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LECG 10-K 2007 Documents found in this filing:UNITED STATES WASHINGTON, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year ended December 31, 2006 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period from to Commission File Number 000-50464 LECG CORPORATION (Exact name of registrant as specified in its charter)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None 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 x 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 x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x 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 or a non-accelerated filer. (See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). Large accelerated filer o Accelerated filer x Non-accelerated filer o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x The approximate aggregate market value of the registrant’s common stock held by non-affiliates as of June 30, 2006 (the last business day of the registrant’s most recently completed second fiscal quarter) was $377,314,764* (based on the closing price for the common stock on the NASDAQ Global Select Market on such date). As of February 28, 2007, there were 24,921,072 shares of the registrant’s common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Definitive Proxy Statement to be filed with the Commission pursuant to Regulation 14A in connection with the registrant’s 2007 Annual Meeting of Stockholders, to be filed subsequent to the date hereof, are incorporated by reference into Part III of this Report. Such Definitive Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the conclusion of the registrant’s fiscal year ended December 31, 2006. * Excludes the Common Stock held by executive officers, directors and stockholders whose ownership equals or exceeds 10% of the Common Stock outstanding at June 30, 2006. This calculation does not reflect a determination that such persons are affiliates for any other purposes.
INDEX TABLE OF CONTENTS
2 The following discussion and other parts of this Annual Report on Form 10-K concerning our future business, operating and financial condition and statements using the terms “believes”, “expects”, “will”‘ “could”, “plans”, “anticipates”, “estimates”, “predicts”, “intends”, “potential”, “continue”, “should”, “may”, or the negative of these terms or similar expressions are “forward-looking” statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based upon our current expectations as of the date of this Report. There may be events in the future that we are not able to accurately predict or control that may cause actual results to differ materially from expectations. Information contained in these forward-looking statements is inherently uncertain, and actual performance is subject to a number of risks, including but not limited to, (1) our ability to successfully attract, integrate and retain our experts and professional staff, (2) dependence on key personnel, (3) successful management of professional staff, (4) dependence on growth of our service offerings, (5) our ability to maintain and attract new business, (6) successful management of additional hiring and acquisitions, (7) successful administration of our business and financial reporting capabilities, including the successful remediation of the material weakness in our internal control over financial reporting, (8) potential professional liability, (9) intense competition and (10) risks inherent in international operations. Further information on these and other potential risk factors that could affect our financial results may be described from time to time in our periodic filings with the Securities and Exchange Commission and include those set forth in this Report under “Risk Factors.” We cannot guarantee any future results, levels of activity, performance or achievement. We undertake no obligation to update any of these forward-looking statements after the date of this Report. We provide expert services. Our highly credentialed experts and professional staff address complex, unstructured business and public policy problems. We deliver independent expert testimony and original authoritative studies in both adversarial and non-adversarial environments. We conduct economic, financial and statistical analyses to provide objective opinions and strategic advice to legislative, judicial, regulatory and business decision makers. Our skills include factual and statistical analyses, report preparation and presentation, electronic discovery and data collection and forensic accounting. Our experts are renowned academics, former senior government officials, experienced industry leaders, technical analysts and seasoned consultants. Our clients include Fortune Global 500 corporations, major law firms and local, state and federal governments and agencies in the United States and other countries throughout the world. In 2006, we increased the number of our experts by 8% to 376 and increased the number of our professional staff by 13% to 634 and had 36 offices in ten countries at December 31, 2006. Our growth has enabled us to deepen our existing service offerings, as well as to add experts and professional staff in new practice areas. BUSINESS ENVIRONMENT FOR EXPERT SERVICES Businesses, courts, arbitration panels, tribunals, regulatory authorities, legislative bodies and boards of directors throughout the world use independent expert analysis and advice to help resolve disputes through litigation, arbitration and negotiation, as well as to understand and address the impact of regulation and legislation. These processes generate ongoing demand for original economic, financial and statistical analyses, irrespective of the business cycle. The credibility of expert analysis and advice is enhanced if the work is independent, is prepared by highly qualified individuals and is informed by the objective facts and 3 circumstances concerned. Judges, jurors, arbitrators, legislators, senior executives and boards of directors tend to give greater weight to experts who do not have a vested interest in the outcome. When trying to resolve or assess important, complex issues, it is frequently insufficient to rely on already published studies. Typically, original and forensic analysis must be conducted based on specific data, documents and facts. Disputes are an inherent element of the economy and occur regardless of the business cycle. Disputes that require expert analysis and advice typically involve significant financial impact for the parties involved, and as the costs of, or potential for adverse outcomes increase, the demand for expert services grows. Expert analysis and advice can also help shape policy choices and can help guide affected parties’ responses. The dispute resolution and decision-making processes can be assisted by independent, objective expert analysis of facts, data, causes and consequences. · Litigation. Complex litigation continues to grow, driven by legislative ambiguities, regulatory activities, judicial interpretations and private actions, including class actions. Litigation arises from many areas of economic activity, including mergers and acquisitions, intellectual property and taxation. Hundreds of millions of dollars in damages are frequently sought and sometimes awarded in the United States. Both defendants and plaintiffs seek expert analysis and advice to inform courts, arbitration panels and juries in determining appropriate remedies. Many aspects of business behavior, including mergers and acquisitions, pricing policies, collaborative arrangements, exclusivity arrangements and patent licensing are scrutinized by governments and private parties with respect to antitrust issues. Antitrust scrutiny creates the need for analyses of effects of mergers and acquisitions, assessment of organizational arrangements and distribution policies, pricing behavior and pricing patterns. While the United States has led the development of antitrust laws, many non-U.S. jurisdictions are increasingly applying antitrust policies, procedures and methods of analysis and assessment. The result is a high degree of transferability of and demand for independent expert analysis and advice across jurisdictional boundaries. Intellectual property disputes have also increased as intellectual property rights, including patents, trade secrets, copyrights and trademarks have become more important and valuable. The rate and complexity of patent applications filed with the United States Patent and Trademark Office have grown dramatically in the last decade. In addition, new fields for which patents were not issued 30 years ago, such as biotechnology and software, are now significant areas for patent applications in the United States. Claims of patent infringement are common and often require independent valuations and assessments. The increased complexity of patent applications and the increased value of these intangible assets have created a significant amount of intellectual property-based litigation. Determination of lost profits, reasonable royalties, valuations and other market impacts require detailed economic, financial and statistical analysis. · Arbitration. Arbitration is often used to resolve commercial disputes under long-term contracts arising from changes in the business environment due to a number of factors, including government action, new technology and shifts in critical input costs. For instance, long-term gas supply contracts for electric utilities may not be able to adequately address changes in world energy prices, and contracting parties may seek a resolution to these unanticipated changes through arbitration rather than litigation. Various governments and financial institutions are signatories to certain treaties which allow for them to engage in dispute resolution through the use of arbitration proceedings. Such proceedings have the potential to provide a multi-national solution to a variety of complex matters. International arbitration has seen a growing number of cases brought before the International Centre for Settlement of Investment Disputes (“ICSID”) created by the World Bank, 4 examples of which include investment disputes between sovereign governments and private foreign investors. Parties increasingly rely on arbitration to maintain commercial contracts over time. Authoritative reports are often commissioned to analyze unanticipated changes and help determine the appropriate adjustments that should be made. · Negotiation. In commercial contexts, parties frequently negotiate to resolve disputes in order to avoid litigation or arbitration. Negotiation is less structured than litigation or arbitration and often involves multiple parties to a transaction or to a settlement. A report or a finding from an expert known to be knowledgeable and independent can help resolve disputes. For instance, in the environmental claims area, the resolution of disputes regarding recoveries or the assessment of exposure can be aided by authoritative reports that calculate the exposure among all parties, including insurers. · Regulation. Government regulation remains considerable and involves high stakes for new and existing businesses. For example, the United States telecommunications industry has over 50 active regulatory agencies, including state agencies, the Federal Communications Commission, and the Department of Justice. In addition to specific regulations covering industries such as electricity, telecommunications, mail, insurance, financial markets, healthcare, railroads and airlines, there are general regulations such as health and safety, environmental protection and international trade. In many instances, affected parties engage experts to evaluate the economic and financial impact of regulation. The Telecommunications Act of 1996 generated the submission of a number of studies and reports by affected parties in an effort to influence rule making by the Federal Communications Commission. Regulatory decisions are frequently challenged in the courts, often resulting in demand for additional studies. Regulatory activity has increased internationally. For example, as the European Union seeks increasingly to harmonize financial services rules across its internal market, the regulatory role of the European Commission has grown correspondingly. Regulatory decisions in Europe have a corresponding impact on financial markets and institutions in the United States. Consequently, United States governmental agencies such as the Federal Reserve have a strong interest in the regulatory environments in which these institutions operate outside the United States. Demand for expert analysis on regulatory issues is both domestic and international, as regulators around the world increasingly draw upon the skills of outside experts to help shape and improve policy. · Legislation. Representative bodies around the world, such as legislatures and parliaments, continuously modify the rules by which society and the economy are organized. The legislative process frequently provides an opportunity for experts to study legislative impact on behalf of businesses and trade associations. In the United States, legislative bodies and executive branches of government often seek expert advice, as do corporations and trade associations. Legislation will often have a material impact on national, state and local economies. For example, environmental legislation like the Clean Air Act and securities legislation like the Sarbanes-Oxley Act of 2002 have had significant economic impact on businesses. Authoritative reports, detailed analysis and the presentation of data can shape business behavior and legislative and market outcomes. Once enacted, legislation invites further analyses and creates the opportunity to provide compliance studies and impact assessments. Experts come from universities, think tanks, public and private research laboratories, governmental bodies, private enterprises and professional services firms. Many potential providers of expert services do not readily offer expert analysis or advice as an identified line of business. 5 Large-scale original studies and analyses often cannot be done in an expert’s primary workplace or are unsuited to traditional consulting environments. For instance, most universities, think tanks and laboratories do not allow faculty or staff to use the institution’s facilities or students when they are on private consulting engagements. Traditional consulting firms are also not designed to support highly specialized experts. Management consulting firms often operate by leveraging particular methodologies and concepts. Providing expert services requires specific analysis and highly customized approaches and can involve the analysis of large numbers of documents and electronic data related to the issues at hand. In order to efficiently and effectively provide expert services, an organization must satisfy the needs of its experts and address the issues facing its clients. Traditional styles of employment often do not work well for many highly talented experts. Effectively utilizing the capabilities and energies of talented experts, while simultaneously providing independent analysis of issues confronting clients, often requires organizational structure, organizational culture and support systems of a non-traditional kind. Experts provide a unique managerial challenge because they are highly intelligent, highly educated, highly independent and self-motivated and may have already enjoyed senior management and/or professional status. We believe experts desire to work in an organization that enables professional autonomy, brings together other experts with deep substantive knowledge, aligns incentives to enhance returns for both the expert and the firm, employs experienced professional staff with strong analytical and project management skills and provides the requisite administrative infrastructure. · Objective rewards. Because professional activities for experts are substantially self-directed, and because of the need for high autonomy, reward systems are more effective if they are tied to objective financial criteria over which the expert has significant control. · Association with other experts. Experts benefit from being able to call upon the expertise of their colleagues. The bringing together of experts in an expert services organization can create a collegial environment in which knowledge can be exchanged, and colleagues can share work, ideas, professional experiences and client opportunities. · Professional staff. Engagements often include a multitude of tasks that require various levels of expertise and sophistication. Expert services are typically requested or required in time-sensitive matters with high financial impact where effective professional staff, and occasionally other experts, are critical factors in completing an engagement. The ability to utilize professional staff enables experts to focus their time on the high level components of a project. Also, because reputations are at stake when experts testify, experts require and demand experienced professional staff who can assist them on substantive issues including data collection, statistical analysis, presentation preparation and project management. Expert services are highly specialized and their effective delivery requires identifying individuals with substantive knowledge of the specific problems or issues under consideration, quality reputations and the ability to clearly communicate and defend analyses and advice under rigorous questioning or cross-examination. On-time performance is critical, especially when there are deadlines for reports and appearances before judges, juries, arbitrators and legislators. In addition, clients expect that experts will be efficient in leveraging the capabilities of professional staff to reduce costs. Our competitive strengths enable us to provide high-quality, independent expert testimony, original authoritative studies and strategic advice to Fortune Global 500 companies, major law firms and local, state 6 and federal government agencies in the United States and internationally. We continually seek new talent to deepen our existing capabilities as well as expand into new areas. We believe that our experts’ qualifications, independence and pursuit of excellence give us a strong presence in the marketplace for expert services. Our experts include internationally recognized faculty and former faculty from many of the world’s best universities, and include significant contributors to academic and professional literature in economics and finance. These experts offer high level expertise in areas such as antitrust, complex financial damages, forensic accounting, electronic discovery, environmental damages assessment, telecommunications regulation and deregulation, bankruptcy, corporate restructuring, electricity market design, public policy, healthcare and intellectual property valuation. Many of our experts also have valuable hands-on industry experience or have worked in or with government agencies, such as the United States Department of Justice, United States Securities and Exchange Commission, United States Federal Trade Commission, Internal Revenue Service, Environmental Protection Agency, European Commission, United Kingdom’s Office of Gas and Electricity Markets and national treasuries around the world. The reputations and experience of our experts drives the demand for our services. Our growth is dependent upon our ability to hire and retain leading independent experts in fields where we believe there is substantial business opportunity for expert analysis and advice due to the significant economic and financial impact of the disputes and decisions involved. Our focus on complex dispute resolution and informing decision-makers enables us to effectively recruit and retain top expert talent from a variety of professional disciplines. Our organizational structure fosters an entrepreneurial culture that enables us to attract, deploy and retain leading independent experts from academia, government and the private sector. Our experts are successful, self-motivated, credentialed individuals who respond best to an organization such as ours that provides experts with a high degree of autonomy and intellectual freedom. In addition, we are constantly seeking to recruit top talent. We have demonstrated the ability to effectively identify, recruit and integrate additional experts into our company. We also have the ability to develop experts from within the firm. We employ an experienced professional staff to support our experts. The utilization of our professional staff is important to the profitability of our business. Many of our professional staff have advanced degrees in economics, finance or related disciplines, and relevant business and public service experience. Our professional staff enables our experts to focus their time on the most significant components of a project by assisting them on issues such as data collection, statistical analysis, data and fact auditing, presentation preparation and project management. This allows the expert to deliver a higher quality, more robust and timely work product in a cost-effective manner. Many of our professional staff have become experts in their own right, testifying, authoring studies, developing sophisticated models and providing strategic advice. We provide expert services including independent expert testimony, original authoritative studies and strategic advice to Fortune Global 500 corporations, major law firms, local, state and regional governments and governmental agencies in the United States and internationally. Demand for our services is driven by clients attempting to resolve disputes through litigation, arbitration or negotiation, or seeking to 7 understand and address regulation and legislation. We apply our core competencies to matters arising from these key drivers to provide independent expert services to our clients. Our experts and professional staff have specialized knowledge in economic, financial and statistical theories, antitrust, complex financial damages, electronic discovery and data organization, forensic accounting and other areas requiring complex analyses. In addition, many of our experts and professional staff also possess in-depth knowledge of specific markets, regulations and industries. These core competencies enable us to incorporate complex methodologies and tools developed in research settings to deliver independent expert testimony, original authoritative studies and strategic advice in adversarial and non-adversarial settings to assist in dispute resolution and decision-making. The reputations of our experts and the quality of our experts’ services have resulted in a high level of repeat business and the development of significant new business. Our experts and professional staff provide independent expert testimony, original, authoritative studies and strategic advisory services to help resolve complex disputes and inform legislative, judicial, regulatory and business decision-makers. Our experts and professional staff manage information and conduct independent, sophisticated economic, financial and statistical analyses for clients attempting to resolve disputes through litigation, arbitration or negotiation or seeking to understand and address regulation and legislation. In addition, we also provide claims management services for large settlements involving a significant number of claimants. · Expert testimony. Our experts provide independent oral and written expert testimony on behalf of plaintiffs and defendants in trial, arbitration and mediation proceedings, as well as in matters before regulatory agencies and legislative bodies. Our experts have testified throughout the world on matters such as antitrust, class certification, complex merger filings, contract damages, employment discrimination, damage quantification and on the valuation of a wide range of intellectual property assets, including patents, copyrights, trademarks, trade secrets and trade dress. · Authoritative studies. We prepare and provide independent authoritative studies generally in connection with litigation; such as studies containing detailed economic, financial and statistical analyses. Authoritative studies are often commissioned in support of expert testimony or to analyze proposed regulations or legislation. Large amounts of information and data must often be assembled by staff to facilitate these analyses. We also conduct studies that are used during arbitration and negotiation. · Advisory services. Our experts and professional staff provide independent strategic advice and expert consulting, particularly in industries with a heavy regulatory or legal component. This advice is usually provided to senior management and boards of directors of our clients. Our services include the analysis and evaluation of potential mergers and the integration of businesses, the economic analysis of prospective investments, securities litigation consulting, transfer pricing expertise, risk management analysis in connection with large insurance claims, the design of regulatory compliance systems and the management of intangible assets. We frequently advise on regulatory strategy and on market design. In the finance area, we perform valuations of assets, including intellectual property, such as patents, trade secrets and trademarks. We provide advice regarding licensing and transfer pricing strategies and protocols. 8 Our experts have specific expertise in practice areas that include competition policy/antitrust; complex damages including intellectual property, environmental and insurance claims; market and regulatory design; valuation analysis; labor and employment; forensic accounting; electronic discovery, bankruptcy and securities litigation. Many of our projects span multiple practice areas, and many of our staff work in several practice areas. We have also developed new practice areas, such as labor and employment, bankruptcy and reorganization and securities litigation, as the issues facing our clients evolve and new business opportunities arise. · Competition policy/antitrust. We have provided expert services in the antitrust field since our founding. Many antitrust projects require special skills and, in many cases, experience with or exposure to approaches and methods used by the antitrust enforcement agencies. Antitrust issues increasingly involve other practice areas in the firm such as regulatory design and intellectual property. Mergers involving large multinational corporations often require coordination across many of our offices worldwide. · Finance and damages. As damages from business litigation become more complex, there is a need for expert advice based on advanced economic and financial analysis. Our practice in this area includes many professionals with a deep understanding of the application of advanced methodologies and techniques in economics, finance, accounting and statistics. An important element of this practice is assessing damages in securities litigation, as well as damage issues related to patent, copyright and trademark infringement and trade secret misappropriation. These issues can involve determinations of lost profits, damages and reasonable royalties. · Environmental and insurance claims. Many industries in the United States are exposed to claims of environmental damages due to current or legacy activities, including oil spills, chemical spills and other sources of environmental contamination. Our experts provide advice on how contamination affects property values. Our experts also quantify damages and estimate penalty exposure. Piecing together the data that addresses liability issues, the amount of damage, and the coverage available under legacy insurance policies involves historical research, the quantification of damages and the apportionment of damages to multiple insurers when the insured has complex insurance coverage profiles. · Public policy. We help businesses and governments understand and address market and regulatory policies through the use of economic and financial analyses. Our insights, analyses, recommendations and presentations are used to respond to proposed policy changes, as well as initiate new policies that address strategic objectives. We offer a broad array of services in market and regulatory design ranging from testimony and guidance in front of regulatory commissions or legislative bodies, to the actual design and oversight of independent system administration in the electricity sector. · Valuation analysis. We are frequently called upon to value assets and rights. These can include contingent claims, options and intellectual property rights. Our experts employ advanced methodologies and tools to value idiosyncratic assets for purposes of helping to resolve disputes and to aid business decisions. · Labor and employment. Our experts perform statistical analyses and evaluate discrimination, wrongful termination and wage and hour claims. Our experts calculate economic loss and damages by analyzing employer statistics for potential disparities in hiring, layoffs, promotions, pay and performance assessments. Our experts have advised on human resource management, benefits, collective bargaining and arbitration. 9 · Forensic accounting. We provide forensic accounting services in connection with complex commercial disputes and regulatory investigations. We gather and analyze voluminous amounts of financial data to uncover evidence, reconstruct complex financial transactions and events and identify potential liabilities or areas of fraud. · Electronic discovery services. The capability for law firms to effectively manage and access case documentation and data is critical to attorneys responsible for the outcome of a case and the clients they represent. Our electronic discovery experts work directly with outside counsel, general counsel and corporate executives to deliver objective advice in all phases of modern electronic discovery. Our electronic discovery services include: litigation readiness planning, electronic discovery consulting, litigation information management, data preservation, computer forensics, email recovery and reconstruction, and transactional data analysis. · Bankruptcy. We provide a comprehensive scope of specialized accounting and tax services to clients, courts and law firms in connection with bankruptcy and reorganization matters, which include providing expert consulting to trustees, receivers, examiners, debtors, creditor committees, and secured creditors. Our experts also serve as trustees, receivers and examiners in Chapter 11 and Chapter 7 cases. · Security litigation services. We provide consulting services to nationally recognized law and securities firms in matters relating to retail securities litigation. Our experts and professional staff in this area apply complex methodologies in their analyses to support our expert testimony and to provide dispute resolution approaches to decision makers. · Claims services. Following the final determination of certain types of disputes, such as class action litigation or bankruptcy proceedings, large settlement funds are frequently established that must be distributed to numerous claimants. The administration of these claims requires highly specialized knowledge and organization. We provide class action settlement administration, specialized claims processing and bankruptcy claims processing. Services include pre-settlement structuring and consulting assistance, media campaigns, class member identification, notification and opt-in/opt-out processing; process, procedures and form development and implementation, claim processing and settlement calculations, customer service call centers, banking management and reporting and benefit distribution and tax reporting. · Intellectual property. We provide a global perspective, solid expertise and recognized credentials to our clients’ intellectual property-related issues. In an increasingly knowledge-driven economy, a company’s intangible assets are often its most important assets and the major source of its competitive advantage. Developing, managing, and protecting these assets is a key component of an effective business strategy. Our intellectual property services include expert testimony, damages analysis, market issues, valuation and management of intellectual property. · Mergers and acquisitions. We advise firms and government agencies in assessing the competitive implications of mergers and acquisitions. We have presented analyses to government agencies and testified in hundreds of merger-related matters. Our experts perform extensive data and information collection to answer important factual questions and provide empirical support for expert opinions based on state-of-the-art merger analyses. · Strategy. We deliver expertise combined with a philosophy of working with our clients to develop actionable solutions that reduce uncertainty. We formulate business strategies based on economic logic and empirical data, and support our clients during the implementation phase of those strategies. We use a structured approach to strategic assessment. We analyze key economic and business dimensions such as industry structure, competitive forces and access to capital. Our experts look at the current situation, the pace of change, and the key forces that affect potential success or 10 failure over a specific time horizon. We emphasize quantification and scenario building as integral to the strategic decision process. Over time we have been able to develop deep knowledge of specific client industries, including the following: · Energy. For over a decade, our experts have been engaged to provide expert advice to the petroleum industry in the areas of exploration, refining, pipeline transportation and distribution. We have advised on mergers and acquisitions, provided analysis of competitive effects, modeled refining operations, assessed intermodal competition facing pipelines and analyzed the effects of multiple channels of distribution. We have detailed knowledge of the oil and gas industry not only in the United States, but also in many other countries and regions, including Canada, Australia, New Zealand and Europe. In the electricity area our experts have been involved in network modeling, market design, auctions and pricing. They have developed a deep understanding of different regulatory regimes around the world. The firm’s experts have provided services to generators, independent system operators, transmission companies and service companies. Our experts have performed cross-jurisdictional studies on electricity policy issues in the United States, Australia, New Zealand, Canada, the United Kingdom and Chile. · Financial services. Our experts provide services related to numerous companies and entities involved in financial services, including banks, insurance companies, capital market organizations and the government and regulatory entities with respective oversight. Our services have typically focused on performing complex economic and financial analyses associated with industry consolidation, the evolving regulatory and accounting environment and risk management. Our services have included expert testimony related to valuation and damages, as well as class certification and authoritative public policy studies assessing the impacts of regulation on markets, product offerings and consumers. · Healthcare and pharmaceuticals. We have a diverse healthcare and pharmaceuticals practice which spans competition analysis, patent damages, commercial disputes, cost and public policy analysis, strategic consulting and regulatory compliance. Our clients include pharmaceutical and biotech companies, hospitals, managed care providers and physicians groups. Our experts and staff have been involved in healthcare and health insurance reform efforts in several states. Our work frequently involves analyzing large amounts of electronic data. We are able to analyze healthcare claim issues, perform regulatory compliance reviews and design systems to help providers comply with regulations and analyze existing and emerging market competition. We advise providers on information systems designs most likely to facilitate regulatory compliance, financial viability and restructuring programs. · Telecommunications. We have a long-standing telecommunications practice that has advised firms regarding regulatory, litigation and strategic planning in the United States and internationally. We have assessed various pricing regimes, analyzed emerging competition, modeled new entry and commented on various proposals to restructure the industry. We have in-depth knowledge of regulatory environments around the world including the United States, Canada, the United Kingdom, Australia, New Zealand, Argentina and the Baltic States. 11 We provide expert services to Fortune Global 500 corporations, major law firms and local, state and federal government agencies in the United States and their international counterparts. Our ten largest clients represented 19%, 19% and 15% of our revenues in 2004, 2005 and 2006, respectively. No single client accounted for more than 4% of our revenues in any of those periods. We are frequently approached directly by law firms on behalf of clients to provide independent testimony, authoritative studies and/or strategic advice in matters involving litigation, arbitration, negotiation, legislation or regulation. In these cases, our engagement and billing arrangements are often with such law firms. The Company has international offices in Argentina, Belgium, Canada, France, Italy, New Zealand, Spain and the United Kingdom. We terminated our joint venture interest in LECG Korea in January 2007. International practice areas include competition policy and antitrust, finance and damages, regulatory expertise and transfer pricing. Through our European operations, we provide law firms, businesses, regulators, and governments with independent and objective advice and analysis on matters of economics, finance and strategy. Our international experts and professional staff work across a range of industries and have particular expertise in communications and media, energy and utilities, financial services, postal delivery and athletics. Financial information about our geographic areas and risks attendant to our international operations appear in Note 2 of the consolidated financial statements of this report under “Segment Reporting” and in Item 1A: “Risk Factors.” As of December 31, 2006, we had 1,196 employees and 95 exclusive independent contractors, consisting of 376 experts, 634 professional staff and 281 administrative staff members. Experts We classify our experts as directors or principals. As of December 31, 2006, we had 376 experts, consisting of 276 directors and 100 principals. Directors tend to be more experienced than principals, and generally have more established reputations. Directors are expected to generate more engagements than principals. Principals are hired from outside the Company or promoted from the ranks of senior professionals after they have achieved a sufficient reputation of their own and developed the ability to attract new work. Directors tend to be paid a higher percentage of their individual billings, which we refer to as pass-through rates, and may receive other forms of variable compensation not typically offered to principals. Our agreements with our directors and principals generally provide for exclusivity with us in consideration for consulting fees determined by the expert’s time billed and collected, as well as project origination fees for work originated or managed by the expert. The agreements are terminable at will and generally do not restrict competition with us following termination. However, our agreements do limit post-departure solicitation of certain clients and staff. From time to time we will allow experts to accept engagements outside the firm, and we also engage experts not otherwise associated with us. In addition to our experts, we have relationships with approximately 1,000 individuals, who work with us on a non-exclusive basis, of whom approximately 700 of such individuals are affiliated with us in connection with our August 2004 acquisition of Silicon Valley Expert Witness Group, Inc. In 2006, expert revenue from affiliates accounted for approximately 5% of our revenues. We compensate these affiliates similarly to the majority of our experts; that is, they are paid upon our receipt of payment from clients. 12 We offer our experts a generous compensation model, a collegial atmosphere, high autonomy and transparency of financial rewards through high pass-through rates on billed and collected work, as well as project origination fees. We refer to this variable compensation as the “expert model”. Under the expert model, our experts are compensated based on a percentage of their billings, or pass-through rates, ranging from 30% to 100%, and currently averaging approximately 72% of their individual billings on respective engagements. Directors tend to have higher pass-through rates on their expert fees than principals. The possibility of generous compensation is, however, coupled with high accountability because the expert’s compensation on each project is linked to our ability to collect on that project leaving them at risk for payment from us. As of December 31, 2006, approximately 76% of our experts participated in this variable compensation model. We also offer experts compensation based on specified revenue and gross margin performance targets. Our performance based compensation is typically aligned with groups of experts and staff working together throughout the year. Experts not participating in either of these variable compensation models are paid a fixed salary and are typically eligible for bonus compensation . We allow our experts to retain significant control over their time commitments. This flexibility enables our experts to pursue the educational, research, publishing and professional activities that add to their reputations and increase their value as experts. Our experts have entered into agreements with us in which they have agreed that they will exclusively utilize our support staff in connection with their consulting work when the necessary staff is available. Experts compensated under the expert model are generally responsible for the cost of their own executive assistants, employment related taxes and certain benefits as well as a portion of their own business development activities. While some of our experts are exclusive independent contractors, most are our employees. Professional staff Our professional staff includes highly educated individuals with a broad range of experience and skills needed to support our experts and complement their talents. We recruit our professional staff from leading universities and through references from our experts. Additionally, we seek individuals with highly relevant business, government or professional experience. Most of our professional staff are full-time employees and are available to our experts throughout our company, based on the expertise required for a given project. The reputation of the firm and of our experts for professional excellence and independence is the most important factor in our business development efforts. We endeavor to capitalize on the professional visibility and accomplishments of our experts and professional staff. We maintain and enhance our name and reputation through our performance and quality of work on engagements, speeches, presentations and articles in industry, business, economic, legal and scientific journals. We also market our services directly through corporate efforts and through the individual efforts of our professionals. We sponsor, attend and organize conferences and seminars on topical issues at which our experts lecture, present studies, speak on panels and meet with attendees. 13 The market for expert services is highly competitive and fragmented. We compete with a large number of service providers in each practice area. We consider some of our principal competitors to be: · economic, legal and management consulting firms such as CRA International, Inc., Navigant Consulting, Inc., National Economic Research Associates, Inc., FTI Consulting, Inc. and Huron Consulting Group Inc.; · current and former consulting arms of large accounting firms such as BearingPoint, Accenture and Capgemini; · general management and strategy consulting firms such as Bain & Company, Booz Allen Hamilton and The Boston Consulting Group; · specialized or industry-specific consulting or research firms; and · individual academics, researchers and private consultants. Many of our competitors have significantly greater personnel, financial, technical and marketing resources as well as greater name recognition. We also expect to continue to face competition from new entrants because the barriers to entry into consulting services are relatively low. We believe the principal competitive factors in our market include: · reputation of the firm and experts; · client referrals; · ability to access leading experts and staff; · ability to provide project management skills; · ability to be responsive and to meet deadlines; · ability to communicate findings to relevant parties; and · fee structure. We believe that we compete favorably with respect to each of these factors. Our internet address is www.lecg.com. Documents we have filed with the Securities and Exchange Commission, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports can be accessed through the investor relations link on our website as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC. The information found on our website is not part of this or any other report we file with or furnish to the SEC. 14 Set forth below and elsewhere in this Report and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Report. The following risks and uncertainties are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our operations. The occurrence of any of the following risks could harm our business, financial condition or results of operations. In that case, the market price of our common stock could decline, and stockholders may lose all or part of their investment. As of December 31, 2006, management assessed that the Company did not maintain effective internal control over financial reporting as the result of a material weakness in connection with the calculation of certain complex, non-standard compensation arrangements and certain performance-based business acquisition agreements. If we fail to maintain an effective system of internal controls, we may not be able to report our financial results accurately, which may cause investors to lose confidence in our reported financial information and have an adverse effect on the trading price of our common stock. In connection with the audit of our consolidated financial statements for the year ended December 31, 2006, we identified a material weakness in our internal control over financial reporting based on criteria established in Internal Control—Integrated Framework resulting from errors in calculating the complex, non-standard compensation arrangements of two groups of experts and the failure to provide timely information relating to certain performance-based business acquisition arrangements. Although the errors discovered were not material to any of the individual periods’ income statements or balance sheets, we identified deficiencies in the design of the underlying internal control put in place to provide reasonable assurance that we would be able to capture information required to perform the calculations accurately and timely. Our internal control system is designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements. Because of this material weakness in our internal control over financial reporting, there is heightened risk that a material misstatement of our annual or quarterly financial statements will not be prevented or detected. In the event that we do not adequately remedy this material weakness, and if we fail to maintain proper and effective internal controls in future periods, our ability to provide timely and reliable financial results would suffer and investors would lose confidence in our reported financial information, which may have an adverse effect on the trading price of our common stock. Our financial results could suffer if we are unable to successfully attract, integrate and retain our experts and professional staff. Many of our clients are attracted to us by their desire to engage individual experts, and the ongoing relationship with our clients is often managed primarily by our individual experts. If an expert terminates his or her relationship with us, it is probable that most of the clients and projects for which that expert is responsible will continue with the expert, and the clients will terminate their relationship with us. We generally do not have non-competition agreements with any of our experts, unless the expert came to us through an acquisition of a business. Consequently, experts without non-compete agreements can terminate their relationship with us at any time and immediately begin to compete against us. Our top five experts accounted for 17% of our revenues in 2005 and 2006. If any of these individuals or our other experts terminate their relationship with us or compete against us, it could materially harm our business and financial results. In addition, if we are unable to retain groups of experts and their staff associated with an acquisition, this could materially harm our business and financial results. In addition, if we are unable to attract, develop, motivate and retain highly qualified experts, professional staff and administrative personnel, our ability to adequately manage and staff our existing 15 projects and obtain new projects could be impaired, which would adversely affect our business and our prospects for growth. Qualified professionals are in great demand, and we face significant competition for both senior and junior professionals with the requisite credentials and experience. Our competition comes from other consulting firms, research firms, governments, universities and other similar enterprises. Many of these competitors may be able to offer significantly greater compensation and benefits or more attractive lifestyle choices, career paths or geographic locations than we do. Increasing competition for these professionals may also significantly increase our labor costs, which could negatively affect our margins and results of operations. The loss of services from, or the failure to recruit, a significant number of experts, professional staff or administrative personnel could harm our business, including our ability to secure and complete new projects. Our financial results could suffer if we are unable to achieve or maintain high utilization and billing rates for our professional staff. Our profitability depends to a large extent on the utilization of our professional staff and the billing rates we are able to charge for their services. Utilization of our professional staff is affected by a number of factors, including: · the number and size of client engagements; · our experts’ use of professional staff to perform the projects they obtain from clients and the nature of specific client engagements, some of which require greater professional staff involvement than others; · the timing of the commencement, completion and termination of projects, which in many cases is unpredictable; · our ability to transition our professional staff efficiently from completed projects to new engagements; · our ability to forecast demand for our services and thereby maintain an appropriate level of professional staff; and · conditions affecting the industries in which we practice as well as general economic conditions. The billing rates of our professional staff that we are able to charge are also affected by a number of additional factors, including: · the quality of our expert services; · the market demand for the expert services we provide; · our competition and the pricing policies of our competitors; and · general economic conditions. If we are unable to achieve and maintain high utilization as well as maintain or increase the billing rates for our professional staff, our financial results could suffer materially. Projects may be terminated or initiated suddenly, which may negatively impact our financial results. Our projects generally center on decisions, disputes, proceedings or transactions in which clients are seeking expert advice and opinions. Our projects can terminate suddenly and without advance notice to us. Our clients may decide at any time to settle their disputes or proceedings, to abandon their transactions or to take other actions that result in the early termination of a project. Our clients are under no contractual obligation to continue using our services. If an engagement is terminated unexpectedly, or even upon the completion of a project, our professionals working on the engagement may be underutilized until we assign 16 them to other projects. The termination or significant reduction in the scope of a single large engagement could negatively impact our results of operations. Conversely, projects may be initiated or expanded suddently, and we may not be able to adequately manage the demands placed upon our experts and staff when that occurs. This could result in inefficiencies and additional time spent on engagements by our experts and staff that we may not be able to bill and collect. For example, in 2006 we experienced a significant increase in work performed that we considered uncollectible, a part of which was the result of our failure to successfully manage certain engagements. If we are unable to successfully manage the requirements and time spent by experts and staff on engagements, our financial results may be adversely impacted. If we are unable to manage the growth of our business successfully, our financial results and business prospects could suffer. Over the past several years, we have experienced significant growth in the number of our experts and professional staff. We have also expanded our practice areas and have opened offices in new locations. We may not be able to successfully manage a significantly larger and more geographically diverse workforce as we increase the number of our experts and professional staff and expand our practice areas. For example, in 2006 we experienced increased and unplanned selling, general and administrative costs. Additionally, growth increases the demands on our management, our internal systems, procedures and controls. To successfully manage growth and maintain our capability of complying with existing and new regulatory requirements, we must add administrative staff and periodically update and strengthen our operating, financial and other systems, procedures and controls, which will increase our costs and may reduce our profitability. As a company subject to public company reporting requirements, we must be able to issue accurate financial reports and disclosures within prescribed timeframes. We have designed our internal disclosure controls and procedures and our internal control over financial reporting to provide reasonable assurance that these controls and procedures will meet their objectives; however, even well designed and operated controls and procedures are susceptible to inherent limitations. These inherent limitations potentially include faulty assumptions in the design of the controls and procedures, fraud by individuals and errors or mistakes by those overseeing the controls procedures. In 2006, we reported a material weakness in connection with the calculation of certain complex, non-standard compensation arrangements and business acquisition performance-based agreements. We may be unable to successfully implement improvements to our information and control systems in an efficient or timely manner and may discover additional deficiencies in existing systems and controls. Moreover, as we acquire new businesses, we will need to integrate their financial reporting systems into ours, including our disclosure controls and procedures. Further related to the issue of providing accurate and timely financial information, there are certain key personnel that have developed over time a deep institutional knowledge of, and have helped shape and implement our expert compensation models, including developing the financial and operational support systems and contractual agreements necessary to administer their complexities. This institutional knowledge has been an essential element in our ability to respond to the demands imposed by our growth. Any failure to successfully manage growth, retain key administrative personnel and maintain adequate internal disclosure controls and procedures or controls over financial reporting, could result in the identification of additional material weaknesses in our controls and the inability to remediate the material weakness assessed in 2006 and could harm our financial results and business prospects. 17 Additional hiring and acquisitions could disrupt our operations, increase our costs or otherwise harm our business. Our business strategy is dependent in part upon our ability to grow by hiring individuals or groups of experts and by acquiring other expert services firms. However, we may be unable to identify, hire, acquire or successfully integrate new experts and consulting practices without substantial expense, delay or other operational or financial problems. And, we may be unable to achieve the financial, operational and other benefits we anticipate from any hiring or acquisition. Hiring additional experts or acquiring other expert services firms could also involve a number of additional risks, including: · the diversion of management’s and key senior experts’ time, attention and resources, especially since Dr. Teece, our Chairman and key senior experts involved in the recruiting and acquisition process also provide consulting services that account for a significant amount of our revenues; · loss of key acquisition related personnel; · the incurrence of signing bonuses, which could adversely impact our profitability and cash flow; · additional expenses associated with the amortization, impairment or write-off of acquired intangible assets, which could adversely impact our profitability and cash flow; · potential assumption of debt to acquire businesses; · potential impairment of existing relationships with our experts, professionals and clients; · the creation of conflicts of interest that require us to decline engagements that we otherwise could have accepted; · increased costs to improve, coordinate or integrate managerial, operational, financial and administrative systems; · increased costs associated with the opening and build-out of new offices, redundant offices in the same city where consolidation is not immediately possible or office closures where consolidation is possible, which would result in the immediate recognition of expense associated with the abandoned lease; · dilution of our stock as a result of issuing equity securities in connection with hiring new experts or acquiring other expert services firms; and · difficulties in integrating diverse corporate cultures. We have encountered these risks after hiring individuals and groups of experts and acquiring expert practices, and we anticipate that we will encounter these risks in connection with future hiring and acquisitions. Competition for future hiring and acquisition opportunities in our markets could increase the compensation we offer to potential experts or the price we have to pay for businesses we wish to acquire. In addition, this increased competition could make it more difficult to retain our experts or result in having to make significant payments to those experts we consider key. The occurrence of any of these events could harm our business, financial condition and results of operations. We depend on complex damages and competition policy/antitrust practices, which could be adversely affected by changes in the legal, regulatory and economic environment. Our business is heavily concentrated in the practice areas of complex damages and competition policy/antitrust, including mergers and acquisitions. Projects in our complex damages practice area account for 24% and 23% of our billings in 2005 and 2006, respectively. Projects in our competition policy/antitrust 18 practice area, including mergers and acquisitions, accounted for 24% and 21% of our billings in 2005 and 2006, respectively. Changes in the federal antitrust laws or the federal regulatory environment, or changes in judicial interpretations of these laws could substantially reduce the need for expert consulting services in these areas. This would reduce our revenues and the number of future projects in these practice areas. In addition, adverse changes in general economic conditions, particularly conditions influencing the merger and acquisition activity of larger companies, could also negatively impact the number and scope of our projects in proceedings before the Department of Justice and the Federal Trade Commission. Conflicts of interest could preclude us from accepting projects. We provide our services primarily in connection with significant or complex decisions, disputes and regulatory proceedings that are usually adversarial or involve sensitive client information. Our engagement by a client may preclude us from accepting projects with our clients’ competitors or adversaries because of conflicts of interest or other business reasons. As we increase the size of our operations, the number of conflict situations can be expected to increase. Moreover, in many industries in which we provide services, for example the petroleum and telecommunications industries, there has been a continuing trend toward business consolidations and strategic alliances, the impact of which is to reduce the number of companies that may seek our services and increase the chances that we will be unable to accept new projects as a result of conflicts of interest. If we are unable to accept new assignments for any reason, our professional staff may become underutilized, which would adversely affect our revenues and results of operations in future periods. Our ability to maintain and attract new business depends upon our reputation, the professional reputation of our experts and the quality of our services on client projects. Our ability to secure new projects depends heavily upon our reputation and the individual reputations of our experts. Any factor that diminishes our reputation or that of our experts could make it substantially more difficult for us to attract new projects and clients. Similarly, because we obtain many of our new projects from clients that we have worked with in the past or from referrals by those clients, any client that questions the quality of our work or that of our experts could seriously impair our ability to secure additional new projects and clients. In litigation, we believe that there has been an increase in the frequency of challenges made by opposing parties to the qualifications of experts. In the event a court or other decision-maker determines that an expert is not qualified to serve as an expert witness in a particular matter, then this determination could harm the expert’s reputation and ability to act as an expert in other engagements which could in turn harm our business reputation and our ability to obtain new engagements. Our engagements could result in professional liability, which could be very costly and hurt our reputation. Our projects typically involve complex analysis and the exercise of professional judgment. As a result, we are subject to the risk of professional liability. Many of our projects involve matters that could have a severe impact on a client’s business, cause a client to gain or lose significant amounts of money or assist or prevent a client from pursuing desirable business opportunities. If a client questions the quality of our work, the client could threaten or bring a lawsuit to recover damages or contest its obligation to pay our fees. Litigation alleging that we performed negligently or breached any other obligations to a client could expose us to significant liabilities and damage our reputation. We carry professional liability insurance to cover most of these types of claims, but the policy limits and the breadth of coverage may be inadequate to cover any particular claim or all claims plus the cost of legal defense. For example, we provide services on engagements in which the amounts in controversy or the impact on a client may substantially exceed the limits of our errors and omissions insurance coverage. If we are found to have professional liability with respect to work performed on such an engagement, we may not have sufficient insurance to cover the 19 entire liability. Litigation, regardless of the outcome, is often very costly, could result in distractions to our management and experts and could harm our business and our reputation. Intense competition from economic, business and financial consulting firms could hurt our business. The market for expert consulting services is intensely competitive, highly fragmented and subject to rapid change. Many of our competitors are national and international in scope and have significantly greater personnel, financial, technical and marketing resources. We may be unable to compete successfully with our existing competitors or with any new competitors. There are relatively low barriers to entry, and we have faced and expect to continue to face additional competition from new entrants into the economic, business and financial consulting industries. In the litigation and regulatory expert services markets, we compete primarily with economic, business and financial consulting firms and individual academics. Expert services are also available from a variety of participants in the business consulting market, including general management consulting firms, the consulting practices of major accounting firms, technical and economic advisory firms, regional and specialty consulting firms, small consulting companies and the internal professional resources of companies. We are subject to additional risks associated with international operations. We currently have operations in Argentina, Belgium, Canada, France, Italy, New Zealand, Spain and the United Kingdom. Revenues attributable to activities outside of the United States, were 14% in 2005 and 2006. We may continue to expand internationally and our international revenues may account for an increasing portion of our revenues in the future. Our international operations carry special financial and business risks, including: · greater difficulties in managing and staffing foreign operations; · less stable political and economic environments; · cultural differences that adversely affect utilization; · currency fluctuations that adversely affect our financial position and operating results; · unexpected changes in regulatory requirements, tariffs and other barriers; · civil disturbances or other catastrophic events that reduce business activity; and · greater difficulties in collecting accounts receivable. The occurrence of any one of these factors could have an adverse effect on our operating results. Our disputes with Navigant Consulting, Inc. and National Economic Research Associates, Inc. could harm our business and financial results. We have a dispute with Navigant Consulting, Inc. arising out of our management led buyout of certain assets and liabilities of LECG, Inc. from Navigant Consulting and LECG, Inc. See Item. 3 Legal Proceedings for further details. If Navigant Consulting initiates legal proceedings against us, a decision against us could harm our financial results and financial position. In June 2004, National Economic Research Associates, Inc., or NERA, and its parent company, Marsh & McLennan Companies, Inc., filed a complaint against us and one of our experts. See Item 3. Legal Proceedings for further details. A decision against us in this matter could harm our financial results and financial position. 20 The price of our common stock has fluctuated widely and may continue to do so, depending upon many factors, including but not limited to the risk factors listed above and the following: · the limited trading volume of our common stock on the NASDAQ Global Select Market; · variations in our quarterly results of operations; · failure to retain key management personnel; · the hiring or departure of key personnel, including experts; · our ability to maintain high utilization of our professional staff; · announcements by us or our competitors; · the loss of significant clients; · changes in our reputation or the reputations of our experts; · acquisitions or strategic alliances involving us or our competitors; · changes in the legal and regulatory environment affecting businesses to which we provide services; · changes in estimates of our performance or recommendations by securities analysts; · inability to meet quarterly or yearly estimates or targets of our performance; and · market conditions in the industry and the economy as a whole. The issuance of preferred stock could discourage or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders. Our board of directors has the authority to issue preferred stock and to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series and the designation of such series, without any further vote or action by our stockholders. The preferred stock could be issued with voting, liquidation, dividend and other rights superior to the rights of our common stock. The potential issuance of preferred stock may make it more difficult for a person to acquire a majority of our outstanding voting stock, and thereby delay or prevent a change in control of us, discourage bids for our common stock over the market price and adversely affect the market price and the relative voting and other rights of the holders of our common stock. Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock. Our amended and restated certificate of incorporation and our bylaws contain provisions that could delay or prevent a change in control of our company. For example, our charter documents prohibit stockholder actions by written consent. In addition, the provisions of Section 203 of Delaware General Corporate Law govern us. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us. These and other provisions in our amended and restated certificate of incorporation, our bylaws and under Delaware law could reduce the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions. 21 ITEM 1B. UNRESOLVED STAFF COMMENTS None. Our principal executive offices are located in a leased facility in Emeryville, California, consisting of approximately 48,000 square feet of office space, under an eight-year lease that expires in July 2010. This facility accommodates our principal administrative and finance operations. We also have a major offices in the following cities: · Washington, D.C.: approximately 55,000 square feet of office space, under a lease that expires in May 2011, · Chicago, Illinois: approximately 28,000 square feet of office space under a lease that expires in 2015, · Lake Oswego, Oregon: approximately 27,000 square feet of office space under a lease that expires in 2007, · San Diego, California: approximately 20,000 square feet of office space, under a lease that expires in July 2016, and · Century City, California: approximately 26,000 square feet office space, under a lease that expires in 2010, · London, England: approximately 17,000 square feet of office space under a lease that expires in March 2019, with an option to cancel in March 2014. We occupy leased facilities in a total of 26 cities throughout the United States and in nine cities in Canada, the United Kingdom, Belgium, Spain, France, Italy, New Zealand and Argentina. We do not own any real property. We believe that our leased facilities are adequate to meet our current needs and that we will be able to obtain additional leased facilities to meet our future needs. We have a dispute with Navigant Consulting, Inc. arising out of our management led buyout of certain assets and liabilities of LECG, Inc. from Navigant Consulting and LECG, Inc. In the management led buyout, we acquired substantially all of the assets and assumed certain liabilities of LECG, Inc. pursuant to an asset purchase agreement with Navigant Consulting and LECG, Inc. dated September 29, 2000. Under the asset purchase agreement, up to $5.0 million of the purchase price was deferred contingent upon whether specific individuals listed on a schedule to the asset purchase agreement had an employment, consulting, contracting or other relationship with us on September 29, 2001. Navigant Consulting contends that it is entitled to a payment of approximately $4.9 million plus interest with respect to the contingent purchase price amount. On several occasions before and after September 29, 2001, we notified Navigant Consulting that several of the individuals listed on the schedule to the asset purchase agreement did not have an employment, consulting, contracting or other relationship with us on September 29, 2001. If Navigant Consulting initiates legal proceedings against us, a decision against us could harm our financial results and financial position. In June 2004, National Economic Research Associates, Inc., or NERA, and its parent company, Marsh & McLennan Companies, Inc., filed a complaint against us and one of our experts. This action arises out of our hiring of a professional in March 2004 who was formerly employed by NERA. The complaint alleges that during and after his employment with NERA, this expert violated contractual commitments and fiduciary duties to NERA. The complaint further alleges that we interfered with NERA’s contractual relations and advantageous business relationship, misappropriated confidential 22 business information and goodwill, and engaged in unfair and deceptive trade practices. The complaint asks for unspecified damages and disgorgement of wrongful gain, invalidation of an indemnification agreement provided to this expert by us and contains a demand for a jury trial. In August 2004, we served a motion to dismiss the breach of contract, tortious interference with contractual relations and the unfair and deceptive trade practices counts, which motion has been denied. We have filed an answer to the complaint denying the substantive allegations of the complaint. The parties are in the process of completing expert discovery, which is currently scheduled to be completed by May 31, 2007. We anticipate that if this dispute goes to trial, it will not do so earlier than the fourth quarter of 2007. We are not able to determine the outcome or resolution of the complaint, or to estimate the amount or potential range of loss with respect to this complaint. We are also a party to certain legal proceedings arising out of the ordinary course of business, the outcomes of which individually or in the aggregate, in the opinion of our management, would not have a material adverse effect on our business, financial position or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 23 ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCK MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Our Common Stock is traded on the NASDAQ Global Select Market under the symbol of XPRT. The following table sets forth, for the period indicated, the low and high closing prices per share for our Common Stock as reported by the NASDAQ Global Select Market.
As of February 28, 2007, there were approximately 80 holders of record of our Common Stock. This number does not include stockholders for whom shares were held in a “nominee” or “street” name. We believe there are approximately 2,500 beneficial owners of our Common Stock. We currently expect that we will retain our future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any dividends in the foreseeable future. Future cash dividends, if any, will be at the discretion of our board of directors and will depend upon, among other things, our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors the board of directors may deem relevant. Our credit facility contains restrictions on our ability to pay cash dividends. No purchases of our equity securities were made by or on behalf of LECG during the three months ended December 31, 2006. On May 9, 2006, we issued 13,291 shares of our common stock at an effective purchase price of $18.81 in connection with our acquisition of certain assets and liabilities of BMB Mack Barclay, Inc. and affiliates. The foregoing purchase and sale were exempt from registration under Rule 506 of Regulation D under the Securities Act of 1933, as amended, pursuant to Section 4(2) thereof on the basis that the transaction did not involve a public offering. 24 The following graph compares our cumulative total stockholder return to that of the NASDAQ Composite Index, and a peer group of companies consisting of CRA International, Inc., Navigant Consulting, Inc. and FTI Consulting, Inc. We consider Huron Consulting Inc. (“Huron”) as one of our competitors, however we have not included Huron in our peer group of companies, as the shares of its common stock were not publicly traded on November 13, 2003. Had we included Huron in our peer group of companies, the following graph would show higher returns for our peer group. The cumulative stockholder returns for shares of our common stock and for the market index and the peer group are calculated assuming $100 was invested on November 13, 2003, the date on which our common stock commenced trading on the NASDAQ Global Select Market, and assuming that shares of our common stock were purchased at the initial public offering price of the common stock. We paid no dividends during the period shown. The performance of the market index and the peer group comparison is shown on a total return, i.e. dividends reinvested basis. The peer group returns are determined based on the returns of each component issuer of the peer group, weighted according to the respective issuer’s stock market capitalization at the beginning of the period presented.
25 ITEM 6. SELECTED FINANCIAL DATA The following table should be read in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8. “Financial Statements and Supplementary Data.”
(1) The Company adopted the provisions of SFAS No. 123(R) in fiscal year 2006. See “Note 2: Summary of Significant Accounting Policies” and Note 8: Equity-based Compensation Expense” in Part II, Item 8 of the Form 10-K
26 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and other parts of this Annual Report on Form 10-K concerning our future business, operating and financial condition and statements using the terms “believes,” “expects,” “will,” “could,” “plans,” “anticipates,” “estimates,” “predicts,” “intends,” “potential,” “continue,” “should,” “may,” or the negative of these terms or similar expressions are “forward-looking” statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based upon our current expectations as of the date of this Report. There may be events in the future that we are not able to accurately predict or control that may cause actual results to differ materially from expectations. Information contained in these forward-looking statements is inherently uncertain, and actual performance is subject to a number of risks, including but not limited to, (1) our ability to successfully attract, integrate and retain our experts and professional staff, (2) dependence on key personnel, (3) successful management of professional staff, (4) dependence on growth of our service offerings, (5) our ability to maintain and attract new business, (6) successful management of additional hiring and acquisitions, (7) successful administration of our business and financial reporting capabilities, including remediating the material weakness in our internal control over financial reporting, (8) potential professional liability, (9) intense competition and (10) risks inherent in international operations. Further information on these and other potential risk factors that could affect our financial results may be described from time to time in our periodic filings with the Securities and Exchange Commission and include those set forth in this Report under “Risk Factors.” We cannot guarantee any future results, levels of activity, performance or achievement. We undertake no obligation to update any of these forward-looking statements after the date of this Report. We provide expert services. Our highly credentialed experts and professional staff address complex, unstructured business and public policy problems. We deliver independent expert testimony and original authoritative studies in both adversarial and non-adversarial environments. We conduct economic, financial and statistical analyses to provide objective opinions and strategic advice to legislative, judicial, regulatory and business decision makers. Our skills include factual statistical analyses and report preparation and presentation, forensic accounting and electronic discovery and data collection. Our experts are renowned academics, former high-level government officials, experienced industry leaders and seasoned consultants. We are organized and operate in a manner that is attractive to our experts by providing them with autonomy, flexibility and the support of a highly capable professional staff. We have provided expert services since 1988, initially operating our business as a corporation under the name “The Law and Economics Consulting Group, Inc.” In 1997, we completed an initial public offering of our common stock under the name “LECG, Inc.” These shares were listed on the New York Stock Exchange under the symbol “XPT.” During the next nine months, we continued to perform expert services as a stand-alone company. In 1998, we were acquired by The Metzler Group, Inc., which changed its name to Navigant Consulting, Inc. We operated as a wholly owned subsidiary of Navigant Consulting under the name “LECG, Inc.” until September 28, 2000. On September 29, 2000, 35 of our experts, including four of our founding experts, with equity sponsorship led by a private equity group, executed a management buyout of substantially all of the assets and certain of the liabilities of LECG, Inc. for a purchase price of approximately $44.3 million. The entity that operated our business from that date until completion of the initial public offering was LECG, LLC, a limited liability company and wholly owned subsidiary of LECG Holding Company, LLC. 27 On November 13, 2003 we completed our initial public offering in which we issued 8,625,000 shares of our Common Stock at $17.00 per share and received net proceeds of $134.1 million. In connection with this offering: · holders of common units of LECG Holding Company, LLC became holders of shares of common stock of LECG Corporation, a Delaware C corporation; · such holders have received $14.1 million previously taxed but undistributed earnings of LECG Holding Company, LLC retained during the period beginning September 29, 2000 and ending November 13, 2003, and approximately $1.3 million to cover their additional income tax liabilities for 2003; and · we redeemed all of the outstanding Redeemable Class A preferred units of LECG Holding Company, LLC for approximately $40.7 million, which was equal to their original issuance price plus cumulative dividends that had accrued at a rate of 8% per annum, compounded quarterly. In December 2004 and January 2005, we completed a secondary public offering in which we issued 324,375, shares of our Common Stock at $18.75 per share and received net proceeds of $5.0 million. An important element of our growth strategy is the recruitment and hiring of additional experts either by direct hiring or through business acquisitions. Such hiring is designed to deepen our existing service offerings and to add new experts and related professional staff to new service areas. The following table summarizes the changes in the number of experts and professional staff since December 2004:
In connection with our hiring efforts in 2004, 2005 and 2006, we paid signing and performance bonuses of $18.7 million, $7.7 million and $23.6 million, respectively, which will be amortized over periods ranging from one to seven years. Amortization of signing and performance bonus expense was $4.3 million, $6.7 million and $8.8 million in 2004, 2005 and 2006 respectively. In connection with our 2004 hires of certain experts and staff in Europe and the United States, we paid performance bonuses of $5.7 million in March 2006 as specified performance targets were achieved in 2005, and we will pay performance bonuses of $5.7 million in March 2007, as specified targets were achieved in 2006. These performance bonuses are amortized from the time the bonus was earned through March 2011. 28 Since August 2003, we have acquired 11 businesses. Total additions to goodwill, including performance-based earnouts, were $34.0 million, $20.2 million, and $24.8 million in 2004, 2005 and 2006, respectively. We have made acquisition-related payments of $27.8 million, $32.1 million and $22.2 million in 2004, 2005 and 2006, respectively, including the initial purchase price payments, the fair value of common stock issued for acquisitions, transaction costs, performance-based payments (earnouts) and guaranteed payments. Our 2004, 2005 and 2006 acquisitions are described below: On May 9, 2006, we acquired substantially all of the assets of BMB Mack Barclay, Inc. and affiliates (“Mack Barclay”), an expert services firm specializing in complex economic and accountancy issues in business and litigation environments. The purchase price was comprised of $12.95 million paid in cash at closing and the issuance of 13,291 unregistered shares of LECG common stock with a fair value of $250,000. The purchase price including an estimated $500,000 of acquisition costs, was allocated as follows: · $11.1 million to goodwill · $1.4 million to contract rights (12-month amortization) · $850,000 to other identifiable intangible assets (7-year amortization), and · $371,000 to net current assets and equipment. As a result of achieving specified performance targets through December 31, 2006, we recognized $1.2 million of additional purchase price, to be paid in July 2007. If specified annual performance targets are achieved through April 2011, we will make additional payments of up to $7.6 million by no later than July 2011. In December 2005, we acquired substantially all of the assets of Lancaster Consulting LLC (“Lancaster”), an expert services firm specializing in general management, mergers and acquisitions, litigation and financial management consulting. The purchase price consisted of $1.5 million paid at closing. The purchase price including acquisition costs was allocated as follows: · $1.46 million to goodwill and · $64,000 to contract rights (six-month amortization), other identifiable intangible assets (six-year amortization) and net current assets and equipment. As a result of achieving specified performance targets through December 31, 2006, we recognized $372,000 of additional purchase price, which we paid in March 2007. If specified performance targets are achieved through December 2009, we will make additional payments of up to $978,000 by no later than March 2010. In December 2005, we acquired substantially all of the assets of Beach & Company International LP, an expert services firm specializing in financial, economic and operational consulting. The purchase price consisted of $500,000 paid at closing. The purchase price, including acquisition costs of $156,000 was allocated as follows: · $578,000 to goodwill, · $78,000 to contract rights (eight-month amortization), other identifiable intangible assets (three-year amortization) and net current assets and equipment. If specified performance targets are achieved by June 2008, we will make an additional payment of $500,000 by no later than August 2008. 29 In November 2005, we acquired substantially all of the assets of Neilson Elggren LLP (“Neilson”), a financial and insolvency expert and consulting services firm. The purchase price of $4.0 million was comprised of $3.75 million of cash paid at closing and 10,832 unregistered shares of our common stock with an estimated fair market value of $250,000. The purchase price including acquisition costs of $56,000 was allocated as follows: · $3.3 million to goodwill, · $380,000 to contract rights (21-month amortization), · $320,000 to other intangible assets (five to seven-year amortization) and · $96,000 to net current assets and equipment. As a result of achieving specified performance targets through December 31, 2006, we recognized $1.4 million ($1.3 million in 2006) of additional purchase price, of which $1.2 million was paid in January 2007 and the remainder will be paid by January 2008. In addition, if specified performance targets are achieved through October 2010, we will make additional payments of up to $2.4 million by no later than January 2011. An additional payment of up to $1.5 million will also be made in December 2010 if higher targets are met by no later than October 2010. On August 15, 2005, we acquired substantially all of the assets of Bates Private Capital Incorporated (“Bates”), an expert services firm specializing in dispute resolution for the retail securities industry. The purchase price of $18.1 million was comprised of $17.0 million paid in cash at closing, the issuance of 44,425 unregistered shares of our common stock with an estimated fair market value of $1.0 million, and acquisition costs of $109,000. The purchase price including acquisition costs was allocated as follows: · $7.0 million to goodwill, · $8.7 million to customer relationships (nine-year amortization), · $1.1 million to contract rights (one-year amortization), · $870,000 to other identifiable intangible assets (seven to 20-year amortization) and · $393,000 to fixed assets and net current assets As a result of achieving certain performance targets through December 31, 2006, we recognized $5.9 million ($4.6 million in 2006) of additional purchase price, of which $3.4 million was paid in September 2006, $29,000 was paid in December 2006 and $2.4 million will be paid in September 2007. In addition, if specified annual performance targets are achieved through July 2011, we will make additional payments of up to $7.1 million by no later than September 2011. On March 1, 2005, we acquired all of the outstanding shares of J. Philip Cook & Associates, Inc. (“Cook”), a company providing appraisal, consulting, feasibility analysis and expert witness services related to real estate and business valuation. The purchase price of $1.6 million was comprised of $1.35 million paid in cash at closing and the issuance of 13,999 unregistered shares of our common stock with a fair value of $250,000. The purchase price including acquisition costs was allocated as follows: · $1.56 million to goodwill, · $90,000 to contract rights (two to 12-month amortization) and net current assets and equipment. As a result of achieving certain performance targets through December 31, 2006, we recognized $243,000 of additional goodwill in 2006, which we paid in February 2007. If specified performance targets are achieved through December 2008, the Company will make additional payments of up to $857,000 by no later than March 2009. 30 In October 2004, we acquired substantially all of the assets of Washington Advisory Group, LLC (“WAG”), a privately held expert services firm specializing in technology assessment and policy, and research and development strategy. The purchase price of $1.06 million was comprised of an initial payment of $658,000 and a minimum guaranteed payment of $400,000 which was paid in February 2007. The purchase price was allocated as follows: · $940,000 to goodwill, · $69,000 to contract rights (six-month amortization) and · $49,000 to net current assets and property and equipment. As a result of achieving specified performance targets through December 31, 2006, we recognized $824,000 of additional purchase price in 2006, which was paid in February 2007. In August 2004, we acquired all of the outstanding shares of Silicon Valley Expert Witness Group, Inc. (“SVEWG”), a company providing expert services involving complex technologies and intellectual property disputes. The purchase price of $9.0 million was comprised of $5.0 million paid in cash, the issuance of 56,850 unregistered shares of common stock with an estimated fair market value of $958,000, and $3.0 million of additional payments to be made no later than 2009. The purchase price was allocated as follows: · $7.8 million to goodwill, · $100,000 to contract rights (ten-month amortization) and · $1.1 million to net current assets and property and equipment. We made guaranteed purchase price payments totaling $1.0 million in September and October 2005 and will make guaranteed purchase price payments of $2.0 million over the period beginning September 2007 and ending no later than September 2009. In addition, if specified performance targets are achieved through July 2009, we will make additional payments of up to $2.4 million over the same period. As the result of achieving specified performance targets during the 12-month period ended July 2005, we recognized goodwill of $87,000. In addition, if specified performance targets are met during the 12-month period ending July 2007, we will make bonus compensation payments of $200,000 in September 2007. In March 2004, we acquired the business of Economic Analysis, LLC (“EA”), a company providing expert services involving complex business litigation and regulatory matters. The purchase price was comprised of $15.4 million paid in cash, and the issuance of 50,891 unregistered shares of common stock with an estimated fair market value of $1.0 million. The purchase price was allocated as follows: · $15.0 million to goodwill, · $900,000 to contract rights (12-month amortization) and · $500,000 to property and equipment and other assets. As a result of achieving specified performance targets through December 31, 2006, we recognized $6.2 million ($1.9 million in 2006) of additional purchase price, of which $2.5 million was paid in March 2005, $1.8 million was paid in March 2006 and $1.9 million was paid in March 2007. In addition , if certain higher performance targets are met through December 2008, we will make additional payments of up to $2.0 million by no later than March 2009. 31 In March 2004, we acquired the business of Low Rosen Taylor Soriano (“LRTS”), an expert services firm located in Toronto, Canada, providing expert services in the areas of business valuation and damages quantification. The purchase price was $3.9 million paid in cash, and allocated as follows: · $3.5 million to goodwill, · $145,000 to contract rights (12-month amortization) and · $312,000 to property and equipment and other assets, net of liabilities assumed. As a result of achieving certain performance targets through December 31, 2006, we recorded $3.3 million ($940,000 in 2006) of additional purchase price, of which $1.0 million was paid in February 2005, $1.6 million was paid in February 2006 and $845,000 was paid in February 2007. In addition, if specified profitability targets are achieved by February 2008, we will make additional payments of up to $1.2 million by no later than April 2008. On March 9, 2007, the Company entered into an agreement to acquire substantially all of the operating assets of The Secura Group, LLC. a privately held expert, consulting and regulatory compliance services firm specializing in the financial services industry. The purchase price will consist of $9,500,000 to be paid in cash at closing. An additional purchase price payment of up to $2,500,000 will be made in cash if specific performance targets are met during the period from closing through December 31, 2010. The acquisition is expected to close on March 16, 2007. We derive our revenues primarily from professional service fees that are billed at hourly rates on a time and expense basis. Revenues related to these services are recognized when the earnings process is complete and collectibility is reasonably assured. Revenues are comprised of: · fees for the services of our professional staff; · fees for the services of our experts; · performance-based expert fees primarily relating to environmental claims; and · amounts we charge for services provided by others and costs that are reimbursable by clients, including travel, document reproduction, subscription data services and other costs. Revenues are recognized net of amounts estimated to be unrealizable. We estimated the following amounts to be unrealizable for the years 2004, 2005 and 2006 and accordingly, revenues recognized have been reduced by these amounts (dollars in thousands):
32 The following table summarizes our revenues from these sources by quarter from January 1, 2005 to December 31, 2006 (in thousands):
(1) Relates primarily to the Insurance Claims Group, whose experts and certain staff departed in September 2005. Compensation and project costs are comprised of: · salary, bonuses, taxes and benefits of all professional staff and salaried experts; · compensation to experts based on a percentage of their individual professional fees; · compensation to experts based on specified revenue and gross margin performance targets; · fees earned by experts and other business generators as project origination fees; · costs that are reimbursable by clients, including travel, document reproduction and subscription data services; and · amortization of signing and performance bonuses that are subject to vesting over time. Hourly fees charged by the professional staff that support our experts, rather than the hourly fees charged by our experts, generate a majority of our gross profit. Most of our experts are compensated based on a percentage of their billings from 30% to 100%, averaging approximately 72% of their individual billings on particular projects in 2006. Such experts are paid when we have received payment from our clients. We make advance payments, or draws, to most of our experts and any outstanding draws previously paid to experts are deducted from the experts’ fee payments. In some cases, we guarantee an expert’s draw at the inception of their employment for a period of time, which is typically one year or less. In such cases, if the expert’s earnings do not exceed their draws within a reasonable period of time prior to the end of the guarantee period, we recognize an estimate of the compensation expense we will ultimately incur by the end of the guarantee period. In 2006, we recognized $2.0 million of expense related to both guaranteed and non-guaranteed draws considered unrecoverable. Some of our experts are compensated based on a percentage of performance targets such as revenue or gross margin associated with the experts’ engagements. Experts not on either of these compensation models are compensated on a salary plus performance-based bonus model. Because of the manner in which we pay our experts, our gross profit is significantly dependent on the margin on our professional staff services. The number of professional staff and the level of experience of professional staff assigned to a project will vary depending on the size, nature and duration of each engagement. We manage our personnel costs by monitoring engagement requirements and utilization of the professional staff. As an inducement to encourage experts to utilize our professional staff, experts generally receive project origination fees. Such fees are based primarily on a percentage of the collected professional staff fees. Project origination fees can also include a percentage of the collected expert fees for those experts acting in a support role on an engagement. In 2006, these fees have averaged 10% of professional staff revenues. Experts are required, to use our professional staff unless the skills required to perform the work are not available through us. In these instances we engage outside individual or firm-based consultants, who are typically compensated on an hourly basis. Both the revenue and the cost 33 resulting from the services provided by these outside consultants are recognized in the period in which the services are performed. Hiring experts sometimes involves the payment of cash signing bonuses. In some cases, the payment of a portion of a signing bonus is deferred until a future date. Signing bonuses are recognized when payment is made or the obligation to pay such bonus is incurred, and are recoverable from the employee if he or she were to leave us prior to a specified date. Signing bonuses are generally amortized over the lesser of seven years or the period for which they are recoverable from the individual expert. We have also paid or are obligated to pay performance bonuses that are subject to the recovery of unearned amounts if the expert leaves prior to a specified date. Like signing bonuses, performance bonuses are generally amortized over the period that the bonus can be recovered or a shorter period of time, and we recognize such performance bonuses at the time we determine that it is considered more likely than not that the performance criteria will be met. Most of our agreements allow us to recover signing and performance bonuses over periods generally ranging from one to 15 years. However for accounting purposes, we amortize such signing and performance bonuses over the shorter of the contractual recovery period or seven years. Revenue includes all amounts earned that are billed or billable, including reimbursable expenses, and have been reduced for amounts related to work performed that are estimated to be unrealizable. Expert revenue consists of revenue generated by experts who are our employees and revenue generated by experts who are independent contractors. There is no operating, business or other substantive distinction between our employee experts and our exclusive independent contractor experts. Revenues are generated primarily from time and material contracts, and recognized in the period the services are performed. We also enter into certain performance-based contracts for which performance fees are dependent upon a successful outcome, as defined by the consulting engagement. Revenues related to performance-based fee contracts are recognized in the period when the earnings process is complete, and when we have received payment for the services we performed under the contract. Performance based fees have been generated primarily by the Insurance Claims Group practice, the experts and staff of which left in September 2005. Consequently, performance based revenues have declined significantly in 2006 and we expect that such performance based fees will not be a material portion of overall revenues in future periods. Revenues are also generated from fixed price contracts, which are recognized as the agreed upon services are performed. Such fixed price contract revenues are not a material component of total revenues. Effective January 1, 2006, we adopted SFAS No. 123(R) Share-Based Payment using the modified prospective transition method and began accounting for our equity-based compensation using a fair-valued based recognition method. Under SFAS No. 123(R), the cost of employee services received in exchange for an award of equity instruments is measured based on the grant-date fair value of the award and is recognized over the service period defined by the terms of the award. Determining the appropriate fair-value model and calculating the estimated fair value of stock-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life, expected dividend rate, risk-free interest rate and expected forfeiture rate. We develop our estimates based on historical data and market information which can change significantly over time. We use the Black-Scholes option valuation model to value employee stock awards. We calculate stock price volatility using historical closing prices of our stock from November 2003, the time of our initial public offering, through the grant date of the options being valued. Forfeiture rate assumptions are also derived from historical data. We recognize compensation expense using the straight-line amortization 34 method for share-based compensation awards with graded vesting. Had we used alternative valuation methodologies, the amount we expense for equity awards could be significantly different. We account for income taxes in accordance with SFAS No. 109 Accounting for Income Taxes, under which deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying values of assets and liabilities and their respective tax bases. In accordance with SFAS No. 109, a valuation allowance is established to reduce the carrying value of deferred tax assets if it is considered more likely than not that such asset will not be realized. Significant management judgment is required in determining if it is more likely than not that we will be able to utilize the potential tax benefit represented by our deferred tax assets. Consideration is given to evidence such as the history of prior year taxable income, expiration periods for net operating losses and our projections. No valuation allowance was recorded at December 31, 2005 or 2006 on deferred tax assets arising from our operations in the United States. As of December 31, 2006, we had $343,000 of deferred tax assets in connection with foreign net operating losses of approximately $1.1 million for which the Company has provided a full valuation allowance due to the uncertainty that these net operating loss carryforwards will eventually be realized. We are entitled to a deduction for federal and state income taxes when non-qualified stock options are exercised and stock purchased through our employee stock purchase plan, or ESPP, is sold prior to the end of a required holding period. In 2005 and 2006, we recognized a total benefit from option exercises and disqualifying dispositions from our ESPP of $6.0 million and $3.0 million, respectively. Our effective tax rate used to provide for estimated quarterly tax expense is determined based on estimates of worldwide pre-tax income, permanent differences and credits, and reviewed quarterly to determine if actual results require modifying the effective tax rate. Our actual effective tax rate for 2004, 2005 and 2006 was 41.0%, 41.0% and 40.7%, respectively. In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of SFAS No. 109. The provisions are effective January 1, 2007. See “Note 2: Summary of Significant Accounting Policies” in Part II, Item 8 of this Form 10-K for further discussion. Goodwill was recorded at the time of the management buyout in September 2000. Additional goodwill and identifiable intangible were recorded related to acquisitions made through December 31, 2006. We have determined that we have one reporting unit based on several factors, one of which was the similarity of operations throughout our individual offices. We evaluate each acquisition on an individual basis to determine if it represents a separate reporting unit, as defined by SFAS No. 142 Goodwill and Other Intangible Assets, for purposes of assigning goodwill and performing subsequent impairment testing. Thus far, our business acquisitions have been integrated within the structure of our organization and our individual offices share similar economic characteristics and consequently are aggregated for purposes of identifying our reporting units. We assess the impairment of goodwill at least annually, and whenever events or significant changes in circumstance indicate that the carrying value may not be recoverable. Factors that we consider important in determining whether to perform an impairment review include significant underperformance relative to forecasted operating results and significant negative industry or economic trends. If we determine that the carrying value of goodwill may not be recoverable, then we will assess impairment based on a projection of discounted future cash flows or some other basis such as our quoted market price and measure the amount of impairment based on fair value. If a portion of a reporting unit that constitutes a business (as defined under accounting principles generally accepted in the United States) has been disposed of by sale or abandonment, goodwill associated with that business is 35 included in the carrying amount of that business in determining the gain or loss on disposal. During the third quarter of 2005, we wrote off $1.1 million of goodwill associated with the departure in September 2005 of certain experts and staff comprising the Insurance Claims Group, who joined us in July 2002 in connection with an acquisition. For the 2006 annual goodwill impairment test, we used the quoted market price of our common stock and compared our fair value to the carrying value of our equity. At October 1, 2006, we concluded that there was no impairment to our goodwill. Intangible assets that are separable from goodwill and have determinable useful lives are valued separately and amortized over their expected useful lives. Intangible assets consist principally of customer-related intangibles, including customer relationships and contract rights, as well as non-compete agreements and trade processes, and are amortized over six months to 20 years. We assess the impairment of intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If we determine that the carrying value of an intangible asset may not be recoverable, then we will assess impairment based on a projection of discounted future cash flows. At December 31, 2006, we concluded that there was no impairment in our intangible assets. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our financial statements contain various estimates including, but not limited to, estimates for unrealizable revenue, estimates for advances considered unrecoverable from experts on the expert model, valuation allowance on deferred tax assets, discretionary and performance-based bonuses and contingent payments for businesses acquired. Actual results could differ from those estimates. Effective December 31, 2006, we adopted the Security and Exchange Commission’s Staff Accounting Bulletin (“SAB”) 108 “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” as required. In December 2006, we discovered errors in our previously issued 2005 annual and 2006 quarterly consolidated financial statements in connection with certain specific expert compensation models. The periods affected by the errors are: · the year ended December 31, 2005 (reduction in net income of $250,000 or $0.01 per diluted share), · the quarter ended June 30, 2006 (reduction in net income of $210,000 or $0.01 per diluted share), and · the quarter ended September 30, 2006 (reduction in net income of $196,000 or $0.01 per diluted share). We believe that the effect of these errors is not material to any of the individual period’s income statements or balance sheets. We have recorded the 2005 correction as a cumulative effect adjustment to the fiscal year 2006 beginning retained earnings. The 2006 consolidated financial statements and the unaudited financial information by quarter included in Item 8 of this Form 10-K include these corrections and we will revise previously issued 2006 quarterly consolidated financial statements to reflect the 2006 corrections whenever those periods are presented in our publicly filed documents. See Note 3 “January 1, 2006 Retained Earnings Cumulative Effect Adjustment” of the Consolidated Financial Statements for further details. 36 Year ended December 31, 2006 compared to year ended December 31, 2005 Revenues Revenues in 2006 increased $67.2 million, or 23%, to $353.9 million from $286.7 million in 2005. This increase included a $63.8 million, or 23%, increase in expert and professional staff revenues. The increase in expert and professional staff revenues resulted from a 25% increase in the number of expert and professional staff billable hours. Expert bill rates increased 3% in 2006 and staff bill rates decreased by 1% overall, due to rate increases offset by the influence of the lower rates for staff associated with our August 2005 acquisition of Bates. We added 28 experts and 71 professional staff members since December 2005 as a result of our recruitment effort and our acquisition of Mack Barclay in May 2006. Our international operations contributed $8.7 million to the overall growth in revenues in 2006. Revenues from our international operations represent 14% of total revenue in 2006 and 2005. We terminated our joint venture interest in LECG Korea, LLC in January 2007. As a result, expert headcount will decline by 26 experts, 23 of which are independent contractors. We expect this will not have a significant impact on our financial results in 2007. The increase in expert and professional staff revenue in 2006 was offset by $10.5 million that we considered unrealizable, which represents an increase of $3.3 million, or 46%, over the $7.2 million considered unrealizable for 2005. In addition, our performance based services decreased $1.7 million, or 84%, to $333,000 in 2006 from $2.0 million in 2005. The decrease was due primarily to the departure of the experts and staff comprising the Insurance Claims Group in September 2005. As a result of their departure, our performance-based fees will be substantially reduced in future periods. Cost of services Cost of services in 2006 increased $47.5 million, or 25%, to $235.7 million from $188.2 million in 2005. Our gross margin percentage was 33.4% in 2006 as compared to 34.3% in 2005. Contributing to the overall margin decrease is the increase in equity-based compensation of $3.5 million, or 1% of revenue, following the adoption of SFAS No. 123(R) as of January 1, 2006. We also recognized $2.0 million of provision for advances paid to experts that we consider unrecoverable. This represents a $1.2 million or 154% increase over the $780,000 recognized in 2005. Reimbursable expenses increased $5.0 million, or 37%, to $18.4 million. We do not generate margin on revenue associated with reimbursable expenses. Expert and professional staff compensation increased $31.9 million as we added 28 experts and 71 professional staff since December 2005. Our growth in revenues resulted in a corresponding increase in expert compensation, as a majority of our experts are paid a percentage of their own billings plus a percentage of professional staff billings on cases they originate. Project origination fees paid to experts increased by $2.1 million consistent with the growth in professional staff revenue in 2006 as compared with 2005. Expert compensation based on performance criteria for specific groups of experts and staff also increased in 2006. Bonus compensation for salaried experts and professional staff increased $3.5 million, or 47% to $10.9 million in 2006, as compared to $7.4 million in 2005. The increase is due to an overall increase in professional staff headcount and higher performance-based bonus arrangements for certain experts and related staff. We expect the use of performance-based compensation models to increase for practices where experts and staff work as a group on multiple engagements over time. Contributing to the increase in cost of services was an increase of $2.1 million in amortization of signing and performance bonuses, or 31%, to $8.8 million in 2006 from $6.7 million in 2005. The increase was the result of adding $11.0 million of signing bonuses and $11.6 million of performance bonuses during 2006, of which we expect to pay $5.7 million in March 2007 and $745,000 throughout the remainder of 37 2007. We also expect continued use of signing and performance bonuses in the future in order to recruit and retain key experts. Operating expenses Operating expenses in 2006 increased $20.8 million, or 34%, to $81.7 million from $60.9 million in 2005. Contributing to the increase in general and administrative expenses was $7.9 million of salary, bonus and related payroll taxes due primarily to salary increases, the addition of approximately 41 administrative staff since December 2005, including the hiring of our Chief Operating Officer in May 2006 and creating a management committee to assist in areas such as recruitment, acquisitions and firm initiatives. We expect that additional administrative staff will continue to be hired as our growth continues. Bonus compensation for administrative staff increased $1.1 million to $1.7 million in 2006 from $683,000 in 2005. The increase was due primarily to additional administrative headcount, bonuses paid in connection with acquisitions and $400,000 of bonuses paid to senior management. We reduced previously accrued senior management bonuses by $1.0 million, in the fourth quarter of 2006 as a result of our performance in 2006. Equity-based compensation expense increased $2.5 million following the adoption of SFAS No. 123(R) as of January 1, 2006. Recruiting fees in connection with hiring experts and professional staff increased by $388,000 in 2006. We anticipate that we will continue to incur fees for recruiting as we pursue our growth strategy of attracting high-level experts and professional staff in practice areas where we are well established, as well as practice areas new to LECG. Our facilities costs increased $1.5 million in connection with the expansion of existing offices and the opening of four new offices since December 31, 2005. Costs related to computers, telecommunications and supplies increased $1.2 million due to increased personnel and the growth in our operations. Depreciation expense and amortization increased $660,000 due to the expansion of certain existing offices and the opening of four new offices, as well as additions to depreciable equipment and software consistent with the overall growth in our operations. Amortization of intangible assets increased by $1.8 million as a result of intangible assets acquired in connection with the acquisitions of Neilson Elggren in November 2005 and Mack Barclay in May 2006. Marketing and related costs increased $2.4 million as a result of our expanded marketing activities such as our print advertising, professional event sponsorship and seminar hosting and website enhancement. Outside services including legal, accounting and personnel service fees increased $2.2 million, including an increase in legal fees of $1.5 million primarily due to ongoing litigation with NERA. We incurred legal, accounting and financial advisory fees of $317,000 in the first quarter of 2006 and $559,000 in the fourth quarter of 2005 in connection with our efforts to make a significant acquisition that did not succeed. Travel and related expenses increased by $872,000 in 2006 compared to 2005. Contributing to this increase is an increased level of management travel and staff travel for training and conferences. Business taxes and licenses increased by $637,000 due to increased activity in locations subject to franchise taxes. The overall increase in 2006 operating expenses compared to 2005 takes into account the previously disclosed goodwill write-off of $1.1 million in the third quarter of 2005 in connection with the departure of the Insurance Claims Group. Interest expense Interest expense increased $307,000 in 2006 to $653,000 from $346,000 in 2005. The increase was due primarily to borrowing $25.0 million under our revolving credit facility in September 2006, $15.0 million of which was repaid prior to September 30, 2006 and the remainder was repaid prior to December 31, 2006, as well as increased annual commitment fees for unused portions of the credit facility. We had no outstanding debt on our term loan or revolving credit facility throughout 2005 and the first eight months of 2006. 38 Income taxes We recognized a $14,734,000 provision for income taxes on pretax income of $36,201,000, resulting in a 40.7% effective tax rate for 2006. We have recognized a reduction of current taxes payable of $3.0 million for non-qualified options exercised and disqualifying dispositions of shares purchased through our ESPP in 2006 and have reduced deferred tax assets by $378,000 and increased additional paid in capital by $2.6 million. Year ended December 31, 2005 compared to year ended December 31, 2004 Revenues Revenues in 2005 increased $70.1 million, or 32%, to $286.7 million from $216.6 million in 2004. This increase included a $72.9 million, or 37%, increase in expert and professional staff revenues, excluding performance-based services. The increase in expert and professional staff revenues resulted from a 35% increase in the number of expert and professional staff billable hours, in addition to a 2% increase in the average hourly billing rate due to rate increases and changes in the expert and staff mix. Underlying this growth is the addition of 59 experts and 165 professional staff members since December 2004 as a result of our recruitment efforts, acquisitions of the businesses of Cook in March 2005, Bates in August 2005, Nielson Elggren in November 2005 and Lancaster and Beach in December 2005, and our growth in Europe and Canada. Our total international operations contributed $13.4 million to the overall growth in revenues in 2005. Revenues from our international operations represent 14% of total revenue as compared to 13% in 2004. The increase in expert and professional staff revenue in 2005 was offset by $7.2 million that we considered unrealizable, which represents an increase of $1.7 million or 31% over the $5.5 million considered unrealizable for 2004. In addition, our performance based services decreased $5.7 million, or 74%, to $2.0 million in 2005 from $7.7 million in 2004. The decrease was due primarily to the departure of the experts and staff comprising the Insurance Claims Group in September 2005. Cost of services Cost of services in 2005 increased $44.5 million, or 31%, to $188.2 million from $143.7 million in 2004. Our gross margin percentage was 34.3% in 2005 as compared to 33.6% in 2004. The overall margin improvement is due primarily to the growth in 2005 in our European operations, as 2004 represented the first year of expansion in continental Europe. Expert and professional staff compensation increased $34.7 million consistent with our headcount increase. Our growth in revenues contributed to the increase in expert compensation, as a majority of our experts are paid a percentage of their own billings plus a percentage of professional staff billings on cases they originate. Bonus compensation for salaried experts and professional staff increased $5.1 million as compared to 2004 due to an increase in professional staff headcount, a professional staff bonus compensation plan introduced in 2005 that is based heavily on utilization, low professional staff bonuses granted in 2004 and an increase in both the amount earned by and the number of salaried experts in 2005 that have a performance-based component to their overall compensation. Contributing to the increase in cost of services is the amortization of signing and performance bonuses of $6.7 million in 2005, representing an increase of $2.4 million as compared to 2004; $1.0 million of the increase relates to amortization of performance bonuses and $1.4 million to increased signing bonuses. Project origination fees increased $3.4 million or 25% to $17.0 million in 2005 from $13.6 million in 2004, consistent with the growth in professional staff revenues. Costs associated with our performance-based services decreased by $4.7 million and $3.1 million for the year and fourth quarter 2005 as compared to the same periods in 2004, which is consistent with the decrease in performance based revenues and the departure of the Insurance Claims Group in September 2005. 39 Operating expenses Operating expenses in 2005 increased $16.9 million, or 39%, to $60.9 million from $44.0 million in 2004. The increase was comprised of $15.8 million increase in general and administrative expenses and $1.1 million write-off of goodwill in connection with the departure of the experts and staff comprising the Insurance Claims Group in September 2005. Contributing to the increase in general and administrative expenses was $6.4 million of salary, bonus and related payroll taxes due primarily to salary increases and the addition of approximately 52 administrative staff since December 2004. Personnel costs and recruiting fees in connection with hiring experts and professional staff increased $973,000 in 2005. Our facilities costs increased $2.4 million in connection with the expansion of existing offices and the opening of four new offices since December 31, 2004. Costs related to computers, telecommunications and supplies increased $2.2 million due to increased personnel and the growth in our operations. Depreciation expense and amortization increased $573,000 due to the expansion of certain existing offices and the opening of four new offices, as well as additions to depreciable equipment and software consistent with the overall growth in our operations. Marketing and related costs increased $1.3 million as the result of our expanded marketing activities and branding initiatives designed to increase the awareness of the LECG brand, examples of which include professional event sponsorship and seminar hosting, website enhancement and underwriting the costs of technical publications authored by our experts. Outside services including legal, accounting and personnel service fees increased $790,000, included in which are $559,000 of legal, accounting and financial advisory fees incurred during the fourth quarter of 2005 in connection with our efforts to make a significant acquisition that did not succeed. Our efforts to acquire this company extended into the first quarter of 2006, and consequently, we expensed additional costs of approximately $375,000 in the quarter ending March 31, 2006. Interest expense We had no outstanding debt throughout 2005 on our term loan or revolving credit facility. Interest expense in 2005 is comprised primarily of amortization of fees paid in connection with our credit facility as well as commitment fees for unused portions of the credit facility. Income taxes We recognized $15.6 million provision for income taxes on pretax income of $37.9 million, resulting in a 41.0% effective tax rate for 2005. We have recognized a reduction of current taxes payable of $6.0 million for non-qualified options exercised in 2005 and have reduced deferred tax assets by $1.0 and increased additional paid in capital by $5.0 million. As of December 31, 2006, we had $26.5 million in cash and cash equivalents, primarily in money market accounts. Our primary financing need will continue to be to fund the growth in our operations, future acquisitions and signing and performance bonuses in connection with recruiting and retaining experts. An important element of our growth strategy is the recruitment of additional experts and our expansion into new geographic and service areas. We expect to continue to search for and acquire top-level experts in order to deepen our existing service offerings and to add new experts and related professional staff to new practice areas. The growth in the number of experts and scope of operations has been accomplished through a mix of individual hires, group hires and acquisitions including our May 2006 acquisition of Mack Barclay and our 2005 acquisitions of Cook in March, Bates in August, Neilson Elggren in November, and both Beach and Lancaster in December. On March 9, 2007, we entered into an agreement to acquire substantially all of the operating assets of The Secura Group, LLC. The purchase price will consist of $9,500,000 to be paid in cash at closing. An additional purchase price payment of up to 40 $2,500,000 will be made in cash if specific performance targets are met during the period from closing through December 31, 2010. The acquisition is expected to close on March 16, 2007. Our current sources of liquidity are our cash on hand, cash generated by operations before payment of signing and performance bonuses and our revolving credit facility, which expires December 2011 and provides for a maximum borrowing capacity of $100 million, of which $25 million can be used to secure letters of credit. The facility includes the option, subject to conditions, to increase the line to $200 million over the life of the facility. In September 2006 we borrowed $25 million, which was repaid prior to December 31, 2006. At December 31, 2006, we had no outstanding borrowings under our revolving credit facility, and we had outstanding letters of credit of $1.7 million. Net cash provided by operations in 2006 was $11.4 million as compared to $20.2 million provided by operations in 2005 and $945,000 used by operations in 2004. The primary sources and uses of cash from operations in 2006 were net income of $21.5 million, which included non-cash expenses of $21.1 million. This was offset by an increase in accounts receivable of $13.6 million resulting from the increase in expert and professional staff revenue. Various factors impact the average collection period of receivables including billing activities associated with new clients, consultancy on matters relating to bankruptcy, and international operations. In 2006, we paid $23.6 million in signing bonuses and performance bonuses, an increase of $15.9 million from the $7.7 million paid in 2005. Signing bonuses and bonuses with performance criteria are an integral part of our recruitment and retention effort. We will likely continue to use signing and performance bonuses in our efforts to recruit and retain key experts and professional staff. Substantially all of the signing bonuses and certain performance bonuses issued have amortization periods ranging from one to seven years and recovery periods of one to 15 years, whereby we are entitled to recover the bonus on a pro rata basis in the event the recipient leaves prior to the end of the vesting period. In the third quarter of 2006, we hired three experts and other professional staff in connection with expansion of our health care and life science, financial services, and other practices. In connection with these hires, we paid $6.5 million in signing bonuses, which will be amortized over seven years. In addition, if certain performance criteria are met by 2011, we will make additional performance bonus payments of up to $5.0 million, which would be amortized over periods ranging from four to seven years. In the fourth quarter of 2006, we paid $4.5 million of performance bonuses to three experts, which will be amortized over periods ranging from five to seven years, and in early 2007, we paid $3,975,000 of performance bonuses to three experts, which will be amortized over seven years. We will also pay performance bonuses of $5.7 million in March 2007 to certain experts in Europe and the United States, as specified performance targets were achieved in 2006. These performance bonuses are amortized from the time the bonus was earned through March 2011. In 2006, we paid $22.6 million for income taxes, $5.5 million of which will be applied to 2007 tax liabilities. Net cash provided by operating activities in 2005 was $20.2 million, resulting primarily from $22.4 million of net income, which included non-cash expenses of $13.3 million, offset by an increase in accounts receivable of $21.4 million. We paid $5.9 million for income taxes in 2005, as we were able to decrease our 2005 tax liability with net operating losses arising from our conversion to a C corporation in conjunction with our initial public offering in November 2003. 41 Net cash used in investing activities was $28.3 million for 2006 as compared to $37.4 million in 2005 and $29.6 million in 2004. Acquisition related payments in 2004, 2005 and 2006 were as follows (in millions):
Investing activities in 2006 also included investments in leasehold improvements related to the expansion our San Diego office, and office equipment, computer hardware and software totaling $6.3 million. Similar activities in 2005, including investments in leasehold improvements in connection with the expansion of our Chicago office totaled $6.9 million. Net cash provided by financing activities was $6.6 million for 2006, as the result of $4.2 million of proceeds from the exercise of options, $265,000 from the issuance of 14,745 shares of common stock in connection with our Employee Stock Purchase Plan and $2.6 million of tax benefit from option exercises and equity compensation plans. We borrowed and repaid $25.0 million under our revolving credit line during 2006, and we paid $503,000 of loan fees to amend our revolving credit line, including increasing the maximum borrowings under the line of credit and extending the expiration date to December 2011. Net cash provided by financing activities was $12.2 million for 2005, as the result of $9.2 million of proceeds from the exercise of options, $2.1 million from the issuance of 140,774 shares of common stock in connection with our Employees Stock Purchase Plan and $1.3 million of net proceeds from our sale of an additional 74,375 shares of our common stock in January 2005 in a secondary public offering, which began in December 2004. We had no borrowings under our revolving credit line during 2005, and we paid $407,000 to increase the maximum borrowings under the line from $10 million to $50 million and to extend the expiration date. In December 2006, we amended our revolving credit facility. The terms of the revised agreement provide for maximum borrowings of $100 million, of which $25 million is available for letters of credit. 42 Borrowings under the facility are guaranteed by LECG Corporation and its domestic subsidiaries. The facility includes the option, subject to customary terms and conditions, to increase the maximum borrowings under the revolving credit facility to $200 million over the life of the facility, which expires in December 2011. We paid $503,000 of loan acquisition fees and related costs, which will be amortized through December 31, 2011. As of December 31, 2006, the Company had no outstanding borrowings and had letters of credit outstanding in the amount of $1.7 million. The rate in effect for the revolving credit facility at December 31, 2006 was 8.25%. Interest rates are determined at the time of borrowing based on the greater of the prime rate or the federal funds rate plus 0.5%. The facility also provides for annual commitment fees on the unused portion of the facility of 0.10%-0.20%. Borrowings under the revolving credit facility are subject to non-financial and financial covenants, including leverage and debt coverage ratios as well as limitations on the total amount of signing and performance bonus payments made within a 12-month period. The Company was in compliance with these covenants in 2006. We believe funds generated by operations and the amounts available to us under our revolving credit facility will provide adequate cash to fund our anticipated cash needs, at least through the next twelve months. Cash payments for signing and performance bonuses and acquisitions could materially affect our anticipated cash needs, as we anticipate continuing to use signing and performance bonuses to recruit and retain high level expert talent. We currently anticipate that we will retain all of our earnings, if any, for development of our business and do not anticipate paying any cash dividends in the foreseeable future. Inflation has not had a material impact on our operating results or financial position to date, nor do we expect inflation to have an impact in the short-term, however there can be no assurance that inflation will not have an adverse effect on our financial results and position in the future. Foreign currency exchange rates in countries we have operations have not had a material impact on our operating results or financial position to date. However there can be no assurance that factors affecting exchange rates in these countries will not have an adverse effect on our financial results and position in the future. 43 CONTRACTUAL OBLIGATIONS AND COMMITMENTS The following table provides summary information concerning our future contractual and contingent obligations and commitments, including the acquisitions and expert hires disclosed below and other contingent commitments relating to other expert agreements, operating leases and purchase commitments.
(1) Includes the maximum potential payments associated with contractual obligations that are contingent upon the achievement of significant specified performance criteria. Consequently, the amounts and timing of such payments included in the table are estimates. Actual payments, if any, may differ materially from the estimates presented. If different assumptions were used, the timing and amounts of the estimates would have been materially different. (2) We lease our office facilities and certain equipment under operating lease arrangements expiring on various dates through 2019. We lease office facilities under noncancelable operating leases that include fixed or minimum payments plus, in some cases, scheduled base rent increases over the term of the lease and additional rents based on the Consumer Price Index. Certain leases provide for monthly payments of real estate taxes, insurance, and other expenses. (3) Includes approximately $4.0 million of performance bonus payments made in the first quarter of 2007 that were not committed to as of December 31, 2006. (4) Represents the maximum payment under the terms of certain expert and acquisition agreements and are subject to achieving certain significant performance criteria. Actual amounts, if any, to be paid could be significantly less than the maximum presented and may vary in timing from that which is presented in the table. (5) Represents actual amounts to be paid. Timing of the payment may vary if certain performance targets are achieved. (6) Represents the maximum payment under the terms of the agreements and are subject to achieving certain significant performance criteria. Actual amounts, if any, to be paid could be significantly less than the maximum presented and may vary in timing from that which is presented in the schedule. (7) Primarily represents maintenance, service and outsourcing contracts. (8) Excludes $9.5 million expected to be paid for the acquisition of The Secura Group, LLC that was not committed to as of December 31, 2006. 44 We have made commitments in connection with our acquisitions and certain expert agreements that will require us to make additional payments and bonus compensation payments if specified performance targets are achieved. The following information is included in the summary of commitments table appearing in the beginning of this section. In connection with our May 2006 acquisition of Mack Barclay, as a result of achieving specified performance targets through December 31, 2006, we recognized $1.2 million of additional purchase price, to be paid in July 2007. If additional specified annual performance targets are achieved through April 2011, we will make additional payments of up to $7.6 million by no later than July 2011. In connection with our December 2005 acquisition of Lancaster, as a result of achieving specified performance targets through December 31, 2006, we paid $372,000 in March 2007. If specified performance targets are achieved through December 2009, we will make additional payments of up to $978,000 by no later than March 2010. In connection with our December 2005 acquisition of Beach, if specified performance targets are achieved through June 2008, we will make an additional payment of $500,000 by no later than August 2008. In connection with our November 2005 acquisition of Neilson, as a result of achieving specified performance targets through December 31, 2006, we paid $1.2 million in March 2007 and we will pay $200,000 by January 2008. If additional specified annual performance targets are achieved through October 2010, we will make additional payments of up to $2.4 million by no later than January 2011. An additional payment of up to $1.5 million will also be made in December 2010 if higher targets are met by no later than October 2010. In connection with our August 2005 acquisition of Bates, as a result of achieving specified performance targets through December 31, 2006, we will pay $2.4 million in September 2007. If additional specified annual performance targets are achieved through July 2011, we will make additional payments of up to $7.1 million by no later than September 2011. In connection with our March 2005 acquisition of Cook, as a result of achieving specified performance targets through December 31, 2006, we paid $243,000 in February 2007. If specified performance targets are achieved through December 2008, we will make additional payments of up to $857,000 by no later than March 2009. In connection with our October 2004 acquisition of Washington Advisory Group, as a result of achieving specified performance targets through December 31, 2006, we paid $824,000 in February 2007 along with $400,000 of guaranteed purchase price. In connection with our August 2004 acquisition of SVEWG, we recognized a liability in the third quarter of 2005 for an estimated performance payment of $87,000. In addition, we will make guaranteed payments of $2.0 million over the period beginning September 2007 and ending no later than September 2009, and if specified performance targets are achieved through July 2009, we will make additional payments of up to $2.4 million over the same period. In connection with our March 2004 acquisition of EA, as a result of achieving specified performance targets through December 31, 2006, we paid $1.9 million in March 2007. Additional payments of up to $2.0 million will also be made by March 2009 if certain higher performance targets are achieved through December 2008. In connection with our March 2004 acquisition of LRTS, as a result of achieving specified performance targets through December 31, 2006, we paid $845,000 in February 2007. If specified 45 performance targets are achieved through February 2008, we will make additional payments of up to $1.2 million by no later than April 2008. In connection with our August 2003 acquisition of CFES, as a result of achieving specified performance targets through December 31, 2006, we will pay $1.9 million in August 2007. In addition, we will pay bonus compensation of up to $580,000 in August 2007 if specified performance targets are achieved through July 2007. In connection with the hiring of certain experts and professional staff in March 2004, we will pay $5.7 million of performance bonuses in March 2007 as specified performance targets for 2006 were achieved. All such performance bonus payments are subject to amortization from the time the bonus is earned through March 2011. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We have established cash investment guidelines consistent with the objectives of preservation and safety of funds invested and ensuring liquidity. Eligible investments include money market accounts, US Treasuries, US Agency securities, commercial paper, municipal bonds, AAA rated asset-backed securities, certificates of deposit and agency backed mortgage securities. We seek the highest quality credit rating available for each type of security used for investment purposes. Maturities are not to exceed 18 months. Our interest income and expense is sensitive to changes in the general level of interest rates in the United States, particularly since the majority of our investments are short-term in nature and interest on our short-term borrowings is based on the greater of the prime rate or the federal funds rate plus 0.5%. Due to the nature of our short-term investments and borrowings, we have concluded that we do not have material market risk exposure. Our investment policy requires us to invest funds in excess of current operating requirements. As of December 31, 2006, our cash and cash equivalents consisted primarily of money market funds. The recorded carrying amounts of cash and cash equivalents approximate fair value due to their short maturities. We currently have international operations in Argentina, Belgium, Canada, France, Italy, New Zealand, Spain and the United Kingdom. The functional currency in each location is the local currency. Fluctuations in exchange rates of the U.S. dollar against foreign currencies may result in foreign exchange gains and losses. If exchange rates on such currencies were to fluctuate 10%, we believe that our results from operations and cash flows would not be materially affected. 46 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
47 To the Board of Directors and Stockholders of LECG Corporation: We have audited the accompanying consolidated balance sheets of LECG Corporation and subsidiary as of December 31, 2005 and 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with 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 LECG Corporation and subsidiary as of December 31, 2005 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 2 to the consolidated financial statements, in 2006, the Company changed its method of accounting for share-based payment arrangements to conform to Statement of Financial Accounting Standards No. 123 (R) “Share Based Payment.” As discussed in Note 3 to the consolidated financial statements, on December 31, 2006, the Company adopted Staff Accounting Bulletin No. 108 “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” and recorded a cumulative effect adjustment to January 1, 2006 retained earnings. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 12, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of a material weakness. /s/ DELOITTE & TOUCHE LLP San Francisco, California 48 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROLS OVER FINANCIAL REPORTING To the Board of Directors and Stockholders of LECG Corporation: We have audited management’s assessment, included in the accompanying “Management Report on Internal Control Over Financial Reporting”, that LECG Corporation and subsidiary (the “Company”) did not maintain effective internal control over financial reporting as of December 31, 2006, because of the effect of the material weakness identified in management’s assessment, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’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 opinions. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel 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 the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment: Internal Controls were not adequately designed to include procedures to ensure all relevant items were accurately comprehended in complex computations for determining (i) earn-out payments under acquisition agreements, and (ii) bonus payments under non-standard expert compensation agreements and did not prevent or detect certain errors that were subsequently identified. These two significant deficiencies, in the aggregate, result in a material weakness in the Company’s internal control over financial reporting. This material weakness was considered in 49 determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements of the Company as of and for the year ended December 31, 2006, and this report does not affect our report on such financial statements. In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2006 of the Company and our report dated March 12, 2007 expressed unqualified opinion on those financial statements and included an explanatory paragraph relating to the adoption of a new accounting standard and an explanatory paragraph relating to a retained earnings cumulative effect adjustment. /s/ DELOITTE & TOUCHE LLP San Francisco, California 50 LECG CORPORATION (formerly LECG Holding Company, LLC)
AND SUBSIDIARY
See notes to consolidated financial statements 51 LECG CORPORATION (formerly LECG Holding Company, LLC)
AND SUBSIDIARY
See notes to consolidated financial statements 52 LECG CORPORATION (formerly LECG Holding Company, LLC) AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
See notes to consolidated financial statements 53 LECG CORPORATION (formerly LECG Holding Company, LLC)
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