Item 1. Business.
General
The following discussion relates to The FINOVA Group Inc. and its subsidiaries (collectively “FINOVA” or the “Company”), including FINOVA Capital Corporation and its subsidiaries (“FINOVA Capital”). FINOVA is a financial services holding company. Through its principal operating subsidiary, FINOVA Capital, the Company has provided a broad range of financing and capital markets products, primarily to mid-size businesses. Throughout this document, “we,” “us” and “our” also refer to The FINOVA Group Inc. and its subsidiaries. FINOVA is a Delaware corporation incorporated in 1991. Our principal executive offices have recently moved to 8320 North Hayden Road, Suite C112, Scottsdale, Arizona 85258, telephone (480) 624-4988.
Since emergence from chapter 11 bankruptcy proceedings in August 2001, our business activities have been limited to maximizing the value of our portfolio through the orderly collection of assets. These activities have included collection efforts pursuant to underlying contractual terms, negotiation of prepayments and sales of assets or collateral. We have sold substantial portions of asset portfolios and are considering future sales of our remaining assets if buyers can be found at acceptable prices; however, there can be no assurance that we will be successful in efforts to sell additional assets. We are currently offering to sell our remaining assets both by portfolio and individual asset. We are prohibited by the Indenture (the “Indenture”) governing our 7.5% Senior Secured Notes (the “Senior Notes”) from engaging in any new lending activities or other business, except to honor existing customer commitments and in certain instances, to restructure financing relationships to maximize value. Any funds generated in excess of cash reserves permitted by our debt agreements have been used to reduce obligations to our creditors.
As of December 31, 2006, we remain obligated to repay $1.5 billion of principal on the Senior Notes. In accordance with the terms of the Indenture, we are required to use any excess cash, as defined in the Indenture, to make semi-annual interest and principal payments on the Senior Notes. Additionally, the Indenture permits voluntary prepayments at our option. Although we have repaid approximately 50% of the Senior Notes as of the date of this report, we do not have sufficient assets to fully repay the Senior Notes.
On November 1, 2006, our Board of Directors (the “Board”) approved the Plan of Complete Liquidation and Dissolution (the “Plan of Liquidation”) and the filing of a motion (the “Motion”) in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). On December 4, 2006, the Bankruptcy Court granted our Motion and approved (i) the previously announced settlement of various litigations associated with The Thaxton Group, Inc. (the “Thaxton Settlement”), (ii) the ongoing sale of our remaining assets, the orderly windup of our operations and our future dissolution, (iii) our sale of all or substantially all of our assets without stockholder approval and our future dissolution without stockholder approval at such time as our Board deems to be appropriate and (iv) channeling to the Bankruptcy Court any claims against us that the holders of our Senior Notes or the indenture trustee for the Senior Notes may have arising from or in any way related to our joint chapter 11 plan, the ongoing liquidation of FINOVA, the senior secured notes, or the windup of our operations.
As a result of the aforementioned approvals, we have taken steps to initiate our complete liquidation and as such, the information provided in this Annual Report on Form 10-K reflects our adoption of the liquidation basis of accounting effective the close of business on December 4, 2006 in accordance with accounting principles generally accepted in the United States. Historical information for periods prior to December 5, 2006 is presented on a going concern basis of accounting. Under the liquidation basis of accounting, we are required to value all assets at their estimated net realizable value, which is the non-discounted amount of cash, or its equivalent, into which an asset is expected to be converted in the due course of business less direct costs, while liabilities are reported at their estimated net settlement amount, which is the non-discounted amounts of cash, or its equivalent, expected to be paid to liquidate an obligation in the due course of business, including direct costs. Additionally, under the liquidation basis of accounting, we are required to establish a reserve for all future estimated general and administrative expenses and other costs expected to be incurred during the liquidation (exclusive of interest expense). These estimates will be periodically reviewed and adjusted as appropriate. There can be no assurance that these estimated values will be realized. Such amounts should not be taken as an indication of the timing or amount of future distributions or our actual dissolution.
The timing and amount of distributions to Senior Note holders will depend on the timing and amount of proceeds we receive upon the sale of the remaining assets, the resolution of claims and other litigation matters, the extent to which reserves for current or future liabilities are required and the length of time required to settle all of our matters. Our goal is to wind-up the affairs of the Company during 2007; however, we cannot control the exact timing of resolving legal matters and claims. Accordingly, the liquidation period may extend beyond 2007 and conservative estimates are up to 24 months or the end of 2008.
We will continue to operate as a public company throughout the liquidation period under a Management Services Agreement with Leucadia National Corporation (“Leucadia”) that expires in 2011. Pursuant to that agreement, Leucadia has designated its employees to act as Chairman of the Board (Ian M. Cumming), President (Joseph S. Steinberg) and Chief Executive Officer (Thomas E. Mara). We will maintain adequate cash reserves to pay all operating expenses as they come due in accordance with the Indenture.
High Investment Risk
As previously stated, we will not be able to fully repay the Senior Notes or make any distributions to our stockholders, absent a court order in connection with the litigation disclosed in Item 3 “Legal Proceedings - Motion Regarding Distribution to Stockholders.” Consequently, investing in the Senior Notes and common stock involves a high level of risk. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operation for a further discussion of the Senior Notes and restrictions on distributions to stockholders.
Because substantially all of our assets (except for a few assets that could not be pledged because those assets already secured other obligations) are pledged to secure obligations under the Intercompany Notes (as defined in Management’s Discussion and Analysis of Financial Condition and Results of Operations) securing the Senior Notes, our ability to obtain additional or alternate financing is severely restricted. Berkadia LLC (“Berkadia”), an entity jointly owned by Berkshire Hathaway Inc. and Leucadia, has no obligation to lend additional sums to or to further invest in the Company. Accordingly, we intend to rely on internally generated cash flows from the liquidation of assets as our only meaningful source of liquidity.
Portfolio Composition and Activity
The asset liquidation process has resulted in a significant reduction to the size of our niche portfolios. To facilitate the orderly collection of our remaining assets, we combined our former operating segments into one operating unit; however, our assets continue to be concentrated in certain specific market niches.
Since our portfolio is primarily concentrated in specialized industries, we are subject to both general economic risk and the additional risk of economic downturns within individual sectors of the economy, particularly those impacting the aviation industry. We also completed multiple financial transactions with individual borrowers and their affiliates, resulting in a greater total exposure to those borrowers beyond the typical transaction size and increased concentration risk to economic events affecting the industries (including aviation) of those borrowers and their affiliates.
At December 31, 2006, the carrying value on a liquidation basis of our top 10 aggregate exposures to borrowers and their affiliates totaled approximately $148.9 million and represented 84.8% of our liquidating portfolio (excluding the severance and bonus trusts of $10.1 million), as compared to our top 10 exposures (on a going concern basis) at December 31, 2005 of $220.3 million, which represented 64.6% of total financial assets (before reserves and excluding the severance and bonus trusts of $14.4 million). The top 10 exposures at December 31, 2006 were primarily concentrated in aviation assets and the loan to The Thaxton Group, which alone makes up about 48% of the net realizable value expected from our liquidating portfolio. As of the date of this report, all of our top 10 exposures have either been liquidated, are under binding definitive agreements or letters of intent to sell or are subject to a negotiated settlement.
At December 31, our transportation portfolio consisted of the following aircraft:
The aircraft presented in the tables represent owned assets and collateral supporting financing arrangements.
At December 31, 2006, 12 aircraft were operated by domestic carriers, while 19 aircraft were operated by foreign carriers. Additionally, one aircraft was off-lease and parked at a storage facility in the United States. At December 31, 2005, 33 aircraft were operated by domestic carriers, while 45 aircraft were operated by foreign carriers. Additionally, 11 aircraft were off-lease and parked at various storage facilities in the United States and Europe, including two aircraft, which were identified for potential dismantling or sale at scrap values.
As of the date of this report, we had 32 aircraft with a total carrying value on a liquidation basis of approximately $85.1 million that had either been liquidated subsequent to December 31, 2006, are under individual letters of intent to sell or are subject to a definitive agreement to sell. Due to the fact these aircraft are operating throughout the world, additional time will be necessary to close the sales. It is to our advantage to close these transactions when the aircraft are in tax friendly jurisdictions to minimize transfer taxes. No assurance can be given that all of these commitments will result in actual sales or the timing of such sales, but all of the aircraft are targeted to close by the end of the first quarter of 2007. There is a possibility for a small number of aircraft sales to slide into the second quarter of 2007.
In addition to the aircraft noted above, our transportation portfolio also includes 13 engines, miscellaneous parts and some unsecured aviation notes and claims with a total carrying value on a liquidation basis of approximately $5.0 million as of December 31, 2006. The majority of these assets have either been liquidated subsequent to December 31, 2006, are under individual letters of intent to sell or are subject to a definitive agreement to sell. We are in the process of marketing the remaining uncommitted assets for sale, all of which are targeted for closure by the end of the first quarter of 2007.
Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations for a further discussion of portfolio activity.
Customer Requirements
Our financing contracts and leases generally require customers to pay taxes, license fees and insurance premiums and to perform maintenance and repairs at the customer’s expense. Contract payment rates for existing customers are based on several factors, including the cost of borrowed funds, term of the contract, creditworthiness of the customer, type and nature of collateral and other security and, in leasing transactions, the timing of tax effects and estimated residual values. In true lease transactions, lessees are granted an option to purchase the equipment at the end of the lease term at its then fair market value and, in some cases, are granted an option to renew the lease at its then fair rental value. The extent to which lessees exercise their options to purchase leased equipment varies from year to year, depending on, among other factors, the state of the economy, the financial condition of the lessee, interest rates, and technological developments.
Portfolio Management
Our portfolio management personnel generally perform detailed reviews and assessments of customer financial statements to analyze financial performance and trends, conduct periodic assessments, appraisals and/or verification of the underlying collateral, seek to identify issues concerning strengths, weaknesses and vulnerabilities of the customer, seek to resolve outstanding issues with the customer, and periodically review and address covenant compliance issues.
Evaluations of borrower performance are an important aspect of the portfolio management review process. In conjunction with this process, portfolio managers update anticipated portfolio cash flows. These evaluations and cash flows serve as a significant component in the determination of portfolio impairment.
Delinquencies and Workouts
We monitor the timing of payments on our accounts and have established policies and procedures for collection of delinquencies. These policies and procedures are generally employed, unless in the opinion of management, an alternate course is warranted. Generally, for term loans and leases, when an invoice is past due, the customer is contacted and a determination is made as to the extent of the problem, if any. A commitment for immediate payment is pursued and the account is observed closely. If an invoice for principal or interest becomes 31 days past due, it is reported as delinquent. A notice of default is generally sent prior to an invoice becoming 45 days past due if satisfactory discussions are not in progress. Between 60 and 90 days past the due date, if satisfactory negotiations are not underway, outside counsel may be retained to help protect our rights and to pursue remedies. If satisfactory results are not obtained as a result of communication with the customer, guarantors, if any, are usually contacted to advise them of the situation and their potential obligation under the guarantee agreement.
Governmental Regulation
Our activities, including the financing of our operations, are subject to a variety of federal and state regulations, such as those imposed by the Federal Trade Commission, the Securities and Exchange Commission, the Internal Revenue Service, the Consumer Credit Protection Act, the Equal Credit Opportunity Act and the Interstate Land Sales Full Disclosure Act. Additionally, a majority of states have ceilings on interest rates that are charged to customers in financing transactions. Some of our financing transactions and servicing activities are subject to additional government regulation. For example, aircraft financing is regulated by the Federal Aviation Administration and communications financing is regulated by the Federal Communication Commission. Our international activities are also subject to a variety of laws and regulations of the countries in which business is conducted. Our operations during the reorganization proceedings were also subject to oversight by the bankruptcy court, which has retained jurisdiction to resolve claims resulting from that restructuring.
Employees
At December 31, 2006, we had 32 employees compared to 60 and 101 at December 31, 2005 and 2004, respectively. As a result of the continued wind-up of our affairs and the sales activity discussed above, we anticipate a significant reduction in employees to occur in early 2007. By the end of April, we anticipate that we will have reduced our workforce to approximately five employees; however, the pace of employee reductions may change as necessitated by our operations, the timing of scheduled asset sales or other factors.
The scheduled employee reductions are intended to reflect the significant continuing liquidation of our portfolio, while retaining appropriate oversight of the smaller operation and maintaining adequate resources to deal with outstanding claims and the future dissolution of our entities.
Employees are covered by a severance program, which was approved by our Board of Directors and continues with no fixed expiration date. We have also developed an annual performance-based incentive program for employees. In an effort to maintain the stability of our workforce through the remainder of the liquidation, our Board of Directors previously approved the establishment of two grantor trusts to secure obligations under the severance and bonus programs. These trusts, which did not increase the obligations to employees, were initially funded during 2003 and totaled $10.1 million at December 31, 2006.
Investor Information
We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Accordingly, we file periodic reports and other information with the Securities and Exchange Commission (the “SEC”). Those reports and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, D.C. 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, information statements and other information regarding issuers that file electronically.
You can access financial and other information on our website. The address is www.finova.com. We also make available on our website, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act within two business days after filing that material with the SEC.
We have a Code of Conduct applicable to all of our employees, including our Chairman, President, Chief Executive Officer and Chief Financial Officer. A copy of the Code of Conduct is available on our website. We intend to post any amendments to, or waivers from, the Code of Conduct applicable to the senior officers listed above.
Item 1A.
Item 1A. Risk Factors
An investment in our Senior Notes and common stock involves a high degree of risk. The risks can generally be divided into three categories: risks relating to our Plan of Liquidation; risks relating to our assets and liabilities; and risks relating to our organization and structure. The risks, uncertainties and other factors that could cause our net assets in liquidation and cash flows to differ materially from those suggested by this filing or which may materially and adversely affect our performance and the timing and amount repaid to the Senior Note holders include, but are not limited to, those discussed below or identified elsewhere in this Report or from time to time in our public filings.
Risks related to our Plan of Liquidation
We cannot assure the Senior Note holders of the timing or amount of their liquidating distributions. If note holders believe that we will be unable to complete our Plan of Liquidation in a timely manner or if liquidating distributions do not meet current estimates, the market price of our notes may decline.
As a result of the adoption of the Plan of Liquidation, our basis of accounting has changed from the going-concern basis to that of the liquidation basis of accounting. Under the liquidation basis of accounting, assets are stated at their estimated net realizable value and liabilities are stated at their estimated settlement amount. These estimates will be periodically reviewed and adjusted as appropriate. The valuation of assets at their net realizable value and liabilities at their anticipated settlement amount represent estimates, based on present facts and circumstances of the net realizable value of our assets and the costs associated with carrying out the Plan of Liquidation based on certain assumptions. The actual values and costs associated with carrying out the Plan of Liquidation are expected to differ from the amounts reflected in the accompanying financial statements because of the plan’s inherent uncertainty. These differences may be material. In particular, the estimates of our costs will vary with the length of time necessary to complete the Plan of Liquidation. Accordingly, it is not possible to predict with certainty the aggregate amount which will ultimately be distributed to note holders and no assurance can be given that the distributions will equal or exceed the estimate presented in the accompanying Statement of Net Assets in Liquidation or the price at which the Senior Notes have traded or are expected to trade in the future.
A number of other factors including (i) unknown liabilities or claims, (ii) greater or less than expected expenses, and (iii) greater or less than anticipated net proceeds of asset sales could result in the distributions to the Senior Note holders being more or less than anticipated or delayed.
As a result of the adoption of a Plan of Liquidation, potential purchasers of our assets may try to take advantage of our liquidation process and offer less-than-optimal prices for our assets. We cannot predict how these factors and changes in aviation markets and the national economy or other factors may affect the prices that we can obtain from sales of our remaining assets or the timing of such sales.
It is becoming more difficult to offset the costs of collecting the remaining portfolio. As we continue to liquidate assets and change our portfolio composition, it becomes increasingly more difficult to offset the costs associated with collecting the remaining portfolio and being a public company. Additionally, we incur the risks of potential liabilities that are associated with dispositions of assets, in the form of indemnifications, representations and warranties.
Our Board may abandon the Plan of Liquidation without further action by our stockholders or the Bankruptcy Court. Furthermore, our Board may modify the Plan of Liquidation as necessary, but any material amendment may require further approval of the Bankruptcy Court or stockholders. Thus, we may decide to conduct the liquidation differently than as described, to the extent we are permitted to do so by Delaware law.
At any time, we may transfer to a liquidating trust any assets not sold or distributed, subject to outstanding liabilities. If a liquidating trust were established, we would distribute to the then holders of Senior Notes interests in the liquidating trust in proportion to the number of notes owned by such note holders. Such a distribution could have tax ramifications to note holders.
Historically, extraordinary corporate actions, such as a plan of liquidation, often lead to securities lawsuits being filed against a company. We are currently not aware of any pending securities lawsuits relating to our Plan of Liquidation; however, in the event such litigation should occur, it is likely to be expensive and, even if we ultimately prevail, the process will be time consuming and will divert management’s attention from implementing the Plan of Liquidation and otherwise operating our business. If we do not prevail in any such lawsuit, we may be liable for damages, the validity of our approval of the Plan of Liquidation may be challenged, or we may be unable to complete some transactions that we contemplated as part of the Plan of Liquidation. We cannot predict the outcome or the amount of expenses and damages, but the amounts could have a material adverse effect on our business, net assets in liquidation, cash flows and the timing and amount of liquidating distributions to Senior Note holders.
Risks related to our Assets and Liabilities
Our ability to sell the remaining assets is impacted by limitations of buyers. Risks associated with the sale of our assets, which if they materialize, could have a material adverse effect on our business, net assets in liquidation and cash flows include:
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Lack of demand by prospective buyers;
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Inability to find qualified buyers;
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Inability of buyers to obtain satisfactory financing;
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Lower than anticipated sale prices; and
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The inability to close on sales of assets under contract.
Our net assets in liquidation and cash flows are greatly affected by economic conditions and the performance of our borrowers. Economic conditions in general or in particular market segments could impair the ability of our borrowers to operate or expand their businesses, which might result in decreased performance, adversely affecting their ability to repay their obligations to us. If this were to occur, the rate of borrower defaults or bankruptcies may increase. A worsening of economic conditions could adversely affect our ability to realize estimated cash flows.
Continued instability and uncertainty in the airline industry could adversely affect the value of our aircraft portfolio, lease rates and demand. Conditions affecting our aircraft portfolio, include changes in Federal Aviation Administration directives and demand for used aircraft and spare parts. Our aircraft are often of older vintage and contain configurations of engines, avionics, fuel tanks and other components that may not be as high in demand as other available aircraft in that class. Future demand for those aircraft may decrease as newer or more desirable aircraft and components become available. High fuel prices may adversely affect the demand for less fuel-efficient aircraft, including many of those in our portfolio.
We rely on information from third parties, which may not be accurate. Third party information is supplied by our borrowers or prepared by appraisers. Inaccuracies in that information could lead to inaccuracies in our estimates, including asset valuations and cash flow projections.
We are increasingly subject to concentrations of credit risk. As our portfolio declines, increasing concentrations of financial assets in certain industries such as aviation could make our overall portfolio more sensitive to changes in performance in that industry. Additionally, we previously completed multiple financial transactions with individual borrowers and their affiliates. As a result, we are subject to greater total exposure to those borrowers beyond the typical transaction size and increased concentration risk to economic events affecting the industries (including aviation) of such borrowers and their affiliates.
Current and future legal and administrative claims and proceedings against us may result in increased costs and diversion of management’s attention. We are party either as plaintiff or defendant to various actions, proceedings and pending claims, including legal actions, some of which involve claims for compensatory, punitive or other damages in significant amounts. Litigation often results from our attempts to enforce our lending agreements against borrowers and other parties to those transactions. Litigation is subject to many uncertainties. It is possible that some of the legal actions, proceedings or claims could be decided against us. Legal matters decided against us could have a material adverse impact on our net assets in liquidation or cash flows. See Item 3. “Legal Proceedings,” for a discussion of specific claims outstanding against us.
We have current and future obligations to creditors. Claims, liabilities and expenses from operations (such as operating costs, salaries, bonuses, management fees, directors’ and officers’ insurance, payroll and local taxes, legal professional services, accounting and consulting fees and miscellaneous office expenses) will continue to be incurred through the liquidation process. As part of this process, we will attempt to satisfy any obligations with creditors remaining after the sale of our assets. These expenses will reduce the amount of assets available for ultimate distribution to Senior Note holders. To the extent our liabilities exceed the estimates that we have made, the amount of liquidating distributions to Senior Note holders will be reduced.
Cash reserve estimations are subject to known and unknown risks, uncertainties, and other factors that could materially impact our ability to meet obligations as they come due. The terms of the Indenture governing the Senior Notes prohibit us from using available funds (after certain permitted uses) for any purpose other than to satisfy our obligations to creditors and to make limited payments to stockholders in certain circumstances. Under the terms of the Indenture, we are permitted to establish a cash reserve in an amount not to exceed certain defined criteria. Due to our limited sources of liquidity, the estimation of cash reserves is critical to our overall liquidity. Failure to adequately estimate a cash reserve in one period could result in insufficient liquidity to meet obligations in that period, or in a subsequent period, if actual cash requirements exceed the cash reserve estimates. Historically, cash reserves typically equaled anticipated cash flows to cover operating costs, tax payments, fundings under existing customer commitments, interest payments and any other necessary cash flows expected to occur during the next six month period. We have the discretion to and have from time to time adjusted our cash reserve methodology. As we continue to liquidate assets, our incoming cash flows will diminish and the estimation of cash reserves will become increasingly more critical to ensure we retain sufficient funds to meet obligations (including, but not limited to, interest payments on the Senior Notes, settlement of known and unknown claims and normal operating expenses) as they become due throughout the liquidation process.
Cash investments are subject to credit exposure and interest rate fluctuations, which could result in the increase or decrease in the value of the investments. A substantial portion of our cash reserves are invested in short-term instruments, including money markets, federal agencies, government sponsored enterprises, commercial paper and other investments. Although our investment policy is designed to provide for short-term liquidity and low levels of risk, such investments are subject to credit exposure and interest rate fluctuations. Consequently, the value of investments could increase or decrease accordingly. Any decrease would reduce the amount available for distribution to Senior Note holders.
Risks related to our Organization and Structure
We may not be able to retain key employees. We must retain a sufficient number of employees with relevant knowledge and skills to continue to monitor, collect and sell our portfolio. Additionally, we must retain key employees that are experienced with our internal systems and have the skills to research information that is vital in our ability to refute known and unknown claims that may surface as we complete the liquidation and dissolution process. Our failure to do so could result in additional losses or more cash being directed towards the settlement of claims. Retention incentives intended to retain those key employees may not be successful in the future. In addition, as staff is reduced, internal controls and procedures must be readjusted to help assure proper handling and reporting of financial and other matters. Doing so becomes more difficult as our staff is reduced, and the loss of key personnel could have a significant impact on our ability to maximize value from our portfolio and minimize the settlement of claims.
It is unlikely we will be able to utilize our tax attributes. We have not recorded a benefit in our financial statements for existing tax attributes and estimated future tax deductions since we do not expect to generate the future taxable income needed to use those tax benefits. We do not anticipate being able to use those tax attributes, including most of our net operating loss carryforwards.
We intend to continue to conduct our operations in a manner that will exempt us from the registration requirements of the Investment Company Act of 1940 (the “1940 Act”). We believe that we are not within or will not be within the definition of “investment company” as that term is defined under the 1940 Act, or alternatively, we may rely on one or more of the 1940 Act’s exemptions. If we were deemed to be an investment company because of our investment securities holdings, we must register as an investment company under the 1940 Act. The 1940 Act places significant restrictions on the capital structure and corporate governance of a registered investment company. Compliance with the 1940 Act could also increase our operating costs. Such changes could have a material adverse effect on our business and the timing and amount of liquidating distributions to Senior Note holders.
Item 1B.
Item 1B. Unresolved Staff Comments.
Not applicable.
Item 2.
Item 2. Properties.
Our principal executive offices have recently moved to 8320 North Hayden Road, Suite C112, Scottsdale, Arizona 85258, telephone (480) 624-4988.
As a result of the continued liquidation and sale of assets, we have consolidated operations and reduced staff, resulting in the need for less office space. By early 2007, we have closed all corporate offices and moved the remaining residual staff to the new location, noted above. This new executive office is on a short-term lease and has no termination costs associated with our ultimate departure. The office closures were completed in conjunction with the expiration of their lease terms and as a result, we incurred no termination costs. We continue to maintain a liability for lease termination damages associated with two UK offices that were previously abandoned. Settlement negotiations with these landlords are on going and expected to be resolved during early 2007. See Annex A, Notes to Consolidated Financial Statements, Note L. “Operating Leases” for more information about the termination costs.
Item 3.
Item 3. Legal Proceedings.
We are party either as plaintiff or defendant to various actions, proceedings and pending claims, including legal actions, some of which involve claims for compensatory, punitive or other damages in significant amounts. Litigation often results from our attempts to enforce our lending agreements against borrowers and other parties to those transactions. Litigation is subject to many uncertainties. It is possible that some of the legal actions, proceedings or claims could be decided against us. Other than the matters described below, we believe that any resulting liability from our legal proceedings should not materially affect our net assets in liquidation or cash flows. The following matters could have a material adverse impact on our net assets in liquidation or cash flows.
It is our policy to accrue for loss contingencies, including litigation, only when the losses are probable and estimable. The determination of when losses become probable and estimable is inherently subjective and requires significant judgment, which may change, including in response to factors outside our control.
If any legal proceedings result in a significant adverse judgment against us, it is unlikely that we would be able to satisfy that liability due to our financial condition. As previously noted, due to our financial condition, we do not expect that we can satisfy all of our secured debt obligations at maturity. Attempts to collect on those judgments could lead to future reorganization proceedings of either a voluntary or involuntary nature.
Litigation Related to Loans to The Thaxton Group Inc. and Related Companies
Our prior periodic filings with the Securities and Exchange Commission have disclosed ongoing litigation against FINOVA Capital with respect to The Thaxton Group Inc. (“TGI”) and several related entities (collectively, the “Thaxton Entities”).
Pursuant to an order of the Thaxton Entities bankruptcy court dated September 11, 2006, we transferred all of the cash received from the Thaxton Entities since commencement of the Thaxton Entities chapter 11 proceedings in October 2003, together with interest earned thereon (an aggregate of approximately $97.2 million), to a trust account to be held by Thaxton under order of the bankruptcy court. No funds in this account will be disbursed other than in accordance with the terms of an order of the bankruptcy court.
On September 12, 2006, we reached a preliminary settlement (the “Settlement”) to resolve all outstanding claims in the ongoing litigation between us, the Thaxton Entities, the holders of subordinated notes issued by the Thaxton Entities (the “Noteholders”), and the Official Committee of Unsecured Creditors of the Thaxton Entities. This Settlement will settle all of the actions involving us and the Thaxton Entities, in particular the actions pending in the United States District Court for the District of South Carolina, Anderson Division (the “District Court”), including the previously described new Thaxton action commenced in the District Court in June 2006, as well as claims in the Thaxton Entities chapter 11 proceedings (collectively, the “Thaxton Litigation”).
Under the principal terms of the Settlement, which was approved by our Board of Directors on September 11, 2006 and the bankruptcy court for the FINOVA Capital and Thaxton Entities bankruptcies in December 2006, on the effective date of the Thaxton Entities plan of reorganization, we will receive all amounts we transferred into the trust on September 11, 2006 - i.e. all amounts paid by the Thaxton Entities to us since commencement of the Thaxton Entities chapter 11 proceedings in October 2003 (together with interest earned thereon), minus $16 million, plus interest actually earned thereon from August 16, 2006, which will be retained by the Thaxton Entities. In addition, we will receive complete releases from all Thaxton parties for all matters related to the Thaxton Entities. The Settlement also required that the summary judgment order of the District Court be vacated, which occurred on February 15, 2007. Consummation of the Settlement remains subject to approval of a Plan of Reorganization by the Thaxton Entities bankruptcy court. We anticipate that consummation of the Settlement will be implemented in the second quarter of 2007.
Thaxton Life Partners Litigation
On February 14, 2007, a group of noteholders of Thaxton Life Partners, Inc. (“TLP”) filed suit against the Company and FINOVA Capital, unrelated to the Thaxton Entities noted above. The suit (the “TLP Action”) purports to be a class action filed on behalf of approximately 150 TLP noteholders with claims related to approximately $20 million in TLP notes. The TLP Action alleges that, in connection with TLP’s sale of its notes, the Company, FINOVA Capital, and several other defendants participated in a civil conspiracy, violated the South Carolina Unfair Trade Practices Act, violated the civil RICO statute, and were unjustly enriched. In its various counts, the TLP Action seeks actual, treble, and/or punitive damages.
The TLP Action is currently pending in the United States District Court for the District of South Carolina (the “South Carolina District Court”). We believe that, under the terms of the TLP notes, the TLP Action must move forward in arbitration. The Company and FINOVA Capital have filed a motion with the South Carolina District Court seeking an order compelling such arbitration. No hearing has yet been scheduled on that motion.
We also believe that all claims against both us and FINOVA Capital are without merit. The Company and FINOVA Capital intend to vigorously defend against the TLP noteholders’ claims asserted against them. If, however, the TLP Action results in a significant adverse final determination against us or FINOVA Capital, which is not anticipated, it is unlikely that the Company or FINOVA Capital would be able to satisfy that liability due to our financial condition. As previously disclosed, due to our financial condition, we do not expect that we can satisfy all of our secured debt obligations at maturity. Attempts to collect on any such judgment could lead to future reorganization proceedings of either a voluntary or involuntary nature.
Motion Regarding Distributions to Stockholders
As discussed more fully in the Notes to the Consolidated Financial Statements, Note G. “Debt”, the Indenture contemplates that as principal payments are made on the Senior Notes, our stockholders would receive a distribution equal to 5.263% of each principal prepayment. However, the Indenture prohibits distribution of those amounts due to our financial condition. Those amounts are held in a restricted account, and totaled $78.1 million as of December 31, 2006. Because we will not be able to repay the Senior Notes in full, on April 1, 2005, we filed a motion in the United States Bankruptcy Court for the District of Delaware seeking an order (1) to
cease directing funds into the restricted account and (2) to allow us to use the funds in the restricted account to satisfy our obligations to creditors.
On February 1, 2006, the Bankruptcy Court issued its order approving our April 1, 2005 motion to the extent that we will be forever insolvent. The Bankruptcy Court did not find that we are presently or will be forever insolvent. As a result, we will continue to direct funds into a restricted account until such time that we are deemed to be forever insolvent and the funds will then be distributed to our creditors.
On December 22, 2006, the reconstituted equity committee filed a motion with the Bankruptcy Court seeking among other things, appointment of a financial expert to review the issue of our solvency, and up to $100,000 to accomplish this task. Over our objection, the Bankruptcy Court granted the equity committee’s motion, ordering that the evaluation be completed within sixty (60) days of an order being entered approving the motion.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.
Our common stock trades over-the-counter (“OTC”) under the symbol “FNVG.” At December 31, 2006 and 2005, we had approximately 122,041,000 shares of common stock outstanding, 50% of which are held by an affiliate of Berkadia. The following table summarizes the high and low bid prices as reported on the OTC by Commodity Systems Inc. The OTC market quotations reflect inter-dealer prices, without retail markup, markdown or commission, and may not represent actual transactions.
We did not pay or declare any dividends during 2005 and 2006. Stockholders should not expect any payments or distributions. Refer to Item 3. “Legal Proceedings” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a further discussion of stockholder payments and our motion regarding distributions to stockholders.
We have not included a performance graph, which would compare our cumulative stockholder return to that of our peer group. We believe our peer group, which would include other liquidating entities, would have similar results and a graph would not provide a meaningful comparison.
Our Certificate of Incorporation prohibits persons (except Berkadia and its affiliates) from acquiring 5% or more of Corporation Securities (as defined) unless the purchase is approved by our Board of Directors. Those restrictions did not apply to the acquisition of shares in connection with the reorganization proceedings. The restrictions will remain in effect until the earlier of (a) the repeal of Section 382 of the Internal Revenue Code (or any comparable successor provision) or (b) the beginning of the taxable year to which certain tax benefits may no longer be carried forward.
As of March 19, 2007, there were approximately 14,208 holders of record of The FINOVA Group Inc.’s common stock. The closing price of the common stock on that date was $0.08.
Item 6.
Item 6. Selected Financial Data.
The following table summarizes selected financial data obtained or derived from our audited consolidated financial statements. The information set forth below should be read in conjunction with Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read in conjunction with Item 1. “Business,” Item 6. “Selected Financial Data,” Item 8. “Financial Statements and Supplemental Data” and the Special Note Regarding Forward-Looking Statements included herein. The discussion relates to The FINOVA Group Inc. and its subsidiaries (collectively “FINOVA” or the “Company”), including FINOVA Capital Corporation and its subsidiaries (“FINOVA Capital”).
OVERVIEW
During 2006, we have continued to make significant progress in the orderly collection and liquidation of our assets. We have successfully liquidated over 97% of our portfolio, which was approximately $7.6 billion when we emerged from bankruptcy in August 2001. At December 31, 2006, the portfolio had declined to $185.5 million on a liquidation basis, which represents a 48% decline since year-end 2005. It is becoming increasingly more difficult for us to offset the incremental costs of collecting those assets in an orderly fashion. As a result, to maximize the value of the remaining assets, we initiated efforts to accelerate the liquidation process.
Plan of Liquidation. On November 1, 2006, our Board of Directors (the “Board”) approved the Plan of Complete Liquidation and Dissolution (the “Plan of Liquidation”) and the filing of a motion (the “Motion”) in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”). On December 4, 2006, the Bankruptcy Court granted our Motion and approved (i) the previously announced settlement of various litigations associated with The Thaxton Group, Inc. (the “Thaxton Settlement”), (ii) the ongoing sale of our remaining assets, the orderly windup of our operations and our future dissolution, (iii) our sale of all or substantially all of our assets without stockholder approval and our future dissolution without stockholder approval at such time as our Board deems to be appropriate and (iv) channeling to the Bankruptcy Court any claims against us that the holders of our Senior Notes or the indenture trustee for the Senior Notes may have arising from or in any way related to our joint chapter 11 plan, the ongoing liquidation of FINOVA, the senior secured notes, or the windup of our operations.
As a result of the aforementioned approvals, we have taken steps to initiate our complete liquidation and as such, the information provided in this Annual Report on Form 10-K reflects our adoption of the liquidation basis of accounting effective the close of business on December 4, 2006 in accordance with accounting principles generally accepted in the United States. Historical information for periods prior to December 5, 2006 is presented on a going concern basis of accounting. Under the liquidation basis of accounting, we are required to value all assets at their estimated net realizable value, while liabilities are reported at their estimated net settlement amount. In connection with adopting the liquidation basis of accounting, assets were marked up a net $60.0 million to reflect their estimated net realizable value or approximately 43% more than their historical going concern carrying values. Additionally, under the liquidation basis of accounting, we are required to establish a reserve for all future estimated general and administrative expenses and other operating costs expected to be incurred during the liquidation (exclusive of interest expense). The reserve for future expenses was estimated to be $26.3 million. There can be no assurance that these estimated values will be realized. Such amounts should not be taken as an indication of the timing or amount of future distributions or our actual dissolution.
The timing and amount of distributions to Senior Note holders will depend on the timing and amount of proceeds we receive upon the sale of the remaining assets, the resolution of claims and other litigation matters, the extent to which reserves for current or future liabilities are required and the length of time required to settle all our matters. Our goal is to wind-up the affairs of the Company during 2007; however, we cannot control the exact timing of resolving legal matters and claims. Accordingly, the liquidation period may extend beyond 2007 and conservative estimates are up to 24 months or the end of 2008.
We will continue to retain sufficient cash reserves to fund our expenses, including the costs associated with the wind-up of our affairs, resolution of outstanding bankruptcy claims and matters related to Thaxton. As a result, we anticipate maintaining a higher cash reserve to cover these potential and uncertain expenditures and claims, which could limit our ability to make and the timing of future voluntary principal prepayments.
Anticipated Shortfall. During 2006 and 2005, we made $207.8 million and $474.9 million, respectively, of partial principal prepayments on the Senior Notes, which reduced the outstanding principal to $1.5 billion as of December 31, 2006. Cumulative prepayments as of December 31, 2006 totaled $1.5 billion or 50% of the face amount ($2.97 billion) of the Senior Notes. Based on the revaluation of our assets at their estimated net realizable value and liabilities at estimated net settlement amount, we currently project the Senior Note holders will receive additional liquidation distributions (principal and interest) of approximately $404.8 million, which is considerably less than the outstanding principal of $1.5 billion, without giving consideration to interest accruals. We clearly
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do not have sufficient assets to fully repay the Senior Note obligation. In order to eliminate the shortfall, the remaining assets (excluding cash and cash equivalents), which have already been marked up approximately 43% over their historical going concern basis, would have to increase in value by almost six times their already marked up value. We do not believe there is any chance of this occurring.
No Stockholder Payments Anticipated. While the Indenture contemplated we would make payments to our stockholders as the Senior Notes were repaid, we have not made those payments. Distributions to stockholders are prohibited due to our financial condition. Based on our liquidation basis financial statements, we will not be able to repay slightly less than $1.1 billion of the Senior Notes. As a result, stockholders should not expect any payments or return on their common stock. Funds related to the restricted distributions are currently being held in a segregated account, pending their final disposition. We anticipate that those funds will eventually be paid to our creditors, not to our stockholders. If the funds were to be paid to our stockholders, affiliates of Berkadia (which are owned by Berkshire Hathaway and Leucadia), as owner of 50% of our stock, would receive half of those payments.
As discussed in Item 3. “Legal Proceedings,” we filed a motion in the United States Bankruptcy Court for the District of Delaware, seeking an order that (1) we no longer need to direct funds into a restricted account, and (2) we may use the funds in the restricted account to satisfy our obligations to creditors. The Bankruptcy Court subsequently issued an order approving our motion to the extent that we will be forever insolvent, which is clearly the case. The Bankruptcy Court did not find that we are presently or will be forever insolvent. As a result, we will continue to direct funds into a restricted account until such time that we are deemed to be forever insolvent.
No Restructuring Plan Contemplated. On numerous occasions, we have been asked whether there is some plan to save the Company and our net operating loss carryforwards (“NOL”). As we have noted for some time, the Board remains willing to consider legitimate proposals presented by note holders or others, but we are not formulating a restructuring plan intended to enable us to emerge as a healthy company.
Many obstacles exist to creation of a viable restructuring plan. A restructuring presumes a sensible business plan emerging from that process. In light of our dwindling asset base, the composition of our remaining assets and the competitive environment, we believe it would be difficult, if not futile, in these circumstances to develop a business model that can produce returns to the creditors and/or new investors greater than that expected from the present course. Absent that, or a substantial new investment in FINOVA, we believe it would be difficult to obtain the requisite approval to restructure the present debt obligations. The task becomes more difficult as the portfolio continues to shrink. We caution investors to carefully evaluate applicable tax regulations, which restrict the ability to transfer or use NOLs in a variety of circumstances. Our financial statements do not anticipate using the NOLs for those and other reasons.
HIGH INVESTMENT RISK OF SECURITIES. As previously stated, we will not be able to fully repay the Senior Notes or make any distributions to our stockholders, absent a court order in connection with the motion referred to above. Consequently, investing in the Senior Notes and common stock involves a high level of risk.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies have changed from those reported in prior SEC filings due to the adoption of the liquidation basis of accounting in December 2006. Our consolidated financial statements continue to be prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to use estimates and assumptions that affect reported amounts of assets and liabilities. These estimates are subject to known and unknown risks, uncertainties and other factors that could materially impact the amounts reported and disclosed in the financial statements. See Item 1A. “Risk Factors” and “Special Note Regarding Forward-Looking Statements” for more information on these risks and uncertainties. We believe the following to be among the most critical judgment areas in the application of our accounting policies.
Liquidation Basis of Accounting
With the approval of our Plan of Liquidation by the Bankruptcy Court, our complete liquidation is considered to be imminent and as such, we adopted the liquidation basis of accounting effective the close of business on December 4, 2006 in accordance with accounting principles generally accepted in the United States. A Statement of Net Assets in Liquidation and a Statement of Changes in Net Assets in Liquidation are the principal financial statements presented under the liquidation basis of accounting. Under the liquidation basis of accounting, assets are stated at their estimated net realizable value, which is the non-discounted amount of cash, or its equivalent, into which an asset is expected to be converted in the due course of business less direct costs,
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while liabilities are reported at their estimated net settlement amount, which is the non-discounted amounts of cash, or its equivalent, expected to be paid to liquidate an obligation in the due course of business, including direct costs. These estimates will be periodically reviewed and adjusted as appropriate. The valuation of assets at their net realizable value and liabilities at their anticipated net settlement amount represent estimates, based on present facts and circumstances, of the net realizable value of the assets and the costs associated with carrying out the Plan of Liquidation based on the assumptions set forth below. The actual values and costs associated with carrying out the Plan of Liquidation are expected to differ from amounts reflected in the accompanying financial statements because of the plan’s inherent uncertainty. These differences may be material. In particular, the estimates of our costs will vary with the length of time necessary to complete the Plan of Liquidation. Accordingly, it is not possible to predict with certainty the timing or aggregate amount which will ultimately be distributed to note holders and no assurance can be given that the distributions will equal or exceed the estimate presented in the accompanying Statement of Net Assets in Liquidation or the price at which our Senior Notes have traded or are expected to trade in the future.
Additionally, under the liquidation basis of accounting, we are required to establish a reserve for all future estimated general and administrative expenses and other costs expected to be incurred during the liquidation (exclusive of interest expense). These estimates will be periodically reviewed and adjusted as appropriate. There can be no assurance that these estimated values will be realized. Such amounts should not be taken as an indication of the timing or amount of future distributions to be made by the Company.
The following are the significant assumptions utilized by management in assessing the value of our liquidating portfolio and the expected net settlement amount of liabilities included in the Statement of Net Assets in Liquidation at December 31, 2006.
Net Realizable Value Supported by Underlying Loan or Direct Financing Agreements. All loans and direct financing leases were adjusted to their estimated net realizable values, which represent all future undiscounted cash flows expected to be collected from each of these transactions including sales and settlement proceeds, principal collections, scheduled rental payments and interest. Anticipated cash collections were partially offset by any known direct costs and liabilities assumed by buyers including aircraft maintenance reserves and security deposits that were previously collected. The estimated net realizable values were determined primarily based on signed contracts, settlement agreements or letters of intent to sell. More than 98% of the net realizable value for loans and direct financing leases at December 31, 2006 was readily determinable based on signed contracts, settlement agreements and letters of intent. The net realizable values for the remainder of the loans and direct financing leases were based upon estimated cash flows on a transaction-by-transaction basis. Cash flow estimates are based on current information and numerous assumptions concerning future general economic conditions, specific market segments, the financial condition of our customers and collateral. Changes in facts and assumptions have resulted in, and may in the future result in, significant positive or negative changes to estimated cash flows and therefore, net realizable values. Additionally, effective December 4, 2006, the balance of the reserve for credit losses was reallocated to individual loans and direct financing leases in conjunction with their valuation at net realizable values.
Net Realizable Value Supported by Underlying Operating Leases and Other Owned Assets. All owned assets (operating leases and off-lease assets) were adjusted to their estimated net realizable values, which represent all future undiscounted cash flows expected to be collected from each of these transactions including sales proceeds and scheduled rental payments. Anticipated cash collections were partially offset by any known direct costs such as maintenance and make ready costs for certain aircraft and liabilities assumed by buyers including aircraft maintenance reserves and security deposits that were previously collected. The estimated net realizable values were determined primarily based on signed contracts or letters of intent to sell. More than 98% of the net realizable value for owned assets at December 31, 2006 was readily determinable based on signed contracts and letters of intent. The net realizable values for the remainder of the owned assets were based upon estimated cash flows on a transaction-by-transaction basis. Cash flow estimates are based on current information and numerous assumptions concerning future general economic conditions, specific market segments, lessee performance and residual value assumptions for leases. Changes in facts and assumptions have resulted in, and may in the future result in, significant positive or negative changes to estimated cash flows and therefore, net realizable values.
Investments. All investments are reported at either their fair value or estimated net realizable values, based on published information, quotes by registered securities brokers or signed contracts. Investments for which market information is not readily available were valued based on estimated future cash flows that may be realized from the investment, if any.
Reserve for Estimated Costs During the Liquidation Period. Under the liquidation basis of accounting, we are required to estimate and accrue for costs associated with implementing and completing the Plan of Liquidation. The reserve for estimated costs includes four primary areas of accruals including people costs (payroll, benefits and severance), Leucadia management fees, professional services and litigation costs and corporate expenses (insurance, directors’ fees and entity related expenses). These amounts can vary significantly due to, among other things, the timing of assets sales, the timing and amounts associated with discharging known and contingent
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liabilities and claims, the costs associated with cessation of our operations including an estimate of costs subsequent to that date (which would include reserve contingencies for the appropriate statutory periods) and the costs of retaining knowledgeable personnel and others to oversee the liquidation. As a result, we have accrued the projected costs including corporate overhead and specific liquidation costs of severance and performance bonuses, professional fees and various other wind-up costs expected to be incurred during the projected period to complete the liquidation and dissolution. These expense accruals will be periodically reviewed for adequacy and adjusted from time to time as projections and assumptions change. Changes to the accruals will be recorded as adjustments to net assets in liquidation in future periods.
Going Concern Basis of Accounting
Our financial statements are presented on a going concern basis of accounting for all periods preceding December 5, 2006. These financial statements reflect the historical basis of assets and liabilities as of December 31, 2005 and the historical results of operations for the period January 1, 2006 to December 4, 2006 and the years ended December 31, 2005 and 2004.
Several of our accounting policies on a going concern basis of accounting pertained to the ongoing determination of impairment reserves on financing assets and the carrying amount valuation of other financial assets. Determination of impairment reserves and carrying amounts relied, to a great extent, on the estimation and timing of future cash flows. Our cash flow estimates assumed that our assets were collected in an orderly fashion over time.
Impairment of financing assets (subsequent to implementation of fresh-start reporting) was recorded through the reserve for credit losses, and accounting rules permitted the reserve for credit losses to be increased or decreased as facts and assumptions changed. However, certain financing assets were previously marked down for impairments that existed at the time fresh-start reporting was implemented. Those marked down values became our cost basis in those assets, and accounting rules did not permit the carrying value of those assets to be increased above that fresh-start cost basis if subsequent facts and assumptions resulted in a projected increase in value. Recoveries of amounts in excess of the fresh-start cost basis were recorded through operations when collected.
Impairment of other financial assets was marked down directly against the asset’s carrying amount. Accounting rules permitted further markdown if changes in facts and assumptions resulted in additional impairment; however, most of those assets (except certain investments and assets held for sale, which could be marked up for subsequent events) could not be marked up even if subsequent facts and assumptions resulted in a projected increase in value. Recoveries of previous markdowns were recorded through operations when collected.
Because of these accounting restrictions under the going concern basis of accounting, we were not permitted to fully reflect some anticipated improvements in the portfolio until they were actually realized. With the adoption of the liquidation basis of accounting, all anticipated improvements or deterioration in the portfolio will be fully reflected in our financial statements as facts and assumptions change.
Refer to prior SEC filings for a more comprehensive listing of the critical accounting policies for historical financial statements prepared under the going concern basis of accounting.
New Accounting Standards. There were no new accounting standards issued during 2006 that impacted FINOVA.
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EFFECTS OF ADOPTING THE LIQUIDATION BASIS OF ACCOUNTING AND CHANGES IN NET ASSETS
The following table summarizes the effects of adopting the liquidation basis of accounting and changes in net assets in liquidation from December 5, 2006 to December 31, 2006 (dollars in thousands):
Effects of Adopting the Liquidation Basis of Accounting
In connection with the adoption of the liquidation basis of accounting, certain assets were written up a net $60.0 million to reflect their estimated net realizable value. We were previously precluded from increasing the recorded carrying values of assets under the going concern basis of accounting. The $60.0 million markup was primarily comprised of a $14.1 million increase to assets supported by underlying loan and direct financing agreements, a $42.7 million increase to owned assets (operating and off-lease assets) and a $4.8 million increase to investments, partially offset by a net $1.6 million mark down to various other assets including the elimination of certain prepaid assets. The majority of the estimated net realizable value of assets was determined based upon actual completed sales proceeds, signed definitive agreements, letters of intent to sell or settlement agreements, while the remainder of the value was supported by estimated cash flows on a transaction by transaction basis.
Under the liquidation basis of accounting, we were required to establish a reserve for all future estimated general and administrative expenses and other costs expected to be incurred during the liquidation (exclusive of interest expense). Our estimate for liquidation costs as of December 4, 2006 was comprised of compensation and benefits (including severance) for the remaining employees ($4.7 million), Leucadia management fees ($8.0 million), professional services and litigation costs ($11.8 million) and general corporate expenses (insurance, directors’ fees and entity related expenses) of $1.8 million. These expense accruals will be periodically reviewed for adequacy and adjusted from time to time as projections and assumptions change. We expect changes will be made to our estimated costs of liquidation and such changes to the accruals will be recorded as adjustments to net assets in liquidation in future periods. These estimates assume that the final liquidation and dissolution of FINOVA will be accomplished by the end of 2007. If there are delays or an acceleration of these matters, actual costs incurred during the liquidation could increase or decrease as a result of a need for additional or fewer internal and external resources. Any corresponding fluctuation will directly impact the ultimate settlement amount of the Senior Notes.
Due to the fact that we do not have sufficient assets to fully satisfy all obligations to our creditors, the principal amount due on the Senior Notes ($1.5 billion) was adjusted down to its estimated settlement amount of $396.6 million at December 4, 2006, while taking into consideration the remaining fresh-start discount ($509.7 million), which has been eliminated.
Changes in Net Assets in Liquidations from December 5, 2006 to December 31,
During the period from December 5, 2006 through December 31, 2006, the estimated net realizable value of our liquidating portfolio and other assets increased an additional $2.1 million primarily as a result of a net $0.9 million increase in offers to purchase certain owned aviation assets, a $0.4 million increase in the estimated value of loans and investments and receiving notification of an unanticipated $0.8 million recovery (recorded in other assets) on certain Senior Notes that reverted back to the Company.
During the period from December 5, 2006 through December 31, 2006, we had an operating loss of $8.2 million, which primarily represents additional interest accruing on the Senior Notes, partially offset by interest income earned on cash investments and other
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operating activity. As of result of the adoption of the liquidation basis of accounting and valuation of our liquidating portfolio at its estimated net realizable value, income is no longer being recognized on the portfolio. All cash received on the portfolio is applied against its estimated net realizable value, which took into consideration all expected interest and rental payments. Additionally, as previously discussed, we established a reserve for estimated costs during the liquidation period and all future expenditures for operating expenses will be charged directly against the reserve. For the period from December 5, 2006 through December 31, 2006, this reserve was reduced for the payment of expenses incurred of $2.1 million.
Due to the fact that we do not have sufficient assets to fully satisfy all obligations to our creditors, changes to the estimated net realizable value of our assets and liabilities results in a corresponding adjustment to the estimated settlement amount of the Senior Notes ($6.0 million reduction from December 5, 2006 to December 31, 2006).
RESULTS OF OPERATIONS (Under Going Concern Basis)
For the Period January 1, 2006 to December 4, 2006 Compared to the Year Ended December 31,
In general, the increase in net income was primarily attributable to the period January 1, 2006 to December 4, 2006 containing a higher level of asset realization in excess of recorded carrying amounts on a going concern basis, a lower level of operating expenses and the prior year including a one-time loss on the settlement of our pension plan. Under the going concern basis, asset realization in excess of recorded carrying amounts was primarily reflected in the financial statements as reversals of excess reserve for credit losses, net gains from sales of financial assets and the recognition of suspended income upon the payoff of assets.
During 2006, the aircraft-financing market continued to display a high level of activity and in certain instances improved aircraft values. As a result, our transportation portfolio continued to generate cash in excess of recorded carrying amounts and surpassed the results for 2005. Additionally, results for 2006 were enhanced by the sale of substantially all of our non-aviation assets (other than The Thaxton Group loan) for proceeds of approximately $20 million in excess of their December 31, 2005 carrying values.
Interest Margin. We continued to post a negative interest margin, which was significantly impacted by a lower level of earning assets during 2006 and 2005 than the principal amount of outstanding debt and a high aggregate cost of funds. Partially offsetting the negative interest margin was the recognition of previously suspended and deferred income ($2.1 million and $15.4 million for the period January 1, 2006 to December 4, 2006 and full year 2005, respectively), which was generated from payoffs of certain assets in excess of their carrying amounts and the return to earning status of certain assets following demonstration of sustained performance.
Reversal of Provision for Credit Losses. We recorded reversals of provision for credit losses to reduce our overall reserve for credit losses. The reserve reductions were primarily due to recoveries ($5.3 million and $11.1 million for the period January 1, 2006 to December 4, 2006 and full year 2005, respectively) of amounts previously written off, proceeds received from prepayments and asset sales exceeding recorded carrying amounts (net of reserves), improved collection experience and our detailed assessment of estimated inherent losses in the portfolio. Additionally, we recorded a $14.7 million reversal of provision for credit losses in 2006 to reduce reserves due to the sale of our non-aviation assets for proceeds in excess of their carrying amount (net of reserves), which was partially offset by the recording of an $8.7 million specific reserve related to the Thaxton loan during the third quarter of 2006. The specific reserve was necessary to adjust the net book value of the Thaxton loan to its estimated settlement of approximately $81.2 million before interest. Refer to Note N. “Litigation and Claims” for a further discussion of the Thaxton settlement.
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The measurement of credit impairment and asset valuation was dependent upon the significant use of estimates and management discretion when expected cash flows were predicted. These estimates were subject to known and unknown risks, uncertainties and other factors that could have materially impacted the amounts reported and disclosed herein.
Net Gain on Financial Assets. Gains are sporadic in nature and not necessarily comparable from one period to the next; however, the increase over the prior year was primarily attributable to an increase in the overall realization during 2006 from our transportation portfolio.
The net gain during 2006 was primarily attributable to sales of owned assets and financing contracts in excess of carrying amounts on a going concern basis, the most significant of which included $93.6 million of net gains realized from sales of aircraft, engines, aircraft related notes and claims, and the forfeiture by aircraft operators of security deposits and maintenance reserves, $4.5 million of net gains realized from the previously announced sale of our non-aviation assets (in addition to the reversal of reserves noted above) $9.9 million of net gains realized from the sale and valuation of private and public investments and a $3.6 million gain from the sale of two Boeing 757 leveraged leases with Northwest Airlines.
The net gain during 2005 was primarily attributable to $45.7 million of net gains realized from sales of aircraft and parts, and the forfeiture by aircraft operators of security deposits and maintenance reserves, $4.5 million of net gains realized from the sale and valuation of private and public investments and $5.3 million of net gains from the valuation and sale of our last two real estate leveraged leases. Partially offsetting the gain activity in 2005 were $19.1 million of net valuation markdowns to leveraged leases in the transportation portfolio.
We have entered into a number of transactions to sell assets over the last couple of years and expect asset sales to continue. As of the date of this report, we had 32 aircraft with a total carrying value on a liquidation basis of approximately $85.1 million that had either been liquidated subsequent to December 31, 2006, are under individual letters of intent to sell or are subject to a definitive agreement to sell. Due to the fact these aircraft are operating throughout the world, additional time will be necessary to close the sales. It is to our advantage to close these transactions when the aircraft are in tax friendly jurisdictions to minimize transfer taxes. Since we adopted the liquidation basis of accounting, the full value expected to be realized from these sales has been reflected in our financial statements as of December 31, 2006. No assurance can be given that all of these commitments will result in actual sales or the timing of such sales, but all of the aircraft are targeted to close by the end of the first quarter of 2007. There is a possibility for a small number of aircraft sales to slide into the second quarter of 2007.
Portfolio Expenses. Portfolio expenses included all costs relating to the maintenance and collection of both performing and non-performing financial transactions. In addition, within the transportation portfolio, portfolio costs included storage, maintenance and costs for potential return to service of aircraft.
The transportation portfolio continued to incur a significant portion of our portfolio costs ($5.1 million and $14.8 million during 2006 and 2005, respectively). Portfolio costs within the transportation portfolio fluctuated with the timing and number of maintenance reinvestment projects. Additionally, during 2006 and 2005, we incurred $5.6 million and $4.8 million, respectively, of legal costs associated with matters related to Thaxton, experienced increased costs associated with the liquidation of a repossessed property and had a higher level of costs associated with the final liquidation and sale of certain assets.
In connection with the adoption of liquidation accounting, we established a reserve for all future costs expected to be incurred, while certain direct costs such as aircraft maintenance were netted against cash flows expected to be collected from the liquidating portfolio.
General and Administrative Expenses. The decrease in general and administrative expenses was primarily due to $10.4 million of cost savings resulting from staffing and office occupancy reductions (37 employees at December 4, 2006 compared to 60 employees at December 31, 2005) and lower severance accruals ($3.6 million). All future general and administrative costs will be charged against the reserve for estimated costs during the liquidation period.
Loss from Settlement of Pension Plan. During 2005, we finalized the termination of a trusteed, noncontributory pension plan that covered substantially all of our employees. We terminated the pension plan effective December 31, 2004 and received final regulatory approvals in late 2005. Upon final distribution of participant benefits, we recognized all remaining unrecognized net actuarial amounts under the plan, which totaled $24.7 million.
Income Tax Expense. No income tax expense or benefit was recorded during the period January 1, 2006 to December 4, 2006 and the year ended December 31, 2005. Any pre-tax book income or loss was entirely offset by a decrease or increase in valuation allowances
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against deferred tax assets, which were previously established due to concerns regarding our ability to utilize income tax benefits generated from losses in prior periods. As of December 31, 2006 and 2005, we had federal net operating loss carryforwards of $1.3 billion and $1.2 billion, respectively, none of which expire prior to 2009. For a further discussion of taxes see Note H. “Income Taxes.”
Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004
Net (Loss) Income. In general, the net loss for the year ended December 31, 2005 was primarily attributable to a lower level of asset realization in excess of recorded carrying amounts and the recognition of a loss on the final settlement of our pension plan.
Even though asset realization in 2005 was less than 2004, we still experienced substantially better than anticipated realization and performance of our asset portfolios. We had been cautioning investors that asset realization trends were not expected to continue at the same level as prior years. Many of our more desirable and marketable assets had been liquidated and the remaining portfolio was becoming more concentrated in non-performing assets and used aircraft, both of which have been more work intensive and difficult to liquidate at acceptable prices. However, during 2005, the aircraft-financing market displayed a high level of activity and in certain instances improved aircraft values. As a result, our transportation portfolio continued to generate cash in excess of recorded carrying amounts, but the total level of realization was lower than 2004.
Interest Margin. The decline in interest margin was primarily attributable to the recognition of a lower level of suspended and deferred income ($15.4 million and $82.9 million for the years ended December 31, 2005 and 2004, respectively), which was generated from payoffs of certain assets in excess of their carrying amounts and the return to earning status of certain assets following demonstration of sustained performance. Income recognition was suspended when an account was classified as a nonaccruing asset and any subsequent interest payments received were applied against our carrying amount to mitigate our exposure. In certain instances, suspended income was recognized upon payoff, if proceeds realized were in excess of their carrying amount, or if after sustained performance was demonstrated, the account was returned to accruing status.
Additionally, our interest margin was significantly impacted by a lower level of earning assets ($123.9 million and $332.8 million at December 31, 2005 and 2004, respectively) than the face amount of outstanding debt ($1.7 billion and $2.2 billion at December 31, 2005 and 2004, respectively) and our high aggregate cost of funds (aggregate effective rate of 13.5% and 11.9% for the years ended December 31, 2005 and 2004, respectively). The increase in the aggregate effective rate was primarily due to the acceleration of fresh-start discount amortization following principal prepayment of the Senior Notes earlier than originally anticipated when fresh-start guidelines were applied upon emergence.
Reversal of Provision for Credit Losses. We recorded reversals of provision for credit losses to reduce our overall reserve for credit losses. The reserve reductions were primarily due to recoveries ($11.1 million and $37.2 million for the years ended December 31, 2005 and 2004, respectively) of amounts previously written off, proceeds received from prepayments and asset sales exceeding recorded carrying amounts (net of reserves), collections and our detailed assessment of estimated inherent losses in our portfolio.
In addition, our income recognition policy for nonaccruing accounts could result in periodic reserve reductions. In accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” impairment reserves were recorded if the carrying amount of a loan exceeded the net present value of expected cash flows. For nonaccruing accounts, any cash received was applied against the carrying amount of the transaction. As a result, carrying amounts declined at a faster pace than net present value, thus reducing the impairment reserves. This policy had a greater impact on the reversal of provision for credit losses in 2004 than in 2005 due to the reinstatement of a number of accounts to accruing status in 2004.
The pace of collections and account payoffs continued to be faster than expected. Amounts collected often exceeded anticipated cash flows, resulting in a partial reversal of previously established reserves. However, as expected, asset realization trends declined from the prior year. During 2004, we experienced substantially better than anticipated realization and performance of our asset portfolios. While 2005 has shown continued accelerated collections, the volume and realization has not kept pace with 2004.
The measurement of credit impairment and asset valuation was dependent upon the significant use of estimates and management discretion when expected cash flows were predicted. These estimates were subject to known and unknown risks, uncertainties and other factors that could have materially impacted the amounts reported and disclosed herein.
Net Gain on Financial Assets. Gains are sporadic in nature and not necessarily comparable from one period to the next; however, the decrease over the prior year was primarily attributable to the prior year including a one-time gain from the sale of a substantial
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THE FINOVA GROUP INC.
portion of our timeshare portfolio, a decrease in the overall realization during 2005 from our transportation portfolio and valuation markdowns taken in 2005 on our transportation leveraged lease portfolio.
The net gain during 2005 was primarily attributable to sales of owned assets and financing contracts in excess of carrying amounts, the most significant of which were comprised of $45.7 million of net gains realized from sales of aircraft, including the forfeiture by aircraft operators of security deposits and maintenance reserves ($10.5 million), $4.5 million of net gains realized from the sale and valuation of private and public investments and $5.3 million of net gains from the valuation and sale of our last two real estate leveraged leases.
Partially offsetting the gain activity for 2005 were $19.1 million of net valuation markdowns and losses on our transportation leveraged lease portfolio. In conjunction with the Northwest Airlines’ bankruptcy filing, the airline notified us of its intent to renegotiate the terms of eight leveraged leases or possibly reject the transactions. Two Boeing 757 aircraft and six regional jets secure the Northwest leveraged leases. The outstanding senior debt on these leveraged leases was significantly in excess of the underlying aircraft values. As a result, the assets, which had a contractual balance of $86.4 million, had virtually no remaining value to us and their remaining carrying value was fully written-off. During 2005, we recognized total valuation markdowns of $14.4 million on the Northwest leveraged leases, while the remainder of the net markdowns and losses on the transportation leveraged lease portfolio were primarily associated with the American Trans Air bankruptcy and a $0.7 million loss recognized on the sale of our last transportation leveraged lease (excluding the Northwest leases).
We will continue to consider future sales of the remaining portfolio or individual assets, if buyers can be found at acceptable prices; however, there can be no assurance that we will be successful in efforts to sell additional assets or that realization will reach prior year levels. In evaluating offers, we will generally compare offers against our internal net present value of estimated future cash flows projected to be collected from those assets less the net present value of our operating costs to collect those assets.
Portfolio Expenses. Portfolio expenses include all costs relating to the maintenance and collection of both performing and non-performing financial transactions. In addition, within the transportation portfolio, portfolio costs include storage, maintenance and costs for potential return to service of aircraft. In most cases, we experienced a decline in the level of problem account and workout expenses as assets have declined.
The transportation portfolio continued to incur the majority of our portfolio costs ($14.8 million and $21.0 million for the years ended December 31, 2005 and 2004, respectively). In certain instances, we believed we could achieve better returns in the current market of improved aircraft values by investing in the maintenance of certain types of aircraft and engines. As a result, portfolio expenses within the transportation portfolio have not declined as fast as the decline in assets. Portfolio costs within the transportation portfolio fluctuate with the timing and number of maintenance reinvestment projects.
Partially offsetting the decline in transportation expenses was an increase in legal costs associated with the Thaxton litigation ($4.8 million and $0.6 million for the years ended December 31, 2005 and 2004, respectively). The increase in Thaxton related expenses was primarily due to amounts previously reimbursed from the Thaxton bankruptcy being deposited into a reserve account beginning in the third quarter of 2005.
General and Administrative Expenses. The increase in general and administrative expenses was primarily the result of the prior year including a one-time $5.8 million reversal of excess accruals related to bankruptcy claims that were settled for amounts less than what had originally been accrued, higher severance accruals ($2.6 million) related to current year and future staffing reductions and $1.8 million of accruals related to anticipated office lease termination costs, partially offset by $8.5 million of cost savings which resulted from staffing and office occupancy reductions (60 employees at December 31, 2005 compared to 101 and 213 employees at December 31, 2004 and 2003, respectively).
During 2005, we had additional and accelerated staff reductions, which were designed to more closely align our operating costs with the size of the remaining portfolio. Total staff reductions included approximately 41% of the workforce (including seven members of senior management). The cost savings from these reductions began during the second half of 2005 and their full benefit was not realized until 2006. A portion of the savings in 2005 was offset by increased severance costs.
Loss from Settlement of Pension Plan. During 2005, we finalized the termination of a trusteed, noncontributory pension plan that covered substantially all of our employees. We terminated the pension plan effective December 31, 2004 and received final regulatory approvals in late 2005. Upon final distribution of participant benefits, we recognized all remaining unrecognized net actuarial amounts under the plan, which totaled $24.7 million.
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THE FINOVA GROUP INC.
Income Tax Expense. No income tax expense or benefit was recorded during the years ended December 31, 2005 and 2004. Any pre-tax book income or loss was entirely offset by a decrease or increase in valuation allowances against deferred tax assets, which were previously established due to concerns regarding our ability to utilize income tax benefits generated from losses in prior periods. As of December 31, 2005 and 2004, we had federal net operating loss carryforwards of $1.2 billion and $1.1 billion, respectively, none of which expire prior to 2009. For a further discussion of taxes see Note H. “Income Taxes.”
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Because substantially all of our assets (except for a few assets that could not be pledged because those assets already secured other obligations) are pledged to secure obligations under the Intercompany Notes securing the Senior Notes, our ability to obtain additional or alternate financing is severely restricted. Berkadia has no obligation to lend additional sums to or to further invest in FINOVA. Accordingly, we intend to rely on internally generated cash flows from the liquidation of assets as our only meaningful source of liquidity.
The terms of the Indenture prohibit us from using available funds (after certain permitted uses) for any purpose other than to satisfy our obligations to creditors and to make limited payments to stockholders in certain circumstances. Under the terms of the Indenture, we are permitted to establish a cash reserve in an amount not to exceed certain defined criteria. Due to our limited sources of liquidity, the estimation of cash reserves is critical to our overall liquidity. Cash reserve estimations are subject to known and unknown risks, uncertainties, and other factors that could materially impact the amounts determined. Failure to adequately estimate a cash reserve in one period could result in insufficient liquidity to meet obligations in that period, or in a subsequent period, if actual cash requirements exceed the cash reserve estimates. Historically, cash reserves typically equaled anticipated cash flows to cover operating costs, tax payments, fundings under existing customer commitments, interest payments and any other necessary cash flows expected to occur during the next six month period. We have the discretion to and have from time to time adjusted our cash reserve methodology. As we continue to liquidate assets, our incoming cash flows will diminish and the estimation of cash reserves will become increasingly more critical to ensure we retain sufficient funds to meet obligations (including, but not limited to, interest payments on the Senior Notes, settlement of known and unknown claims and normal operating expenses) as they become due throughout the liquidation process.
In accordance with the terms of the Indenture, we are required to use any excess cash, as defined in the Indenture, to make semi-annual interest and principal payments on the Senior Notes. Additionally, the Indenture permits voluntary prepayments at our option, which we have previously elected to make from time to time; however, due to the uncertainty of cash requirements associated with the wind-up of our affairs, resolution of outstanding bankruptcy claims and matters related to Thaxton, discussed in Note N. “Litigation and Claims,” we anticipate maintaining a higher cash reserve to cover these potential and uncertain expenditures, which could limit our ability to make future voluntary prepayments.
The timing and amount of distributions to Senior Note holders will depend on the timing and amount of proceeds we receive upon the sale of our remaining assets, the resolution of claims and other litigation matters, the extent to which reserves for current or future liabilities are required and the length of time required to settle all of our matters. Our goal is to wind-up the affairs of the Company during 2007; however, we cannot control the exact timing of resolving legal matters and claims. Accordingly, the liquidation period may extend beyond 2007 and conservative estimates are up to 24 months or the end of 2008.
During 2006 and 2005, we made $207.8 million and $474.9 million, respectively, of partial principal prepayments on the Senior Notes, which reduced the outstanding principal to $1.5 billion as of December 31, 2006. Cumulative prepayments as of December 31, 2006 totaled $1.5 billion or 50% of the face amount ($2.97 billion) of the Senior Notes. Based on the revaluation of our assets at their estimated net realizable value and liabilities at estimated net settlement amount, we currently project the Senior Note holders will receive additional liquidation distributions (principal and interest) of approximately $404.8 million, which is considerably less than the outstanding principal of $1.5 billion, without giving consideration to interest accruals. We clearly do not have sufficient assets to fully repay the Senior Note obligation. In order to eliminate the shortfall, the remaining assets (excluding cash and cash equivalents), which have already been marked up approximately 43% over their historical carrying amounts under the going concern basis of accounting, would have to increase in value by almost six times their already marked up value. We do not believe there is any chance of this occurring.
The Senior Notes have a first priority security interest in substantially all of our remaining assets; however, as noted above, the Indenture requires us to first use any cash and cash equivalents to pay or to fund operating expenses, taxes and reasonable reserves for commitments and general corporate purposes.
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THE FINOVA GROUP INC.
Stockholders should not expect any payments or distributions. The Indenture contemplates that as principal payments are made on the Senior Notes, our stockholders would receive a distribution equal to 5.263% of each principal prepayment. However, the Indenture prohibits us from making distributions to and/or repurchases from stockholders if the payments would render the Company insolvent, would be a fraudulent conveyance or would not be permitted to be made under applicable law. Any such distribution and/or repurchase would be considered an impermissible restricted payment under the Indenture. Based upon the fact that the Senior Notes will not be fully repaid, we are required to retain impermissible restricted payments until such time, if ever, that we are no longer restricted from making a distribution to our stockholders or until it is necessary to use the cash to satisfy our debt obligations.
In conjunction with the prepayments of Senior Notes noted above, we retained a total of $78.1 million at December 31, 2006. Retained amounts are segregated and reflected as restricted cash in our financial statements, pending their final disposition. We anticipate that the retained amounts will eventually be paid to our creditors, not our stockholders. If the funds were to be paid to our stockholders, affiliates of Berkadia (jointly owned by Berkshire Hathaway and Leucadia), which own 50% of our common stock, would receive half of the retained amounts. Berkadia had advised us that it does not believe that stockholders are entitled to the retained amounts since we cannot fully satisfy our creditor obligations.
In April 2005, we filed a motion in the United States Bankruptcy Court for the District of Delaware seeking an order that (1) we no longer need to direct funds into a restricted account, and (2) we may use the funds in the restricted account to satisfy our obligations to creditors. For a further discussion of the motion and its status, see Note N. “Litigation and Claims.”
Based on our financial condition and imminent liquidation, there will not be sufficient funds available to fully repay the outstanding principal on the Senior Notes or make any 5% distribution to common stockholders, absent a court order in connection with the motion referred to above. As a result, there will not be a return to our stockholders. Consequently, investing in the Senior Notes and common stock involves a high level of risk.
Obligations and Commitments
The following is a listing of our significant contractual obligations and contingent commitments at December 31, 2006 and 2005. A detailed repayment schedule has not been provided because our most significant obligations are contractual as to amount, but contingent regarding the timing of repayment. The listing is not intended to be all encompassing and excludes normal recurring trade and other accounts payable obligations.
The Senior Notes mature in November 2009 and bear interest, payable semi-annually, to the extent that cash is available, at a fixed interest rate of 7.5% per annum. Principal prepayments of the Senior Notes are contingent on the availability of excess cash. Our obligations with respect to the payment of interest and principal under the Senior Notes are secured by a first priority security interest in (a) all capital stock of FINOVA Capital, (b) secured promissory notes of FINOVA Capital issued to FINOVA in the aggregate principal amount of the Senior Notes (the “Intercompany Notes”) and (c) certain other property of FINOVA that may be acquired from its subsidiaries in the future. The Intercompany Notes are secured by substantially all of the assets of FINOVA Capital. As noted above, we made $207.8 million and $474.9 million of partial principal prepayments on the Senior Notes in 2006 and 2005, respectively. Based on the revaluation of our assets at their estimated net realizable value and liabilities at estimated net settlement amount, we currently project the Senior Note holders will receive additional liquidation distributions (principal and interest) of approximately $404.8 million, which is considerably less than the outstanding principal of $1.5 billion, without giving consideration to interest accruals.
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THE FINOVA GROUP INC.
Our business continues to be operated under a Management Services Agreement with Leucadia that expires in 2011. We pay Leucadia an annual management fee of $8.0 million and reimburse it for expenses incurred.
Permitted uses of cash are specified in the Indenture. Generally, we are permitted to use cash in the following order: first to fund operating expenses, including payment of taxes and funding customer commitments; then to pay interest on the Senior Notes; then to make optional purchases of the Senior Notes in accordance with the terms of the Indenture in an amount not to exceed $150 million per year. Ninety-five percent (95%) of the remaining available cash after establishment of cash reserves as defined in the Indenture will be used to make prepayments of principal on the Senior Notes and five percent (5%) is identified for distributions to and/or repurchases of stock from common stockholders. However, the Indenture prohibits us from making distributions to and/or repurchases from stockholders if the payments would render us insolvent, would be a fraudulent conveyance or would not be permitted under applicable law. Any such distribution and/or repurchase would be considered an impermissible restricted payment under the Indenture. Since the Senior Notes will not be fully repaid (current shortfall estimated to be almost $1.1 billion), we are required to retain impermissible restricted payments until such time, if ever, that we are no longer restricted from making a distribution to our stockholders or until it is necessary to use the cash to satisfy our debt obligations. As of December 31, 2006, we had retained a total of $78.1 million. Refer to Item 3. “Legal Proceedings” for a discussion of our motion to the Bankruptcy Court regarding the restricted payments.
The Indenture provides that if payment in full is made of the outstanding principal of the Senior Notes and payments are made to our common stockholders in an aggregate amount equal to 5.263% (i.e., 5%/95% as noted above) of the aggregate principal amount of the Senior Notes, ninety-five percent (95%) of any available cash will be used to pay contingent interest to holders of Senior Notes in an aggregate amount of up to $91.2 million (reflecting Senior Notes that have been repurchased by us) and five percent (5%) of remaining available cash will be used for distributions to and/or repurchases of stock from common stockholders, if those distributions can be made to stockholders, as noted above. Our obligation for the contingent interest payments is not secured. Based on our current financial condition, there will not be funds available to fully repay the outstanding principal on the Senior Notes, to make any distributions to common stockholders or to pay any contingent interest.
Unfunded customer commitments were primarily unused contractual lines of credit and to a lesser extent, contractual term financing commitments. Fundings were typically dependent upon certain conditions precedent and the availability of eligible collateral. Typically, in the event of a contractual customer default, we had the legal right to cease funding. In these circumstances, decisions to continue or cease funding were made on a case-by-case basis following an evaluation as to what management believed was in our best interest. As of December 31, 2006, we had no remaining unfunded commitments.
Lease obligations represent total contractual obligations (rent and operating costs) due under operating leases (primarily leased office space), as well as commitments made for tenant improvements and lease damages related to the resolution of previously rejected lease space. Lease obligations declined to $22 thousand at December 31, 2006, which was comprised entirely of our short-term lease on new executive office space.
Not included in the table above is nonrecourse debt associated with leveraged leases. Nonrecourse debt associated with leveraged leases had been completely eliminated as of December 31, 2006 and totaled $125.4 million at December 31, 2005. The balance represented principal amounts due to third party lenders under lease arrangements. We had no direct obligation for repayment of the nonrecourse debt. Accounting rules required that leases financed by nonrecourse borrowings and meeting certain other criteria be classified as leveraged leases. For balance sheet classification purposes, aggregate leveraged lease rental receivables were reduced by the related nonrecourse debt service obligations to determine our investment in the leveraged leases. At December 31, 2005, all of our leveraged leases were classified and accounted for as assets held for sale. Typically, the debt had a first priority lien against the leased equipment or property with no additional recourse to us. Our exposure was limited to our investment in the transaction and we were not contractually obligated or committed to make repayments of this debt. The reduction in nonrecourse debt at December 31, 2006, resulted from $67.8 million of nonrecourse debt being eliminated in conjunction with the senior debt holders foreclosing on the underlying assets in six separate transactions, principal prepayment of $25.4 million of debt and $32.2 million of debt being repaid through the sale of bankruptcy claims held by the senior debt holders. During 2006, we were foreclosed out of six regional jets on lease to Northwest Airlines, while the sale of the senior debt holders’ bankruptcy claims reduced the outstanding debt balance on two Boeing 757 aircraft to an amount below the fair value of the aircraft, thereby creating value for us. As a result, we prepaid the remaining principal balance and sold the aircraft to a third party for a gain of about $3.6 million. We have no further exposure to or assets under leveraged lease transactions as of December 31, 2006.
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THE FINOVA GROUP INC.
Collection of the Portfolio
As noted previously, our current business activities have been limited to maximizing the value of our portfolio through the orderly collection of assets. These activities include collection efforts pursuant to underlying contractual terms, negotiation of prepayments, sales of assets or collateral. We have sold substantial portions of asset portfolios and are considering future sales of our remaining assets if buyers can be found at acceptable prices; however, there can be no assurance that we will be successful in efforts to sell additional assets. We are currently offering to sell our remaining assets both by portfolio and individual asset. Due to restrictions contained in the Indenture as well as our general inability to access capital in the public and private markets, our only viable source of cash flow is from the collection of our portfolio.
The following table presents the activity in our portfolio for the years ended December 31:
Our portfolio declined to $185.5 million at December 31, 2006, down from $326.6 million at December 31, 2005. During 2006, net cash flows from the portfolio totaled $218.3 million, down from $312.4 million in 2005, while non-cash activity resulted in a $14.2 million increase in net assets as compared to $34.4 million for 2005. Additionally, during 2006, the effects of adopting the liquidation basis of accounting and subsequent adjustments to their estimated net realizable values resulted in a $63.0 million net increase in assets. Components of net cash flow for 2006 included $119.3 million of collections (including recoveries) and $154.0 million from the sale of assets (excluding cash gains), offset by $5.2 million of fundings under existing customer commitments, a $25.4 million prepayment of nonrecourse debt associated with two leveraged leases, which were sold in late 2006 and the transfer of $24.4 million of cash collected from the Thaxton Entities since Thaxton’s bankruptcy filing. Collections included prepayments (customer payments in advance of scheduled due dates). Non-cash activity through December 4, 2006 included a $15.4 million reversal of reserves and a $3.3 million net increase related to the valuation of assets, partially offset by other non-cash activity of $4.5 million.
During 2005, net cash flows from the portfolio totaled $312.4 million, while non-cash activity resulted in a $34.4 million increase in net assets. Components of net cash flow included $260.4 million of collections (including reserves) and $66.2 million from the sale of assets (excluding cash gains), offset by $14.2 million of fundings under existing customer commitments. Non-cash activity included a $51.8 million reversal of reserves, partially offset by a $12.5 million net decrease related to the valuation of assets held for sale and owned assets and other non-cash activity of $4.9 million.
During 2006, the $141.1 million decline in the carrying value of our portfolio was primarily attributable to assets sales, prepayments, scheduled amortization and write-offs of certain assets ($7.0 million). During 2006, we completed numerous assets sales with a total carrying amount of $154.0 million, while prepayment activity represented $66.2 million of carrying amount. The remaining portfolio as of December 31, 2006 is primarily comprised of aviation assets and the loan to The Thaxton Group. Refer to Note N. “Litigation and Claims” for a further discussion of the settlement of the Thaxton litigation.
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THE FINOVA GROUP INC.
In connection with the adoption of the liquidation basis of accounting and subsequent adjustments, certain portfolio assets were written up a net $63.0 million to reflect their estimated net realizable value. We were previously precluded from increasing the recorded carrying values of assets under the going concern basis of accounting. The $63.0 million markup was primarily due to initial adjustments comprised of a $14.1 million increase to assets supported by underlying loan and direct financing agreements, a $42.7 million increase to owned assets (operating and off-lease assets) and a $4.8 million increase to investments, while during the period from December 5, 2006 through December 31, 2006, the initial estimated net realizable value of our portfolio was increased another $1.3 million due to an increase in offers to purchase certain owned aviation assets and an increase in the estimated value of loans and investments. The majority of our estimated net realizable value of assets was determined based upon actual completed sales proceeds, signed definitive agreements, letters of intent to sell and settlement agreements, while the remainder of the value was supported by estimated cash flows on a transaction by transaction basis.
As of the date of this report, we had 32 aircraft with a total carrying value on a liquidation basis of approximately $85.1 million that had either been liquidated subsequent to December 31, 2006, are under individual letters of intent to sell or are subject to a definitive agreement to sell. Due to the fact these aircraft are operating throughout the world, additional time will be necessary to close the sales. It is to our advantage to close these transactions when the aircraft are in tax friendly jurisdictions to minimize transfer taxes. No assurance can be given that all of these commitments will result in actual sales or the timing of such sales, but all of the aircraft are targeted to close by the end of the first quarter of 2007. There is a possibility for a small number of aircraft sales to slide into the second quarter of 2007.
In addition to the aircraft noted above, our transportation portfolio also includes 13 engines, miscellaneous parts and some unsecured aviation notes and claims with a total carrying value on a liquidation basis of approximately $5.0 million as of December 31, 2006. The majority of these assets have either been liquidated subsequent to December 31, 2006, are under individual letters of intent to sell or are subject to a definitive agreement to sell. We are in the process of marketing the remaining uncommitted assets for sale, all of which are targeted for closure by the end of the first quarter of 2007.
Our non-aviation portfolio, in addition to the Thaxton loan, at December 31, 2006 was comprised of assets with a net realizable value of approximately $11.9 million, including our $10.1 million investment in two grantor trusts to secure severance and bonus obligations to our employees. These assets are held primarily for the benefit of our employees, but are recorded as investments due to our retained interest in any excess assets. Substantially all of the other non-aviation assets are in the process of being liquidated.
The estimated net realizable value of our portfolio included, among other transactions, a number of customer judgments and claims, nonmarketable private equity securities and certain obligations owed to us by companies that are in liquidation. In many of these instances, we did not attribute any net realizable value to these assets due to our inability to predict the collection of any cash flows from the transactions with even a remote level of confidence. Most of these transactions were previously included in due diligence materials in an attempt to sell the assets, but were excluded on multiple occasions by prospective buyers because of costs of collection and potential liability concerns of the buyers. We continue to monitor these accounts for changes in facts and circumstances that would allow us to attribute value to these assets. As a result, there is the possibility that some net realizable value will be attributed to these assets in the future. An increase in the estimated net realizable values of these assets, if any, will be reflected as a change in net assets in liquidation in future filings. Additionally, we continue to occasionally receive small amounts of proceeds typically from trustees for assets that in certain cases were written off years ago. These cash flows are reflected as a change in net assets in liquidation as they are received.
As we continue to liquidate assets, our incoming cash flows will diminish and the estimation of cash reserves will become increasingly more critical to ensure we retain sufficient funds to meet obligations (including, but not limited to, interest payments on the Senior Notes, settlement of known and unknown claims and normal operating expenses) as they become due throughout the liquidation process. Due to the uncertainty of cash requirements associated with the wind-up of our affairs, resolution of outstanding bankruptcy claims and matters related to Thaxton, discussed in Note N. “Litigation and Claims,” we anticipate maintaining a higher cash reserve to cover these potential and uncertain expenditures, which could limit our ability to make future voluntary prepayments.
Our goal is to wind-up the affairs of the Company during 2007; however, we cannot control the exact timing of resolving legal matters and claims. Accordingly, the liquidation period may extend beyond 2007 and conservative estimates are up to 24 months or the end of 2008. We will continue to operate as a public company throughout the liquidation period under a Management Services Agreement with Leucadia that expires in 2011.
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Special Note Regarding Forward-looking Statements
Certain statements in this report are “forward-looking,” in that they do not discuss historical fact, but instead reflect future expectations, projections, intentions, or other items. Forward-looking statements are made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include assumptions, estimates and valuations implicit in the financial statements and related notes as well as matters discussed throughout this report including, but not limited to projections, our Plan of Liquidation, sections captioned Item 1. “Business,” Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 7A.