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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 29, 1999
REGISTRATION NO. 333-68997
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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PRE-EFFECTIVE
AMENDMENT NO. 1
TO
FORM S-4
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)
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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)
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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 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. [ ] __________
CALCULATION OF REGISTRATION FEE
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PROPOSED MAXIMUM PROPOSED MAXIMUM
TITLE OF EACH CLASS OF AMOUNT TO AGGREGATE PRICE AGGREGATE AMOUNT OF
SECURITIES TO BE REGISTERED BE REGISTERED PER UNIT OFFERING PRICE REGISTRATION FEE(1)
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12 1/2% Subordinated Notes due
2001............................ $41,495,000 100% $41,495,000 $11,536
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(1) $11,522 previously paid
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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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OFFER TO EXCHANGE
ALL OUTSTANDING 12 1/2% SUBORDINATED NOTES DUE 2001
($41,495,000 PRINCIPAL AMOUNT OUTSTANDING)
FOR
12 1/2% SUBORDINATED NOTES DUE 2001
WHICH HAVE BEEN REGISTERED UNDER THE SECURITIES ACT
OF
MEGO MORTGAGE CORPORATION
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THE EXCHANGE OFFER WILL EXPIRE AT 5:00 P.M., NEW YORK CITY TIME,
ON APRIL 14, 1999, UNLESS EXTENDED.
------------------------
SEE RISK FACTORS BEGINNING ON PAGE 18 FOR A DISCUSSION OF CERTAIN FACTORS
WHICH INVESTORS SHOULD CONSIDER IN CONNECTION WITH THE EXCHANGE OFFER AND AN
INVESTMENT IN THE NEW NOTES OFFERED BY THIS PROSPECTUS.
The notes offered by this prospectus will mature on December 1, 2001.
Interest on the notes is payable in cash semi-annually on June 1 and December 1
of each year beginning on June 1, 1999. We may redeem the notes, in whole but
not in part, at any time prior to the maturity date. The redemption price is
described under the heading "Description of The New Notes -- Optional
Redemption" beginning on page 111 of this prospectus. There is no sinking fund.
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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.
------------------------
The Exchange Agent for this exchange offer is American Stock Transfer &
Trust Company. For information with respect to this exchange offer, please call
Imre Farkas at (718) 921-8293.
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This prospectus is dated February 2, 1999.
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TABLE OF CONTENTS
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Prospectus Summary.................... 2
Risk Factors.......................... 18
Significant Deterioration in Our
Financial Condition Due to Losses
in Fiscal 1998................... 18
Risks Associated with Implementing
Our New Strategic Plan........... 19
Risks Associated with New Management
Team............................. 20
Liquidity Risks..................... 20
Performance of Future
Acquisitions..................... 22
Risks Associated with Mortgage
Backed Securities................ 22
Risk from the Sale of Servicing
Rights........................... 24
Interest Rate Risks................. 25
Risk of Variations in Quarterly
Operating Results................ 26
Risks Associated with Delinquencies
and Defaults on Loans............ 26
Risks Associated with Title I Loans
Backing Our Mortgage Related
Securities....................... 27
Risks Associated with Existing
Equity + Loans................... 27
Litigation; Risk of Claims.......... 28
Concentration of Operations......... 28
Competition......................... 28
Factors Inhibiting Takeover; Effect
of Change of Control............. 29
Legislative and Regulatory Risks.... 30
Environmental Risks................. 30
Year 2000........................... 31
Ranking of the New Notes............ 31
Restrictions Imposed by the
Indenture........................ 31
Consequences of the Exchange Offer
on Non-Tendering Holders of the
Current Notes.................... 32
The Exchange Offer.................... 32
Purpose and Effect of the Exchange
Offer............................ 33
Terms of the Exchange Offer......... 34
Conditions of the Exchange Offer.... 39
Exchange Agent...................... 40
Fees and Expenses................... 40
Consequences of Failure to
Exchange......................... 41
Accounting Treatment................ 42
Use of Proceeds....................... 42
Capitalization........................ 43
Selected Financial Data............... 44
Management's Discussion and Analysis
of Financial Condition and Results
of Operations....................... 47
General............................. 47
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Securitization Transactions......... 48
Results of Operations............... 55
Three Months Ended November 30, 1998
Compared to Three Months Ended
November 30, 1997................ 55
Liquidity and Capital Resources..... 71
Quantitative and Qualitative
Disclosure About Market Risk..... 74
Effects Of Changing Prices And
Inflation........................ 75
Recent Accounting Pronouncements.... 75
Impact of the Year 2000 Issue....... 77
Special Cautionary Notice Regarding
Forward-Looking Statements....... 79
The Recapitalization.................. 80
General............................. 80
Private Placements.................. 80
Exchange Offer...................... 81
Management.......................... 81
Transactions with Strategic
Partners......................... 81
Business.............................. 83
General............................. 83
Strategic Initiatives............... 85
Mortgage Industry................... 86
Company Loan Products............... 87
Lending Operations.................. 88
Loan Processing and Underwriting.... 92
Quality Control..................... 94
Technology Systems.................. 95
Loan Servicing...................... 95
Sale of Loans....................... 98
Competition......................... 99
Government Regulation............... 100
Seasonality......................... 101
Employees........................... 102
Properties.......................... 102
Legal Proceedings................... 102
Recent Developments................. 103
Management............................ 104
Directors and Executive Officers.... 104
Executive Compensation.............. 106
Employment Agreements............... 108
Company Stock Option Plans.......... 109
Compensation Committee Interlocks
and Insider Participation........ 110
Principal Stockholders................ 111
Certain Transactions.................. 113
Relationship With Greenwich......... 113
Tax Sharing and Indemnity
Agreement........................ 113
Management Services Agreement with
PEC.............................. 113
Sub-Servicing Agreement with PEC.... 114
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Funding and Guarantees by Mego
Financial........................ 114
Relationships with FBR.............. 115
The Recapitalization................ 115
Description of the New Notes.......... 116
General............................. 116
Subordination....................... 116
Optional Redemption................. 118
Sinking Fund........................ 118
Payment on the New Notes............ 118
Certain Covenants................... 118
Defaults............................ 121
Amendments and Waivers.............. 122
Transfer............................ 123
Defeasance.......................... 124
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Concerning the Trustee.............. 124
Governing Law....................... 125
Book-Entry, Delivery and Form....... 125
Certificated Securities............. 126
Certain Definitions................. 127
Certain United States Federal Tax
Considerations...................... 135
United States Holders............... 136
Non-United States Holders........... 137
Plan of Distribution.................. 139
Where You Can Find More Information... 140
Legal Matters......................... 140
Experts............................... 141
Index to Financial Statements......... F-1
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PROSPECTUS SUMMARY
Because this is a summary, it does not contain all the information that may
be important to you. This prospectus includes specific terms of the Notes, as
well as information regarding our business and detailed financial data. We
encourage you to read the entire prospectus, including the Risk Factors, to
fully understand this Exchange Offer.
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.
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WHOLESALE DIVISION RETAIL DIVISION
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- - 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
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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 buyer 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
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 79.
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 $41,495,000 million principal amount of Current Notes in
exchange for $79.0 million principal amount of Old Notes.
THE EXCHANGE OFFER
The Exchange Offer........... We will issue $41,495,000 principal amount of
New Notes in exchange for $41,495,000 principal
amount of Current Notes that are validly
tendered and not withdrawn. Depository Trust
Company is the sole registered holder of the
Current Notes and there are $41,445,000 of
Current Notes outstanding. See "The Exchange
Offer" beginning on page 32 of this prospectus.
We are offering the New Notes for exchange to
satisfy certain obligations that we have under
our registration rights agreement with Friedman,
Billings, Ramsey & Co., Inc. ("FBR"), as
placement agent for the Current Notes. If your
Current Notes are not tendered and accepted in
this exchange offer you will continue to hold
such Current Notes. In such case, you will be
entitled to all the rights and preferences and
subject to the limitations applicable thereto
under the indenture governing the Current Notes.
After this exchange offer is complete, you will
continue to be subject to the existing
restrictions upon transfer of the Current Notes
and we will have no further obligation to you to
register your Current Notes.
Resale....................... Based on interpretations by the staff of the
Securities and Exchange Commission ("SEC") set
forth in no-action letters issued to third
parties, we believe you may offer the New Notes
issued in exchange for Current Notes for resale,
resold and otherwise transferred by you unless
you are a broker-dealer, as set forth below, or
you are one of our "affiliates" within the
meaning of Rule 405 under the (Securities Act of
1933 (the
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"Securities Act"), without compliance with the
registration and prospectus delivery provisions
of the Securities Act, provided that you
acquired such New Notes in the ordinary course
of your business and that you have no
arrangement or understanding with any person to
participate in the distribution of such New
Notes. If you tender in the exchange offer with
the intention to participate, or for the purpose
of participating, in a distribution of the New
Notes or if you are one of our affiliates, you
may not rely upon such interpretations by the
staff of the SEC. In such case and in the
absence of an exemption, you must comply with
the registration and prospectus delivery
requirements of the Securities Act in connection
with any secondary resale transaction. If you do
not comply with such requirements you may be
held liable under the Securities Act. We will
not indemnify you against any such liability.
Each broker-dealer (other than one of our
affiliates) that receives New Notes for its own
account pursuant to this exchange offer must
acknowledge that it will deliver a prospectus in
connection with any resale of such New Notes.
The Letter of Transmittal accompanying this
prospectus states that by so acknowledging and
by delivering a prospectus, a broker-dealer will
not be deemed to admit that it is an
"underwriter" within the meaning of the
Securities Act. We have agreed that, for a
period of 180 days after the expiration of this
exchange offer, we will make this prospectus
available to any broker-dealer for use in
connection with any such resale. See "Plan of
Distribution" beginning on page 132 of this
prospectus.
This exchange offer is not being made to and we
will not accept surrenders for exchange from,
holders of Current Notes in any jurisdiction in
which this exchange offer violates the
securities or blue sky laws.
Expiration Date.............. This exchange offer will expire on 5:00 p.m.,
New York City time, on April 14, 1999, unless we
extend it, in which case the term "Expiration
Date" shall mean the latest date and time to
which we extend it. We will publicly announce
any extension through a release to the Dow Jones
News Service and as otherwise required by
applicable law or regulations.
Conditions to the Exchange
Offer........................ This exchange offer is not subject to any
condition, other than that it does not violate
any applicable law, policy or interpretation of
the Staff of the SEC.
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Procedures for Tendering
Old Notes.................... If you want to exchange your Current Notes for
New Notes, you must complete, sign and date the
accompanying Letter of Transmittal, or a
facsimile thereof, in accordance with the
instructions contained in this prospectus and in
the Letter of Transmittal. You must mail or
otherwise deliver such Letter of Transmittal, or
a facsimile thereof, together with such Current
Notes and any other required documentation to
American Stock Transfer & Trust Company, New
York, our Exchange Agent, at the address set
forth in this prospectus on or prior to the
Expiration Date. By executing the Letter of
Transmittal, you will make certain
representations to us, including that:
(1) any New Notes acquired pursuant to the
exchange offer will be acquired in the
ordinary course of business of the person
receiving such New Notes;
(2) at the time of the consummation of the
exchange offer you are not engaged in, and
you do not intend to engage in, and have no
arrangement or understanding with any person
to participate in, the distribution of New
Notes; and
(3) you are not (a) one of our "affiliates" as
defined in Rule 405 of the Securities Act,
or (b) a broker-dealer that acquired such
Transfer Restricted Securities directly from
us or one of our affiliates for resale
pursuant to Rule 144A, Regulation S or
another available exemption from the
registration requirements of the Securities
Act (a "Direct Broker-Dealer Buyer").
If you are a broker-dealer and you receive New
Notes for your own account in exchange for
Current Notes that were acquired by you as a
result of market-making activities or other
trading activities, you will be required to
acknowledge that you will give a prospectus in
connection with any resale of such New Notes. We
have agreed that, for a period of 180 days after
the date on which the registration statement is
first declared effective, we will make this
prospectus available to any broker-dealer for
use in connection with any such resales. For a
description of the procedures for certain
resales by broker-dealers, see "Plan of
Distribution" beginning on page 132 of this
prospectus. See "The Exchange Offer -- Terms of
the Exchange Offer -- Procedures for Tendering
Current Notes" beginning on page 35 of this
prospectus and "The Exchange Offer -- Terms of
the Exchange Offer -- Guaranteed Delivery
Procedures" beginning on page 37 of this
prospectus.
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Special Procedures for
Beneficial Owners............ If your Current Notes are registered in the name
of a broker, dealer, commercial bank, trust
company or other nominee and you want to tender
your Current Notes in this exchange offer, you
should contact such registered holder promptly
and instruct such registered holder to tender
the Current Notes on your behalf. If you want to
tender your Current Notes, you must, prior to
completing and executing the Letter of
Transmittal and delivering your Current Notes
either make appropriate arrangements to register
ownership of the Current Notes in your name or
obtain a properly completed bond power from the
registered holder. The transfer of registered
ownership may take considerable time and you may
not be able to complete it prior to the
Expiration Date. See "The Exchange
Offer -- Terms of the Exchange
Offer -- Procedures for Tendering Current Notes"
beginning on page 36 of this prospectus.
Guaranteed Delivery
Procedures................... If you want to tender your Current Notes but
your Current Notes are not immediately available
or you cannot deliver your Current Notes, the
Letter of Transmittal or any other documents
required by the Letter of Transmittal to the
Exchange Agent prior to the Expiration Date, you
must tender your Current Notes according to the
guaranteed delivery procedures set forth in "The
Exchange Offer -- Terms of the Exchange
Offer -- Guaranteed Delivery Procedures"
beginning on page 38 of this prospectus.
Acceptance of Old Notes and
Delivery of Old Notes........ Subject to certain conditions (as described more
fully in "The Exchange Offer -- Conditions of
the Exchange Offer" beginning on page 38 of this
prospectus), we will accept for exchange any and
all Current Notes which are properly tendered in
the Exchange Offer and not withdrawn, prior to
5:00 p.m, New York City time, on the Expiration
Date. The New Notes issued pursuant to this
exchange offer will be delivered as promptly as
practicable following the Expiration Date.
Withdrawal Rights............ Except as otherwise provided herein, you may
withdraw tendered Current Notes at any time
prior to 5:00 p.m., New York City Time on the
Expiration Date. See "The Exchange
Offer -- Terms of the Exchange Offer --
Withdrawal of Tenders of Current Notes"
beginning on page 39 of this prospectus.
Certain Federal Income Tax
Considerations............... For a discussion of federal income tax
considerations relating to the exchange of the
Current Notes for the
10
<PAGE> 14
New Notes, see "Certain Federal Income Tax
Considerations" beginning on page 135 of this
prospectus.
Exchange Agent............... American Stock Transfer & Trust Company is the
Exchange Agent. Its address is 40 Wall Street,
New York, New York 10005.
SUMMARY OF THE TERMS OF THE NEW NOTES
This exchange offer applies to $41,495,000 aggregate principal amount of
Current Notes. The form and terms of the New Notes are identical in all material
respects to the form and terms of the Current Notes except that:
(1) the New Notes have been registered under the Securities Act and,
therefore, will not bear legends restricting the transfer thereof;
(2) holders of New Notes will not be entitled to certain rights of
holders of the Current Notes under the registration rights
agreements, which will terminate upon consummation of this exchange
offer; and
(3) the New Notes will not contain terms with respect to the obligation
to pay "added interest."
The New Notes will evidence the same debt as the Current Notes, will be entitled
to the benefits of the our existing indenture and will be treated as a single
class thereunder with any Current Notes that remain outstanding. See
"Description of the New Notes" beginning on page 109 of this prospectus.
Issuer....................... Mego Mortgage Corporation
Securities Offered........... $41,495,000 aggregate principal amount of
12 1/2% Subordinated Notes due 2001 (the "New
Notes")
Maturity..................... December 1, 2001
Interest..................... Payable in cash semi-annually on June 1 and
December 1 of each year commencing June 1, 1999
Optional Redemption by us.... The New Notes are redeemable at our option, in
whole but not in part, prior to maturity at the
following redemption prices:
- prior to December 1, 1999 at 100%
- after December 1, 1999 but prior to December
1, 2001 at 106%
in either case plus accrued and unpaid interest
to the redemption date.
Mandatory Redemption......... None
Sinking Fund................. None
Ranking...................... The New Notes will be unsecured, general
obligations of us, subordinated in the right of
payment to all of our
11
<PAGE> 15
Senior Indebtedness (as defined in the
indenture), including all of our obligations
under any warehouse facility. The New Notes will
be senior in the right of payment to all of our
future indebtedness that by its terms is
expressly subordinated in right of payment to
the New Notes as described in the indenture and
considered to be Junior Subordinated Obligations
(as defined in the indenture) with respect to
the New Notes.
As of November 30, 1998, our outstanding Senior
Indebtedness, on a consolidated basis, would
have been approximately $59.5 million.
Amendment or Waiver of
Indenture Provisions......... Certain provisions of the indenture may be
amended or waived with the consent of the
holders of at least the majority in principal
amount of then outstanding New Notes, together
with the outstanding Current Notes which have
not been exchanged (collectively, "Notes").
Registration Rights.......... Upon issuing the Current Notes we agreed to:
(1) file this registration statement for the
exchange offer on or before December 15,
1998, and to use our best efforts to cause
to become effective on or before March 15,
1998. The New Notes that will be issued
under the exchange offer will be identical
in all respects to the Current Notes (except
that the registered Notes will not contain
terms with respect to transfer restrictions
or interest rate increases as described
below); and
(2) to use our best efforts to cause the
exchange offer to be completed on or before
April 14, 1999.
In the event of the following situations we will
use our best efforts to cause a shelf
registration statement with respect to the sale
of the Current Notes to become effective by
April 14, 1999 and to remain effective until two
years after such date:
(1) the applicable interpretations of the SEC or
any changes in the law do not permit us to
undertake the exchange offer; or
(2) the exchange offer is not completed on or
before April 14, 1999; or
(3) FBR or any broker-dealer that acquired
Current Notes directly from us or any of our
affiliates notifies us.
12
<PAGE> 16
In the event that this registration statement is
not declared effective on or before March 15,
1999, the interest rate borne by the New Notes
will increase one-half of one percent (.5%) per
annum following March 15, 1999.
In the event that this exchange offer is not
completed and a shelf registration statement is
not declared effective on or before April 14,
1999, the interest rate borne by the New Notes
will increase an additional one-half of one
percent (.5%) per annum following April 14,
1999. This rate will increase by an additional
one-half of one percent (.5%) for each 90-day
period that any such additional interest accrues
until the interest rate reaches one percent (1%)
per annum.
The aggregate amount of such increase from the
original interest rate pursuant to these
provisions will not exceed one percent (1%) per
annum.
Upon any of the following events, the interest
rate borne by the Current Notes from the date of
such event will be reduced by the full amount of
the related increase from, but not to less than,
the original interest rate. However, if any of
the events described above occurs, the interest
rate may again be increased and thereafter
reduced pursuant to the provisions stated above:
- the effectiveness of this registration
statement after March 15, 1999, or
- the day before the completion of this exchange
offer or the effectiveness of the Current
Notes shelf registration after April 14, 1999.
The interest rate will also be reduced on the
date which the Current Notes become eligible for
sale under Rule 144 without limitation as to
volume.
Covenants.................... The indenture pursuant to which the Current
Notes have been issued and the New Notes will be
issued contains certain covenants for the
benefit of the holders of the notes. These
covenants include limits on the occurrence of
additional indebtedness, the incurrence of
liens, transactions with affiliates, certain
mergers and consolidations, status as an
"investment company," expansion of the line of
business, and payments for consent and SEC
reports. See "Description of the New Notes
-- Certain Covenants" beginning on page 118 of
this prospectus.
13
<PAGE> 17
Book-Entry; Delivery and
Form......................... Beneficial interests in the New Notes will be
shown on, and transfers thereof will be effected
only through, records maintained in book-entry
form by The Depository Trust Company and its
participants. See "Description of the New
Notes -- Book Entry, Delivery and Form"
beginning on page 125 of this prospectus.
USE OF PROCEEDS
We will not receive any proceeds from the issuance of the New Notes
pursuant to this prospectus.
RISK FACTORS
For a discussion of certain factors to be considered in evaluating us, our
business and an investment in the notes, see "Risk Factors" beginning on page 18
of this prospectus.
14
<PAGE> 18
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 46 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.
<TABLE>
<CAPTION>
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>
15
<PAGE> 19
<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(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>
- -------------------------
(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 46 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
16
<PAGE> 20
Financial and its affiliates, see "Certain Transactions" beginning on page
113 of this prospectus.
(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 79 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
as of October 1, 1998.
(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 expected to
receive on the sale of these loans. For additional details, see Note 3 to
our financial statements located later in this prospectus.
17
<PAGE> 21
RISK FACTORS
The decision to exchange New Notes for your Current Notes 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 whether to
participate in the exchange offer.
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
18
<PAGE> 22
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.
19
<PAGE> 23
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
20
<PAGE> 24
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.
21
<PAGE> 25
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 +
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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
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government-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.
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
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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 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.
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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 the failure of such parties 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 NationsBank 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.
RANKING OF THE NEW NOTES
The New Notes will be unsecured, general obligations, subordinated in the
right of payment to all of our existing and future Senior Indebtedness,
including without limitation all obligations that we have under any warehouse
facility. The New Notes will also be senior in the right of payment to Junior
Subordinated Obligations (as defined in the indenture). As of November 30, 1998,
our outstanding Senior Indebtedness, on a consolidated basis, would have been
approximately $59.5 million. In the event of bankruptcy, liquidation or
reorganization of the company, our assets would be available to pay the
obligations on the New Notes only after all of our Senior Indebtedness has been
repaid in full. Consequently, sufficient assets may not exist to pay amounts due
on the New Notes. In addition, the subordination provisions of the indenture
provide that if certain nonpayment defaults exist with respect to certain Senior
Indebtedness, the holders of such Senior Indebtedness would be able to prevent
payments on the New Notes for certain periods of time.
RESTRICTIONS IMPOSED BY THE INDENTURE
The warehouse line and the indenture contains certain restrictive
covenants, including, among others, covenants limiting our ability to incur
additional indebtedness, pay dividends, make certain investments, consummate
certain asset sales, enter into transactions with affiliates, incur liens, merge
or consolidate with any other person or sell, assign, transfer, lease, convey or
otherwise dispose of all or substantially all of our assets. Although the
covenants are subject to various exceptions, there can be no assurance that such
restrictions will not adversely affect our ability to finance future operations
or capital needs or engage in business activities which may be in our best
interests.
Our ability to comply with such provisions may be beyond our control. A
breach of any of these covenants could result in a default under the warehouse
line or other agreements which could adversely affect our ability to make
payments on the New Notes.
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CONSEQUENCES OF THE EXCHANGE OFFER ON NON-TENDERING HOLDERS OF THE CURRENT NOTES
In the event the exchange offer is consummated, we will not be required to
register any Current Notes not tendered and accepted in the exchange offer. In
such event, holders of Current Notes seeking liquidity in their investment would
have to rely on exemptions to the registration requirements under the securities
laws, including the Securities Act. Following the exchange offer, none of the
Notes will be entitled to the contingent increase in interest rate provided for
(in the event of a failure to consummate the exchange offer in accordance with
the terms of the Registration Rights Agreement) pursuant to the Current Notes.
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THE EXCHANGE OFFER
PURPOSE AND EFFECT OF THE EXCHANGE OFFER
The Company issued the Current Notes on June 29, 1998 in connection with
the recapitalization in exchange for the outstanding Old Notes. In connection
with the issuance of the Current Notes, the Company and FBR entered into a
Registration Rights Agreement dated as of June 29, 1998 (the "Registration
Rights Agreement"), which requires the Company to file with the SEC a
registration statement under the Securities Act with respect to an issue of New
Notes of the Company identical in all material respects to the Current Notes and
use its best efforts to cause such registration statement to become effective
under the Securities Act and, upon the effectiveness of that registration
statement, to offer to the holders of the Current Notes the opportunity to
exchange their Current Notes for a like principal amount of New Notes. The New
Notes will be issued without a restrictive legend and they may be reoffered and
resold by the holder without restrictions or limitations under the Securities
Act. A copy of the Registration Rights Agreement has been filed as an exhibit to
the Registration Statement of which this prospectus is a part. This exchange
offer is being made pursuant to the Registration Rights Agreement to satisfy the
Company's obligations thereunder with regard to the Notes. The term "Holder"
with respect to this exchange offer means any person in whose name Current Notes
are registered on the trustee's books or any other person who has obtained a
properly completed bond power from the registered holder, or any person whose
Current Notes are held of record by The Depository Trust Company ("DTC") who
desires to deliver such Current Note by book-entry transfer at DTC.
The Company has not requested, and does not intend to request, an
interpretation by the staff of the SEC with respect to whether the New Notes
issued pursuant to this exchange offer in exchange for the Current Notes may be
offered for sale, resold or otherwise transferred by any holder without
compliance with the registration and prospectus delivery provisions of the
Securities Act. Based on interpretations by the staff of the SEC set forth in
no-action letters issued to third parties, the Company believes the New Notes
issued pursuant to this exchange offer in exchange for Current Notes may be
offered for resale, resold and otherwise transferred by any holder thereof
(other than broker-dealers, as set forth below, and any such holder that is an
"affiliate" of the Company within the meaning of Rule 405 under the Securities
Act) without compliance with the registration and prospectus delivery provisions
of the Securities Act, provided that such New Notes are acquired in the ordinary
course of such holder's business and that such holder has no arrangement or
understanding with any person to participate in the distribution of such New
Notes. Any holder who tenders in this exchange offer with the intention to
participate, or for the purpose of participating, in a distribution of the New
Notes or who is an affiliate of the Company may not rely upon such
interpretations by the staff of the SEC and, in the absence of an exemption
therefrom, must comply with the registration and prospects delivery requirements
of the Securities Act in connection with any secondary resale transaction.
Failure to comply with such requirements in such instance may result in such
holder incurring liabilities under the Securities Act for which the holder is
not indemnified by the Company. Each broker-dealer (other than an affiliate of
the Company) that receives New Notes for its own account pursuant to this
exchange offer must acknowledge that it will deliver a prospectus in connection
with any resale of such New Notes. The Letter of Transmittal states that by so
acknowledging and by delivering a prospectus, a broker-dealer will not be deemed
to admit that it is an "underwriter" within the meaning of the Securities Act.
The Company has agreed that, for
33
<PAGE> 37
a period of 180 days after the Expiration Date, it will make this prospectus
available to any broker-dealer for use in connection with any such resale. See
"Plan of Distribution."
This exchange offer is not being made to, nor will the Company accept
surrenders for exchange from, holders of Current Notes in any jurisdiction in
which this exchange offer or the acceptance thereof would not be in compliance
with the securities or blue sky laws of such jurisdiction.
By tendering in this exchange offer, each holder of Current Notes will
represent to the Company that, among other things, (i) the New Notes acquired
pursuant to this exchange offer are being obtained in the ordinary course of
business of the person receiving such New Notes, whether or not such person is
the holder, (ii) neither the holder of Current Notes nor any such other person
has an arrangement of understanding with any person to participate in the
distribution of such New Notes, (iii) if the holder is not a broker-dealer, or
is a broker-dealer but will not receive New Notes for its own account in
exchange for Current Notes, neither the holder nor any such other person is
engaged in or intends to participate in the distribution of such New Notes and
(iv) neither the holder nor any such other person is an "affiliate" of the
Company within the meaning of Rule 405 under the Securities Act or, if such
holder is an "affiliate," that such holder will comply with the registration and
prospectus delivery requirements of the Securities Act to the extent applicable.
Following the completion of this exchange offer, none of the New Notes will
be entitled to the contingent increase in interest rate provided pursuant to the
Current Notes. Following the consummation of this exchange offer, holders of
Notes will not have any further registration rights, and the Current Notes will
continue to be subject to certain restrictions on transfer. See "-- Consequences
of Failure to Exchange." Accordingly, the liquidity of the market for the
Current Notes could be adversely affected. See "Risk Factors -- Consequences of
the Exchange Offer on Non-Tendering Holders of the Current Notes."
Participation in this exchange offer is voluntary and holders should
carefully consider whether to accept. Holders of the Current Notes are urged to
consult their financial and tax advisors in making their own decisions on
whether to participate in this exchange offer.
TERMS OF THE EXCHANGE OFFER
General. Upon the terms and subject to the conditions set forth in this
prospectus and in the Letter of Transmittal provided to you with this
prospectus, the Company will accept any and all Current Notes validly tendered
and not withdrawn prior to 5:00 p.m., New York City time, on the Expiration
Date. The New Notes are issuable only in registered form, without coupons, in
denominations of $1,000 and any integral thereof. The Company will issue up to
$41,445,000 aggregate amount of New Notes in exchange for the entire principal
amount of outstanding Current Notes accepted in the exchange offer. Holders may
tender some or all of their Current Notes pursuant to the exchange offer.
However, Current Notes may be tendered only in integral multiples of $1,000.
The form and terms of the New Notes will be identical in all material
respects to the form and terms of the Current Notes except that (i) the New
Notes will be registered under the Securities Act and, therefore, will not bear
legends restricting the transfer thereof and (ii) holders of the New Notes will
not be entitled to certain rights of holders of Current Notes under the
Registration Rights Agreement, which will terminate upon
34
<PAGE> 38
consummation of the exchange offer. The New Notes will evidence the same debt as
the Current Notes, will be entitled to the benefits of the indenture and will be
treated as a single class thereunder with any Current Notes that remain
outstanding (collectively, "Notes"). The exchange offer is not conditioned upon
any minimum aggregate principal amount of Current Notes being tendered for
exchange.
As of November 30, 1998, approximately $41.5 million aggregate principal
amount of the Current Notes were outstanding. This prospectus, together with the
Letter of Transmittal, is being sent to such registered Holders.
Holders of Current Notes do not have any appraisal or dissenters' rights
under the Delaware General Corporation Law or the indenture in connection with
the exchange offer. The Company intends to conduct the exchange offer in
accordance with the provisions of the Registration Rights Agreement and the
applicable requirements of the Exchange Act, and the rules and regulations of
the SEC thereunder. Current Notes which are not tendered for exchange in the
exchange offer will remain outstanding and interest thereon will continue to
accrue, but such Current Notes will not be entitled to any rights or benefits
under the Registration Rights Agreement.
The Company shall be deemed to have accepted validly tendered Current Notes
when, as and if the Company has given oral or written notice thereof to the
Exchange Agent. The Exchange Agent will act as agent for the tendering holders
for the purposes of receiving the New Notes from the Company.
If any tendered Current Notes are not accepted for exchange because of an
invalid tender, the occurrence of certain other events set forth herein or
otherwise, certificates for any such unaccepted Current Notes will be returned,
without expense, to the tendering holder thereof as promptly as practicable
after the Expiration Date.
Holders who tender Current Notes in the exchange offer will not be required
to pay brokerage commissions or fees or, subject to the instructions in the
Letter of Transmittal, transfer taxes with respect to the exchange of Current
Notes pursuant to the exchange offer. The Company will pay all charges and
expenses, other than certain applicable taxes described below, in connection
with the exchange offer. See "-- Fees and Expenses."
Expiration Date; Extension; Amendments. The term "Expiration Date" shall
mean 5:00 p.m., New York City time, on April 14, 1999, unless the Company, in
its sole discretion, extends the exchange offer, in which case the term
"Expiration Date" shall mean the latest date and time to which the exchange
offer is extended. Although the Company has no current intention to extend the
exchange offer, the Company reserves the right to extend the exchange offer at
any time and from time to time by giving oral or written notice to the exchange
agent and by timely public announcement communicated, unless otherwise required
by applicable law or regulation, by making a release to the Dow Jones News
Service. During any extension of the exchange offer, all Current Notes
previously tendered pursuant to the exchange offer and not withdrawn will remain
subject to the exchange offer. The date of the exchange of the New Notes for
Current Notes will be the first Nasdaq Stock Market trading day following the
Expiration Date.
The Company reserves the right, in its sole discretion (i) to delay
accepting any Current Notes, to extend the exchange offer or to terminate the
exchange offer if any of the conditions set forth below under "-- Conditions of
the Exchange Offer" shall not have been satisfied, by giving oral or written
notice of such delay, extension or termination to the Exchange Agent or (ii) to
amend the terms of the exchange offer in any manner. Any
35
<PAGE> 39
such delay in acceptance, extension, termination or amendment will be followed
as promptly as practicable by oral or written notice thereof to the registered
holders. If the exchange offer is amended in any manner determined by the
Company to constitute a material change, the Company will promptly disclose such
amendment by means of a prospectus supplement that will be distributed to the
registered holders, and the Company will extend the exchange offer for a period
of time, depending upon the significance of the amendment and the manner of
disclosure to the registered holders, if the exchange offer would otherwise
expire during such period.
In all cases, issuance of the New Notes for Current Notes that are accepted
for exchange pursuant to the exchange offer will be made only after timely
receipt by the Exchange Agent, of a properly completed and duly executed Letter
of Transmittal and all other required documents. However, the Company reserves
the absolute right to waive any conditions of the exchange offer or defects or
irregularities in the tender of Current Notes. If any tendered Current Notes are
not accepted for any reason set forth in the terms and conditions of the
exchange offer or if Current Notes are submitted for a greater principal amount
than the holder desires to exchange, such unaccepted or non-exchanged Current
Notes or substitute Current Notes or substitute Current Notes evidencing the
unaccepted portion, as appropriate, will be returned without expense to the
tendering holder, unless otherwise provided in the Letter of Transmittal, as
promptly as practicable after the expiration or termination of the exchange
offer.
Interest on the New Notes. Holders of Current Notes that are accepted for
exchange will not received accrued interest thereon at the time of exchange.
However, each New Note will bear interest from the most recent date to which
interest has been paid on the Current Notes or New Notes, or if no interest has
been paid on the Current Notes or New Notes, from June 9, 1998.
Procedures for Tendering Current Notes. The tender to the Company of
Current Notes by a holder thereof pursuant to one of the procedures set forth
below will constitute an agreement between such holder and the Company in
accordance with the terms and subject to the conditions set forth herein and in
the Letter of Transmittal. A holder of the Current Notes may tender such Current
Notes by (i) properly completing and signing a Letter of Transmittal or a
facsimile thereof (all reference in this prospectus to a Letter of Transmittal
shall be deemed to include a facsimile thereof) and delivering the same,
together with any corresponding certificate or certificates representing the
Current Notes being tendered (if in certificated form) and any required
signature guarantees, to the Exchange Agent at its address set forth in the
Letter of Transmittal on or prior to the Expiration Date (or complying with the
procedure for book-entry transfer described below) or (ii) complying with the
guaranteed delivery procedures described below.
If tendered Current Notes are registered in the name of the signer of the
Letter of Transmittal and the New Notes to be issued in exchange therefore are
to be issued (and any untendered Current Notes are to be reissued) in the name
of the registered holder (which term for the purposes described herein, shall
include any participant in DTC (also referred to as a book-entry facility) whose
name appears on a security listing as the owner of Current Notes), the signature
of such signer need not be guaranteed. In any other case, the tendered Current
Notes must be endorsed or accompanied by written instruments of transfer in form
satisfactory to the Company and duly executed by the registered holder and the
signature on the endorsement or instrument of transfer must be guaranteed by a
member firm of a registered national securities exchange or of the National
Association of Securities Dealers, Inc., a commercial bank or trust company
having an office or
36
<PAGE> 40
correspondent in the United States or an "eligible guarantor institution" as
defined by Rule 17Ad-15 under the Exchange Act (any of the foregoing hereinafter
referred to as and "Eligible Institution"). If the New Notes or Current Notes
not exchanged are to be delivered to an address other than that of the
registered holder appearing on the note register for the Current Notes, the
signature in the Letter of Transmittal must be guaranteed by an Eligible
Institution.
THE METHOD OF DELIVERY OF CURRENT NOTES, THE LETTER OF TRANSMITTAL AND ALL
OTHER REQUIRED DOCUMENTS TO THE EXCHANGE AGENT IS AT THE ELECTION AND RISK OF
THE HOLDER. IF SUCH DELIVERY IS BY MAIL, IT IS RECOMMENDED THAT REGISTERED MAIL,
PROPERLY INSURED, WITH RETURN RECEIPT REQUESTED, BE USED. IN ALL CASES,
SUFFICIENT TIME SHOULD BE ALLOWED TO ASSURE DELIVERY TO THE EXCHANGE AGENT
BEFORE THE EXPIRATION DATE. NO LETTER OF TRANSMITTAL OR OLD NOTES SHOULD BE SENT
TO THE COMPANY. HOLDERS MAY REQUEST THEIR RESPECTIVE BROKERS, DEALERS,
COMMERCIAL BANKS, TRUST COMPANIES OR NOMINEES TO EFFECT THE ABOVE TRANSACTIONS
FOR SUCH HOLDERS.
The Company understands that the Exchange Agent will make a request after
the date of this prospectus to establish an account with respect to the Current
Notes at DTC for the purpose of facilitating the exchange offer. Through DTC's
Automated Tender Offer Program ("ATOP"). Subject to the establishment thereof,
any financial institution that is a participant in DTC's system may make
book-entry delivery of Current Notes by causing DTC to transfer such Current
Notes into the Exchange Agent's account with respect to the Current Notes in
accordance with DTC's procedure for such transfer. Although delivery of the
Current Notes may be effected through book-entry transfer into the Exchange
Agent's account at DTC, an appropriate Letter of Transmittal with any required
signature guarantee and all other required documents must in each case be
transmitted to and received or confirmed by the Exchange Agent at the address
set forth in the Letter of Transmittal on or prior to the Expiration Date, or,
if the guaranteed delivery procedures described below are compiled with, within
the time period provided under such procedures.
A tender will be deemed to have been received as of the date when (i) the
tendering holder's properly completed and duly signed Letter of Transmittal
accompanied by the Current Notes (or a confirmation of book-entry transfer of
such Current Notes into the Exchange Agent's account at DTC), is received by the
Exchange Agent or (ii) a Notice of Guaranteed Delivery, provided to you with
this prospectus, or letter, telegram or facsimile transmission to similar effect
(as provided below) from an Eligible Institution is received by the Exchange
Agent, Issuances of New Notes in exchange for Current Notes tendered pursuant to
a Notice of Guaranteed Delivery or letter, telegram or against submission of a
duly signed Letter of Transmittal (and any other required documents) and deposit
of the tendered Current Notes.
All questions as to the validity, form, eligibility (including time of
receipt) and acceptance for exchange of any tender of Current Notes will be
determined by the Company, whose determination will be final and binding. The
Company reserves the absolute right to reject any or all tenders not in proper
from or the acceptance for exchange of which may, in the opinion of the
Company's counsel, be unlawful. The Company also reserves the absolute right to
waive any of the conditions of the exchange offer or any defect or irregularity
in the tender of any Current Notes. None of the Company, the Exchange Agent or
any other person will be under any duty to give notification of any defects or
irregularities in tenders or incur any liability for failure to give any such
notification. Any Current Notes received by the Exchange Agent that are not
validly tendered and as to which the defects or irregularities have not been
cured or
37
<PAGE> 41
waived, or if Current Notes are submitted in principal amount greater than the
principal amount of Current Notes being tendered by such tendering holder, such
unaccepted or non-exchanged Current Notes will be returned by the Exchange Agent
to the tendering holder, unless otherwise provided in the Letter of Transmittal,
as soon as practicable following the Expiration Date.
In addition, the Company reserves the right in its sole discretion (a) to
purchase or make offers for any Current Notes that remain outstanding subsequent
to the Expiration Date and (b) to the extent permitted by applicable law, to
purchase Current Notes in the open market, in privately negotiated transactions
or otherwise. The terms of any such purchases or offers will differ from the
terms of the exchange offer.
Guaranteed Delivery Procedures. If the holder desires to accept the
exchange offer and (i) cannot deliver a Letter of Transmittal or any other
required document to the Exchange Agent before the Expiration Date or (ii) the
procedure for book-entry transfer cannot be completed on a timely basis, such
person may effect a tender if the Exchange Agent has received at its office, on
or prior to the Expiration Date, a letter, telegram or facsimile transmission
from an Eligible Institution setting forth the name and address of the tendering
holder, the name(s) in which the Current Notes are registered and the
certificate number(s) of the Current Notes to be tendered, and stating that the
tender is being made thereby and guaranteeing that, within three Nasdaq Stock
Market trading days after the date of execution of such letter, telegram or
facsimile transmission by the Eligible Institution, such Current Notes, in
proper form for transfer (or a confirmation of book-entry transfer of such
Current Notes into the Exchange Agent's account at DTC), will be delivered by
such Eligible Institution together with a properly completed and duly executed
Letter of Transmittal (and any other required documents). Unless Current Notes
being tendered by the above-described method as deposited with the Exchange
Agent within the time period set forth above (accompanied or preceded by a
properly completed Letter of Transmittal and any other required documents), the
Company may, at its option, reject the tender. Copies of Notice of Guaranteed
Delivery which may be used by Eligible Institutions for the purposes described
in this paragraph are available from the Exchange Agent.
Terms and Conditions of the Letter of Transmittal. The Letter of
Transmittal contains, among other things, the following terms and conditions,
which are part of the exchange offer.
The party tendering Current Notes for exchange (the "Transferor")
exchanges, assigns and transfers the Current Notes to the Company and
irrevocably constitutes and appoints the Exchange Agent as the transferor's
agent and attorney-in-fact to cause the Current Notes to be assigned,
transferred and exchanged. The transferor represents and warrants that it has
full power and authority to tender, exchange, assign and transfer the Current
Notes and to acquire New Notes issuable upon the exchange of such tender Current
Notes, and that, when the same are accepted for exchange, the Company will
acquire good and unencumbered title to the tendered Current Notes, free and
clear of all liens, restrictions, charges and encumbrances and not subject to
any adverse claim. The transferor also warrants that it will, upon request,
execute and deliver any additional documents deemed by the Company to be
necessary or desirable to complete the exchange, assignment and transfer of
tendered Current Notes or to transfer ownership of such Current Notes on the
account books maintained by DTC. All authority conferred by the Transferor will
survive the death, bankruptcy or incapacity of the transferor and every
obligation of the transferor shall be binding upon the heirs, personal
representatives,
38
<PAGE> 42
executors, administrators, successors, assigns, trustees in bankruptcy and other
legal representatives of such transferor.
By executing a Letter of Transmittal, each holder will make to the Company
the representations set forth above under the heading "-- Purpose and Effect of
the Exchange Offer."
Withdrawal of Tenders of Current Notes. Except as otherwise provided
herein, tenders of Current Notes may be withdrawn at any time prior to 5:00
p.m., New York City time, on the Expiration Date.
To withdraw a tender of Current Notes in the exchange offer, a telegram,
telex, facsimile transmission or letter giving notice of withdrawal must be
received by the Exchange Agent at its address set forth herein prior to 5:00
p.m., New York City time, on the Expiration Date. Any such notice of withdrawal
must (i) specify the name of the Holder having deposited the Current Notes to be
withdrawn (the "Depositor"), (ii) identify the Current Notes to be withdrawn
(including the certificate or numbers and principal amount of such Current
Notes), (iii) contain a statement that such holder is withdrawing his election
to have such Current Notes exchanged, (iv) be signed by the Holder in the same
manner as the original signature on the Letter of Transmittal by which such
Current Notes were tendered (including any required signature guarantees) or be
accompanied by documents of transfer sufficient to have the Trustee with respect
to the Current Notes register the transfer of such Current Notes in the name of
the person withdrawing the tender and (v) specify the name in which any such
Current Notes are to be registered, if different from that of the Depositor. If
Current Notes have been tendered pursuant to the procedure for book-entry
transfer, any notice of withdrawal must specify the name and number of the
account at the book-entry transfer facility. All questions as to the validity,
form and eligibility (including time of receipt) of such notices will be
determined by the Company, whose determination shall be final and binding on all
parties. Any Current Notes so withdrawn will be deemed not to have been validly
tendered for purposes of the exchange offer and no New Notes will be issued with
respect thereto unless the Current Notes so withdrawn are validly retendered.
Any Current Notes which have been tendered but which are not accepted for
exchange will be returned to the Holder thereof without cost to such Holder as
soon as practicable after withdrawal, rejection of tender or termination of the
exchange offer. Property withdrawn Old Notes may be retendered by following one
of the procedures described above under "-- Procedures for Tendering Current
Notes" at any time prior to the Expiration Date.
CONDITIONS OF THE EXCHANGE OFFER
Notwithstanding any other term of the exchange offer, or any extension of
the exchange offer, the Company will not be required to accept for exchange, or
exchange New Notes for, any Current Notes, and may terminate the exchange offer
as provided herein before the acceptance of such Current Notes, if:
(a) any statute, rule or regulation shall have been enacted, or any
action shall have been taken by any court or governmental authority which,
in the reasonable judgment of the Company, would prohibit, restrict or
otherwise render illegal consummation of the exchange offer, or
(b) any change, or any development involving a prospective change, in
the business or financial affairs of the Company or any of its subsidiaries
has occurred
39
<PAGE> 43
which, in the sole judgment of the Company, might materially impair the
ability of the Company to proceed with the exchange offer or materially
impair the contemplated benefits of the exchange offer to the Company; or
(c) there shall occur a change in the current interpretations by the
staff of the SEC which, in the Company's reasonable judgment, might
materially impair the Company's ability to proceed with the exchange offer.
If the Company determines in its sole discretion that any of the above
conditions have occurred, the Company may (i) refuse to accept any Current Notes
and return all tendered Current Notes to the tendering holders, (ii) extend the
exchange offer and retain all Current Notes tendered prior to the Expiration
Date, subject, however, to the right of holders to withdraw such Current Notes
(see "-- Terms of the Exchange Offer -- Withdrawal of Tenders of Current Notes")
or (iii) waive such unsatisfied conditions with respect to the exchange offer
and accept all validly tendered Current Notes which have not been withdrawn. If
such waiver constitutes a material change to the exchange offer, the Company
will promptly disclose such waiver by means of a prospectus supplement that will
be distributed to the registered holders, and the Company will extend the
exchange offer for a period of time, depending upon the significance of the
waiver and the manner of disclosure to the registered holders, if the exchange
offer would otherwise expire during such period.
EXCHANGE AGENT
America Stock Transfer & Trust Company, New York has been appointed as
Exchange Agent for the exchange offer. Questions and requests for assistance,
requests for additional copies of this prospectus or of the Letter of
Transmittal and requests for Notices of Guaranteed Delivery should be directed
to the Exchange Agent Addressed as follows:
American Stock Transfer
& Trust Company
40 Wall Street
New York, NY 10005
Attn: Imre Farkas
Facsimile Transmission:
(718) 921-8334
Confirm by Telephone:
(718) 921-8293
For information with respect to the exchange offer, call
Imre Farkas of the Exchange Agent:
(718) 921-8293
FEES AND EXPENSES
The expenses of soliciting tenders will be borne by the Company. The
principal solicitation is being made by mail; however, additional solicitation
may be made by telecopy, telephone or in person by officers and regular
employees of the Company and its affiliates. No additional compensation will be
paid to any such officers and employees who engage in soliciting tenders.
40
<PAGE> 44
The Company has not retained any dealer-manager or other soliciting agent
in connection with the exchange offer and will not make any payments to brokers,
dealers or others soliciting acceptance of the exchange offer. The Company,
however, will pay the Exchange Agent reasonable and customary fees for its
services and will reimburse if for its reasonable out-of-pocket expenses in
connection therewith. The Company may also pay brokerage houses and other
custodians, nominees and fiduciaries the reasonable out-of-pocket expenses
incurred by them in forwarding copies of this prospectus, the Letter of
Transmittal and related documents to the beneficial owners of the Current Notes
and in handling or forwarding tenders for exchange.
The expenses incurred in connection with the exchange offer will be paid by
the Company. Such expenses include fees and expenses of the Exchange Agent and
transfer agent and registrar, accounting and legal fees and printing costs,
among others.
The Company will pay all transfer taxes, if any, applicable to the exchange
of the Current Notes pursuant to the exchange offer. If, however, New Notes, or
Current Notes for principal amounts not tendered or accepted for exchange, are
to be delivered to, or are to be issued in the name of, any person other than
the registered holder of the Current Notes tendered or if a transfer tax is
imposed for any reason other than the exchange of the Current Notes pursuant to
the exchange offer, then the amount of any such transfer taxes (whether imposed
on the registered holder or any other persons) will be payable by the tendering
holder. If satisfactory evidence of payment of such taxes or exemption therefrom
is not submitted with the Letter of Transmittal, the amount of such transfer
taxes will be billed directly to such tendering holder.
CONSEQUENCES OF FAILURE TO EXCHANGE
The Current Notes that are not exchanged for New Notes pursuant to the
exchange offer will remain restricted securities within the meaning of Rule 144
of the Securities Act. Accordingly, such Current Notes may be resold only (i) to
the Company or any subsidiary thereof, (ii) inside the United States to a
qualified institutional buyer in compliance with Rule 144A, (iii) inside the
United States to an institutional accredited investor that, prior to such
transfer, furnishes to the Trustee a signed letter containing certain
representations and agreements relating to the restrictions on transfer of the
Current Notes (the form of which letter can be obtained from the Trustee) and,
if such transfer of an aggregate principal amount of Current Notes at the time
of transfer of less than $100,000, an opinion of counsel acceptable to the
Company that such transfer is in compliance with the Securities Act, (iv)
outside the United States in compliance with Rule 904 under the Securities Act,
(v) pursuant to the exemption from registration provided by Rule 144 under the
Securities Act (if available), (vi) pursuant to an effective registration under
the Securities Act, or (vii) pursuant to any other available exemption from the
registration requirements of the Securities Act, subject in each of the
foregoing cases to any requirement of law that the disposition of its property
and the property of such account be at all times within its control and to
compliance with applicable state securities laws. The liquidity of the Current
Notes could be adversely affected by the exchange offer. Following the
consummation of the exchange offer, holders of the Current Notes will have no
further registration rights under the Registration Rights Agreement and will not
be entitled to the contingent increase in the interest rate provided for in the
Current Notes.
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<PAGE> 45
ACCOUNTING TREATMENT
The New Notes would be recorded at the same carrying value as the Current
Notes, as reflected in the Company's accounting records on the date of the
exchange. Accordingly, no gain or loss for accounting purposes will be
recognized by the Company. The costs of the exchange offer and the unamortized
expenses related to the issuance of the Current Notes will be amortized over the
term of the New Notes.
USE OF PROCEEDS
The Company will not receive any proceeds from the issuance of the New
Notes offered by this prospectus. In consideration for issuing the New Notes as
contemplated in this prospectus, the Company will receive in exchange Current
Notes in like principal amount, the term, and form of which are identical in all
material respects to the New Notes. The Current Notes surrendered in exchange
for New Notes will be retired and canceled and cannot be reissued. Accordingly,
issuance of the New Notes will not result in any increase in the indebtedness of
the Company.
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<PAGE> 46
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.
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<PAGE> 47
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 and
$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
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
------ ------- ------- ----------- ----------- ----------- -----------
</TABLE>
44
<PAGE> 48
<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>
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 AUGUST 31, AS OF
------------------------------------------------- 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
Loans held for sale, net.................... 1,463 3,676 4,610 9,523 10,975(6) 18,883
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
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
45
<PAGE> 49
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 and 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
1, 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.
46
<PAGE> 50
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.
47
<PAGE> 51
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
48
<PAGE> 52
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
49
<PAGE> 53
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 purchases the
loans 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
50
<PAGE> 54
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.
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 Operations," 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;
51
<PAGE> 55
- Unrealized gain (loss) on mortgage related securities retained in
securitization transactions;
- 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.
52
<PAGE> 56
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 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
53
<PAGE> 57
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 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.
54
<PAGE> 58
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 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
55
<PAGE> 59
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>
56
<PAGE> 60
<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) Excludes 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
========= ========
PRINCIPAL AMOUNT OF LOANS SOLD(2):
Title I............................................... $ 11,075 $ 810
Equity +.............................................. 106,421 12,143
Home Equity........................................... -- 24
--------- --------
Total......................................... $ 117,496 $ 12,977
========= ========
</TABLE>
57
<PAGE> 61
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
-----------------------
1997 1998
---------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
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.
(3) 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.
58
<PAGE> 62
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 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
operations 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 to 90% of the outstanding
principal balance of such Title I Loans, plus appropriate interest and
costs.
59
<PAGE> 63
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.
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
60
<PAGE> 64
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.
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
61
<PAGE> 65
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>
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.
62
<PAGE> 66
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 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.
63
<PAGE> 67
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 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
overcollateralization of
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<PAGE> 68
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 overcollateralization 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 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.
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<PAGE> 69
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.
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
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<PAGE> 70
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>
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<PAGE> 71
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> 72
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> 73
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
located later in this prospectus. For details on mortgage related securities,
see Notes 2 and 4 to the Company's financial statements.
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> 74
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> 75
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> 76
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 Title I loans with an aggregate principal
balance of approximately $9.4 million and $2.6 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> 77
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 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, $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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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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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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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> 81
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.
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 New Notes in exchange for approximately $79.0 million principal amount
of the Current 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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<PAGE> 89
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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<PAGE> 91
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> 93
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> 94
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>
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<PAGE> 95
<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> 96
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> 97
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> 98
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 the 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> 99
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> 100
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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(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> 102
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> 103
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.
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
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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.
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
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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 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.
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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.
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>
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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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 Board 1997 -- -- -- -- --
and Chief Executive
Officer 1996 -- -- -- -- --
James L. Belter(5).......... 1998 $212,519 $100,000(6) $ 9,919 -- $135,868
Executive Vice President 1997 180,003 100,000(6) 15,896 100,000 --
and Treasurer 1996 159,080 50,000(6) 4,330 -- --
</TABLE>
- -------------------------
(1) Other annual compensation consisted of car allowances, contributions to
401(k) plans and moving expenses.
(2) See "-- Employment Agreements" and "-- Company Stock Option Plans" below.
(3) All other compensation consisted of funds received from the Company to
repurchase outstanding SARs and stock options.
(4) Mr. Meyercord became Chief Executive Officer of the Company in August 1998.
(5) Mr. Belter resigned from the Company on November 30, 1998.
(6) Bonuses paid to Mr. Belter during fiscal years 1996 and 1997 were
discretionary bonuses determined by the board of directors. The bonus paid
during fiscal 1998 was paid pursuant to an employment contract entered into
with Mr. Belter in August 1997.
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The following table sets forth certain information concerning grants of
stock options made during the fiscal year ended August 31, 1998 to the Named
Executive Officers.
OPTION GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
-------------------------------------------------
PERCENT OF POTENTIAL REALIZABLE VALUE AT
NUMBER OF TOTAL ASSUMED ANNUAL RATES OF
SECURITIES OPTIONS STOCK PRICE APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM
OPTIONS EMPLOYEES IN PRICE EXPIRATION -----------------------------
NAME GRANTED(#) FISCAL YEAR ($/SH) DATE 5%($) 10%($)
- ---- ---------- ------------ -------- ---------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Champ Meyercord...... 4,818,591 80.1% $1.50 06/23/08 $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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<PAGE> 111
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> 112
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 discussion 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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<PAGE> 113
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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<PAGE> 114
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 30,566,667 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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<PAGE> 115
(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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<PAGE> 116
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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<PAGE> 117
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 and $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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<PAGE> 118
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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<PAGE> 119
DESCRIPTION OF THE NEW NOTES
GENERAL
The Company is offering to issue up to $41,445,000 aggregate principal
amount of New Notes under this exchange offer. The following summary of the
principal terms of the New Notes does not purport to be complete and is
qualified in its entirety by reference to all of the provisions of the indenture
governing the New Notes and the New Notes, copies of which are available from
the Exchange Agent. Capitalized terms used in this section that are not
otherwise defined, have the meanings as set forth below in "-- Certain
Definitions." For the purposes of this description, the Current Notes and the
New Notes shall be collectively referred to as the "Notes." A copy of the
indenture is available from the Company upon request.
The Notes are limited in aggregate principal amount to $41,445,000 and
mature on December 1, 2001. The Notes are general unsecured obligations of the
Company, subordinated in right of payment to all Senior Indebtedness of the
Company. Interest on the 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. Interest
will be computed on the basis of a 360-day year, comprised of twelve 30-day
months.
Principal of, premium, if any, and interest on the Notes is payable, at the
office or agency of the Company in the Borough of Manhattan, the City of New
York, New York 10005, except that, at the option of the Company, payment of
interest may be made by check mailed to the address of the Holders as such
address appears in the Note register.
SUBORDINATION
The Indebtedness represented by the 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,
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 Notes as
described in the Indenture and considered to be Junior Subordinated Obligations
with respect to the Notes. As of November 30, 1998, the outstanding Senior
Indebtedness of the Company, on a consolidated basis was $59.5 million.
If any Senior Indebtedness is disallowed, avoided or subordinated pursuant
to the provisions of Section 548 of the Bankruptcy Law or any applicable state
fraudulent conveyance law, such Indebtedness nevertheless will constitute Senior
Indebtedness for purposes of the indenture.
The Company may not pay the principal of, premium, if any, or interest on,
the Notes or make any deposit pursuant to the provisions described under
"Defeasance" below and may not repurchase, redeem, defease or otherwise retire
any Notes (collectively, "pay" or a "payment" with respect to the Notes) if (i)
any Senior Indebtedness of the Company is not paid when due or (ii) any other
default on any such Senior Indebtedness occurs and the maturity thereof has been
accelerated in accordance with its terms, unless, in either case, (1) the
default has been cured or waived and any such acceleration has been rescinded or
(2) such Senior Indebtedness has been paid in full. During the continuance of
any default (other than a default described in clause (i) or (ii) of the
preceding sentence) with respect to any Designated Senior Indebtedness of the
Company pursuant to
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which the maturity thereof may be accelerated immediately without further notice
(except such notice as may be required to effect such acceleration) or the
expiration of any applicable grace periods, the Company may not pay the New
Notes for a Payment Blockage Period commencing upon the receipt by the Company
and the Trustee of a Blockage Notice and ending 179 days thereafter (or earlier
if such Payment Blockage Period is terminated (i) by written notice to the
Trustee and the Company from the Person or Persons who gave such Blockage
Notice, (ii) by repayment in full of such Designated Senior Indebtedness or
(iii) because the default giving rise to such Blockage Notice is no longer
continuing). Notwithstanding the provisions described in the immediately
preceding sentence (but subject to the provisions contained in the next
preceding sentence), unless the holders of such Designated Senior Indebtedness
or the Representative of such holders shall have accelerated the maturity of
such Designated Senior Indebtedness, the Company may resume payments on the
Notes after such Payment Blockage Period. Not more than one Blockage Notice may
be given in any consecutive 360-day period, irrespective of the number of
defaults with respect to Designated Senior Indebtedness during such period.
Upon any payment or distribution of the assets of the Company to creditors
upon a total or partial liquidation or total or partial dissolution of the
Company or in a bankruptcy, reorganization, insolvency, receivership or similar
proceeding relating to the Company or its property (whether voluntary or
involuntary), (i) the holders of Senior Indebtedness of the Company will be
entitled to receive payment in full before the holders of the Notes are entitled
to receive any payment, and (ii) until the Senior Indebtedness of the Company is
paid in full, any payment to which the Holders of the Notes would be entitled
but for this provision will be made to holders of Senior Indebtedness as their
interests may appear, except that Holders may receive shares of stock or
Indebtedness of the Company that is subordinated to Senior Indebtedness of the
Company to at least the same extent as the New Notes.
In the event that, notwithstanding the foregoing, any payment or
distribution of assets of the Company shall be received by the Trustee or the
Holders at a time when such payment or distribution is prohibited by the
foregoing provisions, such payment or distribution shall be held in trust for
the benefit of the holders of Senior Indebtedness of such Person, and shall be
paid or delivered by the Trustee or such Holders, as the case may be, to the
holders of such Senior Indebtedness remaining unpaid or unprovided for or to
their Representative, ratably according to the aggregate amounts remaining
unpaid on account of the Senior Indebtedness held or represented by each, for
application to the payment of all Senior Indebtedness remaining unpaid, to the
extent necessary to pay or to provide for the payment of all such Senior
Indebtedness in full after giving effect to any concurrent payment or
distribution to the holders of such Senior Indebtedness.
If payment of the Notes is accelerated because of an Event of Default, the
Company or the Trustee shall promptly notify the holders of Senior Indebtedness
or any Representative thereof of the acceleration. If the Trustee provides such
notice, the Trustee also will notify the Company of the acceleration.
By reason of such subordination provisions contained in the Indenture, in
the event of insolvency, holders of the Notes may recover less, ratably, than
other creditors of the Company (including trade creditors), or may recover
nothing.
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OPTIONAL REDEMPTION
The 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 (the "Redemption Price") (expressed as a percentage of principal amount),
(i) prior to December 1, 1999, of 100% and (ii) after December 1, 1999 but prior
to December 1, 2001, of 106%, in either case plus accrued and unpaid interest to
the redemption date (subject to the right of Holders of record on the relevant
record date to receive interest due on the relevant interest payment date).
SINKING FUND
There is no mandatory sinking fund for the Notes.
PAYMENT ON THE NEW NOTES
All payments of principal, premium, if any, and interest (including Added
Interest, if any) is to be made by the Company in immediately available funds.
CERTAIN COVENANTS
Set forth below are descriptions of certain covenants set forth in the
Indenture.
Limitation on Indebtedness. (a) The Company will not Incur, and the
Company will not permit any Subsidiary to Incur, directly or indirectly, any
Indebtedness or Disqualified Stock if, on the date of such Incurrence and after
giving effect thereto, the Consolidated Leverage Ratio exceeds 1.5 to 1.0.
(b) Notwithstanding the foregoing paragraph (a), the Company and its
Subsidiaries may Incur the following Indebtedness and Disqualified Stock while
no Default or Event of Default exists:
(1) Permitted Warehouse Indebtedness and Guarantees by the Company of
any Permitted Warehouse Indebtedness of Subsidiaries, provided that to the
extent any such Indebtedness ceases to constitute Permitted Warehouse
Indebtedness of the Company or a Subsidiary, such event shall be deemed to
constitute the Incurrence of such Indebtedness (and any such Guarantees,
but without duplication) by the Company or such Subsidiary, as the case may
be;
(2) the Notes;
(3) Hedging Obligations directly related to: (i) Indebtedness
permitted to be Incurred by the Company or its Subsidiaries pursuant to the
Indenture; (ii) Receivables held by the Company or its Subsidiaries pending
sale or that have been sold pursuant to a Warehouse Facility; or (iii)
Receivables with respect to which the Company or any Subsidiary has an
outstanding purchase or offer commitment, financing commitment or security
interest;
(4) the Current Notes and other Indebtedness outstanding on the New
Note Issue Date (other than Permitted Warehouse Indebtedness and Guarantees
thereof, which shall be permissible under this paragraph (b) only pursuant
to clause (1) above);
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(5) Indebtedness or Disqualified Stock issued to and held by the
Company or a Wholly Owned Subsidiary; provided, however, that any
subsequent issuance or transfer of any Capital Stock that results in any
such Wholly Owned Subsidiary ceasing to be a Wholly Owned Subsidiary or any
subsequent transfer of such Indebtedness or Disqualified Stock (other than
to the Company or a Wholly Owned Subsidiary) will be deemed, in each case,
to constitute the Incurrence of such Indebtedness or issuance of such
Disqualified Stock by the issuer thereof;
(6) Indebtedness under Capital Lease Obligations incurred in the
ordinary course of business in connection with the acquisition of
equipment;
(7) Permitted Excess Spread Receivables Indebtedness; and
(8) Refinancing Indebtedness in respect of Indebtedness Incurred
pursuant to paragraph (a) or clause (4), (6) or (7) of this paragraph (b).
(c) Notwithstanding the foregoing, (i) the Company and its Subsidiaries may
not Incur any Indebtedness (other than the Notes) if such Indebtedness is
subordinate or junior in ranking in respect to any Senior Indebtedness unless
such Indebtedness is pari passu with the Notes or constitutes a Junior
Subordinated Obligation, and (ii) the Company shall not Incur any Indebtedness
if the proceeds thereof are used, directly or indirectly, to Refinance any
Junior Subordinated Obligations unless such Indebtedness shall be subordinated
to the Notes to at least the same extent as such Junior Subordinated
Obligations. Unsecured Indebtedness is not deemed to be subordinate or junior to
secured Indebtedness merely because it is unsecured.
(d) For purposes of determining compliance with the foregoing covenant: (i)
in the event that an item of Indebtedness meets the criteria of more than one of
the types of Indebtedness described above, the Company, in good faith, will
classify such item of Indebtedness and be required to include the amount and
type of such Indebtedness in one of the above clauses; and (ii) an item of
Indebtedness may be divided and classified in more than one of the types of
Indebtedness described above.
Limitation on Liens. The Company will not, directly or indirectly, incur
or permit to exist any Lien of any nature whatsoever on any of its properties
(including Capital Stock of a Subsidiary), whether owned at the New Note Issue
Date or thereafter acquired, other than Permitted Liens, without effectively
providing that the Notes shall be secured by a Lien on the same property as
secures the obligations so secured, in each case until such time as such other
obligations are no longer secured by a Lien, provided (i) if such other
obligations constitute Senior Indebtedness or are otherwise senior or prior in
right of payment to the obligations under the Indenture and the Notes, such Lien
is expressly made junior and subordinate in priority to the Lien securing such
other obligations; (ii) if such other obligations constitute Junior Subordinated
Obligations or are otherwise subordinate or junior in right of payment to the
obligations under the New Indenture and the Notes, such Lien is expressly made
prior and senior in priority to the Lien securing such other obligations; or
(iii) in any other case, such Lien ranks equally and ratably with the Lien
securing such other obligations so secured.
Limitation on Affiliate Transactions. The Company will not, and will not
permit any Subsidiary to, enter into or permit to exist any transaction
(including without limitation the making of any loan, advance, Guarantee or
capital contribution to or for the benefit of, the purchase, sale, lease or
exchange of any property with, the entering into or amending of employee
compensation arrangements with, or the rendering of any service) with or for
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the benefit of, any Affiliate of the Company (an "Affiliate Transaction") unless
the terms thereof: (i) are in the ordinary course of business and consistent
with past practice; (ii) are fair to the Company and are no less favorable to
the Company or such Subsidiary than those that could be obtained at the time of
such transaction in arm's-length dealings with a Person who is not an Affiliate;
and (iii) if such Affiliate Transaction involves an amount in excess of
$2,000,000, (A) are set forth in writing and (B) have been approved by a
majority of the members of the Board of Directors having no personal stake in
such Affiliate Transaction.
The provisions of the foregoing paragraph shall not apply to (a)
transactions exclusively between or among the Company and any Wholly Owned
Subsidiary or between or among Wholly Owned Subsidiaries, (b) any employment or
related arrangement entered into by the Company in the ordinary course of
business on terms customary in the consumer finance business, provided any such
arrangement is approved by the disinterested members of the Board of Directors,
(c) customary directors' fees and indemnities, (d) payments required by the Tax
Sharing Agreement or any renewal thereof on substantially similar terms, and (e)
all payments to stockholders or holders of Original Notes in connection with the
Recapitalization to the extent described in this Offering Memorandum (including
the payment of fees and expenses to the Placement Agent and its Affiliates as
described herein).
As a result of the Spin-off, no further payments by the Company to Mego
Financial under the Tax Sharing Agreement are required with respect to taxes
accruing for periods after the Spin-off.
Merger and Consolidation. The Company will not consolidate with or merge
with or into, or convey, transfer or lease, in one transaction or a series of
related transactions, all or substantially all its assets to, any Person,
unless: (i) the Successor Company shall be a Person organized and existing under
the laws of the United States of America or any State thereof and the Successor
Company (if not the Company) shall expressly assume, by an indenture
supplemental thereto, executed and delivered to the Trustee, in form
satisfactory to the Trustee, all of the Company's obligations under the Notes
and the Indenture; (ii) immediately after giving effect to such transactions
(and treating any Indebtedness that becomes an obligation of the Successor
Company as a result of such transaction as having been incurred by such
Successor Company at the time of such transaction), no Default shall have
occurred and be continuing; (iii) immediately after giving effect to such
transaction, the Successor Company would be able to incur an additional $1.00 of
Indebtedness pursuant to paragraph (a) of the covenant described under
"Limitation on Indebtedness," (iv) immediately after giving effect to such
transaction, the Successor Company shall have Consolidated Net Worth in an
amount that is not less than the Consolidated Net Worth of the Company prior to
such transaction; and (v) the Company shall have delivered to the Trustee an
Officers' Certificate and an Opinion of Counsel, each stating that such
consolidation, merger or transfer and such supplemental indenture (if any)
comply with the Indenture.
The Successor Company shall be the successor to the Company and shall
succeed to, and be substituted for, and may exercise every right and power of,
the Company under the Indenture, but the predecessor Company, in the case of a
lease, shall not be released from the obligation to pay the principal of,
premium, if any, and interest on the Notes.
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Limitation on Investment Company Status. The Company shall not take any
action, or otherwise permit to exist any circumstances, that would require the
Company to register as an "investment company" under the Investment Company Act
of 1940, as amended.
Line of Business. The Company will not, and will not permit any Subsidiary
to, engage in any line of business that is not a Related Business.
Payments for Consent. The Indenture provides that the Company will not
directly or indirectly pay or cause to be paid any consideration, whether by way
of interest, fee or otherwise, to any Holder of any Notes for or as an
inducement to any consent, waiver or amendment of any of the terms or provisions
of the Indenture or the Notes unless such consideration is offered to be paid or
agreed to be paid to all Holders of the Notes that consent, waive or agree to
amend in the time frame set forth in the solicitation documents relating to such
consent, waiver or agreement.
SEC Reports. Notwithstanding that the Company may not be required to
remain subject to the reporting requirements of Section 13 or 15(d) of the
Exchange Act, the Company shall file with the SEC and provide the Trustee and
Holders with such annual reports, quarterly reports and such other information,
documents and reports as are specified in Sections 13 and 15(d) of the Exchange
Act and applicable to a U.S. corporation subject to such Sections, such
information, documents and other reports to be so filed and provided at the
times specified for the filing of such information, documents and reports under
such Sections.
DEFAULTS
An Event of Default is defined in the Indenture as: (i) a default in the
payment of interest (including Added Interest, if any) on the New Notes when
due, continued for 30 days; (ii) a default in the payment of principal of and
premium, if any, on any New Note when due at its Stated Maturity, upon optional
redemption, upon required repurchase, upon declaration of acceleration or
otherwise; (iii) the failure by the Company to comply with any of its
obligations in the covenants described under "-- Certain Covenants -- Merger and
Consolidation;" (iv) the failure by the Company to comply with any of its
obligations in the covenants described above under "-- Certain Covenants --
Limitation on Affiliate Transactions," "-- Limitation on Indebtedness,"
"-- Limitation on Liens," "-- Certain Covenants -- Limitation on Investment
Company Status" or "-- Certain Covenants -- SEC Reports" and 30 days or more
shall have expired after a Senior Officer of the Company first becomes aware of
such failure; (v) the failure by the Company to comply for 30 days after notice
with its other agreements contained in the Indenture; (vi) Indebtedness of the
Company or any Subsidiary is not paid within any applicable grace period after
final maturity or is accelerated by the holders thereof because of a default and
the total amount of such Indebtedness unpaid or accelerated exceeds $2,000,000
(the "cross acceleration provision"); (vii) certain events of bankruptcy,
insolvency or reorganization of the Company or a Subsidiary (the "bankruptcy
provisions") or (viii) any judgment or decree for the payment of money in excess
of $1,000,000 is rendered against the Company or a Subsidiary, remains
outstanding for a period of 60 days following such judgment and is not
discharged, waived or stayed (the "judgment default provision"). However, a
default under clause (v) will not constitute an Event of Default until the
Trustee or the Holders of 25% in principal amount of the outstanding Notes
notify the Company of the Default and the Company does not cure such Default
within the time specified after receipt of such notice.
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If an Event of Default occurs and is continuing, the Trustee or the Holders
of at least 25% in principal amount of the outstanding Notes may declare the
principal of, premium, if any, and accrued but unpaid interest on all the Notes
to be due and payable. Upon such a declaration, such principal, premium, if any,
and interest shall be due and payable immediately. If an Event of Default
relating to certain events of bankruptcy, insolvency or reorganization of the
Company occurs and is continuing, the principal of, premium, if any, and any
accrued but unpaid interest on all the Notes will ipso facto become and be
immediately due and payable without any declaration or other act on the part of
the Trustee or any Holders of the Notes. Under certain circumstances, the
Holders of a majority in principal amount of the outstanding Notes may rescind
any such acceleration with respect to the Notes and its consequences.
Subject to the provisions of the Indenture relating to the duties of the
Trustee, in case an Event of Default occurs and is continuing, the Trustee will
be under no obligation to exercise any of the rights or powers under the
Indenture at the request or direction of any of the Holders of the Notes unless
such Holders have offered to the Trustee reasonable indemnity or security
against any loss, liability or expense. Except to enforce the right to receive
payment of principal, premium, if any, or interest (if any) when due, no Holder
may pursue any remedy with respect to the Indenture or the Notes unless (i) such
Holder has previously given the Trustee notice that an Event of Default is
continuing, (ii) Holders of at least 25% in principal amount of the outstanding
Notes have requested the Trustee to pursue the remedy, (iii) such Holders have
offered the Trustee reasonable security or indemnity against any loss, liability
or expense, (iv) the Trustee has not complied with such request within 60 days
after the receipt thereof and the offer of security or indemnity and (v) the
Holders of a majority in principal amount of the outstanding Notes have not
given the Trustee a direction inconsistent with such request within such 60-day
period. Subject to certain restrictions, the Holders of a majority in principal
amount of the outstanding Notes have the right to direct the time, method and
place of conducting any proceeding for any remedy available to the Trustee or of
exercising any trust or power conferred on the Trustee. The Trustee, however,
may refuse to follow any direction that conflicts with law or the Indenture or
that the Trustee determines is unduly prejudicial to the rights of any other
Holder or that would involve the Trustee in personal liability.
The Indenture provides that if a Default occurs and is continuing and is
known to the Trustee, the Trustee may mail to each Holder of outstanding Notes
notice of the Default within 60 days after it occurs. Except in the case of a
Default in the payment of principal of, premium, if any, or interest on any
Notes, the Trustee may withhold notice if and so long as a committee of its
trust officers determines that withholding notice is not opposed to the interest
of the Holders. In addition, the Company is required to deliver to the Trustee,
within 120 days after the end of each fiscal year, a certificate indicating
whether the signers thereof know of any Default that occurred during the
previous year. The Company also is required to deliver to the Trustee, within 30
days after a Senior Officer of the Company or any Subsidiary becomes aware of
the occurrence thereof, written notice of any event which would constitute
certain Defaults, their status and what action the Company or such Subsidiary is
taking or proposes to take in respect thereof.
AMENDMENTS AND WAIVERS
Subject to certain exceptions, the Indenture may be further amended with
the consent of the Holders of a majority in principal amount of the Notes then
outstanding, voting as one class (including consents obtained in connection with
a tender offer or exchange for
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the Notes), and any past Default or compliance with any provisions may be waived
with the consent of the Holders of a majority in principal amount of the Notes
then outstanding. However, without the consent of each Holder of an outstanding
Note affected thereby, no amendment or waiver may, among other things, (i)
reduce the amount of Notes whose Holders must consent to an amendment, (ii)
reduce the rate of or extent the time for payment of interest on any Note, (iii)
reduce the principal of or extend the Stated Maturity of any Note, (iv) make any
Note payable in money other than that stated in the Note, (v) impair the right
of any Holder to receive payment of principal of, premium, if any, and interest
on such Holder's Notes on or after the due dates therefor or to institute suit
for the enforcement of any payment on or with respect to such Holder's Notes,
(vi) make any change to the provisions of the Indenture relating to
subordination of the Notes, or (vii) make any change in the amendment provisions
which require each Holder's consent or in the waiver provisions.
Without the consent of each Holder, the Company and Trustee may further
amend the Indenture to cure any ambiguity, omission, defect or inconsistency, to
provide for the assumption by a successor corporation of the obligations of the
Company under the Indenture, to provide for uncertificated Notes in addition to
or in place of certificated Notes (provided that the uncertificated Notes are
issued in registered form for purposes of Section 163(f) of the Code, or in a
manner such that the uncertificated Notes are described in Section 163(f)(2)(B)
of the Code), to add guarantees with respect to the Notes, to secure the Notes,
to add to the covenants of the Company for the benefit of the Holders or to
surrender any right or power conferred upon the Company, to modify the
provisions relating to global Notes, restrictions on transfer and legends set
forth in the Indenture with respect to any Future Notes not then outstanding, to
make any change that does not adversely affect the rights of any Holder or to
comply with any requirement of the SEC in connection with the qualification of
the New Indenture under the Trust Indenture Act.
The consent of the Holders is not necessary under the Indenture to approve
the particular form of any proposed amendment. It is sufficient if such consent
approves the substance of the proposed amendment.
After an amendment under the Indenture becomes effective, the Company will
mail to Holders a notice briefly describing such amendment. However, the failure
to give such notice to all Holders, or any defect therein, will not impair or
affect the validity of the amendment.
TRANSFER
A Holder will be able to register the transfer of or exchange of the Notes
only in accordance with the provisions of the Indenture. The Company may require
a holder to furnish appropriate endorsements and transfer documents, and to pay
a sum sufficient to cover any tax, assessment or other governmental charge
payable in connection with certain registrations of transfers and exchanges. The
Company is not required to register a transfer or exchange of any Note selected
for redemption except for the unredeemed portion of any Note being redeemed in
part. The registered Holder of a note will be treated as the owner for all
purposes.
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DEFEASANCE
The Company at any time may terminate all its obligations under the Notes
and the Indenture (i.e. legal defeasance), except for certain obligations,
including those respecting the defeasance trust and obligations to register the
transfer or exchange of the Notes, to replace mutilated, destroyed, lost or
stolen Notes and to maintain a registrar and paying agent in respect of the
Notes. The Company at any time may terminate its obligations under the covenants
described under "-- Certain Covenants" (other than the covenant described under
"-- Merger and Consolidation"), the operation of the cross acceleration
provision, the bankruptcy provisions with respect to Subsidiaries and the
judgment default provision described under "-- Defaults" and the limitations
contained in clauses (iii) and (iv) under "-- Certain Covenants -- Merger and
Consolidation" (i.e. covenant defeasance).
The Company may exercise its legal defeasance option notwithstanding its
prior exercise of its covenant defeasance option. If the Company exercises its
legal defeasance option, payment of the Notes may not be accelerated because of
an Event of Default with respect thereto (other than an Event of Default with
respect to the obligations referred to in the first sentence of the immediately
preceding paragraph). If the Company exercises its covenant defeasance option,
payment of the Notes may not be accelerated because of an Event of Default under
the provisions described in the last sentence of the foregoing paragraph.
In order to exercise either defeasance option, the Company must irrevocably
deposit in trust (i.e. the defeasement trust) with the Trustee unencumbered
money or U.S. Government Obligations for the payment of principal of, premium,
if any, and interest on the Notes to redemption or maturity, as the case may be,
and must comply with certain other conditions, including delivery to the Trustee
of an Opinion of Counsel to the effect that Holders will not recognize income,
gain or loss for federal income tax purposes as a result of such deposit and
defeasance and will be subject to federal income tax on the same amount and in
the same manner and at the same time as would have been the case if such deposit
and defeasance had not occurred (and, in the case of legal defeasance only, such
Opinion of Counsel must be based on a ruling of the Internal Revenue Service or
other change in applicable federal income tax law).
CONCERNING THE TRUSTEE
American Stock Transfer & Trust Company is the Trustee under the Indenture
and has been appointed by the Company as Exchange Agent with regard to the
Notes.
The Holders of a majority in principal amount of the outstanding Notes will
have the right to direct the time, method and place of conducting any proceeding
for exercising any remedy available to the Trustee, subject to certain
exceptions. The Indenture provides that if an Event of Default occurs (and is
not cured), the Trustee will be required, in the exercise of its power, to use
the degree of care of a prudent man in the conduct of his own affairs. Subject
to such provisions, the Trustee will be under no obligation to exercise any of
its rights or powers under the Indenture at the request of any Holder, unless
such Holder shall have offered to the Trustee security and indemnity
satisfactory to it against any loss, liability or expense and then only to the
extent required by the terms of the Indenture.
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GOVERNING LAW
The Indenture provides that it and the Notes will be governed by, and
construed in accordance with, the laws of the State of New York without giving
effect to applicable principles of conflicts of law to the extent that the
application of the law of another jurisdiction would be required thereby.
BOOK-ENTRY, DELIVERY AND FORM
Except for any New Notes issued in certificated form without coupons as
described below under "-- Certificated Securities" as Certificated Securities,
all New Notes will be represented by one or more Global Exchange Notes without
coupons. (The Global Exchange Notes, along with any global notes representing
Current Notes, herein collectively are referred to as the "Global Notes.") Each
of the Global Exchange Notes will be issued in a denomination equal to the
outstanding New Notes represented thereby and will be held by the DTC, as the
Depositary, or its nominee. Beneficial interests in the Global Exchange Notes
will be shown on, and transfers thereof will be effected only through, records
maintained in book-entry form by the Depositary (with respect to its
Participants' interests) and its participants.
Notwithstanding anything herein to the contrary, New Notes originally
purchased by persons outside the United States pursuant to sales in accordance
with Regulation S under the Securities Act will be represented upon issuance by
a Global Exchange Note which will not be exchangeable for Certificated Notes
until the expiration of the 40-day restricted period within the meaning of Rule
903(c)(2) of Regulation S under the Securities Act.
The Depositary is a limited purpose trust company organized under the New
York Banking Law that was created to hold securities for the Participants (or
the Depositary's Participants) and to facilitate the clearance and settlement of
transactions in such securities between Participants through electronic
book-entry changes in accounts of its Participants. The Depositary's Direct
Participants include securities brokers and dealers (including the Placement
Agent), banks and trust companies, clearing corporations and certain other
organizations. Access to the Depositary's system is also available to the
Indirect Participants or the Depositary Indirect Participants that clear through
or maintain a custodial relationship with a Participant, either directly or
indirectly. Persons who are not Participants may beneficially own securities
held by or on behalf of the Depositary only through the Depositary Participants
or the Depositary's Indirect Participants.
Pursuant to procedures established by the Depositary, upon deposit of the
Global Exchange Notes, the Depositary will credit the accounts of Participants
with portions of the principal amount of the Global Exchange Notes. Purchases of
participation interests in the Global Exchange Notes under the Depositary's
system must be made by or through Direct Participants, which will receive a
credit for the Exchange Notes on the Depositary's records. The ownership
interest of the beneficial owner of each Exchange Note is in turn to be recorded
on the Direct and Indirect Participants' records and ownership of the Exchange
Notes evidenced by the Global Exchange Notes will be shown on, and the transfer
of ownership thereof will be effected only through, records maintained and
procedures established by the Depositary (with respect to the interests of the
Depositary's Participants) and the Indirect Participants.
So long as the Depositary or a Global Note Holder is the registered owner
of any Notes, the Global Note Holder will be considered the sole Holder under
the Indenture of
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any Notes evidenced by a Global Note. Beneficial owners of Notes evidenced by a
Global Note will not be considered the owners or Holders thereof under the
Indenture for any purpose, including with respect to the giving of any
directions, instructions or approvals to the Trustee thereunder. Accordingly,
beneficial owners of an interest in a Global Note must rely on the procedures of
the Depositary, and if such person is not a Participant, on the procedures of
the Participant or Indirect Participant through which such person owns its
interest, to exercise any rights and fulfill any obligations of a Holder under
the Indenture. None of the Company, the Trustee, the Registrar or any Paying
agent will have any responsibility or liability for any aspect of the records of
the Depositary, any Participant or any Indirect Participant or for maintaining,
supervising or reviewing any records of any of them relating to the New Notes,
and each of the Company, the Trustee, the Registrar or any Paying Agent may
conclusively rely on, and will be protected in relying on, instructions from the
Global Note Holder or the Depositary for all purposes.
Payments in respect of the principal of, premium, if any, and interest on
any Notes registered in the name of the Global Note Holder on the applicable
record date will be payable by the Trustee to or at the direction of the Global
Note Holder in its capacity as the registered Holder under the Indenture. Under
the terms of the Indenture, the Company and the Trustee may treat the persons in
whose names Notes, including the Global Notes, are registered as the owners
thereof for the purpose of receiving such payments. Consequently, none of the
Company, the Trustee, the Registrar or the Paying Agent has or will have any
responsibility or liability for the payment of such amounts (or the timing of
such payments) to beneficial owners of Notes. The Company believes, however,
that it is currently the policy of the Depositary to immediately credit the
accounts of the relevant Participants with such payments, in amounts
proportionate to their respective holdings of beneficial interests in the
relevant security as shown on the records of the Depositary. Payments by the
Depositary's Participants and the Depositary's Indirect Participants to the
beneficial owners of Notes will be governed by standing instructions and
customary practice and will be the responsibility of the Depositary's
Participants or the Depositary's Indirect Participants.
Although the Depositary and its Participants are expected to follow the
foregoing procedures in order to facilitate transfers of interests in the Global
Notes among Participants, they are under no obligation to perform or continue to
perform such procedures, and such procedures may be discontinued at any time.
None of the Company, the Trustee, the Registrar or any Paying agent will have
any responsibility for the performance by the Depositary, Participants or
Indirect Participants of their respective obligations under the rules and
procedures governing their operations.
The information in this section concerning the Depositary and its
book-entry system has been obtained from sources that the Company believe to be
reliable, but the Company takes no responsibility for the accuracy thereof.
CERTIFICATED SECURITIES
Subject to certain conditions, any person having a beneficial interest in a
Global Note may, upon request to the Trustee, exchange such beneficial interest
for Certificated Securities. Upon any such exchange, the Trustee is required to
register such Certificated Securities in the name of, and cause the same to be
delivered to, such person or persons (or the nominee of any thereof). All Notes
that are or become Certificated Securities will be subject to the legend
requirements described under "Transfer Restrictions" below. In
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addition, if (i) the Company notifies the Trustee in writing that the Depositary
is no longer willing or able to act as a Depositary and the Company is unable to
locate a qualified successor within 90 days, (ii) the Company, at its option,
notifies the Trustee in writing that it elects to cause the issuance of Notes in
the form of Certificated Securities under the Indenture, or (iii) if a Default
or Event of Default occurs and any owner of a beneficial interest in a Global
Note so requests, then, upon surrender by the Global Note Holder of a Global
Note, Notes in the form of Certificated Securities will be issued to each person
that the Global Note Holder and the Depositary identify as being the beneficial
owner of the related Notes. Upon the transfer of Certificated Securities to a
person entitled to hold an interest in a Global Note under the New Indenture,
such Certificated Securities may, unless a Global Note has previously been
exchanged for Certificated Securities, be exchanged for an interest in a Global
Note representing the principal amount of Notes being transferred.
CERTAIN DEFINITIONS
"Affiliate" of any specified person means any other Person, directly or
indirectly, controlling or controlled by or under direct or indirect common
control with such specified Person. For the purposes of this definition,
"control" when used with respect to any Person means the power to direct the
management and policies of such Person, directly or indirectly, whether through
the ownership of voting securities, by contract or otherwise; provided that a
Person shall be deemed to have such power with respect to the Company if such
Person is the beneficial owner of Capital Stock representing 5% or more of the
total voting power of the Voting Stock (on a fully diluted basis) of the Company
or of rights or warrants to purchase such Capital Stock (whether or not
currently exercisable). The terms "controlling" and "controlled" have meanings
correlative to the foregoing.
"Average Life" means, as of the date of determination, with respect to any
Indebtedness or Preferred Stock, the quotient obtained by dividing (i) the sum
of the products of numbers of years from the date of determination to the dates
of each successive scheduled principal payment of such Indebtedness or
redemption or similar payment with respect to such Preferred Stock multiplied by
the amount of such payment by (ii) the sum of all such payments.
"Board of Directors" means the Board of Directors of the Company or any
committee thereof duly authorized to act on behalf of such Board.
"Business Day" means each day which is not a Legal Holiday.
"Capital Lease Obligation" means an obligation that is required to be
classified and accounted for as a capital lease for financial reporting purposes
in accordance with GAAP. The amount of Indebtedness represented by such
obligation shall be the capitalized amount of such obligation determined in
accordance with GAAP, and the Stated Maturity thereof shall be the date of the
last payment of rent or any other amount due under such lease prior to the first
date upon which such lease may be terminated by the lessee without payment of a
penalty.
"Capital Stock" of any Person means any and all shares, interests, rights
to purchase, warrants, options, participations or other equivalents of or
interests in (however designated) equity of such Person, including any Preferred
Stock, but excluding any debt securities convertible into such equity.
"Code" means the Internal Revenue Code of 1986, as amended.
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"Consolidated Leverage Ratio" as of any date of determination means the
ratio of (i) the aggregate amount of all Indebtedness and Disqualified Stock of
the Company and its Subsidiaries, excluding (A) Permitted Warehouse
Indebtedness, (B) Hedging Obligations, (C) Capital Lease Obligations, and (D)
Permitted Excess Spread Receivables Indebtedness, provided in the case of (A),
(B), (C) or (D), such Indebtedness is then permitted to be Incurred pursuant to
clause (b)(1), (3), (6) or (7), as applicable, of the covenant described under
"Certain Covenants -- Limitation on Indebtedness," to (ii) the Consolidated Net
Worth of the Company.
"Consolidated Net Worth" means the consolidated stockholders' equity of the
Company and its Subsidiaries, as determined in accordance with GAAP, as of the
end of the most recent fiscal quarter of the Company for which financial
statements are available, less (i) all write-ups by the Company or any
Subsidiary (other than write-ups resulting from foreign currency translations,
write-ups of tangible assets of a going concern business made within 12 months
after acquisition thereof and write-ups of Excess Spread Receivables or mortgage
servicing rights in accordance with GAAP), (ii) all Investments in
unconsolidated Subsidiaries (except Temporary Cash Investments), (iii) all
unamortized debt discount and expense and unamortized deferred charges of the
Company and its Subsidiaries, in each case as of such date and (iv) any amounts
attributable to Disqualified Stock. For purposes of this definition, "deferred
charges" does not include deferred taxes, costs associated with mortgage
servicing rights and loan origination costs, in each case to the extent deferred
in accordance with GAAP.
"Currency Agreement" means, with respect to any Person, any foreign
exchange contract, currency swap agreement or other similar agreement to which
such Person is a party or of which it is a beneficiary.
"Default" means any event which is, or after notice or passage of time or
both would be, an Event of Default.
"Designated Senior Indebtedness" means, as of any date of determination,
any Senior Indebtedness designated as such by the Company in the related credit
documentation, provided the unpaid principal amount thereof, or the amount of
Senior Indebtedness committed to be extended by the lender or lenders under the
related credit facility, equals or exceeds $1,000,000 on such date of
determination.
"Disqualified Stock" means, with respect to any Person, any Capital Stock
that by its terms (or by the terms of any security into which it is convertible
or for which it is exchangeable) or upon the happening of any event (i) matures
or is mandatorily redeemable pursuant to a sinking fund obligation or otherwise,
(ii) is convertible or exchangeable for Indebtedness or Disqualified Stock or
(iii) is redeemable at the option of the holders thereof, in each case in whole
or in part on or prior to the first anniversary of the Stated Maturity of the
Notes.
"Excess Spread" means (i) with respect to a "pool" of Receivables that has
been sold to a trust or other Person in a securitization, the excess of (a) the
weighted average coupon on each pool of Receivables sold over (b) the sum of the
pass-through interest rate plus a normal servicing fee, a trustee fee, an
insurance fee and an estimate of annual future credit losses related to such
assets, in each case calculated in accordance with any applicable GAAP, and (ii)
with respect to Receivables that have been sold to a Person in a whole loan
sale, the cash flow of the Company and its Subsidiaries from such Receivables,
net of, to the extent applicable, a normal servicing fee, a trustee fee, an
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insurance fee and an estimate of annual future credit losses related to such
assets, in each case calculated in accordance with any applicable GAAP.
"Excess Spread Receivables" of a Person means the contractual or
certificated right to Excess Spread capitalized on such Person's consolidated
balance sheet (the amount of which shall be the present value of the Excess
Spread, calculated in accordance with GAAP, net of any allowance for losses on
loans sold with recourse or other liability allocable thereto, to the extent not
otherwise reflected in such amount). Excess Spread Receivables (a) include
mortgage backed securities attributable to Receivables sold by the Company or
any Subsidiary, and (b) do not include any mortgage servicing rights.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"GAAP" means generally accepted accounting principles in the United States
of America as in effect from time to time, including those set forth in (i) the
opinions and pronouncements of the Accounting Principles Board of the American
Institute of Certified Public Accountants, (ii) statements and pronouncements of
the Financial Accounting Standards Board, (iii) such other statements by such
other entity as approved by a significant segment of the accounting profession
and (iv) the rules and regulations of the SEC governing the inclusion of
financial statements (including pro forma financial statements) in periodic
reports required to be filed pursuant to Section 13 of the Exchange Act,
including opinions and pronouncements in staff accounting bulletins and similar
written statements from the accounting staff of the SEC and releases of the
Emerging Issues Task Force.
"Guarantee" means any obligation, contingent or otherwise, of any Person
directly or indirectly guaranteeing any Indebtedness or other obligation of any
Person and any obligation, direct or indirect, contingent or otherwise, of such
Person (i) to purchase or pay (or advance or supply funds for the purchase or
payment of) such Indebtedness or other obligation of such Person (whether
arising by virtue of partnership arrangements, or by agreements to keep-well, to
purchase assets, goods, securities or services, to take-or-pay or to maintain
financial statement conditions or otherwise) or (ii) entered into for the
purpose of assuring in any other manner the obligee of such Indebtedness or
other obligation of the payment thereof or to protect such obligee against loss
in respect thereof (in whole or in part); provided, however, that the term
"Guarantee" shall not include endorsements for collection or deposit in the
ordinary course of business. The term "Guarantee" used as a verb has a
corresponding meaning. The term "Guarantor" means any person Guaranteeing any
obligation.
"Hedging Obligations" of any Person means the obligations of such Person
pursuant to any Interest Rate Agreement or Currency Agreement.
"Holders" means the Person in whose name a Note is registered on the
Registrar's books.
"Incur" means issue, assume, Guarantee, incur or otherwise become liable
for; provided, however, that any Indebtedness or Capital Stock of a Person
existing at the time such Person becomes a Subsidiary (whether by merger,
consolidation, acquisition or otherwise) shall be deemed to be Incurred by such
Subsidiary at the time it becomes a Subsidiary. The term "Incurrence" when used
as a noun shall have a correlative meaning. The accretion of principal of a
non-interest bearing or other discount security shall not be deemed the
Incurrence of Indebtedness.
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"Indebtedness" means, with respect to any Person on any date of
determination (without duplication): (i) the principal of and premium, if any,
in respect of (A) indebtedness of such Person for money borrowed and (B)
indebtedness evidenced by notes, debentures, bonds or other similar instruments
for the payment of which such Person is responsible or liable; (ii) all Capital
Lease Obligations of such Person; (iii) all obligations of such Person issued or
assumed as the deferred purchase price of property, all conditional sale
obligations of such Person and all obligations of such Person under any title
retention agreement (including any such obligations under repurchase agreements,
but excluding trade accounts payable and expense accruals arising in the
ordinary course of business); (iv) all obligations of such Person for the
reimbursement of any obligor on any letter of credit, banker's acceptance or
similar credit transaction; (v) Warehouse Indebtedness; (vi) all obligations of
the type referred to in clauses (i) through (v) of other Persons and all
dividends of other Persons for the payment of which, in either case, such Person
is responsible or liable, directly or indirectly, as obligor, guarantor or
otherwise, including by means of any Guarantee; (vii) all obligations of the
type referred to in clauses (i) through (vi) of other Persons secured by any
Lien on any property or asset of such Person (whether or not such obligation is
assumed by such Person) and (viii) to the extent not otherwise included in this
definition, hedging obligations of such Person. Notwithstanding the foregoing,
"Indebtedness" shall not include obligations under the Tax Sharing Agreement or
any renewal or other modification thereof. Except in the case of Warehouse
Indebtedness (the amount of which shall be determined in accordance with the
definition thereof), the amount of unconditional Indebtedness of any Person at
any date shall be the outstanding balance at such date of all unconditional
obligations as described above. The amount of any Indebtedness under clause (vi)
of this definition shall be equal to the amount of the outstanding obligation
for which such Person is responsible or liable, directly or indirectly,
including by way of Guarantee. Notwithstanding the foregoing, any securities
issued in a securitization by a special purpose owner trust or similar entity
(including any Subsidiary established exclusively for the purpose of issuing
securities in connection with any securitization of Receivables (a
"Securitization Vehicle")) formed by or on behalf of a Person and to which
Receivables have been sold or otherwise transferred by or on behalf of such
Person or its Subsidiaries shall not be treated as Indebtedness of such Person
or its Subsidiaries under the Indenture, regardless of whether such securities
are treated as indebtedness for tax purposes, provided (1) neither the Company
nor any of its Subsidiaries (other than the Securitization Vehicle and Special
Purpose Subsidiaries) (a) provides credit support of any kind (including any
undertaking, agreement or instrument that would constitute Indebtedness), except
for credit support in the form of "over-collateralization" of the senior
certificates issued in, or subordination of or recourse to all or a portion of
Excess Spread Receivables attributable to, such securitization, in each case to
the extent reflected in the book value of such Excess Spread Receivables, or (b)
is directly or indirectly liable (as a guarantor or otherwise), and (2) no
default with respect to such securities would permit (upon notice, lapse of time
or both) any holder of any other Indebtedness of the Company or any of its
Subsidiaries to declare a default on such other Indebtedness or cause the
payment thereof to be accelerated or payable prior to its stated maturity.
"Interest-only Certificate" means a certificate issued in a securitization
of a pool of Receivables which pays a fixed or floating interest rate on a
notional principal amount.
"Interest Rate Agreement" means any interest rate swap agreement, interest
rate cap agreement, repurchase agreement, futures contract or other financial
agreement or
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arrangement designed to protect the Company or any Subsidiary against
fluctuations in interest rates.
"Junior Subordinated Obligation" is defined under "Subordination."
"Legal Holiday" means any Saturday, Sunday or other day on which banks in
the States of New York or Georgia are authorized or obligated by law to be
closed for business.
"Lien" means (i) any mortgage, pledge, security interest, encumbrance, lien
or charge of any kind (including any conditional sale or other title retention
agreement or lease in the nature thereof) and (ii) any claim (whether direct or
indirect through subordination or other structural encumbrance) against any
Excess Spread Receivables sold or otherwise transferred by such Person to a
buyer, unless such Person is not liable for any losses thereon.
"New Note Issue Date" means the date on which the New Notes are originally
issued.
"Permitted Excess Spread Receivables Indebtedness" means any Indebtedness
secured by a Permitted Lien referred to in clause (vii) of the definition
thereof.
"Permitted Liens" means, with respect to the Company and any Subsidiary:
(i) pledges or deposits by such Person under worker's compensation laws,
unemployment insurance laws or similar legislation, or good faith deposits in
connection with bids, tenders, contracts (other than for the payment of
Indebtedness) or leases to which such Person is a party, or deposits to secure
public or statutory obligations of such Person or deposits of cash or United
States government bonds to secure surety or appeal bonds to which such Person is
a party, or deposits as security for contested taxes or for the payment of rent,
in each case incurred in the ordinary course of business; (ii) Liens imposed by
law, such as carriers', warehousemen's and mechanics' Liens, in each case for
amounts not yet due or being contested in good faith by appropriate proceedings
or other Liens arising out of judgments or awards against such Person with
respect to which such Person shall then be proceeding with an appeal or other
proceedings for review; (iii) Liens for property taxes not yet subject to
penalties for nonpayment or which are being contested in good faith and by
appropriate proceedings; (iv) minor survey exceptions, minor encumbrances,
easements or reservations of, or rights of others for, licenses, rights of way,
sewers, electric lines, telegraph and telephone lines and other similar
purposes, or zoning or other restrictions as to the use of real property, or
leases, subleases or other Liens incidental to the conduct of the business of
such Person or to the ownership of its properties which were not Incurred in
connection with Indebtedness and which do not in the aggregate materially
adversely affect the value of said properties or materially impair their use in
the operation of the business of such Person; (v) Liens securing Indebtedness
(including Capital Lease Obligations) of such Person Incurred to finance the
construction, purchase or lease of, or repairs, improvements or additions to,
equipment (including vehicles) of such Person (but excluding Capital Stock of
another Person); provided, however, that the Lien may not extend to any other
property owned by such Person or any of its Subsidiaries at the time the Lien is
Incurred, and the Indebtedness secured by the Lien may not be Incurred more than
180 days after the later of the acquisition, completion of construction, repair,
improvement, addition or commencement of full operation of the property subject
to the Lien; (vi) Liens on Receivables of the Company or a Subsidiary, as the
case may be, to secure Indebtedness permitted under the provisions described in
clause (b)(1) under
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"-- Certain Covenants -- Limitation on Indebtedness"; (vii) Liens on Excess
Spread Receivables (or on the Capital Stock of any Person substantially all the
assets of which are Excess Spread Receivables) securing Permitted Excess Spread
Receivables Indebtedness); (viii) Liens existing on the New Note Issue Date and
listed on a schedule to the Indenture; (ix) Liens on property or shares of
Capital Stock of another Person at the time such other Person becomes a
Subsidiary of such Person; provided, however, that (A) such Liens are not
created, incurred or assumed in connection with, or in contemplation of, such
other Person becoming a Subsidiary and (B) such Liens may not extend to any
other property owned by such Person or any of its Subsidiaries; (x) Liens on
property at the time such Person or any of its Subsidiaries acquires the
property, including any acquisition by means of a merger or consolidation with
or into such Person or a Subsidiary of such Person; provided, however, that (A)
such Liens are not created, incurred or assumed in connection with, or in
contemplation of, such acquisition and (B) such Liens may not extend to any
other property owned by such Person or any of its Subsidiaries; (xi) Liens
securing Indebtedness or other obligations of a Subsidiary of such Person owing
to such Person or a Wholly Owned Subsidiary of such Person; (xii) Liens securing
Hedging Obligations of the Company or such Subsidiary so long as such Hedging
Obligations relate to Indebtedness that is, and is permitted under the Indenture
to be, secured by a Lien on the same property securing such Hedging Obligations;
(xiii) Liens to secure any Refinancing (or successive Refinancings) as a whole,
or in part, of any Indebtedness of the Company or such Subsidiary secured by any
Lien referred to in the foregoing clauses (v), (vii), (viii), (ix) or (x);
provided, however, that (A) such new Lien shall be limited to all or part of the
same property that secured the original Lien (plus improvements to or on such
property), (B) the Indebtedness secured by such Lien at such time is not
increased to any amount greater than the sum of (1) the outstanding principal
amount or, if greater, committed amount of the Indebtedness described under
clause (v), (vii), (viii), (ix) or (x), as the case may be, at the time the
original Lien became a Permitted Lien and (2) an amount necessary to pay any
fees and expenses, including premiums, related to such refinancing, and (C) the
Average Life of such Indebtedness is not decreased, and (xiv) any Lien in the
form of "over-collateralization" of the senior certificates issued in, or
subordination of or recourse to all or a portion of Excess Spread Receivables of
the Company or any Subsidiary attributable to a securitization of Receivables,
in each case to the extent reflected in the book value of such Excess Spread
Receivables, which Lien is in favor of the holders of other interests in the
trust or other vehicle relating to such securitization.
"Permitted Warehouse Indebtedness" means Warehouse Indebtedness in
connection with a Warehouse Facility; provided, however, that (i) the assets
being financed are or, prior to any funding under the Warehouse Facility with
respect to such assets, were eligible to be recorded as held for sale on the
consolidated balance sheet of the Company and its Subsidiaries in accordance
with GAAP, (ii) Warehouse Indebtedness constitutes Permitted Warehouse
Indebtedness only (a) if, in the case of Warehouse Indebtedness under a Purchase
Facility, recourse with respect to the obligations of the Company and its
Subsidiaries under such Warehouse Facility is limited to the Receivables
financed thereby plus an amount equal to [20]% of the principal amount of such
Receivables or (b) in the case of any other Warehouse Indebtedness, to the
extent of the lesser of (A) the amount advanced by the lender with respect to
the Receivables financed under the Warehouse Facility, and (B) the principal
amount of such Receivables, and (iii) any such Indebtedness has not been
outstanding in excess of 360 days.
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"Person" means any individual, corporation, partnership, joint venture,
association, joint-stock company, limited liability company, trust,
unincorporated organization, government or any agency or political subdivision
thereof or any other entity.
"Preferred Stock" as applied to the Capital Stock of any Person, means
Capital Stock of any class or classes (however designated) which is preferred as
to the payment of dividends, or as to the distribution of assets upon any
voluntary or involuntary liquidation or dissolution of such Person, over shares
of Capital Stock of any other class of such corporation.
"Principal" of a Note means the principal of the Note payable on the Note
which is due or overdue or is to become due at the relevant time.
"Purchase Facility" means any Warehouse Facility pursuant to which the
Company or a Subsidiary sells Receivables to a financial institution or other
Person and retains a right of first refusal (or a right with similar effect)
upon the subsequent resale of such Receivables by such financial institution.
"Receivables" means loans, leases and receivables purchased or originated
by the Company or any Subsidiary in the ordinary course of business; provided,
however, that for purposes of determining the amount of a Receivable at any
time, such amount shall be determined in accordance with GAAP, consistently
applied, as of the most recent practicable date.
"Refinance" means, in respect of any Indebtedness, to refinance, extend,
renew, refund, repay, prepay, redeem, defease or retire, or to issue other
Indebtedness in exchange or replacement for, such indebtedness. "Refinanced" and
"Refinancing" shall have correlative meanings.
"Refinancing Indebtedness" means Indebtedness that Refinances any
Indebtedness of the Company or any Subsidiary existing on the New Note Issue
Date or Incurred in compliance with the Indenture, including Indebtedness that
Refinances Refinancing Indebtedness; provided, however, that (i) such
Refinancing Indebtedness has a Stated Maturity no earlier than the Stated
Maturity of the Indebtedness being Refinanced, (ii) such Refinancing
Indebtedness has an Average Life at the time such Refinancing Indebtedness is
Incurred that is equal to or greater than the Average Life of the Indebtedness
being Refinanced, (iii) such Refinancing Indebtedness has an aggregate principal
amount (or, if Incurred with original issue discount, an aggregate issue price)
that is equal to or less than the aggregate principal amount (or, if Incurred
with original issue discount, the aggregate accreted value) then outstanding or
committed (plus fees and expenses, including any premium and defeasance costs)
under the Indebtedness being Refinanced, and (iv) in the case of Refinancing
Indebtedness that Refinances any Junior Subordinated Obligations, such
Refinancing Indebtedness constitutes a Junior Subordinated Obligation; provided
further, however, that Refinancing Indebtedness shall not include Indebtedness
of a Subsidiary that Refinances Indebtedness of the Company or another
Subsidiary.
"Related Business" means any consumer lending business or any financial
service business directly relating to such business.
"Representative" means, with respect to any Senior Indebtedness, any holder
thereof or any agent, trustee or other representative for any such holder.
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"Senior Indebtedness" means principal of and interest (including interest
accruing on or after the filing of any petition in bankruptcy or for
reorganization relating to the Company, to the extent postpetition interest is
allowed in such proceeding) and premium, if any, on (a) any Indebtedness of the
Company of the type referred to in clause (i), (ii), (iii), (iv) or (v) of the
definition of "Indebtedness," or (b) all Guarantees by the Company or any
Subsidiary with respect to Indebtedness referred to in the foregoing clause (a),
unless, in the case of clause (a) or (b), the instrument under which such
Indebtedness is incurred expressly provides that it is pari passu with or
subordinated in right of payment to the Notes. Notwithstanding the foregoing,
Senior Indebtedness shall not include (a) any liability for federal, state,
local, foreign or other taxes, (b) any Indebtedness of the Company or any
Subsidiary to any Affiliates, (c) any trade accounts payable and expense
accruals, (d) Indebtedness owed for compensation or for services rendered and
(e) any Original Notes.
"Special Purpose Subsidiary" means a Subsidiary formed in connection with a
securitization of Receivables (i) all the Capital Stock of which (other than
directors' qualifying shares and shares held by other Persons to the extent such
shares are required by applicable law to be held by a Person other than the
Company or a Subsidiary) is owned by the Company or one or more Subsidiaries,
(ii) that has no assets other than Excess Spread Receivables created in such
securitization, (iii) that conducts no business other than holding such Excess
Spread Receivables, and (iv) that has no Indebtedness (other than (a) short-term
Indebtedness to the Company or any Wholly Owned Subsidiary attributable to the
purchase by such Subsidiary from the Company or such Wholly Owned Subsidiary of
such Receivables, which Indebtedness is paid in full upon closing of such
securitization, and (b) Permitted Excess Spread Receivables Indebtedness.
"Stated Maturity" means, with respect to any security or Indebtedness, the
date specified in such security or Indebtedness as the fixed date on which the
final payment of principal of such security or Indebtedness is due and payable,
including pursuant to any mandatory redemption provision (but excluding any
provision providing for the repurchase or prepayment of such security or
Indebtedness at the option of the holder thereof upon the happening of any
contingency unless such contingency has occurred).
"Subsidiary" means, in respect of any Person, any corporation, association,
partnership or other business entity of which more than 50% of the total voting
power of shares of Capital Stock or other interests (including partnership
interests) entitled (without regard to the occurrence of any contingency) to
vote in the election of directors, managers or trustees thereof is at the time
owned or controlled, directly or indirectly, by (i) such Person, (ii) such
Person and one or more Wholly Owned Subsidiaries of such Person or (iii) one or
more Wholly Owned Subsidiaries of such Person. Unless otherwise specified,
"Subsidiary" means a Subsidiary of the Company.
"Tax Sharing Agreement" means the tax allocation and indemnity agreement,
dated as of November 22, 1996, by and between Mego Financial and the Company,
without regard to any amendments, supplements or other modifications thereof
after the New Note Issue Date.
"U.S. Government Obligations" means direct obligations (or certificates
representing an ownership interest in such obligations) of the United States of
America (including any agency or instrumentality thereof) for the payment of
which the full faith and credit of the United States of America is pledged and
which are not callable at the issuer's option.
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"Voting Stock" of a Person means all classes of Capital Stock or other
interests (including partnership interests) of such Person then outstanding and
normally entitled (without regard to the occurrence of any contingency) to vote
in the election of directors, managers or trustees thereof.
"Warehouse Facility" means any funding arrangement with a financial
institution or other lender or purchaser exclusively to finance the purchase or
origination of Receivables by the Company or a Subsidiary of the Company for the
purpose of pooling such Receivables prior to securitization or sale in the
ordinary course of business, including any Purchase Facilities.
"Warehouse Indebtedness" means the consideration received by the Company or
its Subsidiaries under a Warehouse Facility with respect to Receivables until
such time such Receivables are (i) securitized, (ii) repurchased by the Company
or its Subsidiaries or (iii) sold by the counterpart under the Warehouse
Facility to a Person who is not an Affiliate of the Company.
"Wholly Owned Subsidiary" means a Subsidiary all the Capital Stock of which
(other than directors' qualifying shares and shares held by other Persons to the
extent such shares are required by applicable law to be held by a Person other
than the Company or a Subsidiary) is owned by the Company or one or more Wholly
Owned Subsidiaries.
CERTAIN UNITED STATES FEDERAL TAX CONSIDERATIONS
The following summary describes the material United States federal income
tax consequences of the acquisition, ownership and disposition of the New Notes.
This discussion is based on currently existing provisions of the Internal
Revenue Code of 1986, as amended (the "Code"), existing and proposed Treasury
regulations promulgated thereunder, and administrative and judicial
interpretations thereof, all as in effect or proposed on the date hereof and all
of which are subject to change, possibly with retroactive effect, or different
interpretations. This discussion assumes that all of the New Notes will be held
as capital assets (i.e., generally assets that are held for investment), within
the meaning of Section 1221 of the Code, and will not be part of a straddle, a
hedge or a conversion transaction, within the meaning of Section 1258 of the
Code. The discussion is for general information only, and does not address all
of the tax consequences that may be relevant to particular purchasers in light
of their personal circumstances, or to certain types of purchasers (such as
certain financial institutions, insurance companies, tax-exempt entities,
dealers in securities or persons that have a "functional currency" other than
the U.S. dollar). Persons considering the exchange of Current Notes for New
Notes should consult their tax advisors with regard to the applications of the
United States federal income tax laws to their particular situations, as well as
any tax consequences arising under the laws of any state, local, or foreign
taxing jurisdictions.
As used herein, the term "United States Holder" means a beneficial owner of
a Current Note or a New Note that for United States federal income tax purposes
is (i) a citizen or resident of the United States, (ii) treated as a domestic
corporation or domestic partnership, or (iii) an estate or trust other than a
"foreign estate" or "foreign trust" as defined in Section 7701(a)(31) of the
Code.
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<PAGE> 139
UNITED STATES HOLDERS
Exchange of Current Notes for New Notes. The terms of the New Notes that
differ from the Current Notes should not constitute a "significant modification"
of the Current Notes under applicable Treasury Regulations and thus the exchange
by a holder of a Current Note for a New Note should not constitute a taxable
exchange. Each New Note should be treated as having been originally issued at
the time the Current Note exchanged therefor was originally issued. Hereinafter,
references to a "Note" shall include both a Current Note and a New Note.
Stated Interest. Each United States Holder of Notes must include as
ordinary interest income the interest attributable to such Notes at the time it
accrues or is received, in accordance with such holder's accounting method for
United States federal income tax purposes.
Sale, Exchange or Redemption. Upon the sale, exchange or redemption of a
Note, a United States Holder will recognize taxable gain or loss equal to the
difference between the amount realized on the sale, exchange or redemption
(excluding, in the case of a cash basis taxpayer, any amount attributable to
accrued interest, which is taxable as such) and such holder's adjusted tax basis
in such Note. A holder's adjusted tax basis in a Note will generally equal the
cost of such Note to such holder, increased by any accrued interest and market
discount previously included in taxable income by the holder, and reduced by any
amortized bond premium and any payments received by the holder, all with respect
to such Note.
Subject to the exception discussed below for market discount, gain or loss
recognized on the sale, exchange or retirement of a Note generally will be
capital gain or loss and will be a long-term capital gain or loss if at the time
of sale, exchange or retirement such Note has been held for more than one year.
Amortizable Bond Premium and Market Discount. If a United States Holder
purchases a Note for an amount that is greater than the amount payable at
maturity, such holder will be considered to have purchased such Note with "bond
premium." The amount of bond premium is the excess of (i) the holder's tax basis
in such Note, over (ii) the amount payable at maturity (or on an earlier call
date if it results in a smaller amortizable bond premium). Such holder may elect
(in accordance with applicable Code provisions) to amortize such premium using a
constant yield method over the remaining term of such Note (or until an earlier
call date if it resulted in a smaller amortizable bond premium) and to offset
interest otherwise required to be included in income in respect of such Note
during any taxable year by the amortized amount of such excess for such taxable
year. Such election, once made, is irrevocable (unless permission is received
from the Internal Revenue Service (the "IRS")) and applies to all taxable bonds
held during the taxable year for which the election is made or subsequently
acquired.
If a United States Holder purchases a Note for an amount that is less than
the stated redemption price at maturity, such holder will generally be
considered to have purchased such Note with "market discount." For this purpose,
the stated redemption price at maturity of a Note generally will equal its
principal amount. Market discount with respect to a Note is the excess of the
stated redemption price at maturity over the amount paid by the holder for such
Note. However, the amount of market discount will be considered zero if it would
otherwise be less than 1/4 of 1 percent of the stated redemption price of such
Note at maturity multiplied by the number of complete years to maturity (after
the holder
136
<PAGE> 140
acquired such Note). If a Note is subject to the market discount rules, a holder
will generally be required to (i) treat any gain realized with respect to such
Note as ordinary income to the extent market discount accrued during the period
such holder held the Note, (ii) possibly treat any payment on such Note (other
than stated interest) as ordinary income to the extent market discount accrued
during the period such holder held such Note and (iii) defer the deduction of
all or a portion of the interest expense on any indebtedness incurred or
maintained by such holder to purchase or carry such Note. If such Note is
disposed of in a nontaxable transaction (other than a nonrecognition transaction
described in Section 1276(c) of the Code), accrued market discount will be
includable as ordinary income to the holder as if such holder had sold such Note
at its then fair market value. Market discount will be considered to accrue
ratably during the period from the date of acquisition to the maturity date of
such Note, unless the holder irrevocably elects (on an instrument-by-instrument
basis) to accrue market discount on the basis of a constant interest rate. A
holder may elect to include market discount in income currently as it accrues
(on either a ratable or constant yield basis), in which case the rules described
above regarding the treatment of gain realized and the deferral of interest
deductions will not apply. An election to include market discount currently,
once made, will apply to all market discount obligations acquired by the holder
on or after the first day of the first taxable year to which the election
applies, and may not be revoked without the consent of the IRS.
Because of the complexity of the rules relating to bond premium and market
discount, United States Holders should consult their tax advisors as to the
application of these rules to their particular circumstances and as to the merit
of making any elections in connection therewith.
Backup Withholding and Information Reporting. In general, the 31% "backup"
withholding and information reporting requirements apply to certain payments of
principal, premium, if any, and interest on a debt instrument and to proceeds of
the sale or redemption of a debt instrument. Certain holders may be subject to
backup withholding at a rate of 31% on any payments made with respect to, and
proceeds of disposition of, the Notes. Backup withholding will apply only if the
holder fails to furnish its taxpayer identification number (social security
number or employer identification number), to certify that such holder is not
subject to backup withholding, or otherwise to comply with the applicable
requirements of the backup withholding rules. Any amount withheld under these
backup withholding rules will be creditable against the holder's federal income
tax liability. Certain holders (including, among others, corporations) are not
subject to the backup withholding and information reporting requirements.
NON-UNITED STATES HOLDERS
As used herein, the term "Non-United States Holder" means any beneficial
owner of a Note that is not a United States Holder. The rules governing the
United States federal income and estate taxation of a Non-United States Holder
are complex, and no attempt will be made herein to provide more than a summary
of such rules. NON-UNITED STATES HOLDERS SHOULD CONSULT WITH THEIR OWN TAX
ADVISORS TO DETERMINE THE EFFECT OF FEDERAL, STATE, LOCAL AND FOREIGN TAX LAWS,
INCLUDING TREATIES, WITH RESPECT TO THE NOTES, INCLUDING ANY REPORTING
REQUIREMENTS.
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<PAGE> 141
Payment of Interest. Generally, payment of interest on a Note by the
Company or any Paying Agent to a Non-United States Holder will qualify for the
"portfolio interest" exemption and therefore will not be subject to United
States federal income tax or withholding tax, provided that such interest income
is not effectively connected with a United States trade or business of the
Non-United States Holder and provided that the Non-United States Holder (i) does
not actually or constructively own 10% or more of the combined voting power of
all classes of stock of the Company entitled to vote, (ii) is not a controlled
foreign corporation related to the Company actually or constructively through
stock ownership, (iii) is not a bank receiving interest on a loan entered into
in the ordinary course of business, and (iv) either (a) provides a Form W-8 (or
suitable substitute form) signed under penalties of perjury that includes its
name and address and certifies as to its non-United States status in compliance
with applicable law and regulations, or (b) a securities clearing organization,
bank or other financial institution that holds the Note provides a statement to
the Company or its agent under penalties of perjury in which it certifies that
such a Form W-8 (or suitable substitute form) has been received by it from the
Non-United States Holder or qualifying intermediary and furnishes the Company or
its agent with a copy thereof.
Treasury Regulations issued in 1997 provide alternative methods for
satisfying the certification requirements described in clause (iv) above. Based
on IRS Notice 98-16, these regulations generally are effective for payments made
after December 31, 1999, subject to certain transition rules. Non-United States
Holders are urged to consult their own tax advisors regarding the new Treasury
Regulations.
Except to the extent that an applicable treaty otherwise provides, a
Non-United States Holder generally will be taxed in the same manner as a United
States Holder with respect to interest if the interest income is effectively
connected with a United States trade or business of the Non-United States
Holder. Effectively connected interest received by a corporate Non-United States
Holder may also, under certain circumstances, be subject to an additional
"branch profits tax" at a 30% rate (or, if applicable, a lower treaty rate).
Even though such effectively connected interest is subject to income tax, and
may be subject to the branch profits tax, it is not subject to withholding if
the Non-United States Holder delivers IRS Form 4224 (or a suitable substitute
form) to the payor.
Sale, Exchange or Redemption of the Notes. A Non-United States Holder of a
Note generally will not be subject to United States federal income tax or
withholding tax on any gain recognized on the sale, exchange or redemption of a
Note unless (1) the gain is effectively connected with a United States trade or
business of the Non-United States Holder, (2) in the case of a Non-United States
Holder who is an individual, such Holder is present in the United States for a
period or periods aggregating 183 days or more during the taxable year of the
disposition and certain other conditions apply, or (3) the Holder is subject to
tax pursuant to the provisions of the Code applicable to certain United States
expatriates.
Certain United States Federal Estate Tax Considerations. A Note
beneficially owned by an individual who is not a citizen or resident of the
United States at the time of death will not be included in the decedent's gross
estate for United States federal estate tax purposes, provided that such
Non-United States Holder did not at the time of death actually or constructively
own 10% or more of the combined voting power of all classes of stock of the
Company entitled to vote, and provided that, at the time of death, payments with
respect to such Note would not have been effectively connected with the conduct
by such Non-United States Holder of a trade or business within the United
States.
138
<PAGE> 142
Information Reporting and Backup Withholding Tax. United States
information reporting requirements and backup withholding tax will not apply to
payments on a Note to a Non-United States Holder if the statement described in
"Non-United States Holders -- Payment of Interest" is duly provided by such
Holder, provided that the payor does not have actual knowledge that the Holder
is a United States person.
Information reporting requirements and backup withholding tax will not
apply to payment of the proceeds of the sale of a Note effected outside the
United States by a foreign office of a "broker" (as defined in applicable
Treasury Regulations), unless such broker (i) is a United States person, (ii)
derives 50% or more of its gross income for certain periods from the conduct of
a trade or business in the United States, or (iii) is a controlled foreign
corporation as to the United States. Payment of the proceeds of any such sale
effected outside the United States by a foreign office of any broker that is
described in (i), (ii), or (iii) of the preceding sentence will not be subject
to backup withholding, but will be subject to information reporting unless the
broker has documentary evidence in its records that the beneficial owner is a
Non-United States Holder or otherwise establishes an exemption. Payment of the
proceeds of any such sale to or through the United States office of a broker is
subject to information reporting and backup withholding requirements, unless the
beneficial owner of the Note provides the statement described in "Non-United
States Holders -- Payment of Interest" or otherwise establishes an exemption.
Treasury Regulations issued in 1997 make certain modifications to the
withholding, backup withholding and information reporting rules described above.
Based on IRS Notice 98-16, the new regulations generally will be effective for
payments made after December 31, 1999, subject to certain transition rules.
Non-United States Holders of the Notes are urged to consult their own tax
advisors regarding these new regulations.
PLAN OF DISTRIBUTION
Except as described below, (i) a broker-dealer may not participate in the
exchange offer in connection with a distribution of the New Notes, (ii) such
broker-dealer would be deemed an underwriter in connection with such
distribution and (iii) such broker-dealer would be required to comply with the
registration and prospectus delivery requirements of the Securities Act in
connection with any secondary resale transactions. A broker-dealer may, however,
receive New Notes for its own account pursuant to the exchange offer in exchange
for Current Notes when such Current Notes were acquired as a result of market-
making activities or other trading activities. Each such broker-dealer must
acknowledge that it will deliver a prospectus in connection with any resale of
such New Notes. This prospectus, as it may be amended or supplemented from time
to time, may be used by a broker-dealer (other than an "affiliate" of the
Company) in connection with resales of such New Notes. The Company has agreed
that for a period of 90 days after the Expiration Date, it will make this
prospectus, as amended or supplemented, available to any such broker-dealer for
use in connection with any such resale.
The Company will not receive any proceeds from any sale of New Notes by
broker-dealers. New Notes received by broker-dealers for their own account
pursuant to the exchange offer may be sold from time to time in one or more
transactions in the over-the-counter market, in negotiated transactions, through
the writing of options on the New Notes or a combination of such methods of
resale, at market prices prevailing at the time of resale, at prices related to
such prevailing market prices or negotiated prices. Any such
139
<PAGE> 143
resale may be made directly to purchasers or to or through broker-dealers or
dealers who may receive compensation in the form of commissions or concessions
from any such broker-dealer and/or the purchasers of any such New Notes. Any
broker-dealer that resells New Notes that were received by it for its own
account pursuant to the exchange offer may be deemed to be an "underwriter" with
the meaning of the Securities Act and any profit on any such resale of the New
Notes and any commissions or concessions received by any such persons may be
deemed to be underwriting compensation under the Securities Act. The Letter of
Transmittal states that by acknowledging that it will deliver and by delivering
a prospectus, a broker-dealer will not be deemed to admit that it is an
"underwriter" within the meaning of the Securities Act.
For a period of 90 days after the Expiration Date, the Company will
promptly send additional copies of this prospectus and any amendment or
supplement to this prospectus to any broker-dealer that requests such documents
in a Letter of Transmittal. The Company has agreed to pay all expenses incident
to the Exchange Offer other than commissions or concessions of any brokers or
dealers and transfer taxes and will indemnify the holders of the Current Notes
(including any broker-dealers) against certain liabilities, including
liabilities under the Securities Act.
The New Notes will constitute a new issue of securities with no established
trading market. The Company does not intend to list the New Notes on any
national securities exchange or to seek approval for quotation through any
automated quotation system.
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-4 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 New Notes offered by this prospectus will be passed
upon for the Company by King & Spalding, Atlanta, Georgia.
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<PAGE> 144
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 upon their authority as experts in accounting and
auditing.
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<PAGE> 145
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 for the Years Ended August 31,
1996, 1997 and 1998 and the unaudited Three Months Ended
November 30, 1997 and 1998................................ F-8
</TABLE>
F-1
<PAGE> 146
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> 147
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> 148
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> 149
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> 150
<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> 151
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> 152
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> 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
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> 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
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> 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
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> 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
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> 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
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> 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
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> 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
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> 160
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> 161
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> 162
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> 163
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> 164
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> 165
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> 166
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> 167
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> 168
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> 169
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> 170
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> 171
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> 172
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> 173
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> 174
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> 175
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> 176
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> 177
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> 178
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> 179
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> 180
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> 181
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> 182
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> 183
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> 184
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> 185
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> 186
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> 187
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> 188
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> 189
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> 190
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> 191
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
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)
OFFER TO EXCHANGE
12 1/2% SUBORDINATED NOTES DUE 2001
($41,495,000 PRINCIPAL AMOUNT OUTSTANDING)
FOR
12 1/2% SUBORDINATED NOTES DUE 2001
WHICH HAVE BEEN REGISTERED UNDER THE SECURITIES ACT
PROSPECTUS
February 2, 1999
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE> 192
PART II
INFORMATION NOT REQUIRED IN THE PROSPECTUS
ITEM 20. 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 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.
II-1
<PAGE> 193
ITEM 21. 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 legality of the
notes 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.
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
</TABLE>
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<PAGE> 194
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- -------- -----------
<C> <C> <S>
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
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(5) -- Form of Director Indemnification Agreement
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>
- -------------------------
* To be filed by amendment.
(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.
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<PAGE> 195
(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 Registration Statement on Form S-1 filed by the
Company, as amended (File No. 333-68995), and incorporated herein by
reference.
(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.
ITEM 22. UNDERTAKINGS.
The Company hereby undertakes:
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.
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<PAGE> 196
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 December 15, 1998.
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 15th day of December, 1998.
<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>
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<PAGE> 1
EXHIBIT 5.1
January 29, 1999
Mego Mortgage Corporation
1000 Parkwood Circle
6th Floor
Atlanta, Georgia 30339
Re: Mego Mortgage Corporation - Registration Statement on Form S-4
Relating to $41,500,000 of 12 1/2% Subordinated Notes Due 2001
Ladies and Gentlemen:
We have acted as counsel for Mego Mortgage Corporation, a Delaware
corporation (the "Company"), in connection with the preparation of a
Registration Statement on Form S-4 (the "Registration Statement") filed with
the Securities and Exchange Commission under the Securities Act of 1933, as
amended, relating to the proposed exchange of up to $41,500,000 of 12 1/2
Subordinated Notes Due 2001 (the "New Notes") for a like principal amount of
the Company's issued and outstanding 12 1/2 Subordinated Notes Due 2001 (the
"Old Notes").
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.
We have assumed that the execution and delivery of, and the performance of
all obligations under, the Indenture between the Company and American Stock
Transfer & Trust Company, as trustee (the "Trustee") dated as of June 29, 1998
(the "Indenture") have been duly authorized by all requisite action by the
Trustee, and that the Indenture has been duly executed and delivered by, and is
a valid and binding agreement of the Trustee, enforceable against the Trustee
in accordance with its terms.
<PAGE> 2
Mego Mortgage Corporation
January 29, 1999
Page 2
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 the New Notes have been duly authorized
by the Company and, when executed by the Company and duly authenticated by the
Trustee in accordance with the terms of the Indenture and delivered in exchange
for the Old Notes in accordance with the terms of the Indenture, will (x) be
valid and binding obligations of the Company enforceable against the Company in
accordance with their terms except as (A) the enforceability thereof may be
limited by bankruptcy, insolvency, reorganization, moratorium and other similar
laws affecting the rights and remedies of creditors and (B) remedies may be
limited by general principles of equity, whether applied by a court of law or
equity and (y) be entitled to the benefits of the Indenture.
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 furnished
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 23.2
INDEPENDENT AUDITORS' CONSENT
We consent to the use in this Amendment No. 1 to Registration Statement No.
333-68997 of Mego Mortgage Corporation on Form S-4 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
