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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
--- SECURITIES EXCHANGE ACT OF 1934
FOR FISCAL YEAR ENDED: AUGUST 31, 1998
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: 0-25880
--------
ILM II LEASE CORPORATION
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
VIRGINIA 04-3248639
- ----------------------- -------------------
(State of organization) (I.R.S. Employer
Identification No.)
8180 Greensboro Drive, Suite 850, McLean, VA 22102
- -------------------------------------------------------------------------------
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (888) 257-3550
--------------
</TABLE>
Securities registered pursuant to Section 12(b) of the Act:
<TABLE>
<S> <C>
Name of each exchange on
Title of each class which registered
- ----------------------- --------------------------
None None
</TABLE>
Securities registered pursuant to Section 12(g) of the Act:
SHARES OF COMMON STOCK, $.01 PAR VALUE
--------------------------------------
(Title of class)
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
---
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 No X .
--- ---
Shares of common stock outstanding as of August 31, 1998: 5,180,952. The
aggregate sales price of the shares sold was $500,000. This does not reflect
market value. There is no current market for these shares.
DOCUMENTS INCORPORATED BY REFERENCE
Documents FORM 10-K REFERENCE
- ---------------------------------------------------- -------------------
Registration Statement on Form 10 of registrant Part III, Part IV
dated July 20, 1995, as supplemented
Current Report on Form 8-K of Part IV
registrant dated August 21, 1998
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<PAGE>
ILM II LEASE CORPORATION
1998 FORM 10-K/A
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I PAGE
<S> <C> <C>
Item 1 Business.............................................................................I-1
Item 2 Properties...........................................................................I-5
Item 3 Legal Proceedings....................................................................I-6
Item 4 Submission of Matters to a Vote of Security Holders..................................I-7
PART II
Item 5 Market for the Registrant's Shares and Related
Stockholder Matters.................................................................II-1
Item 6 Selected Financial Data.............................................................II-1
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations.......................................................II-2
Item 8 Financial Statements and Supplementary Data.........................................II-7
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure........................................................II-7
PART III
Item 10 Directors and Executive Officers of the Registrant.................................III-1
Item 11 Executive Compensation.............................................................III-3
Item 12 Security Ownership of Certain Beneficial Owners and Management.....................III-3
Item 13 Certain Relationships and Related Transactions.....................................III-3
PART IV
Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K.....................IV-1
Signatures.......................................................................................................IV-2
Index to Exhibits................................................................................................IV-3
Financial Statements and Supplementary Data....................................................................F1-F17
</TABLE>
<PAGE>
ILM II LEASE CORPORATION
PART I
ITEM 1. BUSINESS
ILM II Lease Corporation (the "Company") was formed in 1994 by ILM II
Senior Living, Inc. ("ILM II"), formerly PaineWebber Independent Living Mortgage
Inc. II, a publicly-held, non-traded Real Estate Investment Trust ("REIT"), for
the purpose of operating six rental housing projects that provide
independent-living and assisted-living services for senior citizens (the "Senior
Housing Facilities") under the terms of a master lease agreement. ILM II
contributed $500,000 in return for all of the issued and outstanding shares of
the Company's common stock. ILM II had originally made mortgage loans secured by
the Senior Housing Facilities to Angeles Housing Concepts, Inc. ("AHC") between
July 1990 and July 1992. In March 1993, AHC defaulted under the terms of such
mortgage loans and in connection with the settlement of such default, title to
the Senior Housing Facilities was transferred, effective April 1, 1994, to
certain majority-owned, indirect subsidiaries of ILM II, subject to the mortgage
loans. Subsequently, the indirect subsidiaries of ILM II were merged into ILM II
Holding, Inc. ("ILM II Holding"). As part of the fiscal 1994 settlement
agreement with AHC, AHC was retained as the property manager for all of the
Senior Housing Facilities pursuant to the terms of a management agreement which
was assigned to the Company as of September 1, 1995. As discussed further in
Item 7, the agreement with AHC was terminated in July 1996.
ILM II has elected to be taxed as a REIT under the Internal Revenue
Code of 1986, as amended ("the Code"), for each taxable year of operations. In
order to maintain its status as a REIT, 75% of ILM II's annual gross income must
be Qualified Rental Income as defined by the Code. The rent paid by the
residents of the Senior Housing Facilities likely would not be deemed to be
Qualified Rental Income because of the extent of services provided to residents.
Consequently, the operation of the Senior Housing Facilities by ILM II or its
subsidiaries over an extended period of time could adversely affect ILM II's
status as a REIT. Therefore, ILM II formed the Company to operate the Senior
Housing Facilities, and by means of a distribution, transferred the ownership of
the common stock of the Company to the holders of ILM II common stock on
September 1, 1995. Because the Company, which is taxed as a regular C
corporation, is no longer a subsidiary of ILM II, it can receive service-related
income without endangering the REIT status of ILM II.
On September 1, 1995, after ILM II received the required regulatory
approval, it distributed all of the outstanding shares of capital stock of the
Company to the holders of record of ILM II's common stock. One share of common
stock of the Company was issued for each full share of ILM II's common stock
held. No fractional shares were issued. Holders of ILM II's common stock were
not required to pay any cash or other consideration or to exchange their common
stock of ILM II for the common stock of the Company. Prior to the distribution
of the Company's stock, ILM II's Shareholders received an information statement
fully describing the Company and the distribution of its capital stock.
The Company's sole business is the operation of the Senior Housing
Facilities. The Company leases the Senior Housing Facilities from ILM II
Holding, a majority-owned and consolidated affiliate of ILM II, which currently
holds title to the Senior Housing Facilities, pursuant to a master lease which
commenced on September 1, 1995 and expires on December 31, 2000 (December 31,
1999 with respect to the Santa Barbara Facility); provided, however, that such
master lease may be terminated earlier by ILM II Holding, in connection with a
sale of the Senior Housing Facilities to a non-affiliated third party, upon 30
days notice to the Company.
In July 1996, the Company terminated the property management agreement
with AHC and entered into a property management agreement (the "Management
Agreement") with Capital Senior Management 2, Inc. ("Capital") to handle the
day-to-day operations of the Senior Housing Facilities. Since November 1996,
Lawrence A. Cohen, who, until July 28, 1998, served as a Director of the Company
and President, Chief Executive Officer and Director of ILM II, has also served
as Vice Chairman and Chief Financial Officer of Capital Senior Living
Corporation, an affiliate of Capital. As a result, through July 28, 1998, the
management agreement with Capital was considered a related party transaction.
I-1
<PAGE>
ITEM 1. BUSINESS (CONTINUED)
The master lease agreement, which commenced on September 1, 1995, is
between ILM II Holding, as owner of the properties and Lessor, and the Company,
as Lessee. The master lease is a "triple-net" lease whereby the Lessee pays all
operating expenses, governmental taxes and assessments, utility charges and
insurance premiums, as well as the costs of all required maintenance, personal
property and non-structural repairs in connection with the operation of the
Senior Housing Facilities. ILM II Holding, as the Lessor, is responsible for all
major capital improvements and structural repairs to the Senior Housing
Facilities. During the initial term of the master lease, which expires on
December 31, 2000 (December 31, 1999 with respect to the Santa Barbara
Facility), the Company is obligated to pay annual base rent for the use of all
of the Facilities in the aggregate amount of $4,035,600 per year. Beginning in
January 1997, and for the remainder of the lease term, the Company is also
obligated to pay variable rent for each Senior Housing Facility. Such variable
rent is payable quarterly and equals 40% of the excess, if any, of the aggregate
total revenues for the Senior Housing Facilities, on an annualized basis, over
$13,021,000. Variable rent expense related to fiscal years 1998 and 1997 was
$984,000 and $412,000, respectively.
I-2
<PAGE>
ITEM 1. BUSINESS (CONTINUED)
The Senior Housing Facilities which the Company has leased from ILM II
Holding as of August 31, 1998 are described below:
<TABLE>
<CAPTION>
YEAR
FACILITY RENTABLE RESIDENT
PROPERTY NAME AND LOCATION (1) TYPE OF PROPERTY BUILT UNITS (3) CAPACITIES (3)
- ------------------------------ ---------------- ----- --------- --------------
<S> <C> <C> <C> <C>
The Palms
Fort Myers, FL Senior Housing Facility 1988 205 255
Crown Villa
Omaha, NE Senior Housing Facility 1992 73 73
Overland Park Place
Overland Park, KS Senior Housing Facility 1994 141 153
Rio Las Palmas
Stockton, CA Senior Housing Facility 1988 164 190
The Villa at Riverwood
St. Louis County, MO Senior Housing Facility 1986 120 140
Villa Santa Barbara (2)
Santa Barbara, CA Senior Housing Facility 1979 125 125
</TABLE>
(1) See Notes to the financial statements filed with this annual report for
a description of the agreements through which the Company has leased
these facilities.
(2) The Company operates Villa Santa Barbara under a co-tenancy arrangement
with an affiliated company, ILM I Lease Corporation ("Lease I"). The
Company has entered into an agreement with Lease I regarding such joint
tenancy. Lease I was formed for similar purposes as the Company by an
affiliated company, ILM Senior Living, Inc. ("ILM I"), a subsidiary of
which owns 25% of the Villa Santa Barbara property. The portion of the
Senior Housing Facility leased by the Company represents 75% of the
total project. Villa Santa Barbara is 25% owned by ILM Holding Inc. and
75% by ILM II Holding, Inc., a direct subsidiary of ILM II, as tenants
in common. Upon the sale of ILM I or ILM II, arrangements would be made
to transfer the Santa Barbara facility to the non-selling joint tenant
(or one of its subsidiaries). The property was extensively renovated in
1995.
(3) Rentable units represent the number of apartment units and is a measure
commonly used in the real estate industry. Resident capacity equals the
number of bedrooms contained within the apartment units and corresponds
to measures commonly used in the healthcare industry.
The Senior Housing Facilities are subject to competition from similar
properties in the vicinities in which they are located. The properties are
located in areas with significant senior citizen populations and, as a result
there are, and will likely continue to be, a variety of competing projects aimed
at attracting senior residents. Such projects will generally compete on the
basis of rental rates, services, amenities and location. The Company has no real
estate investments located outside the United States. The Company's sole
business is the operation of the Senior Housing Facilities. Therefore,
presentation of information about industry segments is not applicable.
I-3
<PAGE>
ITEM 1. BUSINESS (CONTINUED)
Through June 18, 1997, and subject to the supervision of and pursuant
to the general policies set by the Company's Board of Directors, assistance in
managing the business of the Company was provided by PaineWebber Lease Advisors,
L.P. ("PaineWebber"). For discussion purposes, PaineWebber will refer to
PaineWebber Lease Advisors, L.P. and all affiliates of PaineWebber that provided
services to the Company in the past. PaineWebber resigned from this position
effective as of June 18, 1997. PaineWebber agreed to perform certain
administrative services for the Company and its affiliates through August 31,
1997. Through the date of its resignation, PaineWebber performed the day-to-day
operations of the Company and acted as the investment advisor and consultant for
the Company. PaineWebber provided cash management, accounting, tax preparation,
financial reporting, investor communications and relations as well as asset
management services to the Company. These services are now being provided to the
Company, subject to the supervision of the Company's Board of Directors, by
various companies and consultants including Greenberg Traurig, Fleet Bank, Ernst
& Young LLP, and MAVRICC Management Systems, Inc.
There are currently three Directors of the Company, none of whom are
affiliates of PaineWebber or the property management company. The Directors are
subject to removal by the vote of the holders of a majority of the outstanding
shares of the Company's common stock.
The terms of transactions between the Company and PaineWebber and
similar disclosures with respect to relationships of other related parties which
provide services to the Company are set forth in Items 11 and 13 below to which
reference is hereby made for a description of such terms and transactions.
As discussed further in Item 7, on July 29, 1996, the Company
terminated the property management agreement with AHC and retained Capital to be
the property manager of the Senior Housing Facilities, and ILM II has guaranteed
the payment of all fees due to Capital under the terms of the Management
Agreement. Lawrence A. Cohen, who served through July 28, 1998 as a Director of
the Company and President, Chief Executive Officer and Director of ILM II, has
also served in various management capacities at Capital Senior Living
Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as
Chief Executive Officer and Acting Chief Financial Officer of Capital Senior
Living Corporation. As a result, through July 28, 1998, Capital was considered a
related party (see Item 13). Capital earned property management fees from Lease
II of $980,000 and $899,000 for the years ended August 31, 1999 and 1998,
respectively.
At a meeting of the boards of directors of ILM II and an affiliated
entity, IlM Senior Living, Inc. ("ILM I"), formerly PaineWebber Independent
Living Mortgage Fund, Inc., on January 10, 1997, PaineWebber recommended the
immediate sale of the Senior Housing Facilities operated by the Company and held
by ILM II as well as the Senior Housing Facilities held by ILM I, by means of a
controlled auction to be conducted by PaineWebber, at no additional
compensation, with PaineWebber offering to purchase the Senior Housing
Facilities held by ILM I and ILM II for $127 million, thereby guaranteeing the
shareholders a "floor" price. The Senior Housing Facilities operated by the
Company under its master lease with ILM II Holding would represent approximately
$52 million of this amount. After taxes and closing costs, net proceeds to ILM
II would equal approximately $48 million or approximately $9.36 per share of ILM
II common stock. PaineWebber also stated that if it purchased the properties at
the specified price and were then able to resell the properties at a higher
price, PaineWebber would pay any "excess profits" to the shareholders. To assist
the Company and ILM II in evaluating PaineWebber's proposal, NatWest Securities,
a disinterested, independent investment banking firm with expertise in
healthcare REITs and independent/assisted living financings, was engaged by the
Company, ILM I and ILM II, and their affiliates. Following a comprehensive
analysis, the investment banking firm recommended that PaineWebber's proposal
should be declined and that instead investigation of expansion and restructuring
alternatives should be pursued. After analyzing PaineWebber's proposal and the
recommendations and other information provided by the independent investment
banking firm, the Boards of ILM I and ILM II voted unanimously to decline
PaineWebber's proposal and to explore the alternatives recommended by the
independent
I-4
<PAGE>
investment banking firm. The Boards declined to seek an immediate sale of the
properties because, in the Boards' view, the liquidation price would not
reflect the "going concern" values of ILM I and ILM II and, therefore, would
not maximize shareholder value. In addition, the Boards did not consider it
advisable to liquidate ILM I and ILM II on the suggested terms three years
prior to their scheduled termination date.
PaineWebber indicated to the ILM I and ILM II Boards in its January 10,
1997, proposal that it would not wish to continue to serve as advisor to ILM I,
ILM II and their affiliates if they declined to accept PaineWebber's proposal.
The Company, ILM I Lease Corporation ("Lease I"), ILM I and ILM II accepted the
resignation of PaineWebber, effective June 18, 1997. PaineWebber continued to
provide certain administrative services to the Company, Lease I, ILM I, and ILM
II through August 31, 1997, pursuant to the terms of a transition services
agreement. The Company and its affiliates also accepted, effective as of June
18, 1997, the resignations of those Officers and Directors who were employees of
or otherwise affiliated with PaineWebber.
The Company and ILM II are continuing to review various strategic
alternatives to maximize shareholder value and liquidity and have engaged
professional financial and legal advisors to formulate and present plans and
proposals for consideration by the Board. Although no definitive plans,
arrangements or understandings have been agreed to at this time, ILM II is
actively reviewing the feasibility of a variety of financial transactions and
proposals, including the reorganization of the ownership of the Senior Housing
Facilities, business combinations with third parties and the sale of ILM I by
means of cash and or stock-for-stock merger. There can be no assurance that any
definitive transaction will be formulated, agreed to or consummated. In
addition, because the master lease is due to terminate on December 31, 2000, but
could be terminated earlier by ILM II Holding if the Senior Housing Facilities
are sold by ILM II Holding, the Company's operations would not be expected to
continue beyond the date of any such transaction.
ITEM 2. PROPERTIES
As of August 31, 1998, the Company has leased the six operating
properties referred to under Item 1 to which reference is made for the
description, name and location of such properties.
Average occupancy levels for each fiscal quarter during 1998, along
with an average for the year, are presented below for each property:
<TABLE>
<CAPTION>
Average Quarterly Occupancy
-----------------------------------------------------------------------------------------
Fiscal 1998
11/30/97 2/28/98 5/31/98 8/31/98 Average
-------- ------- ------- ------- -----------
<S> <C> <C> <C> <C> <C>
The Palms 92% 97% 97% 97% 96%
Crown Villa 97% 98% 97% 97% 97%
Overland Park Place 99% 99% 99% 99% 99%
Rio Las Palmas 88% 90% 89% 90% 89%
The Villa at Riverwood 94% 93% 95% 94% 94%
Villa Santa Barbara 96% 97% 95% 96% 96%
</TABLE>
I-5
<PAGE>
ITEM 3. LEGAL PROCEEDINGS
On July 29, 1996, the Company and ILM II Holding (collectively for this
Item 3, the "Companies") terminated a property management agreement with AHC
which covered the six Senior Housing Facilities leased by the Company from ILM
II Holding and engaged Capital as property manager. The management agreement
with AHC was terminated for cause pursuant to Sections 1.05 (a) (i), (iii) and
(iv) of the agreement. Simultaneously with the termination of the management
agreement, the Companies, together with certain affiliated entities, filed suit
against AHC in the United States District Court for the Eastern District of
Virginia for breach of contract, breach of fiduciary duty and fraud. The
Companies alleged, among other things, that AHC willfully performed actions
specifically in violation of the agreement and that such actions caused damages
to the Companies.
Due to the termination of the agreement for cause, no termination fee
was paid to AHC. Subsequent to the termination of the management agreement, AHC
filed for protection under Chapter 11 of the U.S. Bankruptcy Code in its
domestic state of California. The filing was challenged by the Companies, and
the Bankruptcy Court dismissed AHC's case effective October 15, 1996. In
November 1996, AHC filed with the Virginia District Court an answer in response
to the litigation initiated by the Companies and a counterclaim against ILM II
Holding. The counterclaim alleged that the management agreement was wrongfully
terminated for cause and requested damages which included the payment of the
termination fee in the amount of $750,000, payment of management fees pursuant
to the contract from August 1, 1996 through October 15, 1996, which is the
earliest date that the agreement could have been terminated without cause, and
recovery of attorney's fees and expenses.
The aggregate amount of damages against all parties as requested in
AHC's counterclaim exceeded $2,000,000. ILM II had guaranteed the payment of a
termination fee at issue in these proceedings to the extent that any termination
fee was deemed payable by the court and in the event that the Company failed to
perform pursuant to its contractual obligations under the management agreement.
On June 13, 1997 and July 8, 1997, the court issued orders to enter judgment
against ILM I and ILM II in the amount of $1,000,000 (the "Orders"). The Orders
do not contain any findings of fact or conclusions of law. On July 10, 1997, the
Company, ILM I, ILM II and Lease I filed a notice of appeal to the United States
Court of Appeals for the Fourth Circuit from the Orders.
On February 4, 1997, AHC filed a complaint in the Superior Court of the
State of California against Capital, the new property manager; Lawrence A.
Cohen, who, through July 28, 1998, was a Director of the Company and President,
Chief Executive Officer and Director of ILM II, and others alleging that the
defendants intentionally interfered with AHC's agreement (the "California
litigation"). The complaint sought damages of at least $2,000,000. On March 4,
1997, the defendants removed the case to Federal District Court in the Central
District of California. At a Board meeting on February 26, 1997, the Company's
Board of Directors concluded that since all of Mr. Cohen's actions relating to
the California litigation were taken either on behalf of the Company under the
direction of the Board or as a PaineWebber employee, the Company or its
affiliates should indemnify Mr. Cohen with respect to any expenses arising from
the California litigation, subject to any insurance recoveries for those
expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen
totaled $227,000 as of August 31, 1998. The Company's Board also concluded that,
subject to certain conditions, the Company or its affiliates should advance up
to $20,000 to pay reasonable legal fees and expenses incurred by Capital in the
California litigation. Subsequently, the Boards of the Company and Lease I voted
to increase the maximum amount of the advance to Capital to $100,000. By the end
of November 1997, Capital had incurred $100,000 of legal expenses in the
California litigation. On February 2, 1998, the amount to be advanced to Capital
was increased to include 75% of the California litigation legal fees and costs
incurred by Capital for December 1997 and January 1998, plus 75% of such legal
fees and costs incurred by Capital thereafter, not to exceed $500,000. By August
31, 1998, Capital had incurred $683,000 of legal expenses in the California
litigation. At August 31, 1998, the amount of legal fees either advanced to
Capital or accrued in the financial statements of the Company and Lease I
totaled approximately $519,000, although the final amount to be reimbursed to
Capital has not yet been determined.
I-6
<PAGE>
ITEM 3. LEGAL PROCEEDINGS (CONTINUED)
On August 18, 1998, the Company and its affiliates along with Capital
and its affiliates entered into a settlement agreement with AHC. The Company and
Lease I agreed to pay $1,625,000 and Capital and its affiliates agreed to pay
$625,000 to AHC in settlement of all claims including those related to the
Virginia litigation and the California litigation. The Company and its
affiliates also entered into an agreement with Capital and its affiliates to
mutually release each other from all claims that any such parties may have
against each other, other than any claims under the property management
agreements. The Company's Board of Directors believes that settling the AHC
litigation is a prudent course of action because the settlement amount
represents a small percentage of the increases in cash flow and value achieved
for the Company and its affiliates over the past two years.
Due to the Order, $1,000,000 had been recorded as a liability by the
Company and Lease I at the end of fiscal year 1997. At August 31, 1997, a
provision of $400,000 for the liability which might have resulted to the Company
had been recorded as "termination fee payable" in the financial statements of
the Company, with the remaining $600,000 provision recorded by Lease I. Due to
the final settlement agreement, the 1997 provisions were increased by $625,000
at August 31, 1998. An additional provision of $250,000 was recorded in the
financial statements of the Company with the remaining $375,000 recorded in the
financial statements of Lease I. On September 4, 1998, subsequent to the end of
the fiscal year, the full settlement amounts were paid to AHC and its
affiliates.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of Shareholders held on July 28, 1998, Julien G.
Redele, Jeffry R. Dwyer, and J. William Sharman, Jr., were elected to serve as
Directors of the Company until the 1999 Annual Meeting, and the designation of
Ernst & Young LLP as auditors for the fiscal year ending August 31, 1998, was
ratified. Jeffry R. Dwyer has served as a Director since September 13, 1994, the
date of incorporation of the Company. J. William Sharman, Jr., has served as a
Director of the Company since September 18, 1997.
I-7
<PAGE>
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S SHARES AND RELATED STOCKHOLDER MATTERS
Prior to September 1, 1995, the Company was a wholly-owned subsidiary
of ILM II. Pursuant to a reorganization and distribution agreement, ILM II
capitalized the Company with $500,000, an amount estimated to provide the
Company with necessary working capital. On September 1, 1995, MAVRICC Management
Systems, Inc., as the distribution agent, caused to be issued on the stock
records of the Company the distributed common stock of the Company, in
uncertificated form, to the holders of record of ILM II common stock at the
close of business on July 14, 1995. One share of the Company's common stock was
distributed for each outstanding share of ILM II common stock. No certificates
or scrip representing fractional shares of the Company's common stock were
issued to holders of ILM II common stock as part of the distribution. In lieu of
receiving fractional shares, each holder of ILM II common stock who would
otherwise have been entitled to receive a fractional share of the Company's
common stock received a cash payment equivalent to $0.14 per share for such
fractional interest. At August 31, 1998, there were 3,337 record holders of the
Company's shares. The shares do not trade on an established exchange and the
only market that has developed is a secondary market. Although PaineWebber and
others may endeavor to assist Shareholders desiring to sell their shares by
attempting to match requests to sell shares with requests to purchase shares,
such transfers are not expected to be frequent.
The Company did not pay cash dividends in fiscal years 1998, 1997 and
1996. The Company intends to review this policy during fiscal 1999, and may or
may not determine to pay cash dividends in the future. Payment of dividends, if
any, will be at the discretion of the Company's Board of Directors and will
depend upon such factors as the Company's financial condition, earnings,
anticipated investments and other relevant factors.
ITEM 6. SELECTED FINANCIAL DATA
ILM II LEASE CORPORATION
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
For the year For the year For the year
ended ended ended
August 31, 1998 August 31, 1997 August 31, 1996
--------------------- --------------------- ---------------------
<S> <C> <C> <C>
Revenues $15,524 $14,433 $13,201
Income (loss) before income taxes $ (36) $ (67) $ 433
Income tax expense (benefit) $ (14) $ (27) $ 173
Net income (loss) $ (22) $ (40) $ 260
======= ======= =====
Net income (loss) per share of common
stock $ 0.00 $ (0.01) $ 0.05
======= ======= ======
Total assets $ 2,733 $ 2,126 $ 1,935
Shares outstanding 5,180,952 5,180,952 5,180,952
</TABLE>
The above selected financial data should be read in conjunction with
the financial statements and related notes appearing in Item 14 in this annual
report.
II-1
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
LIQUIDITY AND CAPITAL RESOURCES
The Company was formed in 1995 by ILM II, a publicly-held, non-traded
REIT, for the purpose of operating six Senior Housing Facilities under the terms
of a master lease agreement. ILM II contributed $500,000 in return for all of
the issued and outstanding shares of the Company's common stock. ILM II had
originally made mortgage loans secured by the Senior Housing Facilities to AHC
between July 1990 and July 1992. In March 1993, AHC defaulted under the terms of
such mortgage loans and in connection with the settlement of such default, title
to the Senior Housing Facilities was transferred, effective April 1, 1994, to
certain majority-owned, indirect subsidiaries of ILM II, subject to the mortgage
loans. Subsequently, these indirect subsidiaries were merged into ILM II
Holding, which is also a majority-owned subsidiary of ILM II. As part of the
fiscal 1994 settlement agreement with AHC, AHC was retained as the property
manager for the Senior Housing Facilities pursuant to the terms of an agreement
which was assigned to the Company as of September 1, 1995. As discussed further
below, the agreement with AHC was terminated in July 1996.
ILM II has elected to be taxed as a REIT under the Internal Revenue
Code of 1986, as amended ("the Code"), for each taxable year of operations. In
order to maintain its status as a REIT, 75% of ILM II's annual gross income must
be Qualified Rental Income as defined by the Code. The rent paid by the
residents of the Senior Housing Facilities likely would not be deemed to be
Qualified Rental Income because of the extent of services provided to residents.
Consequently, the operation of the Senior Housing Facilities by ILM II or its
subsidiaries over an extended period of time could adversely affect ILM II's
status as a REIT. Therefore, ILM II formed the Company to operate the Senior
Housing Facilities, and by means of a distribution, transferred the ownership of
the common stock of the Company to the holders of ILM II common stock. Because
the Company, which is taxed as a regular C corporation, is no longer a
subsidiary of ILM II, it can receive service-related income without endangering
the REIT status of ILM II. On September 1, 1995, after ILM II received the
required regulatory approval, it distributed all of the outstanding shares of
capital stock of the Company to the holders of record of ILM II's common stock.
One share of common stock of the Company was issued for each full share of ILM
II's common stock held. No fractional shares were issued. Holders of ILM II's
common stock were not required to pay any cash or other consideration or to
exchange their common stock of ILM II for the common stock of the Company. Prior
to the distribution of the Company's stock, ILM II's Shareholders received an
information statement fully describing the Company and the distribution of its
capital stock.
The master lease agreement, which commenced on September 1, 1995, is
between ILM II Holding, as owner of the properties and Lessor, and the Company,
as Lessee. The master lease is a "triple-net" lease whereby the Company as the
Lessee, pays all operating expenses, governmental taxes and assessments, utility
charges and insurance premiums, as well as the costs of all required
maintenance, personal property and non-structural repairs in connection with the
operation of the Senior Housing Facilities. ILM II Holding, as the Lessor, is
responsible for all major capital improvements and structural repairs to the
Senior Housing Facilities. If the Company and ILM II Holding decide that any of
the Senior Housing Facilities should be expanded, the master lease agreement
between the Company and ILM II Holding would be amended to include such
expansion. During the initial term of the master lease, which expires on
December 31, 2000 (December 31, 1999 with respect to the Santa Barbara
Facility), the Company is obligated to pay annual base rent for the use of all
of the Senior Housing Facilities in the aggregate amount of $4,035,600 per year.
Beginning in January 1997, and for the remainder of the lease term, the Company
is also obligated to pay variable rent for each Senior Housing Facility. Such
variable rent is payable quarterly and equals 40% of the excess, if any, of the
aggregate total revenues for the Senior Housing Facilities, on an annualized
basis, over $13,021,000. Variable rent expense related to fiscal years 1998 and
1997 was $984,000 and $412,000, respectively.
As noted above, the Company's master lease is scheduled to expire on
December 31, 2000. Accordingly, since the Company does not have any current
plans to operate or own any other facilities or engage in any other business
outside of its relationship with ILM II, there is no assurance that the
Company's operations will continue beyond December 2000. The master lease may be
terminated earlier, however, by ILM II Holding upon 30 days notice to the
Company in connection with a sale to a non-affiliated third party of the Senior
Housing Facilities.
II-2
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
On July 29, 1996, the Company terminated the agreement with AHC
covering six Senior Housing Facilities leased by the Company (see "Item 3. Legal
Proceedings") and retained Capital to be the manager of the Senior Housing
Facilities. Lawrence A. Cohen, who through July 28, 1998 served as a Director of
the Company and President, Chief Executive Officer and Director of ILM II, has
also served as Vice Chairman and Chief Financial Officer of Capital Senior
Living Corporation, an affiliate of Capital, since November 1996. As a result,
until July 28, 1998, Capital was considered a related party. Under the terms of
the management agreement, Capital earns a base management fee equal to 4% of the
gross operating revenues of the Senior Housing Facilities, as defined, as well
as an incentive management fee equal to 25% of the amount by which net cash flow
of the Senior Housing Facilities, as defined, exceeds a specified base amount.
Each August 31, beginning on August 31, 1997, the base amount is increased based
on the percentage increase in the Consumer Price Index as well as 15% of
facility expansion costs. ILM II has guaranteed the payment of all fees due to
Capital under the terms of the management agreement.
On February 4, 1997, AHC filed a complaint in the Superior Court of the
State of California against Capital, the new property manager; Lawrence A.
Cohen, who, through July 28, 1998, was a Director of the Company and President,
Chief Executive Officer and Director of ILM II, and others alleging that the
defendants intentionally interfered with AHC's agreement (the "California
litigation"). The complaint sought damages of at least $2,000,000. On March 4,
1997, the defendants removed the case to Federal District Court in the Central
District of California. At a Board meeting on February 26, 1997, the Company's
Board of Directors concluded that since all of Mr. Cohen's actions relating to
the California litigation were taken either on behalf of the Company under the
direction of the Board or as a PaineWebber employee, the Company or its
affiliates should indemnify Mr. Cohen with respect to any expenses arising from
the California litigation, subject to any insurance recoveries for those
expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen
totaled $227,000 as of August 31, 1998. The Company's Board also concluded that,
subject to certain conditions, the Company or its affiliates should advance up
to $20,000 to pay reasonable legal fees and expenses incurred by Capital in the
California litigation. Subsequently, the Boards of the Company and Lease I voted
to increase the maximum amount of the advance to Capital to $100,000. By the end
of November 1997, Capital had incurred $100,000 of legal expenses in the
California litigation. On February 2, 1998, the amount to be advanced to Capital
was increased to include 75% of the California litigation legal fees and costs
incurred by Capital for December 1997 and January 1998, plus 75% of such legal
fees and costs incurred by Capital thereafter, not to exceed $500,000. By August
31, 1998, Capital had incurred $683,000 of legal expenses in the California
litigation. At August 31, 1998, the amount of legal fees either advanced to
Capital or accrued in the financial statements of the Company and Lease I
totaled approximately $519,000, although the final amount to be reimbursed to
Capital has not yet been determined.
Occupancy levels for the six properties which the Company leases from
ILM II Holding averaged 96% for the year ended August 31, 1998. The City of
Stockton has announced plans to build a railroad underpass on the street located
immediately adjacent to Rio Las Palmas in Stockton, California. The City plans
to use a portion of the Rio Las Palmas property for a temporary bypass during
the expected 18-month construction process. Although this road construction
would not directly affect facility operations, it would eliminate several
parking spaces and would result in increased noise and traffic during the
construction period while the traffic is re-routed closer to the facility.
Negotiations with the City are currently underway to minimize any disruption to
the operations of Rio Las Palmas and to secure a settlement that will pay for
any damages.
The Senior Housing Facilities have generated sufficient net cash flow
to cover the base master lease payments at their current level of $4,035,600 per
year since inception of the Company's operations. As noted above, the master
lease also provides for the payment of variable rent beginning in January 1997.
The Senior Housing Facilities are currently generating gross revenues which are
in excess of the specified threshold in the variable rent calculation, as
discussed further above. Accordingly, the Company had variable rental expense in
fiscal years 1998 and 1997 in the amount of $984,000 and $412,000, respectively.
II-3
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
At August 31, 1998, the Company had cash and cash equivalents of
$1,497,000. Such amounts will be used for the Company's working capital
requirements. As noted above, under the terms of the master lease, the Lessor is
responsible for any major capital improvements or structural repairs to the
Senior Housing Facilities. Consequently, the Company does not have any material
commitments for capital expenditures. Furthermore, the Company does not
currently anticipate the need to engage in any borrowing activities. As a
result, substantially all of the Company's cash flow will be generated from
operating activities. The Company did not pay cash dividends in fiscal years
1998, 1997 and 1996. The Company intends to review this policy during fiscal
1999, and may or may not determine to pay cash dividends in the future. Payment
of dividends, if any, will be at the discretion of the Company's Board of
Directors and will depend upon such factors as the Company's financial
condition, earnings, anticipated investments and other relevant factors. The
source of future liquidity is expected to be from operating cash flow from the
Senior Housing Facilities, net of the master lease payments to ILM II Holding,
and interest income earned on invested cash reserves. Such sources of liquidity
are expected to be adequate to meet the Company's operating requirements on both
a short-term and long-term basis.
YEAR 2000
The Year 2000 issue is the result of computer programs being written
using two digits rather than four to define the applicable year. Any of the
Company's computer programs or hardware that have date-sensitive software or
embedded chips may recognize the year 2000 as a date other than the year 2000.
This could result in a system failure or miscalculations causing disruptions of
operations, including, among other things, a temporary inability to process
transactions, send invoices or engage in similar normal business activities.
Based on ongoing assessments, the Company, through Capital, its
property manager, has developed a program to modify or replace portions of its
software and certain hardware, which are generally PC-based systems, so that
those systems will properly recognize and utilize dates beyond December 31,
1999. While there can be no assurance, as of August 31, 1998, the Company
believes that it will substantially complete all software and hardware upgrades
as of December 31, 1998. The Company believes that these modifications and
replacements of existing software and certain hardware will mitigate the Year
2000 issue. However, if such modifications and replacements are not completed
timely, the Year 2000 issue could have a material impact on the operations of
the Company. The costs of Year 2000 remediation are not expected to be material
based on the Company's operations.
The Company has assessed its exposure to operating equipment, and such
exposure is not significant due to the nature of the Company's business.
The Company is not aware of any external agent with a Year 2000 issue
that would materially impact the Company's results of operations, liquidity or
capital resources. However, the Company has no means of determining whether or
ensuring those external agents will be Year 2000 ready. The inability of
external agents to complete their Year 2000 resolution process in a timely
fashion could impact the Company.
Management of the Company believes it has an effective program in place
to resolve the Year 2000 issue in a timely manner. As noted above, the Company
has substantially completed all necessary phases of its Year 2000 program. In
addition, disruptions in the economy generally resulting from Year 2000 issues
could also adversely affect the Company. Although the amount of potential
liability and lost revenue cannot be reasonably estimated at this time, in a
worst case situation, if Capital, the Company's most significant third party
contractor, were to experience a year 2000 problem, it is likely that the
Company would not receive rental income as it became due from Senior Living
Facility residents. The Company in turn would fail to pay ILM II Holding lease
payments as they arise under the master lease, and ILM II Holding in turn would
fail to pay ILM II mortgage payments due it. However, the Company believes that
given the nature of its business, such problem would be temporary and is easily
remedied with a simple accounting.
II-4
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
RESULTS OF OPERATIONS
1998 COMPARED TO 1997
REVENUES. Total revenues were $15,524,000 for the year ended August 31,
1998 compared to $14,433,000 for the year ended August 31, 1997, representing an
increase of $1,091,000, or 7.6%. Rental and other income from the Company's
senior housing operations was $15,481,000 for the year ended August 31, 1998,
representing an increase of $1,087,000 or 7.6%, primarily as a result of
improved occupancies in all markets and increases in rental rates at certain
other facilities located in strong markets.
EXPENSES. Total expenses were $15,560,000 in 1998 compared to $14,500,000
in 1997, representing an increase of $1,060,000, or 7.3%. This increase was
principally comprised of increases in master lease rent expense of $572,000 or
13%; marketing salaries, wages and expenses of $31,000 or 4.7%; repairs and
maintenance of $23,000 or 4.3%; property management fees of $192,000 or 27.2%;
and general and administrative expenses of $701,000 or 121%. These increases in
expenses were offset by decreases in dietary and food service salaries, wages
and expenses of $25,000 or 1%; administrative salaries, wages and expenses of
$138,000 or 11.2%; other property operating expenses of $175,000 or 10.9%;
advisory fees of $58,000 or 100%; and termination fee expense of $250,000,
representing a decrease of $150,000 or 37.5% (see "Item 3, Legal Proceedings");
and minor decreases in certain other expenses. The increase in master lease
expense is the result of the increase in variable rents due under the Master
Lease Agreement. General and administrative expense increased as a result of
higher AHC litigation expenses in 1998. The increases in other operating costs
cited above were the result of higher operating levels associated with improved
occupancies. In addition, total charges to depreciation expense in 1998 include
additional depreciation expense of $36,000 in recognition of changes in the
remaining useful life for certain assets purchased in 1997 and prior to conform
to the lease termination date, as such assets are not subject to repurchase by
ILM II Holding. As a result, depreciation expense increased $98,000 or 175% when
compared to fiscal year 1997.
INCOME TAX EXPENSE. Income tax benefit decreased $13,000 or 48.1%, from
$27,000 in fiscal 1997 to a $14,000 benefit in fiscal 1998. The 1997 deferred
tax provision reflects a reclassification of $160,000 of current tax expense in
1997, which was ultimately determined to be deductible in 1998.
NET INCOME (LOSS). Primarily as a result of the factors discussed above,
net loss decreased $18,000 or 45%, from a net loss of $40,000 in fiscal 1997 to
a net loss of $22,000 in fiscal 1998.
1997 COMPARED TO 1996
REVENUES. Total revenues were $14,433,000 for the year ended August 31,
1997, compared to $13,201,000 for the year ended August 31, 1996, representing
an increase of $1,232,000 or 9.3%. Rental and other income from the Company's
senior housing operations was $14,394,000 for the year ended August 31, 1997,
representing an increase of $1,231,000 or 9.4%, primarily as a result of
improved occupancies in all markets, in particular, improvements in leasing
activity at the Company's Villa Santa Barbara facility, and increases in rental
rates at certain other facilities located in strong markets.
EXPENSES. Total expenses were $14,500,000 in 1997 compared to
$12,768,000 in 1996, representing an increase of $1,732,000, or 13.6%. This
increase was principally comprised of increases in master lease expense of
$412,000 or 10.3%; dietary and food service salaries, wages and expenses of
$293,000 or 12.2%; administrative salaries, wages and expenses of $167,000 or
15.7%; general and administrative expenses of $290,000 or 101.8%, other property
operating expenses of $196,000 or 13.9%, as well as the $400,000 termination fee
expense which was accrued in 1997 (see "Item 3, Legal Proceedings"),
representing a 100% increase from fiscal year 1996. The increase in master lease
expense is the result of variable rents due under the Master Lease Agreement for
the first time in 1997. General and administrative expense increased as a result
of higher AHC litigation expenses in 1997 coupled with the analysis of
restructuring alternatives performed by an independent investment banking firm.
The
II-5
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
increases in other operating costs cited above were the result of higher
operating levels associated with improved occupancies and the implementation of
a health insurance program for property-level staff.
INCOME TAX EXPENSE. Income tax expense decreased $200,000 or 115.6%,
from $173,000 in fiscal 1996 to a $27,000 benefit in fiscal 1997 as a result of
a net loss before taxes of $67,000 as the effective income tax rate was 40% in
both years.
NET INCOME. Primarily as a result of the factors discussed above, net
income decreased $300,000 or 115.4%, from $260,000 in fiscal 1996 to a net loss
of $40,000 in fiscal 1997.
INFLATION
The Company completed its third full year of operations in fiscal 1998.
The effects of inflation and changes in prices on the Company's operating
results to date have not been significant.
Inflation in future periods is likely to cause increases in the
Company's expenses, which may be partially offset by increases in revenues from
the tenant leases at the Senior Housing Facilities. Rental revenues may tend to
rise with inflation since the rental rates on the tenant leases, which are
short-term in nature, can be adjusted to keep pace with inflation as market
conditions allow. As noted above, under the terms of the master lease agreement
between the Company and ILM II Holding, Inc., the Company is obligated to pay
variable rent, in addition to the base rent owed, in an amount equal to 40% of
the excess of total revenues from the Senior Housing Facilities over a specified
base amount. Accordingly, to the extent that the total revenues are in excess of
this threshold, a portion of the increase in revenues would be payable to the
Lessor.
II-6
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (CONTINUED)
FORWARD-LOOKING INFORMATION
CERTAIN STATEMENTS INCLUDED IN THIS ANNUAL REPORT ON FORM 10-K ("ANNUAL
REPORT") CONSTITUTE "FORWARD-LOOKING STATEMENTS" INTENDED TO QUALIFY FOR THE
SAFE HARBORS FROM LIABILITY ESTABLISHED BY SECTION 27A OF THE SECURITIES ACT OF
1933, AS AMENDED (THE "SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES ACT
OF 1934, AS AMENDED (THE "EXCHANGE ACT"). THESE FORWARD-LOOKING STATEMENTS
GENERALLY CAN BE IDENTIFIED AS SUCH BECAUSE THE CONTEXT OF THE STATEMENT WILL
INCLUDE WORDS SUCH AS "BELIEVES," "COULD," "MAY," "SHOULD," "ENABLE," "LIKELY,"
"PROSPECTS," "SEEK," "PREDICTS," "POSSIBLE," "FORECASTS," "PROJECTS,"
"ANTICIPATES," "EXPECTS" AND WORDS OF ANALOGOUS IMPORT AND CORRELATIVE
EXPRESSIONS THEREOF, AS WELL AS STATEMENTS PRECEDED OR OTHERWISE QUALIFIED BY:
"THERE CAN BE NO ASSURANCE" OR "NO ASSURANCE CAN BE GIVEN." SIMILARLY,
STATEMENTS THAT DESCRIBE THE COMPANY'S FUTURE PLANS, OBJECTIVES, STRATEGIES OR
GOALS ALSO ARE FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS MAY ADDRESS FUTURE
EVENTS AND CONDITIONS CONCERNING, AMONG OTHER THINGS, THE COMPANY'S CASH FLOWS,
RESULTS OF OPERATIONS AND FINANCIAL CONDITION; THE CONSUMMATION OF ACQUISITION
AND FINANCING TRANSACTIONS AND THE EFFECT THEREOF ON THE COMPANY'S BUSINESS,
ANTICIPATED CAPITAL EXPENDITURES, PROPOSED OPERATING BUDGETS AND ACCOUNTING
RESERVES; LITIGATION; PROPERTY EXPANSION AND DEVELOPMENT PROGRAMS OR PLANS;
REGULATORY MATTERS; AND THE COMPANY'S PLANS, GOALS, STRATEGIES AND OBJECTIVES
FOR FUTURE OPERATIONS AND PERFORMANCE. ANY SUCH FORWARD-LOOKING STATEMENTS ARE
SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN SUCH FORWARD-LOOKING
STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO A NUMBER OF
ASSUMPTIONS REGARDING, AMONG OTHER THINGS, GENERAL ECONOMIC, COMPETITIVE AND
MARKET CONDITIONS. SUCH ASSUMPTIONS NECESSARILY ARE BASED ON FACTS AND
CONDITIONS AS THEY EXIST AT THE TIME SUCH STATEMENTS ARE MADE, THE PREDICTION OR
ASSESSMENT OF WHICH MAY BE DIFFICULT OR IMPOSSIBLE AND, IN ANY CASE, BEYOND THE
COMPANY'S CONTROL. FURTHER, THE COMPANY'S BUSINESS IS SUBJECT TO A NUMBER OF
RISKS THAT MAY AFFECT ANY SUCH FORWARD-LOOKING STATEMENTS AND ALSO COULD CAUSE
ACTUAL RESULTS OF THE COMPANY TO DIFFER MATERIALLY FROM THOSE PROJECTED OR
IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. ALL FORWARD-LOOKING STATEMENTS
CONTAINED IN THIS ANNUAL REPORT ARE EXPRESSLY QUALIFIED IN THEIR ENTIRETY BY THE
CAUTIONARY STATEMENTS IN THIS PARAGRAPH. MOREOVER, THE COMPANY DOES NOT INTEND
TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS TO REFLECT ANY CHANGES IN
GENERAL ECONOMIC, COMPETITIVE OR MARKET CONDITIONS AND DEVELOPMENTS BEYOND ITS
CONTROL.
READERS OF THIS ANNUAL REPORT ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE
ON ANY OF THE FORWARD-LOOKING STATEMENTS SET FORTH HEREIN AND THE COMPANY MAKES
ABSOLUTELY NO PROMISES, GUARANTEES, REPRESENTATIONS OR WARRANTIES AS TO THE
ACCURACY THEREOF.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary data are included under Item
14 of this annual report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
II-7
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
There currently are three Directors of the Company. The Directors are
subject to removal by the vote of the holders of a majority of the outstanding
shares of the Company's common stock. The Directors are responsible for the
general policies of the Company, but they are not required to personally conduct
the business of the Company in their capacities as Directors.
(a) and (b) The names and ages of the Directors and Executive Officers
of the Company during fiscal 1998 are as follows:
<TABLE>
<CAPTION>
DATES
NAME OFFICE AGE OF OFFICE
---- ------ --- -----------------
<S> <C> <C> <C>
Julien G. Redele President and Director 63 7/28/98-present
Jeffry R. Dwyer Secretary and Director 52 9/13/94*-present
J. William Sharman, Jr. Director 58 9/18/97-present
Lawrence A. Cohen Director 45 9/13/94*-9/28/98
John B. Watts, III Director 45 9/13/94*-9/28/98
</TABLE>
* The date of incorporation of the Company.
(c) There is no family relationship among any of the foregoing
Directors or Officers. All of the foregoing Directors and Officers of
the Company have been elected to serve until the Company's next annual
meeting.
(d) The business experience of each of the Directors and Executive
Officers of the Company is as follows:
JULIEN G. REDELE is President and Director of the Company. Mr. Redele
is one of the original founders of SFRE, Inc., a Dutch owned real estate
investment and development firm which has served since 1963 as advisor to Dutch
institutional, corporate and individual investors active in the United States.
Mr. Redele serves as a Director of the Island Preservation Partnership. Mr.
Redele attended Westersingel Business School, Rotterdam, where he studied
economics, law and finance. Mr. Redele also presently serves as a Director of
ILM II.
JEFFRY R. DWYER is Secretary and Director of the Company. Mr. Dwyer has
been a shareholder of Greenberg Traurig, which has provided legal services to
the Company and its affiliates since June 1997. From 1993 to 1997, Mr. Dwyer was
a partner with the law firm of Akin, Gump, Strauss, Hauer & Feld in the District
of Columbia. Prior to joining Akin, Gump, Strauss, Hauer & Feld, Mr. Dwyer was a
partner with the law firm of Morrison & Foerster from 1989 to 1993. Mr. Dwyer
also presently serves as Secretary and a Director of ILM I, ILM II and Lease I.
Mr. Dwyer has written several law review articles and a major treatise on real
estate financing and taught Real Estate Planning as an Adjunct Professor at the
Georgetown University Law Center. Mr. Dwyer graduated from Georgetown University
and received his law degree from the Georgetown University Law Center.
J. WILLIAM SHARMAN, JR. was President and Director of the Company until
July 28, 1998, when Julien G. Redele succeeded him as President. Mr. Sharman is
also a Director of Lease I. Mr. Sharman is the Chairman of the Board and Chief
Executive Officer of Lancaster Hotels and Resorts, Inc., Management, L.C., a
hotel management company. Mr. Sharman served for ten years as Chairman of the
Board and President of The Lancaster Group, Inc., a real estate development firm
based in Houston, Texas, which is the predecessor of Lancaster Hotel Management
III-1
<PAGE>
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (CONTINUED)
L.C. and Bayou Equities, Inc. Mr. Sharman serves as a Director of Small Luxury
Hotels, Ltd. of the United Kingdom, an international hotel marketing and
reservations firm. Mr. Sharman also presently serves as a Director and President
of ILM I and ILM II. He has a Bachelor of Science degree from the University of
Notre Dame.
LAWRENCE A. COHEN served as Director of the Company from inception
until July 28, 1998. In November 1996, he also became Vice Chairman and Chief
Financial Officer of Capital Senior Living Corporation, an affiliate of Capital,
which was contracted by the Company in July 1996 to perform property management
services for the Senior Housing Facilities. Mr. Cohen was President and Chief
Executive Officer of PaineWebber Properties Incorporated until August 1996. Mr.
Cohen joined PaineWebber in January 1989 as its Executive Vice President and
Director of Marketing and Sales. Mr. Cohen had also been a Director of Lease I
and President, Chief Executive Officer and Director of ILM I and ILM II until
July 28, 1998. Mr. Cohen received his LL.M. (in Taxation) from New York
University School of Law and his J.D. degree from St. John's University School
of Law. Mr. Cohen received his B.B.A. degree in accounting from George
Washington University. He is a member of the New York Bar and is a Certified
Public Accountant.
JOHN B. WATTS, III was a Director of the Company and of Lease I until
July 28, 1998. Mr. Watts currently directs institutional real estate
acquisitions for the PNL Companies in New York. Mr. Watts was Senior Vice
President and Director of Real Estate Advisory and Portfolio Management at
PaineWebber, where he was employed from June 1988 to August 1996. Mr. Watts has
over 19 years of experience in acquisitions, dispositions and finance of real
estate and has directed the portfolios of real estate partnerships and REITs. He
received degrees of Bachelor of Architecture, Bachelor of Arts and Master of
Business Administration from the University of Arkansas.
(e) Except for the Feldman litigation as discussed below, none of the
current Directors and Officers was involved in legal proceedings which are
material to an evaluation of his or her ability or integrity as a Director or
Officer. On May 8, 1998, Andrew A. Feldman and Jeri Feldman, as Trustees for the
Andrew A. & Jeri Feldman Revocable Trust dated September 18, 1990, commenced a
purported class action on behalf of that trust and all other shareholders of ILM
I and ILM II (affiliates of the Company, as previously discussed) in the Supreme
Court of the State of New York, County of New York, against ILM I, ILM II and
Lawrence A. Cohen, Jeffry R. Dwyer, Julien G. Redele, Carl J. Schramm and J.
William Sharman, Jr. as the Directors of both corporations. The class action
complaint alleges that the Directors engaged in wasteful and oppressive conduct
and breached fiduciary duties in preventing the sale or liquidation of the
assets of ILM I and ILM II, diverting certain of their assets and changing the
nature of ILM I and ILM II. The complaint seeks damages in an unspecified
amount, punitive damages, the judicial dissolution of ILM I and ILM II, an order
requiring the Directors to take all steps to maximize shareholder value,
including either an auction or liquidation, and rescinding certain agreements,
and attorney's fees. On July 8, 1998, the defendants moved to dismiss the
complaint on all counts.
Subsequent to the end of the fiscal year, in an oral ruling from the
bench on December 8, 1998, the Court granted the Company's dismissal motion in
part and gave the plaintiffs leave to amend their complaint. In sum, the Court
accepted the defendant's position that all claims relating to so-called
"derivative" actions were filed improperly and were properly dismissed. In
addition, the Court dismissed common law claims for punitive damages, but
allowed plaintiffs 30 days to allege any claims which allegedly injured
shareholders without injuring ILM II as a whole. The defendants doubt that such
a cause of action could be alleged and continue to believe that this lawsuit is
meritless. The defendants have directed outside counsel to continue vigorously
contesting the action.
III-2
<PAGE>
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (CONTINUED)
(f) Compliance With Exchange Act Filing Requirements: The Securities
Exchange Act of 1934 requires the Officers and Directors of the Company, and
persons who own more than ten percent of the Company's outstanding common stock,
to file certain reports of ownership and changes in ownership with the
Securities and Exchange Commission. Officers, Directors and ten-percent
beneficial holders are required by SEC regulations to furnish the Company with
copies of all Section 16(a) forms they file.
Based solely on its review of the copies of such forms received by it,
the Company believes that, during the year ended August 31, 1998, there was
compliance with all filing requirements applicable to its Officers and Directors
and ten-percent beneficial holders.
ITEM 11. EXECUTIVE COMPENSATION
The Company's Directors each receive annual compensation of $12,000
plus $500 for attending each Board of Directors meeting and reimbursement for
expenses incurred in attending meetings and as a result of other work performed
for the Company. Officers of the Company are not compensated.
Lawrence A. Cohen, who was a Director of the Company until July 28,
1998, received compensation from and was an employee of Capital Senior Living
Corporation, an affiliate of Capital, a related party.
Jeffry R. Dwyer receives compensation from and is a shareholder of
Greenberg Traurig, which acts as Counsel to the Company and its affiliates.
The former Officers of the Company who were also Officers of
PaineWebber received compensation from PaineWebber which indirectly related to
services to the Company because the Company was required to pay certain fees to
PaineWebber as described in Item 13. When PaineWebber resigned as advisor to the
Company, the former officers resigned effective the same date, therefore no
services were provided by such persons subsequent to June 18, 1997.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
(a) As of the date hereof, no person of record owns or is known by the
Registrant to own beneficially more than five percent of the
outstanding shares of common stock of the Company.
(b) The Directors and Officers of the Company do not have any direct or
indirect ownership of shares of the Company's common stock as of the
date hereof.
(c) There exists no arrangement, known to the Company, the operation of
which may at a subsequent date result in a change in control of the
Company.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Subject to the supervision of the Company's Board of Directors,
assistance in managing the business of the Company was provided by PaineWebber.
As previously discussed in Item 1, PaineWebber resigned effective June 18, 1997.
Under the advisory agreement, PaineWebber had specific management
responsibilities; to perform day-to-day operations of the Company and to act as
the investment advisor and consultant for the Company in connection with general
policy and investment decisions. PaineWebber received a fee in an amount equal
to 0.5% of the gross operating revenue of the facilities. PaineWebber earned
management fees totaling $0, $58,000 and $66,000 for the years ended August 31,
1998, 1997 and 1996, respectively. PaineWebber was reimbursed for direct
expenses relating to the administration of the Company. PaineWebber performed
certain accounting, tax preparation, securities law compliance and investor
communications and relations services for the Company. Included in general and
administrative expenses on the accompanying statements of income for the years
ended August 31, 1998, 1997 and 1996 are $0, $59,000 and $55,000, respectively,
representing reimbursements to
III-3
<PAGE>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED)
PaineWebber for providing such services to the Company. As discussed in Items 1
and 7, the Company, ILM I, ILM II, and their affiliates accepted the resignation
of PaineWebber effective as of June 18, 1997. The Company, ILM I, ILM II, and
their affiliates and PaineWebber entered into a transition services agreement
pursuant to which PaineWebber would continue to provide certain administrative
services to the Company, ILM I, ILM II, and their affiliates through August 31,
1997.
The advisory relationship with PaineWebber ceased on June 18, 1997;
therefore, the payment of advisory fees ceased as of that date. Other services,
such as accounting, compliance, investor communications and relations, and cash
management services ceased on August 31, 1997; therefore, the Company was not
obligated to pay service fees past August 31, 1997 to PaineWebber.
The Company retained Capital to be the property manager of the Senior
Housing Facilities pursuant to a Management Agreement which commenced on July
29, 1996. As discussed in Note 1, Lawrence A. Cohen, who served as a Director of
the Company as well as President, Chief Executive Officer and Director of ILM II
through July 28, 1998, has also served as Vice Chairman and Chief Financial
Officer of Capital Senior Living Corporation, an affiliate of Capital, since
November 1996. Under the Management Agreement, Capital generally is required to
perform all operational functions necessary to operate the Senior Housing
Facilities other than certain administrative functions. The functions performed
by Capital include periodic reporting to and coordination with the Company,
leasing the individual units in the Senior Housing Facilities maintaining bank
accounts, maintaining books and records, advertising and marketing the Senior
Housing Facilities, hiring and supervising on-site personnel, and performing
maintenance. Under the terms of the Management Agreement, Capital earns a base
management fee equal to 4% of the gross operating revenues of the Senior Housing
Facilities, as defined. Capital also earns an incentive management fee equal to
25% of the amount by which the net cash flow of the Senior Housing Facilities,
as defined, exceeds a specified base amount. Each August 31, beginning on August
31, 1997, the base amount is increased based on the percentage increase in the
Consumer Price Index as well as 15% of Facility expansion costs. ILM II has
guaranteed the payment of all fees due to the terms of the Management Agreement.
Capital earned property management fees from the Company of $899,000, $707,000
and $60,000 for the years ended August 31, 1998, 1997 and 1996, respectively.
On September 18, 1997, the Company entered into an agreement with
Capital Senior Development, Inc., an affiliate of Capital, to manage the
development process for the potential expansions of the Senior Housing
Facilities. Capital Senior Development, Inc. will receive a fee equal to 7% of
the total development costs of these expansions if they are pursued. ILM II
Holding will reimburse the Company for all costs related to these potential
expansions including fees to Capital Senior Development, Inc. For the years
ended August 31, 1998 and 1997, Capital Senior Development, Inc. earned fees
from the Company of $73,000 and $0, respectively, for managing pre-construction
development activities for potential expansions of the Senior Housing
Facilities.
On February 4, 1997, AHC filed a complaint in the Superior Court of the State of
California against Capital, Lawrence Cohen, and others alleging that the
defendants intentionally interfered with AHC's agreement (the "California
litigation"). The complaint sought damages of at least $2,000,000. On March 4,
1997, the defendants removed the case to federal district court in the Central
District of California. At a Board meeting on February 26, 1997, the Company's
Board of Directors concluded that since all of Mr. Cohen's actions relating to
the California litigation were taken either on behalf of the Company under the
direction of the Board or as a PaineWebber employee, the Company or its
affiliates should indemnify Mr. Cohen with respect to any expenses arising from
the California litigation, subject to any insurance recoveries for those
expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen
totaled $227,000 as of August 31, 1998. The Company's Board also concluded that,
subject to certain conditions, the Company or its affiliates should advance up
to $20,000 to pay reasonable legal fees and expenses incurred by Capital in the
California litigation. Subsequently, the Boards of the Company and Lease I voted
to increase the maximum amount of the advance to Capital to $100,000. On
February 2, 1998, the amount to be advanced to Capital was increased to include
75% of the California litigation legal fees and costs incurred by Capital for
December 1997 and January 1998 plus 75% of such legal fees and costs incurred by
Capital thereafter, not to exceed $500,000. By August 31, 1998, Capital had
incurred $683,000 of legal expenses in the
III-4
<PAGE>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED)
California litigation. At August 31, 1998, $208,000 of legal fees have been
either advanced or accrued in the Company's financial statements and $311,000 of
legal fees have either been advanced or accrued in Lease I's financial
statements for Capital's California litigation costs, although the final amount
to be reimbursed to Capital has not yet been determined.
Jeffry R. Dwyer, Secretary and Director of the Company, is a
shareholder of Greenberg Traurig, which began acting as Counsel to the Company
and its affiliates in late fiscal 1997. For the years ended August 31, 1998 and
1997, Greenberg Traurig earned fees from the Company of $153,000 and $0,
respectively.
III-5
<PAGE>
ILM II LEASE CORPORATION
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
(1) and (2) FINANCIAL STATEMENTS AND SCHEDULES:
The response to this portion of Item 14 is submitted as a
separate section of this report. See Index to Financial
Statements and Financial Statement Schedules at page F-1.
(3) EXHIBITS:
The exhibits listed on the accompanying index to exhibits
at page IV-3 are filed as part of this Report.
(b) Exhibits:
See (a)(3) above.
The Company filed a Current Report on Form 8-K dated
August 21, 1998, reporting the Company's settlement of the
AHC litigation.
(c) Financial Statement Schedules:
The response to this portion of Item 14 is submitted as a
separate section of this report. See Index to Financial
Statements and Financial Statement Schedules at page F-1.
IV-1
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
ILM II LEASE CORPORATION
By: /S/ JEFFRY R. DWYER
-----------------------------------------
Jeffry R. Dwyer
Chief Operating Officer
(Principal Accounting Officer)
Dated: NOVEMBER 12, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Company in the
capacity and on the dates indicated.
<TABLE>
<S> <C>
By: /S/ JEFFRY R. DWYER Date: NOVEMBER 12, 1999
------------------------------------------- ----------------------------------------------
Jeffry R. Dwyer
Director
By: /S/ JULIEN G. REDELE Date: NOVEMBER 16, 1999
------------------------------------------- ----------------------------------------------
Julien G. Redele
Director
By: /S/ J. WILLIAM SHARMAN, JR. Date: NOVEMBER 16, 1999
------------------------------------------- ----------------------------------------------
J. William Sharman, Jr.
Director
</TABLE>
IV-2
<PAGE>
ANNUAL REPORT ON FORM 10-K/A
ITEM 14(A)(3)
ILM II LEASE CORPORATION
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
PAGE NUMBER IN THE REPORT
EXHIBIT NO. DESCRIPTION OF DOCUMENT OR OTHER REFERENCE
----------- ----------------------- -------------------------
<S> <C> <C>
(3) and (4) Registration Statement on Form 10 Filed with the Commission
of the Registrant dated July 20, 1995, pursuant to Rule 424(c) and
as supplemented incorporated herein by reference
(13) Annual Reports to Shareholders No Annual Report for the year
ended August 31, 1998 has been
sent to the Shareholders. An
Annual Report will be sent to the
Shareholders subsequent to this
filing.
(27) Financial Data Schedule Filed as last page of EDGAR
submission following the
Financial Statements and
Financial Statement Schedule
required by Item 14.
</TABLE>
IV-3
<PAGE>
ILM II LEASE CORPORATION
ANNUAL REPORT ON FORM 10-K/A
ITEM 14(a)(1) AND (2) AND 14(d)
ILM II LEASE CORPORATION
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
<TABLE>
<CAPTION>
REFERENCE
<S> <C>
ILM II LEASE CORPORATION:
Report of Ernst & Young LLP, Independent Auditors F-2
Balance Sheets as of August 31, 1998 and 1997 F-3
Statements of Operations for the years ended August 31, 1998, 1997 and 1996 F-4
Statements of Changes in Shareholders' Equity for the years ended August 31, F-5
1998, 1997 and 1996
Statements of Cash Flows for the years ended August 31, 1998, 1997 and 1996 F-6
Notes to Financial Statements F-7
</TABLE>
Financial statement schedules have been omitted since the required
information is not present or not present in amounts sufficient to require
submission of the schedule, or because the information required is included
in the financial statements, including the notes thereto.
F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Shareholders of
ILM II Lease Corporation:
We have audited the accompanying balance sheets of ILM II Lease Corporation as
of August 31, 1998 and 1997, and the related statements of operations, changes
in shareholders' equity, and cash flows for each of the three years in the
period ended August 31, 1998. These financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assisting the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of ILM II Lease Corporation at
August 31, 1998 and 1997, and the results of its operations and its cash flows
for each of the three years in the period ended August 31, 1998, in conformity
with generally accepted accounting principles.
ERNST & YOUNG LLP
Dallas, Texas
October 13, 1998
F-2
<PAGE>
ILM II LEASE CORPORATION
BALANCE SHEETS
August 31, 1998 and 1997
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
ASSETS
1998 1997
---------- ----------
<S> <C> <C>
Cash and cash equivalents $1,497 $1,156
Accounts receivables, net 89 55
Accounts receivable - related party 102 -
Prepaid taxes and other assets 50 243
Tax refund receivable 158 -
------- ---------
Total current assets 1,896 1,454
Furniture, fixtures and equipment 783 486
Less: accumulated depreciation (225) (70)
-------- ---------
558 416
Deposits 9 -
Deferred tax asset 270 256
------ -------
$2,733 $2,126
====== =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Accounts payable and accrued expenses $ 789 $ 547
Termination fee payable 650 400
Real estate taxes payable 209 199
Accounts payable - related party 287 152
Security deposits 25 9
-------- --------
Total current liabilities 1,960 1,307
Deferred rent payable 76 100
-------- -------
Total liabilities 2,036 1,407
Commitments and contingencies
Shareholders' equity:
Common stock, $0.01 par value, 20,000,000 shares
authorized, 5,180,952 shares issued and outstanding 52 52
Additional paid-in capital 448 448
Retained earnings 197 219
-------- ---------
Total shareholders' equity 697 719
-------- ---------
$2,733 $2,126
======== =========
</TABLE>
See accompanying notes.
F-3
<PAGE>
STATEMENTS OF OPERATIONS
For the years ended August 31, 1998, 1997 and 1996
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
1998 1997 1996
---------- ----------- ----------
<S> <C> <C> <C>
REVENUES:
Rental and other income $ 15,481 $ 14,394 $ 13,163
Interest income 43 39 38
--------- --------- ---------
15,524 14,433 13,201
EXPENSES:
Master lease rent expense 4,988 4,416 4,004
Dietary, salaries, wages and food service
expenses 2,677 2,702 2,409
Administrative salaries, wages and expenses 1,090 1,228 1,061
Marketing salaries, wages and expenses 688 657 684
Utilities 1,045 1,051 1,008
Repairs and maintenance 554 531 597
Real estate taxes 506 511 508
Property management fees 899 707 720
Other property operating expenses 1,433 1,608 1,412
General and administrative 1,276 575 285
Termination fee expense 250 400 -
Advisory fees - 58 66
Depreciation expense 154 56 14
-------- --------- ---------
15,560 14,500 12,768
-------- --------- ---------
Income (loss) before income taxes (36) (67) 433
Income tax expense (benefit):
Current - 191 211
Deferred (14) (218) (38)
--------- ----------
(14) (27) 173
--------- ---------- ---------
NET INCOME (LOSS) $ (22) $ (40) $ 260
========= ========== =========
NET INCOME (LOSS) PER SHARE OF COMMON STOCK $ 0.00 $ (0.01) $ 0.05
========= ========== =========
</TABLE>
The above net income (loss) per share of common stock is based upon the weighted
average number of shares outstanding for the year ended August 31, 1998, 1997
and 1996, of 5,180,952.
See accompanying notes.
F-4
<PAGE>
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the years ended August 31, 1998, 1997 and 1996
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Common Stock
$.01 Par Value Additional
--------------------- Paid-in Retained
Shares Amount Capital Earnings Total
--------- --------- --------- --------- -------
<S> <C> <C> <C> <C> <C>
BALANCE AT AUGUST 31, 1995 15,000 $ -- $ 1 $ (1) $ --
Issuance of common stock 5,165,952 52 447 -- 499
52
Net income -- -- -- 260 260
--------- --------- --------- --------- ---------
BALANCE AT AUGUST 31, 1996 5,180,952 52 448 259 759
Net loss -- -- -- (40) (40)
--------- --------- --------- --------- ---------
BALANCE AT AUGUST 31, 1997 5,180,952 52 448 219 719
Net loss -- -- -- (22) (22)
--------- --------- --------- --------- ---------
BALANCE AT AUGUST 31, 1998 5,180,952 $ 52 $ 448 $ 197 $ 697
========= ========= ========= ========= =========
</TABLE>
See accompanying notes.
F-5
<PAGE>
STATEMENTS OF CASH FLOWS
For the years ended August 31, 1998, 1997 and 1996
(In thousands)
<TABLE>
<CAPTION>
1998 1997 1996
-------------- ------------- -------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (22) $ (40) $ 260
Adjustments to reconcile net income (loss) to
net cash provided by (used in) operating activities
Depreciation expense 154 56 14
Deferred taxes (14) (218) (38)
Changes in assets and liabilities:
Accounts receivable, net (34) 5 (5)
Prepaid taxes and other assets 193 (125) (118)
Income tax refund receivable (158) - -
Accounts receivable - related party (102) (55) -
Accounts payable and accrued expenses 242 196 503
Accounts payable - related party 135 (327) 327
Termination fee payable 250 400 -
Real estate taxes payable 10 (4) 203
Security deposits, net 8 (3) 12
Deferred rent payable (24) (31) 131
-------- -------- --------
Net cash provided by (used in) operating 638 (146) 1,289
-------- ------- -------
activities
Cash flows from investing activities:
Additions to furniture, fixtures and equipment (297) (289) (197)
------- ------- --------
Net cash used in investing activities (297) (289) (197)
------- ------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock - - 499
----------- -----------
Net cash provided by financing activities - - 499
----------- -----------
Net increase (decrease) in cash and cash equivalents 341 (435) 1,591
Cash and cash equivalents, beginning of period 1,156 1,591 -
-------- --------
Cash and cash equivalents, end of period $ 1,497 $ 1,156 $ 1,591
======== ======== ========
SUPPLEMENTAL DISCLOSURE:
Cash paid during the period for income taxes $ 116 $ 288 $ 220
======== ======== ========
</TABLE>
See accompanying notes.
F-6
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements
1. ORGANIZATION, RESTRUCTURING, AND NATURE OF OPERATIONS
ILM II Lease Corporation ("the Company") was organized as a corporation
on September 12, 1994 under the laws of the state of Virginia. Through
August 31, 1995, the Company had no significant operations. The Company was
formed by ILM II Senior Living, Inc. ("ILM II"), formerly PaineWebber
Independent Living Mortgage Inc. II, to operate six rental housing projects
that provide independent-living and assisted-living services for
independent senior citizens ("the Senior Housing Facilities") under a
master lease agreement. ILM II initially made mortgage loans to Angeles
Housing Concepts, Inc. ("AHC") secured by the Senior Housing Facilities
between July 1990 and July 1992. In March 1993, AHC defaulted under the
terms of such mortgage loans and in connection with the settlement of such
default, title to the Senior Housing Facilities was transferred, effective
April 1, 1994, to certain majority-owned, indirect subsidiaries of ILM II,
subject to the mortgage loans. Subsequently, the indirect subsidiaries of
ILM II were merged into ILM II Holding, Inc. ("ILM II Holding"). As part of
the fiscal 1994 settlement agreement with AHC, AHC was retained as the
property manager for all of the Senior Housing Facilities pursuant to the
terms of a management agreement which was assigned to the Company as of
September 1, 1995. As discussed further in Note 6, the agreement with AHC
was terminated in July 1996.
ILM II has elected to be taxed as a Real Estate Investment Trust
("REIT") under the Internal Revenue Code of 1986, as amended ("the Code"),
for each taxable year of operations. In order to maintain its status as a
REIT, 75% of ILM II's annual gross income must be Qualified Rental Income
as defined by the Code. The rent paid by the residents of the Senior
Housing Facilities likely would not be deemed to be Qualified Rental Income
because of the extent of services provided to residents. Consequently, the
operation of the Senior Housing Facilities by ILM II or its subsidiaries
over an extended period of time could adversely affect ILM II's status as a
REIT. Therefore, ILM II formed the Company to operate the Senior Housing
Facilities, and by means of a distribution, transferred the ownership of
the common stock of the Company to the holders of ILM II common stock on
September 1, 1995 (see Note 4). Because the Company, which is taxed as a
regular C corporation, is no longer a subsidiary of ILM II, it can receive
service-related income without endangering the REIT status of ILM II.
The Company's sole business is the operations of the Senior Housing
Facilities. The Company leases the Senior Housing Facilities from ILM II
Holding, a majority-owned and consolidated affiliate of ILM II which
currently holds title to the Senior Housing Facilities, pursuant to a
master lease which commenced on September 1, 1995 and expires on December
31, 2000 (December 31, 1999 with respect to the Santa Barbara Facility)
(see Note 5). In July 1996, the Company terminated the property management
agreement with AHC and entered into a property management agreement (the
"Management Agreement") with Capital Senior Management 2, Inc. ("Capital")
to handle the day-to-day operations of the Senior Housing Facilities. Since
November 1996, Lawrence A. Cohen, who served as a Director of the Company
and President, Chief Executive Officer and Director of ILM I and ILM II
until July 28, 1998, has also served as Vice Chairman and Chief Financial
Officer of Capital Senior Living Corporation, an affiliate of Capital. As a
result, through July 28, 1998, the Management Agreement with Capital was
considered a related party transaction (see Note 3).
2. USE OF ESTIMATES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying financial statements have been prepared on the accrual
basis of accounting in accordance with generally accepted accounting
principles which require management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities as of August 31, 1998 and 1997 and
revenues and expenses for the years ended August 31, 1998, 1997 and 1996.
Actual results could differ from the estimates and assumptions used.
F-7
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
2. USE OF ESTIMATES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Furniture, fixtures and equipment are carried at the lower of cost,
reduced by accumulated depreciation, or fair value in accordance with FAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets To Be Disposed Of." Depreciation expense was provided on
a straight-line basis using an estimated useful life of 3 to 5 years. In
1998, the Company changed the estimated useful lives of its assets to the
lease termination date of December 31, 2000, as such assets are not subject
to repurchase by ILM II Holding. This increased depreciation expense by
$36,000.
Units at the Senior Housing Facilities are generally rented for terms
of twelve months or less. The base rent charged varies depending on the
unit size, with added fees collected for more than one occupant per unit
and for assisted living services. Included in the amount of base rent
charged are certain meals, housekeeping, medical and social services
provided to the residents of each Facility.
The Company rents the Facilities from ILM II Holding pursuant to a
multi-year operating lease. Rent expense is recognized on a straight-line
basis over the term of the lease agreement. Deferred rent payable
represents the difference between rent expense recognized on a
straight-line basis and cash paid for rent pursuant to the terms of the
lease agreement.
The Company's policy is to expense all advertising costs as incurred.
Advertising expenses were $688,000 $657,000 and $684,000 for the years
ended August 31, 1998, 1997 and 1996, respectively.
The cash and cash equivalents, receivables, accounts payable and
accrued liabilities appearing on the accompanying balance sheets represent
financial instruments for purposes of Statement of Financial Accounting
Standards No. 107, "Disclosures about Fair Value of Financial Instruments."
The carrying amount of these assets and liabilities approximates their fair
value as of August 31, 1998 due to the short-term nature of these
instruments.
Income tax expense is provided for using the liability method as
prescribed by Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes."
For purposes of reporting cash flows, cash and cash equivalents include
all highly liquid investments with original maturities of 90 days or less.
The Financial Accounting Standards Board issued, Statement No. 130,
Reporting Comprehensive Income, and Statement No. 131, Disclosures about
Segments of an Enterprise and Related Information, all effective for fiscal
1998. Statement No. 130 requires reporting and display of comprehensive
income and its components in the financial statements. Statement No. 131
requires reporting about operating segments and other disclosures about the
business in its annual and interim financial statements. The Company does
not believe adoption of these new Statements will have a material impact on
its financial statements.
3. RELATED PARTY TRANSACTIONS
The Company entered into an advisory agreement (the "Advisory
Agreement") with PaineWebber Lease Advisor, L.P. For discussion purposes,
PaineWebber Lease Advisors L.P. and all affiliates of PaineWebber will be
collectively referred to as ("PaineWebber"). Subject to the supervision of
and pursuant to the general policies set by the Company's Board of
Directors, assistance in the managing of the business of the Company was
provided by PaineWebber. Under the Advisory Agreement, the Company engaged
PaineWebber and PaineWebber agreed to use its best efforts to manage the
day-to-day affairs and operations of the Company and to provide
administrative services and facilities appropriate for such management. The
specific duties of PaineWebber under the Advisory Agreement included
recommending selections of providers of professional
F-8
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
3. RELATED PARTY TRANSACTIONS (CONTINUED)
and specialized services and handling other managerial functions with
respect to the Senior Housing Facilities. PaineWebber was also obligated to
provide office and clerical facilities adequate for the Company's
operations and to provide, or obtain others to provide, accounting,
custodial, funds collection and payment, stockholder communications, legal
and other services necessary in connection with the Company's operations.
The Advisory Agreement also obligated PaineWebber to handle or arrange for
the handling of the Company's financial and other records.
PaineWebber received a base fee in an amount equal to 0.5% of the gross
operating revenues of the Senior Housing Facilities operated by the Company
as compensation for its services. This fee amounted to $0, $58,000 and
$66,000 for the years ended August 31, 1998, 1997 and 1996, respectively.
In addition, PaineWebber is entitled to reimbursement for expenses incurred
in providing certain financial, accounting and investor communication
services to the Company. Included in general and administrative expense for
the year ended August 31, 1998, 1997 and 1996, are $0, $59,000 and $55,000,
respectively, representing reimbursements to PaineWebber for providing such
services to the Company. In performing its services under the Advisory
Agreement, PaineWebber was required to pay certain employment expenses of
its personnel, certain expenses of employees and agents of PaineWebber and
of directors, officers and employees of the Company who are also employees
of PaineWebber or its affiliates, and certain of its overhead and
miscellaneous administrative expenses relating to performance of its
functions under the Advisory Agreement. The Company was responsible for
reimbursing out-of-pocket expenses of directors, officers and employees of
the Company incurred by them exclusively in such capacity and for all other
costs of its operations.
At a meeting of the Boards of Directors of ILM II and an affiliated
entity, ILM Senior Living, Inc. ("ILM I") on January 10, 1997, PaineWebber
recommended the immediate sale of the Senior Housing Facilities operated by
the Company and held by ILM II as well as the Senior Housing Facilities
held by an affiliated entity, ILM Senior Living, Inc. ("ILM I"), by means
of a controlled auction to be conducted by PaineWebber, at no additional
compensation, with PaineWebber offering to purchase the Senior Housing
Facilities held by ILM I and ILM II for $127 million, thereby guaranteeing
the shareholders a "floor" price. The Senior Housing Facilities operated by
the Company under its master lease with ILM II Holding would represent
approximately $52 million of this amount. After taxes and closing costs,
net proceeds to ILM II would equal approximately $48 million or
approximately $9.36 per share of ILM II common stock. PaineWebber also
stated that if it purchased the properties at the specified price and were
then able to resell the properties at a higher price, PaineWebber would pay
any "excess profits" to the shareholders. To assist the Company and ILM II
in evaluating PaineWebber's proposal, NatWest Securities, a disinterested,
independent investment banking firm with expertise in healthcare REITs and
independent/assisted living financings was engaged by the Company, ILM I
and ILM II, and their affiliates. Following a comprehensive analysis, the
investment banking firm recommended that PaineWebber's proposal should be
declined and that instead investigation of expansion and restructuring
alternatives should be pursued. After analyzing PaineWebber's proposal and
the recommendations and other information provided by the independent
investment banking firm, the Boards of ILM I and ILM II voted unanimously
to decline PaineWebber's proposal and to explore the alternatives
recommended by the independent investment banking firm. The Boards declined
to seek an immediate sale of the properties because, in the Boards' view,
the liquidation price would not reflect the "going concern" values of ILM I
and ILM II and, therefore, would not maximize shareholder value. In
addition, the Boards did not consider it advisable to liquidate ILM I and
ILM II on the suggested terms several years prior to their scheduled
termination dates.
PaineWebber indicated to the Board in its January 10, 1997 proposal
that it would not wish to continue to serve as advisor to ILM I, ILM II and
their affiliates if they declined to accept PaineWebber's proposal. ILM I
and ILM II accepted the resignation of PaineWebber effective June 18, 1997.
PaineWebber agreed to continue
F-9
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
3. RELATED PARTY TRANSACTIONS (CONTINUED)
to provide certain administrative services to ILM I, ILM II and their
affiliates through August 31, 1997, pursuant to the terms of a transition
services agreement entered into with ILM I, ILM II and their affiliates.
The Company, ILM I, ILM II, and their affiliates also accepted, effective
June 18, 1997, the resignations of those Officers and Directors who were
employees or otherwise affiliated with PaineWebber.
The Company and ILM II are continuing to review various strategic
alternatives to maximize shareholder value and liquidity and have engaged
professional financial and legal advisors to formulate and present plans
and proposals for consideration by the Board. Although no definitive plans,
arrangements or understandings have been agreed to at this time, ILM II is
actively reviewing the feasibility of a variety of financial transactions
and proposals, including the reorganization of the ownership of the Senior
Housing Facilities, business combinations with third parties and the sale
of ILM I by means of cash and or stock-for-stock merger. There can be no
assurance that any definitive transaction will be formulated, agreed to or
consummated.
The Company retained Capital to be the property manager of the Senior
Housing Facilities pursuant to a Management Agreement which commenced on
July 29, 1996. As discussed in Note 1, since November 1996, Lawrence A.
Cohen, who served as a Director of the Company as well as President, Chief
Executive Officer and Director of ILM II through July 28, 1998, has also
served as Vice Chairman and Chief Financial Officer of Capital Senior
Living Corporation, an affiliate of Capital. Under the Management
Agreement, Capital generally is required to perform all operational
functions necessary to operate the Senior Housing Facilities other than
certain administrative functions. The functions performed by Capital
include periodic reporting to and coordinating with the Company, leasing
the individual units in the Senior Housing Facilities, maintaining bank
accounts, maintaining books and records, advertising and marketing the
Senior Housing Facilities, hiring and supervising on-site personnel, and
performing maintenance. Under the terms of the Management Agreement,
Capital earns a base management fee equal to 4% of the gross operating
revenues of the Senior Housing Facilities, as defined. Capital also earns
an incentive management fee equal to 25% of the amount by which the net
cash flow of the Senior Housing Facilities, as defined, exceeds a specified
base amount. Each August 31, beginning on August 31, 1997, the base amount
is increased based on the percentage increase in the Consumer Price Index
as well as 15% of Facility expansion costs. ILM II has guaranteed the
payment of all fees due to Capital under the terms of the Management
Agreement. Capital earned property management fees from the Company of
$899,000, $707,000 and $60,000 for the years ended August 31, 1998, 1997
and 1996, respectively.
On February 4, 1997, AHC filed a complaint in the Superior Court of the
State of California against Capital, Lawrence Cohen, and others alleging
that the defendants intentionally interfered with AHC's agreement (the
"California litigation"). The complaint sought damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to federal
district court in the Central District of California. At a Board meeting on
February 26, 1997, the Company's Board of Directors concluded that since
all of Mr. Cohen's actions relating to the California litigation were taken
either on behalf of the Company under the direction of the Board or as a
PaineWebber employee, the Company or its affiliates should indemnify Mr.
Cohen with respect to any expenses arising from the California litigation,
subject to any insurance recoveries for those expenses. Legal fees paid by
the Company and Lease I on behalf of Mr. Cohen totaled $227,000 as of
August 31, 1998. The Company's Board also concluded that, subject to
certain conditions, the Company or its affiliates should advance up to
$20,000 to pay reasonable legal fees and expenses incurred by Capital in
the California litigation. Subsequently, the Boards of the Company and
Lease I voted to increase the maximum amount of the advance to Capital to
$100,000. On February 2, 1998, the amount to be advanced to Capital was
increased to include 75% of the California litigation legal fees and costs
incurred by Capital for December 1997 and January 1998 plus 75% of such
legal fees and costs incurred by Capital thereafter, not to exceed
$500,000. By August 31, 1998, Capital had incurred $683,000 of legal
expenses in the California litigation. At August 31, 1998, $208,000 of
legal fees have been either advanced or accrued in the Company's financial
statements and
F-10
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
3. RELATED PARTY TRANSACTIONS (CONTINUED)
$311,000 of legal fees have either been advanced or accrued in Lease I's
financial statements for Capital's California litigation costs, although
the final amount to be reimbursed to Capital has not yet been determined.
On September 18, 1997, the Company entered into an agreement with
Capital Senior Development, Inc., an affiliate of Capital, to manage the
development process for the potential expansions of the Senior Housing
Facilities. Capital Senior Development, Inc. will receive a fee equal to 7%
of the total development costs of these expansions if they are pursued. ILM
II Holding will reimburse the Company for all costs related to these
potential expansions including fees to Capital Senior Development, Inc. For
the years ended August 31, 1998 and 1997, Capital Senior Development, Inc.
earned fees from the Company of $73,000 and $0, respectively, for managing
pre-construction development activities for potential expansions of the
Senior Housing Facilities.
Jeffry R. Dwyer, Secretary and Director of the Company, is a
shareholder of Greenberg Traurig, which began acting as Counsel to the
Company and its affiliates in late fiscal 1997. For the years ended August
31, 1998 and 1997, Greenberg Traurig earned fees from the Company of
$153,000 and $0, respectively.
Accounts receivable - related party at August 31, 1998 is an insurance
refund due to the Company from Lease I in the amount of $102,000 ($0 in
1997). Accounts payable - related party at August 31, 1998 and 1997
includes $287,000 and $152,000, respectively, for variable rent due to ILM
II Holding.
4. CAPITAL STOCK
Prior to September 1, 1995, the Company was a wholly-owned subsidiary
of ILM II. Pursuant to a reorganization and distribution agreement, ILM
capitalized the Company with $500,000, an amount estimated to provide the
Company with necessary working capital. On September 1, 1995, MAVRICC
Management Systems, Inc., as the distribution agent, caused to be issued on
the stock records of the Company the distributed Common Stock of the
Company, in uncertificated form, to the holders of record of ILM II Common
Stock at the close of business on July 14, 1995. One share of the Company's
Common Stock was distributed for each outstanding share of ILM II Common
Stock. No certificates or scrip representing fractional shares of the
Company's Common Stock were issued to holders of ILM II Common Stock as
part of the distribution. In lieu of receiving fractional shares, each
holder of ILM II Common Stock who would otherwise have been entitled to
receive a fractional share of the Company's Common Stock received a cash
payment equivalent to $0.14 per share for such fractional interest.
5. THE MASTER LEASE AGREEMENT
ILM II Holding (the "Lessor") has leased the Senior Housing Facilities
to the Company (the "Lessee") pursuant to a master lease which commenced on
September 1, 1995. Under the terms of the master lease, which has a
scheduled expiration date of December 31, 2000 (December 31, 1999 with
respect to the Santa Barbara Facility), the Lessor has the right to
terminate the master lease as to any Facility sold as of the date of such
sale. The master lease is accounted for as an operating lease in the
Company's financial statements.
F-11
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
5. THE MASTER LEASE AGREEMENT (CONTINUED)
Descriptions of the properties covered by the master lease between the
Company and ILM II Holding are summarized as follows:
<TABLE>
<CAPTION>
YEAR
FACILITY RENTABLE RESIDENT
NAME LOCATION BUILT UNITS (2) CAPACITY (2)
---- -------- ----- --------- ------------
<S> <C> <C> <C> <C>
The Palms Fort Myers, FL 1988 205 255
Crown Villa Omaha, NE 1992 73 73
Overland Park Place Overland Park, KS 1984 141 153
Rio Las Palmas Stockton, CA 1988 164 190
The Villa at Riverwood St. Louis County, MO 1986 120 140
Villa Santa Barbara (1) Santa Barbara, CA 1979 125 125
</TABLE>
(1) The Company operates Villa Santa Barbara under a co-tenancy
arrangement with an affiliated company, ILM I Lease Corporation
("Lease I"). The Company has entered into an agreement with Lease I
regarding such joint tenancy. Lease I was formed for similar
purposes as the Company by an affiliated company, ILM Senior Living,
Inc. ("ILM I"), a subsidiary of which owns 25% of the Villa Santa
Barbara property. The portion of the Senior Housing Facility leased
by the Company represents 75% of the total project. Villa Santa
Barbara is 25% owned by ILM Holding Inc. and 75% by ILM II Holding,
Inc., a direct subsidiary of ILM II, as tenants in common. Upon the
sale of ILM I or ILM II, arrangements would be made to transfer the
Santa Barbara facility to the non-selling joint tenant (or one of
its subsidiaries). The property was extensively renovated in 1995.
(2) Rentable units represent the number of apartment units and is a
measure commonly used in the real estate industry. Resident capacity
equals the number of bedrooms contained within the apartment units
and corresponds to measures commonly used in the healthcare
industry.
During the term of the master lease, the Company is obligated to pay
annual base rent for the Senior Housing Facilities. For calendar year 1996
and subsequent years, the annual base rent is $4,035,600, allocated as
follows: $966,439 for the Florida Facility, $615,240 for the Nebraska
Facility, $819,074 for the Kansas Facility, $672,576 for the Stockton,
California Facility, $482,098 for the Missouri Facility and $480,173 for
the Santa Barbara, California Facility. The master lease is a "triple-net"
lease whereby the Lessee pays all operating expenses, governmental taxes
and assessments, utility charges and insurance premiums, as well as the
costs of all required maintenance, personal property and non-structural
repairs in connection with the operation of the Senior Housing Facilities.
ILM II Holding, as the Lessor, is responsible for all major capital
improvements and structural repairs to the Senior Housing Facilities. In
addition, beginning in January 1997 and for the remainder of the lease
term, the Company is also obligated to pay variable rent for each Senior
Housing Facility. Such
F-12
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
5. THE MASTER LEASE AGREEMENT (CONTINUED)
variable rent is payable quarterly and equals 40% of the excess, if any, of
the aggregate total revenues for the Facilities, on an annualized basis,
over $13,021,000. Variable rental expense related to fiscal years 1998 and
1997 was $984,000 and $412,000, respectively.
Under the master lease, the Company's use of the Senior Housing
Facilities is limited to use as a Senior Housing Facility unless the
Lessor's consent to some other use is obtained. The Company has
responsibility to obtain and maintain all licenses, certificates and
consents needed to use and operate each Facility, and to use and maintain
each Senior Housing Facility in compliance with all local board of health
and other applicable governmental and insurance regulations. The Senior
Housing Facilities located in California, Florida and Kansas are licensed
by such states to provide assisted living services. Also, various health
and safety regulations and standards which are enforced by state and local
authorities apply to the operation of all of the Senior Housing Facilities.
Violations of such health and safety standards could result in fines,
penalties, closure of a Senior Housing Facility or other sanctions.
6. LEGAL PROCEEDINGS AND CONTINGENCIES
A management agreement between ILM II Holding and AHC which covered the
management of all six Senior Housing Facilities was assigned to the Company
effective September 1, 1995. On July 29, 1996, the Company and ILM II
Holding ("the Companies") terminated the property management agreement with
AHC. The management agreement was terminated for cause pursuant to the
terms of the contract. Simultaneously with the termination of the
management agreement, the Companies, together with certain affiliated
entities, filed suit against AHC in the United States District Court for
the Eastern District of Virginia for breach of contract, breach of
fiduciary duty and fraud. The Company and ILM II Holding alleged, among
other things, that AHC willfully performed actions specifically in
violation of the agreement and that such actions caused damages to the
Companies.
Due to the termination of the agreement for cause, no termination fee
was paid to AHC. Subsequent to the termination of the agreement, AHC filed
for protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic
state of California. The filing was challenged by the Companies, and the
Bankruptcy Court dismissed AHC's case effective October 15, 1996. In
November 1996, AHC filed with the Virginia District Court an Answer in
response to the litigation initiated by the Companies and a counterclaim
against ILM II Holding. The counterclaim alleged that the agreement was
wrongfully terminated for cause and requested damages which include the
payment of the termination fee in the amount of $750,000, payment of
management fees pursuant to the contract from August 1, 1996 through
October 15, 1996, which is the earliest date that the management agreement
could have been terminated without cause, and recovery of attorney's fees
and expenses. The aggregate amount of damages against all parties as
requested in AHC's counterclaim exceeded $2,000,000. ILM II had guaranteed
the payment of the termination fee at issue in these proceedings to the
extent that any termination fee would be deemed payable by the court and in
the event that the Company fails to perform pursuant to its contractual
obligations. On June 13, 1997 and July 8, 1997, the court issued orders to
enter judgment against ILM I and ILM II in the amount of $1,000,000 (the
"Orders"). The Orders do not contain any findings of fact or conclusions of
law. On July 10, 1997, the Company, ILM I, ILM II and Lease I filed a
notice of appeal to the United States Court of Appeals for the Fourth
Circuit from the Orders.
On February 4, 1997, AHC filed a complaint in the Superior Court of the
State of California against Capital, Lawrence Cohen, and others alleging
that the defendants intentionally interfered with AHC's agreement (the
"California litigation"). The complaint sought damages of at least
$2,000,000. On March 4, 1997, the defendants removed the case to federal
district court in the Central District of California. At a Board meeting on
February 26, 1997, the Company's Board of Directors concluded that since
all of Mr. Cohen's actions relating to the California litigation were taken
either on behalf of the Company under the direction of
F-13
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
6. LEGAL PROCEEDINGS AND CONTINGENCIES (CONTINUED)
the Board or as a PaineWebber employee, the Company or its affiliates
should indemnify Mr. Cohen with respect to any expenses arising from the
California litigation, subject to any insurance recoveries for those
expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen
totaled $227,000 as of August 31, 1998. The Company's Board also concluded
that, subject to certain conditions, the Company or its affiliates should
advance up to $20,000 to pay reasonable legal fees and expenses incurred by
Capital in the California litigation. Subsequently, the Boards of the
Company and Lease I voted to increase the maximum amount of the advance to
Capital to $100,000. On February 2, 1998, the amount to be advanced to
Capital was increased to include 75% of the California litigation legal
fees and costs incurred by Capital for December 1997 and January 1998 plus
75% of such legal fees and costs incurred by Capital thereafter, not to
exceed $500,000. By August 31, 1998, Capital had incurred $683,000 of legal
expenses in the California litigation. At August 31, 1998, $208,000 of
legal fees have been either advanced or accrued in the Company's financial
statements and $311,000 of legal fees have either been advanced or accrued
in Lease I's financial statements for Capital's California litigation
costs, although the final amount to be reimbursed to Capital has not yet
been determined.
On August 18, 1998, the Company and its affiliates along with Capital
and its affiliates entered into a settlement agreement with AHC. The
Company and Lease I agreed to pay $1,625,000 and Capital and its affiliates
agreed to pay $625,000 to AHC in settlement of all claims, including those
related to the Virginia litigation and the California litigation. The
Company and its affiliates also entered into an agreement with Capital and
its affiliates to mutually release each other from all claims that any such
parties may have against each other, other than any claims under the
property management agreements. The Company's Board of Directors believes
that settling the AHC litigation is a prudent course of action because the
settlement amount represents a small percentage of the increases in cash
flow and value achieved for the Company and its affiliates over the past
two years.
Due to the Order, $1,000,000 had been recorded as a liability by the
Company and Lease I at the end of fiscal year 1997. At August 31, 1997, a
provision of $400,000 for the liability which might have resulted to the
Company had been recorded on the Company's financial statements as
"termination fee payable" with the remaining $600,000 provision recorded on
the financial statements of Lease I. Due to the final settlement agreement,
the 1997 provisions were increased by $625,000 at August 31, 1998, with an
additional $250,000 recorded on the financial statements of the Company and
the remaining $375,000 recorded on the financial statements of Lease I.
Subsequent to the end of the fiscal year, on September 4, 1998, the full
settlement amounts were paid to AHC and its affiliates.
F-14
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
7. FEDERAL INCOME TAXES
The Company is taxable as a regular C corporation and, therefore, its
income is subject to tax at the federal and state levels. The Company
reports on a calendar year for tax purposes. Income taxes at the
appropriate statutory rates have been provided for in the accompanying
financial statements.
Deferred income tax benefit reflects the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax purposes.
The Company's deferred tax assets and liabilities as of August 31, 1998 and
1997, are comprised of the following amounts (in thousands):
<TABLE>
<CAPTION>
1998 1997
------- -------
<S> <C> <C>
Deferred tax asset - straight-line rent expense $28 $40
Deferred tax asset - book over tax depreciation 44 11
Deferred tax asset - book over tax amortization 30 45
Deferred tax asset - termination fee - 160
Net operating loss carryforward (expires 2013) 168 -
----- ------
Net deferred tax asset $270 $256
==== ====
</TABLE>
The 1997 deferred tax provision reflects a reclassification of
$160,000 of current tax expense in 1997 which was ultimately determined to
be deductible in 1998.
The components of income tax expense (benefit) for fiscal 1998, 1997
and 1996 are as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
--------- ------ ------
<S> <C> <C> <C>
Current:
Federal $ - $ 162 $179
State - 29 32
--------- ----- -----
- -- --
Total current - 191 211
--------- ----- -----
Deferred:
Federal (12) (185) (32)
State (2) (33) (6)
--------- ----- -----
--------- ----- -----
Total deferred (14) (218) (38)
--------- ----- -----
$(14) $(27) $173
--------- ----- -----
--------- ----- -----
</TABLE>
The reconciliation of income tax computed for fiscal 1998, 1997 and
1996, at U.S. federal statutory rates to income tax expense (benefit) is as
follows (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
------------------ ---------------- -----------------
<S> <C> <C> <C> <C> <C> <C>
Tax at U.S. statutory rates (12) (34%) $(23) (34%) $147 34%
State income taxes, net
of federal tax benefit (2) (6%) (6%) (4) 26 6%
--- ----- ----- ----- ---- ---
$(14) (40%) $(27) (40%) $173 40%
===== ===== ===== ===== ==== ===
</TABLE>
F-15
<PAGE>
ILM II LEASE CORPORATION
Notes to Financial Statements (continued)
8. SUBSEQUENT EVENT
On February 11, 1999, the Company's Board of Directors elected Jeffry
R. Dwyer to the office of Chief Operating Officer.
F-16
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE BALANCE
SHEET AS OF AUGUST 31, 1998 AND THE STATEMENT OF INCOME FOR THE PERIOD ENDED
AUGUST 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> AUG-31-1998
<PERIOD-END> AUG-31-1998
<CASH> 1,497
<SECURITIES> 0
<RECEIVABLES> 399
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 1,896
<PP&E> 783
<DEPRECIATION> 225
<TOTAL-ASSETS> 2,733
<CURRENT-LIABILITIES> 1,960
<BONDS> 0
0
0
<COMMON> 52
<OTHER-SE> 645
<TOTAL-LIABILITY-AND-EQUITY> 2,733
<SALES> 15,481
<TOTAL-REVENUES> 15,524
<CGS> 0
<TOTAL-COSTS> 15,560
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (36)
<INCOME-TAX> (14)
<INCOME-CONTINUING> (22)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (22)
<EPS-BASIC> .00
<EPS-DILUTED> .00
</TABLE>
