<PAGE> 1
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON OCTOBER 9, 1997
REGISTRATION NO. 333-33679
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
AMENDMENT NO. 2
TO
FORM S-11
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN GOVERNING INSTRUMENTS)
445 MARINE VIEW AVENUE, SUITE 230, DEL MAR, CALIFORNIA 92014
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
------------------------
JOHN M. ROBBINS
CHIEF EXECUTIVE OFFICER
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
445 MARINE VIEW AVENUE, SUITE 230
DEL MAR, CALIFORNIA 92014
(619) 350-5000
(NAME AND ADDRESS OF AGENT FOR SERVICE)
------------------------
COPIES TO:
<TABLE>
<S> <C>
CAMERON JAY RAINS, ESQ. PETER T. HEALY, ESQ.
GRAY CARY WARE & FREIDENRICH O'MELVENY & MYERS LLP
4365 EXECUTIVE DRIVE, SUITE 1600 EMBARCADERO CENTER WEST
SAN DIEGO, CA 92121 275 BATTERY STREET, SUITE 2600
TELEPHONE: (619) 677-1400 SAN FRANCISCO, CA 94111
FACSIMILE: (619) 677-1477 TELEPHONE: (415) 984-8833
FACSIMILE: (415) 984-8701
</TABLE>
------------------------
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 effective registration statement
for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [ ]
CALCULATION OF REGISTRATION FEE
<TABLE>
==================================================================================================
PROPOSED MAXIMUM PROPOSED MAXIMUM
TITLE OF EACH CLASS OF AMOUNT TO BE OFFERING PRICE AGGREGATE AMOUNT OF
SECURITIES REGISTERED(1) PER SHARE OFFERING REGISTRATION FEE
TO BE REGISTERED PRICE(1)(2)
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Common Stock, $.01 par value.. 7,475,000 $16.00 $119,600,000 $36,243(3)
==================================================================================================
</TABLE>
(1) Assumes exercise of an over-allotment option granted to the Underwriters.
See "Underwriting."
(2) Estimated solely for the purpose of computing the amount of the registration
fee.
(3) $26,137 previously paid at the time of the original filing.
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 the Registration Statement
shall become effective on such date as the Commission, acting pursuant to said
Section 8(a), may determine.
================================================================================
<PAGE> 2
SUBJECT TO COMPLETION,
PRELIMINARY PROSPECTUS DATED OCTOBER 9, 1997
6,500,000 SHARES
LOGO
COMMON STOCK
------------------------
All of the shares of Common Stock offered hereby are being sold by American
Residential Investment Trust, Inc. ("AMREIT" or the "Company"), a real estate
investment trust organized in February 1997 to acquire adjustable-rate
residential Mortgage Securities and Mortgage Loans initially in the following
categories: small multifamily home, manufactured housing, mixed use, rural home,
mini-ranch home and condominium/resort. As of the closing of this Offering $90
million, or 28% of the Company's net assets will be uncommitted. Prior to this
Offering, there has been no public market for the Common Stock of the Company.
It is currently estimated that the initial public offering price per share will
be between $14.00 and $16.00. See "Underwriting" for information relating to the
determination of the initial public offering price.
Application has been made to list the Common Stock on the New York Stock
Exchange under the symbol "INV."
SEE "RISK FACTORS" STARTING ON PAGE 10 FOR MATERIAL RISKS THAT SHOULD BE
CONSIDERED BY PROSPECTIVE INVESTORS. THESE RISKS INCLUDE:
- - Sudden Interest Rate Fluctuations May Reduce Income From Operations
- - Increased Levels of Mortgage Loan Prepayments May Reduce Operating Income
- - Material Portion of Offering Proceeds Not Committed to Specific Mortgage
Assets; Inability to Acquire Mortgage Assets.
- - Limited Operating History Does Not Predict Future Performance
- - Failure to Implement Company's Leverage Strategy May Adversely Affect Results
of Operations
- - Failure to Successfully Manage Interest Rate Risks May Adversely Affect
Results of Operations
------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR
HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
<TABLE>
<CAPTION>
================================================================================================
Underwriting
Price to Discount and Proceeds to
Public Commissions(1) Company(2)
- ------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Per Share................................. $ $ $
- ------------------------------------------------------------------------------------------------
Total..................................... $ $ $
- ------------------------------------------------------------------------------------------------
Total Assuming Full Exercise of
Over-allotment Option(3)................ $ $ $
================================================================================================
</TABLE>
(1) See "Underwriting" for information regarding indemnification of the
Underwriters and other matters.
(2) Before deducting expenses estimated at $1,200,000, all of which are payable
by the Company. See "Underwriting."
(3) Assuming exercise in full of the 30-day option granted by the Company to the
Underwriters to purchase up to 975,000 additional shares, on the same terms,
solely to cover over-allotments. See "Underwriting."
------------------------
The shares of Common Stock are offered by the Underwriters, subject to
prior sale, when, as and if delivered to and accepted by the Underwriters, and
subject to their right to reject orders in whole or in part. It is expected that
delivery of the Common Stock will be made in New York City on or about
, 1997.
------------------------
PAINEWEBBER INCORPORATED
OPPENHEIMER & CO., INC.
EVEREN SECURITIES, INC.
SUTRO & CO. INCORPORATED
------------------------
THE DATE OF THIS PROSPECTUS IS , 1997.
INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A
REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR
MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT
BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR
THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE
SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE
UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS
OF ANY SUCH STATE.
<PAGE> 3
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK.
SPECIFICALLY, THE UNDERWRITERS MAY OVERALLOT IN CONNECTION WITH THE OFFERING AND
MAY BID FOR AND PURCHASE SHARES OF THE COMMON STOCK IN THE OPEN MARKET. FOR A
DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING."
The Company intends to furnish its stockholders with annual reports
containing financial statements audited by its independent auditors and
quarterly reports for the first three quarters of each fiscal year containing
unaudited financial information.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
-----
<S> <C>
PROSPECTUS SUMMARY............................. 3
The Company.................................. 3
Business..................................... 3
Recent Developments.......................... 4
Summary Risk Factors......................... 4
Management of the Company.................... 6
The Manager.................................. 7
Conflicts of Interest........................ 7
Federal Income Tax Consequences.............. 8
Dividend Policy and Distributions............ 8
The Offering................................. 8
Purpose of the Offering...................... 8
Summary Financial Information................ 9
RISK FACTORS................................... 10
Sudden Interest Rate Fluctuations May Reduce
Income From Operations..................... 10
Increased Levels of Mortgage Loan Prepayments
May Reduce Operating Income................ 10
Material Portion of Offering Proceeds Not
Committed to Specific Mortgage Assets;
Inability to Acquire Mortgage Assets....... 11
Limited Operating History Does Not Predict
Future Performance......................... 11
Failure to Implement Company's Leverage
Strategy May Adversely Affect Results of
Operations................................. 12
Failure to Successfully Manage Interest Rate
Risks May Adversely Affect Results of
Operations................................. 12
Borrower Credit May Decrease Value of
Mortgage Loans............................. 13
Characteristics of Underlying Property May
Decrease Value of Mortgage Loans........... 13
Conflicts of Interests; Management Also
Employed by and Owns Securities of
Manager.................................... 14
Dependence on Key Personnel for Successful
Operations................................. 14
Failure to Manage Expansion May Adversely
Affect Results of Operations............... 14
Real Estate Market Conditions May Adversely
Affect Results of Operations............... 15
Investments in Mortgage Assets May Be
Illiquid................................... 15
Policies and Strategies May Be Revised at the
Discretion of the Board of Directors....... 15
Management and Certain Affiliates Will
Control Approximately 20% of Outstanding
Shares After Offering...................... 15
Failure to Maintain REIT Status May Subject
Company to Corporate Level Tax............. 16
Market for Common Stock May be Limited and
Market Price May Fluctuate Below Offering
Price...................................... 16
Failure to Qualify for Exemption Under
Investment Company Act Would Result in
Significant Regulatory Burden.............. 16
<CAPTION>
PAGE
-----
<S> <C>
Future Offerings of Common Stock May Affect
Market Price of Common Stock............... 17
Ownership of Common Stock May Be
Restricted................................. 17
Default of Manager under Securities Purchase
Agreement; Restrictive Covenants........... 18
Limitations on Acquisition and Change in
Control.................................... 18
Shares Eligible for Future Sale.............. 19
Dilution to Stockholders Purchasing in
Offering................................... 19
THE COMPANY.................................... 20
USE OF PROCEEDS................................ 21
DIVIDEND POLICY AND DISTRIBUTIONS.............. 21
CAPITALIZATION................................. 22
DILUTION....................................... 23
SELECTED FINANCIAL DATA........................ 24
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF
OPERATIONS................................... 25
Overview..................................... 25
Certain Accounting Policies and Procedures... 27
Results Of Operations........................ 28
Liquidity And Capital Resources.............. 29
Recent Developments.......................... 29
BUSINESS....................................... 30
Residential Mortgage Industry................ 30
Investments.................................. 30
Funding...................................... 35
Capital Guidelines........................... 37
Risk Management.............................. 38
Competition.................................. 42
Employees.................................... 42
Facilities................................... 43
Legal Proceedings............................ 43
MANAGEMENT OF THE COMPANY...................... 44
THE MANAGER.................................... 54
CERTAIN TRANSACTIONS........................... 60
CONFLICTS OF INTEREST.......................... 63
PRINCIPAL STOCKHOLDERS......................... 65
DESCRIPTION OF CAPITAL STOCK................... 66
SHARES ELIGIBLE FOR FUTURE SALE................ 69
FEDERAL INCOME TAX CONSEQUENCES................ 70
ERISA CONSIDERATIONS........................... 79
UNDERWRITING................................... 80
CERTAIN PROVISIONS OF MARYLAND LAW AND THE
COMPANY'S CHARTER AND BYLAWS................. 82
LEGAL MATTERS.................................. 85
EXPERTS........................................ 85
ADDITIONAL INFORMATION......................... 85
GLOSSARY....................................... 86
INDEX TO FINANCIAL STATEMENTS.................. F-1
</TABLE>
2
<PAGE> 4
PROSPECTUS SUMMARY
The following summary is qualified in its entirety by the more detailed
information appearing in this Prospectus. Capitalized and other terms relating
to the mortgage industry used herein shall have the definitive meanings assigned
to them in the Glossary which begins on page 86. Unless otherwise indicated, the
information in this Prospectus (i) assumes that the Underwriters' over-allotment
option will not be exercised and (ii) has been adjusted to reflect the 0.8-for-1
reverse stock split to be effected prior to the closing of this Offering. See
Note 8 of Notes to Financial Statements.
This Prospectus contains forward looking statements that inherently involve
risks and uncertainties. The Company's actual results could differ materially
from those anticipated in these forward looking statements as a result of
certain important factors. Investors should carefully consider the information
set forth under the heading "Risk Factors."
THE COMPANY
American Residential Investment Trust, Inc. ("AMREIT" or the "Company") is
a real estate investment trust that invests in residential adjustable-rate
Mortgage Assets. The Company finances its acquisitions of Mortgage Assets with
equity and secured borrowings. AMREIT expects generally to earn interest on the
portion of its portfolio of Mortgage Assets financed with equity and to earn a
net interest spread on the leveraged portion of its portfolio of Mortgage
Assets. The Company is structured as a real estate investment trust, thereby
generally eliminating federal taxes at the corporate level on income it
distributes to stockholders.
BUSINESS
Investments
The Company has entered into an agreement with Home Asset Management Corp.
(the "Manager") to manage the day-to-day operations of the Company (the
"Management Agreement"). Certain of the executive officers of the Company will
also be executive officers, employees and stockholders of the Manager. Pursuant
to the terms of the Management Agreement, the Manager will advise the Company's
Board of Directors with respect to the formulation of investment criteria and
preparation of policy guidelines, and will be compensated based upon the
principal amount and type of Mortgage Assets held by the Company. See "The
Manager" and "Conflicts of Interest."
AMREIT's current investment portfolio is comprised solely of Mortgage
Securities issued or guaranteed by federal government sponsored agencies.
Following the closing of this Offering, the Company will begin investing in
other types of Mortgage Securities and in Mortgage Loans (collectively "Mortgage
Assets"). The Company's goal is to use the mortgage banking experience of its
management team to acquire nonconforming Mortgage Loans with higher overall
returns than similar Mortgage Loans originated by its competitors. Accordingly,
it has developed tailored underwriting guidelines for nonconforming Mortgage
Loans that it intends to acquire from third-party originators through its Direct
Purchase Program. Management has initially developed tailored underwriting
guidelines for the following segments of the residential Mortgage Loan market:
small multifamily home loans, manufactured housing loans (not including mobile
homes), mixed use loans, rural home loans, mini-ranch home loans, and
condominium/resort loans. The Company expects that additional opportunities in
other market segments will become available as the Mortgage Loan market
continues to change. The Company has not yet acquired any Mortgage Loans
pursuant to the Direct Purchase Program and there can be no assurance that the
program will be successfully implemented or that any Mortgage Assets acquired
through the program will be higher yielding than Mortgage Loans originated by
the Company's competitors. The Company has not specifically identified any
Mortgage Assets in which to invest the net proceeds of this Offering.
Funding
The Company generally expects to finance the acquisition of 8% to 12% of
its Mortgage Assets with equity and the balance with third-party borrowing
facilities. The Company will earn interest on the Mortgage Assets financed with
equity and a net interest spread on the Mortgage Assets financed with
borrowings. AMREIT generally borrows funds pursuant to reverse repurchase
agreements. In a reverse repurchase agreement transaction, the Company agrees to
sell a Mortgage Asset and simultaneously agrees to repurchase
3
<PAGE> 5
the same Mortgage Asset one to six months later at a higher price. The price
differential represents the Company's interest expense. From time to time the
Company also intends to securitize Mortgage Loans acquired through the Direct
Purchase Program as part of its overall financing strategy.
Capital Guidelines
The Company's capital management goal is to strike a balance between the
under-utilization of leverage, which reduces potential returns to stockholders,
and the over-utilization of leverage, which could reduce the Company's ability
to meet its obligations during adverse market conditions. For this purpose, the
Company has established a "Capital Policy" which establishes a minimum ratio of
the Company's equity capital to the total value of its Mortgage Assets. The
Board of Directors of the Company adjusts this ratio when it determines in its
discretion that the percentage of Mortgage Assets financed with debt is either
too low or too high. The Company expects that its aggregate minimum equity
capital requirement under the Capital Policy will generally range between 8% to
12% of the total market value of the Company's Mortgage Assets. It may fluctuate
out of the expected range from time to time as a result of market conditions,
performance of hedges, credit risk, prepayments, general economic conditions and
general availability of financing. There can be no assurance that the Company's
equity capital will be sufficient to protect the Company against adverse effects
from interest rate adjustments or the obligation to sell Mortgage Assets on
unfavorable terms or at a loss.
Risk Management
AMREIT will implement certain processes and will follow a hedging program
intended to protect the Company against significant unexpected changes in
prepayment rates and interest rates. The Company will seek to minimize the
effects on earnings caused by higher than anticipated prepayment rates by
purchasing Mortgage Assets with prepayment penalties or which are fully-indexed
and have previously experienced periods of rising or falling interest rates. The
Company will seek to manage its Mortgage Asset portfolio to offset the potential
adverse effects from (i) lifetime and periodic rate adjustment caps on its
Mortgage Assets, (ii) the differences between interest rate adjustment indices
applicable to its Mortgage Assets and related borrowings, and (iii) the
differences between interest rate adjustment periods applicable to its Mortgage
Assets and related borrowings.
In order to reduce the credit risks associated with acquisitions of
Mortgage Loans under the Direct Purchase Program, Management will (i) employ a
quality control program, (ii) acquire Mortgage Loans that represent a broad
range of moderate risks as opposed to a concentrated risk, (iii) monitor the
credit quality of newly acquired and existing Mortgage Assets, and (iv)
periodically adjust loan loss allowances. The Company also expects to arrange
for servicing of any Mortgage Loans acquired pursuant to the Direct Purchase
Program with servicing entities that have expertise and experience in the types
of Mortgage Loans being acquired. Although Management intends to manage risks
associated with prepayment rates, interest rates and credit quality, there can
be no assurance that Management will be able to effectively manage such risks.
RECENT DEVELOPMENTS
For the quarter ended September 30, 1997, AMREIT generated net income of
approximately $519,000 and net income per share of $0.31. From the commencement
of operations on February 11, 1997 through September 30, 1997, the Company
generated net income of approximately $1.1 million and net income per share of
$0.66. At September 30, 1997, the Company held Mortgage Assets that had a
carrying value of approximately $229 million. All Mortgage Assets held at
September 30, 1997 were Agency Securities backed by adjustable-rate single
family residential Mortgage Loans.
SUMMARY RISK FACTORS
Each prospective purchaser of the shares of Common Stock (the "Shares")
offered hereby should review "Risk Factors" beginning on page 10 for a
discussion of certain factors that should be considered before acquiring the
Shares, including the following:
- - Sudden Interest Rate Fluctuations May Reduce Income From Operations. To the
extent the Company's cost of borrowings rises more rapidly than the earnings
on its Mortgage Assets, the Company's income from operations may be reduced.
4
<PAGE> 6
- - Increased Levels of Mortgage Loan Prepayments May Reduce Operating Income. In
the event that prepayments on the Company's Mortgage Assets exceed
expectations, the Company may (i) have lost the opportunity to receive
interest at the fully indexed rate, (ii) need to write-off capitalized premium
amounts, and (iii) be unable to acquire new Mortgage Assets to replace the
prepaid Mortgage Assets. The Company experienced higher than expected levels
of prepayments in the quarter ended June 30, 1997. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Results of Operations."
- - Limited Operating History Does Not Predict Future Performance. The Company
began operations in February 1997, and the Company's financial results to date
may not be indicative of future results. The Company's Management has had no
prior experience in managing a real estate investment trust.
- - Material Portion of Offering Proceeds Not Committed to Specific Mortgage
Assets; Inability to Acquire Mortgage Assets. At the closing of this Offering,
$90 million, or 28%, of the Company's assets will not be committed to Mortgage
Assets. The Company's net interest income will depend on the Company's ability
to acquire Mortgage Assets on acceptable terms and at favorable spreads over
the Company's borrowing costs. To the extent the Company is unable to acquire
a sufficient number of Mortgage Assets meeting its investment criteria, the
Company's results of operations may be adversely affected.
- - Failure to Implement Company's Leverage Strategy May Adversely Affect Results
of Operations. The Company relies on short-term borrowings to fund
acquisitions of Mortgage Assets. Any failure to obtain or renew adequate
funding on favorable terms could have a material adverse effect on the
Company's operations. In such event, the Company could be required to sell
Mortgage Assets under adverse market conditions and incur losses as a result.
- - Failure to Successfully Manage Interest Rate Risks May Adversely Affect
Results of Operations. Developing an effective interest rate risk management
strategy is complex and no strategy can completely insulate the Company from
risks associated with unexpected interest rate changes. Further, the cost of
hedging transactions and the federal tax laws applicable to real estate
investment trusts may limit the Company's ability to fully hedge its interest
rate risks. In addition, a provider of interest rate derivatives may become
financially unsound or insolvent, thereby rendering the Company unprotected
against interest rate risks.
- - Borrower Credit May Decrease Value of Mortgage Loans. In the event of a
default on any Mortgage Loan held by the Company, the Company will bear the
risk of loss of principal and the Mortgage Loan will cease to be eligible
collateral for borrowings.
- - Characteristics of Underlying Property May Decrease Value of Mortgage
Loans. Mortgage Loans acquired pursuant to the Direct Purchase Program will
have certain distinct risk characteristics and will result in increased credit
risk to the Company.
- - Conflicts of Interest; Management Also Employed by and Owns Securities of
Manager. The executive officers of the Company will also be executive
officers, employees and stockholders of the Manager. Emphasis by Management on
maximizing income in order to achieve higher incentive fees for the Manager
could result in increased risk to the value of the Company's Mortgage Asset
portfolio.
- - Dependence on Key Personnel for Successful Operations. The Company's
operations depend in significant part upon the skills and experience of John
Robbins, Jay Fuller and other key personnel. The loss of any key person could
have a material adverse effect on the Company's business.
- - Failure to Manage Expansion May Adversely Affect Results of Operations. The
Company's expansion as a result of its investment of the net proceeds of this
Offering may cause a significant strain on the Company's and the Manager's
financial, management and other resources. If the Company is unable to manage
growth effectively, the Company's business, financial condition and results of
operations may be adversely affected.
- - Real Estate Market Conditions May Adversely Affect Results of Operations. The
Company's business may be adversely affected by periods of economic slowdown
or recession which may be accompanied by declining real estate values.
5
<PAGE> 7
- - Investments in Mortgage Assets May Be Illiquid. Certain of the Company's
investments may lack a regular trading market and may be illiquid. The
Company's inability to liquidate Mortgage Assets could render it insolvent.
- - Policies and Strategies May Be Revised at the Discretion of the Board of
Directors. The Board of Directors has established, and generally can waive and
modify, the investment, and operating policies and strategies of the Company.
These policies and strategies do not limit the amount of capital which may be
invested in any one type of Mortgage Asset.
- - Management and Certain Affiliates Will Control approximately 20% of
Outstanding Shares After the Offering. Upon the closing of this Offering, the
Company's directors and officers, the Manager and certain affiliates thereof
will beneficially own or have a right to control approximately 20% of the
outstanding shares of Common Stock of the Company. As stockholders, they could
exert significant influence over corporate actions requiring stockholder
approval.
- - Failure to Maintain REIT Status May Subject Company to Corporate Level Tax. If
the Company fails to qualify as a real estate investment trust in any taxable
year, the Company may be subject to federal income tax as a regular, domestic
corporation, thereby significantly reducing or eliminating the amount of cash
available for distribution to its stockholders. Failure to qualify for real
estate investment trust status may reduce or eliminate the Company's advantage
over non-real estate investment trust companies.
MANAGEMENT OF THE COMPANY
The Company has entered into an agreement with the Manager to provide
management services to the Company. Although the management team has had no
prior experience managing a real estate investment trust, each of the executive
officers of the Company has between 10 and 24 years, and collectively, have an
average of 19 years of experience in the mortgage origination business and
extensive experience in originating nonconforming Mortgage Loans.
The Company is subject to conflicts of interest with the Manager and its
executive officers. The executive officers of the Company will also be executive
officers, employees and stockholders of the Manager. In evaluating Mortgage
Assets for investment and other strategies, Management could emphasize
maximizing income at the expense of other criteria, in order to achieve higher
incentive compensation for the Manager, which could result in increased risk to
the value of the Company's portfolio of Mortgage Assets. In addition, the
Management Agreement does not limit or restrict the right of the Manager to
render services of any kind to any third party, except that the Manager and its
officers, directors or employees will not be permitted to provide any such
services to any real estate investment trust which invests in residential
Mortgage Assets, other than the Company.
The Company's bylaws require that a majority of the members of its Board of
Directors must be independent directors who are not officers or employees of the
Company. Upon the closing of this Offering, the Company will have seven members
serving on its Board of Directors, five of whom will be independent directors.
In addition to approval by the Board of Directors, the following actions require
approval by a majority of the independent directors:
- termination of the Management Agreement between the Company and the
Manager;
- revisions to the Company's investment policies; and
- an amendment of the Company's Bylaws.
The Board of Directors may amend the Company's investment policies without
further approval by the Company's stockholders.
Although no additional fees will be payable to the Company's management
team solely as a result of this Offering, investment of the net proceeds of this
Offering will result in an increase in the Company's Mortgage Assets and thus an
increase in the management fees to be paid to the Manager. At the discretion of
the Manager's Board of Directors, the Manager may elect to pay a portion of such
fees to the Company's
6
<PAGE> 8
management team as a bonus. Moreover, upon the closing of this Offering, certain
executive officers of the Company will realize an immediate increase in the
value of certain options and shares of the Common Stock of the Company. In
addition, certain options held by the management team will vest in full in the
event the Company completes additional public or private offerings which
generate proceeds that, when combined with the net proceeds of this Offering,
exceed $150 million. See "Management of the Company -- Option Grants."
THE MANAGER
Pursuant to a Management Agreement, AMREIT has engaged the Manager to
generate and manage the Company's Mortgage Assets and to oversee the day-to-day
operations of the Company, subject to direction by the Company's Board of
Directors. The Manager funded AMREIT at its formation with a $20 million
investment through an intermediary entity. See "The Manager -- Relationship
between the Manager and the Company." Currently, the Manager derives
substantially all of its income from the Company, a majority of which is from
dividends and incentive fees. Accordingly, the success of the Manager is
substantially dependent upon the success of the Company. In addition, the
executive officers of the Company are also the executive officers of the Manager
and beneficially own an interest in the Manager. See "The Manager," "Certain
Transactions," "Conflicts of Interest" and "Principal Stockholders."
In addition to reimbursing the Manager for certain expenses incurred on
behalf of the Company, the Company will pay to the Manager the base management
fees and incentive compensations, as follows:
- 1/8 of 1% per year, to be paid monthly, of the principal amount of Agency
Securities;
- 3/8 of 1% per year, to be paid monthly, of the principal amount of all
Mortgage Assets other than Agency Securities; and
- 25% of the amount by which the Company's net income (before deducting the
amount to be paid as incentive compensation) exceeds the annualized
return on equity equal to the average ten year U.S. Treasury Rate plus
2%.
Investment of the net proceeds of this Offering will result in an increase
in the Company's Mortgage Assets and, thus, an increase in the management fees
and incentive compensation to be paid to the Manager.
The Management Agreement has an initial term of two years with automatic
one-year renewals. It may be terminated by the Company without cause only upon
each renewal date and may be terminated for cause at any time by either party.
In the event that the Management Agreement is terminated by the Company without
cause, the Company is obligated to pay the Manager a termination fee pursuant to
a specified formula. See "The Manager -- The Management Agreement."
------------------------
The Company was incorporated in Maryland on February 6, 1997. The principal
executive offices of the Company and the Manager are located at 445 Marine View
Avenue, Suite 230, Del Mar, California 92014. The telephone number is (619)
350-5000.
CONFLICTS OF INTEREST
Certain of the executive officers of the Company are executive officers,
employees and stockholders of the Manager. The Manager's base management fee and
incentive compensation is determined based upon the principal amount and type of
assets held by the Company. Because the fees received by the Manager are greater
as the amount of non-Agency Securities held by the Company is increased, the
Manager may have an incentive to invest in Mortgage Assets of higher risks than
those associated with Agency Securities. Accordingly, the Company's Mortgage
Assets may be subject to greater risk of loss. See "Conflicts of Interest."
7
<PAGE> 9
FEDERAL INCOME TAX CONSEQUENCES
The Company intends to elect, with the filing of its first federal
corporate income tax return in 1998, to be treated as a real estate investment
trust ("REIT") for federal income tax purposes. A corporation qualifying as a
REIT may avoid corporate income taxation by distributing its taxable income to
its stockholders annually. Subject to the qualifications stated in the section
of the Prospectus entitled "Federal Income Tax Consequences," Jeffers, Wilson,
Shaff & Falk, LLP ("Special Tax Counsel") has given the Company an opinion that
the Company is organized in conformity with the requirements for qualification
and taxation as a REIT under the Code and that its actual and proposed method of
operation as described in the Prospectus and as represented to Special Tax
Counsel will enable it to meet the requirements for qualification as a REIT. See
"Federal Income Tax Consequences -- Opinion of Special Counsel."
DIVIDEND POLICY AND DISTRIBUTIONS
The Company intends to distribute 95% or more of its net taxable income
(which does not necessarily equal net income as calculated in accordance with
GAAP) to its stockholders on a quarterly basis each year so as to comply with
the REIT provisions of the Code. Any taxable income remaining after the
distribution of the regular quarterly dividends will be distributed annually in
a special dividend on or prior to the date of the first regular quarterly
dividend payment date of the following taxable year. The dividend policy is
subject to revision in the discretion of the Board of Directors of the Company.
THE OFFERING
<TABLE>
<S> <C>
Common Stock Offered by the Company (1)...... 6,500,000 Shares
Common Stock to be Outstanding after the
Offering (1)(2).............................. 8,114,000 Shares
Use of Proceeds.............................. To fund purchases of Mortgage Assets and for
general corporate purposes. See "Use of
Proceeds."
Proposed NYSE Symbol......................... "INV"
</TABLE>
- ---------------
(1) Assumes that the Underwriters' option to purchase up to an additional
975,000 shares of Common Stock to cover overallotments is not exercised.
(2) Excludes (i) 315,200 shares of Common Stock reserved for issuance pursuant
to options outstanding under the Company's 1997 Stock Incentive Plan (the
"Incentive Plan") and (ii) 337,800 shares of Common Stock reserved for
issuance pursuant to options to be issued under the Company's 1997 Stock
Option Plan (the "Option Plan") upon the closing of this Offering. See
"Management of the Company" and "Shares Eligible for Future Sale."
PURPOSE OF THE OFFERING
Pursuant to its reverse repurchase agreements, the Company must provide
collateral which has a greater value than the amount it borrows. Accordingly,
the Company is not able to finance the entirety of its acquisitions of Mortgage
Assets with debt. In order to obtain the debt financing necessary to implement
its investment strategy, the Company must have an equity base. The net proceeds
of this Offering will substantially increase the Company's current equity base.
The Company generally intends to finance the acquisition of between 8% and 12%
of its Mortgage Assets with equity and the balance with borrowings. The net
proceeds of this Offering available for investment purposes, after deducting the
expenses of this Offering ($1.2 million) and the underwriting discounts and
commissions ($6.3 million), and assuming no exercise of the Underwriters' option
to purchase shares of Common Stock to cover over-allotments, will be
approximately $90.0 million. Accordingly, the Company anticipates that it will
finance the acquisition of additional Mortgage Assets with a value of
approximately $720 million to $1.1 billion as a result of the additional
borrowings it may incur.
8
<PAGE> 10
SUMMARY FINANCIAL INFORMATION
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
PERIOD FROM PERIOD FROM
FEBRUARY 11, 1997 QUARTER FEBRUARY 11, 1997
TO ENDED TO
JUNE 30, 1997 JUNE 30, 1997 MARCH 31, 1997
----------------- ------------- -----------------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Total interest income........................... $ 3,640 $ 3,334 $ 306
Net interest income............................. 724 568 156
Net income...................................... 584 438 146
Net income per share of Common Stock(1)......... $ 0.35 $ 0.26 $0.09
</TABLE>
<TABLE>
<CAPTION>
AS OF AS OF
JUNE 30, 1997 MARCH 31, 1997
------------- --------------
<S> <C> <C>
BALANCE SHEET DATA:
Mortgage Assets.................................................. $ 228,620 $152,883
Total assets..................................................... 231,518 161,302
Reverse repurchase agreements.................................... 209,539 141,068
Stockholders' equity............................................. 20,603 20,094
</TABLE>
- ---------------
(1) See Note 1 of Notes to Financial Statements for additional information.
9
<PAGE> 11
RISK FACTORS
This Prospectus contains forward looking statements that inherently involve
risks and uncertainties. Before investing in the Shares, prospective investors
should give special consideration to the information set forth below, in
addition to the information set forth elsewhere in this Prospectus. The
following risk factors are interrelated and, consequently, investors should
consider such risk factors as a whole.
SUDDEN INTEREST RATE FLUCTUATIONS MAY REDUCE INCOME FROM OPERATIONS
Substantially all of the Company's Mortgage Assets will have a repricing
frequency of one year or less, and substantially all of the Company's borrowings
will have maturities of six months or less. The interest rates on the Company's
borrowings may be based on interest rate indices which are different from, and
adjust more rapidly than, the interest rate indices of its related Mortgage
Assets. Consequently, changes in interest rates may significantly influence the
Company's net interest income. While increases in interest rates will generally
increase the yields on the Company's adjustable-rate Mortgage Assets, rising
rates will also increase the cost of borrowings by the Company. To the extent
such costs rise more rapidly than the yields on such Mortgage Assets, the
Company's net interest income will be reduced or a net interest loss may result.
Adjustable-rate Mortgage Assets are typically subject to periodic and
lifetime interest rate caps which limit the amount an adjustable-rate Mortgage
Asset interest rate can change during any given period. The Company's borrowings
will not be subject to similar restrictions. Hence, in a period of increasing
interest rates, the cost of the Company's borrowings could increase without
limitation by caps while the yields on the Company's Mortgage Assets could be
limited. Further, some adjustable-rate Mortgage Assets may be subject to
periodic payment caps that result in some portion of the interest being deferred
and added to the principal outstanding. This could result in receipt by the
Company of a lesser amount of cash income on its adjustable-rate Mortgage Assets
than is required to pay interest on the related borrowings, which will not have
such payment caps. These factors could lower the Company's net interest income
or cause a net interest loss during periods of rising interest rates, which
would negatively impact the Company's financial condition and results of
operations.
INCREASED LEVELS OF MORTGAGE LOAN PREPAYMENTS MAY REDUCE OPERATING INCOME
Prepayments of Mortgage Assets could adversely affect the Company's results
of operations in several ways. The Company anticipates that a portion of the
adjustable-rate Mortgage Assets to be acquired by the Company may bear initial
"teaser" interest rates which are lower than their "fully-indexed" rates (the
applicable index plus a margin). In the event that such an adjustable-rate
Mortgage Asset is prepaid prior to or soon after the time of adjustment to a
fully-indexed rate, the Company will have held the Mortgage Asset during its
least profitable period and lost the opportunity to receive interest at the
fully-indexed rate over the expected life of the adjustable-rate Mortgage Asset.
In addition, the prepayment of any Mortgage Asset that had been purchased with a
premium by the Company would result in the immediate write-off of any remaining
capitalized premium amount and consequent reduction of the Company's net
interest income by such amount. Finally, in the event that the Company is unable
to acquire new Mortgage Assets to replace the prepaid Mortgage Assets, the
Company's financial condition and results of operations could be materially
adversely affected.
Mortgage Asset prepayment rates generally increase when new Mortgage Loan
interest rates fall below the interest rates on the adjustable-rate Mortgage
Assets. Prepayment experience also may be affected by the geographic location of
the property securing the adjustable-rate Mortgage Assets, the assumability of
the adjustable-rate Mortgage Assets, the ability of the borrower to obtain or
convert to a fixed-rate loan, conditions in the housing and financial markets
and general economic conditions. The level of prepayments is also subject to the
same seasonal influences as the residential real estate industry with prepayment
rates generally being highest in the summer months and lowest in the winter
months. The Company experienced higher than expected levels of prepayments in
the quarter ended June 30, 1997. Although the Company does not expect prepayment
rates to continue at such levels, there can be no assurance that the Company
will be able to achieve or maintain lower prepayment rates. Accordingly, the
Company's financial condition and
10
<PAGE> 12
results of operations could be materially adversely affected. See
"Business -- Risk Management -- Interest Rate Risk Management."
It is expected that Mortgage Loans acquired by the Company may contain
provisions restricting prepayments of such Mortgage Loans and require a charge
in connection with the prepayment thereof. Such prepayment restrictions can, but
do not necessarily, provide a deterrent to prepayments. Prepayment charges may
be in an amount which is less than the figure which would fully compensate the
Company for a lower yield upon reinvestment of the prepayment proceeds.
MATERIAL PORTION OF OFFERING PROCEEDS NOT COMMITTED TO SPECIFIC MORTGAGE ASSETS;
INABILITY TO ACQUIRE MORTGAGE ASSETS
The Company has not specifically identified any Mortgage Assets in which to
invest the net proceeds of this Offering. The Company may acquire Mortgage
Assets with geographic, issuer, industry and other types of concentrations.
Accordingly, a significant portion of the Company's Mortgage Assets may be
subject to the risks associated with a single type of occurrence. In the event
of such an occurrence, the adverse effects on the Company's results of
operations will be significantly greater than if the Company's Mortgage Assets
were diversified with respect to such factors. See "Business -- Capital
Guidelines."
The Company's net interest income will depend, in large part, on the
Company's ability to acquire Mortgage Assets on acceptable terms and at
favorable spreads over the Company's borrowing costs. As a result of this
Offering, the Company will seek to acquire approximately $900 million or more of
additional Mortgage Assets. However, the Company has not specifically identified
any Mortgage Assets in which to invest the net proceeds of this Offering. As of
the closing of this Offering, approximately $90 million, or 28%, of the
Company's net assets will not be committed to specific Mortgage Assets. There
can be no assurance that the Company will be able to acquire sufficient Mortgage
Assets at spreads above the Company's cost of funds. In acquiring Mortgage
Assets, the Company will compete with numerous investment banking firms, savings
and loan associations, banks, mortgage bankers, insurance companies, mutual
funds, other lenders, federal government sponsored agencies such as GNMA, FNMA
and FHLMC, and other entities purchasing Mortgage Assets, many of which have
greater financial resources than the Company. In addition, there are several
REITs similar to the Company and others may be organized in the future. The
effect of the existence of additional REITs may be to increase competition for
the available supply of Mortgage Assets suitable for purchase by the Company. As
it relates to the Direct Purchase Program, the Company competes on the basis of
product type. The Company will face competition from others already established
in these markets. There can be no assurance that the Company will be able to
successfully compete with its competition.
The availability of Mortgage Loans meeting the Company's criteria is
dependent upon, among other things, the size of and level of activity in the
residential real estate lending market and, in particular, the demand for
nonconforming Mortgage Loans. The size and level of activity in the residential
real estate lending market depends on various factors, including the level of
interest rates, regional and national economic conditions and inflation and
deflation in residential property values. To the extent that the Company is
unable to acquire a sufficient amount of Mortgage Loans meeting its criteria,
the Company's results of operations will be materially adversely affected.
LIMITED OPERATING HISTORY DOES NOT PREDICT FUTURE PERFORMANCE
The Company began operations in February 1997 and, accordingly, has not yet
developed an extensive financial history or experienced a wide variety of
interest rate fluctuations or market conditions. Consequently, the Company's
financial results to date may not be indicative of future results.
Additionally, although Management has considerable expertise in the
acquisition and management of Mortgage Assets, mortgage finance, asset/liability
management and the management of corporations in real estate lending business,
Management has had no prior experience in managing a REIT and with certain
tailored Mortgage Loan products. There can be no assurance that the past
experience of Management will be appropriate to the business of the Company.
Additionally, the Company has not yet begun acquiring Mortgage Loans under the
Direct Purchase Program.
11
<PAGE> 13
FAILURE TO IMPLEMENT COMPANY'S LEVERAGE STRATEGY MAY ADVERSELY AFFECT RESULTS OF
OPERATIONS
The Company relies on short term borrowings to fund acquisitions of
Mortgage Assets. Accordingly, the ability of the Company to achieve its
investment objectives depends on its ability to (i) borrow money in sufficient
amounts and on favorable terms, (ii) to renew or replace on a continuous basis
its maturing short term borrowings and (iii) to successfully leverage its
Mortgage Assets. In addition, the Company is dependent upon a few lenders to
provide the primary credit facilities for its purchases of Mortgage Assets. Any
failure to obtain or renew adequate funding under these facilities or other
financings on favorable terms, could reduce the Company's net interest income
and have a material adverse effect on the Company's operations. The Company has
no long term commitments with its lenders. The Company's current borrowing
facilities may be collateralized only by Mortgage Securities.
In the event the Company is not able to renew or replace maturing
borrowings, the Company could be required to sell Mortgage Assets under adverse
market conditions and could incur losses as a result. In addition, in such
event, the Company may be required to terminate hedge positions, which could
result in further costs to the Company. Any event or development, such as a
sharp rise in interest rates or increasing market concern about the value or
liquidity of a type or types of Mortgage Assets in which the Company's Mortgage
Asset portfolio is concentrated, will reduce the market value of the Mortgage
Assets, which would likely cause lenders to require additional collateral. A
number of such factors in combination may cause difficulties for the Company,
including a possible liquidation of a major portion of the Company's Mortgage
Assets at disadvantageous prices with consequent losses, which could have a
material adverse effect on the Company and could render it insolvent.
Lenders will have claims on the Company's assets superior to the claims of
the holders of the Shares and may require that the Company agree to covenants
that could restrict its flexibility in the future and limit the Company's
ability to pay dividends. In the event of the insolvency or bankruptcy of the
Company, any creditor under a reverse repurchase agreement may be allowed to
avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on
the collateral agreements without delay. In the event of the insolvency or
bankruptcy of a lender during the term of a reverse repurchase agreement, the
lender may be permitted to repudiate the contract, and the Company's claim
against the lender for damages therefrom may be treated simply as one of the
unsecured creditors. Should this occur, the Company's claims would be subject to
significant delay and, if received, may be substantially less than the damages
actually suffered by the Company.
Due to the underlying loan to collateral values established by the
Company's lenders, the Company may be subject to calls for additional capital in
the event of adverse market conditions. Such conditions include (i) higher than
expected levels of prepayments on Mortgage Loans and (ii) sudden increases in
interest rates. To the extent that the Company is highly leveraged, it may not
be able to meet its loan to collateral value requirements, which may result in
losses to the Company. There can be no assurance that the Company will not face
a call for additional capital. See "Business -- Funding," and "-- Capital
Guidelines."
The Company's Capital Policy, which is set by the Company's Board of
Directors, requires the Company to maintain a minimum equity capital of between
8% and 12%. However, the Company is not subject to additional statutory,
regulatory or third party limitations on incurring debt. Accordingly, there can
be no assurance that the Company's ability to incur debt will not be increased
by the Board of Directors following the closing of this Offering. See
"-- Policies and Strategies May Be Revised at the Discretion of the Board of
Directors."
FAILURE TO SUCCESSFULLY MANAGE INTEREST RATE RISKS MAY ADVERSELY AFFECT RESULTS
OF OPERATIONS
The Company will follow a program intended to protect against interest rate
changes. However, developing an effective interest rate risk management strategy
is complex and no management strategy can completely insulate the Company from
risks associated with interest rate changes. In addition, hedging involves
transaction costs. In the event the Company hedges against interest rate risks,
the Company may substantially reduce its net income. Further, the federal tax
laws applicable to REITs may limit the
12
<PAGE> 14
Company's ability to fully hedge its interest rate risks. Such federal tax laws
may prevent the Company from effectively implementing hedging strategies that
Management determines, absent such restrictions, would best insulate the Company
from the risks associated with changing interest rates. See "Business -- Risk
Management -- Interest Rate Risk Management."
In the event that the Company purchases interest rate caps or other
interest rate derivatives to hedge against lifetime, periodic rate or payment
caps, and the provider of such caps on interest rate derivatives becomes
financially unsound or insolvent, the Company may be forced to unwind such caps
on its interest rate derivatives with such provider and may take a loss thereon.
Further, the Company could suffer the adverse consequences that the hedging
transaction was intended to protect against. Although the Company intends to
purchase interest rate caps and derivatives only from financially sound
institutions and to monitor the financial strength of such institutions on a
periodic basis, no assurance can be given that the Company can avoid such third
party risks.
Currently, the Company has entered into hedging transactions which seek to
protect only against the Mortgage Loans' lifetime rate caps and not against
periodic rate caps or unexpected payments. In addition, the Company's lifetime
cap hedges are for a two year period which does not begin until the second
quarter of 1998. Accordingly, the Company may not be adequately protected
against risks associated with interest rate changes and such changes could
adversely affect the Company's financial condition and results of operations.
BORROWER CREDIT MAY DECREASE VALUE OF MORTGAGE LOANS
The Company expects that a portion of its Mortgage Assets will consist of
Mortgage Loans. Accordingly, during the time it holds Mortgage Loans, the
Company will be subject to increased credit risks, including risks of borrower
defaults and bankruptcies and special hazard losses that are not covered by
standard hazard insurance (such as those occurring from earthquakes or floods).
In the event of a default on any Mortgage Loan held by the Company, the Company
will bear the risk of loss of principal to the extent of any deficiency between
the value of the secured property, and the amount owing on the Mortgage Loan,
less any payments from an insurer or guarantor. Defaulted Mortgage Loans will
also cease to be eligible collateral for borrowings, and will have to be
financed by the Company out of other funds until ultimately liquidated. Although
the Company intends to establish an allowance for Mortgage Loan losses in
amounts adequate to cover these risks, in view of its limited operating history
and lack of experience with the Direct Purchase Program to date, there can be no
assurance that any allowance for Mortgage Loan losses which are established will
be sufficient to offset losses on Mortgage Loans in the future. See
"Business -- Investments -- Direct Purchase Program."
Even assuming that properties secured by the Mortgage Loans held by the
Company provide adequate security for such Mortgage Loans, substantial delays
could be encountered in connection with the foreclosure of defaulted Mortgage
Loans, with corresponding delays in the receipt of related proceeds by the
Company. State and local statutes and rules may delay or prevent the Company's
foreclosure on or sale of the mortgaged property and may prevent the Company
from receiving net proceeds sufficient to repay all amounts due on the related
Mortgage Loan. In addition, the Company's servicing agent may be entitled to
receive all expenses reasonably incurred in attempting to recover amounts due
and not yet repaid on liquidated Mortgage Loans, thereby reducing amounts
available to the Company. Some properties which will collateralize the Company's
Mortgage Loans may have unique characteristics or may be subject to seasonal
factors which could materially prolong the time period required to resell such
properties. See "-- Characteristics of Underlying Property May Decrease Value of
Mortgage Loans."
CHARACTERISTICS OF UNDERLYING PROPERTY MAY DECREASE VALUE OF MORTGAGE LOANS
The Company anticipates that in the future a portion of its Mortgage Assets will
consist of Mortgage Loans acquired pursuant to the Direct Purchase Program.
These Mortgage Loans will have certain distinct risk characteristics and
generally lack standardized terms, which may complicate their structure. The
underlying properties themselves may be unique and more difficult to value than
typical residential properties. Although the Company intends to seek geographic
diversification of the properties which are collateral for the Company's
Mortgage Loans, it does not intend to set specific diversification requirements
(whether by state,
13
<PAGE> 15
zip code or other geographic measure). Concentration in any one geographic area
will increase the exposure of the Company's Mortgage Assets to the economic and
natural hazard risks associated with that area.
Certain properties securing Mortgage Loans may be contaminated by hazardous
substances resulting in reduced property values. If the Company forecloses on a
defaulted Mortgage Loan collateralized by such property, the Company may be
subject to environmental liabilities regardless of whether the Company was
responsible for the contamination. The results of the Direct Purchase Program
may also be affected by various factors, many of which are beyond the control of
the Company, such as (i) local and other economic conditions affecting real
estate values, (ii) the ability of tenants to make lease payments, (iii) the
ability of a property to attract and retain tenants, (iv) interest rate levels
and the availability of credit to refinance such Mortgage Loans at or prior to
maturity, and (v) increased operating costs, including energy costs, real estate
taxes and costs of compliance with regulations.
CONFLICTS OF INTERESTS; MANAGEMENT ALSO EMPLOYED BY AND OWNS SECURITIES OF
MANAGER
The Company is subject to conflicts of interest with the Manager and its
executive officers. The executive officers of the Company generally will also be
executive officers, employees and stockholders of the Manager. Under the
Management Agreement, the Manager will receive an annual base management fee
payable monthly in arrears and the Manager will have the opportunity to earn
incentive compensation under the Management Agreement based on the Company's
annualized net income. The ability of the Company to achieve the performance
level required for the Manager to earn the incentive compensation is dependent
upon the level and volatility of interest rates, the Company's ability to react
to changes in interest rates and to implement the operating strategies described
herein, and other factors, many of which are not within the Company's control.
In evaluating Mortgage Assets for investment and other strategies, an undue
emphasis on maximizing income at the expense of other criteria, such as
preservation of capital, in order to achieve higher incentive compensation for
the Manager, could result in increased risk to the value of the Company's
Mortgage Asset portfolio. See "The Manager -- The Management
Agreement -- Management Fees" and "Conflicts of Interest."
The Management Agreement does not limit or restrict the right of the
Manager or any of its officers, directors, employees or affiliates to engage in
any business or to render services of any kind to any other person, including
purchasing, or rendering advice to others purchasing, Mortgage Assets which meet
the Company's policies and criteria, except that the Manager and its officers,
directors, or employees will not be permitted to provide any such services to
any REIT which invests primarily in residential Mortgage Assets, other than the
Company.
DEPENDENCE ON KEY PERSONNEL FOR SUCCESSFUL OPERATIONS
The Company's operations depend in significant part upon the skill and
experience of John Robbins and Jay Fuller. Although these executive officers
currently have employment agreements with the Manager, there can be no assurance
of the continued employment of such officers. The Company is also dependent on
other key personnel and on its ability to continue to attract, retain and
motivate qualified personnel. The loss of any key person could have a material
adverse effect on the Company's business, financial condition and results of
operations. See "Management of the Company -- Executive Compensation" and
"-- Employment Contracts and Termination of Employment and Change of Control
Arrangements."
FAILURE TO MANAGE EXPANSION MAY ADVERSELY AFFECT RESULTS OF OPERATIONS
The Company's expansion as a result of its investment of the net proceeds
of this Offering may cause a significant strain on the Company's and the
Manager's financial, management and other resources. To manage the Company's
growth effectively, the Company and the Manager must continue to improve and
expand their existing resources and management information systems and attract,
train and motivate qualified personnel. If the Company and the Manager are
unable to manage growth effectively, the Company's financial conditions and
results of operations may be adversely affected.
14
<PAGE> 16
In order to further develop the Direct Purchase Program, the Manager must
significantly expand its level of operations. The Company's operating results
may be adversely affected if the Company is not able to acquire a significant
number of Mortgage Loans directly from Correspondents pursuant to the Direct
Purchase Program.
The Company may require up to twelve months to fully implement its
financing strategy and increase its investment in Mortgage Assets to the desired
level. Until such level is achieved, the net interest income on the Company's
Mortgage Asset portfolio is expected to be lower than would be the case if its
financing strategy were fully implemented. Further, the Company may acquire new
Mortgage Assets with coupons that are initially low relative to prevailing short
term interest rates. As a result, the Company's interest income may be lower
during periods of rapid growth in the Company's Mortgage Assets.
REAL ESTATE MARKET CONDITIONS MAY ADVERSELY AFFECT RESULTS OF OPERATIONS
The Company's business may be adversely affected by periods of economic
slowdown or recession which may be accompanied by declining real estate values.
Any material decline in real estate values reduces the ability of borrowers to
use home equity to support borrowings and increases the loan-to-value ratios of
Mortgage Loans previously made, thereby weakening collateral coverage and
increasing the possibility of a loss in the event of default. In addition,
delinquencies, foreclosures and losses generally increase during economic
slowdowns and recessions.
INVESTMENTS IN MORTGAGE ASSETS MAY BE ILLIQUID
Although the Company expects that a majority of the Company's investments
will be in Mortgage Assets for which a resale market exists, certain of the
Company's investments may lack a regular trading market and may be illiquid. In
addition, during turbulent market conditions, the liquidity of all of the
Company's Mortgage Assets may be adversely impacted. There is no limit to the
percentage of the Company's investments that may be invested in illiquid
Mortgage Assets. In the event the Company required additional cash as a result
of a margin call pursuant to its financing agreements or otherwise, the Company
may be required to liquidate Mortgage Assets on unfavorable terms. The Company's
inability to liquidate Mortgage Assets could render it insolvent.
POLICIES AND STRATEGIES MAY BE REVISED AT THE DISCRETION OF THE BOARD OF
DIRECTORS
The Board of Directors has established the investment policies and
operating policies and strategies of the Company set forth in this Prospectus.
These policies and strategies may be modified or waived by the Board of
Directors without stockholder consent. Further, the Board of Directors is not
limited by its charter or bylaws in determining the Company's policies and
strategies. Accordingly, investors are not able to evaluate the credit or other
risks which may be applicable to the Mortgage Assets to be acquired by the
Company. A change in the Company's policies and strategies could adversely
affect the Company's business, financial condition and results of operations.
The Company does not currently intend to (i) issue senior securities, (ii)
make loans to other persons, (iii) invest in the securities of others for the
purpose of exercising control, (iv) underwrite securities of other issuers, (v)
offer securities in exchange for property or (vi) repurchase or otherwise
reacquire its shares or other securities.
MANAGEMENT AND CERTAIN AFFILIATES WILL CONTROL APPROXIMATELY 20% OF OUTSTANDING
SHARES AFTER OFFERING
Immediately following the closing of this Offering, the Company's directors
and officers, the Manager and certain of their affiliates will beneficially own
or have the right to control approximately 20% of the Company's outstanding
shares of Common Stock. Accordingly, these stockholders may continue to exert
significant influence over the outcome of most corporate actions requiring
stockholder approval, including the election of directors and the approval of
transactions involving a change in control of the Company. See "Principal
Stockholders."
15
<PAGE> 17
FAILURE TO MAINTAIN REIT STATUS MAY SUBJECT COMPANY TO CORPORATE LEVEL TAX
The Company intends at all times to operate so as to qualify as a REIT for
federal income tax purposes. To qualify as a REIT, the Company must satisfy
certain tests related to the nature of its assets and income and it must also
distribute substantially all of its income (as specially defined for these
purposes) to its stockholders. If the Company fails to qualify as a REIT in any
taxable year and certain relief provisions of the Code do not apply, the Company
would be subject to federal income tax as a regular, domestic corporation, and
its stockholders would be subject to tax in the same manner as stockholders of
such corporation. Distributions to stockholders in any years in which the
Company fails to qualify as a REIT would not be deductible by the Company in
computing its taxable income. As a result, the Company could be subject to
income tax liability, thereby significantly reducing or eliminating the amount
of cash available for distribution to its stockholders. Further, the Company
could also be disqualified from re-electing REIT status for the four taxable
years following the year during which it became disqualified.
No assurance can be given that future legislation, regulations,
administrative interpretations or court decisions will not significantly change
the tax laws with respect to the Company's qualification as a REIT or the
federal income tax consequences of such qualification, which changes may reduce
or eliminate the Company's advantage over other companies not organized as
REITs. See "Federal Income Tax Considerations."
MARKET FOR COMMON STOCK MAY BE LIMITED AND MARKET PRICE MAY FLUCTUATE BELOW
OFFERING PRICE
Prior to this Offering, there has not been a public market for the Common
Stock, and there can be no assurance that a regular trading market for the
Shares offered hereby will develop or, if developed, that any such market will
be sustained. In the absence of a public trading market, an investor may be
unable to liquidate his investment in the Company. The initial public offering
price will be determined by the Company and representatives of the Underwriters.
There can be no assurance that the price at which the Shares sell in the public
market after the closing of this Offering will not be lower than the price at
which they are sold by the Underwriters. See "Underwriting."
In the event that a public market for the Shares develops, it is likely
that the market price of the Shares will be influenced by any variations between
the net yield on the Company's Mortgage Assets and prevailing market interest
rates. The Company's net income will be derived primarily from any positive
spread between the yield on the Company's Mortgage Assets and the cost of the
Company's borrowings. Such positive spread will not necessarily be greater in
high interest rate environments than in low interest rate environments. However,
in periods of high interest rates, the net income of the Company, and therefore
the dividend yield on the Shares, may be less attractive compared with
alternative investments, which could negatively impact the price of the Shares.
If the dividend yield on the Company's Shares declines, or if prevailing market
interest rates rise, the market price of the Shares may be adversely affected.
Accordingly, fluctuations in interest rates could have a material adverse affect
on the trading market for the Shares. See "-- Sudden Interest Rate Fluctuations
May Reduce Income From Operations -- Material Portion of Offering Proceeds Not
Committed to Specific Mortgage Assets. -- Failure to Successfully Manage
Interest Rate Risks May Adversely Affect Results of Operations."
FAILURE TO QUALIFY FOR EXEMPTION UNDER INVESTMENT COMPANY ACT WOULD RESULT IN
SIGNIFICANT
REGULATORY BURDEN
The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act.
Accordingly, the Company does not expect to be subject to the restrictive
provisions of the Investment Company Act. However, if the Company fails to
qualify for exemption from registration as an investment company, its ability to
use leverage would be substantially reduced, and it would be unable to conduct
its business as described herein. Any such failure to qualify for such exemption
could have a material adverse effect on the Company.
The Investment Company Act exempts entities that are "primarily engaged in
the business of purchasing or otherwise acquiring mortgages and other liens on
and interests in real estate." Under the current interpretation of the staff of
the Securities and Exchange Commission, in order to qualify for this exemption,
16
<PAGE> 18
the Company must maintain at least 55% of its assets directly in Mortgage Loans,
qualifying Mortgage Securities and certain other qualifying interests in real
estate. In addition, unless certain Mortgage Securities represent all the
certificates issued with respect to an underlying pool of Mortgage Loans, such
Mortgage Securities may be treated as securities separate from the underlying
Mortgage Loans and, thus, may not qualify for purposes of the 55% requirement.
Therefore, the Company's ownership of certain Mortgage Assets may be limited by
the provisions of the Investment Company Act.
FUTURE OFFERINGS OF COMMON STOCK MAY AFFECT MARKET PRICE OF COMMON STOCK
The Company may in the future increase its capital resources by making
additional offerings of equity and debt securities, including classes of
preferred stock, Common Stock, commercial paper, medium-term notes, CMOs and
senior or subordinated notes. All debt securities and classes of preferred stock
will be senior to the Common Stock in a liquidation of the Company. The effect
of additional equity offerings may be the dilution of the equity of stockholders
of the Company or the reduction of the price of the Company's Common Stock, or
both. The Company is unable to estimate the amount, timing or nature of
additional offerings as they will depend upon market conditions and other
factors. There can be no assurance that the Company will be able to raise the
capital it will require through such offerings on favorable terms or at all. The
inability of the Company to obtain needed sources of capital on favorable terms
could have a material adverse affect on the Company. See
"Business -- Investments -- Funding."
OWNERSHIP OF COMMON STOCK MAY BE RESTRICTED
In order that the Company may meet the requirements for qualification as a
REIT at all times, the Company's Articles of Amendment and Restatement (the
"Charter") prohibits any person from acquiring or holding, directly or
indirectly, shares of Common Stock in excess of 9.9% in value of the aggregate
of the outstanding shares of Common Stock of the Company. The Company's Charter
further prohibits (i) any person from beneficially or constructively owning
shares of Common Stock that would result in the Company being "closely held"
under Section 856(h) of the Internal Revenue Code of 1986, as amended (the
"Code") or otherwise cause the Company to fail to qualify as a REIT, and (ii)
any person from transferring shares of Common Stock if such transfer would
result in shares of Common Stock being owned by fewer than 100 persons. If any
transfer of shares of Common Stock occurs which, if effective, would result in
any transfer or ownership limitations, then that number of shares of Common
Stock the beneficial or constructive ownership of which otherwise would cause
such person to violate such limitations (rounded to the nearest whole shares)
shall be automatically transferred to a trustee as trustee of a trust for the
exclusive benefit of one or more charitable beneficiaries, and the intended
transferee shall not acquire any rights in such shares. Subject to certain
limitations, the Board of Directors may increase or decrease the ownership
limitations or waive the limitations for individual investors. See "Description
of Capital Stock -- Repurchase of Shares and Restriction on Transfer."
Every owner of more than 5% (or such lower percentage as required by the
Code or the regulations promulgated thereunder) of the Company's Common Stock,
within 30 days after the end of each taxable year, is required to give written
notice to the Company stating the name and address of such owner, the number of
shares of Common Stock of the Company beneficially owned and a description of
the manner in which such shares are held. Each such owner shall provide to the
Company such additional information as the Company may request in order to
determine the effect, if any, of such beneficial ownership on the Company's
status as a REIT and to ensure compliance with the ownership limitations.
These provisions may inhibit market activity and the resulting opportunity
for the holders of the Company's Common Stock to receive a premium for their
stock that might otherwise exist in the absence of such provisions. Such
provisions also may make the Company an unsuitable investment vehicle for any
person seeking to obtain ownership of more than 9.9% of the Company's Common
Stock. Further, a violation of the ownership limitations of the Common Stock of
the Company could result in the Company's loss of its REIT status. A loss of its
REIT status could have a material adverse affect on the Company. See "-- Failure
to Maintain REIT Status May Subject Company to Corporate Level Tax."
17
<PAGE> 19
DEFAULT OF MANAGER UNDER SECURITIES PURCHASE AGREEMENT; RESTRICTIVE COVENANTS
In connection with the private financing of the Manager and the Company,
the Company, the Manager and MDC REIT Holdings, LLC. ("Holdings") entered into a
Securities Purchase Agreement dated as of February 11, 1997 (the "Securities
Purchase Agreement") with the institutional investors therein (the "Investors")
providing for, among other things, the purchase by the Investors of senior
secured notes of the Manager due February 11, 2002 (the "Notes"). Pursuant to
the Securities Purchase Agreement, the Company must comply with various
covenants, including covenants restricting the Company's investment, hedging and
leverage policies, leverage ratio and indebtedness levels, and business and tax
status. These restrictions may limit the Company's ability to adequately respond
to changing market conditions, even when such changes may be in the best
interest of the Company, which could have a material adverse affect on the
Company's financial condition and results of operations. See "Certain
Transactions -- Discussion of Securities Purchase Agreement."
If the Manager defaults on its obligations with respect to the Notes, such
default may result in a default and termination of the Management Agreement, in
which case the operations of the Company could be materially and adversely
affected pending either the engagement of a new manager or the development
internally of the resources necessary to manage the operation of the Company. In
addition, Holdings has pledged 1,600,000 shares of its Common Stock of the
Company to secure the Manager's obligations under the Securities Purchase
Agreement. Upon a default under the Securities Purchase Agreement, the pledged
shares will be transferred to the holders of the Notes, who will then have
certain demand registration rights. See "-- Shares Eligible for Future Sale."
LIMITATIONS ON ACQUISITION AND CHANGE IN CONTROL
The Charter and Bylaws of the Company contain a number of provisions, and
the Board of Directors has taken certain actions, that could impede a change in
control in the Company. See "Certain Provisions of Maryland Law and the
Company's Charter and Bylaws -- Certain Anti-Takeover Provisions." These
provisions include the following:
Staggered Board of Directors. The Board of Directors of the Company has
three classes of directors. The staggered terms for directors may adversely
affect the stockholders' ability to cause a change in control of the Company,
even if a change in control were in the interest of some, or a majority, of the
stockholders.
Capital Stock. The Charter authorizes the Board of Directors to create new
classes and series of securities and to establish the preferences and rights of
any such classes and series. The issuance of securities by the Board of
Directors pursuant to this Charter provision could have the effect of delaying
or preventing a change of control of the Company, even if a change in control
were in the interest of some, or a majority, of stockholders. See "Description
of Capital Stock."
Statutory Provisions. Under the Maryland General Corporation Law (the
"MGCL"), unless exempted by action of the Board of Directors, certain "business
combinations" between a Maryland corporation and a stockholder holding 10% or
more of the corporation's voting securities (an "Interested Stockholder") are
subject to certain conditions, including approval by a super-majority vote of
all voting stock, excluding those held by the Interested Stockholder or
affiliate thereof, and may not occur for a period of five years after the
stockholder becomes an Interested Stockholder. Accordingly, certain business
combinations may be impeded or prohibited, even if such a combination may be in
the interest of some, or a majority, of the Company's stockholders. The MGCL
also provides that "control shares" may be voted only upon approval of
two-thirds of the outstanding stock of the corporation, excluding the control
shares and shares held by affiliates of the corporation. Under certain
circumstances, the corporation also may redeem the control shares for cash and,
in the event that control shares are permitted to vote, the other stockholders
of the corporation are entitled to appraisal rights. See "Certain Provisions of
Maryland Law and the Company's Charter and Bylaws -- Business
Combinations -- Control Share Acquisitions."
These provisions may inhibit market activity and the resulting opportunity
for stockholders of the Company to receive a premium for their Shares that might
otherwise exist if any person were to attempt to
18
<PAGE> 20
assemble a block of shares of Common Stock in excess of the number of shares
permitted under the Charter. Such provisions also may make the Company an
unsuitable investment vehicle for any person seeking to obtain ownership of more
than 9.9% of the outstanding shares of Common Stock.
SHARES ELIGIBLE FOR FUTURE SALE
A substantial number of shares of Common Stock outstanding prior to this
Offering and issuable upon exercise of outstanding options will be eligible for
sale in the public market following the closing of this Offering, and such sales
could have an adverse effect on the price of the Company's Common Stock. On the
date of this Prospectus, the 6,500,000 Shares offered hereby (assuming no
exercise of the Underwriters' over-allotment option) will be immediately
eligible for sale in the public market. In addition, upon the expiration of
lock-up agreements 180 days after the date of this Prospectus, 1,614,000 shares
of Common Stock held by the current stockholders of the Company will become
eligible for sale in the public market, subject in some cases to the volume
restrictions of Rule 144 promulgated under the Securities Act of 1933, as
amended (the "Securities Act"). In addition, the holders of such shares of
Common Stock are entitled to certain rights with respect to the registration of
such shares under the Securities Act. An increase in the number of shares of
Common Stock of the Company sold in the public market could have an adverse
effect on the market price of the Company's Common Stock. See "Shares Eligible
for Future Sale."
DILUTION TO STOCKHOLDERS PURCHASING IN OFFERING
The initial offering price is higher than the book value per share of
Common Stock. Investors purchasing shares of Common Stock in this Offering will,
therefore, incur immediate dilution of $1.37 per share. See "Dilution."
19
<PAGE> 21
THE COMPANY
American Residential Investment Trust, Inc. is a mortgage REIT which
currently invests in residential adjustable-rate Mortgage Securities. Following
this Offering, AMREIT will also invest in Mortgage Loans. The Company has
developed tailored underwriting guidelines for Mortgage Loans to be acquired
directly from mortgage originators. The Company will then acquire Mortgage Loans
directly from those Correspondents. The Company finances its acquisitions of
Mortgage Assets with equity and secured borrowings. AMREIT expects generally to
maintain an equity-to-assets ratio of approximately 8% to 12% and to earn
interest on the portion of its Mortgage Asset portfolio financed with equity and
to earn a net interest spread on the leveraged portion of its Mortgage Asset
portfolio. The Company is structured to qualify as a REIT and, therefore, will
generally not be subject to federal taxes at the corporate level on the net
income it distributes to its stockholders. The Company is similar to a bank or
savings and loan in its business purpose, however, it does not collect deposits
or incur the overhead costs related to originating retail Mortgage Loans and it
is not subject to a number of the regulations governing banks and savings and
loans. The Company believes its REIT structure is the most efficient form in
which to invest in adjustable-rate Mortgage Assets.
The Company's day to day operations are managed by the Manager. Certain of
the executive officers of the Company will also be executive officers, employees
and stockholders of the Manager. Pursuant to the terms of the Management
Agreement, the Manager will advise the Company's Board of Directors with respect
to the formulation of investment criteria and preparation of policy guidelines,
and will be compensated based upon the principal amount and type of Mortgage
Assets held by the Company. See "The Manager" and "Conflicts of Interest."
In addition to reimbursing the Manager for expenses incurred on behalf of
the Company, the Company will pay to the Manager: (i) 1/8 of 1% per year, to be
paid monthly, of the principal amount of Agency Securities; (ii) 3/8 of 1% per
year, to be paid monthly, of the principal amount of all Mortgage Assets other
than Agency Securities; and (iii) 25% of the amount by which the Company's net
income (before deducting the amount to be paid as incentive compensation)
exceeds the annualized return on equity equal to the average Ten Year U.S.
Treasury Rate plus 2%.
Investment of the net proceeds of this Offering will result in an increase
in the Company's Mortgage Assets and, thus, an increase in the base management
fee and incentive compensation to be paid to the Manager. See "The
Manager -- The Management Agreement" and "Conflicts of Interest."
AMREIT was incorporated on February 6, 1997, and began operations on
February 11, 1997 as a result of a private equity funding from the Manager. The
Manager was created for the purpose of managing the day-to-day operations of the
Company, subject to direction by the Company's Board of Directors. The Manager
and the Company were financed by McCown De Leeuw & Co., TCW/Crescent Mezzanine,
L.L.C., certain of their respective affiliates and members of the management
team of the Company. The Manager and its affiliates own 1,614,000 shares of
Common Stock of the Company which will constitute approximately 20% of the
outstanding shares of Common Stock of the Company immediately after the closing
of this Offering. In addition, David E. De Leeuw and George E. McCown, the
principles of McCown De Leeuw & Co., currently serve on the Board of Directors
of the Company. Mr. De Leeuw will continue as a director after the closing of
this Offering.
The Company's management team is lead by John Robbins and Jay Fuller,
former executive officers and founders of AMRES Mortgage. Mr. Robbins, Mr.
Fuller and other members of the management team led AMRES Mortgage from a
start-up company to one with originations of approximately $9.7 billion and a
servicing portfolio of approximately $16.1 billion in 1993, its last full year
of independent operations. In 1994, AMRES Mortgage was sold to The Chase
Manhattan Corporation for approximately $330 million.
The Company was incorporated in Maryland on February 6, 1997. The principal
executive offices of the Company and the Manager are located at 445 Marine View
Avenue, Suite 230, Del Mar, California 92014. The telephone number is (619)
350-5000.
20
<PAGE> 22
USE OF PROCEEDS
The proceeds of this Offering, assuming an offering price of $15.00 per
share, will be as follows:
<TABLE>
<CAPTION>
6.5 MILLION 7.5 MILLION
SHARES SHARES(1)
----------- -----------
(IN MILLIONS)
<S> <C> <C>
Total proceeds......................................... $97.5 $ 112.1
Expenses............................................... 1.2 1.3
Underwriting discount and commissions.................. 6.3 7.3
----- -----
Net proceeds available for investment........ $90.0 $ 103.5
</TABLE>
- ---------------
(1) Assumes exercise by the Underwriters of an option to purchase shares to
cover over-allotments.
The net proceeds of this Offering, together with borrowings, will be used
primarily to purchase Mortgage Assets and otherwise for general corporate
purposes. The Company has not specifically identified any Mortgage Assets in
which to invest the net proceeds of this Offering. Pending the purchase of the
Mortgage Assets, the net proceeds of this Offering may be invested in short term
investments consistent with the applicable REIT Provisions of the Code. The
Company intends to increase its investment in Mortgage Assets by borrowing
against existing Mortgage Assets and using the net proceeds from its borrowings
to acquire additional Mortgage Assets. The Company's borrowings generally will
be secured by the Mortgage Assets owned by the Company. The Company may, but
does not expect to, require up to twelve months to fully implement its financing
strategy and increase its investment in Mortgage Assets to the desired level.
Until the desired level is achieved, the net interest income on the Company's
Mortgage Asset portfolio is expected to be lower than would be the case if its
financing strategy were fully implemented.
Management believes that cash flow from operations, the net proceeds of
this Offering and funds available pursuant to financing facilities and credit
arrangements will be sufficient to meet the Company's cash requirements for at
least one year following the closing of this Offering. Thereafter, if the
Company's cash resources are insufficient to satisfy the Company's liquidity
requirements, the Company may be required to sell additional equity or debt
securities. There is no assurance that additional financing will be available to
the Company on favorable terms, or at all. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources" and "Risk Factors -- Future Offerings of Common Stock May
Affect Market Price of Common Stock."
DIVIDEND POLICY AND DISTRIBUTIONS
The Company intends to distribute substantially all of its taxable income
(which does not ordinarily equal net income as calculated in accordance with
GAAP) to its stockholders in each year so as to comply with the REIT Provisions
of the Code. The Company intends to declare regular quarterly dividends. The
dividend policy is subject to revision at the discretion of the Board of
Directors. All distributions will be made by the Company at the discretion of
the Board of Directors and will depend on the taxable income of the Company, the
financial condition of the Company, maintenance of REIT status and such other
factors as the Board of Directors deems relevant. On July 17, 1997 and May 1,
1997, the Company declared dividends of $0.27 and $0.09, respectively, per share
of Common Stock for the quarter ended June 30, 1997 and the period ended March
31, 1997, respectively. There can be no assurance that the Company will generate
sufficient income in the future to declare comparable levels of dividends, or to
declare dividends at all. See "Risk Factors -- Limited Operating History Does
Not Predict Future Performance," "-- Policies and Strategies May Be Revised at
the Discretion of the Board of Directors," "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Certain Accounting Policies
and Procedures" and "Federal Income Tax Consequences -- Requirements for
Qualification as a REIT -- Distribution Requirement."
Distributions to stockholders will generally be taxable as ordinary income,
although a portion of such distributions may be designated by the Company as
capital gain or may constitute a tax-free return of capital. The Company will
annually furnish to each of its stockholders a statement setting forth
distributions paid during the preceding year and their characterization as
ordinary income, capital gains, or return on capital. See "Business -- Certain
Accounting Policies and Procedures" and "Federal Income Tax Consequences --
Taxation of Stockholders."
21
<PAGE> 23
CAPITALIZATION
The capitalization of the Company, as of June 30, 1997, and as adjusted to
reflect the sale of the Shares offered hereby, is as follows:
<TABLE>
<CAPTION>
JUNE 30, 1997
---------------------------
AS
ACTUAL ADJUSTED(1)(2)
-------- --------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Reverse repurchase agreements...................................... $209,539 $209,539
Stockholders' equity:
Preferred Stock, par value $.01 per share; 1,000,000 shares
authorized; no shares issued and outstanding.................. -- --
Common Stock, par value $.01 per share; 3,000,000 shares
authorized; 1,614,000 shares issued and outstanding, actual;
8,114,000 shares issued and outstanding as adjusted(3)........ 16 81
Additional paid-in capital....................................... 20,149 110,047
Cumulative dividends declared.................................... (146) (146)
Retained earnings................................................ 584 584
-------- --------
Total stockholders' equity............................... $ 20,603 $110,566
-------- --------
Total capitalization..................................... $230,142 $320,105
======== ========
</TABLE>
- ---------------
(1) After deducting offering expenses estimated to be $1,200,000 payable by the
Company, and assumes no exercise of the Underwriters' over-allotment option
to purchase up to an additional 975,000 shares of Common Stock. Assumes an
initial public offering price of $15.00 per share of Common Stock. See
"Underwriting."
(2) Excludes 315,200 shares of Common Stock reserved for issuance pursuant to
options outstanding as of June 30, 1997 under the Incentive Plan.
(3) The Company's authorized Common Stock and Preferred Stock as of June 30,
1997, was 3,000,000 and 1,000,000 shares, respectively. The Company's
authorized Capital Stock will be increased to 25,000,000 shares prior to the
closing of this Offering all of which will initially be designated Common
Stock. See "Description of Capital Stock" and Note 8 of Notes to Financial
Statements.
22
<PAGE> 24
DILUTION
The pro forma net tangible book value of the Company, as of June 30, 1997,
was approximately $20.6 million or $12.77 per share of Common Stock. Pro forma
net tangible book value per share of Common Stock is equal to the Company's
total tangible assets less its total liabilities, divided by the number of
outstanding shares of Common Stock. After giving effect to the sale of the
6,500,000 Shares offered by the Company hereby (at an assumed initial public
offering price of $15.00 per share and after deducting the estimated
underwriting discount and commissions and offering expenses), the pro forma net
tangible book value of the Company at June 30, 1997 would have been
approximately $110.6 million or $13.63 per share of Common Stock. This
represents an immediate increase in such net tangible book value of $0.86 per
share of Common Stock to existing stockholders and an immediate dilution of
$1.37 per share of Common Stock to new investors purchasing Shares in this
Offering. The following table illustrates this per share dilution:
<TABLE>
<S> <C> <C>
Assumed initial public offering price per share of Common Stock..... $15.00
Pro forma net tangible book value per share of Common Stock as of
June 30, 1997.................................................. 12.77
Increase per share of Common Stock attributable to this
Offering....................................................... .86
-----
Pro forma net tangible book value per share of Common Stock
immediately after the closing of this Offering.................... $13.63
------
Dilution per share of Common Stock to new investors................. $ 1.37
======
</TABLE>
The following table summarizes, on a pro forma basis, as of June 30, 1997,
the differences between the number of shares of Common Stock purchased from the
Company, the total consideration paid and the average price paid per share of
Common Stock by the existing holders of Common Stock and by the new investors at
an assumed initial public offering price of $15.00 per share of Common Stock
(See "Underwriting"):
<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION
------------------- ---------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- ------- ------------ ------- -------------
<S> <C> <C> <C> <C> <C>
Existing stockholders............ 1,614,000 19.9% $ 20,175,000 17.1% $ 12.50
New investors.................... 6,500,000 80.1 97,500,000 82.9 $ 15.00
--------- ----- ----------- -----
Total.................. 8,114,000 100.0% $117,675,000 100.0%
========= ===== =========== =====
</TABLE>
The foregoing tables exclude 315,200 shares of Common Stock reserved for
issuance pursuant to options outstanding as of June 30, 1997 under the Company's
Incentive Plan.
23
<PAGE> 25
SELECTED FINANCIAL DATA
The following selected statement of operations and balance sheet data for
the period from February 11, 1997 (inception) through June 30, 1997, and as of
June 30, 1997 have been derived from the Company's financial statements audited
by KPMG Peat Marwick LLP, independent auditors whose reports with respect
thereto appear elsewhere herein. Such selected financial data should be read in
conjunction with those financial statements and the notes thereto and with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" also included elsewhere herein. The following selected financial
data for the period ended March 31 and the quarter ended June 30, 1997 have been
derived from the financial statements of the Company and include adjustments,
consisting only of normal recurring adjustments, which Management considers
necessary for a fair presentation of such financial information for those
periods. Results for the periods ended June 30, 1997 are not necessarily
indicative of results for the year ending December 31, 1997.
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
PERIOD FROM PERIOD FROM
FEBRUARY 11, 1997 FEBRUARY 11, 1997
TO QUARTER ENDED TO
JUNE 30, 1997 JUNE 30, 1997 MARCH 31, 1997
----------------- ------------- -----------------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Interest income.................................. $ 3,640 $ 3,334 $ 306
Interest expense................................. 2,916 2,766 150
------ ------ -----
Net interest income.............................. 724 568 156
------ ------ -----
General and administrative expenses.............. 140 130 10
------ ------ -----
Net income....................................... $ 584 $ 438 $ 146
====== ====== =====
Net income per share of Common Stock(1).......... $ 0.35 $ 0.26 $0.09
Dividends per share of Common Stock(2)........... $ 0.36 $ 0.27 $0.09
</TABLE>
<TABLE>
<CAPTION>
AS OF AS OF
JUNE 30, 1997 MARCH 31, 1997
------------- --------------
<S> <C> <C>
BALANCE SHEET DATA:
Mortgage Assets.................................................. $ 228,620 $152,883
Total assets..................................................... 231,518 161,302
Reverse repurchase agreements.................................... 209,539 141,068
Total liabilities................................................ 210,915 141,208
Stockholders' equity............................................. 20,603 20,094
</TABLE>
- ---------------
(1) See Note 1 of Notes to Financial Statements for information regarding the
calculation of this item.
(2) The level of quarterly dividends is determined by the Board of Directors
based upon its consideration of a number of factors and should not be deemed
indicative of taxable income for the quarter in which declared or future
quarters, or of income calculated in accordance with GAAP. See "Dividend
Policy and Distributions."
24
<PAGE> 26
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Prospectus contains forward looking statements that inherently involve
risks and uncertainties. The Company's actual results could differ materially
from those anticipated in these forward looking statements as a result of
certain factors, including those set forth in the following section and in "Risk
Factors." The following discussion should be read in conjunction with the
Financial Statements and Notes thereto appearing elsewhere in this Prospectus.
OVERVIEW
All of the Company's income to date has been interest income generated from
its Mortgage Assets and its cash balances ("earning assets"). The Company funds
its acquisitions of earning assets with both its equity capital and with
borrowings. For that portion of the Company's earning assets funded with equity
capital ("equity-funded lending"), net interest income is derived from the
average yield on earning assets. Due to the adjustable-rate nature of its
earning assets, Management expects that income from this source will tend to
increase as interest rates rise and will tend to decrease as interest rates
fall.
For that portion of the Company's earning assets funded with borrowings
("spread lending"), resulting net interest income is a function of the volume of
spread lending and the difference between the Company's average yield on earning
assets and the cost of borrowed funds and interest rate hedging agreements.
Income from spread lending may initially decrease following an increase in
interest rates and then, after a lag period, be restored to its former level as
earning assets yields adjust to market conditions. Income from spread lending
may likewise increase following a fall in interest rates, but then decrease as
earning assets yields adjust to the new market conditions after a lag period.
See "Risk Factors -- Sudden Interest Rate Fluctuations May Reduce Income From
Operations" and "Business -- Funding."
The Company seeks to generate growth in net income in a variety of ways,
including through (i) issuing new Common Stock and increasing the size of the
earning assets when opportunities in the mortgage market are likely to allow
growth in net income per share of Common Stock, (ii) seeking to improve
productivity by increasing the size of the earning assets at a rate faster than
operating expenses increase, (iii) changing the mix of Mortgage Asset types
among the earning assets in an effort to improve returns, and (iv) increasing
the efficiency with which the Company uses its equity capital over time by
increasing the Company's use of debt when prudent and by issuing subordinated
debt, preferred stock or other forms of debt and equity. There can be no
assurance, however, that the Company's efforts will be successful or that the
Company will increase or maintain its income level. See "Risk Factors -- Limited
Operating History Does Not Predict Future Performance -- Future Offerings of
Common Stock May Affect Market Price of Common Stock."
Interest Income and the Earning Asset Yield
On average, the Company had $196 million in earning assets during the
quarter ended June 30, 1997. The Company's sole source of income during fiscal
1997 for both equity-funded lending and spread lending was the interest income
earned from these earning assets. As a residential mortgage REIT, the Company
expects to continue to rely on interest income as its primary source of income
in the future. At June 30, 1997, the weighted average net coupon on the
Company's Mortgage Assets was 7.78% per annum based on the amortized cost of the
Mortgage Assets.
The annualized mortgage principal repayment rate for the Company was 29% in
the quarter ended June 30, 1997. The Company adjusts its rate of premium
amortization monthly based on actual principal repayments received. As a result,
premium amortization accelerates as the rate of principal repayment increases.
This lowers the earning assets yields and reportable net income. See "Risk
Factors -- Increased Levels of Mortgage Loan Prepayments May Reduce Operating
Income."
The Company may acquire new Mortgage Assets with coupons that are initially
low relative to prevailing short term interest rates. As a result, the overall
earning assets yields may be temporarily lower during periods of rapid growth in
the Company's Mortgage Assets.
25
<PAGE> 27
Borrowings
To date, the Company's debt has consisted entirely of borrowings
collateralized by a pledge of the Company's Mortgage Assets. These borrowings
appear on the balance sheet as reverse repurchase agreements. Institutions with
high quality pledgable assets such as banks, savings and loans, brokerage firms,
federal agencies and the Federal Reserve Bank are the largest U.S. borrowers in
this market. The Company has established uncommitted borrowing facilities with
10 lenders in this market in amounts aggregating at least $500 million. The
Company also has in place a line of credit that it may use to fund certain cash
flow shortages. The Company intends to expand its uncommitted reverse repurchase
agreements following the closing of this Offering. There can be no assurance,
however, that the Company will be able to obtain debt financing in the future
under these facilities or otherwise. Further, the Company's current borrowing
facilities may be collateralized only by Mortgage Securities and may not be used
to finance acquisitions of Mortgage Loans pursuant to the Direct Purchase
Program. See "Risk Factors -- Failure to Implement Company's Leverage Strategy
May Adversely Affect Results of Operations" and "Business -- Funding."
With the Company's current asset/liability strategy, changes in the
Company's cost of funds are expected to be closely correlated with changes in
the two-month LIBOR interest rate, although the Company may choose to extend or
shorten the maturity of its liabilities at any time.
The term to maturity of the Company's borrowings has ranged from one day to
six months, with a weighted average term to maturity of 62 days at quarter
ending June 30, 1997. The weighted average cost of funds for all of the
Company's borrowings was 5.69% per annum as of June 30, 1997.
Net Interest Income from Equity-Funded Lending and Spread Lending
For the purpose of analyzing net interest income, the Company focuses on
the two component activities with respect to its earning assets: equity-funded
lending and spread lending. Each of these two components must be considered
separately when analyzing changes in interest rates, asset/liability strategy,
growth and other factors.
When analyzing the profitability of equity-funded lending and spread
lending, the Company does not assign specific Mortgage Assets to each type of
lending, but rather assumes that one portion of aggregate earning assets is
funded with equity and another portion of aggregate earning assets is funded
with borrowings.
Management believes equity-funded lending has a large influence on the
Company's profitability relative to financial institutions which have (i) lower
equity-to-assets ratios, (ii) intangible capital, or (iii) significant amounts
of non-earning assets or net working capital on their books.
Liquidity of Mortgage Assets
Liquidity is the Company's ability to convert its Mortgage Assets to cash.
The liquidity of the Company's Mortgage Assets enables the Company to borrow
funds to purchase additional Mortgage Assets and allows the Company to pledge
additional Mortgage Assets to secure existing borrowings should the value of
pledged Mortgage Assets decline. The Company will typically pledge its least
liquid Mortgage Assets for secured borrowings so that the Company's pool of
unpledged Mortgage Assets is made up of its most liquid Mortgage Assets. Unused
borrowing capacity will vary over time as the market value of the Company's
Mortgage Assets varies and due to other factors.
The Company's Mortgage Assets generate liquidity on an ongoing basis
through mortgage principal repayments and net income held prior to payment as
dividends. Should the Company's needs ever exceed these ongoing sources of
liquidity, Management believes that the Company's Mortgage Assets and interest
rate agreements could be sold in most circumstances to raise cash. There can be
no assurance, however, that such Mortgage Assets could be sold on terms
favorable to the Company, or at all. See "Risk Factors -- Investments in
Mortgage Assets May be Illiquid."
26
<PAGE> 28
Asset/Liability Management and Effect of Changes in Interest Rates
Management continually reviews the Company's asset/liability strategy with
respect to interest rate risk, mortgage prepayment risk, credit risk and the
related issues of capital adequacy and liquidity. The net effect of changes in
interest rates, relative changes in one- and six-month LIBOR rates, changes in
short term interest rates relative to long term interest rates, changes in
mortgage principal repayment rates, changes in the market value of Mortgage
Assets and interest rate agreements and other factors cannot be determined in
advance. The Company seeks attractive stockholder returns while seeking to
maintain a strong balance sheet and pattern of net income which is stable and
growing over time.
Inflation
Management believes that interest rates and other factors influence the
Company's performance to a greater extent than inflation. Changes in interest
rates do not necessarily correlate with inflation rates or changes in inflation
rates. The Company's financial statements are prepared in accordance with GAAP
and the Company's dividends are determined by the Company's net income as
calculated for tax purposes.
Seasonality
The level of prepayments of the Company's Mortgage Assets is subject to the
same seasonal influences as the residential real estate industry with
prepayments generally being higher in the summer months and lower in the winter
months. Likewise, management anticipates that any originations under the Direct
Purchase Program would parallel these seasonal trends.
CERTAIN ACCOUNTING POLICIES AND PROCEDURES
Mortgage Security Accounting Treatment
Because the Company's Mortgage Securities are classified for accounting
purposes as "available for sale" accounting treatment, unrealized fluctuations
in the market value of the Mortgage Securities does not impact GAAP or taxable
income, but rather is reflected on the balance sheet by changing the carrying
value of the Mortgage Assets and reflecting the change in stockholders' equity
under "Net Unrealized Gains or Losses on Assets Available for Sale." As a result
of this mark-to-market accounting treatment, the book value and book value per
share of the Company are likely to fluctuate far more than if the Company used
historical amortized cost accounting. As a result, comparisons with companies
that use historical cost accounting for some or all of their balance sheet may
be misleading.
Unrealized changes in the estimated net market value of Mortgage Assets
have one direct effect on the Company's potential net income and dividends:
positive mark-to-market changes will increase the Company's equity base and
allow the Company to increase its spread lending activities while negative
changes will tend to limit spread lending growth under the Company's Capital
Policy. A very large negative change in the net market value of Mortgage Assets
and interest rate cap agreements might impair the Company's liquidity position,
requiring the Company to sell Mortgage Assets with the likely result of realized
losses upon sale. See "Risk Factors -- Failure to Implement Company's Leverage
Strategy May Adversely Affect Results of Operations."
Taxable Income and GAAP Income
Income as calculated for tax purposes ("taxable income") differs from
income as calculated according to generally accepted accounting principles
("GAAP income") for various reasons. Interest income differs due to different
methods of calculating the rate of amortization of the premium or discount when
Mortgage Assets are acquired at a price above or below the stated principal
amount of the Mortgage Loans. Credit losses differ between tax and GAAP methods
of accounting because the Company takes credit provisions in order to build a
credit allowance for GAAP whereas only actual credit losses are deducted in
calculating taxable income. General and administrative expenses differ due to
differing treatment of leasehold amortization and other items. The Company's
largest expense is the cost of borrowed funds. Interest expense is calculated in
the same manner for GAAP and tax purposes.
27
<PAGE> 29
These distinctions are important to the Company's stockholders as dividends
are based on taxable income. The Company generally will not pay federal taxes so
long as it meets the REIT Provisions of the Code and distributes dividends to
stockholders in an amount equal to its taxable income. See "Federal Income Tax
Consequences -- Requirements of Qualifications as a REIT."
Taxable Income and Dividends
The Company intends to declare and pay dividends equal to its taxable
income over time. The Company's current practice is to declare quarterly
dividends per share immediately following the regular March, June, September and
December meetings of the Board of Directors. In general, the Company has
endeavored to declare a quarterly dividend per share of Common Stock which would
result in the distribution of most or all of the taxable income earned in that
quarter. See "Risk Factors -- Limited Operating History Does Not Predict Future
Performance" and "Dividend Policy and Distributions."
RESULTS OF OPERATIONS
For the quarter ended June 30, 1997, the Company generated net income of
approximately $438,000 and net income per share of Common Stock of $0.26. From
the commencement of operations on February 11, 1997 through June 30, 1997, the
Company generated net income of approximately $584,000 and net income per share
of Common Stock of $0.35. At June 30, 1997, the Company held Mortgage Assets
that had a carrying value of approximately $229 million. All Mortgage Assets
held at June 30, 1997, were Agency Securities backed by adjustable-rate single
family residential Mortgage Loans.
Net income for the Company increased 200% from approximately $146,000 for
the period ended March 31, 1997, to approximately $438,000 for the quarter ended
June 30, 1997. The growth in net income was directly attributable to an increase
in net interest income. Net interest income grew 264% between the period ended
March 31, 1997 and the quarter ended June 30, 1997, from approximately $156,000
to approximately $568,000, respectively. This increase in net interest income
was partially offset by an increase in general and administrative expenses. From
the period ended March 31, 1997 to the quarter ended June 30, 1997, general and
administrative expenses increased from approximately $10,000 to approximately
$130,000.
The growth in net interest income between the period ended March 31, 1997
and the quarter ended June 30, 1997 was due to the increase in the Company's
Mortgage Assets. The Company commenced operations on February 11, 1997, but did
not complete the initial purchase of Mortgage Assets until March 24, 1997.
Therefore, the Company did not earn interest income from Mortgage Assets nor
incur premium amortization or reverse repurchase agreement expense until late in
the period ended March 31. Similarly, the increase in general and administrative
expenses between the period ended March 31, 1997 and the quarter ended June 30,
1997 is the result of the Company not starting operations until the middle of
the period ended March 31.
The Company experienced higher than expected levels of repayments in the
quarter ended June 30, 1997. The annualized mortgage principal repayment rate
for the Company was 29% in the quarter ending June 30, 1997. Although the
Company does not expect repayment rates to continue at such levels, there can be
no assurance that the Company will be able to achieve or maintain lower
repayment rates. Accordingly, the Company's financial condition and results of
operations could be materially adversely affected if prepayments continue at
higher than anticipated levels. See "Business -- Risk Management -- Interest
Rate Risk Management."
The Company was in the process of investing the net proceeds of its initial
sale of privately placed Common Stock through May 15, 1997. Accordingly, the
full impact of the Company's use of proceeds was not realized in operations
until the middle of the quarter ended June 30, 1997. See "Risk
Factors -- Limited Operating History Does Not Predict Future Performance."
28
<PAGE> 30
LIQUIDITY AND CAPITAL RESOURCES
The Company's principal liquidity needs result from the long term
investment in Mortgage Assets. Generally, reverse repurchase agreement
borrowings and the issuance of Common Stock provide the Company funding for its
investment needs. To a lesser extent, the Company may use funds available under
its line of credit. Pursuant to the line of credit, the Company may borrow the
lesser of $25 million and the outstanding principal and interest receivable
balance with one counterparty, for a period of up to 36 days, at an interest
rate equal to LIBOR plus 0.6%. The line of credit has no set expiration date.
See "Business -- Funding."
During the period from February 11, 1997 (commencement of operations)
through June 30, 1997, net cash provided by operating activities was $259,000.
Net cash provided by operating activities was negatively impacted by an increase
in accrued interest receivable. There were no Mortgage Assets held at February
11, 1997 and, therefore, the total accrued interest receivables at June 30, 1997
negatively affected cash. Net cash for the period was positively affected by an
increase in accrued interest payable.
Net cash used in investing activities for the period from February 11, 1997
through June 30, 1997 was $229.7 million. Net cash used for the period was
negatively affected by the purchase of Mortgage Assets and positively affected
by principal repayments.
For the period from February 11, 1997 through June 30, 1997, net cash
provided by financing activities was $229.6 million. Net cash provided was
primarily affected by borrowings under reverse repurchase agreements and net
proceeds received from the issuance of Common Stock in the Company's private
placement.
At June 30, 1997 the Company had uncommitted reverse repurchase agreement
facilities in place to provide over $500 million to finance investments in
Mortgage Assets. Management believes that cash flow from operations, the
proceeds of this Offering and funds available pursuant to reverse repurchase
agreement facilities and other credit arrangements will be sufficient to meet
the Company's cash requirements for at least one year following the closing of
this Offering. Thereafter, if the Company's cash resources are insufficient to
satisfy the Company's liquidity requirements, the Company may be required to
sell additional equity or debt securities. There is no assurance that such
financing will be available to the Company on favorable terms, or at all. See
"Risk Factors -- Failure to Implement Company's Leverage Strategy May Adversely
Affect Results of Operations -- Future Offerings of Common Stock May Affect
Market Price of Common Stock."
RECENT DEVELOPMENTS
For the quarter ended September 30, 1997, the Company generated net income
of approximately $519,000 and net income per share of Common Stock of $0.31.
From the commencement of operations on February 11, 1997 through September 30,
1997, the Company generated net income of approximately $1.1 million and net
income per share of Common Stock of $0.66. At September 30, 1997 the Company
held Mortgage Assets that had a carrying value of approximately $229 million,
including an $804,000 net unrealized gain recorded during the quarter. All
Mortgage Assets held at September 30, 1997 were Mortgage Securities issued or
guaranteed by federal government sponsored agencies ("Agency Securities") backed
by adjustable-rate single family residential Mortgage Loans.
Net income for the Company increased 18% from approximately $438,000 for
the quarter ended June 30, 1997, to approximately $519,000 for the quarter ended
September 30, 1997. The growth in net income was directly attributable to an
increase in net interest income. Net interest income grew 21% between the
quarter ended June 30, 1997 and the quarter ended September 30, 1997, from
approximately $568,000 to approximately $689,000, respectively. This increase in
net interest income was partially offset by an increase in general and
administrative expenses. From the quarter ended June 30, 1997 to the quarter
ended September 30, 1997, general and administrative expenses increased from
approximately $130,000 to approximately $170,000.
29
<PAGE> 31
BUSINESS
RESIDENTIAL MORTGAGE INDUSTRY
The residential mortgage market has experienced considerable growth over
the past 15 years with total residential mortgage debt outstanding growing from
approximately $965 billion in 1980 to approximately $3.9 trillion in 1996
according to the Mortgage Market Statistical Annual for 1997. In addition, the
total residential mortgage debt securitized into Mortgage Securities has grown
from approximately $110 billion in 1980 to approximately $1.9 trillion in 1996.
Management believes that the current size of the residential mortgage market
will provide the Company with opportunities with respect to the purchase of
Mortgage Assets.
INVESTMENTS
AMREIT currently acquires adjustable-rate residential Mortgage Securities
in the capital markets. While the Company expects that a substantial portion of
its Mortgage Assets will continue to be Mortgage Securities, it anticipates that
it will increasingly invest in adjustable-rate Mortgage Loans, including
Mortgage Loans acquired directly from originators through its Direct Purchase
Program. Under the Direct Purchase Program, the Company believes that its
management team can enhance the overall yield of the Mortgage Asset portfolio by
acquiring relatively higher yielding Mortgage Loans and avoiding the cost of
using intermediaries. While the Company does not currently intend to acquire
residual interests issued by REMICs or sub-prime Mortgage Loans, it is not
prohibited from doing so under the terms of its Capital Policy. The Company has
not yet specifically identified any Mortgage Assets in which to invest the
proceeds of this Offering. See "Risk Factors -- A Material Portion of the Net
Proceeds of this Offering is Not Committed to Specific Mortgage Assets;
Inability to Acquire Mortgage Assets" and "Use of Proceeds."
The Company will only acquire those Mortgage Assets which the Company
believes it has the expertise to evaluate and manage and which are consistent
with the Company's balance sheet guidelines and risk management objectives. The
Company also considers (i) the amount and nature of anticipated cash flows from
the Mortgage Assets, (ii) the Company's ability to pledge the Mortgage Assets to
secure collateralized borrowings, (iii) the increase in the Company's capital
requirements resulting from the purchase and financing of the Mortgage Assets,
as determined pursuant to the Company's capital policies, and (iv) the costs of
financing, hedging, managing, servicing, securitizing and reserving for the
Mortgage Asset. Prior to the acquisition of Mortgage Assets, potential returns
on capital employed are assessed over the life of the Mortgage Assets and in a
variety of interest rate, yield spread, financing cost, credit loss and
prepayment scenarios. The Board of Directors of the Company can revise the
Company's investment policies in its sole discretion subject to approval by a
majority of the Company's directors which are not employees or officers of the
Company. See "Risk Factors -- Policies and Strategies May Be Revised at the
Discretion of the Board of Directors."
The Company finances acquisitions of Mortgage Assets with short term
borrowings which generally mature in six months or less. Upon maturity, the
Company refinances the Mortgage Assets with new short term borrowings which then
bear interest at the applicable market rate. Accordingly, the Company's interest
expense changes rapidly with changes in the market interest rates. In order to
maintain a margin between the Company's interest expense and the interest income
generated by Mortgage Assets, the Company generally acquires Mortgage Assets
with interest rates that also adjust with changing market interest rates.
Accordingly, the Company expects that substantially all of the Mortgage Assets
acquired by it will be adjustable-rate rather then fixed-rate Mortgage Assets.
Capital Markets Program
The Company has purchased and will continue to purchase Mortgage Securities
in the capital markets. These Mortgage Securities generally have a higher level
of liquidity than the Mortgage Loans to be acquired under the Direct Purchase
Program and are expected to provide a relatively stable flow of interest income
with relatively low levels of credit risk compared to such Mortgage Loans. The
Mortgage Securities to be acquired
30
<PAGE> 32
by the Company will be backed by a pool of adjustable-rate Mortgage Loans. These
Mortgage Securities entitle the holder to receive a pass-through of principal
and interest payments on the underlying pool of Mortgage Loans and will be
guaranteed by federal government sponsored agencies or issued by certain private
institutions. Mortgage Securities issued by private institutions are usually but
not always rated by one of the major rating services. The Company may from time
to time invest in Mortgage Securities that are not investment grade.
From the commencement of operations on February 11, 1997 through June 30,
1997, the Company acquired Mortgage Securities that had a carrying value at June
30, 1997 of approximately $229 million. All Mortgage Securities held by the
Company at June 30, 1997 were Agency Securities evidencing an interest in
adjustable-rate single family residential Mortgage Loans. At June 30, 1997, all
investments in Mortgage Assets consisted of interests in adjustable rate
Mortgage Loans on residential properties. The securitized interests in pools of
adjustable rate mortgages from the Federal Home Loan Mortgage Corporation and
the Federal National Mortgage Association are guaranteed as to principal and
interest. The original maturity of the majority of the Mortgage Assets is over a
period of thirty years; the actual maturity is subject to change based on the
prepayments of the underlying Mortgage Loans. See Note 2 of Notes to Financial
Statements.
Direct Purchase Program
Management intends to leverage its expertise in the residential Mortgage
Loan industry to develop a program for the purchase of Mortgage Loans by the
Company directly from originators ("Correspondents"). Under the Direct Purchase
Program, the Company will (i) identify segments of the residential Mortgage Loan
market that meet its general criteria for potential originations, (ii) develop
tailored underwriting guidelines for Mortgage Loans to be generated in each
market segment, (iii) acquire Mortgage Loans originated by Correspondents
directly from such Correspondents, hence avoiding certain loan broker or other
intermediary fees, and (iv) arrange for the servicing of the Mortgage Loans by
entities experienced in servicing the particular types of Mortgage Loans
involved.
The Company has not acquired any Mortgage Loans under the Direct Purchase
Program, and there can be no assurance that the Direct Purchase Program will be
successfully implemented or that the Mortgage Loans acquired through the program
will be higher yielding than Mortgage Securities. See "Risk Factors -- Material
Portion of Offering Proceeds Not Committed to Specific Mortgage Assets;
Inability to Acquire Mortgage Assets."
Tailored Mortgage Loan Products. Under the Direct Purchase Program, the
Manager will identify market segments of the residential Mortgage Loan market
that it believes have the potential for generating Mortgage Loans with higher
yields than other Mortgage Loans with generally comparable risks. These segments
generally are present where there is less competition among Mortgage Loan
originators and, hence, fewer resources available to borrowers. Management has
identified a number of such segments and expects that new opportunities in other
market segments will become available as the Mortgage Loan market continues to
change. These emerging market segments typically will include Mortgage Loans
that are not readily available from large, nationally-based Mortgage Loan
originators due to factors related to the Mortgage Loan underwriting process
itself (such as the need to value a complex, mixed use property) or a limited
secondary market for resale of such types of Mortgage Loans.
Management has identified the following market segments of the residential
Mortgage Loan market for its initial tailored Mortgage Loan products:
- Small Multifamily Home Mortgage Loans. A small multifamily home Mortgage
Loan will be secured by a first lien on a 5-unit to 20-unit residential
property. The Company's underwriting guidelines for small multifamily
home Mortgage Loans will place emphasis on the appraised value, the
existence and terms of underlying leases, a cash flow analysis, the
condition of the mortgaged property and favorable credit reports.
- Manufactured Housing Mortgage Loans. A manufactured housing Mortgage Loan
will be secured by a first lien on an owner occupied manufactured housing
unit (excluding mobile homes) permanently
31
<PAGE> 33
affixed to a foundation and the underlying lot. The underwriting of
manufactured housing Mortgage Loans will place emphasis on appraised
value (relying on comparable sales), condition of the property, the
quality of the borrower's income and favorable credit reports.
- Mixed Use Mortgage Loans. A mixed use Mortgage Loan will be secured by a
first lien on a combined commercial and up-to-twelve-unit residential
property. The qualifying commercial uses of the properties will be
generally limited to retail, professional, light industrial or office
use. The underwriting for mixed use Mortgage Loans will place emphasis on
appraised value (relying on comparable sales), condition of the property
(and environmental compliance), cash flow analysis and credit reports
(including credit reports on commercial tenants).
- Rural Home Mortgage Loans. A rural home Mortgage Loan will be secured by
a first lien on a residential property in a rural area where agricultural
use is present but limited to noncommercial use. The underwriting of
rural home Mortgage Loans will place emphasis on appraised value (relying
on comparable sales), condition of the property, quality of the
borrower's income and favorable credit reports. Rural home Mortgage Loan
amounts will generally be higher with respect to the appraised value of
the residence, and the first five acres and lower with respect to any
additional acreage.
- Mini-Ranch Home Mortgage Loans. A mini-ranch home Mortgage Loan will be
secured by a first lien on a residential ranch property. The underwriting
of mini-ranch home Mortgage Loans will place emphasis on appraised value
(relying on comparable sales), condition of the property, the quality of
the borrower's income (primarily non-ranch income) and favorable credit
reports. Mini-ranch home Mortgage Loan amounts will generally be higher
with respect to the appraised value of the residence and the first five
acres, and lower with respect to any additional acreage.
- Condominium/Resort Mortgage Loans. A condominium/resort Mortgage Loan
will be secured by a first lien on a vacation property, including those
located in ski, golf and other recreational resort areas. The
underwriting of condominium/resort Mortgage Loans will place emphasis on
appraised value (relying on comparable sales with same complex
comparables preferred), same complex rental history, the quality of the
borrower's income and favorable credit reports.
The Manager has created tailored underwriting guidelines for Mortgage Loans
in the Company's initial target market segments. Such Mortgage Loan underwriting
guidelines will set forth the various characteristics (such as combinations of
loan-to-value levels and credit ranking of borrowers) for Mortgage Loans that
the Company is prepared to purchase from Correspondents. These Mortgage Loans
generally will be nonconforming, primarily as a result of the property type,
and, to a lesser extent, the borrower's credit characteristics. See "Risk
Factors -- Borrower Credit May Decrease Value of Mortgage Loans --
Characteristics of Underlying Property May Decrease Value of Mortgage Loans."
Management intends to draw upon its experience in the residential mortgage
industry to build a network of Correspondents with expertise in market segments
targeted by the Company. The Manager will make arrangements for the Company to
acquire Mortgage Loans through the Manager's relationships with these
Correspondents. Management will identify and work with a number of
Correspondents to generate Mortgage Loans products for the Direct Purchase
Program, although it has not yet begun acquiring Mortgage Loans through the
Direct Purchase Program.
The Company anticipates that in the future a portion of its Mortgage Assets
will consist of Mortgage Loans acquired pursuant to the Direct Purchase Program.
These Mortgage Loans will have certain distinct risk characteristics and
generally lack standardized terms, which may complicate their structure. The
underlying properties themselves may be unique and more difficult to value than
typical residential real estate properties. Although the Company intends to seek
geographic diversification of the properties which are collateral for the
Company's Mortgage Loans, it does not intend to set specific diversification
requirements (whether by state, zip code or other geographic measure).
Concentration in any one area will increase exposure of the Company's Mortgage
Assets to the economic and natural hazard risks associated with that
32
<PAGE> 34
area. Further, certain properties securing Mortgage Loans may be contaminated by
hazardous substances resulting in reduced property values. If the Company
forecloses on a defaulted Mortgage Loan collateralized by such property, the
Company may be subject to environmental liabilities regardless of whether the
Company was responsible for the contamination. The results of the Direct
Purchase Program may also be affected by various factors, many of which are
beyond the control of the Company, such as (i) local and other economic
conditions affecting real estate values, (ii) the ability of tenants to make
lease payments, (iii) the ability of a property to attract and retain tenants,
(iv) interest rate levels and the availability of credit to refinance such
Mortgage Loans at or prior to maturity, and (v) increased operating costs,
including energy costs, real estate taxes and costs of compliance with
regulations.
Other Products. In addition to the tailored Mortgage Loan products
described above, the Company may also acquire conforming Mortgage Loans and
nonconforming jumbo Mortgage Loans from Correspondents, and purchase Mortgage
Loans on a bulk basis. Conforming Mortgage Loans meet underwriting guidelines
with respect to principal balance, loan repayment schedule and borrower credit
history, as defined by certain government-sponsored agencies. These Mortgage
Loans will consist of (i) conventional Mortgage Loans that comply with
requirements for inclusion in certain programs sponsored by the FHLMC or FNMA,
(ii) Mortgage Loans insured by the Federal Housing Administration ("FHA") and
(iii) Mortgage Loans partially guaranteed by the Department of Veterans Affairs
("VA"), that comply with requirements for inclusion in a pool of Mortgage Loans
guaranteed by the GNMA. The nonconforming Mortgage Loans will be conventional
Mortgage Loans that vary in one or more respects from the requirements for
participation in FHLMC or FNMA programs.
The Company expects that substantially all of the nonconforming Mortgage
Loans it purchases outside its target market segments will be nonconforming
primarily because they have original principal balances which exceed the
requirements for FHLMC or FNMA programs and, to a lesser extent, because they
vary in certain other respects from the requirements of such programs, including
the requirements relating to creditworthiness of the borrowers. The Company may
in the future invest in sub-prime Mortgage Loans. Sub-prime Mortgage Loans are
residential Mortgage Loans made to borrowers with credit ratings below the
conforming loan guidelines. Additionally, sub-prime Mortgage Loans generally are
subject to greater frequency of loss and delinquency than conforming Mortgage
Loans. Accordingly, lower credit grade Mortgage Loans normally bear a higher
rate of interest than conforming Mortgage Loans. See "Risk Factors -- Value of
Mortgage Loans May Be Affected by Characteristics of Underlying Property and
Borrower Credit." The Company may, when opportunities arise, acquire Mortgage
Loans on a bulk basis.
The Company does not expect to acquire or retain residual interests issued
by REMICs. Such residual interests, if acquired by a REIT, would generate excess
inclusion income. See "Federal Income Tax Consequences -- Taxation of
Stockholders."
Pricing. For Mortgage Loans to be acquired from Correspondents on a "flow"
basis (i.e., on a periodic basis shortly after the Mortgage Loans are funded),
the Company expects to review the prices at which it is purchasing such Mortgage
Loans daily and to adjust the prices frequently. Mortgage Loans acquired on a
bulk basis will typically be priced on a negotiated basis with Correspondents or
pursuant to a bidding process. In each case, different prices will be
established for the various types of Mortgage Loans to be acquired based on
current market conditions, with price adjustments for any "buy-ups" or
"buy-downs" (i.e., where the gross margin is higher or lower than the standard
margin set forth in the Company's pricing specifications).
Underwriting. In developing the tailored underwriting guidelines for
Mortgage Loans to be acquired under the Direct Purchase Program, the Company
will create a matrix of specific underwriting standards based on various
combinations of the underwriting characteristics described below. Each
Correspondent will generally be required to represent and warrant that all
Mortgage Loans originated by it and sold to the Company have been underwritten
in accordance with the Company's specific underwriting standards as well as
standards consistent with those used by mortgage lenders generally.
Underwriting standards are applied by or on behalf of a lender to evaluate
the borrower's credit standing and repayment ability, and the value and adequacy
of the related mortgaged property as collateral. In general, a prospective
borrower applying for a Mortgage Loan is required to fill out a detailed
application designed to
33
<PAGE> 35
provide to the underwriting officer pertinent credit information. As part of the
description of the borrower's financial condition, the borrower generally is
required to provide a current list of assets and liabilities and a statement of
income and expenses, as well as an authorization to apply for a credit report
which summarizes the borrower's credit history with local merchants and lenders
and any record of bankruptcy. In most cases, an employment verification is
obtained from an independent source (typically the borrower's employer) which
verification reports, among other things, the length of employment with that
organization, the current salary, and whether it is expected that the borrower
will continue such employment in the future. If a prospective borrower is
self-employed, the borrower may be required to submit copies of signed tax
returns. The borrower may also be required to authorize verification of deposits
at financial institutions where the borrower has demand or savings accounts.
The Company may elect to have the borrower's credit report reviewed, and a
credit score produced, by an independent credit-scoring firm, such as Fair,
Issac and Company ("FICO"). The Company has not engaged FICO or discussed any
such engagement with FICO. Credit scores estimate, on a relative basis, which
borrowers are most likely to default on Mortgage Loans. Lower scores imply
higher default risks relative to higher scores. FICO scores are empirically
derived from historical credit bureau data and represent a numerical weighing of
a borrower's credit characteristics over a two year period. A FICO score is
generated through the statistical analysis of a number of credit-related
characteristics or variables. Common characteristics include the following: the
number of credit lines (trade lines), payment history, past delinquencies,
severity of delinquencies, current levels of indebtedness, types of credit and
length of credit history. Attributes are the specific values of each
characteristic. A scorecard (the model) is created with weights or points
assigned to each attribute. An individual loan applicant's credit score is
derived by summing together the attribute weights for that applicant.
In determining the adequacy of the mortgaged property as collateral, an
appraisal is made of each property considered for financing. The appraiser is
required to inspect the property and verify that it is in good condition and
that construction, if new, has been completed. The appraisal is based on the
market value of comparable homes, the estimated rental income (if considered
applicable by the appraiser) and the cost of replacing the home. The value of
the property being financed, as indicated by the appraisal, must be such that it
currently supports, and is anticipated to support in the future, the outstanding
Mortgage Loan balance.
Once all applicable employment, credit and property information is
received, a determination generally is made as to whether the prospective
borrower has sufficient monthly income available to meet (i) the borrower's
monthly obligations on the proposed Mortgage Loan (determined on the basis of
the monthly payments due in the year of origination) and other expenses related
to the mortgaged property (such as property taxes and hazard insurance), and
(ii) monthly housing expenses and other financial obligations and monthly living
expenses. The underwriting standards applied by the Correspondent may be
permitted to vary in appropriate cases where factors such as low loan-to-value
ratios or other favorable credit issues exist.
Because certain types of Mortgage Loans which will be acquired by the
Company under the Direct Purchase Program will be recently developed, they may
involve additional uncertainties not present in traditional types of Mortgage
Loans. The Company expects that these recently developed types of Mortgage Loans
may be underwritten primarily upon the basis of loan-to-value ratios or
favorable credit factors rather than on the borrower's credit standing or income
ratios. See "Risk Factors -- Borrower Credit May Decrease Value of Mortgage
Loans -- Characteristics of Underlying Property May Decrease Value of Mortgage
Loans."
Quality Control. The Company has developed a quality control program to
monitor the quality of Mortgage Loan underwriting at the time of acquisition and
on an ongoing basis. All Mortgage Loans purchased by the Company will be subject
to this quality control program. A legal document review of each Mortgage Loan
acquired will be conducted to verify the accuracy and completeness of the
information contained in the Mortgage Loan documents, security instruments and
other pertinent documents in the file. A sample of Mortgage Loans originated
under the Direct Purchase Program will normally be submitted to a third party,
nationally recognized underwriting review firm for a compliance check of
underwriting and review of income, asset and appraisal information. For purposes
of this compliance check, Mortgage Loans will be
34
<PAGE> 36
selected by focusing on Mortgage Loans with higher risk characteristics. In
addition, Management expects to conduct post-acquisition audits to monitor
ongoing documentation and servicing compliance.
Servicing. Management expects to acquire certain of its Mortgage Loans on a
"servicing released" basis (i.e., the Company will acquire both the Mortgage
Loans and the rights to service them) and to act as the servicer of such
Mortgage Loans while they are in the Company's Mortgage Asset portfolio.
Management believes this strategy will have the effect of increasing the yield
to the Company from the Mortgage Loans above what it would otherwise be. The
Company will contract with a subservicer for a fixed dollar fee per Mortgage
Loan per year or a percentage of the outstanding mortgage balance and the right
to hold escrow account balances and retain certain ancillary charges. Management
expects to arrange for servicing of the Mortgage Loans originated through the
Direct Purchase Program with servicing entities that have particular expertise
and experience in the types of Mortgage Loans being acquired. Management does
not expect to acquire Mortgage Loan servicing rights with respect to Mortgage
Loans beneficially owned by others.
FUNDING
The Company employs a debt financing strategy to increase its investment in
Mortgage Assets. By using the Company's Mortgage Assets as collateral to borrow
funds, the Company is able to purchase Mortgage Assets with significantly
greater value than its equity. The Company has a targeted ratio of
equity-to-assets of between 8% and 12%, which is generally greater than the
levels of many other companies that invest in Mortgage Assets, including many
commercial banks, savings and loans, FNMA and FHLMC. The Company has borrowing
arrangements with ten financial institutions consisting primarily of large
investment banking firms. At June 30, 1997, the Company had borrowed funds under
reverse repurchase agreements with five of these firms. The Company intends to
expand its uncommitted reverse repurchase agreements following the closing of
this Offering. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources."
The Company's financing strategy is designed to maintain a cushion of
equity sufficient to provide required liquidity to respond to the effects under
its borrowing arrangements of interest rate movements and changes in the market
value of its Mortgage Assets. However, a major disruption of the reverse
repurchase or other markets relied on by the Company for short term borrowings
would have a material adverse effect on the Company unless the Company was able
to arrange alternative sources of financing on comparable terms. The Company
intends to finance its acquisition of Mortgage Assets primarily through reverse
repurchase agreements and, to a lesser extent, through lines of credit,
securitizations and other financings.
At June 30, 1997, total borrowings outstanding were $209.5 million, with
Mortgage Assets valued at $221.0 million pledged to secure such borrowings.
These borrowings are carried on the balance sheet at historical cost, which
approximates market value. All of the borrowings were undertaken pursuant to
reverse repurchase agreements. At June 30, 1997, the weighted average term to
maturity was 62 days and the weighted average borrowing rate was 5.69% per
annum. Under the reverse repurchase agreements outstanding at June 30, 1997, the
original aggregate "haircut," or the percentage by which the market value of the
pledged collateral must exceed the borrowing amount, was 4.4%. The Company
anticipates that, upon its repayment of each borrowing, the collateral will
immediately be used for a further borrowing pursuant to a new reverse repurchase
agreement. However, there can be no assurance that the Company would be able to
borrow additional funds. See "Risk Factors -- Failure to Implement Company's
Leverage Strategy May Adversely Affect Results of Operations."
The Company expects that all of its borrowing agreements will require the
Company to pledge cash or additional Mortgage Assets in the event the market
value of existing collateral declines. To the extent that cash reserves are
insufficient to cover such deficiencies in collateral, the Company may be
required to sell Mortgage Assets to reduce the borrowings. The Company's current
borrowing facilities may be collateralized only by Mortgage Securities and may
not be used to finance acquisitions of Mortgage Loans pursuant to the Direct
Purchase Program. See "Risk Factors -- Failure to Implement Company's Leverage
Strategy May Affect Results of Operations."
35
<PAGE> 37
Reverse Repurchase Agreements
The Company finances its portfolio of Mortgage Assets primarily through a
form of borrowing known as reverse repurchase agreements. In a reverse
repurchase agreement transaction, the Company agrees to sell a Mortgage Asset
and simultaneously agrees to repurchase the same Mortgage Asset one to six
months later at a higher price with the price differential representing the
interest expense. These transactions constitute collateralized borrowings for
the Company, based on the market value of the Company's Mortgage Assets. The
Company generally will retain beneficial ownership of the Mortgage Security,
including the right to distributions on the collateral and the right to vote.
Upon a payment default under any such reverse repurchase agreement, the lending
party may liquidate the collateral.
The Company intends to enter into reverse repurchase agreements primarily
with national broker/dealers, commercial banks and other lenders who typically
offer such financing. The Company does not intend at the present time to enter
into commitment agreements under which the lender would be required to enter
into new reverse repurchase agreements during a specified period of time. The
Manager and the Company will monitor the need for such commitment agreements and
may enter into such commitment agreements in the future if deemed favorable to
the Company. At June 30, 1997 the Company had uncommitted reverse repurchase
facilities to provide over $500 million to finance investments in Mortgage
Assets. See "Risk Factors -- Failure to Implement Company's Leverage Strategy
May Adversely Affect Results of Operations."
In the event of the insolvency or bankruptcy of the Company, the creditor
under reverse repurchase agreements may be allowed to avoid the automatic stay
provisions of the Bankruptcy Code and to foreclose on the collateral agreements
without delay. In the event of the insolvency or bankruptcy of a lender during
the term of a reverse repurchase agreement, the lender may be permitted to
repudiate the contract, and the Company's claim against the lender for damages
therefrom may be treated simply as one of the unsecured creditors. Should this
occur, the Company's claims would be subject to significant delay and, if
received, may be substantially less than the damages actually suffered by the
Company.
To reduce its exposure to the credit risk of reverse repurchase agreement
lenders, the Company intends to enter into such agreements with several
different parties and to follow credit exposure policies approved by the Board
of Directors, which include (i) conducting a financial review of each potential
lender, (ii) imposing minimum equity and credit rating (if rated) requirements
on such lenders, and (iii) limiting the percentage of Mortgage Assets that are
the subject of reverse repurchase agreements with a single lender to 45% of the
Company's total Mortgage Assets. Any exceptions to these policies must be
approved by both the Chief Executive Officer and the Chief Operating Officer of
the Company. The Company will monitor the financial condition of its reverse
repurchase agreement lenders on a regular basis. Notwithstanding these measures,
no assurance can be given that the Company will be able to avoid such counter
party risks.
Line of Credit
The Company has in place a line of credit facility that it may use to fund
portions of cash flow shortages which may result from prepayments on Mortgage
Loans underlying its Mortgage Securities. Generally, the Company's reverse
repurchase agreements, which are collateralized by the Company's Mortgage
Securities, demand immediate receipt of additional collateral to the extent that
the value of the Mortgage Securities is reduced as a result of prepayments.
However, the federal government agencies that issue the Mortgage Securities do
not deliver the proceeds from such prepayments for periods ranging from 15 to 36
days following the announcement of such prepayments. Accordingly, the Company
may be required to draw on its line of credit for the period between the date
the prepayments are announced and the Company is required to surrender
additional collateral and the date it receives the proceeds from the
prepayments. The line of credit is with one lender and is secured by the
proceeds of prepayments pursuant to collateral which secures the Company's
borrowings with that lender. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources."
36
<PAGE> 38
Securitizations
The Company intends to securitize from time to time Mortgage Loans acquired
through the Direct Purchase Program as part of its overall financing strategy.
Securitization is the process of pooling Mortgage Loans and issuing equity
securities, such as mortgage pass-through, or debt securities, such as
Collateralized Mortgage Obligations ("CMOs"). The Company intends to securitize
its Mortgage Loans primarily by issuing structured debt. Under this approach,
for accounting purposes the Mortgage Loans so securitized remain on the balance
sheet as assets and the debt obligations (i.e., the CMOs) appear as liabilities.
A structured debt securitization is generally expected to result in substituting
one type of debt financing for another, as proceeds from the structured debt
issuance are applied against preexisting borrowings (i.e., advances under the
warehouse line of credit or borrowings under reverse repurchase agreements). The
structured debt securities issued will constitute non-recourse, long term
financing, the payments on which correspond to the payments on the Mortgage
Loans serving as collateral for the debt. Such financings are not subject to a
margin call if a rapid increase in rates would reduce the value of the
underlying Mortgage Loans and, hence, reduce the liquidity risk to the Company
for the Mortgage Loans so financed.
In addition to securitizing its Mortgage Loans, the Company also plans from
time to time to "re-securitize" portions of its Mortgage Securities portfolio.
In a re-securitization transaction, Mortgage Securities rather than Mortgage
Loans are used as collateral to create new Mortgage Securities. Only those
Mortgage Securities originally issued with (or subsequently downgraded to) a
rating below the two highest rating categories would benefit from
re-securitization. While the Company's investment strategy does not contemplate
purchasing such lower rated Mortgage Securities, the Company anticipates that it
may acquire such types of Mortgage Securities from time to time in connection
with securitizing its own Mortgage Loans as described above. A re-securitization
would typically be carried out when the Mortgage Loans underlying the Company's
Mortgage Securities improve in credit quality through seasoning, as values rise
on the underlying properties, or when the credit quality of a junior class of
Mortgage Security improves due to prepayment of more senior classes. Such
transactions can result in improved credit ratings, higher market values and
lowered borrowing costs. The Company has not engaged in any securitization or
re-securitization transactions to date and there can be no assurances that the
Company will be able to securitize or otherwise finance its Mortgage Loans
acquired pursuant to the Direct Purchase Program.
CAPITAL GUIDELINES
The Company's capital management goal is to strike a balance between the
under-utilization of leverage, which could reduce potential returns to
stockholders, and the over-utilization of leverage, which could reduce the
Company's ability to meet its obligations during periods of adverse market
conditions. For this purpose, the Company has established a "Capital Policy"
which limits Management's ability to acquire additional Mortgage Assets during
times when the actual capital base of the Company is less than a required amount
defined in the Capital Policy. In this way, Management believes the use of
balance sheet leverage can be better controlled. For purposes of the Capital
Policy, the actual capital base, is equal to the market value of total Mortgage
Assets, less the book value of total collateralized borrowings. In addition,
when the actual capital base falls below the Capital Policy requirement,
Management is required to submit to the Board of Directors of the Company a plan
for bringing the actual capital base into compliance with the Capital Policy. It
is anticipated that in most circumstances this goal will be achieved over time
without specific Management action through the natural process of mortgage
principal repayments and increases in the market values of Mortgage Assets as
their coupon rates adjust upwards to market levels. Management anticipates that
the actual capital base is likely to exceed the Capital Policy requirement
during periods following new equity offerings and during periods of falling
interest rates and that the actual capital base is likely to fall below the
Capital Policy requirement during periods of rising interest rates. The Board of
Directors has the discretion to modify or waive the Company's policies and
restrictions without stockholder consent. See "Risk Factors -- Policies and
Strategies May Be Revised at the Discretion of the Board of Directors."
The Company assigns to each Mortgage Asset a specified amount of capital to
be maintained against it by aggregating three component requirements of the
Capital Policy. The first component of the Company's Capital Policy is the
current aggregate over-collateralization amount or "haircut" the lenders require
the
37
<PAGE> 39
Company to hold as capital. The Company is required to pledge as collateral
Mortgage Assets with a market value that exceeds the amount it borrows. The
haircut for each Mortgage Asset is determined by the lender based on the risk
characteristics and liquidity of that Mortgage Asset. For example, haircut
levels on individual borrowings could range from 3% for Agency Securities to 20%
for certain Mortgage Loans acquired through the Direct Purchase Program.
The second component of the Company's Capital Policy is the "liquidity
capital cushion." The Company expects that substantially all of its borrowing
agreements will require the Company to deposit additional collateral in the
event the market value of existing collateral declines. The liquidity capital
cushion is an additional amount of capital in excess of the haircut maintained
by the Company designed to assist the Company in meeting the demands of the
lenders for additional collateral should the market value of the Company's
Mortgage Assets decline. Alternatively, the Company might sell Mortgage Assets
to reduce the borrowings. See "Risk Factors -- Investments in Mortgage Assets
May Be Illiquid."
The third component of the Company's capital requirement is the "capital
cushion" assigned to each Mortgage Asset based on Management's assessment of the
Mortgage Asset's credit risk. This represents an assessment of the risk of
delinquency, default or loss on individual Mortgage Assets.
Finally, the Board of Directors establishes, subject to revision from time
to time, a minimum equity to total assets ratio for the Company pursuant to its
Capital Policy. The Board of Directors reviews on a periodic basis various
analyses prepared by Management of the risks inherent in the Company's balance
sheet, including an analysis of the effects of various scenarios on the
Company's net cash flow, net income, dividends, liquidity and net market value.
Should the Board of Directors determine, in its discretion, that the minimum
required capital base is either too low or too high, the Board of Directors will
raise or lower the capital requirement accordingly.
The Company expects that its aggregate minimum equity capital required
under the Capital Policy will range between 8% to 12% of the total market value
of the Company's Mortgage Assets. This percentage will fluctuate over time, and
may fluctuate out of the expected range, as the composition of the balance sheet
changes, haircut levels required by lenders change, the market value of the
Mortgage Assets change and as the capital cushion percentages set by the Board
of Directors are adjusted over time. The Company will actively monitor and
adjust, if necessary, its Capital Policy, both on an aggregate portfolio level
as well as on an individual pool or Mortgage Loan basis. In monitoring its
Capital Policy, the Company expects to take into consideration current market
conditions and a variety of interest rate scenarios, performance of hedges,
performance of Mortgage Assets, credit risk, prepayments of Mortgage Assets, the
restructuring of Mortgage Assets, general economic conditions, potential
issuance of additional equity, pending acquisitions or sales of Mortgage Assets,
Mortgage Loan securitizations and the general availability of financing. There
can be no assurance that the Company's capital will be sufficient to protect the
Company against adverse effects from interest rate adjustments or the obligation
to sell Mortgage Assets on unfavorable terms or at a loss. See "Risk
Factors -- Sudden Interest Rate Fluctuations May Reduce Income from Operations."
RISK MANAGEMENT
Prior to acquiring Mortgage Assets, Management gives consideration to
balance sheet management and risk diversification issues. A specific Mortgage
Asset which is being evaluated for potential acquisition is deemed more or less
valuable to the Company to the extent it serves to increase or decrease certain
interest rate or prepayment risks which may exist in the balance sheet, to
diversify or concentrate credit risk, and to meet the cash flow and liquidity
objectives Management may establish for the balance sheet from time to time.
Accordingly, an important part of the Mortgage Asset evaluation process is a
simulation, using the Company's risk management model, of the addition of
proposed Mortgage Assets and its associated borrowings and hedgings to the
balance sheet and an assessment of the impact any proposed acquisition of
Mortgage Assets would have on the risks in, and returns generated by, the
Company's balance sheet as a whole over a variety of scenarios.
38
<PAGE> 40
Interest Rate Risk Management
To the extent consistent with its election to qualify as a REIT, the
Company will implement certain processes and will follow a hedging program
intended to protect the Company against significant unexpected changes in
prepayment rates and interest rates.
Prepayment Risk Management Process. The Company will seek to minimize the
effects on earnings caused by faster than anticipated prepayment rates by
purchasing Mortgage Assets with prepayment penalties or which are fully-indexed
and have previously experienced periods of rising or falling interest rates. In
particular, the Company intends to include prepayment penalties in the
underwriting guidelines for the tailored Mortgage Loan products in the Direct
Purchase Program. See "Risk Factors -- Increased Levels of Mortgage Loan
Prepayments May Reduce Operating Income."
During the quarter ended June 30, 1997, the Company received $10.4 million
in principal payments on its Mortgage Assets. The annualized rate of principal
repayment the Company experienced was 29%. The amortized cost of the Company's
Mortgage Assets at June 30, 1997 was equal to 103.7% of the face value of the
Mortgage Assets. The smaller the level of net premium, the less risk there is
that fluctuations in prepayment rates will affect earnings in the long run. See
"Risk Factors -- Increased Levels of Mortgage Loan Prepayments May Reduce
Operating Income" and "Management Discussion and Analysis of Financial Condition
and Results of Operations -- Overview."
Other Processes. The Company manages its Mortgage Asset portfolio to offset
the potential adverse effects from (i) lifetime and periodic rate adjustment
caps on its Mortgage Assets, (ii) the differences between interest rate
adjustment indices of its Mortgage Assets and related borrowings, and (iii) the
differences between interest rate adjustment periods of its Mortgage Assets and
related borrowings. The Company generally purchases Mortgage Assets which are
fully indexed and have previously experienced periods of rising and falling
interest rates. The Company also attempts to structure its acquisitions so that
the Mortgage Assets purchased by the Company have interest rate adjustment
indices and adjustment periods that, on an aggregate basis, correspond as
closely as advisable by the Company to the interest rate adjustment indices and
adjustment periods of its anticipated borrowings. In addition, the Company
structures its short term borrowing agreements to have a range of different
maturities (although the majority will be six months or less). As a result, the
Company expects to be able to adjust the average maturity of its borrowings on
an ongoing basis by changing the mix of maturities as borrowings come due and
are renewed. In this way, the Company intends to reduce the differences between
adjustment periods of Mortgage Assets and related borrowings.
At June 30, 1997, the Company's weighted average Mortgage Assets and
liabilities were matched within a two-month period in terms of adjustment
frequency and speed of adjustment to market conditions. All of the Company's
Mortgage Assets at June 30, 1997 had coupon rates that adjust to market levels
at least annually, with a weighted average term to reset of approximately four
months. All of the Company's borrowings at June 30, 1997 will either mature or
adjust to a market interest rate level within four months of such date. The
borrowings had a weighted average term to expiration of 62 days at June 30,
1997. Changes in coupon rates earned on Mortgage Assets highly correlated with
changes in LIBOR rates and CMT rates. The rates paid on borrowings generally
correlate with the changes in either LIBOR or FED fund rates (subject to the
effects of periodic and lifetime caps). There can be no assurance that the
Company's processes will protect the Company against interest rate fluctuations
which may adversely affect the Company's net interest income and results of
operations. See "Risk Factors -- Sudden Interest Rate Fluctuations May Reduce
Income From Operations."
Hedging. The Company recognizes the need to hedge specific interest rate
risks associated with its Mortgage Asset portfolio and will seek the hedging
instrument most appropriate for the specific risk. Currently, all of the
Company's Mortgage Assets are subject to both lifetime interest rate caps and
periodic interest rate caps. The Company actively hedges the lifetime cap risks
associated with its Mortgage Assets. The Company has entered into hedging
transactions with respect to lifetime interest rate caps in order to reduce the
negative impact to the Company's earnings which might otherwise result from a
significant rise in interest rates. The Company may enter into additional types
of hedging transactions in the future if
39
<PAGE> 41
Management believes there exists a significant risk to earnings. These types of
hedging transactions may include hedging against risks associated with (i)
periodic interest rate adjustment caps, and (ii) Mortgage Assets denominated in
different interest rate indices, such as U.S. Treasury bills and Eurodollars.
Management intends to monitor and evaluate the results of its hedging strategy
and to adjust its hedging strategy as it deems is in the best interest of the
Company.
The cost of the interest rate cap agreements at June 30, 1997 was
approximately $502,000. Cap premiums are amortized from the purchase date
through the effective date of the cap on a straight-line basis. During the
quarter ended June 30, 1997, the cap amortization expense was approximately
$40,000. There was no income from the caps during this period and there were no
sales or termination of caps. During the quarter ended June 30, 1997, net cap
expense equaled approximately 0.02% of the average balance of the Company's
Mortgage Assets and 0.02% of the average balance of the Company's interest
bearing liabilities. For such periods, the net cap expense was approximately 7%
of net interest income. At June 30, 1997, the range of strike rates was 7.52% to
9.95% and the weighted average strike rate was 8.11%. Some of the Company's
interest rate cap agreements have strike rates and/or notional face amounts
which vary over time. The cap agreements do not become effective until the first
half of 1998. All of the interest rate caps reference the one month LIBOR.
Mortgage derivative securities can also be effective hedging instruments in
certain situations as the value and yields of some of these securities tend to
increase as interest rates rise and tend to decrease in value and yields as
interest rates decline, while the experience for others is the converse. As part
of its hedging program, the Company will monitor on an ongoing basis the
prepayment risks which arise in fluctuating interest rate environments and
consider alternative methods and costs of hedging such risks, which may include
the use of mortgage derivative securities. The Company intends to limit its
purchases of mortgage derivative securities to investments that qualify as
Qualified REIT Assets so that income from such securities will constitute
qualifying income for purposes of the 95% and 75% Gross Income Tests. The
Company does not currently intend to, but may in the future enter, into interest
rate swap agreements, buy and sell financial futures contracts and options on
financial futures contracts and trade forward contracts as a hedge against
future interest rate changes; however, the Company will not invest in these
instruments unless the Company and the Manager are exempt from the registration
requirements of the Commodities Exchange Act or otherwise comply with the
provisions of that act. The REIT Provisions of the Code may restrict the
Company's ability to purchase hedges and may severely restrict the Company's
ability to employ other strategies. In all its hedging transactions, the Company
will contract only with counterparties that the Company believes are sound
credit risks. See "Federal Income Tax Consequences -- Requirements for
Qualification as a REIT -- Gross Income Tests."
Hedging involves transaction and other costs, and such costs increase as
the period covered by the hedging protection increases and also increase in
periods of rising and fluctuating interest rates. For example, in a typical
interest rate cap agreement, the cap purchaser makes an initial lump sum cash
payment to the cap seller in exchange for the seller's promise to make cash
payments to the purchaser on fixed dates during the contract term if prevailing
interest rates exceed the rate specified in the interest rate cap agreement.
Because of the cost involved, the Company may be prevented from effectively
hedging its interest rate risks, without significantly reducing the Company's
return on equity.
Certain of the federal income tax requirements that the Company must
satisfy to qualify as a REIT limit the Company's ability to fully hedge its
interest rate and prepayment risks. The Company monitors carefully, and may have
to limit, its asset/liability management program to assure that it does not
realize excessive hedging income, or hold hedging assets having excess value in
relation to total assets, which would result in the Company's disqualification
as a REIT or, in the case of excess hedging income, the payment of a penalty tax
for failure to satisfy certain REIT income tests under the Code, provided such
failure was for reasonable cause. In addition, asset/liability management
involves transaction costs which increase dramatically as the period covered by
the hedging protection increases. Therefore, the Company may be prevented from
effectively hedging its interest rate and prepayment risks. See "Federal Income
Tax Consequences -- Requirements for Qualification as a REIT."
40
<PAGE> 42
In particular, income from hedging the Company's variable rate borrowings
(other than with hedging instruments that are Qualified REIT Assets) qualifies
for the 95 percent of income test, but not for the 75 percent of income test,
for REIT qualification. The Company must limit its income from such hedging or
the sale of hedging contracts, along with other types of income that qualifies
for the 95 percent of income test, but not for the 75 percent of income test, to
less than 25 percent of the Company's gross revenues. In addition, hedging
instruments, such as swaps, caps, floors, collars, and financial futures
contracts, are securities for purposes of the quarterly asset tests for REIT
qualification. The Company must ascertain that securities, including the hedging
instruments (other than hedging instruments that are Qualified REIT Assets),
issued by a single issuer do not account for 5 percent or more of the value of
the Company's assets as of the last day of each calendar quarter. The Company
does not expect to encounter material problems complying with these tests.
Although Management believes it has developed a cost effective interest
rate risk management program to provide a level of protection against interest
rate risks, developing an effective program is complex and no program can
completely insulate the Company from the effects of interest rate changes.
Further, the cost of hedging transactions and the federal tax laws applicable to
REITs may limit the Company's ability to fully hedge its interest rate risks.
See "Risk Factors -- Failure to Successfully Manage Interest Rate Risks May
Adversely Affect Results of Operations" and "Federal Income Tax
Consequences -- Requirements for Qualification as a REIT."
Interest Rate Sensitivity Gap. The interest rate sensitivity gap is a tool
used by financial institutions such as banks and savings and loans to analyze
the possible effects of interest rate changes on net income over time. Time gap
analysis ignores many important factors, and, in the Company's case, it ignores,
among other factors, the effect of the Company's hedging activities, the effect
of the periodic and lifetime caps on the Company's Mortgage Assets, and the
effect of changes in mortgage principal repayment rates. Nevertheless, the gap
time analysis can provide some useful information on the interest rate risk
profile of a financial institution.
A negative cumulative gap over a particular period means that the amount of
liabilities that will have an expense rate adjusting to prevailing market
conditions during that period will be greater than the amount of Mortgage Assets
that will have an earning rate adjustment. Thus a negative gap implies that
increasing interest rates would result in a falling level of net interest income
during the time period in question, as the cost of funds on the liabilities
would adjust more quickly to the interest rate increase than would the interest
income from the Mortgage Assets. A negative gap also implies that falling
interest rates would result in an increasing level of net interest during the
period in question.
Credit Risk Management
The Company will review credit risks and other risks of loss associated
with each investment and determine the appropriate allocation of capital to
apply to such investment under its Capital Policy. In addition, the Company will
attempt to diversify its Mortgage Asset portfolio to avoid undue geographic,
issuer, industry and certain other types of concentrations. The Company will
attempt to obtain protection against some risks from sellers and servicers
through representations and warranties and other appropriate documentation. The
Board of Directors will monitor the overall portfolio risk and increase the
allowance for loan losses when it believes appropriate.
The risks presented by each Mortgage Loan acquired under the Direct
Purchase Program will be unique and must be analyzed separately. In order to
reduce the credit risks associated with acquisitions of these Mortgage Loans,
the Company will (i) employ a quality control program, (ii) acquire Mortgage
Loans that represent a broad range of moderate risks as opposed to a
concentrated risk, (iii) monitor the credit quality of newly acquired and
existing Mortgage Assets, and (iv) periodically adjust the Mortgage Loan loss
allowances. The Company also expects to arrange for servicing of Mortgage Loans
acquired pursuant to the Direct Purchase Program with servicing entities that
have particular expertise and experience in the types of Mortgage Loans being
acquired. See "Risk Factors -- Borrower Credit May Decrease Value of Mortgage
Loans -- Characteristics of Underlying Property May Decrease Value of Mortgage
Loans."
41
<PAGE> 43
With respect to its Mortgage Securities, the Company will be exposed to
levels of credit and special hazard risk, depending on the nature of the
underlying Mortgage Loans and the nature and level of credit enhancements
supporting such Mortgage Securities. Most of the Mortgage Securities acquired by
the Company will have protection from normal credit losses. At June 30, 1997,
100% of the Company's Mortgage Securities were Agency Securities.
Management may decide to sell Mortgage Assets from time to time for a
number of reasons, including, without limitation, to dispose of Mortgage Assets
as to which credit risk concerns have arisen, to seek to reduce interest rate
risk, to substitute one type of Mortgage Asset for another to seek to improve
yield or to maintain compliance with the 55% requirement under the Investment
Company Act, and generally to re-structure the balance sheet when Management
deems such action advisable. The REIT Provisions of the Code limit in certain
respects the ability of the Company to sell Mortgage Assets. See "Federal Income
Tax Consequences -- Requirements of Qualifications as a REIT -- Gross Income
Tests" and "Federal Income Tax Consequences -- Taxation of the Company."
COMPETITION
The Company's net interest income will depend, in large part, on the
Company's ability to acquire Mortgage Assets on acceptable terms and at
favorable spreads over the Company's borrowing costs. As a result of this
Offering, the Company will seek to acquire approximately $900 million or more of
additional Mortgage Assets. There can be no assurance that the Company will be
able to acquire sufficient Mortgage Assets at spreads above the Company's cost
of funds. In acquiring Mortgage Assets, the Company will compete with investment
banking firms, savings and loan associations, banks, mortgage bankers, insurance
companies, mutual funds, other lenders, GNMA, FNMA, FHLMC and other entities
purchasing Mortgage Assets, many of which have greater financial resources than
the Company. In addition, there are several REITs similar to the Company, and
others may be organized in the future. The effect of the existence of additional
REITs may be to increase competition for the available supply of Mortgage Assets
suitable for purchase by the Company. As it relates to the Direct Purchase
Program, the Company competes on the basis of product type. The Company will
face competition from companies already established in these markets. There can
be no assurance that the Company will be able to successfully compete with its
competition.
The availability of Mortgage Loans meeting the Company's criteria is
dependent upon, among other things, the size of and level of activity in the
residential real estate lending market. The size and level of activity in the
residential real estate lending market depend on various factors, including the
level of interest rates, regional and national economic conditions and inflation
and deflation in residential property values. To the extent the Company is
unable to acquire a sufficient number of Mortgage Loans meeting its criteria,
the Company's results of operations will be adversely affected. See "Risk
Factors -- Material Portion of Offering Proceeds Not Committed to Specific
Mortgage Assets; Inability to Acquire Mortgage Assets."
EMPLOYEES
Currently, the Manager employs the five executive officers of the Company
and three additional employees, a sixth executive officer will begin employment
in October 1997. At the closing of the Offering, there will be a total of nine
employees. Each of the executive officers has between 10 and 24 years, and
collectively, have an average of 19 years of experience in the residential
mortgage industry and worked together previously as a management team. The
Manager is currently in the process of recruiting employees to support the
Direct Purchase Program. At the closing of this Offering, each employee of the
Manager will also become an employee of the Company. The Company anticipates
that at least through the end of 1997 employees hired by the Manager will also
be employees of the Company. See "Risk Factors -- Conflicts of Interests;
Management Also Employed by and Owns Securities of Manager."
42
<PAGE> 44
FACILITIES
The Company's and the Manager's executive offices are located at 445 Marine
View Avenue, Suite 230, Del Mar, California. The Company and the Manager
currently occupy approximately 4,000 square feet of space and the Manager has a
right of first refusal on an additional 1,000 square feet at its current
location beginning March 1998. The Manager leases facilities pursuant to a lease
expiring in March 2000. Management believes that these facilities are adequate
for the Company's and the Manager's foreseeable needs.
LEGAL PROCEEDINGS
There are no material pending legal proceedings to which the Company is a
party or to which any property of the Company is subject.
43
<PAGE> 45
MANAGEMENT OF THE COMPANY
DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
The following table presents certain information concerning the directors
and executive officers of the Company:
<TABLE>
<CAPTION>
NAME AGE POSITION(1)
---- --- -----------
<S> <C> <C>
John M. Robbins(2)................ 50 Chairman of the Board, Chief
Executive Officer and Director
Jay M. Fuller(2).................. 47 President, Chief Operating Officer
and Director
Mark A. Conger.................... 38 Executive Vice President and Chief
Financial Officer
John Dahl......................... 44 Executive Vice President, Capital
Markets and Loan Production
Rollie O. Lynn.................... 43 Senior Vice President, Capital
Markets
Lisa S. Faulk(3).................. 40 Senior Vice President, Operations
David E. De Leeuw(2)(4)(5)(7)..... 53 Director
George E. McCown(2)(6)............ 62 Director
</TABLE>
In addition, the following individuals have been elected directors of the
Company effective immediately following the closing of this Offering:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
H. James Brown, Ph.D.(4)(7)....... 56 Director
Ray McKewon(5)(7)................. 49 Director
Richard T. Pratt, Ph.D.(4)(7)..... 60 Director
Mark J. Riedy, Ph.D.(5)(7)........ 55 Director
</TABLE>
- ---------------
(1) Each executive officer and director holds the same position with the
Manager. See "The Manager."
(2) Each of Mr. Robbins, Mr. Fuller, Mr. De Leeuw and Mr. McCown and the private
equity firm of McCown De Leeuw & Co., of which Messrs. McCown and De Leeuw
are principles, was a founder of the Company.
(3) Ms. Faulk will begin employment in October, 1997.
(4) Member of the Audit Committee. See "Board Committees."
(5) Member of the Compensation Committee. See "Board Committees."
(6) Mr. McCown will resign as a director of the Company upon the closing of this
Offering.
(7) The directors who will be in office after the closing of this Offering and
who are not officers or employees of either the Company or the Manager are
deemed independent directors of the Company. See "-- Action by Independent
Directors."
JOHN M. ROBBINS has served as Chairman of the Board of Directors and Chief
Executive Officer and Director of the Company since its formation in February
1997. Prior to joining the Company, Mr. Robbins was Chairman of the Board of
AMRES Mortgage from 1990 until 1994 and President of AMRES Mortgage from the
time he co-founded it in 1983 until 1994. He also served as Executive Vice
President of Imperial Savings Association from 1983 to 1987. Mr. Robbins has
worked in the mortgage banking industry since 1973. Mr. Robbins has served two
terms on the Board of Governors and the Executive Committee of the Mortgage
Association of America, and has served on FNMA's National Advisory Board. Mr.
Robbins also serves as a director of Pacific Research & Engineering Corporation,
Garden Fresh Restaurant Corporation, National Bankcard and the University of San
Diego.
JAY M. FULLER has served as President, Chief Operating Officer and Director
of the Company since its formation in February 1997. Prior to joining the
Company Mr. Fuller served as President of Victoria Mortgage
44
<PAGE> 46
from 1995 to 1996. Mr. Fuller was an Executive Vice President and Chief
Administration Officer of AMRES Mortgage from 1985 to 1994 and Senior Vice
President from 1983 to 1985. In these capacities, at various times, Mr. Fuller
was responsible for, among other things, Mortgage Loan originations and
servicing for AMRES Mortgage. Mr. Fuller has worked in the mortgage banking
industry continuously since 1975. Mr. Fuller currently serves as President of
Friends of Santa Fe Christian Schools.
MARK A. CONGER has served as Senior Vice President and Chief Financial
Officer of the Company since its formation in February 1997 and recently became
an Executive Vice President. From 1994 through 1997 Mr. Conger was the sole
proprietor and manager of an unrelated business. Mr. Conger was a Senior Vice
President, Finance, of AMRES Mortgage from 1992 to 1994 responsible for the
areas of accounting, treasury and corporate planning. He was a Vice President of
AMRES Mortgage from 1987 to 1992 responsible for corporate planning and human
resources. Prior to joining AMRES Mortgage, Mr. Conger was an Assistant Vice
President, Accounting, for Imperial Savings Association from 1985 to 1987 and an
auditor for KPMG Peat Marwick LLP from 1981 to 1985. Mr. Conger has worked in
the mortgage banking industry for ten years. Mr. Conger received a Bachelor of
Science degree from the University of Missouri in 1981 and is a Certified Public
Accountant.
JOHN DAHL has served as Executive Vice President, Capital Markets and Loan
Production, of the Company since October 1997. Prior to joining the Company Mr.
Dahl served as Managing Director of First Union Capital Markets Corporation from
1995 to 1997, responsible for marketing capital markets products and services to
corporate customers and prospects in diversified industries on the west coast,
and the speciality finance industry on a national basis. Prior to joining First
Union, Mr. Dahl served as Managing Director of First Chicago from 1988 to 1995,
responsible for marketing financial and operating services to corporate
customers and prospects in the mortgage banking industry. Mr. Dahl has worked in
the real estate and financial services industries continuously since 1976. Mr.
Dahl received his Bachelor of Science degree in 1976 from Northern Illinois
University and his Masters in Business Administration degree from San Francisco
State University in 1979.
ROLLIE O. LYNN has served as Senior Vice President, Capital Markets,
responsible for the areas of portfolio management for the Company since its
formation in February 1997. Prior to joining the Company, Mr. Lynn served as
Vice President, Capital Markets, of Long Beach Mortgage Company responsible for
managing, hedging and trading the firm's sub-prime residential Mortgage Loans.
Prior to joining Long Beach Mortgage, Mr. Lynn served as Vice President,
Secondary Marketing, of AMRES Mortgage from 1991 to 1994, as Vice President,
Capital Markets, of Imperial Savings from 1988 to 1992, and as Vice President of
Great American First Savings Bank of San Diego from 1985 to 1988. Mr. Lynn has
worked in the mortgage banking business continuously since 1977. Mr. Lynn
received two Bachelor of Arts degrees in 1976 from California State University
at Chico. Mr. Lynn is a licensed real estate broker in the State of California.
LISA S. FAULK will serve as Senior Vice President, Operations of the
Company in October 1997. Prior to joining the Company Ms. Faulk served as Vice
President, Conduit Underwriting for Advanta Mortgage Corporation where she
managed the Conduit Division's underwriting, funding and processing functions in
the non-conforming credit markets. Ms. Faulk was Vice President, Manager Credit
Risk Review for Homefed Bank, Federal Savings Bank from 1984 to 1993.
DAVID E. DE LEEUW has served as a Director of the Company since its
formation in February 1997. Mr. De Leeuw is a co-founder and a Managing Partner
of McCown De Leeuw & Co., a private equity firm that buys and builds
middle-market companies in partnership with management teams. Prior to
co-founding McCown De Leeuw & Co. in 1984, Mr. De Leeuw was employed by Citibank
as Vice President and Deputy Head of the Merger and Acquisition Department and
as Head of the Leveraged Acquisition Unit. Mr. De Leeuw currently serves as a
Vice Chairman of Vans, Inc. and a director of Nimbus CD International, Inc. and
several other private companies.
GEORGE E. MCCOWN has served as a Director of the Company since its
formation in February 1997. Mr. McCown is a co-founder and a Managing Partner of
McCown De Leeuw & Co. Prior to co-founding McCown De Leeuw & Co. in 1984, Mr.
McCown spent 18 years at Boise-Cascade Corporation in a series of general
management positions in the paper, packaging, building materials and real estate
divisions.
45
<PAGE> 47
Mr. McCown is Chairman of BMC West Corporation, Vice Chairman of Vans, Inc. and
a director of Nimbus CD International, Inc. and FiberMark, Inc.
In addition to the directors of the Company set forth above, the following
individuals have been elected directors of the Company to become effective upon
the closing of this Offering:
H. JAMES BROWN, PH.D. has served since 1996, as the President and Chief
Executive Officer of the Lincoln Institute of Land Policy, an educational
institution formed to study and teach land policy, including land economics and
land taxation. Prior to 1996, Dr. Brown was a professor at the Kennedy School of
Government at Harvard University from 1970 to 1996. During his tenure at Harvard
University, Dr. Brown served as a director of the Joint Center Housing Studies,
chairman of the City and Regional Planning Program and as a Director of the
State, Local and Intergovernmental Center at Harvard University and MIT/Harvard
University Joint Center for Urban Studies. In addition, Dr. Brown has served as
a Managing Partner of Strategic Property Investments, Inc., a company
specializing in real estate asset management from 1988 to 1991. Dr. Brown also
serves as a director of BMC West Corporation and Pelican Companies, Inc.,
distributors and retailers of building materials.
RAY MCKEWON is a co-founder and Executive Vice President of Accredited Home
Lenders, a mortgage banking firm founded in 1990 which specializes in sub-prime
credit. From 1980 to 1990, Mr. McKewon was a managing partner of the Enterprise
Management Company, a venture capital firm that he co-founded and which provided
capital to companies including Dura Pharmaceuticals, Cytotech (sold to Quidel),
Impulse Enterprise, McKewon & Timmins (sold to First Affiliated), Garden Fresh
Restaurants, Intelligent Images (merged into and renamed Darox) and Sunward
Technology (merged into Read-Rite).
RICHARD T. PRATT, PH.D. currently serves as Chairman of Richard T. Pratt
Associates, a position he has held since 1992, performing consulting activities,
including strategic studies for the Federal Home Loan Mortgage Corporation,
on-site consulting for the Housing Section Perform Project in Russia and
Kazakhstan for the U.S. Agency for International Development and various
strategic consultations for private sector institutions. Dr. Pratt is also a
Professor of Finance at the David Eccles School of Business at the University of
Utah, a position he has held since 1966. From 1983 to 1991, Dr. Pratt served as
the Chairman of Merrill Lynch Mortgage, Inc., a subsidiary of Merrill Lynch &
Company. From 1991 to 1994, Dr. Pratt served as Managing Director of the
Financial Institutions Group of Merrill Lynch. Dr. Pratt also serves as a member
of the Board of Directors of Avigen, a development level gene therapy company.
Dr. Pratt was Chairman of the Federal Home Loan Mortgage Corporation from 1981
to 1983, and as Chairman of the Federal Savings and Loan Insurance Corporation
from 1981 to 1983.
MARK J. RIEDY, PH.D. is currently employed as an Ernest W. Hahn Professor
of Real Estate Finance at the University of San Diego. In such capacity, he
teaches courses in real estate finance. Prior to his employment at the
University, Dr. Riedy served as President and Chief Executive Officer of the
National Council of Community Bankers in Washington, D.C. from 1988 to 1992.
From 1987 to 1988, Dr. Riedy served as President and Chief Operating Officer of
the J. E. Robert Companies. Dr. Riedy was President, Chief Operating Officer and
Director of the Federal National Mortgage Association from 1985 to 1986.
BENEFITS OF THIS OFFERING TO MANAGEMENT
No additional fees will be payable to the Manager solely as a result of
this Offering, however, investment of the net proceeds of this Offering will
result in an increase in the Company's Mortgage Assets and thus an increase in
the management fees to be paid to the Manager. At the discretion of the
Manager's board of directors, the Manager may elect to pay a portion of such
fees to the Company's management team as a bonus. Moreover, upon the closing of
this Offering, John Robbins and Jay Fuller will realize net increases in the
value of certain of their shares of Common Stock of the Company of $20,000 and
$15,000, respectively, and net increases in the implied value of their vested
options of $70,000 each assuming a market price at the mid-point of the range
set forth on the cover of the Prospectus. In addition, certain options held by
the management team will vest in full in the event the Company completes
additional public or private offerings which generate proceeds that, when
combined with the net proceeds of this Offering, exceed $150 million. See
"-- Option Grants" and "Conflict of Interest."
46
<PAGE> 48
TERM OF OFFICE
Effective upon the closing of the Offering, the Board of Directors of the
Company will be divided into three classes. Each class of Directors will consist
of two or three directors who will serve for a one, two or three year period
until the annual meeting or until their successors are elected and qualified.
Thereafter, Directors will serve staggered three year terms. The initial
classification of the directors is as follows:
<TABLE>
<CAPTION>
TERM OF
DIRECTOR CLASS OFFICE
-------- ----- -------
<S> <C> <C>
Dr. Brown................................... I 1998
Mr. McKewon................................. I 1998
Mr. De Leeuw................................ II 1999
Dr. Pratt................................... II 1999
Mr. Robbins................................. III 2000
Mr. Fuller.................................. III 2000
Dr. Riedy................................... III 2000
</TABLE>
Officers are elected by and serve at the discretion of the Board of
Directors.
BOARD COMMITTEES
The Board of Directors has recently appointed a compensation committee (the
"Compensation Committee") which will make recommendations to the Board of
Directors concerning salaries and incentive compensation for officers and
employees of the Company. Upon the closing of this Offering, the Compensation
Committee will consist of Mr. De Leeuw, Mr. McKewon and Dr. Riedy. The Board of
Directors also has appointed an audit committee (the "Audit Committee") which
will review the results and scope of the audit and accounting related issues.
Upon the closing of this Offering, the Audit Committee will consist of Dr.
Brown, Mr. De Leeuw and Dr. Pratt.
ACTION BY INDEPENDENT DIRECTORS
The Company's Bylaws require that a majority of the members of its Board of
Directors must be independent directors who are not officers or employees of the
Company. In addition to approval by the Board of Directors, the following
actions require approval by a majority of the independent directors:
- termination of the Management Contract between the Company and the
Manager;
- revisions to the Company's investment policies; and
- amendment of the Company's Bylaws.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION
DECISIONS
To date, the Company has had no compensation committee or other committee
performing an equivalent function. No officer or employee of the Company has
participated in deliberations by the Company's Board of Directors concerning
executive officer compensation except that Mr. Robbins and Mr. Fuller
participated in the determination of Mr. Dahl's compensation at the time he was
hired by the Company.
After the closing of this Offering, Mr. McKewon will be a director of the
Company and a member of the Compensation Committee. Mr. McKewon is an executive
officer and director of Accredited Home Lenders. Mr. Robbins serves as a
director of Accredited Home Lenders. The Company may acquire Mortgage Loans
pursuant to the Direct Purchase Program from Accredited Home Lenders.
DIRECTOR COMPENSATION
Each independent director of the Company will be paid annual compensation
of $15,000 with an additional $1,000 paid for attendance of a regularly
scheduled meeting and $500 for attendance of a special or committee meeting. All
directors will be reimbursed for any expenses related to attendance at meetings
of the
47
<PAGE> 49
Board of Directors or committees of the Board of Directors. In addition to cash
compensation, it is currently anticipated that each non-employee director of the
Company, except Mr. De Leeuw, will receive an initial grant of options to
purchase 7,500 shares of the Common Stock of the Company at fair market value
which will vest over a three year period (one-third every twelve months).
Thereafter, following the Annual Meeting of Stockholders, the Company
anticipates making annual grants to each non-employee director, except Mr. De
Leeuw, of options to purchase 2,500 shares of the Company's Common Stock which
will vest after one year.
LIMITATION OF LIABILITY AND INDEMNIFICATION
As permitted by the MGCL, the Company's Charter obligates the Company to
indemnify its present and former directors and officers and to pay or reimburse
reasonable expenses for such individuals in advance of the final disposition of
a proceeding to the maximum extent permitted from time to time by Maryland law.
The MGCL permits a corporation to indemnify its present and former directors and
officers, among others, against judgments, penalties, fines, settlements and
reasonable expenses actually incurred by them in connection with any proceeding
to which they may be made a party by reason of their service in those or other
capacities, unless it is established that (a) the act or omission of the
director or officer was material to the matter giving rise to such proceeding
and was committed in bad faith or was the result of active and deliberate
dishonesty, (b) the director or officer actually received an improper personal
benefit in money, property or services, or (c) in the case of any criminal
proceeding, the director or officer had reasonable cause to believe that the act
or omission was unlawful. The Bylaws implement the provisions relating to
indemnification contained in the Company's Charter. Maryland law permits the
charter of a Maryland corporation to include a provision limiting the liability
of its directors and officers to the corporation and its stockholders for money
damages, except to the extent that (i) the person actually received an improper
benefit or profit in money, property or services, or (ii) a judgment or other
final adjudication is entered in a proceeding based on a finding that the
person's action, or failure to act, was the result of active and deliberate
dishonesty and was material to the cause of action adjudicated in the
proceeding. The Company's Charter contains a provision providing for elimination
of the liability of its directors or officers to the Company or its stockholders
for money damages to the maximum extent permitted by Maryland law from time to
time. In addition, the Underwriters are indemnified against certain liabilities
by the Company under the Underwriting Agreement relating to the Offering. See
"Underwriting."
The Company will maintain officers' and directors' insurance for the
benefit of its officers and directors. The Company intends to enter into
indemnity agreements with each of its officers and directors pursuant to which
the Company will indemnify its officers and directors to the fullest extent
allowed by law.
48
<PAGE> 50
EXECUTIVE COMPENSATION
None of the Company's executive officers received compensation from the
Company or any of its affiliates in 1996. The following table sets forth
information with respect to the estimated compensation for 1997 for the five
executive officers of the Company.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
1997 LONG-TERM
COMPENSATION
1997 ANNUAL AWARDS
COMPENSATION --------------
(ESTIMATED) SECURITIES
------------------------- UNDERLYING
NAME AND PRINCIPAL POSITION SALARY(1) BONUS OPTIONS
------------------------------------ --------- ----------- --------------
<S> <C> <C> <C>
John M. Robbins..................... $ 266,250 (2) 220,000(3)
CEO, Chairman of the Board of
Directors
Jay M. Fuller....................... 221,875 (2) 220,000(3)
President and Chief Operating
Officer
Mark A. Conger...................... 133,125 (2) 30,400(3)
Executive Vice President and Chief
Financial Officer
John Dahl........................... 43,750 $100,000(4) 75,000(3)
Executive Vice President, Capital
Markets and Loan Production
Rollie O. Lynn...................... 88,750 (2) 26,400(3)
Senior Vice President, Capital
Markets
</TABLE>
- ---------------
(1) Includes cash compensation paid or estimated to be paid to employees of the
Company and the Manager. Based on amounts actually paid from February 11,
1997 through July 31, 1997 and estimated payments from August 1, 1997
through December 31, 1997 based on current salary levels. All salary amounts
are currently paid by the Manager. After the closing of this Offering, all
base salary amounts will be paid directly by the Company and reimbursed to
the Company by the Manager. See "The Manager."
(2) Bonuses during years 1997 and 1998 will be paid solely in the discretion of
the Board of Directors of the Company. Thereafter, bonuses will be paid as a
percentage of salary if certain financial objectives agreed upon by
management of the Company and the Board of Directors are achieved. See
"-- Employment Contracts and Termination of Employment and Change in Control
Arrangements". All bonus amounts are to be paid by the Manager. The Company
currently estimates that each executive officer may be paid a bonus in 1997
equal to between 75% and 100% of his annualized base salary.
(3) Includes options to purchase 80,000, 80,000, 16,000, 75,000 and 14,400
shares of Common Stock to be issued to Mr. Robbins, Mr. Fuller, Mr. Conger,
Mr. Dahl and Mr. Lynn, respectively, at the closing of this Offering
pursuant to their employment agreements. See "-- Employment Contracts and
Termination of Employment and Change of Control Arrangements."
(4) At the commencement of his employment, Mr. Dahl received a $100,000 note
from the Manager representing a signing bonus and his bonus for 1997.
49
<PAGE> 51
OPTION GRANTS
None of the executive officers of the Company were granted options to
purchase the Company's Common Stock in 1996. The following table sets forth
information concerning stock options granted or to be granted to the executive
officers in 1997. Each of the stock options is exercisable to purchase Common
Stock of the Company. None of the options has been exercised.
OPTION/SAR GRANTS IN 1997
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS IN 1997 POTENTIAL REALIZABLE
---------------------------------------------------- VALUE AT ASSUMED
NUMBER OF % OF TOTAL EXERCISE ANNUAL RATES OF STOCK
SECURITIES OPTIONS/SARS OR PRICE APPRECIATION FOR
UNDERLYING GRANTED TO BASE OPTION TERM
OPTIONS/SARS EMPLOYEES IN PRICE EXPIRATION -----------------------
NAME GRANTED (#)(1) 1997 (2) ($/SH) DATE 5%($)(3) 10%($)(3)
- --------------------------------- -------------- ------------ ------ --------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
John M. Robbins.................. 140,000(4) 21.4% $12.50 2/11/07 $1,100,568 $2,789,052
80,000(5) 12.3 15.00(6) (7) 754,672 1,912,488
Jay M. Fuller.................... 140,000(4) 21.4 12.50 2/11/07 1,100,568 2,789,052
80,000(5) 12.3 15.00(6) (7) 754,672 1,912,488
Mark A. Conger................... 14,400(8) 2.2 12.50 2/11/07 113,201 286,874
16,000(5) 2.5 15.00(6) (7) 150,934 382,498
John Dahl........................ 75,000(5) 11.5 15.00(6) (7) 707,505 1,792,958
Rollie O. Lynn................... 12,000(8) 1.8 12.50 2/11/07 94,334 239,062
14,400(5) 2.2 15.00(6) (7) 135,841 344,248
</TABLE>
- ---------------
(1) Options issued by the Company to date provide for acceleration of vesting at
such time as the Company receives cumulative gross proceeds from all public
or private offerings of at least $150,000,000. In addition, the options
accelerate and become fully vested upon the consummation of a transaction
resulting in a change of control of the Company.
(2) Based on currently outstanding options and options to be issued upon the
closing of this Offering. See "-- Employment Contracts and Termination of
Employment and Change in Control Arrangements."
(3) Amounts represent hypothetical gains that could be achieved for the
respective options if exercised at the end of the option term. The assumed
5% and 10% rates of stock price appreciation are mandated by rules of the
Securities and Exchange Commission and do not represent the Company's
estimate or projection of the future price of the Common Stock. The
potential realizable value set forth in the table is based on the fair
market value of the Common Stock on the date of grant, as determined by the
Board of Directors.
(4) Includes options to purchase 140,000 shares of Common Stock and SAR's with
respect to an additional 140,000 shares of Common Stock granted in tandem
with such options. The SARs are for 35% of the difference between the fair
market value of the Common Stock at the time the related option is exercised
and the exercise price, up to a maximum of $20 per share. Options and tandem
SARs are each vested and exercisable as to 20% of the shares of Common Stock
with an additional 20% to vest and become exercisable on February 11 of
1998, 1999, 2000 and 2001.
(5) Options to be granted upon the closing of this Offering. The exercise price
will equal the initial public offering price. These options will vest 20% on
the closing of this Offering with an additional 20% on each anniversary of
the closing of this Offering for four years.
(6) Based on an assumed initial public offering price of $15.00. See
"Underwriting."
(7) Options will expire 10 years after the closing of this Offering.
(8) Options to purchase Common Stock of the Company are vested and exercisable
as to 20% of the shares of Common Stock with an additional 20% to vest and
become exercisable on each of February 11, 1998, 1999, 2000 and 2001.
50
<PAGE> 52
1997 STOCK INCENTIVE PLAN
The Company's 1997 Stock Incentive Plan (the "Incentive Plan") provides for
the grant of incentive stock options, nonqualified stock options and stock
appreciation rights ("SARs"). The Incentive Plan was adopted on February 11,
1997 (the "Effective Date") and a total of 315,200 shares of Common Stock have
been reserved for issuance under the Incentive Plan. As of August 1, 1997, a
total of 315,200 shares of Common Stock were subject to outstanding options
under the Incentive Plan at an exercise price of $12.50 per share of Common
Stock. In addition, SARs with respect to an additional 280,000 shares were
outstanding at an exercise price of $12.50 per share of Common Stock. The SARs
were granted in tandem with options and provide the participant with the right
to receive payment equal to 35% of the difference between the fair market value
of a share of Common Stock on the date of the option exercise and the fair
market value of a share of Common Stock on the date of grant up to a maximum of
$20 per share. Payment upon the exercise of the SAR may be made in cash, shares
of Common Stock, or any combination thereof. The Company does not intend to
issue any additional options or SARs under the Incentive Plan.
1997 STOCK OPTION PLAN
The Board of Directors has reserved a total of 474,800 of Common Stock for
issuance under the Company's 1997 Stock Option Plan (the "Option Plan"). The
Option Plan permits the grant of options intended to qualify as incentive stock
options ("ISOs") within the meaning of section 422 of the Internal Revenue Code
of 1986, as amended, as well as nonstatutory stock options. Options to purchase
337,800 shares of Common Stock are reserved for issuance upon the closing of
this Offering and options to purchase 137,000 shares of Common Stock will remain
available for future grant under the Option Plan. Options may be granted to
employees (including officers and directors who are also employees), consultants
and directors and prospective employees, consultants, and directors although
only employees (including officers and directors who are also employees) may
receive ISOs. The exercise price per share of a nonstatutory stock option must
equal at least 85% of the fair market value of a share of Common Stock on the
date of grant, and in the case of an incentive stock option, must be no less
than the fair market value of a share of Common Stock on the date of grant. In
addition, the exercise price for any option granted to an optionee who owns 10%
or more of the total combined voting power of the Company or any parent or
subsidiary of the Company must equal at least 110% of the fair market value of a
share of Common Stock on the date of grant. Generally, options granted under the
Option Plan are immediately exercisable and must be exercised within ten years,
and shares subject to an option generally will vest over four years from the
date of grant. In the event of certain "change in control" transactions
involving the Company, shares subject to options granted under the Option Plan
will become fully vested and exercisable. In addition, the acquiring company may
assume or substitute for such outstanding options.
1997 EMPLOYEE STOCK PURCHASE PLAN
A total of 20,000 shares of Common Stock have been reserved for issuance
under the Company's 1997 Employee Stock Purchase Plan (the "Purchase Plan"),
none of which have yet been issued. The Purchase Plan permits eligible employees
to purchase Common Stock at a discount through accumulated payroll deductions.
Employees (including officers and directors who are also employees) are
generally eligible to participate in the Purchase Plan if they are customarily
employed for more than 20 hours per week and five months per calendar year. The
Purchase Plan is implemented through sequential offering periods, each of which
is approximately six months in duration. However, the initial offering period
under the Purchase Plan will commence on the closing of this Offering and will
end on July 31, 1998. Participants will purchase shares of Common Stock on the
last day of each offering period. The price at which shares are purchased under
the Purchase Plan is equal to 85% of the fair market value of a share of Common
Stock on the first day of the offering period or the last day of the offering
period, whichever is lower. Employees may end their participation in the
Purchase Plan at any time during an offering period and participation ends
automatically upon the participant's termination of employment.
51
<PAGE> 53
1997 OUTSIDE DIRECTORS STOCK OPTION PLAN.
A total of 60,000 shares of Common Stock have been reserved for issuance
under the Company's 1997 Outside Directors Stock Option Plan (the "Directors
Plan"). Prior to the closing of this Offering, no options have been granted
under the Directors Plan. The Directors Plan provides for the automatic grant of
nonstatutory stock options to directors of the Company who are not employees of
the Company or any parent or subsidiary of the Company or McCown De Leeuw & Co.
("Outside Directors"). On the closing of this Offering, each Outside Director
automatically will be granted under the Directors Plan an option to purchase
7,500 shares of Common Stock, and thereafter, each new Outside Director elected
after the closing of this Offering automatically will be granted on the date of
his or her initial election an option to purchase 7,500 shares of Common Stock
("initial options"). Shares of Common Stock subject to initial options will vest
in three equal annual increments following the date of grant. In addition, each
Outside Director, other than an Outside Director who has served on the Board of
Directors for less than six months, will thereafter be granted automatically an
option to purchase 2,500 shares of Common Stock at each annual meeting of the
stockholders provided the Outside Director continues to serve in such capacity
following the annual meeting ("annual options"). Shares of Common Stock subject
to annual options will become fully vested one year after the date of grant. The
exercise price per share of Common Stock for options granted under the Directors
Plan will be equal to the fair market value of a share of Common Stock on the
date of grant. Options granted under the Directors Plan must be exercised within
ten years from the date of grant. In the event of certain "change in control"
transactions involving the Company, shares subject to options granted under the
Directors Plan will become fully vested and exercisable. In addition, the
acquiring company may assume or substitute for such outstanding options.
EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE OF CONTROL
ARRANGEMENTS
The Manager has entered into Employment and Non-Competition Agreements with
Mr. Robbins and Mr. Fuller effective as of February 11, 1997 (the "Employment
Agreements"). The Employment Agreements are for a term of five years, commencing
on February 11, 1997 and provide for a minimum monthly base salary of not less
than $25,000 in the case of Mr. Robbins and $20,833 in the case of Mr. Fuller.
The Employment Agreements also provide for one year's salary to be paid upon
termination of either of such employees without cause. Bonus payments in 1997
and 1998 will be at the discretion of the Board of Directors of the Manager.
Subsequent to 1998, the Employment Agreements provide for payment of a bonus of
up to 100% base salary if certain financial targets and objectives are achieved.
Upon the closing of this Offering, each of Messrs. Robbins and Fuller will be
granted options to purchase 80,000 shares of the Company's Common Stock at an
exercise price equal to the initial public offering price.
Mr. Robbins and Mr. Fuller each purchased stock of the Manager which is
subject to repurchase by the Manager in the event the executive officer
terminates his employment with the Company and the Manager. See "Certain
Transactions."
The Manager has also entered into letter agreements with Mr. Conger, Mr.
Dahl and Mr. Lynn which provide for a base compensation of $150,000, $175,000
and $100,000 per year, respectively. In addition, the agreements provide for
bonus payments after 1998 of up to 75%, 100% and 75%, respectively, of the
employee's base salary if certain financial targets and objectives are achieved.
Mr. Conger and Mr. Lynn were each issued Contingent Warrants to purchase up to
34,299 shares of the common stock of the Manager at an exercise price of $0.01
per share (the "Contingent Warrants"). The Contingent Warrants expire on
February 11, 2007 and are exercisable only to the extent that certain letters of
credit which collateralize debt of the Manager are reduced from their current
principal amounts. Mr. Conger and Mr. Lynn were also issued percentage interests
in Holdings initially equal to 1.5% each. These interests may also vary based
upon the extent to which such letters of credit continue to be outstanding. See
"Certain Transactions." Upon the closing of this Offering, Mr. Conger, Mr. Dahl,
and Mr. Lynn will be granted options to purchase 16,000 shares, 75,000 shares
and 14,400 shares of the Company's Common Stock, respectively, at an exercise
price equal to the initial public offering price.
52
<PAGE> 54
All options and SARs granted to date and to be granted at the closing of
this Offering pursuant to the Incentive Plan and the Option Plan contain
provisions pursuant to which unvested portions of outstanding options become
immediately exercisable and vested upon a change of control in the Company, as
defined under the relevant plan.
Each of the officers of the Manager has modified his Employment Agreement
with the Manager to allow each such person to become an employee of the Company
upon the closing of this Offering. The Manager will reimburse the Company on a
dollar for dollar basis for the actual cost to the Company of paying the base
salaries of such officers. See "The Manager -- The Management Agreement."
FIDUCIARY OBLIGATIONS
Generally, under applicable state corporate law, a director of a company is
required to first offer to the company corporate opportunities learned of solely
as a result of his or her service as a member of the board of directors.
Maryland law provides that in order for a contract or other transaction between
a corporation and any of its directors or in which a director has a material
financial interest not to be void or voidable (i) the contract or transaction
must be fair and reasonable to the corporation or (ii) the fact of such interest
must be disclosed or known to the board or committee that authorizes, approves
or ratifies the contract or transaction and such authorization, approval or
ratification must be by a vote of the majority of disinterested directors.
The Company's policy is that the approval of the Board of Directors (with
any interested director abstaining) is required for any director, officer,
securityholder or affiliate of the Company (i) to engage for their own account
in realizing upon a corporate opportunity learned of solely as a result of their
service to or representation of the Company or (ii) to have any direct or
indirect pecuniary interest in any investment to be acquired or disposed of by
the Company or in any transaction to which the Company is a party or has an
interest.
53
<PAGE> 55
THE MANAGER
The Manager was created for the purpose of managing the day-to-day
operations of the Company, subject to direction by the Company's Board of
Directors. The Manager and the Company were financed by McCown De Leeuw & Co.,
TCW/Crescent Mezzanine, L.L.C., certain of their respective affiliates and
members of the management team of the Company. The Manager and its affiliates
own 1,614,000 shares of the Common Stock of the Company, which will constitute
approximately 20% of the outstanding shares of the Common Stock of the Company
immediately after the closing of this Offering. In addition, David E. De Leeuw
and George E. McCown, the principals of McCown De Leeuw & Co., currently serve
on the Board of Directors of the Company. Mr. De Leeuw will continue as a
director of the Company after the closing of this Offering.
The Manager funded the Company at its formation with a $20 million
investment through an intermediary entity. See "-- Relationship between the
Manager and the Company." Currently, the Manager derives substantially all of
its income from the Company, a majority of which is from dividends and incentive
fees. In addition, the executive officers of the Company are also the executive
officers of the Manager and four of the executive officers beneficially own an
interest in the Manager. See "Management of the Company -- Conflicts of
Interest," "Certain Transactions" and "Principal Stockholders."
The Manager has expertise in the acquisition and management of Mortgage
Assets, mortgage finance, asset/liability management and the management of
corporations in the real estate lending business. Each of the executive officers
of the Manager has between 10 and 24 years, and collectively, have an average of
19 years of experience in the residential mortgage industry. Four of the
executive officers have worked together previously as a management team.
However, the Manager and the management team has had no experience in managing a
REIT and limited experience with certain tailored Mortgage Loan products, and
there can be no assurance that the past experience will be appropriate to the
business of the Company. The Manager is currently in the process of recruiting
employees to support the Direct Purchase Program. At the closing of this
Offering, each employee of the Manager will become an employee of the Company.
See "Conflicts of Interest."
DIRECTORS AND EXECUTIVE OFFICERS OF THE MANAGER
The following table represents certain information concerning the Directors
and Executive Officers of the Manager:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
John M. Robbins (1) 50 Chairman of the Board and Chief Executive Officer
Jay M. Fuller (1) 47 President, Chief Operating Officer and Director
Mark A. Conger (1) 38 Executive Vice President and Chief Financial Officer
John Dahl (1) 44 Executive Vice President Capital Markets and Loan
Production
Rollie O. Lynn (1) 43 Senior Vice President, Capital Markets
Lisa S. Faulk (1) 40 Senior Vice President, Operations
David E. De Leeuw (1) 53 Director
George E. McCown (1) 62 Director
Jean-Marc Chapus 38 Director
</TABLE>
- ---------------
(1) See "Management of the Company -- Directors and Executive Officers of the
Company."
JEAN-MARC CHAPUS serves as a Director of the Manager. Mr. Chapus is
currently Managing Director and Portfolio Manager of Trust Company of the West,
a diversified investment management firm, and President of TCW/Crescent
Mezzanine Partners, L.L.C., a private investment fund. From 1991 to 1995, Mr.
Chapus served as a Managing Director and principal of Crescent Capital
Corporation, with primary responsibility for the firm's private lending and
private placement activities. From 1986 to 1991, Mr. Chapus was a First Vice
54
<PAGE> 56
President at Drexel Burnham Lambert Incorporated in the firm's High Yield and
Corporate Finance Departments. Mr. Chapus is currently a director of Starwood
Lodging Corporation and FirstAmerica Automotive, Inc. Mr. Chapus received his
A.B. degree in Economics from Harvard College in 1981 and his Masters in
Business Administration degree from Harvard Business School in 1986.
THE MANAGEMENT AGREEMENT
Term of the Management Agreement and Termination Fee
The Company has entered into a Management Agreement with the Manager for an
initial term of two years beginning February 11, 1997. The Management Agreement
is renewed automatically for successive one year periods unless a notice of
non-renewal is timely delivered by the Company. The Company may elect to prevent
the automatic renewal of the Management Agreement only by vote of both a
majority of the Board of Directors and a majority of the directors who are not
executive officers or employees of the Company followed by delivery of a written
notice of non-renewal to the Manager at least 60 days prior to the end of the
then-current period of the Management Agreement. The Management Agreement shall
terminate at the expiration of the then-current period in which such notice of
non-renewal is delivered. Upon non-renewal of the Management Agreement without
cause, a termination fee will be payable to the Manager in an amount equal to
the greater of (i) the fair value of the Management Agreement as established by
an independent appraiser, or (ii) three times the total of the base and
incentive compensation fees paid to the Manager for the four most recently
completed calendar quarters ending on or prior to the date of termination. In
addition, the Company has the right to terminate the Management Agreement at any
time upon the happening of certain specified events, after notice and an
opportunity to cure, including a material breach by the Manager of any provision
contained in the Management Agreement. Upon such a termination for cause, no
termination fee will be payable to the Manager.
Administrative Services Provided by the Manager
The Manager will be responsible for the day-to-day operations of the
Company and will perform such services and activities relating to the assets and
operations of the Company as may be appropriate, including:
(i) serving as the Company's consultant with respect to the
formulation of investment criteria and the preparation of policy
guidelines;
(ii) assisting the Company in developing criteria for Mortgage Asset
purchase commitments that are specifically tailored to the Company's long
term investment objectives and making available to the Company its
knowledge and experience with respect to Mortgage Loan underwriting
criteria;
(iii) representing the Company in connection with the purchase of, and
commitment to purchase, Mortgage Assets, including the formation of
Mortgage Asset purchase commitment criteria;
(iv) arranging for the issuance of Mortgage Securities from pools of
Mortgage Loans and providing the Company with supporting services in
connection with the creation of Mortgage Securities;
(v) furnishing reports and statistical and economic research to the
Company regarding the Company's activities and the performance of the
Manager;
(vi) monitoring and providing to the Board of Directors on an ongoing
basis price information and other data, which price information and other
data shall be obtained from certain nationally recognized dealers and other
entities that maintain markets in Mortgage Assets as selected by the Board
of Directors from time to time, and providing advice to the Board of
Directors to aid the Board of Directors in the selection of such dealers
and other entities;
(vii) administering the day-to-day operations of the Company and
performing and supervising the performance of such other administrative
functions necessary in the management of the Company as may be agreed upon
by the Manager and the Board of Directors, including the collection of
revenues and the payment of the Company's expenses, debts and obligations
and maintenance of appropriate computer services to perform such
administrative functions;
55
<PAGE> 57
(viii) designating a servicer and/or subservicer for those Mortgage
Loans sold to the Company by originators that have elected not to service
such Mortgage Loans and arranging for the monitoring and administering of
such servicer and subservicer;
(ix) counseling the Company in connection with policy decisions to be
made by the Board of Directors;
(x) evaluating and recommending hedging strategies to the Board of
Directors and, upon approval by the Board of Directors, facilitating the
implementation and monitoring the performance of these strategies;
(xi) supervising compliance with the REIT Provisions of the Code and
Investment Company Act status, including setting up a system to monitor
hedging activities on a periodic basis for such compliance;
(xii) establishing quality control procedures for the Mortgage Assets
of the Company, including audits of Mortgage Loan underwriting files and
the hiring of any agents with such particular knowledge and expertise as
may be appropriate to perform any such quality control procedures, and
administering, performing and supervising the performance of the quality
control procedures of the Company and performing and supervising the
performance of such other functions related thereto necessary or advisable
to assist in the performance of such procedures and the attainment of the
purposes thereof;
(xiii) upon request by and in accordance with the directions of the
Board of Directors, investing or reinvesting any money of the Company;
(xiv) conducting, or causing to be conducted, a legal document review
of each Mortgage Loan acquired to verify the accuracy and completeness of
the information contained in the Mortgage Loans, security instruments and
other pertinent documents in the mortgage file;
(xv) providing the Company with data processing, legal and
administrative services to the extent required to implement the business
strategy of the Company;
(xvi) providing all actions necessary for compliance by the Company
with all federal, state and local regulatory requirements applicable to the
Company in respect of its business activities, including preparing or
causing to be prepared all financial statements required under applicable
regulations and contractual undertakings and all reports and documents, if
any, required under the Securities Exchange Act of 1934, as amended;
(xvii) providing all actions necessary to enable the Company to make
required federal, state and local tax filings and reports and to generally
enable the Company to maintain its status as a REIT, including soliciting
stockholders for required information to the extent provided in the REIT
Provisions of the Code;
(xviii) communicating on behalf of the Company with the holders of the
equity and debt securities of the Company as required to satisfy the
reporting and other requirements of any governmental bodies or agencies and
to maintain effective relations with such holders; and
(xix) performing such other services as may be required from time to
time for management and other activities relating to the assets of the
Company as the Board of Directors shall reasonably request or the Manager
shall deem appropriate under the particular circumstances.
Except in certain circumstances, the Manager may not assign its rights and
duties under the Management Agreement, in whole or in part, without the written
consent of the Company and the consent of a majority of the Company's
independent directors who are not affiliated with the Manager.
Servicing of the Mortgage Loans
The Company expects to acquire certain of its Mortgage Loans on a servicing
released basis and to act as the servicer of such Mortgage Loans while they are
in the Company's Mortgage Asset portfolio. The Company will contract with a
subservicer for a fixed dollar fee per Mortgage Loan per year or a percentage of
the
56
<PAGE> 58
outstanding mortgage balance and the right to hold escrow account balances and
retain certain ancillary charges. The Manager will monitor the servicing of the
Mortgage Loans. Such monitoring will include, but not be limited to, the
following: (i) serving as the Company's consultant with respect to the servicing
of Mortgage Loans; (ii) collection of information and submission of reports
pertaining to the Mortgage Loans and to moneys remitted to the Manager or the
Company by any servicer; (iii) periodic review and evaluation of the performance
of each servicer to determine its compliance with the terms and conditions of
the applicable subservicing or servicing agreement and, if deemed appropriate,
recommending to the Company the termination of such agreement; (iv) acting as a
liaison between servicers and the Company and working with servicers to the
extent necessary to improve their servicing performance; (v) review of and
recommendations as to fire losses, easement problems and condemnation,
delinquency and foreclosure procedures with regard to the Mortgage Loans; (vi)
review of servicer's delinquency, foreclosure and other reports on Mortgage
Loans; (vii) supervising claims filed under any mortgage insurance policies; and
(viii) enforcing the obligation of any servicer to repurchase Mortgage Loans
from the Company. The Manager may enter into subcontracts with other parties,
including its affiliates, to provide any such services for the Manager.
Management Fees
The Manager will receive an annual base management fee payable monthly in
arrears of an amount representing the monthly portion of the per annum
percentage of "gross mortgage assets" of the Company and its subsidiaries. These
fees shall be applicable during the entire operational stage of the Company's
business. The Company will pay to the Manager the following management fees and
incentive compensation:
- 1/8 of 1% per year, to be paid monthly (the "Agency Percentage"), of the
principal amount of Agency Securities;
- 3/8 of 1% per year, to be paid monthly (the "Non-Agency Percentage"), of
the principal amount of all other Mortgage Assets; and
- 25% of the amount by which the Company's net income (calculated prior to
deduction of this incentive compensation fee) exceeds the annualized
return on equity equal to the average Ten Year U.S. Treasury Rate plus
2%.
The term "gross mortgage assets" means for any month the aggregate book
value of the consolidated Mortgage Assets of the Company and its subsidiaries,
before allowances for depreciation or bad debts or other similar noncash
allowances, computed at the end of such month prior to any dividend distribution
made during each month.
The incentive compensation calculation and payment will be made quarterly
in arrears. The term "Return on Equity" is calculated for any quarter by
dividing the Company's Net Income for the quarter by its Average Net Worth for
the quarter. For such calculations, the "Net Income" of the Company means the
net income of the Company determined in accordance with GAAP before the
Manager's incentive compensation, the deduction for dividends paid and net
operating loss deductions arising from losses in prior periods. A deduction for
the Company's interest expenses for borrowed money is taken when calculating Net
Income. "Average Net Worth" for any period means (i) $20,165,000 plus (ii) the
arithmetic average of the sum of the gross proceeds from any offering of its
equity securities by the Company, before deducting any underwriting discount and
commissions and other expenses and costs relating to the offering, plus the
Company's retained earnings (without taking into account any losses incurred in
prior periods and excluding amounts reflecting taxable income to be distributed
as dividends and amounts reflecting valuation allowance adjustments) computed by
taking the daily average of such values during such period. The definition
"Return on Equity" is used only for purposes of calculating the incentive
compensation payable, and is not related to the actual distributions received by
stockholders. The incentive compensation payments to the Manager will be made
before any income distributions are made to the stockholders of the Company.
The Manager's base management fee shall be calculated by the Manager within
15 days after the end of each month, and such calculation shall be promptly
delivered to the Company. The Company is obligated to
57
<PAGE> 59
pay the amount of the final base management fee in excess of the amount paid to
the Manager at the beginning of the month pursuant to the Manager's good faith
estimate within 30 days after the end of each month. The Company shall pay the
incentive fee with respect to each fiscal quarter within 15 days following the
delivery to the Company of the Manager's written statement setting forth the
computation of the incentive fee for such quarter. The Manager shall compute the
annual incentive fee within 45 days after the end of each fiscal year, and any
required adjustments shall be paid by the Company or the Manager within 15 days
after the delivery of the Manager's written computation to the Company.
Although no additional fees will be payable to the Manager solely as a
result of this Offering, investment of the net proceeds of this Offering will
result in an increase in the Company's Mortgage Assets and, thus, an increase in
the management fees to be paid to the Manager. See "Conflicts of Interest."
Set forth below for illustrative purposes only is a breakdown of management
fees which might be paid to the Manager under hypothetical circumstances. For
purposes of this illustration, the following is assumed: (i) that the aggregate
principal amount of Mortgage Assets held by the Company remained static at $1.13
billion for an entire year; (ii) that the relative allocation of Mortgage Assets
for the entire year remained static at 70% and 30%, respectively, for the Agency
Percentage and Non-Agency Percentage, and (iii) the Company's net income
(calculated prior to the deduction of the incentive compensation fee) exceeded
by $5,000,000 the annualized Return on Equity equal to the average Ten Year U.S.
Treasury Rate plus 2%.
<TABLE>
<CAPTION>
ANNUAL MANAGER COMPENSATION
- ----------------------------------------------------------------------
BASE COMPENSATION
- --------------------------------------- INCENTIVE TOTAL
AGENCY NON-AGENCY TOTAL COMPENSATION COMPENSATION
- --------- ----------- ----------- ----------- ------------
<S> <C> <C> <C> <C>
$988,750 $1,271,250 $2,260,000 $1,250,000 $3,510,000
</TABLE>
The Company emphasizes that the foregoing information is provided for
illustrative purposes only and that actual compensation could be less or
greater. Significant variables in the determination of actual compensation paid
to the Manager include (i) the time period over which funds are invested in
Mortgage Assets, (ii) the relative allocation of Mortgage Assets between Agency
Securities and all other Mortgage Assets, (iii) the Company's actual net income
which will be affected by (i) and (ii) above plus other factors, such as the
Company's ability to execute its leveraging strategy and interest rate
fluctuations and (iv) fluctuations (positive or negative) in the average Ten
Year U.S. Treasury Rate which may be caused by factors unrelated to the
performance of the Manager.
Expenses
The Company will pay all operating expenses except those specifically
required to be borne by the Manager under the Management Agreement. The
operating expenses required to be borne by the Manager include the compensation
and other employment costs of the Manager's officers in their capacities as such
and the cost of office space and out-of-pocket costs, equipment and other
personnel required for performance of the Company's day-to-day operations. The
expenses that will be paid by the Company will include issuance and transaction
costs incident to the acquisition, disposition and financing of investments,
regular legal and auditing fees and expenses, the fees and expenses of the
Company's directors, premiums for directors' and officers' liability insurance,
premiums for fidelity and errors and omissions insurance, subservicing expenses,
the costs of printing and mailing proxies and reports to stockholders, and the
fees and expenses of the Company's custodian and transfer agent, if any. The
Company, rather than the Manager, will also be required to pay expenses
associated with litigation and other extraordinary or non-recurring expenses.
Expense reimbursements will be made monthly.
58
<PAGE> 60
Salary Reimbursements
The Company will employ certain employees of the Manager involved in the
day-to-day operations of the Company, including the Company's executive
officers, so that such employees may maintain certain benefits that are
available only to employees of the Company under the Internal Revenue Code of
1986, as amended. These benefits include the ability to receive incentive stock
options under the 1997 Stock Option Plan and to participate in the Company's
Employee Stock Purchase Plan. In order to receive the aggregate benefits of the
Management Agreement originally negotiated between the Company and the Manager,
the Company will pay the base salaries of such employees and will be reimbursed
monthly by the Manager for all costs incurred with respect to such payments.
Limits of Responsibility
Pursuant to the Management Agreement, the Manager will not assume any
responsibility other than to render the services called for thereunder and will
not be responsible for any action of the Company's Board of Directors in
following or declining to follow its advice or recommendations. The Manager, its
directors, officers, stockholders and employees will not be liable to the
Company, any issuer of Mortgage Securities, any subsidiary of the Company, the
independent directors, the Company's stockholders or any subsidiary's
stockholders for acts performed in accordance with and pursuant to the
Management Agreement, except by reason of acts or omissions constituting bad
faith, willful misconduct, gross negligence or reckless disregard of their
duties under the Management Agreement. The Manager is a newly formed company and
does not have significant assets other than its interest in the Management
Agreement. Consequently, there can be no assurance that the Company would be
able to recover any damages for claims it may have against the Manager. The
Company has agreed to indemnify the Manager, and its respective directors,
officers, stockholders and employees with respect to all expenses, losses,
damages, liabilities, demands, charges and claims arising from any acts or
omissions of the Manager made in good faith in the performance of its duties
under the Management Agreement and not constituting bad faith, willful
misconduct, gross negligence or reckless disregard of its duties. The Management
Agreement does not limit or restrict the right of the Manager or any of its
officers, directors, employees or Affiliates to engage in any business or to
render services of any kind to any other person, including the purchase of, or
rendering advice to others purchasing Mortgage Assets which meet the Company's
policies and criteria, except that the Manager and its officers, directors or
employees will not be permitted to provide for any such services to any
residential mortgage REIT, other than the Company or another REIT sponsored by
the Manager or its Affiliates, which has operating policies and strategies
different in one or more material respects from those of the Company, as
confirmed by a majority of the independent directors of the Company. See "Risk
Factors -- Conflicts of Interest; Management also Employed by and Owns
Securities of Manager."
RELATIONSHIP BETWEEN THE MANAGER AND THE COMPANY
In addition to the Management Agreement between the Manager and the
Company, the Manager also has limited rights in the shares of the Company's
Common Stock held by Holdings, an intermediate holding company. The Manager
contributed $20 million in 1997 to Holdings which used the funds to acquire the
shares of the Company's Common Stock. In exchange for its contribution to
Holdings, the Manager received a senior right to receive distributions equal to
5% per quarter of the capital contributed by the Manager, compounded quarterly
to the extent unpaid. After payment of the preference amount in full, the
Manager has a right to receive approximately 50% of any remaining distributions
in repayment of its capital contribution. The Manager has also been appointed to
oversee the day-to-day operations of Holdings. However, after payment in full of
its preference amount and return of its capital contribution, the Manager will
have no further rights to distributions from Holdings. Holdings' sole asset is
its shares of the Company's Common Stock and its sole source of income is
dividends declared by the Company.
59
<PAGE> 61
CERTAIN TRANSACTIONS
DISCUSSION OF SECURITIES PURCHASE AGREEMENT
The following summary of certain terms from the Securities Purchase
Agreement (as defined below) between Manager and the Company does not purport to
be complete and is subject to and qualified in its entirety by the Securities
Purchase Agreement, a copy of which is filed as an exhibit to the Registration
Statement of which this Prospectus is a part. When particular provisions or
terms used in the Securities Purchase Agreement are referred to, the actual
provisions (including definitions of terms) are incorporated by reference to
such agreement.
In connection with the private financing of the Manager and the Company in
February 1997, the Company, the Manager and Holdings entered into a Securities
Purchase Agreement, dated as of February 11, 1997 (the "Securities Purchase
Agreement"), with the institutional investors therein named (the "Investors")
providing for, among other things, the purchase by the Investors of senior
secured notes due February 11, 2002 (the "Notes") issued by the Manager.
Covenants
The Securities Purchase Agreement contains various covenants of the Company
and the Manager setting forth requirements respecting financial reporting, and
minimum acceptable financial ratio compliance and limitations on operating
activities, among other things, which will apply so long as the Notes remain
outstanding. The following is a general summary of certain covenants affecting
the activities of the Company (as opposed to the Manager).
Limitation on Restricted Payments. The Company shall not make any
investment except "Permitted REIT Investments," as defined in the Securities
Purchase Agreement; provided, however, that any Multifamily Mortgage Assets,
Commercial Mortgage Assets, Derivative Mortgage Securities, Fixed Rate Mortgage
Assets and REMIC residual interests to be acquired, together with any
investments to be made in Permitted REIT Subsidiaries, will not constitute
Permitted REIT Investments to the extent that the aggregate fair market value
thereof on any date, when aggregated with the aggregate fair market value of all
other Multifamily Mortgage Assets, Commercial Mortgage Assets, Derivative
Mortgage Securities, Fixed Rate Mortgage Assets, REMIC residual interests and
investments in Permitted REIT Subsidiaries held on such date, would exceed 5% of
the total fair market value on such date of the Mortgage Assets then held.
Limitation on Transactions with Affiliate. Neither the Company nor the
Manager shall sell, lease, transfer or otherwise dispose of any of its
properties or assets to or purchase any property or assets from, or enter into
any contract, agreement, understanding, loan, advance or guarantee with, or for
the benefit of, an affiliate of either company (an "Affiliate Transaction"),
unless (i) such Affiliate Transaction is on terms that are no less favorable to
such company than those that could have been obtained in a comparable
transaction by such company from an unrelated person, and (ii) with respect to
any Affiliate Transaction (or series of related Affiliate Transactions)
involving or having a potential value of more than $100,000, in addition to
compliance with clause (i), such Affiliate Transaction shall also be approved by
a majority of the disinterested members of the board of directors of the
Manager, and (iii) with respect to any Affiliate Transaction (or series of
related Affiliate Transactions) involving or having a potential value of more
than $2,500,000, in addition to compliance with clauses (i) and (ii), the board
of directors of the Manager shall have obtained an opinion of a nationally
recognized investment banking firm or appraiser to the effect that such
transaction is fair, from a financial point of view, to such company; provided,
however, that the board of directors of the Manager need not obtain such an
opinion in connection with immaterial modifications of the Management Agreement.
Limitation on Dividend and Other Payment Restrictions Affecting
Subsidiaries. The Company shall not, directly or indirectly, create or otherwise
cause or suffer to exist or become effective any consensual encumbrance or
restriction on the ability of the Company to (a) pay dividends or make any other
distributions on its Common Stock or any other interest or participation in, or
measured by its profits, or pay any indebtedness owed to the Manager, (b) make
loans or advances to the Manager or (c) transfer any of its
60
<PAGE> 62
properties or assets to the Manager, except for certain limited encumbrances or
restrictions specified in the Securities Purchase Agreement.
Limitation on Capital Expenditures. The Company shall not make or incur
capital expenditures in any fiscal year in an aggregate amount in excess of
$100,000.
Limitation on Business and Tax Status. The Company shall not engage in any
business or activity other than the business of investing in and disposing of
Permitted REIT Investments. Prior to the consummation of a Qualified Public
Equity Offering (which this Offering will constitute), the Company shall not
invest in or hold any B/C Mortgages (i.e., below "A" or "A-") unless the
aggregate fair market value of the investments by the Company in B/C Mortgages
does not exceed 20% of the aggregate fair market value of all of the assets of
the Company. At all times, the Company shall operate and qualify as a REIT under
Section 856 et seq. of the Code, the income of which is taxed pursuant to
Section 857 of the Code.
Leverage Ratio and Indebtedness of the Company. During each calendar month,
the Company shall cause the average of the fifteen REIT Leverage Ratios
calculated on each of the last fifteen days of such calendar month,
respectively, to be less than or equal to the REIT Leverage Ratio Limit. "REIT
Leverage Ratio" means, on any date, the ratio of (a) the total consolidated
indebtedness of the Company on such date (subject to certain exceptions) to (b)
the fair market value (as determined in good faith by the Board of Directors of
the Company) of all the assets of the Company on such date (other than any such
assets upon which there is a lien that secures any such Permitted REIT
Indebtedness). "REIT Leverage Ratio Limit" means (i) 0.925 during all calendar
months other than the calendar months described in clauses (ii) and (iii) of
this definition, (ii) 0.935 during the sixty days immediately preceding the
anticipated closing date of a Qualified Public Equity Offering and (iii) 0.935
during the first sixty days following such anticipated closing date, if any such
anticipated Qualified Public Equity Offering of REIT is not consummated on or
prior to such anticipated closing date.
The Company shall not, directly or indirectly, incur any indebtedness other
than Permitted REIT Indebtedness, which is defined as any and all forms of
obligations of the Company accounted for as liabilities under GAAP, including,
without limitation, notes, bonds and Reverse Repurchase Agreements; provided
that such obligations have a maturity of greater than 30 days and either (x)
bear a variable interest rate that resets at least once every six months or (y)
bear a fixed rate of interest and have a maturity of not more than one year;
provided, further, that either: (a)(i) under the agreement pursuant to which any
such obligation is incurred, such obligation is secured primarily by Permitted
REIT Investments and the amount of such obligation may not exceed the fair
market value of the collateral as determined under such agreement, or (ii) such
obligations are REMIC regular interests or other forms of structured securities
(x) that, in any case, are obligations with recourse limited solely to the
collateral securing such obligations and (y) as to which the fair market value
of the Company's equity interest in the entity issuing such security does not
exceed 5% of the fair market value of the collateral securing such obligations
on the date of incurrence of such obligations; or (b) the obligations constitute
one of the following: (i) trade debt incurred in the ordinary course of
business; (ii) indebtedness secured by permitted liens; (iii) capitalized lease
obligations in an aggregate amount not to exceed at any one time $500,000; or
(iv) indebtedness of the Company in an amount not to exceed $1,000,000 incurred
solely for the purchase or financing of fixed or capital assets acquired by the
Company.
Investment, Hedging and Leverage Policy. At least once during each fiscal
year, the Board of Directors of the Company shall adopt a statement of policy
regarding investment of the assets of the Company, the duration of the Company's
assets and liabilities, hedging activities to be conducted by the Company, the
range of leverage ratios to be maintained by the Company and the types of
indebtedness that may be incurred by the Company, which statement of policy
shall be at least as detailed as the similar statement of policy initially
adopted and delivered to the Investors; provided, however, that any material
difference between any policy to be so adopted and the then most recently
adopted policy must be approved by Investors holding a majority interest in the
Notes. At least once during each fiscal year, the Manager shall engage a
professional services firm, which is not an affiliate of the Manager or the
Company, to issue a report (a "REIT Compliance Report") addressed to each of the
Manager, Holdings, the Company and the Investors stating whether the Company has
complied in all material respects with the then most recently adopted policy.
The Company
61
<PAGE> 63
shall not permit to exist, on a general portfolio average basis, a repricing
differential between the Company's assets and liabilities of greater than 180
days.
Board of Director Observation Rights. Each of the Investors shall have the
right to have one representative present (whether in person or by telephone) at
all meetings of the Board of Directors (and committees thereof) of the Manager
and the Company; provided that such representative shall not be entitled to vote
at such meetings.
Events of Default. The Securities Purchase Agreement provides for certain
Events of Default including, among other things, breach of a covenant by the
Manager or the Company (subject to a 30-day cure period in certain instances)
and failure by the Company to pay dividends for two consecutive quarters
beginning in October 1997. Upon an Event of Default, the Notes can be
accelerated and the shares of Common Stock of the Company pledged to secure the
Notes can be sold to satisfy the debt. See "Risk Factors -- Additional Risk
Factors -- Default of Manager Under Securities Purchase Agreement; Restrictive
Covenants."
Amendment and Waiver. The Securities Purchase Agreement can be amended, and
waivers of terms and provisions given, by the Investors holding a majority
interest in the Notes.
OTHER TRANSACTIONS
On February 11, 1997, in connection with the founding of the Company,
Holdings, Mr. Robbins and Mr. Fuller each purchased 1.6 million, 8,000 and 6,000
shares, respectively, of the Company's Common Stock at a price of $12.50 per
share in cash.
The Company and the Manager entered into a Management Agreement pursuant to
which the Company pays base Management fees and incentive compensation to the
Manager. The executive officers and directors of the Company are also executive
officers and directors of the Manager. See "The Manager -- The Management
Agreement" and "Conflicts of Interest."
On February 11, 1997, in connection with the founding of the Manager, the
Manager issued the following securities to the Company's officers, directors,
beneficial holders of 5% or more of the Company's Common Stock and their
Affiliates:
- The Manager issued 1,000,000 shares of its common stock to entities
affiliated with McCown De Leeuw & Co. and 127,032 shares to each of Mr.
Robbins and Mr. Fuller. The shares of Manager's common stock were issued
at a purchase price of $0.01 per share and paid in cash.
- The Manager issued 12% senior secured notes in the principal amount of
$25,000,000 (the "Notes") to entities affiliated with TCW/Crescent
Mezzanine, L.L.C. The Notes were issued at a purchase price equal to
$994.56 per $1,000 principal amount, paid in cash.
- The Manager issued warrants to purchase up to 666,667 shares of its
common stock to entities affiliated with TCW/Crescent Mezzanine, L.L.C.
The warrants were purchased at a price of $0.20 per warrant share paid in
cash and have an exercise price of $0.01 per share. The warrants expire
on February 11, 2007; the Company paid TCW/Crescent Mezzanine, L.L.C. a
fee of approximately $500,000 in connection with the sale and issuance of
the Notes and these warrants.
- The Manager issued warrants to purchase up to 17,149, 51,448, 34,299, and
34,299 shares of its common stock to entities affiliated with
TCW/Crescent Mezzanine, L.L.C., entities affiliated with McCown De Leeuw
& Co., Mr. Conger and Mr. Lynn, respectively. The warrants have an
exercise price of $0.01 per share. The warrants expire on February 11,
2007. The warrants are not currently exercisable and will become
exercisable only to the extent that certain letters of credit issued for
the benefit of the Manager are reduced over a period of four years.
The shares of the Manager's common stock held by Mr. Robbins and Mr. Fuller
are subject to a right of repurchase by the Manager which lapses after the
earlier of February 11, 2002 and the closing of a public offering by the Company
which generates proceeds to the Company, which, when aggregated with the
proceeds of all other public offerings, equals $150 million or more. The
purchase price for the shares of the Manager's common stock in the event of a
repurchase shall be (i) equal to the book value of the securities in the event
that the executive officer's employment is terminated without cause or in the
event that the
62
<PAGE> 64
executive officer resigns for good cause, (ii) fair market value of the
securities in the case of death, and (iii) a nominal amount in all other
circumstances.
In connection with the founding of the Manager and the Company, on February
11, 1997, Holdings issued 0.75%, 2.25%, 1.5% and 1.5% ownership interests to
entities affiliated with TCW/Crescent Mezzanine, L.L.C., entities affiliated
with McCown De Leeuw & Co., Mr. Conger and Mr. Lynn, respectively.
The Manager and MDC Management Company II, L.P., ("MDC"), an affiliate of
McCown De Leeuw & Co., have entered into an advisory services agreement pursuant
to which MDC will provide financial and management services to the Manager.
Under the terms of the advisory services agreement, the Manager has accrued an
initial fee obligation of $500,000 with an additional annual fee of $250,000 to
be paid to MDC. The annual payments will begin in March 1998 and continue for a
minimum of five years. The initial fee will be paid only after the Manager has
retired certain debt and preferred equity obligations.
The Company intends to enter into indemnity agreements with each of its
officers and directors. For a description of the limitations of liability
applicable to the Company's officers and directors, see "Management of the
Company -- Limitation of Liability and Indemnification."
CONFLICTS OF INTEREST
Manager
Certain Common
Executive Officers(1) Services Fees(3)
Directors(2)
AMREIT
- ---------------
(1) John Robbins, Jay Fuller, Mark Conger, John Dahl, Rollie Lynn and Lisa Faulk
will serve as executive officers of both the Company and the Manager. See
"Management of the Company" and "The Manager."
(2) John Robbins, Jay Fuller and David De Leeuw will serve as directors of both
the Company and the Manager. See "Management of the Company" and "The
Manager."
(3) In evaluating Mortgage Assets for investment, Management could emphasize
maximizing income at the expense of other criteria, in order to achieve
higher compensation for the Manager, which could result in increased risk to
the value of the Company's portfolio of Mortgage Assets. See "Risk
Factors -- Conflicts of Interests; Management Also Employed by and Owns
Securities of Manager" and "The Manager -- The Management
Agreement -- Management Fees."
The Company is subject to conflicts of interest with the Manager and
certain of its executive officers, directors and principal stockholders. Upon
the closing of this Offering, John Robbins, Jay Fuller, Mark Conger, John Dahl,
Rollie Lynn and Lisa Faulk will serve as executive officers of both the Company
and the Manager, and Messrs. Robbins and Fuller will also be directors and
principal stockholders of the Company. In addition, David DeLeeuw will serve as
a director of the Company and the Manager. Mr. DeLeeuw and George McCown are
affiliated with MDC. MDC and TCW/Crescent Mezzanine L.L.C. are principal
stockholders of the Manager and affiliates of Holdings, a principal stockholder
of the Company.
Under the terms of the Management Agreement, the Manager will receive an
annual base management fee payable monthly in arrears and the Manager will have
the opportunity to earn incentive compensation under the Management Agreement
based upon the Company's annualized net income. The Management Agreement does
not limit or restrict the right of the Manager to render services of any kind to
any third party except that the Manager and its officers, directors or employees
will not be permitted to provide any such services to any real estate investment
trust which invests in residential Mortgage Assets other than the Company.
Additionally, under the Company's Capital Policy, the Company is not prohibited
from acquiring Mortgage Assets originated by affiliates of the Manager. See "The
Manager -- The Management Agreement -- Management Fees."
The base management fee is calculated using the Agency Percentage and the
Non-Agency Percentage. Because the Non-Agency Percentage is three times greater
than the Agency Percentage, the Manager has an
63
<PAGE> 65
incentive to invest in Mortgage Assets other than Agency Securities in order to
maximize the base management fee. By holding a larger amount of Mortgage Assets
other than Agency Securities, the Company's portfolio may be subject to a higher
risk of loss. In addition, the incentive compensation fee paid to the Manager
increases proportionally with any increase in the Company's net income.
Accordingly, in evaluating Mortgage Assets for investment and other strategies,
Management could emphasize maximizing income at the expense of other criteria,
in order to achieve higher incentive compensation for the Manager, which could
result in increased risk to the value of the Company's portfolio of Mortgage
Assets. Moreover, in the event of termination of the Management Agreement
without cause, the termination fee will not be less than three times the total
of the base and incentive compensation fees paid to the Manager for the four
most recently completed calendar quarters ending on or prior to the date of
termination. See "The Manager -- The Management Agreement -- Term of the
Management Agreement and Termination Fee."
Management of the Company is, however, subject to the Capital Policy and
other guidelines which have been approved by the Company's Board of Directors.
Upon the closing of this Offering, a majority of the directors of the Company
will be independent directors and not subject to the conflicts of interest set
forth under this section. Additionally, the executive officers of the Company
also own securities of the Company, with an incentive to ensure the success of
the Company's operations. Moreover, certain large stockholders of the Manager
are also the beneficial owners of shares of the Company's Common Stock. Finally,
because the Manager derives substantially all of its income from the Company,
the success of the Manager is substantially dependent upon the success of the
Company. See "Risk Factors -- Conflicts of Interests, Management Also Employed
by and Owns Securities of Manager," "-- Policies and Strategies May Be Revised
at the Discretion of the Board of Directors," "-- Management and Certain
Affiliates Will Control Approximately 20% of Outstanding Shares after Offering,"
"Management of the Company -- Directors and Executive Officers of the Company,"
"-- Action by Independent Directors," "-- Benefits of this Offering to
Management," "The Manager -- Relationship between the Manager and the Company,"
"Certain Transactions," and "Principal Stockholders."
64
<PAGE> 66
PRINCIPAL STOCKHOLDERS
The following table sets forth certain information known to the Company
with respect to beneficial ownership of the Company's Common Stock as of October
1, 1997, and as adjusted to reflect the sale of Common Stock being offered
hereby, by (i) each person known to the Company to beneficially own more than 5%
of the Company's Common Stock, (ii) each director, (iii) each executive officer
and (iv) all directors and executive officers as a group. Unless otherwise
indicated in the footnotes to the table, the beneficial owners named have, to
the knowledge of the Company, sole voting and investment power with respect to
the shares of Common Stock beneficially owned, subject to community property
laws where applicable.
<TABLE>
<CAPTION>
PERCENTAGE OF SHARES
BENEFICIALLY OWNED
------------------------
AFTER
NUMBER OF SHARES BEFORE OFFERING
NAME OF BENEFICIAL OWNER BENEFICIALLY OWNED OFFERING (1)
- ---------------------------------------------------------- ------------------ ---------- -----------
<S> <C> <C> <C>
MDC REIT Holdings, LLC (2)................................ 1,600,000 91.7% 19.4%
John M. Robbins (3)....................................... 52,000 3.0 *
Jay M. Fuller (3)......................................... 50,000 2.9 *
Mark A. Conger (4)........................................ 6,080 * *
John Dahl (5)............................................. 15,000 * *
Rollie O. Lynn (6)........................................ 5,280 * *
David E. De Leeuw (7)..................................... -- -- --
George E. McCown (7)...................................... -- -- --
All Directors and Executive Officers as a group
(7 persons) (3)(7)(8)................................... 128,360 7.4 1.6
</TABLE>
- ---------------
* Less than 1%
(1) Assuming no exercise of the Underwriters' over-allotment option.
(2) The address for MDC REIT Holdings, L.L.C. is 445 Marine View Avenue, Suite
230, Del Mar, CA 92014. The Manager is the managing member of Holdings
pursuant to an operating agreement. Accordingly, the Manager may be deemed
to have voting control of the shares of the Company's Common Stock held by
Holdings with respect to ordinary and usual matters. See "The Manager."
Transactions which could result in the disposition of the shares of the
Company's Common Stock require the approval of the members of Holdings
having membership interests which constitute more than 80% of all
membership interests. No single member or group of affiliated members of
Holdings holds 80% of the membership interests of Holdings. The shares of
the Company's Common Stock held by the LLC have been pledged as collateral
to certain entities affiliated with TCW/Crescent Mezzanine, L.L.C. See
"Risk Factors -- Additional Risk Factors -- Default of Manager Under
Securities Purchase Agreement; Restrictive Covenants."
(3) Includes 44,000 shares of Common Stock of the Company issuable upon
exercise of options within 60 days of October 1, 1997, including shares
issuable upon exercise of options to be issued at the closing of this
Offering. Mr. Robbins and Mr. Fuller are directors of the Manager. They
each disclaim beneficial ownership of the shares of the Company's Common
Stock held by Holdings. See Note 2 above.
(4) Includes 6,080 shares of Common Stock of the Company issuable upon exercise
of options within 60 days of October 1, 1997, including shares issuable
upon exercise of options to be issued at the closing of this Offering.
(5) Includes 15,000 shares of Common Stock of the Company issuable upon
exercise of options within 60 days of October 1, 1997, including shares
issuable upon exercise of an option to be issued at the closing of this
Offering.
(6) Includes 5,280 shares of Common Stock of the Company issuable upon exercise
of options within 60 days of October 1, 1997, including shares issuable
upon options to be issued at the closing of this Offering.
(7) Mr. De Leeuw and Mr. McCown are also directors of the Manager. They each
disclaim beneficial ownership of the shares of the Company's Common Stock
held by Holdings. See Note 2 above.
(8) Includes 99,360 shares of Common Stock of the Company issuable upon
exercise of options within 60 days of August 10, 1997, including shares
issuable upon the exercise of options to be issued at the closing of this
Offering.
65
<PAGE> 67
DESCRIPTION OF CAPITAL STOCK
GENERAL
The following summary is a description of provisions of the Company's
Charter and Bylaws with respect to the Company's Capital Stock. This summary
does not purport to be complete and is qualified by reference to the Charter and
Bylaws. Under the Company's Charter and Bylaws, the total number of shares of
all classes of capital stock that the Company has authority to issue is
25,000,000 shares, par value $0.01 per share, initially consisting of 25,000,000
shares of Common Stock. The Board of Directors is authorized to classify or
reclassify any unissued portion of the authorized shares of capital stock to
provide for the issuance of shares in other classes or series, including
Preferred Stock in one or more series. The Company has no current intention to
issue shares of any class or series other than Common Stock.
COMMON STOCK
The holders of Common Stock are entitled to one vote for each share held of
record on all matters submitted to a vote of the stockholders. Holders of Common
Stock do not have cumulative voting rights in the election of directors, which
means that holders of more than 50% of the shares of Common Stock voting for the
election of directors can elect all of the directors if they choose to do so and
the holders of the remaining shares cannot elect any directors. Subject to
preferential rights with respect to any outstanding shares of preferred stock,
holders of Common Stock are entitled to receive ratably such dividends as may be
declared by the Board of Directors out of funds legally available therefor. The
shares of Common Stock are not convertible into any other class or series.
Holders of Common Stock do not have preemptive rights, which means they have no
right to acquire any additional shares of Common Stock that may be issued by the
Company at a subsequent date. The outstanding shares of Common Stock are, and
the Shares to be outstanding upon the closing of this Offering will be, fully
paid and nonassessable. The Shares have been approved for listing on the New
York Stock Exchange, subject only to official notice of issuance.
ADDITIONAL CLASSES AND SERIES OF STOCK
The Board of Directors is authorized to establish one or more classes and
series of stock, including series of preferred stock, from time to time, and to
establish the number of shares in each class or series and to fix the
preferences, conversion and other rights, voting powers, restrictions,
limitations as to dividends, qualifications and terms and conditions of
redemption of such class or series, without any further vote or action by the
stockholders, unless such action is required by applicable law or the rules of
any stock exchange or automated quotation system on which the Company's
securities may be listed or traded. The issuance of additional classes or series
of capital stock may have the effect of delaying, deferring or preventing a
change in control of the Company without further action of the stockholders. The
issuance of additional classes or series of capital stock with voting and
conversion rights may adversely affect the voting power of the holders of
capital stock of the Company, including the loss of voting control to others.
The ability of the Board of Directors to issue additional classes or series of
capital stock, while providing flexibility in connection with possible
acquisitions or other corporate purposes, could have the effect of making it
more difficult for a third party to acquire, or of discouraging a third party
from acquiring, a majority of the outstanding voting stock of the Company, even
where such an acquisition may be beneficial to the Company or its stockholders.
REGISTRATION RIGHTS
Upon the closing of this Offering the beneficial holders of approximately
1.6 million shares of Common Stock of the Company are entitled to certain rights
with respect to the registration of such shares under the Securities Act.
Subject to certain limitations, if the Company registers any of its securities
under the Securities Act, either for its own account or the account of other
security holders, such holders are entitled to written notice of the
registration and are entitled to include such shares therein, provided, among
other conditions, that the underwriters of any offering have the right to limit
the number of such shares included in the registration. All fees, costs and
expenses of such registrations (other than the underwriting discount and
commissions and legal expenses of such holders) will generally be borne by the
Company. In addition,
66
<PAGE> 68
beginning 180 days after the closing of this Offering, certain of such
beneficial holders may require, on up to six occasions, the Company to use its
best efforts to file a registration statement under the Securities Act at the
Company's expense with respect to their shares of Common Stock, subject to
certain conditions and limitations. Further, such holders may require the
Company, at the Company's expense, to register their shares on Form S-3 when
such form becomes available to the Company, subject to certain conditions and
limitations.
REPURCHASE OF SHARES AND OWNERSHIP LIMITATIONS
Two of the requirements of qualification for the tax benefits accorded by
the REIT Provisions of the Code are that (1) during the last half of each
taxable year not more than 50% in value of the outstanding shares may be owned
directly or indirectly by five or fewer individuals (the "50%/5 stockholder
test") and (2) there must be at least 100 stockholders on 335 days of each
taxable year of 12 months.
In order that the Company may meet these requirements at all times, the
Charter prohibits any person from acquiring or holding, directly or indirectly,
shares of Common Stock in excess of 9.9% in value of the aggregate of the
outstanding shares of Common Stock or in excess of 9.9% in value of the
aggregate of the outstanding shares of Common Stock of the Company. For this
purpose, the term "ownership" is defined in accordance with the REIT Provisions
of the Code and the constructive ownership provisions of Section 544 of the
Code, as modified by Section 856(h)(1)(B) of the Code.
For purposes of the 50%/5 stockholder test, the constructive ownership
provisions applicable under Section 544 of the Code attribute ownership of
securities owned by a corporation, partnership, estate or trust proportionately
to its stockholders, partners or beneficiaries, attribute ownership of
securities owned by family members and partners to other members of the same
family, treat securities with respect to which a person has an option to
purchase as actually owned by that person, and set forth rules as to when
securities constructively owned by a person are considered to be actually owned
for the application of such attribution provisions (i.e., "reattribution").
Thus, for purposes of determining whether a person holds shares of Common Stock
in violation of the ownership limitations set forth in the Charter, many types
of entities may own directly more than the 9.9% limit because such entities'
shares are attributed to its individual stockholders. For example, it is
contemplated that Holdings and perhaps other corporate investors will own in
excess of 9.9% of the Common Stock outstanding immediately after closing of this
Offering. On the other hand, a person will be treated as owning not only shares
of Common Stock actually or beneficially owned, but also any shares of Common
Stock attributed to such person under the attribution rules described above.
Accordingly, under certain circumstances, shares of Common Stock owned by a
person who individually owns less than 9.9% of the shares of Common Stock
outstanding may nevertheless be in violation of the ownership limitations set
forth in the Charter. Ownership of shares of the Company's Common Stock through
such attribution is generally referred to as constructive ownership. The 100
stockholder test is determined by actual, and not constructive, ownership. The
Company will have greater than 100 stockholders of record.
The Charter further provides that if any transfer of shares of Common Stock
occurs which, if effective, would result in any person beneficially or
constructively owning shares of Common Stock in excess or in violation of the
above transfer or ownership limitations, then that number of shares of Common
Stock the beneficial or constructive ownership of which otherwise would cause
such person to violate such limitations (rounded to the nearest whole shares)
shall be automatically transferred to a trustee (the "Trustee") as trustee of a
trust (the "Trust") for the exclusive benefit of one or more charitable
beneficiaries (the "Charitable Beneficiary"), and the intended transferee shall
not acquire any rights in such shares. Shares of Common Stock held by the
Trustee shall be issued and outstanding shares of Common Stock. The intended
transferee shall not benefit economically from ownership of any shares held in
the Trust, shall have no rights to dividends, and shall not possess any rights
to vote or other rights attributable to the shares held in the Trust. The
Trustee shall have all voting rights and rights to dividends or other
distributions with respect to shares held in the Trust, which rights shall be
exercised for the exclusive benefit of the Charitable Beneficiary. Any dividend
or other distribution paid to the intended transferee prior to the discovery by
the Company that shares of Common Stock have been transferred to the Trustee
shall be paid with respect to such shares to the Trustee by the intended
transferee upon demand and any dividend or other distribution authorized but
unpaid
67
<PAGE> 69
shall be paid when due to the Trustee. The Board of Directors of the Company
may, in their discretion, waive these requirements on owning shares in excess of
the ownership limitations.
Within 20 days of receiving notice from the Company that shares of Common
Stock have been transferred to the Trust, the Trustee shall sell the shares held
in the Trust to a person, designated by the Trustee, whose ownership of the
shares will not violate the ownership limitations set forth in the Charter. Upon
such sale, the interest of the Charitable Beneficiary in the shares sold shall
terminate and the Trustee shall distribute the net proceeds of the sale to the
intended transferee and to the Charitable Beneficiary as follows. The intended
transferee shall receive the lesser of (1) the price paid by the intended
transferee for the shares or, if the intended transferee did not give value for
the shares in connection with the event causing the shares to be held in the
Trust (e.g., in the case of a gift, devise or other such transaction), the
Market Price (as defined below) of the shares on the day of the event causing
the shares to be held in the Trust, and (2) the price per share received by the
Trustee from the sale or other disposition of the shares held in the Trust. Any
net sales proceeds in excess of the amount payable to the intended transferee
shall be immediately paid to the Charitable Beneficiary. In addition, shares of
Common Stock transferred to the Trustee shall be deemed to have been offered for
sale to the Company, or its designee, at a price per share equal to the lesser
of (i) the price per share in the transaction that resulted in such transfer to
the Trust (or, in the case of a devise or gift, the Market Price at the time of
such devise or gift) and (ii) the Market Price on the date the Company, or its
designee, accepts such offer. The Company shall have the right to accept such
offer until the Trustee has sold shares held in the Trust. Upon such a sale to
the Company, the interest of the Charitable Beneficiary in the shares sold shall
terminate and the Trustee shall distribute the net proceeds of the sale to the
intended transferee.
The term "Market Price" on any date shall mean, with respect to any class
or series of outstanding shares of the Company's stock, the Closing Price (as
defined below) for such shares on such date. The "Closing Price" on any date
shall mean the last sale price for such shares, regular way, or, in case no such
sale takes place on such day, the average of the closing bid and asked prices,
regular way, for such shares, in either case as reported in the principal
consolidated transaction reporting system with respect to securities listed or
admitted to trading on the New York Stock Exchange ("NYSE") or, if such shares
are not listed or admitted to trading on the NYSE, as reported on the principal
consolidated transaction reporting system with respect to securities listed on
the principal national securities exchange on which such shares are listed or
admitted to trading or, if such shares are not listed or admitted to trading on
any national securities exchange, the last quoted price, or, if not so quoted,
the average of the high bid and low asked prices in the over-the-counter market,
as reported by the National Association of Securities Dealers, Inc. Automated
Quotation System or, if such system is no longer in use, the principal other
automated quotation system that may then be in use or, if such shares are not
quoted by any such organization, the average of the closing bid and asked prices
as furnished by a professional market maker making a market in such shares
selected by the Board of Directors or, in the event that no trading price is
available for such shares, the fair market value of the shares, as determined in
good faith by the Board of Directors.
Every owner of more than 5%, in the case of 2,000 or more stockholders of
record and 1% in the case of more than 200 but fewer than 2,000 stockholders of
record, of all classes or series of the Company's stock, within 30 days after
the end of each taxable year, is required to give written notice to the Company
stating the name and address of such owner, the number of shares of each class
and series of stock of the Company beneficially owned and a description of the
manner in which such shares are held. Each such owner shall provide to the
Company such additional information as the Company may request in order to
determine the effect, if any, of such beneficial ownership on the Company's
status as a REIT and to ensure compliance with the ownership limitations.
Subject to certain limitations, the Board of Directors may increase or
decrease the ownership limitations. In addition, to the extent consistent with
the REIT Provisions of the Code, the Board of Directors may waive the ownership
limitations for and at the request of certain purchasers in this Offering or
subsequent purchasers.
68
<PAGE> 70
The provisions described above may inhibit market activity and the
resulting opportunity for the holders of the Company's Common Stock to receive a
premium for their shares that might otherwise exist in the absence of such
provisions. Such provisions also may make the Company an unsuitable investment
vehicle for any person seeking to obtain ownership of more than 9.9% of the
outstanding shares of Common Stock. See "Risk Factor -- Ownership of Common
Stock May Be Restricted."
TRANSFER AGENT AND REGISTRAR
American Stock Transfer & Trust Company will act as the transfer agent and
registrar with respect to the Common Stock.
SHARES ELIGIBLE FOR FUTURE SALE
Upon the closing of this Offering, the Company will have outstanding
8,114,000 shares of Common Stock. Of the outstanding shares, the 6,500,000
shares of Common Stock to be sold in this Offering will be freely tradable
without restriction or further registration under the Securities Act, unless
purchased by "affiliates" of the Company, as that term is defined in Rule 144
under the Securities Act.
The remaining 1,614,000 shares of Common Stock to be outstanding after the
closing of this Offering will be "restricted securities" as that term is defined
in Rule 144, none of which will become eligible for sale under Rule 144 until
February 11, 1998. As described below, Rule 144 permits resales of restricted
securities subject to certain restrictions.
In general, under Rule 144, as currently in effect, a person (or persons
whose shares are aggregated) who beneficially owned shares for at least one
year, including any person who may be deemed an "affiliate" of the Company,
would be entitled to sell within any three month period a number of such shares
that does not exceed the greater of 1% of the shares of the Company's Common
Stock then outstanding or the average weekly trading volume in the Company's
Common Stock during the four calendar weeks preceding the date on which notice
of the sale is filed with the Commission. A person who is not deemed to have
been an "affiliate" of the Company at any time during the three months preceding
a sale and who has beneficially owned shares for at least two years would be
entitled to sell such shares under Rule 144 without regard to the volume
limitation described above.
Beginning 180 days after the closing of this Offering, the beneficial
holders of the 1,614,000 shares of Common Stock currently outstanding may
require the Company to register such shares of sale in the public market. See
"Description of Capital Stock -- Registration Rights."
The Company and its stockholders have agreed with the Underwriters that,
for a period of 180 days following the closing of this Offering, they will not
sell, contract to sell or otherwise dispose of any shares of Common Stock or
rights to acquired such shares (other than pursuant to employee plans) without
the prior written consent of PaineWebber Incorporated.
In addition, upon the closing of this Offering, the Company will have
outstanding options to purchase 683,000 shares of Common Stock and will have
reserved an aggregate of 167,000 additional shares of Common Stock for grant of
future options under the Option Plan and the Directors Plan. The Company has
also reserved 20,000 shares of Common Stock for issuance under the Purchase
Plan. The Company intends to file Registration Statements on form S-8 covering
the shares that have been reserved for issuance under these plans, thus
permitting the resale of such shares in the public market after such stock
options have been exercised.
69
<PAGE> 71
FEDERAL INCOME TAX CONSEQUENCES
THE FOLLOWING DISCUSSION SUMMARIZES THE MATERIAL FEDERAL INCOME TAX
CONSEQUENCES THAT MAY BE RELEVANT TO A PROSPECTIVE HOLDER OF SHARES OF STOCK OF
THE COMPANY. THIS DISCUSSION IS BASED ON CURRENT LAW. THE FOLLOWING DISCUSSION
IS NOT EXHAUSTIVE OF ALL POSSIBLE TAX CONSEQUENCES. IT DOES NOT GIVE A DETAILED
DISCUSSION OF ANY STATE, LOCAL OR FOREIGN TAX CONSEQUENCES, NOR DOES IT DISCUSS
ALL OF THE ASPECTS OF FEDERAL INCOME TAXATION THAT MAY BE RELEVANT TO A
PROSPECTIVE STOCKHOLDER IN LIGHT OF SUCH STOCKHOLDER'S PARTICULAR CIRCUMSTANCES
OR TO CERTAIN TYPES OF STOCKHOLDERS (INCLUDING INSURANCE COMPANIES, CERTAIN
TAX-EXEMPT ENTITIES, FINANCIAL INSTITUTIONS, BROKER/DEALERS, FOREIGN
CORPORATIONS AND PERSONS WHO ARE NOT CITIZENS OR RESIDENTS OF THE UNITED STATES)
SUBJECT TO SPECIAL TREATMENT UNDER FEDERAL INCOME TAX LAWS.
EACH PROSPECTIVE PURCHASER OF COMMON STOCK OF THE COMPANY SHOULD CONSULT
WITH HIS OR HER OWN TAX ADVISOR REGARDING THE SPECIFIC CONSEQUENCES TO HIM OR
HER OF THE PURCHASE, OWNERSHIP AND SALE OF STOCK IN AN ENTITY ELECTING TO BE
TAXED AS A REIT, INCLUDING THE FEDERAL, STATE, LOCAL, FOREIGN AND OTHER TAX
CONSEQUENCES OF SUCH PURCHASE, OWNERSHIP, SALE AND ELECTION AND THE POTENTIAL
CHANGES IN APPLICABLE TAX LAWS.
GENERAL
The Code provides special tax treatment for organizations that qualify and
elect to be taxed as REITs. The discussion below summarizes the material
provisions applicable to the Company as a REIT for federal income tax purposes
and to its stockholders in connection with their ownership of shares of stock of
the Company. However, it is impractical to set forth in this Prospectus all
aspects of federal, state, local and foreign tax law that may have tax
consequences with respect to an investor's purchase of the Company's Common
Stock. The discussion of various aspects of federal taxation contained herein is
based on the Code, administrative regulations, judicial decisions,
administrative rulings and practice, all of which are subject to change. In
brief, if certain detailed conditions imposed by the Code are met, entities that
invest primarily in real estate assets, including Mortgage Loans, and that
otherwise would be taxed as corporations are, with certain limited exceptions,
not taxed at the corporate level on their taxable income that is currently
distributed to their stockholders. This treatment eliminates most of the "double
taxation" (at the corporate level and then again at the stockholder level when
the income is distributed) that typically results from the use of corporate
investment vehicles. A qualifying REIT, however, may be subject to certain
excise and other taxes, as well as normal corporate tax, on Taxable Income that
is not currently distributed to its stockholders. See "-- Taxation of the
Company."
The Company plans to make an election to be taxed as a REIT under the Code
commencing with its taxable year ending December 31, 1997.
OPINION OF SPECIAL COUNSEL
Jeffers, Wilson, Shaff & Falk, LLP ("Special Tax Counsel"), special tax and
ERISA counsel to the Company, has advised the Company in connection with this
Offering of the Company's Common Stock and the Company's election to be taxed as
a REIT. Based on existing law and certain representations made to Special Tax
Counsel by the Company and assuming that the Company operates in the manner
described in this Prospectus, in the opinion of Special Tax Counsel, commencing
with the Company's taxable year ending December 31, 1997, the Company has been
organized in conformity with the requirements for qualification as a REIT under
the Code and the Company's actual and proposed method of operation described in
this Prospectus and as represented by the Company to Special Tax Counsel will
enable the Company to qualify as a REIT. However, whether the Company will in
fact so qualify will depend on actual operating results and compliance with the
various tests for qualification as a REIT relating to its income, assets,
distributions,
70
<PAGE> 72
ownership and certain administrative matters, the results of which may not be
reviewed by Special Tax Counsel. Moreover, certain aspects of the Company's
method of operations have not been considered by the courts or the Service.
There can be no assurance that the courts or the Service will agree with this
opinion. In addition, qualification as a REIT depends on future transactions and
events that cannot be known at this time. Accordingly, Special Tax Counsel is
unable to opine whether the Company will in fact qualify as a REIT under the
Code in all events. In the opinion of Special Tax Counsel, the section of the
Prospectus entitled "Federal Income Tax Consequences" identifies and fairly
summarizes the federal income tax consequences that are likely to be material to
holders of the Common Stock of the Company, and, to the extent such summaries
involve matters of law, such statements of law are correct under the Code.
Special Tax Counsel's opinions are based on various assumptions and on the
factual representations of the Company concerning its business and assets.
Accordingly, no assurance can be given that the actual results of the Company's
operation for any one taxable year will satisfy such requirements. See
"Termination or Revocation of REIT Status" below.
The opinions of Special Tax Counsel are based upon existing law, including
the Internal Revenue Code of 1986, as amended, existing Treasury Regulations,
Revenue Rulings, Revenue Procedures, proposed regulations and case law, all of
which are subject to change either prospectively or retroactively. Moreover,
relevant laws or other legal authorities may change in a manner that could
adversely affect the Company or its stockholders. Special Tax Counsel's opinions
also are based in part on the opinion of special Maryland counsel, Piper &
Marbury, L.L.C., that the Company is duly organized and existing under Maryland
law.
In the event that the Company does not qualify as a REIT in any year, it
will be subject to federal income tax as a domestic corporation and its
stockholders will be taxed in the same manner as stockholders of ordinary
corporations. To the extent that the Company would, as a consequence, be subject
to potentially significant tax liabilities, the amount of earnings and cash
available for distribution to its stockholders would be reduced. See
"Termination or Revocation of REIT Status" below.
REQUIREMENTS FOR QUALIFICATION AS A REIT
To qualify for tax treatment as a REIT under the Code, the Company must
meet certain tests which are described immediately below.
Stock Ownership Tests
For all taxable years after the first taxable year for which a REIT
election is made, the Company's shares of stock must be transferable and must be
held by a minimum of 100 persons for at least 335 days of a 12 month year (or a
proportionate part of a short tax year). The Company must also use the calendar
year as its taxable year. In addition, at all times during the second half of
each taxable year, no more than 50% in value of the shares of any class of the
stock of the Company may be owned directly or indirectly by five or fewer
individuals. In determining whether the Company's shares are held by five or
fewer individuals, the attribution rules of Sections 544 of the Code apply. For
a description of these attribution rules, see "Description of Capital Stock."
The Company's Charter imposes certain repurchase provisions and transfer
restrictions to avoid more than 50% by value of any class of the Company's stock
being held by five or fewer individuals (directly or constructively) at any time
during the last half of any taxable year. Such repurchase and transfer
restrictions will not cause the stock not to be treated as "transferable" for
purposes of qualification as a REIT. The Company intends to satisfy both the 100
stockholder and 50%/5 stockholder individual ownership limitations described
above for as long as it seeks qualification as a REIT. See "Description of
Capital Stock." The Company uses the calendar year as its taxable year for
income tax purposes.
Asset Tests
On the last day of each calendar quarter at least 75% of the value of the
Company's assets must consist of Qualified REIT Assets, government securities,
cash and cash items (the "75% of assets test"). The Company expects that
substantially all of its assets will be Qualified REIT Assets. Qualified REIT
Assets include interests in real property, interests in Mortgage Loans secured
by real property and interests in REMICs.
71
<PAGE> 73
On the last day of each calendar quarter, of the investments in securities
not included in the 75% of assets test, the value of any one issuer's securities
may not exceed 5% by value of the Company's total assets and the Company may not
own more than 10% of any one issuer's outstanding voting securities. Hedging
contracts (other than those which are Qualified REIT Assets) and certain types
of other Mortgage Assets may be treated as securities of the entity issuing such
agreements or interests. The Company will take measures to prevent the value of
such contracts, interests or assets issued by any one entity to exceed 5% of the
value of the Company's assets as of the end of each calendar quarter. Moreover,
pursuant to its compliance guidelines, the Company intends to monitor closely
(on not less than a quarterly basis) the purchase and holding of the Company's
assets in order to comply with the above assets tests. In particular, as of the
end of each calendar quarter the Company intends to limit and diversify its
ownership of hedging contracts and other mortgage securities that do not
constitute Qualified REIT Assets to less than 25%, in the aggregate, by value of
its portfolio, to less than 5% by value as to any single issuer, and to less
than 10% of the voting stock of any single issuer (collectively the "25% of
assets limits"). If such limits are ever exceeded, the Company intends to take
appropriate remedial action to dispose of such excess assets within the 30 day
period after the end of the calendar quarter, as permitted under the Code.
When purchasing mortgage-related securities, the Company may rely on
opinions of counsel for the issuer or sponsor of such securities given in
connection with the offering of such securities, or statements made in related
offering documents, for purposes of determining whether and to what extent those
securities (and the income therefrom) constitute Qualified REIT Assets (and
income) for purposes of the 75% of assets test (and the source of income tests
discussed below). If the Company invests in a partnership, the Company will be
treated as receiving its share of the income and loss of the partnership and
owning a proportionate share of the assets of the partnership and any income
from the partnership will retain the character that it had in the hands of the
partnership. If the Company forms a taxable affiliate to conduct mortgage
origination and other activities, the Company will obtain an opinion of counsel
that the proposed organization and ownership of an interest in the taxable
affiliate will not adversely affect the Company's status as a REIT.
Where a failure to satisfy any of the asset tests discussed above results
from an acquisition of securities or other property during a quarter, the
failure can be cured by disposition of sufficient non-qualifying assets within
30 days after the close of such quarter. The Company intends to maintain
adequate records of the value of its assets to determine its compliance with the
asset tests, and intends to take such action as may be required to cure any
failure to satisfy the test within 30 days after the close of any quarter.
Gross Income Tests
The Company must meet three separate income-based tests for each year in
order to qualify a REIT.
1. The 75% Test. At least 75% of the Company's gross income (the "75% of
income test") for the taxable year must be derived from the following sources:
(i) rents from real property; (ii) interest (other than interest based in whole
or in part on the income or profits of any person) on obligations secured by
mortgages on real property or on interests in real property; (iii) gains from
the sale or other disposition of interests in real property and real estate
mortgages other than gain from stock in trade, inventory or property held
primarily for sale to customers in the ordinary course of the Company's trade or
business ("dealer property"); (iv) dividends or other distributions on shares in
other REITs and, provided such shares are not dealer property, gain from the
sale of such shares; (v) abatements and refunds of real property taxes; (vi)
income from the operation, and gain from the sale, of property acquired at or in
lieu of a foreclosure of the mortgage secured by such property or as a result of
a default under a lease of such property ("foreclosure property"); (vii) income
received as consideration for entering into agreements to make loans secured by
real property or to purchase or lease real property (including interests in real
property and interests in mortgages on real property) (for example, commitment
fees); and (viii) income attributable to stock or debt instruments acquired with
the proceeds from the sale of stock or certain debt obligations ("new capital")
of the Company received during the one year period beginning on the day such
proceeds were received ("qualified temporary investment income"). The
investments that the Company intends to make (as described under "Description of
Mortgage Assets") will give rise primarily to mortgage interest qualifying under
the 75% of income test.
72
<PAGE> 74
2. The 95% Test. In addition to deriving 75% of its gross income from the
sources listed above, at least an additional 20% of the Company's gross income
for the taxable year must be derived from those sources, or from dividends,
interest or gains from the sale or disposition of stock or other securities that
are not dealer property (the "95% of income test"). Income attributable to
mortgage warehouse participations, Mortgage Securities (other than Qualified
REIT Assets) that the Company holds directly, dividends on stock, interest on
any other obligations not secured by real property, and gains from the sale or
disposition of stock or other securities that are not Qualified REIT Assets will
constitute qualified income for purposes of the 95% of income test only, but
will not be qualified income for purposes of the 75% of income test. Income from
mortgage servicing contracts, loan guarantee fees (or other contracts under
which the Company would earn fees for performing services) and hedging (other
than from Qualified REIT Assets) will not qualify for either the 95% or 75% of
income tests. The Company intends to severely limit its acquisition of any
assets or investments the income from which does not qualify for purposes of the
95% of income test. Moreover, in order to help ensure compliance with the 95% of
income test and the 75% of income tests, the Company intends to limit
substantially all of the assets that it acquires to Qualified REIT Assets. The
policy of the Company to maintain REIT status may limit the type of assets,
including hedging contracts, that the Company otherwise might acquire.
For purposes of determining whether the Company complies with the 75% of
income test and the 95% of income test detailed above, gross income does not
include gross income from "prohibited transactions." A "prohibited transaction"
is one involving a sale of dealer property, other than foreclosure property. Net
income from "prohibited transactions" is subject to a 100% tax. See "-- Taxation
of the Company."
3. The 30% of Income Limit. For the 1997 taxable year, the Company must
also derive less than 30% of its gross income from the sale or other disposition
of (i) Qualified REIT Assets held for less than four years, other than
foreclosure property or property involuntarily or compulsorily converted through
destruction, condemnation or similar events, (ii) stock or securities held for
less than one year (including hedges) and (iii) property in a prohibited
transaction (together the "30% of income limit"). As a result of the Company's
having to closely monitor such gains, the Company may have to hold Mortgage
Loans and Mortgage Securities although the Company might otherwise have opted
for the disposition of such assets for short term gains, in order to ensure that
it maintains compliance with the 30% of income limit. Effective with the 1998
taxable year, the 30% of income limit has been repealed from the Code and will
no longer apply. The Company expects to make the election to treat any real
property taken by the Company in foreclosure, or in lieu of foreclosure, of a
Mortgage Loan as foreclosure property.
The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions, futures contracts and sales
of Mortgage Assets to comply with the 75% of income test, the 95% of income test
and, for the 1997 taxable year, the 30% of income limit. See "-- Taxation of the
Company" for a discussion of the potential tax cost of the Company's selling
certain Mortgage Securities on a regular basis. In order to help insure its
compliance with the REIT Provisions of the Code, the Company has adopted
guidelines the effect of which will be to limit the Company's ability to earn
certain types of income, including income from hedging, other than hedging
income from Qualified REIT Assets. See "Business -- Risk Management -- Interest
Rate Risk Management."
If the Company fails to satisfy one or both of the 75% or 95% of income
tests for any year, it may face either (a) assuming such failure was for
reasonable cause and not willful neglect, a 100% tax on the greater of the
amounts of income by which it failed to comply with the 75% test of income or
the 95% of income test, reduced by estimated related expenses or (b) loss of
REIT status. There can be no assurance that the Company will always be able to
maintain compliance with the gross income tests for REIT qualification despite
the Company's periodic monitoring procedures. Moreover, there is no assurance
that the relief provisions for a failure to satisfy either the 95% or the 75% of
income tests will be available in any particular circumstance.
73
<PAGE> 75
Distribution Requirement
The Company must distribute to its stockholders on a pro rata basis each
year an amount equal to (i) 95% of its Taxable Income before deduction of
dividends paid and excluding net capital gain, plus (ii) 95% of the excess of
the net income from foreclosure property over the tax imposed on such income by
the Code, less (iii) any "excess noncash income" (the "95% distribution test").
See "Dividend Policy and Distributions." The Company intends to make
distributions to its stockholders in amounts sufficient to meet the 95%
distribution test. Such distributions must be made in the taxable year to which
they relate or, if declared before the timely filing of the Company's tax return
for such year and paid not later than the first regular dividend payment after
such declaration, in the following taxable year. A nondeductible excise tax,
equal to 4% of the excess of such required distributions over the amounts
actually distributed will be imposed on the Company for each calendar year to
the extent that dividends paid during the year (or declared during the last
quarter of the year and paid during January of the succeeding year) are less
than the sum of (i) 85% of the Company's "ordinary income," (ii) 95% of the
Company's capital gain net income plus, and (iii) income not distributed in
earlier years.
The Service has ruled that if a REIT's dividend reinvestment plan allows
stockholders of the REIT to elect to have cash distributions reinvested in
shares of the REIT at a purchase price equal to at least 95% of fair market
value on the distribution date, then such cash distributions qualify under the
95% distribution test. See "Dividend Reinvestment Plan."
If the Company fails to meet the 95% distribution test as a result of an
adjustment to the Company's tax returns by the Service, the Company by following
certain requirements set forth in the Code, may pay a deficiency dividend within
a specified period which will be permitted as a deduction in the taxable year to
which the adjustment is made. The Company would be liable for interest based on
the amount of the deficiency dividend. A deficiency dividend is not permitted if
the deficiency is due to fraud with intent to evade tax or to a willful failure
to file a timely tax return.
RECORDKEEPING REQUIREMENTS
A REIT is required to maintain records regarding the actual and
constructive ownership of its shares, and other information, and within 30 days
after the end of its taxable year, to demand statements from persons owning
above a specified level of the REIT's shares (e.g., if the Company has over 200
but fewer than 2,000 stockholders of record, from persons holding 1% or more of
the Company's outstanding shares of stock and if the Company has 200 or fewer
stockholders of record, from persons holding 1/2% or more of the stock)
regarding their ownership of shares. The Company must maintain, as part of the
Company's records, a list of those persons failing or refusing to comply with
this demand. Stockholders who fail or refuse to comply with the demand must
submit a statement with their tax returns setting forth the actual stock
ownership and other information. The Company also is required to maintain
permanent records of its assets as of the last day of each calendar quarter. The
Company intends to maintain the records and demand statements as required by
these regulations.
TERMINATION OR REVOCATION OF REIT STATUS
The Company's election to be treated as a REIT will be terminated
automatically if the Company fails to meet the requirements described above. In
that event, the Company will not be eligible again to elect REIT status until
the fifth taxable year which begins after the year for which the Company's
election was terminated unless all of the following relief provisions apply: (i)
the Company did not willfully fail to file a timely tax return with respect to
the termination taxable year; (ii) inclusion of incorrect information in such
return was not due to fraud with intent to evade tax; and (iii) the Company
establishes that failure to meet requirements was due to reasonable cause and
not willful neglect. The Company may also voluntarily revoke its election,
although it has no intention of doing so, in which event the Company will be
prohibited, without exception, from electing REIT status for the year to which
the revocation relates and the following four taxable years.
74
<PAGE> 76
If the Company fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions do not apply, the Company would be subject to tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. Distributions to stockholders of the Company with
respect to any year in which the Company fails to qualify as a REIT would not be
deductible by the Company nor would they be required to be made. Failure to
qualify as a REIT would result in the Company's reduction of its distributions
to stockholders in order to pay the resulting taxes. If, after forfeiting REIT
status, the Company later qualifies and elects to be taxed as a REIT again, the
Company could face significant adverse tax consequences.
TAXATION OF THE COMPANY
In any year in which the Company qualifies as a REIT, it generally will not
be subject to federal income tax on that portion of its taxable income or net
capital gain which is distributed to its stockholders. The Company will,
however, be subject to tax at normal corporate rates upon any net income or net
capital gain not distributed. The Company intends to distribute substantially
all of its taxable income to its stockholders on a pro rata basis in each year.
See "Dividend Policy and Distributions."
In addition, the Company will also be subject to a tax of 100% of net
income from any prohibited transaction and will be subject to a 100% tax on the
greater of the amount by which it fails either the 75% or 95% of income tests,
reduced by approximated expenses, if the failure to satisfy such tests is due to
reasonable cause and not willful neglect and if certain other requirements are
met. The Company may be subject to the alternative minimum tax on certain items
of tax preference.
If the Company acquires any real property as a result of foreclosure, or by
a deed in lieu of foreclosure, the Company may elect to treat such real property
as "foreclosure property." Net income from the sale of foreclosure property is
taxable at the maximum federal corporate rate, currently 35%. Income from
foreclosure property will not be subject to the 100% tax on prohibited
transactions. The Company will determine whether to treat such real property as
foreclosure property on the tax return for the fiscal year in which such
property is acquired.
The Company may securitize Mortgage Loans and sell such Mortgage Loans
through a taxable subsidiary. However, if the Company itself were to sell such
Mortgage Securities on a regular basis, there is a substantial risk that they
would be deemed "dealer property" and that all of the profits from such sales
would be subject to tax at the rate of 100% as income from prohibited
transactions. The Company, therefore, intends to make any such sales through a
taxable subsidiary. The taxable subsidiary will form mortgage pools and create
mortgage-backed securities. See "Taxable Subsidiaries" The taxable subsidiary
will not be subject to this 100% tax on income from prohibited transactions,
which is only applicable to REITs.
The Company will also be subject to a nondeductible 4% excise tax if it
fails to make timely dividend distributions for each calendar year. See
"Requirements for Qualification as a REIT -- Distribution Requirements." The
Company intends to declare its fourth regular annual dividend during the final
quarter of the year and to make such dividend distribution no later than 31 days
after the end of the year in order to avoid imposition of the excise tax. Such a
distribution would be taxed to the stockholders in the year that the
distribution was declared, not in the year paid. Imposition of the excise tax on
the Company would reduce the amount of cash available for distribution to the
Company's stockholders.
TAXABLE SUBSIDIARIES
The Company may, in the future, cause the creation and sale of Mortgage
Securities through a taxable corporation. The Company and one or more persons or
entities will own all of the capital stock of that taxable corporation,
sometimes referred to as a "taxable subsidiary." In order to ensure that the
Company will not violate the prohibition on ownership of more than 10% of the
voting stock of a single issuer and the prohibition on investing more than 5% of
the value of its assets in the stock or securities of a single issuer, the
Company will own only shares of nonvoting preferred stock of that taxable
subsidiary corporation and will not own any of the taxable subsidiary's common
stock. The Company will monitor the value of its investment in the taxable
subsidiary on a quarterly basis to limit the risk of violating any of the tests
that comprise the 25% of assets limits. In addition, the dividends that the
taxable subsidiary pays to the Company will not qualify as income
75
<PAGE> 77
from Qualified REIT Assets for purposes of the 75% of income test, and in all
events would have to be limited, along with the Company's other interest,
dividends, gains on the sale of securities, hedging income, and other income not
derived from Qualified REIT Assets to less than 25% of the Company's gross
revenues in each year. The taxable subsidiary will not elect REIT status, will
be subject to income taxation on its net earnings and will generally be able to
distribute only its net after-tax earnings to its stockholders, including the
Company, as dividend distributions. If the taxable subsidiary creates a taxable
mortgage pool, such pool itself will constitute a separate taxable subsidiary of
the taxable subsidiary. The taxable subsidiary would be unable to offset the
income derived from such a taxable mortgage pool with losses derived from any
other activities.
TAXATION OF STOCKHOLDERS
For any taxable year in which the Company is treated as a REIT for federal
income purposes, amounts distributed by the Company to its stockholders out of
current or accumulated earnings and profits will be includible by the
stockholders as ordinary income for federal income tax purposes unless properly
designated by the Company as capital gain dividends. In the latter case, the
distributions will be taxable to the stockholders as long-term capital gains.
Distributions of the Company will not be eligible for the dividends
received deduction for corporations. Stockholders may not deduct any net
operating losses or capital losses of the Company.
Any loss on the sale or exchange of shares of the stock of the Company held
by a stockholder for six months or less will be treated as a long-term capital
loss to the extent of any capital gain dividend received on the stock held by
such stockholders.
If the Company makes distributions to its stockholders in excess of its
current and accumulated earnings and profits, those distributions will be
considered first a tax-free return of capital, reducing the tax basis of a
stockholder's shares until the tax basis is zero. Such distributions in excess
of the tax basis will be taxable as gain realized from the sale of the Company's
shares.
The Company does not expect to acquire or retain residual interests issued
by REMICs. Such residual interests, if acquired by a REIT, would generate excess
inclusion income. Excess inclusion income cannot be offset by net operating
losses of a stockholder. If the stockholder is a Tax-Exempt Entity, the excess
inclusion income is fully taxable as UBTI. If allocated to a foreign
stockholder, the excess inclusion income is subject to Federal income tax
withholding without reduction pursuant to any otherwise applicable tax treaty.
Potential investors, and in particular Tax Exempt Entities, are urged to consult
with their tax advisors concerning this issue.
The Company intends to finance the acquisition of Mortgage Assets by
entering into reverse repurchase agreements, which are essentially loans secured
by the Company's Mortgage Assets. The Company expects to enter into master
repurchase agreements with secured lenders known as "counterparties." Typically,
such master repurchase agreements have cross-collateralization provisions that
afford the counterparty the right to foreclose on the Mortgage Assets pledged as
collateral. If the Service were to successfully take the position that the
cross-collateralization provisions of the master repurchase agreements result in
the Company having issued debt instruments (the reverse repurchase agreements)
with differing maturity dates secured by a pool of Mortgage Loans, a portion of
the Company's income could be characterized as "excess inclusion income."
Special Tax Counsel has advised the Company that it is more likely than not that
the cross-collateralization provisions of the master repurchase agreements will
not cause the Company to realize excess inclusion income. Nevertheless, in the
absence of any definitive authority on this issue, Special Tax Counsel cannot
give complete assurance.
The Company will notify stockholders after the close of the Company's
taxable year as to the portions of the distributions which constitute ordinary
income, return of capital and capital gain. Dividends and distributions declared
in the last quarter of any year payable to stockholders of record on a specified
date in such month will be deemed to have been received by the stockholders and
paid by the Company on December 31 of the record year, provided that such
dividends are paid before February 1 of the following year.
76
<PAGE> 78
TAXATION OF TAX-EXEMPT ENTITIES
In general, a Tax-Exempt Entity that is a stockholder of the Company is not
subject to tax on distributions. The Service has ruled that amounts distributed
by a REIT to an exempt employees' pension trust do not constitute UBTI and thus
should be nontaxable to such a Tax-Exempt Entity. Based on that ruling, but
subject to the discussion of excess inclusion income set forth under the heading
"Taxation of Stockholders," Special Tax Counsel is of the opinion that
indebtedness incurred by the Company in connection with the acquisition of real
estate assets such as Mortgage Loans will not cause dividends of the Company
paid to a stockholder that is a Tax-Exempt Entity to be UBTI, provided that the
Tax-Exempt Entity has not financed the acquisition of its stock with
"acquisition indebtedness" within the meaning of the Code. Under certain
conditions, if a tax-exempt employee pension or profit sharing trust were to
acquire more than 10% of the Company's stock, a portion of the dividends on such
stock could be treated as UBTI.
For social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans exempt
from federal income taxation under Code Sections 501(c)(7), (c)(9), (c)(17) and
(c)(20), respectively, income from an investment in the Company will constitute
UBTI unless the organization is able to properly deduct amounts set aside or
placed in reserve for certain purposes so as to offset the UBTI generated by its
investment in the Company. Such entities should review Code Section 512(a)(3)
and should consult their own tax advisors concerning these "set aside" and
reserve requirements.
STATE AND LOCAL TAXES
The Company and its stockholders may be subject to state or local taxation
in various jurisdictions, including those in which it or they transact business
or reside. The state and local tax treatment of the Company and its stockholders
may not conform to the federal income tax consequences discussed above.
Consequently, prospective stockholders should consult their own tax advisors
regarding the effect of state and local tax laws on an investment in the Common
Stock.
CERTAIN UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS APPLICABLE TO FOREIGN
HOLDERS
The following discussion summarizes certain United States tax consequences
of the acquisition, ownership and disposition of the Common Stock by an initial
purchaser of the Common Stock that, for United States income tax purposes, is
not a "United States person" (a "Foreign Holder"). For purposes of discussion, a
"United States person" means: a citizen or resident of the United States; a
corporation, partnership, or other entity created or organized in the United
States or under the laws of the United States or of any political subdivision
thereof; or an estate or trust whose income is includible in gross income for
United States income tax purposes regardless of its source. This discussion does
not consider any specific facts or circumstances that may apply to a particular
Foreign Holder prospective investors are urged to consult their tax advisors
regarding the United States tax consequences of acquiring, holding and disposing
of Common Stock, as well as any tax consequences that may arise under the laws
of any foreign, state, local or other taxing jurisdiction.
Dividends
Dividends paid by the Company out of earnings and profits, as determined
for United States income tax purposes, to a Non-United States Holder will
generally be subject to withholding of United States federal income tax at the
rate of 30%, unless reduced or eliminated by an applicable tax treaty or unless
such dividends are treated as effectively connected with a United States trade
or business conducted by the Foreign Holder. A Foreign Holder eligible for a
reduction in withholding under an applicable treaty must so notify the Company
by completing the appropriate IRS form. Distributions paid by the Company in
excess of its earnings and profits will be treated as a tax-free return of
capital to the extent of the holder's adjusted basis in his Common Stock, and
thereafter as gain from the sale or exchange of a capital asset as described
below. If it cannot be determined at the time a distribution is made whether
such distribution will exceed the Company's earnings and profits (which, under
most circumstances, will correspond to the Company's net income before the
deduction for dividends paid), the distribution will be subject to withholding
at the same rate as dividends.
77
<PAGE> 79
Amounts so withheld, however, will be refundable or creditable against the
Foreign Holder's United States tax liability if the Company subsequently
determines that such distribution was, in fact, in excess of the earnings and
profits of the Company. If the receipt of the dividend is treated as being
effectively connected with the conduct of a trade or business within the United
States by a Foreign Holder, the dividend received by such holder will be subject
to the United States Federal income tax on net income that applies to United
States persons generally (and, in addition with respect to foreign corporate
holders and under certain circumstances, the branch profits tax).
For any year in which the Company qualifies as a REIT, distributions to a
Foreign Holder that are attributable to gain from the sales or exchanges by the
Company of "United States real property interests" will be treated as if such
gain were effectively connected with a United States business and will thus be
subject to tax at the normal capital gain rates applicable to United States
stockholders (subject to applicable alternative minimum tax) under the
provisions of the Foreign Investment in Real Property Tax Act of 1980
("FIRPTA"). Also, distributions subject to FIRPTA may be subject to a 30% branch
profits tax in the hands of a foreign corporate stockholder not entitled to a
treaty exemption. The Company is required to withhold 35% of any distribution
that could be designated by the Company as a capital gains dividend. This amount
may be credited against the Foreign Holder's FIRPTA tax liability.
Gain on Disposition
A Foreign Holder will generally not be subject to United States Federal
income tax on gain recognized on a sale or other disposition of the Common Stock
unless (i) the gain is effectively connected with the conduct of a trade or
business within the United States by the Foreign Holder, (ii) in the case of a
Foreign Holder who is a nonresident alien individual and holds the Common Stock
as a capital asset, such holder is present in the United States for 183 or more
days (computed in part by reference to days present in the two prior years) in
the taxable year and certain other requirements are met, or (iii) the Foreign
Holder is subject to tax under the FIRPTA rules discussed below. Gain that is
effectively connected with the conduct of a United States Holder will be subject
to the United States federal income tax on net income that applies to United
States persons generally (and, with respect to corporate holders and under
certain circumstances, the branch profits tax) but will not be subject to
withholding. Foreign Holders should consult applicable treaties, which may
provide for different rules.
Gain recognized by a Foreign Holder upon a sale of its Common Stock will
generally not be subject to tax under FIRPTA if the Company is a "domestically
controlled REIT," which is defined generally as a REIT in which at all times
during a specified testing period less than 50% in value of its shares were held
directly or indirectly by non-U.S. persons. Because only a minority of the
Company's stockholders are expected to be Foreign Holders, the Company
anticipates that it will qualify as a "domestically controlled REIT."
Accordingly, a Foreign Holder should not be subject to U.S. tax from gains
recognized upon disposition of the Common Stock.
Information Reporting and Backup Withholding
Under temporary United States Treasury regulations, United States
information reporting requirements and backup withholding tax will generally not
apply to dividends paid on the Common Stock to a Non-United States Holder at an
address outside the United States. Payments by a United States office of a
broker of the proceeds of a sale of the Common Stock is subject to both backup
withholding at a rate of 31% and information reporting unless the holder
certifies its Foreign Holder status under penalties of perjury or otherwise
establishes an exemption. Information reporting requirements (but not backup
withholding) will also apply to payments of the proceeds of sales of the Common
Stock by foreign offices of United States brokers, or foreign brokers with
certain types of relationships to the United States, unless the broker has
documentary evidence in its records that the holder is a Foreign Holder and
certain other conditions are met, or the holder otherwise establishes an
exemption.
78
<PAGE> 80
Backup withholding is not an additional tax. Any amounts withheld under the
backup withholding rules will be refunded or credited against the Foreign
Holder's United States federal income tax liability, provided that the required
information is furnished to the Service.
These information reporting and backup withholding rules are under review
by the United States Treasury and their application to the Common Stock could be
changed by future regulations.
ERISA CONSIDERATIONS
In considering an investment in the Common Stock of the Company, a
fiduciary of a profit-sharing, pension stock bonus plan, or individual
retirement account, including a plan for self-employed individuals and their
employees or any other employee benefit plan subject to prohibited transaction
provisions of the Code or the fiduciary responsibility provisions of ERISA (an
"ERISA Plan") should consider (a) whether the ownership of Common Stock is in
accordance with the documents and instruments governing such ERISA Plan, (b)
whether the ownership of Common Stock is consistent with the fiduciary's
responsibilities and satisfies the requirements of Part 4 of Subtitle B of Title
I of ERISA (where applicable) and, in particular, the diversification, prudence
and liquidity requirements of Section 404 of ERISA, (c) ERISA's prohibitions in
improper delegation of control over, or responsibility for, "plan assets" and
ERISA's imposition of co-fiduciary liability on a fiduciary who participates in,
permits (by action or inaction) the occurrence of, or fails to remedy a known
breach of duty by another fiduciary, and (d) the need to value the assets of the
ERISA Plan annually.
In regard to the "plan assets" issue noted in clause (c) above, Special Tax
Counsel is of the opinion that, effective as of the date of the closing of this
Offering and the listing of the shares of Common Stock on the NYSE, and based on
certain representations of the Company, the Common Stock should qualify as a
"publicly-offered security," and, therefore, the acquisition of such Common
Stock by ERISA Plans should not cause the Company's assets to be treated as
assets of such investing ERISA Plans for purposes of the fiduciary
responsibility provisions of ERISA or the prohibited transaction provisions of
the Code. Fiduciaries of ERISA Plans and IRA's should consult with and rely upon
their own advisors in evaluating the consequences under the fiduciary provisions
of ERISA and the Code of an investment in Common Stock in light of their own
circumstances.
79
<PAGE> 81
UNDERWRITING
The underwriters named below (the "Underwriters"), represented by
PaineWebber Incorporated, Oppenheimer & Co., Inc., EVEREN Securities, Inc. and
Sutro & Co. Incorporated (the "Representatives"), have severally agreed to
purchase, and the Company has agreed to sell, subject to the terms and
conditions set forth in an underwriting agreement (the "Underwriting
Agreement"), the respective number of shares of Common Stock set forth opposite
their names below:
<TABLE>
<CAPTION>
NUMBER OF SHARES
UNDERWRITER TO BE PURCHASED
----------- ----------------
<S> <C>
PaineWebber Incorporated.............................................
Oppenheimer & Co., Inc. .............................................
EVEREN Securities, Inc...............................................
Sutro & Co. Incorporated.............................................
---------
Total...................................................... 6,500,000
</TABLE>
In the Underwriting Agreement, the Underwriters have severally agreed,
subject to the terms and conditions set forth therein, to purchase all of the
shares of Common Stock being sold pursuant to the Underwriting Agreement (other
than those covered by the over-allotment option described below) if any shares
of Common Stock are purchased. The Underwriting Agreement provides that the
obligations of the Underwriters to purchase such shares of Common Stock are
subject to certain conditions precedent. The Underwriting Agreement also
provides that in the event of a default by any Underwriter, the purchase
commitments of the nondefaulting Underwriters may be increased or the
Underwriting Agreement may be terminated.
The Representatives have advised the Company that the Underwriters propose
to offer the shares of Common Stock in part to the public at the initial public
offering price set forth on the cover page of this Prospectus, and in part to
certain securities dealers (who may include the Underwriters) at such price less
a concession not in excess of $ per share of Common Stock, and the
Underwriters and such dealers may reallow to certain dealers a discount not in
excess of $ per share of Common Stock. After the closing of this
Offering, the public offering price, concessions to selected dealers and the
discount to other dealers may be changed by the Representatives. The Shares are
offered subject to receipt and acceptance by the Underwriters, and to certain
other conditions, including the right to reject orders in whole or in part.
The Company has granted the Underwriters an option exercisable for 30 days
after the date hereof to purchase up to 975,000 additional shares of Common
Stock to cover over-allotments, if any, at the initial public offering price
less the underwriting discount and commissions. If the Underwriters exercise
this option, each Underwriter will have a firm commitment, subject to certain
conditions, to purchase approximately the same percentage of such additional
shares of Common Stock as the number of shares of Common Stock to be purchased
by it shown in the foregoing table bears to the shares of Common Stock initially
offered hereby. The Underwriters may purchase such shares of Common Stock only
to cover over-allotments made in connection with this Offering.
The Company has agreed to indemnify the several Underwriters against
certain civil liabilities, including liabilities under the federal securities
laws, or to contribute to payments which the Underwriters may be required to
make in respect thereof.
The Company and the officers and directors of the Company have agreed that,
for a period of 180 days from the date of this Prospectus, they will not,
without the prior written consent of PaineWebber Incorporated, directly or
indirectly, sell, offer to sell, grant any option for the sale of, or otherwise
dispose of any shares of Common Stock or any security convertible into Common
Stock, except upon exercise of the options outstanding or to be issued pursuant
to the Incentive Plan, the Option Plan or the Outside Directors Plan or shares
of Common Stock to be issued pursuant to the Stock Purchase Plan.
PaineWebber Incorporated has in the past performed, and may continue to
perform, investment banking, broker dealer, lending and financial advisory
services for the Company and the Manager, and has received customary
compensation therefor. In connection with this Offering, the Company has agreed
to pay
80
<PAGE> 82
PaineWebber Incorporated an advisory fee equal to 0.5% of the gross proceeds of
this Offering for structuring and advisory services rendered in connection with
this Offering. In addition, the Company has a secured repurchase credit facility
and a collateralized line of credit with an affiliate of PaineWebber
Incorporated.
The Representatives have informed the Company that they do not expect the
Underwriters to confirm sales of Common Stock offered by this Prospectus to any
accounts over which they exercise discretionary authority.
Prior to this Offering, there has been no public market for the Common
Stock. Accordingly, the public offering price has been determined by
negotiations between the Company and the Representatives. Among the factors
which were considered in determining the initial public offering price were the
Company's future prospects, the experience of its management, the economic
condition of the financial services industry in general, the general condition
of the equity securities market, the demand for similar securities of companies
considered comparable to the Company and other relevant factors.
The initial public offering price set forth on the cover page of this
Prospectus should not be considered an indication of the actual value of the
Common Stock. The initial public offering price is subject to change as a result
of market conditions and other factors and no assurance can be given that the
Common Stock can be resold at the offering price.
Until the distribution of the Common Stock is completed, rules of the
Securities and Exchange Commission may limit the ability of the Underwriters and
certain selling group members to bid for and purchase shares of Common Stock. As
an exception to these rules, the Representatives are permitted to engage in
certain transactions that stabilize the price of Common Stock. Such transactions
consist of bids or purchases for the purpose of pegging, fixing or maintaining
the price of the Common Stock.
In addition, if the Representatives over-allot (i.e., if they sell more
shares of Common Stock than are set forth on the cover page of this Prospectus)
and thereby create a short position in the Common Stock in connection with this
Offering, then the Representatives may reduce that short position by purchasing
Common Stock in the open market. The Representatives may also elect to reduce
any short position by exercising all or part of the over-allotment option
described herein.
The Representatives may also impose a penalty bid on certain Underwriters
and selling group members. This means that if the Representatives purchase
shares of Common Stock in the open market to reduce the Underwriters' short
position or to stabilize the price of the Common Stock, they may reclaim the
amount of the selling concession from the Underwriters and selling group members
who sold those shares as part of the offering.
In general, purchases of a security for the purpose of stabilization or to
reduce a short position could cause the price of the security to be higher than
it might otherwise be in the absence of such purchases. The imposition of a
penalty bid might also have an effect on the price of a security to the extent
that it were to discourage resales of the security by purchasers in the
offering.
Neither the Company nor any of the Underwriters makes any representation or
prediction as to the direction or magnitude of any effect that the transactions
described above may have on the price of the Common Stock. In addition, neither
the Company nor any of the Underwriters makes any representation that the
Representatives will engage in such transactions or that such transactions, once
commenced, will not be discontinued without notice.
81
<PAGE> 83
CERTAIN PROVISIONS OF MARYLAND LAW
AND THE COMPANY'S CHARTER AND BYLAWS
The following summary of material provisions of the MGCL and of the Charter
and the Bylaws of the Company does not purport to be complete and is subject to
and qualified in its entirety by reference to Maryland law and to the Charter
and the Bylaws of the Company, copies of which are filed as exhibits to the
Registration Statement of which this Prospectus is a part.
CERTAIN ANTI-TAKEOVER PROVISIONS
The Charter and the Bylaws of the Company contain certain provisions that
could discourage, impede or impair acquisition of control of the Company by
means of a tender offer, a proxy contest or otherwise. These provisions are
expected to discourage certain types of coercive takeover practices and
inadequate takeover bids and to encourage persons seeking to acquire control of
the Company to negotiate first with the Board of Directors. The Company believes
that these provisions increase the likelihood that proposals initially will be
on more attractive terms than would be the case in their absence and increases
the likelihood of negotiations, which might outweigh the potential disadvantages
of discouraging such proposals because, among other things, negotiation of such
proposals might result in improvement of terms. The description set forth below
is a summary only, and is qualified in its entirety by reference to the Charter
and the Bylaws which have been filed as exhibits to the Registration Statement
of which this Prospectus is a part. See "Description of Capital
Stock -- Repurchase of Shares and Restrictions on Transfer" and "Risk
Factors -- Additional Risk Factors -- Limitations on Acquisition and Change in
Control."
STAGGERED BOARD OF DIRECTORS
The Charter and the Bylaws divide the Board of Directors into three classes
of directors, each class constituting approximately one-third of the total
numbers of directors, with the classes serving staggered three-year terms. The
classification of the Board of Directors will make it more difficult for
stockholders to change the composition of the Board of Directors because only a
minority of the directors can be elected at once. The Company believes, however,
that the staggered Board of Directors will help to ensure continuity and
stability of the Company's management and policies. The classification
provisions could also discourage a third party from accumulating the Company's
stock or attempting to obtain control of the Company, even though this attempt
might be beneficial to the Company and some, or a majority, of its stockholders.
Accordingly, under certain circumstances stockholders could be deprived of
opportunities to sell their shares of Common Stock at a higher price than might
otherwise be available.
NUMBER OF DIRECTORS, REMOVAL, FILLING VACANCIES
The Charter and Bylaws provide that, subject to any rights of holders of
preferred stock to elect additional directors under specified circumstances
("Preferred Holders Rights"), the number of directors will be four and may be
changed by a majority of the entire Board of Directors. Upon the closing of this
Offering, the number of directors will be increased to seven. In addition, the
Charter provides that, subject to any Preferred Holders Rights, and unless the
Board of Directors otherwise determines, any vacancies may be filled by a vote
of the stockholders or a majority of the remaining directors, though less than a
quorum, except vacancies created by the increase in the number of directors,
which only may be filled by a vote of the stockholders or a majority of the
entire Board of Directors. Accordingly, the Board of Directors could temporarily
prevent any stockholder from enlarging the Board of Directors and filling the
new directorship with such stockholder's own nominees. The Charter and the
Bylaws provide that, subject to the rights of any class or series to elect
directors, directors may be removed only for cause upon the affirmative vote of
a majority of holders of all the then outstanding shares of stock entitled to
vote generally in the election of directors, voting together as a single class.
82
<PAGE> 84
ADVANCE NOTICE PROVISIONS FOR STOCKHOLDER NOMINATIONS AND STOCKHOLDER PROPOSALS
The Charter and the Bylaws establish an advance notice procedure for
stockholders to make nominations of candidates for director or bring other
business before an annual meeting of stockholders of the Company (the
"Stockholder Notice Procedure"). The Bylaws provide that (i) only persons who
are nominated by, or at the direction of, the Board of Directors, or by a
stockholder who has given timely written notice containing specified information
to the Secretary of the Company prior to the meeting, at which directors are to
be elected, will be eligible for election as directors of the Company and (ii)
at an annual meeting, only such business may be conducted as has been brought
before the meeting by, or at the direction of, the Chairman or the Board of
Directors or by a stockholder who has given timely written notice to the
Secretary of the Company of such stockholder's intention to bring such business
before such meeting. In general, for notice of stockholder nominations or
proposed business (other than business to be included in the Company's Proxy
Statement under the Securities and Exchange Commission's Rule 14a-8) to be
conducted at an annual meeting to be timely, such notice must be received by the
Company not less than 60 days nor more than 90 days prior to the first
anniversary of the previous year's annual meeting. The purpose of requiring
stockholders to give the Company advance notice of nominations and other
business is to afford the Board of Directors a meaningful opportunity to
consider the qualifications of the proposed nominees or the advisability of the
other proposed business and, to the extent deemed necessary or desirable by the
Board of Directors, to inform stockholders and make recommendations about such
nominees or business, as well as to ensure an orderly procedure for conducting
meetings of stockholders. Although the Charter and the Bylaws do not give the
Board of Directors power to block stockholder nominations for the election of
directors or proposals for action, they may have the effect of discouraging a
stockholder from proposing nominees or business, precluding a contest for the
election of directors or the consideration of stockholder proposals if
procedural requirements are not met and deterring third parties from soliciting
proxies for a non-management slate of directors or proposals, without regard to
the merits of such slate or proposals.
RELEVANT FACTORS TO BE CONSIDERED BY THE BOARD OF DIRECTORS
The Charter provides that, in determining what is in the best interest of
the Company in a business combination or certain change of control events, a
director of the Company shall consider the interests of the stockholders of the
Company and, in his or her discretion, also may consider (i) the interests of
the Company's employees, suppliers, creditors and tenants, (ii) the economy of
the nation, (iii) community and societal interests, and (iv) both the long-term
and short-term interests of the Company and its stockholders, including the
possibility that these interests may be best served by the continued
independence of the Company. Pursuant to this provision, the Board of Directors
may consider subjective factors affecting a proposal, including certain
non-financial matters, and on the basis of these considerations may oppose a
business combination or other transaction which, evaluated only in terms of its
financial merits, might be attractive to some, or a majority, of the Company's
stockholders.
RIGHTS TO PURCHASE SECURITIES AND OTHER PROPERTY
The Board of Directors may create and authorize the Company to issue rights
entitling the holders thereof to purchase from the Company shares of capital
stock or other securities or property. The times at which and terms upon which
such rights are to be issued are within the discretion of the Board of
Directors. The provision is intended to confirm the Board of Directors'
authority to issue share purchase rights which could have terms that would
impede a merger, tender offer or other takeover attempt, or other rights to
purchase securities of the Company or any other entity.
BUSINESS COMBINATIONS
The MGCL prohibits certain "business combinations" (including certain
mergers, consolidations, share exchanges, asset transfers, sales, leases,
issuance or reclassification of equity securities and benefits) involving a
Maryland corporation and an "Interested Stockholder." Interested Stockholders
are all persons (i) who beneficially own 10% or more of the voting power of the
corporation's stock or (ii) an affiliate or associate of the corporation who, at
any time within the two-year period prior to the date in question, was an
Interested
83
<PAGE> 85
Stockholder or an affiliate or an associate thereof. Such business combinations
are prohibited for five years after the most recent date on which the Interested
Stockholder became an Interested Stockholder. Thereafter, any such business
combination must be recommended by the board of directors of such corporation
and approved by the affirmative vote of at least (a) 80% of the votes entitled
to be cast by all holders of voting shares of the corporation, and (b) 66 2/3%
of the votes entitled to be cast by all holders of voting shares of the
corporation other than the voting shares held by the Interested Stockholder or
an affiliate or associate of the Interested Stockholder, with whom the business
combination is to be effected, unless, among other things, the corporation's
stockholders receive a minimum price (as defined in the MGCL) for their shares
and the consideration is received in cash or in the same form as previously paid
by the Interested Stockholder for its shares. These provisions of Maryland law
do not apply, however, to business combinations that are approved or exempted by
the board of directors of the corporation prior to the time that the Interested
Stockholder becomes an Interested Stockholder. A Maryland corporation may adopt
an amendment to its charter electing not to be subject to the special voting
requirements of the foregoing legislation. Any such amendment would have to be
approved by the affirmative vote of at least 80% of the votes entitled to be
cast by all holders of outstanding shares of voting stock and 66 2/3% of the
votes entitled to be cast by holders of outstanding shares of voting stock who
are not Interested Stockholders.
CONTROL SHARE ACQUISITIONS
The MGCL provides the "control shares" of a Maryland corporation acquired
in a "control share acquisition" have no voting rights except to the extent
approved by a vote of two-thirds of the votes entitled to be cast on the matter,
excluding shares of stock owned by the acquiror or by the officers or directors
who are employees of the company. Control shares are voting shares of stock
which, if aggregated with all other shares of stock previously acquired by such
a person, would entitle the acquiror to exercise voting power in electing
directors within one of the following ranges of voting power: (i) 20% or more
but not less than 33 1/3%; (ii) 33 1/3% or more but less than a majority; or
(iii) a majority of all voting power. Control Shares do not include shares of
stock an acquiring person is entitled to vote as a result of having previously
obtained stockholder approval. A control share acquisition means, subject to
certain exceptions, the acquisition of, ownership of or the power to direct the
exercise of voting power with respect to, control shares. A person who has made
or proposed to make a "control share acquisition," upon satisfaction of certain
conditions (including an undertaking to pay expenses), may compel the board of
directors to call a special meeting of stockholders to be held within 50 days of
demand therefor to consider the voting rights of the shares. If no request for a
meeting is made, the corporation may itself present the question at any
stockholders' meeting. If voting rights are not approved at the meeting or if
the acquiring person does not deliver an acquiring person statement as permitted
by the statute, then, subject to certain conditions and limitations, the
corporation may redeem any or all of the control shares (except those for which
voting rights have previously been approved) for fair value determined, without
regard to voting rights, as of the date of the last control share acquisition or
of any meeting of stockholders at which the voting rights of such shares are
considered and not approved. If voting rights for "control shares" are approved
at a stockholders' meeting and the acquiror becomes entitled to vote a majority
of the shares entitled to vote, all other stockholders may exercise appraisal
rights. The fair value of the stock as determined for purposes of such appraisal
rights may not be less than the highest price per share paid in the control
share acquisition, and certain limitations and restrictions otherwise applicable
to the exercise of dissenters' rights do not apply in the context of a "control
share acquisition." The control share acquisition statute does not apply to
stock acquired in a merger, consolidation or stock exchange if the corporation
is a party to the transaction, or to acquisitions previously approved or
exempted by a provision in the charter or by-laws of the corporation. The
limitation on ownership of shares of Common Stock set forth in the Charter, as
well as the provisions of the MGCL, could have the effect of discouraging offers
to acquire the Company and of increasing the difficulty of consummating any such
offer. See "Description of Capital Stock -- Repurchase of Shares and
Restrictions on Transfer."
84
<PAGE> 86
LEGAL MATTERS
Certain legal matters will be passed on for the Company by Gray Cary Ware &
Freidenrich, a professional corporation, San Diego, California as Counsel to the
Company in connection with this Offering. The validity of the Common Stock
offered hereby will be passed on by Piper & Marbury L.L.P., special Maryland
counsel to the Company. Certain tax matters will be passed on by Jeffers,
Wilson, Shaff & Falk, LLP, Irvine, California as Special Tax Counsel to the
Company in connection with this Offering. Certain legal matters will be passed
on for the Underwriters by O'Melveny & Myers LLP, San Francisco, California.
Counsel to the Company, Gray Cary Ware & Freidenrich, Special Tax Counsel and
O'Melveny & Myers LLP have relied as to all matters of Maryland law on the
opinion of special Maryland counsel to the Company.
EXPERTS
The financial statements of American Residential Investment Trust, Inc. as
of June 30, 1997, and for the period from February 11, 1997 (commencement of
operations) through June 30, 1997, have been included herein in reliance on the
report of KPMG Peat Marwick LLP, independent auditors, appearing elsewhere
herein, and upon the authority of said firm as experts in accounting and
auditing.
ADDITIONAL INFORMATION
The Company has filed with the Securities and Exchange Commission (the
"Commission"), Washington, D.C. 20549, a Registration Statement on Form S-11
under the Securities Act of 1933, as amended, with respect to the Common Stock
offered hereby. This Prospectus does not contain all the information set forth
in the Registration Statement and the exhibits and schedules thereto. For
further information with respect to the Company and such Common Stock, reference
is made to the Registration Statement and the exhibits and schedules filed as
part thereof. Statements contained in this Prospectus as to the contents of any
contract or other document referred to are not necessarily complete, and, in
each instance, if such contract or document is filed as an exhibit, reference is
made to the copy of such contract or other document filed as an exhibit to the
Registration Statement, each statement being qualified in all respects by such
reference to such exhibit. The Registration Statement, including exhibits and
schedules thereto, may be inspected without charge at the Commission's principal
office in Washington, D.C., and copies of all or any part thereof may be
obtained from such office after payment of fees prescribed by the Commission.
The Commission maintains a Website that contains reports, proxy and information
statements and other information regarding registrants that file electronically
with the Commission. The address of the site is http://www.sec.gov.
85
<PAGE> 87
GLOSSARY
As used in this Prospectus, the capitalized and other terms listed below
have the meanings indicated.
"AGENCY SECURITIES" means mortgage participation certificates issued by
FNMA, FHLMC or GNMA. These securities entitle the holder to receive a
pass-through of principal and interest payments on the underlying pool of
Mortgage Loans and are issued or guaranteed by federal government sponsored
agencies.
"CAPITAL CUSHION" is a term defined in the Company's Capital Policy. It
represents the equity reserve amount assigned to each Mortgage Asset which is
adjusted based upon the Company's assessment of the risk of delinquency, default
or loss on such Mortgage Asset.
"CAPITAL POLICY" means the policy established by the Company which limits
Management's ability to acquire additional Mortgage Assets during such times
that the actual capital base of the Company is less than a required amount
defined in the policy. The required amount is the sum of the "haircuts" required
by the Company's secured lenders (the required haircut) and the additional
capital levels called for under the policy which are determined with reference
to the various risks inherent in the Company's Mortgage Assets (the liquidity
capital cushion).
"CODE" means the Internal Revenue Code of 1968, as amended.
"CORRESPONDENTS" means entities which originate Mortgage Loans for resale
to the Company. The Company's Correspondents may include mortgage banks, savings
and loans, credit unions, commercial banks, institutional mortgage brokers' and
other entities.
"COUPON RATE" means, with respect to Mortgage Assets, the annualized cash
interest income actually received from the asset, expressed as a percentage of
the face value of the asset.
"EARNING ASSETS" means the Company's Mortgage Assets and cash balances.
"EQUITY-FUNDED LENDING" means the portion of the Company's earning assets
acquired using the Company's equity capital.
"FEDERAL FUNDS RATE" means the interest rate that is charged by banks with
excess reserves at a Federal Reserve District Bank to banks needing the money to
meet reserve requirements. The Federal Funds Effective Rate is the average rate
that fed funds were traded at over the course of a day. The Fed will act to
ensure that the Fed Funds rate trades within a range of its Fed Funds Target
Rate, which is set at the FOMC meetings.
"FHA" means the United States Federal Housing Administration.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FNMA" means the Federal National Mortgage Association.
"FULLY-INDEXED RATE" means, with respect to adjustable-rate Mortgage
Assets, the rate that would be paid by the borrower ("GROSS") or received by the
Company as owner of the Mortgage Asset ("NET") if the coupon rate on the
adjustable-rate Mortgage Assets were able to adjust immediately to a market rate
without being subject to adjustment periods, periodic caps, or life caps. It is
equal to the current yield of the adjustable-rate Mortgage Assets index plus the
gross or net margin.
"GAAP" means generally accepted accounting principles.
"GNMA" means the Government National Mortgage Association.
"GROSS ASSETS" means for any month the aggregate book value of the
consolidated assets of the Company and its subsidiaries, before reserves for
depreciation or bad debts or other similar noncash reserves, computed at the end
of such month prior to any dividend distribution made during each month.
"HAIRCUT" means the percentage by which the market value of the pledged
collateral is required by a lender to exceed the borrowing amount in connection
with a collateralized borrowing.
86
<PAGE> 88
"INTEREST RATE ADJUSTMENT INDICES" means, in the case of Mortgage Assets,
any of the objective indices based on the market interest rates of a specified
debt instrument (such as United States Treasury Bills in the case of the
Treasury Index and United States dollar deposits in London in the case of LIBOR)
or based on the average interest rate of a combination of debt instruments (such
as the 11th District Cost of Funds Index), used as a reference base to reset the
interest rate for each adjustment period on the Mortgage Asset, and in the case
of borrowings, is used herein to mean the market interest rates of a specified
debt instrument (such as reverse repurchase agreements for Mortgage Securities)
as well as any of the objective indices described above that are used as a
reference base to reset the interest rate for each adjustment period under the
related borrowing instrument.
"INTEREST RATE ADJUSTMENT PERIOD" means, in the case of Mortgage Assets,
the period of time set forth in the debt instrument that determines when the
interest rate is adjusted and, with respect to borrowings, is used to mean the
term to maturity of a short-term, fixed-rate debt instrument (such as a 30-day
reverse repurchase agreement) as well as the period of time set forth in a
long-term, adjustable-rate debt instrument that determines when the interest
rate is adjusted.
"LIBOR" means London Inter-bank Offered Rate as specifically used as
interest rate adjustment indicia for Mortgage Assets and related borrowings.
"LIFETIME INTEREST RATE CAP" or "LIFE CAP" means the maximum coupon rate
that may accrue during any period over the term of an adjustable-rate Mortgage
Loan or, in the case of a Mortgage Security, the maximum weighted average coupon
rate that may accrue during any period over the term of such Mortgage Security.
"LIQUIDITY CAPITAL CUSHION" is a term defined in the Company's Capital
Policy. It represents a portion of the capital the Company is required to
maintain as part of this policy in order to continue to make asset acquisitions.
The liquidity capital cushion is that part of the required capital based which
is in excess of the Company's haircut requirements.
"MORTGAGE ASSETS" means Mortgage Securities and Mortgage Loans.
"MORTGAGE LOANS" means mortgage loans secured by residential or mixed use
properties.
"MORTGAGE SECURITIES" means Agency Securities and Privately Issued
Securities.
"NONCONFORMING MORTGAGE LOANS" means conventional single-family and
multifamily Mortgage Loans that do not conform to one or more requirements of
FHLMC or FNMA for participation in one or more of such agencies' mortgage loss
credit support programs.
"PERIODIC INTEREST RATE CAP" or "PERIODIC CAP" means the maximum change in
the coupon rate permissible under the terms of the loan at each coupon
adjustment date. Periodic caps limit both the speed by which the coupon rate can
adjust upwards in a rising interest rate environment and the speed by which the
coupon rate can adjust downwards in a falling rate environment.
"PRIVATELY ISSUED SECURITIES" means mortgage participation certificates
issued by certain private institutions. These securities entitle the holder to
receive a pass-through of principal and interest payments on the underlying pool
of Mortgage Loans and are issued or guaranteed by the private institution.
"REIT" means real estate investment trust.
"REIT PROVISIONS OF THE CODE" means sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit.
"REVERSE REPURCHASE AGREEMENT" means a borrowing device evidenced by an
agreement to sell securities or other assets to a third-party and a simultaneous
agreement to repurchase them at a specified future date and price, the price
difference constituting the interest on the borrowing.
"SPREAD LENDING" means the portion of the Company's earning assets acquired
using borrowed funds.
87
<PAGE> 89
"TEN YEAR U.S. TREASURY RATE" for a quarterly period shall mean the
arithmetic average of the weekly per annum Ten Year Average Yields published by
the Federal Reserve Board during such quarter. In the event that the Federal
Reserve Board does not publish a weekly per annum Ten Year Average Yield during
any week in a quarter, then the Ten Year U.S. Treasury Rate for such week shall
be the weekly per annum Ten Year Average Yields published by any Federal Reserve
Bank or by any U.S. Government department or agency selected by the Company for
such week. In the event that the Company determines in good faith that for any
reason the Company cannot determine the Ten Year U.S. Treasury Board for any
quarter as provided above, then the Ten Year U.S. Treasury Rate for such quarter
shall be the arithmetic average of the per annum average yields to maturity
based upon the daily closing bids during such quarter for each of the issues of
actively traded marketable U.S. Treasury fixed interest rate securities (other
than securities which can, at the option of the holder, be surrendered at face
value in payment of any federal estate tax) with a final maturity date not less
than eight nor more than twelve years from the date of each such quotation, as
chosen and for each business day (or less frequently if daily quotations shall
not be generally available) in each such quarterly period in New York City and
quoted to the Company by at least three recognized dealers in U.S. Government
securities selected by the Company.
"VA" means the United States Department of Veterans Affairs.
88
<PAGE> 90
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Auditors......................................................... F-2
Balance Sheet.......................................................................... F-3
Statement of Operations................................................................ F-4
Statement of Stockholders' Equity...................................................... F-5
Statement of Cash Flows................................................................ F-6
Notes to Financial Statements.......................................................... F-7
</TABLE>
F-1
<PAGE> 91
When the transaction referred to in Note 8 of the Notes to Financial
Statements has been consummated, we will be in a position to render the
following report.
/s/ KPMG PEAT MARWICK LLP
REPORT OF INDEPENDENT AUDITORS
The Board of Directors
American Residential Investment Trust, Inc.
Del Mar, California:
We have audited the accompanying balance sheet of American Residential
Investment Trust, Inc. (the Company) as of June 30, 1997 and the related
statements of operations, stockholders' equity and cash flows for the period
from February 11, 1997 (commencement of operations) through June 30, 1997. 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 audit.
We conducted our audit 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of the Company as of June 30,
1997, and the results of its operations and its cash flows for the period from
February 11, 1997 (commencement of operations) through June 30, 1997 in
conformity with generally accepted accounting principles.
San Diego, California
October , 1997.
F-2
<PAGE> 92
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
BALANCE SHEET
(IN THOUSANDS, EXCEPT SHARE DATA)
ASSETS
<TABLE>
<CAPTION>
JUNE 30, 1997
-------------
<S> <C>
Cash and cash equivalents....................................................... $ 127
Mortgage Assets available-for-sale.............................................. 228,620
Interest rate agreements........................................................ 502
Accrued interest receivable..................................................... 2,259
Other assets.................................................................... 10
--------
$ 231,518
========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Reverse repurchase agreements................................................... $ 209,539
Accrued interest payable........................................................ 1,088
Accrued expense and other liabilities........................................... 215
Management fee payable.......................................................... 73
--------
Total liabilities..................................................... 210,915
--------
Commitments and contingencies (Note 10)
Stockholders' Equity:
Preferred stock, par value $.01 per share; 1,000,000 shares authorized; no
shares issued and outstanding................................................. --
Common Stock, par value $.01 per share; 3,000,000 shares authorized; 1,614,000
shares issued and outstanding................................................. 16
Additional paid-in capital...................................................... 20,149
Cumulative dividends declared................................................... (146)
Retained earnings............................................................... 584
--------
Total stockholders' equity............................................ 20,603
--------
$ 231,518
========
</TABLE>
See accompanying notes to financial statements.
F-3
<PAGE> 93
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
FOR THE PERIOD
FEBRUARY 11, 1997
(COMMENCEMENT OF
OPERATIONS) THROUGH
JUNE 30, 1997
-------------------
<S> <C>
Interest income:
Mortgage Assets........................................................... $ 3,489
Cash and investments...................................................... 151
------
3,640
Interest expense:........................................................... 2,916
------
Net interest income......................................................... 724
Other expenses
Management fee............................................................ 69
General and administrative expenses....................................... 71
------
140
------
Net income.................................................................. $ 584
======
Net income per share of Common Stock........................................ $ 0.35
Dividends per share of Common Stock......................................... $ 0.09
</TABLE>
See accompanying notes to financial statements.
F-4
<PAGE> 94
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL CUMULATIVE
------------------ PAID-IN DIVIDENDS RETAINED
SHARES AMOUNT CAPITAL DECLARED EARNINGS TOTAL
--------- ------ ---------- ---------- --------- -------
<S> <C> <C> <C> <C> <C> <C>
Initial capital contribution,
February 11, 1997................... 1,614,000 $ 16 $ 20,149 $ -- $ -- $20,165
--------- --- ------- ----- ---- -------
Net income............................ -- -- -- -- 584 584
Dividends declared.................... -- -- -- (146) -- (146)
--------- --- ------- ----- ---- -------
Balance, June 30, 1997................ 1,614,000 $ 16 $ 20,149 $ (146) $ 584 $20,603
========= === ======= ===== ==== =======
</TABLE>
See accompanying notes to financial statements.
F-5
<PAGE> 95
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
STATEMENT OF CASH FLOWS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
FOR THE PERIOD
FEBRUARY 11, 1997
(COMMENCEMENT OF
OPERATIONS) THROUGH
JUNE 30, 1997
-------------------
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................................ $ 584
Adjustments to reconcile net income to net cash used in operating
activities:
Amortization of mortgage assets premiums............................... 528
Amortization of interest rate cap agreements........................... 40
Increase in accrued interest receivable................................ (2,259)
Increase in other assets............................................... (10)
Increase in accrued interest payable................................... 1,088
Increase in accrued expenses........................................... 288
----------
Net cash provided by operating activities......................... 259
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of Mortgage Assets available-for-sale........................... (239,555)
Principal payments on Mortgage Assets available-for-sale.................. 10,407
Purchase of interest rate cap agreements.................................. (542)
----------
Net cash used in investing activities............................. (229,690)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements......................... 209,539
Net proceeds from stock issuance.......................................... 20,165
Dividends paid............................................................ (146)
----------
Net cash provided by financing activities......................... 229,558
Net increase in cash and cash equivalents................................... 127
Cash and cash equivalents at beginning of period............................ --
----------
Cash and cash equivalents at end of period.................................. $ 127
==========
Supplemental Information
Interest Paid............................................................. $ 1,828
==========
</TABLE>
See accompanying notes to financial statements.
F-6
<PAGE> 96
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization
American Residential Investment Trust, Inc. (the "Company"), a newly formed
Maryland corporation, commenced operations on February 11, 1997. The Company was
formed through a private equity funding from its manager, Home Asset Management
Corporation (the "Manager"). The Company operates as a mortgage real estate
investment trust which will elect to be taxed as a real estate investment trust
("REIT") for Federal income tax purposes, which generally will allow the Company
to pass through income to stockholders without payment of corporate level
federal income tax. The Company was formed for the purpose of investing in
residential adjustable-rate mortgage-backed securities and mortgage loans. The
Company has developed tailored mortgage loan products for mortgage loans to be
originated by and acquired directly from correspondents. The Company finances
its acquisitions of Mortgage Assets with equity and secured borrowings.
Basis of Financial Statement Presentation
The preparation of financial statements in conformity with generally
accepted accounting principles requires management of the Company to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the report amounts of revenue and expenses during
the reported period. Actual results could differ from those estimates.
A summary of the Company's significant accounting policies follows:
Cash and Cash Equivalents
For purposes of the statement of cash flows, cash and cash equivalents
include cash on hand and highly liquid investments with original maturities of
three months or less.
Mortgage Assets
The Company's Mortgage Assets consist of interests in mortgage loans which
have been securitized by others prior to acquisition by the Company.
Statement of Financial Accounting Standards No. 115, Accounting for Certain
Investments in Debt and Equity Securities ("SFAS 115"), requires the Company to
classify its investments as either trading investments, available-for-sale
investments or held-to-maturity investments. Although the Company generally
intends to hold most of its Mortgage Assets until maturity, it may, from time to
time, sell any of its Mortgage Assets as part of its overall management of its
balance sheet. Accordingly, this flexibility requires the Company to classify
all of its Mortgage Assets as available-for-sale. All Mortgage Assets classified
as available-for-sale are reported at fair value, with unrealized gains and
losses excluded from earnings and reported as a separate component of
stockholders' equity.
Unrealized losses on Mortgage Assets that are considered other than
temporary, as measured by the amount of decline in fair value attributable to
factors other than temporary, are recognized in income and the cost basis of the
Mortgage Asset is adjusted. The determination of whether unrealized losses are
other than temporary is based on management of the Company's assessment of
various factors affecting the Mortgage Assets.
Interest income is accrued based on the outstanding principal amount of the
Mortgage Assets and their contractual terms. Premiums relating to Mortgage
Assets are amortized into interest income over the lives of
F-7
<PAGE> 97
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
the Mortgage Assets using the interest method. Gains or losses on the sale of
Mortgage Assets are based on the specific identification method.
Interest Rate Agreements
The Company uses interest rate cap agreements (the "Cap Agreements") for
interest rate risk protection. The Cap Agreements are purchased primarily to
reduce the Company's exposure to rising interest rates which would increase the
cost of liabilities above the maximum yield which could be earned on the
adjustable rate Mortgage Assets. The Company periodically evaluates the
effectiveness of these Cap Agreements under various interest rate scenarios.
The cost of the agreements are amortized over the life of the interest rate
agreements using the straight-line method. The Company has credit risk to the
extent counterparties to the Cap Agreements do not perform their obligations
under the Cap Agreements. In order to lessen this risk and to achieve
competitive pricing, the Company has entered into Cap Agreements only with
counterparties which are investment grade rated.
Income Taxes
The Company has elected to be taxed as a REIT and intends to comply with
the REIT Provisions of the Internal Revenue Code (the "Code") and the
corresponding provisions of State law. Accordingly, the Company will not be
subject to Federal or state income tax to the extent of its distributions to
stockholders. In order to maintain its status as a REIT, the Company is
required, among other requirements, to distribute at least 95% of its taxable
income.
Earnings per Share
Earnings per share are based on the weighted average shares of Common Stock
outstanding plus common share equivalents outstanding for the period. The
treasury stock method calculation assumes all dilutive stock options and
Warrants are exercised and the funds generated by the exercise are used to buy
back outstanding Common Stock at the average market price during the reporting
period, for primary earnings per share, or at the end of period market price if
higher, for fully diluted earnings per share.
Recent Accounting Developments
In June 1996, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 125 (SFAS 125), "Accounting for
Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,"
which supersedes SFAS 122. SFAS 125 provides accounting and reporting standards
for transfers and servicing of financial assets and extinguishments of
liabilities. These standards are based on consistent application of a financial
components approach that focuses on control. Under that approach, after a
transfer of financial assets, an entity recognizes the financial and servicing
assets it controls and the liabilities it has incurred, derecognizes financial
assets when control has been surrendered and derecognizes liabilities when
extinguished. SFAS 125 provides consistent standards for distinguishing
transfers of financial assets that are sales from transfers that are secured
borrowings. SFAS 125 requires that liabilities and derivatives incurred or
obtained by transferors as part of a transfer of financial assets be initially
measured at fair value, if practicable. It also requires that servicing assets
and other retained interests in the transferred assets be measured by allocating
the previous carrying amount between the assets sold, if any, and retained
interests, if any, based on their relative fair values at the date of the
transfers. SFAS 125 includes specific provisions to deal with servicing assets
or liabilities. SFAS 125 will be effective for transactions occurring after
December 31, 1996, except for certain transactions which according to Statement
of Financial Accounting
F-8
<PAGE> 98
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
Standards No. 127, "Deferral of the Effective Date of Certain Provisions of FASB
125," will be effective if occurring after December 31, 1997.
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128 ("SFAS 128"). "Earnings per Share",
SFAS 128 supersedes APB Opinion No. 15 ("APB 15"), "Earnings per Share" and
specifies the computation, presentation and disclosure requirements for earnings
per share ("EPS") for entities with publicly held common stock or potential
common stock. SFAS 128 will replace the presentation of primary EPS with a
presentation of basic EPS, and fully diluted EPS with diluted EPS. SFAS 128 will
also require dual presentation of basic and diluted EPS on the face of the
income statement for all entities with complex capital structures and requires a
reconciliation of the numerator and denominator of the basic EPS computation to
the numerator and denominator of the diluted EPS computation. This statement is
effective for financial statements issued for periods ending after December 15,
1997, including interim periods; earlier application is not permitted. The
Company has determined that this statement will have no significant impact on
the Company's financial position or results of operations.
NOTE 2. MORTGAGE ASSETS
At June 30, 1997, Mortgage Assets consisted of the following Agency
Securities available-for-sale:
<TABLE>
<CAPTION>
FEDERAL HOME FEDERAL NATIONAL
LOAN MORTGAGE MORTGAGE
CORPORATION ASSOCIATION TOTAL
------------- ---------------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Mortgage Securities available-for-sale, principal....... $ 132,818 $ 87,571 $220,389
Unamortized premium..................................... 4,701 3,530 8,231
-------- ------- --------
Amortized cost.......................................... $ 137,519 $ 91,101 $228,620
======== ======= ========
</TABLE>
At June 30, 1997, all investments in Mortgage Assets consisted of interests
in adjustable rate mortgage loans on residential properties. The securitized
interests in pools of adjustable rate mortgages from the Federal Home Loan
Mortgage Corporation and the Federal National Mortgage Association are
guaranteed as to principal and interest. The original maturity of the vast
majority of the Mortgage Assets is over a period of thirty years; the actual
maturity is subject to change based on the prepayments of the underlying
mortgage loans.
At June 30, 1997, the weighted average net coupon on the Mortgage Assets
was 7.78% per annum based on the amortized cost of the Mortgage Assets. All
Mortgage Assets have repricing frequency of one year or less. At June 30, 1997,
the estimated fair value of Mortgage Assets approximated amortized cost.
NOTE 3. INTEREST RATE AGREEMENTS
The amortized cost of the Company's interest rate agreements was $502,000,
net of accumulated amortization of $40,000, at June 30, 1997.
Cap Agreements
The Company had twelve outstanding Cap Agreements at June 30, 1997.
Potential future earnings from each of these Cap Agreements are based on
variations in the London Interbank Offered Rate ("LIBOR"). The Cap Agreements at
June 30, 1997 have contractually stated notional amounts which vary over the
life of
F-9
<PAGE> 99
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
the Cap Agreements. Under these Cap Agreements the Company will receive cash
payments should the agreed-upon reference rate, one month LIBOR, increase above
the strike rates of the Cap Agreements.
All of the adjustable-rate mortgage securities and mortgage loans are
limited by periodic caps (generally interest rate adjustments are limited to no
more than 1% every six months) and lifetime interest rate caps. At June 30, 1997
the weighted average lifetime cap was 10.324%.
Cap agreements outstanding at June 30, 1997 are as follows:
<TABLE>
<CAPTION>
AVERAGE CAP EXPECTED
NOTIONAL FACE AVERAGE CAP LOW CAP HIGH CAP CAP EXPENSE
YEAR AMOUNT STRIKE RATE STRIKE RATE STRIKE RATE AMORTIZATION
- ---- ------------- ----------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
1997................................... $ -- 0% 0% 0% $ 132
1998................................... 133,903 8.11 7.52 9.95 182
1999................................... 121,284 8.11 7.52 9.95 182
2000................................... 93,179 8.11 7.52 9.95 46
----
Total........................ $ 542
====
</TABLE>
NOTE 4. REVERSE REPURCHASE AGREEMENTS
The Company has entered into reverse repurchase agreements to finance the
acquisition of its Mortgage Assets. The maximum aggregate amount available under
the reverse repurchase agreements at June 30, 1997 is over $500 million. These
reverse repurchase agreements are collateralized by a portion of the Company's
Mortgage Assets. At no time were there more than approximately 45% of the
reverse repurchase agreements with any one investment banking firm. At June 30,
1997, Mortgage Assets pledged had an estimated fair value of approximately $221
million.
At June 30, 1997, the Company had approximately $210 million of reverse
repurchase agreements outstanding with a weighted average borrowing rate of
5.69% per annum and a weighted average remaining maturity of 62 days. The
maximum month end balance and the average balance outstanding for the period
February 11, 1997 through June 30, 1997, was $210 million and $151.3 million,
respectively. At June 30, 1997, the reverse repurchase agreements had the
following characteristics:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
----------------------------------------------------------------------
REVERSE WEIGHTED AVERAGE
REPURCHASE UNDERLYING INTEREST RATE WEIGHTED AVERAGE
LIABILITY COLLATERAL (PER ANNUM) MATURITY DATE
---------- ---------- ---------------- -------------------
<S> <C> <C> <C> <C>
PaineWebber Incorporated......... $ 21,984 $ 22,588 5.60% July 21, 1997
Morgan Stanley................... 32,012 33,955 5.90 October 6, 1997
Goldman Sachs.................... 85,577 91,863 5.69 September 17, 1997
Federal Home Loan Mortgage
Corporation.................... 34,316 36,193 5.65 August 21, 1997
Lehman Brothers.................. 35,650 35,980 5.60 July 26, 1997
-------- -------- ----
$209,539 $220,579 5.69% August 31, 1997
======== ======== ====
</TABLE>
At June 30, 1997, the Company had funds available under a $25 million
short-term line of credit at an interest rate equal to LIBOR plus 0.6%, secured
by certain receivables related to the Mortgage Assets. The balance under such
line of credit was zero at June 30, 1997.
F-10
<PAGE> 100
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial
instruments as of June 30, 1997, is made in accordance with the requirements of
Statement of Financial Accounting Standards ("SFAS") No. 107, Disclosure About
Fair Value of Financial Instruments, and SFAS 119, Disclosures About Derivative
Financial Instruments and Fair Value of Financial Instruments. The estimated
fair value amounts have been determined by the Company's management using
available market information and appropriate valuation methodologies; however,
considerable judgment is necessarily require to interpret market data to develop
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
<TABLE>
<CAPTION>
AS OF
JUNE 30, 1997
---------------------
CARRYING FAIR
AMOUNT VALUE
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Assets
Cash and cash equivalents............................ $ 127 $ 127
Mortgage Assets available-for-sale................... 228,620 228,620
Interest rate agreements............................. 502 206
Liabilities
Reserve repurchase agreements........................ $209,539 $209,539
</TABLE>
The following describes the methods and assumptions used by the Company in
estimating fair values.
Cash and Cash Equivalents
The carrying amount for cash and cash equivalents approximates fair value
because these instruments are demand deposits and money market mutual funds and
do not present unanticipated interest rate or credit concerns.
Mortgage Assets Available-for-Sale
The fair value of Mortgage Assets available-for-sale is estimated based on
quoted market prices from dealers and brokers for similar types of Mortgage
Securities.
Interest Rate Agreements
The fair value of interest rate agreements is estimated based on quoted
market prices from dealers and brokers.
Reverse Repurchase Agreements
The fair value of reverse repurchase agreements approximates the carrying
amounts because of the short term maturity of the liabilities.
F-11
<PAGE> 101
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
NOTE 6. STOCK OPTION PLANS
The Company has adopted the 1997 Stock Incentive Plan (the "Incentive
Plan") and the 1997 Stock Option Plan (the "Option Plan") for executive officers
and key employees and has adopted the 1997 Outside Directors Option Plan (the
"Directors Plan") for directors who are not employees of the Company.
The Incentive Plan, the Option Plan and the Directors Plan authorize the
Board of Directors (or a committee appointed by the Board of Directors) to grant
incentive stock options ("ISOs"), as defined under section 422 of the Code,
options not so qualified ("NQSOs"), and stock appreciation rights ("Awards") to
such eligible recipients.
The Incentive Plan was adopted on February 11, 1997 (the "Effective Date"),
and a total of 315,200 shares of Common Stock have been reserved for issuance
under the Incentive Plan. During the period ended June 30, 1997, the Company
granted 315,200 options at an exercise price of $12.50 per share, 216,000 of
which were NQSOs and 99,200 of which were ISOs. All stock options granted under
the Incentive Plan vest the earlier of a four year period from the date of grant
or once the Company issues $150 million of new equity, and will expire within
ten years after the date of grant. As of June 30, 1997, the Company also granted
280,000 stock appreciation rights at an exercise price of $12.50 per share.
Stock appreciation rights were granted in tandem with options.
Also, the Company has adopted the 1997 Employee Stock Purchase Plan (the
"Purchase Plan") which permits eligible employees to purchase Common Stock at a
discount through accumulated payroll deductions. No shares were issued under the
Purchase Plan as of June 30, 1997.
The Board of Directors has reserved a total of 474,800, 60,000 and 20,000
shares of Common Stock for issuance under the Company's Stock Option Plan,
Directors Plan and Purchase Plan respectively. Upon the closing of the Company's
initial public offering (the "Offering"), options for 337,800 shares of Common
Stock are reserved for issuance under the Option Plan and 137,000 and 20,000
shares of Common Stock will remain available for future grant under the Option
Plan and the Purchase Plan, respectively. On the effective date of the Offering,
each Outside Director will be granted under the Directors Plan an option to
purchase 7,500 shares of Common Stock.
In November 1995, the FASB issued Statement of Financial Accounting
Standards No. 123 (SFAS 123), "Accounting for Stock Based Compensation." This
statement establishes financial accounting standards for stock-based employee
compensation plans. SFAS 123 permits the Company to choose either a new fair
value based method or the current APB Opinion 25 Intrinsic value based method of
accounting for its stock-based compensation arrangements. SFAS 123 requires pro
forma disclosures of net income (loss) computed as if the fair value based
method had been applied in financial statements of companies that continue to
follow current practice in accounting for such arrangements under Opinion 25.
SFAS 123 applies to all stock-based employee compensation plans in which an
employer grants shares of its stock or other equity instruments to employees
except for employee stock ownership plans. SFAS 123 also applies to plans in
which the employer incurs liabilities to employees in amounts based on the price
of the employer's stock, i.e., stock option plans, stock purchase plans,
restricted stock plans, and stock appreciation rights. The statement also
specifies the accounting for transactions in which a company issues stock
options or other equity instruments for services provided by nonemployees or to
acquire goods or services from the outside suppliers or vendors.
The Company elected to apply the APB Opinion 25 in accounting for its Plan
and, accordingly, no compensation cost has been recognized for its stock options
in the financial statements. Had the Company determined compensation cost based
on the fair value at the grant date for its stock options exercisable under SFAS
No. 123, the Company's net income and income per share for the period February
11, 1997
F-12
<PAGE> 102
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
(commencement of operations) through June 30, 1997 would have decreased to the
pro forma amounts indicated below.
<TABLE>
<CAPTION>
FOR THE PERIOD FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
--------------------------------
(IN THOUSANDS EXCEPT SHARE DATA)
<S> <C>
Net income as reported............................................. $ 584
=====
Pro forma net income............................................... $ 47
=====
Income per share as reported....................................... $ 0.35
=====
Pro forma income per share......................................... $ 0.03
=====
</TABLE>
The derived fair value of the options granted during the period February
11, 1997 (commencement of operations) through June 30, 1997 was approximately
$1.9 million, using the Black-Scholes option pricing model with the following
assumptions; risk-free interest rate of 6.0%, expected life of 10 years, and
expected volatility of 20%.
NOTE 7. STOCKHOLDERS' EQUITY
On February 11, 1997, the Company issued 1,614,000 shares of Common Stock
at a price of $12.50 per share. The Company received proceeds of $20,165,000,
net of issuance costs of $10,000.
On July 17, 1997, the Company declared a dividend of $438,000, or $0.27 per
common share. This dividend was paid on July 17, 1997 to holders record of
Common Stock as of June 30, 1997. On May 1, 1997, the Company declared a
dividend of $146,000, or $0.09 per share of Common Stock. This dividend was paid
on May 1, 1997 to common stockholders of record as of March 31, 1997.
NOTE 8. STOCK SPLIT AND AUTHORIZED SHARES
On August 6, 1997, the Company authorized a 0.8-for-one reverse stock split
of all of the Common Stock. All references in the financial statements to the
number of shares, per share amounts and prices of the Company's Common Stock
have been retroactively restated to reflect the decreased number of shares of
Common Stock outstanding. On October , 1997, the Company increased the number
of total authorized shares of Capital Stock to 25,000,000 from 4,000,000.
NOTE 9. MANAGEMENT AGREEMENT
Effective February 11, 1997, the Company entered into a Management
Agreement with the Manager for an initial term of two years, to provide
management services to the Company. These services include the purchase,
financing, and administration of mortgage loans and mortgage securities.
The Manager receives management fees and incentive compensation as follows:
- 1/8 of 1% per year, to be paid monthly, of the principal amount of agency
securities;
- 3/8 of 1% per year, to be paid monthly, of the principal amount of all
Mortgage Assets other than agency securities; and
- 25% of the amount by which the Company's net income (before deducting the
amount to be paid as incentive compensation) exceeds the annualized
return on equity equal to the average ten year U.S. Treasury Rate plus
2%.
Management fees of $69,000 were recorded for the period from February 11,
1997 (commencement of operations) through June 30, 1997. The incentive
compensation is calculated for each fiscal quarter, and paid to the Manager
quarterly in arrears before any income distributions are made to stockholders.
No incentive
F-13
<PAGE> 103
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE PERIOD FROM FEBRUARY 11, 1997
(COMMENCEMENT OF OPERATIONS)
THROUGH JUNE 30, 1997
compensation was recorded for the period from February 11, 1997 (commencement of
operations) to June 30, 1997.
The incentive compensation is calculated for each fiscal quarter, and paid
to the Manager quarterly in arrears before any income distributions are made to
stockholders. No incentive compensation was recorded for the period from
February 11, 1997 (commencement of operation) to June 30, 1997.
NOTE 10. COMMITMENTS AND CONTINGENCIES
As of June 30, 1997, the Company had no outstanding commitments to purchase
or sell Mortgage Assets or to purchase, sell or terminate interest rate
agreements. The Company also had no commitments to enter into additional reverse
repurchase agreements or other borrowings.
F-14
<PAGE> 104
======================================================
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS IN CONNECTION WITH THIS OFFERING OTHER THAN THOSE CONTAINED IN
THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH OTHER INFORMATION AND REPRESENTATION
MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR THE
UNDERWRITERS. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE
HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THERE HAS
BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR THAT THE
INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO ITS DATE.
THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN
OFFER TO BUY ANY SECURITIES OTHER THAN THE REGISTERED SECURITIES TO WHICH IT
RELATES. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION
OF AN OFFER TO BUY SUCH SECURITIES IN ANY CIRCUMSTANCES IN WHICH SUCH OFFER OR
SOLICITATION IS UNLAWFUL.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
-----
<S> <C>
Prospectus Summary..................... 3
Risk Factors........................... 10
The Company............................ 20
Use of Proceeds........................ 21
Dividend Policy and Distributions...... 21
Capitalization......................... 22
Dilution............................... 23
Selected Financial Data................ 24
Management's Discussion and Analysis of
Financial Condition and Results of
Operations........................... 25
Business............................... 30
Management of the Company.............. 44
The Manager............................ 54
Certain Transactions................... 60
Conflicts of Interest.................. 63
Principal Stockholders................. 65
Description of Capital Stock........... 66
Shares Eligible for Future Sale........ 69
Federal Income Tax Consequences........ 70
ERISA Considerations................... 79
Underwriting........................... 80
Certain Provisions of Maryland Law and
the Company's Charter and Bylaws..... 82
Legal Matters.......................... 85
Experts................................ 85
Additional Information................. 85
Glossary............................... 86
Index to Financial Statements.......... F-1
</TABLE>
UNTIL , ALL DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK,
WHETHER OR NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A
PROSPECTUS. THIS IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A
PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD
ALLOTMENTS OR SUBSCRIPTIONS.
======================================================
======================================================
6,500,000 SHARES
LOGO
COMMON STOCK
-----------------
PROSPECTUS
-----------------
PAINEWEBBER INCORPORATED
OPPENHEIMER & CO., INC.
EVEREN SECURITIES, INC.
SUTRO & CO. INCORPORATED
------------------------
, 1997
======================================================
<PAGE> 105
ITEM 30. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not Applicable.
ITEM 31. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION
The following table sets forth the costs and expenses, other than
underwriting discounts and commissions, payable by the Registrant in connection
with the sale of Common Stock being registered. All amounts are estimates except
the SEC registration fee, the New York Stock Exchange ("NYSE") filing fee and
the structuring fee.
<TABLE>
<CAPTION>
AMOUNT
TO BE
PAID
-----------
<S> <C>
SEC Registration Fee..................................... $ 36,000
NYSE filing fee.......................................... 100,000
Printing and engraving expenses.......................... 125,000
Legal fees and expenses.................................. 250,000
Accounting fees and expenses............................. 125,000
Structuring fee(1)....................................... 487,500
Transfer agent and custodian fees........................ 20,000
Miscellaneous............................................ 56,500
----------
Total(2)................................................. $ 1,200,000
==========
</TABLE>
- ---------------
(1) $560,625 if the underwriter's over-allotment option is exercised in full.
(2) $1,300,000 if the underwriter's over-allotment option is exercised in full.
ITEM 32. SALES TO SPECIAL PARTIES
The securities described in Item 33(a) were issued to the founders of the
Company in exchange for cash.
ITEM 33. RECENT SALES OF UNREGISTERED SECURITIES.
(a) Pursuant to the exemption provided by Section 4(2) of the Securities
Act, on February 11, 1997 the Company issued 1,614,000 shares of Common Stock
for an aggregate purchase price of $20,175,000.
(b) Pursuant to the exemption provided by Rule 701 promulgated under the
Securities Act, on February 11, 1997, the Company issued options to purchase
315,200 shares of Common Stock with an exercise price of $12.50 per share.
ITEM 34. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
As permitted by the Maryland General Corporate Law ("MGCL"), the Company's
Charter obligates the Company to indemnify its present and former directors and
officers and to pay or reimburse reasonable expenses for such individuals in
advance of the final disposition of a proceeding to the maximum extent permitted
from time to time by Maryland law. The MGCL permits a corporation to indemnify
its present and former directors and officers, among others, against judgments,
penalties, fines, settlements and reasonable expenses actually incurred by them
in connection with any proceeding to which they may be made a party by reason of
their service in those or other capacities, unless it is established that (a)
the act or omission of the director or officer was material to the matter giving
rise to such proceeding and (i) was committed in bad faith or (ii) was the
result of active and deliberate dishonesty, (b) the director or officer actually
received an improper personal benefit in money, property or services, or (c) in
the case of any criminal proceeding, the director or officer had reasonable
cause to believe that the act or omission was unlawful. The Bylaws implement the
provisions relating to indemnification contained in the Company's Charter.
Maryland law permits the charter of a Maryland corporation to include a
provision limiting the liability of its directors and officers to the
corporation and its stockholders for money damages, except to the extent that
(i) the person actually received an improper benefit or profit in money,
property or services, or (ii) a judgment or other final
II-1
<PAGE> 106
adjudication is entered in a proceeding based on a finding that the person's
action, or failure to act, was the result of active and deliberate dishonesty
and was material to the cause of action adjudicated in the proceeding. The
Company's Charter contains a provision providing for elimination of the
liability of its directors or officers to the Company or its stockholders for
money damages to the maximum extent permitted by Maryland law from time to time.
In addition, the officers, directors, and controlling persons of the Company are
indemnified against certain liabilities by the Company under the Underwriting
Agreement relating to the Offering. The Company will maintain for the benefit of
its officers and directors, officers' and directors' insurance.
In addition, the Registrant intends to enter into an Indemnity Agreement
(Exhibit 10.14 hereto) with its officers and Directors. The Underwriting
Agreement (Exhibit 1.1) also provides for indemnification by the Underwriters of
the Company, its Directors and officers and persons who control the Company
within the meaning of Section 15 of the Securities Act with respect to certain
liabilities, including liabilities arising under the Securities Act.
ITEM 35. TREATMENT OF PROCEEDS FROM STOCK BEING REGISTERED.
Not Applicable.
ITEM 36. FINANCIAL STATEMENTS AND EXHIBITS.
(a) Financial Statements included in the Prospectus are:
Balance sheet at June 30, 1997
Statement of Operations for the period from February 11, 1997
(commencement of operations) through June 30, 1997
Statement of Stockholders' Equity for the period from February 11, 1997
(commencement of operations) through June 30, 1997
Statement of Cash Flows for the period from February 11, 1997
(commencement of operations) through June 30, 1997
Notes to financial statements
All schedules have been omitted because they are either not applicable,
not required or the information required has been disclosed in the
financial statements and related notes or otherwise in the Prospectus.
(b) Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- ------------------------------------------------------------------------------
<C> <S>
*1.1 Form of Underwriting Agreement
+3.1 Amended and Restated Articles of Incorporation of the Registrant
+3.2 Amended and Restated Bylaws of the Registrant
+4.1 Registration Rights Agreement dated February 11, 1997
5.1 Opinion of Piper & Marbury L.L.P.
8.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP
+10.1 Management Agreement between the Registrant and Home Asset Management Corp.
and Amendment thereto
+10.2 Employment and Noncompetition Agreement between Home Asset Management Corp.
dated February 11, 1997 and John Robbins and Amendment thereto
+10.3 Employment and Noncompetition Agreement between Home Asset Management Corp.
and Jay Fuller dated February 11, 1997 and Amendment thereto
</TABLE>
II-2
<PAGE> 107
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- ------------------------------------------------------------------------------
<C> <S>
+10.4 Mark Conger Employment Letter dated January 7, 1997 and amendment thereto
+10.5 Rollie Lynn Employment Letter dated January 7, 1997 and amendment thereto
10.5a John Dahl Employment Letter
10.5b Lisa Faulk Employment Letter
+10.6 1997 Stock Incentive Plan and forms of option agreement and SAR agreement
+10.7 1997 Employee Stock Option Plan
+10.8 1997 Outside Directors Stock Option Plan
+10.9 Employee Stock Purchase Plan
+10.10 Securities Purchase Agreement between Registrant, Home Asset Management Corp.
and MDC REIT Holdings, LLC dated February 11, 1997
+10.11 Subscription Agreement
+10.12 Secured Promissory Note dated June 25, 1997
+10.13 Lease Agreement with Louis and Louis dated March 7, 1997
+10.14 Form of Indemnity Agreement
+11.1 Statement of Computations of per share earnings
*23.1 Consent of KPMG Peat Marwick LLP
23.2 Consent of Piper & Marbury L.L.P. (included in Exhibit 5.2)
23.3 Consent of Jeffers, Wilson, Shaff & Falk, LLP (included in Exhibit 8.1)
+24.1 Power of Attorney
+27.1 Financial Data Schedule
+99.1 Consents to be named as a director pursuant to Rule 438
</TABLE>
- ---------------
* To be filed by amendment.
+ Previously filed.
ITEM 37. UNDERTAKINGS
The undersigned Registrant hereby undertakes to provide to the Underwriters
at the closing certificates in such denominations and registered in such names
as required by the Underwriters to permit prompt delivery to each purchaser.
Insofar as indemnification by the Registrant for liabilities arising under
the Securities Act may be permitted to directors, officers and controlling
persons of the Registrant pursuant to the provisions referenced in Item 14 of
this Registration Statement or otherwise, the Registrant has been advised that
in the opinion of the Securities and Exchange Commission such indemnification is
against 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 Registrant of expenses incurred or
paid by a director, officer, or controlling person of the Registrant 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 hereunder, the Registrant will, unless in the opinion of its counsel
the matter has been settled by controlling precedent, submit to a court of
appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act and will be governed by
the final adjudication of such issue.
II-3
<PAGE> 108
The undersigned Registrant hereby undertakes:
(1) That for purposes of determining any liability under the
Securities Act, the information omitted from the Prospectus filed as part
of this Registration Statement in reliance upon Rule 430A and contained in
a form of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or
(4) or 497(h) under the Securities Act shall be deemed to be part of this
Registration Statement as of the time it was declared effective.
(2) For the purpose of determining any liability under the Securities
Act, each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall be
deemed to be the initial bona fide offering thereof.
II-4
<PAGE> 109
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant
certifies that it has reasonable grounds to believe that it meets all of the
requirements for filing on Form S-11 and has duly caused this Amendment No. 2 to
Registration Statement to be signed on its behalf by the undersigned, thereto
duly authorized, in the City of San Diego, State of California, on the 9th day
of October, 1997.
AMERICAN RESIDENTIAL INVESTMENT TRUST,
INC.
By: /s/ MARK A. CONGER
------------------------------------
Mark A. Conger
Chief Financial Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, THIS
REGISTRATION STATEMENT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ----------------------------------------------- ----------------------------- ----------------
<S> <C> <C>
By: * JOHN M. ROBBINS Chairman of the Board and October 9, 1997
- ----------------------------------------------- Chief Executive Officer
John M. Robbins (Principal Executive Officer)
By: /s/ MARK A. CONGER Chief Financial Officer October 9, 1997
- ----------------------------------------------- (Principal Financial and
Mark A. Conger Accounting Officer)
By: * JAY M. FULLER Director October 9, 1997
- -----------------------------------------------
Jay M. Fuller
By: * GEORGE MCCOWN Director October 9, 1997
- -----------------------------------------------
George McCown
By: * DAVID DE LEEUW Director October 9, 1997
- -----------------------------------------------
David De Leeuw
By: /s/ MARK A. CONGER
- -----------------------------------------------
Mark A. Conger, Attorney-in-Fact
</TABLE>
II-5
<PAGE> 110
EXHIBIT INDEX
<TABLE>
<CAPTION>
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER DESCRIPTION PAGE
- ------ ---------------------------------------------------------------------- ------------
<C> <S> <C>
*1.1 Form of Underwriting Agreement
+3.1 Articles of Amendment and Restatement of the Registrant
+3.2 Amended and Restated Bylaws of the Registrant
+4.1 Registration Rights Agreement dated February 11, 1997
5.1 Opinion of Piper & Marbury L.L.P.
8.1 Opinion of Jeffers, Wilson, Shaff & Falk, LLP
+10.1 Management Agreement between the Registrant and Home Asset Management
Corp. dated February 11, 1997 and Amendment thereto
+10.2 Employment and Noncompetition Agreement between Home Asset Management
Corp. and John Robbins dated February 11, 1997 and Amendment thereto
+10.3 Employment and Noncompetition Agreement between Home Asset Management
Corp. and Jay Fuller dated February 11, 1997 and Amendment thereto
+10.4 Mark Conger Employment Letter dated January 7, 1997 and amendment
thereto
+10.5 Rollie Lynn Employment Letter dated January 7, 1997 and amendment
thereto
10.5a John Dahl Employment Letter
10.5b Lisa Faulk Employment Letter
+10.6 1997 Stock Incentive Plan
+10.7 Form of 1997 Stock Option Plan
+10.8 Form of 1997 Outside Directors Stock Option Plan
+10.9 Form of Employee Stock Purchase Plan
+10.10 Securities Purchase Agreement between Registrant, Home Asset
Management Corp. and MDC REIT Holdings, LLC dated February 11, 1997
+10.11 Form of Subscription Agreement dated February 11, 1997
+10.12 Secured Promissory Note dated June 25, 1997
+10.13 Lease Agreement with Louis and Louis dated March 7, 1997
+10.14 Form of Indemnity Agreement
+11.1 Statement of Computations of per share earnings
*23.1 Consent of KPMG Peat Marwick LLP
23.2 Consent of Piper & Marbury L.L.P. (included in Exhibit 5.1)
23.3 Consent of Jeffers, Wilson, Shaff & Falk, LLP (included in Exhibit
8.1)
+24.1 Power of Attorney
+27.1 Financial Data Schedule
+99.1 Consents to be named as a director pursuant to Rule 438
</TABLE>
- ---------------
* To be filed by amendment.
+ Previously filed.
<PAGE> 1
EXHIBIT 5.1
PIPER & MARBURY
L.L.P.
CHARLES CENTER SOUTH
36 SOUTH CHARLES STREET WASHINGTON
BALTIMORE, MARYLAND 21201-3018 NEW YORK
410-539-2530 PHILADELPHIA
FAX: 410-539-0489 EASTON
October 8, 1997
American Residential Investment Trust, Inc.
445 Marine View Avenue, Suite 230
Del Mar, California 92014
Registration Statement on Form S-11
Ladies and Gentlemen:
We have acted as special Maryland counsel to American Residential
Investment Trust, Inc., a Maryland corporation (the "Company"), in connection
with the registration under the Securities Act of 1933, as amended (the "Act"),
pursuant to a Registration Statement on Form S-11 of the Company (Registration
No. 333-33679) (the "Registration Statement") filed with the Securities and
Exchange Commission (the "Commission"), of up to 7,475,000 shares of Common
Stock, par value $.01 per share, of the Company (the "Shares"), pursuant to an
Underwriting Agreement between the Company and Painewebber Incorporated,
Oppenheimer & Co., Inc., Everen Securities, Inc. and Sutro & Co. Incorporated as
representatives of the several underwriters (the "Underwriting Agreement"). This
opinion is being provided at your request in connection with the filing of the
Registration Statement.
In rendering the opinion expressed herein, we have examined the
Registration Statement as amended to date (and the Preliminary Prospectus
contained therein), a draft of the Underwriting Agreement, the Charter and
By-Laws of the Company, minutes of the proceedings of the Company's Board of
Directors or a committee thereof relating to the issuance of the Shares, a
Certificate of an Officer of the Company dated October 8, 1997 (the
"Certificate") and such other statutes, certificates, instruments and documents
relating to the Company and matters of law as we have deemed necessary to the
issuance of this opinion. In such examination, we have assumed, without
independent investigation, the genuineness of all signatures, the legal capacity
of all individuals who have executed any of the aforesaid documents, the
authenticity of all documents submitted to us as originals, the conformity with
originals of all documents submitted to us as copies (and the authenticity of
the originals of such copies), there has been no substantial change in the final
documents of documents submitted to us as drafts and that all
<PAGE> 2
public records reviewed are accurate and complete. As to factual matters, we
have relied upon the Certificate and have not independently verified the matters
stated therein.
Based upon the foregoing, and having regard for such legal considerations
as we deem relevant, we are of the opinion and so advise you that upon the
issuance and delivery of the Shares in accordance with the terms set forth in
the Registration Statement and the Underwriting Agreement, the Shares will have
been duly and validly authorized and will be legally issued, fully-paid and
non-assessable.
The opinion expressed herein is solely for the use of (i) the Company in
connection with the Registration Statement, and (ii) Jeffers, Wilson, Shaff &
Falk, LLP in giving their tax opinion to be filed as an exhibit to the
Registration Statement. This opinion may not be relied on by any other person or
in any other connection without our prior written approval. This opinion is
limited to the matters set forth herein, and no other opinion should be inferred
beyond the matters expressly stated.
We hereby consent to the filing of this opinion as an exhibit to the
Registration Statement and to the reference to us under the heading "Legal
Matters" in the Prospectus included in the Registration Statement.
Very truly yours,
/s/ PIPER & MARBURY L.L.P.
-2-
<PAGE> 1
EXHIBIT 8.1
JEFFERS, WILSON, SHAFF & FALK, LLP
ATTORNEYS AT LAW
18881 VON KARMAN AVENUE
SUITE 1400
IRVINE, CALIFORNIA 92612
TELEPHONE: (714) 660-7700
FACSIMILE: (714) 660-7799
October 8, 1997
American Residential Investment Trust, Inc.
445 Marine View Avenue, Suite 250
Del Mar, CA 92014
RE: INITIAL PUBLIC OFFERING
Gentlemen:
This is an opinion (the "Opinion") which you have requested as to (a) the
discussion entitled "Federal Income Tax Consequences" and (b) the discussion
entitled "ERISA Investors," both as set forth in the Prospectus (the
"Prospectus"), contained in the Registration Statement on Form S-11 of American
Residential Investment Trust, Inc. (the "Company"), registration no. 333-33679,
as amended by Pre-Effective Amendment No. 2, filed by the Company, in connection
with the issuance (the "Offering") of 6,500,000 shares of Common Stock (such
shares of Common Stock are sometimes referred to herein as the "Shares") of the
Company.
The Company is a Maryland corporation that is intended to qualify as a real
estate investment trust ("REIT") under the Code. Capitalized terms used in this
Opinion and not otherwise defined are as defined in the Prospectus. Our Opinion
is based on existing law, including the Code, existing Treasury Regulations,
Revenue Rulings, Revenue Procedures, U.S. Department of Labor regulations and
administrative interpretations, proposed regulations and case law, all of which
are subject to change either prospectively or retroactively. No assurance can be
given that such existing law may not change in a manner that would modify the
conclusions expressed in this Opinion. Moreover, relevant laws could change in a
manner that could adversely affect the Company or its stockholders. We have no
obligation to inform you of any such change in the law. We have not been
requested to opine, and we have not opined, as to any issues other than those
expressly set forth herein. This Opinion extends only to questions under the
Code and ERISA. We express no opinion with respect to any other law or the laws
of any other jurisdiction.
Our Opinion is based upon certain statements, representations and
warranties made by the Company as to factual matters regarding the Company's
assets, business and Common Stock as set forth in the Prospectus and in the
Company's letter, dated October 8, 1997, to us, and we have assumed that such
statements, representations and warranties are true and accurate. As to such
factual matters material to our Opinion, we have relied solely upon such
statements, representations and warranties of the Company. We have assumed the
authenticity of all documents submitted to us, the genuineness of all
signatures, the legal capacity of all natural
<PAGE> 2
American Residential Investment Trust, Inc.
October 8, 1997
Page 2
persons, the conformity to the originals of all documents submitted to us as
copies and the due execution and delivery of all documents where due execution
and delivery are prerequisites to the effectiveness thereof. Without any
independent investigation, no facts have come to our attention, however, that
would cause us to question the accuracy in a material way of any documents,
letters, statements, representations or warranties of the Company.
We are admitted to practice law in the State of California and our Opinion
is limited to federal law. As to matters of Maryland law, including the
formation and good standing of the Company as a Maryland corporation and the
validity and terms of the Shares, we have relied solely on the opinion of Piper
& Marbury L.L.P., special Maryland counsel to the Company. Our Opinion is solely
for the benefit of the Company in connection with the Offering, and is not to be
circulated or quoted or otherwise relied upon by the Company for any other
purpose without our prior written consent.
1 Federal Income Tax Consequences. We have acted as special tax counsel to
the Company in connection with the Company's Offering of the Shares. In that
connection, we have reviewed the section of the Prospectus entitled "Federal
Income Tax Consequences" and in our opinion such section identifies and fairly
summarizes the federal income tax consequences that are likely to be material to
the Company and to a holder of the Common Stock and to the extent that such
summaries involve matters of law, we are of the opinion that such statements of
law are correct under the Code. We expressly confirm that all of the opinions
attributed to Special Tax Counsel in the section of the Prospectus entitled
"Federal Income Tax Consequences" accurately reflect our opinion on the likely
outcome of each such issue if challenged by the Service.
The Company's qualification as a REIT under the Code will depend upon the
Company's ability to meet, through actual operating results, distribution
levels, diversity of stock ownership and the various income and asset
qualification tests imposed under the Code. Such operating results may not be
reviewed by us as Counsel, and accordingly, no assurance can be given that the
actual results of the Company's operations for any one taxable year will satisfy
the requirements under the Code for REIT qualification. Moreover, certain
aspects of the Company's operations have not been considered by the courts or
the Service. There can be no assurance that the courts or the Service will agree
with this Opinion. In addition, qualification as a REIT depends on future
transactions and events that cannot be known at this time.
2 ERISA Investors. The Company has requested our opinion as to whether the
Shares will constitute "publicly-offered securities" under regulations (the
"Regulations") issued by the U.S. Department of Labor so that the assets of the
Company will not be deemed to constitute "plan assets" for purposes of ERISA or
for purposes of Code Section 4975 following an investment in the Shares by an
ERISA Plan.
<PAGE> 3
American Residential Investment Trust, Inc.
October 8, 1997
Page 3
The Regulations generally provide that, in the case of an ERISA Plan's
investment in an equity interest of an entity, the ERISA Plan's assets include
both the equity investment and an undivided interest in each of the underlying
assets of the entity unless the entity can satisfy at least one of a number of
exceptions set forth in the Regulations. One exception to such plan assets
treatment is for an equity interest that is a "publicly-offered security."
The Regulations provide that a security is a "publicly-offered security" if
it is (a) "freely transferable," (b) part of a class of securities that is
"widely held" (namely, owned by 100 or more investors independent of the issuer
and of one another ("Independent Investors")), and (c) either (1) part of a
class of securities that is registered under Section 12(b) or 12(g) of the
Securities Exchange Act of 1934, or (2) sold to the ERISA Plan as part of an
offering to the public pursuant to an effective registration statement under the
Securities Act of 1933, and the class of securities of which it is part is
registered under the Securities Exchange Act of 1934 within a specified period
of time (generally 120 days) after the end of the entity's fiscal year in which
the offering occurs.
The Company has represented that the Shares will be timely registered with
the Securities and Exchange Commission pursuant to Section 12(b) of the
Securities Exchange Act of 1934. Assuming that the Shares will be properly
registered under the Securities Exchange Act of 1934 within the time period
specified in the Regulations and that the initial closing of the sale of Shares
out of escrow pursuant to the terms of the Offering will not take place unless
and until the Company has properly determined (a) that the Shares would be
acquired by at least 150 purchasers who are Independent Investors and (b) that
the Shares will be widely held after the initial offering, the assets of the
Company will not be deemed to be plan assets of an ERISA Plan if the Shares are
freely transferable within the meaning of the Regulations.
The Regulations provide that a determination as to whether a security is
freely transferable is inherently factual in nature and must be made on the
basis of all relevant facts and circumstances. The Regulations provide that if a
security is part of an offering in which the minimum investment is $10,000 or
less (as is the case with the Shares since there is no minimum investment
required for the Shares), certain restrictions on transfer or assignment
enumerated in the Regulations (the "Enumerated Restrictions") ordinarily will
not, alone or in combination, affect a finding that such securities are freely
transferable.
The preamble to the Regulations (the "Preamble") (which is not primary
legal authority) goes one step further, providing that if the minimum investment
amount is not exceeded and if a security has no restrictions other than the
Enumerated Restrictions, the security in effect will be presumed to be freely
transferable. However, even if a security is not entitled to this
<PAGE> 4
American Residential Investment Trust, Inc.
October 8, 1997
Page 4
presumption, it may nevertheless be considered to be "freely transferable" if
the facts and circumstances so indicate. The Regulations and the Preamble
provide little additional guidance as to what restrictions would cause a
security to fail to be freely transferable.
We have examined the Prospectus and copies that the Company has provided to
us of a specimen certificate of the Common Stock, the Company's Articles of
Amendment and Restatement, and the Company's Amended and Restated Bylaws, and
have determined that the Shares contain no restriction that is not permitted
under the Enumerated Restrictions. The Company has represented that the Shares
are not subject to any restrictions on transferability other than those
described in the section of the Prospectus entitled "Description of Capital
Stock." Based on the foregoing, in our opinion, the Shares are freely
transferable within the meaning of the Regulations. The Company has represented
to us that the initial closing out of escrow of the purchase of the Shares will
not take place unless the Shares would be held by 150 or more Independent
Investors immediately after such closing.
Consequently, assuming that (1) the Shares are properly registered for
securities purposes under the requirements discussed above, and (2) at least 150
Independent Investors purchase Shares in the initial public offering, in our
opinion, the Shares will constitute "publicly-offered securities" so that the
assets invested in the Company by an ERISA Plan will not constitute plan assets.
We have not opined concerning whether the requirements of any of the alternative
exemptions to plan assets treatment would be satisfied by the Company.
3 Consent. We hereby consent to the filing of this opinion as an exhibit to
the Registration Statement and to the references to this firm under the captions
"Federal Income Tax Consequences," "ERISA Investors" and "Legal Matters" in
connection with this opinion.
Very truly yours,
/s/ JEFFERS, WILSON, SHAFF & FALK, LLP
<PAGE> 1
EXHIBIT 10.5a
October 6, 1997
John Dahl
18 Meryton
Irvine, CA 92612
Dear John:
As a result of our conversation, I am outlining the proposed terms of your
employment with American Residential and Home Asset Management. We are very
encouraged by your interest and look forward to working together to create a
very exciting company. Please call me after reviewing these terms if you have
any questions.
Position: Executive Vice President.
Responsibility: Capital Markets and Loan Production.
Base Salary: $175,000.00.
Bonus Potential: up to 100% of Base Salary.
Options: Initial Grant of 75,00 options at market at time
of employment. Full vesting upon change of
control Current vesting and 90 day exercise
provision for termination without cause.
Benefits: Participation in all company programs available to
Senior Officers:
401K program [starting in 1998]
company pays 100% of health care and insurance
premiums employee stock purchase program [available
after IPO] employee loan program to purchase AmReit
stock [after IPO]
Severance: one year's salary for termination without cause.
Transition: up to $25,000 of out of pocket expenses associated
with a move to the San Diego area if within 18
months of hire date. Transition payment in the
form of a note in the amount of $100,000 this
represents bonus for 1997 and signing bonus.
John, again we are very excited about you helping us and look forward to your
response. Feel free to contact me at home over the weekend to discuss any
aspects of this offer.
<PAGE> 2
John Dahl
October 6, 1997
Page Two
My home phone number is 619-756-5441 and you have the work number.
We look forward to your response.
Sincerely,
Jay M. Fuller
President
<PAGE> 1
EXHIBIT 10.5b
October 6, 1997
Ms. Lisa Faulk
4410 Santa Monica Blvd.
San Diego, CA 92107
Dear Lisa:
As a result of our conversation, I am outlining the proposed terms of your
employment with American Residential and Home Asset Management. We are very
encouraged by your interest and look forward to working together to create a
very exciting company. Please call me after reviewing these terms if you have
any questions.
Position: Senior Vice President.
Responsibility: Operations.
Reporting Responsibility: To E.V.P. of Capital Markets and Production
Base Salary: $120,000.00 per year.
Bonus Potential: up to 75% of Base Salary.
Options: Initial Grant of 50,000 options at market at time
of employment.
Full vesting upon change of control
Current vesting and 90 day exercise provision for
termination without cause.
Benefits: Participation in all company programs available to
Senior Officers:
401K program [starting in 1998]
company pays 100% of health care and insurance premiums
employee stock purchase program [available after IPO]
employee loan program to purchase AmReit stock [after IPO]
Severance: six month's salary for termination without cause.
Transition: Transition payment in the amount of $40,000: payable
$20,000 in Feb. 1998 and $20,000 in the form of a note
payable on or before Feb. 1999; this represents bonus
for 1997 and signing bonus.
Lisa, again we are very excited about you helping us and look forward to your
response. Feel free to contact me at home over the weekend to discuss any
aspect of this offer.
<PAGE> 2
Ms. Lisa Faulk
October 6, 1997
Page Two
My home phone number is 619-756-5441 and you have the work number.
We look forward to your response.
Sincerely,
Jay M. Fuller
President
Agreed and Accepted: _________________________________________
