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FirstCity Financial 10-K 2006 Documents found in this filing:
Use these links to rapidly review the document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Form 10-K
Commission file number 033-19694 FirstCity Financial Corporation
Securities registered pursuant to Section 12(g) of the Act: Title of Each Class Indicate by check mark if the registrant: is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý Indicate by check mark if the registrant: is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý 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 ý No o 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. o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check One) Large accelerated filer o Accelerated filer ý Non-accelerated filer o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý The aggregate market value of the voting and non-voting common equity held by non-affiliates, based upon the closing price of the common stock on the Nasdaq National Market System as of June 30, 2005, was approximately $104,527,351. The number of shares of common stock outstanding at March 8, 2006, was 11,307,187.
None.
Some of the statements in this report constitute forward-looking statements by words such as "believe," "expect," "anticipate," "optimistic," "intend," "plan," "aim," "will," "may," "should," "could," "would," "likely," "estimate," "predict," "potential," or "continue" or other similar expressions. Under "Item 1A. Risk Factors.", we discuss certain factors that affect our business and operations and factors that may cause our actual results to differ materially from these forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any forward-looking statements. 2 General FirstCity Financial Corporation (the "Company", "FirstCity," "we" or "us"), a Delaware corporation, is a financial services company headquartered in Waco, Texas with offices throughout the United States and Mexico and a presence in Europe and South America. The Company began operating in 1986 as a specialty financial services company focused on acquiring and resolving distressed loans and other assets purchased at a discount relative to the aggregate unpaid principal balance of the loans or the appraised value of the other assets ("Face Value"). To date the Company has acquired, for its own account and through various affiliated partnerships, pools of assets or single assets (collectively referred to as "Portfolio Assets" or "Portfolios") with a Face Value of approximately $8.7 billion. The Company's servicing expertise, which it has developed largely through the resolution of distressed assets, is a cornerstone of its growth strategy. Today the Company is engaged in one reportable business segment—Portfolio Asset acquisition and resolution. See Note 8 of the Company's Consolidated Financial Statements for certain financial information about this segment of the Company. The Company's consumer lending operations have been discontinued as of September 21, 2004. The only asset remaining from discontinued mortgage operations is an investment security resulting from the retention of a residual interest in a securitization transaction. See Note 3 of the Consolidated Financial Statements. Securities Exchange Act Reports and Additional Information FirstCity makes available free of charge on or through its website at www.fcfc.com, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K and other information releases including all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission ("SEC"). Also, the SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC. The public can obtain any documents that the Company files with the SEC at www.sec.gov. Business Strategy The Company's core business is the acquisition, management, servicing and resolution of Portfolio Assets. Key elements of the Company's overall business strategy include:
3 Background The Company began operating in the financial service business in 1986 as a purchaser of distressed assets from the Federal Deposit Insurance Corporation ("FDIC") and the Resolution Trust Corporation ("RTC"). From its original office in Waco, Texas, with a staff of four professionals, the Company's asset acquisition and resolution business grew to become a significant participant in an industry fueled by the problems experienced by banks and thrifts throughout the United States. In the late 1980s, the Company also began acquiring assets from healthy financial institutions interested in eliminating nonperforming assets from their portfolios. The Company began its relationship with Cargill in 1991. Since that time, the Company and Cargill have formed a series of Acquisition Partnerships through which they have jointly acquired over $7.5 billion in Face Value of Portfolio Assets. In July 1995, the Company acquired by merger (the "Merger") First City Bancorporation of Texas, Inc. ("FCBOT"), a former bank holding company that had been engaged in a proceeding under Chapter 11 of the United States Bankruptcy Code since November 1992. As a result of the Merger, the Common Stock of the Company became publicly held. In addition, as a result of the Merger, the Company retained FCBOT's rights to approximately $596 million in NOLs, which the Company uses to offset taxable income generated by the Company and its consolidated subsidiaries. In July 1997, the Company acquired Harbor Financial Group, Inc. and its subsidiaries (collectively referred to as "Mortgage Corp."), a company engaged in the residential and commercial mortgage banking business since 1983, and expanded into related niche financial services markets, such as mortgage conduit banking, conducted through one of its subsidiaries, FC Capital Corp. ("Capital Corp."), and consumer finance, conducted through another of its subsidiaries, FirstCity Consumer Lending Corporation ("Consumer Corp."). In 1999, Harbor Financial Group, Inc., Harbor Financial Mortgage Corporation ("Harbor") and four subsidiaries of Harbor filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code. These bankruptcy proceedings were later converted to liquidation proceedings under Chapter 7 of the United States Bankruptcy Code. Effective during the third quarter of 1999, management of the Company adopted formal plans to discontinue the operations of Mortgage Corp. and Capital Corp. These entities comprised the operations that were previously reported as the Company's mortgage banking operations, including the operations of Harbor. Because the Company formally adopted plans to discontinue the operations of Mortgage Corp. and Capital Corp., and operations at each such entity have ceased, the results of historical operations for Mortgage Corp. and Capital Corp. have been reflected as discontinued mortgage operations. As a result of the liquidity constraints created by the discontinued operations of Mortgage Corp. and Capital Corp., in the third quarter of 2000, Consumer Corp. completed the sale of a 49% equity interest in its automobile finance operation to IFA Drive GP Holdings LLC ("IFA-GP") and IFA Drive LP Holdings LLC ("IFA-LP"), wholly-owned subsidiaries of BoS(USA), Inc. ("BoS(USA)"), a wholly-owned subsidiary of Bank of Scotland, for a purchase price of $15 million cash and resulted in a gain of $12.1 million ($4 million was deferred and recognized in the December 2002 recapitalization discussed below). Simultaneously, the Bank of Scotland, BoS(USA) and the Company completed a debt restructure whereby the Company reduced the outstanding debt under its senior and subordinate facilities from $113 million to approximately $44 million. The Company also retired approximately $6.4 million of debt owed to other lenders. In December 2002, FirstCity completed a recapitalization in which holders of FirstCity's redeemable preferred stock, par value $.01 per share ("New Preferred Stock"), representing 89.3% of the shares previously outstanding, exchanged 1,092,210 shares of New Preferred Stock for 2,417,388 shares of common stock and $10.5 million. FirstCity also recognized the $4 million gain (previously deferred) from the release of its guaranty of Drive's indebtedness to BoS(USA). BoS(USA)'s warrant to purchase 1,975,000 shares of non-voting common stock was cancelled. FirstCity also acquired the minority interest in 4 FirstCity Holdings held by Terry R. DeWitt, G. Stephen Fillip and James C. Holmes, each of whom were Senior Vice Presidents of FirstCity, by issuing 400,000 shares of common stock of the Company and a note payable with an imputed balance of $.6 million at December 31, 2005. This note is to be paid from incentive servicing fees received from the Mexican Acquisition Partnerships, with an aggregate payout to the note holders not to exceed $3.2 million. On November 1, 2004, FirstCity and certain of its subsidiaries completed the sale of its remaining 31% beneficial ownership interest in Drive Financial Services LP ("Drive") and its general partner, Drive GP LLC, to IFA-GP, IFA-LP and Drive Management LP ("MG-LP") for a total purchase price of $108.5 million in cash, which resulted in distributions and payments to FirstCity and Consumer Corp. in the aggregate amount of $86.8 million in cash from various sources. On December 30, 2004, FirstCity redeemed all of the outstanding shares of its New Preferred Stock at a total redemption price of $21.525 per share. The redemption price represented the liquidation preference of the New Preferred Stock plus the final normal quarterly dividend of $.525 per share. Portfolio Asset Acquisition and Resolution Business In the Portfolio Asset acquisition and resolution business, FirstCity primarily acquires loans in groups or portfolios that have experienced deterioration of credit quality between origination and the Company's acquisition of the loans. The amount paid for a loan reflects FirstCity's determination that it is probable the Company will be unable to collect all amounts due according to the loan's contractual terms. On January 1, 2005, FirstCity adopted the provisions of Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer ("SOP 03-3"). For loan portfolios acquired prior to January 1, 2005, FirstCity designated these loans as non-performing Portfolio Assets or performing Portfolio Assets. Such designation was made at the acquisition of the pool and does not change even though the actual performance of the loans may change. FirstCity accounts for all loans acquired after 2004 in accordance with SOP 03-3. See Note 1 of the consolidated financial statements for discussion of the impact of SOP 03-3, on FirstCity's accounting for Portfolio Assets in 2005. Portfolios are either acquired for FirstCity's own account or through investment entities formed with Cargill or one or more other co-investors (each such entity, an "Acquisition Partnership"). See "—Relationship with Cargill". To date, FirstCity and the Acquisition Partnerships have acquired over $8.7 billion in Face Value of assets, with FirstCity's equity investment being $389 million. In the early 1990s large quantities of nonperforming assets were available for acquisition from the RTC and the FDIC. Since 1993, sellers of nonperforming assets have included private sellers as well as government agencies such as the Small Business Administration. Private sellers include financial institutions, insurance companies, and other institutional lenders, both in the United States and in various foreign countries. As a result of mergers, acquisitions and corporate downsizing efforts, other business entities frequently seek to dispose of excess real estate or other financial assets not meeting the strategic needs of a seller. Sales of such assets improve the seller's balance sheet, reduce overhead costs, reduce staffing requirements and avoid management and personnel distractions associated with the intensive and time-consuming task of resolving loans and disposing of real estate. Consolidations within a broad range of industries, especially banking, have augmented the trend of financial institutions and other sellers packaging and selling asset portfolios to investors as a means of disposing of nonperforming loans or other surplus or non-strategic assets. 5 FirstCity acquires and manages Portfolio Assets, which are generally purchased at a discount to Face Value by FirstCity or through Acquisition Partnerships. The Portfolio Assets are generally nonhomogeneous assets, including loans of varying qualities that are unsecured or secured by diverse collateral types and real estate. Some of the secured Portfolio Assets are loans for which resolution is tied primarily to the real estate securing the loan, while others may be collateralized business loans, the resolution of which may be based either on real estate, business assets or other collateral cash flow. FirstCity seeks to resolve Portfolio Assets through (i) a negotiated settlement with the borrower in which the borrower pays all or a discounted amount of the loan, (ii) conversion of the loan into a performing asset through extensive servicing efforts followed by either a sale of the loan to a third party or retention of the loan by FirstCity or the Acquisition Partnerships or (iii) foreclosure and sale of the collateral securing the loan. FirstCity has substantial experience acquiring, managing and resolving a wide variety of asset types and classes. As a result, it does not limit itself as to the types of Portfolios it will evaluate and purchase. FirstCity's willingness to acquire Portfolio Assets is generally determined by factors including the information that is available regarding the assets in a Portfolio, the price at which the Portfolio can be acquired and the expected net cash flows from the resolution of such assets. FirstCity and the Acquisition Partnerships have acquired Portfolio Assets in virtually all 50 states, the Virgin Islands, Dominican Republic, Puerto Rico, Chile, France, Germany, Japan, Mexico, and Argentina. FirstCity believes that its willingness to acquire nonhomogeneous Portfolio Assets without regard to geographic location provides it with an advantage over certain competitors that limit their activities to either a specific asset type or geographic location. FirstCity also seeks to capitalize on emerging opportunities in foreign countries in which the market for nonperforming loans of the type generally purchased by FirstCity is less efficient than the market for such assets in the United States. FirstCity has a 20.43% effective interest in MCS et Associes ("MCS"), a French asset servicing company. FirstCity is, in conjunction with MCS and Cargill, actively pursuing opportunities to purchase pools of Portfolio Assets in France and other areas of Western Europe. In addition, FirstCity has offices in Guadalajara and Mexico City, Mexico that facilitate FirstCity's participation in acquisition of Portfolios in Mexico. Since 2004, FirstCity has also participated in Portfolio acquisitions in Germany and South America, primarily in Argentina. The following table presents selected data for the Portfolio Assets acquired by FirstCity: Portfolio Assets
6 Portfolio Purchases by Region
FirstCity develops its Portfolio Asset opportunities through a variety of sources. Since the activities or contemplated activities of expected sellers are generally publicized in industry publications and through other similar sources, FirstCity monitors such publications and similar sources. FirstCity also maintains relationships with a variety of parties involved as sellers or as brokers or agents for sellers. Many of the brokers and agents concentrate by asset type and have become familiar with FirstCity's acquisition criteria and periodically approach FirstCity with identified opportunities. In addition, business referrals from other investors in Acquisition Partnerships, repeat business from previous sellers, focused marketing by FirstCity and the nationwide presence of FirstCity are important sources of business. FirstCity identifies investment opportunities in foreign markets in much the same manner as in the United States. In varying degrees of volume and efficiency, the markets of Europe, Asia, and Latin America all include sellers of nonperforming assets. In some countries, such as Mexico, the government has taken a very active role in the management and orderly disposition of these types of assets. FirstCity's established presence in Mexico and France provides a strong base for the identification, valuation, and acquisition of assets in those countries, as well as in adjacent markets. FirstCity continues to identify partners who have contacts within various foreign markets and or can assist in locating Portfolio Asset opportunities with FirstCity. Prior to making an offer to acquire any Portfolio, FirstCity performs an extensive evaluation of the assets that comprise the Portfolio. If, as is often the case, the Portfolio Assets are nonhomogeneous, FirstCity will evaluate all individual assets determined to be significant to the total of the proposed purchase. If the Portfolio Assets are homogenous in nature, a sample of the assets comprising the Portfolio may be selected for evaluation. The evaluation of individual assets generally includes analyzing the credit and collateral file or other due diligence information supplied by the seller. Based upon such seller-provided information, FirstCity will undertake additional evaluations of the asset, that, to the extent permitted by the seller, will include site visits to, and environmental reviews of the property securing the 7 loan or the asset proposed to be purchased. FirstCity will also analyze relevant local economic and market conditions based on information obtained from its prior experience in the market or from other sources, such as local appraisers, real estate principals, realtors and brokers. The evaluation includes an analysis of an asset's projected cash flow and sources of repayment, including the availability of third party guarantees. FirstCity values loans (and other assets included in a portfolio) on the basis of its estimate of the present value of estimated cash flow to be derived in the resolution process. Once the cash flow estimates for a proposed purchase and the financing and partnership structure, if any, are finalized, FirstCity can complete the determination of its proposed purchase price for the targeted Portfolio Assets. Purchases are subject to purchase and sale agreements between the seller and the purchasing affiliate of FirstCity. The analysis and underwriting procedure in foreign markets follows the same extensive diligence philosophy as that employed by the Company domestically. Additional risks are evaluated in foreign markets, including economic factors (inflation or deflation), currency strength, short and long-term market stability and political concerns. These risks are evaluated and priced into the cost of the acquisition. After a Portfolio is acquired, FirstCity assigns the Portfolio Assets to account servicing officers who are independent of the personnel that performed the due diligence evaluation in connection with the purchase of the Portfolio. Portfolio Assets are serviced either at the Company's headquarters or in one of FirstCity's other offices. FirstCity may establish servicing operations in locations in close proximity to significant concentrations of Portfolio Assets. Such offices are reviewed for closing after the assets in the geographic region surrounding the office are substantially resolved. The assigned account servicing officer develops a business plan and budget for each asset based upon an independent review of the cash flow projections developed during the investment evaluation, physical inspections of assets or collateral underlying the related loans, evaluation of local market conditions and discussions with the relevant borrower. Budgets are periodically reviewed and revised as necessary. FirstCity employs loan-tracking software and other operational systems that are generally similar to systems used by commercial banks, but which have been enhanced to track both the collected and the projected cash flows from Portfolio Assets. FirstCity services, in all material respects, the Portfolio Assets owned for its own account, the Portfolio Assets owned by the Acquisition Partnerships and, to a very limited extent, certain Portfolio Assets owned by third parties. In connection with the Acquisition Partnerships in the United States, FirstCity generally earns a servicing fee, which is a percentage of gross cash collections generated rather than a management fee based on the Face Value of the asset being serviced. The rate of servicing fee charged is generally a function of the average Face Value of the assets within each pool being serviced (the larger the average Face Value of the assets in a Portfolio, the lower the fee percentage within the prescribed range), the type of assets and the level of servicing required on each asset. For the Mexican Acquisition Partnerships, FirstCity earns a servicing fee based on costs of servicing plus a profit margin. The Company also has certain consulting contracts with its Mexican investment entities pursuant to which the Company is entitled to additional compensation for servicing once a specified return to the investors has been achieved. The Acquisition Partnerships in France are serviced by MCS in which the Company maintains a 20.4% direct and indirect equity interest. Portfolio Assets are either acquired for the account of a subsidiary of FirstCity or through the Acquisition Partnerships. Portfolio Assets owned directly by a subsidiary of FirstCity may be funded with loans made by FirstCity to its subsidiaries, equity financing provided by an affiliate of Cargill, the Bank of Scotland or other third parties and secured debt that is recourse only to the Acquisition Partnership. 8 Each Acquisition Partnership is a separate legal entity, (generally a limited partnership, but may instead be a limited liability company, trust, corporation or other type of entity). FirstCity and an investor typically form a corporation to serve as the corporate general partner of each Acquisition Partnership. Generally, for domestic Acquisition Partnerships, FirstCity and another investor each own 50% of the general partner and a 49.5% limited partnership interest in the domestic Acquisition Partnership (the general partner owns the other 1% interest). Cargill or its affiliates are the investor in the vast majority of the Acquisition Partnerships currently in existence. See "—Relationship with Cargill." Certain institutional investors have also held limited partnership interests in the Acquisition Partnerships and may hold interests in the related corporate general partners. The Acquisition Partnerships are generally financed by debt, secured only by the assets of the individual entity, and are nonrecourse to the Company, its co-investors and the other Acquisition Partnerships. FirstCity believes that this legal structure insulates the Company and the other Acquisition Partnerships from certain potential risks, while permitting FirstCity to share in the economic benefits of each Acquisition Partnership. Senior secured acquisition financing by Bank of Scotland and Cargill provides the majority of the funding for the purchase of Portfolios. Senior acquisition financing is obtained at variable interest rates with negotiated spreads to the base rates. The terms of the senior acquisition debt of the Acquisition Partnerships often allow, under certain conditions, distributions to equity partners before the debt is repaid in full. Prior to maturity of the senior acquisition debt, the Acquisition Partnerships typically refinance the senior acquisition debt with long-term debt secured by the assets of the partnership. Such long-term debt generally accrues interest at a lower rate than the senior acquisition debt, has collateral terms similar to the senior acquisition debt, and permits distributions of excess cash flow generated by the Acquisition Partnership to the equity partners so long as the partnership is in compliance with applicable financial covenants. In foreign markets, FirstCity conducts analysis with respect to the establishment of ownership structures. Prior to investment, FirstCity, in conjunction with its co-investors, performs significant due diligence and planning on the tax, licensing, and other ownership issues of the particular country. As in the United States, each foreign Acquisition Partnership is a separate legal entity, generally formed as the equivalent of a limited liability company or a liquidating trust. Cargill, a diversified financial services company, is a wholly owned subsidiary of Cargill, Incorporated, which is generally regarded as one of the world's largest privately held corporations and has offices worldwide. Cargill and its affiliates provide significant debt and equity financing to the Acquisition Partnerships. In addition, FirstCity believes its relationship with Cargill significantly enhances FirstCity's credibility as a purchaser of Portfolio Assets and facilitates its ability to expand into related businesses and foreign markets. The Company, FirstCity Servicing Corporation, Cargill and its wholly owned subsidiary CFSC Capital Corp. II ("CFSC"), under the terms of Right of First Refusal Agreement, were parties to a Right of First Refusal Agreement and Due Diligence Reimbursement Agreement effective as of January 1, 1998, as amended (the "Right of First Refusal Agreement") from 1992 through February 1, 2006. The Right of First Refusal Agreement had a termination date of February 1, 2006 which would renew automatically for an additional year on an annual basis thereafter unless either party gave notice to the other of its desire to discontinue the arrangement six months prior to the termination date. Pursuant to the Right of First Refusal Agreement, if the Company received an invitation to bid on or otherwise obtain an opportunity to acquire Portfolio Assets in the United States, Mexico, Central America or South America within certain thresholds, CFSC had the option to participate in the proposed purchase through an Acquisition 9 Partnership. The Right of First Refusal Agreement was extended through February 28, 2006 while the parties negotiated the terms under which the Right of First Refusal Agreement might be extended. The Right of First Refusal Agreement terminated on February 28, 2006. The parties are continuing to negotiate the terms on which an arrangement similar to the Right of First Refusal Agreement might be entered into by the parties. The Right of First Refusal Agreement did not prohibit the Company from holding discussions with entities other than CFSC regarding potential joint purchases of interests in loans, receivables, real estate or other assets, provided that any such purchase was subject to CFSC's right to participate in the Company's share of the investment. The Right of First Refusal Agreement further provided that, subject to certain conditions, CFSC would pay to the Company a monthly amount to cover due diligence expense, plus 50% of the third party due diligence expenses incurred by the Company in connection with proposed asset purchases. The Right of First Refusal Agreement was a restatement and extension of a similar agreement entered into among the Company, certain members of the Company's management and Cargill in 1992. Future increases in the Company's investments in Portfolio Assets acquired from institutions and government agencies may be obtained through investment entities formed with Cargill, whereby Cargill shares a general partner interest, thereby capitalizing on the expertise of Cargill whose skills complement those of the Company. FirstCity has had a significant relationship with the Bank of Scotland or its subsidiaries since September 1997. FirstCity has a $95 million revolving acquisition facility that matures in November 2008. This facility is used to finance the senior debt and equity portion of distressed asset pool purchases and to provide for the issuance of Letters of Credit and working capital loans. The $95 million facility (i) allows loans to be made in Euros up to a maximum amount in Euros that is equivalent to $35 million, (ii) allows loans to be made for acquisition of Portfolio Assets originated in Latin America of up to $35 million, (iii) provides for an interest rate of Libor plus 2.50% to 2.75%, (iv) provides for a commitment fee of 0.20% of the unused balance of the revolving acquisition facility, (v) provides that the aggregate borrowings under the facility will not exceed 60% of the net present value of FirstCity's interest in Portfolio Assets held for the account of Acquisition Partnerships pledged to secure the acquisition facility, and (vi) provides for a reduction in the total loan commitment of $1.3 million per quarter, commencing on December 27, 2005. In August 2005, FH Partners, L.P., an indirect wholly-owned affiliate of FirstCity, and Bank of Scotland, acting through its New York branch ("BoS(USA)"),, as agent for itself as lender, entered into a Revolving Credit Agreement that provides a $50 million revolving portfolio acquisition facility for FH Partners, L.P. to be secured by all of the assets of FH Partners, L.P. The loan facility is used to finance portfolio and asset purchases. The facility (i) allows loans to be made for the acquisition of Portfolio Assets in the United States, (ii) provides that each loan may be in an amount of up to 70% of the net present value of the assets being acquired with the proceeds of the loan, (iii) provides that the aggregate outstanding balances of all loans will not exceed 65% of the net present value of the assets securing the loan facility, (iv) provides for an interest rate of LIBOR plus 2.0%, (v) provides for an annual commitment fee of 0.20% of the unused balance of the revolving acquisition facility, (vi) provides for a utilization fee of 0.75% of the amount of each loan made under the loan facility, (vii) provides for an upfront fee of $350,000, (viii) provides for facility fees of $100,000, for the period commencing on the Effective Date to but excluding the first anniversary thereof, $75,000, for the period commencing on the first anniversary of the Effective Date to but excluding the second anniversary thereof, and $50,000, for each subsequent one-year period, and (ix) provides for a maturity date of November 12, 2008. The obligations of FH Partners, L.P. under the Revolving Credit Agreement are guaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity. 10 BoS(USA) has a warrant to purchase 425,000 shares of the Company's voting Common Stock at $2.3125 per share. BoS(USA) is entitled under certain circumstances to additional warrants in connection with the existing warrant for 425,000 shares to retain its ability to acquire approximately 4.86% of the Company's voting Common Stock. The warrant will expire on August 31, 2010, if it is not exercised prior to that date. Historically, FirstCity has leveraged its expertise in asset resolution and servicing by investing in a wide variety of asset types across a broad geographic scope. FirstCity continues to follow this investment strategy and seeks expansion opportunities into new asset classes and geographic areas when it believes it can achieve attractive risk adjusted returns. The following items are significant elements of FirstCity's business strategy in the portfolio acquisition and resolution business:
Consumer Lending—Discontinued Operations On September 21, 2004, FirstCity and certain of its subsidiaries entered into a definitive agreement to sell the remaining 31% beneficial ownership interest in Drive and its general partner, Drive GP LLC, to IFA-GP, IFA-LP and MG-LP for a total purchase price of $108.5 million in cash, resulting in distributions and payments to FirstCity in the aggregate amount of $86.8 million in cash, from various sources. The sale was completed on November 1, 2004, and the net cash proceeds from these transactions were primarily used to pay off debt. Pursuant to Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the consolidated financial statements have been reclassified for all periods presented to reflect the operations, assets and liabilities of the consumer business segment as discontinued operations. The assets and liabilities of such operations have been classified as "Discontinued Consumer Assets Held for Sale" and "Liabilities from Discontinued Consumer Operations." Government Regulation Certain aspects of the Company's Portfolio Asset acquisition and resolution business are subject to regulation under various federal, state and local statutes and regulations that impose requirements and restrictions affecting, among other things, disclosures to obligors, the terms of secured transactions, collection, repossession and claims handling procedures, multiple qualification and licensing requirements for doing business in various jurisdictions, and other trade practices. 11 Competition The Portfolio Asset acquisition business is highly competitive. Some of the Company's principal competitors are substantially larger and better capitalized than the Company. Because of these resources, these companies may be better able than the Company to acquire Portfolio Assets, to pursue new business opportunities or to survive periods of industry consolidation. Generally, there are three aspects of the distressed asset business: due diligence, Portfolio management, and servicing. The Company is a major participant in all three areas. In comparison, certain of its competitors (including certain securities and banking firms) have historically competed primarily as portfolio purchasers and have customarily engaged other parties to conduct due diligence on potential Portfolio purchases and to service acquired assets, and certain other competitors (including certain banking and other firms) have historically competed primarily as servicing companies. The Company believes that its ability to acquire Portfolios for its own account and through Acquisition Partnerships will be an important component of the Company's overall future growth. Acquisitions of Portfolios are often based on competitive bidding, which involves the danger of bidding too low (which generates no business), or bidding too high (which could result in the purchase of a Portfolio at an economically unattractive price). Employees The Company had 214 employees as of December 31, 2005. No employee is a member of a labor union or party to a collective bargaining agreement. The Company believes that its relations with its employees are good. Foreign Operations We have investments in various Acquisition Partnerships and servicing entities in Europe and Central and South America. Revenues outside of the U.S. are a material part of our business, and they accounted for more than 40% of our consolidated revenue in each year in the three-year period ended December 31, 2005. See Note 8 to the Consolidated Financial Statements for the year ended December 31, 2005. In maintaining foreign operations, our business is exposed to risks inherent in such operations, including those of currency fluctuations. Information on currency exchange risk appears in Part II, Item 7A of this Annual Report on Form 10-K, which information is incorporated herein by reference. Financial information about geographic areas, including net sales and assets, for the years in the period ended December 31, 2005 appears in Note 8 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K, which information is incorporated herein by reference. 12 This section highlights specific risks that could affect our Company and its businesses. You should carefully consider each of the following risks and all of the other information set forth in this Annual Report on Form 10-K. Based on the information currently known to us, we believe that the following information identifies the most significant risk factors affecting our Company. However, the risks and uncertainties our Company faces are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. If any of the following risks and uncertainties develops into actual events or the circumstances described in the risks and uncertainties occur, these events or circumstances could have a material adverse effect on our business, financial condition or results of operations. These events could also have a negative effect on the trading price of our securities. We may not predict the availability of Portfolio Assets. Long-term cycles in the general economy affect the business of acquiring and resolving Portfolio Assets. We cannot predict our future annual acquisition volume of Portfolio Assets. Moreover, our future purchase of Portfolio Assets will depend on the availability of Portfolios offered for sale, the availability of capital and our ability to submit successful bids to purchase Portfolio Assets. Due to the highly competitive environment of the business of acquiring Portfolio Assets in the United States, we may be required to acquire Portfolio Assets at higher prices lowering our profit margins on the resolution of such Portfolios. To offset these changes in the domestic arena, we continue to develop our presence in other markets. Under certain circumstances, we may choose not to bid for Portfolio Assets that we believe cannot be acquired at attractive prices. As a result of all the above factors, we may be materially adversely affected by variations on our Portfolio Asset purchases, and the revenue derived from the resolution of such Portfolio Assets. It is likely that our actual experience will not be consistent with the assumptions underlying our Portfolio Asset performance and that the differences may be material and adverse. We determine the purchase price and carrying value of Portfolio Assets acquired by us by estimating expected future cash flows from such assets. We develop and revise such estimates based on our historical experience and current market conditions, and based on the discount rates that we believe are appropriate for the assets comprising the Portfolios. In addition, many obligors on Portfolio Assets have impaired or poor credit history, low income or other adverse credit events. We are subject to various risks associated with these borrowers, including, but not limited to, the risk that the borrowers will not satisfy their debt service obligations and that the realizable value of the assets securing their loans will not be sufficient to repay the borrowers' debt. If our Portfolio Asset performance differs from our assumptions and estimates, we may be materially adversely affected. Investments in and revenues from our foreign operations are subject to the risks associated with transactions involving foreign currencies. We have acquired, and manage and resolve, Portfolio Assets located in Europe and Latin America and are actively pursuing opportunities to purchase additional pools of distressed assets in these locations. Foreign operations are subject to various special risks, including currency translation risks, currency exchange rate fluctuations, exchange controls and different political, social and legal environments within such foreign markets. To the extent future financing in foreign currencies is unavailable at reasonable rates, we will be further exposed to currency translation risks, currency exchange rate fluctuations and exchange controls. In addition, earnings of foreign operations may be subject to foreign income taxes that reduce cash flow available to meet debt service requirements and our other obligations, which may be payable 13 even if we have no earnings on a consolidated basis. Fluctuation in our reported results from operations in foreign countries could materially adversely affect us. We may be materially adversely affected by fluctuation in interest rates. Most of our borrowings are at variable rates of interest. We will be materially impacted by fluctuations in interest rates. In addition, a substantial and sustained decline in interest rates may adversely impact the amount of distressed assets available for purchase by us. The value of our interest-earning assets and liabilities may be directly affected by the level of and fluctuations in interest rates, including the valuation of any residual interests in securitizations that would be severely impacted by increased loan prepayments resulting from declining interest rates. Our liquidity or ability to raise capital may be limited. The successful execution of our business strategy depends on our continued access to financing. In addition, we must also have access to liquidity to invest as equity or subordinated debt to meet our capital needs. We rely upon access to the capital markets and the cash flow from our subsidiaries to fund asset growth and to provide sources of liquidity. Our ability to issue and sell common equity (including securities convertible into, or exercisable or exchangeable for, common equity) is limited as a result of the tax laws relating to the preservation of the NOLs available to us as a result of the Merger. There can be no assurance that our funding relationships with commercial banks, investment banks and financial services companies (including the Bank of Scotland) will continue past their respective current maturity dates. If these credit facilities are not extended and we cannot find alternative funding sources on satisfactory terms, or at all, we may be materially adversely affected. See "Liquidity and Capital Resources." We may be materially adversely affected by the decline in value of collateral securing loans acquired for resolution. The value of the collateral securing loans acquired for resolution, as well as real estate or other acquired distressed assets, is subject to various risks, including uninsured damage, change in location or decline in value caused by use, age or market conditions. We may be materially adversely affected by any material decline in the value of such collateral. We may not have access to the estimated net operating loss carryforwards. We believe that, as a result of the Merger, approximately $596 million of NOLs were available to us to offset future taxable income as of December 31, 1995. Since December 31, 1995, we have generated an additional $132 million in tax operating losses, utilized $31 million of NOLs, written-off $84 million of NOLs, and had expiring NOLs of $38 million in 2005. Accordingly, as of December 31, 2005, we believe that we have approximately $575 million of NOLs available to offset future taxable income. Out of the total $575 million of NOLs, we estimate that we will be able to utilize $57 million, which equates to a $20 million deferred tax asset on our books and records. However, because our position in respect of the $596 million NOLs resulting from the Merger is based upon factual determinations and upon legal issues with respect to which there is uncertainty and because no ruling has been obtained from the Internal Revenue Service (the "IRS") regarding the availability of the NOLs to us, there can be no assurance that the IRS will not challenge the availability of such NOLs and, if challenged, that the IRS will not be successful in disallowing this portion of our NOLs, with the result that our $20 million deferred tax asset would be reduced or eliminated. Some of the NOLs may be carried forward to offset our future federal taxable income through the year 2021; however, the availability of some of the NOLs began to expire beginning in 2005. Our ability to utilize such NOLs will be severely limited if there is a more than 50% ownership change at our company 14 during a three-year testing period within the meaning of section 382 of the Internal Revenue Code of 1986, as amended (the "Tax Code"). If we were unable to utilize our NOLs to offset future taxable income, we would lose our ability to generate capital to support our expansion plans on a tax-advantaged basis, to offset our pretax income and our consolidated subsidiaries' pretax income, and to have access to the cash flow that would otherwise be represented by payments of federal tax liabilities. It is possible that our actual experience will not be consistent with the assumptions regarding recognition of deferred tax asset and that the differences may be material and adverse. As noted above, we have NOLs available for federal income tax purposes to offset future federal taxable income, if any, through the year 2021. A valuation allowance is provided to reduce the deferred tax assets to a level, which, more likely than not, will be realized. Realization is determined based on our management's expectation of generating sufficient taxable income in a look forward period over the next four years. The ultimate realization of the resulting net deferred tax asset is dependent upon generating sufficient taxable income prior to expiration of the net operating loss carryforwards. Although realization is not assured, management believes it is more likely than not that all of the recorded deferred tax asset, net of the allowance, will be realized. The amount of the deferred tax asset considered realizable, however, could be adjusted in the future if estimates of future taxable income during the carryforward period change. The change in valuation allowance represents a change in the estimate of the future taxable income during the carryforward period since the prior year-end and utilization of net operating loss carryforwards since the Merger. Our ability to realize the deferred tax asset is periodically reviewed and the valuation allowance is adjusted accordingly. See "Discussion of Critical Accounting Policies—Deferred Tax Asset." We may incur significant costs relating to removal of hazardous substances or waste from real property in its Portfolio Assets. We acquire through our subsidiaries and affiliates real property in our Portfolio Asset acquisition and resolution business. There is a risk that properties acquired by us could contain hazardous substances or waste, contaminants or pollutants. We may be required to remove such substances from the affected properties at our expense, and the cost of such removal may substantially exceed the value of the affected properties or the loans secured by such properties. Furthermore, we may not have adequate remedies against the prior owners or other responsible parties to recover our costs, either as a matter of law or regulation, or as a result of such prior owners' financial inability to pay such costs. We may find it difficult or impossible to sell the affected properties either prior to or following any such removal. We have evaluated the potential impact of Hurricanes Katrina and Rita, in order to determine the full extent of any losses experienced on the Gulf Coast. As a result of these hurricanes, our management has been diligently reviewing any exposure that we may have in the region. Based on information available as of the date of this report on Form 10-K, results have indicated that the hurricanes did not have a material impact on the consolidated financial statements. We may not be able to successfully compete in the business in which we operate. The business in which we operate is highly competitive. Some of our principal competitors are substantially larger and better capitalized than us. Because of their resources, these companies may be better able than us to acquire Portfolio Assets, to pursue new business opportunities or to survive periods of industry consolidation. Access to and the cost of capital are critical to our ability to compete. Many of our competitors have superior access to capital sources and can arrange or obtain lower cost of capital, resulting in a competitive disadvantage to us with respect to such competitors. 15 In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow these competitors to establish lower margin requirements and pricing levels than those established by us. In the event a significant number of competitors establish pricing levels below those established by us, our ability to compete would be materially adversely affected. We may be adversely affected by a general deterioration in economic conditions. Periods of economic slowdown or recession, or declining demand for commercial real estate or commercial or consumer loans may adversely affect our business. Periods of economic slowdown or recession, whether general, regional or industry-related, may adversely affect the resolution of Portfolio Assets, lead to a decline in prices or demand for collateral underlying Portfolio Assets, or increase the cost of capital invested by us and the length of time that capital is invested in a particular Portfolio. All or any one of these events could decrease the rate of return and profits to be realized from such Portfolio and materially adversely affect our consolidated financial position, results of operations and business prospects. We may be adversely affected by the regulated environment in which we operate. Some aspects of our business are subject to regulation, examination and licensing under various federal, state and local statutes and regulations that impose requirements and restrictions affecting, among other things, credit activities, maximum interest rates, finance and other charges, disclosures to obligors, the terms of secured transactions, collection, repossession and claims handling procedures, multiple qualification and licensing requirements for doing business in various jurisdictions, and other trade practices. We believe to be currently in compliance in all material respects with applicable regulations, but there can be no assurance that we will be able to maintain such compliance. Failure to comply with, or changes in, these laws or regulations, or the expansion of our business into jurisdictions that have adopted more stringent regulatory requirements than those in which we currently conduct business, could have an adverse effect on our company by, among other things, limiting the income we may generate on existing and additional loans, limiting the states in which we may operate or restricting our ability to realize on the collateral securing its loans. See "Item 1—Business—Government Regulation." We may be adversely affected by the result of certain legal proceedings. Periodically, our company, our subsidiaries, our affiliates and the Acquisition Partnerships are parties to or otherwise involved in legal proceedings arising in the normal course of business. We may be adversely affected by a termination of our relationship with Cargill. Our relationship with Cargill is material in a number of respects. Cargill, a subsidiary of Cargill, Incorporated, a privately held, multi-national agricultural and financial services company, provides equity and debt financings for many of the Acquisition Partnerships. Cargill owns approximately 1.97% of our outstanding Common Stock, and a Cargill designee, Jeffery Leu, is a member of our Board of Directors. We believe that our relationship with Cargill significantly enhances our credibility as a purchaser of Portfolio Assets and facilitates its ability to expand into other businesses and foreign markets. Although our management believes that our relationship with Cargill is excellent, there can be no assurance that such relationship will continue in the future. Absent such relationship, our company and the Acquisition Partnerships would be required to find alternative sources for the financing that Cargill has historically provided. There can be no assurance that such alternative financing would be available. Any termination of such relationship could have a material adverse effect on our consolidated financial position, results of operations and business prospects. 16 We may be adversely affected by a termination of employment of certain key personnel. We are dependent on the efforts of our senior executive officers, particularly James T. Sartain (President and Chief Executive Officer). We are also dependent on several of the key members of our management who are instrumental in developing and implementing the business strategy for the Company. In addition, our borrowing facilities include key personnel provisions. These provisions generally provide that if certain key personnel are no longer employed and suitable replacements are not found within a defined time limit, certain facilities become due and payable. We may be adversely affected by the inability or unwillingness of one or more of these individuals to continue in his present role. There can be no assurance that any of the foregoing individuals will continue to serve in his current capacity or for what time period such service might continue. We do not maintain key person life insurance for any of its senior executive officers. Our directors and executive officers may effectively control any vote of stockholders of our company. Our directors and executive officers collectively beneficially own 21.95% of the Common Stock. Although there are no agreements or arrangements with respect to voting such Common Stock among such persons except as described below, such persons, if acting together, may effectively be able to control any vote of our stockholders and thereby exert considerable influence over the affairs of our company. James T. Sartain, President and Chief Executive Officer of our company, is the beneficial owner of 5.22% of the Common Stock. There can be no assurance that the interests of management or the other entities and individuals named above will be aligned with our other stockholders. Restrictions on transfer of shares may prevent certain holders of our Common Stock from transferring such stock. Our Amended and Restated Certificate of Incorporation (the "Certificate of Incorporation") contains provisions restricting the transfer of its securities that are designed to delay, defer or prevent a change of control of our company by deterring unsolicited tender offers or other unilateral takeover proposals and compelling negotiations with our Board of Directors rather than non-negotiated takeover attempts even if such events may be in the best interests of our stockholders. Our Certificate of Incorporation also contains certain provisions restricting the transfer of securities in our company that are designed to prevent ownership changes that might limit or eliminate our ability to use our NOLs resulting from the Merger. Such restrictions may prevent certain holders of Common Stock from transferring such stock even if such holders are permitted to sell such stock without restriction under the Securities Act of 1933, as amended, and may limit our ability to sell Common Stock to certain existing holders of Common Stock at an advantageous time or at a time when capital may be required but unavailable from any other source. We may be adversely affected by period to period variances. The revenue of our company and Acquisition Partnerships is based on proceeds realized from the resolution of the Portfolio Assets, which proceeds have historically varied significantly and likely will continue to vary significantly from period to period. Consequently, our period-to-period revenue and results of operations have historically varied, and are likely to continue to vary, correspondingly. Such variances, alone or with other factors, such as conditions in the economy or the financial services industries or other developments affecting us, may result in significant fluctuations in our reported operations and in the trading prices of our securities, particularly the Common Stock. We may be adversely affected tax, monetary and fiscal policy changes. We originate and acquire financial assets, the value and income potential of which are subject to influence by various state and federal tax, monetary and fiscal policies in effect from time to time. The nature and direction of such policies are entirely outside our control, and we cannot predict the timing or 17 effect of changes in such policies. Changes in such policies could have a material adverse effect on our consolidated financial position, results of operations and business prospects. We may be adversely affected by changes in future cash receipts. We have in the past been able to establish with reasonable accuracy the estimated future cash receipts over the life of a purchased asset pool. Changes in economic conditions, fluctuations in interest rates, deterioration of collateral values, and other factors described in this section could cause the estimates of future cash flows to be materially different than actual cash receipts. The effects of an increase in the estimated future cash receipts would generally increase revenues from Portfolio Assets by increasing gross profit on a non-performing or real estate pool and increasing the effective yield on a performing or SOP 03-3 Portfolio while a decrease in future cash receipts would generally have the effect of reducing revenues by reducing gross profit on a non-performing or real estate pool and decreasing the effective yield on a performing or SOP 03-3 Portfolio. In some cases a reduction in the total future cash receipts by collecting those cash receipts sooner than expected could have a positive impact on our revenues from Portfolio Assets due to reduced interest expense and other carrying costs associated with the Portfolio Assets. Although such trend is a generally positive trend, we may be adversely affected by the higher levels of interest expense and other carrying costs of the Portfolios negating any potentially positive effects.
None. The Company occupies approximately 57,000 square feet of office space, all of which is leased. The Company leases its current headquarters building from a related party under a noncancellable operating lease, which expires December 31, 2006 with an option to renew for an additional five years. All leases of the other offices of the Company and subsidiaries expire prior to 2015. Such office space is suitable and adequate for the Company's current needs, and plan to utilize substantially all of our leased office space. The following is a list of the Company's principal physical properties leased as of December 31, 2005.
On January 19, 2005, Prudential Financial, Inc. filed a petition in interpleader seeking to interplead 321,211 shares of Prudential common stock and any associated dividends arising from the demutualization of Prudential Financial, Inc. in December 2000. The shares of Prudential common stock related to group annuity contracts purchased by First-City National Bank of Houston, as trustee of the First City Bancorporation Employee Retirement Trust (the "Trust") to fund obligations to participants in the First City Bancorporation Employee Retirement Plan (the "Plan") in connection with termination of the Plan and the Trust in 1987. FirstCity, FCLT Loans Asset Corp. ("FCLT"), as assignee of the FirstCity Liquidating Trust, JP Morgan Chase Bank, National Association ("JPMCB"), and First-City National Bank of Houston as trustee of the Trust were made defendants in the suit as claimants to the Prudential common 18 stock. An agreed order dated January 27, 2005, was entered providing that the Prudential common stock be transferred to JPMBC as record owner and for the sale of the stock. The January 27, 2005 court order also provided that the proceeds from the sale are to be held by JPMCB pending resolution, by agreement or court order, of all conflicting claims to the proceeds. JPMBC has indicated that the Prudential common stock was sold on January 28, 2005 for total proceeds of approximately $17.5 million. JPMCB also holds funds in the amount of approximately $489,000, which were dividend payments related to the Prudential common stock. FirstCity and FCLT have filed cross claims asserting ownership of the proceeds. JPMCB, in its capacity as successor trustee of the Trust filed an answer indicating that it was only acting in the suit in its capacity as trustee for the Trust. JPMBC also sought to add as additional parties to the suit a putative class of former employees of First City Bancorporation of Texas, Inc. (now FirstCity) who were participants in the Plan. JPMCB also seeks a declaration from the court as to whether the proceeds should be distributed to the successor of First City Bancorporation or to the putative class. Timothy Blair answered JPMCB's third party action and the class of former employees has been certified by the court. FCLT has included in its counterclaim against FirstCity claims for damages related to alleged breaches of contract by FirstCity related to failure to assign the proceeds to FCLT and FirstCity's assertion of a claim to the proceeds and a claim for tortious interference by FirstCity as a result of FirstCity's claim for the proceeds. FirstCity believes that the claims of FCLT are without merit and that it has valid defenses to these claims. Periodically, FirstCity, its subsidiaries, its affiliates and the Acquisition Partnerships are parties to or otherwise involved in legal proceedings arising in the normal course of business. While the outcome of the ordinary course legal proceedings, and the related activities, are not certain, based on present assessments, management does not believe that they will have a material adverse effect on the consolidated financial position, results of operations or liquidity of FirstCity, its subsidiaries, its affiliates or the Acquisition Partnerships.
No matters were submitted to a vote of security holders during the quarter ended December 31, 2005. 19
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. The Company's common stock, $.01 par value per share ("Common Stock") is traded on the Nasdaq Stock Market under the symbol FCFC. The number of holders of record of Common Stock on March 6, 2006 was approximately 768, as provided by American Stock Transfer, the Company's transfer agent. High and low stock prices for the Common Stock in the two years ended December 31, 2005 and December 31, 2004 are displayed in the following table:
The Company has never declared or paid a dividend on the Common Stock. The Company currently intends to retain future earnings to finance its growth and development and therefore does not anticipate that it will declare or pay any dividends on the Common Stock in the foreseeable future. Any future determination as to payment of dividends will be made at the discretion of the Board of Directors of the Company and will depend upon the Company's operating results, financial condition, capital requirements, general business conditions and such other factors that the Board of Directors deems relevant. Certain loan facilities to which the Company and its subsidiaries are parties contain restrictions relating to the payment of dividends and other distributions. There were no stock repurchases by the Company in the fourth quarter of 2005. 20
The following tables set forth selected consolidated financial information regarding the Company's results of operations and balance sheets. The data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Item 7 and with the related Consolidated Financial Statements and Notes thereto under Item 8 of this Annual Report on Form 10-K, respectively.
In December 2004, FirstCity redeemed all of the outstanding shares of its New Preferred Stock at a total redemption price of $21.525 per share. The redemption price represented the liquidation preference of the New Preferred Stock plus the fourth quarter 2004 dividend of $.525 per share. FirstCity completed the sale of its 31% investment in Drive in November 2004. As a result, the consumer lending segment conducted through Drive was no longer considered a principal reportable segment and is treated as a discontinued operation. The results of historical operations have been reflected as discontinued operations in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." In December 2002, FirstCity completed a recapitalization in which holders of the New Preferred Stock exchanged 1,092,210 shares of New Preferred Stock, representing 89.3% of the 1,222,901 shares previously outstanding, for 2,417,388 shares of common stock and $10.5 million. As a result, common equity was increased by $18.9 million. Upon the completion of the recapitalization, 130,691 shares of New Preferred Stock remained outstanding. During the first quarter of 2003, 4,400 shares of New Preferred Stock were redeemed for 8,200 shares of common stock and $50,000 in cash, leaving 126,291 shares outstanding at December 31, 2003. FirstCity also recorded a $4 million gain from the release of its guaranty of Drive's indebtedness to BoS(USA). BoS(USA)'s warrant to purchase 1,975,000 shares of non-voting common stock was cancelled in connection with the recapitalization. FirstCity issued 400,000 shares of common stock to acquire the minority interest in FirstCity Holdings Inc from Terry R. DeWitt, G. Stephen Fillip and James C. Holmes. 21
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements of the Company (including the Notes thereto) included elsewhere in this Annual Report on Form 10-K. Overview FirstCity is a financial services company engaged in the acquisition and resolution of portfolios of assets or single assets (collectively referred to as "Portfolio Assets"). The Portfolio Asset acquisition and resolution business involves acquiring Portfolio Assets at a discount to face value and servicing and resolving such portfolios in an effort to maximize the present value of the ultimate cash recoveries. During 2005, the Company recorded earnings to common stockholders on a diluted basis of $8.2 million or $0.69 per common share. The operating contribution from the Portfolio Asset acquisition and resolution segment was $13.8 million compared with $14.4 million for 2004. The Company was able to invest $71.4 million in portfolio acquisitions of $146.6 million during 2005 of which $58.6 million was invested in the United States, $10.6 million in Europe, and $2.2 million in Latin America. The 2005 investment level of $71.4 million represents the highest amount invested in a single year in the history of the Company's Portfolio Asset acquisition and resolution business. In the fourth quarter of 2004, FirstCity sold its 31% beneficial ownership interest in Drive. This sale generated a $53.3 million net gain ($54.4 million gain, net of $1.1 million in taxes) which was reflected in the 2004 results of the Company as "earnings from discontinued operations". The $86.8 million proceeds from the sale were primarily used to retire debt. Following the sale, FirstCity and Bank of Scotland restructured the then-existing $50 million revolving credit facility into a $96 million revolving acquisition facility that will mature in November 2008. The Company's financial results are affected by many factors including levels of and fluctuations in interest rates, fluctuations in the underlying values of real estate and other assets, the timing of and ability to liquidate assets, and the availability and prices for loans and assets acquired in all of the Company's businesses. The Company's business and results of operations are also affected by the availability of financing with terms acceptable to the Company and the Company's access to capital markets, including the securitization markets. As a result of the significant period to period fluctuations in the revenues and earnings of the Company's Portfolio Asset acquisition and resolution business, period to period comparisons of the Company's results of continuing operations may not be meaningful. Results of Operations The Company reported earnings from continuing operations of $8.1 million in 2005 compared to $5.0 million in 2004. Earnings from discontinued operations were $.2 million in 2005 and $58.6 million in 2004. Net earnings to common stockholders were $8.2 million in 2005 compared to $63.6 million in 2004. On a per share basis, diluted net earnings to common stockholders were $.69 in 2005 compared to $5.37 in 2004. The operating contribution of $13.8 million in 2005 decreased from $14.4 million in 2004. FirstCity purchased $147 million of Portfolio Assets during 2005 ($115 million through the Acquisition Partnerships) compared to $174 million in acquisitions in 2004. FirstCity's investment in these acquisitions was $71.4 million and $59.8 million in 2005 and 2004, respectively. FirstCity's year-end investment in wholly- 22 owned Portfolio Assets was $49.3 million at December 31, 2005 compared to $38.0 million at December 31, 2004. Servicing fee revenues. Servicing fee revenues decreased by 14% to $11.8 million in 2005 from $13.7 million in 2004. Service fees from the Latin American partnerships (including incentive service fees) decreased by $.7 million or 8% as a result of efforts to reduce operating costs in Mexico. For the Mexican Acquisition Partnerships, FirstCity earns a servicing fee based on costs of servicing plus a profit margin. Service fees from domestic Acquisition Partnerships decreased by $1.3 million or 26% due to lower collections. Gain on resolution of Portfolio Assets. The net gain on resolution of Portfolio Assets increased to $5.4 million in 2005 from $1.6 million in 2004. The gross profit percentage on the resolution of Portfolio Assets of 27% in 2005 was consistent with 2004. Equity in earnings of investments. Equity in earnings of investments decreased by 19% to $12.0 million in 2005 compared to $14.9 million in 2004. Equity earnings in Acquisition Partnerships decreased by 19% to $11.4 million in 2005 from $14.0 in 2004. Equity in earnings of servicing entities decreased by 32% to $.6 million in 2005 from $.9 million in 2004. Following is a discussion of equity earnings in Acquisition Partnerships by geographic region. See note 6 to the consolidated financial statements for a summary of revenues and earnings of the Acquisition Partnerships and equity in earnings of the Acquisition Partnerships.
Interest income. Interest income increased by 51% to $4.7 million in 2005 from $3.1 million in 2004. This increase is primarily due to increased purchases of wholly-owned Portfolios. Also, income on all Portfolios purchased in 2005 is reflected as interest income as a result of FirstCity adopting a new accounting pronouncement on January 1, 2005 (see note 1(e) to the consolidated financial statements). Other income. Other income was $1.7 million in 2005 compared to $2.1 million in 2004. This decrease was primarily due to a reduction in 2004 of the estimated carrying value of loans payable to certain members of management, which increased other income by $.8 million. See further discussion 23 related to these loans in note 7 of the consolidated financial statements. In 2005, the decrease was offset in part by an increase in reimbursements of due diligence expenses which will vary from period to period. Expenses. Operating expenses were $21.6 million in 2005 compared to $21.0 in 2004. Interest and fees on notes payable increased slightly to $4.0 million in 2005 compared to $3.8 million in 2004. The average debt for the period increased to $56.4 million in 2005 from $43.6 million in 2004; however, the average cost of borrowing declined to 7.1% in 2005 from 8.71% in 2004. Salaries and benefits decreased slightly to $12.1 million in 2005 from $12.4 million in 2004. Total personnel within the Portfolio Asset acquisition and resolution segment were 184 and 204 at December 31, 2005 and 2004, respectively. The provision for loan and impairment losses was $212,000 in 2005 and $30,000 in 2004. See note 1(e) of the consolidated financial statements for a detailed discussion on FirstCity's allowance for loan losses. Occupancy, data processing, communication and other expenses increased by 12% to $5.3 million in 2005 from $4.7 million in 2004 primarily due to higher property protection expenses. Minority interest expense was minimal from year to year. The following items affect the Company's overall results of operations and are not directly allocated to the Portfolio Asset acquisition and resolution business discussed above. Corporate interest and overhead. Company level interest expense was zero in 2005 compared to $3.4 million in 2004 as a result of the payoff of corporate debt in November 2004 from proceeds received on the sale of the Company's 31% beneficial interest in Drive. Other corporate overhead expenses (excluding taxes) decreased to $6.1 million in 2005 from $6.6 million in 2004. Income taxes. Provision for income taxes was $250,000 in 2005 and related primarily to state income taxes. Taxes in 2004 were $75,000 and related primarily to federal alternative minimum taxes. Federal income taxes are provided at a 35% rate applied to taxable income or loss and are offset by NOLs that the Company believes are available. The tax benefit of the NOLs is recorded in the period during which the benefit is realized. The Company recorded no deferred tax provision in 2005 and 2004. Discontinued Operations. The Company recorded a provision of $.4 million in 2005 for additional losses from discontinued mortgage operations compared to $3.8 million in 2004. At December 31, 2005, the only asset remaining from discontinued mortgage operations was an investment security resulting from the retention of a residual interest in a securitization transaction. This security is in "run-off," and the Company is contractually obligated to service the underlying asset. The assumptions used in the valuation model consider both industry as well as the Company's historical experience. As the security "runs off," assumptions are reviewed in light of historical evidence in revising the prospective results of the model. These revised assumptions could potentially result in either an increase or decrease in the estimated cash receipts. An additional provision is booked based on the output of the valuation model if deemed necessary. In April 2005, the Company exercised an early purchase option on the 1998-1 securitization. Loans receivable were recorded at $6.1 million in accordance with EITF 02-9, Accounting for Changes that Result in a Transferor Regaining Control of Financial Assets Sold. The transaction did not have an impact on the results of operations, but did result in the elimination of $.8 million of residual interest previously classified as discontinued mortgage assets. Earnings from discontinued consumer operations were $.5 million in 2005 compared to $62.5 million in 2004. On November 1, 2004, FirstCity completed the sale of its remaining 31% interest in Drive and 24 recognized at net gain of $53.3 million. During the third quarter of 2005, an estimated tax provision of $.6 million was reversed due to lower than anticipated state income taxes related to the sale. The Company reported earnings from continuing operations of $5.0 million in 2004 compared to $4.4 million in 2003. Earnings from discontinued operations were $58.6 million in 2004 and $4.8 million in 2003. Net earnings to common stockholders were $63.6 million in 2004 compared to $9.1 million in 2003. On a per share basis, diluted net earnings to common stockholders were $5.37 in 2004 compared to $.80 in 2003. The operating contribution of $14.4 million in 2004 decreased slightly from $14.5 million in 2003. FirstCity purchased $174 million of Portfolio Assets during 2004 ($136 million through the Acquisition Partnerships) compared to $129 million in acquisitions in 2003. FirstCity's investment in these acquisitions was $59.8 million and $22.9 million in 2004 and 2003, respectively. FirstCity's year-end investment in wholly-owned Portfolio Assets increased to $38.0 million from $4.5 million at December 31, 2004 and 2003, respectively. Servicing fee revenues. Servicing fee revenues decreased by 9% to $13.7 million in 2004 from $15.1 million in 2003. Service fees from the Latin American partnerships (including incentive service fees) decreased $1.3 million or 13% as a result of efforts to reduce operating costs in Mexico. For the Mexican Acquisition Partnerships, FirstCity earns a servicing fee based on costs of servicing plus a profit margin. Service Fees from the domestic Acquisition Partnerships were flat from year to year. Gain on resolution of Portfolio Assets. The net gain on resolution of Portfolio Assets increased from $1.4 million in 2003 to $1.6 million in 2004. The gross profit percentage on the resolution of Portfolio Assets in 2004 was 27% as compared to 18% in 2003 as a result of a payoff of three performing loans in July 2003 generating proceeds of $1.5 million and no gain. Equity in earnings of investments. Equity in earnings of Acquisition Partnerships increased 3% to $14.0 million in 2004 compared to $13.6 million in 2003. The Acquisition Partnerships reflected net earnings of $43.0 million in 2004 compared to net earnings of $15.1 million in 2003. Following is a discussion of equity earnings by geographic region.
25
Interest income. Interest income on loans was $3.1 million in 2004 compared to $3.3 million in 2003. Other income. Other income was $2.1 million in 2004 compared to $1.2 million in 2003. In the first quarter of 2004, FirstCity reduced the estimated carrying value of loans payable to certain members of management by $.8 million. See further discussion related to these loans in note 7 of the consolidated financial statements. Expenses. Operating expenses were $21.0 million in 2004 compared to $20.5 in 2003. Interest and fees on notes payable increased 31% to $3.8 million in 2004 from $2.9 million in 2003. The average debt for the period increased to $43.6 million in 2004 from $31.1 million in 2003. Salaries and benefits decreased slightly to $12.4 million in 2004 from $12.5 million in 2003. The provision for loan and impairment losses was $30,000 in 2004 and $98,000 in 2003. See note 1(e) of the consolidated financial statements for a detailed discussion on FirstCity's allowance for loan losses. Occupancy, data processing and other expenses declined 4% to $4.7 million in 2004 from $5.0 million in 2003 partially as a result of efforts to reduce operating costs in Mexico. Also, in 2004 FirstCity recorded foreign currency exchange gains of $.7 million, which are included in other expenses, compared to $1.1 million in 2003. Minority interest expense was minimal from year to year. The following items affect the Company's overall results of operations and are not directly allocated to the Portfolio Asset acquisition and resolution business discussed above. Corporate interest and overhead. Company level interest expense decreased by 26% to $3.4 million in 2004 from $4.6 million in 2003. Average debt declined to $32.1 million in 2004 from $45.8 million in 2003. Also, beginning with the third quarter of 2003, dividends on the New Preferred Stock are included in corporate interest expense. Other corporate overhead expenses increased by 12% to $6.6 million in 2004 from $5.9 million in 2003 primarily due to increased salaries and benefits and other operating expenses at the corporate level. Income taxes. Provision for income taxes was $75,000 in 2004 and related primarily to federal alternative minimum taxes. Taxes in 2003 were $185,000 and related primarily to state income taxes. Federal income taxes are provided at a 35% rate applied to taxable income or loss and are offset by NOLs that the Company believes are available. The tax benefit of the NOLs is recorded in the period during which the benefit is realized. The Company recorded no deferred tax provision in 2004 and 2003. Discontinued Operations. The Company recorded a provision of $3.8 million in 2004 for additional losses from discontinued mortgage operations compared to $.5 million in 2003. The only assets remaining from discontinued mortgage operations are the investment securities resulting from the retention of residual interests in securitization transactions. In 2004, the Company elected to initiate efforts to liquidate these residual interests. As a result, during the fourth quarter of 2004, FirstCity adjusted the carrying value of the residual interests to fair value, resulting in impairment of $2.6 million for the quarter and reducing the carrying value to $1.8 million. Prior to 2004, these securities were recorded at the estimated future 26 gross cash receipts. These securities are in "run-off," and the Company is contractually obligated to service these assets. The assumptions used in the valuation model consider both industry as well as the Company's historical experience. As the securities "run off," assumptions are reviewed in light of historical evidence in revising the prospective results of the model. These revised assumptions could potentially result in either an increase or decrease in the estimated cash receipts. An additional provision is booked based on the output of the valuation model if deemed necessary. Earnings from discontinued consumer operations were $62.5 million in 2004 compared to $5.3 million in 2003. As discussed above, On November 1, 2004, FirstCity completed the sale of its remaining 31% interest in Drive and recognized a net gain of $53.3 million ($54.4 million gain, net of $1.1 million in taxes). Pursuant to SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," the consolidated financial statements have been reclassified for all periods presented to reflect the operations, assets and liabilities of the consumer business segment as discontinued consumer operations. Analysis of Revenues and Expenses The following table summarizes the revenues and expenses of the Portfolio Asset acquisition and resolution business and presents the contribution that this business made to the Company's operating margin. 27
28 Fourth Quarter 2005 Net earnings for the fourth quarter of 2005 were $2 million, or $.16 per share on a diluted basis. The following table presents a summary of operations for the fourth quarters of 2005 and 2004.
Portfolio Asset Acquisition and Resolution In 2005 the Company invested $71.4 million in Portfolios acquired through Acquisition Partnerships and subsidiaries. Acquisitions by the Company over the last five years are summarized as follows:
The Company believes that prospects for investment in distressed assets in 2006 continue to be positive. In the United States, opportunities remain strong as many sellers use the sale of distressed assets as an ongoing balance sheet management tool. Additionally, with the bank merger activity, acquiring banks are using the sale of portfolios to facilitate their acquisition activities. In foreign markets, the availability of distressed assets in Europe and Latin America remains strong. As the Company continues to expand its franchise base into these markets, FirstCity has implemented marketing programs to identify new opportunities for investment in Portfolio Assets, both on a bid and negotiated basis. Revenues with respect to the Company's Portfolio Asset acquisition and resolution segment consist primarily of (i) servicing fees from Acquisition Partnerships for the servicing activities performed related to the assets held in the Acquisition Partnerships, (ii) interest income on performing Portfolio Assets and loans receivable, and (iii) gains on disposition of assets. The Company also records equity in earnings of affiliated Acquisition Partnerships and servicing entities. The following table presents selected information regarding the revenues and expenses of the Company's Portfolio Asset acquisition and resolution business. 29
30 The following tables present selected information regarding the revenues and expenses of the Acquisition Partnerships, FirstCity's average investment in and equity earnings in the Acquisition Partnerships.
31 change had no impact on the consolidated net earnings as the effect is offset through equity earnings in these Partnerships. Liquidity and Capital Resources The Company requires liquidity to fund its operations, working capital, payment of debt, equity for acquisition of Portfolio Assets, investments in and advances to entities formed with other investors to acquire Portfolios ("Acquisition Partnerships") and other investments. The potential sources of liquidity are funds generated from operations, equity distributions from the Acquisition Partnerships, interest and principal payments on subordinated intercompany debt, dividends from the Company's subsidiaries, borrowings from revolving lines of credit and other credit facilities, proceeds from equity market transactions, securitization and other structured finance transactions and other special purpose short-term borrowings. FirstCity has a $95 million revolving acquisition facility with Bank of Scotland that matures in November 2008. This facility is used to finance the equity portion of distressed asset pool purchases and to provide for the issuance of Letters of Credit and working capital loans. This facility (i) allows loans to be made in Euros up to a maximum amount in Euros that is equivalent to 35 million U.S. dollars, (ii) allows loans to be made for acquisition of Portfolio Assets originated in Latin America of up to $35 million, (iii) provides for an interest rate of LIBOR plus 2.50% to 2.75%, (iv) provides for a commitment fee of 0.20% of the unused balance of the revolving acquisition facility, (v) provides that the aggregate borrowings under the facility will not exceed 60% of the net present value of FirstCity's interest in Portfolio Assets and in Acquisition Partnerships pledged to secure the acquisition facility, and (vi) provides for a reduction in the total loan commitment of $1.3 million per quarter, commencing on December 27, 2005. In August 2005, FH Partners, L.P., an indirect wholly-owned affiliate of FirstCity, and Bank of Scotland, acting through its New York branch, as agent for itself as lender, entered into a Revolving Credit Agreement that provides a $50 million revolving portfolio acquisition facility for FH Partners, L.P. to be secured by all of the assets of FH Partners, L.P. The loan facility will be used to finance portfolio and asset purchases. The facility (i) allows loans to be made for the acquisition of Portfolio Assets in the United States, (ii) provides that each loan may be in an amount of up to 70% of the net present value of the assets being acquired with the proceeds of the loan, (iii) provides that the aggregate outstanding balances of all loans will not exceed 65% of the net present value of the assets securing the loan facility, (iv) provides for an interest rate of LIBOR plus 2.0%, (v) provides for an annual commitment fee of 0.20% of the unused balance of the revolving acquisition facility, (vi) provides for a utilization fee of 0.75% of the amount of each loan made under the loan facility, (vii) provides for an upfront fee of $350 thousand, (viii) provides for facility fees of $100 thousand, for the period commencing on the Effective Date to but excluding the first anniversary thereof, $75 thousand, for the period commencing on the first anniversary of the Effective Date to but excluding the second anniversary thereof, and $50 thousand, for each subsequent one-year period, and (ix) provides for a maturity date of November 12, 2008. The obligations of FH Partners, L.P. under the Revolving Credit Agreement are guaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity. BoS (USA) has a warrant to purchase 425,000 shares of the Company's voting Common Stock at $2.3125 per share. BoS (USA) is entitled to additional warrants in connection with this existing warrant for 425,000 shares under certain specific situations to retain its ability to acquire approximately 4.86% of the Company's voting Common Stock. The warrant will expire on August 31, 2010, if it is not exercised prior to that date. FirstCity's $35 million loan facility with CFSC Capital Corp. XXX, a subsidiary of Cargill, terminated according to the terms of the agreement on March 31, 2005. This facility had been used to provide equity in new Portfolio acquisitions in partnerships with Cargill and its affiliates. On November 12, 2004, the 32 outstanding balances on the Cargill facility were paid down to zero funded out of proceeds from the $95 million facility. FirstCity had not used the facility since September 2004 and determined that the facility was no longer necessary in light of the $95 million revolving acquisition facility provided by Bank of Scotland. Excluding the term acquisition facilities of the unconsolidated Acquisition Partnerships, as of December 31, 2005, the Company and its subsidiaries had credit facilities providing for borrowings in an aggregate principal amount of $149 million and outstanding borrowings of $90 million. Management believes that the Bank of Scotland facilities, the related fees generated from the servicing of assets, equity distributions from existing Acquisition Partnerships and wholly-owned portfolios, as well as sales of interests in equity investments, will allow the Company to meet its obligations as they come due during the next twelve months. The following table summarizes the material terms of the credit facilities to which the Company, its major operating subsidiaries and the Acquisition Partnerships were parties to as of March 1, 2006, and the outstanding borrowings under such facilities as of December 31, 2005.
33 Discussion of Critical Accounting Policies In the ordinary course of business, the Company has made a number of estimates and assumptions relating to the reporting of results of operations and financial position in the preparation of its consolidated financial statements in conformity with accounting principles generally accepted in the United States. Actual results could differ significantly from those estimates under different assumptions and conditions. The Company believes that the following discussion addresses the Company's most critical accounting policies, which are those that are most important to the portrayal of the Company's consolidated financial position and results and require management's most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. On January 1, 2005, FirstCity adopted the provisions of SOP 03-3 (as defined under "Effect of New Accounting Standards"). For loan portfolios acquired prior to January 1, 2005, FirstCity designated these loans as non-performing Portfolio Assets or performing Portfolio Assets. Such designation was made at the acquisition of the pool and does not change even though the actual performance of the loans may change. FirstCity accounts for all nonperforming loans acquired after 2004 in accordance with SOP 03-3. Following is a description of each classification and the related accounting policy accorded to each Portfolio type. Non-performing Portfolio Assets consist primarily of distressed loans and loan related assets, such as foreclosed upon collateral. Accounting for non-performing portfolios is on a pool basis as opposed to an individual asset-by-asset basis. Prior to January 1, 2005, Portfolio Assets were designated as non-performing if a majority of all of the loans in the Portfolio were significantly under performing in accordance with the contractual terms of the underlying loan agreements at the date of acquisition. Net gain on resolution of non-performing Portfolio Assets is recognized as income to the extent that proceeds collected exceed a pro rata portion of allocated cost from the pool. Cost allocation is based on a proration of actual proceeds divided by total estimated proceeds of the pool. No interest income is recognized separately on non-performing Portfolio Assets. All proceeds, of whatever type, are included in proceeds from resolution of Portfolio Assets in determining the gain on resolution of such assets. All non-performing Portfolio Assets are purchased at discounts from their outstanding legal principal amount, the total of the aggregate of expected future sales prices and the total payments to be received from obligors. Subsequent to acquisition, the adjusted cost of non-performing Portfolio Assets is evaluated for impairment on a quarterly basis. The evaluation of impairment is determined based on the review of the estimated future cash receipts, which represents the net realizable value of the non-performing pool. Once it is determined that there is impairment, a valuation allowance is established for any impairment identified through provisions charged to operations in the period the impairment is identified. The Company recorded no allowance for impairment 2005, $16,000 in 2004 and $31,000 in 2003. The actual future proceeds of the pool could vary materially from the estimated proceeds of the pool due to changes in economic conditions, deterioration of collateral values, deterioration in the borrower's financial condition and other conditions described in the risk factors discussed earlier in this document. In the event that the actual future proceeds of the pool exceed the current estimates, the reported future results of the Company could be higher than anticipated and would result in a higher net gain on resolution of non-performing Portfolio Assets. In the event that actual future proceeds of the pool are less than current estimates, the reported future results of the Company could be lower than anticipated and would result in lower net gain on resolution of non-performing Portfolio Assets or possibly require the Company to recognize impairment in the value of the pool. 34 Performing Portfolio Assets consist primarily of portfolios of loans acquired at a discount from the aggregate amount of the borrowers' obligation. Prior to January 1, 2005, performing Portfolio Assets were accounted for using the interest method—acquisition discounts for the Portfolio as a whole are accreted as an adjustment to yield over the estimated life of the Portfolio. Performing Portfolio Assets are carried at the unpaid principal balance of the underlying loans, net of acquisition discounts and allowance for loan losses. Significant increases in expected future cash flows may be recognized prospectively through an upward adjustment of the internal rate of return ("IRR") over a portfolio's remaining life. Any increase to the IRR then becomes the new benchmark for impairment testing. Income on performing Portfolio Assets is accrued monthly based on each loan pool's effective IRR. Cash flows greater than the interest accrual will reduce the carrying value of the pool. Likewise, cash flows that are less than the accrual will increase the carrying balance. The IRR is estimated and periodically recalculated based on the timing and amount of anticipated cash flows using the Company's proprietary collection model. Gains are recognized on the performing Portfolio Assets when sufficient funds are received to fully satisfy the obligation on loans included in the pool, either from funds from the borrower or sale of the loan. The gain recognized represents the difference between the proceeds received and the allocated carrying value of the individual loan in the pool. The actual future cash flows of the pool could vary materially from the expected future cash flows of the pool due to changes in economic conditions, changes in collateral values, deterioration in the borrowers financial condition, restructure or renewal of individual loans in the pool, sale of loans within the pool and other conditions described in the risk factors discussed earlier in this document. In the event that the actual future cash flows of the pool exceed the current estimates, the reported future results of the Company could be higher than anticipated and would result in a higher level of interest income due to greater amounts of discount accretion being included in revenue derived from the performing Portfolio Assets as well as higher gains recognized on the sale of individual loans from a pool. In the event that actual future cash flows of the pool are less than current estimates, the reported future results of the Company could be lower than anticipated and would result in a lower level of interest income and reduced gains from the sale of assets from a pool, lower levels of interest income as a result of lower amounts of discount accretion being included in revenue derived from performing Portfolio Assets or possibly require the Company to recognize impairment in the value of the pool due to a decline in the present value of the expected future cash flows. Management's best estimate of IRR as of January 1, 2005, is the basis for subsequent impairment testing. If it is probable that all cash flows estimated at acquisition plus any changes to expected cash flows arising from changes in estimates after acquisition would not be collected, the carrying value of a pool would be written down to maintain the then current IRR. Prior to January 1, 2005, impairment charges would be taken to the income statement with a corresponding write-off of the receivable balance. Consequently, no allowance for loan loss was recorded prior to January 1, 2005. The Company recorded provision for impairment of loans in the amounts of $121,000 in 2005, $13,000 in 2004 and $57,000 in 2003. A pool can become fully amortized (zero carrying balance on the balance sheet) while still generating cash collections. In this case, all cash collections are recognized as revenue when received. Additionally, the Company uses the cost recovery method when timing and amount of collections on a particular pool of accounts cannot be reasonably predicted. Under the cost recovery method, no revenue is recognized until the Company has fully collected the cost of the Portfolio, or until such time that the Company considers the collections to be probable and estimable and begins to recognize income based on the interest method as described above. 35 At acquisition, FirstCity reviews each loan to determine whether there is evidence of deterioration of credit quality since origination and if it is probable that FirstCity will be unable to collect all amounts due according to the loan's contractual terms. If both conditions exist, FirstCity determines whether each such loan is to be accounted for individually or whether such loans will be assembled into pools of loans based on common risk characteristics (including loan type, collateral type, geographical location, performance status and borrower relationship). FirstCity considers expected prepayments, and estimates the amount and timing of undiscounted expected principal, interest, and other cash flows (expected at acquisition) for each loan and each subsequently aggregated pool of loans. FirstCity determines the excess of the loan's or pool's scheduled contractual principal and contractual interest payments over all cash flows expected at acquisition as an amount that should not be accreted ("nonaccretable difference"). The excess of the loan's cash flows expected to be collected at acquisition over the initial investment in the loan or pool is accreted into interest income over the remaining life of the loan or pool ("accretable yield"). Over the life of the loan or pool, FirstCity continues to estimate cash flows expected to be collected. FirstCity evaluates at the balance sheet date whether the present value of its loans determined using the effective interest rates has decreased below book value and if so, a valuation allowance is established for any impairment identified through provisions charged to operations in the period the impairment is identified. The present value of any subsequent increase in the loan's or pool's actual cash flows or cash flows expected to be collected is used first to reverse any existing valuation allowance for that loan or pool. Any remaining increases in the present value of cash flows expected to be collected will be used to recalculate the amount of accretable yield recognized on a prospective basis over the pool's remaining life. FirstCity establishes valuation allowances for all acquired loans subject to SOP 03-3 to reflect only those losses incurred after acquisition—that is, the present value of cash flows expected at acquisition that are not expected to be collected. Loans acquired without evidence of credit deterioration at acquisition for which FirstCity has the positive intent and ability to hold for the foreseeable future are classified as held for investment and reported at their unpaid principal balance net of unamortized purchase discounts or premiums. Interest accrual ceases when payments become 90 days contractually past due. An allowance for loan losses is established when a loan becomes impaired. A loan is impaired when full payment under the loan terms is not expected. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged off. Loan losses are charged against the allowance when management believes that the uncollectibility of a loan balance is confirmed. At December 31, 2005, the Company had established a valuation allowance of $31,000 on these loans. Real estate portfolios consist of real estate acquired from a variety of sellers. Such Portfolios are carried at the lower of cost or fair value less estimated costs to sell. Costs relating to the development and improvement of real estate for its intended use are capitalized, whereas those relating to holding assets are charged to expense. Income or loss is recognized upon the disposal of the real estate. Rental income, net of expenses, on real estate Portfolios is recognized when received. Accounting for the Portfolios is on an 36 individual asset-by-asset basis as opposed to a pool basis. Subsequent to acquisition, the amortized cost of real estate portfolios is evaluated for impairment on a quarterly basis. The evaluation of impairment is determined based on the review of the estimated future cash receipts, net of costs to sell, which represents the net realizable value of the real estate portfolio. Impairment losses are charged to operations in the period the impairment is identified. The Company recorded impairment losses of $60,000, $1,000, $10,000 as of December 31, 2005, 2004 and 2003, respectively. As a part of the process of preparing its consolidated financial statements, the Company is required to estimate its income taxes in each of the jurisdictions in which it operates. This process involves estimating the Company's actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effects of future changes in tax laws or changes in tax rates are not anticipated. The measurement of deferred tax assets, if any, is reduced by the amount of any tax benefits that, based on available evidence, are not expected to be realized. As a result of the Merger, the Company has substantial federal NOLs that can be used to offset the tax liability associated with the Company's pre-tax earnings until the earlier of the expiration or utilization of such NOLs. The Company accounts for the benefit of the NOLs by recording the benefit as an asset and then establishing an allowance to value the net deferred tax asset at a value commensurate with the Company's expectation of being able to utilize the recognized benefit in the foreseeable future. Such estimates are reevaluated on a quarterly basis with the adjustment to the allowance recorded as an adjustment to the income tax expense generated by the quarterly operating results. Significant events that change the Company's view of its currently estimated ability to utilize the tax benefits result in substantial changes to the estimated allowance required to value the deferred tax benefits recognized in the Company's periodic consolidated financial statements. The Company's analysis resulted in no change in 2005, 2004 and 2003. The Company has a net deferred tax asset of $20 million in the consolidated balance sheet as of December 31, 2005, which is composed of a gross deferred tax asset of $198 million net of a valuation allowance of $178 million. As discussed in note 3 of the consolidated financial statements, FirstCity sold its remaining 31% interest in Drive in November 2004. The ultimate realization of the resulting net deferred tax asset is dependent upon generating sufficient taxable income from its continuing operations prior to expiration of the net operating loss carryforwards. Although realization is not assured, management believes that the deferred tax asset, net of allowance, has been carried at low levels, and thus, the sale of Drive has no impact on FirstCity's ability to realize all of the deferred tax asset, net of allowance. The amount of the deferred tax asset considered realizable, however, could be adjusted in the future if estimates of future taxable income during the carryforward period change. The ability of the Company to realize the deferred tax asset is periodically reviewed and the valuation allowance is adjusted accordingly. See "Item 1A. Risk Factors." FirstCity accounts for its investments in Acquisition Partnerships and their general partners using the equity method of accounting. This accounting method generally results in the pass-through of its pro rata share of earnings from the partnerships' activities as if it had a direct investment in the underlying Portfolio Assets held by the partnerships. The revenues and earnings of the partnerships are determined on a basis consistent with the accounting methodology applied to Portfolio Assets as described in the preceding 37 paragraphs. FirstCity has ownership interests in the various partnerships that range from 3% to 50%. The Company also holds investments in servicing entities that are accounted for under the equity method. Distributions of cash flow from the Acquisition Partnerships are a function of the terms and covenants of the loan agreements related to the secured borrowings of the Acquisition Partnerships. Generally, the terms of the underlying loan agreements permit some distribution of cash flow to the equity partners so long as loan to cost and loan to value relationships are in compliance with the terms and covenants of the applicable loan agreement. Once the secured borrowings of the Acquisition Partnerships are fully paid, all cash flow in excess of operating expenses is available for distribution to the equity partners. Discontinued Operations Discontinued operations are comprised of two components previously reported as the Company's residential and commercial mortgage banking business and the consumer lending business conducted through FirstCity's minority interest investment in Drive. In November 2004, FirstCity completed the sale of its interest in Drive, and as of December 31, 2004, the Company had zero assets remaining from the discontinued consumer operations, but certain income realized from such operations. The only asset remaining from discontinued mortgage operations is an investment security resulting from the retention of a residual interest in a securitization transaction. This security is in "run-off," and the Company is contractually obligated to service this asset. Prior to the fourth quarter of 2004, FirstCity classified these securities as held to maturity and considered the estimated future gross cash receipts for such investment securities in the computation of the value of such investment securities. In the fourth quarter of 2004, FirstCity's management elected to pursue a strategy to liquidate these assets and carry them as held for sale. Consequently, in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," the remaining security is recorded at the lower of their carrying value or fair value less cost to sell. The cash flows are collected over a period of time and are valued using a discount rate of 18% and prepayment assumptions of 32% for fixed rate loans and 33% for variable rate loans. Overall loss rates are estimated at 14% of collateral. The assumptions used in the valuation model consider both industry as well as the Company's historical experience and are reviewed quarterly in light of historical evidence in revising the prospective results of the model. These revised assumptions could potentially result in either an increase or decrease in the estimated cash receipts. An additional provision is booked based on the output of the valuation model if deemed necessary. The Company recorded provisions of $.3 million in 2005, $3.8 million in 2004 and $.5 million in 2003 for additional losses from discontinued mortgage operations. In 2004, the provision primarily relates to FirstCity adjusting the carrying value of the residual interests to fair value. The additional provision in 2005 and 2003 primarily related to a decrease in the estimated future gross cash receipts on residual interests in securitizations as a result of the actual losses exceeding the losses projected by the valuation model. The Company uses estimates to determine future cash receipts from Portfolio Assets. These estimates of future cash receipts from acquired Portfolio Asset pools are utilized in four primary ways:
38 The Company uses a proprietary asset management software program to manage the Portfolio Assets it owns and services. Each asset within a pool is analyzed by an account manager who is responsible for analyzing the characteristics of each asset within a pool. The account manager projects future cash receipts and expenses related to each asset and the sum of which provides the total estimated future cash receipts related to a particular purchased asset pool. These estimates are routinely monitored by the Company to determine reasonableness of the estimates provided. The Company has in the past been able to establish with reasonable accuracy the estimated future cash receipts over the life of a purchased asset pool. Changes in economic conditions, fluctuations in interest rates, deterioration of collateral values, and other factors described in the risk factors section could cause the estimates of future cash flows to be materially different than actual cash receipts. The effects of an increase in the estimated future cash receipts would generally increase revenues from Portfolio Assets by increasing gross profit on a non-performing or real estate pool and increasing the effective yield on a performing or SOP 03-3 portfolio while a decrease in future cash receipts would generally have the effect of reducing revenues by reducing gross profit on a non-performing or real estate pool and creating impairment on a performing or SOP 03-3 portfolio. In some cases a reduction in the total future cash receipts by collecting those cash receipts sooner than expected could have a positive impact on the Company's revenues from Portfolio Assets due to reduced interest expense and other carrying costs associated with the Portfolio Assets. Likewise an increase in future cash receipts, although generally a positive trend, could have a negative impact on future revenues of the Company if collected over a longer period, resulting in higher levels of interest expense and other carrying costs of the portfolios negating any potentially positive effects. The accompanying consolidated financial statements include the accounts of all of the majority owned subsidiaries of the Company. All significant intercompany transactions and balances have been eliminated in consolidation. Investments in 20%- to 50%- owned affiliates are accounted for on the equity method since the Company has the ability to exercise significant influence over operating and financial policies of those affiliates. For domestic Acquisition Partnerships, the Company owns a limited partner interest and generally shares in a general partner interest. Regarding the foreign investments, the Company participates as a limited partner. In all cases, the Company's direct and indirect equity interest never exceeds 50%. Investments in less than 20% owned affiliates are also accounted for on the equity method. These investments are partnerships formed to share in the risks and rewards in developing new markets as well as to pool resources. Also, the Company has the ability to exercise significant influence over operating and financial policies, despite its comparatively smaller equity percentage, due to its leading role in the formation of these partnerships as well as its involvement in the day-to-day management activities. In December 2003, the FASB issued a revision to Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46R"), which was originally issued in January 2003. FIN 46R provides guidance on the consolidation of certain entities when control exists through other than voting (or similar) interests and was effective immediately with respect to entities created after January 31, 2003. For certain special purpose entities created prior to February 1, 2003, FIN 46R became effective for financial statements issued after December 15, 2003. For all other entities created prior to February 1, 2003, FIN 46R became effective January 1, 2004. FIN 46R requires consolidation by the primary beneficiary of expected losses or residual gains of the activities of a variable interest entity ("VIE"). FirstCity holds significant variable interests in certain 39 Acquisition Partnerships, which would be characterized as VIE's. However, FirstCity is not deemed to be the primary beneficiary of any of these entities based on the criteria set forth in FIN 46R. At December 31, 2005 FirstCity's maximum exposure to loss as a result of its involvement with the VIE's is $22.3 million. Equity earnings in most of the foreign Acquisition Partnerships are recorded on a one-month lag due to the timing of FirstCity's receipt of those financial statements. Contractual Obligations and Commercial Commitments The following tables present contractual cash obligations and commercial commitments of the Company as of December 31, 2005. See Notes 7, 12 and 14 of the Notes to Consolidated Financial Statements (dollars in thousands).
Effect of New Accounting Standards On January 1, 2006, FirstCity adopted Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS 123R"). SFAS No. 123R supersedes APB Opinion No. 25, which requires recognition of an expense when goods or services are provided. SFAS No. 123R requires the determination of the fair value of the share-based compensation at the grant date and the recognition of the related expense over the period in which the share-based compensation vests. SFAS No. 123R permits a prospective or two modified versions of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by the original SFAS No. 123. The Company will utilize the prospective method. Therefore, on January 1, 2006, the Company began recognizing an expense for unvested share-based compensation that has been issued. Unvested compensation cost at January 1, 2006 to be expensed prospectively based on unvested stock options at that date outstanding was approximately $1.7 million. On June 29, 2005, the FASB ratified the consensus reached by Emerging Issues Task Force ("EITF") on Issue No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity when the Limited Partners Have Certain Rights ("EITF 04-5"). The consensus reached by the EITF at the June 2005 meeting was that a sole general partner is presumed to control a limited partnership (or similar entity) and should consolidate the limited partnership unless (1) the limited partners possess substantive kick-out rights or (2) the limited partners possess substantive participating rights. This ratification of EITF Issue No. 04-5 has caused the amendments of Statement of Position 78-9, Accounting for Investments in Real Estate Ventures, and EITF Issue No. 96-16, Investor's Accounting for an Investee When the Investor has a Majority of the Voting Interest but the Minority Shareholder 40 or Shareholders Have Certain Approval or Veto Rights. EITF 04-5 is effective for all new and modified agreements effective June 29, 2005. For pre-existing agreements that are not modified, the EITF is effective as of the beginning of the first fiscal reporting period beginning after December 15, 2005. The adoption of EITF 04-5 had no impact on the Company's results of operations or financial position. In July 2005, the Financial Accounting Standards Board issued SFAS No.154, Accounting for Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3 ("SFAS 154"). Under the provisions of SFAS 154, a voluntary change in accounting principle requires retrospective application to prior period financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. A change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets must be accounted for as a change in accounting estimate effected by a change in accounting principle. The guidance contained in Opinion No. 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate was not changed. SFAS 154 was adopted by the Company as of January 1, 2006 and had no impact on the consolidated financial position or earnings.
Market risk is the risk of loss from adverse changes in market prices and interest rates. The Company's operations are materially impacted by net gains on sales of loans and net interest margins. The level of gains from loan sales the Company achieves is dependent on demand for the products originated. Net interest margins are dependent on the Company's ability to maintain the spread or interest differential between the interest it charges the customer for loans and the interest the Company is charged for the financing of those loans. The following describes each component of interest bearing assets held by the Company and how each could be affected by changes in interest rates. The Company invests in Portfolio Assets both directly through consolidated subsidiaries and indirectly through equity investments in Acquisition Partnerships. Portfolio Assets consist of investments in pools of non-homogenous assets that predominantly consist of loan and real estate assets. Earnings from these assets are based on the estimated future cash flows from such assets and recorded when those cash flows occur. The underlying loans within these pools bear both fixed and variable rates. Due to the non-performing nature and history of these loans, changes in prevailing benchmark rates (such as the prime rate or LIBOR) generally have a nominal effect on the ultimate future cash flow to be realized from the Portfolio Assets. Loans receivable consist of investment loans made to Acquisition Partnerships and bear interest at predominately fixed rates. The collectibility of these loans is directly related to the underlying Portfolio Assets of those Acquisition Partnerships, which are non-performing in nature. Therefore, changes in benchmark rates would have minimal effect on the collectibility of these loans. Additionally, the Company has various sources of financing which have been previously described in "Item 7—Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources." 41 The following table is a summary of the interest earning assets and interest bearing liabilities, as of December 31, 2005, segregated by asset type as described in the previous paragraphs, with expected maturity or sales dates as indicated (dollars in thousands):
The Company currently has investments in Europe and Latin America (i.e. Mexico, Argentina and Dominican Republic.) In Europe, the Company's investments are in the form of equity and represent a significant portion of the Company's total equity investments. As of December 31, 2005, one U.S. dollar equaled .84 Euros. A sharp change of the Euro relative to the U.S. dollar could materially adversely affect the financial position and results of operations of the Company. A 5% and 10% incremental depreciation of the Euro would result in an estimated decline in the valuation of the Company's equity investments in Europe of approximately $1.3 million and $2.5 million, respectively. These amounts are estimates of the financial impact of a depreciation of the Euro relative to the U.S. dollar. Consequently, these amounts are not necessarily indicative of the actual effect of such changes with respect to the Company's consolidated financial position or results of operations. As discussed above, the revolving acquisition facility with Bank of Scotland for $95 million allows loans to be made in Euros up to a maximum amount in Euros that is equivalent to $35 million U.S. dollars. At December 31, 2005, the Company had $20.3 million in Euro-denominated debt for the purpose of hedging a portion of the net equity investments in Europe. Management of the Company feels that this loan agreement will help reduce the risk of adverse effects of currency changes on Euro-denominated investments. 42 In Mexico, approximately 95% of the Company's investments are made through U.S. dollar denominated loans to the Partnerships located in Mexico. The remaining investment is in the form of equity in these same Partnerships. The loans receivable are required to be repaid in U.S. dollars. Although the U.S. dollar balance of these loans will not change due to a change in the Mexican peso, the future estimated cash flows of the underlying assets in Mexico could become less valuable as a result of a change in the exchange rate for the Mexican peso, and thus could affect the overall total returns to the Company on these investments. As of December 31, 2005, one U.S. dollar equaled 10.78 Mexican pesos. A 5% and 10% incremental depreciation of the Mexican peso would result in an estimated decline in the valuation of the Company's total investments in Mexico of approximately $.8 million and $1.6 million, respectively. These amounts are estimates of the financial impact of a depreciation of the Mexican peso relative to the U.S. dollar. Consequently, these amounts are not necessarily indicative of the actual effect of such changes with respect to the Company's consolidated financial position or results of operations. FirstCity has loans and equity investments in South America—primarily from Argentine Acquisition Partnerships. As of December 31, 2005, one U.S. dollar equaled 3.04 Argentine pesos. The Company estimates that a 5% and 10% incremental depreciation of the Argentine peso would result in a decline in the valuation of the Company's total investments in Argentina of approximately $.1 million and $.2 million, respectively. These amounts are estimates of the financial impact of a depreciation of the Argentine peso relative to the U.S. dollar. Consequently, these amounts are not necessarily indicative of the actual effect of such changes with respect to the Company's consolidated financial position or results of operations. 43
See accompanying notes to consolidated financial statements. 44
See accompanying notes to consolidated financial statements. 45
See accompanying notes to consolidated financial statements. 46
See accompanying notes to consolidated financial statements. 47
December 31, 2005, 2004 and 2003 1. Summary of Significant Accounting Policies
On July 3, 1995, FirstCity Financial Corporation (the "Company" or "FirstCity") was formed by the merger of J-Hawk Corporation and First City Bancorporation of Texas, Inc. (the "Merger"). The Company's merger with Harbor Financial Group, Inc. ("Mortgage Corp.") on July 1, 1997 was accounted for as a pooling of interests. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include the estimation of future collections on purchased Portfolio Assets used in the calculation of net gain on resolution of Portfolio Assets, interest rate environments, valuation of the deferred tax asset, and prepayment speeds and collectibility of loans held in inventory, securitization trusts and for investment. Actual results could differ materially from those estimates.
The Company is a financial services company with offices throughout the United States and Mexico, with a presence in France and South America. At December 31, 2005, the Company was engaged in one principal reportable segment—Portfolio Asset acquisition and resolution. On September 21, 2004, FirstCity and certain of its subsidiaries entered into a Securities Purchase Agreement relating to the sale of the Company's remaining 31% beneficial ownership interest in Drive Financial Services LP ("Drive") and its general partner, Drive GP LLC, to IFA Drive GP Holdings LLC ("IFA-GP"), IFA Drive LP Holdings LLC ("IFA-LP") and Drive Management LP ("MG-LP"). This sale was completed on November 1, 2004 and resulted in a $53.3 million net gain ($54.4 million gain, net of $1.1 million in taxes). The $86.8 million proceeds from the sale were primarily used to retire debt. Following the sale, FirstCity and Bank of Scotland restructured the existing $50 million revolving credit facility into a $96 million revolving acquisition facility that matures in November 2008, which is reduced by $1.3 million per quarter, commencing on December 27, 2005. As a result of the execution of the sale agreement which was completed on November 1, 2004, the consumer lending segment conducted through Drive was no longer considered a principal reportable segment and is treated as a discontinued operation. Effective in the third quarter of 1999, the Company adopted formal plans to discontinue its mortgage banking operations which had previously also been reported as a segment. Activities related to the mortgage banking and consumer lending operations have been reclassified in the accompanying consolidated financial statements to discontinued operations. Refer to Note 3 for information related to the mortgage banking and consumer lending discontinued operations. In the Portfolio Asset acquisition and resolution business, the Company acquires and resolves portfolios of performing and nonperforming commercial and consumer loans and other assets (collectively, "Portfolio Assets" or "Portfolios"), which are generally acquired at a discount to their legal principal balance or appraised value. Purchases may be in the form of pools of assets or single assets. The Portfolio Assets are generally aggregated, including loans of varying qualities that are secured or unsecured by diverse collateral types and foreclosed properties. Some Portfolio Assets are loans for which resolution is tied primarily to the real estate securing the loan, while others may be collateralized business loans, the resolution of which may be based either on real estate, business assets or other collateral cash flow. 48 Portfolio Assets are acquired on behalf of the Company or its wholly owned subsidiaries, and on behalf of legally independent domestic and foreign partnerships and other entities ("Acquisition Partnerships" or "WAMCO Partnerships") in which a partially owned affiliate of the Company is the general partner and the Company and other investors (including but not limited to Cargill) are limited partners. The Company services, manages and ultimately resolves or otherwise disposes of substantially all of the assets it, its Acquisition Partnerships, or other related entities acquire. The Company services such assets until they are collected or sold and normally does not manage assets for non-affiliated third parties.
The accompanying consolidated financial statements include the accounts of all majority owned subsidiaries of the Company. Furthermore, variable interest entities in which the Company has an interest have been consolidated where the company is identified as the primary beneficiary. All significant intercompany transactions and balances have been eliminated in consolidation. Investments in 20%- to 50%-owned affiliates are accounted for on the equity method since the Company has the ability to exercise significant influence over operating and financial policies of those affiliates. The following is a listing of the 20%- to 50%-owned owned affiliates accounted for on the equity method and held at December 31, 2005:
49
Investments in less than 20% owned affiliates are also accounted for on the equity method. FirstCity has the ability to exercise significant influence over operating and financial policies of these entities, despite its comparatively smaller equity percentage, due primarily to its active participation in the policy making process as well as its involvement in the day-to-day management activities. These partnerships are formed to share in the risks and rewards in developing new markets as well as to pool resources. Following 50 is a listing of the less than 20 percent owned affiliates accounted for on the equity method and held at December 31, 2005:
Equity earnings in the foreign Acquisition Partnerships are recorded on a one-month lag due to the timing of FirstCity's receipt of those financial statements. The Company has loans receivable from certain Acquisition Partnerships (see note 1(f)). In situations where the Company is not required to advance additional funds to the Acquisition Partnership and previous losses have reduced the equity investment to zero, the Company continues to report its share of equity method losses in its consolidated statements of operations to the extent of and as an adjustment to the adjusted basis of the related loan receivable in compliance with EITF 98-13, Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee ("EITF 98-13") (See Note 5).
For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents. The Company has maintained balances in various operating and money market accounts in excess of federally insured limits.
FirstCity primarily acquires loans in groups or portfolios that have experienced deterioration of credit quality between origination and the Company's acquisition of the loans. The amount paid for a loan reflects FirstCity's determination that it is probable the Company will be unable to collect all amounts due according to the loan's contractual terms. On January 1, 2005, FirstCity adopted the provisions of SOP 03-3. For loan Portfolios acquired prior to January 1, 2005, FirstCity designated these loans as non-performing Portfolio Assets or performing Portfolio Assets. Such designation was made at the acquisition of the pool and does not change even though the actual performance of the loans may change. FirstCity accounts for all loans acquired after 2004 in accordance with SOP 03-3. 51 Following is a description of each classification and the related accounting policy accorded to each Portfolio type: Non-performing Portfolio Assets consist primarily of distressed loans and loan related assets, such as foreclosed upon collateral. Prior to January 1, 2005, Portfolio Assets were designated as non-performing if a majority of all of the loans in the Portfolio were significantly under performing in accordance with the contractual terms of the underlying loan agreements at the date of acquisition. Net gain on resolution of non-performing Portfolio Assets is recognized as income to the extent that proceeds collected exceed a pro rata portion of allocated cost from the pool. Cost allocation is based on a proration of actual proceeds divided by total estimated proceeds of the pool. No interest income is recognized separately on non-performing Portfolio Assets. All proceeds, of whatever type, are included in proceeds from resolution of Portfolio Assets in determining the gain on resolution of such assets. Accounting for non-performing Portfolios is on a pool basis as opposed to an individual asset-by-asset basis. Performing Portfolio Assets consist primarily of Portfolios of consumer and commercial loans acquired at a discount from the aggregate amount of the borrowers' obligation. Prior to January 1, 2005, performing Portfolio Assets were accounted for using the interest method—acquisition discounts for the Portfolio as a whole are accreted as an adjustment to yield over the estimated life of the Portfolio. Performing Portfolio Assets are carried at the unpaid principal balance of the underlying loans, net of acquisition discounts and allowance for loan losses. Significant increases in expected future cash flows may be recognized prospectively through an upward adjustment of the internal rate of return ("IRR") over a portfolio's remaining life. Any increase to the IRR then becomes the new benchmark for impairment testing. Income on performing Portfolio Assets is accrued monthly based on each loan pool's effective IRR. Cash flows greater than the interest accrual will reduce the carrying value of the pool. Likewise, cash flows that are less than the accrual will increase the carrying balance. The IRR is estimated and periodically recalculated based on the timing and amount of anticipated cash flows using the Company's proprietary collection model. Gains are recognized on the performing Portfolio Assets when sufficient funds are received to fully satisfy the obligation on loans included in the pool, either from funds from the borrower or sale of the loan. The gain recognized represents the difference between the proceeds received and the allocated carrying value of the individual loan in the pool. Management's best estimate of IRR as of January 1, 2005, is the basis for subsequent impairment testing. If it is probable that all cash flows estimated at acquisition plus any changes to expected cash flows arising from changes in estimates after acquisition would not be collected, the carrying value of a pool would be written down to maintain the then current IRR. Prior to January 1, 2005, impairment charges would be taken to the income statement with a corresponding write-off of the receivable balance. Consequently, no allowance for loan loss was recorded prior to January 1, 2005. A pool can become fully amortized (zero carrying balance on the balance sheet) while still generating cash collections. In this case, all cash collections are recognized as revenue when received. Additionally, the Company uses the cost recovery method when timing and amount of collections on a particular pool of accounts cannot be reasonably predicted. Under the cost recovery method, no revenue is recognized until 52 the Company has fully collected the cost of the portfolio, or until such time that the Company considers the collections to be probable and estimable and begins to recognize income based on the interest method as described above. FirstCity considers expected prepayments, and estimates the amount and timing of undiscounted expected principal, interest, and other cash flows (expected at acquisition) for each loan and each subsequently aggregated pool of loans. FirstCity determines the excess of the loan's or pool's scheduled contractual principal and contractual interest payments over all cash flows expected at acquisition as an amount that should not be accreted ("nonaccretable difference"). The excess of the loan's cash flows expected to be collected at acquisition over the initial investment in the loan or pool is accreted into interest income over the remaining life of the loan or pool ("accretable yield"). Over the life of the loan or pool, FirstCity continues to estimate cash flows expected to be collected. FirstCity evaluates at the balance sheet date whether the present value of its loans determined using the effective interest rates has decreased below book value and if so, a valuation allowance is established for any impairment identified through provisions charged to operations in the period the impairment is identified. The present value of any subsequent increase in the loan's or pool's actual cash flows or cash flows expected to be collected is used first to reverse any existing valuation allowance for that loan or pool. Any remaining increases in the present value of cash flows expected to be collected will be used to recalculate the amount of accretable yield recognized on a prospective basis over the pool's remaining life. FirstCity establishes valuation allowances for all acquired loans subject to SOP 03-3 to reflect only those losses incurred after acquisition—that is, the present value of cash flows expected at acquisition that are not expected to be collected. Loans acquired without evidence of credit deterioration at acquisition for which FirstCity has the positive intent and ability to hold for the foreseeable future are classified as held for investment and reported at their unpaid principal balance net of unamortized purchase discounts or premiums. Interest accrual ceases when payments become 90 days contractually past due. An allowance for loan losses is established when a loan becomes impaired. A loan is impaired when full payment under the loan terms is not expected. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged off. Loan losses are charged against the allowance when management believes that the uncollectibility of a loan balance is confirmed. Real estate Portfolios consist of real estate acquired from a variety of sellers. Such Portfolios are carried at the lower of cost or fair value less estimated costs to sell. Costs relating to the development and improvement of real estate for its intended use are capitalized, whereas those relating to holding assets are charged to expense. Income or loss is recognized upon the disposal of the real estate. Rental income, net of expenses, on real estate Portfolios is recognized when received. Accounting for the Portfolios is on an 53 individual asset-by-asset basis as opposed to a pool basis. Subsequent to acquisition, the amortized cost of a real estate Portfolio is evaluated for impairment on a quarterly basis. The evaluation of impairment is determined based on the review of the estimated future cash receipts, which represents the net realizable value of the real estate Portfolio. Impairment losses are charged to operations in the period the impairment is identified. The Company recorded impairment losses of $60,000, $1,000, and $10,000 as of December 31, 2005, 2004 and 2003, respectively.
Loans receivable consist primarily of loans made to Acquisition Partnerships located in Mexico at fixed rates ranging between 0% and 18%, the repayment of which is generally dependent upon future cash flows and distributions made from those Acquisition Partnerships. Interest is accrued when earned in accordance with the contractual terms of the loans. The evaluation for impairment is determined based on the review of the estimated future cash receipts of the underlying nonperforming Portfolio Assets of each related Acquisition Partnership. The Company recorded no allowance for impairment in 2005, 2004 and 2003. During 2004 and 2003, the Company amended loan agreements with four and three Mexican partnerships, respectively, to provide for no interest to be payable with respect to periods after the effective date of the amendments. At December 31, 2005 and 2004, the balance of nonaccrual loans receivable was $7.6 million and $8.9 million, respectively.
Property and equipment are carried at cost, less accumulated depreciation and are included in other assets. Depreciation is provided using straight-line method over the estimated useful lives of the assets.
Intangible assets represent the excess of purchase price over fair value of assets acquired in connection with purchase transactions (goodwill) as well as the purchase price of future service fee revenues and are included in other assets. Goodwill and intangible assets with indefinite useful lives are tested for impairment in accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets.
The Company has no capitalized servicing rights because servicing is not contractually separated from the underlying assets by sale or securitization of the assets with servicing retained or separate purchase or assumption of the servicing. The Company services, in all material respects, the Portfolio Assets owned for its own account, the Portfolio Assets owned by the Acquisition Partnerships and, to a very limited extent, certain Portfolio Assets owned by third parties. In connection with the Acquisition Partnerships in the United States, the Company generally earns a servicing fee, which is a percentage of gross cash collections generated rather than a management fee based on the Face Value of the asset being serviced. The rate of servicing fee charged is generally a function of the average Face Value of the assets within each pool being serviced (the larger the average Face Value of the assets in a Portfolio, the lower the fee percentage within the prescribed range), the type of assets and the level of servicing required on each assets. For the Mexican Acquisition Partnerships, the Company earns a servicing fee based on costs of servicing plus a profit margin. The Acquisition Partnerships in Europe and South America are serviced by various entities in which the Company maintains an equity interest. In all cases, service fees are recognized as they are earned in accordance with the servicing agreements. 54
The Company currently has certain servicing contracts with its Mexican investment entities whereby the Company is entitled to additional compensation for servicing once a specified return to the investors has been achieved. The Company will not recognize any revenue related to these contracts until the investors have received the required level of returns specified in the contracts and the Mexican investment entity has received cash in an amount greater than the required returns. There is no guarantee that the required level of returns to the investors will be achieved or that any additional compensation to the Company related to the contracts will be realized. The amount of these fees recognized by the Company was $359 in 2005, $332 in 2004 and $334 in 2003. The Mexican investment entities record an accrued expense for these contingent fees provided that these fees are probable and reasonably estimable.
Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS 130"), established standards for reporting and displaying comprehensive income (loss) and its components in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130 also requires the accumulated balance of other comprehensive income (loss) to be displayed separately in the equity section of the consolidated balance sheet. The Company's other comprehensive income (loss) consists of foreign currency transactions and unrealized gains (losses) on securitization transactions.
The Company has determined that the local currency is the functional currency for its operations outside the United States (primarily Europe and Latin America). Assets and liabilities denominated in foreign functional currencies are translated at the exchange rate as of the balance sheet date. Translation adjustments are recorded as a separate component of stockholders' equity in accumulated other comprehensive income (loss). Revenues, costs and expenses denominated in foreign currencies are translated at the weighted average exchange rate for the period. An analysis of the changes in the cumulative adjustments during 2005, 2004 and 2003 follows (dollars in thousands):
Increases or decreases in expected functional currency cash flows upon settlement of a foreign currency transaction are recorded as foreign currency transaction gains or losses and included in the results of operations in the period in which the transaction is settled. Aggregate foreign currency transaction gains included in the consolidated statements of operations for 2005, 2004 and 2003 were $848, $678 and $1,136 respectively. 55 At December 31, 2005, the Company had $20.3 million in Euro-denominated debt for the purpose of hedging a portion of the net equity investments in Europe. In general, the type of risk hedged relates to the foreign currency exposure of net investments in Europe caused by movements in Euro exchange rates. The Company entered into the hedging relationship such that changes in the net investments being hedged are expected to be offset by corresponding changes in the values of the Euro-denominated debt. Effectiveness of the hedging relationship is measured and designated at the beginning of each month by comparing the outstanding balance of the Euro-denominated debt to the carrying value of the designated net equity investments. The net foreign currency translation (gain) loss included in accumulated other comprehensive income relating to the Euro-denominated debt was ($1,348) for 2005, $297 for 2004 and zero for 2003.
Prior to November 1, 2004, the Company had equity investments in certain entities which had retained unrated interests in securitization transactions. These retained interests represented the present value of the right to the excess cash flow generated by the securitized contracts. The residual certificates were accounted for under Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. Because such assets could be contractually prepaid or otherwise settled in such a way that the holder would not receive all of the recorded investment, the assets were classified as available-for-sale investments and carried at estimated fair value with any accompanying increases or decreases in estimated fair value being recorded as unrealized gains or losses in other comprehensive income (loss) in the accompanying statements of stockholders' equity and comprehensive income. An analysis of the changes in the unrealized net gains on securitization transactions during 2005, 2004 and 2003 follows.
The Company files a consolidated federal income tax return with its 80% or greater owned subsidiaries. The Company records all of the allocated federal income tax provision of the consolidated group in the parent corporation. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effects of future changes in tax laws or changes in tax rates are not anticipated. The measurement of deferred tax assets, if any, is reduced by the amount of any tax benefits that, based on available evidence, are not expected to be realized. 56
Basic net earnings per common share calculations are based upon the weighted average number of common shares outstanding. Potentially dilutive common share equivalents include warrants and employee stock options in the diluted loss per common share calculations. Basic and diluted earnings from continuing operations per share were determined as follows:
The Company assesses the impairment of long-lived assets and certain identifiable intangibles whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
At December 31, 2005, the Company has a stock-based employee compensation plan, which is described more fully in Note 9. The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in the consolidated statements of operations, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net loss and loss 57 per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
On January 1, 2006, FirstCity adopted Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS 123R"). SFAS No. 123R supersedes APB Opinion No. 25, which requires recognition of an expense when goods or services are provided. SFAS No. 123R requires the determination of the fair value of the share-based compensation at the grant date and the recognition of the related expense over the period in which the share-based compensation vests. SFAS No. 123R permits a prospective or two modified versions of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by the original SFAS No. 123. The Company will utilize the modified prospective transition method. Therefore, on January 1, 2006, the Company began recognizing an expense for unvested share-based compensation that has been issued. Unvested compensation cost at January 1, 2006 to be expensed prospectively based on unvested stock options at that date outstanding was estimated at approximately $1.7 million. On June 29, 2005, the FASB ratified the consensus reached by Emerging Issues Task Force ("EITF") on Issue No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity when the Limited Partners Have Certain Rights ("EITF 04-5"). The consensus reached by the EITF at the June 2005 meeting was that a sole general partner is presumed to control a limited partnership (or similar entity) and should consolidate the limited partnership unless (1) the limited partners possess substantive kick-out rights or (2) the limited partners possess substantive participating rights. This ratification of EITF Issue No. 04-5 has caused the amendments of Statement of Position 78-9, Accounting for Investments in Real Estate Ventures, and EITF Issue No. 96-16, Investor's Accounting for an Investee When the Investor has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights. EITF 04-5 is effective for all new and modified agreements effective June 29, 2005. For pre-existing agreements that are not modified, the EITF is effective as of the beginning of the first fiscal reporting period beginning after December 15, 2005. The adoption of EITF 04-5 had no impact on the Company's results of operations or financial position. In July 2005, the Financial Accounting Standards Board issued SFAS No.154, Accounting for Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3 ("SFAS 154"). 58 Under the provisions of SFAS 154, a voluntary change in accounting principle requires retrospective application to prior period financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. A change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets must be accounted for as a change in accounting estimate effected by a change in accounting principle. The guidance contained in Opinion No. 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate was not changed. SFAS 154 was adopted by the Company as of January 1, 2006 and had no impact on the consolidated financial position or earnings. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity ("SFAS 150"). SFAS 150 establishes standards for how an issuer measures certain financial instruments with characteristics of both liabilities and equity and classifies them in its statement of financial position. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) when that financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective on July 1, 2003. As it relates to FirstCity, on July 1, 2003, the carrying value of the New Preferred Stock was $3.7 million and approximated fair value. Beginning with the third quarter of 2003, the New Preferred Stock was presented as a liability in the consolidated financial statements and any related accretion of discount and dividends was charged to the consolidated results of operations.
Certain amounts in the consolidated financial statements for prior years have been reclassified to conform with current consolidated financial statement presentation. In 2005, equity in earnings of investments was reclassified outside of revenues, which in prior periods was included with revenues. Also in 2005, the Company has separately disclosed the operating, investing and financing portions of the cash flows attributable to its discontinued operations, which in prior periods were reported on a combined basis as a single amount. 2. Restructure, Liquidity and Capital Resources The Company requires liquidity to fund its operations, working capital, payment of debt, equity for acquisition of Portfolio Assets, investments in and advances to entities formed to acquire Portfolios ("Acquisition Partnerships"), retirement of and dividends on preferred stock, and other investments. The potential sources of liquidity are funds generated from operations, equity distributions from the Acquisition Partnerships, interest and principal payments on subordinated intercompany debt, dividends from the Company's subsidiaries, borrowings from revolving lines of credit and other credit facilities, proceeds from equity market transactions, securitization and other structured finance transactions and other special purpose short-term borrowings. In December 2002, FirstCity completed a recapitalization in which holders of redeemable preferred stock, par value $.01 per share, ("New Preferred Stock") exchanged 1,092,210 shares of New Preferred Stock for 2,417,388 shares of common stock and $10.5 million in cash. FirstCity also recorded a $4 million gain in December 2002 from the release of its guaranty of Drive's indebtedness to BoS(USA), Inc. ("BoS(USA)"). BoS(USA)'s warrant to purchase 1,975,000 shares of non-voting common stock was cancelled. FirstCity also acquired the minority interest in FirstCity Holdings Corporation held by Terry R. DeWitt, G. Stephen Fillip and James C. Holmes, each of whom were Senior Vice Presidents of FirstCity, by issuing 400,000 shares of common stock of the Company and a note payable, to be periodically 59 redeemed by the Company for an aggregate of up to $3.2 million out of certain cash collections from servicing income from Portfolios in Mexico. As a part of the recapitalization, BoS(USA) provided a non-recourse loan in the amount of $16 million to FirstCity which was used to pay the cash portion of the exchange offer to the holders of the New Preferred Stock, to pay expenses of the exchange offer and recapitalization, and to reduce FirstCity's debt to the Bank of Scotland. In connection with the $16 million loan, FirstCity was obligated to pay an arrangement fee to BoS(USA) equal to 20% of all amounts received by FirstCity in excess of $16 million from any sale or other disposition of FirstCity's 20% interest in Drive and all dividends and other distributions paid by Drive or its general partner on FirstCity's 20% interest in Drive. This arrangement was settled as part of the Drive Sale discussed below. Also related to the recapitalization, the Bank of Scotland and BoS(USA) (the "Lenders") refinanced the remainder of the Company's debt facilities. The Lenders also provided new financing to FirstCity, with a total commitment of up to $59 million, consisting of (a) a $5 million revolving credit loan and (b) an acquisition term loan facility for loans in a maximum aggregate amount of $54 million. Effective as of March 31, 2004, the Company amended the acquisition term loan facility which provided for term loans of a maximum amount of $54 million to become a revolving loan facility with a maximum principal balance of $45 million outstanding at any time. On November 1, 2004, FirstCity completed the sale of the Company's 31% beneficial ownership interest in Drive and its general partner, Drive GP LLC, which resulted in net proceeds of $86.8 million. A portion of the proceeds were used to pay off debt. As a result of the sale, FirstCity owed the Bank of Scotland an arrangement fee of $8.0 million relating to the $16 million loan to FirstCity discussed above. This fee was paid in January 2005. On November 12, 2004, FirstCity and Bank of Scotland restructured the $5 million revolving credit loan and the $45 million revolving portfolio acquisition facility into a $96 million revolving acquisition facility that matures in November 2008. This facility is used to finance the senior debt and equity portion of distressed asset pool purchases and to provide for the issuance of Letters of Credit and working capital loans. The $96 million facility (i) allows loans to be made in Euros up to a maximum amount in Euros that is equivalent to $35 million U.S. dollars, (ii) allows loans to be made for acquisition of Portfolio Assets in Latin America of up to $35 million, (iii) provides for an interest rate of Libor plus 2.50% to 2.75%, (iv) provides for a commitment fee of 0.20% of the unused balance of the revolving acquisition facility, (v) provides that the aggregate borrowings under the facility will not exceed 60% of the net present value of FirstCity's interest in Portfolio Assets in Acquisition Partnerships pledged to secure the acquisition facility, and (vi) provides for a reduction in the total loan commitment of $1.3 million per quarter, commencing on December 27, 2005. In August 2005, FH Partners, L.P., an indirect wholly-owned affiliate of FirstCity, and Bank of Scotland, acting through its New York branch, as agent for itself as lender, entered into a Revolving Credit Agreement that provides a $50 million revolving portfolio acquisition facility for FH Partners, L.P. to be secured by all of the assets of FH Partners, L.P. The loan facility will be used to finance portfolio and asset purchases. The facility (i) allows loans to be made for the acquisition of Portfolio Assets in the United States, (ii) provides that each loan may be in an amount of up to 70% of the net present value of the assets being acquired with the proceeds of the loan, (iii) provides that the aggregate outstanding balances of all loans will not exceed 65% of the net present value of the assets securing the loan facility, (iv) provides for an interest rate of LIBOR plus 2.0%, (v) provides for an annual commitment fee of 0.20% of the unused balance of the revolving acquisition facility, (vi) provides for a utilization fee of 0.75% of the amount of each loan made under the loan facility, (vii) provides for an upfront fee of $350 thousand, (viii) provides 60 for facility fees of $100 thousand, for the period commencing on the Effective Date to but excluding the first anniversary thereof, $75 thousand, for the period commencing on the first anniversary of the Effective Date to but excluding the second anniversary thereof, and $50 thousand, for each subsequent one-year period, and (ix) provides for a maturity date of November 12, 2008. The obligations of FH Partners, L.P. under the Revolving Credit Agreement are guaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity. At December 31, 2005, the Company had $20.3 million in Euro-denominated debt for the purpose of hedging a portion of the net equity investments in Europe. In general, the type of risk hedged relates to the foreign currency exposure of net investments in Europe caused by movements in Euro exchange rates. The Company entered into the hedging relationship such that changes in the net investments being hedged are expected to be offset by corresponding changes in the values of the Euro-denominated debt. Effectiveness of the hedging relationship is measured and designated at the beginning of each month by comparing the outstanding balance of the Euro-denominated debt to the carrying value of the designated net equity investments. The net foreign currency translation gain (loss) included in accumulated other comprehensive income relating to the Euro-denominated debt was $1.3 million for the year ended December 31, 2005 and zero for 2004 and 2003. BoS (USA) has a warrant to purchase 425,000 shares of the Company's voting Common Stock at $2.3125 per share. BoS (USA) is entitled to additional warrants in connection with this existing warrant for 425,000 shares under certain specific situations to retain its ability to acquire approximately 4.86% of the Company's voting Common Stock. The warrant will expire on August 31, 2010, if it is not exercised prior to that date. FirstCity's $35 million loan facility with CFSC Capital Corp. XXX, a subsidiary of Cargill, terminated according to the terms of the agreement on March 31, 2005. This facility had been used to provide equity in new Portfolio acquisitions in partnerships with Cargill and its affiliates. On November 12, 2004, the outstanding balances on the Cargill facility were paid down to zero funded out of proceeds from the $96 million facility. Management believes that the Bank of Scotland facilities, the related fees generated from the servicing of assets, equity distributions from existing Acquisition Partnerships and wholly-owned portfolios, as well as sales of interests in equity investments, will allow the Company to meet its obligations as they come due during the next twelve months. 3. Discontinued Operations Discontinued operations are comprised of two components previously reported as the Company's residential and commercial mortgage banking business ("Mortgage") and the consumer lending business conducted through the Company's minority interest investment in Drive ("Consumer"). Earnings (loss) from discontinued operations is summarized as follows:
61 Mortgage Assets remaining from discontinued mortgage operations are investment securities resulting from the retention of a residual interest in a securitization transaction. These securities are in "run-off," and the Company is contractually obligated to service these assets. Prior to the fourth quarter of 2004, FirstCity classified these securities as held to maturity and considered the estimated future gross cash receipts for such investment securities in the computation of the value of such investment securities. In the fourth quarter of 2004, FirstCity's management elected to pursue a strategy to liquidate these assets and carry them as held for sale. Consequently, in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"), the securities are recorded at the lower of their carrying value or fair value less cost to sell. In April 2005, the Company exercised an early purchase option on the 1998-1 securitization. Loans receivable were recorded at $6.1 million in accordance with EITF 02-9, Accounting for Changes That Result in a Transferor Regaining Control of Financial Assets Sold. FirstCity evaluated each loan at the acquisition date to determine whether there was evidence of credit deterioration since origination. At December 31, 2005, the acquired loans are included in Portfolio Assets in the consolidated balance sheet and classified as either "loans acquired with credit deterioration" or "loans acquired without credit deterioration." See note 1(e) for a description of the accounting policy for these loans. As of December 31, 2005 only one investment security remained from discontinued mortgage operations. The assumptions used in the valuation model consider both industry as well as the Company's historical experience and are reviewed quarterly in light of historical evidence in revising the prospective results of the model. These revised assumptions could potentially result in either an increase or decrease in the estimated cash receipts. An additional provision is booked based on the output of the valuation model if deemed necessary. The Company recorded provisions of $.4 million in 2005, $3.8 million in 2004 and $.5 million in 2003 for additional losses from discontinued mortgage operations. In 2004, the provision primarily relates to FirstCity adjusting the carrying value of the residual interests to fair value. The additional provision in 2003 primarily related to a decrease in the estimated future gross cash receipts on residual interests in securitizations as a result of the actual losses exceeding the losses projected by the valuation model. Consumer On September 21, 2004, FirstCity and certain of its subsidiaries entered into a definitive agreement to sell the Company's remaining 31% beneficial ownership interest in Drive and its general partner, Drive GP LLC, to IFA-GP, IFA-LP and MG-LP for a total purchase price of $108.5 million in cash, resulting in distributions and payments to FirstCity in the aggregate amount of $86.8 million in cash, from various sources. The sale was completed on November 1, 2004, and net cash proceeds from these transactions were primarily used to pay off debt. Pursuant to SFAS No. 144, the consolidated financial statements have been reclassified for all periods presented to reflect the operations, assets and liabilities of the consumer business segment as discontinued operations. There were no consumer assets held for sale as of December 31, 2005 and 2004. The liabilities of $.1 million and $9.0 million of such operations have been classified as "Liabilities from discontinued consumer operations," respectively on the December 31, 2005 and 2004 consolidated balance sheets and consisted of state taxes payable as of December 31, 2005. Liabilities from discontinued consumer operations at December 31, 2004 included an arrangement fee of $8 million owed to the Bank of Scotland relating to a $16 million loan made to FirstCity as part of the recapitalization in 2002 (see note 2). This fee was subsequently paid in the first quarter of 2005. The Company also had approximately $1 million of 62 estimated accrued state income taxes at December 31, 2004 resulting from the sale of Drive. Of this, $.6 million was reversed in third quarter of 2005 due to lower than anticipated state income taxes related to the sale of Drive. The net earnings from discontinued consumer operations are classified on the consolidated statements as a component of "Earnings from discontinued operations." Summarized results of discontinued consumer operations are as follows:
The net gain on sale of Drive of $53.3 million is comprised of $67.2 gross gain on sale and adjustments to the Company's basis in Drive of $2.8 million of equity earnings for October 2004, $15.6 million in minority interest expense and $1.1 in taxes. The pro forma condensed consolidated statements of operations for the years ended December 31, 2004 and 2003 illustrating the effects of the Drive sale as if it had occurred as of the beginning of the years are as follows:
63 $67.8 million × average rate of 7.65% × .833 = $4.3 million and amortization of loan fees of $.6 million).
4. Portfolio Assets Portfolio Assets are pledged to secure notes payable that are non-recourse to FirstCity or any affiliate other than the entity that incurred the debt. See Note 2 for a description of the Revolving Credit agreement between FH Partners, L.P. and Bank of Scotland, which is guaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity. Portfolio Assets are summarized as follows:
64 The Company recorded an allowance for impairment on Portfolio Assets of approximately $212, $30 and $98 in 2005, 2004 and 2003, respectively. During 2005, the Company established an allowance for loan losses by a charge to the income statement of $163, comprised of $462 in provisions for loan losses, net of reversals of provisions of $299. The Company previously had not recorded any other valuation allowances on its loans. Changes in accretable yield at December 31, 2005 on loans acquired after 2004 with evidence of credit deterioration were as follows:
Loans acquired during each period for which it was probable at acquisition that all contractually required payments would not be collected are as follows:
5. Loans Receivable from Acquisition Partnerships Held for Investment Loans receivable from Acquisition Partnerships held for investment consist primarily of loans from certain partnerships located in Mexico and are summarized as follows:
There were no provisions recorded on these loans during 2005, 2004 and 2003. The loans receivable from the Acquisition Partnerships are secured by the assets/loans acquired by the partnerships with purchase money loans provided by the investors to the partnerships to purchase the asset pools held in those entities. These loans are evaluated for impairment by analyzing the expected future cash flows from the underlying assets within each pool to determine that the cash flows were sufficient to repay these notes. The Company applies the asset valuation methodology consistently in all venues and uses the same proprietary asset management system to evaluate impairment on all asset pools. The results of this 65 evaluation indicated that cash flows from the pools will be sufficient to repay the loans and no allowances for impairment were necessary. Equity method losses, which were recorded to reduce the loans and interest receivable from the Mexican partnerships, were $.1 million, $.3 million and $2.8 million during 2005, 2004 and 2003, respectively, in compliance with EITF 98-13, Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee. The Company has amended loan agreements with seven Mexican partnerships, with a combined balance of $7.6 million at December 31, 2005 which currently provide for no interest to be payable with respect to periods after the effective dates of the amendments. This change had no impact on the consolidated net earnings as the effect is offset through equity earnings in the partnerships. 6. Equity Investments The Company has investments in Acquisition Partnerships and their general partners that are accounted for under the equity method. The Company also has investments in servicing entities that are accounted for on the equity method. During the first quarter of 2005, FirstCity invested $2.0 million to increase its ownership percentage in MCS et Associes, S.A. ("MCS"), a French servicing company, from 10.00% to 11.89% and in PRL Development, SAS, a French Acquisition Partnership, from 33.50% to 43.50%. PRL Development, SAS increased its ownership percentage in MCS from 14.72% to 19.63% in 2005. These additional investments provided a combined direct and indirect ownership interest in MCS of 20.43%. In 2005, MCS sold its investment in Common Stock of FirstCity resulting in a gain of $1.5 million. FirstCity accounted for its proportionate interest in this gain as an increase in the Company's carrying amount of its investment in MCS of $.3 million and an increase in additional paid-in capital. The condensed combined financial position and results of operations of the Acquisition Partnerships (excluding servicing entities), which include the domestic and foreign Acquisition Partnerships and their general partners, are summarized as follows: Condensed Combined Balance Sheets
66
The assets and equity (deficit) of the Acquisition Partnerships and equity investments in those entities are summarized by geographic region below. The WAMCO Partnerships represent domestic Texas limited partnerships and limited liability companies in which the Company has a common ownership with Cargill.
67 Revenues and earnings (loss) of the Acquisition Partnerships and equity in earnings (loss) of those entities are summarized by geographic region below.
FirstCity holds significant variable interests in certain domestic Acquisition Partnerships and all of the French and Mexico partnerships, which would be characterized as VIE's. However, FirstCity is not deemed to be the primary beneficiary of any of these entities. At December 31, 2005, FirstCity's maximum exposure to loss as a result of its involvement with the VIE's is $22.3 million. 68 7. Notes Payable Notes payable consisted of the following:
Refer to Note 2 for a description of terms related to the Company's Senior Credit Facility at December 31, 2005 and other matters concerning the Company's liquidity. The Company has unsecured notes payable to Terry R. DeWitt, G. Stephen Fillip and James C. Holmes, each of whom were Senior Vice Presidents of FirstCity, in connection with the acquisition of the minority interest in FirstCity Holdings. The notes are to be periodically redeemed by the Company for an aggregate of up to $3.2 million out of certain cash collections from servicing income from Portfolios in Mexico. FirstCity valued the loans at the inception date using an imputed interest rate based on the Company's cost of funds. At December 31, 2005, these notes had an imputed balance of $606 and mature in December 2011. Under terms of certain borrowings, the Company and its subsidiaries are required to maintain certain tangible net worth levels and debt to equity and debt service coverage ratios. The terms also restrict future levels of debt. At December 31, 2005, the Company was in compliance with the aforementioned covenants. The aggregate maturities of notes payable for the five years ending December 31, 2010 are as follows: $318 in 2006, $336 in 2007, $88,999 in 2008, zero in 2009 and 2010, and $606 thereafter. 69 8. Segment Reporting The Company is engaged in one reportable segment—Portfolio Asset acquisition and resolution. The Portfolio Asset acquisition and resolution business involves acquiring Portfolio Assets at a discount to Face Value and servicing and resolving such Portfolios in an effort to maximize the present value of the ultimate cash recoveries. The following is a summary of results of operations for the Portfolio Asset acquisition and resolution segments and reconciliation to earnings from continuing operations.
Revenues and equity in earnings of investments from the Portfolio Asset acquisition and resolution segment attributable to domestic and foreign operations are summarized as follows:
70 Total assets for each of the segments and a reconciliation to total assets are as follows:
The average investment in Portfolio Assets and loans receivable and related income from those investments are as follows:
9. Preferred Stock and Stockholders' Equity On July 17, 1998, the Company filed a shelf registration statement with the Securities and Exchange Commission, which allows the Company to issue up to $250 million in debt and equity securities from time to time in the future. The registration statement became effective July 28, 1998. As of December 31, 2005, there have been no securities issued under this registration statement. In connection with the recapitalization discussed in Note 2, 400,000 shares of Common Stock were issued to purchase a minority interest. BoS(USA) is entitled to additional warrants in connection with its existing warrant for 425,000 shares to retain its ability to acquire approximately 4.86% of the Company's Common Stock. The holders of shares of Common Stock are entitled to one vote for each share on all matters submitted to a vote of common stockholders. In order to preserve certain tax benefits available to the Company, transactions involving stockholders holding or proposing to acquire more than 4.75% of outstanding common shares are prohibited unless the prior approval of the Board of Directors is obtained. 71 On December 30, 2004, FirstCity redeemed all of the outstanding shares of its New Preferred Stock at a total redemption price of $21.525 per share. The redemption price represented the liquidation preference of the New Preferred Stock plus the final normal quarterly dividend of $.525 per share. The Board of Directors of the Company may designate the relative rights and preferences of the optional preferred stock when and if issued. Such rights and preferences can include liquidation preferences, redemption rights, voting rights and dividends and shares can be issued in multiple series with different rights and preferences. The Company has no current plans for the issuance of an additional series of optional preferred stock. The Company has a stock option and award plan for the benefit of key individuals, including its directors, officers and key employees. The plan is administered by a committee of the Board of Directors and provides for the grant of up to a total of 300,000 shares (net of shares cancelled and forfeited) of Common Stock. The Company had a 1995 Stock Option and Award Plan, and a 1996 Stock Option and Award Plan, which provided for a grant of up to 700,000 shares. These plans expired by their own terms in 2005. Stock option activity during the years indicated is as follows:
The following table summarizes stock options granted by grant date.
72 The fair value of stock options granted was estimated on the date of grant using the Black-Scholes option pricing model. The following table sets forth the weighted average assumptions used to calculate the fair value of the stock options for 2005, 2004 and 2003.
In addition, 502,325, 490,000 and 542,813 options were exercisable with a weighted-average exercise price of $6.20, $7.40 and $8.33 at December 31, 2005, 2004 and 2003, respectively. 10. Income Taxes Income tax expense from continuing operations consists of:
The actual income tax benefit (expense) attributable to earnings (loss) from continuing operations differs from the expected tax benefit (expense) (computed by applying the federal corporate tax rate of 35% to earnings (loss) from continuing operations before income taxes, minority interest and accounting change) as follows:
73 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets at December 31, 2005 and 2004 are as follows:
The Company has net operating loss carryforwards for federal income tax purposes of approximately $604 million from continuing operations and $9 million from discontinued operations at December 31, 2005, less expiring net operating loss for 2005 of $38 million, available to offset future federal taxable income, if any, through the year 2021. A valuation allowance is provided to reduce the deferred tax assets to a level, which, more likely than not, will be realized. During 2005, 2004 and 2003, the Company adjusted the previously established valuation allowance to recognize a deferred tax benefit of $2.9 million, $1.8 million and $1.6 million, respectively. Realization of the deferred tax asset is determined based on management's expectation of generating sufficient taxable income in a look forward period over the next four years. As discussed in note 3, FirstCity sold its remaining 31% interest in Drive in November 2004. The ultimate realization of the resulting net deferred tax asset is dependent upon generating sufficient taxable income from its continuing operations prior to expiration of the net operating loss carryforwards. Although realization is not assured, management believes that the deferred tax asset, net of allowance, has been carried at low levels, and thus, the sale of Drive has no impact on FirstCity's ability to realize all of the deferred tax asset, net of allowance. The amount of the deferred tax asset considered realizable, however, could be adjusted in the future if estimates of future taxable income during the carryforward period change. The ability of the Company to realize the deferred tax asset is periodically reviewed and the valuation allowance is adjusted accordingly. 11. Employee Benefit Plan The Company has a defined contribution 401(k) employee profit sharing plan pursuant to which the Company matches employee contributions at a stated percentage of employee contributions to a defined maximum. The Company's contributions to the 401(k) plan were $134 in 2005, $143 in 2004 and $162 in 2003. 12. Leases The Company leases its current headquarters from a related party under a noncancellable operating lease. The lease calls for monthly payments of $10 through its expiration in December 2006 and includes an option to renew for an additional five-year period. Rental expense under this lease was $120 for 2005, 74 2004 and 2003. The Company also leases office space and equipment from unrelated parties under operating leases expiring in various years through 2009. Rental expense under these leases for 2005, 2004 and 2003 was $545, $557 and $689, respectively. As of December 31, 2005, the future minimum lease payments under all noncancellable operating leases are: $493 in 2006, $290 in 2007, $269 in 2008, $229 in 2009 and $229 in 2010. 13. Other Related Party Transactions The Company has contracted with the Acquisition Partnerships and related parties as a third party loan servicer. Servicing fees totaling $11.8 million, $13.7 million and $15.1 million, for 2005, 2004 and 2003, respectively, and due diligence fees (included in other income) were derived from such affiliates. During 2003, the Company acquired the minority interest in MCSFC, Ltd. for $1.4 million. The book value of the minority interest at the time of purchase was $1.3 million. Also in 2003, the Company participated in the purchase of an Acquisition Partnership from an affiliate of Cargill for $9.4 million. FirstCity's total investment in this partnership was $4.5 million comprising a $4.1 million loan receivable and $.4 million equity contribution. J-Hawk I, Ltd., a limited partnership of which James R. Hawkins is an affiliate, and FirstStreet Investments, LLC, an affiliate of FirstCity Financial Corporation, entered into a loan sale agreement dated June 30, 2004, pursuant to which J-Hawk I, Ltd. purchased from FirstStreet Investments, LLC, a promissory note executed on behalf of Combined Entertainment, Inc. (also an affiliate of Mr. Hawkins) as maker. The note was guaranteed by James R. Hawkins, Rick R. Hagelstein and J-Hawk Corporation (now FirstCity Financial Corporation). The purchase price for the note was $2.0 million, an amount equal to the outstanding principal balance of the promissory note plus all outstanding accrued interest due on the note. Pursuant to the loan sale agreement, J-Hawk I, Ltd., Park Central Recreation, Inc., Combined Entertainment, Inc. and James R. Hawkins released FirstCity, FirstStreet Investments, LLC, FirstCity Servicing Corporation, WAMCO IX, Ltd. and their affiliates and subsidiaries from all obligations under a guaranty of the promissory note and indemnified FirstCity, FirstStreet Investments, LLC, FirstCity Servicing Corporation, WAMCO IX, Ltd. and their subsidiaries and affiliates and all officers, directors, employees, agents and representatives of all such persons from any claims related to the promissory note, the guaranty and the ownership and servicing of the promissory note and guaranty. The sale was without representations or warranties except as to ownership of the promissory note. FirstCity Servicing Corporation and MCS, in which FirstCity Servicing Corporation is an 11.89% shareholder as of December 31, 2005, are parties to Consulting, License and Confidentiality Agreements dated June 30, 1999 pursuant to which FirstCity Servicing Corporation provides consultation services and personnel to be employed by MCS to assist in developing and managing due diligence and servicing systems. Pursuant to those agreements, MCS agrees to provide the supplied personnel with compensation, tax equalization payments, housing allowances, transportation allowance, tax preparation and MCS pays consulting fees to FirstCity Servicing Corporation and reimburses FirstCity Servicing Corporation for travel, hotel, airfare, and meal expenses paid by it related to the provision of the services. EuroTex Partners, Ltd., a subsidiary of FirstCity Commercial Corporation, purchased real and personal property used as a personal residence of the supplied employee in Paris, France for a purchase price of $2.2 million. FirstCity recorded $364, $255 and $216 in 2005, 2004 and 2003, respectively, from MCS as reimbursement fees included in other income. During 2005, the Company sold all of its equity interest of 33.33% in Compagnie Transatlantique de Portefeuilles for no gain. 75 14. Commitments and Contingencies Periodically, FirstCity, its subsidiaries, its affiliates and the Acquisition Partnerships are parties to or otherwise involved in legal proceedings arising in the normal course of business. FirstCity does not believe that there is any proceeding threatened or pending against it, its subsidiaries, its affiliates or the Acquisition Partnerships which, if determined adversely, would have a material adverse effect on the consolidated financial position, results of operations or liquidity of FirstCity, its subsidiaries, its affiliates or the Acquisition Partnerships. In August 2000, Consumer Corp. and Funding LP contributed all of the assets utilized in the operations of the automobile finance operation to Drive pursuant to the terms of a Contribution and Assumption Agreement by and between Consumer Corp. and Drive, and a Contribution and Assumption Agreement by and between Funding LP and Drive (collectively, the "Contribution Agreements"). Drive assumed substantially all of the liabilities of the automobile finance operation as set forth in the Contribution Agreements. In addition, pursuant to the terms of a Securities Purchase Agreement dated as of August 18, 2000 (the "2000 Securities Purchase Agreement"), by and among FirstCity, Consumer Corp., FirstCity Funding LP ("Funding LP"), and FirstCity Funding GP Corp. ("Funding GP"), IFA-GP and IFA-LP; FirstCity, Consumer Corp., Funding LP and Funding GP made various warranties concerning (i) their respective organizations, (ii) the automobile finance operation conducted by Consumer Corp. and Funding LP, and (iii) the assets transferred by Consumer Corp. and Funding LP to Drive. The Company, Consumer Corp., Funding LP and Funding GP also agreed to indemnify BoS(USA), IFA-GP and IFA-LP from damages resulting from a breach of any representation or warranty contained in the 2000 Securities Purchase Agreement or otherwise made by the Company, Consumer Corp. or Funding LP in connection with the transaction. The indemnity obligation under the 2000 Securities Purchase Agreement survives for a period of seven (7) years from August 25, 2000 (the "2000 Closing Date") with respect to tax-related representations and warranties and for thirty months from the 2000 Closing Date with respect to all other representations and warranties. Neither the Company, Consumer Corp., Funding LP, or Funding GP is required to make any payments as a result of the indemnity provided under the 2000 Securities Purchase Agreement until the aggregate amount payable exceeds $.25 million, and then only for the amount in excess of $.25 million in the aggregate; however certain representations and warranties are not subject to this $.25 million threshold. Pursuant to the terms of the Contribution Agreements, Consumer Corp. and Funding LP have agreed to indemnify Drive from any damages resulting in a material adverse effect on Drive resulting from breaches of representations or warranties, failure to perform, pay or discharge liabilities other than the assumed liabilities, or claims, lawsuits or proceedings resulting from the transactions contemplated by the Contribution Agreements. Pursuant to the terms of the Contribution Agreements, Drive has agreed to indemnify Consumer Corp. and Funding LP for any breach of any representation or warranty by Drive, the failure of Drive to discharge any assumed liability, or any claims arising out of any failure by Drive to properly service receivables after August 1, 2000. Liability for indemnification pursuant to the terms of the Contribution Agreements will not arise until the total of all losses with respect to such matters exceeds $.25 million and then only for the amount by which such losses exceed $.25 million; however this limitation will not apply to any breach of which the party had knowledge at the time of the Closing Date or any intentional breach by a party of any covenant or obligation under the Contribution Agreements. Management of the Company believes that FirstCity will not have to pay any amounts related to these agreements. On September 21, 2004, FirstCity, Consumer Corp., Funding LP and Funding GP entered into the a Securities Purchase Agreement to sell a 31% beneficial ownership interest in Drive and its general partner, Drive GP LLC, to IFA GP, IFA LP and MG-LP (the "2004 Securities Purchase Agreement"). In the 2004 Securities Purchase Agreement, FirstCity, Consumer Corp., Funding LP and Funding GP made various 76 representations and warranties concerning (i) their respective organizations, (ii) their power and authority to enter into the 2004 Securities Purchase Agreement and the transactions contemplated therein, (iii) the ownership of the limited partnership interests in Drive by Funding LP, (iv) the ownership of membership interests in Drive-GP by Consumer Corp., and (iv) the capital structure of Funding LP. FirstCity, Consumer Corp., Funding LP and Funding GP also agreed to indemnify BoS (USA), IFA-GP, IFA-LP and MG-LP from damages resulting from a breach of any representation or warranty contained in the 2004 Securities Purchase Agreement or otherwise made by FirstCity, Consumer Corp. or Funding LP in connection with the transaction. The indemnity obligations under the 2004 Securities Purchase Agreement survive for a maximum period of five (5) years from November 1, 2004. Neither FirstCity, Consumer Corp., Funding LP, or Funding GP is required to make any payments as a result of the indemnity provided under the 2004 Securities Purchase Agreement until the aggregate amount payable exceeds $.25 million, and then only for the amount in excess of $.25 million in the aggregate; however certain representations and warranties are not subject to this $.25 million threshold. Management of the Company believes that FirstCity will not have to pay any amounts relating to these representations and warranties. FirstCity has minority interests in various limited-life partnerships with a carrying value of $1.2 million at December 31, 2005. The estimated amount that would be paid to the minority interest holder if the instruments were to be settled at December 31, 2005 is $1.5 million. 15. Financial Instruments SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires that the Company disclose estimated fair values of its financial instruments. Fair value estimates, methods and assumptions are set forth below. The carrying amount of cash and cash equivalents approximated fair value at December 31, 2005 and 2004. The Portfolio Assets and loans receivable are carried at the lower of cost or estimated fair value. The estimated fair value is calculated by discounting projected cash flows on an asset-by-asset basis using estimated market discount rates that reflect the credit and interest rate risks inherent in the assets. The carrying value of the Portfolio Assets and loans receivable was $69 million and $59.2 million, respectively, at December 31, 2005 and 2004. The estimated fair value of the Portfolio Assets and loans receivable was approximately $73.2 million and $61.9 million, respectively, at December 31, 2005 and 2004. Through December 31, 2003, residual interests in securitizations included in discontinued mortgage operations were carried at estimated future gross cash receipts. The estimated fair value was calculated using various assumptions regarding prepayment speeds and credit losses. Beginning in December 2004, the residual interests are carried at fair value. The carrying value of the residual interests was $.2 million and $1.8 million at December 31, 2005 and 2004, respectively. Management believes that the repayment terms for similar rate financial instruments with similar credit risks and the stated interest rates at December 31, 2005 and 2004 approximate the market terms for 77 similar credit instruments. Accordingly, the carrying amount of notes payable is believed to approximate fair value. 16. Selected Quarterly Financial Data (Unaudited) The following are summarized quarterly financial data for the years ended December 31, 2005 and 2004:
78
The
Board of Directors and Stockholders We have audited the accompanying consolidated balance sheets of FirstCity Financial Corporation and its subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, statements of stockholders' equity and comprehensive income and statements of cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of FirstCity Financial Corporation and its subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, in 2003, the Company changed its presentation of preferred stock in accordance with Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of FirstCity Financial Corporation's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2006 expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting. KPMG LLP Dallas,
Texas 79
The
Board of Directors and Stockholders We have audited management's assessment, included in Management's Report on Internal Control over Financial Reporting, that FirstCity Financial Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). FirstCity Financial Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that FirstCity Financial Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, FirstCity Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of FirstCity Financial Corporation and its subsidiaries as of December 31, 2005 and 2004, and the related consolidated income statements, statements of stockholders' equity and comprehensive income and statements of cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 16, 2006 expressed an unqualified opinion on those consolidated financial statements. KPMG LLP Dallas,
Texas 80 WAMCO PARTNERSHIPS
81
The
Partners We have audited the accompanying combined balance sheets of the WAMCO Partnerships as of December 31, 2005 and 2004, and the related combined statements of operations, changes in partners' capital, and cash flows for each of the years in the three-year period ended December 31, 2005. These combined financial statements are the responsibility of the Partnerships' management. Our responsibility is to express an opinion on these combined financial statements based on our audits. We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Partnerships are not required to have, nor were we engaged to perform, an audit of their internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnerships' internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the combined financial statements referred to above present fairly, in all material respects, the financial position of the WAMCO Partnerships as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
82
See accompanying notes to combined financial statements. 83
See accompanying notes to combined financial statements. 84
See accompanying notes to combined financial statements. 85
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