Item 1 - Business - Planned Reorganization.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table sets forth, as of December 31, 2006, information concerning compensation plans under which our securities are authorized for issuance. The table does not reflect exercises, terminations or expirations since that date.
(1)
Both the Incentive Plan and the Directors’ Plan expired on January 3, 2006. Accordingly, there were no shares authorized for issuance under either of those plans on December 31, 2006. Effective December 31, 2006, there were 3,000,000 shares issuable under the Omnibus Plan, which became effective on December 19, 2006.
(2)
The number of securities remaining for future issuance at December 31, 2006 consisted of 131,500 shares issuable under the Incentive Plan. Since December 31, 2006, no options have been granted under the Inducement Plan.
Item 13.
Certain Relationships and Related Transactions
Under the Company’s Code of Business Conduct, Practices and Ethics (“Code”), which is attached to this Form 10-K as Exhibit 14, all directors and employees owe complete and undivided loyalty to the Company and are to avoid any situations that are or have the appearance of being a conflict between their personal interests and those of the Company. Any transaction or personal relationship that might involve a conflict of interest is to be reviewed by the Code Administrator (who is the Company’s Vice President of Internal Audit or such other party designated by the Audit Committee to administer the Code).
Certain Transactions
During 2006, Bally paid approximately $8 million for goods and services from two companies that each employ a relative of Mr. Wildman. Bally believes that the terms of these arrangements were at least as favorable to Bally as those which could be obtained from unrelated parties.
During 2006, Bally paid $987,000 to Tatum LLC, a financial and accounting services provider in which Messrs. Eidell and Goldberg are partners. Bally utilized the services of several partners and associates of Tatum LLC to manage and assist in certain projects related to accelerating the accounting close process and remediation of material weaknesses. Bally believes that the terms of these arrangements were at least as favorable to Bally as those which could be obtained from unrelated parties.
Item 14.
Principal Accountant Fees and Services
Fees Paid to the Principal Accountant
The table below sets forth the fees billed for the services of KPMG LLP for the years ended December 31, 2006 and 2005:
(1)
Audit fees include work performed in connection with the audit of the 2006 consolidated financial statements, the reports on management’s assessment regarding the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting, and the reviews of the financial statements included in our 2006 Forms 10-Q. It also includes fees for professional services that are normally provided by our registered public accounting firm in connection with statutory and regulatory filings.
(2)
Audit related fees include work performed in connection with separate audits of subsidiaries and affiliated entities not required by statute or regulation.
(3)
Tax fees include services performed in connection with the Company’s assessment of the implications of an ownership change for purposes of Internal Revenue Code Section 382.
Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Registered Public Accounting Firm
The Audit Committee has responsibility for retaining, setting fees, and overseeing the work of the registered public accounting firm. The retention of the firm is subject to stockholder ratification. In recognition of this responsibility, the Audit Committee has established a policy to pre-approve all audit and permissible non-audit services provided by the registered public accounting firm. The Audit Committee has delegated pre-approval authority to the chairman of the committee. The chairman must report any pre-approval decisions to the Audit Committee at its next scheduled meeting for approval by the Audit Committee as a whole.
PART IV
Item 15.
Exhibits and Financial Statement Schedules
Financial Statements
An “Index to Financial Statements and Financial Statement Schedules” has been filed as a part of this Report beginning on page and is incorporated in this Item 15 by reference.
Exhibits
An “Exhibit Index” has been filed as a part of this Report beginning on page E-1 and is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. This report may be signed in multiple identical counterparts all of which, taken together, shall constitute a single document.
BALLY TOTAL FITNESS HOLDING CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Bally Total Fitness Holding Corporation:
We have audited the accompanying consolidated balance sheets of Bally Total Fitness Holding Corporation and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ deficit and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Bally Total Fitness Holding Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” and Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements in Current Year Financial Statements” as of January 1, 2006.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from operations and negative cash flows, has a net capital deficiency, and has short-term obligations that cannot be satisfied by available funds, all of which raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Bally Total Fitness Holding Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated June 29, 2007 expressed an unqualified opinion on management’s assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Chicago, Illinois
June 29, 2007
BALLY TOTAL FITNESS HOLDING CORPORATION
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
BALLY TOTAL FITNESS HOLDING CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
BALLY TOTAL FITNESS HOLDING CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT
AND COMPREHENSIVE INCOME (LOSS)
See accompanying notes to consolidated financial statements.
BALLY TOTAL FITNESS HOLDING CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All dollar amounts in thousands, except share data)
Note 1
Nature of Operations
Description of Business
Bally Total Fitness Holding Corporation (the “Company”), through its subsidiaries, is a nationwide commercial operator of fitness centers. As of December 31, 2006, the Company operated three hundred seventy-five facilities, located in twenty-six states and Canada. Additionally, thirty-five clubs were operated pursuant to franchise and joint venture agreements in the United States, Mexico, Asia, and the Caribbean. All significant revenues arise from the commercial operation of fitness centers, primarily in major metropolitan areas in the United States and Canada. Unless otherwise specified in the text, references to the Company include the Company and its subsidiaries.
The Company reported a loss from continuing operations for the years 2002 through 2005, and reported modest income from continuing operations in 2006. In addition, our December 31, 2006 consolidated balance sheet reflects a stockholders’ deficit of $1,400,422. During the last five years, the Company’s primary markets have become more competitive, with competitors entering and opening new fitness centers. At the same time, the Company’s ability to invest in its fitness centers has been constrained by its financial condition, particularly as it relates to liquidity. These conditions are expected to persist.
The Company has a substantial amount of debt. As of December 31, 2006, total consolidated debt (excluding trade debt) was $761,347. Of this amount, $513,913 is due in 2007 and is classified as a current liability in the Company’s consolidated balance sheet. This debt level resulted in reported interest expense of $101,859 in 2006, including cash-payable interest of $79,292. This substantial amount of debt service adversely affected financial health and business operations by, among other things, limiting the Company’s ability to obtain additional financing to fund future working capital, capital expenditures, acquisitions of clubs and other general corporate requirements; continuing to require that the Company dedicate a substantial portion of any cash flows from operations and future business opportunities; and increasing the Company’s vulnerability to adverse economic conditions.
Planned Reorganization
As a result of the Company’s deteriorating financial condition and pending debt requirements, in November 2005 the Company began considering strategic alternatives. To this end, the Company engaged JP Morgan Securities, Inc. and The Blackstone Group to assist the Company in commencing a process to identify and evaluate strategic alternatives, including without limitation a sale of substantially all of the Company’s assets. This process, which was conducted under the direction of the Strategic Alternatives Committee of the Board, did not result in a strategic transaction. The Company subsequently retained Jefferies & Company in February 2007 as its financial advisors. In March 2007, certain holders of our Senior Notes and Senior Subordinated Notes formed an Ad Hoc Committee and the Company began discussions with them with respect to de-leveraging its balance sheet. In April 2006, the Company was required to make an interest payment of $14,812 on its Senior Subordinated Notes. It elected not to make this interest payment and an event of default occurred under the Senior Subordinated Notes Indenture, which also triggered an event of default under the Senior Notes Indenture. In April and May 2007, the Company entered into Forbearance Agreements with lenders under its New Facility and holders of its Senior Subordinated Notes and Senior Notes, which agreements expire on July 13, 2007.
On June 27, 2007, the Company commenced a solicitation of votes on the Plan of Reorganization from holders of the Senior Notes and Senior Subordinated Notes. If the Company receives the requisite votes in favor of the Plan of Reorganization, it intends to file a voluntary prepackaged petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the Bankruptcy Court in late July 2007. Prior to commencement of the consent solicitation, the Company entered into a Restructuring Support Agreement with holders of a majority of the Senior Notes and more than 80% of the Senior Subordinated Notes, in which the consenting noteholders agreed to vote in favor of the Plan of Reorganization, on the terms and conditions specified therein. Under certain
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
circumstances, the Company may file for bankruptcy prior to the end of the solicitation period. The Plan of Reorganization includes, among other things, the following key terms:
•
New Facility. The New Facility would be unimpaired. As a condition to effectiveness of the Plan of Reorganization, the Company will amend and restate (with the consent of the Lenders) or replace the New Facility with a $292,000 senior secured credit facility agreement on terms no less favorable than described in the Plan of Reorganization.
•
Senior Notes. The Company does not intend to make the cash interest payment due on the Senior Notes on July 15, 2007. The Plan of Reorganization would, if approved, confirmed and consummated, result in the cancellation and discharge of all claims relating to the Senior Notes. Each holder of Senior Notes would receive a pro rata share of new senior notes (the “New Senior Notes”) in the principal amount of $247,337.5 with an interest rate of 123/8%. The maturity and guarantees of the New Senior Notes would be the same as for the Senior Notes. Upon effectiveness of the Plan, holders of the Senior Notes would receive a fee equal to 2% of the face value of their notes.
•
Senior Notes Indenture. The Senior Notes Indenture would be amended to provide the holders with a “silent” second lien on substantially all of the Company’s assets and the assets of its subsidiary guarantors. Under the amended Senior Note Indenture, the Company would have a permitted debt basket for the New Facility of $292,000, with a reduction for proceeds of asset sales completed after June 15, 2007 that are used to permanently pay down indebtedness under the New Facility and are not reinvested in replacement assets within 360 days after the applicable asset sale. The amended Senior Note Indenture would also permit the Company to issue, in addition to the Rights Offering Senior Subordinated Notes, an additional $90,000 of pay-in-kind senior subordinated notes, as described more fully under “Rights Offering” section below after emergence from bankruptcy.
•
Senior Subordinated Notes. Holders of Senior Subordinated Notes would receive, in exchange for their claims, New Subordinated Notes representing approximately 24.8% of their claims, New Junior Subordinated Notes representing approximately 21.7% of their claims, and shares of common stock representing 100% of the equity in the reorganized company, subject to reduction for common stock to be issued to holder of certain other claims. The New Subordinated Notes would mature five years and nine months after the effective date of the Plan of Reorganization and would bear interest payable annually at 135/8% per annum if paid in kind or 12% per annum if paid in cash, at our option, subject to a toggle covenant based on specified cash EBITDA and minimum liquidity thresholds.
•
Rights Offering. In addition to the consideration described above, holders of Senior Subordinated Notes would receive non-detachable rights to participate in a rights offering of Rights Offering Senior Subordinated Notes in principal amount equal to approximately 27.9% of their claims, or $90,000. The Rights Offering Senior Subordinated Notes would rank senior to the New Subordinated Notes and New Junior Subordinated Notes but otherwise have the same terms. Holders of certain other claims against the Company will be given the opportunity to participate in the rights offering, which, if exercised, would generate incremental proceeds beyond the $90,000 to be funded by electing Senior Subordinated Noteholders.
•
Subscription and Backstop Purchase Agreement. On June 27, 2007, the Company entered into a Subscription and Backstop Purchase Agreement with certain holders of Senior Subordinated Notes, who have agreed to subscribe for their pro rata share of Rights Offering Senior Subordinated Notes and to purchase any Rights Offering Senior Subordinated Notes not subscribed for in the rights offering. The Company has agreed to pay a fee to each backstop provider in the amount of 4% of its backstop commitment, subject to a rebate of approximately 80% of such amount if the Plan is consummated.
•
Existing Equity. All existing equity would be cancelled for no consideration.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
The Company expects to continue normal club operations during the restructuring process. If the Company files the Plan of Reorganization, it would seek to obtain the necessary relief from the Bankruptcy Court to pay the majority of its employee, trade and certain other creditors in full and on time in accordance with existing business terms. Upon effectiveness of the Plan of Reorganization, the Company would, among other things, amend its charter and by-laws and enter into a stockholders’ agreement and a registration rights agreement with holders of the Company’s common shares. In addition, the Company’s new Board of Directors will consider adopting a new management long-term incentive plan intended to provide incentives to certain employees to continue their efforts to foster and promote the Company’s long-term growth objectives.
If the Company does not receive the necessary votes in favor of the Plan of Reorganization during the solicitation period, it will evaluate other available options, including filing one or more traditional, non-prepackaged Chapter 11 cases.
Note 2
Summary of Significant Accounting Policies
Description of Business: The Company, through its subsidiaries, is a nationwide commercial operator of fitness centers. As of December 31, 2006, the Company operated three hundred seventy-five facilities, located in twenty-six states and Canada. Additionally, thirty-five clubs were operated pursuant to franchise and joint venture agreements in the United States, Mexico, Asia, and the Caribbean. All significant revenues arise from the commercial operation of fitness centers, primarily in major metropolitan areas in the United States and Canada. Unless otherwise specified in the text, references to the Company include the Company and its subsidiaries.
Principles of Presentation and Consolidation: The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries and other controlled entities. All significant intercompany balances and transactions have been eliminated in consolidation.
The Company has prepared the consolidated financial statements on the basis that the Company will continue as a going concern.
Use of Estimates: The preparation of consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make extensive use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Significant estimates in these consolidated financial statements include estimates of future cash flows associated with assets, useful lives of depreciable and amortizable assets, expected member attrition, future taxable income, future cash flows resulting from retained risk arrangements, and contingencies and litigation. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances in making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Cash: The Company considers all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. The carrying amount of cash equivalents approximates fair value due to the short maturity of those instruments.
Property and Equipment: Property and equipment are stated at cost. Property and equipment acquired in business combinations are recorded at their estimated fair values on the date of acquisition under the purchase method of accounting. Equipment under capital leases is stated at the present value of the minimum lease payments. Improvements are capitalized, while repair and maintenance costs are charged to operations when incurred.
Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of the related assets. Buildings and related improvements are depreciated over 5 to 35 years and useful lives for
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
equipment and furnishings range from 5 to 10 years. Equipment held under capital leases and leasehold improvements are amortized on the straight-line method over the shorter of the estimated useful life of the asset or the remaining lease term. Depreciation of construction in progress is not recorded until the assets are placed into service. Depreciation of property and equipment amounted to $53,434, $56,462 and $64,547 for 2006, 2005 and 2004, respectively.
Long-Lived Assets: The Company accounts for its long-lived tangible assets and definite-lived intangible assets in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Under SFAS No. 144, the Company assesses the recoverability of long-lived assets (excluding goodwill) and identifiable acquired intangible assets with finite useful lives, whenever events or changes in circumstances indicate that the Company may not be able to recover the asset’s carrying amount. The Company measures the recoverability of assets to be held and used by a comparison of the carrying amount of the asset to the projected and estimated net future cash flows to be generated by that asset, or, for identifiable intangibles with finite useful lives, by determining whether the amortization of the intangible asset balance over its remaining life can be recovered through undiscounted projected and estimated future cash flows. The amount of impairment of identifiable intangible assets with finite useful lives, if any, to be recognized is measured based on projected discounted future cash flows. The Company measures the amount of impairment of other long-lived assets (excluding goodwill) by the amount by which the carrying value of the asset exceeds the fair market value of the asset, which is generally determined based on projected discounted future cash flows. The Company presents an impairment charge as a separate line item within income (loss) from continuing operations in the Company’s consolidated statements of operations, unless the impairment is associated with a discontinued operation. In that case, the Company includes the impairment charge, on a net-of-tax basis, within the results of discontinued operations. The Company classifies long-lived assets to be disposed of other than by sale as held and used until they are disposed.
Primary indicators of impairment include significant declines in the operating results or an expectation that a long-lived asset may be disposed of before the end of its useful life. Impairment is assessed at a club operation level, which is the lowest level at which identifiable cash flows are largely independent of the cash flows of other assets. Costs to reduce the carrying value of long-lived assets are separately identified in the Statements of Operations as “Asset impairment charges.” See Note 5 for a description of asset impairment charges recorded in 2006, 2005 and 2004.
The Company accounts for discontinued operations under SFAS No. 144, which requires that a component of an entity that has been disposed of or is classified as held for sale after January 1, 2002 and has operations and cash flows that can be clearly distinguished from the rest of the entity be reported as discontinued operations. In the period that a component of an entity has been disposed of or classified as held for sale, the Company reclassifies the results of operations for current and prior periods into a single caption titled “discontinued operations”.
Deferred Lease Liabilities and Noncash Rental Expense: The Company recognizes rental expense for leases with scheduled rent increases, leasehold incentives and rent concessions on the straight-line basis over the life of the lease beginning upon the commencement of the lease.
Software for Internal Use: Certain costs incurred related to software developed for internal use are accounted for in accordance with the American Institute of Certified Public Accountants’ Statement of Position No. 98-1 (“SOP 98-1”), “Accounting for Costs of Computer Software Developed or Obtained for Internal Use.” In accordance with SOP 98-1, costs incurred in the planning and post-implementation stages are expensed as incurred, while costs relating to application development are capitalized. Qualifying software development costs are included as an element of property and equipment in the consolidated balance sheets. The Company amortizes such software costs over the shorter of the estimated useful life of the software or five years.
Goodwill and Other Intangible Assets: The Company’s intangible assets are comprised principally of goodwill, member relationships, leasehold rights and certain trademarks. Goodwill represents the excess of cost
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
over fair value of assets of businesses acquired. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”) goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life, which consist of certain trademarks, are not amortized, but instead tested for impairment at least annually.
The Company is required to test goodwill for impairment on an annual basis for each of its reporting units. The Company is also required to evaluate goodwill for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Certain indicators of potential impairment that could impact the Company’s reporting units include, but are not limited to, a significant long-term adverse change in the business climate that is expected to cause a substantial decline in membership, or a significant change in the delivery of health and fitness services that results in a substantially more cost effective method of delivery than health clubs. The Company tested to determine if the fair value of each of its reporting units was in excess of its respective carrying values at December 31, 2006, 2005 and 2004, for purposes of the annual impairment test.
Income Taxes: Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.
The Company considers future taxable income, the scheduled reversal of deferred tax liabilities, and ongoing tax strategies in assessing the need for a valuation allowance with respect to its deferred tax assets. The Company records a valuation allowance to reduce deferred tax assets to a level which management believes more likely than not will be realized.
Deferred Financing Costs: The costs related to the issuance of debt are capitalized and amortized to interest expense over the life of the related debt instrument using the effective interest method. The costs incurred in 2006, 2005 and 2004 related to the execution of waivers with respect to certain of the Company’s debt covenants. During the years ended December 31, 2006, 2005 and 2004, the Company recognized amortization expense of $21,100, $8,500 and $3,400, respectively. Accumulated amortization of deferred financing costs amounted to $28,651 and $18,167 as of December 31, 2006 and 2005, respectively.
Prepaid Expenses: Prepaid expenses consist of prepaid rent and prepaid advertising expenses.
Other Current Assets: Other current assets consist primarily of inventory and other prepaid expenses, including insurance expenses and other. Inventory consists primarily of nutritional products, apparel and other retail products. Inventory is valued at the lower of cost or market.
Fair Values of Financial Instruments: The Company determined by using quoted market prices that the fair value of the Senior Subordinated Notes was $276,930 and $288,507 at December 31, 2006 and 2005, respectively, and that the carrying value at December 31, 2006 was $297,774. The Company determined by using quoted market prices that the fair value of the Company’s 101/2% Senior Notes due 2011 (the “Senior Notes”) was $229,907 and $242,299 at December 31, 2006 and 2005, respectively, and that the carrying value at December 31, 2006 was $235,199. Since considerable judgment is required in interpreting market information, the fair value of the Senior Subordinated Notes and the Senior Notes is not necessarily indicative of the amount which could be realized in a current market exchange. The carrying values of accounts payable, income taxes payable, and accrued liabilities approximate fair value due to the short maturity of these instruments.
Revenue Recognition: The Company’s principal sources of revenue include membership services, principally health club memberships and personal training services, and the sale of nutritional products. The Company
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
recognizes revenue in accordance with SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements,” as amended by SEC Staff Accounting Bulletin No. 104, “Revenue Recognition.” As a general principle, revenue is recognized when the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and services have been rendered, (iii) the price to the buyer is fixed or determinable, and (iv) collectability is reasonably assured. With respect to health club memberships and personal training, the Company relies upon a signed contract between the Company and the customer as the persuasive evidence of a sales arrangement. Delivery of health club services extends throughout the term of membership. Delivery of personal training services occurs when individual personal training sessions have been rendered.
The Company receives membership fees and monthly dues from its members. Membership fees, which customers often finance, become customer obligations upon contract execution and after a “cooling off” period of three to fifteen calendar days depending on jurisdiction, while monthly dues become customer obligations on a month-to-month basis as services are provided. Membership fees and monthly dues are recognized at the later of when collected or earned.
Membership fees and monthly dues collected but not earned are included in deferred revenue. The majority of members commit to a membership term of between 12 and 36 months. The majority of these contracts are 36-month contracts. Contracts include a member’s right to renew the membership at a discount compared to the monthly payments made during the initial contractual term.
Additional members may be added to the primary joining member’s contract. These additional members may be added as obligatory members that commit to the same membership term as the primary member, or nonobligatory members that may discontinue their membership at any time.
Membership revenue is earned on a straight-line basis over the longer of the contractual term or the estimated membership term. Membership term is estimated on an aggregate basis at time of contract execution based on historical trends of actual attrition, and these estimates are updated quarterly to reflect actual membership retention. Estimates of membership term were up to 360 months during 2006, 2005, and 2004. The table below presents the current member duration distribution of our members that have continuously maintained membership and were members as of December 31, 2006, 2005 and 2004. Reactivation members include members that have experienced discontinuous periods of membership, having ceased membership to later return to membership status through our ongoing reactivation solicitations of expired members. Nonrenewable members are those which have a definite term of three years or less and do not have a right to renew their membership at the conclusion of the term.
As of December 31, 2006 and 2005, the weighted average membership life for members that commit to a membership term of between 12 and 36 months was 34 months and 38 months, respectively. Members with these terms that finance their initial membership fee have a weighted average membership life of 33 months and 36 months at December 31, 2006 and 2005, respectively, while those members that pay their membership fee in full at point of sale have a weighted average membership life of 48 months and 57 months at December 31, 2006 and
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
2005, respectively. As a result of the Company’s business practice of discounting monthly payments made during the renewal term when compared to monthly payments made in the initial contractual term, the estimate of membership term impacts the amount of revenue deferred in the initial contractual term. Changes in member behavior, competition, and our performance may cause actual attrition to differ significantly from estimated attrition. A resulting change in estimated attrition may have a material effect on reported revenues in the period in which it is first identified.
Beginning in the fourth quarter of 2004, the Company increased contractual renewal rates associated with its typical membership offering. Historically when a member reaches renewal, the Company’s business practice is to reduce renewal rates in order to increase retention during the renewal period. Because the Company includes a discount in its membership contract and does not have a demonstrated history of collecting the contractual renewal rate, it uses the current collections of members in renewal to estimate both ultimate collections and the portion attributable to the initial term.
To the extent that actual cash collected in renewal is different from the estimated amount, revenues in the period of the change in estimate may be materially impacted. If the Company is successful in collecting the contractual renewal rate, revenue deferred during the initial term is expected to decline. If the Company offers discounts to renewing members that are more significant than those that have been offered in the past, revenue required to be deferred during the initial contract term will increase. The potential effects of this change in estimate may be amplified if, for example, the collection of higher contractual renewal rates results in a decline in membership retention, which will reduce the Company’s estimate of total membership life and further reduce the amount of deferred revenue recorded. Changes in member behavior, competition, and Company performance may cause actual collected renewal rates to differ significantly from estimated renewal rates. A resulting change in estimated renewal rates may have a material effect on reported revenues in the period in which the change of estimate is made.
Members in their non-obligatory renewal period of membership totaled approximately 62% of total members at December 31, 2006 and 2005, and approximately 61% of total members at December 31, 2004. Renewal members may cancel their membership at any time prior to their monthly or annual due date. Membership revenue from members in renewal includes monthly dues paid to maintain their membership, as well as amounts paid during the obligatory period that have been deferred as described above, to be recognized over the estimated term of membership, including renewal periods.
Month-to-month members may cancel their membership prior to their monthly due date. Membership revenue for these members is earned on a straight-line basis over the estimated membership life. Membership life for month-to-month members is currently estimated at between 2 and 67 months, with an average of 15 months, as of December 31, 2006, and were estimated between 4 and 41 months, with an average of 15 months, as of December 31, 2005.
Paid-in-full members who purchase nonrenewable memberships must purchase a new membership plan to continue membership beyond the initial contractual term. Such membership fees are deferred and amortized over the contract term.
Personal training and other services are provided at most of the Company’s fitness centers. Revenue related to personal training services is recognized when the four criteria of recognition described above are met, which is generally upon rendering of services. Personal training services contracts are either paid-in-full at the point of origination, or are financed and collected over periods generally up to three months after an initial payment. Collections of amounts related to paid-in-full personal training services contracts are deferred and recognized as personal training services are rendered. Revenue related to personal training contracts that have been financed is recognized at the later of cash receipt or the rendering of personal training services.
Sales of nutritional products and other fitness-related products occur primarily through the Company’s in-club retail stores and are recognized upon delivery to the customer, generally at point of sale. Revenue recognized in the
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
accompanying consolidated statement of operations as “miscellaneous” includes amounts earned as commissions in connection with a long-term licensing agreement related to the third-party sale of Bally branded fitness equipment. Such amounts are recognized prior to collection based on commission statements from the licensee. Other amounts included in miscellaneous revenue are recorded upon receipt and include franchising fees, facility rental fees, locker fees, late charges and other marketing fees pursuant to in-club promotion agreements.
The Company enters into contracts that include a combination of (i) health club services (which may include two or more members on a single contract), (ii) personal training services, and (iii) nutritional and weight management products. In these multiple element arrangements, health club services are typically the last delivered service. The Company accounts for these arrangements as single units of accounting because it does not have objective and reliable evidence of the fair value of health club services. Under Emerging Issues Task Force Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (“Issue 00-21”), elements qualify for separation when the services have value on a stand-alone basis, fair value of the separate elements exists and, in arrangements that include a general right of refund relative to the delivered element, performance of the undelivered element is considered probable and substantially in the Company’s control. The Company does not have objective and reliable evidence of the fair value of health club services and, as a result, treats these arrangements as single units of accounting.
Costs related to acquiring members and delivering membership services are expensed as incurred. Advertising costs are charged to expense as incurred, or in the case of television commercial production, upon the first airing.
Derivative Financial Instruments: The Company is a limited user of derivative financial instruments to manage risks generally associated with interest rate volatility. The Company does not hold or issue derivative financial instruments for trading purposes. Derivative financial instruments are accounted for in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”) as amended by SFAS No. 149, “Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities” (“SFAS No. 149”). This standard requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not classified as qualifying hedging instruments are adjusted to fair value through earnings. Changes in the fair value of derivatives that are designated and qualify as effective hedges are recorded either in accumulated other comprehensive loss or through earnings, as appropriate. The ineffective portion of derivatives that are classified as hedges is immediately recognized in earnings.
Investments: Investments in the common stock of entities for which the Company has significant influence over the investee’s operating and financial policies, but less than a controlling interest, are accounted for using the equity method. Under the equity method, the Company’s investment in an investee is included in the consolidated balance sheet under the caption “other assets” and the Company’s share of the investee’s earnings or loss is included in the consolidated statements of operations under the caption “other, net.”
Commitments and Contingencies - Litigation: The Company accounts for contingencies in accordance with SFAS 5, “Accounting for Contingencies”, which requires the Company to accrue loss contingencies when the loss is both probable and estimable. All legal costs expected to be incurred in connection with loss contingencies are expensed as incurred.
Comprehensive Income (Loss): SFAS No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”), establishes standards for reporting comprehensive income. Comprehensive income includes net income as currently reported under GAAP, and also considers the effects of additional economic events that are not required to be reported in determining net income, but rather are reported as a separate component of stockholders’ deficit. The Company reports the effects of currency translation as components of comprehensive income (loss).
Insurance Proceeds: Insurance proceeds for reimbursement of costs incurred as a result of investigations, disputes and legal proceedings pursuant to the Company’s director and officer insurance policies are recorded upon receipt and are recorded as a reduction of selling, general and administrative costs in the statement of operations.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Income (Loss) Per Share: Income (loss) per share is computed in accordance with SFAS No. 128, “Earnings per Share” (“SFAS No. 128”). Basic income (loss) per share is computed on the basis of the weighted average number of common shares outstanding. Diluted income (loss) per share is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding stock options, certain restricted stock, and warrants using the “treasury stock” method. The per share amounts presented in the Consolidated Statements of Operations are based on the following amounts:
The following potentially dilutive shares were not included in the computation of diluted loss for the years ended December 31 as their effects would be anti-dilutive:
Employee Share-based Compensation: On January 1, 2006, the Company adopted the provisions of the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”) to record compensation expense for its employee stock options and restricted stock. SFAS No. 123R is a revision of SFAS No. 123, “Accounting for Stock-based Compensation,” (“SFAS No. 123”) and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and its related implementation guidance. Prior to the adoption of SFAS No. 123R, the Company followed the intrinsic value method in accordance with APB 25, in accounting for its employee stock options. For information regarding share-based compensation, see Note 15 (Share-based Payments) to these Consolidated Financial Statements.
Foreign Currency Translation: Foreign operations of non-U.S. subsidiaries whose functional currency is not the U.S. dollar have been translated into U.S. dollars in accordance with the principles prescribed in SFAS No. 52, “Foreign Currency Translation” (“SFAS No. 52”). All assets, liabilities, and minority interests are translated at the period end exchange rates, stockholders’ equity is translated at historical rates, and revenues and expenses are translated at the average rates of exchange prevailing during the year. Translation adjustments are included in the accumulated other comprehensive loss component of stockholders’ deficit. Gains and losses resulting from foreign currency transactions are reflected in net income (loss).
Reclassifications: In the 2006 balance sheet, the Company has reported its self-insurance liabilities gross of excess insurance and recorded receivables for the amounts to be recovered from the insurance provider. The Company has increased other current assets by $3,511, other assets by $11,494, accrued liabilities by $3,511, and other liabilities by $11,494 in the 2005 balance sheet to conform with the presentation in the 2006 balance sheet.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Note 3
Other Current Assets
Other current assets consist of:
Note 4
Property and Equipment
Property and equipment consists of:
(1)
Shorter of lease term or estimated useful life, not to exceed 15 years.
Depreciation of property and equipment amounted to $53,434, $56,462 and $64,547 in 2006, 2005 and 2004, respectively. The Company capitalized interest of $516 and $309 for the years ended December 31, 2006 and 2005, respectively, related to the construction and equipping of clubs.
Note 5
Asset Impairment Charges
In accordance with SFAS No. 144, all long-lived assets are reviewed when events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. The Company reviews assets at the lowest level for which there are identifiable cash flows, which is at the club level. The carrying amount of the club assets is compared to the expected undiscounted future cash flows to be generated by those assets over the estimated remaining useful life of the club. Cash flows are projected for each club based upon historical results and expectations. In cases where the expected future cash flows are less than the carrying amount of the assets, those clubs are considered impaired and the assets are written down to fair value. For purposes of estimating fair value, the Company has discounted the projected future cash flows of the impaired clubs at a weighted average cost of capital.
The Company has recorded total impairment losses of $38,258, $10,115 and $11,490 in the years ended December 31, 2006, 2005 and 2004, respectively.
Note 6
Insurance Proceeds
Costs incurred as a result of the Audit Committee investigation, costs of cooperating with the various government agencies investigating accounting-related matters, attorneys’ and other professional fees advanced by the Company to various current and former Company officers, directors and employees, as provided in the Company’s by-laws, subject to the undertaking of the recipients to repay the advanced fees should it ultimately be determined by a court of law that they were not entitled to be indemnified, and related class action and other
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
litigation are reflected in “General and Administrative” expenses in the Consolidated Statements of Operations. The Company received insurance payments of $2,797 and $7,270 during the years ended December 31, 2006 and 2005, respectively, for reimbursement of costs incurred in this period and in prior periods pursuant to the Company’s Director and Officer insurance policies. See Note 18.
Note 7
Goodwill and Other Intangible Assets
The Company’s intangible assets are comprised principally of goodwill, member relationships, leasehold rights and certain trademarks. Goodwill represents the excess of cost over fair value of assets of businesses acquired. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life, which consist of certain trademarks, are not amortized but instead tested for impairment at least annually.
The Company is required to test goodwill for impairment on an annual basis for each of its reporting units. The Company is also required to evaluate goodwill for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Certain indicators of potential impairment that could impact the Company’s reporting units include, but are not limited to, a significant long-term adverse change in the business climate that is expected to cause a substantial decline in membership, or a significant change in the delivery of health and fitness services that results in a substantially more cost effective method of delivery than health clubs. The Company tested to determine if the fair values of each of its reporting units were in excess of their respective carrying values at December 31, 2006, 2005 and 2004, for purposes of the annual impairment test.
As a result of the adoption of SFAS No. 142, the Company ceased amortization of goodwill in 2002 in accordance with the provisions of this standard. As stated above, the Company’s intangible assets other than goodwill consist primarily of member relationships, leasehold rights, and certain trademarks. The Company has determined member relationships and leasehold rights have finite useful lives of six and ten years, respectively, and are amortized on a straight-line basis over these useful lives. The Company also evaluates other intangible assets on an annual basis to determine if the carrying values of these assets exceed their respective fair values. This evaluation utilizes an expected cash flow technique to determine fair value. Certain acquired clubs’ estimated future cash flows were found to be insufficient to recover the carrying value of acquired intangible assets. As a result of this evaluation, the Company recorded an impairment charge against other intangible assets of $1,462, $1,220 and $209 in the years ended December 31, 2006, 2005 and 2004, respectively. This charge is reported as an element of operating expenses under the caption “Impairment of goodwill and other intangibles” in the consolidated statement of operations.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
The following table summarizes the changes in the Company’s net goodwill balance during 2006, 2005 and 2004:
The following tables summarize the December 31, 2006 and 2005 gross carrying amounts and accumulated amortization of amortizable and unamortizable intangible assets, intangible additions, intangible impairments, amortization expense for the years ended December 31, 2006, 2005 and 2004, and the estimated amortization expense for the five succeeding years:
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Note 8
Accrued Liabilities
Accrued liabilities consist of the following:
Other, at December 31, 2006, includes $15,375 relating to the sale/leaseback transaction of October 2006. This amount represents interim financing for the four properties included in this transaction. In the first quarter 2007, the Company amended this transaction and recorded the sale and subsequent leaseback transaction.
Note 9
Derivative Instruments
The Company accounts for derivative financial instruments in accordance with SFAS No. 133. This standard requires the Company to recognize all derivatives on the balance sheet at fair value. Fair value changes are recorded in income for any contracts not classified as qualifying hedging instruments. For derivatives qualifying as interest rate hedging instruments, the effective portion of the derivative fair value change must be recorded through other
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
comprehensive income, a component of stockholders’ equity (deficit). For hedges qualifying as fair value hedges, both the swap and the hedged portion of the debt are recorded in the balance sheets.
The Company entered into two interest rate swap agreements in 2003 which change the fixed-rate interest rate exposure on $200,000 of the Company’s 97/8% Senior Subordinated Notes due 2007, to variable-rate based on the six-month Eurodollar rate plus 6.01%, by entering into a receive-fixed, pay-variable interest rate swap. Under the swap, the Company receives fixed rate payments and makes variable rate payments, thereby creating variable-rate long-term debt. These swap agreements are accounted for as qualifying interest rate hedges of the future fixed-rate interest payments in accordance with SFAS No. 133, whereby changes in the fair market value are reflected as adjustments to the fair value of the derivative instrument as reflected on the accompanying consolidated balance sheets. The change in fair value of the swaps exactly offsets the change in fair value of the hedged debt, with no impact on earnings.
The fair values of the interest rate swap agreements are determined periodically by obtaining quotations from the financial institution that is the counterparty to the Company swap arrangements. The fair value represents an estimate of the net amounts that the Company would receive or pay if the agreements were transferred to another party or cancelled as of the date of the valuation. During the years ended December 31, 2006 and 2005, approximately $3,392 and $1,472, respectively, related to the swaps were reported as an addition and offset, respectively, to interest expense and represent a yield adjustment of the hedged debt obligation. The balance sheets at December 31, 2006 and 2005 reflect other long-term liabilities of $2,099 and $3,798, respectively, to reflect the fair value of the swap agreements.
Note 10
Long-Term Debt
New Facility
On October 16, 2006, the Company entered into the New Facility with a group of financial institutions led by JPMorgan, the proceeds of which were used to fully satisfy the Company’s obligations under its Credit Agreement which is discussed below. The New Facility, which amended and restated the Credit Agreement, provides (i) a term
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
loan in the amount of $205,900, (ii) a delayed-draw term loan facility in the amount of $34,100, and (iii) a revolving credit facility in the amount of $44,000. The New Facility has a termination date which is the earlier of (i) 14 days prior to the maturity of the Senior Subordinated Notes (due October 15, 2007), including extensions or refinancing, and (ii) October 1, 2010. The current termination date is October 1, 2007 and, as such, amounts outstanding under the New Facility are included in current maturities of long-term debt on the Company’s Consolidated Balance Sheet at December 31, 2006. The term loan is payable in quarterly installments of $514.75 beginning on October 31, 2007 with a final installment of $199,723 due on October 1, 2010, or any earlier termination date related to the maturity of the Senior Subordinated Notes. The delayed draw term loan is payable in a single installment on the termination date. The rate of interest on the borrowings under the New Facility is, at the Company’s option, either the reference rate (higher of the prime rate or federal funds rate plus .50%) plus a margin of 3.25% or a Eurodollar rate plus a margin of 4.25%. Commitment fees of 0.50% and 1.00% per annum are payable on the unused portion of the revolving credit facility and the undrawn portion of the delayed draw term loan, respectively. At December 31, 2006, the average rate on borrowings under the New Facility was 9.70% per annum. The proceeds from the term loan and revolving credit were used to refinance the amounts outstanding under the Company’s existing Credit Agreement and to provide additional working capital. The delayed draw term loan is available to be drawn for 18 months from October 2006 and will be used to fund capital expenditures. The amount available under the revolving credit facility is reduced by any letters of credit outstanding ($18,152 at December 31, 2006). A fee of 4.25% per annum and a fronting fee of 0.25% per annum are paid on outstanding letters of credit.
The New Facility is secured by substantially all the Company’s real and personal property, including member obligations under installment contracts. The Company’s obligations under the New Facility are guaranteed by most of its domestic subsidiaries. The New Facility contains restrictive covenants that include minimum monthly cash EBITDA and minimum monthly liquidity requirements, financial reporting requirements, and restrictions on use of funds; additional indebtedness; incurring liens; certain types of payments (including, without limitation, capital stock dividends and redemptions, payments on existing indebtedness and intercompany indebtedness); incurring or guaranteeing debt; investments; mergers, consolidations, sales and acquisitions; transactions with subsidiaries; conduct of business; sale and leaseback transactions; incurrence of judgments; and changing our fiscal year; all subject to certain exceptions. The New Facility also contains various financial reporting requirements, including an annual audit opinion, provided that the receipt of a “going concern” qualification or exception to such audit opinion does not violate the terms of the New Facility so long as the Company is otherwise in compliance with the New Facility.
The New Facility provides the Company with the ability to enter into and to retain the proceeds from permitted (i) sale/leaseback transactions of up to $25,000 and (ii) asset sales of up to $25,000 and, thereafter, 50% of incremental proceeds from permitted sale/leaseback and asset sale transactions up to $25,000. Additionally, the New Facility contains a covenant that required the Company to raise additional liquidity in the amount of $20,000 by December 31, 2006 from permitted sale/leasebacks, permitted asset sales or issuances of capital stock. Proceeds of $22,494 from sale/leaseback transactions that were completed in October and December 2006 met this requirement.
Costs incurred related to obtaining the New Facility totaled approximately $5,900. The Company expensed approximately $4,000 of these costs in the fourth quarter of 2006 and the remaining $1,900 were capitalized and will be amortized to interest expense over the term of the New Facility, which currently has a termination date of October 1, 2007. If the termination date of the New Facility is extended, the deferral period for any remaining unamortized costs will also be extended to the new termination date. Unamortized deferred financing costs relating to the Credit Agreement of approximately $3,600 were expensed in the fourth quarter of 2006 and the remaining $300 will be amortized over the term of the New Facility.
At December 31, 2006, the Company was in compliance with all covenants under the New Facility.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
On April 2, 2007, the Company failed to comply with certain financial reporting covenants under the New Facility. On April 12, 2007, the Company entered into a Forbearance Agreement with the lenders under the New Facility. Under this agreement the lenders agreed to forbear from exercising any remedies under the New Facility as a result of defaults arising from the Company’s failure to deliver audited financial statements for the fiscal year ended December 31, 2006, a certificate of KPMG LLP or other independent public accountant of national reputation certifying that such accountants have not obtained knowledge of any event or act which would constitute a default or event of default with respect to financial covenant and certain computations (the “Accountant’s Certificate”) and updated financial projections through December 2010 due to the lenders by April 2, 2007; and cross defaults arising from defaults under the indentures governing its Senior Subordinated Notes and Senior Notes due to the Company’s inability to timely file its 2006 Annual Report on Form 10-K and Quarterly Report on Form 10-Q for the quarter ending March 31, 2007 with the SEC, and the failure to make a scheduled interest payment due April 16, 2007 on the Senior Subordinated Notes. The Forbearance Agreement contains restrictions during its term on additional indebtedness, liens, investments, asset sales and sale/leasebacks. However, the Forbearance Agreement permitted the Company to sell its Canadian assets and does not prohibit sale/leaseback transactions or the sale of assets with a total value not to exceed $7,500. The Company was permitted to retain the net proceeds from the sale of its Canadian assets, and $5,000 of net proceeds from other asset sales. The Forbearance Agreement requires the Company to deliver its audited financial statements within three days of receipt, to provide a restructuring plan by June 28, 2007, to provide additional monthly reporting and waives the requirement for the Accountant’s Certificate. Furthermore, the Forbearance Agreement required that the Company enter into forbearance agreements with respect to defaults under its public indentures with the holders of at least a majority of the Senior Notes and at least 75% of the Senior Subordinated Notes, which the Company effected on May 14, 2007. The Forbearance Agreement will terminate on the earlier of July 13, 2007 or the date on which (i) a default occurs which is not a default covered by the Forbearance Agreement, (ii) any payment of principal or interest is made on the Senior Subordinated Notes, (iii) the commencement of any enforcement action under the indenture governing either the Senior Notes or Senior Subordinated Notes, including acceleration of the Senior Notes or the Senior Subordinated Notes, or (iv) upon certain challenges to the validity or enforceability of the New Facility or the Forbearance Agreement. The Company paid fees of $587 related to the Forbearance Agreement.
Credit Agreement
On October 14, 2004, the Company entered into a credit agreement (the “Credit Agreement”) with a group of financial institutions led by JP Morgan Chase Bank that amended and restated its revolving credit agreement. The Credit Agreement provided for a $175,000 term loan expiring in October 2009 and a $100,000 revolving credit facility expiring in June 2008. The term loan was payable in quarterly installments of $437.5 beginning March 31, 2005, with a final installment of $166,687.5 due on October 14, 2009. The rate of interest on borrowings under the revolving credit facility was, at the Company’s option, either the reference rate (higher of the prime rate or the federal funds rate plus 0.50%) plus a margin of 2.25% to 3.0% per annum, or a Eurodollar rate plus a margin of 3.25% to 4.0% per annum. The margins applicable to the reference rate and Eurodollar rate loans are determined by reference to a pricing matrix based on total leverage of the Company. A commitment fee of 0.75% or 0.50% per annum, based on utilization, is payable on the unused portion of the revolving credit facility. The rate of interest on the term loan was, at the Company’s option, either the reference rate plus 3.75% per annum or a Eurodollar rate plus 4.75% per annum. At December 31, 2005, the average rate on borrowings under the Credit Agreement was 9.02%. The Credit Agreement was secured by substantially all of the Company’s real and personal property, including member obligations under installment contracts. The Company’s obligations under the Credit Agreement were guaranteed by most of its domestic subsidiaries. The Credit Agreement contained restrictive covenants that included certain interest coverage and leverage ratios, and restrictions on use of funds; capital expenditures; additional indebtedness; incurring liens; certain types of payments (including without limitation, capital stock dividends and redemptions, payments on existing indebtedness and intercompany indebtedness); incurring or guaranteeing debt; investments; mergers, consolidations, sales and acquisitions; transactions with subsidiaries;
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
conduct of business; sale and leaseback transactions; incurrence of judgments; changing fiscal year; and financial reporting, and all subject to certain exceptions. The amount available under the revolving credit facility was reduced by any outstanding letters of credit ($13,605 at December 31, 2005), which were limited to $30,000. A fee of 2.25% to 3.0% per annum and a fronting fee of 0.25% were paid on outstanding letters of credit. During 2006 the Company applied proceeds of $37,386 from asset sales to repay the term loan.
The Company entered into a number of amendments, waivers and consents with its lenders under the Credit Agreement. On June 23, 2006, the Company entered into the Fourth Amendment to the Credit Agreement, which extended the 10 day period to 28 days after which a cross-default will occur upon receipt of any financial reporting covenant default notice under the indentures governing the Senior Subordinated Notes or Senior Notes for the third quarter of 2006. On March 30, 2006, the Company entered into the Third Amendment and Waiver to the Credit Agreement that modified the definition of “Consolidated Interest Expense,” modified permitted dispositions, clarified the definition of “Banking Day,” extended the time for delivering the audited financial statements for the year ended December 31, 2005 and the unaudited financial statements for the quarter ended March 31, 2006 until July 10, 2006, extended the time for delivering the unaudited financial statements for the quarter ending June 30, 2006 until September 11, 2006, with an option to elect to extend until October 11, 2006, permitted payment of the consent fees to the holders of the Senior Subordinated Notes and the Senior Notes and excluded fees and expenses incurred in connection with the consent solicitation from the computation of financial covenants. On October 17, 2005, the Company entered into a consent under the Credit Agreement which permitted entering into stockholders’ rights plans, subject to certain conditions. Effective August 9, 2005, the Company entered into a consent under the Credit Agreement to extend the 10-day cross-default period until August 31, 2005. Effective August 24, 2005, the Company amended the Credit Agreement to permit payment of consent fees to the holders of the Senior Subordinated Notes and Senior Notes, to exclude certain additional expenses from the computation of various financial covenants and to reduce the required interest coverage ratio for the period ending March 31, 2006 and to limit revolver borrowings under the Credit Agreement if the Company’s unrestricted cash exceeds certain levels. On March 31, 2005, the Company entered into the First Amendment and Waiver to the Credit Agreement that, among other things, excluded certain expenses incurred by the Company in connection with the SEC and Department of Justice investigations and other matters, from the calculation of various financial covenants, waived certain events of default related to, among other things, delivery of financial information and leasehold mortgages, reduced permitted capital expenditures, and increased financial reporting requirements.
101/2% Senior Notes
In July 2003, the Company issued $235,000 in aggregate principal of 101/2% Senior Notes due 2011 in two offerings under Rule 144A and Regulation S under the Securities Act of 1933, as amended. The Senior Notes are jointly and severally guaranteed by substantially all of the domestic subsidiaries of the Company, on an unsecured basis. Proceeds from the note issuances were used to refinance the Company’s $131,990 term loan and $56,000 outstanding on the revolving credit facility, and to repay $25,000 on the series 2001-1. As a result, the Company wrote off $1,669 of unamortized issuance costs from the extinguished debt in the third quarter of 2003. Prior to July 2006, the Company could have redeemed up to 35% of the Senior Notes at a redemption price of 110.5% with the proceeds from one or more equity offerings. Beginning in July 2007, the Senior Notes may be redeemed at the Company’s option, in whole or in part, with premiums ranging from 5.25% in 2007 to zero in 2009 and thereafter. Upon a change of control, as defined in the indenture, holders may require the Company to purchase the Senior Notes at a price of 101%. The indenture governing the Senior Notes contains certain covenants which are described below.
97/8% Senior Subordinated Notes
The 97/8% Series B Senior Subordinated Notes and the 97/8% Series D Senior Subordinated Notes mature on October 15, 2007. The Series D Notes are not subject to any sinking fund requirement but may be redeemed at the
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Company’s option, in whole or in part, with premiums ranging from 3.29% in December 2003 to zero as of October 2005 and thereafter. Upon a change of control, as defined in the indenture, holders may require the Company to purchase the Senior Subordinated Notes at a price of 101%. The payment of the Senior Subordinated Notes is subordinated to the payment in full of all senior indebtedness of the Company, as defined (approximately $458,463 at December 31, 2006).
The indentures governing the Senior Subordinated Notes and the Senior Notes contain covenants including restrictions on use of funds; additional indebtedness; incurring liens; certain types of payments (including without limitation, capital stock dividends and redemptions, payments on existing indebtedness and intercompany indebtedness); incurring or guaranteeing debt of an affiliate; capital expenditures; making certain investments; mergers, consolidations, sales and acquisitions; transactions with subsidiaries; conduct of business; sale and leaseback transactions; incurrence of judgments; changing fiscal year; and financial reporting, and all subject to certain exceptions.
The Company did not comply with its covenant obligations under the indentures governing the Senior Subordinated Notes and the Senior Notes to file its 2005 Annual Report on Form 10-K and its Quarterly Report on Form 10-Q for the three months ended March 31, 2006 with the SEC by the required filing dates. See below for descriptions of the March 2006 consent solicitation waiving for limited periods defaults so arising under the financial reporting covenant obligations and the May 2007 forbearance agreements with respect to the Company’s 2006 10-K report and first quarter 2007 10-Q report.
Consent Solicitations
The Company has entered into a number of waivers, consents and amendments to its debt, agreements primarily as a result of its failure to timely file reports with the SEC as discussed below. The fees paid for these waivers and consents are contained in the table at the end of this discussion.
As a result of the Audit Committee investigation into certain accounting issues and the retention of new independent auditors, the Company announced on August 9, 2004 that it was unable to timely file its consolidated financial statements for the quarter ending June 30, 2004 with the SEC. Although the filing delay constituted a default of the financial reporting covenants under the indentures, it did not result in an event of default until delivery to the Company of a default notice and the expiration of a 30-day cure period. On October 29, 2004, the trustee advised the Company of its intention to send the Company a notice of default no later than December 15, 2004 unless the default was cured or waived prior to that date. On December 7, 2004, the Company completed consent solicitations to amend the indentures governing its Senior Subordinated Notes and its Senior Notes to waive through July 31, 2005 any default arising under the financial reporting covenants in the indentures from a failure to timely file its consolidated financial statements with the SEC. In order to secure the waiver until July 31, 2005, the Company was required to pay additional consent fees on or before June 3, 2005 and July 6, 2005.
On July 13, 2005, the Company commenced the solicitation of consents to extend the original waivers of defaults obtained on December 7, 2004 from holders of its Senior Notes and Senior Subordinated Notes (“Noteholders”) under the indentures governing the notes. On August 4 and 5, 2005, the Company received notices of default under the indentures following the expiration of the waiver of the financial reporting covenant default on July 31, 2005. The notices commenced a 30-day cure period and a 10-day period after which a cross-default would have occurred under the Company’s Credit Agreement. Effective August 9, 2005, the Company entered into a consent with its lenders under the Credit Agreement to extend the 10-day period until August 31, 2005. On August 24 and August 30, the Company received consents from holders of a majority of its Senior Subordinated Notes and its Senior Notes, respectively, to extend the waivers until November 30, 2005. Effective August 24, 2005, the Company further amended the Credit Agreement to permit payment of consent fees to the holders of the Senior Subordinated Notes and Senior Notes, to exclude certain additional expenses from the computation of various financial covenants and to reduce the required interest coverage ratio for the period ending
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
March 31, 2006 and to limit revolver borrowings under the Credit Agreement if the Company’s unrestricted cash exceeds certain levels. On November 1, 2005, the Company completed a consent solicitation of those holders of Senior Subordinated Notes who were not party to the August 24, 2005 consent agreement.
On March 14, 2006, the Company announced that it would not meet the March 16, 2006 deadline for filing its Annual Report on Form 10-K for the year ended December 31, 2005 with the SEC. Although the delay in filing resulted in defaults of the financial reporting covenants under the indentures governing the Senior Subordinated Notes and Senior Notes, it did not constitute an event of default without delivery of a notice of default and expiration of a 30-day cure period. A cross-default under the Credit Agreement would have occurred 10 days after receipt of such notice. Additionally, a default would also have occurred under the Credit Agreement if the Company did not deliver audited financial statements for the year ended December 31, 2005 to the lenders by March 31, 2006.
On March 24, 2006, the Company announced that it would seek waivers of the defaults of the financial reporting covenants under the indentures governing the Senior Subordinated Notes and the Senior Notes through a consent solicitation, which was commenced on March 27, 2006. In connection with the consent solicitation, the Company entered into agreements with approximately 53% of the holders of the Senior Subordinated Notes to consent to the requested waivers.
On March 30, 2006, the Company entered into the Third Amendment and Waiver with the lenders under the Credit Agreement that modified the definition of “Consolidated Interest Expense,” modified permitted dispositions, clarified the definition of “Banking Day,” extended the time for delivering the audited financial statements for the year ended December 31, 2005 and the unaudited financial statements for the quarter ended March 31, 2006 until July 10, 2006, extended the time for delivering the unaudited financial statements for the quarter ending June 30, 2006 until September 11, 2006, with an option to elect to extend until October 11, 2006, permitted payment of the consent fees to the holders of the Senior Subordinated Notes and the Senior Notes and excludes fees and expenses incurred in connection with the consent solicitation from the computation of financial covenants.
On April 10, 2006, the Company completed the consent solicitations to amend the indentures governing the Senior Subordinated Notes and the Senior Notes to waive any default arising under the financial reporting covenants from a failure to timely file financial statements with the SEC for the year ended December 31, 2005 and the quarter ended March 31, 2006 through July 10, 2006, and for the quarter ended June 30, 2006 through September 11, 2006, with an option to elect to extend through October 11, 2006.
On June 23, 2006, the Company entered into the Fourth Amendment to the Credit Agreement, which extended the 10 day period to 28 days after which a cross-default will occur upon receipt of any financial reporting covenant default notice under the indentures governing the Senior Subordinated Notes or Senior Notes for the third quarter of 2006.
Additionally, on April 11, 2006, the Company entered into stock purchase agreements (the “Stock Purchase Agreements”) to sell 400,000 shares of unregistered common stock to each of Wattles Capital Management, LLC and investment funds affiliated with Ramius Capital Group, L.L.C. Proceeds of $5,600 from the sales of Common Stock were used to fund: (i) the cash portion of the consent fees paid to holders of the Senior Subordinated Notes and Senior Notes and related expenses; (ii) fees and expenses relating to the Credit Agreement amendment and waiver; and (iii) additional working capital.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
The table below provides a summary of these waivers and associated fees.
Notes
1 Extend cross default period
2 Failure to timely file reports with the SEC
3 Potential covenant default
Noteholder Forbearance Agreements
On March 15, 2007, the Company announced that it would not meet the March 16, 2007 deadline for filing its Annual Report on Form 10-K for the year ended December 31, 2006. Although the delay in filing resulted in defaults of the financial reporting covenants under the indentures governing the Senior Notes and the Senior Subordinated Notes, it did not constitute an event of default without delivery of notice and the expiration of a 30-day grace period. Pursuant to the New Facility a cross-default occurs 28 days from the delivery of such notice. On April 16, 2007, the Company did not make the $14,812 interest payment due on its Senior Subordinated Notes.
On May 14, 2007, the Company entered into the Senior Notes Forbearance Agreement with holders representing over 80% of the aggregate principal amount outstanding of the Senior Notes. Pursuant to the Senior Notes Forbearance Agreement, holders of the Senior Notes waived defaults arising from the Company’s failure to (i) timely file its 2006 Annual Report on Form 10-K and Quarterly Report on Form 10-Q for the quarter ending March 31, 2007 with the SEC, (ii) make a scheduled interest payment on the Senior Subordinated Notes due April 16, 2007, (iii) provide the required notices of default to the trustee, and (iv) potential failure to satisfy conditions regarding the execution of sale and leaseback transactions, and agreed to forbear from exercising any
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
related remedies until July 13, 2007. Holders of the Senior Notes also consented to amend certain provisions of the Senior Notes Indenture in connection with the waiver of the defaults. The Company paid cash consent fees of $279 to holders of the Senior Notes that executed the Senior Note Forbearance Agreement and consented to the related amendments to the Senior Notes Indenture.
On May 14, 2007, the Company also entered into the Senior Subordinated Notes Forbearance Agreement with holders representing over 80% of the aggregate principal amount outstanding of the Senior Subordinated Notes. Pursuant to the Senior Subordinated Notes Forbearance Agreement, holders of the Senior Subordinated Notes waived defaults arising from the Company’s failure to (i) make the scheduled interest payment on the Senior Subordinated Notes due April 16, 2007, (ii) timely file its 2006 Annual Report on Form 10-K and Quarterly Report on Form 10-Q for the quarter ending March 31, 2007 with the SEC, (iii) provide the required notices of default to the trustee, and (iv) potential failure to satisfy conditions regarding the execution of sale and leaseback transactions, and agreed to forbear from exercising any related remedies until July 13, 2007. Holders of the Senior Subordinated Notes also consented to amend certain provisions of the Senior Subordinated Notes Indenture in connection with the waiver of the defaults. The Company did not pay a consent fee to holders of the Senior Subordinated Notes in connection with the Senior Subordinated Notes Forbearance Agreement.
On May 22, 2007, the Company entered into a Senior Notes Supplemental Indenture and a Senior Subordinated Notes Supplemental Indenture with the Trustee, which amended the Senior Notes Indenture and the Senior Subordinated Notes Indenture, respectively. The Supplemental Indentures were entered into in connection with the successful completion of the Forbearance Agreements.
Other Secured Debt
As of December 31, 2006 and 2005, the Company’s unrestricted Canadian subsidiary was not in compliance with the terms of its credit agreement. As a result, the outstanding amounts of $197 and $2,428 as of December 31, 2006 and 2005, respectively, have been classified as current as of such date. The amount outstanding on the Canadian subsidiary’s credit agreement was repaid in full on January 31, 2007.
The Company was not in compliance with the financial reporting covenants under two mortgage agreements which required the provision of audited 2006 consolidated financial statements by March 31, 2007 and April 15, 2007. At May 31, 2007, the amount outstanding under these agreements was $2,083. Upon filing this Form 10-K, the Company will be in compliance with these agreements.
Capital Leases
The Company leases certain equipment under capital leases expiring in periods ranging from one to five years. Included in “Property and Equipment” at December 31, 2006 and 2005 were assets under capital leases of $7,549 and $9,860, respectively, net of accumulated amortization of $11,611 and $29,556, respectively. The Company was not in compliance with the financial reporting covenants which required the provision of audited 2006 consolidated financial statements by April 15, 2007 under capital leases with amounts outstanding at May 31, 2007 of $3,374. Upon filing this Form 10-K, the Company will be in compliance with these agreements.
Liquidity
The Company requires operating cash flows to fund its capital spending and working capital requirements. We maintain a substantial amount of debt, the terms of which require significant interest payments each year. We are unsure that our cash flow and availability under our revolving credit facility and delayed draw term loan will be sufficient to meet our expected needs for working capital and other cash requirements in 2007. In light of our current financial situation, the Company did not make the $14,812 interest payment due on the Senior Subordinated Notes in April 2007. Further, as discussed below, the Company will not have sufficient liquidity in the event that it is
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
unable to refinance or extend the maturity of $300,000 of debt outstanding under the Senior Subordinated Notes issue and as a result the New Facility terminates on October 1, 2007. The Company’s cash flows and liquidity may, however, be negatively impacted by various items, including declines in membership revenues, changes in terms or other requirements by vendors, regulatory fines, penalties, settlements or adverse results in securities or other litigations, future consent payments to lenders or noteholders if required and unexpected capital requirements. The Company has substantial interest payments due on its Senior Notes in July 2007 and interest and principal on the Senior Subordinated Notes in October 2007 and it has been required to provide additional letters of credit and cash deposits to support certain vendors, credit card payment processing and insurance programs, which has reduced available liquidity under the revolving credit facility. Accordingly, no assurances can be provided that the Company will have sufficient liquidity to meet all known and unforeseen requirements.
On October 1, 2007, the New Facility will terminate in the event that the Senior Subordinated Notes have not been extended or refinanced. If this occurs, the Company will not have access to its revolving credit and delayed draw term loan facilities and amounts outstanding under the New Facility will become due. Furthermore, pursuant to the New Facility the Company’s depository accounts are subject to control agreements, and in the event of a default, its lenders could exercise their rights under these agreements. Absent an agreement by the lenders to extend the maturity of the New Facility, the Company will not have sufficient liquidity to operate its business and will be unable to satisfy the New Facility obligations when due. If such events were to occur, the holders of the Senior Notes and the Senior Subordinated Notes could accelerate the obligations under those instruments, and the Company would be unable to satisfy those obligations.
Maturities of long-term debt and future minimum payments under capital leases, together with the present value of future minimum rentals as of December 31, 2006, are as follows:
The above maturities present amounts under the New Facility as due in 2007, pursuant to the early termination provisions related to the refinancing of the Senior Subordinated Notes.
Note 11
Deferred Revenue
Deferred revenue represents cash received from members, but not yet earned. The summary set forth below of the activity and balances in deferred revenue at December 31, 2005 and 2006 and for the years then ended includes as cash additions all cash received for membership services. Revenue recognized includes all revenue earned during the periods from membership services. Financed members are those members who have financed their initial membership fee to be paid monthly. Advanced payments from financed members are included within this table as advanced payments of periodic dues and membership fees.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
The Company estimates membership term for contracts originated during each month. Each quarter it updates its estimate of membership term for each individual monthly origination group to take into account attrition experience specific to that group. As monthly sales originations mature, each quarter it monitors the specific attrition of each group and makes adjustments to the estimated membership term. During the first three years of multi-year value plan financed memberships, it closely monitors collection history and changes the estimates of membership term based on this experience. During the renewal term, the Company monitors membership term by reviewing actual membership term experience in each membership term group. In the fourth quarter of 2006, as a result of a change in estimate as to membership term length based on the most recent historical experience, the Company recorded a decrease in deferred revenue of $71,022 and increased revenue recognized by the same amount (with a consequent increase in income from continuing operations and net income of $71,022 and income per common share of $1.78).
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Note 12
Stockholders’ Deficit
Preferred Stock: The Company is authorized to issue 10,000,000 shares, $.10 par value, of preferred stock in one or more series and to designate the rights, preferences, limitations, and restrictions of and upon shares of each series, including voting, redemption, and conversion rights. 100,000 shares of Series B Junior Participating Preferred Stock have been authorized; no shares are issued or outstanding.
On October 18, 2005, the Company’s Board of Directors adopted a Stockholder Rights Plan (“Rights Plan”), authorized a new class of and issuance of up to 100,000 shares of Series B Junior Participating Preferred Stock, and declared a dividend of one preferred share purchase right (the “Right”) for each share of Common Stock held of record at the close of business on October 31, 2005. Each Right, if and when exercisable, entitled its holder to purchase one one-thousandth of a share of Series B Junior Participating Preferred Stock at a price of $13.00 per one one-thousandth of a Preferred Share subject to certain anti-dilution adjustments.
The Rights Plan provided that the Rights became exercisable only after a triggering event, including a person or group acquiring 15% or more of the Company’s Common Stock. The Company’s Board of Directors was entitled to redeem the Rights for $0.001 per Right at any time prior to a person acquiring 15% or more of the outstanding Common Stock. The Rights Plan terminated pursuant to its terms on July 15, 2006.
Common Stock: The Company is authorized to issue 60,200,000 shares of Common Stock, $.01 par value. Each share of Common Stock is entitled to one vote per share. At December 31, 2006, 3,867,201 shares of Common Stock were reserved for future issuance; 735,701 shares in connection with outstanding warrants and 3,131,500 shares in connection with certain stock plans.
Restrictions on Net Assets: The Company’s ability to meet its future financial obligations is dependent on the availability of cash flows from its subsidiaries. As further described in Note 10, the Company’s subsidiaries are subject to contractual restrictions that limit their ability to, among other things, incur additional indebtedness, pay dividends or other distributions on or redeem or repurchase their capital stock, make investments, enter into transactions with affiliates, issue stock, engage in unrelated lines of business, create liens to secure debt, and transfer or sell assets or merge with other companies. As a result, substantially all of the net assets of the Company’s subsidiaries were restricted at December 31, 2006.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Note 13
Income Taxes
The income tax provision applicable to income (loss) from continuing operations before income taxes consists of the following:
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial accounting and income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2006 and 2005, along with their classification, are as follows:
At December 31, 2006, the Company has estimated federal Alternative Minimum Tax (“AMT”) credits and tax loss carryforwards of $5,896 and $791,868, respectively. The AMT credits can be carried forward indefinitely, while the tax loss carryforwards expire beginning in 2011 through 2026. In addition, the Company has substantial state tax loss carryforwards that began to expire in 2005 and fully expire through 2026. On September 28, 2005, the Company underwent an ownership change for purposes of IRC Section 382. Due to the ownership change that occurred, the utilization of the Company’s federal tax loss carryforwards is subject to an annual limitation under Section 382, which will significantly limit their use. The amount of the limitation may, under certain circumstances, be increased by built-in gains held by the Company at the time of the change that are recognized in the five-year period after the ownership change. Depending upon how the pending restructuring is accomplished, certain federal and state tax loss and AMT credit carryforwards could be severely limited and may not be fully utilizable by the Company.
Based upon the Company’s past performance, the expiration dates of its carryforwards, and the change in ownership under IRC Section 382, the ultimate realization of all of the Company’s deferred tax assets cannot be assured. Accordingly, a valuation allowance has been recorded to reduce deferred tax assets to a level which, more
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
likely than not, will be realized. Included in the deferred tax asset and valuation allowance is $7,037 resulting from the exercise of stock options and the Company-sponsored stock purchase plan. The related benefit will be included as additional paid-in capital when realized. Also included in the deferred tax asset and valuation allowance is $795 resulting from loss carryovers acquired. The related benefit will be credited to goodwill when realized.
A reconciliation of the income tax provision with amounts determined by applying the U.S. statutory tax rate to income (loss) from continuing operations before income taxes is as follows:
In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109”. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company is currently evaluating the impact FIN 48 will have on its financial condition and results of operations. FIN 48 is effective for public companies for annual periods that begin after December 15, 2006.
Note 14
Warrants and Stock Transactions
The Company issued warrants in 1996, which as of December 31, 2006 were held by the former Chairman of the Board of Directors, President and Chief Executive Officer of the Company, Lee Hillman, entitling him to acquire 735,701 shares of Common Stock at an exercise price of $5.26 per share, subject to possible reduction of the exercise price by a maximum of $1.00 per share based on the closing price of Common Stock on the day immediately prior to exercise of the warrant. The warrants expire on December 31, 2007.
Note 15
Share-based Payments
In December 2004 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R is a revision of SFAS No. 123, “Accounting for Stock-based Compensation,” (“SFAS No. 123”) and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and its related implementation guidance. SFAS No. 123R primarily focuses on accounting for transactions in which an entity obtains employee services in share-based payment transactions and requires entities to recognize compensation expense from all share-based payment transactions in the financial statements. SFAS No. 123R establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all companies to apply a fair-value-based measurement method in accounting for all share-based payment transactions with employees.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
The Company adopted SFAS No. 123R on January 1, 2006 using the modified prospective method. Accordingly, prior period amounts have not been restated. Under this method, the Company must record compensation expense for all awards granted after the adoption date and for the unvested portion of previously granted awards that remain outstanding at the adoption date, under the fair value method. The Company has elected to recognize compensation expense on a straight-line basis over the vesting period of the award. Total stock-based compensation expense for the year ended December 31, 2006 was $5,022, which is comprised of $2,095 related to stock options, $2,546 related to restricted shares, and $381 related to estimated income tax obligations which are liability classified.
Pursuant to the terms of restricted stock grants to Mr. Landeck (former Chief Financial Officer), Mr. Toback (former Chairman, President and Chief Executive Officer) and Mr. Gaan (former Senior Vice President), remaining unrecognized compensation cost of $345 on 55,000 shares, $788 on 135,000 shares and $222 on 40,000 shares was recognized at the dates of their terminations in April, August and September 2006, respectively. In addition, pursuant to the separation agreement for Mr. Toback, the Company accelerated the vesting on approximately 332,000 options granted to Mr. Toback in 2003 and 2005 and recognized the remaining unrecognized compensation cost of $370 in August 2006.
Prior to the adoption of SFAS No. 123R, the Company accounted for its stock-based awards using the intrinsic value method in accordance with APB 25, and recognized no compensation costs for its stock plans other than for its restricted stock awards. Specifically, the adoption of SFAS No. 123R resulted in the recording of compensation expense for employee stock options. The following table shows the effect of adopting SFAS No. 123R on selected items (“As Reported”) and what those items would have been under previous guidance under APB 25:
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
The following table illustrates the pro forma effect on net loss attributable to common stockholders if the fair value-based method had been applied to all outstanding and unvested awards in each period:
Stock-based Compensation Plans
In January 1996, the Board of Directors of the Company adopted the 1996 Non-Employee Directors’ Stock Option Plan (the “Directors’ Plan”). The Directors’ Plan provided for the grant of non-qualified stock options to non-employee directors of the Company. Options under the Directors’ Plan were generally granted with an exercise price equal to the fair market value of the Common Stock at the day prior to the date of grant. Option grants under the Directors’ Plan became exercisable in three equal annual installments commencing one year from the date of grant and had a 10-year term. The Directors’ Plan expired as of January 3, 2006. As such, stock options may no longer be granted under the Directors’ Plan.
Also in January 1996, the Board of Directors of the Company adopted the 1996 Long-Term Incentive Plan (the “Incentive Plan”). The Incentive Plan provided for the grant of non-qualified stock options, incentive stock options and compensatory restricted stock awards (collectively “Awards”) to officers and key employees of the Company. Pursuant to the Incentive Plan, non-qualified stock options were generally granted with an exercise price equal to the fair market value of the Common Stock on the day prior to the date of grant. Incentive stock options could not be granted at less than the fair market value of the Common Stock on the date of grant. Option grants become exercisable generally in three equal annual installments commencing one year from the date of grant. Option grants in 2005, 2004 and 2003 have 10-year terms. The Incentive Plan expired as of January 3, 2006. As such, awards may no longer be granted under the Incentive Plan.
On March 8, 2005, the Company adopted the Inducement Award Equity Incentive Plan (the “Inducement Plan”) as a means of providing equity compensation in order to induce individuals to become employed by the Company. The Inducement Plan provides for the issuance of up to 600,000 shares of the Company’s Common Stock in the form of stock options and restricted shares, subject to various restrictions. Pursuant to the Inducement Plan, non-qualified stock options are generally granted with an exercise price equal to the fair market value of the Common Stock on the day prior to the date of grant. Inducement stock options must be granted at not less than the fair market value of the Common Stock on the date of grant. Options are granted at the discretion of the Compensation Committee of the Board of Directors (the “Compensation Committee”). Option grants become exercisable generally in three equal annual installments commencing one year from the date of grant and have 10-year terms. As of December 31, 2006, 131,500 shares remain available for issuance under the Inducement Plan.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Certain employment arrangements contain provisions that provide for the payment to the participant of amounts which represent estimated income tax obligations related to the vesting of awards. The amounts related to the estimated income tax obligations are liability classified awards.
On December 19, 2006, the Company’s stockholders approved the adoption of the 2007 Omnibus Equity Compensation Plan (the “2007 Plan”), which was previously approved by the Board. The 2007 Plan provides for the issuance of a maximum of 3,000,000 shares of common stock in connection with the grant of stock options, stock units, stock awards, dividend equivalents and other stock-based awards to the Company’s employees, non-employee directors and employees of the Company’s subsidiaries. The exercise price of stock options may be equal to or greater than the fair market value of the Company’s common stock on the date of grant. The Compensation Committee will determine the criteria for exercisability option grants and each grant will have a 10-year term. The 2007 Plan will expire on December 19, 2016.
Stock Options
A summary of stock based compensation activity within the Company’s stock-based compensation plans for the year ended December 31, 2006 is as follows:
Other information pertaining to option activity during the years ended December 31, 2006, 2005 and 2004 was as follows:
The Company received $277 of cash from stock options exercised during the year ended December 31, 2006. At December 31, 2006, there was approximately $1,061 of total unrecognized compensation cost related to non-vested stock options. This cost will be recognized over a weighted average period of 1.7 years.
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
The fair value of each option granted is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
For 2006, the expected life of each award granted was calculated using historical experience. Expected volatility was based on historical volatility levels of the Company’s common stock. The risk-free interest rate is based on the implied yield currently available on U.S. Treasury strip rates with a remaining term equal to the expected term. Expected dividend yield is based on historical dividend payments.
Restricted Stock
The Company also grants restricted stock awards to certain employees. Restricted stock awards are valued at the closing market value of the Company’s common stock on the day prior to the grant, and the total value of the award is recognized as expense ratably over the vesting period of the employees receiving the grants. The Company did not grant restricted stock awards in 2006.
A summary of restricted stock activity for the year ended December 31, 2006 is as follows:
Pursuant to the Incentive Plan and the Inducement Plan, restricted stock awards are rights granted to an employee to receive shares of stock without payment but subject to forfeiture and other restrictions as set forth in the Incentive Plan or the Inducement Plan, as applicable. Generally, the restricted stock awarded, and the right to vote such stock or to receive dividends thereon, may not be sold, exchanged or otherwise disposed of during the restricted period. Except as otherwise determined by the Compensation Committee, the restrictions and risks of forfeiture generally lapse four years after the date of grant.
The restrictions on the shares issued in 2002 lapse upon a change in control of the Company (defined as an Acquiring Person becoming the Beneficial Owner of Shares representing 10% or more of the combined voting power of the then outstanding shares other than in a transaction or series of transactions approved by the Company’s Board of Directors), the employee’s death, termination of employment due to disability or the first date prior to December 31, 2005 which follows seven consecutive trading days on which the trading price equals or exceeds the targeted stock price of $42 per share. The weighted average fair value of the 2002 grant cannot be determined due to its variable nature. The restrictions on the shares issued in 2003 lapse four years after the date of issuance, upon a change in control of the Company (as previously defined), the employee’s death or termination of employment other than for cause. Vesting on the shares issued in 2003 can accelerate based on the attainment of certain performance goals. The Company is recognizing compensation expense on these shares over the four-year vesting
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
period. In addition, 100,000 shares were granted in 2003 to Paul A. Toback with restrictions that lapse upon a change in control of the Company, his death or termination of employment due to disability. The weighted average fair value of this grant cannot be determined due to the variable nature of the grant. Upon the resignation of the Company’s former Chief Financial Officer in April 2004, the Company recognized $465 of additional compensation expense relating to the conversion of 100,000 shares of restricted stock at a market price of $6.03 per share. In the eleven month period prior to the resignation, $138 of compensation expense was recognized on the shares which converted.
On May 4, 2005, 1,320,500 shares of restricted stock became vested under the terms of the 1996 Long-Term Incentive Plan’s change in control provision, which provides for accelerated vesting in the event of a change in control. For these purposes, a change in control is defined as an Acquiring Person becoming the Beneficial Owner of Shares representing 10% or more of the combined voting power of the then outstanding shares other than in a transaction or series of transactions approved by the Company’s Board of Directors. The acquisition on May 4, 2005 of the Company’s Common Stock by Liberation Investment Group LLC, Liberation Investments, Ltd., Liberation Investments, L.P. and Emanuel R. Pearlman constituted such a change in control. Accordingly, 808,000 shares of restricted stock subject to four-year cliff vesting conditions and 512,500 shares of restricted stock subject to certain performance-based conditions lapsed. In connection with this event, $2,201 of unearned compensation was reported as general and administrative expense in the three-month period ended June 30, 2005 which related to the time-based restricted shares, and $1,609 in compensation was reported as general and administrative expense in the three-month period ended June 30, 2005 which related to the performance-based restricted shares. Existing employment agreements with certain executives contain tax consequence gross-up provisions the effects of which resulted in $977 in compensation reported as general and administrative expense in the three-months ended June 30, 2005.
As of December 31, 2005, 385,000 restricted shares and stock options covering an additional 153,000 shares have been granted under the Inducement Plan. 330,000 shares of restricted stock became vested in May and September 2005 under the terms of the Inducement Plan’s change in control provision, which provides for accelerated vesting in the event of a change in control. For these purposes, a change in control was defined as an Acquiring Person becoming the Beneficial Owner of Shares representing 10% or more of the combined voting power of the then-outstanding shares other than in a transaction or series of transactions approved by the Company’s Board of Directors. The acquisition on May 4, 2005 of the Company’s Common Stock by Liberation Investment Group LLC, Liberation Investments, Ltd., Liberation Investments, L.P. and Emanuel R. Pearlman and on September 6, 2005 by Pardus Capital Management L.P. constituted such a change in control. In the three-month periods ended June 30, 2005 and September 30, 2005, $397 and $618 respectively, in compensation was reported as general and administrative expense, related to these time-based awards.
Stock Issued for Services
The Company issued 11,936 shares of its common stock to its tabulation agent for their services in connection with the Company’s consent solicitation. The shares were valued as of the agreement date and the Company has recorded general and administrative expense of $98 for this transaction.
Note 16
Defined Contribution Plan
The Company has sponsored several defined contribution plans, including a 401(k), that provides retirement benefits for certain full-time employees. Eligible employees elect to participate by contributing a percentage of their pre-tax earnings to the plans. Employee contributions to the plans, up to certain limits, are matched in various percentages by the Company. The Company’s matching contributions related to the plans totaled $730, $827 and $862 for 2006, 2005 and 2004, respectively. In the third quarter of 2004, the Company terminated the Management
BALLY TOTAL FITNESS HOLDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(All dollar amounts in thousands, except share data)
Retirement Savings Plan (“MRSP”), a non-qualified deferred compensation plan (“rabbi trust”), and paid out the entire amount to the key employees who participated in the plan.
Note 17
Related Party Transactions
The Company has regular transactions in the normal course of business for fitness equipment and services with two companies that employ relatives of John Wildman, Senior Vice President and Chief Operating Officer. During 2006 and 2005, the Company paid $8,038 and $6,688 to those companies, respectively, for providing such goods and services.
In 2006, the Board of Directors named Ronald G. Eidell as Senior Vice President and Chief Financial Officer and principal financial officer of the Company and Michael L. Goldberg as Vice President, Corporate Controller. Mr. Eidell and Mr. Goldberg are also partners of Tatum LLC, a financial and accounting services provider. The Company has also utilized the services of several partners and associates of Tatum LLC, to manage and assist in certain projects related to accelerating the accounting close process and remediation of material internal control weaknesses. The Company paid Tatum LLC an aggregate of $987 in 2006.
Note 18
Commitments and Contingencies
Operating leases. The Company leases various fitness center facilities, office facilities, and equipment under operating leases expiring in periods ranging from one to 25 years, excluding optional renewal periods. Certain leases contain contingent rental provisions generally related to cost-of-living criteria or revenues of the respective fitness centers. Rent expense under operating leases was $126,470, $126,444 and $124,600 for 2006, 2005 and 2004, respectively.
Minimum future rent payments under long-term noncancellable operating leases in effect as of December 31, 2006, exclusive of taxes, insurance, other expenses payable directly by the Company and contingent rent, are $141,226, $132,178, $117,919, $105,152 and $94,609 for 2007 through 2011, respectively, and $417,130 thereafter.
In connection with the Company’s January 2006 sale of its “Crunch Fitness” brand along with certain additional health clubs located in San Francisco, California, the Company and/or certain of its subsidiaries remain liable for the obligations on certain leases transferred to the purchaser in the amount of $80,679. The amount of foregoing contingent liabilities will reduce over time as obligations are paid by the purchaser under these leases. However, certain of the leases possess renewal options which, if exercised by the purchaser, will again increase the amount of liability of the Company and/or certain of its subsidiaries under such lease existing as of the date of such exercise by purchaser but for no more than the obligations for a 5 year period under any such lease. The Company’s exposure for these retained contingent liabilities is mitigated by two letters of credit naming the Company as beneficiary, aggregating $3,228 and having a term equal to the longer of three years or the time the purchaser has a Debt to EBITDA Ratio of less than 3 to 1. The Company has recorded a liability on its balance sheet for the estimated fair value of these retained liabilities in the amount of $600.
Capital leases. Under the terms of an agreement with the landlord, the Company is obligated to purchase at the landlord’s option the leased premises at the Greenwood, Indiana location for a predetermined amount of $5,099 at any time during a ten-year period ending July 2009. The Company has included this contingent liability under capital leases.
Litigation:
Putative Securities Class Actions
Between May and July 2004, ten putative securities class actions, now consolidated and designated In re Bally Total Fitness Securities Litigation were filed in the United States District Court for the Northern District of Illinois
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against the Company and certain of its former and current officers and directors. Each of these substantially similar lawsuits alleged that the defendants violated Sections 10(b) and/or 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as well as the associated Rule 10b-5, in connection with the Company’s proposed restatement.
On March 15, 2005, the Court appointed a lead plaintiff and on May 23, 2005 the Court appointed lead plaintiff’s counsel. By stipulation of the parties, the consolidated lawsuit was stayed pending restatement of the Company’s financial statements in November 2005. On December 30, 2005, plaintiffs filed an amended consolidated complaint, asserting claims on behalf of a putative class of persons who purchased Bally stock between August 3, 1999 and April 28, 2004, and adding the Company’s former outside audit firm, Ernst & Young LLP as an additional defendant. On July 12, 2006, the Court granted defendants’ motions to dismiss the amended consolidated complaint and dismissed the complaint in its entirety, without prejudice to plaintiffs filing an amended complaint on or before August 14, 2006. An amended complaint was filed on August 14, 2006. Defendants filed motions to dismiss the amended complaint on September 28, 2006. On February 20, 2007 the Court issued a Memorandum Opinion and Order dismissing claims against all defendants with prejudice. Plaintiffs filed a Notice of Appeal on March 23, 2007. On April 18, 2007, the Court granted Plaintiff’s unopposed Motion to Suspend Briefing, suspending briefing pending a ruling by the United States Supreme Court regarding the Seventh Circuit’s standard for pleading scienter in Makor Issues & Rights v. Tellabs and directing the parties to file position statements within 14 days of the issuance of the Supreme Court’s decision. The Supreme Court’s decision was issued on June 21, 2007. It is not yet possible to determine the ultimate outcome of this action.
Stockholder Derivative Lawsuits in Illinois State Court
On June 8, 2004, two stockholder derivative lawsuits were filed in the Circuit Court of Cook County, Illinois, by two Bally stockholders, David Schacter and James Berra, purportedly on behalf of the Company against Paul Toback, James McAnally, John Rogers, Jr., Lee Hillman, John Dwyer, J. Kenneth Looloian, Stephen Swid, George Aronoff, Martin Franklin and Liza Walsh, who are former officers and/or directors. These lawsuits allege claims for breaches of fiduciary duty against those individuals in connection with the Company’s restatement regarding the timing of recognition of prepaid dues. The two actions were consolidated on January 12, 2005. By stipulation of the parties, the consolidated lawsuit was stayed pending restatement of the Company’s financial statements in November 2005. An amended consolidated complaint was filed on February 27, 2006. The Company filed a motion to dismiss on May 20, 2006, directed solely to the issue of whether plaintiffs have adequately alleged demand futility as required by applicable Delaware law in order to establish standing to sue derivatively. Shortly before oral argument on that motion, the parties executed a Memorandum of Understanding memorializing a settlement in principle of all claims. On May 18, 2007, the Court entered a Preliminary Order provisionally approving the Stipulation of Settlement subject to notice and a hearing on June 19, 2007. On June 19, 2007, the Court entered a final order approving the parties’ settlement and dismissing the action with prejudice.
Stockholder Derivative Lawsuits in Illinois Federal Court
On April 5, 2005, a stockholder derivative lawsuit was filed in the United States District Court for the Northern District of Illinois, purportedly on behalf of the Company against certain former officers and directors of the Company by another of the Company’s stockholders, Albert Said. This lawsuit asserts claims for breaches of fiduciary duty in failing to supervise properly its financial and corporate affairs and accounting practices. Plaintiff also requests restitution and disgorgement of bonuses and trading proceeds under Delaware law and the Sarbanes-Oxley Act of 2002. By stipulation of the parties, the lawsuit was stayed pending restatement of the Company’s financial statements In November 2005. An amended consolidated complaint was filed on February 27, 2006. Bally filed a motion to dismiss on May 30, 2006, directed solely to the issues of whether the court has subject matter jurisdiction and whether plaintiffs have adequately alleged demand futility as required by applicable Delaware law in order to establish standing to sue derivatively. On March 27, 2007, the Court entered an order indicating its
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intention to convert the Company’s motion to a motion for summary judgment and requiring the Company to file a new motion and brief, which the Company did on April 13, 2007. That motion is currently pending. On June 18, 2007, the Company and plaintiffs reached an agreement in principle to resolve the action. It is not yet possible to determine the ultimate outcome of this action.
Individual Securities Action in Illinois
On March 15, 2006, a lawsuit captioned Levine v. Bally Total Fitness Holding Corporation, et al., Case No. 06 C 1437 was filed in the United States District Court for the Northern District of Illinois against the Company, certain of its former officers and directors, and its former outside audit firm, Ernst & Young, LLP. Plaintiff’s complaint alleged violations of Sections 10(b), 18 and 20(a) of the Exchange Act, SEC Rule 10b-5, and the Illinois Consumer Fraud and Deceptive Practices Act, as well common law fraud in connection with the Company’s restatement. The Court found this action related to the consolidated securities class action discussed above, and transferred it to the judge before whom the class action cases were pending. After defendants filed motions to dismiss the complaint and after the Court granted motions to dismiss the class action cases, plaintiff moved for leave to amend its complaint. On July 19, 2006, the Court denied plaintiff’s motion and ordered completion of briefings on defendant’s motions to dismiss on statute of limitations issues. On September 29, 2006, the Court granted defendant’s motion to dismiss plaintiff’s Section 18 claim as untimely, denied the motion as to Sections 10(b) and 20(a), dismissed Ernst & Young, LLP as a defendant and granted plaintiff leave to amend his complaint. An amended complaint was filed on November 3, 2006. The Company filed a motion to dismiss the amended complaint on January 5, 2007. On April 2, 2007, the Court granted the Company’s motion and dismissed the case with prejudice. Plaintiff did not file a timely Notice of Appeal of this dismissal, but instead filed a new action in the Circuit Court of Cook County, Illinois, Case No. 07 L 4280, asserting only claims for common law fraud and under the Illinois Consumer Fraud and Deceptive Practices Act. The Company has not yet answered the complaint. It is not yet possible to determine the ultimate outcome of this action.
Lawsuit in Oregon
On September 17, 2004, a lawsuit captioned Jack Garrison and Deane Garrison v. Bally Total Fitness Holding Corporation, Lee S. Hillman and John W. Dwyer, CV 04 1331, was filed in the United States District Court for the District of Oregon. The plaintiffs alleged that the defendants violated certain provisions of the Oregon Securities Act, breached the contract of sale, and committed common-law fraud in connection with the acquisition of the plaintiffs’ business in exchange for shares of Bally stock.
On April 7, 2005, all defendants joined in a motion to dismiss two of the four counts of plaintiffs’ complaint, including plaintiffs’ claims of breach of contract and fraud. On November 28, 2005, the District Court granted the motion to dismiss plaintiffs’ claims for breach of contract and fraud against all parties. Motions for summary judgment were filed on April 21, 2006. On July 27, 2006, the presiding Magistrate Judge issued proposed Findings and Conclusions recommending that summary judgment be entered in favor of all defendants on all remaining claims. The parties thereafter reached agreement under which plaintiffs would dismiss their case without appealing the Magistrate Judge’s recommendation. The parties executed a final Settlement Agreement on October 16, 2006, and final judgment dismissing the action with prejudice was entered on November 26, 2006.
Lawsuit in Massachusetts
On March 11, 2005, plaintiffs filed a complaint in the matter of Fit Tech Inc., et al. v. Bally Total Fitness Holding Corporation, et al., Case No. 05-CV-10471 MEL, pending in the United States District Court for the District of Massachusetts. This action is related to an earlier action brought in 2003 by the same plaintiffs in the same court alleging breach of contract and violation of certain earn-out provisions of an agreement whereby the Company acquired certain fitness centers from plaintiffs in return for shares of Bally stock. The 2005 complaint
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asserted new claims against the Company for violation of state and federal securities laws on the basis of allegations that misrepresentations in Bally’s financial statements resulted in Bally’s stock price to be artificially inflated at the time of the Fit-Tech transaction. Plaintiffs also asserted additional claims for breach of contract and common law claims. Certain employment disputes between the parties to this litigation are also subject to arbitration in Chicago.
Plaintiffs’ claims are brought against the Company and its former Chairman and CEO Paul Toback, as well as former Chairman and CEO Lee Hillman and former CFO John Dwyer. Plaintiffs have voluntarily dismissed all claims under the federal securities laws, leaving breach of contract, common law and state securities claims pending. On April 4, 2006, the Court granted motions to dismiss all claims against defendants Hillman and Dwyer for lack of jurisdiction. All remaining claims were dismissed with prejudice pursuant to a confidential stipulation of settlement, which was filed on November 3, 2006.
Securities and Exchange Commission Investigation
In April 2004, the Division of Enforcement of the SEC commenced an investigation in connection with the Company’s restatement. The Company continues to fully cooperate in the ongoing SEC investigation. It is not yet possible to determine the ultimate outcome of this investigation.
Department of Justice Investigation
In February 2005, the United States Justice Department commenced a criminal investigation in connection with the Company’s restatement. The investigation is being conducted by the United States Attorney for the Northern District of Illinois. The Company is fully cooperating with the investigation. It is not yet possible to determine the ultimate outcome of this investigation.
Demand Letters
On December 27, 2004, the Company received a stockholder demand that it bring actions or seek other remedies against parties potentially responsible for the Company’s accounting errors. The Board appointed a Special Demand Evaluation Committee consisting of three independent directors to evaluate that request. On June 21, 2005, the Company received a second, substantially similar, stockholder demand, which the Special Demand Evaluation Committee also evaluated along with the other stockholder demand. The Special Demand Evaluation Committee retained independent counsel, Sidley & Austin LLP, to assist it in evaluating the demands.
On March 10, 2006, the Company’s Board of Directors accepted the recommendation of its Special Demand Evaluation Committee that no further action be taken at this time against any current or former officers or directors of the Company regarding the matters raised in the two shareholder demand letters. The Committee’s recommendation, based on the report of its independent counsel and adopted by the Board of Directors, was based on consideration of a variety of factors, including (i) the nature and strength of the Company’s potential claims; (ii) defenses available to the officers and directors; (iii) potential damages and resources available to satisfy any damages award; (iv) the Company’s indemnification and advancement obligations under its charter, bylaws, and individual agreements; (v) potential expenses to the Company and potential counterclaims arising from the pursuit of potential civil claims; and (vi) business disruption and employee morale issues.
Insurance Lawsuits
On November 10, 2005, two of the Company’s excess directors and officers liability insurance providers filed a complaint captioned Travelers Indemnity Company and ACE American Insurance Company v. Bally Total Fitness Holding Corporation; Holiday Universal, Inc. n/k/a Bally Total Fitness of the Mid-Atlantic, Inc; George N. Aronoff; Paul Toback; John W. Dwyer; Lee S. Hillman; Stephen C. Swid; James McAnally; J. Kenneth Looloian; Liza M. Walsh; Annie P. Lewis, as Executor of the Estate of Aubrey C. Lewis, Deceased; Theodore Noncek;
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Geoff Scheitlin; John H. Wildman; John W. Rogers, Jr.; and Martin E. Franklin, Case No. 05C 6441, in the United States District Court for the Northern District of Illinois. The complaint alleged that financial information included in the Company’s applications for directors and officers liability insurance in the 2002-2004 policy years was materially false and misleading. Plaintiff requested the Court to declare two of the Company’s excess policies for the year 2002-2003 void, voidable and/or subject to rescission, and to declare that the exclusions and/or conditions of a separate excess policy for the year 2003-2004 bar coverage with respect to certain of the Company’s claims. Firemans Fund, another excess carrier, was allowed to join in the case on January 4, 2006. Defendants filed motions to dismiss or stay the proceedings on February 10, 2006. The motion to dismiss was granted on September 11, 2006.
On April 6, 2006, an additional excess directors and officers liability insurance provider filed a complaint captioned RLI Insurance Company v. Bally Total Fitness Holding Corporation; Holiday Universal, Inc.; George N. Aronoff; Paul Toback; John H. Dwyer; Lee S. Hillman; Stephen C. Swid; James McAnally; J. Kenneth Looloian; Liza M. Walsh; Annie P. Lewis, as Executor of the Estate of Aubrey C. Lewis, Deceased; Theodore Noncek; Geoff Scheitlin; John H. Wildman; John W. Rogers, Jr.; and Martin E. Franklin, Case No. 06CH06892 in the circuit court of Cook County, Illinois, County Department Chancery Division. The complaint alleged that financial information included in the Company’s applications for directors and officers liability insurance in the 2002-2003 policy year was materially false and misleading. Plaintiff requested the Court to declare the Company’s excess policy for the year 2002-2003 void, voidable and/or subject to rescission. Defendants filed motions to dismiss or stay the proceedings on July 10, 2006, and a motion for advancement of defense costs and to compel interim funding on October 20, 2006. On November 16, 2006, the Court granted Defendants’ motion to dismiss.
On August 22, 2006, the Company’s primary directors and officers insurance provider for the policy years 2001-2002 and 2002-2003 filed a complaint captioned Great American Insurance Company v. Bally Total Fitness Holding Corporation, Case No. 06 C 4554 in the United States District Court for the Northern District of Illinois. The complaint alleged that financial information included in the Company’s applications for directors and officers liability insurance in the 2001-2002 and 2002-2003 policy years was materially false and misleading. Plaintiff requested the Court to declare the Company’s primary policies for those years void ab initio and rescinded, and to award plaintiff all sums that plaintiff has paid pursuant to an Interim Funding and Non-Waiver Agreement between the parties, which consists of the $10,000,000 limit of the 2002-2003 primary policy and additional amounts paid pursuant to the 2001-2002 primary policy. The Company filed a motion to dismiss or stay the proceedings on October 12, 2006. On April 26, 2007, the Court denied Defendant’s motion. On June 8, 2007, plaintiff filed a motion for summary judgment, which motion remains pending. On June 11, 2007, the Company filed its answer and counterclaims to Great American’s compliant for rescission, as well as a third-party complaint against RLI Insurance Company and other third party defendants. It is not yet possible to determine the ultimate outcome of the insurance litigation.
Other
The Company is also involved in various other claims and lawsuits incidental to its business, including claims arising from accidents at its fitness centers. In the opinion of management, the Company is adequately insured against such claims and lawsuits, and any ultimate liability arising out of such claims and lawsuits should not have a material adverse effect on the financial condition or results of operations of the Company. In addition, from time to time, customer complaints are investigated by various governmental bodies. In the opinion of management, none of these other complaints or investigations currently pending should have a material adverse effect on our financial condition or results of operations.
In addition, we are, and have been in the past, named as defendants in a number of purported class action lawsuits based on alleged violations of state and local consumer protection laws and regulations governing the sale, financing and collection of membership fees. To date we have successfully defended or settled such lawsuits without a material adverse effect on our financial condition or results of operations. However, we cannot assure you
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that we will be able to successfully defend or settle all pending or future purported class action claims, and our failure to do so may have a material adverse effect on our financial condition or results of operations. See Item 1 - Business - Government Regulation and Item 1A