UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [FEE REQUIRED]
For the fiscal year ended December 31, 1996
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from _______ to _____________
Commission File Number 0-17338
HOMEOWNERS GROUP, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 65-0033743
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State or other jurisdiction of (IRS Employer
incorporation or organization Identification No.)
400 SAWGRASS CORPORATE PARKWAY, SUNRISE, FLORIDA 33325
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(Address of principle executive offices) (Zip Code)
Registrant's telephone number, including area code (954) 845-9100
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of Each Class on which registered
NONE NOT APPLICABLE
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Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, PAR VALUE $.01 PER SHARE
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(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES [X] NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Based upon the closing market price of the registrant's common stock as of March
27, 1997 of $1.56, the aggregate market value of the voting stock held by
non-affiliates of the registrant is $6,948,976.
Number of shares of common stock outstanding as of March 27, 1997, is 5,558,350.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement for the Annual Meeting of
Stockholders are incorporated by reference as Part III of this Annual Report.
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PART I
RECENT DEVELOPMENTS
Homeowners Group, Inc. ("HOMG" or the "Company") announced on May 15, 1996 that
it had entered into a definitive merger agreement under which The Cross Country
Group, Inc. ("Cross Country") agreed to acquire the Company for $2.35 per share
in cash. The merger agreement stated that the merger was subject to a number of
conditions including approval of the transaction by the Company's stockholders
and regulatory authorities. The Company also announced on May 15, 1996 that it
had reached an agreement to settle the judgment obtained by Acceleration
National Insurance Company ("Acceleration" or "ANIC") by paying to Acceleration
a reduced amount of approximately $4.4 million in cash at the closing of the
merger, which Cross Country had agreed, as a condition to the merger, to
satisfy.
On November 7, 1996, the Company, announced that it had entered into an
amendment to the merger agreement with Cross Country, which, among other things,
reduced the price at which Cross Country will acquire HOMG stock to $2.06 per
share in cash. The amendment also extended the anticipated closing date to no
later than March 1, 1997. In addition, the amendment modified the Company's
stock rights plan to permit Cross Country and its affiliates to buy an unlimited
number of shares in privately negotiated transactions. This stock rights plan
amendment was not effective until three business days after the information was
released, provided that no other bid for the Company was received within such
three day period. The three day period passed with no other bids submitted to
purchase the Company.
An affiliate of Cross Country purchased, for approximately $2.75 million, the
$5.2 million judgment obtained by Acceleration (the "Judgment"). The purchase
price of the judgment reflected a $1.4 million payment previously made by the
Company. The Cross Country affiliate also agreed, under certain conditions, to
take no action to collect on the Judgment before January 31, 1997.
On February 10, 1997, the Company entered into a second amendment to the merger
agreement with Cross Country, which extended the anticipated closing date to the
earlier of July 1, 1997 or termination of the merger agreement. The Company also
entered into an amendment to the agreement with the affiliate of Cross Country
which holds the Judgment, extending the date through which the Cross Country
affiliate agreed, under certain conditions, to take no action to collect on the
Judgment until the earlier of July 1, 1997 or termination of the merger
agreement. The Company guaranteed the obligation of HMS and pledged the shares
of HMS and another subsidiary of the Company to secure such guarantee. HMS and
the subsidiary granted security interests in their assets as part of the First
Amendment to the Merger Agreement. Should the Merger fail to be consummated by
July 1, 1997, Cross Country will be entitled to take action to collect on its
judgment. In the event the judgment creditor proceeds to execute on its
judgment, it is likely that the Company will be without adequate resources to
pay the full amount due.
As of the date of this filing, the Company has obtained regulatory approval for
the merger in all states.
COMPANY HISTORY
HOMG was incorporated in 1988 in Delaware to act as the holding company for
Homeowners Marketing Services, Inc. ("HMS") and its subsidiaries, which became
subsidiaries of the Company in the same year as a result of a reorganization
prior to the Company's sale of its shares in a public offering. HMS has provided
products and services to real estate brokerage firms since 1980.
DESCRIPTION OF BUSINESS
The Company has developed a national network of real estate brokers ("Members"),
enrolled by the Company's franchisees ("Affiliates") and the field sales force
employed in the Corporate Owned Regions ("COR"). The Company believes that it is
a leading supplier of products and services to real estate brokerage firms which
market primarily residential properties. The Company offers various types of
memberships including a "full membership," under which participating brokers and
agents have access to all of the Company's products and services, and a "limited
membership," under which participating brokers and agents have access to certain
of the Company's products and services, principally the home warranty product.
The Company operates in the District of Columbia and in all states except
Alaska.
Full members generally pay an initial membership fee and annual renewal fees in
order to retain the rights of membership. Full members participate in the
Company's Errors & Omissions insurance ("E&O") program and generally pay
marketing or placement fees to the Company for access to the program. Members
also have the right to use products and services provided by
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other vendors with which the Company has made preferred arrangements. See
"Membership" for specific information regarding the membership programs. Full
membership also provides access to the following programs: a membership-wide
referral networking system (REFNET/registered trademark/), the HMS
BuyerTrack/registered trademark/ Follow-up System, the HMS Risk Management
System, HMS Photocard and certain other advertising, public relations and
marketing materials, products and services. Both full members and limited
members have access to the home warranty product, which they sell to either
sellers or buyers of a home. Historically, through 1996, the Company has derived
at least 88% of its annual revenues from the sale of home warranty contracts by
Members and from membership related fees.
The Company has granted the Affiliates the exclusive right, within defined
geographical territories, to enroll Members and train them in the utilization
and sale of the Company's products and services. The Company directly enrolls
Members in California, Colorado, Idaho, Florida (except northwest Florida, which
territory has been granted to an Affiliate), Hawaii, Idaho, Indiana, Iowa,
Nebraska, North Dakota, Oregon, Pennsylvania, South Dakota and Washington, and
is a 45% partner in a partnership which directly enrolls Members in Texas.
Collectively, these territories are known as Corporate Owned Regions. The
Company manages, for a fee, the Kansas, Oklahoma, Missouri territory and the
Arizona, New Mexico territory. The company has combined administrative functions
of the Kansas, Oklahoma and Missouri region and of the Arizona, New Mexico
region with the Texas region. The Colorado region and the Washington, Oregon and
Idaho regions have combined administrative functions with the California region.
In late 1996 and early 1997, the Company has focused on improving the operating
results of its Corporate Owned Regions, and has entered into several management
and option arrangements, under which independent non-employee managers have
agreed to operate the regions. Payments to these managers will generally be made
from commissions earned on the sales generated within each region, and the
managing company is generally responsible for expenses incurred in generating
such sales.
Franchise realty organizations, such as CENTURY 21/registered trademark/,
ReMax/registered trademark/ and others, provide to their franchisees certain
products and services, some of which are similar to those offered by the
Company. However, access to such products and services generally requires an
initial financial commitment by the real estate brokerage firm, payment of a
predetermined percentage of revenues to the franchisor and mandatory utilization
of some of the franchisor's products and services. Under the Company's program,
Members pay for the Company's products and services which they elect to use,
once the initial membership fee and/or annual renewal fee has been paid. The
Company's membership agreement does not prohibit membership in any real estate
related franchise or service, and many HMS Members are also members of franchise
realty organizations.
DISTRIBUTION OF PRODUCTS AND SERVICES
FRANCHISEES
Homeowners Marketing Services International, Inc. ("HMSI"), a wholly-owned
subsidiary of the Company, has entered into franchise agreements with Affiliates
encompassing the District of Columbia and 35 states in which HMS does not
directly enroll Members. The Affiliates are granted exclusive five-year licenses
within defined territories to enroll, as Members, real estate brokerage firms
and agents which market primarily residential properties and to market all
products offered through the real estate brokerage community by the Company.
The Affiliates pay an initial fee for the grant of such license, which is based
upon the potential market for Member enrollment and product sales in the defined
territory. The franchise agreements are renewable by the Affiliates with no
additional franchise fee. Affiliates are paid a predetermined commission from
all membership fees and from sales of E&O insurance programs, home warranty
contracts, HMS BuyerTrack/registered trademark/ programs, and other products
sold within their territories.
The Affiliates are required to meet certain percentage quotas with respect to
enrollment of Members and sales of home warranty contracts in connection with
residential real estate closings transacted by Members within their territories.
In the event of continuing failure to achieve the prescribed percentage quotas
after notice, the Company may, at its discretion, terminate the franchise
agreement. The Affiliates are responsible for obtaining all necessary licenses
in connection with the conduct of their businesses within their territories. The
primary duties of the Affiliates are to enroll Members and train them in the
proper utilization and sale of the Company's products and services. Marketing,
sales and promotional expenses associated with these activities are borne by the
Affiliates.
In 1996, there were no franchise agreements up for renewal. Seven agreements
expired in 1995 and were extended to December 31, 1996. These agreements have
been further extended until September 30, 1997. In May, 1995, the Company
franchised the New England territory, consisting of the states of Maine,
Massachusetts, New Hampshire and Vermont. In February 1996, the Company
terminated the Pennsylvania franchise agreement for defaults under the
agreement, and began operating this territory
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as a COR. The former franchisee filed a suit, and in March 1997, the Company and
the former franchisee entered into a settlement agreement.
MEMBERSHIP
The Company relies upon its Affiliates and COR sales force to continually
recruit new Members. To join the membership network, Members generally pay an
initial membership fee and each year thereafter, the Member must remit an annual
renewal fee in order to maintain membership. Members are entitled to utilize the
Company's products and services during the term of their membership. Members are
not, however, obligated to use all or any portion of the products and services
offered. Full Members generally pay a marketing fee or placement fee for each
real estate closing in which the member participates for access to the E&O
program. Since December 1993, the Company has offered its new and renewal
members an annually funded program for all fees. Annual marketing/placement fees
are determined based on the Member's anticipated annual transaction volume.
Members who select annual funding pay either one lump sum upon
enrollment/renewal, or three installments over 180 days. At the end of 1996,
nearly 59% of the Company's Full Members were enrolled in annual/installment E&O
programs, as opposed to a transactional payment program.
When a home warranty contract is sold in connection with a real estate closing
in which a Member participates, the Member may receive reimbursement (except in
California, Arizona and Iowa, where it is prohibited by law), in a predetermined
amount, from the proceeds of the sale of such contract in order to cover its
administrative, inspection and processing costs.
From time to time, the Company seeks endorsements of large Realtor companies and
state and local Realtor organizations. In the first quarter of 1997, the Company
gained the endorsement of the Prudential Real Estate Associates, Inc. ("PREA").
PREA will recommend that its franchisees use all of the Company's products and
services. The terms of this arrangement are being finalized, and the Company
anticipates that this endorsement will have a positive impact on its future
warranty and other product sales.
As of December 31, 1996, 14,329 real estate brokerage firms operating 17,315
offices were included as Members, including 5,304 firms operating 5,663 offices
which enrolled during 1996. The current E&O program with Continental Casualty
Company ("CNA"), pursuant to which the Company markets policies through Victor
O. Schinnerer ("Schinnerer"), CNA's exclusive underwriting manager, has produced
a marked increase in attrition and a shift from participation in full membership
to limited membership. Approximately 35% of the Members who participated in the
E&O program at December 31, 1995 did not renew or were terminated by the Company
during 1996. Through 1996, full members declined from 5,773 to 4,600, while
"limited" members increased from 9,467 to 12,715. These trends are due to the
shift in E&O program underwriting techniques, from a program approach (i.e.
large groups of Members received identical premium rates and were subject to
less stringent underwriting criteria), to an individual approach under the
current CNA/Schinnerer program. Also, the E&O market is extremely price
sensitive and the price competition has had a significant negative impact on the
Company's renewal rates. The Company believes that some of its competition has
reduced prices to gain market share, a practice in which CNA/Schinnerer does not
engage.
In response to the decline in membership resulting from the transition to the
new E&O carrier, the Company has more aggressively marketed its "limited
membership" plans, which had been available, but did not previously comprise a
large portion of its total membership. Also, during 1995 and 1996, the Company
allowed certain brokers to continue as limited members beyond their expiration
date, permitting them to use all of the Company's products and services, with
the exception of the E&O program, with no membership fee. As of December 31,
1996, there were approximately 5,900 such Members included in the Company's
total membership of 17,315. At December 31, 1996, approximately 73% of the
Company's membership was comprised of limited members, as opposed to only 62% at
December 31, 1995. Based upon Member enrollments as of December 31, 1996, Member
offices constitute approximately 11% of all National Association of
REALTORS/registered trademark/ ("NAR") member offices.
PRODUCTS AND SERVICES
HOME WARRANTY CONTRACT
The Company offers, through its Members, home warranty contracts for a fixed fee
paid at the time of closing of residential sale transactions participated in by
HMS Members. The home warranty contract provides for the repair or replacement,
at the Company's discretion, of the major mechanical systems and certain of the
appliances of a residence which malfunction as a result of normal wear and tear
during the term of the contract. The Company currently offers a home warranty
contract for sale in every state in which the Company operates, with the
exception of Connecticut.
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The home warranty contract is marketed by Members to sellers and buyers of
residences. If the home warranty contract is purchased by the seller of a
residence, coverage is provided for the seller at no charge (except in
California and Nevada where there is a pro-rata charge) during the period
between the listing of the residence for sale and the closing. During this
listing period, the home warranty contract generally does not cover the air
conditioning and heating components of the residence. If the residence is not
sold within 180 days of the commencement of coverage, the contract terminates,
unless closing is scheduled within the next 60 days. Payment is generally made
at closing, either from the proceeds of the sale if the warranty was placed with
the seller, or from the buyer's closing costs if the warranty was placed with
the buyer. The home warranty contract continues for a period of one year from
closing for the benefit of the buyer of the residence.
The home warranty contract is frequently purchased by the home seller, enabling
him/her to offer to a prospective buyer a residence with all of the major
systems and appliances covered for a period of one year from the date of
closing. The Company believes that the home warranty contract makes a home more
attractive to prospective buyers and causes a home to be sold more rapidly by
providing protection from unforeseen and expensive repairs at low cost. The
Company also believes that a home warranty helps the Real Estate Broker by
lowering risk from errors and omissions lawsuits. The Company has noted that the
sales mix is shifting more towards buyers than sellers, indicating a greater
awareness by the ultimate user of the value of this product. The Company offers
one year renewals to selected existing home warranty contract holders. The
Company also offers a four-year home warranty contract for purchasers of newly
constructed homes. Renewed one year contracts, including second, third and
beyond year renewals, and four-year "new" home warranty contracts account for
14% and 0.2%, respectively, of total home warranty contracts in force as of
December 31, 1996.
In 1996, the Company continued its efforts to expand renewal warranty contract
sales, which increased by 20% in 1996 and 70% in 1995. The increase in renewal
contract sales has been achieved by improved marketing and collection techniques
which have increased renewal rates to approximately 25% in 1996, from the 5%
rate experienced in 1994.
Generally, while the coverage and other terms differ to a degree between states,
under the terms of a home warranty contract, the Company agrees to repair or
replace, at the Company's discretion, for claims made during the term of the
contract, substantially all working component parts of a residence's built-in
appliances, refrigerator, washer, dryer, and central heating, air conditioning,
plumbing, hot water heater and electrical systems. Optional coverage is provided
at an additional charge for swimming pools, spas, whirlpools and well pumps.
Certain component parts are not covered under the home warranty contract, and in
every instance, pre-existing defects and repairs or replacements occasioned as a
result of other than mechanical failure from normal wear and tear are not
covered. Consequential damages resulting from the failure of any component part
of the system or appliance, such as water damage from leaking pipes, are also
outside the scope of the home warranty contract. The Company has the flexibility
of offering several products with varying coverages within each state. The
Company also offers a lower priced warranty product which covers primarily home
appliances and electrical systems, but excludes heating, ventilation, plumbing
and air conditioning systems. Generally the home warranty contract does not
provide for any monetary limit on the Company's obligations. The average selling
price of a warranty was $353 in 1996, and $352 and $348 in 1995 and 1994,
respectively. The average claim incurred in 1996 by the Company under its home
warranty contracts was $215, compared to $213 in 1995 and $218 in 1994. A claim
occurred on approximately 71% of all warranties in force in 1996, and 68% in
1995 and 1994. Although the Company will issue a home warranty contract
regardless of the age and size of the residence, in certain states there are
surcharges based upon these factors. The home warranty contract generally
provides for a deductible to be paid by the holder of the contract on each
service call. As the contract terms are generally for a one year period, claims
are incurred and reported to the Company within a short period of time.
Repair services under the home warranty contract are performed by independent
contractors located in the areas in which the contract is in force. The Company
has service arrangements with approximately 17,000 independent service
contractors. Approximately 90% of the Company's claims cost is paid to 1,900 of
these contractors. When a problem occurs, the homeowner makes a toll-free
telephone call to the Company's central processing center in Sunrise, Florida. A
customer service employee verifies that the home warranty contract is in force
and that the contract provides coverage of the reported problem. Utilizing an
automated search procedure, which attempts to locate the closest vendor with the
highest approval rating, the employee advises the homeowner of the service
contractor's phone number to arrange for a service call. If the service
contractor determines upon review that the repair will cost less than the
homeowner's deductible, the homeowner may elect to proceed with the repair and
pay the contractor, with no reimbursement from the Company. If the repair is
expected to exceed the deductible, the service contractor is required to call
the Company for authorization of the repair. The Company's staff of
authorization employees has practical, and most of the time specialized,
professional repair experience.
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Seventeen of the states in which the Company operates have enacted a variety of
legislation addressing home warranty contracts. Generally, regulation of home
warranty contracts requires the Company to reserve a portion of its liquid and
invested assets and/or place deposits with regulatory agencies. As of December
31, 1996, approximately $10,800,000 of cash and investments were needed to
maintain the regulated subsidiaries' required minimum reserve and surplus
levels. Increases in warranty production, as seen thus far in the first quarter
of 1997, result in increases in the Company's required reserve and surplus
levels in the regulated states. In addition, state regulators generally seek
reserve balances in excess of the minimum standards. In certain states,
withdrawal of any reserves in excess of statutory minimums requires approval
from the regulatory authorities. The Company has been advised by certain
authorities that such approval will not be granted. Accordingly, the Company
maintained reserves of approximately $13,500,000 as of December 31, 1996. See
"Management's Discussion and Analysis of Financial Position and Results of
Operations - Liquidity and Capital Resources" for reserve and surplus policies
in regulated states. The Company is currently in compliance with all statutory
deposit, reserve and surplus requirements.
Although the Company is not aware of any pending legislation which would
negatively affect the sale of home warranty contracts, it is impossible to
predict legislation or regulations that may be adopted in the future and which
could affect the Company's home warranty contract business.
ERRORS AND OMISSIONS INSURANCE
INSURANCE POLICIES:
Members have access to real estate E&O insurance as a benefit of membership.
Historically, an attractive feature of the Company's E&O program to Members has
been that the premium could be paid monthly for each closing participated in,
with a one transaction per month minimum premium. Beginning December 1, 1993, in
conjunction with the CNA program, the Company added an annually funded premium,
which may be paid in either one lump sum or in three installments over 180 days.
This insurance generally provides limits of between $100,000 and $1,000,000 per
loss and from $100,000 to $1,000,000 aggregate per policy year. The policies
generally provide coverage for unintentional wrongful acts which occur during
the term of the policy and are reported up to 60 days after expiration of the
policy and all claims after expiration for which notice of wrongful act is given
prior to expiration. The policy provides for a deductible per loss and covers
the real estate brokerage firm and all officers, partners, stockholders,
employees, salespersons and sales associates or independent contractor brokers
of the brokerage firm. At December 31, 1996, approximately 27% of all the
Company's Members had active insurance policies.
In order to obtain E&O coverage, a potential Full Member submits an application
for coverage to the insurer through an Affiliate field staff representative. The
insurer, through its underwriting manager, determines whether to insure the
applying Member and at what rate. All insurance premiums are collected by the
Company along with membership and marketing/placement fees, and then the
premium, net of the Company's commission, is periodically remitted by the
Company to the insurer. In 1996, the E&O program generated total premiums of
approximately $9 million, essentially all of which related to the CNA program.
Under agreements between the Company and CNA/Schinnerer, outlining the
responsibilities for the marketing, underwriting and administration of this
insurance program, the Company and its Affiliates are required to market
exclusively, on a right of first refusal basis, through December 31, 1999, CNA's
real estate errors and omissions insurance products. If a potential insured is
declined and not quoted, the Company may offer a secondary E&O product. Premiums
written through secondary carriers approximated 2% of total premiums in 1996 and
1995.
PROGRAM:
From 1986 through April 1991, ANIC was the insurer of the Company's E&O program,
and from May 1991 through November 30, 1993, the insurer was a member company of
American International Group, Inc. ("AIG"). Under these two prior programs,
through November 30, 1992, Meridian Insurance Company, Ltd. ("Meridian"), a 100%
owned subsidiary of the Company's former insurance broker, was the reinsurer. In
December 1991, ANIC filed suit against the Company relating to the 1986 - 1991 E
& O program. The case went to trial in November 1995, and on December 13, 1995 a
jury rendered a verdict against HMS, in favor of ANIC in the amount of
$5,156,022. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Recent Developments" for the current status of this
matter.
In December 1992, the Company formed a reinsurance subsidiary, POMG Insurance
Company, Ltd. ("POMG"), which acquired certain net assets from Meridian and
replaced Meridian as the reinsurer of all E&O policies written beginning May 1,
1991. There was no monetary consideration given and no loss recorded on the
transaction. Under the ANIC and AIG programs, the
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Company bore reinsurance risk either directly through POMG or through letters of
credit ("LOCs") that the Company was required to post with Meridian as
collateral to be drawn upon in the event that the assets in the reinsurance
pool, together with investment income earned thereon, were insufficient to cover
the claims and related expenses incurred. The LOC amount under the ANIC program
was fixed at $2,059,274. The amounts of the LOC's required to be posted by the
Company under the AIG program were subject to change at the discretion of the
insurer, based on contract volume and underwriting risk.
In the second and third quarters of 1993, the E&O program experienced
significant losses. Effective December 1, 1993, CNA replaced POMG as the
reinsurer and AIG as the insurer of the E&O policies issued through November 30,
1993 by AIG. This transaction took place through a novation of previous
reinsurance agreements in effect. The Company now markets CNA policies to its
membership network through Schinnerer, CNA's exclusive Realtors E&O program and
underwriting manager. Pursuant to the agreement with CNA, the Company
discontinued POMG's operations and no longer participates in any reinsurance
risk under the CNA program. The Company, through its HOMS Insurance Agency, Inc.
("HOMS") subsidiary acts solely in the capacity of an insurance broker. Under
the terms of the agreement, the Company receives commissions based on a fixed
percentage of the E&O premiums collected. The Company pays a portion of these
commissions to the Affiliates and Company Owned Regions generating the premium
volume. The Company has recorded certain liabilities and is subject to certain
contingencies in connection with the agreements with CNA. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources."
Under the program offered through CNA, the Company also receives a fee on
transactional premium collections, which is recorded as an offset to G&A
expense. In addition, under the CNA program, the Company receives a commission
of 10% on all premiums collected, a portion of which is paid to the Affiliate
and COR offices generating the premium volume. The Company earned approximately
$900,000 in commissions under the current program in 1996, $1,250,000 in 1995
and $1,002,000 in 1994.
In connection with the CNA program, the Company is obligated to pay CNA $5
million over a period originally estimated to be three to five years. The
Company makes payments against this obligation through reductions in the
commission it earns on the premiums generated under the program. Accordingly,
the Company agreed to meet certain premium volume quotas (the "Quotas"), on an
annualized basis. If, on an annualized basis, premium volume falls below the
Quotas, a cash payment equal to 5% of the difference between actual premium
volume and the Quotas must be made to CNA to be applied against the obligation
to CNA. Additionally, there are were specified minimum premium volume levels
(the "Levels") which were required to be attained. If E&O premiums were to fall
below the Levels, CNA had the option to review the program, give the Company an
opportunity to address the issue and then, at its option, may stop the program
and take ownership of the Company's expiration list, and the Company could still
be required to make a cash payment equal to 5% of the difference in the actual
premium volume and the Quotas, to be applied against the obligation to CNA. As a
result of the Company's failure in 1995 to meet the minimum Levels, in March
1996, the Company and CNA amended the agreement, waiving the minimum Levels. In
addition, the Quotas were modified to $17 million in 1995, $18 million in 1996,
and $20 million for each year thereafter. The agreement to market CNA insurance
exclusively to its membership was extended through December 31, 1999. As of
December 31, 1996, the balance due CNA totaled approximately $3.1 million. The
Company is currently in default, as it has failed to achieve the minimum Quotas,
and the Company could be required by CNA to make a payment against the
obligation to the Holdback Fund in the amount of approximately $200,000.
However, the Company and CNA have entered into a further amendment, which would
delete the minimum Quotas and the Levels, and release the Company from its
current obligation to pay the remaining $3.1 million. Following the effective
date of this amendment, the Company's obligation will be limited to the payment
of 50% of actual commissions to CNA. The proposed amendment becomes effective if
the Merger is consummated prior to July 1, 1997, and the dispute with Sphere
Drake (as described below) is settled within 14 days of the consummation of the
Merger.
In connection with the transfer of the net assets of POMG to CNA and the
assumption by CNA of the obligations of POMG under certain Realtor's errors and
omissions policies, the Company guaranteed the performance by Sphere Drake
Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a $5
million reinsurance treaty purchased by POMG to protect it from losses in excess
of a predetermined amount. Under the terms of the Company's guaranty, CNA, as
the transferee of the reinsurance treaty, bears any credit risk under the
treaty, including, but not limited to, any risk that Sphere Drake becomes
insolvent, is adjudicated as a bankrupt or has liquidation or similar
proceedings commenced against it. The Company has placed $3 million into a
collateral account to secure its guarantee (the "Collateral Account"). On April
10, 1996, CNA issued a Notice of Arbitration to the reinsurer with respect to
its refusal to honor the reinsurance treaty.
The Company, CNA and Sphere Drake are engaged in settlement discussions with
respect to the reinsurance treaty. Although terms are not finalized, it is
possible that the Company could pay a substantial portion of the Collateral
Account to CNA under
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the currently proposed settlement agreement. As a result of the settlement
negotiations, the Company has recorded a loss provision of $2.5 million for the
guaranty in its consolidated statements of operations for 1996. Should the
Merger fail to be consummated, the potential settlement agreement will be null
and void, and the Company will continue to be contingently liable for the entire
$5 million under the conditions described in the preceding paragraph. In such
event, the Company will attempt to negotiate a settlement but there can be no
assurance that it will be successful in such efforts.
As part of the transfer of the POMG assets, the Company is further obligated to
pay five percent of all commissions on Realtor's errors and omissions policies
up to a maximum of $5 million to cover the losses of CNA on assumed policies. A
"holdback fund" has been established to accumulate said funds. Under the current
agreement, the Company is obligated to make accelerated payments to the holdback
fund if certain premium production levels are not met. In connection with the
proposed settlement with CNA which is, as noted above, contingent upon the
closing of the Merger, the holdback fund agreement will be modified to require
payment to the fund only out of commissions actually earned on policies sold.
Should the Merger fail to be consummated, there will be no adjustment to the
current agreement, and the Company could be required to make a $200,000 payment
against its obligation to the Holdback Fund.
HMS BUYERTRACK/registered trademark/ FOLLOW-UP SYSTEM
The Company offers Members eight-year and three-year BuyerTrack/registered
trademark/ programs which are funded at the closing of the sale of a residence.
The program provides a system for maintaining contact with former customers of
the Member with the goal of generating listings through direct referrals and
repeat business. The BuyerTrack/registered trademark/ program utilizes
personalized direct mail, return mail responses, mailgrams, survey
questionnaires and similar reminder items. The eight-year and three-year
programs are identical except for their duration and the number of contacts
between the Member and the former customer. The BuyerTrack/registered trademark/
program is provided to Members under agreement with the Personal Marketing
Company, one of the nation's largest producers of newsletters.
HMS REFNET/registered trademark/
The Company's REFNET/registered trademark/ system connects Members in 49 states
and the District of Columbia. The Company makes available a toll-free number
through which Members can make referral inquiries. The Company obtains from its
Members an office profile which contains information which would be of interest
to other Members when placing referrals, such as office location, company size,
number of agents, certified referral training, average sales price per home
offered, percentage referral fee offered and other information concerning a
Member's office. This information is maintained in the REFNET/registered
trademark/ computer data base.
Upon receiving an inquiry from a referring Member, the REFNET/registered
trademark/ representative provides the referring Member with the addresses and
telephone numbers of three Members registered in the system which are identified
as the closest match to the needs of the referring Member. Once the referring
Member has selected a receiving Member, the referral fee between the two is
privately negotiated. Unlike traditional referral systems, the Company does not
participate in any portion of the referral fee. Access to REFNET/registered
trademark/ is a benefit of membership, and no separate fee is charged for this
service for Members.
HMS RISK MANAGEMENT SYSTEM/registered trademark/
The Company offers a Risk Management System to its Members that extends beyond
basic E&O coverage. It is a national program providing specific risk reduction
measures. In addition to professional liability protection, elements of the
system include a Risk Management Advisory Center, Risk Management Educational
Programs, Home Warranty Protection Plan, and Home Warranty Indemnification.
There is no fee for participating Members.
ADVERTISING AND SALES PROMOTION PROGRAM
As a benefit of membership, the Company offers various advertising and public
relations materials and ideas designed to enhance the business of Members. These
materials include a public relations guide, camera ready advertising materials
for use by Members, sample creative ads, displays, and other materials.
COMPETITION
The Company encounters competition with respect to most of its products and
services, principally in the home warranty contract business. Competition in
that industry has increased as consumer awareness and acceptance of the home
warranty concept has grown. The Company's largest national competitor in the
home warranty contract business is American Home
8
<PAGE>
Shield. The primary competitive factors in that industry are sales force
presence, price, scope of coverage and quality of service. Through the Company's
focus on maintaining and educating its members, its franchise distribution
network, its vendor network, and its focus on service, the Company believes it
can effectively compete in the home warranty contract business. The price and
scope of coverage of its home warranty contract are competitive with those
generally offered by the industry. The Company encounters additional warranty
competition from companies offering the same or similar services as the Company
on an individual appliance or system contract basis.
In early 1994, Employers Re, which had been a relatively small Realtor E&O
competitor, joined forces with American Home Shield, a major competitor in the
warranty arena, and became a strong competitive force, and continues to be a
strong competitive force. The Realtor E&O market is extremely price sensitive.
The Company is required to offer the CNA program, which has impacted the
Company's ability to compete. Additional competition has entered the Realtor E&O
market through independent insurance agents who can offer a variety of insurance
products, thus meeting all of the customer's insurance needs. These independent
insurance agents often provide a selection of E&O products.
EMPLOYEES
As of February 28, 1997, the Company employed 178 persons on a full-time basis,
85 of whom administer the home warranty contract business in the United States,
and 20 of whom enroll and service Members in the CORs. The Company believes that
its employee relations are good. None of the Company's employees are represented
by a labor union or covered by any collective bargaining agreement.
ITEM 2. PROPERTIES
The Company's corporate offices are located at 400 Sawgrass Corporate Parkway,
Sunrise, Florida. The Company leases approximately 24,980 square feet in a
two-story office building for a ten year term, expiring December 31, 2005. The
Company currently pays rent of approximately $33,000 per month, including sales
tax and maintenance charges. The Company also leases office space for a regional
sales and administrative office in Texas, under a lease with a remaining term of
three years.
ITEM 3. LEGAL PROCEEDINGS
The Company incurs numerous lawsuits in the ordinary course of its home warranty
contract business, typically concerning whether claims under such home warranty
contracts are entitled to coverage. The Company does not believe any of these
suits are material to the Company's operations or financial results.
In December 1991, suit was brought against HMS and the Company by Acceleration
National Insurance Company ("ANIC") for damages related to the E & O insurance
program in which ANIC was the policy issuing company. On December 13, 1995, a
jury in the Court of Common Pleas of Franklin County, Ohio rendered a verdict
against HMS in favor of ANIC, in the amount of $5,156,022, which accrues
interest at the rate of 10% per annum. In May, 1996, the Company entered into a
definitive merger agreement with Cross Country, pursuant to which Cross Country
agreed to purchase all of the outstanding shares of the Company for $2.35 per
share in cash and pay the balance due to ANIC under a settlement agreement, upon
closing of the Merger. Pursuant to the settlement agreement, on September 4,
1996, the Company paid to ANIC the full amount of its 1995 federal income tax
refund, together with interest, which totaled $1,401,485. An affiliate of Cross
Country purchased the judgment from ANIC as of October 31, 1996, for
approximately $2.75 million, and pursuant to a new settlement agreement ("the
Settlement Agreement"), the Cross Country affiliate agreed, under certain
conditions, to take no action to collect on the judgment before January 31,
1997. In January 1997, under the Second Amendment to the Merger Agreement, the
Cross Country affiliate extended the date until which it agreed to take no
action to collect on the judgment to July 1, 1997. The Company guaranteed the
obligation of HMS and pledged the shares of HMS and another subsidiary of the
Company to secure such guarantee. HMS and the subsidiary granted security
interests in their assets as part of the First Amendment to the Merger
Agreement. Should the Merger fail to be consummated by July 1, 1997, Cross
Country will be entitled to take action to collect on its judgment. In the event
the judgment creditor proceeds to execute on its judgment, it is likely that the
Company will be without adequate resources to pay the full amount due.
In February 1996, a lawsuit was filed against the Company in the Court of Common
Pleas of Bucks County, Pennsylvania, by the former franchisee of the
Pennsylvania territory, alleging breach of contact, fraud and misrepresentation.
In March 1997, this case was settled for $110,000.
9
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
MARKET INFORMATION
The Company's common stock is listed on the Nasdaq National Market under the
symbol HOMG. The following table sets forth the high and low transaction prices
for each quarterly period during 1996 and 1995. Stock price data reflects
inter-dealer prices, without retail mark-up, mark-down or commission, and may
not represent actual transactions.
YEAR QUARTER HIGH LOW
---- ------- ---- ---
1996 First $1.75 $ 0.50
Second 2.06 1.50
Third 2.13 1.88
Fourth 2.06 1.50
1995 First $1.75 $ 0.63
Second 2.13 1.13
Third 2.00 1.00
Fourth 1.94 0.50
As of March 15, 1997, there were approximately 140 shareholders of record of the
Company's common stock, some of whom are brokerage firms which hold shares in
nominee name on behalf of their clients. The Company believes that there are
over 690 beneficial owners of its common stock.
DIVIDENDS
The agreements reached with CNA impose certain restrictions on dividends until
funds due to CNA are paid in full. The Company declared no dividends in 1996,
1995 or 1994. The Company does not anticipate paying any dividends in the
future.
10
<PAGE>
<TABLE>
<CAPTION>
ITEM 6: SELECTED FINANCIAL DATA
Years Ended December 31, 1996 1995 1994 1993 1992
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS (in thousands)
Operating revenue $45,431 $44,692 $53,194 $51,397 $45,578
Income (loss) from continuing operations
before income taxes (1,597) 2,208 (742) 5,361 3,891
Income (loss) from continuing operations (1,038) 1,361 (658) 3,216 1,879
Discontinued operation:
Loss from operation of discontinued
reinsurance segment (1,559) (3,216) - (6,228) -
Estimated loss on reinsurance
portfolio transfer - - - (9,009) -
Net income (loss) ($2,597) ($1,855) ($658) ($12,021) $1,879
CASH FLOW FROM OPERATING ACTIVITIES
(in thousands) $4,347 ($667) $3,046 ($1,557) $2,755
Dividends Declared Per
Common Share $0.00 $0.00 $0.00 $0.10 $0.20
Balance Sheet (in thousands)
Cash and investments $15,346 $17,054 $19,625 $18,154 $19,176
Total assets 37,755 38,757 39,527 45,894 41,068
Long-term debt, net of current portion 2,941 2,592 3,317 3,107 22
Deferred home warranty revenue
in excess of deferred home
warranty acquisition costs 11,631 10,572 10,441 9,994 8,196
Stockholders' equity 3,760 6,365 8,152 8,782 21,820
PER SHARE DATA
Income (loss) from continuing operations ($0.19) $0.25 ($0.12) $0.58 $0.34
Discontinued operation:
Loss from operation of discontinued (0.28) (0.58) - (1.12) -
reinsurance subsidiary
Estimated loss on reinsurance - - - (1.62) -
portfolio transfer
Net income (loss) ($0.47) ($0.33) ($0.12) ($2.16) $0.34
Stockholders' equity $0.68 $1.15 $1.47 $1.58 $3.93
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING (in thousands) 5,558 5,558 5,558 5,559 5,561
KEY BUSINESS INDICATORS:
Member offices 17,315 15,240 16,137 19,798 19,838
Home warranty contracts sold 117,955 105,324 112,737 100,914 82,672
RATIOS
Pre-tax margin on income from
continuing operations (4)% 5% (1)% 10% 9%
Margin on income from
continuing operations (2)% 3% (1)% 6% 4%
Effective income tax rate (35)% 38% (11)% (40)% 52%
Return from continuing operations
on beginning assets (3)% 3% (1)% 8% 5%
Return from continuing operations
on average stockholders' equity (21)% 30% (8)% 21% 9%
</TABLE>
NOTE: CERTAIN AMOUNTS REFLECT RECLASSIFICATIONS FROM AMOUNTS REPORTED PREVIOUSLY
TO CONFORM TO CURRENT PRESENTATION.
11
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following table presents certain relationships deemed to be pertinent
indicators of the Company's results of operations:
<TABLE>
<CAPTION>
1996 1995 1994
- --------------------------------------------------------------------------------------------------------
$ % of $ % of $ % of
(dollars in 000's) REVENUE* REVENUE* REVENUE*
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Warranty revenue $40,136 88.4% $37,181 83.2% $38,911 73.1%
Membership & other revenue 4,331 9.5 6,258 14.0 11,755 22.1
E&O brokerage 964 2.1 1,253 2.8 2,528 4.8
------- ------ ------- ------ ------- ------
Total operating revenue 45,431 100.0 44,692 100.0 53,194 100.0
Warranty costs 31,938 79.6 29,244 78.7 32,317 83.1
Membership & other costs 3,258 75.2 4,358 69.6 7,255 61.7
E&O brokerage 657 68.2 648 51.7 512 20.3
-------- ---- ------- ---- ------- ----
Total direct costs 35,853 78.9 34,250 76.6 40,084 75.4
Unusual items 677 1.5 -- -- 1,787 3.4
G&A expense 10,491 23.1 9,262 20.7 12,013 22.8
------ ---- ----- ---- ------ ----
Operating income (loss) ($1,590) (3.5%) $1,180 2.6% ($690) (1.3%)
====== ===== ====== ==== ====== =====
</TABLE>
* DIRECT COSTS ARE PRESENTED AS A PERCENTAGE OF THE RELATED REVENUES.
- -------------------------------------------------------------------------------
1996 COMPARED TO 1995
HOME WARRANTY OPERATIONS:
Home warranty revenue, totaling $40,136,000 and representing 88% of total
operating revenue for 1996, increased 8% from the 1995 figure of $37,181,000, or
83% of total operating revenue, due primarily to increases in home warranty
contract sales. The increase in contract sales is due to additional membership
and to a strong residential real estate market. Due to the Company's warranty
revenue recognition method, which recognizes contract revenue over the one year
term of the contract, warranty revenue for any period of time is also impacted
by production in the eleven months immediately preceding that period. There have
been no major pricing changes which would have significantly affected warranty
revenue.
Direct expenses of the warranty product, which consist primarily of claims
expense and acquisition costs, as a percentage of related operating revenue,
increased to 80% in 1996 from 79% in 1995, primarily due to a 2% increase in
average claim severity and a 6% increase in warranty claim frequency. Claim
frequency experienced in 1996 returned to the unusually high frequency
experienced in 1994, as a result of the severe weather patterns experienced
across the country during 1996. Through December, 1996 the winter season has
been extremely severe, resulting in negative experience in the last quarter of
the year. This trend has continued into the first quarter of 1997, and has had a
continued negative impact on the Company's cash position and its results of
operations.
The 1996 warranty acquisition cost ratio of 35% is slightly lower than the 1995
ratio, which approximated 36%. As the volume of contract sales shifts between
geographic regions, the Company's overall acquisition cost ratio changes, since
the Company's acquisition costs vary in different locations. In addition, the
increasing proportion of renewal warranty contracts reduces the acquisition cost
ratio, as renewal contract acquisition costs are generally lower than
acquisition costs for first year contract sales. The acquisition cost ratio is
expected to remain relatively stable at its current level, assuming that the
warranty product mix and geographic distribution do not change significantly.
Management, at this time, does not expect such a change to occur.
The amount of general and administrative ("G&A") expenses of the home warranty
operation, which primarily include allocated fixed costs, increased slightly
from the prior year period due primarily to increases in overhead costs related
to the pending sale of the Company.
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<PAGE>
MEMBERSHIP AND OTHER OPERATIONS:
Membership and other related revenue of $4,331,000 in 1996 was 31% lower than
1995 revenue of $6,258,000, which is primarily related to the continued change
in mix of the Company's membership base. As in the prior year, the portion of
the Company's membership which no longer participates in the Company's E&O
program and which pays the associated marketing/placement fees has continued to
decline. These factors have caused continuing decreases in related revenue and
earnings in 1996, a continuing reflection of the effects of the change in the
Company's E&O carrier. As a result of this change, and due to continued
increased competitive pressures within the E&O market, the Company has continued
to experience declines in Members as participants in its current E&O program.
Additionally, attraction of new full members continues to be difficult, due to
premium quotes which are not competitive for certain brokers.
Throughout 1996, the Company has also continued to focus on attracting new
members and retaining as participants in the warranty program former members who
are not covered by CNA. This strategy has somewhat reduced the negative impact
of the loss of members through increases in warranty production.
Direct expense of the membership operations approximated 75% of related revenue
for 1996 and 70% of related revenue for 1995. The disproportionate cost ratio is
related primarily to certain fixed costs, which do not decline with decreases in
revenues, and to the results of the CORs, which were particularly impacted by
the Full E&O membership declines, especially in the states of California and
Texas. Also impacting the direct cost ratio is the effect of continued
promotional discounting of some of the Company's membership programs, a step the
Company has taken to retain some of its top producing members.
As with the home warranty operations, G&A expenses of the Company's membership
and other operations increased from 1995 totals, again related to increases in
general overhead costs related to the pending acquisition.
E&O OPERATIONS:
E&O related revenue for 1996, totaling $964,000, was 23% lower than the 1995
revenue of $1,253,000. The decrease relates to the decline in the Company's
membership base, which has a corresponding effect on the premium volume of the
program and, thus, the commissions earned.
Direct expenses of the E&O operations increased from $648,000, or 52% of revenue
in 1995 to $657,000 or 68% of revenue in 1996. Under the current E&O program,
the Company has agreed to pay a portion of the commission it receives on the E&O
premiums collected to the Affiliates generating the premium volume. There are
also certain fixed costs related to the Company's risk management programs which
result in the cost ratio being disproportionate.
UNUSUAL ITEMS:
In 1996, the Company reported approximately $677,000 in the "Unusual Items"
caption in its consolidated statements of operations, related to several
infrequently occurring events that occurred in 1996. Specifically, in the third
quarter of 1996, the Company terminated its Agency Agreement and Administration
Agreement with New Hampshire Insurance Company ("NHIC"), as it determined that
it no longer desired to carry the program previously negotiated with NHIC. As
part of the termination arrangement, the Company has paid approximately $260,000
to NHIC, and has also agreed to indemnify NHIC for all claims incurred under
contracts issued during the time the agreements were in effect by paying for all
claims on covered components which may be reported under such contracts, as if
the arrangement with NHIC had not taken place. To the extent that claims have
been paid or reported on these contracts, such amounts have been included in the
"Direct costs" caption in the Company's consolidated statements of operations,
and any related accrual for unpaid amounts is included in the "Accounts payable"
caption in the consolidated balance sheets. In addition, effective September 15,
1996, in conjunction with its plans for future organization and growth, the
Company terminated an employment contract with one of its officers, and has
agreed to pay the former officer severance and related benefits totaling
approximately $157,000 through the month of July 1997. In the fourth quarter of
1996, in connection with the Company's plan to improve the operating results of
its Corporate Owned Regions, the employment of three regional managers of the
Company's Corporate Owned Regions was terminated, and the California office was
closed. In connection with these changes, the Company agreed to pay amounts
totaling approximately $260,000 for severance, related benefits and rents on the
California office. Charges for these items are included in the accompanying
consolidated statements of operations under the caption "Unusual Items".
13
<PAGE>
OTHER INCOME (EXPENSE):
Investment income approximated $636,000 in 1996, a decrease of approximately 53%
from the 1995 level of $1,367,000. Unrealized holding gains/losses on trading
securities are included in the Company's earnings for the period, and unrealized
gains/losses on securities available for sale are reported as a separate
component of stockholders' equity. In 1995, decreasing interest rates caused the
Company's investments in debt securities to generate significant income,
especially on its trading securities portfolio, which has been included in the
Company's consolidated statement of operations. In 1996 this trend slowed,
reducing the amount of income recognized. Also, in mid-1996, the Company
transferred a portion of its trading portfolio to available for sale, which
changed the presentation of market value adjustments from a statement of
operations impact to a balance sheet impact. This transfer was made to maximize
earnings potential and to consolidate investment balances for one of the
Company's regulated subsidiaries. Investment income is generated primarily from
the securities currently invested by the Company's regulated home warranty
subsidiaries, as well as from additional investment of funds generated through
the sales of warranty products. Funds generated through the other operations of
the Company's business are generally invested in highly liquid overnight
investments, and therefore earn a minimal amount of interest over the course of
a year.
Other expenses include interest expense of approximately $351,000, related
primarily to the CNA obligation, losses from the Company's share of investment
in an Internet access provider joint venture of approximately $220,000, and a
loss on disposal of fixed assets of approximately $120,000. In 1995, the Company
formed a partnership through which it planned to offer services as an Internet
access provider to its members. Due to continued losses, and lower than
anticipated sales, in December 1996, the Company stopped funding the
partnership, and plans to sell its partnership interest or otherwise dissolve
the partnership agreement. The losses on fixed asset disposals resulted from the
Company's change in corporate office locations, at which time the Company
disposed of certain office furniture and equipment, for which it received only
nominal proceeds. In 1995, other expense included interest on the CNA obligation
of approximately $275,000 and losses incurred by the Internet access provider
joint venture of approximately $80,000.
INCOME TAXES:
The Company's effective tax rate in 1996 was a benefit of 35%, as compared to a
provision of 38.4% on income from continuing operations in 1995.
As a result of the losses generated in 1996, and by the 1995 ANIC judgment, the
1994 work-force reduction and termination of its UK operations, combined with
the 1993 losses generated by the Company's discontinued reinsurance operations,
the Company has recognized significant income tax benefits since 1993. A portion
of the Company's 1993 and 1994 pre-tax losses was carried back for income tax
purposes, to offset taxable income earned in the prior three years, generating
tax refunds for the Company. The remaining pre-tax losses give rise to
significant deferred tax benefits, which will be recognized in future years, as
the temporary book to tax differences which create the deferred tax benefits
become deductible for tax purposes. The total deferred tax benefit which is
expected to be realized in future years approximates $9.5 million at December
31, 1996. Based upon management's estimates of future taxable income and of the
positive and negative evidence regarding the likelihood of ultimate recognition
of this benefit, it has been determined that no valuation allowance is
necessary. This determination was based on the Company's taxable earnings
history, exclusive of non-recurring charges, and the period anticipated for full
recognition, assuming the Company maintains its current level of taxable income,
exclusive of the charges incurred for its discontinued operations, the
restructuring charges reported in 1994 and 1996, and certain other non-recurring
items. The Company is currently undergoing an examination by the Internal
Revenue Service of its tax returns for the years of 1993, 1994 and 1995, which
could result in the proposal of significant adjustments to its taxes in those
years. The Company believes that the returns as originally filed are correct in
all material respects.
DISCONTINUED OPERATIONS:
In connection with the transfer of the net assets of POMG to CNA and the
assumption by CNA of the obligations of POMG under certain Realtor's errors and
omissions policies, the Company guaranteed the performance by Sphere Drake
Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a $5
million reinsurance treaty purchased by POMG to protect it from losses in excess
of a predetermined amount. Under the terms of the Company's guaranty, CNA, as
the transferee of the reinsurance treaty, bears any credit risk under the
treaty, including, but not limited to, any risk that Sphere Drake becomes
insolvent, is adjudicated as a bankrupt or has liquidation or similar
proceedings commenced against it. The Company placed $3 million into a
collateral account to secure its guarantee (the "Collateral Account"), and has
also agreed, if necessary, to pay the additional $2 million related to the
guarantee from future commissions. On April 10, 1996, CNA issued a Notice of
Arbitration to the reinsurer with respect to its refusal to honor the
reinsurance treaty.
14
<PAGE>
The Company, CNA and Sphere Drake are engaged in settlement discussions with
respect to the reinsurance treaty. Although terms are not finalized, it is
possible that the Company could pay a substantial portion of the Collateral
Account to CNA under the currently proposed settlement agreement. As a result of
the settlement negotiations, the Company has recorded a loss provision of $2.5
million for the guaranty in its consolidated statements of operations for 1996.
Should the Merger fail to be consummated, the potential settlement agreement
will be null and void, and the Company will continue to be contingently liable
for the entire $5 million under the conditions described in the preceding
paragraph. In such event, the Company will attempt to negotiate a settlement but
there can be no assurance that it will be successful in such efforts.
As a result of the settlement negotiations, the Company has recorded a loss
provision of $2.5 million for the guarantee, which is reflected in the
discontinued operations caption in the accompanying 1996 consolidated statement
of operations, and the offsetting reserve is reflected as a reserve against
the restricted cash balance in the accompanying 1996 consolidated balance sheet.
In its role under this program, the Company bore reinsurance risk through its
reinsurance subsidiary. With the change in carriers to CNA, in 1993, the Company
removed itself from any risk bearing position in connection with the claims
reported under its E&O program, and currently no longer operates in this
capacity. The 1995 amount included in the discontinued operations caption was
the Acceleration judgment, which was also related to this prior E&O program.
1995 COMPARED TO 1994
HOME WARRANTY OPERATIONS:
Home warranty revenue, totaling $37,181,000 and representing 84% of total
operating revenue for 1995, decreased 4% from the 1994 figure of $38,911,000, or
74% of total operating revenue, due primarily to declines in home warranty
contract sales. The decrease in contract sales is primarily due to the loss of
membership. Due to the Company's warranty revenue recognition method, which
recognizes contract revenue over the one year term of the contract, warranty
revenue for any period of time is also impacted by production in the eleven
months immediately preceding that period. There have been no major pricing
changes which would have significantly affected warranty revenue.
Direct expenses of the warranty product, which consist primarily of claims
expense and acquisition costs, as a percentage of related operating revenue
decreased to 79% in 1995 from 83% in 1994, primarily due to a 2% decrease in
average claim severity and a 1% increase in warranty claim frequency. Claim
frequency experienced in 1995 returned to the 1993 levels, after the unusually
high frequency experienced in 1994, as a result of the severe weather patterns
experienced across the country throughout the first eight months of 1994.
Through December, 1995 the winter season has been extremely severe, resulting in
negative experience in the last quarter of the year. This trend has continued
into the first quarter of 1996, and has had a significant negative impact on the
Company's cash position and its results of operations.
The 1995 warranty acquisition cost ratio of 36% is slightly lower than the 1994
ratio, which approximated 38%. As the volume of contract sales shifts between
geographic regions, the Company's overall acquisition cost ratio changes, since
the Company's acquisition costs vary in different locations. The acquisition
cost ratio is expected to remain relatively stable at its current level,
assuming that the warranty product mix and geographic distribution do not change
significantly. Management, at this time, does not expect such a change to occur.
The amount of general and administrative ("G&A") expenses of the home warranty
operation, which primarily include allocated fixed costs, decreased
significantly from the prior year period, and as a percentage of related
revenue. The 1995 expenses were positively impacted by the work-force reduction
that took place in September 1994.
MEMBERSHIP AND OTHER OPERATIONS:
Membership and other related revenue of $6,258,000 in 1995 was 45%, lower than
1994 revenue of $11,755,000, which is primarily related to the changing mix of
the membership base. A large portion of the Company's membership no longer
participates in the Company's E&O program and is exempted from paying the
associated marketing/placement fees. Further impacting the membership results is
the 6% decline in the Company's membership base from the prior year level. These
factors have caused continuing decreases in related revenue and earnings in
1995, and reflect the continuing effects of the change in Company's E&O
carriers. As a result of this change and the related increased competitive
pressures within the E&O market, the Company has been unable to retain some of
its Members as participants in its current E&O program. Additionally, attraction
of new full members is more difficult, due to premium quotes which are not
competitive for certain brokers and also due to declinations by the Company's
primary insurance carrier of certain other brokers.
15
<PAGE>
In 1995, the Company changed its method of recognizing revenue and expenses
related to the annual new membership and renewal membership revenues and
expenses. Prior to 1995, the Company recognized these items upon collection of
the membership fees and upon payment of the associated commission expenses.
Currently, these revenue items are deferred as collected and the expense items
are deferred when paid, and both items are subsequently recognized in the income
statement on a straight line basis over the membership period, generally one
year. This change in revenue and expense recognition method was deemed to be a
correction of an error, and the accompanying consolidated balance sheets and
statements of operations have been restated to reflect the appropriate
accounting for these items. The current year effect on revenue and associated
direct costs recognized approximates 2% and 1%, respectively, of the current
year total membership revenue and expense totals.
Throughout 1995, the Company continued to focus on attracting new members and
retaining existing members who have either been declined coverage by CNA or who
have obtained their E&O coverage through another entity, as participants in the
Company's warranty and Consumer Reach programs. A new membership program
targeted at brokers desiring to use the Company's warranty was introduced in
mid-1995. This strategy has somewhat reduced the negative impact of the loss of
members on other revenues, evidenced by the 1995 fourth quarter improvements in
first year warranty contract sales, as compared to prior quarters.
Direct expense of the membership operations approximated 70% of related revenue
for 1995 and 62% of related revenue for 1994. The disproportionate cost ratio is
related primarily to the results of the CORs, which were particularly impacted
by the membership declines, especially in the states of California and Texas.
Also impacting the direct cost ratio is the effect of promotional discounting of
some of the Company's membership programs, a step the Company has taken to ease
the membership transition and retain some of its top producing members.
As with the home warranty operations, G&A expenses of the Company's membership
and other operations decreased from 1994 totals, due to the September 1994
work-force reduction, combined with the focus on controlling costs.
E&O OPERATIONS:
E&O related revenue for 1995, totaling $1,253,000 was 50% lower than the 1994
revenue of $2,528,000. The decrease in this revenue relates to the decline in
the Company's membership base, which has a corresponding effect on the premium
volume of the program and, thus, the commissions earned.
Direct expenses of the E&O operations increased from $512,000 in 1994 to
$648,000 in 1995. Under the current E&O program, the Company has agreed to pay a
portion of the commission it receives on the E&O premiums collected to the
Affiliates generating the premium volume. There was no such arrangement under
previous E&O programs, and, as 1994 was a transition year, the 1995 increase was
anticipated. As the premium volume under the new program grows, the commission
paid to the Affiliates will grow proportionately.
UNITED KINGDOM OPERATIONS:
HGC was liquidated in 1995, and there were no activities of HGC to include in
the 1995 financial statements. HGC did not generate any significant revenue and
incurred an operating loss of $761,000 in 1994, exclusive of the charges
recorded by the parent company in writing off the net assets of this subsidiary.
REDUCTION OF WORK-FORCE:
In early September 1994, the Company underwent an organizational restructuring,
reducing its total work-force by approximately 20%. This restructuring resulted
in annual cost savings of approximately $1,700,000 in 1995, through reductions
in salary, benefits and payroll tax expenses, excluding the effects of any other
personnel or staffing changes. The 1994 one time charge for severance pay and
related benefits, totaling $1,063,000 is included in "Unusual items" in the
accompanying consolidated statements of operations. Approximately $400,000 of
this total relates to an agreement to terminate the employment contract between
the Company and its former Chairman of the Board of Directors.
OTHER INCOME (EXPENSE):
Investment income approximated $1,367,000 in 1995, an increase of approximately
1000% from the 1994 level of $120,000. Unrealized holding gains/losses on
trading securities are included in the Company's earnings for the period, and
unrealized gains/losses on securities available for sale are reported as a
separate component of stockholders' equity. In 1994, rising interest rates
caused the Company's investments in debt securities to generate significant
unrealized holding losses, especially on its trading securities portfolio, which
have been included in the Company's consolidated income statement. In 1995, this
trend reversed, and the Company recognized significant income. Investment income
is generated primarily from the securities currently invested by the Company's
regulated home warranty subsidiaries, as well as from additional investment of
funds
16
<PAGE>
generated through the sales of warranty products. Funds generated through the
other operations of the Company's business are generally invested in highly
liquid overnight investments, and therefore earn a minimal amount of interest
over the course of a year.
INCOME TAXES:
The Company's 1995 effective tax rate on income from continuing operations was
38.4%, as compared to a benefit of 11.3% on income from continuing operations in
1994.
As a result of losses generated by the current year Acceleration judgment (see
Discontinued Operations below), the 1994 work-force reduction and termination of
its UK operations, combined with the prior year losses generated by the
Company's discontinued reinsurance operations, the Company has recognized
significant income tax benefits in 1993 and 1994. A portion of the Company's
1993 and 1994 pre-tax losses was carried back for income tax purposes, to offset
taxable income earned in the prior three years, generating tax refunds for the
Company. The remaining pre-tax losses give rise to significant deferred tax
benefits, which will be recognized in future years, as the temporary book to tax
differences which create the deferred tax benefits become deductible for tax
purposes. The total deferred tax benefit which is expected to be realized in
future years approximates $8.2 million at December 31, 1995. Based upon
management's estimates of future taxable income and of the positive and negative
evidence regarding the likelihood of ultimate recognition of this benefit, it
has been determined that no valuation allowance is necessary. This determination
was based on the Company's taxable earnings history, exclusive of non-recurring
charges, and the period anticipated for full recognition, assuming the Company
maintains its current level of taxable income, exclusive of the charges incurred
for its discontinued operations, the restructuring charges reported in 1994 and
1996, and certain other non-recurring items.
DISCONTINUED OPERATIONS:
In December 1995, a judgment was awarded against a wholly owned subsidiary of
the Company in the amount of $5,156,022. This judgment related to the Company's
1991 and prior E&O program, which was carried by Acceleration National Insurance
Companies (Acceleration). Under this program, the Company bore reinsurance risk
through the letters of credit that it was required to post as collateral to be
drawn upon in the event that the assets in the reinsurance pool, together with
investment income earned thereon were insufficient to cover the claims and
related expenses incurred. With the change in carriers to CNA, in 1993, the
Company removed itself from any risk bearing position in connection with the
claims reported under its E&O program, and currently no longer operates in this
capacity. Accordingly, the judgment amount was reported in discontinued
operations in the accompanying consolidated statements of operations.
LIQUIDITY AND CAPITAL RESOURCES
The Company generally receives payment for products and services before
disbursing funds for related direct expenses. Fees from Members and from sales
of home warranty contracts are received before related marketing commissions are
paid out and before claims are made under home warranty contracts. As a result
of increases in home warranty production in 1996 as compared to 1995, cash
collected on warranty contracts in 1996 was approximately $4,623,000 higher than
1995. In 1996, membership and related revenues and cash flows were negatively
affected by the decrease in members and in the related fees generated by the
Company's membership, and the Company continued to provide its Affiliates with
various discounted membership options. The Company expects that cash flow
generated from its warranty and other operations, in combination with the cost
saving measures implemented, will be sufficient to meet its normal operating
needs on an ongoing basis. However, should the merger fail to be consummated by
July 1, 1997, Cross Country will be entitled to take action to collect on its
judgment. In the event the judgment creditor proceeds to execute on its
judgment, it is likely that the Company will be without adequate resources to
pay the full amount due to Cross Country, as holder of the judgment, which would
become immediately due and payable. In such event, the Company would be forced
to seek alternatives to paying the remaining unpaid balance of the judgment. No
other alternatives are presently being considered.
In 1996, net cash provided by operating activities totaled $4,347,000, as
compared to cash used in operations of $667,000 in 1995. This increase in cash
is primarily due to liquidation of some of the Company's investment portfolio,
relating to a transfer of investments from trading to available for sale in
mid-1996, paired with increases in warranty production in 1996 as compared to
the 1995 levels. In the first quarter of 1996, the Company modified its payment
terms to its claims service contractors to move from 20 to 30 day terms,
consistent with industry standards, which further positively impacted cash
flows. Also impacting operating cash flows are various payments for claims
payable, Affiliate and Member commissions and E&O premium
17
<PAGE>
remittances. In 1996, the Company used $3,513,000 in investing activities, as
compared to $2,207,000 in 1995, primarily due to the transfer of investments
previously noted, offset by decreases in purchases of property and equipment.
Net cash provided by financing activities totaled $3,000 in 1996, as compared to
cash used in financing activities of $2,005,000 in the comparable 1995 period.
The 1995 financing activities reflect the collateral fund contributions related
to the Sphere Drake reinsurance recoverable.
In consideration for CNA's assumption of POMG's reinsurance obligations, which
is more fully discussed in the BUSINESS ERRORS & OMISSIONS INSURANCE section
herein, the Company has agreed to pay CNA $5 million by December 1999 toward the
ultimate settlement of the transferred losses and expenses. The agreements with
CNA impose certain restrictive covenants until the $5 million CNA obligation is
satisfied, including limits on dividends and on future borrowings. The funds due
to CNA are a senior obligation of the Company, secured by an interest in the
common stock of the Company's HOMS subsidiary and in the Company's Member list.
Through December 31, 1999, the Company and its Affiliates must provide
CNA/Schinnerer with right of first refusal on E&O insurance offered to its
membership. The Company forwards half of its commissions earned under the CNA
E&O program to CNA, to be applied as debt repayments on the obligation until its
satisfaction. The Company is currently in default with the terms of this
agreement, as it has failed to achieve the minimum premium volume quotas as
defined in the agreements, and the Company could be required by CNA to make a
payment against its obligation to the Holdback Fund in the amount of
approximately $200,000. However, the Company and CNA have entered into an
amendment to the Holdback Agreement which would delete the premium volume quotas
and release the Company from its current obligation to pay the remaining $3.1
million. Following the effective date of this amendment, the Company's
obligation will be limited to the payment of 50% of actual commissions to CNA.
The proposed amendment becomes effective if the Merger is consummated prior to
July 1, 1997, and the dispute with Sphere Drake (as described below) is
settled within 14 days of the consummation of the Merger.
During 1996 the Company made principal repayments of approximately $725,000
against the CNA obligation. As of December 31, 1996, the net present value of
the balance due to CNA under this obligation was $3,075,000. In addition, in
connection with the transfer of the net assets of POMG to CNA and the assumption
by CNA of the obligations of POMG under certain Realtor's errors and omissions
policies, the Company guaranteed the performance by Sphere Drake Insurance, PLC
("Sphere Drake"), a third party reinsurance company, under a $5 million
reinsurance treaty purchased by POMG to protect it from losses in excess of a
predetermined amount. Under the terms of the Company's guaranty, CNA, as the
transferee of the reinsurance treaty, bears any credit risk under the treaty,
including, but not limited to, any risk that Sphere Drake becomes insolvent, is
adjudicated as a bankrupt or has liquidation or similar proceedings commenced
against it. The Company has agreed, if necessary, to pay an additional $2
million out of future commissions related to the guarantee. Should this occur,
the repayments on the $5 million obligation will be delayed until the $2 million
is paid. The Company will not be required to further reduce its collected
commission by more than 50% under these agreements. On April 10, 1996, CNA
issued a Notice of Arbitration to Sphere Drake, with respect to its refusal to
honor the reinsurance treaty. Accordingly, the Company, CNA and Sphere Drake
have engaged in settlement negotiations with respect to the reinsurance treaty.
Although terms are not yet finalized, its is possible that the Company could pay
a substantial portion of the Collateral Account to CNA under the terms of the
currently proposed settlement agreement. As a result of the settlement
negotiations between CNA and Sphere Drake, the Company has recorded a loss
provision of $2.5 million for the guarantee.
In December 1991, ANIC, the insurer of the Company's E&O program through April
1991, brought suit against the Company and HMS. On December 13, 1995, a jury
verdict in the amount of $5,156,022 was rendered in favor of the Plaintiff and
against HMS. Under the terms of the Merger Agreement with Cross Country, Cross
Country agreed to pay the balance due to ANIC under a settlement agreement, upon
closing of the Merger. Pursuant to the settlement agreement, on September 4,
1996, the Company paid to ANIC the full amount of its 1995 federal income tax
refund, together with interest, which totaled $1,401,485. The remaining balance
due bears interest at the rate of 10% per annum from September 1, 1996 until the
settlement amount is paid in full. An affiliate of Cross Country purchased the
judgment from ANIC as of October 31, 1996, for approximately $2.75 million. The
Cross Country affiliate agreed, under certain conditions, to take no action to
collect on the judgment before January 31, 1997. In January 1997, under the
Second Amendment to the Merger Agreement, the Cross Country affiliate extended
the date until which it agreed to take no action to collect on the judgment to
July 1, 1997. The Company has guaranteed the obligation of HMS and pledged the
shares of HMS and another subsidiary of the Company to secure such guarantee.
HMS and the subsidiary granted security interests in their assets as part of the
First Amendment to the merger agreement. Should the merger fail to be
consummated by July 1, 1997, Cross Country will be entitled to take action to
collect on its judgment. In the event the judgment creditor proceeds to execute
on its judgment, it is likely that the Company will be without adequate
resources to pay the full amount due to Cross Country, as holder of the
judgment, which would become immediately due and payable. In such event, the
Company would be forced to seek alternatives to paying the remaining unpaid
balance of the judgment. No other alternatives are presently being considered.
The Company's efforts in 1996 to contest the
18
<PAGE>
domestication of the judgment in Florida, appeal the judgment and otherwise
prevent the judgment creditor from executing on its judgment have resulted in
substantial fees to professionals and other advisors, which further negatively
impacted the Company's liquidity during 1996.
Seventeen of the states in which the Company's subsidiaries operate regulate the
home warranty business. Certain of these states require that reserves be
maintained to cover future repairs for the remaining terms of warranty contracts
(generally one year). As of December 31, 1996, approximately $10,800,000 of cash
and investments are needed to maintain the regulated subsidiaries' required
minimum reserve and surplus levels. Of this amount, approximately $1,200,000 of
cash and investments are held by the regulated states to assure the Company's
fulfillment of its obligations to contract holders. Increases in warranty
production, as seen thus far in the first quarter of 1996, result in increases
in the Company's required reserve and surplus levels in the regulated states. In
addition, state regulators generally seek reserve balances in excess of the
minimum standards. In certain states, withdrawal of any reserves in excess of
statutory minimums requires approval from the regulatory authorities. The
Company has been advised by certain authorities that such approval will not be
granted. Accordingly, the Company maintained reserves of approximately
$13,500,000 as of December 31, 1996. The Company is currently in compliance with
all applicable surplus and reserve requirements.
The Company is continuing its efforts to upgrade its current computer and
processing environments over the next two years, in an attempt to increase
operational efficiency, improve management information, and allow for future
growth in the Company's business. This plan is currently expected to have an
incremental cost of approximately $750,000 in excess of the cost of maintaining,
servicing and improving the existing system, over the life of the project.
Management expects that sufficient funds will be available to cover the cost of
the upgrade. If such funds are not available, this project will be deferred.
19
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS PAGE
- -------------------------------------------------------------------------------
Independent Auditors' Report 21
Consolidated Balance Sheets - December 31, 1996 and 1995 22
Consolidated Statements of Operations - Years Ended
December 31, 1996, 1995 and 1994 23
Consolidated Statements of Cash Flows - Years Ended
December 31, 1996, 1995 and 1994 24
Consolidated Statements of Stockholders' Equity - Years Ended
December 31, 1996, 1995 and 1994 25
Notes to Consolidated Financial Statements 26
20
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Homeowners Group, Inc.
Sunrise, Florida:
We have audited the accompanying consolidated balance sheets of Homeowners
Group, Inc. and its subsidiaries (the "Company") as of December 31, 1996
and 1995 and the related consolidated statements of operations, stockholders'
equity and cash flows for each of the three years in the period ended
December 31, 1996. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. These standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a resonable basis
for our opinion.
In our opinion, such consolidated financial statements present fairly,
in all material respects, the financial position of the Company at
December 31, 1996 and 1995 and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1996 in
conformity with generally accepted accounting principles.
The accompanying financial statements for the year ended December 31, 1996 have
been prepared assuming the Company will continue as a going concern. As
discussed in Notes 1, 2 and 10, the Company could be obligated to pay on an
outstanding judgement. In the event the judgement creditor proceeds to execute
on its judgement, it is likely the Company will be without adequate resources
to pay the full amount due, which raises substantial doubt about its ability
to continue as a going concern. Management's plans in regard to this matter are
also described in Note 1. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
As discussed in Note 10 to the consolidated financial statements the Company
is currently undergoing an examination by the Internal Revenue Service of its
tax returns for the years 1993, 1994 and 1995.
DELOITTE & TOUCHE LLP
Certified Public Accountants
Miami, Florida
April 8, 1997
21
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 1996 1995
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS:
Current assets:
Cash and cash equivalents $ 1,833,977 $ 997,336
Trading securities 4,927,225 9,250,349
Current portion of securities available for sale 507,050 1,811,624
Miscellaneous receivables 990,644 1,278,044
Deferred home warranty acquisition costs 6,137,476 5,666,899
Refundable income taxes 28,000 1,277,449
Deferred income taxes 6,336,602 6,896,920
Prepaid expenses and other current assets 840,250 1,196,026
----------- -----------
Total current assets $21,601,224 $28,374,647
Restricted cash (net of allowance of $2,500,000 in 1996) 660,000 3,160,000
Non-current portion of securities available for sale 7,417,599 1,834,981
Property and equipment - net 4,403,030 3,581,893
Other assets 432,755 432,327
Deferred income taxes - net of current portion 3,239,965 1,373,608
----------- -----------
TOTAL $37,754,573 $38,757,456
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts payable $1,122,885 $1,220,140
Accrued expenses 7,088,961 5,647,433
Litigation settlement 3,881,567 5,156,022
Current maturities of long term debt 1,191,601 1,537,257
Deferred home warranty revenue 17,768,964 16,239,431
----------- -----------
Total current liabilities 31,053,978 29,800,283
Long term debt - net of current portion 2,940,711 2,591,929
Commitments and contingencies - See Note 10
Stockholders' equity:
Preferred stock - $0.01 par value; 5,000,000
shares authorized; none issued and outstanding - -
Common stock - $0.01 par value; 45,000,000
shares authorized; 5,558,350 shares issued and
outstanding at December 31, 1996 and 1995 55,584 55,584
Additional paid-in capital 7,458,288 7,458,288
Retained earnings (accumulated deficit) (3,799,406) (1,201,845)
Unrealized holding gain on securities
available for sale (net of taxes of $28,022 and
$34,745 in 1996 and 1995, respectively) 45,418 53,217
----------- -----------
Total stockholders' equity 3,759,884 6,365,244
----------- -----------
TOTAL $37,754,573 $38,757,456
=========== ===========
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
22
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
- --------------------------------------------------------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31, 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Operating Revenue $45,431,035 $44,691,749 $53,194,278
Operating costs and expenses:
Direct expenses 35,852,860 34,249,673 40,084,151
Unusual items 676,546 - 1,787,355
General and administrative expenses 10,491,150 9,261,562 12,012,742
----------- ----------- ----------
Total 47,020,556 43,511,235 53,884,248
----------- ----------- ----------
Operating income (loss) (1,589,521) 1,180,514 (689,970)
Other income (expenses):
Investment income, net 636,061 1,367,482 120,455
Other, net (643,542) (340,307) (172,707)
------------ ----------- -----------
Total (7,481) 1,027,175 (52,252)
------------ ----------- -----------
Income (loss) from continuing
operations before income taxes (1,597,002) 2,207,689 (742,222)
(Provision) benefit for income
taxes 558,691 (847,099) 84,119
----------- ----------- ----------
Income (loss) from continuing operations (1,038,311) 1,360,590 (658,103)
Loss from operation of discontinued reinsurance
segment (net of income tax benefit of $940,750
and $1,940,211 in 1996 and 1995, respectively) (1,559,250) (3,215,811) -
----------- ----------- ----------
Net loss ($2,597,561) ($1,855,221) ($658,103)
=========== =========== ==========
Per share information:
Income (loss) from continuing operations ($0.19) $0.25 ($0.12)
Loss from operation of discontinued reinsurance
segment (0.28) (0.58) -
------------ ------------ ----------
Net loss ($0.47) ($0.33) ($0.12)
============ ============ ==========
Dividends declared per common share $0.00 $0.00 $0.00
Weighted average common shares outstanding 5,558,350 5,558,350 5,558,350
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
23
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31, 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ($2,597,561) ($1,855,221) ($658,103)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Provision for loss on discontinued operation 1,559,250 3,215,811 -
Depreciation and amortization 958,824 601,884 827,919
Allowance for loss on franchising fee revenue - - 3,112,328
Provision (benefit) for deferred income taxes on continuing operations (358,566) 292,323 1,575,345
Unrealized holding (gain) loss 76,146 (300,318) 627,189
Foreign currency translation adjustment - - 43,280
Other changes in assets and liabilities:
(Increase) decrease in miscellaneous receivables 287,400 (124,856) (495,855)
(Increase) decrease in deferred home warranty acquisition costs (470,577) 10,423 52,572
Decrease in refundable income taxes on continuing operations 1,249,449 538,700 751,483
(Increase) decrease in prepaid expenses and other assets 183,579 959,060 (2,231,844)
Increase (decrease) in accounts payable (97,255) (543,578) 488,955
Increase (decrease) in accrued expenses payable 1,441,528 (3,462,035) (544,155)
Decrease in litigation settlement (1,274,455) - -
Increase in deferred home warranty revenue 1,529,533 120,679 395,328
Payments on reserve for loss on reinsurance portfolio transfer - - (727,915)
Payments for purchases of trading securities (3,848,583) (7,434,195) (8,276,460)
Proceeds from sales of trading securities 5,708,294 7,314,642 8,106,104
----------- ---------- -----------
Net cash provided by (used in) operating activities 4,347,006 (666,681) 3,046,171
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Property and equipment expenditures (1,608,194) (2,138,361) (1,313,701)
Purchases of securities classified as available for sale (8,239,427) (817,812) (11,149,647)
Proceeds from sale of securities classified as available for sale 6,334,129 749,641 8,960,902
----------- ---------- -----------
Net cash used in investing activities (3,513,492) (2,206,532) (3,502,446)
------------ ----------- ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments of debt (1,106,451) (830,409) (528,951)
Amortization of discount on long term debt 193,603 167,849 312,585
Borrowings under financing arrangements 915,975 409,414 425,884
Collateralization of contingent guarantee to CNA - (1,752,149) (1,247,851)
----------- ----------- -----------
Net cash provided by (used in) in financing activities 3,127 (2,005,295) (1,038,333)
----------- ----------- -----------
Net increase (decrease) in cash and cash equivalents 836,641 (4,878,508) (1,494,608)
Cash and cash equivalents at beginning of year 997,336 5,875,844 7,370,452
----------- ----------- -----------
Cash and cash equivalents at end of year $ 1,833,977 $ 997,336 $ 5,875,844
=========== =========== ===========
SUPPLEMENTAL DISCLOSURE:
Cash paid during the period for:
Interest $351,497 $285,911 $322,665
Income taxes 150,157 31,442 328,007
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
24
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
- ----------------------------------------------------------------------------------------------------------------------
FOREIGN
HOLDING CURRENCY
COMMON PAID IN RETAINED GAIN TRANSLATION TOTAL
STOCK CAPITAL EARNINGS (LOSS) ADJUSTMENT EQUITY
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE AT
DECEMBER 31, 1993 $55,584 $7,458,288 $1,311,479 $ - ($43,283) $8,782,068
-----------------------------------------------------------------------------------------
Net loss for the year (658,103) (658,103)
Unrealized holding loss (14,813) (14,813)
Foreign currency
translation gain 43,283 43,283
-----------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 1994 55,584 7,458,288 653,376 (14,813) - 8,152,435
-----------------------------------------------------------------------------------------
Net loss for the year (1,855,221) (1,855,121)
Unrealized holding gain 68,030 68,030
-----------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 1995 55,584 7,458,288 (1,201,845) 53,217 - 6,365,244
-----------------------------------------------------------------------------------------
Net loss for the year (2,597,561) (2,597,561)
Unrealized holding loss (7,799) (7,799)
------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 1996 $55,584 $7,458,288 ($3,799,405) $45,418 $ - $3,759,884
=========================================================================================
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
25
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
1. THE COMPANY
- -------------------------------------------------------------------------------
Homeowners Group, Inc. ('HOMG') and its subsidiaries (collectively the
'Company') provide home warranty contracts, access to real estate errors and
omissions liability insurance ('E&O') and other products and services primarily
to residential real estate brokerage firms and agents. The Company enters into
agreements with real estate brokerage firms and agents ('Members') which grant
Members the right to use the products and services provided by the Company. The
Company generally markets its products and services through franchise agreements
whereby the third party operators ('Affiliates') have exclusive geographic
territories in which to enroll real estate brokerage firms as Members. Through
December 31, 1996, the Company had entered into agreements with Affiliates for
territories encompassing 35 states and the District of Columbia. In 1996, the
Company marketed directly in California, Florida, except Northwest Florida which
territory has been granted to an Affiliate, Colorado, Hawaii, Idaho, Indiana,
Iowa, Nebraska, North Dakota, Pennsylvania, South Dakota, Oregon, and
Washington, ('Corporate-Owned Regions'), and is a 45% partner in a partnership
which directly enrolls Members in Texas. In 1994 and part of 1995, the Company
also directly enrolled Members in Maine, Massachusetts, New Hampshire and
Vermont, however, in May 1995, the Company franchised this New England
territory. Under management agreements executed in 1995, the Company continued
in 1996 to manage the operations and administration of the Kansas, Missouri,
Oklahoma, Arizona and New Mexico territories.
In October 1991, the Company acquired an 80% interest in a British subsidiary
which began marketing home warranty contracts in the United Kingdom in February
1992. The home warranty contract program and other insurance products offered by
this subsidiary were completely underwritten by Lloyd's of London, thereby
eliminating any underwriting risk to the Company. In the third quarter of 1994,
the Company ceased funding the UK operation, effectively closing down the
subsidiary. Accordingly, there was no foreign operations activity in 1995. See
further discussion of this transaction in Note 9.
Although the Company's home warranty contracts are generally not considered to
be insurance products, the Company is subject to insurance-type regulations in
many of the states in which the home warranty contracts are sold. Certain of
these states require that reserves be maintained to cover future repairs for the
remaining terms of the warranty contracts (generally one year). As of December
31, 1996, approximately $10,800,000 of cash and securities were needed to
maintain the regulated subsidiaries' minimum reserve and surplus levels.
Increases in warranty production, as seen thus far in the first quarter of 1997,
result in increases in the Company's required reserve and surplus levels in the
regulated states. In addition, state regulators generally seek reserve balances
in excess of the minimum standards. In certain states, withdrawal of any
reserves in excess of statutory minimums requires approval from the regulatory
authorities. The Company has been advised by certain authorities that such
approval will not be granted. Accordingly, the Company maintained reserves of
approximately $13,500,000 as of December 31, 1996. The Company is currently in
compliance with all applicable surplus and reserve requirements.
As warranty production increases, the Company's required reserve and surplus
levels increase, which reduces the cash available to the Company to fund its
operations. During 1996 the fees generated by the Company's membership continued
to decline, and the Company continued to provide its Affiliates with various
discounted membership options to maintain competitiveness in the marketplace. As
a result of these factors, the Company's cash flow from membership operations
has been significantly impacted. The Company expects that cash flow generated
from its warranty and other operations, in combination with the cost saving
measures implemented, will be sufficient to meet its normal operating needs on
an ongoing basis. However, should the merger fail to be consummated by July 1,
1997, Cross Country will be entitled to take action to collect on its judgment.
In the event the judgment creditor proceeds to execute on its judgment, it is
likely that the Company will be without adequate resources to pay the full
amount due to Cross Country, as holder of the judgment, which would become
immediately due and payable. In such event, the Company would be forced to seek
alternatives to paying the remaining unpaid balance of the judgment. No other
alternatives are presently being considered.
See also Note 2, for discussion of the Company's cash collateral requirements
relative to the 1993 transfer of its discontinued reinsurance operations and
Note 10 for discussion of other commitments and contingencies impacting cash
flow.
The Company announced on May 15, 1996 that it had entered into a definitive
merger agreement (the "Merger") under which The Cross Country Group, Inc.
("Cross Country") agreed to acquire the Company for $2.35 per share in cash. The
merger agreement stated that the merger was subject to a number of conditions
including approval of the transaction by the Company's stockholders and
regulatory authorities. The Company also announced on May 15, 1996 that it had
reached an agreement to settle the judgment obtained by Acceleration National
Insurance Company ("Acceleration" or "ANIC") by paying to Acceleration a reduced
amount of approximately $4.4 million in cash at the closing of the merger, which
Cross Country had agreed, as a condition to the merger, to satisfy.
26
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
1. THE COMPANY (Continued)
- -------------------------------------------------------------------------------
On November 7, 1996, the Company, announced that it had entered into an
amendment to the merger agreement with Cross Country, which, among other things,
reduced the price at which Cross Country will acquire HOMG stock to $2.06 per
share in cash. The amendment also extended the anticipated closing date to no
later than March 1, 1997. In addition, the amendment modified the Company's
stock rights plan to permit Cross Country and its affiliates to buy an unlimited
number of shares in privately negotiated transactions. This stock rights plan
amendment was not effective until three business days after the information was
released, provided that no other bid for the Company was received within such
three day period. The three day period passed with no other bids submitted to
purchase the Company.
An affiliate of Cross Country purchased, for approximately $2.75 million, the
$5.2 million judgment obtained by Acceleration (the "Judgment"). The purchase
price of the judgment reflected a $1.4 million payment previously made by the
Company. The Cross Country affiliate also agreed, under certain conditions, to
take no action to collect on the Judgment before January 31, 1997.
On February 10, 1997, the Company entered into a second amendment to the merger
agreement with Cross Country, which extended the anticipated closing date to the
earlier of July 1, 1997 or termination of the merger agreement. The Company also
entered into an amendment to the agreement with the affiliate of Cross Country
which holds the Judgment, extending the date through which the Cross Country
affiliate agreed, under certain conditions, to take no action to collect on the
Judgment until the earlier of July 1, 1997 or termination of the merger
agreement. The Company guaranteed the obligation of HMS and pledged the shares
of HMS and another subsidiary to secure such guarantee. HMS and the subsidiary
granted security interests in their assets as part of the First Amendment to the
Merger Agreement.
As of the date of this filing, the Company has obtained regulatory approval for
the merger in all states.
Management anticipates that the Merger will be approved by the majority of its
stockholders at the special meeting to vote on the Merger, and that the various
issues related to the judgment held by the Cross Country affiliate will be
resolved by the consummation of the Merger.
2. DISCONTINUED REINSURANCE OPERATIONS
- -------------------------------------------------------------------------------
In December 1992, the Company formed its own reinsurance subsidiary, POMG
Insurance Company, Ltd. ('POMG'), which acquired certain net assets from
Meridian Insurance Company, Ltd. ('Meridian'), the previous reinsurer of the
Company's E&O program. In December 1992, the subsidiary purchased a $5,000,000
aggregate stop loss reinsurance policy to further protect it from the risk of
loss in excess of a predetermined amount on the first two E&O policy years.
In the second and third quarters of 1993, the E&O program experienced
significant losses. Effective December 1, 1993, Continental Casualty Company,
("CNA") replaced POMG as the reinsurer of the E&O policies issued through
November 30, 1993 to the Company's Members by certain subsidiaries of American
International Group, Inc. ("AIG"). This transaction took place through a
novation of previous reinsurance agreements in effect. For policies issued from
December 1, 1993 forward, CNA became the insurer, and the Company began
marketing CNA policies to its Members through Victor O. Schinnerer and Company,
Inc. ("Schinnerer"), CNA's exclusive program and underwriting manager. Pursuant
to the agreement with CNA, the Company discontinued POMG's operations. The
Company, through its HOMS Insurance Agency, Inc. ("HOMS") subsidiary acts solely
in the capacity of an insurance broker. Under the terms of the agreements, the
Company receives a fixed percentage of the E&O premiums collected as a
commission. The Company pays a portion of these commissions to the Affiliates
generating the premium volume. In February 1994, the Company, CNA and AIG
entered into definitive agreements, effective as of December 1, 1993, setting
forth the terms described above.
The Company is further obligated to pay CNA $5,000,000 (the 'CNA Obligation')
over a period originally estimated to be three years and subsequently revised to
be five years, toward the ultimate settlement of the transferred losses and
expenses. CNA is maintaining a separate accounting for the POMG net assets.
Additionally, a separate fund, the 'Holdback Fund,' has been established to
accumulate the aforementioned $5,000,000 from the Company, additional funds to
be contributed by Schinnerer and CNA over the same period, and investment income
earned on these funds, to pay claims and expenses related to the reinsured
policies in excess of the POMG net assets.
In connection with the transfer of the net assets of POMG to CNA and the
assumption by CNA of the obligations of POMG under certain Realtor's errors and
omissions policies, the Company guaranteed the performance by Sphere Drake
Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a
$5,000,000 reinsurance treaty purchased by POMG to protect it from losses in
excess of a predetermined amount. Under the terms of the Company's guaranty,
CNA, as the transferee of the reinsurance treaty, bears any credit risk under
the treaty, including, but not limited to, any risk that Sphere Drake becomes
insolvent, is adjudicated as a bankrupt or has liquidation or similar
proceedings commenced against it. The reinsurance treaty represents amounts
recoverable from a third party insurance company under the reinsurance treaty
purchased by POMG. This guarantee is secured by $3,000,000 cash collateral
posted by the Company. This amount is reported as restricted cash in the
accompanying consolidated balance sheet. The Company has agreed, if necessary,
to pay an additional $2,000,000, related to the guarantee, out of future
commissions. On April 10,
27
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
2. DISCONTINUED REINSURANCE OPERATIONS (Continued)
- -------------------------------------------------------------------------------
1996, CNA issued a Notice of Arbitration to the reinsurer with respect to its
refusal to honor the reinsurance treaty. The Company, CNA and Sphere Drake are
engaged in settlement discussion with respect to the reinsurance treaty.
Although terms are not finalized, it is possible that the Company could pay a
substantial portion of the Collateral Account to CNA under the currently
proposed settlement agreement. The potential settlement agreement is contingent
upon the closing of the Merger. Should the Merger fail to be consummated, the
potential settlement agreement will not be consummated and the Company and
Sphere Drake will either continue arbitration or seek some other resolution of
this issue. If the Merger is not consummated, the Company will continue to be
contingently liable for the entire $5 million under the conditions described in
the preceding paragraph. As a result of the settlement negotiations, the Company
has recorded a loss provision of $2.5 million for the guarantee, which is
included in the Discontinued Operations caption in the accompanying 1996
consolidated statements of operations. The restricted cash amount is presented
net of the $2.5 million reserve in the 1996 consolidated balance sheets.
The agreements with CNA impose certain restrictive covenants until the
$5,000,000 CNA Obligation is satisfied. These covenants include limits on
dividends and on future borrowings. The funds due to CNA are a senior obligation
of the Company, secured by an interest in the common stock of the Company's HOMS
subsidiary and in the Company's Member list. For a five year period ending
November 30, 1999, the Company and its Affiliates must provide CNA/Schinnerer
with right of first refusal on E&O insurance offered to its membership. In
addition to the restrictive covenants, the Company has agreed to meet certain
production quotas with respect to annual premium volume. Based on the 1996
premium volume achieved, the Company is currently in default of the terms of the
agreements as modified, and could be required by CNA to make a payment against
its obligation to the Holdback Fund in the amount of approximately $200,000.
However, the Company and CNA have entered into an amendment to the Holdback
Agreement which would delete the premium volume quotas and release the Company
from its current obligation to pay the remaining $3.1 million. Following
the effective date of this amendment, the Company's obligation will be limited
to the payment of 50% of actual commissions to CNA. The proposed amendment
becomes effective if the Merger is consummated prior to July 1, 1997, and the
dispute with Sphere Drake (as described above) is settled within 14 days of the
consummation of the Merger.
On December 13, 1995, a jury verdict in the amount of $5,156,022 was rendered in
favor of the Plaintiff and against Homeowners Marketing Services, Inc. ("HMS"),
a subsidiary of the Company, in the following matter: Acceleration National
Insurance Company, Plaintiff, vs. Homeowners Marketing Services, Inc., et al.,
Defendants, in the Court of Common Pleas of Franklin County, Ohio. This amount
has been accrued as an adjustment to the Company's loss from discontinued
reinsurance operation, and reported net of taxes in the amount of $2,036,629 in
the accompanying consolidated income statements. See also note 10 regarding
contingencies and anticipated resolution of this matter.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
- -------------------------------------------------------------------------------
PRINCIPLES OF CONSOLIDATION -- The accompanying consolidated financial
statements include the accounts of HOMG and all of its majority owned
subsidiaries. All significant intercompany transactions have been eliminated in
consolidation. The Company's 45% interest in the partnership enrolling and
servicing Members in Texas is accounted for by the equity method. The earnings
from the partnership are included in operating revenue in the accompanying
consolidated statements of operations.
ACCOUNTING ESTIMATES -- The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
REVENUE AND EXPENSE RECOGNITION -- Home warranty contract revenue is recognized
over the life of the contract (generally one year) in proportion to historical
experience of repair costs. Direct costs incurred in acquiring the contracts are
recognized in the same manner. Direct acquisition costs include certain
additional expenses, such as incentive bonuses paid to the Company's Members and
Affiliates, costs of personnel directly involved in acquiring the contracts, and
premium taxes. Repair costs under home warranty contracts are expensed as
mechanical breakdowns are reported to and repairs are authorized by the Company.
Initial and renewal membership fees and associated commission expenses are
deferred upon collection of the fees and are recognized over the life of the
membership period, generally one year. E&O premium commissions are recognized
upon collection of the related premiums. All other revenues and expenses are
recognized upon delivery or receipt of the related products or services.
PROPERTY AND EQUIPMENT -- Property and equipment is carried at cost and
depreciated on the straight-line method over their estimated useful lives, which
range from three to seven years. Leasehold improvements are amortized over the
shorter of the lease term or the estimated useful lives of the improvements.
INVESTMENTS -- The Company accounts for its investments according to Statement
of Financial Accounting Standards ('SFAS') No. 115, 'Accounting for Certain
Investments in
28
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
- -------------------------------------------------------------------------------
Debt and Equity Securities.' This standard requires that the Company report at
fair value the securities which are held for trading purposes, or which are
available for sale. Unrealized holding gains and losses on trading securities
are determined based upon the change in fair value and are included in
investment income in the accompanying consolidated statements of operations.
Unrealized holding gains on securities available for sale are also determined
based upon the changes in fair values, and are reported net of tax as a separate
component in the stockholders equity section of the balance sheet. Gains and
losses on securities are determined based upon specific identification of the
securities sold. The Company does not currently have any securities which are
classified as held to maturity.
INCOME TAXES -- Income taxes are provided in accordance with SFAS No. 109,
'Accounting for Income Taxes.' Under this standard, deferred tax assets and
liabilities represent the tax effects, based on current tax law, of future
deductible or taxable amounts attributable to events that have been recognized
in the financial statements.
FOREIGN CURRENCY TRANSLATION -- The financial statements of the Company's
previous 80% owned British subsidiary are translated into US dollars in
accordance with SFAS No. 52, 'Foreign Currency Translation.' Net assets of the
subsidiary, whose functional currency is the British Pound Sterling, are
translated at current exchange rates, while results of operations are translated
at average exchange rates in effect for the year.
NET INCOME PER COMMON SHARE -- Net income per common share is based upon the
weighted average number of common shares outstanding during each year. Dilutive
stock options and warrants are included in the calculation of weighted average
shares utilizing the Treasury Stock Method. Primary and fully diluted earnings
per share are essentially the same in all years presented in the accompanying
consolidated statements of operations.
DISCONTINUED OPERATIONS -- The Company reviews the liabilities recorded in
association with its 1993 discontinued reinsurance operations annually, and
adjusts the balances as necessary. In 1995 and 1994, the Company revised its
estimate of the net present value of the CNA obligation, based upon the actual
payments remitted during each year, and in 1994, to reflect an estimated
repayment term of five years, as opposed to the original estimated term of three
years. This change in estimate resulted in an increase in the discount on the
obligation, which will be amortized to interest expense over the life of the
obligation. Further, in both years, the Company revised its estimate of expenses
incurred relative to the reinsurance portfolio transfer, and recorded an
adjustment for the additional balances due. The net effect of these two
adjustments had no impact on the Company's consolidated results of operations.
In 1996, this evaluation did not result in any adjustment.
FRANCHISING FEE REVENUE -- The Company records franchising fee revenue in
accordance with SFAS No. 45, 'Accounting for Franchise Fee Revenue.' Under this
standard, franchising revenue is recorded when all material services or
conditions related to the sale are complete, substantially all of the initial
services of the franchisor required by the franchise agreement are complete, and
no other material conditions or obligations related to the determination of
substantial performance exist.
STOCK-BASED COMPENSATION -- SFAS No. 123 'Accounting for Stock-Based
Compensation', encourages, but does not require companies to record compensation
cost for stock-based employees and non-employee members of the Board
compensation plans at fair value. The Company has chosen to continue to account
for stock-based compensation to employees and non-employee members of the Board
using the intrinsic value method as prescribed by Accounting Principles Board
Opinion ("APB") No. 25, 'Accounting for Stock Issued to Employees', and related
interpretations. Accordingly, compensation cost for stock options issued to
employees and non-employee members of the Board are measured as the excess, if
any, of the fair value of the Company's stock at the date of grant over the
amount an employee or non-employee member of the Board must pay for the stock.
RECLASSIFICATIONS -- Certain amounts in the accompanying 1995 and 1994
consolidated financial statements have been reclassified from amounts previously
reported to conform to the current presentation.
4. UNITED KINGDOM OPERATIONS
- -------------------------------------------------------------------------------
The 1994 general and administrative expenses incurred by the Company's previous
80% owned British subsidiary approximated $777,000, and are included in the
accompanying 1994 consolidated statements of operations. Operating revenue
generated by the subsidiary in 1994 approximated $16,000. During the third
quarter of 1994, the Company ceased funding this operation, effectively closing
down the subsidiary. See further discussion of this transaction at Note 10.
5. PROPERTY AND EQUIPMENT
- -------------------------------------------------------------------------------
Property and equipment consists of the following at December 31:
1996 1995
---- ----
Office furnishings and equipment $1,130,428 $1,497,939
Leasehold improvements 529,600 713,970
Computer equipment and software 4,608,420 3,985,487
Automobiles 47,533 47,533
Assets held under capital lease 1,204,804 499,032
---------- ----------
Total 7,520,785 6,743,961
Accumulated depreciation
and amortization (3,117,755) (3,162,068)
----------- -----------
Property & equipment--net $4,403,030 $3,581,893
=========== ===========
Depreciation and amortization expense on property and equipment for the years
ended December 31, 1996, 1995 and 1994 approximated $959,000, $602,000 and
$749,000, respectively, and is included in general and administrative expenses
in the accompanying consolidated statements of operations. In 1996, in
connection with the Company's
29
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
5. PROPERTY AND EQUIPMENT (Continued)
- -------------------------------------------------------------------------------
change in corporate office locations, the Company disposed of office furniture
and equipment having a net book value of approximately $120,000, for which it
received only nominal proceeds. A charge for the net book value of the disposed
assets is included in other income (expense) in the accompanying consolidated
statements of operations.
6. INVESTMENTS
- -------------------------------------------------------------------------------
Investments consist of the following at December 31:
1996 1995
---- ----
Trading securities, at fair value $4,927,225 $9,250,349
Current securities available for sale,
at fair value 507,050 1,811,624
Non-current securities available
for sale, consisting primarily
of debt securities, at fair value 7,417,599 1,834,981
----------- -----------
Total carrying value
of investments $12,851,874 $12,896,954
=========== ===========
Information with respect to unrealized holding gains and losses and securities
classified as available for sale, as of December 31, 1996 and 1995 is as
follows:
GROSS
AMORTIZED UNREALIZED HOLDING FAIR
COST GAINS LOSSES VALUE
---------- ---------- -------- ----------
1996
Money markets $ 221,560 $ - $ - $ 221,560
US Gov't obligations 6,331,527 69,185 5,567 6,395,145
Corporate bonds 403,122 6,308 1,659 407,771
Municipal bonds 895,000 5,173 - 900,173
---------- ---------- -------- ----------
Total $7,851,209 $ 80,666 $7,226 $7,924,649
========== ========== ======== ==========
1995
Money markets $ 651,014 $ - $ - $ 651,014
US Gov't obligations 1,051,167 37,555 - 1,088,722
Corporate bonds 961,462 50,958 1,464 1,010,956
Municipal bonds 895,000 913 - 895,913
---------- ---------- -------- ----------
Total $3,558,643 $ 89,426 $1,464 $3,646,605
========== ========== ======== ==========
Information with respect to unrealized holding gains and losses and trading
securities, as of December 31, 1996 and 1995 is as follows:
GROSS
AMORTIZED UNREALIZED HOLDING FAIR
COST GAINS LOSSES VALUE
---------- ---------- -------- ----------
1996
Mutual funds $4,423,627 $ 54,336 $155,564 $4,322,399
Partnership holding 570,070 34,756 - 604,826
---------- ---------- -------- ----------
Total $4,993,697 $ 89,092 $155,564 $4,927,225
========== ========== ======== ==========
1995
Mutual funds $8,419,962 $ 234,985 $ 22,404 $8,632,543
Partnership holding 550,000 67,806 - 617,806
---------- ---------- -------- ----------
Total $8,969,962 $ 302,791 $ 22,404 $9,250,349
========== ========== ======== ==========
1994
Mutual funds $8,011,093 $ - $371,509 $7,639,584
Partnership holding 550,000 51,825 - 604,825
---------- ---------- -------- ----------
$8,561,093 $ 51,825 $371,509 $8,244,409
========== ========== ======== ==========
Gross realized gains and losses from sales of securities available for sale
totaled $19,717 and $5,497, respectively for the year ended December 31, 1996.
Gross realized gains from sales of securities available for sale totaled
$106,139 for the year ended December 31, 1995. Gross unrealized holding gains
and losses from sales of securities available for sales totaled $1,744 and
$143,774, respectively, for the year ended December 31, 1994. Gains and losses
on securities are determined based upon specific identification of the
securities sold.
Contractual maturities of securities classified as available for sale as of
December 31, 1996 are as follows:
AMORTIZED FAIR
COST VALUE
--------- ----------
Due in one year or less $508,262 $507,050
Due after one year through five years 7,112,926 7,187,353
Due after five years 230,021 230,246
---------- ----------
Total securities classified as
available for sale $7,851,209 $7,924,649
========== ==========
At December 31, 1996, treasury bonds, municipal bonds and cash deposits in the
amount of $1.2 million were held by various state regulatory agencies to assure
performance of the Company's obligations under home warranty contracts.
7. INCOME TAXES
- -------------------------------------------------------------------------------
Income (loss) from continuing operations before income taxes consists of the
following for the years ended December 31:
1996 1995 1994
---- ---- ----
Domestic ($1,597,002) $2,207,689 $18,735
Foreign - - (760,957)
----------- ---------- ----------
Total ($1,597,002) $2,207,689 ($742,222)
------------ ---------- ----------
The provision (benefit) for income taxes consists of the following for the years
ended December 31:
1996 1995 1994
---- ---- ----
Continuing Operations:
Current:
Federal ($70,000) $501,776 ($1,678,495)
State (130,125) 53,000 19,031
---------- ------- ----------
Total (200,125) 554,776 (1,659,464)
Deferred (358,566) 292,323 1,575,345
---------- -------- ----------
Total provision (benefit)
on income from
continuing operations (558,691) 847,099 (84,119)
Discontinued Operation:
Tax benefit from loss on
operation of discontinued
reinsurance segment (940,750) (1,940,211) -
---------- ----------- ----------
Total provision (benefit)
for income taxes ($1,499,441) ($1,093,112) ($84,119)
=========== ============ ==========
Tax benefits resulting from the 1993 operations of the Company's discontinued
reinsurance subsidiary have been carried back to the prior three years for
refunds of taxes paid in those years. The remaining tax benefits from the 1993
losses generated by the discontinued operation and the 1994 unusual charges will
be carried forward for realization in future years. Based upon management's
analysis of the positive and negative evidence regarding the likelihood of
realization of this asset, a valuation allowance was deemed to be unnecessary.
The Company historically has provided deferred income taxes primarily on
deferred home warranty contract revenues and acquisition costs, which are
recognized for tax purposes before recognition in the financial statements. The
Company also provides deferred income taxes on deferred marketing fee revenue
and expenses under the annually funded E&O
30
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
7. INCOME TAXES (Continued)
- -------------------------------------------------------------------------------
programs. The major portion of these benefits reverse within one year. The
components of the net deferred income tax assets are as follows:
1996 1995
---------- ----------
Deferred home warranty revenue $6,686,461 $6,414,575
Deferred home warranty acquisition costs (2,309,536) (2,238,425)
Litigation accrual 1,460,634 2,036,628
Deferred member fee revenue 312,457 487,601
Deferred member fee commissions (124,077) (191,052)
Current portion of provision for loss
on disposal of reinsurance operation 273,213 493,750
Miscellaneous 37,450 (106,157)
---------- ----------
Current portion of deferred income tax asset 6,336,602 6,896,920
Non-current portion of provision for loss on
disposal of reinsurance operation 884,060 991,855
Provision for reinsurance recoverable 940,750 -
NOL tax carryforward 1,528,737 342,292
Capitalized software (812,597) (659,554)
AMT credit 699,015 699,015
---------- ----------
Total deferred income tax asset $9,576,567 $8,270,528
========== ==========
Realization of the deferred tax asset is dependent on generating sufficient
taxable income during the carryforward periods. Although realization is not
assured, management believes it is more likely than not that all of the deferred
tax asset will be realized. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term, if estimates of future
taxable income during the carryforward period are reduced. In reaching this
determination, management reviewed the Company's historical performance, and
projections of future results, should the Company's performance continue at the
current level, exclusive of non-recurring events and transactions. These
projections provided positive evidence of future probable realization of the
full tax asset within the prescribed carryforward time frame. The projected
realization also considered the negative impact of charges which could result
from adverse resolution of certain outstanding contingencies; most notably the
Company's guarantee to CNA of a $5 million reinsurance recoverable, related to
the transfer of the POMG net assets. Negative evidence reviewed consisted of
several non-recurring charges incurred by the Company over the past three years.
As each of these charges was deemed to be unusual in nature, each of them
different from the other, and there was no expectation of future recurrences of
such items, the positive evidence was determined to outweigh the negative
evidence.
The provision (benefit) for income taxes on income from continuing operations
included in the accompanying consolidated statements of operations differs from
the provision (benefit) computed using the statutory federal income tax rate
(34%), due to the effects of the following items:
<TABLE>
<CAPTION>
1996 1995 1994
- ------------------------------------------------------------------------------------------------
%OF % OF % OF
$ PRETAX $ PRETAX $ PRETAX
AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME
- -------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Provision (benefit)
at statutory rate ($542,980) (34.0%) $750,614 34.0% ($252,355) (34.0)%
Tax exempt income (32,640) (2.0) (32,640) (1.5) - -
State taxes, net of
Federal benefit (53,906) (3.4) 83,412 3.8 21,628 2.9
Non-deductible losses
of UK subsidiary - - - - 52,320 7.1
Other 70,835 4.4 45,713 2.1 94,288 12.7
--------- ----- -------- ----- -------- ------
Provision (benefit)
on income from
continuing
operations ($558,691) (35.0%) $847,099 38.4% ($84,119) (11.3)%
========= ===== ======== ===== ======== =======
</TABLE>
- -------------------------------------------------------------------------------
8. LONG TERM DEBT
- -------------------------------------------------------------------------------
Long term debt consists of the following at December 31:
1996 1995
---- ----
Net present value of obligation
to CNA, discounted at 6% $3,075,397 $3,601,513
Obligations under capital
leases 966,637 319,166
Other notes payable, due in
monthly installments of $3,472
plus interest 90,278 208,507
------ -------
Total 4,132,312 4,129,186
Less current portion 1,191,601 (1,537,257)
----------- -----------
Long term debt, net of
current portion $2,940,711 $2,591,929
========== ==========
Estimated aggregate annual maturities of long term debt are as follows:
YEAR MATURITIES
---- ----------
1997 1,191,601
1998 2,668,720
1999 271,991
In connection with the CNA program, the Company is obligated to pay CNA $5
million. The Company makes payments against this obligation through reductions
in the commission it earns on the premiums generated under the program (see Note
2). Accordingly, the Company has agreed to meet certain premium volume quotas
(the "Quotas"), on an annualized basis, which will ensure that the obligation is
paid in full over the term of the agreement, with scheduled minimum repayments.
If, on an annualized basis, premium volume falls below the Quotas, a cash
payment equal to 5% of the difference between actual premium volume and the
Quotas must be made to CNA to be applied against the obligation to CNA.
Additionally, there are specified minimum premium volume levels (the "Levels")
which must be attained. If E&O premiums fall below the Levels, CNA may review
the program, give the Company an opportunity to address the issue and then, at
its option, may stop the program and take ownership of the Company's expiration
list, and the Company may still be required to make a cash payment equal to 5%
of the difference in the actual premium volume and the Quotas, to be applied
against the obligation to CNA. As a result of the Company's failure in 1995 to
meet the minimum Levels, in March 1996, the Company and CNA amended the
agreement, waiving the minimum Levels. In
31
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
8. LONG TERM DEBT (Continued)
- -------------------------------------------------------------------------------
addition, the Quotas were modified to $17 million in 1995, $18 million in 1996,
and $20 million for each year thereafter. The agreement to market CNA insurance
exclusively to its membership was extended through December 31, 1999. As of
December 31, 1996, the balance due CNA totaled approximately $3.1 million. The
Company is currently in default, as it has failed to achieve the minimum Quotas,
and the Company could be required by CNA to make a payment against its
obligation to the Holdback Fund in the amount of approximately $200,000.
However, the Company and CNA have entered into a further amendment to the
Holdback Agreement which would delete the Quotas and the Levels, and release the
Company from its current obligation to pay the remaining $3.1 million. Following
the effective date of this amendment, the Company's obligation will be limited
to payment of 50% of actual commissions to CNA. The proposed amendment becomes
effective if the Merger is consummated prior to July 1, 1997, and the dispute
with Sphere Drake (See Note 2) is settled within 14 days of the consummation of
the Merger.
Estimated annual repayments of the CNA obligation are based on anticipated
premium volume. In 1995 and 1994, the Company revised its estimate of the net
present value of the CNA obligation, based upon the actual payments remitted in
each year, and in 1994, to reflect an estimated repayment term of five years, as
opposed to the original estimate of three years. This change in estimate
resulted in an increase in the discount on the obligation, which will be
amortized to interest expense over the life of the obligation. The funds due to
CNA, which are recorded at net present value, are a senior obligation of the
Company, secured by an interest in the common stock of the Company's HOMS
subsidiary and in the Company's Member list.
9. UNUSUAL ITEMS
- -------------------------------------------------------------------------------
In 1996, the Company reported approximately $677,000 in the "Unusual Items"
caption in its consolidated statements of operations, related to several
infrequently occurring events that occurred in 1996. Specifically, in the third
quarter of 1996, the Company terminated its Agency Agreement and Administration
contract with New Hampshire Insurance Company ("NHIC"), as it determined that it
no longer desired to carry the program previously negotiated with NHIC. As part
of the termination arrangement, the Company has paid approximately $260,000 to
NHIC, and has also agreed to indemnify NHIC for all claims incurred under
contracts issued during the time the agreements were in effect by paying for all
claims on covered components which may be reported under such contracts, as if
the arrangement with NHIC had not taken place. To the extent that claims have
been paid or reported on these contracts, such amounts have been included in the
"Direct costs" caption in the Company's consolidated statements of operations,
and any related accrual for unpaid amounts is included in the "Accounts payable"
caption in the consolidated balance sheets. In addition, effective September 15,
1996, in conjunction with its plans for future organization and growth, the
Company terminated an employment contract with one of its officers, and has
agreed to pay the former officer severance and related benefits totaling
approximately $157,000 through the month of July 1997. In the fourth quarter of
1996, in connection with the Company's plan to improve the operating results of
its Corporate Owned Regions, the employment of three regional managers of the
Company's Corporate Owned Regions was terminated, and the California office was
closed. In connection with these changes, the Company agreed to pay amounts
totaling approximately $190,000 for severance and related benefits and $70,000
for rent on the California office. Charges for these items are included in the
accompanying consolidated statements of operations under the caption "Unusual
Items". At December 31, 1996, approximately $283,000 of the charges for unusual
items remained accrued and unpaid. There were no adjustments to the liability
other than to reflect payments made under the terms of the agreements.
During September 1994, the Company recorded unusual charges totaling $1,787,355.
These charges represent expenses related to a reduction in the Company's
workforce and the closing of its UK operations.
In early September 1994, the Company underwent an organizational restructuring,
reducing its total work force by approximately 20%, or 40 employees, including
clerical staff, supervisors, managers and executives. This restructuring is
expected to result in annual cost savings of approximately $1,700,000, through
reductions in salary, benefits and payroll tax expenses. The charge, consisting
of payroll, related taxes and benefits of the terminated employees, and included
in the `Unusual items' caption in the accompanying consolidated statements of
operations, totaled approximately $1,063,000. Approximately $400,000 of this
total related to an agreement to terminate the employment contract between the
Company and its former Chairman of the Board of Directors. The plan to terminate
employees was approved and carried out prior to September 30, 1994. The benefit
arrangement awarded to the terminated employees was within the Company policy,
or according to employment contracts with certain employees. As of December 31,
1994, approximately $923,000 had been paid against the liability, and $140,000
remained accrued and unpaid. There were no adjustments to the liability other
than to reflect payments to terminated employees.
The Company, in the third quarter of 1994 ceased funding HGC. One time charges
for severance pay of $80,000, the balance due under the subsidiary's lease
agreements and other obligations of $371,000 and write-off of the subsidiary's
net assets of $273,000, for a total of approximately $724,000, is included in
the 'Unusual items' caption in the accompanying consolidated statements of
operations. In 1995, the Company
32
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
9. UNUSUAL ITEMS (Continued)
- -------------------------------------------------------------------------------
liquidated the subsidiary and negotiated reduced payments in full settlement of
the balances owed, resulting in payment of approximately $175,000. The remaining
accrued balance of $276,000 was reversed, and reflected in net income in the
year ended December 31, 1995.
- -------------------------------------------------------------------------------
10. COMMITMENTS AND CONTINGENCIES
- -------------------------------------------------------------------------------
The Company is currently undergoing an examination by the Internal Revenue
Service of its tax returns for the years 1993, 1994 and 1995, which could result
in the proposal of significant adjustments to its taxes in those years. The
Company believes that the returns as originally filed are correct in all
material respects.
The Company is subject to various lawsuits and claims arising in the normal
course of business. In the opinion of management, the resolution of these
matters will not have a material adverse effect on the Company's consolidated
financial position or results of operations.
The Company currently rents office space in Sunrise, Florida, under a lease
which expires on December 31, 2005. The lease requires annual increases of 3% of
the base rent per square foot through the end of the lease term plus actual
maintenance expenses and property tax increases. The Company also leases office
space in one of the Corporate-Owned Regions for a remaining term of three years.
Future minimum annual rental payments approximate $353,241 in 1997, $347,481 in
1998, $345,191 in 1999, $330,316 in 2000, $311,306 in 2001, and $1,702,347
thereafter. Rental expense for 1996, 1995 and 1994 approximated $593,000,
$563,000 and $601,000, respectively, and is included in general and
administrative expenses in the accompanying consolidated statements of
operations.
On December 13, 1995, a jury verdict in the amount of $5,156,022 was rendered in
favor of the Plaintiff and against Homeowners Marketing Services, Inc. ("HMS"),
a subsidiary of the Company, in the following matter: Acceleration National
Insurance Company, Plaintiff, vs. Homeowners Marketing Services, Inc., et al.,
Defendants, in the Court of Common Pleas of Franklin County, Ohio. The causes of
action included breach of contract, unjust enrichment, and negligent
misrepresentation. Under the Acceleration program, the Company bore reinsurance
risk through the letters of credit that it was required to post as collateral to
be drawn upon in the event that the assets in the reinsurance pool, together
with investment income earned thereon were insufficient to cover the claims and
related expenses incurred. With the change in carriers to CNA in 1993, the
Company removed itself from any risk bearing position in connection with the
claims reported under its E&O program, and currently no longer operates in this
capacity. Accordingly, the judgment amount was reported in discontinued
operations in the accompanying consolidated statements of operations.
Under the terms of the Merger Agreement, Cross Country agreed to pay the balance
due to Acceleration National Insurance Company ("ANIC") under a settlement
agreement, upon closing of the Merger. Pursuant to the settlement agreement, on
September 4, 1996, the Company paid to ANIC the full amount of its 1994 federal
income tax refund, together with interest, which totaled $1,401,485. The
remaining balance due bears interest at the rate of 10% per annum from September
1, 1996 until the settlement amount is paid in full. An affiliate of Cross
Country purchased the judgment from ANIC as of October 31, 1996, for
approximately $2.75 million. The Cross Country affiliate agreed, under certain
conditions, to take no action to collect on the judgment before January 31,
1997. In January 1997, under a second amendment to the merger agreement, the
Cross Country affiliate extended the date until which it agreed to take no
action to collect on the judgment to July 1, 1997, or failure to consummate the
merger. The Company guaranteed the obligation of HMS and pledged the shares of
HMS and another subsidiary of the Company to secure such guarantee. HMS and the
subsidiary granted security interests in their assets as part of the First
Amendment to the Merger Agreement.In the event the judgment creditor proceeds to
execute on its judgment, it is likely that the Company will be without adequate
resources to pay the full amount due to Cross Country, as holder of the
judgment, which would become immediately due and payable. In such event, the
Company would be forced to seek alternatives to paying the remaining unpaid
balance of the judgment. No other alternatives are presently being considered.
The judgment, which accrues interest at the rate of 10% per annum, is recorded
in discontinued operations in the accompanying consolidated statements of
operations, and is separately stated in the accompanying consolidated balance
sheets.
In February 1996, a lawsuit was filed against the Company in the Court of Common
Pleas of Bucks County, Pennsylvania, by the former franchisee of the
Pennsylvania territory, alleging breach of contact, fraud and misrepresentation,
and seeking damages in the amount of $50,000, trebled, reimbursement of costs
and attorney's fees, and an injunction to prevent the Company from terminating
the franchise agreement. In March, 1997, this suit was settled for $110,000, the
charge for which is reflected in other income (expense) in the accompanying
consolidated statements of operations.
The Company has entered into various employment contracts with certain of its
executive officers and management personnel, which provide for salary
continuation of a minimum of six months in the event of termination without
cause. In addition, the Company entered into an agreement with an officer in
December 1995, which provides for annual compensation of $377,211, adjusted for
changes in the Consumer Price Index, through December 31, 2000, with an
automatic three year extension, unless notice of termination is given by either
party six months prior to the termination of the initial term. The agreement
also contains a change in control provision that would entitle the officer to
receive a minimum of 2.99 times the annual compensation. The agreement also
calls for certain other fringe benefits during the term of the agreement.
The Company also entered into an engagement agreement with a director, to
provide legal services to the Company for a one year period. The agreement calls
for a minimum payment of a non-refundable $100,000 retainer.
33
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
10. COMMITMENTS AND CONTINGENCIES (Continued)
- -------------------------------------------------------------------------------
In connection with the transfer of the net assets of POMG to CNA and the
assumption by CNA of the obligations of POMG under certain Realtor's errors and
omissions policies, the Company guaranteed the performance by Sphere Drake
Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a
$5,000,000 reinsurance treaty purchased by POMG to protect it from losses in
excess of a predetermined amount. Under the terms of the Company's guaranty,
CNA, as the transferee of the reinsurance treaty, bears any credit risk under
the treaty, including, but not limited to, any risk that Sphere Drake becomes
insolvent, is adjudicated as a bankrupt or has liquidation or similar
proceedings commenced against it. This guarantee is secured by $3,000,000 cash
collateral posted by the Company. This amount is reported as restricted cash in
the accompanying consolidated balance sheet. The Company has agreed, if
necessary, to pay an additional $2,000,000, related to the guarantee, out of
future commissions. On April 10, 1996, CNA issued a Notice of Arbitration to the
reinsurer with respect to its refusal to honor the reinsurance treaty. The
Company, CNA and Sphere Drake are engaged in settlement discussions with respect
to the reinsurance treaty. Although terms are not finalized, it is possible that
the Company could pay a substantial portion of the Collateral Account to CNA
under the currently proposed settlement agreement. As a result of the settlement
negotiations, the Company has recorded a loss provision of $2.5 million for the
guaranty in its consolidated statements of operations for 1996. Should the
Merger fail to be consummated, the potential settlement agreement will be null
and void, and the Company will continue to be contingently liable for the entire
$5 million under the conditions described in the preceding paragraph. In such
event, the Company will attempt to negotiate a settlement but there can be no
assurance that it will be successful in such efforts. As a result of the
settlement negotiations, the Company has recorded a loss provision of $2.5
million against the guarantee, which is included in the Discontinued Operations
caption in the accompanying 1996 consolidated statements of operations. The
restricted cash amount is presented net of the $2.5 million reserve in the 1996
consolidated balance sheets. See also Note 2.
11. STOCK OPTIONS, WARRANTS AND PURCHASE RIGHTS
- -------------------------------------------------------------------------------
The Company adopted stock option plans in 1988 authorizing issuance of up to
600,000 shares of common stock to officers and other employees. Of the
authorized shares, 300,000 may be issued as 'incentive stock options' within the
meaning of Section 422 of the Internal Revenue Code, and 300,000 may be issued
as non-qualified options. The options issued through 1992 generally become
exercisable two years after the date of grant and expire no later than ten years
after the date of grant. The options issued in 1993 generally become exercisable
over a five year period, beginning on the date of grant. Information with
respect to options under the above plans follows:
OPTION PRICE AVAILABLE
STOCK OPTIONS PER SHARE OUTSTANDING EXERCISABLE FOR GRANT
- -------------------------------------------------------------------------------
At December 31, 1993 4.00 - 9.75 558,550 206,050 38,450
Granted 2.00 80,000 (80,000)
Became exercisable 5.75 75,900
Canceled 4.00 - 9.75 (156,250) (43,650) 156,250
----------- -------- -------- -------
At December 31, 1994 2.00 - 9.00 482,300 238,300 114,700
Granted 2.00 240,000 (240,000)
Became exercisable 2.00 203,000
Canceled 2.00 - 3.00 (286,600) (224,600) 286,600
----------- -------- -------- -------
At December 31, 1995 $2.00 435,700 216,700 161,300
=========== ======== ======== =======
Became exercisable 2.00 30,500
Canceled 2.00 (1,900) (500) 1,900
----------- -------- -------- -------
At December 31, 1996 $2.00 433,800 246,700 163,200
=========== ======== ======== =======
The Company applies APB No. 25 and related interpretations in accounting for its
stock option plan to employees and non-employee members of the Board as
described in Note 3. Accordingly, no compensation expense has been recognized in
the year ended December 31, 1996 related to this plan. Had compensation costs
for the Company's stock option plans been determined based upon the fair value
at the grant date for awards under these plans consistent with the methodology
prescribed under SFAS 123, 'Accounting for Stock-Based Compensation,' the
Company's pro forma net loss for 1995 would have been $2,660,340. Pro forma
primary and fully diluted loss per share for 1995 would have been $0.48. There
were no options granted in 1996. The weighted average fair value of options
granted during 1995 was estimated at $2.38, based upon the date of grant using
the Black-Scholes option pricing model with the following weighted average
assumptions; no dividend yield, expected volatility of 47.7%, tax free interest
rate of 5.78% and expected lives of five years.
In May 1992, effective September 1991, the Company adopted a non-employee
directors' stock option plan authorizing issuance of up to 300,000 shares of
common stock. Options under this plan become exercisable annually over the five
years following the date of grant and expire no later than ten years after the
date of grant. Options for 75,000 shares were granted at $6.50 per share on
September 26, 1991, 67,500 of which remain outstanding at December 31, 1996;
options for 25,000 shares were granted at $5.50 per share on January 28, 1993,
all of which remain outstanding at December 31, 1996; options for 25,000 shares
were granted at $3.375 per share on September 23, 1993, which have since been
canceled; and options for 25,000 shares were granted at $0.75 per share on
December 22, 1995, all of which remain outstanding at December 31, 1996. Options
for 87,500 shares are exercisable at December 31, 1996.
The following table summarizes information about stock options outstanding
as of December 31, 1996:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
------------------------------------------------ ------------------------------
Number Weighted-Average Weighted Number Weighted
Range of Outstanding Remaining Average Exercisable Average
Exercise Price at 12/31/96 Contractual Life Exercise Price at 12/31/96 Exercise Price
-------------- ----------- ----------------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$2.00 433,800 5.0 $2.00 246,700 $2.00
$0.75-$6.50 117,500 6.2 5.06 87,500 6.14
</TABLE>
In 1991, the Company issued five-year stock purchase warrants for 25,000 shares
to an outside director. These warrants were for $10.80 per share, expired April
11, 1996; none had been exercised. In 1990, the Company declared a dividend of
one right for each share of common stock outstanding as of November 12, 1990.
The rights will be distributed and become immediately exercisable upon the
earlier of 10 days following a public announcement that a person or group of
affiliated persons has acquired the rights to acquire beneficial ownership of
20% or more of the Company's outstanding shares or 10 days following the
commencement of a tender offer or exchange offer that would result in a person
or affiliated group beneficially owning 30% or more of the outstanding shares.
Each right permits the holder to acquire one share of common stock for a price
of $30 per share. The rights may be redeemed by the Company at any time prior to
the tenth day after the acquisition of 20% of the outstanding shares or the
announcement of an offer for 30% of the outstanding shares. Upon the occurrence
of certain events after the rights become exercisable, each right
34
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------
11. STOCK OPTIONS WARRANTS AND PURCHASE RIGHTS (Continued)
- -------------------------------------------------------------------------------
would, subject to certain adjustments and alternatives, entitle the holder to
purchase common stock of the Company or the acquiring entity having a market
value of twice the $30 exercise price of the right (except that acquiring
persons would not be able to exercise the rights).
In connection with the amendment to the definitive merger agreement with Cross
Country, the Company's stock rights plan was modified to permit Cross Country
and its affiliates to buy an unlimited number of shares in privately negotiated
transactions. This stock rights plan amendment was not effective until three
business days after the information was released, or November 7, 1996, provided
that no other bid for the Company was received within such three day period. The
three day period passed with no other bids submitted to purchase the Company.
The rights are intended to enable all of the Company's stockholders to realize
the long term value of their investment in HOMG. They will not prevent a
takeover, but should encourage anyone seeking to acquire the Company to
negotiate with the Board of Directors prior to attempting the takeover. The
rights will expire at the close of business November 1, 2000.
In December 1994, the Company repriced all outstanding options to $2.00 per
share, with the exception of the options granted to the current Chairman and the
former Chairman of the Board of Directors and the Chief Financial Officer. The
options granted to the Chief Financial Officer were repriced to $3.00 per share.
The options granted to the former Chairman were canceled effective January 1995.
Upon such cancellation, 100,000 options were granted to the current Chairman of
the Board, at $3.00 per share. In December 1995, all of the options granted to
the Chief Financial Officer were repriced to $2.00 per share. Also in December
1995, 140,000 options granted to the Chairman from 1988 through 1992 were
canceled, and replaced by a new grant of 140,000 options, exercisable for a ten
year period at $2.00 per share.
- -------------------------------------------------------------------------------
12. QUARTERLY FINANCIAL RESULTS (UNAUDITED)
- -------------------------------------------------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- ------- ------- -------
(In thousands except per share amounts)
1996
Operating revenue $10,415 $11,575 $12,054 $11,387
Loss from continuing
operations before
income taxes (360) (25) (140) (1,072)
Net (loss) from
continuing operations (230) (13) (97) (699)
Loss from discontinued
operation -- -- -- (1,559)
Net loss ($230) ($13) ($97) ($2,258)
Per share data:
Net income (loss) from
continuing operations ($0.04) $0.00 ($0.02) ($0.13)
Loss from discontinued
operation -- -- -- (0.28)
Net loss ($0.04) ($0.00) ($0.02) ($0.41)
In the fourth quarter of 1996, the Company recorded unusual charges for certain
employee contract terminations and for its California office closing, in the
approximate amount of $260,000. Also, in the fourth quarter, the Company charged
to expense the balance due from its 50% Internet access provider joint venture
in the amount of $150,000, and accrued $110,000 related to a lawsuit
settlement with a former franchisee. The fourth quarter 1996 loss from
discontinued operation consists of a provision of $2,500,000, related to the
Sphere Drake reinsurance recoverable, for which the Company has guaranteed to
CNA the validity of the reinsurance treaty. See also Note 10.
35
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The names, ages and positions of all directors and executive officers of the
Company as of March 25, 1997 are listed below, followed by a brief account of
their business experience during the past five years. Directors are elected at
the Company's Annual Meeting of Stockholders and serve three years or until
their successors are elected and qualified. All of the Company's five directors
listed below are currently serving three-year terms. There are no family
relationships among directors or executive officers of the Company. All
non-employee directors are currently compensated at the rate of $3,500 for each
Board meeting attended. The Board met four times in 1996 and all Directors in
office at the time of such meetings attended all of the meetings. The directors
of the Company are as follows:
<TABLE>
<CAPTION>
DIRECTOR
NAME AGE POSITION SINCE
---- --- -------- --------
DIRECTOR WHOSE TERM EXPIRES AT THE NEXT ANNUAL MEETING
<S> <C> <C>
Gary D. Lipson 44 Director 1991
DIRECTORS WHOSE TERM EXPIRES IN 1997
Carl Buccellato 54 Chairman, President, Chief 1988
Executive, Officer and
Director
Michael A. Nocero, Jr., M.D. 56 Director 1988
DIRECTORS WHOSE TERM EXPIRES IN 1998
Diane M. Gruber 56 Director 1993
Melvin Stewart 55 Director 1988
</TABLE>
Mr. Lipson has been an attorney in the South Florida area for more than 19
years. From May 1993 to December 1996, he served as Chairman of the Board of KMG
Fiber Optics, Inc., a manufacturer and distributor of fiber optic cable. From
January, 1988 through March 1996, he served as Chairman of the Board of Spring
Water, Ltd., a distributor of bottled water in South Florida. From November,
1988 to September, 1991, he served as a Vice President of Montenay International
Corp., which is primarily engaged in the design, construction and operation of
waste-to-energy facilities.
Mr. Buccellato has been President and Chief Executive Officer of the Company
since May, 1992 and Chairman of the Company since September, 1994. Prior to May,
1992, he served as Chief Operating Officer. Mr. Buccellato currently serves as
President and Chief Executive Officer of Homeowners Marketing Services, Inc.
("HMS"), a wholly owned subsidiary of the Company. Mr. Buccellato holds various
executive positions in other subsidiaries of the Company and was Secretary of
the Company until January, 1993.
Dr. Nocero is a practicing cardiologist with the Central Florida Cardiology
Group in Orlando, Florida and is a Diplomate of the American Board of Internal
Medicine and Cardiovascular Diseases. Dr. Nocero is on the Board of Trustees of
The American College of Cardiology and formerly served as the Chairman of the
Board of the American College of Cardiology.
Ms. Gruber has been in the real estate and insurance industries for more than
thirty years. She is a licensed life, health and property and casualty insurance
broker. Ms. Gruber, along with her spouse, owns 100% of the stock of the firm
that is the Company's franchisee for Rhode Island and Connecticut, and 50% of
the stock of the firm that is the Company's franchisee for
36
<PAGE>
Maine, Vermont, New Hampshire and Massachusetts. She is Executive Vice President
of the Company's franchisee for New Jersey/New York.
Mr. Stewart served as the Chairman of the Company from June, 1988 to September,
1994. Mr. Stewart served as President and Chief Executive Officer from
incorporation until May, 1992. He has served as a Director of HMS since its
formation in 1980. The Company was organized to become the holding company for
HMS and its subsidiaries in 1988. Mr. Stewart has also held various executive
positions in HMS and other subsidiaries of the Company.
EXECUTIVE OFFICERS
C. Gregory Morris, 42, has been the Vice President, Treasurer and Chief
Financial Officer of the Company since October, 1992. Prior to that he was Vice
President of Finance and Administration of Arby's, Inc.
COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
directors and officers and any persons who own more than ten percent of a
registered class of the Company's equity securities, to file with the Securities
and Exchange commission initial reports of ownership and reports of changes in
ownership of Common Stock and other equity securities of the Company. Officers,
directors and greater than ten percent shareholders are required by SEC
regulation to furnish the Company with copies of all forms they file pursuant to
Section 16(a). To the Company's knowledge, based solely on review of the copies
of such reports furnished to the Company and written representations that no
other reports were required during the year ended December 31, 1996, all Section
16(a) filing requirements applicable to its officers, directors and greater than
ten percent beneficial owners were complied with.
COMMITTEES
The Company has a Stock Option and Compensation Committee, an Audit and
Investment Committee, a Nominating Committee and an Executive Committee. The
Stock Option and Compensation Committee is comprised of Messrs. Stewart and
Lipson, Ms. Gruber and Dr. Nocero; the Audit and Investment Committee is
comprised of Dr. Nocero and Mr. Stewart; the Nominating Committee is comprised
of Dr. Nocero, Mr. Lipson and Mrs. Gruber; and the Executive Committee is
comprised of Messrs. Buccellato and Lipson and Mrs. Gruber. In 1996, the
Executive Committee met four times. The other committees did not meet. All
Directors in office at the time of such meetings attended their respective
committee meetings. Non-employee directors are compensated at the rate of $500
for each committee meeting attended and are entitled to reimbursement for travel
expenses incurred in connection with attending meetings. However, Mr. Lipson,
the non-employee director on the Executive Committee, was paid $3,500 for each
of the four Executive Committee meetings he attended.
The function of the Audit and Investment Committee is to review the investment
strategy and performance of the investment portfolio, to recommend the firm to
be appointed as independent certified public accountants to audit the Company's
financial statements, to review the scope and results of the audit with the
independent certified public accountants, to receive reports from the
independent auditors and to review the adequacy of the internal controls and
accounting procedures of the Company.
The function of the Stock Option and Compensation Committee is to administer the
stock option plans (including making awards and determining the terms and
conditions upon which they are granted) and to review and establish the
compensation of the executive officers.
The function of the Nominating Committee is to assist management with respect to
matters of succession, to review the qualifications of candidates for the
position of Director and to recommend candidates to the Board as nominees for
election at the Annual Meeting of Stockholders or to fill such Board vacancies
as may occur during the year. The Nominating Committee will consider nominees
recommended by security holders. Recommendations may be forwarded to the
Nominating Committee at the Company.
The function of the Executive Committee is to review Company activity and make
recommendations to the full Board of Directors.
In January, 1995, in response to several inquiries from unaffiliated third
parties relating to various proposed transactions with the Company, including
the purchase of all of the outstanding shares of the Company, the Board formed a
Special Committee to
37
<PAGE>
evaluate the alternatives available to the Company. Mr. Lipson is Chair of the
Special Committee on which Ms. Gruber, Dr. Nocero and Mr. Stewart also serve.
The Special Committee met ten times in 1996.
ITEM 11. EXECUTIVE COMPENSATION
The following table discloses compensation received by the Company's Chief
Executive Officer and the only other executive officer receiving in excess of
$100,000 per year (the "Named Executive Officers") for the three fiscal years
ended December 31, 1996.
<TABLE>
<CAPTION>
SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION LONG-TERM COMPENSATION
--------------------------------------- ----------------------------------
STOCK ALL OTHER
NAME/TITLE YEAR SALARY BONUS OTHER(1) OPTION GRANTS COMPENSATION(2)
- ---------------------- ----- --------- ------- ---------- ------------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Carl Buccellato, 1996 $407,740 0 $16,576 0 $2,850
Chairman, 1995 368,359 0 14,523 360,000 2,772
President, Chief 1994 368,359 0 30,319 0 2,772
Executive Officer
and Director
C. Gregory Morris, 1996 $148,750 0 $13,239 0 $2,850
Vice President, 1995 150,000 0 11,052 0 2,250
Treasurer and Chief 1994 152,104 0 6,595 0 2,772
Financial Officer
</TABLE>
_____________________
(1) Totals in this column reflect the aggregate value of perquisites,
including personal use of Company automobiles, outside financial
counseling, executive health benefits, relocation expenses and payments
made on life insurance policies for their benefit. During 1996, Mr.
Buccellato received health benefits of $6,069, financial counseling of
$5,500 and life insurance payments of $5,007; and Mr. Morris received
$4,239 of health benefit payments and $9,000 auto allowance.
(2) These amount represent the Company's matching contributions to the
Company's 401(k) plan.
EMPLOYMENT AGREEMENTS
The Company entered into an employment agreement, commencing on January 1, 1996
and expiring on December 31, 2000, with Carl Buccellato. Under the terms of his
employment agreement, Mr. Buccellato is currently entitled to a base salary of
$407,610, subject to an annual cost of living increase based on the Consumer
Price Index and a performance bonus as determined by the Board of Directors. The
Company provides Mr. Buccellato with the use of a Company car and reimbursement
of medical expenses in addition to annual salary. The Company also provides Mr.
Buccellato with life insurance in the amount of $1,000,000 and a lump sum death
or permanent disability benefit equal to his annual salary and bonus for the
immediately preceding year.
Mr. Buccellato's employment agreement provides that, in the event of termination
of employment due to a change in control of the Company, he shall be entitled to
a lump sum distribution of compensation in an amount equal to 2.99 times the sum
of the annual base salary currently provided for in the employment agreement.
Upon a change of control and termination, all stock options then held by him
immediately become exercisable to the extent otherwise permitted by the
Company's Option Plans, and the non-competition provisions contained in the
employment agreement terminate. The agreement provides that the lump sum
distributions will be limited to the maximum amount which may be deducted by the
Company pursuant to Section 280G of the Internal Revenue Code of 1986.
38
<PAGE>
OPTIONS GRANTED DURING 1996
No options were granted to the named executive officers in 1996.
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION/SAR VALUES
The following table sets forth certain information concerning exercises of stock
options by the Named Executive Officers during the 1996 fiscal year and the
fiscal year-end value of the unexercised stock options held by the Named
Executive Officers.
<TABLE>
<CAPTION>
SHARES NUMBER OF SECURITIES VALUE OF UNEXERCISED IN-THE-MONEY
ACQUIRED ON UNDERLYING UNEXERCISED OPTIONS OPTIONS AT 1996 FISCAL YEAR-END
NAME EXERCISE VALUE REALIZED AT 1996 FISCAL YEAR END EXERCISABLE (E) UNEXERCISABLE (U)(1)
- ------------------ ------------ -------------- --------------------------------- ------------------------------------
EXERCISABLE UNEXERCISABLE EXERCISED UNEXERCISED
------------ ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Carl Buccellato... -0- -0- 260,000 -0- -0- -0-
C. Gregory Morris. -0- -0- 60,000 -0- -0- -0-
</TABLE>
__________________________
(1) The market value of the shares of Common Stock underlying the options
held by the Named Executive Officers was less than the exercise price
of the options at December 31, 1996.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The following directors serve on the Stock Option and Compensation Committee
("Compensation Committee") of the Company's Board of Directors: Gary D. Lipson
(Chairman), Diane M. Gruber and Michael A. Nocero, Jr., M.D.
Subsequent to the 1994 termination by mutual agreement of Mr. Stewart's prior
employment contract with the Company, Mr. Stewart provided consulting services
upon the request of the Company through November 30, 1996, for a consulting fee
of $15,922 per month. Mr. Stewart also received medical benefits as previously
provided under his employment contract. He further agreed not to compete with
the Company through January, 1998 and relinquished all stock options granted to
him during his employment with the Company.
Homeowners Marketing Services International, Inc. ("HMSI"), a wholly-owned
subsidiary of the Company, is party to a franchise agreement with Southwest
Marketing Services, Inc. ("SMS"), a corporation owned 25% by Michael A. Nocero,
Jr., M.D., granting such corporation the exclusive right to market HMS products
and services and enroll Member-Brokers in Arizona and New Mexico. In 1996, the
Company paid $390,286 to SMS. The terms and provisions of this franchise
agreement are comparable to those entered into with non-affiliated third
parties.
Broker Marketing Services of Texas, Inc. ("BMST"), a corporation owned 100% by
Dr. Nocero and HMS Texas, Inc., a wholly-owned subsidiary of the Company, have
entered into a partnership agreement for the operation of the Texas territory.
Pursuant to the terms of this partnership agreement, HMS Texas, Inc. and BMST
are each entitled to 45% of the profits and cash distributions from the
partnership, with a third-party manager entitled to the remaining 10%. The
partnership agreement names HMS Texas, Inc. as managing partner with sole
authority to make all major operational decisions and provides for restrictions
on transferability and rights of first refusal with respect to interests in the
partnership. In 1996, distributions of $31,957 were paid to BMST.
HMSI is also party to a franchise agreement with O & A Marketing Services of the
West, Inc. ("O&A"), a corporation owned 20% by Dr. Nocero, granting such
corporation the exclusive right to market HMS products and services and enroll
Member-Brokers in Kansas, Missouri and Oklahoma. In 1996, the Company paid
$691,942 to O&A. The terms and provisions of this franchise agreement are
comparable to those entered into with non-affiliated third parties.
Homeowners Marketing Services, Inc. ("HMS"), a wholly owned subsidiary of the
Company, has entered into a partnership agreement with Professional Forum
Enterprises, Inc. ("PFE"), a corporation 80% owned by Michael A. Nocero, Jr.,
M.D., to market Internet access and related products and services to real estate
professionals. Pursuant to the partnership agreement,
39
<PAGE>
HMS and PFE share in the partnership profits or losses at the rate of 50% each,
and both HMS and PFE are obligated to make joint contributions to fund the
partnership operations. During 1996, HMS contributed $222,500 toward the joint
funding of the partnership and purchased $37,961 in computer equipment and
materials on behalf of the partnership.
In 1996, the Company paid approximately $157,308 in fees and reimbursable
expenses for consulting services rendered by Gary D. Lipson, which fees and
expenses the Company believes are more favorable to the Company than those which
would have been paid to an unrelated party. On December 22, 1995, the Company
and Mr. Lipson entered into an Engagement Agreement pursuant to which Mr. Lipson
agreed to make himself available to provide legal services on behalf of the
Company and its subsidiaries for a minimum of 500 hours per year at an hourly
rate of $200. Upon his execution of the Engagement Agreement, Mr. Lipson became
entitled to a non-refundable retainer of $100,000. The Company has the right to
terminate the Engagement Agreement at any time. If the Company terminated the
Engagement Agreement without cause (as such term is defined in the Agreement),
then the Company is obligated to immediately pay the non-refundable retainer to
Mr. Lipson.
HMSI is also party to a franchise agreement with HMS New Jersey/New York
("HMSNJNY") of which Diane M. Gruber is Executive Vice President. HMSNJNY has
the exclusive right to market HMS products and services and enroll
Member-Brokers in New Jersey and New York. In 1996, the Company paid $528,384 to
HMSNJNY. HMSI has also entered into an agreement with a firm that is the
Company's franchisee for Rhode Island and Connecticut of which Diane Gruber,
with her spouse, owns 100% of the stock. This firm has the exclusive right to
market HMS products and services and enroll Member-Brokers in Rhode Island and
Connecticut. In connection with the purchase of this territory, as of December
31, 1996, the franchisee firm owes HMSI $12,399, under a promissory note issued
at the time of purchase. In 1996, the Company paid $23,874 to this firm. The
terms and provisions of the franchise agreements with HMSNJNY and HMSRIC are
comparable to those entered into with non-affiliated third parties. In
connection with the franchise operations, these two firms have purchased
computer equipment through HMS and currently owe $714 and $535 under promissory
notes issued to HMS.
HMSI has also entered into an agreement with a firm that is the Company's
franchisee for the Massachusetts, Maine, New Hampshire and Vermont of which
Diane Gruber, with her spouse, owns 50% of the stock. This firm has the
exclusive right to market HMS products and services and enroll Member-Brokers in
Massachusetts, Maine, New Hampshire and Vermont. In connection with this
arrangement, the franchisee firm owes HMSI $51,443 under a promissory note
issued at the time of the purchase of the franchised territory. In 1996, the
Company paid $125,204 to this firm. The terms and provisions of the franchise
agreements with this firm are comparable to those entered into with
non-affiliated third parties. This firm also has the first right of refusal to
the franchise rights to the states of Pennsylvania and Florida should the
Company decide to sell the franchise rights to those territories.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information concerning beneficial ownership, as
of March 23, 1997, by persons known to the Company (based upon filings on
Schedules 13D and 13G filed pursuant to the Securities Exchange Act of 1934) to
own more than 5% of the Company's outstanding voting securities. The table also
shows information concerning beneficial ownership by all directors, by each of
the executive officers named in the Summary Compensation Table and by all
directors and executive officers as a group. The number of shares beneficially
owned by each director or executive officer is determined under rules of the
Commission, and the information is not necessarily indicative of beneficial
ownership for any other purpose. Under such rules, beneficial ownership includes
any shares as to which the individual has the sole or shared voting power or
investment power and also any shares which the individual has the right to
acquire within 60 days of March 23, 1997 through the exercise of any stock
option or other right. Unless otherwise indicated, each person has sole
investment and voting power (or shares such powers with his or her spouse) with
respect to the shares set forth in the following table.
40
<PAGE>
BENEFIICIAL OWNERSHIP
----------------------------
NAME AND ADDRESS OF BENEFICIAL OWNER (1) SHARES PERCENT
---------- -------
Carl Buccellato....................... 523,453(2) 8.8%
Diane M. Gruber....................... 27,550(3) 0.5%
Gary D. Lipson........................ 45,000(4) 0.8%
Michael A. Nocero, Jr., M.D........... 140,000(5) 2.5%
Melvin Stewart........................ 307,875(6) 5.2%
C. Gregory Morris..................... 60,000(7) 1.0%
Sandra Stewart Bernstein.............. 406,862(8) 7.3%
2810 North 46th Avenue
Hollywood, Florida 33021
Dimensional Fund Advisors, Inc........ 293,500(8) 4.9%
1299 Ocean Avenue
Santa Monica, California 90401
NAPAQ Corporation, et al ............. 611,500(9) 10.3%
4040 Mystic Valley Parkway
Boston, MA 02155
DC Investment Partners ............... 989,500(10) 16.6%
Opportunity Fund, L.P.
2200 Abbott Martin Road, Suite 201
Nashville, TN
All Directors and Executive Officers
as a Group (6 persons).............. 1,103,878(11) 18.6%
- ----------------------
(1) The address of all executive officers and directors is 400 Sawgrass
Corporate Parkway, Sunrise, Florida 33325.
(2) Includes 14,397 shares of Common Stock held by Carl Buccellato as Trustee
of the Renee Buccellato Trust, the Lori Ann Buccellato Trust and the
Matthew Buccellato Trust. Includes presently exercisable options to
purchase 260,000 shares of Common Stock.
(3) Includes presently exercisable options to purchase 17,500 shares of
Common Stock at $5.50 per share. The total does not include 1,000 shares
owned by Gayle N. Gruber, Mrs. Gruber's daughter, as to which beneficial
ownership is disclaimed by Mrs. Gruber.
(4) Includes presently exercisable options to purchase 25,000 shares of
common stock at $6.50 per share.
(5) Includes 78,500 shares of Common Stock owned under a retirement plan for
the benefit of Michael A. Nocero, Jr., M.D. and indirect ownership of
33,000 shares owned by his daughters. Includes presently exercisable
options to purchase 25,000 shares of Common Stock at $6.50 per share.
(6) Includes presently exercisable options to purchase 2,500 shares of Common
Stock at $0.75 per share. Includes 243,701 shares of Common Stock held by
Melvin Stewart as Trustee of the Melvin Stewart Trust. Also includes
15,788 shares of Common Stock held by Mitchell Stewart as Trustee of the
Bari Udell Trust, as to which trusts Melvin Stewart has the power to
direct the voting and investment of such shares as trust advisor and as
to which beneficial ownership is disclaimed by Mr. Stewart.
(7) Consists of presently exercisable options to purchase 60,000 shares of
Common Stock at $2.00 per share.
41
<PAGE>
(8) Ownership shares and percentage based upon Schedules 13G as provided to
the Company.
(9) Ownership shares and percentages based on Schedules 13D, as amended, as
provided to the Company. Consists of four related persons that own
positions: NAPAQ Corporation, HAC. Inc., Cross Country Motor Club, Inc.
and Jeffrey C. Wolk. Each of these persons is affiliated with The Cross
Country Group, Inc.
(10) Ownership shares and percentages based on Schedule 13D, as amended, as
provided to the Company. Consists of four related parties that own
positions: D. Robert Crants, Michael W. Devlin, Lucius E. Burch and the
Stephens Group, Inc.
(11) Includes (i) an aggregate of 285,000 shares of common stock which the
officers and directors have the right to acquire through the exercise of
presently exercisable options and (ii) an additional 50,000 shares of
common stock which the officers and directors will have the right to
acquire through the exercise of options that will become exercisable
contemporaneously with the consummation of the merger.
Ms. Gruber, Messrs. Buccellato, Lipson, Morris and Dr. Nocero have advised the
Company that they have granted proxies to Cross Country with respect to the
right to vote the Shares held by them, currently 698,481 Shares (12.56% of the
outstanding Shares), with respect to all matters relating to the merger.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
See Item 11 "Executive Compensation - Compensation Committee Interlocks and
Insider Participation."
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
FINANCIAL STATEMENTS
The following consolidated financial statements of Homeowners Group, Inc. and
subsidiaries are included in Part II, Item 8 of this annual report.
Independent Auditors' Report
Consolidated Balance Sheets - December 31, 1996 and 1995
Consolidated Statements of Operations - Years Ended December 31, 1996, 1995 and
1994
Consolidated Statements of Cash Flows - Years Ended December 31, 1996, 1995 and
1994
Consolidated Statements of Stockholders' - Equity Years Ended December 31, 1996,
1995 and 1994
Notes to Consolidated Financial Statements
42
<PAGE>
<TABLE>
<CAPTION>
EXHIBITS
FILING IN WHICH EXHIBIT
IS
INCORPORATED BY
EXHIBIT NUMBER REFERENCE
- -------------------------------------------------------------------------- -----------------------------
<S> <C>
3.1 Articles of Incorporation *
3.2 By-Laws *
3.3 Amendments to By-laws Form 10-K for the Year
Ended December 31, 1992
4.1 Form of Representative's Warrants *
4.2 Form of Outside Directors' Warrants *
4.3 Amendment to Stock Purchase Warrant issued to Hambrecht & Form 10-Q for the Quarter
Quist Ended June 30, 1989
4.4 Amendment to Stock Purchase Warrants issued to Directors Form 10-K for the Year
Campora, Nocero, Sayers and Woodman dated February 8, 1990 Ended December 31, 1989
10.1 Form of Franchise Agreement Form 10-K for the Year
Ended December 31, 1989
10.2 Management Consulting Agreement with Form 10-K for the Year
Phoenix Financial, Inc. dated February 8, 1990 Ended December 31, 1989
10.11 1988 Incentive Stock Option Plan *
10.12 1988 Stock Option Plan *
10.13 Form of Selling Shareholder Standstill Agreement *
10.15 Agreement to Market, Underwrite, Issue and Administer Form 10-K for the Year
Policies of Insurance dated as of July 1, 1988 among the Ended December 31, 1989
Company, Acceleration National Insurance Company
and Corroon & Black of Ohio, Inc.
10.20 Amendment to 1988 Incentive Stock Option Plan Form 10-K for the Year
ended December 31, 1990
10.21 Amendment to 1988 Stock Option Plan Form 10-K for the Year
Ended December 31, 1990
43
<PAGE>
FILING IN WHICH EXHIBIT
IS
INCORPORATED BY
EXHIBIT NUMBER REFERENCE
- -------------------------------------------------------------------------- -----------------------------
10.22 Novation Agreement, dated as of December 1, 1992, by and Form 8-K dated
among Birmingham Fire Insurance Company of Pennsylvania, December 1, 1992
Meridian Insurance Company, Ltd., and POMG Insurance
Company, Ltd.
10.23 Agency Pledge Account Agreement, dated as of December 1, Form 8-K dated
1992 by and among the Northern Trust Company, POMG December 1, 1992
Insurance Company, Ltd., and Morgan Guaranty Trust Company
of New York
10.21 Pledge Agreement dated as of December 1, 1992, by and Form 8-K dated
among Morgan Guaranty Trust Company of New York and POMG December 1, 1992
Insurance Company, Ltd.
10.25 Employment Agreement with Melvin Stewart, dated June 1, Form 10-K for the year
1992 Ended December 31, 1992
10.27 Employment Agreements with individual members of the Form 10-K for the Year
Company's Executive management Group, dated August 2, Ended December 31, 1993
1993
10.28 Novation Agreement, dated as of December 1, 1993, by and Form 8-K dated
among Birmingham Fire Insurance Company of the State of February 11, 1994
Pennsylvania, POMG Insurance Company, Ltd. and Continental
Casualty Company
10.29 Real Estate Errors & Omissions Program Administration and Form 8-K dated
Holdback Fund Agreement dated as of December 1, 1993, February 11, 1994
between Continental Casualty Company, Homeowners Group,
Inc., HOMS Insurance Agency, Inc. and POMG Insurance
Company, Ltd.
10.30 Amendment No. 1 to Real Estate Errors & Omissions Program Form 10-K for the year
Administration and Holdback Fund Agreement Ended December 31, 1995
10.31 Employment Agreement with Carl Buccellato, dated December Form 10-K for the year
22, 1995 Ended December 31, 1995
44
<PAGE>
FILING IN WHICH EXHIBIT
IS
INCORPORATED BY
EXHIBIT NUMBER REFERENCE
- -------------------------------------------------------------------------- -----------------------------
10.32 Engagement agreement between Homeowners Group, Inc. and Form 10-K for the year
Gary D, Lipson, dated December 25, 1995 Ended December 31, 1995
10.33 Lease between Camtech Associates and Homeowners Group, Form 10-K for the year
Inc. dated November 1, 1995 Ended December 31, 1995
10.34 Guaranty and Pledge agreement between The Cross Country Form 8-K dated
Group, Inc. and Homeowners Group, Inc. November 14, 1996
10.35 Security Agreement between The Cross Country Group, Inc., Form 8-K dated
Homeowners Marketing Services, Inc. and HMS International, November 14, 1996
Inc.
10.36 Agreement for Satisfaction of Judgment between Homeowners Form 8-K dated
Group, Inc., Homeowners Marketing Services, Inc. and The November 14, 1996
Cross Country Group, Inc.
10.37 First Amendment to Rights Agreement` Form 8-K dated
November 14, 1996
11 Computation of Income Per Common Share for Each of the Filed herewith
Three Years Ended December 31, 1996
22 Subsidiaries of the Registrant Form 10-K for the year
Ended December 31, 1995
27.1 Financial Data Schedule Filed herewith
</TABLE>
___________________
*AMENDMENT NO. 2 TO FORM S-1 OF HOMEOWNERS GROUP, INC. FILED WITH THE SEC ON
JULY 13, 1988
REPORTS ON FORM 8-K
The Company filed a report on Form 8-K on November 14, 1996, reporting the
execution of the amendment to the merger agreement with The Cross Country Group,
Inc.
45
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of
1934, the Registrant has duly caused this Annual Report to be signed on its
behalf by the undersigned, thereunto duly authorized.
HOMEOWNERS GROUP, INC.
Date: April 15, 1997 /S/ CARL BUCCELLATO
-------------------
Carl Buccellato, Chairman of the Board
President and Chief Executive Officer
Date: April 15, 1997 /S/ C. GREGORY MORRIS
---------------------
C. Gregory Morris, Vice-President,
Treasurer and Chief Financial Officer
Date: April 15, 1997 /S/ KAREN CHILDRESS
-------------------
Karen Childress, Controller, Secretary and
Principal Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934 this Annual
Report has also been signed by the following persons on behalf of the Registrant
in the capacities indicated:
MEMBERS OF THE BOARD OF DIRECTORS
Date: April 15, 1997 /S/ CARL BUCCELLATO
-------------------
Carl Buccellato, President and
Chief Executive Officer
Date: April 15, 1997 /S/ DIANE M. GRUBER
-------------------
Diane M. Gruber, Director
Date: April 15, 1997 /S/ GARY D. LIPSON
------------------
Gary D. Lipson, Director
Date: April 15, 1997 /S/ MICHAEL A. NOCERO, JR. MD.
-------------------------------------
Michael A. Nocero, Jr. M.D., Director
Date: April 15, 1997 /S/ MELVIN STEWART
------------------
Melvin Stewart, Chairman
46
<PAGE>
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
11 Computation of Net Loss Per Common Share
27.1 Financial Data Schedule
<TABLE>
<CAPTION>
EXHIBIT 11
HOMEOWNERS GROUP, INC. AND SUBSIDIARIES
COMPUTATION OF NET LOSS PER COMMON SHARE
FOR EACH OF THE THREE YEARS ENDED DECEMBER 31,
1996 1995 1994
---------------- ---------------- ------------------
<S> <C> <C> <C>
Income (loss) from continuing operations ($1,038,311) $1,360,590 ($658,103)
Discontinued operation:
Loss from discontinued reinsurance operations (1,559,250) (3,215,811) -
---------------- ---------------- ------------------
Net loss ($2,597,561) ($1,855,221) ($658,103)
---------------- ---------------- ------------------
CALCULATION OF PRIMARY NET INCOME (LOSS) PER COMMON SHARE:
Weighted average common shares outstanding during the year 5,558,350 5,558,350 5,558,350
---------------- ---------------- ------------------
Weighted average primary common shares outstanding 5,558,350 5,558,350 5,558,350
---------------- ---------------- ------------------
Income (loss) from continuing operations per common share ($0.19) $0.25 ($0.12)
Discontinued operation:
Per share loss from discontinued reinsurance operations (0.28) (0.58) -
---------------- ---------------- ------------------
Primary net loss per common share ($0.47) ($0.33) ($0.12)
================ ================ ==================
CALCULATION OF AVERAGE FULLY DILUTED EARNINGS (LOSS) PER COMMON SHARE:
Weighted average common shares outstanding during the year 5,558,350 5,558,350 5,558,350
---------------- ---------------- ------------------
Weighted average fully diluted common shares outstanding 5,558,350 5,558,350 5,558,350
---------------- ---------------- ------------------
Income (loss) from continuing operations per common share ($0.19) $0.25 ($0.12)
Discontinued operation:
Per share loss from discontinued reinsurance operations (0.28) (0.58) -
---------------- ---------------- ------------------
Fully diluted net loss per common share ($0.47) ($0.33) ($0.12)
================ ================ ==================
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-END> DEC-31-1996
<CASH> 2,493,977
<SECURITIES> 4,927,225
<RECEIVABLES> 990,644
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 21,601,224
<PP&E> 4,403,030
<DEPRECIATION> 0
<TOTAL-ASSETS> 37,754,573
<CURRENT-LIABILITIES> 31,053,978
<BONDS> 0
0
0
<COMMON> 55,584
<OTHER-SE> 3,704,300
<TOTAL-LIABILITY-AND-EQUITY> 37,754,573
<SALES> 0
<TOTAL-REVENUES> 45,431,035
<CGS> 0
<TOTAL-COSTS> 35,852,860
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (1,597,002)
<INCOME-TAX> 558,691
<INCOME-CONTINUING> (1,038,311)
<DISCONTINUED> (1,559,250)
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (2,597,561)
<EPS-PRIMARY> (0.47)
<EPS-DILUTED> (0.47)
</TABLE>
