaining books and records, providing financial statements and
reports, maintaining its properties, maintaining adequate insurance and fidelity
bond coverage and providing timely notice of material proceedings. As of
November 30, 1998, the Company had approximately $14.9 million outstanding under
the Sovereign Warehouse Line.
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<PAGE> 60
In April 1997, the Company entered into a pledge and security agreement
with another financial institution for an $11.0 million revolving credit
facility. The amount that can be borrowed under the agreement was increased to
$15.0 million in June 1997 and $25.0 million in July 1997. This facility is
secured by a pledge of certain of the Company's interest only and residual class
certificates relating to securitizations carried as mortgage related securities
on the Company's Statements of Financial Condition, payable to the Company
pursuant to its securitization agreements. A portion of the borrowings under the
credit line agreement accrues interest at one-month LIBOR + 3.5% (9.1% at August
31, 1998 and 8.5% at November 30, 1998) with the remaining borrowings under the
credit line accrues interest at one-month LIBOR + 2.0% (7.6% at August 31, 1998
and 7.0% at November 30, 1998), expiring one year from the initial advance. As
of August 31, 1998 and November 30, 1998, approximately $10.0 million was
outstanding under the agreement. The agreement, which was originally scheduled
to mature in December 1998, was extended until December 1999. Certain material
covenant restrictions exist in the credit agreement governing the April 1997
revolving line of credit. These covenants include limitations to incur
additional indebtedness, provide adequate collateral and achieve certain
financial tests. These tests include achieving a minimal net worth (as defined
therein) and that the debt-to-net worth ratio (as defined therein) shall not
exceed 2.5:1. As of August 31, 1998, the Company's net worth was $15.9 million
below the minimal required and the debt-to-net worth ratio was 2.93:1. On
December 2, 1998, the Company obtained an amendment to the agreement whereby the
financial institution waived its right to declare an event of default of
borrower due to the Company's failure to comply with the minimal required net
worth as of August 31, 1998. Additionally, the minimal net worth test was
amended such that the Company is required to maintain a net worth equal to or
greater than 75% of the Company's net worth as of the end of the preceding
fiscal quarter. Additionally, the Company agreed to pay down the outstanding
borrowings from $10.0 million at August 31, 1998 to $6.0 million at December 31,
1998 and subsequently agreed to pay the remaining $6.0 million in equal monthly
payments during calendar 1999. As of November 30, 1998, the Company's net worth
was $4.2 million above the minimal required and the debt-to-net worth ratio was
2.86:1.
In October 1997, the Company entered into a credit agreement with another
financial institution for an $8.8 million revolving line of credit. This
institution initially funded $5.0 million of this credit facility. The facility
is secured by a pledge of certain of the Company's mortgage related securities.
The loan balance under this agreement bears interest at the prime rate plus 2.5%
(11.0% at August 31, 1998 and 10.5% at November 30, 1998). In May 1998, this
loan converted into a term loan with monthly amortization derived from the cash
flow generated from the respective mortgage related certificates. This term loan
bears interest at the prime rate plus 2.5% (11.0% at August 31, 1998 and 10.5%
at November 30, 1998). This facility matures in October 2002. As of August 31,
1998 and November 30, 1998, approximately $4.6 million was outstanding under the
agreement. The credit agreement governing the October 1997 revolving line of
credit includes certain material covenants. These covenants include restrictions
relating to extraordinary corporate transactions, maintenance of adequate
insurance and achieving certain financial tests. These tests include achieving a
minimal consolidated adjusted tangible net worth (as defined therein) and that
the consolidated adjusted leverage ratio (as defined therein) shall not exceed
3:1. As of August 31, 1998, the Company's consolidated adjusted tangible net
worth was $54.1 million below the minimum required and the consolidated adjusted
leverage ratio was 0.53:1. On December 9, 1998, the Company agreed to
temporarily amend the borrowing base definition for the period from September
30, 1998 through April 30, 1999 to increase the borrowing base from 50% to
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<PAGE> 61
55%. After April 30, 1999, the borrowing base will return to 50%. The minimum
consolidated tangible net worth covenant was also adjusted, commencing
retroactively, as of September 30, 1998 and the Company agreed to paydown the
line by approximately $405,000 (the amount exceeding the applicable maximum
amount of tranche credit) and pay an accommodation fee of $10,000. As of
November 30, 1998, the Company's consolidated adjusted tangible net worth was
$44.4 million above the minimum required and the consolidated adjusted leverage
ratio was 0.66:1.
The Company believes that its financing sources are adequate to meet its
current needs.
Liquidity Uses
The Company's liquidity is primarily used to originate loans, pay operating
and interest expenses and historically, to fund the negative cash flow from the
sale of loans in securitization transactions. Substantially all of the loans
produced by the Company are sold. The Sovereign Warehouse Line is to be repaid
primarily from the proceeds from the sale of the loans collateralizing the line
in the secondary market. The Company resumed the production of new loans on July
1, 1998. The Company's cash requirements necessitate continued access to sources
of warehouse financing and sales of loans in the secondary market for premiums.
In the ordinary course of business, the Company makes representations and
warranties to the purchasers of mortgage loans and the related servicing rights
regarding compliance with laws, regulations and program standards and as to
accuracy of information. Under certain recourse provisions the Company may
become liable for certain damages or may be required to repurchase a loan if
there has been a breach of these representations or warranties. Pursuant to
recourse provisions under certain wholesale agreements, the Company was
obligated to repurchase Equity + and $2.6 million and Title I loans with an
aggregate principal balance of approximately $9.4 million at August 31, 1998 and
November 30, 1998, respectively. These loans, which are reflected in the
Company's Statement of Financial Condition under Loans Held for Sale, were
valued utilizing the Company's estimate of the price to be received upon their
final disposition. Based on the estimated price, a lower of cost or market
allowance of $4.2 million was recorded for fiscal 1998, as a charge to gain
(loss) on sale of loans in the Company's Statement of Operations. An additional
lower of cost or market allowance of $6.7 million relating to the $21.9 million
principal balance of the Company's loans held for sale at August 31, 1998 was
recorded for fiscal 1998, as a charge to gain (loss) on sale of loans in the
Company's Statement of Operations. No such adjustments were made in the three
months ended November 30, 1998.
The Company generally expects to incur monthly operating expenses of
approximately $1.0 million. Until the Company begins to operate on a positive
cash flow basis, such monthly operating expenses are expected to be funded out
of the remaining proceeds of the recapitalization and from amounts borrowed
under the Company's credit facilities. The Company may effect a reduction in its
real-estate lease expenditures through the subletting of all or a portion of its
current office space. If the Company subleases all of its current office space,
the Company intends to relocate its corporate offices to another location
suitable for the Company's needs.
At August 31 and November 30, 1998, no commitments existed for additional
material capital expenditures. However, the Company expects to incur additional
costs in connection with the implementation of its revised business strategy.
Specifically, the Company anticipates that it may need to hire additional
personnel in order to carry out its
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<PAGE> 62
strategic plan. The hiring of such additional personnel would require the
Company to incur additional expenses.
Net cash used in the Company's operating activities was $72.4 million in
fiscal 1997, $39.7 million in fiscal 1998 and $59.4 million and $20.2 million
during the three months ended November 30, 1997 and 1998, respectively. The
Company used net cash of $1.7 million in fiscal 1997 and $329,000 in fiscal
1998, in investing activities, substantially for office equipment and furnishing
and data processing equipment. Cash provided by financing activities amounted to
$79.8 million in fiscal 1997 and $70.4 million in fiscal 1998 and $58.5 million
and $13.8 million during the three months ended November 30, 1997 and 1998,
respectively. This resulted principally from the sale of $40.0 million of Old
Notes in October 1997, the sale of $20.0 million of common stock and $40.0
million principal amount of Old Notes in November 1996 and the sale of $50.0
million of common stock and preferred stock in the recapitalization.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company's various business activities generate liquidity, market and
credit risk:
- liquidity risk is the possibility of being unable to meet all present and
future financial obligations in a timely manner.
- market risk is the possibility that changes in future market rates or
prices will make the Company's positions less valuable.
- credit risk is the possibility loss from a customer's failure to perform
according to the terms of the transaction.
Compensation for assuming these risks is reflected in interest income and
fee income. The following table provides information as of August 31, 1998 about
the Company's mortgage related securities and other financial instruments that
are sensitive to changes in interest rates. The table presents sensitivity
analysis associated with fluctuations in prepayment speeds, increase or decrease
in defaulted loans and the discount rates associated with valuing the
securities.
[Chart reflecting effect of changing interest rates on the Company's
assumptions with respect to default rates, discount rates and prepayment rates
on the Company's financial instruments with exposure to interest rate risk:]
<TABLE>
<CAPTION>
% Change in
Interest Rate Default Rate Discount Rate Prepayment Rate
- ------------- ------------ ------------- ---------------
<S> <C> <C> <C>
+5% $ 8,742,665 $27,899,921 $31,972,595
+3% $19,619,236 $30,429,329 $32,645,484
+1% $25,715,408 $33,273,770 $33,509,045
0% $34,829,719 $34,829,719 $34,829,719
-1% $39,712,288 $36,484,374 $35,240,082
-3% $49,947,812 $40,122,559 $35,971,596
-5% $60,750,176 $44,262,566 $36,648,294
</TABLE>
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<PAGE> 63
Although the Company is exposed to credit loss in the event of
non-performance by the borrowers, this exposure is managed through credit
approvals, review and monitoring procedures into the extent possible restricting
the period during which unpaid balances are allowed to accumulate.
As of November 30, 1998 the net fair value of all financial instruments
with exposure to interest rate risk was approximately $34.9 million. The
potential decrease in fair value resulting from a hypothetical 5% increase in
interest rates would be approximately $26.1 million.
There are certain shortcomings inherent to the sensitivity analysis
presented. The model assumes interest rate changes are instantaneous parallel
shifts in the yield curve. In reality, changes are rarely instantaneous.
Although certain assets and liabilities may have similar maturities or periods
to repricing, they may not react in line with changes in market interest rates.
Also, the interest rates on certain types of assets and liabilities may
fluctuate with changes in market interest rates while interest rates on other
types of assets may lag behind changes in market rates. Prepayments on the
Company's mortgage related instruments are directly affected by a change in
interest rates. As such, the table considers prepayment risk. However, in the
event of a change in interest rates, actual loan prepayments may deviate
significantly from assumptions used in the table. Further, certain assets, such
as adjustable rate loans, have features, such as annual and lifetime caps that
restrict changing the interest rates both on a short term basis and over the
life of the asset. Finally, the ability of certain borrowers to make scheduled
payments on their adjustable rate loans may decrease in the event of an
interiors rate increase.
EFFECTS OF CHANGING PRICES AND INFLATION
The Company's operations are sensitive to increases in interest rates and
to inflation. Increased borrowing costs resulting from increases in interest
rates may not be immediately recoverable from prospective purchasers. The
Company's loans held for sale consist primarily of fixed-rate long term
obligations the interest rates of which do not increase or decrease as a result
of changes in interest rates charged to the Company. In addition, delinquency
and loss exposure may be affected by changes in the national economy. See Note 4
to the Company's financial statements located later in this prospectus.
RECENT ACCOUNTING PRONOUNCEMENTS
SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" was issued by the FASB in June 1996. SFAS 125
provides accounting and reporting standards for transfers and servicing of
financial assets and extinguishments of liabilities. This statement also
provides consistent standards for distinguishing transfers of financial assets
that are sales from transfers that are secured borrowings. It requires that
liabilities and derivatives incurred or obtained by transferors as part of a
transfer of financial assets be initially measured at fair value. SFAS 125 also
requires that servicing assets be measured by allocating the carrying amount
between the assets sold and retained interests based on their relative fair
values at the date of transfer. Additionally, this statement requires that the
servicing assets and liabilities be subsequently measured by (a) amortization in
proportion to and over the period of estimated net servicing income or loss and
(b) assessment for asset impairment or increased obligation based on their fair
values. The statement requires that the Company's excess servicing rights be
measured at fair market value and be reclassified as interest only receivables
and
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<PAGE> 64
accounted for in accordance with SFAS No. 115 "Accounting for Certain
Investments in Debt and Equity Securities". As required by the statement, the
Company adopted the new requirements effective January 1, 1997. Implementation
of the statement did not have any material impact on the financial statements of
the Company, as the book value of the Company's excess servicing rights and
mortgage related securities approximated fair value.
SFAS No. 128, "Earnings per Share" was issued by the FASB in March 1997,
effective for financial statements issued after December 15, 1997. SFAS 128
provides simplified standards for the computation and presentation of earnings
per share ("EPS"), making EPS comparable to international standards. SFAS 128
requires dual presentation of "Basic" and "Diluted" EPS, by entities with
complex capital structures, replacing "Primary" and "Fully Diluted" EPS under
APB Opinion No. 15.
Basic EPS excludes dilution from Common Stock equivalents and is computed
by dividing income available to stockholders by the weighted-average number of
shares of Common Stock outstanding for the period. Diluted EPS reflects the
potential dilution from Common Stock equivalents, similar to fully diluted EPS,
but uses only the average stock price during the period as part of the
computation.
In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive
Income", and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information". SFAS No. 130 establishes standards for reporting and
display of comprehensive income and its components in a full set of
general-purpose financial statements. SFAS No. 131 establishes standards of
reporting by publicly held business enterprises and disclosure of information
about operating segments in annual financial statements and, to a lesser extent,
in interim financial reports issued to shareholders. SFAS Nos. 130 and 131 are
effective for fiscal years beginning after December 15, 1997. As both SFAS Nos.
130 and 131 deal with financial statement disclosure, the Company does not
anticipate the adoption of these new standards will have a material impact on
its financial position, results of operations or cash flows. The Company has not
yet determined what its reporting segments will be under SFAS No. 131.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"), which establishes accounting
and reporting standards for derivative instruments and for hedging activities.
It requires the entity to recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. The accounting for changes in fair value of these designated
derivatives ("hedge accounting") depends on the intended use and designation. An
entity that elects to apply hedge accounting is required to establish at the
inception of its hedge the method it will use for assessing the effectiveness of
the hedging derivative and the measurement approach for determining the
ineffective aspect of the hedge. Those methods must be consistent with the
entity's approach to managing risk. SFAS 133 is effective for the fiscal years
beginning after June 15, 1999. The Company has not yet evaluated the effect of
adopting SFAS 133.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by Mortgage Banking Enterprise" ("SFAS 134"), which allows the
reclassification of mortgage-related securities and other beneficial interests
retained after the securitization of mortgage loans held for sale from the
trading category, as required by FASB 115, to either available for sale or held
to maturity based upon the Company's ability and intent to hold those
investments. SFAS 134 is effective for the first quarter beginning after
December 15, 1998.
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<PAGE> 65
The Company has not yet evaluated the effect of adopting SFAS 134. As of August
31 and November 30, 1998, all mortgage-related securities are classified as
trading securities.
IMPACT OF THE YEAR 2000 ISSUE
The term "Year 2000 issue" is a general term used to describe the various
problems that may result from the improper processing of dates and
date-sensitive calculations by computers and other machinery as the year 2000 is
approached and reached. These problems generally arise from the fact that most
of the world's computer hardware and software have historically used only two
digits to identify the year in a date, often meaning that the computer will fail
to distinguish dates in the "2000's" from dates in the "1900's." These problems
may also arise from other sources as well, such as embedded computer chips
contained in devices and special codes in software that make use of the date
field.
The Company has developed plans to address the Year 2000 issue. The
Company's present Year 2000 plan consists of five phases:
(1) inventory of business critical information technology assets;
(2) assessment of repair requirements;
(3) repair or replacement;
(4) testing of systems; and
(5) creation of contingency plans in the event of Year 2000 failures.
As of November 30, 1998, the Company had completed the first and second
phases of the Year 2000 plan for its own business critical information
technology assets including its accounting systems, loan origination systems,
word and data processing systems, customer telephone service center, and
business machines. The Company is relying upon the representations of third
party vendors as to the Year 2000 readiness of certain of its software, its
business machines, such as copiers and facsimile machines, and of facilities,
such as physical office locations. The Company does not have plans for testing
embedded computer chips contained in devices, or in special codes in software
that make use of the date field incidental to their operation.
All five phases of the Company's Year 2000 plan are expected to be
completed by August 31, 1999. Based on information currently available, the
Company's costs to remedy its own critical information technology assets are
estimated to be approximately $225,000. These costs will cover hardware and
software upgrades, systems consulting and computer maintenance. The Company
plans to charge these costs to expense as incurred, and it believes such costs
will not have a material effect on its liquidity or financial condition. As part
of its Year 2000 plan, the Company has accelerated the schedule of
implementation of certain of the Company's previously planned information
technology projects. Therefore, the Company does not expect to defer any
specific information technology project as a result of the implementation of its
Year 2000 plan.
Until system testing is substantially in process, the Company cannot fully
estimate the risks of the Year 2000 issue. To date, the Company has not
identified any of its own business critical information technology assets that
it believes present a material risk of not being Year 2000 compliant or for
which a suitable alternative cannot be implemented. However, as the Company's
Year 2000 plan proceeds into subsequent phases, it is possible that the Company
may identify assets that do present a risk of a Year 2000-related
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<PAGE> 66
disruption. Such a disruption would have a material adverse effect on financial
condition and results of operations. Because the Company has not begun system
testing, and, accordingly, has not fully assessed its risks from potential Year
2000 failures, the Company has not yet developed specific Year 2000 contingency
plans.
As of August 31, 1998, the Company had begun to make inquiry of
substantially all of its strategic partners, vendors and third party entities
with which it has material relationships, and had begun to compile data related
to their Year 2000 plans. The Company's reliance upon certain third parties,
vendors and strategic partners for loan servicing, investor reporting, document
custody and other functions, means that their failure to adequately address the
Year 2000 issue could have a material adverse impact on the Company's operations
and financial results. The Company has received assurances from its two major
strategic partners, City National Bank and Sovereign Bancorp, that they have
implemented plans to address the Year 2000 issue. The Company has not evaluated
these plans or assurances for their accuracy and adequacy, or developed
contingency plans in the event of their failure. As of December 31, 1998, the
Company had received responses from approximately 20% of its Year 2000
inquiries. Of those responses, approximately 76% indicated that they had some
plan to address the Year 2000 issue. Because the Company has not yet received a
significant number of responses from its vendors or other third parties,
potential risks related to their failure to address Year 2000 issues are not
known at this time.
The Company also relies upon certain government entities (such as the U.S.
Dept. of Housing and Urban Development and various state regulatory agencies),
utility companies, telecommunication service companies and other service
providers outside of the Company's control. There can be no assurance that such
suppliers, government entities, or other third parties will not suffer a Year
2000 business disruption. Such failures would have a material adverse effect on
the Company's financial condition and results of operations.
In addition, the Company's credit risk associated with its borrowers may
increase as a result of borrowers' individual Year 2000 issues. Negative impact
of Year 2000 issues upon borrowers may result in borrowers' inability to pay,
increases in delinquent loans, and a loss of residual income to the Company.
While at this time, it is not possible to calculate the potential impact of such
increased delinquent loans, it is believed that increased delinquencies would
have a material adverse impact on the financial condition of the Company.
Because of uncertainties, the actual effects of the Year 2000 issue on the
Company may be different from the Company's current assessment. The effect on
the Company's results of operations if the Company, its strategic partners,
vendors or other third parties are not fully Year 2000 compliant is not
reasonably estimable. The description of the Company's Year 2000 plans contain
"forward-looking" statements about matters that are inherently difficult to
predict. Those statements include statements regarding the intent, belief or
current expectations of the Company and its management. Some of the important
factors that affect these statements have been briefly described. Such
forward-looking statements involve risks and uncertainties that may affect
future developments such as, for example, the ability to deal with the Year 2000
issue, including problems that may arise on the part of third parties. If the
repairs and modifications required to make the Company Year 2000 ready are not
made or are not completed on a timely basis, the resulting problems would have a
material adverse impact on the operations and financial condition of the
Company.
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SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
This prospectus contains certain statements as to our future expectations,
which are referred to as forward-looking statements. These forward-looking
statements are based on our beliefs as well as assumptions made by and
information currently available to us. These forward-looking statements are
principally contained in the sections "Prospectus Summary," "Risk Factors,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business." They relate to our expectations and estimates of the
Company's business operations, including the implementation of new business and
operating strategies, future financial performance, and expected growth in
revenues, net income and cash flows. However, these statements reflect only our
current views with respect to future events and are subject to risks,
uncertainties and assumptions. In addition to factors that are described
elsewhere in this prospectus, you must keep in mind that the factors listed
under the caption "Risk Factors," located earlier in this prospectus, could
cause actual results to differ materially from those expressed in any
forward-looking statement. If one or more of these risks or uncertainties
materialize, or if our assumptions prove incorrect, actual results may
materially differ from the results expressed in this prospectus, as anticipated,
believed, estimated or expected. In addition, we believe that due to recent
substantial changes to the Company's business and operating strategies, the
Company's historical financial and operating data are not likely to be
indicative of the Company's future performance.
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THE RECAPITALIZATION
GENERAL
As described earlier in this prospectus, the Company has historically
operated on a negative cash flow basis primarily due to substantial increases in
loan production and general and administrative expenses used to support the
expansion of the Company's operations and the significant negative cash flow
from the Company's sale of a substantial majority of its loan production in
securitization transactions.
Continuing deficits in cash flow combined with a $32.5 million loss
recognized by the Company for the three months ended November 30, 1997 and a
$32.5 million loss recognized for the Company for the six months ended February
28, 1998 resulted in the Company's violation of certain covenants contained in
agreements with its warehouse lender and some of its other lenders. From January
1998, when the Company violated these covenants with its lenders, until the
completion of the recapitalization on July 1, 1998, the Company's principal
activities consisted of liquidating its portfolio of loans to reduce the
Company's borrowings, maintaining the systems and personnel necessary to enable
the Company to resume operations and exploring alternatives to raise new
capital.
PRIVATE PLACEMENTS
In an effort to resume operations, the Company explored a number of
alternatives to raise new capital. These activities resulted in the Company's
recapitalization, completed on July 1, 1998, which provided the Company with
approximately $84.5 million of new equity. Two strategic partners, City National
Bank and Sovereign Bancorp, each purchased 10,000 shares of the Company's newly
designated Series A convertible preferred stock at a price of $1,000 per share.
The terms of the preferred stock are described under "Description of Capital
Stock -- Preferred Stock" later in this prospectus. In addition, City National
Bank and Sovereign Bancorp were each granted an option, which expires in
December 2000, to acquire 6.67 million shares of common stock at a price of
$1.50 per share. City National Bank and Sovereign Bancorp each has a right of
first refusal to purchase the Company in the event the Company's board of
directors determines to sell the Company. In addition, one other private
investor purchased an aggregate of 5,000 shares of Series A Convertible
preferred stock at a purchase price of $1,000 per share and several other
investors purchased an aggregate of 16.67 million shares of common stock at a
purchase price of $1.50 per share. An additional 1.6 million shares of common
stock were issued to FBR as the placement agent's fees for the recapitalization.
In addition, the Company has paid FBR an advisory fee of $416,667 in connection
with the recapitalization and reimbursed FBR for out-of-pocket expenses of
approximately $250,000. These sales were made pursuant to private placements.
The cash proceeds from the recapitalization were approximately $50.0
million. Approximately $5.1 million was used to pay interest on the Company's
Old Notes, $2.4 million was used to retire the old warehouse line, $1.6 million
was used for the payment of loan and management fees and other miscellaneous
charges due to Mego Financial, and approximately $428,000 was used for the
payment of a portion of the costs of the recapitalization. The balance will be
used to fund, purchase and make new loans and for general and administrative
expenses and other corporate purposes.
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EXCHANGE OFFER
As part of the recapitalization, the Company completed an exchange offer of
Current Notes and preferred stock for any and all of the outstanding $80.0
million principal amount of the Company's Old Notes. Pursuant to that exchange
offer, the Company issued approximately 37,500 shares of Series A convertible
preferred stock at a price of $1,000 per share and $41.5 million principal
amount of Current Notes in exchange for approximately $79.0 million principal
amount of the Old Notes. The Company completed the purchase of all of the
remaining Old Notes in September and October 1998.
MANAGEMENT
Upon completion of the recapitalization, Jerome J. Cohen, Robert
Nederlander, Herbert B. Hirsch and Don A. Mayerson resigned as directors of the
Company and Champ Meyercord was elected the Company's Chairman of the board of
directors and Chief Executive Officer. Mr. Meyercord has been a special
consultant to the Company since May 1998. In addition, City National Bank and
Sovereign Bancorp each were granted the right to appoint one member to the
Company's board of directors and have the right to appoint an additional board
member if they exercise their option to purchase additional shares of common
stock. Upon completion of the recapitalization, David J. Vida, Jr. was appointed
to the board of directors at the request of City National Bank. Three private
investors each have the right to appoint one board member. Wm. Paul Ralser was
appointed to the board of directors at the request of an ad hoc committee of
holders of the Old Notes, and Hubert J. Stiles, Jr. was appointed to the board
of directors at the request of one of the two private investors. Sovereign
Bancorp and the other private investor have not exercised their right to appoint
a board member, but have exercised their right to have a representative attend
each board meeting. On August 14, 1998, Jeffrey S. Moore resigned as President
of the Company. Effective September 1, 1998, Mr. Ralser was elected the
President and Chief Operating Officer of the Company.
TRANSACTIONS WITH STRATEGIC PARTNERS
As part of the recapitalization, the Company and each of Sovereign Bancorp
and City Holding Company entered into the following agreements (some of which
are described earlier in the prospectus) that the Company believes will provide
liquidity and increase the efficiency of the Company's operations:
- Sovereign Bancorp and City National Bank each purchased 10,000 shares of
Series A convertible preferred stock at a price of $1,000 per share
- Sovereign Bancorp agreed to provide the Company up to $90.0 million in
borrowings under the Sovereign Warehouse Line to fund its loan production
prior the sale of the loans
- Sovereign Bancorp agreed to purchase up to $100.0 million of the
Company's loans per quarter and has a right of first refusal to purchase
all other loans produced by the Company
- City National Bank purchased the Company's existing mortgage servicing
rights
- City Mortgage Services agreed to service all of the Company's mortgage
loans held for sale and loans sold on a servicing retained basis by the
Company
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- Sovereign Bancorp and City National Bank were each granted an option to
purchase 6.67 million shares of common stock at a price of $1.50 per
share
- Sovereign Bancorp and City National Bank each has a right of first
refusal to purchase a controlling voting interest or a majority of the
Company's assets if the board of directors determines to sell the Company
- City National Bank has appointed, and Sovereign Bancorp has the right to
appoint, one member to the board of directors. Each has the right to
appoint an additional member to the board of directors if they exercise
their option to purchase shares of common stock
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BUSINESS
GENERAL
The Company is a specialized consumer finance company that funds,
purchases, makes and sells consumer loans secured by deeds of trust on
single-family residences. Historically, the Company retained the right to
service a substantial portion of the loans it has sold. The Company's borrowers
generally do not qualify for traditional "A" credit mortgage loans. Typically,
their credit histories, income or other factors do not conform to the lending
criteria of government-chartered agencies (including GNMA, FNMA, FHLMC) that
traditional lenders rely on in evaluating whether to make loans to potential
borrowers.
The Company's loan products are:
- Home Equity loans that typically are secured by first liens, and in some
cases by second liens, on the borrower's residence. In making Home Equity
loans, the Company relies primarily on the appraised value of the
borrower's residence. The Company determines the loan amount based on the
loan-to-value ratio and the creditworthiness of the borrower. These loans
generally are used to purchase single-family residences and refinance
existing mortgages.
- Equity + loans that are based on the borrowers' credit. These loans
typically are secured by second liens on the borrowers' primary
residences. The initial amount of an Equity + loan, when added to other
outstanding senior or secured debt on the residence, resulted in a
combined loan-to-value ratio that averaged 112% during fiscal 1997 and
1998. The loan-to-value ratio on these loans may be as high as 125%.
These loans generally are used to consolidate debt and make home
improvements.
The Company funds loans originated by its network of pre-approved mortgage
brokers which numbered over 169 mortgage brokers as of August 31, 1998. These
brokers submit loan packages to the Company which in turn funds loans made to
approved borrowers. The loans are made directly by the Company to the borrower.
Historically, the Company has produced substantially all of its loans by
purchasing previously closed loans from approved mortgage bankers and other
financial intermediaries and purchasing closed Title I loans from its network of
home improvement contractors. All loans produced by the Company are underwritten
and graded by the Company's personnel. The Company's current operating strategy
is to sell substantially all of the loans it produces for cash to institutional
purchasers. The Company currently does not intend to produce a material amount
of Title I loans in the future.
The Company's loans are primarily produced by its wholesale division and,
to a lesser extent, is retail division. The wholesale division funds loans
originated by a network of pre-approved mortgage brokers. The wholesale division
also underwrites and purchases closed loans sometimes at a premium to their
principal amount from a nationwide network of independent mortgage bankers and
other qualified financial intermediaries. To diversify its loan production
channels, the Company, through its retail division, currently intends to resume
making direct-to-consumer loans during fiscal 1999. The retail division makes
loans directly to consumers charging fees to the borrower that are expected to
offset the Company's total cost of making the loan.
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The Company historically has sold, in securitization transactions, a
substantial majority of the loans it produces on servicing-retained basis (which
means the Company retains the right to service the loans and receives an annual
fee based on a fractional percentage of the outstanding principal balance of the
loans). Generally, sales on a servicing released basis (which means the
servicing on the loan is sold or "released" to the purchaser of the loan) and
some sales on a servicing retained basis are at a premium to the principal
amount of the loan. For additional details on the sale of loans in
securitization transactions, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Securitization Transactions"
earlier in this prospectus. For additional details on the risks of the Company's
mortgage related securities retained in securitizations, see "Risk
Factors -- Liquidity Risks" earlier in this prospectus.
As described earlier in this prospectus, the Company, during fiscal 1996
and 1997 and the first four months of fiscal 1998, substantially expanded its
operations. During these periods the Company's loan production was $139.4
million (fiscal 1996), $526.9 million (fiscal 1997) and $268.5 million (first
four months of fiscal 1998). As the Company expanded its business, the general
and administrative expenses required to support the expansion also increased
from $11.8 million in fiscal 1996 to $23.8 million in fiscal 1997 and $13.8
million in the first four months of fiscal 1998. As a percentage of the total
principal amount of loans produced, general and administrative expenses during
these periods represented 8.5% in fiscal 1996, 4.5% in fiscal 1997 and 5.2% in
the first four months of fiscal 1998.
Prior to January 1998, a substantial majority of the Company's loan
production was sold in securitization and similar transactions. The sale of
loans in securitization transactions typically results in negative cash flow
because the cash proceeds from the sale of the loans in a securitization
transaction is substantially less than the Company's total cost of producing the
loans sold. The combination of negative cash flow from the sale of loans in
securitization transactions and the level of general and administrative expenses
caused the Company, historically, to operate on a substantial negative cash flow
basis.
During fiscal 1996 and 1997 and the six months ended February 28, 1998, the
Company used $12.4 million, $72.4 million and $59.5 million of cash used in
operations, respectively. The cash was principally funded from the sale of $20.0
million of common stock and $40.0 million of subordinated debt in November 1996
and $40.0 million principal amount of subordinated debt in October 1997, as well
as its warehouse line of credit and other borrowings.
As a result of a $11.7 million loss in the Company's first quarter of
fiscal 1998 and continuing cash flow deficits, the Company violated certain
provisions of its old warehouse line. The warehouse lender requested in February
1998 that the Company, in order to avoid a default, repay a significant portion
of the principal balance of the line. Since a default on the warehouse line
would have triggered, among other things, a default on the Company's $80.0
million principal amount of outstanding Old Notes, the Company agreed to
periodically reduce the outstanding balance of the old warehouse line from $55.0
million and the Company repaid the balance on June 29, 1998.
To generate cash to reduce the outstanding amount of the warehouse line and
continue to operate, the Company began to liquidate, through sales for cash, its
mortgage loan portfolio and explore a number of alternatives to locate new
capital. In addition, because the old warehouse line was used to fund loans
produced by the Company prior to their sale, the Company greatly curtailed its
loan production beginning in January 1998.
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The cash received from the Company's sale of loans was used to pay down the old
warehouse line and other Company borrowings and to pay general and
administrative expenses to retain personnel and maintain the Company's
operations while it sought to locate new capital. These matters, among others,
raised substantial doubt in the opinion of the Company's independent auditors,
with respect to the Company's ability to continue as a going concern.
On July 1, 1998, the Company completed the recapitalization. As part of the
recapitalization, the Company received $50.0 million in cash proceeds from the
private placement of approximately 16.7 million shares of common stock at a
price of $1.50 per share and 25,000 shares of Series A convertible preferred
stock at a price of $1,000 per share. In addition, the Company issued $37.5
million of Series A convertible preferred stock and $41.5 million principal
amount of Current Notes in exchange for $79.0 million principal amount of Old
Notes. The recapitalization resulted in $84.5 million of additional equity. For
more information on the recapitalization, see "The Recapitalization" earlier in
this prospectus.
STRATEGIC INITIATIVES
Our strategic initiatives have been substantially impacted by recent events
in the capital markets and their effect on the specialty finance industry. There
has been a significant reduction in the number of institutions willing to
provide warehouse facilities to mortgage lenders producing home equity and high
loan-to-value loans. Additionally, there has been a reduction in the number of
buyers of senior interests issued in securitization transactions backed by home
equity and high loan-to-value loans, and a concurrent increase in the yield (and
a reduction in the price) demanded by such buyers on the senior interests they
purchase. Finally, the number of institutional investors acquiring loans similar
to the Company's Home Equity and Equity + loans has declined, along with the
premiums, if any, these investors are willing to pay for these loans. These
events have substantially reduced the liquidity available to companies in our
business to make new loans. With these events in mind, we have redefined our
strategic initiatives.
OUR PRIMARY FOCUS WILL BE IN PRODUCING HOME EQUITY LOANS. We anticipate
reducing our reliance on Equity + loans with high loan-to-value ratios and
significantly increasing the percentage and amount of our business devoted to
the production of Home Equity loans by expanding our network of brokers and
bankers and acquiring other companies that produce Home Equity loans. The
Company will produce Home Equity loans solely for sale for cash, generally at
premiums to their principal amounts, to institutional purchasers in the
secondary market without recourse for credit losses or risk of prepayment. Based
on our experience in the industry, we believe that currently there are more
buyers for Home Equity loans than for Equity + loans.
DUAL PRODUCTION PLATFORMS SHOULD LOWER OUR TOTAL LOAN PRODUCTION COSTS.
While pursuing our broker and mortgage banker wholesale loan programs, we intend
to pursue loan production on a retail (direct-to-consumer) basis. Although a
retail loan platform is relatively expensive, we expect it to produce loans at a
lower cost than our wholesale platform. When the Company makes a loan directly
to a consumer, it typically receives loan fees and it avoids any premium due
when the Company purchases a loan from its network of mortgage bankers. The
Company expects its dual loan production platform strategy to lower its overall
cost of producing mortgage loans and improve its cash flow.
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THE COMPANY INTENDS TO INCREASE PRODUCTION BY ACQUIRING OTHER MORTGAGE
LENDING COMPANIES. The Company intends to increase its loan production
significantly by acquiring companies that produce mortgage loans. Because the
Company raised cash in the recapitalization, it expects the current lack of
liquidity available to companies in the industry to create opportunities for the
Company in this area.
SELLING LOANS FOR CASH WILL BE THE COMPANY'S PRIMARY METHOD OF LOAN
DISPOSITION. The Company intends to sell substantially all of the loans it
produces for cash to institutional purchasers in the secondary market as our
primary loan disposition strategy. The Company expects this method of loan sales
to generate positive cash flow, because Home Equity and Equity + loans can
generally be sold for more than their principal amount. To this end, we are
expanding the number of institutions with which it has loan purchase and sale
relationships. The Company does not anticipate selling its loans in
securitization transactions. Securitization transactions tend to result in
negative cash flow, because the initial cash proceeds to the Company are less
than the Company's total cost of producing the loans to be sold.
THE COMPANY INTENDS TO CONTINUE TO IMPLEMENT COST SAVING MEASURES. We are
continuing an internal restructuring, which has resulted in a reduction of our
workforce from a peak of 475 employees in January 1998 to 134 employees as of
August 31, 1998 and 63 employees as of December 1, 1998. This reduction and
other cost saving measures the Company has taken, have significantly reduced our
monthly recurring general and administrative expenses from approximately $2.7
million in June 1998 (the month prior to completion of the recapitalization) to
approximately $800,000 in November 1998. In addition, the Company has reduced by
$4.7 million the annual interest expense on its outstanding subordinated notes
by issuing 37,500 shares of preferred stock and $41.5 million principal amount
of Current Notes in exchange for $79.0 million principal amount of Old Notes.
MORTGAGE INDUSTRY
Home Equity
A substantial number of residential homeowners are unable or unwilling to
obtain mortgage financing from conventional financing sources, whether for
reasons of credit impairment, income qualification, credit history, or a desire
to receive loan approval and funding more quickly than that offered by
conventional sources. Many of these homeowners have credit scores or debt ratios
that prohibit them from meeting the requirements of lenders who sell loans to
FNMA or FHLMC. Such borrowers seek loans that rely more heavily upon the
borrower's equity in their home, and to a lesser extent, upon the borrower's
credit scores or debt ratios. Because the properties securing such loans are the
borrower's primary residence, the borrower is less likely to default on payment
than might be the case with unsecured debt -- and in the event of the borrower's
bankruptcy, the loan is fully secured. Such loans rely more heavily on accurate
appraisals of the property prior to funding, and are generally made in
loan-to-value ratios of less than 80%.
Home Improvement
As the costs of home improvements escalate, home owners are seeking
financing to improve their property and maintain and enhance its value. The
National Association of Home Builders Economics Forecast in 1995 estimates that
home improvement expenditures will exceed $200.0 billion by the year 2003.
Lenders of home improvement financing
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typically rely more heavily on the borrowers' creditworthiness, and ability to
pay their debts than the value of the collateral. These loans are secured by a
real estate mortgage lien on the property improved. The market for Equity +
loans and Home Equity loans continues to grow, as many homeowners have limited
access to traditional financing sources due to insufficient home equity, limited
or impaired credit history or high ratios of debt service-to-income. The loan
proceeds can be used for a variety of improvements such as large remodeling
projects. Borrowers also have the opportunity to consolidate a portion of their
outstanding debt in order to reduce their monthly debt service.
Debt Consolidation
An increasing number of financial institutions are originating loans to
borrowers who use the proceeds to reduce outstanding consumer finance
obligations. These loans may also be made in conjunction with a home improvement
project where the borrowers seek to enhance the value of their residence and
ultimately reduce their monthly debt service obligations. These consumer finance
obligations are often in the form of unsecured credit card debt which have high
interest rates and relatively short-term maturity dates. Under this type of
loan, the consumer uses the loan proceeds to consolidate multiple outstanding
debt into a single loan. In turn, the consumer receives the benefit of a lower
interest rate and an extended loan maturity date, often as high as 25 years,
reducing the amount of monthly debt service payments, and in certain instances
the interest paid may be tax deductible. These loan products are secured by a
mortgage lien on the consumer's primary residence. These liens are typically in
a junior position and when combined with first mortgage liens may exceed the
market value of the subject residence. Debt consolidation loans are typically
made to high credit worthy borrowers who have a credit history of honoring their
financial obligations on a timely basis. Within the specialty finance industry
it is typical for loans to qualified borrowers to be limited to the amount
which, when added to the outstanding senior liens on the property, will not
exceed 125% of the market value of the property.
COMPANY LOAN PRODUCTS
The Company originates Home Equity loans and, to a lesser extent, Equity +
loans. Home Equity loans generally have a lower loan-to-value ratio than Equity
+ loans. When combined with other outstanding senior secured indebtedness on the
residence, Equity + loans may result in a combined loan-to-value ratio of up to
125%. During both fiscal 1997 and 1998, the Company's Equity + loans had an
average loan-to-value ratio of 112%. The Company lends to borrowers of varying
degrees of creditworthiness. See "-- Loan Processing and Underwriting." The
Company's primary loan products include the following:
<TABLE>
<CAPTION>
HOME EQUITY LOANS EQUITY + LOANS
- ----------------- --------------
<S> <C> <C> <C>
- - fixed and adjustable rate - fixed rate
- - typically secured by first liens, - secured by a junior lien on the
and to a lesser extent, second borrowers' principal residence
mortgage liens on the borrowers'
principal residences
- - terms of up to 360 months - terms from 60 to 300 months
- - principal amounts up to $500,000 - principal amounts up to $50,000
</TABLE>
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Home Equity Loans
In furtherance of its strategy to expand its loan products, in December
1997 the Company commenced the production of Home Equity loans to borrowers with
a credit grade ranging from "A" to "D". Loan amounts may range up to a maximum
of $500,000 for "A" credit borrowers with maturities of up to 360 months. The
Company expects the average loan amount to be less than $100,000. The average
loan amount in this program for the fiscal year ended August 31, 1998 was
$60,019. In making Home Equity loans, the Company places increased emphasis on
the underlying collateral value of the residence which is fully supported by an
independent appraisal. The Company intends to pool its Home Equity loans for
eventual sale in the secondary market to institutional purchasers on a servicing
released basis, without recourse for credit losses or risk of prepayment, for
cash premiums over the principal amount of the loan. To date, substantially all
of the Home Equity loans produced by the Company have been to borrowers with "B"
and "C" credit grades under the Company's underwriting guidelines. The Company
believes that there are several advantages to producing Home Equity loans
including:
- the existence of a more liquid secondary market than for Equity + loans
- the larger average principal amount of such loans which are typically two
times greater than that of a Equity + loan
- the lower total costs of producing Home Equity loans from mortgage
bankers and brokers than the Company's Equity + loans
Equity + Loans
An Equity + loan is a non-insured debt consolidation or home improvement
loan typically used to retire consumer debt and/or pay for a home improvement
project. All of the Equity + loans produced by the Company are secured by a
mortgage lien on the borrower's principal residence. The Company began producing
Equity + loans through its wholesale division in May 1996. Currently, Equity +
loans are offered through both the Company's wholesale and retail divisions.
Debt consolidation loans account for a major portion of the Company's Equity +
loan production.
The Company has focused its Equity + loan program on higher credit quality
borrowers who may have limited equity in their residence after giving effect to
other debt secured by the residence. Most of the Company's Equity + loans have
loan-to-value ratios greater than 100% and, accordingly, the value of the
residence securing the loan generally will not be sufficient to cover the
principal amount of the loan in the event of default. The Company relies
principally on the creditworthiness and income stability of the borrower and, to
a lesser extent, on the underlying value of the borrower's residence for
repayment of its Equity + loans. For fiscal 1998, the average market value of
the residence securing the Equity + loans produced by the Company was
approximately $108,000 without added value from the respective home improvement
work, the amount of senior liens was approximately $88,500 and the Company's
loan amount was approximately $31,700.
LENDING OPERATIONS
Mortgage Brokers and Bankers
The Company produces loans through its wholesale and, to a lesser extent,
retail divisions. The wholesale division represents the Company's largest source
of loan
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production. Through its wholesale division, the Company funds loans originated
through a nationwide network of licensed mortgage brokers and purchases loans
from a nationwide network of licensed mortgage bankers. Mortgage bankers produce
mortgage loans by lending their own funds to the borrower and closing the loan
in their own name. Mortgage brokers, like mortgage bankers, initiate the loan
application and process necessary underwriting documentation. However, unlike
mortgage bankers, mortgage brokers ordinarily do not fund loans with their own
money, but work as agents on behalf of investors, including mortgage bankers,
banks, savings and loans or investment bankers. The Company funds loans
originated by mortgage brokers by lending the Company's funds to the borrower
and closing the loan to the borrower in the Company's name.
The Company funds loans originated by mortgage brokers on an individual
loan basis, pursuant to which each loan is underwritten by the Company and is
closed in the Company's name. The Company's network of mortgage brokers earn
fees which are paid by the borrower at closing, and which are disclosed and
agreed to by the borrower as required by law. The Company purchases loans from
its network of mortgage bankers after underwriting closed loans or pools of
closed loans for compliance with the Company's underwriting criteria. When the
Company buys closed loans from mortgage bankers, the Company has historically,
and may in the future, pay premiums based upon the characteristics of the loans,
including the range of credit scores of the borrowers and the interest rates on
the loans. The wholesale division conducts operations from its headquarters in
Atlanta, Georgia. To build and maintain its networks of mortgage bankers and
brokers, the wholesale division uses account executives responsible for
developing and maintaining relationships with mortgage bankers and brokers. At
August 31, 1998, the Company had a network of 169 active mortgage brokers and 56
active mortgage bankers.
Mortgage bankers and brokers qualify to participate in the Company's
programs only after a review by the Company's management of the mortgage
brokers' and mortgage bankers' respective reputations and expertise, including a
review of references and financial statements. The Company's compliance
department performs a periodic review of each mortgage banker and broker,
recommending suspension or continuance of a relationship with the mortgage
banker or broker based upon the results of the review. We do not believe that
the loss of any particular mortgage banker or broker would have a material
adverse effect upon the Company.
None of the Company's arrangements with its mortgage bankers and brokers is
on an exclusive basis. Each relationship is documented by a written agreement,
in which the Company agrees to fund or purchase loans that comply with the
Company's underwriting guidelines. On each loan produced, the mortgage banker or
broker makes customary representations and warranties regarding, among other
things, the credit history of the borrower, the status of the loan and its lien
priority, if applicable, and agrees to indemnify the Company for breaches of any
representation or warranty. In the agreements, the mortgage banker or broker
makes customary representations and warranties regarding, among other things,
their corporate status, as well as regulatory compliance, title to the property,
enforceability, status of payments and advances on the loans. The mortgage
bankers and brokers agree, among other things, not to disclose confidential
information of the Company, to provide supplementary financial and licensing
information, maintain government approvals, and to refrain from soliciting the
Company's borrowers. Each agreement also contains provisions requiring that the
mortgage banker or broker indemnify the Company against material
misrepresentations or non-performance of its obligations.
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<PAGE> 78
Retail Loans
The Company commenced making direct-to-consumer Equity + loans in September
1997 and Home Equity loans in December 1997, although the Company's retail
channels are not being actively pursued. Marketing strategies typically used in
retail production include telemarketing, direct mail, television and radio
advertising, third-party loan programs and consumer trade shows. Telemarketing
services, both inbound and outbound, are outsourced to keep the cost of
originations to a minimum. A Company website is currently under construction and
may be used to provide consumers loan applications and information to the public
about the Company's products and services. As part of its business strategy, the
Company intends to acquire retail mortgage lending companies in fiscal 1999.
By making direct-to-consumer loans, the Company avoids the payment of
premiums that it pays when it purchases closed loans from its network of
mortgage bankers. The loan fees charged by the Company to consumers on the
direct loans are expected to cover the Company's total cost of the underwriting
and making the loan and place the Company on a positive cash flow basis with
respect to the production of direct-to-consumer loans.
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<PAGE> 79
The following table provides information about the Company's loan
applications processed and loans produced during the periods indicated. As a
result of recent changes to the Company's business strategy, we do not believe
that this information is indicative of future loan applications and loans
produced.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
------------------------------------------------------
1996 1997 1998
---------------- ---------------- ----------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
TOTAL LOAN APPLICATIONS:
Number processed.............. 42,236 92,165 46,361
Number approved............... 20,910 52,269 24,876
Approved ratio................ 49.5% 56.7% 53.7%
LOAN PRODUCTION:
Principal balance of loans
produced:
Wholesale:
Title I.................... $ 82,596 59.3% $ 50,815 9.7% $ 7,081 2.1%
Equity + loans............. 11,582 8.3 409,603 77.7 289,354 85.4
-------- ----- -------- ----- -------- -----
Total Wholesale....... 94,178 67.6% 460,418 87.4% 296,435 87.5%
Dealers/Bankers/Brokers(1):
Title I.................... 45,189 32.4% 47,270 9.0% 11,619 3.4%
Equity + loans............. -- -- 19,229 3.6 14,051 4.2
Home Equity................ -- -- -- -- 8,940 2.6
-------- ----- -------- ----- -------- -----
Total
Dealers/Bankers/Brokers.. 45,189 32.4% 66,499 12.6% 34,610 10.2%
Retail:
Equity + loans............. -- -- -- -- $ 7,114 2.1%
Home Equity................ -- -- -- -- 783 0.2
-------- ----- -------- ----- -------- -----
Total Retail.......... -- -- -- -- $ 7,897 2.3%
-------- ----- -------- ----- -------- -----
Total principal
balance of loans
produced............ $139,367 100.0% $526,917 100.0% $338,942 100.0%
======== ===== ======== ===== ======== =====
Number of loans produced:
Wholesale:
Title I.................... 4,382 50.9% 2,445 12.0% 327 2.9%
Equity + loans............. 392 4.6 12,831 62.7 8,848 78.6
-------- ----- -------- ----- -------- -----
Total Wholesale....... 4,774 55.5% $ 15,276 74.7% 9,175 81.5%
Dealers/Bankers/Brokers (1):
Title I.................... 3,836 44.5% 3,893 19.0% 975 8.7%
Equity + loans............. -- -- 1,296 6.3 744 6.6
Home Equity................ -- -- -- -- 145 1.2
-------- ----- -------- ----- -------- -----
Total
Dealers/Bankers/Brokers.. 3,836 44.5% 5,189 25.3% 1,864 16.5%
Retail:
Equity + loans............. -- -- -- -- 208 1.8%
Home Equity................ -- -- -- -- 17 0.2
-------- ----- -------- ----- -------- -----
Total Retail.......... -- -- -- -- 225 2.0%
-------- ----- -------- ----- -------- -----
Total number of loans
produced............ 8,610 100.0% 20,465 100.0% 11,264 100.0%
======== ===== ======== ===== ======== =====
</TABLE>
78
<PAGE> 80
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
------------------------------------------------------
1996 1997 1998
---------------- ---------------- ----------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Average principal balance of
loans produced................ $ 16 $ 26 $ 30
Weighted-average interest rate
on loans produced............. 14.03% 13.92% 13.89%
Weighted-average term of loans
produced (months)............. 198 226 235
</TABLE>
- -------------------------
(1) The Company closed its dealer division, which purchased loans from home
improvement contractors, in February 1998.
LOAN PROCESSING AND UNDERWRITING
The Company's loan application and approval process generally is conducted
over the telephone with applications usually received from mortgage bankers,
mortgage brokers and consumers at the Company's centralized processing facility
in Atlanta, Georgia. After receiving an application, the information is entered
into the Company's system and processing begins. The information provided in
loan applications is first verified by, among other things, the following:
- written confirmations of the applicant's income and, if necessary, bank
deposits
- a formal credit bureau report on the applicant from a credit reporting
agency
- a title report
- a real estate appraisal, if necessary
- evidence of flood insurance, if necessary
Loan applications are then reviewed to determine whether or not they
satisfy the Company's underwriting criteria, including loan-to-value ratios,
occupancy status, borrower income qualifications, employment stability,
purchaser requirements and necessary insurance and property appraisal
requirements.
The Company has developed its credit index profile ("CIP") as a statistical
credit based tool to predict likely future performance of a borrower. A
significant component of the CIP system is the credit evaluation score
methodology developed by Fair Isaacs Company ("FICO"), a consulting firm
specializing in creating default predictive models using a number of variable
components. A FICO score is calculated by a system of scorecards. FICO uses
actual credit data on millions of consumers, and applies complex mathematical
methods to perform extensive research into credit patterns that attempt to
forecast consumer credit performance. The principal components of the FICO
predictive model include a consumer's credit payment history, outstanding debt,
availability and pursuit of new credit and types of credit in use. Through this
scorecard process, FICO identifies distinctive credit patterns, which correspond
to a likelihood that consumers will make their future loan payments. The score
is based on all the credit-related data in the credit report. The other major
components of the CIP include debt-to-income analysis, employment stability,
self employment criteria, residence stability and whether the applicants use the
premises as their primary residence. By using both scoring models
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<PAGE> 81
together, all applicants are considered on the basis of their ability to repay
the loan obligation while allowing the Company to price the loan based on the
extent of the evaluated risk.
The Company's underwriters review the applicant's credit history, based on
the information contained in the application and reports available from credit
reporting bureaus and the Company's CIP score, to determine whether the
applicant meets the Company's underwriting guidelines. Based on the
underwriter's approval authority level, certain exceptions to the guidelines may
be made when there are compensating factors subject to approval from a more
senior designated authority. The underwriter's decision is communicated to the
broker, banker or consumer depending on the source of the loan and, if approved,
the proposed loan terms are fully explained. The Company attempts to respond
within 24 hours of receipt of a loan application.
Loan commitments are generally issued for periods of up to 30 days. Prior
to disbursement of funds, all loans are carefully reviewed by funding auditors
to ensure that all documentation is complete, all contingencies specified in the
approval have been met and the loan complies with Company and regulatory
procedures.
Home Equity Loans
The Company produces Home Equity loans through a mortgage banker and broker
loan source network as well as through the Company's retail division. Home
Equity loan mortgages produced under this program are limited to a first or
second lien position. Loan amounts are determined by taking a specific amount of
the collateral value of the property and adjusting the percentage based on the
creditworthiness of the borrower. For example, if the Company's guidelines set a
minimum loan-to-value ratio of 75% ($75,000 for a home with a collateral value
of $100,000), a more creditworthy borrower may be able to borrow in excess of
$75,000, and a less credit worthy borrower may only be able to borrow $65,000.
Full appraisals generated by approved licensed appraisers are required on all
loans within the Uniform Standards of Professional Appraisal Practice (the
"Uniform Standards of Appraisal"). Any loan amount of $250,000 or more would
require two independent appraisals. The credit grade will be determined by using
the CIP. In connection with Home Equity loans, the Company seeks commitments
from third party financial institutions to purchase the loans in accordance with
their respective guidelines, without recourse for credit losses or risk of
prepayment.
As part of the underwriting process, the Company requires an appraisal of
the residence that will be the collateral for the loan. The Company requires the
independent appraiser to be state licensed and certified. The Company requires
that all independent appraisals be completed within the Uniform Standards of
Appraisal as adopted by the Appraisal Standards Board of the Appraisal
Foundation. The Company audits the appraisal for accuracy to ensure that the
appraiser used sufficient care in analyzing data to avoid errors that would
significantly affect the appraiser's opinion and conclusion. This audit includes
a review of housing demand, physical adaptability of the real estate,
neighborhood trends and the highest and best use of the real estate. In the
event the audit reveals any discrepancies as to the method and technique that
the Company believes are necessary to produce a credible appraisal, the Company
will perform additional property data research or may request a second appraisal
to be performed by an independent appraiser selected by the Company in order to
further substantiate the value of the subject property.
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<PAGE> 82
The Company may require a full title insurance policy substantially in
compliance with the requirements of the American Loan Title Association. The
applicant also is required to secure hazard insurance and may be required to
secure flood insurance if the mortgaged property has been identified by the
Federal Emergency Management Agency as having special flood hazards.
Equity + Loans
The Company has implemented policies for its Equity + loan program that are
designed to minimize losses by adhering to high credit quality standards. Based
on FICO score default predictors and the Company's internal CIP score, borrowers
are classified by the Company based on its belief of their credit risk and
quality, from "A" credits to "D" credits. Quality is a function of both the
borrowers' creditworthiness and the extent of the value of the collateral, which
is typically a second lien on the borrowers' primary residence. "A+" credits
generally have a FICO score greater than 700. An applicant with a FICO score of
less than 640 would be rated a "C" credit. Currently, the Company will not
approve an Equity + loan to a borrower with less than an "A" or "B" credit grade
using the CIP. All of the Equity + loans originated to date by the Company are
secured by first or second mortgage liens on single-family, owner occupied
properties.
Terms of Equity + loans produced by the Company, as well as the maximum
combined loan-to-value ratios and debt service to income coverage (calculated by
dividing fixed monthly debt payments by gross monthly income), vary depending
upon the Company's evaluation of the borrower's creditworthiness. In general,
Equity + loans have higher interest rates than Home Equity loans, but are
generally lower than rates changed on credit cards. Borrowers with lower
creditworthiness generally pay higher interest rates and loan origination fees.
QUALITY CONTROL
The Company employs various quality control personnel and procedures in
order to ensure that loan product standards are adhered to and regulatory
compliance is maintained.
In accordance with Company policy, the quality control department reviews a
statistical sample of loans produced each month. This review is generally
completed within 60 days and circulated to appropriate department heads and
senior management. Finalized reports generally are maintained in the Company's
files for a period of two years from completion. Typical review procedures
include reverification of employment and income, re-appraisal of the subject
property, obtaining separate credit reports and recalculation of debt-to-income
ratios. The statistical sample is intended to cover 10% of all new loan
products. Emphasis will also be placed on those loan sources where higher levels
of delinquency are experienced or payment defaults occur within the first six
months of funding. On occasion, the quality control department may review all
loans generated from a particular loan source in the event an initial review
determines a higher than normal number of exceptions. The account selection of
the quality control department is also designed to include a statistical sample
of loans by each processor, closer and underwriter, and provides management with
information as to any material difference from Company policies and procedures
in the loan production process.
On a daily basis, a sample of recently approved loans are reviewed to
insure compliance with underwriting guidelines and criteria. Particular
attention may be focused on those underwriters who have developed a higher than
normal level of exceptions.
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<PAGE> 83
TECHNOLOGY SYSTEMS
The Company uses a computerized loan production tracking system that allows
us to monitor the performance of our wholesale and retail divisions. The system
automates various other functions such as Home Mortgage Disclosure Act and HUD
reporting requirements and routine tasks such as decline letters and the flood
certification process. The system also gives management access to a wide range
of decision support information including data on the approval pipeline and the
activities and performance of underwriters and loan funders. The Company uses
intercompany electronic mail for internal communications and for receiving loan
servicing, collection and delinquency information from City Mortgage Services on
each group of loans being serviced.
The Company's existing loan production system provides for the automation
of the loan production process as well as loan file indexing and routing. This
system includes automated credit report inquiries and consumer credit scoring,
along with on-screen underwriting and approval functions. The Company also uses
a system which allows for electronic routing of loan application facsimiles. The
Company recognizes that there have been significant advances made by a number of
mortgage production software vendors in the last year and intends to review a
number of the solutions provided by these vendors. It is the intention of the
Company to upgrade its automation infrastructure by the purchase of a new
system. This approach will shift the burden of development and maintenance of
the production system from the Company's in-house development staff to third
party vendors to allow the Company to focus its in-house development efforts to
its own unique business automation needs. Currently, the Company's existing loan
production system is not Year 2000 compliant. The cost for replacing the
Company's existing loan production system has been included in its plans and
estimated expenses for Year 2000 compliance. For additional details on Year 2000
compliance, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Impact of Year 2000 Issue" earlier in this prospectus.
LOAN SERVICING
The Company's strategy has historically been to retain the bulk of the
servicing rights associated with the loans it originates. As part of the
recapitalization, City Mortgage Services purchased the Company's existing loan
servicing rights and agreed to service all of the Company's loans held for sale
and loans sold on a servicing retained basis. The Company has an option,
contingent upon the delivery to City Mortgage Services of servicing on $1.0
billion of loans to purchase up to 20% equity position in a new entity to be
created should City National Bank determine to spin-off City Mortgage Services
into a separate entity. When the Company sold its loan servicing portfolio to
City Mortgage, the Company eliminated substantially all of its collections and
claim staff.
Among the Company's loan servicing activities performed by City Mortgage
Services are processing and administering loan payments, reporting and sending
principal and interest to the owners who own interests in the loans and to the
trustee of loans sold in securitization transactions, collecting delinquent loan
payments, processing Title I insurance claims, conducting foreclosure
proceedings and disposing of foreclosed properties and other loan administration
duties. In addition, under the loan servicing agreements, the Company is
entitled to receive a certain portion of the servicing fees collected by City
Mortgage Services. The Company will retain responsibility for certain functions
related to initial customer service and continued tax and insurance monitoring.
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<PAGE> 84
The following table sets forth certain historical information regarding the
Company's loan servicing for the periods indicated:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
--------------------------------
1996 1997 1998
-------- --------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Servicing portfolio at beginning of period(2)... $ 92,286 $ 214,189 $ 628,068
Additions to servicing portfolio................ 139,367 526,917 338,942
Reductions in servicing portfolio(1)............ (17,464) (113,038) (935,788)
-------- --------- ---------
Servicing portfolio at end of period(2)......... $214,189 $ 628,068 $ 31,222
======== ========= =========
Servicing portfolio at end of period(2):
Company-owned loans:
Equity +...................................... $ 922 $ 8,661 $ 8,217
Title I....................................... 3,776 902 4,233
-------- --------- ---------
Total Company-owned loans............. 4,698 9,563 12,450
Loans sold in securitization transactions:
Equity +...................................... 10,501 363,961 --
Title I....................................... 198,990 254,544 18,772
-------- --------- ---------
Total loans sold in securitization
transactions....................... 209,491 618,505 18,772
-------- --------- ---------
Total servicing portfolio(2).......... $214,189 $ 628,068 $ 31,222
======== ========= =========
</TABLE>
- ---------------
(1) Reductions resulted from scheduled payments, prepayments, loans sold with
servicing released, and writeoffs during the period.
(2) Not adjusted for the sale of the Company's mortgage servicing rights to City
Mortgage Services on August 1, 1998 as part of the recapitalization.
Excludes approximately $9.4 million of Equity + loans to be repurchased at
August 31, 1998.
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<PAGE> 85
The following table sets forth the Title I Loan and Equity + loan
delinquency and Title I insurance claims experience of loans serviced by the
Company as of the dates indicated. The Company is not producing a significant
amount of Title I Loans.
<TABLE>
<CAPTION>
AUGUST 31,
--------------------------------
1996 1997 1998
-------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Equity + loan delinquency data(1):
31-60 days past due.......................... 0.44% 0.40% 7.14%
61-90 days past due.......................... 0.00 0.20 1.52
91 days and over past due.................... 0.00 0.34 24.83
Total past due................................. 0.44 0.94 33.49
Title I loan delinquency data(1):
31-60 days past due.......................... 2.27 3.19 7.88
61-90 days past due.......................... 0.90 1.68 2.39
91 days and over past due.................... 4.78(2) 7.06(2) 25.00
Total past due................................. 7.95 11.93 35.27
91 days and over past due,
net of claims filed(3).................... 2.05 5.20 8.54
Outstanding claims filed with HUD(4)........... 2.73 1.86 16.46
Amount of FHA insurance available for Title I
loans serviced............................... $ 21,205 $ 21,094 $ 14,134(5)
Amount of FHA insurance available as a
percentage of Title I loans serviced......... 10.46% 8.26% 61.44%(5)
Total delinquency data:
31-60 days past due.......................... 2.17 1.54 7.69
61-90 days past due.......................... 0.85 0.80 2.16
91 days and over past due.................... 4.53(7) 3.07(2) 24.95
Total past due................................. 7.55 5.41 34.88
91 days and over past due, net of claims
filed(6).................................. 1.94 2.32 7.56
Outstanding claims filed with HUD(7)........... 2.59 0.75 17.39
Outstanding number of Title I insurance claims
filed........................................ 255 269 207
Total servicing portfolio(9)................... $214,189 $628,068 $ 31,222
Title I loans serviced......................... 202,766 255,446 23,005
Equity + loans serviced(9)..................... $ 11,423 $372,622 $ 8,217
Home Equity loans serviced..................... -- -- --
Aggregate losses on liquidated loans(8)........ $ 32.0 $ 201.0 $1,368.0
</TABLE>
- ---------------
(1) Represents the dollar amount of delinquent loans as a percentage of the
total dollar amount of each respective type of loan serviced by the Company
(including loans owned by the Company but excluding loans repurchased and
loans contained in securitization 1998-1) as of period end. Equity + loan
delinquencies represented 0.31% of the Company's total delinquencies for the
year ended August 31, 1996, 10.35% for the year ended August 31, 1997 and
17.39% for the year ended August 31, 1998 of the Company's total
delinquencies. The Company did not produce Equity + loans until May 1996.
The Company did not produce Home Equity loans until December 1997.
(2) During fiscal 1996 and the first two quarters of fiscal 1997, the processing
and payment of claims filed with HUD was delayed. Claims paid by HUD during
fiscal 1998 totaled $8.8 million.
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<PAGE> 86
(3) Represents the dollar amount of delinquent Title I loans net of delinquent
Title I loans for which claims have been filed with HUD and payment is
pending as a percentage of the total dollar amount of Title I loans serviced
by the Company (including loans owned by the Company) as of the dates
indicated.
(4) Represents the dollar amount of delinquent Title I loans for which claims
have been filed with HUD and payment is pending as a percentage of the total
dollar amount of Title I loans serviced by the Company (including loans
owned by the Company) as of the dates indicated.
(5) If all claims filed with HUD had been processed and paid as of August 31,
1998, the amount of FHA insurance available for all serviced Title I loans
would have been reduced to $8.9 million, which as a percentage of Title I
loans serviced would have been 4.2%.
(6) Represents the dollar amount of delinquent loans net of delinquent Title I
loans for which claims have been filed with HUD and payment is pending as a
percentage of the total dollar amount of loans serviced by the Company
(including loans owned by the Company) as of the dates indicated.
(7) Represents the dollar amount of delinquent Title I loans for which claims
have been filed with HUD and payment is pending as a percentage of the total
dollar amount of total loans serviced by the Company (including loans owned
by the Company) as of the dates indicated.
(8) On Title I loans, a loss is recognized upon receipt of payment of a claim or
final rejection thereof. Claims paid in a period may relate to a claim filed
in an earlier period. Since the Company commenced its Title I lending
operations in March 1994, there has been no final rejection of a claim by
the FHA. Aggregate losses on liquidated Title I loans related to 1,227 Title
I insurance claims made by the Company, as servicer, since commencing
operations through August 31, 1998. Losses on Title I loans liquidated will
increase as the balance of the claims are processed by HUD. The Company has
received an average payment from HUD equal to 90% of the outstanding
principal balance of such Title I loans, plus appropriate interest and
costs.
(9) Excludes approximately $9.4 million of Equity + loans to be repurchased at
August 31, 1998.
SALE OF LOANS
The Company has historically sold on a servicing-retained basis a
substantial majority of all loans it produced in securitization transactions.
The balance was sold for cash servicing released to institutional purchasers.
Currently, sales on a servicing-released basis, and some sales on a
servicing-retained basis, are sold at a premium to their principal balance. As
part of the sale of loans in securitization transactions, senior securities in
the related securitization are sold to institutional purchasers with a junior
subordinated interest in the transaction retained by or issued to the Company as
a mortgage related security. As part of its business strategy, the Company
intents to sell its loan production in the secondary market to institutional
purchasers for cash premiums and reduce its historically dependence on
securitization transactions as a method to sell loans. The Company will also
attempt to reduce the acquisition premiums paid to its network of mortgage
bankers of Equity + and Home Equity loans. During the year ended August 30,
1997, these cash acquisition premiums totaled $18.0 million or approximately
3.5% of the Company's total loan production and, for the year ended August 31,
1998, these premiums totaled $13.7 million or approximately 4.1% of the
Company's total loan production.
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<PAGE> 87
Pursuant to the Flow Purchase Agreement entered into as part of the
recapitalization, the Company agreed to sell, and Sovereign Bancorp agreed to
buy, $100.0 million principal amount of Home Equity and Equity + loans, on a
quarterly basis, commencing in the calendar quarter beginning January 1, 1999.
Up to $200.0 million of the $400.0 million in principal amount of the loans the
Company is required to sell to Sovereign Bancorp on an annual basis can be
Equity + loans. The Flow Purchase Agreement, which is renewable every six
months, expires on December 31, 1998, but is renewable for additional six-month
periods until September 2001. Sovereign Bancorp has the exclusive right to
acquire the first $100 million of mortgage loans produced by the Company each
quarter during the term of the Flow Purchase Agreement. The Flow Purchase
Agreement does not require the Company to sell loans to Sovereign Bancorp at a
loss.
When the Company completed the recapitalization, the Company terminated its
existing master purchase agreement with a financial institution in which the
financial institution agreed to purchase up to $2.0 billion of loans over a
five-year period ending in September 2001. For a description of the risks to the
Company from the Flow Purchase Agreement with Sovereign Bancorp, see "Risk
Factors -- Liquidity Risks" earlier in this prospectus. For additional details
of the master purchase agreement that was terminated, see "Certain Transactions"
later in this prospectus.
The following table sets forth certain data regarding loans securitized or
sold by the Company during the periods indicated with servicing retained, and
excluding loans sold with servicing released:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
-------------------------------
1996 1997 1998
-------- -------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Principal amount of loans sold................... $137,908 $462,318 $ 181,931
Gain (loss) on sales of loans(1)................. 16,539 45,123 (26,578)
Net unrealized gain (loss) on mortgage related
securities..................................... 2,697 3,518 (70,024)
Weighted-average stated interest rate on loans
sold(2)........................................ 14.09% 13.91% 11.77%
Weighted-averaged pass-through interest rate on
loans sold(2).................................. 7.50 7.36 6.77
Weighted-average excess spread retain on loans
sold(2)
6.59 6.55 5.00
</TABLE>
- -------------------------
(1) Excludes gain on sale of $2.0 million relating to whole loan sales with
servicing released of $59.2 million during the year ended August 31, 1997.
Excludes gain on sale of $2.3 million relating to whole loan sales with
servicing released of $160.1 million during the year ended August 31, 1998.
(2) Includes all loans sold with servicing released or servicing retained.
COMPETITION
The Company faces intense competition in the business of originating and
selling Home Equity loans and, to a lesser extent, Equity + loans. The Company's
competitors include other consumer finance companies, mortgage banking
companies, commercial banks, credit unions, thrift institutions, credit card
issuers and insurance companies. Many of these entities are substantially
larger, have lower costs of capital and have considerably greater financial,
technical and marketing resources than the Company. In addition, many
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<PAGE> 88
of the financial services organizations that are much larger than the Company
have formed national loan production networks offering loan products that are
substantially similar to the Company's loan programs. The Company believes that
Conti Mortgage Corp., The Money Store, First Plus Financial Group, Associates
First Capital Corporation, and Household Finance Corporation are some of its
largest direct competitors. The Company competes principally by providing
prompt, professional service to its mortgage bankers, brokers and retail
customers and, depending on circumstances, by providing competitive lending
rates.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, customer service, marketing and distribution
channels, amount and term of the loan, loan origination fees and interest rates.
Additional competition may lower the rates the Company can charge borrowers,
potentially lowering the gain on future loan sales. The Company may face
competition from, among others, government-chartered entities, such as FNMA,
FHLMA, and GNMA. The Company's competitors may expand their existing or new loan
purchase programs to include Home Equity loans. Entries of government-sponsored
entities into the Home Equity loan market could lower the interest rates the
Company is able to charge its borrowers and reduce or eliminate premiums on loan
sales. To the extent any of these competitors significantly expand their
activities in the Company's market, the Company could be materially adversely
affected. Fluctuations in interest rates and general economic conditions may
also affect the Company's competition. During periods of rising rates,
competitors that have locked in low borrowing costs may have a competitive
advantage. During periods of declining rates, competitors may solicit the
Company's customers to refinance their loans. See "Risk Factors -- Competition"
located earlier in this prospectus.
If the Company is unable to remain competitive in these areas, the volume
of the Company's loan production may be materially adversely affected as
borrowers seek out other lenders for their financing needs. Lower loan
production may have an adverse effect on the Company's ability to negotiate and
obtain sufficient financing under warehouse lines of credit upon acceptable
terms. Establishing a broker-sourced loan business typically requires a
substantially smaller commitment of capital and personnel resources than a
direct-sourced loan business. This relatively low barrier to entry permits new
competitors to enter the broker-sourced loan market quickly, particularly
existing direct-sourced lenders which can draw upon existing branch networks and
personnel in seeking to sell products through independent brokers. Competition
may be affected by fluctuations in interest rates and general economic
conditions. During periods of rising rates, competitors which have locked in low
borrowing costs may have a competitive advantage.
The Company has historically been dependent on certain of its competitors
to purchase loans not purchased by Sovereign Bancorp. If such competitors
refrained from purchasing the Company's loans and the Company were unable to
replace such purchasers, the Company's financial condition and results of
operations could be materially adversely affected. The Flow Purchase Agreement
between the Company and Sovereign Bancorp is expected to alleviate this
situation. See "-- Sale of Loans" located earlier in this prospectus. The
Company continues to seek other purchasers who are not competitors of the
Company.
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GOVERNMENT REGULATION
The Company's lending activities are subject to the Truth in Lending Act
and Regulation Z (including the Home Ownership and Equity Protection Act of
1994), the Equal Credit Opportunity Act and Regulation B, the Fair Credit
Reporting Act, as amended, the Real Estate Settlement Procedures Act and
Regulation X, the Home Mortgage Disclosure Act of 1975, the Fair Debt Collection
Practices Act and the Fair Housing Act, as well as other federal and state
statutes and regulations affecting the Company's activities. Failure to comply
with these requirements can lead to loss of approved status, termination or
suspension of servicing contracts without compensation to the servicer, demands
for indemnifications or mortgage loan repurchases, certain rights of rescission
for mortgage loans, class action lawsuits and administrative enforcement
actions.
The Company is subject to the rules and regulations of, and examinations
by, HUD, FHA and other federal and state regulatory authorities with respect to
originating, underwriting, funding, acquiring, selling and to the extent that it
engages in servicing activities, to servicing consumer and mortgage loans. In
addition, there are other federal and state statutes and regulations affecting
the Company's activities. These rules and regulations, among other things,
impose licensing obligations on the Company, establish eligibility criteria for
loans, prohibit discrimination, provide for inspection and appraisals of
properties, require credit reports on prospective borrowers, regulate payment
features and, in some cases, fix maximum interest rates, fees and loan amounts.
The Company is required to submit annual audited financial statements to various
governmental regulatory agencies that require the maintenance of specified net
worth levels. The Company's affairs are also subject to examination, at all
times, by the Federal Housing Commissioner to assure compliance with FHA
regulations, policies and procedures.
Although the Company is no longer originating a significant volume of Title
I Loans, the Company is a HUD approved Title I mortgage lender and is subject to
the supervision of HUD. In addition, the Company's operations are subject to
supervision by state authorities (typically state banking or consumer credit
authorities), many of which generally require that the Company be licensed to
conduct its business. This normally requires state examinations and reporting
requirements on an annual basis.
The Federal Consumer Credit Protection Act ("FCCPA") requires a written
statement showing an annual percentage rate of finance charges and requires that
other information be presented to debtors when consumer credit contracts are
executed. The Fair Credit Reporting Act requires certain disclosures to
applicants concerning information that is used as a basis for denial of credit.
The Equal Credit Opportunity Act prohibits discrimination against applicants
with respect to any aspect of a credit transaction on the basis of sex, marital
status, race, color, religion, national origin, age, derivation of income from
public assistance program, or the good faith exercise of a right under the
FCCPA.
The interest rates which the Company may charge on its loans are subject to
state usury laws, which specify the maximum rate which may be charged to
consumers. In addition, both federal and state truth-in-lending regulations
require that the Company disclose to its customers prior to execution of the
loans, all material terms and conditions of the financing, including the payment
schedule and total obligation under the loans. The Company believes that it is
in compliance in all material respects with such regulations.
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SEASONALITY
The Company's production of Home Equity and Equity + loans is seasonal to
the extent that borrowers used the proceeds for home improvement contract work.
The Company's production of loans for this purpose tends to build during the
spring and early summer months, particularly where the proceeds are used for
pool installations. A decline is typically experienced in late summer and early
fall until temperatures begin to drop. This change in seasons precipitates the
need for new siding, window and insulation contracts. Peak volume is experienced
in November and early December and declines dramatically from the holiday season
through the winter months. While the Company does not have substantial
experience making loans to borrowers who intend to use the proceeds to purchase
a residence, management believes that the market for such loans will follow the
home sale cycle, higher in the spring through early fall than during the
remainder of the year.
EMPLOYEES
As of January 1, 1999, the Company had 56 employees. None of the Company's
employees is represented by a collective bargaining agreement. The Company
believes that its relations with its employees are satisfactory.
PROPERTIES
The Company leases 45,950 square feet of office space at 1000 Parkwood
Circle, Atlanta, Georgia, consisting of two full floors. The Company's corporate
headquarters have been consolidated into 22,975 square feet, consisting of one
floor at this location. The Company has subleased the other floor at this
location. The Company's lease is for an initial six-year term expiring August
2002 with a conditional option to extend the term to August 2007. The Company is
searching for alternative space for its corporate headquarters. If it finds
space, the Company expects to sublease the presently occupied space and relocate
its corporate headquarters. The Company also leases 10,478 square feet of office
space at its prior headquarters location in Atlanta, Georgia pursuant to a lease
that expires in March 1999. In addition, as of December 11, 1998 the Company
also leased office space on short-term or month-to-month leases in Phoenix,
Arizona; Dublin, California; Denver, Colorado; Ft. Lauderdale, Florida; Miami
Lakes, Florida; Elmhurst, Illinois; Woburn, Massachusetts; Waterford, Michigan;
Blue Springs, Missouri; Waldwick, New Jersey; Las Vegas, Nevada; Patchogue, New
York; Columbus, Ohio; Oklahoma City, Oklahoma; Bridgeville, Pennsylvania;
Brentwood, Tennessee; Austin, Texas; and Seattle, Washington. The Company
believes that all of its facilities are suitable and adequate for the current
conduct of its operations.
LEGAL PROCEEDINGS
On February 23, 1998, an action was filed in the United States District
Court for the Northern District of Georgia by Robert J. Feeney, as a purported
class action against the Company and Jeffrey S. Moore, the Company's former
President and Chief Executive Officer. The complaint alleges, among other
things, that the defendants violated the federal securities laws in connection
with the preparation and issuance of certain of the Company's financial
statements. The named plaintiff seeks to represent a class consisting of
purchasers of the Common Stock between April 11, 1997 and December 18, 1997, and
seeks damages in an unspecified amount, costs, attorney's fees and such other
relief as the court may
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deem proper. On June 30, 1998, the plaintiff amended the complaint to add
additional plaintiffs, to add as a defendant Mego Financial, the Company's
former parent, and to extend the class period through and including May 20,
1998. On September 18, 1998, the Company filed a motion to dismiss the
complaint. The Company believes it has meritorious defenses to this lawsuit and
that resolution of this matter will not result in a material adverse effect on
the business or financial condition of the Company.
On October 2, 1998, an action was filed in the United States District Court
for the Western Division of Tennessee by Traci Parris, as a purported class
action against Mortgage Lenders Association, Inc., the Company and City Mortgage
Services, Inc., one of the Company's strategic partners. The complaint alleges,
among other things, that the defendants charged interest rates, origination fees
and loan brokerage commissions in excess of those allowed by law. The named
plaintiff seeks to represent a class of borrowers and seeks damages in an
unspecified amount, reform or nullification of loan agreements, injunction,
costs, attorney's fees and such other relief as the court may deem just and
proper. On October 27, 1998, the Company filed a motion to dismiss the
complaint. The Company believes it has meritorious defenses to this lawsuit and
that resolution of this matter will not result in a material adverse effect on
the business or financial condition of the Company.
On October 8, 1998, the Office of the Consumer Credit Commissioner of the
State of Texas issued a denial of the Company's application for licensing as a
secondary mortgage lender. On October 20, 1998, the Company filed an appeal of
the Commissioner's decision and an administrative hearing will be held after
March 1999. The denial will not become final until the Company's appeal has been
resolved. The Company believes that it is capable of meeting such requirements
as the Commissioner may set to amend the Company's license application. If the
denial becomes final, the Company will not be able to make secondary mortgage
loans in the State of Texas at interest rates of greater than 10%. The Company
is not required to hold a secondary mortgage lender license in order to continue
to produce or acquire unregulated first mortgage loans in the state of Texas.
The Company believes that resolution of this matter will not result in a
material adverse effect on the business or financial condition of the Company.
In the ordinary course of its business, the Company is, from time to time,
named in lawsuits. The Company believes that it has meritorious defenses to
these lawsuits and that resolution of these matters will not have a material
adverse effect on the business or financial condition of the Company.
RECENT DEVELOPMENTS
As part of the Company's strategic initiatives, the Company entered into an
agreement to purchase certain assets of LL Funding Corp., a privately-held loan
origination company headquartered in Columbia, Maryland. Through December 31,
1998, the Company has purchased from LL Funding Corp. approximately $16.2
million principal amount of loans at a purchase price of 102.75%. In addition,
the Company has advanced approximately $1.3 million to LL Funding Corp. to fund
their operations. On January 4, 1999, the Company terminated the asset purchase
agreement pursuant to provisions contained therein. LL Funding Corp. disputed
the Company's right to terminate the asset purchase agreement, and on January
11, 1999, the Company filed suit asking that the court declare that the Company
properly terminated the asset purchase agreement and is not liable to LL Funding
Corp. as a result of such termination.
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The Company, on January 8, 1999, consummated the purchase of substantially
all of the operating assets of a retail, sub-prime loan production facility
located in Las Vegas, Nevada from FirstPlus Financial, Inc. for approximately
$3.25 million in cash.
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MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth certain information with respect to the
directors and executive officers of the Company as of December 1, 1998.
<TABLE>
<CAPTION>
NAME AGE POSITION
- ---- --- --------
<S> <C> <C>
Champ Meyercord........................... 57 Chairman of the Board and Chief
Executive Officer
Wm. Paul Ralser........................... 57 President, Chief Operating Officer and
Director
J. Richard Walker......................... 51 Executive Vice President and Chief
Financial Officer
Spencer I. Browne......................... 48 Director
Hubert M. Stiles.......................... 51 Director
David J. Vida, Jr......................... 32 Director
John D. Williamson, Jr.................... 63 Director
</TABLE>
Edward B. "Champ" Meyercord has been Chairman and Chief Executive Officer
of the Company since July 1998 and, prior thereto, he was a special consultant
to the Company since May 1998. From 1994 to 1998, Mr. Meyercord was a senior
investment banker with Greenwich Capital Markets, most recently as a co-head of
the Mortgage and Asset Backed Finance Group. In addition to his involvement with
asset backed securities, Mr. Meyercord was involved in the development of
financing vehicles for specialty finance companies. Greenwich Capital Markets
has performed investment banking services for the Company since 1994. Prior to
1994, Mr. Meyercord was a co-managing partner of Hillcrest Partners, a private
investment bank specializing in mergers and acquisitions for financial
institutions. Mr. Meyercord is a member of the Board of Directors of The
National Home Equity Mortgage Association.
Wm. Paul Ralser. Mr. Ralser has been a Director of the Company since June
1998 and President and Chief Operating Officer since September 1998. Mr. Ralser
has served as President and Chairman of the Board of First Fidelity Bancorp,
Inc. since June 1996. Since December 1994, Mr. Ralser has been President and
Chief Executive Officer of First Fidelity Thrift & Loan Association. From
October 1992 to December 1994, Mr. Ralser was Executive Vice President and
Director of Affordable Housing for Countrywide Funding Corporation
("Countrywide") and, from September 1986 until August 1992, he served as
President and Chief Executive Officer of Countrywide Thrift and Loan.
J. Richard Walker has been Executive Vice President and Chief Financial
Officer of the Company since October 1998. Since 1988, Mr. Walker has been a
principal of Walker & Mikloucich, P.C., an accounting firm. Since 1986, Mr.
Walker has been managing director of Vulcan Capital, Inc., formerly TVG
Associates, Inc., a business advisory services firm.
Spencer I. Browne has been a Director of the Company since consummation of
the initial public offering in November 1996. For more than five years prior to
September 1996, Mr. Browne held various executive and management positions with
several publicly traded companies engaged in businesses related to the
residential and commercial mortgage loan industry. From August 1988 until
September 1996, Mr. Browne served as
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President, Chief Executive Officer and a Director of Asset Investors Corporation
("AIC"), a New York Stock Exchange ("NYSE") traded company he co-founded in
1986. He also served as President, Chief Executive Officer and a Director of
Commercial Assets, Inc., an American Stock Exchange traded company affiliated
with AIC, from its formation in October 1993 until September 1996. In addition,
from June 1990 until March 1996, Mr. Browne served as President and a Director
of M.D.C. Holdings, Inc., a NYSE traded company and the parent company of a
major home builder in Colorado.
Hubert M. Stiles, Jr. Mr. Stiles has been a Director of the Company since
July 1998. Since September 1996, Mr. Stiles has been a money manager for and
President of T. Rowe Price Recovery Fund II Associates, L.L.C. Mr. Stiles has
been Vice President of T. Rowe Price Associates, Inc. and a money manager for
and President of T. Rowe Price Recovery Fund Associates, Inc. since May 1988.
David J. Vida, Jr. Mr. Vida has been a Director of the Company since June
1998. Since July 1996, Mr. Vida has been President of City Mortgage Services, a
division of City National Bank. Mr. Vida served as Chief Financial Officer of
Prime Financial Corp. from June 1994 until June 1996. From January 1992 to June
1996, Mr. Vida was a Senior Accountant for KPMG Peat Marwick LLP.
John D. Williamson, Jr. has been a Director of the Company since September
1998. Since January 1997, Mr. Williamson has been practicing law as a sole
practitioner, focusing on consulting, mediation and expert witnesses. From 1976
to January 1997, Mr. Williamson worked in various capacities at Transport Life
Insurance Company (a subsidiary of Travelers Group, Inc.) including Vice
Chairman of the Board from 1995 to 1997 and Chairman of the Board from 1995 to
1998.
The Company's officers are elected annually by the Board of Directors and
serve at the discretion of the Board of Directors. The Company's directors hold
office until the next annual meeting of stockholders and until their successors
have been duly elected and qualified. The Company reimburses all directors for
their expenses in connection with their activities as directors of the Company.
Directors of the Company who are also employees of the Company do not receive
additional compensation for their services as directors. Members of the Board of
Directors of the Company who are not employees of the Company receive an annual
retainer fee of $30,000 plus $1,500 for chairing a committee or $1,000 for
serving as a member of a committee. In addition, each director receives $1,000
for each Board or committee meeting (but only $500 for a committee meeting held
on the same day as a board meeting). Directors are also reimbursed for their
expenses incurred in attending meetings of the board of directors and its
committees.
The board of directors has delegated certain functions to the following
standing committees:
Audit Committee. The Audit Committee's functions include recommending to
the board the engagement of the Company's independent certified public
accountants, reviewing with the accountants the plan and results of their audit
of the Company's financial statements and determining the independence of the
accountants. The Audit Committee held six meetings in fiscal 1998. The Audit
Committee is currently composed of Messrs. Stiles, Browne and Vida.
Compensation Committee. The Compensation Committee has the authority to
approve the compensation of the Company's executive officers. The Compensation
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<PAGE> 95
Committee held three meetings in fiscal 1998. Currently, the Compensation
Committee consists of Messrs. Williamson and Browne.
Nominating Committee. During fiscal 1998, the Nominating Committee had the
responsibility to recommend the nominees for election as Directors of the
Company to the Board of Directors. The Nominating Committee met one time during
fiscal 1998. The Company currently does not maintain a nominating committee.
Plan Committee. The Plan Committee was established in January 1999 to
administer the Plan. The Plan Committee is currently composed of Messrs. Stiles
and Williamson.
EXECUTIVE COMPENSATION
The following table sets forth information concerning the annual and
long-term compensation earned by the Company's chief executive officer and the
other executive officer as of August 31, 1998 whose annual salary and bonus
during fiscal 1998 exceeded $100,000 (the "Named Executive Officers").
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
AWARDS
ANNUAL ------------
COMPENSATION NUMBER OF
FISCAL ------------------- OTHER ANNUAL OPTIONS ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION(1) GRANTED(2) COMPENSATION(3)
- --------------------------- ------ -------- -------- --------------- ------------ ---------------
<S> <C> <C> <C> <C> <C> <C>
Champ Meyercord(4)....... 1998 $ 63,462 $ -- $ -- 4,818,591 $ --
Chairman of the 1997 -- -- -- -- --
Board and Chief 1996 -- -- -- -- --
Executive Officer
James L. Belter(5)....... 1998 $212,519 $100,000(6) $ 9,919 -- $135,868
Executive Vice 1997 180,003 100,000(6) 15,896 100,000 --
President and 1996 159,080 50,000(6) 4,330 -- --
Treasurer
</TABLE>
- -------------------------
(1) Other annual compensation consisted of car allowances, contributions to
401(k) plans and moving expenses.
(2) See "-- Employment Agreements" and "-- Company Stock Option Plans" below.
(3) All other compensation consisted of funds received from the Company to
repurchase outstanding SARs and stock options.
(4) Mr. Meyercord became Chief Executive Officer of the Company in August 1998.
(5) Mr. Belter resigned from the Company on November 30, 1998.
(6) Bonuses paid to Mr. Belter during fiscal years 1996 and 1997 were
discretionary bonuses determined by the board of directors. The bonus paid
during fiscal 1998 was paid pursuant to an employment contract entered into
with Mr. Belter in August 1997.
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<PAGE> 96
The following table sets forth certain information concerning grants of
stock options made during the fiscal year ended August 31, 1998 to the Named
Executive Officers.
OPTION GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
------------------------------------------------- POTENTIAL REALIZABLE VALUE
PERCENT OF AT ASSUMED ANNUAL RATES
NUMBER OF TOTAL OF STOCK PRICE
SECURITIES OPTIONS APPRECIATION FOR OPTION
UNDERLYING GRANTED TO EXERCISE TERM
OPTIONS EMPLOYEES IN PRICE EXPIRATION ---------------------------
NAME GRANTED(#) FISCAL YEAR ($/SH) DATE 5%($) 10%($)
- ---- ---------- ------------ -------- ---------- ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Champ Meyercord...... 4,818,591 80.1% $1.50 06/29/08 $11,773,465 $18,747,276
Chairman of the
Board and Chief
Executive Officer
James L. Belter...... -- -- -- -- -- --
Executive Vice
President and
Treasurer(1)
</TABLE>
- -------------------------
(1) Mr. Belter resigned from the Company on November 30, 1998.
The following table sets forth certain information concerning unexercised
stock options held by the Named Executive Officers as of August 31, 1998. No
stock options were exercised by the Named Executive Officers during the fiscal
year ended August 31, 1998. See "-- Company Stock Option Plans."
AGGREGATED FISCAL YEAR-END OPTION VALUE TABLE
<TABLE>
<CAPTION>
VALUE OF UNEXERCISED
NUMBER OF UNEXERCISED IN-THE-MONEY OPTIONS
OPTIONS HELD AT HELD AT
AUGUST 31, 1998 AUGUST 31, 1998(1)
--------------------------- ---------------------------
EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Champ Meyercord.................. -- 4,818,591 $ -- $144,558
James L. Belter(2)............... 20,000 80,000 -- --
</TABLE>
- -------------------------
(1) The closing sales price of the Company's common stock as reported on the
Nasdaq Stock Market on August 31, 1998 was $1.53. All options held by Mr.
Belter as of August 31, 1998 were granted at exercise prices in excess of
such market price.
(2) Mr. Belter resigned from the Company on November 30, 1998.
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EMPLOYMENT AGREEMENTS
On June 23, 1998, the Company entered into an employment agreement with
Champ Meyercord ( the "Meyercord Agreement") pursuant to which Mr. Meyercord
became the Chairman of the Board and Chief Executive Officer of the Company. The
initial term of the agreement terminates on December 31, 2001 and the agreement
will continue on a year-to-year basis unless terminated by either party. The
agreement provides for an initial annual base salary of $300,000. From the date
of the Meyercord Agreement until December 31, 1998, Mr. Meyercord is entitled to
a bonus of at least $250,000. For each subsequent calendar year during the term
of the agreement, Mr. Meyercord shall be entitled to receive bonuses pursuant to
a management incentive compensation plan for senior management to be established
by the Company. Pursuant to the Meyercord agreement, upon consummation of the
Exchange Offer, Mr. Meyercord was granted options to purchase 5% of the total
outstanding shares of common stock outstanding after the recapitalization on a
fully-diluted basis at an exercise price equal to the per share price in the
private placements. In addition, the Meyercord Agreement provides that upon
consummation of an offering of rights to purchase common stock, Mr. Meyercord
shall be granted options to purchase a number of shares of common stock equal to
5% of the number of shares of common stock issued in the offering at an exercise
price equal to price per share in the offering.
Upon termination of the agreement for "cause," Mr. Meyercord will be
entitled to receive his base salary through the effective date of termination
and any determined but unpaid incentive compensation for any bonus period ending
on or before the date of termination. In the event of termination "without
cause," Mr. Meyercord will be entitled to (1) any unpaid base salary through the
date of termination, (2) accrued but unpaid incentive compensation, if any, for
the bonus period ending on or before the date of termination, (3) the
continuation of any benefits through the expiration of the Meyercord Agreement
and (4) the payment, through the date of expiration of the Meyercord Agreement,
of his base salary and incentive compensation (in an amount equal to the
incentive compensation paid to Mr. Meyercord for the calendar year immediately
preceding termination). In the event of a change of control of the Company
accompanied within two years by either (1) termination of Mr. Meyercord's
employment by the Company "without cause" or (2) Mr. Meyercord's voluntarily
termination for "good reason," Mr. Meyercord will be entitled to the amounts
receivable upon a termination "without cause." In addition, upon a change of
control any vested stock options granted to Mr. Meyercord will accelerate and
become immediately vested. The Meyercord Agreement contains a non-competition
provision that generally prohibits Mr. Meyercord from competing with the Company
during his employment by the Company and for the two-year period following the
termination of his employment for any reason.
The Company and Mr. Meyercord currently are engaged in discussions which
may result in revisions to the Meyercord Agreement, all of which would be
retroactive to July 1, 1998. The Company initiated these discussions, and the
discussions on behalf of the Company are handled by the Compensation Committee.
The Company is requesting that Mr. Meyercord agree to waive his right under the
Meyercord Agreement to an option to purchase 5% of the Company's common stock in
exchange for an option to be granted under a stock option plan to be adopted by
the Company subject to the Company's shareholders approving the plan and the
related grant to Mr. Meyercord. The Company also desires to make the Meyercord
Agreement subject to the laws of the State of Georgia and to restructure Mr.
Meyercord's noncompetition provision and his other restrictive
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<PAGE> 98
covenants to increase the likelihood that a court will enforce these provisions
against Mr. Meyercord. Mr. Meyercord through his attorney in turn has asked for
certain revisions to the Meyercord Agreement, including adding a provision which
would protect him from any excise tax liability and any related income tax
liability from a change in control of the Company, deleting a provision under
which the Company could delay the payment of his compensation if the Company was
unable to claim an income tax deduction for the compensation and clarifying
certain provisions related to his fringe and other benefits. It is not clear
whether an agreement will be reached on any revisions to the Meyercord Agreement
or, if an agreement is reached, when that agreement will be reached. Neither the
Company nor Mr. Meyercord have set a deadline for either reaching an agreement
or abandoning further discussions on revisions to the Meyercord Agreement.
During fiscal 1998, James Belter, the Company's Executive Vice President
and Chief Financial Officer until November 30, 1998, was employed pursuant to an
employment agreement entered into in August 1997. The employment agreement
provided that Mr. Belter was entitled to receive discretionary performance
bonuses based on factors determined by the Committee and the board of directors
in accordance with the Company's executive bonus pool program. Notwithstanding
the foregoing, Mr. Belter was guaranteed to receive a bonus of $100,000 for each
of the first two years of his employment agreement.
The Company intends to enter into employment agreements with certain other
members of senior management, including Messrs. Ralser and Walker.
COMPANY STOCK OPTION PLANS
1996 Plan
Under the Company's 1996 Employee Stock Option Plan (the "1996 Plan"),
10,000 shares of common stock remain reserved for issuance upon exercise of
stock options. The 1996 Plan was designed as a means to retain and motivate key
employees and directors. The board of directors, or a committee thereof,
administers and interprets the 1996 Plan and is authorized to grant options
thereunder to all eligible employees and directors of the Company, except that
no incentive stock options (as defined in Section 422 of the Code) may be
granted to a director who is not also an employee of the Company or a
subsidiary. The 1996 Plan provides for the granting of both incentive stock
options and nonqualified stock options. Options may be granted under the 1996
Plan on such terms and at such prices as determined by the board of directors,
or a committee thereof, except that the per share exercise price of incentive
stock options cannot be less than the fair market value of the common stock on
the date of grant. Each option is exercisable after the period or periods
specified in the related option agreement, but no option may be exercisable
after the expiration of ten years from the date of grant. Options granted to an
individual who owns (or is deemed to own) at least 10% of the total combined
voting power of all classes of stock of the Company must have an exercise price
of at least 110% of the fair market value of the common stock on the date of
grant and a term of no more than five years. The 1996 Plan also authorizes the
Company to make or guarantee loans to optionees to enable them to exercise their
options. Such loans must (1) provide for recourse to the optionee, (2) bear
interest at a rate no less than the prime rate of interest, and (3) be secured
by the shares of common stock purchased. The board of directors has the
authority to amend or terminate the 1996 Plan, provided that no such action may
impair the rights of the holder of any outstanding option without the written
consent of such holder, and provided further that certain amendments of the 1996
Plan are subject to
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stockholder approval. Unless terminated sooner, the 1996 Plan will continue in
effect until all options granted thereunder have expired or been exercised,
provided that no options may be granted ten years after commencement of the 1996
Plan. In connection with the spin-off of the Company, all options outstanding
under the 1996 Plan were converted into SARs in August 1997. In October 1997,
the Company repurchased all SARs outstanding under the 1996 Plan.
1997 Plan
In August 1997, the Company's Board of Directors adopted the Company's 1997
Stock Option Plan (the "1997 Plan"). The 1997 Plan was approved by the
stockholders of the Company in June 1998. Under the 1997 Plan, as amended,
2,000,000 shares of common stock are reserved for issuance upon the exercise of
stock options and/or SARs. The board of directors, or a committee thereof,
administers and interprets the 1997 Plan and is authorized to grant options
and/or SARs thereunder to any person who has rendered services to the Company,
except that no incentive stock options may be granted to any person who is not
also an employee of the Company or any subsidiary. As of August 31, 1998, a
total of 1,200,000 options had been granted under the 1997 Plan, of which
632,500 were held by directors and executive officers.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Company's Compensation Committee was formed by the board of directors
in August 1997. From September 1, 1997 until June 29, 1998, the Compensation
Committee was comprised of Robert Nederlander and Spencer I. Browne,
non-employee directors. From July 1, 1998 until November 14, 1998, the Company
did not have a Compensation Committee and compensation decisions were made by
the full Board of Directors. Champ Meyercord did not participate in decisions
regarding his specific employment by the Company. On November 14, 1998, Spencer
I. Browne and John D. Williamson, Jr. were appointed to the Compensation
Committee. See "Certain Transactions" located later in this prospectus.
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PRINCIPAL STOCKHOLDERS
The following table sets forth, as of January 20, 1999, information with
respect to the beneficial ownership of the common stock by (1) each person known
by the Company to be the beneficial owner of more than 5% of the outstanding
shares of common stock, (2) each director of the Company, (3) each of the Named
Executive Officers, and (4) all directors and executive officers of the Company
as a group. Unless otherwise noted, the Company believes that all persons named
in the table have sole voting and investment power with respect to all shares of
common stock beneficially owned by them.
<TABLE>
<CAPTION>
NAME AND ADDRESS OF NUMBER OF SHARES PERCENTAGE
BENEFICIAL OWNER(1) BENEFICIALLY OWNED OWNERSHIP(2)
- ------------------- ------------------ ------------
<S> <C> <C>
DIRECTORS AND EXECUTIVE OFFICERS:
Champ Meyercord................................... -- *
J. Richard Walker................................. -- *
Spencer I. Browne................................. 37,260 *
Wm. Paul Ralser................................... 20,000 *
Hubert M. Stiles, Jr.(3).......................... 6,666,667 21.8%
David J. Vida, Jr................................. -- *
John D. Williamson, Jr............................ -- *
All executive officers and directors of the
Company as a group (8 persons).................. 6,723,927 22.0%
OTHER LARGE STOCKHOLDERS:
Value Partners, Ltd.(4)........................... 14,666,740 32.4%
City National Bank(5)............................. 13,333,367 30.1%
Sovereign Bancorp(6).............................. 13,333,367 30.1%
Friedman, Billings, Ramsey Group, Inc.(7)......... 9,472,470 27.9%
Emanuel J. Friedman(7)(8)......................... 6,666,667 21.8%
T. Rowe Price Recovery Fund II, L.P.(3)........... 6,666,667 21.8%
</TABLE>
- -------------------------
* Less than 1%.
(1) A person is deemed to be the beneficial owner of securities that can be
acquired by such person within 60 days from the date of this prospectus
upon the exercise of options and warrants. Each beneficial owner's
percentage ownership is determined by assuming that options and warrants
that are held by such person (but not those held by any other person) and
that are exercisable within 60 days from the date of this prospectus have
been exercised.
(2) Based on 30,566,660 shares of common stock outstanding as of December 1,
1998.
(3) The address of Mr. Stiles and T. Rowe Price Recovery Fund II, L.P. is 100
East Pratt Street, Baltimore, Maryland 21202. Represents shares
beneficially owned by T. Rowe Price Recovery Fund II, L.P., T. Rowe Price
Recovery Fund II Associates, L.L.C. and T. Rowe Price Associates, Inc. (of
which Mr. Stiles is a vice president). Mr. Stiles disclaims beneficial
ownership of these shares. Based on a Schedule 13G filed with the SEC on
July 10, 1998.
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(4) The address of Value Partners, Ltd. is 4514 Cole Avenue, Suite 808, Dallas,
Texas 75205. Represents shares issuable upon the conversion of 22,000
shares of preferred stock.
(5) City National Bank's address is 25 Gatewater Road, Charleston, West
Virginia 25313. Represents (i) 6,666,700 shares issuable upon conversion of
preferred stock and (ii) 6,666,667 shares issuable upon exercise of
currently outstanding options.
(6) Sovereign Bancorp's address is 1130 Berkshire Boulevard, P.O. Box 12646,
Reading, Pennsylvania 19612. Represents (i) 6,666,700 shares issuable upon
conversion of preferred stock and (ii) 6,666,667 shares issuable upon
exercise of currently outstanding options.
(7) The address of Friedman, Billings, Ramsey Group, Inc. ("FBRG") is 1001 19th
Street North, Arlington, Virginia 22209. As of December 1, 1998, FBRG,
through its three wholly-owned subsidiaries Friedman, Billings, Ramsey
Investment Management, Inc. ("Investment Management"), FBR Offshore
Management, Inc. ("Offshore Management") and Orkney Holdings, Inc.
("Orkney"), had sole voting and dispositive power with respect to 5,359,116
shares of common stock. This number does not include 6,666,667 shares of
common stock owned by Emanuel J. Friedman, as to which FBRG disclaims
beneficial ownership. Investment Management serves as general partner and
discretionary investment manager for FBR Ashton, L.P. ("Ashton") which, as
of December 1, 1998, owned 824,187 shares of common stock and 4,450 shares
of preferred stock (which are convertible into 2,966,681 shares of common
stock). Offshore Management serves as discretionary manager for FBR
Opportunity Fund, Ltd. ("Opportunity Fund") which, as of December 1, 1998,
owned 82,622 shares of Common Stock. Each of FBRG, Investment Management
and Offshore Management disclaims beneficial ownership of shares of common
stock owned by the other two entities. Orkney is a wholly-owned subsidiary
of FBRG which, as of December 1, 1998, owned 4,452,307 shares of common
stock and 2,125 shares of preferred stock (which are convertible into an
aggregate of 1,416,673 shares of common stock). Each of FBRG, Ashton,
Opportunity Fund and Orkney disclaims beneficial ownership of the shares of
common stock owned by the other three entities. In addition, Emanuel J.
Friedman, Eric F. Billings and W. Russell Ramsey are each control persons
with respect to FBRG.
(8) Mr. Friedman's address is 1001 19th Street, Arlington, Virginia 22209.
Excludes 5,359,116 shares beneficially owned by FBRG, as to which Mr.
Friedman disclaims beneficial ownership. Mr. Friedman has notified the
Company that, until the earlier of (i) the first date on which he, together
with FBR and its affiliates, holds shares of common stock representing less
than 20% of the total issued and outstanding common stock or (ii) the date
on which he deposits his shares of common stock in a voting trust to be
voted by an unaffiliated third party, he waives the right to vote his
shares of common stock.
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SELLING STOCKHOLDERS
The following table assumes that each selling stockholder is offering for
sale securities previously issued by the Company. The Company has agreed to pay
all expenses in connection therewith (other than brokerage commissions and fees
and expenses of their respective counsel). None of the selling stockholders has
ever held any position with the Company or had any other material relationship
with the Company, except that certain of the selling stockholders are also
Principal Stockholders of the Company as described under "The Recapitalization",
"Principal Stockholders" and "Certain Transactions."
The following table sets forth the beneficial ownership of the shares of
common stock of each person who is a selling stockholder. The Company will not
receive any proceeds from the sale of the common stock by the selling
stockholders.
<TABLE>
<CAPTION>
PERCENTAGE
OWNERSHIP(2)
-------------------
NUMBER OF SHARES NUMBER OF SHARES BEFORE AFTER
NAME OF SELLING STOCKHOLDER(1) BENEFICIALLY OWNED OFFERED HEREBY OFFERING OFFERING
- ------------------------------ ------------------ ---------------- -------- --------
<S> <C> <C> <C> <C>
Value Partners, Ltd.(3).............. 14,666,740 14,666,740 32.4% 0
City National Bank(4)................ 13,333,367 13,333,367 30.1% 0
Sovereign Bancorp, Inc.(4)........... 13,333,367 13,333,367 30.1% 0
Friedman, Billings, Ramsey Group,
Inc.(5)............................ 9,472,470 4,566,681 27.9% 0
Emanuel J. Friedman(6)............... 6,666,667 6,666,667 21.8% 0
T. Rowe Price Recovery Fund II,
L.P................................ 6,666,667 6,666,667 21.8% 0
Continental Casualty Company(3)...... 5,242,666 5,242,666 14.6% 0
First Fidelity Bancorp, Inc.(3)...... 3,333,350 3,333,350 9.8% 0
Merrill Lynch Phoenix Fund, Inc...... 3,000,000 3,000,000 9.8% 0
West Broadway Partners, LP(3)........ 390,000 390,000 * 0
Rath Foundation, Inc.(3)............. 253,333.33 253,333.33 * 0
ITLA Capital Corporation............. 250,000 250,000 * 0
West Broadway Securities, LTD(3)..... 182,000 182,000 * 0
Thomas Baer and Michelle Baer(3)..... 133,333.33 133,333.33 * 0
James R. Sanger(3)................... 133,333.33 133,333.33 * 0
Marathon Associates, L.P............. 50,000 50,000 * 0
Dorothy S. Lockspeiser(3)............ 50,000 50,000 * 0
J. Rock Tonkel, Jr.(7)............... 33,333 33,333 * 0
Premium Total Return
Portfolio -- Boston Partners Asset
Management(3)...................... 4,000 4,000 * 0
</TABLE>
- ---------------------
*Less than 1%.
(1) A person is deemed to be the beneficial owner of securities that can be
acquired by such person within 60 days from the date of this prospectus upon
the exercise of options and warrants. Each beneficial owner's percentage
ownership is determined by assuming that options and warrants that are held
by such person (but not those held by any other person) and that are
exercisable within 60 days from the date of this prospectus have been
exercised.
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(2) Based on 30,566,660 shares of Common Stock outstanding as of December 1,
1998. Assumes the sale of all shares being offered by the selling
stockholder in this prospectus.
(3) Represents shares issuable upon conversion of preferred stock.
(4) Represents (i) 6,666,700 shares issuable upon conversion of preferred stock
and (ii) 6,666,667 shares issuable upon exercise of currently outstanding
options.
(5) Represents shares held by Ashton and Orkney. Orkney is a wholly-owned
investment subsidiary of FBRG. FBR, a wholly-owned subsidiary of FBRG, was a
managing underwriter for the Company's IPO and its public offering of Old
Notes in November 1996. In addition, FBR acted as initial purchaser for the
Company's private placement of Current Notes in October 1997. The 1,600,000
shares offered hereunder were acquired by FBR as compensation for FBR's
service, in connection with the recapitalization, as placement agent for the
common stock and the Series A convertible preferred stock as well as
dealer-manager in connection with the Company's offer to exchange the Old
Notes for the Current Notes. FBR is also entitled to a cash fee in
connection with the recapitalization. FBR distributed the shares received to
FBRG, is corporate parent, and FBRG contributed the shares to Orkney In
addition to the relationships set forth above, FBR is currently serving as
the Company's exclusive financial advisor, and FBR will be entitled to a
portion of the proceeds generated should the Company elect to proceed with a
stock purchase rights offering.
(6) Mr. Friedman is a control person with respect to Friedman, Billings, Ramsey
Group, Inc., which is the beneficial owner of 5,459,116 shares of common
stock or % of the issued and outstanding common stock, not including the
shares owned by Mr. Friedman.
(7) J. Rock Tonkel, Jr. is a managing director of FBR.
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CERTAIN TRANSACTIONS
Listed below are transactions the Company has entered into with its
affiliates in the past three years. An "affiliate" generally is a person or
entity that is (1) "controlled by the Company," such as an officer of the
Company, (2) that "controls the Company" such as a director of a company, and in
the case of the Company, Mego Financial, the Company's former parent; or (3)
entities under "common control" with a company. PEC, a subsidiary of Mego
Financial, is an affiliate of Mego Financial because it is "controlled by" Mego
Financial, and is an affiliate of the Company, because the directors that
controlled the Company until the completion of the recapitalization also
controlled Mego Financial.
RELATIONSHIP WITH GREENWICH
Champ Meyercord, the Company's Chairman of the Board and Chief Executive
Officer, was formerly a senior investment banker at Greenwich Capital Markets
("Greenwich"). In October 1996, Greenwich agreed to purchase from the Company
$2.0 billion of loans over a five year period. The Company has sold Greenwich
approximately $800 million in loans from the inception of the agreement. The
agreement with Greenwich was terminated in June 1998 and the Company has no
further obligation under the agreement.
In April 1997, the Company entered into a pledge and security agreement
with Greenwich for an $11.0 million revolving credit facility. The amount which
could be borrowed under the agreement was increased to $15.0 million in June
1997 and to $25.0 million in July 1997. This facility is secured by a pledge of
certain of the Company's interest only and residual class certificates relating
to securitizations carried as mortgage related securities on the Company's
Statements of Financial Condition, payable to the Company pursuant to its
securitization agreements. As of August 31, 1998, approximately $10.0 million
was outstanding under the agreement. This agreement, which was originally
scheduled to mature in December 1998, was extended until December 1999.
TAX SHARING AND INDEMNITY AGREEMENT
For taxable periods up to the date of the spin-off, the Company's results
of operations were includable in the tax returns filed by Mego Financial's
affiliated group for federal income tax purposes. Under a tax allocation and
indemnity agreement with Mego Financial, the Company recorded a liability to
Mego Financial for federal income taxes calculated on a separate company basis.
Under a prior tax sharing arrangement with Mego Financial, the Company recorded
a liability to Mego Financial for federal income taxes applied to the Company's
financial statement income after giving consideration to applicable income tax
law and statutory rates. In addition, both the agreement and the arrangement
provided that the Company and Mego Financial each will indemnify the other under
certain circumstances. The Company no longer files consolidated returns with
Mego Financial's affiliated group. The Company believes that all obligations
under the tax sharing agreement have been satisfied.
MANAGEMENT SERVICES AGREEMENT WITH PEC
Until the recapitalization; PEC, a subsidiary of Mego Financial, supplied
the Company on an as-needed basis with certain executive, accounting, legal,
management information, data processing, human resources, advertising services
and promotional
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personnel of PEC provided services to the Company on an "as needed" basis. The
Company paid management fees to PEC in an amount equal to the direct and
indirect expenses of PEC related to the services supplied by its employees to
the Company, including an allocable portion of the salaries and expenses of
these employees based upon the percentage of time these employees spent
performing services for the Company. This arrangement was formalized on
September 1, 1996 by execution of a management agreement (the "Management
Agreement"), in which PEC agreed to provide management services to the Company
for an aggregate annual fee of approximately $967,000. Effective January 1,
1998, the annual fee payable by the Company under the Management Agreement was
reduced to $528,000. The Management Agreement was terminated on June 29, 1998.
For the years ended August 31, 1996, 1997 and 1998 and the three months
ended November 30, 1997 and 1998, approximately $671,000, $967,000, $617,000,
$242,000 and $0, respectively, of the salaries and expenses of these employees
of PEC were attributable to and paid by the Company in connection with services
supplied by these employees to the Company. In addition, during the years ended
August 31, 1996 and 1997, the Company paid PEC for developing computer
programming, incurring costs of $56,000 and $0, respectively. During the year
ended August 31, 1998 and the three months ended November 30, 1997 and 1998,
these costs were $0.
SUB-SERVICING AGREEMENT WITH PEC
Prior to September 1, 1996, PEC sub-serviced the Company's loans pursuant
to which it paid servicing fees of 50 basis points on the principal balance of
loans serviced per year. For the years ended August 31, 1996, 1997 and 1998 and
the three months ended November 30, 1997 and 1998, the Company paid
sub-servicing fees to PEC of approximately $709,000, $1.9 million, $2.1 million,
$661,000 and $0, respectively. The Company entered into a servicing agreement
with PEC (the "Servicing Agreement"), effective as of September 1, 1996,
providing for the payment of servicing fees of 50 basis points on the principal
balance of loans serviced per year. For the years ended August 31, 1996, 1997
and 1998 and the three months ended November 30, 1997 and 1998, the Company
incurred interest expense in the amount of $29,000, $16,000, $0, $0 and $0,
respectively, related to fees payable to PEC for these services. The interest
rates were based on PEC's average cost of funds and equaled 10.68% in 1996 and
10.48% in 1997. Effective September 1, 1997, the servicing fees were reduced to
40 basis points per year and effective January 1, 1998, the servicing fees were
further reduced to 35 basis points per year. The Servicing Agreement has been
terminated as the mortgage servicing rights were transferred to City National
Bank.
FUNDING AND GUARANTEES BY MEGO FINANCIAL
In order to fund the Company's past operations and growth, and in
conjunction with filing consolidated returns, the Company borrowed money from
Mego Financial. As of August 31, 1996, 1997 and 1998, the amount of intercompany
debt owed to Mego Financial was $12.0 million, $9.7 million and $0,
respectively. Prior to the initial public offering, Mego Financial had
guaranteed the Company's obligations under the Company's credit agreements and
an office lease. The guarantees of the Company's credit agreements were released
on the completion of the initial public offering. The Company did not pay any
compensation to Mego Financial for such guarantees.
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In November 1996, Greenwich agreed to purchase from the Company $2.0
billion of loans over a five year period. Pursuant to the agreement, Mego
Financial issued to Greenwich four-year warrants to purchase 1.0 million shares
of Mego Financial's common stock. The value of the warrants, estimated at $3.0
million (0.15% of the commitment amount) as of the commitment date (the "Warrant
Value") plus a $150,000 fee has been written off as the commitment for the
purchase of loans has been terminated.
On August 29, 1997, the Company and Mego Financial entered into the Payment
Agreement for the Company's repayment after the spin-off of (1) a portion of the
debt owed by the Company to Mego Financial as of May 31, 1997 and (2) debt owed
by the Company to Mego Financial as of August 31, 1997. Upon consummation of the
sale of the Old Notes in October 1997, $3.9 million was paid in accordance with
the Payment Agreement. In April 1998, the Company and Mego Financial entered
into an agreement (the "1998 Agreement") superseding the Payment Agreement.
Pursuant to the 1998 Agreement, the parties agreed to reduce the amounts owed to
Mego Financial and agreed to pay such amounts upon the occurrence of certain
events. In connection with the Recapitalization, the Company paid PEC $1.6
million to satisfy fully all amounts owed to Mego Financial pursuant to the
Payment Agreement and the 1998 Agreement, and the 1998 Agreement was terminated.
RELATIONSHIPS WITH FBR
FBR served as placement agent for the private placements pursuant to a
placement agreement (the "Placement Agreement"). Under the terms of the
Placement Agreement, the Company paid FBR a fee of 1.6 million shares of common
stock equal to 6.0% of the gross proceeds received by the Company from the sale
of the shares of common stock and preferred stock in the recapitalization. The
gross proceeds did not include $10.0 million of Common Stock acquired by an
affiliate of FBR. In addition, the Company has agreed, pursuant to the Placement
Agreement, to indemnify FBR against certain liabilities, including liabilities
under the Securities Act, and other liabilities incurred in connection with the
recapitalization. In addition, the Company paid FBR an advisory fee of $416,667
in connection with the recapitalization.
FBR was a managing underwriter for the Company's initial public offering
and the Company's public offering of $40.0 million of the Old Notes, and was the
initial purchaser for the Company's private offering of another $40.0 million of
the Old Notes. FBR received compensation for such services and the Company
agreed to indemnify FBR against certain liabilities, including liabilities under
the Securities Act, and other liabilities arising in connection with such
offerings. In addition, FBR has in the past provided certain investment banking
services to the Company and affiliates of the Company.
THE RECAPITALIZATION
For a description of transactions with related parties in connection with
the recapitalization, see "The Recapitalization" located earlier in this
prospectus.
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DESCRIPTION OF NOTES
GENERAL
In the exchange offer, the Company issued $41.5 million aggregate principal
amount of Current Notes under an indenture together with shares of Series A
convertible preferred stock in exchange for $79.0 million of Old Notes. The
Current Notes mature on December 1, 2001 and are general unsecured obligations
of the Company, subordinated in right of payment to all senior indebtedness of
the Company. Interest on the Current Notes accrues at a rate of 12 1/2% per year
and is payable in cash semi-annually on June 1 and December 1 of each year.
Guarantees. The Current Notes are not guaranteed by any entity.
Subordination. The indebtedness represented by the Current Notes is
subordinated in right of payment to all existing and future senior indebtedness
of the Company, including without limitation, all obligations of the Company
under any Warehouse Facility, (as defined) and will be senior in right of
payment to all future indebtedness of the Company that by its terms is expressly
subordinated in right of payment to the Current Notes.
Redemption. The Current Notes are redeemable, in whole but not in part,
prior to maturity at the option of the Company at any time and from time to time
at a redemption price (expressed as a percentage of principal amount), (1) prior
to December 1, 1999, of 100% and (2) after December 1, 1999 but prior to
December 1, 2001, of 106%, in either case plus accrued and unpaid interest
(including added interest, if any) to the redemption date (subject to the right
of holders of record on the relevant record date to receive interest (including
added interest, if any) due on the relevant interest payment date).
Covenants. The Current Notes contain covenants limiting the incurrence of
certain indebtedness, liens, affiliate transactions, and merger and
consolidation.
REGISTRATION RIGHTS
The Company has entered into a registration rights agreement with FBR (the
"Current Notes Registration Rights Agreement") on behalf of the holders of the
Current Notes pursuant to which the Company has agreed, for the benefit of the
holders of the Current Notes, at the Company's cost, (1) to file a registration
statement (the "Current Notes Registration Statement") pursuant to which the
Company will offer to exchange notes (the "Current Notes Exchange Offer") for
registered notes ("New Notes") for Current Notes with the SEC on or before
December 15, 1998 and (2) to use its best efforts to cause the Current Notes
Registration Statement to be declared effective under the Securities Act on or
before March 15, 1999. The New Notes will have terms substantially identical in
all material respect to the Current Notes, except that the New Notes will not
contain terms with respect to transfer restrictions, registration rights or
interest rate increases as described herein. Promptly after the Current Notes
Registration Statement has been declared effective, the Company will offer the
New Notes in exchange for surrender of the Current Notes. The Company will keep
the Current Notes Exchange Offer open for not less than 30 days (or longer if
required by applicable law) after the date notice of the Current Notes Exchange
Offer is mailed to the holders of the Current Notes. For each Current Note
validly tendered to the Company pursuant to the Current Notes Exchange Offer and
not withdrawn by the holder thereof, the holder of such Current Note will
receive a New Note having a principal amount equal to that of the tendered
Current Note. Interest on each New Note will accrue from the last interest
payment date on which interest was paid on the tendered Current Note in exchange
therefor or, if no interest has been paid on such New Note, from the date of its
original issue.
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DESCRIPTION OF CAPITAL STOCK
GENERAL
The Company's authorized capital stock consists of 400,000,000 shares of
common stock, $.01 par value, and 5,000,000 shares of preferred stock, par value
$.01 per share. The following brief description of the Company's capital stock
is not complete and is subject in all respects to applicable law and the
provisions of the Company's Certificate of Incorporation and Bylaws, copies of
which have been filed or incorporated as exhibits in the Company's various
filings with the SEC and to the applicable provisions of the Delaware General
Corporation Law.
COMMON STOCK
The holders of common stock are entitled to one vote per share on all
matters to be voted on by the stockholders. Such stockholders do not have
cumulative voting rights in the election of directors. Subject to the rights of
any holders of preferred stock, holders of common stock are entitled to receive
ratably dividends, if any, as may be declared by the Board of Directors out of
funds legally available for dividend. For a description of the Company's
dividend policy see "Dividend Policy" located earlier in this prospectus. In the
event of any liquidation, dissolution or winding up of the Company, the holders
of the common stock would be entitled to receive, after payment or provision for
payment of all its debts and liabilities, all of the assets of the Company
available for distribution, subject to the rights of any holders of preferred
stock. The holders of common stock have no preemptive rights to subscribe for
additional shares of the Company and no right to convert their stock into other
securities. In addition, there are no redemption or sinking fund provisions
applicable to the common stock. All of outstanding shares of common stock are
fully paid and nonassessable.
PREFERRED STOCK
The Company has 5,000,000 shares of authorized preferred stock, of which
65,000 shares have been designated as Series A convertible preferred stock. The
Board of Directors is authorized to provide for the issuance of additional
classes and series of preferred stock out of remaining undesignated shares, and
the Board of Directors may establish the voting powers, designations,
preferences and relative, participating, optional or other special rights and
qualifications, limitations or restrictions of any such additional class or
series of preferred stock, including the dividend rights, dividend rate, terms
of redemption, redemption price or prices, conversion rights and liquidation
preferences of the shares constituting any series, without any further vote or
action by the stockholders of the Company. The issuance of preferred stock by
the Board of Directors could have the effect of making it more difficult for a
third party to acquire a majority of the outstanding voting stock of the
Company, thereby delaying, deferring or preventing a change in control of the
Company.
Series A Convertible Preferred Stock. As part of the recapitalization the
Company issued 62,500 shares of Series A convertible preferred stock. On any
matter on which the holders of Series A Preferred Stock may vote, each holder is
entitled to one vote for each share held. The holders of Series A convertible
preferred stock may vote only as a separate class, and their votes will not be
counted together with the holders of common stock as a single class. If declared
by the board of directors, holders of shares of Series A convertible
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preferred stock are entitled to receive cash dividends, out of funds legally
available therefor, equal to the amount of dividends payable on the number of
shares of common stock into which each share of Series A Preferred Stock is
convertible. With respect to dividend rights, the Series A Preferred Stock ranks
on a parity with the common stock. No class or series of equity securities may
rank senior to the Series A Preferred Stock as to the payment of dividends. In
the event of any voluntary or involuntary liquidation, dissolution or winding up
of the Company, the holders of shares of Series A Preferred Stock are entitled
to receive out of assets of the Company available for distribution to
stockholders under applicable law, before any payment or distribution of assets
is made to holders of common stock or any other class or series of stock ranking
junior to the Series A Preferred Stock upon liquidation, liquidating
distributions in the amount of $1,000 per share plus accrued and unpaid
dividends (whether or not earned) to the date fixed for such liquidation,
dissolution or winding up. The Series A Preferred Stock is convertible at the
option of the holder on or after 180 days from the date of issuance, and will
automatically convert on the second anniversary of the date of issuance, into a
number of shares of common stock equal to $1,000 divided by the conversion price
(equal to $1.50, subject to certain adjustments). The holders of Series A
Preferred Stock have no preemptive rights to subscribe for additional shares of
the Company. In addition, there are no redemption or sinking fund provisions
applicable to the Series A Preferred Stock. All of the outstanding shares of
Series A Preferred Stock are fully paid and nonassessable.
CERTAIN PROVISIONS OF DELAWARE LAW
The Company is subject to the provisions of section 203 of the Delaware
General Corporation Law. Section 203 prohibits a publicly held Delaware
corporation from engaging in a "business combination" with an "interested
stockholder" for a period of three years after the date of the transaction in
which the person became an interested stockholder, unless the business
combination is approved in a prescribed manner. A "business combination"
includes a merger, asset sale or other transaction resulting in a financial
benefit to the interested stockholder. Subject to certain exceptions, an
"interested stockholder" is a person who, together with affiliates and
associates, owns or within three years prior to the proposed business
combination has owned 15% or more of the corporation's voting stock.
CERTAIN CHARTER AND BYLAW PROVISIONS
The Company's Certificate of Incorporation and Bylaws contain certain
provisions that could discourage potential takeover attempts and make attempts
by stockholders to change management more difficult. The Certificate of
Incorporation and Bylaws provide that special meetings of stockholders may be
called only by the board of directors or upon the written demand of the holders
of not less than 30% of the votes entitled to be cast at a special meeting.
The Certificate of Incorporation permits the board of directors to create
new directorships and the Company's Bylaws permit the board of directors to
elect new directors to serve the full term of the class of directors in which
the new directorship was created. The Bylaws also provide that the board of
directors (or its remaining members, even though less than a quorum) is
empowered to fill vacancies on the board of directors occurring for any reason
for the remainder of the terms of the class of directors in which the vacancy
occurred.
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The Company's Certificate of Incorporation provides that liability of
directors of the Company is eliminated to the fullest extent permitted under the
Delaware General Corporation Law. As a result, no director of the Company will
be liable to the Company or its stockholders for monetary damages for breach of
fiduciary duty as a director, except for liability: (1) for any breach of the
director's duty of loyalty to the Company or its stockholders; (2) for acts or
omissions not in good faith or which involve intentional misconduct or a knowing
violation of law; (3) for any willful or negligent payment of an unlawful
dividend, stock purchase or redemption; or (4) for any transaction from which
the director derived an improper personal benefit.
REGISTRATION RIGHTS
The Company has entered into a registration rights agreement with FBR (the
"Equity Registration Rights Agreement") on behalf of the purchasers of common
stock and preferred stock in the Recapitalization and on behalf of the holders
of Old Notes who received preferred stock in the Exchange Offer. In addition,
the Company has entered into registration rights agreements with each of City,
Sovereign and one private investor which are substantially identical to the
Equity Registration Rights Agreement. Together these agreements are referred to
as the "Equity Registration Rights Agreements." Pursuant to the Equity
Registration Rights Agreements, as amended, the Company had agreed to file with
the SEC, on or before September 16, 1998 a registration statement relating to
the shares of common stock issued as part of the recapitalization and the shares
of common stock underlying the shares of preferred stock issued in the Exchange
Offer. The purchasers in the Recapitalization have agreed to extend this
deadline to December 15, 1998, and this Registration Statement has been filed in
accordance with the Equity Registration Rights Agreement. The Company will use
its reasonable efforts to maintain the effectiveness of this registration
statement continuously for a period of two years or until the shares of common
stock covered by this registration statement may be sold without restriction
under the Securities Act. However, such continual effectiveness is subject to
periods of time when the Company must suspend the use of this prospectus for the
purpose of amending the registration statement.
TRANSFER AGENT
The transfer agent and registrar for the common stock and Series A
convertible preferred stock is American Stock Transfer & Trust Company.
109
<PAGE> 111
SHARES ELIGIBLE FOR FUTURE SALE
As of December 1, 1998 the Company had 30,566,660 shares of common stock
outstanding. Of these shares, 10,528,519 shares of common stock are freely
tradable without restriction or further registration under the Securities Act,
unless purchased by "affiliates" of the Company, as defined under the Securities
Act. In addition 41,675,541 shares are issuable upon the conversion of preferred
stock. The remaining 20,038,148 shares of common stock are "restricted shares"
and are subject to restrictions under the Securities Act. These shares will be
eligible for sale beginning in June 1999.
In general, under Rule 144, a person (or person whose shares are
aggregated) who has beneficially owned restricted shares for at least one year,
including a person who may be deemed an affiliate of the Company, is entitled to
sell within any three-month period a number of shares of common stock that does
not exceed the greater of 1% of the then-outstanding shares of common stock
(approximately 305,667 shares) or the average weekly trading volume of the
common stock on the Nasdaq Stock Market during the four calendar weeks preceding
such sale. Sale under Rule 144 are subject to certain restrictions relating to
manner of sale, notice and the availability of current public information about
the Company. A person who has not been an affiliate of the Company at any time
during the 90 days preceding a sale, and who has beneficially owned shares for
at least two years, would be entitled to sell such shares without regard to the
volume limitations, manner of sale provisions and other requirements of Rule
144.
Sovereign Bancorp and City National Bank each have the option to purchase
6,666,667 shares of common stock at a price of $1.50 per share which, if
exercised in full, would add 13,333,334 shares of common stock to the number of
shares of common stock outstanding on the date these options are exercised. All
of these shares are being registered in this registration statement. In
addition, options to purchase 4,818,591 shares of the common stock at a price of
$1.50 per share were granted to Champ Meyercord, the Company's Chief Executive
Officer, as part of his employment agreement. Furthermore, the Company's stock
option plans authorize the granting of options to purchase an aggregate of
2,010,000 shares of common stock, of which options to purchase 1,200,000 shares
of common stock were granted prior to this offering.
The Company has filed, and intends to continue to file, registration
statements on Form S-8 under the Securities Act to register shares of common
stock subject to outstanding options or future grants under the Company's stock
option plans.
110
<PAGE> 112
PLAN OF DISTRIBUTION
The shares may be sold from time to time by the selling stockholders on the
Nasdaq National Market or any national securities exchange or automated
interdealer quotation system on which shares of common stock are then listed,
through negotiated transactions or otherwise. The shares will be sold at prices
and on terms then prevailing, at prices related to the then current market price
or in negotiated transactions. The selling stockholders may effect sales of the
shares through "brokers' transactions" (within the meaning of Section 4(4) of
the Securities Act) or in transactions directly with a "market maker" (as
defined in Section 3(a)(38) of the Securities Exchange Act of 1934). Upon the
Company being notified by any selling stockholder that a material arrangement
has been entered into with a broker or dealer for the sale of shares, a
prospectus supplement will be filed and distributed, if required, pursuant to
Rule 424(c) under the Securities Act, disclosing (a) the name of each such
broker-dealer, (b) the number of shares involved, (c) the price at which shares
were sold, (d) the commissions paid or discounts or concessions allowed to such
broker-dealer(s), where applicable and (e) other facts material to the
transaction. In effecting sales, broker-dealers engaged by any selling
stockholder and/or the purchasers of the shares may arrange for other
broker-dealers to participate. Broker-dealers will receive commissions,
concessions or discounts from the selling stockholders and/or the purchasers of
the shares in amounts to be negotiated prior to the sale. Sales will be made
only through broker-dealers registered as such in a subject jurisdiction or in
transactions exempt from such registration. As of the date of this prospectus,
there are no selling arrangements between the selling stockholders and any
broker or dealer.
In offering the shares covered by this prospectus, the selling stockholders
and any broker-dealers who participate in a sale of the shares by the selling
stockholders may be considered "underwriters" within the meaning of Section
2(11) of the Securities Act, and any profits realized by the selling
stockholders and the compensation of any broker-dealers may be deemed to be
underwriting discounts and commissions. However, the selling stockholders
disclaim being underwriters under the Securities Act.
As required by the Equity Registration Rights Agreement, the Company has
filed the registration statement, of which this prospectus forms a part, with
respect to the sale of the Shares. The Company has agreed to use its best
efforts to keep the registration statement current and effective for two years,
with certain exceptions.
The Company will not receive any of the proceeds from the sale of the
shares by the selling stockholders. The Company will bear the costs of
registering the shares under the Securities Act, including the registration fee
under the Securities Act, certain legal and accounting fees and any printing
fees. The selling stockholders will bear all other expenses in connection with
this offering, including brokerage fees and the fees and disbursements of
counsel representing the selling stockholders.
Pursuant to the terms of the Equity Registration Rights Agreement, the
Company and the selling stockholders have agreed to indemnify each other and
certain other related parties for certain liabilities in connection with the
registration of the shares.
111
<PAGE> 113
WHERE YOU CAN FIND MORE INFORMATION
Our company files annual, quarterly and current reports, proxy statements
and other information with the SEC. You may read and copy these reports,
statements or other information at the SEC's public reference room in
Washington, D.C. located at 450 Fifth Street, N.W., Washington, D.C. 20549. The
SEC also maintains regional offices where you can read and copy the reports.
These are located at 500 West Madison Street, Room 1400, Chicago, Illinois 60606
and at 7 World Trade Center, Suite 1300, New York, New York 10048. You can
request copies of these documents, upon payment of photocopying fees, by writing
to the SEC. Please call the SEC at 1-800-SEC-0330 for further information on the
operation of the public reference rooms. Our SEC filings are also available to
the public on the SEC's internet site (http://www.sec.gov). These documents are
also available for viewing and copying at the offices of The Nasdaq Stock
Market, Inc. at 1735 K Street, NW, Washington, D.C. 20006-1506.
This prospectus is part of a registration statement on Form S-1 that we
filed with the SEC. This prospectus does not contain all of the information in
that registration statement. For further information with respect to the Company
and the securities offered under the registration statement, you should review
the registration statement. You can obtain the registration statement from the
SEC and The Nasdaq Stock Market at the public reference facilities we referred
to above.
LEGAL MATTERS
The validity of the shares of common stock offered by this prospectus will
be passed upon for the Company by King & Spalding, Atlanta, Georgia.
EXPERTS
The financial statements of Mego Mortgage Corporation as of August 31, 1997
and 1998 and for each of the three years in the period ended August 31, 1998
included in this prospectus have been audited by Deloitte & Touche LLP,
independent auditors, as stated in their reports appearing herein and elsewhere
in the registration statement, and have been so included in reliance upon the
reports of such firm given their authority as experts in accounting and
auditing.
112
<PAGE> 114
MEGO MORTGAGE CORPORATION
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE NO.
--------
<S> <C>
Independent Auditors' Report................................ F-2
Statements of Financial Condition at August 31, 1997 and
1998 and November 30, 1998 (unaudited).................... F-3
Statements of Operations -- Years Ended August 31, 1996,
1997 and 1998 and the Three Months Ended November 30, 1997
(unaudited) and 1998 (unaudited).......................... F-4
Statements of Cash Flows -- Years Ended August 31, 1996,
1997 and 1998 and the Three Months Ended November 30, 1997
(unaudited) and 1998 (unaudited).......................... F-5
Statements of Stockholders' Equity -- Years Ended August 31,
1996, 1997 and 1998 and the Three Months Ended November
30, 1998 (unaudited)...................................... F-7
Notes to Financial Statements (unaudited for the Three
Months Ended November 30, 1997 and 1998).................. F-8
</TABLE>
F-1
<PAGE> 115
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Mego Mortgage Corporation
Atlanta, Georgia
We have audited the accompanying statements of financial condition of Mego
Mortgage Corporation (the "Company") as of August 31, 1997 and 1998, and the
related financial statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended August 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of Mego Mortgage Corporation at August 31, 1997
and 1998, and the results of its operations and its cash flows for each of the
three years in the period ended August 31, 1998 in conformity with generally
accepted accounting principles.
DELOITTE & TOUCHE LLP
San Diego, California
December 14, 1998
F-2
<PAGE> 116
MEGO MORTGAGE CORPORATION
STATEMENTS OF FINANCIAL CONDITION
<TABLE>
<CAPTION>
AUGUST 31,
----------------------- NOVEMBER 30,
1997 1998 1998
---------- ---------- ------------
(THOUSANDS OF DOLLARS, (UNAUDITED)
EXCEPT PER SHARE
AMOUNTS)
<S> <C> <C> <C>
ASSETS
Cash and cash equivalents...................... $ 6,104 $ 36,404 $ 30,010
Cash deposits, restricted...................... 6,890 3,662 2,960
Loans held for sale, net of allowance for
credit losses of $100, $76 and $120
(unaudited) and valuation allowance of $0,
$10,901 and $4,586 (unaudited)............... 9,523 10,975 18,883
Mortgage related securities, at fair value..... 106,299 34,830 34,927
Mortgage servicing rights...................... 9,507 83 --
Other receivables.............................. 7,945 5,078 6,055
Property and equipment, net of accumulated
depreciation of $675, $1,181 and $1,328
(unaudited).................................. 2,153 1,813 1,711
Organizational costs, net of amortization...... 289 96 64
Prepaid debt expenses.......................... 2,362 2,790 2,625
Prepaid commitment fee......................... 2,333 -- --
Deferred federal income tax asset.............. 2,354 5,376 6,707
Deferred state income tax asset................ -- 3,064 3,201
Other assets................................... 795 364 697
-------- -------- --------
Total assets......................... $156,554 $104,535 107,840
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes and contracts payable.................. $ 35,572 $ 16,345 31,058
Accounts payable and accrued liabilities..... 20,212 16,431 8,405
Allowance for credit losses on loans sold
with recourse............................. 7,014 2,472 2,476
State income taxes payable................... 649 -- --
Subordinated debt............................ 40,000 42,693 41,801
-------- -------- --------
Total liabilities.................... 103,447 77,941 83,740
-------- -------- --------
Commitments and contingencies (Note 16)
Stockholders' equity:
Convertible Preferred stock, $.01 par value
per share (authorized -- 5,000,000 shares;
issued and outstanding -- 0, 62,500, and
62,500 (unaudited))....................... -- 1 1
Common stock, $.01 par value per share
(authorized -- 400,000,000 shares; issued
and outstanding -- 12,300,000, 30,566,667,
and 30,566,660 (unaudited))............... 123 306 306
Additional paid-in capital................... 29,185 122,143 122,143
Retained earnings (accumulated deficit)...... 23,799 (95,856) (98,350)
-------- -------- --------
Total stockholders' equity........... 53,107 26,594 24,100
-------- -------- --------
Total liabilities and stockholders'
equity............................ $156,554 $104,535 $107,840
======== ======== ========
</TABLE>
See notes to financial statements.
F-3
<PAGE> 117
MEGO MORTGAGE CORPORATION
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
FOR THE YEARS ENDED AUGUST 31, (UNAUDITED)
----------------------------------------- -------------------------
1996 1997 1998 1997 1998
--------- ------------- ------------- ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE
AMOUNTS)
<S> <C> <C> <C> <C> <C>
REVENUES:
Gain (loss) on sale of loans..... $16,539 $ 45,123 $ (26,578) $ 3,721 $ 172
Net unrealized gain (loss) on
mortgage related securities.... 2,697 3,518 (70,024) (13,108) 270
Loan servicing income, net....... 3,348 3,036 999 1,194 240
Interest income.................. 2,104 9,507 14,786 4,296 1,602
Less: interest expense........... (1,116) (6,374) (13,162) (3,086) (1,764)
------- ----------- ----------- ----------- -----------
Net interest income
(expense).................... 988 3,133 1,624 1,210 (162)
------- ----------- ----------- ----------- -----------
Total revenues (losses)... 23,572 54,810 (93,979) (6,983) 520
------- ----------- ----------- ----------- -----------
COST AND EXPENSES:
Net provision (benefit) for
credit losses.................. 55 6,300 (3,198) 1,590 43
Depreciation and amortization.... 394 672 1,013 208 215
Other interest................... 167 245 439 77 42
General and administrative:
Payroll and benefits........... 6,328 13,052 18,582 5,686 1,979
Credit reports................. 367 1,387 510 272 17
Rent and lease expenses........ 338 1,199 1,616 321 359
Professional services.......... 1,771 2,271 4,783 1,516 964
Sub-servicing fees............. 709 1,874 2,160 661 22
Other services................. 665 1,352 2,068 399 --
FHA insurance.................. 572 558 430 106 82
Travel......................... 677 1,005 1,159 367 109
Other.......................... 374 1,085 2,448 662 650
------- ----------- ----------- ----------- -----------
Total costs and
expenses................ 12,417 31,000 32,010 11,865 4,482
------- ----------- ----------- ----------- -----------
Income (Loss) Before Income
Taxes............................ 11,155 23,810 (125,989) (18,848) (3,962)
Income Tax Expense (Benefit)....... 4,235 9,062 (6,334) -- (1,468)
------- ----------- ----------- ----------- -----------
Net Income (Loss).................. $ 6,920 $ 14,748 $ (119,655) $ (18,848) $ (2,494)
======= =========== =========== =========== ===========
EARNINGS PER COMMON SHARE:
Basic:
Net income (loss).............. $ 1.25 $ (7.72) $ (1.53) $ (0.08)
=========== =========== =========== ===========
Weighted-average number of
common shares................ 11,802,192 15,502,926 12,300,000 30,566,666
=========== =========== =========== ===========
Diluted:
Net income (loss).............. $ 1.25 $ (7.72) $ 1.53 $ (0.08)
=========== =========== =========== ===========
Weighted-average number of
common shares and assumed
conversions.................. 11,802,192 15,502,926 12,300,000 30,566,666
=========== =========== =========== ===========
</TABLE>
See notes to financial statements.
F-4
<PAGE> 118
MEGO MORTGAGE CORPORATION
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
THREE MONTHS
ENDED NOVEMBER 30,
FOR THE YEARS ENDED AUGUST 31, (UNAUDITED)
--------------------------------- --------------------
1996 1997 1998 1997 1998
--------- --------- --------- --------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)................................ $ 6,920 $ 14,748 $(119,655) $ (18,848) $ (2,494)
--------- --------- --------- --------- --------
Adjustments to reconcile net income to net cash
used in operating activities:
Loans originated for sales, net of loan fees... (139,367) (526,917) (365,694) (202,517) (15,434)
Proceeds from sale of loans.................... 135,483 514,413 360,303 155,856 12,977
Payments on loans held for sale................ 504 431 2,191 443 816
Lower of cost or market adjustment............. -- -- 10,901 -- (6,315)
Net provisions (benefit) for estimated credit
losses....................................... 55 6,300 (3,198) 1,590 43
Additions to mortgage related securities....... -- (135,549) (22,469) (1,980) --
Accretion of residual interest on mortgage
related securities........................... (243) (6,207) (8,467) (2,838) (349)
Write-off/sale of mortgage related
securities................................... -- 67,040 27,573 (565) 105
Market valuation of mortgage related
securities................................... (2,697) 5,612 73,390 17,319 --
Payments on mortgage related securities........ 1,547 801 1,442 100 147
Additions to excess servicing rights........... (20,563) (3,887) -- -- --
Amortization of excess servicing rights........ 2,144 956 -- -- --
Additions to mortgage servicing rights......... (3,306) (7,184) (3,529) (1,530) --
Amortization of mortgage servicing rights...... 555 1,504 3,166 611 7
Proceeds from sale of mortgage servicing
rights....................................... -- -- 4,137 -- 76
Write-off /valuation of mortgage servicing
rights....................................... -- -- 3,870 -- --
Gain on disposal of fixed assets............... -- -- (16) -- --
Depreciation and amortization expense.......... 394 672 1,013 208 215
Additions to prepaid debt expenses, net........ -- -- (4,066) (2,879) (64)
Amortization of prepaid debt expense........... 163 684 1,387 243 229
Additions to prepaid commitment fee, net....... -- -- (1,250) -- --
Amortization/write-off of prepaid commitment
fee.......................................... -- 817 3,583 218 --
Changes in operating assets and liabilities:
Cash deposits, restricted.................... (1,942) (2,416) 3,228 (1,902) 702
Deferred income taxes (benefit).............. 673 (3,267) (6,086) (2,148) (1,468)
Other assets, net............................ 1,056 (1,813) 5,017 560 (1,342)
State income taxes payable................... 670 (260) (649) (649) --
Other liabilities, net....................... 5,514 1,084 (5,845) (737) (8,012)
--------- --------- --------- --------- --------
Total adjustments.......................... (19,360) (87,186) 79,932 (40,597) (17,667)
--------- --------- --------- --------- --------
Net cash used in operating activities...... (12,440) (72,438) (39,723) (59,445) (20,161)
--------- --------- --------- --------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment............... (608) (1,688) (345) -- (44)
Proceeds from the sale of property and
equipment...................................... -- 4 16 -- --
--------- --------- --------- --------- --------
Net cash used in investing activities...... (608) (1,684) (329) -- (44)
--------- --------- --------- --------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings on notes and contracts
payable........................................ 146,448 511,878 334,143 204,074 14,873
Payments on notes and contracts payable.......... (133,709) (490,503) (353,370) (185,919) (170)
Issuance of subordinated debt.................... -- 37,750 40,400 40,400 --
Repurchase of subordinated debt.................. -- -- (125) -- (867)
Amortization of premium of subordinated debt..... -- -- (82) (8) (25)
Sale of common stock............................. -- 20,658 25,000 -- --
</TABLE>
F-5
<PAGE> 119
<TABLE>
<CAPTION>
THREE MONTHS
ENDED NOVEMBER 30,
FOR THE YEARS ENDED AUGUST 31, (UNAUDITED)
--------------------------------- --------------------
1996 1997 1998 1997 1998
--------- --------- --------- --------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
Sale of preferred stock.......................... -- -- 25,000 -- --
Payment of issuance costs........................ -- -- (614) -- --
--------- --------- --------- --------- --------
Net cash provided by financing
activities............................... 12,739 79,783 70,352 58,547 13,811
--------- --------- --------- --------- --------
NET (DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS...................................... (309) 5,661 30,300 (898) (6,394)
CASH AND CASH EQUIVALENTS -- BEGINNING OF YEAR..... 752 443 6,104 6,104 36,404
--------- --------- --------- --------- --------
CASH AND CASH EQUIVALENTS -- END OF YEAR........... $ 443 $ 6,104 $ 36,404 $ 5,206 $ 30,010
========= ========= ========= ========= ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest....................................... $ 964 $ 5,212 $ 12,380 $ 2,912 $ 290
State income taxes............................. $ 25 $ 1,691 $ 506 -- 55
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
Additional paid-in capital created from deferred
tax asset...................................... $ -- $ -- $ 2,354 $ 2,354 $ --
Forgiveness of due to Mego Financial liability... $ -- $ -- $ 6,153 $ -- $ --
Record liability to repurchase loans from City
Mortgage Services.............................. $ -- $ -- $ 9,255 $ -- $ --
Exchange of Subordinated Notes for Subordinated
Notes.......................................... $ -- $ -- $ 41,500 $ -- $ --
Exchange of Subordinated Notes for Preferred
Stock.......................................... $ -- $ -- $ 37,500 $ -- $ --
Placement agent service fee paid in common
stock.......................................... $ -- $ -- $ 2,400 $ -- $ --
Addition to prepaid commitment fee and due to
Mego Financial in connection with loan sale
commitment received............................ $ -- $ 3,000 $ -- $ -- $ --
In connection with the securitization of loans
and creation of mortgage related securities,
the Company retained an interest only security
and a residual interest security............... $ 20,096 $ -- $ -- $ -- $ --
</TABLE>
See notes to financial statements.
F-6
<PAGE> 120
MEGO MORTGAGE CORPORATION
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998 AND THE THREE MONTHS ENDED
NOVEMBER 30, 1998
<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED STOCK COMMON STOCK
$.01 PAR VALUE $.01 PAR VALUE ADDITIONAL RETAINED
--------------- -------------------- PAID-IN EARNINGS
SHARES AMOUNT SHARES AMOUNT CAPITAL (DEFICIT) TOTAL
------ ------ ----------- ------ ---------- --------- ---------
(THOUSANDS OF DOLLARS, EXCEPT SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at September 1,
1995................... -- $-- 10,000,000 $100 $ 8,550 $ 2,131 $ 10,781
Net income............... -- -- -- -- -- 6,920 6,920
------ -- ----------- ---- -------- --------- ---------
Balance at August 31,
1996................... -- -- 10,000,000 100 8,550 9,051 17,701
Sale of common stock, net
of issuance costs...... -- -- 2,300,000 23 20,635 -- 20,658
Net income............... -- -- -- -- -- 14,748 14,748
------ -- ----------- ---- -------- --------- ---------
Balance at August 31,
1997................... -- -- 12,300,000 123 29,185 23,799 53,107
Increase in additional
paid-in capital due to
adjustment of deferred
federal income tax
asset related to
Spin-off............... -- -- -- -- 2,354 -- 2,354
Increase in additional
paid-in capital due to
settlement of amount
payable to Mego
Financial Corp. related
to Spin-off............ -- -- -- -- 6,153 -- 6,153
Sale of common stock, net
of issuance costs...... -- -- 18,266,667 183 26,854 -- 27,037
Sale of Series A
convertible preferred
stock and exchange of
Senior Subordinated
Notes for Series A
convertible preferred
stock, net of issuance
costs.................. 62,500 1 -- -- 57,597 -- 57,598
Net loss................. -- -- -- -- -- (119,655) (119,655)
------ -- ----------- ---- -------- --------- ---------
Balance at August 31,
1998................... 62,500 1 30,566,667 306 122,143 (95,856) 26,594
Retirement of Common
Stock (unaudited)...... -- -- (7) -- -- -- --
Net Loss (unaudited)..... -- -- -- -- -- (2,494) (2,494)
------ -- ----------- ---- -------- --------- ---------
Balance at November 30,
1998 (unaudited)....... 62,500 $1 30,566,660 $306 $122,143 $ (98,350) $ 24,100
====== == =========== ==== ======== ========= =========
</TABLE>
See notes to financial statements.
F-7
<PAGE> 121
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
1. NATURE OF OPERATIONS
Mego Mortgage Corporation (the "Company") was incorporated on June 12,
1992, in the State of Delaware. The Company is a specialized consumer finance
company that funds, purchases, makes and sells consumer loans secured by deeds
of trust on one-to-four family residences. These loans are used to, among other
things, purchase one-to-four family residences, refinance existing mortgages,
consolidate debt and finance home improvements. The Company's loan products are:
- Home Equity loans, primarily secured by first liens, and to a
substantially lesser extent by second liens, on the borrower's residence.
The Company's Home Equity loans are made to borrowers who, because of
their credit history, income or other factors, do not conform to the
lending criteria of government-chartered agencies (including GNMA, FHLMC
or FNMA) mortgage guarantee or purchase programs. As a result, the
Company's borrowers pay a higher rate of interest and are able to borrow
a lesser amount of the appraised value of their residences than
conforming borrowers;
- Equity + loans, typically secured by a second lien on the borrower's
primary residence. The initial principal amount of an Equity + loan when
added to the other outstanding senior secured debt on the residence may
result in a loan to value ("LTV") of up to 125%.
Historically, a significant majority of the Company's loan production was
purchased from approved mortgage bankers and other financial intermediaries. The
Company funds loans that are originated through its network of over 169
pre-approved mortgage brokers as of August 31, 1998. These brokers submit loan
packages to the Company, which in turn funds the loans to approved borrowers.
All loans funded or purchased by the Company are underwritten and graded by the
Company's personnel. Effective in January 1998, the Company's operating strategy
was to sell substantially all of its loan production for cash to institutional
purchasers.
Certain of the loans produced by the Company qualify under the provisions
of Title I of the National Housing Act which is administered by the U.S.
Department of Housing and Urban Development ("HUD"). Prior to May 1996, the
Company produced only Title I loans. Pursuant to the Title I credit insurance
program, 90% of the principal balances of the loans are U.S. government insured
("Title I loans"), with cumulative maximum coverage equal to 10% of all Title I
loans produced by the Company. As a result of prior losses, no FHA insurance
remained with respect to the Company's portfolio of Title I loans as of August
31, 1998. In May 1996, the Company commenced the production of Equity + home
improvement loans, generally secured by residential real estate, and debt
consolidation loans ("Equity + loans") through its network of mortgage bankers
and mortgage brokers.
During fiscal 1995, all loans produced were Title I loans. During fiscal
1996, 91.7% of loans produced were Title I loans and 8.3% of loans produced were
Equity + loans. The Company's loan production during the fiscal year ended
August 31, 1997 was comprised of
F-8
<PAGE> 122
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
81.4% Equity + loans and 18.6% Title I loans. In December 1997, the Company
commenced the origination of Home Equity loans. The Company's loan production
during the fiscal year ended August 31, 1998 was comprised of 91.6% Equity +
loans, 5.5% Title I loans, and 2.9% Home Equity loans.
The Company was a wholly owned subsidiary of Mego Financial Corp. ("Mego
Financial") until November 1996, when the Company issued 2.3 million shares of
its Common Stock, $.01 par value per share (the "Common Stock"), in an
underwritten public offering (the "IPO") at $10.00 per share. As a result of the
IPO, Mego Financial's ownership in the Company was reduced from 100% at August
31, 1996 to 81.3%. Concurrently with the IPO, the Company issued $40.0 million
of 12.5% Senior Subordinated Notes due in 2001 in an underwritten public
offering. The proceeds from the offerings received by the Company were used to
repay borrowings and provide funds for production and securitizations of loans.
In October 1997, the Company issued an additional $40.0 million of 12.5% Senior
Subordinated Notes due in 2001 in a private placement (the "Private Placement").
The proceeds from the Private Placement were used to repay borrowings, including
borrowings from Mego Financial, and to provide funds for loan production, the
securitizations of loans and working capital. The $80.0 million of 12.5% Senior
Subordinated Notes due in 2001 are herein referred to as old notes (the "Old
Notes").
On September 2, 1997, Mego Financial distributed all of its 10 million
shares of the Company's Common Stock to its stockholders in a tax-free spin-off
("Spin-off").
On July 1, 1998, the Company completed a series of transactions to
recapitalize the Company (the "Recapitalization"). Pursuant to the
Recapitalization, the Company raised approximately $84.5 million of additional
equity, net of issuance costs. Two strategic partners each purchased 10,000
shares of the Company's newly-designated Series A Convertible Preferred Stock
(the "Preferred Stock") at a purchase price of $1,000 per share. The purchasers
have each been granted an option, which expires in December 2000, to acquire
6.67 million shares of the Company's Common Stock, subject to adjustment. The
number and price of the Company's Common Stock purchasable upon exercise of the
option is subject to adjustment from time to time upon the occurrence of: (1)
mergers and reclassifications; (2) dividends, subdivisions, and combinations;
(3) adjustments for issuance below option price; (4) adjustments for issuances
below fair market value; (5) special rules and (6) other actions affecting
capital stock. The Preferred Stock will be mandatorily converted into Common
Stock on June 18, 2000. Each purchaser has a right of first refusal to purchase
the Company in the event the Company's Board of Directors determines to sell the
Company. In addition, other private investors purchased an aggregate of 5,000
shares of Preferred Stock at a purchase price of $1,000 per share and 16.67
million shares of Common Stock at a purchase price of $1.50 per share. All of
the foregoing sales were made pursuant to private placements.
As part of the Recapitalization, the Company completed an offer to exchange
(the "Exchange Offer") new subordinated notes and Preferred Stock, subject to
certain limitations, for any and all of the outstanding Old Notes. The Exchange
Offer was
F-9
<PAGE> 123
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
conditioned upon at least $76.0 million aggregate principal amount of Old Notes
being tendered for exchange and conditioned upon at least $30.0 million shares
of Common Stock and Preferred Stock being sold in the offerings. The Company
would not have consummated the Exchange Offer if less than $30.0 million was
raised in the offerings. Pursuant to the Exchange Offer, the Company issued
approximately 37,500 shares of Preferred Stock at an issuance price of $1,000
per share, and $41.5 million principal amount of new 12.5% Subordinated Notes
due 2001 (the "Current Notes") in exchange for approximately $79.0 million
principal amount of Old Notes. The balance of the Old Notes was repurchased by
the Company in September and October 1998. The proceeds of the Recapitalization
was $50.0 million. The proceeds were used to repay indebtedness, including $1.6
million to a subsidiary of Mego Financial, $5.1 million of interest on the Old
Notes and $2.4 million on the warehouse line of credit, to provide capital to
originate loans and for other general corporate uses.
In the opinion of management, the accompanying unaudited financial
statements contain all adjustments (consisting only of various normal accruals)
necessary to present fairly the Company's financial position, results of
operations and cash flows. The financial position at November 30, 1998 is not
necessarily indicative of the financial position to be expected at August 31,
1999 and results of operations for the three months ended November 30, 1998 are
not necessarily indicative of the results of operations to be expected for the
year ending August 31, 1999.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash and Cash Equivalents -- Cash and cash equivalents consist of cash on
hand and on deposit at financial institutions and short term investments with
original maturities of 90 days or less when purchased.
Cash Deposits, Restricted -- Restricted cash represents cash on deposit
which is restricted in accordance with the loan sale agreements and funds
received from collection of loans which have not yet been disbursed to the
purchasers of such loans in accordance with the loan sale agreements.
Loans Held for Sale -- Loans held for sale are carried at the lower of
aggregate cost or market value in the accompanying Statements of Financial
Condition, net of allowance for credit losses.
Allowance for Credit Losses -- Provision for credit losses relating to
unsold loans is recorded as expense in amounts sufficient to maintain the
allowance at a level considered adequate to provide for anticipated probable
losses resulting from liquidation of outstanding loans. The provision for credit
losses is based upon periodic analysis of the portfolio, economic conditions and
trends, historical credit loss experience, borrowers' ability to repay,
collateral values, and estimated FHA insurance recoveries on loans produced.
Valuation Allowance -- Provision for decreases in the market value relating
to unsold loans is recorded as expense in amounts sufficient to maintain the
allowance at a level considered adequate to provide for anticipated probable
losses from liquidation of
F-10
<PAGE> 124
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
outstanding loans. The provision for valuation is based upon the estimated fair
market value of the portfolio primarily derived from recent sale data in the
marketplace.
Loan Origination Costs and Fees -- Loan origination costs and fees
including non-refundable loan origination fees and incremental direct costs
associated with loan production are deferred in compliance with Statement of
Financial Accounting Standards ("SFAS") No. 91 "Accounting for Nonrefundable
Fees and Costs associated with Originating or Acquiring Loans and Indirect
Direct Costs of Leases." ("SFAS 91") and recorded as expense or income upon the
sale of the related loans.
Mortgage Related Securities -- In fiscal 1996, the Company securitized a
majority of loans produced into the form of a REMIC. A REMIC is a trust issuing
multi-class securities with certain tax advantages to investors and which
derives its cash flow from a pool of underlying mortgages. Certain of the senior
classes of the REMIC are sold, and an interest only strip and a subordinated
residual class are retained by the Company. The subordinated residual class is
in the form of residual certificates which are classified as residual interest
securities. The documents governing the Company's securitizations require the
Company to establish initial over-collateralization or build
over-collateralization levels through retention of distributions by the REMIC
trust otherwise payable to the Company as the residual interest holder. This
over-collateralization causes the aggregate principal amount of the loans in the
related pool and/or cash reserves to exceed the aggregate principal balance of
the outstanding investor certificates. Such excess amounts serve as credit
enhancement for the related REMIC trust. To the extent that borrowers default on
the payment of principal or interest on the loans, losses will reduce the over-
collateralization and cash flows otherwise payable to the residual interest
security holder to the extent that funds are available. If payment defaults
exceed the amount of over-collateralization, as applicable, the insurance policy
maintained by the related REMIC trust will pay any further losses experienced by
holders of the senior interests in the related REMIC trust. The Company does not
have any recourse obligations for credit losses in the REMIC trust.
In fiscal 1997, the Company completed five securitizations, including two
non-monoline securitizations, two owner's trust securitizations and a combined
REMIC grantor trust securitization. No securitizations were completed during the
three months ended November 30, 1998.
The two non-monoline securitizations completed in June and August 1997 were
accomplished on a senior subordinated basis without insurance as a credit
enhancement and were generally collateralized by Equity + home improvement and
debt consolidation mortgage loans with typically high loan-to-value ratios. The
other three securitization transactions were insured and collateralized by a
combination of Title I and Equity + loans. The two monoline owner's trust
securitizations were completed in March and May 1997. The REMIC/grantor trust
securitization, completed in December 1996, placed all secured Title I loans and
those Equity + loans which qualified with a loan-to-value ratio of 125% or less,
into the REMIC pool. The grantor trust pool was comprised of
F-11
<PAGE> 125
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
unsecured Title I loans and other Equity + loans which did not qualify for the
REMIC pool.
In August 1998, the Company pooled approximately $90.5 million (27.4%) of
its loans with an additional $239.6 million (72.6%) from a second party to
create a home loan owner trust securitization. The Company is to receive a
residual interest in this securitization calculated on a pro rata share of the
Company loans originated in the total pool. This residual interest will be owned
two-thirds by the Company and one-third by another financial institution.
Cashflow on the Company's residual interest will be subordinated to recovery by
the financial institution of: (1) premium paid for in the acquisition of the
pool; (2) upfront overcollateralization of 1.25% of the total pool; (3) the
financial institution's underwriting fee and (4) transaction costs. The total of
these recoveries will accrue interest at a 12% per annum rate until recovered.
The target overcollateralization level of 6% must be achieved prior to the
financial institution receiving any recoveries.
Pursuant to these securitizations, various classes of mortgage-backed notes
and certificates were issued and sold to the public. The Company received
residual interest securities, servicing rights and, in some of the transactions,
interest-only strip securities, all of which (except for the servicing rights)
were recorded as mortgage related securities on the Statements of Financial
Condition. The residual interest securities and the servicing rights represent
the excess differential (after payment of any subservicing, interest and other
fees, and the contractual obligations payable to the note and certificate
holders) between the interest paid by the obligors of the sold loans and the
yield on the sold notes, certificates and interest-only strip securities. The
Company has also received interest-only strip securities from the first two
securitizations completed in fiscal 1996 and the first two securitizations
completed in fiscal 1997. These interest-only securities yield annual rates
between 0.45% and 1.00% calculated on the principal balances of loans not in
default. The Company may be required to repurchase loans that do not conform to
the representations and warranties made by the Company in the securitization
agreements, and as servicer, may be required to advance interest in connection
with the securitizations. Effective January 1, 1997, the Company prospectively
adopted SFAS 125 (as defined below).
In accordance with the provisions of SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115"), the Company classifies
residual-interest securities, interest-only strip securities and interest-only
receivables as trading securities which are recorded at fair value with any
unrealized gains or losses recorded in the results of operations in the period
of the change in fair value. Valuations at origination and at each reporting
period are based on discounted cash flow analyses. The cash flows are estimated
as the excess of the weighted-average coupon on each pool of loans securitized
over the sum of the pass-through interest rate, servicing fees, a trustee fee,
an insurance fee and an estimate of annual future credit losses, net of Federal
Housing Administration ("FHA") insurance recoveries, related to the loans
securitized, over the life of the loans. These cash flows are projected over the
life of the loans using prepayment, default, and loss assumptions that the
Company believes market participants would use for similar financial instruments
and are discounted using an interest rate that
F-12
<PAGE> 126
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
the Company believes a purchaser unrelated to the seller of such a financial
instrument would require. The valuation includes consideration of
characteristics of the loans including loan type and size, interest rate,
origination date, and term. The Company also uses other available information
such as externally prepared reports on prepayment rates and industry default
rates of the type of loan portfolio under review. To the Company's knowledge,
there is no active market for the sale of these mortgage-related securities. The
range of values attributable to the factors used in determining fair value is
broad. Although the Company believes that it has made reasonable estimates of
the fair value of the mortgage-related securities, the rate of prepayments,
discount and default rates utilized are estimates, and actual experience may
differ.
Revenue Recognition-Gain(Loss) on Sale of Loans -- Gain on sale of loans
includes the gain on sale of mortgage-related securities and the gain(loss) on
sale of loans held for sale. In accordance with SFAS 125 (as discussed below)
the gain on sale of mortgage-related securities is determined by an allocation
of the cost of the securities based on the relative fair value of the securities
sold and the securities retained. In sales of loans through securitization
transactions, the Company retains residual-interest securities and may retain
interest-only strip securities. The fair value of the interest-only strip
securities and residual interest securities is the present value of the
estimated cash flow to be received after considering the effects of estimated
prepayments and credit losses. The interest-only strip securities and
residual-interest securities are included in mortgage-related securities on the
Company's Statements of Financial Condition. Market valuation adjustments on
loans held for sale and loans reacquired under recourse provisions are included
in the gain(loss) on sale of loans.
In discounting cash flows related to loan sales, the Company defers
servicing income at annual rates of 1% to 1.25% and discounts cash flows on its
sales at the rate it believes a purchaser would require as a rate of return. The
cash flows were discounted to present value using discount rates which
approximated 12% for each of the years ended August 31, 1996 and 1997 and 16%
for the year ended August 31, 1998 and the three months ended November 30, 1998.
The Company has developed its assumptions based on experience with its own
portfolio, available market data and ongoing consultation with its investment
bankers.
In determining expected cash flows, management considers economic
conditions at the date of sale. In subsequent periods, these estimates may be
revised as necessary using the original discount rate, and any losses arising
from prepayment and loss experience will be recognized as realized.
Mortgage Servicing Rights -- The fair value of capitalized mortgage
servicing rights is estimated by calculating the present value of expected net
cash flows from mortgage servicing rights using assumptions the Company believes
market participants would use in their estimates of future servicing income and
expense, including assumptions about prepayment, default and interest rates.
Mortgage servicing rights are amortized in proportion to and over the period of
estimated net servicing income. The estimate of fair value was based on a 125,
100, 100 and 100 basis points per annum, respectively, servicing
F-13
<PAGE> 127
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
fee reduced by estimated costs of servicing for the years ended August 31, 1996,
1997 and 1998 and the three months ended November 30, 1998. The estimated net
cash flow from servicing utilized a discount rate of 12% for the fiscal years
ending August 31, 1996 and 1997 and 16% for the year ended August 31, 1998 and
the three months ended November 30, 1998. At August 31, 1997 and 1998 and at
November 30, 1998, the book value of mortgage servicing rights approximated fair
value. The Company periodically reviews mortgage servicing rights to determine
impairment. This review is performed on a disaggregated basis, based upon loan
type and date of origination. Impairment is recognized in a valuation allowance
for each pool in the period of impairment. The Company has developed its
assumptions based on experience with its own portfolio, available market data
and ongoing consultation with its investment bankers.
Property and Equipment -- Property and equipment is stated at cost and is
depreciated over its estimated useful life (generally five years) using the
straight-line method. Costs of maintenance and repairs that do not improve or
extend the life of the respective assets are recorded as expense.
Organizational Costs -- Organizational costs associated with the
organization of the Company, which commenced loan production on March 1, 1994,
are being amortized over a five year period. These organizational costs are
comprised of costs to incorporate, and legal, accounting, and other professional
fees. Such amortization is included in depreciation and amortization expense on
the Statements of Operations. Accumulated amortization related to organizational
costs was $482,000, $675,000 and $867,000 during the years ended August 31,
1996, 1997 and 1998, respectively, and $723,000 and $930,000 at November 30,
1997 and 1998, respectively.
Allowance for Credit Losses on Loans Sold with Recourse -- Recourse to the
Company on sales of loans is governed by the agreements between the purchasers
and the Company. The allowance for credit losses on loans sold with recourse
represents the Company's estimate of the fair value of its probable future
credit losses to be incurred, considering estimated future FHA insurance
recoveries on Title I loans. No allowance for credit losses on loans sold with
recourse is established on loans sold with servicing released, as the Company
has no recourse obligation for credit losses under those whole loan sale
agreements. Estimated credit losses on loans sold through securitizations are
considered in the Company's valuation of its mortgage-related securities.
Proceeds from the sale of loans with recourse provisions were $118.1 million,
$415.5 million and $146.4 million during the years ended August 31, 1996, 1997
and 1998, respectively, and $105.9 million and $0 during the three months ended
November 30, 1997 and 1998, respectively.
Loan-Servicing Income -- Fees for servicing loans produced or acquired by
the Company and sold with servicing rights retained are generally based on a
stipulated percentage of the outstanding principal balance of such loans and are
recognized when earned. Interest received on loans sold, less amounts paid to
investors, is reported as loan-servicing income. Capitalized mortgage servicing
rights are amortized in proportion to and over the period of estimated servicing
income. Late charges and other miscellaneous
F-14
<PAGE> 128
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
income are recognized when collected. Costs to service loans are recorded to
expense as incurred.
Interest Income -- Interest income is recorded as earned. Interest income
represents the interest earned on loans held for sale during the period prior to
their securitization or other sale, mortgage-related securities, and short term
investments. The Company computes an effective yield based on the carrying
amount of each mortgage-related security and its estimated future cash flow.
This yield is then used to accrue interest income on the mortgage-related
security.
During the period that a Title I loan is 30 days through 270 days
delinquent, the Company previously accrued interest at the HUD guaranteed rate
of 7% in lieu of the contractual rate of the loan. When a Title I loan becomes
over 270 days contractually delinquent, it is placed on non-accrual status and
interest is recognized only as cash is received. As the HUD reserve was depleted
in fiscal 1998, the Company ceased the accrual of interest on delinquent Title I
loans. During the year ended August 31, 1997, interest income on Equity + and
Home Equity loans greater than 90 days delinquent was recognized on a cash
basis. During the year ended August 31, 1998 and the three months ended November
30, 1998, interest income on Equity + and Home Equity loans greater than 30 days
delinquent was recognized on a cash basis.
Income Taxes -- The Company has historically filed consolidated federal
income tax returns with its former parent, Mego Financial. Income taxes for the
Company were provided for on a separate return basis. As part of a tax sharing
arrangement, the Company had recorded a liability to Mego Financial for federal
income taxes applied to the Company's financial statement income after giving
consideration to applicable income tax law and statutory rates. This liability
was forgiven by Mego Financial at the time of the Recapitalization. The Company
accounts for taxes under SFAS No. 109, "Accounting for Income Taxes" ("SFAS
109"), which requires an asset and liability approach. For the period after
September 2, 1997 (after the Spin-off), the Company is in the process of filing
separate consolidated federal tax returns for the tax year ended February 28,
1998.
The provision for income taxes includes deferred income taxes, which result
from reporting items of income and expense for financial statement purposes in
different accounting periods than for income tax purposes. The Company also
provides for state income taxes at the rate of 6% of income before income taxes.
Recently Issued Accounting Standards -- In June 1997, The Financial
Accounting Standards Board (the "FASB") issued SFAS No. 130, "Reporting
Comprehensive Income" ("SFAS 130"), and SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information", ("SFAS 131"). SFAS No. 130
establishes standards for reporting and display of comprehensive income and its
components in a full set of general-purpose financial statements. SFAS No. 131
establishes standards of reporting by publicly-held business enterprises and
disclosure of information about operating segments in annual financial
statements and, to a lesser extent, in interim financial reports issued to
shareholders. SFAS Nos. 130 and 131 are effective for fiscal years beginning
after December 15, 1997. As both SFAS Nos. 130 and 131 deal with financial
statement
F-15
<PAGE> 129
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
disclosure, the Company does not anticipate the adoption of these new standards
will have a material impact on its financial position, results of operations or
cash flows. The Company has not yet determined what its reporting segments will
be under SFAS 131.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"), which establishes accounting
and reporting standards for derivative instruments and for hedging activities.
It requires the entity to recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. The accounting for changes in fair value of these designated
derivatives ("Hedge Accounting") depends on the intended use and designation. An
entity that elects to apply Hedge Accounting is required to establish at the
inception of its hedge the method it will use for assessing the effectiveness of
the hedging derivative and the measurement approach for determining the
ineffective aspect of the hedge. Those methods must be consistent with the
entity's approach to managing risk. SFAS 133 is effective for the fiscal years
beginning after June 15, 1999. The Company has not yet evaluated the effect of
adopting SFAS 133.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by Mortgage Banking Enterprise" ("SFAS 134"), which allows the
reclassification of mortgage-related securities and other beneficial interests
retained after the securitization of mortgage loans held for sale from the
trading category, as required by FASB 115, to either available for sale or held
to maturity based upon the Company's ability and intent to hold those
investments. SFAS 134 is effective for the first quarter beginning after
December 15, 1998. The Company has not yet evaluated the effect of adopting SFAS
134. As of August 31, and November 30, 1998, all mortgage-related securities are
classified as trading securities.
Stock Split -- The accompanying financial statements retroactively reflect
a 1,600 for 1 stock split, an increase in authorized shares of Common Stock to
50 million and the establishment of a $.01 par value per share effective October
28, 1996.
Reclassification -- Certain reclassifications have been made to conform
prior years with the current year presentation.
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 reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
F-16
<PAGE> 130
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
3. LOANS HELD FOR SALE, ALLOWANCE FOR CREDIT LOSSES, LOAN ORIGINATIONS, AND
LOANS SERVICED
Loans held for sale, net of allowance for credit losses and allowance for
valuation consist of the following:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
----------------- ------------
1997 1998 1998
------ -------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Loans held for sale..................... $9,345 $ 21,860 $ 23,239
Deferred loan fees...................... 278 93 350
Less allowance for credit losses........ (100) (76) (120)
Less allowance for valuation to lower of
cost or market........................ -- (10,902) (4,586)
------ -------- --------
Total......................... $9,523 $ 10,975 $ 18,883
====== ======== ========
</TABLE>
The Company provides an allowance for credit losses in an amount that the
Company believes will be adequate to absorb probable losses after FHA insurance
recoveries on the Title I loans. The Company bases its belief on its continual
review of its portfolio of loans, historical experience and current economic
factors. These reviews take into consideration changes in the nature and level
of the portfolio, historical rates, collateral values, current and future
economic conditions which may affect the obligors' ability to pay and overall
F-17
<PAGE> 131
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
portfolio quality. Changes in the allowance for credit losses and the allowance
for credit losses on loans sold with recourse consist of the following:
<TABLE>
<CAPTION>
FOR THE THREE
MONTHS ENDED
FOR THE YEARS ENDED AUGUST 31, NOVEMBER 30,
------------------------------- ---------------
1996 1997 1998 1997 1998
-------- --------- -------- ------ ------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
Balance at beginning of
year....................... $ 960 $ 1,015 $ 7,114 $7,114 $2,548
Net provision (benefit) for
credit losses.............. 1,510 23,048 (3,198) 1,702 43
Reductions to the provision
due to securitizations or
loans sold without
recourse................... (1,455) (16,748) (0) (112) --
Reductions due to charges to
allowance for credit
losses..................... -- (201) (1,368) (5) --
Increase due to adjustment to
allowance for credit
losses..................... -- -- -- -- 5
------- -------- ------- ------ ------
Balance at end of year....... $ 1,015 $ 7,114 $ 2,548 $8,699 $2,596
======= ======== ======= ====== ======
Allowance for credit
losses..................... $ 95 $ 100 $ 76 $ 116 $ 120
Allowance for credit losses
on loans sold with
recourse................... 920 7,014 2,472 8,583 2,476
------- -------- ------- ------ ------
Total.............. $ 1,015 $ 7,114 $ 2,548 $8,699 $2,596
======= ======== ======= ====== ======
</TABLE>
Changes in the valuation allowance on loans held for sale for the three
months ended November 30, 1998 consist of the following (thousands of dollars)
while no such valuation allowance was provided for the three months ended
November 30, 1997:
<TABLE>
<S> <C>
Balance at August 31, 1998.................................. $10,901
Provision for valuation changes........................... 433
Reductions to the allowance on loans sold................. (6,748)
-------
Balance at November 30, 1998................................ $ 4,586
=======
</TABLE>
F-18
<PAGE> 132
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
During fiscal 1997 and 1998 and the three months ended November 30, 1998,
$398.3 million, $0 and $0, respectively, of loans sold under recourse provisions
were repurchased and securitized as further described in Note 2. Reductions to
the provision due to securitizations or loans sold without recourse represent
amounts transferred to the valuation basis of the mortgage-related securities
and reductions in the allowance due to a lack of recourse provisions on loans
sold without recourse. Loans produced and serviced consist of the following:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
------------------- ------------
1997 1998 1998
-------- -------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Loan production:
Title I.............................. $ 98,085 $ 18,701 $ 4
Equity +............................. 428,832 310,518 4,907
Home Equity.......................... -- 9,723 11,607
-------- -------- -------
Total........................ $526,917 $338,942 $16,518
======== ======== =======
Loans serviced (including notes
securitized, sold to investors, and
held for sale):
Title I.............................. $255,446 $ 23,005 $ 2,599
Equity +............................. 372,622 8,217 18,404
-------- -------- -------
Total........................ $628,068 $ 31,222 $21,003
======== ======== =======
</TABLE>
4. MORTGAGE-RELATED SECURITIES
Mortgage-related securities consist of interest-only strips and
residual-interest certificates of FHA Title I and Equity + mortgage-backed
securities collateralized by loans produced, purchased and serviced by the
Company.
Mortgage-related securities are classified as trading securities and are
recorded at estimated fair value. Changes in the estimated fair value are
recorded in current operations. Mortgage-related securities consist of the
following:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
------------------- ------------
1997 1998 1998
-------- ------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Interest-only strip securities............ $ 6,398 $ 2,748 $ 2,387
Residual-interest securities.............. 84,597 28,189 28,674
Interest-only receivables (formerly excess
servicing rights)....................... 15,304 3,893 3,866
-------- ------- -------
Total........................... $106,299 $34,830 $34,927
======== ======= =======
</TABLE>
F-19
<PAGE> 133
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
Activity in total mortgage-related securities consist of the following:
<TABLE>
<CAPTION>
FOR THE THREE
FOR THE YEARS ENDED MONTHS ENDED
AUGUST 31, NOVEMBER 30,
------------------- -------------
1997 1998 1998
-------- -------- -------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year.................. $ 22,944 $106,299 $34,830
Additions due to securitizations, at cost..... 135,549 22,469 --
Net unrealized (loss)......................... (5,612) (73,390) --
Accretion of residual interest................ 6,207 8,467 349
Write-off/sale of mortgage-related
securities.................................. (67,040) (27,573) (105)
Net transfers from excess servicing rights.... 15,052 -- --
Principal reductions.......................... (801) (1,442) (147)
-------- -------- -------
Balance at end of year........................ $106,299 $ 34,830 $34,927
======== ======== =======
</TABLE>
During the year ended August 31, 1998, the Company experienced
significantly higher prepayment activity and delinquencies with regard to its
securitized Equity + and Title I loans than the levels which had been assumed.
This acceleration in the speed of prepayment has caused management, after
consultation with its financial advisors, to adjust the assumptions previously
utilized in calculating the carrying value of its mortgage-related securities.
The Equity + loan prepayment speed assumptions reflect an annualized rate
of 4.5% in the first month following securitization with that annualized rate
building in level monthly increments so that by the 18th month the annualized
rate is 18.75%. The annualized prepayment rate is maintained at that level
through the 36th month at which time it is assumed to decline in level monthly
increments to 15.25% by the 43rd month, and is maintained at 15.25% for the
remaining life of the portfolio. The loss assumptions for Equity + loans have
also been increased to reflect losses commencing in the second month following a
securitization and building in level monthly increments until a 4.25% annualized
loss rate is achieved in the 15th month. The annualized loss rate is maintained
at that level through the 43rd month at which time it is assumed to decline in
level monthly increments to 4.0% at month 48 and is maintained for the life of
the portfolio. On a cumulative basis this model assumes aggregate losses of
approximately 16% of the original portfolio balance.
F-20
<PAGE> 134
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
The estimated loss on Title I loans is reduced by recoveries on defaulted
loans of 5%-10% assuming the Title I insurance has been exhausted. On a
cumulative basis, this assumes aggregate losses of approximately 11.92% of the
original principal balance. The prepayment speed utilized for Title I loans is
23% for the remaining life of the portfolio. The loss assumptions for Title I
loans are based on the aging of each portfolio and a historical migration
analysis resulting in the following estimated default rates:
<TABLE>
<CAPTION>
DELINQUENCY STATUS (IN DAYS) ESTIMATED DEFAULT RATES
- ---------------------------- ----------------------------
<S> <C> <C>
Current.................... 5%
31-60...................... 5%
61-90...................... 20-25%
91-120..................... 50%
121-150.................... 80%
151-180.................... 95%
Over 180................... 100%
</TABLE>
The Company utilized a 16% discount rate at August 31 and November 30, 1998
to calculate the present value of cash flow streams. Taken in conjunction with
the above prepayment and loss assumptions, management believes these valuations
reflect current market values. Because of the inherent uncertainty of the
valuations, those estimated market values may differ from values that would have
been used had a ready market for the securities existed, and the difference
could be material. The Company has not obtained an independent validation of the
assumptions utilized in calculating the carrying value of mortgage-related
securities for any period subsequent to August 31, 1997.
During fiscal 1996 and 1997, the Company generally utilized annual
prepayment assumptions ranging from 1% to 15%, annual estimated loss factor
assumptions of up to 1.75%, and annual weighted average discount rates of up to
12% for Title I and Equity + loans.
The Company has pledged certain of its interest-only and residual class
certificates, that are included in its mortgage-related securities, pursuant to
the pledge and security agreement with a financial institution. The Company has
also pledged certain residual interests and interest-only securities pursuant to
its revolving credit facility with another financial institution. See Note 9.
F-21
<PAGE> 135
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
5. EXCESS SERVICING RIGHTS
Activity in excess servicing rights for the year ended August 31, 1997
consist of the following (thousands of dollars):
<TABLE>
<S> <C>
Balance at beginning of year................................ $ 12,121
Plus additions.............................................. 3,887
Less amortization........................................... (956)
Less amounts related to loans repurchased, securitized and
transferred to mortgage-related securities................ (15,052)
--------
Balance at end of year...................................... $ --
========
</TABLE>
As of August 31, 1997 and 1998, interest-only receivables consisted of
excess cash flows on serviced loans totaling $88.2 million, and $87.4 million,
yielding weighted-average interest rates of 12.5%, and 12.2% and net of normal
servicing and pass-through fees with weighted-average pass-through yields to the
investor of, 8.8%, and 9.5% respectively. These loans were sold under recourse
provisions as described in Note 2 and the interest-only receivables are included
in Mortgage-Related Securities in the Company's Statement of Financial
Condition.
6. MORTGAGE SERVICING RIGHTS
Activity in mortgage servicing rights consist of the following:
<TABLE>
<CAPTION>
FOR THE THREE
MONTHS ENDED
FOR THE YEARS ENDED AUGUST 31, NOVEMBER 30,
-------------------------------- -------------
1996 1997 1998 1998
-------- --------- --------- -------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
Balance at beginning of
year........................ $1,076 $ 3,827 $ 9,507 $ 83
Plus additions................ 3,306 7,184 3,529 --
Less amortization............. (555) (1,504) (3,166) (7)
Less write-down of
valuation................... -- -- (3,870) --
Less sale of servicing
rights...................... -- -- (5,917) (76)
------ ------- ------- ------
Balance at end of year........ $3,827 $ 9,507 $ 83 $ --
====== ======= ======= ======
</TABLE>
The Company had no valuation allowance for mortgage servicing rights during
fiscal 1996, 1997 or 1998, as the cost basis of mortgage servicing rights
approximated fair value.
The Company also entered into an agreement with City Mortgage Services in
June 1998, to acquire and service the majority of the mortgage loans that the
Company owned at the date of the Recapitalization at 90% of its carrying value.
As a result, the Company recorded an impairment of $703,225, which is reflected
in the accompanying Statement of Operations as a charge to Loan Servicing
Income. In addition, the Company and City Mortgage Services entered into an
agreement in June, 1998 for City Mortgage Services to
F-22
<PAGE> 136
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
service all of the mortgage loans produced or purchased by the Company after the
Recapitalization.
7. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
------------------ ------------
1997 1998 1998
------ ------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Office equipment and furnishings.... $1,702 $ 1,768 $ 1,769
EDP equipment....................... 948 1,226 1,268
Building improvements............... 144 -- 2
Vehicles............................ 34 -- --
------ ------- -------
2,828 2,994 3,039
Less accumulated depreciation....... (675) (1,181) (1,328)
------ ------- -------
Total..................... $2,153 $ 1,813 $ 1,711
====== ======= =======
</TABLE>
Included in property and equipment as of August 31, 1997 and 1998 and
November 30, 1998 are various capitalized leases totaling $1.5 million, $1.8
million and $1.6 million, net of accumulated amortization of approximately
$532,000, $1.1 million and $1.2 million, respectively.
8. OTHER ASSETS
Other assets consist of the following:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
----------- ------------
1997 1998 1998
---- ---- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Accrued income from securitizations........... $537 $111 $ --
Software costs, net of amortization (See Note
15)......................................... 92 31 --
Deposits and impounds......................... 80 81 81
Debt offering costs........................... -- -- 285
Other......................................... 86 141 331
---- ---- ----
Total............................... $795 $364 $697
==== ==== ====
</TABLE>
F-23
<PAGE> 137
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
9. NOTES AND CONTRACTS PAYABLE
Notes and contracts payable consist of the following:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
------------------ ------------
1997 1998 1998
------- ------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Note payable -- warehouse line of
credit............................. $ 8,500 $ -- $14,874
Notes payable -- revolving lines of
credit............................. 24,976 9,961 9,943
Term Note............................ -- 4,615 4,615
Contracts payable.................... 2,096 1,769 1,626
------- ------- -------
Total...................... $35,572 $16,345 $31,058
======= ======= =======
</TABLE>
Loan production was initially funded principally through the Company's
$40.0 million warehouse line of credit that was executed in June 1997 and
increased to $65.0 million in October 1997. This line accrued interest at the
lower of one month LIBOR plus 1.5% or the Federal Funds rate plus 0.25%. At
August 31, 1997, $8.5 million was outstanding under this warehouse line of
credit. This line was paid off with the proceeds of the Recapitalization.
Loan sale transactions generally require the subordination of certain cash
flows payable to the Company to the payment of scheduled principal and interest
due to the loan purchasers. In connection with certain of such sale
transactions, a portion of amounts payable to the Company from the excess
interest spread is required to be maintained in a reserve account to the extent
of the subordination requirements. The subordination requirements generally
provide that the excess interest spread is payable to the reserve account until
a specified percentage of the principal balances of the sold loans is
accumulated therein. The excess interest required to be deposited and maintained
in the respective reserve accounts is not available to support the cash flow
requirements of the Company. At August 31, 1997 and 1998 and November 30, 1998,
amounts on deposit in such reserve accounts totaled $6.9 million, $3.7 million
and $3.0 million, respectively, and are included in Cash Deposits -- Restricted
on the Statement of Financial Position.
As part of the Recapitalization, the Company executed a new warehouse line
of credit for up to $90.0 million with Sovereign Bancorp (the "Sovereign
Warehouse Line"), which replaced the Company's existing warehouse line of
credit. The Sovereign Warehouse Line originally terminated on December 29, 1998
and is renewable, at Sovereign's option, in six-month intervals. During December
1998, the Sovereign Warehouse Line was extended through August 1999. The
Sovereign Warehouse Line may be increased with certain consents and contains
pricing/fees which vary by product and the dollar amount outstanding. The
Sovereign Warehouse Line is to be secured by specific loans held for sale and
includes certain material covenants including maintenance of books and records,
provide financial statements and reports, maintenance of its existence and
properties, maintenance of adequate fidelity bond coverage and insurance and
provision of timely notice of material proceedings. As of August 31, 1998, the
Company had not utilized the
F-24
<PAGE> 138
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
Sovereign Warehouse Line. At November 30, 1998, approximately $14.9 million was
outstanding under the Sovereign Warehouse Line.
In April 1997, the Company entered into a pledge and security agreement
with another financial institution for an $11.0 million revolving credit
facility. The amount which can be borrowed under the agreement was increased to
$15.0 million in June 1997 and $25.0 million in July 1997. This facility is
secured by a pledge of certain of the Company's interest-only and residual class
certificates carried as mortgage-related securities on the Company's Statements
of Financial Condition. A portion of the advances under the credit line
agreement accrues interest at one-month LIBOR + 3.5% (9.1% at August 31, 1998
and 8.5% at November 30, 1998), expiring one year from the initial advance. The
remaining advances accrue interest at one-month LIBOR + 2.0% (7.64% at August
31, 1998 and 7.03% at November 30, 1998). As of August 31 and November 30, 1998,
approximately $10.0 million was outstanding under the agreement. The agreement,
which was originally scheduled to mature in December 1998, was extended until
December 1999.
Certain material covenants restrictions exist in the credit agreement
governing the April 1997 revolving line of credit. These covenants include
limitations to incur additional indebtedness, provide adequate collateral and
achieve certain financial tests. These tests include achieving a minimal net
worth (as defined therein) and that the debt-to-net worth ratio (as defined
therein) shall not exceed 2.5:1. As of August 31, 1998, the Company's net worth
was $15.9 million below the minimal required and the debt-to-net worth ratio as
2.93:1. On December 2, 1998, the Company obtained a waiver for the minimal
required net worth and debt-to-net worth ratio for the period that the Company
was not in compliance. Additionally, the Company agreed to pay down the
outstanding borrowings from $10.0 million at August 31, 1998 to $6.0 million at
December 31, 1998 and subsequently agreed to pay the remaining $6.0 million in
equal monthly payments during calendar 1999. As of November 30, 1998, the
Company's net worth was $4.2 million above the minimal required and the
debt-to-net worth ratio was 2.86:1.
In October, 1997, the Company entered into a credit agreement with another
financial institution for an $8.8 million revolving line of credit. This
institution funded $5.0 million of this credit facility and is seeking a
participatory lender for the balance of the credit facility. As of August 31 and
November 30, 1998, a participatory lender has not been obtained. The facility is
secured by a pledge of certain of the Company's mortgage-related securities. The
loan balance under this agreement bears interest at the prime rate plus 2.5%
(11.0% at August 31, 1998 and 10.5% at November 30, 1998). In May, 1998 this
loan converted to a term loan with monthly amortization derived from the
cashflow generated from the respective mortgage-related certificates. This term
loan bears interest at the prime rate plus 2.5% (11.0% at August 31, 1998 and
10.5% at November 30, 1998). The final maturity of this loan is October, 2002.
As of August 31 and November 30, 1998, approximately $4.6 million was
outstanding under the agreement.
The credit agreement governing the October 1997 revolving line of credit
includes certain material covenants. These covenants include restrictions
relating to extraordinary
F-25
<PAGE> 139
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
corporate transactions, maintenance of adequate insurance and achieving certain
financial tests. These tests include achieving a minimal consolidated adjusted
tangible net worth (as detailed therein) and that the consolidated adjusted
leverage ratio (as defined therein) shall not exceed 3:1. As of August 31, 1998,
the Company's consolidated adjusted tangible net worth was $54.1 million below
the minimum required and the consolidated adjusted leverage ratio was 0.53:1. On
December 9, 1998, the Company agreed to temporarily amend the borrowing base
definition for the period from September 30, 1998 through April 30, 1999 to
increase the borrowing base from 50% to 55%.
After April 30, 1999, the borrowing base will return to 50%. The minimum
consolidated tangible net worth covenant was also adjusted, commencing
retroactively, as of September 30, 1998 and the Company agreed to paydown the
line by approximately $405,000 (the amount exceeding the applicable maximum
amount of tranche credit) and pay an accommodation fee of $10,000. As of
November 30, 1998, the Company's consolidated adjusted tangible net worth was
$44.4 million above the minimum required and the consolidated adjusted leverage
ratio was 0.66:1.
At August 31, 1997 and 1998, and November 30, 1998, contracts payable
consisted of $2.1 million, $1.8 million and $1.6 million, respectively, in
obligations under lease purchase arrangements secured by property and equipment,
bearing a weighted-average interest rate of 9.25% at August 31, 1998.
Scheduled maturities of the Company's contracts payable of $1.8 million at
August 31, 1998 are as follows:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
--------------------------------
TOTAL 1999 2000 2001 2002 2003
- ------ ---- ---- ---- ---- ----
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
$1,769 $534 $525 $425 $268 $17
</TABLE>
10. SUBORDINATED DEBT
In November 1996, the Company consummated the IPO, pursuant to which it
issued 2.3 million shares of Common Stock at $10.00 per share. Concurrently with
the IPO, the Company issued $40.0 million of its Old Notes in an underwritten
public offering. The Company used approximately $13.9 million of the aggregate
net proceeds from these offerings to repay intercompany debt due to Mego
Financial and Preferred Equities Corporation ("PEC") and approximately $24.3
million to reduce the amounts outstanding under the Company's lines of credit.
The balance of the net proceeds has been used to originate loans. At August 31,
1997, $40.0 million principal amount of Old Notes were outstanding. Prepaid debt
expenses related to these notes was $2.4 million at August 31, 1997, and it was
being amortized over the term of the Old Notes. In October 1997, the Company
issued an additional $40.0 million of Old Notes in a private placement, which
increased the aggregate principal amount of outstanding Old Notes from $40.0
million to $80.0 million. The Company used the net proceeds to repay $3.9
million of debt due to Mego Financial, to reduce by $29.0 million the amounts
outstanding under the Company's
F-26
<PAGE> 140
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
lines of credit, and to provide capital to originate and securitize loans. The
Old Notes were subject to the Indenture governing all of the Company's
subordinated notes.
As part of the Recapitalization, the Company completed an offer to exchange
(the "Exchange Offer") new subordinated notes and Preferred Stock, subject to
certain limitations, for any and all of the outstanding $80.0 million principal
amount of the Company's Old Notes. The Exchange Offer was conditioned upon at
least $76.0 million aggregate principal amount of Old Notes being tendered for
exchange and conditioned upon at least $30.0 million shares of Common Stock and
Preferred Stock being sold in the offerings. The Company would not have
consummated the Exchange Offer if less than $30.0 million was raised in the
offerings. Pursuant to the Exchange Offer, the Company issued approximately
37,500 shares of Preferred Stock at $1,000 per share, and $41.5 million
principal amount of new 12.5% Subordinated Notes due 2001 (the "Current Notes")
in exchange for approximately $79.0 million principal amount of Old Notes. The
balance of the Old Notes were retired in September and October 1998.
Certain material covenant restrictions exist in the Indenture governing the
Current Notes. These covenants include limitations on the Company's ability to
incur indebtedness, grant liens on its assets and to enter into extraordinary
corporate transactions. The Company may not incur indebtedness if, on the date
of such incurrence and after giving effect thereto, the Consolidated Leverage
Ratio would exceed 1.5:1, subject to certain exceptions. At August 31 and
November 30, 1998, the Consolidated Leverage Ratio, as defined herein, was 2.4:1
and 2.0:1, respectively, and the Company could not incur any additional
indebtedness other than permitted indebtedness.
F-27
<PAGE> 141
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
11. INCOME TAXES
As described in Note 2, prior to the Spin-off, the Company recorded a
liability to Mego Financial for federal income taxes at the statutory rate
(currently 34%). State income taxes are computed at the appropriate state rate
(currently 3.5%) net of any available operating loss carryovers and are recorded
as state income taxes payable. Income tax expense (benefit) has been computed as
follows:
<TABLE>
<CAPTION>
FOR THE THREE
MONTHS ENDED
FOR THE YEARS ENDED AUGUST 31, NOVEMBER 30,
-------------------------------- ------------------
1996 1997 1998 1997 1998
-------- -------- ---------- -------- -------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
Income (loss) before
income taxes........... $11,155 $23,810 $(125,989) $(18,848) $(3,962)
======= ======= ========= ======== =======
Federal income taxes at
34% of income.......... $ 3,793 $ 8,095 (40,683) (6,408) (1,347)
Lost benefits due to
change in control...... -- -- 27,142 -- --
Valuation allowance...... -- -- 7,715 -- --
State income taxes, net
of federal income tax
benefit................ 442 943 (553) (746) (92)
Other.................... -- 24 45 7,154 (29)
------- ------- --------- -------- -------
Income tax expense
(benefit).............. $ 4,235 $ 9,062 $ (6,334) $ -- $(1,468)
======= ======= ========= ======== =======
Income tax expense
(benefit) is comprised
of the following:
Current................ $ 3,562 $12,319 $ (405) $ -- $(1,468)
Deferred............... 673 (3,257) (5,929) -- --
------- ------- --------- -------- -------
Total.......... $ 4,235 $ 9,062 $ (6,334) $ -- $(1,468)
======= ======= ========= ======== =======
</TABLE>
F-28
<PAGE> 142
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
Deferred income taxes reflect the net tax effects of (a) temporary
differences between the carrying amount of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes, (b) temporary
differences between the timing of revenue recognition for book purposes and
income tax purposes and (c) operating loss and tax credit carry forwards. The
tax effects of significant items comprising the Company's net deferred tax asset
are as follows:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
---------------------- ------------
1997 1998 1998
------- --------- ------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Deferred tax assets:
Realized gain on mortgage-related
securities...................... $2,373 $ 9,838 $ 9,948
Net operating loss carry forward... -- 6,002 7,547
Receivable due from carrybacks and
payments........................ -- 2,511 2,511
Other.............................. 91 -- 5
------ -------- --------
2,464 18,351 20,011
------ -------- --------
Deferred tax liabilities:
Provision for loan loss............ -- 2,196 2,239
Difference between book and tax
carrying value of assets........ 110 -- --
------ -------- --------
110 2,196 2,239
------ -------- --------
Net deferred tax asset before
valuation.......................... 2,354 16,155 17,772
------ -------- --------
Less valuation allowance............. -- (7,715) (7,864)
------ -------- --------
Net deferred tax asset............... $2,354 $ 8,440 $ 9,908
====== ======== ========
</TABLE>
Beginning September 1, 1997, the Company filed a separate tax return for
both federal and state tax purposes. On July 1, 1998, the Company had a change
in control as defined by Section 382 of the Internal Revenue Code. As a result
of this change in control, no material tax benefit is available to the Company
attributed to losses incurred prior to July 1, 1998. Accordingly, a deferred tax
asset has not been recorded for losses incurred prior to this date.
The Company has provided a partial valuation allowance against the net
deferred tax assets recorded as of August 31 and November 30, 1998 due to
uncertainties as to their ultimate realization. The net operating loss generated
subsequent to July 1, 1998 will expire in the year 2018. In the event of any
future ownership changes, Section 382 of the Internal Revenue Code imposes
certain restrictions on the amount of net operating loss carry forwards that can
be used in any year by the Company.
F-29
<PAGE> 143
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
12. STOCKHOLDERS' EQUITY
General In November 1996, additional paid-in capital was increased by $20.6
million due to the sale of 2.3 million shares of Common Stock, net of issuance
costs, in the IPO.
Prior to the Spin-off, the Company filed a consolidated federal income tax
return with Mego Financial's affiliated group under a Tax Allocation and
Indemnity Agreement ("Tax Agreement"). As a result of the Spin-Off, $2.4 million
due to Mego Financial under the Tax Agreement was recorded as a deferred tax
asset and as additional paid-in capital. Additionally, in April 1998, an
agreement was made to adjust by $6.2 million the income tax portion of a payable
that the Company owed Mego Financial under the Tax Agreement. The final
settlement of the $6.2 million is recorded as an additional capital contribution
as if the settlement occurred on the date of Spin-off.
In July 1998, the Company issued 62,500 shares of Preferred Stock and
approximately 18.27 million shares of Common Stock in the Recapitalization. As a
result, additional paid-in capital increased by $84.5 million.
Earnings Per Share Data utilized in calculating actual earnings per share
under SFAS 128 is as follows:
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
FOR THE YEARS ENDED AUGUST 31, NOVEMBER 30,
------------------------------- ----------------------------
1997 1998 1997 1998
------------- --------------- ------------ -------------
<S> <C> <C> <C> <C>
BASIC:
Net income (loss)...... $14,748,000 $(119,655,000) $(18,848,000) $ (2,494,000)
=========== ============= ============ =============
Weighted-average number
of common shares..... 11,802,192 15,502,926 12,300,000 30,566,666
=========== ============= ============ =============
DILUTED:
Net income (loss)...... $14,748,000 $(119,655,000) $(18,848,000) $ (2,494,000)
=========== ============= ============ =============
Weighted-average number
of common shares and
assumed
conversions.......... 11,802,192 15,502,926 12,300,000 30,566,666
=========== ============= ============ =============
</TABLE>
F-30
<PAGE> 144
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
The following tables reconcile the net income applicable to Common
Stockholders, basic and diluted shares, and EPS for the following periods:
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31, 1997 YEAR ENDED AUGUST 31, 1998
------------------------------------ --------------------------------------
PER-SHARE PER-SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
----------- ---------- --------- ------------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net income (loss)..... $14,748,000 $(119,655,000)
----------- -------------
BASIC EPS
Income (loss)
applicable to Common
Stockholders........ 14,748,000 11,802,192 $ 1.25 (119,655,000) 15,502,926 $(7.72)
----------- ---------- ------ ------------- ---------- ------
Effect of dilutive
securities:
Warrants............ -- -- -- -- -- --
Stock options....... -- -- -- -- -- --
----------- ---------- ------------- ----------
DILUTED EPS
Income (loss)
applicable to Common
Stockholders and
assumed
conversions......... $14,748,000 11,802,192 $ 1.25 $(119,655,000) 15,502,926 $(7.72)
=========== ========== ====== ============= ========== ======
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED THREE MONTHS ENDED
NOVEMBER 30, 1997 NOVEMBER 30, 1998
------------------------------------- --------------------------------------
PER-SHARE PER-SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
------------ ---------- --------- ------------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net (loss)........... $(18,848,000) $ (2,494,000)
------------ -------------
BASIC EPS
(Loss) applicable to
Common
Stockholders....... (18,848,000) 12,300,000 $(1.53) (2,494,000) 30,566,666 $(0.08)
------------ ---------- ------ ------------- ---------- ------
Effect of dilutive
securities:
Warrants........... -- -- -- -- -- --
Stock options...... -- -- -- -- -- --
------------ ---------- ------------- ----------
DILUTED EPS
(Loss) applicable to
Common Stockholders
and assumed
conversions........ $(18,848,000) 12,300,000 $(1.53) $ (2,494,000) 30,566,666 $(0.08)
============ ========== ====== ============= ========== ======
</TABLE>
Stock options after the years ended August 31, 1997 and 1998 and the three
month periods ended November 30, 1997 and 1998 are anti-dilutive. The earnings
per share for the year ended August 31, 1996 is not presented because the
Company was a wholly-owned subsidiary of Mego Financial Corporation.
13. STOCK OPTIONS
The Company has several stock option plans ("1996 Stock Option Plan" and
"1997 Stock Option Plan", collectively the "Stock Option Plans") for officers
and employees
F-31
<PAGE> 145
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
which provide for both incentive stock options and non-qualified incentive
options. The Company's Board of Directors (the "Board") determines the option
price (not to be less than fair value for incentive stock options) at the date
of grant. The options generally expire ten years from the date of grant and as a
result of a change in control of the Company, in conjunction with the
recapitalization, all options outstanding on June 28, 1998 became fully
exercisable. All other options granted subsequent to the recapitalization, are
exercisable at various points in time ranging from fully exercisable at grant
date to 33% increments over 3 years. In addition, the Board is authorized to
grant stock appreciation rights ("SARs") under the Stock Option Plans to any
person who has rendered services to the Company.
During August 1997, all stock options outstanding under the 1996 Stock
Option Plan were converted into SARs. As of August 31, 1997, an aggregate of
915,000 SARs were issued and outstanding under the 1996 Stock Option Plan. As a
result no SFAS 123 disclosures were required for the fiscal year ended August
31, 1997.
In October 1997, the Board voted to purchase all of the outstanding SARs
under the Stock Option Plans at $1.00 per share for SARs previously held at
$10.00 to $11.00 per share and $0.70 per share for SARs held at $12.00 per
share. During the year ended August 31, 1998, $761,250, (excluding payroll tax
items) was expensed related to the purchase of SARs.
Additionally, in October 1997, the Board voted, subject to stockholder
approval, to amend the Company's 1997 Stock Option Plan to increase the number
of shares of stock reserved for issuance upon the exercise of options to
purchase Common Stock granted from one million to two million shares.
F-32
<PAGE> 146
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
A summary of the stock options granted under the Stock Option Plans as of
August 31, 1997 and 1998 and the changes during the years ending on those dates
is presented below:
<TABLE>
<CAPTION>
AS OF AUGUST 31, 1997 AS OF AUGUST 31, 1998
----------------------------- ------------------------------
SHARES WEIGHTED-AVERAGE SHARES WEIGHTED AVERAGE
(000) EXERCISE PRICE (000) EXERCISE PRICE
---------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C>
Outstanding at
beginning of
year............... 0 $ 0 0 $ 0
Granted.............. 915,000 10.22 19,354,425 2.23
Exercised............ 0 0 0 0
Forfeited............ 915,000 10.22 620,000 14.75
Outstanding at end of
year............... 0 0 18,734,425 1.81
Options Exercisable
at year end........ 0 0 582,500 11.57
Weighted-average fair
value of options
granted during the
year............... $6,115,516 $24,238,512
</TABLE>
The following table summarizes information about stock options outstanding
at August 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------- ------------------------------
NUMBER WEIGHTED-AVERAGE NUMBER
RANGE OF OUTSTANDING REMAINING WEIGHTED-AVERAGE EXERCISABLE WEIGHTED-AVERAGE
EXERCISE PRICES AT 8/31/98 CONTRACTUAL LIFE EXERCISE PRICE AT 8/31/98 EXERCISE PRICE
--------------- ----------- ---------------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C> <C>
1.50 18,291,925 4.01 1.50 140,000 1.50
14.75 442,500 5.08 14.75 442,500 14.75
</TABLE>
SFAS 123 establishes financial accounting and reporting standards for
stock-based employee compensation plans and for transactions in which an entity
issues its equity instruments to acquire goods or services from non-employees.
Those transactions must be accounted for based on the fair value of the
considerations received or the fair value of the equity instruments issued,
whichever is more reliably measured. The Company elected to continue to apply
the provisions of Accounting Principles Bulletin ("APB") Opinion 25 as permitted
by SFAS 123 and accordingly, provides pro forma disclosure.
The fair value of each option granted during the year ended August 31, 1998
is estimated on the date of grant using the Black-Scholes option-pricing model
with the following assumptions: (1) dividend yield of zero; (2) expected
volatility of 48.9%; (3) risk-free interest rate of 5.45% and; (4) expected life
of two to ten years. The weighted average fair value of the options granted
during the year ended August 31, 1998 was $24,238,512. As of August 31, 1998,
there were 18,734,425 options outstanding which
F-33
<PAGE> 147
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
have an exercise price ranging from $1.50 to $14.75 per common share and a
weighted average contractual life of 4.21 years.
14. RETIREMENT PLAN
The Company participates in a defined contribution plan (the "Plan") with a
plan year end of December 31st. During fiscal 1996 and 1997, the Company
participated in PEC's defined contribution plan. Effective January 1, 1998, the
Company established its owned defined contribution plan. Employees may
contribute between 1% and 15% of their gross salary. The Company's matching
contribution equals 25% of the first 6% of gross salary that the participant
elects to contribute to the Plan. In addition, the Company may elect to make an
additional matching contribution or qualified nonelective contribution, as
defined in the Plan document, at its discretion. For the years ended August 31,
1996, 1997 and 1998 and the three months ended November 30, 1997 and 1998, the
Company contributed approximately $14,116, $24,779, $80,391, $22,715 and
$10,233, respectively, to the Plan.
15. RELATED PARTY TRANSACTIONS
Preferred Equity Corporation (PEC) During the years ended August 31, 1996,
1997 and 1998 and the three months ended November 30, 1997 and 1998, PEC, a
wholly owned subsidiary of Mego Financial, provided certain services to the
Company including loan servicing and collection for a cost of $709,000, $1.9
million, $2.2 million, $661,000 and $0, respectively, which is included in
general and administrative expense. In addition, PEC provided services including
executive, accounting, legal, management information, data processing, human
resources, advertising, and promotional materials (management services),
totaling $671,000, $967,000, $617,000, $242,000 and $0, which were included in
general and administrative expenses for the years ended August 31, 1996, 1997
and 1998, and the three months ended November 30, 1997 and 1998, respectively.
Included in other interest expense for the years ended August 31, 1996, 1997 and
1998, and the three months ended November 30, 1997 and 1998, are $29,000,
$16,000, $0, $0, and $0, respectively, related to advances from PEC.
During the year ended August 31, 1996, the Company paid PEC for developing
certain computer programming (see Note 8), incurring costs of $56,000. No such
costs were incurred during the years ended August 31, 1997 and 1998 and the
three months ended November 30, 1998. The Company is amortizing these costs over
a five year period. During fiscal 1996, 1997 and 1998 and the three months ended
November 30, 1997 and 1998, amortization of $29,000, $62,000, $62,000, $15,400
and $15,400, respectively, was included in expense. As of August 31, 1998, the
Company had terminated the management services and loan servicing agreement with
PEC.
Management believes the allocation methodologies and contractual
arrangements for services performed by PEC have been reasonable and are
representative of an approximation of the expense the Company would have
incurred had it operated as a stand alone entity performing such services.
F-34
<PAGE> 148
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
Mego Financial Corporation In April 1998, an agreement was made to reduce
by $5.3 million the income tax portion of a payable that the Company owed Mego
Financial under a Tax Allocation and Indemnity Agreement dated November 19,
1996. The Company filed a consolidated federal tax return with Mego Financial's
affiliated group prior to the Spin-off under such Tax Allocation and Indemnity
Agreement. The final settlement of the amount payable is recorded as an
additional capital contribution as if the settlement occurred on the date of the
Spin-off.
At August 31, 1996, 1997 and 1998, and November 30, 1998, the Company had a
non-interest bearing liability to Mego Financial of $12.0 million, $9.7 million,
$6.2 million and $0, respectively, for federal income taxes and cash advances
which is included in Accounts Payable in the accompanying Statements of
Financial Position.
Activity in Due to Mego Financial consists of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
--------------------------------
1996 1997 1998
--------- -------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year............... $ 8,453 $11,994 $ 9,653
Provision for federal income taxes......... 3,566 7,630 (5,284)
Cash advances from Mego Financial.......... 5,475 5,123 --
Forgiveness of advances.................... -- -- (869)
Repayment of advances...................... (5,500) (15,094) (3,500)
-------- ------- --------
Balance at end of year..................... $ 11,994 $ 9,653 $ 0
======== ======= ========
Average balance during the year............ $ 11,874 $ 6,876 $ 3,624
======== ======= ========
</TABLE>
Greenwich Capital Markets Champ Meyercord, the Company's Chairman of the
Board and Chief Executive Officer, was formerly a senior investment banker at
Greenwich Capital Markets ("Greenwich"). In October 1996, Greenwich agreed to
purchase $2.0 billion of loans over a five year period from the Company. The
Company has sold Greenwich approximately $800.0 million in loans from the
inception of the agreement. The agreement with Greenwich was terminated in June
1998 and the Company has no further obligation under the agreement.
In April 1997, the Company entered into a pledge and security agreement
with Greenwich for an $11.0 million revolving credit facility. The amount which
could be borrowed under the agreement was increased to $15.0 million in June
1997 and to $25.0 million in July 1997. As of August 31 and November 30, 1998,
approximately $10.0 million and $10.0 million was outstanding under the
agreement. Amounts borrowed under this facility are secured by certain of the
Company's mortgage-related securities. The Company was in default under the
first credit facility as a result of a default under the indenture governing the
Old Notes. The default was waived on December 2, 1998 effective August 31, 1998.
Additionally, the Company agreed to pay down the outstanding borrowings from
$10.0 million at August 31, 1998 to $6.0 million at December 31, 1998 and
subsequently agreed to pay the remaining $6.0 million in equal monthly payments
F-35
<PAGE> 149
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
during calendar 1999. As of November 30, 1998, the Company's net worth was $4.2
million above the minimal required and the debt-to-net worth ratio was 2.86:1.
The agreement, which was originally scheduled to mature in December 1998, was
extended until December 1999.
Friedman, Billings, Ramsey & Co., Inc. Friedman, Billings, Ramsey & Co.,
Inc. ("FBR") served as placement agent for the Old Notes pursuant to a placement
agreement (the "Placement Agreement"). Under the terms of the Placement
Agreement, the Company paid the placement agent a fee of 1.6 million shares of
common stock representing 6.0% of the gross proceeds received by the Company
from the shares of Common Stock and Preferred Stock in the Recapitalization. The
gross proceeds did not include $10.0 million of common stock acquired by an
affiliate of FBR received by the Company from the shares of common stock and
preferred stock in the Recapitalization. In addition, the Company has agreed,
pursuant to the Placement Agreement, to indemnify the Placement Agent against
certain liabilities, including liabilities under the Securities Act, and other
liabilities incurred in connection with the Recapitalization.
According to FBR, as of December 1, 1998, Friedman, Billings, Ramsey Group,
Inc. ("FBRG"), through its three wholly owned subsidiaries, Friedman, Billings,
Ramsey Investment Management, Inc. ("Investment Management"), FBR Offshore
Management, Inc. ("Offshore Management") and Orkney Holdings, Inc. ("Orkney"),
had sole voting and dispositive power with respect to 5,359,116 shares of Common
Stock. FBR has advised the Company that it may at any time hold long or short
positions in such securities. Investment Management serves as general partner
and discretionary investment manager for FBR Ashton, L.P. ("Ashton") which, as
of December 1, 1998, owned 824,187 shares of Common Stock. Offshore Management
serves as discretionary manager for FBR Opportunity Fund, Ltd. ("Opportunity
Fund") which, as of December 1, 1998, owned 82,622 shares of Common Stock. Each
of FBRG, Investment Management and Offshore Management disclaims beneficial
ownership of shares of Common Stock owned by the other two entities. Orkney is a
wholly owned subsidiary of FBRG which, as of December 1, 1998, owned 4,452,307
shares of Common Stock and 2,125 shares of Preferred Stock (which are
convertible into an aggregate of 1,416,673 shares of Common Stock). Each of
FBRG, Ashton, Opportunity Fund and Orkney disclaims beneficial ownership of
shares of Common Stock owned by the other three entities. In addition, Emmanuel
J. Friedman, Eric F. Billings and W. Russell Ramsey are each control persons
with respect to FBR. In addition, Emmanuel J. Friedman owns and has shared
voting and dispositive power with his wife over an additional 6,766,667 shares
of Common Stock.
In addition, FBR was a managing underwriter for the Company's initial
public offering and the Company's offering of the Current Notes, and was the
purchaser of Current Notes. FBR received compensation for such services and the
Company agreed to indemnify FBR against certain liabilities, including
liabilities under the Securities Act, and other liabilities arising in
connection with such offerings. In addition, FBR has in the past provided
certain investment banking services to the Company and affiliates of the
Company.
F-36
<PAGE> 150
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
During fiscal 1998, the Company paid FBR 1.6 million shares of common stock
for its fee in conjunction with the Recapitalization. Additionally, the Company
has reimbursed FBR for out-of-pocket expenses totaling approximately $250,000.
FBR is also entitled to a cash fee of $416,667 in connection with the
recapitalization.
Sovereign Bancorp and City Mortgage Services
As a result of their investment in the Company in the recapitalization,
both Sovereign Bancorp and City Mortgage Services have a substantial ownership
position in the Company. As part of the Recapitalization, the Company, entered
into agreements with Sovereign Bancorp, for a new $90.0 million warehouse line,
(subject to the availability of collateral), and a mortgage loan purchase and
sale commitment. As of August 31, 1998, the Company had not utilized the
Sovereign warehouse line. At November 30, 1998, approximately $14.9 million was
outstanding under the Sovereign warehouse line.
The Company also entered into an agreement with City Mortgage services to
acquire and service all of the mortgage loans that the Company owned at the date
of the Recapitalization at 90% of its carrying value for approximately $5.9
million. The Company, as a result, recorded an impairment of $703,225, which is
reflected in the accompanying Statement of Operations as a charge to Loan
Servicing Income. In addition, the Company and City Mortgage Services entered
into an agreement for City Mortgage Services to acquire and service all of the
mortgage loans produced or purchased by the Company after the Recapitalization
on a servicing-retained basis. During August 1998 and the three months ended
November 30, 1998, the Company paid City Mortgage Services approximately $9,000
and approximately $22,000, respectively, to service the Company's loans.
Other
In June 1998, the Company retained Spencer I. Browne, a member of the
Company's Board of Directors, as a special consultant to the Company. In
connection with certain business development activities of the Company during
the period beginning May 15, 1998 and ending December 31, 1998, the Company has
paid a total of approximately $177,500 to Strategic Asset Management, LLC for
Mr. Browne's services and reimbursement of out-of-pocket expenses. In addition,
the Company has tentatively agreed to grant Mr. Browne options to purchase
500,000 shares of the Company's common stock. The stock options have an exercise
price of equal to the cost of common stock in the Recapitalization of $1.50 per
share. During this period, Mr. Browne continued as a Director of the Company.
F-37
<PAGE> 151
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
16. COMMITMENTS AND CONTINGENCIES
Leases. The Company leases office space and equipment under operating
leases that expire at various dates through February 2003. The office space
lease is subject to an annual rent escalation of 2%. During fiscal 1996, 1997
and 1998, the Company's rent expense totaled $338,000, $1.2 million and $1.6
million respectively. Future minimum payments at August 31, 1998 under these
operating leases are set forth below (thousands of dollars):
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
- ------------------------------
<S> <C>
1999........................................................ $1,478
2000........................................................ 1,336
2001........................................................ 1,208
2002........................................................ 844
2003........................................................ 15
------
Total............................................. $4,881
======
</TABLE>
Litigation. On February 23, 1998, an action was filed in the United States
District Court for the Northern District of Georgia by Robert J. Feeney, as a
purported class action against the Company and its former President and Chief
Executive Officer. The complaint alleges, among other things, that the
defendants violated the federal securities laws in connection with the
preparation and issuance of certain of the Company's financial statements. The
named plaintiff seeks to represent a class consisting of purchasers of the
Common Stock between April 11, 1997 and December 18, 1997, and seeks damages in
an unspecified amount, costs, attorney's fees and such other relief as the court
may deem just and proper. Although the Company believes that it has meritorious
defenses and will vigorously defend the action, no assurance can be given as to
its outcome or effect on the Company's financial condition.
In the general course of business, the Company, at various times, has been
named in lawsuits. The Company believes that it has meritorious defenses to
these lawsuits and that resolution of these matters will not have a material
adverse affect on the business or financial condition, results of operation or
cash flows of the Company.
Other Commitments. In the first quarter of fiscal 1997, the Company
entered into an agreement with Greenwich Capital Markets providing for the
purchase of up to $2.0 billion of loans over a 5 year period. Pursuant to the
agreement, Mego Financial issued to Greenwich Capital Markets four-year warrants
to purchase 1 million shares of Mego Financial's Common Stock at an exercise
price of $7.125 per share. The value of the warrants of $3.0 million plus a
$150,000 fee (0.15% of the commitment amount) as of the commitment date (the
"Warrant Value"), were being amortized as the commitment for the purchase of
loans was utilized.
In December, 1997, an agreement was reached with Greenwich Capital Markets
in regards to various modifications to the master purchase agreement, in return
for which the Company agreed to pay $1.0 million in December 1997, with a
further $1.0 million to be paid in quarterly installments in 1998.
F-38
<PAGE> 152
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
As part of the Recapitalization, the Company terminated its existing master
purchase agreement with Greenwich Capital Markets. In connection with the
termination of this master purchase agreement, the remaining unamortized prepaid
commitment fees totaling approximately $2.8 million were written-off and are
reflected as a loss on the sale of loans in the Company's Statement of
Operations.
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosure about Fair Value of Financial Instruments" ("SFAS
107"), requires disclosure of estimated fair value information for financial
instruments, whether or not recognized in the Statements of Financial Condition.
Fair values are based upon estimates using present value or other valuation
techniques in cases where quoted market prices are not available. Those
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. In that regard, the derived
fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. SFAS 107 excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements. Accordingly, the aggregate fair
value amounts presented do not represent the underlying value of the Company.
Estimated fair values, carrying values and various methods and assumptions
used in valuing the Company's financial instruments at August 31, 1997 and 1998
and November 30, 1998 are set forth below:
<TABLE>
<CAPTION>
AUGUST 31, 1997 AUGUST 31, 1998 NOVEMBER 30, 1998
------------------------- ------------------------- -------------------------
CARRYING ESTIMATED FAIR CARRYING ESTIMATED FAIR CARRYING ESTIMATED FAIR
VALUE VALUE VALUE VALUE VALUE VALUE
-------- -------------- -------- -------------- -------- --------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C> <C>
FINANCIAL ASSETS:
Cash and cash
equivalents(a).... $ 6,104 $ 6,104 $36,404 $36,404 $30,010 $30,010
Loans held for sale,
net(b)............ 9,523 11,414 10,975 10,975 18,883 18,883
Mortgage-related
securities(c)..... 106,299 106,299 34,830 34,830 34,927 34,927
Mortgage-servicing
rights(c)......... 9,507 9,507 83 83 -- --
FINANCIAL LIABILITIES:
Notes and contracts
payable(d)........ 35,572 35,572 16,345 16,345 31,058 31,058
Subordinated
debt(e)........... 40,000 40,000 42,693 32,020 41,801 31,351
</TABLE>
- -------------------------
(a) Carrying value was used as the estimate of fair value as of August 31,
1997.
(b) Since it is the Company's business to sell loans it makes, the fair value
was estimated by using outstanding commitments from investors adjusted for
non-qualified loans and the collateral securing such loans.
F-39
<PAGE> 153
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
(c) The fair value was estimated by discounting future cash flows of the
instruments using discount rates, default, loss and prepayment assumptions
based upon available market data, opinions from investment bankers and
portfolio experience. As part of the Recapitalization, an agreement was
reached with City Mortgage Services for the sale of the Mortgage Servicing
Rights at 90% of their computed carrying value. The Company, as a result,
recorded an impairment of $703,225, which is reflected in the accompanying
Statement of Operations as a charge to Loan Servicing Income.
(d) Notes payable generally are adjustable rate, indexed to the prime rate;
therefore, carrying value approximates fair value. Contracts payable
represent capitalized equipment leases with a weighted-average interest
rate of 9.32% at August 31, 1997, 9.25% at August 31, 1998 and 9.24% at
November 30, 1998, which approximates fair value.
(e) The fair value was calculated based upon estimated market prices obtained
from investment bankers.
At August 31, 1997 and 1998, the Company had $190.5 million and $3.6
million, respectively, in outstanding commitments to originate and purchase
loans. The fair value of the commitments was estimated at $14.9 million at
August 31, 1997 and $145,000 at August 31, 1998. The fair values were calculated
based on a theoretical gain or loss on the sale of a funded loan adjusted for an
estimate of loan commitments not expected to fund, considering the difference
between investor yield requirements and the committed loan rates. The estimated
fair value is not necessarily representative of the actual gain to be recorded
on such loan sales in the future.
The fair value estimates made at August 31, 1997 and 1998 and November 30,
1998 were based upon pertinent market data and relevant information on the
financial instruments at that time. These estimates do not reflect any premium
or discount that could result from the sale of the entire portion of the
financial instruments. Because no market exists for a substantial portion of the
financial instruments, fair value estimates are based upon judgments regarding
future expected loss experience, current economic conditions, risk
characteristics of various financial instruments and other factors. These
estimates are subjective in nature and involve uncertainties and matters of
significant judgment and therefore cannot be determined with precision. Changes
in assumptions could significantly affect the estimates. The Company had no
other off-balance sheet instruments at August 31, 1997 and 1998 and November 30,
1998.
Fair value estimates are based upon existing on-and off-balance sheet
financial instruments without attempting to estimate the value of anticipated
future business and the value of assets and liabilities that are not considered
financial instruments. [For instance, the Company has certain fee-generating
business lines (e.g., its loan servicing operations) that were not considered in
these estimates since these activities are not financial instruments.] In
addition, the tax implications related to the realization of the unrealized
gains and losses can have a significant effect on fair value estimates and have
not been considered in any of the estimates.
F-40
<PAGE> 154
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
18. CONCENTRATIONS OF RISK
Availability of Funding Source -- The Company funds substantially all of
the loans which it produces or purchases with borrowings through its financing
facilities and internally generated funds, as well as public and private sales
of debt and equity securities. These borrowings are in turn repaid with the
proceeds received by the Company from selling such loans through loan sales or
securitizations. Any failure to renew or obtain adequate financing under its
financing facilities, or other borrowings, or any substantial reduction in the
size of or pricing in the markets for the Company's loans, could have a material
adverse effect on the Company's operations. To the extent that the Company is
not successful in maintaining or replacing its existing financing, it would have
to curtail its loan production activities or sell loans earlier than is optimal,
thereby having a material adverse effect on the Company's financial condition,
results of operations and cash flows.
Dependence on Securitizations -- In 1996, 1997 and to a lesser extent in
1998, the Company pooled and sold through securitizations a significant
percentage of the loans that it produced. The Company historically has derived a
significant portion of its income by recognizing gains on sale of loans through
securitizations. Adverse changes in the securitization market could impair the
Company's ability to sell loans through securitizations on a favorable or timely
basis. Any such impairment could have a material adverse effect upon the
Company's financial condition , results of operations and cash flows.
The Company has relied on credit enhancement and over-collateralization to
generally achieve the "AAA/Aaa" rating for the senior interests in its
securitizations. The credit enhancement has generally been in the form of an
insurance policy issued by an insurance company insuring the timely repayment of
senior interests in each of the trusts. The Company's last three securitizations
were completed without the requirement of an insurance policy. There can be no
assurance that the Company will be able to obtain credit enhancement in any form
from the current insurer or any other provider of credit enhancement on
acceptable terms or that future securitizations will be similarly rated. A
downgrading of the insurer's credit rating or its withdrawal of credit
enhancement could have a material adverse effect on the Company's financial
condition, results of operations and cash flows.
Geographic Concentrations -- The Company's servicing portfolio and loans
sold with recourse are geographically diversified within the United States. At
August 31, 1997 and 1998, 26% of the loans in the Company's portfolio had been
produced in California, and 15% in Florida. No other state accounted for more
than 10% of the servicing portfolio for either period. The risk inherent in such
concentrations is dependent upon regional and general economic stability which
affects property values and the financial stability of the borrowers.
Credit Risk -- The Company is exposed to on-balance sheet credit risk
related to its loans held for sale and mortgage-related securities. The Company
is exposed to off-balance sheet credit risk related to loans which the Company
has committed to originate and loans sold under recourse provisions. The
outstanding balance of loans sold with recourse
F-41
<PAGE> 155
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
provisions totaled $88.2 million and $87.4 million at August 31, 1997 and 1998,
respectively.
Off-Balance Sheet Activities -- These financial instruments consist of
commitments to extend credit to borrowers and commitments to purchase loans from
others. As of August 31, 1997 and 1998, the Company had outstanding commitments
to extend credit or purchase loans in the amounts of $190.5 million and $3.6
million, respectively. These commitments do not represent the expected total
cash outlay of the Company, as historically only 40% of these commitments result
in loan production or purchases. The prospective borrower or seller is under no
obligation as a result of the Company's commitment. The Company's credit and
interest rate risk is therefore limited to those commitments which result in
loan production and purchases. The commitments are made for a specified fixed
rate of interest, therefore the Company is exposed to interest rate risk, to the
extent changes in market interest rates change prior to the origination and
prior to the sale of the loan.
Interest Rate Risk -- The Company's profitability is in part determined by
the difference, or "spread," between the effective rate of interest received on
the loans produced or purchased by the Company and the interest rates payable
under its financing facilities during the warehousing period and yield required
by investors on loan sales and securitizations. The spread can be adversely
affected after a loan is produced or purchased and while it is held during the
warehousing period by increases in the interest rate demanded by investors in
securitizations or sales. In addition, because the loans produced and purchased
by the Company have fixed rates, the Company bears the risk of narrowing spreads
because of interest rate increases during the period from the date the loans are
produced or purchased until the closing of the sale or securitization of such
loans. Additionally, the fair value of mortgage related securities and mortgage
servicing rights owned by the Company may be adversely affected by changes in
the interest rate environment which could effect the discount rate and
prepayment assumptions used to value the assets. Any such adverse change in
assumptions could have a material adverse effect on the Company's financial
condition, results of operations and cash flows.
19. SUBSEQUENT EVENTS
In September and October 1998, the Company repurchased the remaining
$250,000 and $651,000, respectively, principal amounts of the Old Notes issued
November 22, 1996 for 101% of the principal balance and accrued interest at
13.5%.
On October 2, 1998, an action was filed in the United States District Court
for the Western Division of Tennessee by Traci Parris, as a purported class
action against Mortgage Lenders Association Inc., the Company and City Mortgage
Services, Inc., one of the Company's strategic partners. The complaint alleges,
among other things that the defendants charged interest rates, origination fees,
and loan brokerage commissions in excess of those allowed by law. The named
plaintiff seeks to represent a class of borrowers and seeks damages in an
unspecified amount, reform or nullification of loan agreements, injunction,
costs, attorney's fees and such other relief as the court may deem just and
F-42
<PAGE> 156
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
proper. On October 27, 1998, the Company filed a motion to dismiss the
complaint, The Company believes it has meritorious defenses to this lawsuit and
that any resolution of this matter will not result in a material adverse effect
on the business or financial condition of the Company.
On October 8, 1998, the Office of the Consumer Credit Commissioner of the
State of Texas issued a denial of the Company's application for licensing as a
secondary mortgage lender. On October 20, 1998, the Company filed an appeal of
the Commissioner's decision and an administrative hearing has been set for
December 3, 1998. The administrative hearing, originally set for December 3,
1998, was postponed and no new hearing date has been scheduled. The denial will
not become final until the Company's appeal has been resolved. The Company
believes that it is capable of meeting such requirements as the Commissioner may
set to amend the Company's license application. If the denial becomes final, the
Company will not be able to make secondary mortgage loans in the State of Texas
at interest rates greater than 10%. The Company is not required to hold a
secondary mortgage lender license in order to continue to produce or acquire
first mortgage loans. The Company believes that any resolution of this matter
will not result in a material adverse effect on the business or financial
condition of the Company.
On December 1, 1998, the Company completed a 39.4% reduction in its
workforce, the majority of which were loan production and administrative
personnel. The Company believes that its remaining workforce is adequate to meet
its needs for the foreseeable future.
The Company entered into an agreement to purchase certain assets of LL
Funding Corp., a privately-held loan origination company headquartered in
Columbia, Maryland on December 15, 1998. Through December 31, 1998, the Company
had purchased from LL Funding Corp. approximately $16.2 million principal amount
of loans at a purchase price of 102.75%. In addition, the Company had advanced
approximately $1.3 million to LL Funding Corp. to fund their operations. On
January 4, 1999, the Company terminated the asset purchase agreement pursuant to
provisions contained therein. LL Funding Corp. has disputed the Company's right
to terminate the asset purchase agreement, and on January 11, 1999, the Company
filed suit asking that the court declare that the Company properly terminated
the asset purchase agreement and is not liable to LL Funding Corp. as a result
of such termination.
The Company, on January 8, 1999, consummated the purchase of substantially
all of the operating assets of a retail, sub-prime loan production facility
located in Las Vegas, Nevada from FirstPlus Financial, Inc. for approximately
$3.25 million in cash.
F-43
<PAGE> 157
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
20. QUARTERLY FINANCIAL DATA (UNAUDITED)
The following tables reflect quarterly financial data for the Company.
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
--------------------------------------------------
NOVEMBER 30, FEBRUARY 29, MAY 31, AUGUST 31,
1995 1996 1996 1996
------------ ------------ ------- ----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenues:
Gain on sale of loans and net
unrealized gain on
mortgage-related securities..... $5,965 $4,845 $2,151 $6,275
Interest income (expense), net..... 138 (3) 403 450
Loan-servicing income, net......... 891 870 1,288 299
------ ------ ------ ------
Total revenues............. 6,994 5,712 3,842 7,024
------ ------ ------ ------
Expenses:
Operating expenses................. 2,805 2,882 3,305 3,203
Net provision (benefit) for credit
losses.......................... 297 200 (524) 82
Interest........................... 47 31 42 47
------ ------ ------ ------
Total expenses............. 3,149 3,113 2,823 3,332
------ ------ ------ ------
Income before income taxes........... 3,845 2,599 1,019 3,692
Income tax expense................... 1,538 1,040 255 1,402
------ ------ ------ ------
Net income........................... $2,307 $1,559 $ 764 $2,290
====== ====== ====== ======
</TABLE>
F-44
<PAGE> 158
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
-------------------------------------------------------
NOVEMBER 30, FEBRUARY 28, MAY 31, AUGUST 31,
1996 1997 1997 1997
------------ ------------ ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenues:
Gain on sale of loans and
net unrealized gain on
mortgage-related
securities............... $ 9,366 $ 8,966 $ 15,532 $ 14,777
Interest income, net........ 355 526 1,137 1,115
Loan-servicing income,
net...................... 638 560 726 1,112
----------- ----------- ----------- -----------
Total revenues...... 10,359 10,052 17,395 17,004
----------- ----------- ----------- -----------
Expenses:
Operating expenses.......... 4,589 5,352 6,274 8,240
Net provision (benefit) for
credit losses............ 1,711 (800) 4,108 1,281
Interest.................... 47 51 122 25
----------- ----------- ----------- -----------
Total expenses...... 6,347 4,603 10,504 9,546
----------- ----------- ----------- -----------
Income before income taxes.... 4,012 5,449 6,891 7,458
Income tax expense............ 1,533 2,078 2,619 2,832
----------- ----------- ----------- -----------
Net income.................... $ 2,479 $ 3,371 $ 4,272 $ 4,626
=========== =========== =========== ===========
Earnings per share:
Basic....................... $ 0.24 $ 0.27 $ 0.35 $ 0.38
=========== =========== =========== ===========
Diluted..................... $ 0.24 $ 0.27 $ 0.35 $ 0.38
=========== =========== =========== ===========
Weighted-average number of
shares outstanding:
Basic....................... 10,317,102 12,476,069 12,379,368 12,300,000
=========== =========== =========== ===========
Diluted..................... 10,319,051 12,544,291 12,379,368 12,300,000
=========== =========== =========== ===========
</TABLE>
F-45
<PAGE> 159
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
AND THE UNAUDITED THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
----------------------------------------------------------------------
NOVEMBER 30, FEBRUARY 28, MAY 31, AUGUST 31, NOVEMBER 30,
1997 1998 1998 1998 1998
------------ ------------ ----------- ----------- ------------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
Revenues:
(Loss) Gain on sale of
loans and net
unrealized gain (loss)
on mortgage-related
securities............ $ (9,387) $ (5,564) $ (44,731) $ (36,920) $ 442
Interest income
(expense), net........ 1,210 684 132 (402) (162)
Loan-servicing income,
net................... 1,194 1,310 (1,367) (138) 240
----------- ----------- ----------- ----------- -----------
Total revenues
(losses)....... (6,983) (3,570) (45,966) (37,460) 520
----------- ----------- ----------- ----------- -----------
Expenses:
Operating expenses...... 10,198 9,265 7,984 7,322 4,397
Net provision (benefit)
for credit losses..... 1,590 706 108 (5,602) 43
Interest................ 77 150 103 109 42
----------- ----------- ----------- ----------- -----------
Total expenses... 11,865 10,121 8,195 1,829 4,482
----------- ----------- ----------- ----------- -----------
Loss before income
taxes................... (18,848) (13,691) (54,161) (39,289) (3,962)
Income tax expense
(benefit)............... (7,153) 7,153 -- (6,334) (1,468)
----------- ----------- ----------- ----------- -----------
Net (loss)................ $ (11,695) $ (20,844) $ (54,161) $ (32,955) $ (2,494)
=========== =========== =========== =========== ===========
Loss per share:
Basic................... $ (0.95) $ (1.69) $ (4.40) $ (1.32) $ (0.08)
=========== =========== =========== =========== ===========
Diluted................. $ (0.95) $ (1.69) $ (4.40) $ (1.32) $ (0.08)
=========== =========== =========== =========== ===========
Weighted-average number of
shares outstanding:
Basic................... 12,300,000 12,300,000 12,300,000 25,007,247 30,566,666
=========== =========== =========== =========== ===========
Diluted................. 12,300,000 12,300,000 12,300,000 25,007,247 30,566,666
=========== =========== =========== =========== ===========
</TABLE>
F-46
<PAGE> 160
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
THE COMPANY HAS NOT AUTHORIZED ANY PERSON TO MAKE A STATEMENT THAT DIFFERS
FROM WHAT IS IN THIS PROSPECTUS. IF ANY PERSON DOES MAKE A STATEMENT THAT
DIFFERS FROM WHAT IS IN THIS PROSPECTUS, YOU SHOULD NOT RELY ON IT. THIS
PROSPECTUS IS NOT AN OFFER TO SELL, NOR IS IT SEEKING AN OFFER TO BUY, THESE
SECURITIES IN ANY STATE WHERE THE OFFER OR SALE IS NOT PERMITTED. THE
INFORMATION IN THIS PROSPECTUS IS COMPLETE AND ACCURATE AS OF ITS DATE, BUT THE
INFORMATION MAY CHANGE AFTER THAT DATE.
MEGO MORTGAGE CORPORATION
(MEGO MORTGAGE LOGO)
70,688,838 SHARES
COMMON STOCK
($.01 PAR VALUE)
PROSPECTUS
February 2, 1999
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE> 161
PART II
INFORMATION NOT REQUIRED IN THE PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION
The following are the estimated expenses in connection with the issuance
and distribution of the securities being registered, all of which will be paid
by the Company.
<TABLE>
<S> <C>
Securities and Exchange Commission registration fee......... $ 11,831
Nasdaq National Market listing fee.......................... 17,500
Blue Sky qualification fees and expenses.................... 2,000
Printing and engraving expenses............................. 150,000
Legal fees and expenses..................................... 150,000
Accounting fees and expenses................................ 100,000
Miscellaneous............................................... 68,669
--------
Total............................................. $500,000
========
</TABLE>
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
Section 145 of the General Corporation Law of the State of Delaware
("DGCL") provides that a corporation has the power to indemnify any director or
officer, or former director or officer, who was or is a party or is threatened
to be made a party to any threatened, pending or completed action, suit or
proceeding, whether civil, criminal, administrative or investigative (other than
an action by or in the right of the corporation) against the expenses,
(including attorney's fees), judgments, fines or amounts paid in settlement
actually and reasonably incurred by them in connection with the defense of any
action by reason of being or having been directors or officers, if such person
shall have acted in good faith and in a manner reasonably believed to be in or
not opposed to the best interests of the corporation, and, with respect to any
criminal action or proceeding, provided that such person had no reasonable cause
to believe his conduct was unlawful, except that, if such action shall be in the
right of the corporation, no such indemnification shall be provided as to any
claim, issue or matter as to which such person shall have been judged to have
been liable to the corporation unless and to the extent that the Court of
Chancery of the State of Delaware, or any court in which such suit or action was
brought, shall determine upon application that, in view of all of the
circumstances of the case, such person is fairly and reasonably entitled to
indemnity for such expenses as such court shall deem proper.
As permitted by Section 102(b)(7) of the DGCL, the Amended and Restated
Certificate of Incorporation of the Company (filed herewith as Exhibit 3.2) (the
"Restated Certificate of Incorporation") provides that no director shall be
liable to the Company or its stockholders for monetary damages for breach of
fiduciary duty as a director other than (i) for breaches of the director's duty
of loyalty to the Company and its stockholders, (ii) for acts or omissions not
in good faith or which involve intentional misconduct or a knowing violation of
law, (iii) for the unlawful payment of dividends or unlawful stock purchases or
redemptions under Section 174 of the DGCL, and (iv) for any transaction from
which the director derived an improper personal benefit.
The Company's Bylaws provide indemnification of the Company's directors and
officers, both past and present, to the fullest extent permitted by the DGCL,
and allow the Company to advance or reimburse litigation expenses upon
submission by the director or
II-1
<PAGE> 162
officer of an undertaking to repay such advances or reimbursements if it is
ultimately determined that indemnification is not available to such director or
officer pursuant to the Bylaws. The Company's Bylaws also authorize the Company
to purchase and maintain insurance on behalf of an officer or director, past or
present, against any liability asserted against him in any such capacity whether
or not the Company would have the power to indemnify him against such liability
under Section 145 of the DGCL.
The Company has entered into indemnification agreements with each of its
directors and certain of its executive officers. The indemnification agreements
require the Company, among other things, to indemnify such directors and
officers against certain liabilities that may arise by reason of their status or
service as directors or officers (other than liabilities arising from willful
misconduct of a culpable nature), and to advance their expenses incurred as a
result of any preceding against them as to which they could be indemnified.
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES
On July 1, 1998, the Company completed a private placement of 25,000 shares
of Series A convertible preferred stock (the "Series A Preferred Stock") and
18,266,667 shares of common stock to a number of qualified institutional
investors, as defined under Rule 144A under the Securities Act, and to other
accredited investors, as defined in Rule 501 under Regulation D ("Rule 501").
These sales were conducted pursuant to Rule 506 under Regulation D ("Rule 506").
The aggregate purchase price of the Series A Preferred Stock was $25.0 million,
and the aggregate purchase price of the common stock was $25.0 million.
Friedman, Billings, Ramsey & Co. ("FBR") acted as the placement agent for
the preferred stock and the common stock. Under a placement agreement between
FBR and the Company, the Company issued FBR 1.6 million shares of common stock.
This issuance was conducted pursuant to Rule 506.
In addition, on July 1, 1998, the Company issued 37,500 shares of preferred
stock and $41.5 million principal amount of a new series of 12 1/2% Subordinated
Notes due 2001 (the "Current Notes") in exchange for approximately $79.0 million
of 12 1/2% Subordinated Notes due 2001 (the "Old Notes"). The Exchange Offer was
conducted pursuant to Rule 506.
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a) Exhibits:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- -------- -----------
<C> <C> <S>
3.1(1) -- Amended and Restated Certificate of Incorporation of the
Company.
3.2(1) -- By-laws of the Company, as amended.
4.1(1) -- Specimen Common Stock Certificate.
5.1 -- Opinion of King & Spalding regarding the validity of the
shares being registered
10.1(1) -- 1996 Stock Option Plan.
10.2(1) -- Office Lease by and between Mass Mutual and the Company
dated April 1996.
</TABLE>
II-2
<PAGE> 163
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- -------- -----------
<C> <C> <S>
10.3(2) -- Credit Agreement between the Company and Textron Financial
Corporation dated October 22, 1997.
10.4(2) -- Excess Yield and Servicing Rights and Assumption Agreement
between the Company and Greenwich Capital Markets, Inc.
dated January 22, 1998
10.5(2) -- Agreement between the Company and Preferred Equities
Corporation, dated February 9, 1998, regarding assignment of
rights related to the Loan Program Sub-Servicing Agreement
to Greenwich Capital Markets, Inc.
10.6(2) -- Amendment to Excess Yield and Servicing Rights and
Assumption Agreement between the Company and Greenwich
Capital Markets, Inc. dated February 10, 1998
10.7(2) -- Second Amendment to Excess Yield and Servicing Rights and
Assumption Agreement between the Company and Greenwich
Capital Markets, Inc. dated February, 1998
10.8(3) -- Preferred Stock Purchase Agreement dated as of June 9, 1998
between City National Bank of West Virginia and Mego
Mortgage Corporation
10.9(3) -- Stock Option Agreement dated as of June 29, 1998 by Mego
Mortgage Corporation in favor of City National Bank of West
Virginia
10.10(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and City National Bank of
West Virginia*
10.11(3) -- Bulk Servicing Purchase Agreement dated as of June 26, 1998
between City National Bank of West Virginia and Mego
Mortgage Corporation
10.12(3) -- Servicing Agreement dated as of June 26, 1998 between Mego
Mortgage Corporation and City Mortgage Services
10.13(3) -- Subservicing Agreement dated as of June 29, 1998 between
Mego Mortgage Corporation and City Mortgage Services
10.14(3) -- City Mortgage Services Option Agreement dated as of June 29,
1998 between City National Bank of West Virginia and Mego
Mortgage Services
10.15(3) -- Right of First Refusal Agreement dated as of June 29, 1998
among City National Bank of West Virginia, Sovereign
Bancorp, Inc. and Mego Mortgage Corporation
10.16(3) -- Preferred Stock Purchase Agreement dated as of June 9, 1998
between Mego Mortgage Corporation and Sovereign Bancorp,
Inc.
10.17(3) -- Stock Option Agreement Dated as of June 29, 1998 by Mego
Mortgage Corporation in favor of Sovereign Bancorp, Inc.
10.18(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation in favor of Sovereign
Bancorp, Inc.
10.19(4) -- Participation Agreement dated as of June 29, 1998 between
Mego Mortgage Corporation and Sovereign Bank
10.20(4) -- Master Mortgage Loan Purchase Agreement dated as of June 29,
1998 between Sovereign Bank and Mego Mortgage Corporation
10.21(4) -- Form of Custodian Agreement dated as of June 29, 1998 among
Sovereign Bank, State Street Bank and Trust Company and Mego
Mortgage Corporation
</TABLE>
II-3
<PAGE> 164
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- -------- -----------
<C> <C> <S>
10.22(4) -- Common Stock Purchase Agreement dated as of June 9, 1998
between Mego Mortgage Corporation and Emanuel J. Friedman
10.23(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and Emanuel J. Friedman
10.24(4) -- Indenture dated as of June 29, 1998 between Mego Mortgage
Corporation and American Stock Transfer & Trust Company, as
Trustee
10.25(4) -- Form of Note issued pursuant to Indenture dated as of June
29, 1998 between Mego Mortgage Corporation and American
Stock Transfer & Trust Company, as Trustee
10.26(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and Friedman, Billings,
Ramsey & Co., Inc., as placement agent
10.27(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and Friedman, Billings,
Ramsey & Co., Inc., as placement agent
10.28(4) -- Certificate of Designations, Preferences and Rights of
Series A Convertible Preferred Stock of Mego Mortgage
Corporation
10.29(3) -- Co-Sale Agreement dated as of June 29, 1998 among Mego
Mortgage Corporation, Emanuel J. Friedman, Friedman,
Billings, Ramsey & Co., Inc., City National Bank of West
Virginia and Sovereign Bancorp, Inc.
10.30(4) -- Employment Agreement dated June 23, 1998 between Mego
Mortgage Corporation and Edward B. "Champ" Meyercord
10.31 -- Form of Director Indemnification Agreement
21.1(5) -- Subsidiaries of the Registrant
23.1 -- Consent of King & Spalding (contained in Exhibit 5.1)
23.2 -- Consent of Deloitte & Touche LLP
24.1(6) -- Power of Attorney
</TABLE>
- -------------------------
(1) Filed as part of the Registration Statement on Form S-1 filed by the
Company, as amended (File No. 333-12443), and incorporated herein by
reference.
(2) Filed as part of the Form 10-Q for the quarter ended February 28, 1998 and
incorporated herein by reference.
(3) Filed as part of the Form 10-Q for the quarter ended May 31, 1998 and
incorporated herein by reference.
(4) Filed as part of the Form 10-Q/A for the quarter ended May 31, 1998.
(5) Filed as part of the Form 10-K for the year ended August 31, 1998.
(6) Previously filed.
(b) Financial Statement Schedules of Mego Mortgage Corporation.
All schedules are omitted because the information is not required or
because the information is included in the combined financial statements or
notes thereto.
II-4
<PAGE> 165
ITEM 17. UNDERTAKINGS.
The Company hereby undertakes:
(1) To file, during any period in which offers or sales are being
made, a post-effective amendment to this registration statement:
(i) To include any prospectus required by Section 10(a)(3) of the
Securities Act of 1993;
(ii) To reflect in the prospectus any facts or events arising after
the effective date of the registration statement (or the most recent
post-effective amendment thereof) which, individually or in the
aggregate, represent a fundamental change in the information set forth
in the registration statement. Notwithstanding the foregoing, any
increase or decrease in volume of securities offered (if the total
dollar value of securities offered would not exceed that which was
registered) and any deviation from the low or high end of the estimated
maximum offering range may be reflected in the form of prospectus filed
with the Commission pursuant to Rule 424(b) if, in the aggregate, the
changes in volume and price represent no more than 20 percent change in
the maximum aggregate offering price set forth in the "Calculation of
Registration Fee" table in the effective registration statement.
(iii) To include any material information with respect to the plan
of distribution not previously disclosed in the registration statement
or any material change to such information in the registration
statement;
(2) That, for the purpose of determining any liability under the
Securities Act of 1933, each such post-effective amendment shall be deemed
to be a new registration statement relating to the securities offered
therein, and the offering of such securities at that time shall be deemed
to be the initial bona fide offering thereof.
(3) To remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons of the Company
pursuant to the provisions referred to in Item 14 or otherwise, the Company has
been advised that in the opinion of the Commission such indemnification is
against the public policy as expressed in the Securities Act and is, therefore,
unenforceable. In the event that a claim for indemnification against such
liabilities (other than the payment by the Company of expenses incurred or paid
by a director, officer or controlling person of the Company in the successful
defense of any action, suit or proceeding) is asserted by such director, officer
or controlling person in connection with the securities being registered, the
Company will, unless in the opinion of its counsel the matter has been settled
by controlling precedent, submit to a court of appropriate jurisdiction the
question whether such indemnification by it is against public policy as
expressed in the Securities Act and will be governed by the final adjudication
of such issue.
II-5
<PAGE> 166
The Company hereby undertakes that:
1. For purposes of determining any liability under the Securities Act,
the information omitted from the form of prospectus filed as part of this
Registration Statement in reliance upon Rule 430A and contained in a form
of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or
497(h) under the Securities Act shall be deemed to be a part of this
Registration Statement as of the time it was declared effective.
2. For the purpose of determining any liability under the Securities
Act, each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall be
deemed to be the initial bona fide offering thereof.
II-6
<PAGE> 167
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized in the City of Atlanta, State of Georgia
on January 29, 1999.
MEGO MORTGAGE CORPORATION
By: /s/ EDWARD B. MEYERCORD
-----------------------------------
Edward B. Meyercord
Chairman and Chief Executive
Officer
Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed below by the following persons in the
capacities indicated on this 29th day of January, 1999.
<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<C> <S>
/s/ EDWARD B. MEYERCORD Chairman and Chief Executive Officer
- ---------------------------------------- (Principal Executive Officer)
Edward B. Meyercord
/s/ J. RICHARD WALKER Executive Vice President and Chief
- ---------------------------------------- Financial Officer (Principal Financial
J. Richard Walker Officer)
/s/ WM. PAUL RALSER Director, President and Chief Operating
- ---------------------------------------- Officer
Wm. Paul Ralser
/s/ SPENCER I. BROWNE* Director
- ----------------------------------------
Spencer I. Browne
/s/ HUBERT M. STILES, JR.* Director
- ----------------------------------------
Hubert M. Stiles, Jr.
/s/ DAVID J. VIDA, JR.* Director
- ----------------------------------------
David J. Vida, Jr.
/s/ JOHN D. WILLIAMSON, JR.* Director
- ----------------------------------------
John D. Williamson, Jr.
*By: /s/ EDWARD B. MEYERCORD
- ----------------------------------------
Edward B. Meyercord
As Attorney-in-Fact
</TABLE>
II-7
<PAGE> 1
EXHIBIT 5.1
January 29, 1999
Mego Mortgage Corporation
1000 Parkwood Circle
6th Floor
Atlanta, Georgia 30339
Re: Mego Mortgage Corporation - Common Stock
Ladies and Gentlemen:
We have acted as counsel for Mego Mortgage Corporation, a Delaware
corporation (the "Company"), in connection with the registration under the
Securities Act of 1933, as amended, of Shares of Common Stock (the "Shares")
pursuant to a Registration Statement dated January 27, 1999.
In connection with this opinion, we have examined and relied upon such
records, documents, certificates and other instruments as in our judgment are
necessary or appropriate to form the basis for the opinions hereinafter set
forth. In all such examinations, we have assumed the genuineness of signatures
on original documents and the conformity to such original documents of all
copies submitted to us as certified, conformed or photographic copies, and as to
certificates of public officials, we have assumed the same to have been properly
given and to be accurate. As to matters of fact material to this opinion, we
have relied upon statements and representations of representatives of the
Company and of public officials.
This opinion is limited in all respects to the federal laws of the
United States of America and the laws of the State of Delaware, and no opinion
is expressed with respect to the laws of any other jurisdiction or any effect
which such laws may have on the opinions expressed herein. This opinion is
limited to the matters stated herein, and no opinion is implied or may be
inferred beyond the matters expressly stated herein.
Based upon the foregoing, and the other limitations and qualifications
set forth herein, we are of the opinion that:
(i) The Company is a corporation validly existing and, based
solely on a certificate of the Secretary of State of the State of
Delaware, in good standing under the laws of the State of Delaware.
(ii) The Shares previously issued by the Company, as
described in the Registration Statement, are validly issued, fully paid
and nonassessable.
<PAGE> 2
Mego Mortgage Corporation
January 29, 1999
Page 2
(iii) When issued in accordance with the terms of the Company's
Series A convertible preferred stock (the "Preferred Stock"), the Shares issued
upon conversion of the Preferred Stock will be validly issued, fully paid and
nonassessable.
The opinions set forth above are subject, as to enforcement, to (i)
bankruptcy, insolvency, reorganization, moratorium and other similar laws
relating to or affecting the enforcement of creditors' rights generally, and
(ii) general equitable principles (regardless of whether enforcement is
considered in a proceeding in equity or law).
This opinion is given as of the date hereof, and we assume no
obligation to advise you after the date hereof of facts or circumstances that
come to our attention or changes in law that occur which could affect the
opinions contained herein. This letter is being rendered solely for the benefit
of the Company in connection with the matters addressed herein. This opinion may
not be finished to or relied upon by any person or entity for any purpose
without our prior written consent.
We hereby consent to the filing of this opinion as an Exhibit to the
Registration Statement and to the reference to us under the captions "Legal
Matters" and "Certain Federal Tax Consequences" in the Prospectus that is
included in the Registration Statement.
Very truly yours,
KING & SPALDING
<PAGE> 1
EXHIBIT 10.31
FORM OF INDEMNIFICATION AGREEMENT
THIS INDEMNIFICATION AGREEMENT, dated as of the ____ day of _________,
1998, between MEGO MORTGAGE CORPORATION, a Delaware corporation (the
"Company"), and _______________, a resident of the State of ___________ (the
"Indemnitee").
RECITALS
--------
A. The Indemnitee is currently serving as a director and/or executive
officer of the Company and the Company desires to continue to retain the
services of the Indemnitee as a director and/or executive officer of the
Company and/or as a consultant to the Company.
B. The Company and the Indemnitee recognize the increased risk of
litigation and other claims being asserted against directors, officers and/or
employees of, and consultants to, public companies and the subsidiaries of such
companies.
C. The Certificate of Incorporation of the Company requires the
Company to indemnify its directors and officers to the fullest extent permitted
by law and the Indemnitee has been serving and continues to serve as a director
and/or officer of the Company, in part, in reliance on such provisions of the
Certificate of Incorporation.
D. The Indemnitee has indicated that he does not regard the
indemnities available under the Company's Certificate of Incorporation and
bylaws and available insurance, if any, as adequate to protect him against the
risks associated with his services to the Company. As a condition to the
Indemnitee's agreement to continue to serve as such, the Indemnitee requires
that he be indemnified from liability in accordance with the provisions of this
Agreement to the fullest extent permitted by law.
E. The Company recognizes that the Indemnitee needs substantial
protection against personal liability in order to maintain the Indemnitee's
continued service to the Company in an effective manner and is willing to
indemnify the Indemnitee in accordance with the provisions of this Agreement to
the fullest extent permitted by law in order to continue to retain the services
of the Indemnitee.
F. The Company desires to provide in this Agreement for
indemnification of, and the advance of expenses to, Indemnitee to the fullest
extent (whether partial or complete) permitted by law, as set forth in this
Agreement and, to the extent officers' and directors' liability insurance is
maintained by the Company, to provide for the continued coverage of the
Indemnitee under the Company's officers' and directors' liability insurance
policies, in part to provide the Indemnitee with specific contractual assurance
that the protection promised by the indemnification provisions of the
Certificate of Incorporation will be available to the Indemnitee (regardless
of, among other things, any amendment to or revocation of such provisions of
the Certificate of Incorporation or any change in the composition of the
Company's Board of Directors or any acquisition transaction relating to the
Company).
NOW, THEREFORE, for and in consideration of the premises and the
mutual covenants contained herein and the Indemnitee's past and continued
service to the Company, the Company and the Indemnitee agree as follows:
<PAGE> 2
SECTION 1. MANDATORY INDEMNIFICATION IN PROCEEDINGS OTHER THAN THOSE
BY OR IN THE RIGHT OF THE COMPANY. Subject to Section 4 hereof, the Company
shall indemnify and hold harmless the Indemnitee form and against any and all
claims, damages, expenses, costs (including attorneys' fees and costs of other
professionals), judgments, penalties, fines (including excise taxes assessed
with respect to an employee benefit plan), settlements, and all other
liabilities incurred or paid by him in connection with the investigation,
defense, prosecution, settlement or appeal of, or being or preparing to be a
witness in, or participating in, any threatened, pending or completed action,
suit, investigation that the Indemnitee in good faith believes might lead to the
institution of such action, or proceeding, whether civil, criminal,
administrative or investigative (other than an action by or in the right of the
Company) and to which the Indemnitee was or is a party or is threatened to be
made a party or was or is a witness or participates or may participate in by
reason of the fact that the Indemnitee is or was an officer, director, manager,
consultant, stockholder, employee or agent of the Company or any of its
subsidiaries, or is or was serving at the request of the Company or any of its
subsidiaries as an officer, director, consultant, partner, trustee, employee or
agent of another corporation, partnership, joint venture, trust, employee
benefit plan or other enterprise, or by reason of anything done or not done by
the Indemnitee in any such capacity or capacities, provided that the Indemnitee
acted in good faith and in a manner he reasonably believed to be in or not
opposed to the best interests of the Company, and, with respect to any criminal
action or proceeding, did not know his conduct was unlawful.
SECTION 2. MANDATORY INDEMNIFICATION IN PROCEEDINGS BY OR IN THE RIGHT
OF THE COMPANY. Subject to Section 4 hereof, the Company shall indemnify and
hold harmless the Indemnitee from and against any and all expenses (including
attorneys' fees) and amounts actually and reasonably incurred or paid by him in
connection with the investigation, defense, prosecution, settlement or appeal
of, or being or preparing to be a witness in, or participating in, any
threatened, pending or completed action, suit, investigation that the Indemnitee
in good faith believes might lead to the institution of such action, or
proceeding by or in the right of the Company to procure a judgment in its favor,
whether civil, criminal, administrative or investigative, and to which the
Indemnitee was or is a party or is threatened to be made a party or was or is a
witness or participate or may participate in by reason of the fact that the
Indemnitee is or was an officer, director, manager, consultant, stockholder,
employee or agent of the Company or any of its subsidiaries, or is or was
serving at the request of the Company or any of its subsidiaries as an officer,
director, consultant, partner, trustee, employee or agent of another
corporation, partnership, joint venture, trust, employee benefit plan or other
enterprise, or by reason of anything done or not done by the Indemnitee in any
such capacity or capacities, provided that (i) the Indemnitee acted in good
faith and in a manner he reasonably believed to be in or not opposed to the best
interests of the Company and (ii) no indemnification shall be made under this
Section 2 in respect of any claim, issue or matter as to which the Indemnitee
shall have been adjudged to be liable to the Company for knowingly, fraudulent,
deliberate, dishonest or willful misconduct in the performance of his duty to
the Company unless, and only to the extent that, the court in which such
proceeding was brought (or any other court of competent jurisdiction) shall
determine upon application that, despite the adjudication of such liability but
in view of all the circumstances of the case, the Indemnitee is fairly and
reasonably entitled to indemnity for such expenses which such court shall deem
proper.
SECTION 3. REIMBURSEMENT OF EXPENSES FOLLOWING ADJUDICATION OF
NEGLIGENCE. The Company shall reimburse the Indemnitee for any expenses
(including attorney's fees) and amounts actually and reasonably incurred or paid
by him in connection with the investigation, defense, settlement or appeal of
any action, suit or proceeding described in Section 2 hereof that results in an
adjudication that the Indemnitee was liable other
2
<PAGE> 3
than for willful misconduct in the performance of his duty to the Company;
provided, however, that the Indemnitee acted in good faith and in a manner he
believed to be in the best interests of the Company.
SECTION 4. AUTHORIZATION OF INDEMNIFICATION. Any indemnification under
Sections 1 and 2 hereof (unless ordered by a court) and any reimbursement made
under Section 3 hereof shall be made by the Company only as authorized in the
specific case upon a determination (the "Determination") that indemnification or
reimbursement of the Indemnitee is proper in the circumstances because the
Indemnitee has met the applicable standard of conduct set forth in Section 1, 2
or 3 hereof, as the case may be. Subject to Sections 5.5, 5.6 and 8 of this
Agreement, the Determination shall be made in the following order of preference:
(1) first, by the Company's Board of Directors (the "Board") by
majority vote or consent of a quorum consisting of directors ("Disinterested
Directors") who are not, at the time of the Determination, named parties to such
action, suit or proceeding; or
(2) next, if such a quorum of Disinterested Directors cannot be
obtained, by majority vote or consent of a committee duly designated by the
Board (in which designation all directors, whether or not Disinterested
Directors, may participate) consisting solely of two or more Disinterested
Directors; or
(3) next, if such a committee cannot be designated, by any
independent legal counsel in a written opinion, which independent legal counsel
shall be selected in accordance with Section 5.5.
4.1. No Presumptions. The termination of any action, suit or proceeding
by judgment, order, settlement, conviction, or upon a plea of nolo contendere or
its equivalent, shall not, of itself, create a presumption that the Indemnitee
did not act in good faith and in a manner that he reasonably believed to be in
or not opposed to the best interests of the Company, and with respect to any
criminal action or proceeding, knew that his conduct was unlawful.
4.2. Benefit Plan Conduct. The Indemnitee's conduct with respect to an
employee benefit plan for a purpose he reasonably believed to be in the
interests of the participants in and beneficiaries of the plan shall be deemed
to be conduct that the Indemnitee reasonably believed to be not opposed to the
best interests of the Company.
4.3. Reliance as Safe Harbor. For purposes of any Determination
hereunder, the Indemnitee shall be deemed to have acted in good faith and in a
manner he reasonably believed to be in or not opposed to the best interests of
the Company, or, with respect to any criminal action or proceeding, to have had
no reasonable cause to believe or did not know his conduct was unlawful, if his
action is based on (i) the records or books of account of the Company or another
enterprise, including financial statements, (ii) information supplied to him by
the officers of the Company or another enterprise in the course of their duties,
(iii) the advice of legal counsel for the Company or another enterprise, or (iv)
information or records given or reports made to the Company or another
enterprise by an independent certified public accountant or by an appraiser or
other expert selected with reasonable care by the Company or another enterprise.
The term "another enterprise" as used in this Section 4.3 shall mean any other
corporation or any partnership, joint venture, trust, employee benefit plan or
other enterprise of which the Indemnitee is or was serving at the request of the
Company or any of its subsidiaries as an officer, director, consultant, partner,
trustee, employee or agent. The provisions of this Section 4.3 shall not be
deemed to be exclusive or to limit in any way the other circumstances in which
3
<PAGE> 4
the Indemnitee may be deemed to have met the applicable standard of conduct set
forth in Sections 1, 2 or 3 hereof, as the case may be.
4.4. Success on Merits or Otherwise. Notwithstanding any other provision
of this Agreement, to the extent that the Indemnitee has been successful on the
merits or otherwise in defense of any action, suit or proceeding described in
Section 1 or 2 hereof, or in defense of any claim, issue or matter therein, he
shall be indemnified against expenses (including attorneys' fees) actually and
reasonably incurred by him in connection with the investigation, defense,
settlement or appeal thereof. For purposes of this Section 4.4, the term
"successful on the merits or otherwise" shall include, but not be limited to,
(i) any termination, withdrawal, or dismissal (with or without prejudice) of
any claim, action, suit or proceeding against the Indemnitee without any
express finding of liability or guilt against him, (ii) the expiration of 120
days after the making of any claim or threat of an action, suit or proceeding
without the institution of the same and without any promise or payment made to
induce a settlement, or (iii) the settlement of any action, suit or proceeding
under Section 1, 2 or 3 hereof pursuant to which the Indemnitee pays less than
$10,000.
4.5. Partial Indemnification or Reimbursement. If the Indemnitee is
entitled under any provision of this Agreement to indemnification and/or
reimbursement by the Company for some or a portion of the claims, damages,
expenses (including attorneys' fees and costs of other professionals),
judgments, fines or amounts paid in settlement by the Indemnitee in connection
with the investigation, defense, settlement or appeal of any action specified
in Section 1, 2 or 3 hereof, but not, however, for the total amount thereof,
the Company shall nevertheless indemnify and/or reimburse the Indemnitee for
the portion thereof to which the Indemnitee is entitled. The party or parties
making the Determination shall determine the portion (if less than all) of such
claims, damages, expenses (including attorneys' fees), judgments, fines or
amounts paid in settlement for which the Indemnitee is entitled to
indemnification and/or reimbursement under this Agreement.
SECTION 5. PROCEDURES FOR DETERMINATION OF WHETHER STANDARDS HAVE BEEN
SATISFIED.
5.1. Costs. All costs of making any Determination required by Section 4
or 5 hereof shall be borne solely by the Company, including, but not limited
to, the costs of legal counsel and judicial determinations. The Company shall
also be solely responsible for paying (i) all reasonable expenses incurred by
the Indemnitee to enforce this Agreement, including, but not limited to, the
costs incurred by the Indemnitee to obtain court-ordered indemnification
pursuant to Section 8 hereof, regardless of the outcome of any such application
or proceeding, and (ii) all costs of defending any suits or proceedings
challenging payments to the Indemnitee under this Agreement.
5.2. Timing of the Determination. The Company shall use its best efforts
to make the Determination contemplated by Section 4 or 5 hereof promptly. In
addition, the Company agrees:
(a) if the Determination is to be made by the Board or a committee
thereof, such Determination shall be not later than 15 days after a written
request for a Determination (a "Request") is delivered to the Company by the
Indemnitee; and
(b) if the Determination is to be made by independent legal
counsel, such Determination shall be made not later than 30 days after a
Request is delivered to the Company by the Indemnitee.
4
<PAGE> 5
The failure to make a Determination within the above-specified time period
shall constitute a Determination approving full indemnification or
reimbursement of the Indemnitee. Notwithstanding anything herein to the
contrary, the Determination may be made in advance of (i) the Indemnitee's
payment (or incurring) of expenses with respect to which indemnification or
reimbursement is sought, and/or (ii) final disposition of the action, suit or
proceeding with respect to which indemnification or reimbursement is sought.
5.3. REASONABLENESS OF EXPENSES. The evaluation and finding as to the
reasonableness of expenses incurred by the Indemnitee for purposes of this
Agreement shall be made (in the following order of preference) within 15 days
of the Indemnitee's delivery to the Company of a Request that includes a
reasonable accounting of expenses incurred:
(a) first, by the Board by a majority vote of a quorum consisting of
Disinterested Directors; or
(b) next, if a quorum cannot be obtained under subdivision (a), by
majority vote or consent of a committee duly designated by the Board (in which
designation all directors, whether or not Disinterested Directors, may
participate), consisting solely of two or more Disinterested Directors; or
(c) next, if such a committee cannot be designated, by any
independent legal counsel.
All expenses shall be considered reasonable for purposes of this Agreement if
the finding contemplated by this Section 5.3 is not made within the prescribed
time. The finding required by this Section 5.3 may be made in advance of the
payment (or incurring) of the expenses for which indemnification or
reimbursement is sought.
5.4 PAYMENT OF INDEMNIFIED AMOUNT. Immediately following a Determination
that the Indemnitee has met the applicable standard of conduct set forth in
Section 1, 2 or 3 hereof, as the case may be, and the finding of reasonableness
of expenses contemplated by Section 5.3 hereof, or the passage of time
prescribed for making such determination(s), the Company shall pay to the
Indemnitee in cash the amount to which the Indemnitee is entitled to be
indemnified and/or reimbursed, as the case may be, without further
authorization or action by the Board; provided, however, that the expenses for
which indemnification or reimbursement is sought have actually been incurred by
the Indemnitee.
5.5 SELECTION OF INDEPENDENT LEGAL COUNSEL. If the Determination required
under Section 4 or 5 is to be made by independent legal counsel, such counsel
shall be selected by the Indemnitee with the approval of the Board, which
approval shall not be unreasonably withheld. The fees and expenses incurred by
counsel in making any Determination (including Determinations pursuant to
Section 5.7 hereof) shall be borne solely by the Company regardless of the
results of any Determination and, if requested by counsel, the Company shall
give such counsel an appropriate written agreement with respect to the payment
of their fees and expenses and such other matters as may be reasonably
requested by counsel.
5.6 RIGHT OF INDEMNITEE TO APPEAL AN ADVERSE DETERMINATION BY BOARD. If a
Determination is made by the Board or a committee thereof that the Indemnitee
did not meet the applicable standard of conduct set forth in Section 1, 2 or 3
hereof or that the Indemnitee's expenses are not reasonable as set forth in
Section 5.3 hereof, upon the written request of the Indemnitee and the
Indemnitee's delivery of $500 to the Company, the Company shall cause a new
Determination to be made by independent legal counsel, which independent legal
counsel
5
<PAGE> 6
shall be selected in accordance with Section 5.5. Subject to Section 8 hereof,
such Determination by such independent legal counsel shall be binding and
conclusive for all purposes of this Agreement.
5.7. Right of Indemnitee To Select Forum For Determination. If, at
any time subsequent to the date of this Agreement, "Continuing Directors" do
not constitute a majority of the members of the Board, or there is otherwise a
change in control of the Company (as contemplated by Item 403(c) of Regulation
S-K), then the Determination required by Section 4 or 5 hereof shall be made by
independent legal counsel selected by the Indemnitee and approved by the Board
(which approval shall not be unreasonably withheld), which counsel shall be
deemed to satisfy the requirements of clause (3) of Section 4 and clause (c) of
Section 5.3 hereof. If none of the legal counsel selected by the Indemnitee are
willing and/or able to make the Determination, then the Company shall cause the
Determination to be made by a majority vote or consent of a Board committee
consisting solely of Continuing Directors. For purposes of this Agreement, a
"Continuing Director" means either a member of the Board at the date of this
Agreement or a person nominated to serve as a member of the Board by a majority
of the then Continuing Directors.
5.8. Access by Indemnitee to Determination. The Company shall
afford to the Indemnitee and his representatives ample opportunity to present
evidence of the facts upon which the Indemnitee relies for indemnification or
reimbursement, together with other information relating to any requested
Determination.
5.9. Judicial Determination in Derivative Suits. In each action or
suit described in Section 2 hereof, the Company shall cause its counsel to use
its best efforts to obtain from the Court in which such action or suit was
brought (i) an express adjudication whether the Indemnitee is liable for
negligence or misconduct in the performance of his duty to the Company, and, if
the Indemnitee is so liable, (ii) a determination whether and to what extent,
despite the adjudication of liability but in view of all the circumstances of
the case (including this Agreement), the Indemnitee is fairly and reasonably
entitled to indemnification.
5.10. Burden of Proof. In the event of any claim by the Indemnitee
for indemnification hereunder, there shall be a presumption that the Indemnitee
is entitled to indemnification hereunder and the Company shall have the burden
of proving that the Indemnitee is not entitled to such indemnification.
SECTION 6. SCOPE OF INDEMNITY. The actions, suits and proceedings
described in Sections 1 and 2 hereof shall include, for purposes of this
Agreement, any actions that involve, directly or indirectly, activities of the
Indemnitee both in his official capacities as a Company director or officer and
actions taken in another capacity while serving as director or officer,
including, but not limited to, actions or proceedings involving (i)
compensation paid to the Indemnitee by the Company, (ii) activities by the
Indemnitee on behalf of the Company, including actions in which the Indemnitee
is plaintiff, (iii) actions alleging a misappropriation of a "corporate
opportunity," (iv) responses to a takeover attempt or threatened takeover
attempt of the Company, (v) transactions by the Indemnitee in Company
securities, and (vi) the Indemnitee's preparation for and appearance (or
potential appearance) as a witness in any proceeding relating, directly or
indirectly, to the Company. In addition, the Company agrees that, for purposes
of this Agreement, all services performed by the Indemnitee on behalf of, in
connection with or related to any subsidiary of the Company, any employee
benefit plan established for the benefit of employees of the Company or any
subsidiary, any corporation or partnership or other entity in which the Company
or any subsidiary has a 5% ownership interest, or any other affiliate shall be
deemed to be at the request of the Company.
6
<PAGE> 7
SECTION 7. ADVANCE FOR EXPENSES.
7.1 Mandatory Advance. Expenses (including attorney's fees) incurred by the
Indemnitee in investigating, defending, settling or appealing, or being or
preparing to be a witness in, any action, suit or proceeding described in
Section 1 or 2 hereof shall be paid by the Company in advance of the final
disposition of such action, suit or proceeding. The Company shall promptly pay
the amount of such expenses to the Indemnitee, but in no event later than 5
days following the Indemnitee's delivery to the Company of a written request
for an advance pursuant to this Section 7, together with a reasonable
accounting of such expenses.
7.2 Undertaking to Repay. The Indemnitee hereby undertakes and agrees to repay
to the Company any advances mad e pursuant to this Section 7 if and to the
extent that a court of competent jurisdiction shall make a final judgment (as to
which all rights of appeal therefrom have been exhausted or lapsed) that the
Indemnitee is not entitled to be indemnified by the Company for such amounts.
7.3 Miscellaneous. The Company shall make the advances contemplated by this
Section 7 regardless of the Indemnitee's financial ability to make repayment,
and regardless whether indemnification of the Indemnitee by the Company will
ultimately be required. Any advances and undertakings to repay pursuant to this
Section 7 shall be unsecured and interest-free.
SECTION 8. COURT-ORDERED INDEMNIFICATION. Regardless of whether the Indemnitee
has met the standard of conduct set forth in Sections 1, 2 or 3 hereof, as the
case may be, and notwithstanding the presence or absence of any Determination
whether such standards have been satisfied and notwithstanding any other
provision hereof, the Indemnitee may apply for indemnification (and/or
reimbursement pursuant to Section 3 or 12 hereof) to the court conducting any
proceeding to which the Indemnitee is a party or a witness or to any other
court of competent jurisdiction. On receipt of an application, the court, after
giving any notice the court considers necessary, may order indemnification
(and/or reimbursement) if it determines the Indemnitee is fairly and reasonably
entitled to indemnification (and/or reimbursement) in view of all the relevant
circumstances (including this Agreement).
SECTION 9. CONTRIBUTION. If and to the extent that a final adjudication shall
specify that the Company is not obligated to indemnify Indemnitee under this
Agreement for any reason (by reason of public policy, as a matter of law or
otherwise), then in respect of any threatened, pending or completed action, suit
or proceeding in which the Company is jointly liable with Indemnitee (or would
be so liable if joined in such action, suit or proceeding), the Company shall
contribute to the amount of expenses (including attorney's fees and costs of
other Company shall contribute to the amount of expenses (including attorneys'
fees and costs of other professionals), judgment, penalties, fines (including
excise taxes assessed), settlements and all other liabilities incurred and paid
or payable by Indemnitee in connection with such action, suit or proceeding in
such proportion as is appropriate to reflect (i) the relative benefits received
by the Company on the one hand and Indemnitee on the other hand from the
transaction with respect to which such action, suit or proceeding arose, and
(ii) the relative fault of the Company on the one hand and of Indemnitee on the
other hand in connection with the circumstances which resulted in such
expenses, judgments, fines or settlement amounts, as well as any other relevant
equitable considerations. The relative fault of the Company on the one hand and
of Indemnitee on the other hand shall be determined by reference to among other
things, the parties' relative intent, knowledge, access to information and
opportunity to correct or prevent the circumstances resulting in such expense,
judgments, fines or settlement amounts. The Company agrees that it would not be
just and equitable if contribution pursuant to this Section 9 were determined by
pro
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rata allocation or any other method of allocation which does not take account
of the foregoing equitable considerations.
SECTION 10. NONDISCLOSURE OF PAYMENTS. Except as expressly required by
Federal securities laws, neither party shall disclose any payments under this
Agreement unless prior approval of the other party is obtained. Any payments to
the Indemnitee that must be disclosed shall, unless otherwise required by law,
be described only in Company proxy or information statements relating to
special and/or annual meetings of the Company's stockholders, and the Company
shall afford the Indemnitee the reasonable opportunity to review all such
disclosures and, if requested, to explain in such statement any mitigating
circumstances regarding the events reported.
SECTION 11. COVENANT NOT TO SUE, LIMITATION OF ACTIONS AND RELEASE OF
CLAIMS. No legal action shall be brought and no cause of action shall be
asserted by or on behalf of the Company (or any of its subsidiaries) against
the Indemnitee, his spouse, heirs, executors, personal representatives or
administrators after the expiration of 2 years from the date the Indemnitee
ceases (for any reason) to serve as either an officer or a director of the
Company, and any claim or cause of action of the Company (or any of its
subsidiaries) shall be extinguished and deemed released unless asserted by
filing of a legal action within such 2-year period.
SECTION 12. INDEMNIFICATION OF INDEMNITEE'S ESTATE. Notwithstanding any
other provision of this Agreement, and regardless whether indemnification of
the Indemnitee would be permitted and/or required under this Agreement, if the
Indemnitee is deceased, the Company shall indemnify and hold harmless the
Indemnitee's estate, spouse, heirs, administrators, personal representatives
and executors (collectively the "Indemnitee's Estate") against, and the Company
shall assume, any and all claims, damages, expenses, costs (including
attorneys' fees and costs of other professionals), penalties, judgments, fines
and amounts paid in settlement actually incurred by the Indemnitee or the
Indemnitee's Estate in connection with the investigation, defense, settlement
or appeal of any action described in Section 1 or 2 hereof. Indemnification of
the Indemnitee's Estate pursuant to this Section 12 shall be mandatory and not
require a Determination or any other finding that the Indemnitee's conduct
satisfied a particular standard of conduct.
SECTION 13. REIMBURSEMENT OF ALL LEGAL EXPENSES. Notwithstanding any
other provision of this Agreement, and regardless of the presence or absence of
any Determination, the Company promptly (but not later than 10 days following
the Indemnitee's submission of a reasonable accounting) shall reimburse the
Indemnitee for all attorneys' fees and related court costs and other expenses
incurred by the Indemnitee in connection with the investigation, defense,
settlement or appeal of or preparation to be a witness in or participating in
(including an appeal) or preparing to defend any action described in Section 1
or 2 hereof (including, but not limited to, the matters specified in Section 6
hereof).
SECTION 14. MAINTENANCE OR INSURANCE. The Company represents that a copy
of the policies of directors and officers liability insurance that are in
effect are set forth as Exhibit A hereto. The Company hereby agrees that during
the period commencing on the date hereof and ending six years from the date the
Indemnitee ceases to serve the Company, the Company shall purchase and maintain
in effect for the benefit of the Indemnitee such insurance providing coverage
at least as favorable to the Indemnitee as that presently provided, if such
insurance can be purchased for premiums not in excess of 200% of the amount of
the current premiums, adjusted from time to time in accordance with the
Consumer Price Index, or, if such coverage cannot be obtained, the maximum
coverage that can be obtained for 200% of the
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amount of the current premiums adjusted from time to time in accordance with the
Consumer Price Index.
SECTION 15. CHANGES IN THE LAW. If any change after the date of this
Agreement in any applicable law, statute or rule or the Company's Certificate of
Incorporation expands the power of the Company to indemnify the Indemnitee, such
change shall be within the purview of the Indemnitee's rights and the Company's
obligations under this Agreement. If any change in any applicable law, statute
or rule or the Company's Certificate of Incorporation narrows the right of the
Company to indemnify a person such as the Indemnitee, such change, to the extent
not otherwise required by such law, statute or rule or the Company's Certificate
of Incorporation to be applied to this Agreement, shall have no effect on this
Agreement or the parties' rights and obligations thereunder.
SECTION 16. MISCELLANEOUS.
16.1. Notice Provision. Any notice, payment, demand or communication
required or permitted to be delivered or given by the provisions of this
Agreement shall be deemed to have been effectively delivered or given and
received on the date personally delivered to the respective party to whom it is
directed, or when deposited by registered or certified mail, with postage and
charges prepaid and addressed to the parties at the addresses set forth below
opposite their signatures to this Agreement.
16.2. Entire Agreement. Except for the Company's Certificate of
Incorporation, this Agreement constitutes the entire understanding of the
parties and supersedes all prior understandings, whether written or oral,
between the parties with respect to the subject matter of this Agreement.
Nothing in this Agreement shall be deemed to limit any other indemnification to
which the Indemnitee may be entitled, including under the Company's
Certificate of Incorporation, without duplication of payment.
16.3. Severability of Provisions. If any provision of this Agreement
is held to be illegal, invalid, or unenforceable under present or future laws
effective during the term of this Agreement, such provision shall be fully
severable; this Agreement shall be construed and enforced as if such illegal,
invalid, or unenforceable provision had never comprised a part of this
Agreement; and the remaining provisions of this Agreement shall remain in full
force and effect and shall not be affected by the illegal, invalid, or
unenforceable provision or by its severance from this Agreement. Furthermore, in
lieu of each such illegal, invalid, or unenforceable provision there shall be
added automatically as a part of this Agreement a provision as similar in terms
to such illegal, invalid or unenforceable provision as may be possible and be
legal, valid, and enforceable.
16.4. Applicable Law. This Agreement shall be governed by and
construed under the laws of the State of Delaware.
16.5. Execution in Counterparts. This Agreement and any amendment may
be executed simultaneously or in counterparts, each of which together shall
constitute one and the same instrument.
16.6. Cooperation and Intent. The Company shall cooperate in good
faith with the Indemnitee and use its best efforts to ensure that the
Indemnitee is indemnified and/or reimbursed for liabilities described herein to
the fullest extent permitted by law.
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16.7. Amendment. No amendment, modification or alteration of the
terms of this Agreement shall be binding unless in writing, dated subsequent to
the date of this Agreement, and executed by the parties.
16.8. Binding Effect. The obligations of the Company to the
Indemnitee hereunder shall survive and continue as to the Indemnitee even if the
Indemnitee ceases to be a director, officer, consultant, employee and/or agent
of the Company. Each and all of the covenants, terms and provisions of this
Agreement shall be binding upon and inure to the benefit of the successors to
the Company and, upon the death of the Indemnitee, to the benefit of the estate,
heirs, executors, administrators and personal representatives of the Indemnitee.
16.9 Nonexclusitivity. The rights of indemnification and
reimbursement provided in this Agreement shall be in addition to any rights to
which the Indemnitee may otherwise be entitled by statute, bylaw, agreement,
vote of stockholders or otherwise.
16.10 Effective Date. The provisions of this Agreement shall cover
claims, actions, suits and proceedings whether now pending or hereafter
commenced and shall be retroactive to cover acts or omissions or alleged acts or
omissions which heretofore have taken place.
EXECUTED AS OF THE DATE FIRST ABOVE WRITTEN.
ADDRESS THE COMPANY
1000 Parkwood Circle MEGO MORTGAGE CORPORATION
Suite 500
Atlanta, Georgia 30339
Attention: Robert Chastain By:
-----------------------
Vice President/Corporate Counsel Name:
--------------------
Title:
--------------------
ADDRESS THE INDEMNITEE
--------------------------
Name:
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EXHIBIT 23.2
INDEPENDENT AUDITORS' CONSENT
We consent to the use in this Amendment No. 1 to Registration Statement
No. 333-68995 of Mego Mortgage Corporation on Form S-1 of our
report dated December 14, 1998, appearing in the Prospectus which is part
of this Registration Statement. We also consent to the reference to us
under the heading "Experts" in such Prospectus.
DELOITTE & TOUCHE LLP
San Diego, California
January 29, 1999
