Item 1. Business --------
General - -------
Warrantech Corporation, a Nevada corporation, and its subsidiaries (collectively, "Warrantech" or the "Company") maintains executive offices and operating facilities at 2200 Highway 121 Suite 100 Bedford, Texas 76021, where the telephone number is (800) 544-9510. Prior to February 28, 2005 and since its inception, the Company had been incorporated in Delaware.
Warrantech, through its wholly owned subsidiaries, designs, develops, markets and acts as a third party administrator for programs ("Programs") for service contracts, limited warranties and replacement plans (collectively, "Plans"). The Company provides these services to a variety of clients in selected industries. On a Program by Program basis in the Automotive, Consumer Products and Direct segments, the Company contracts with highly rated independent insurance companies or risk retention groups to provide coverage for the Plans to be sold or issued under the Programs. This coverage obligates the insurer to pay the cost of repairs or replacements of the products covered by the Plans. In the Home segment, the Company is self insured.
Plans issued under the Company's Programs provide consumers with expanded and/or extended product breakdown coverage for a specified period of time (and/or mileage in the case of automobiles and recreational vehicles), similar to that provided by manufacturers under the terms of their product warranties. Coverage generally provides for the repair or replacement of the product, or a component thereof, in the event of its failure. The Company's Programs provide clients with the opportunity for increased revenue and income without incurring the costs and responsibilities of operating their own programs.
The Plans for the Automotive, Consumer Products and Direct segments generally have terms extending up to one hundred twenty (120) months or, in the case of mileage based Plans, up to one hundred fifty thousand (150,000) miles. All repairs and/or replacements required under the Plans are performed by independent third party repair facilities or dealers. The cost of any repair or replacement under these plans is generally paid by the insurance company. Notwithstanding the forgoing, however, certain Plans were insured by Reliance Insurance Company ("Reliance") which was placed in liquidation in 2002. For a more detailed discussion of claims handling under Plans insured by Reliance, see "Management's Discussion and Analysis-Insurer in Liquidation" below. Plans for the Home segment are generally for twelve months. The cost of any repair or replacement for plans in the Home segment is paid for by the Company. For a more detailed discussion of the responsibilities of obligors and insurers under the Plans, see "Contract Obligors" and "Insurance" below.
Essential to the Company's success is its ability to capture, maintain, track and analyze all relevant information regarding its Plans. The Company has internally developed, and continues to develop and operate proprietary computer software that allows it to maintain millions of Plans. The software includes custom designed relational databases with interactive capabilities. The Company's computer systems provide ample capacity and processing speed for its current and future requirements. Additionally, Warrantech's web-enabled applications such as VSCOnline(R) and WCPSOnline(R) facilitate information exchange with outside businesses such as clients and service centers via the Internet. These applications optimize the data acquisition, service processing and claims processing functions. The software programs also allow for the analysis of current and historical statistical data which the Company uses to monitor its Programs and support future growth.
Until April 2006, the Company operated in four major business segments: Automotive, Consumer Products, Direct and International, each of which is discussed below. Effective with April 2006, the Company ceased operations in its International segment.
Warrantech Automotive Segment - -----------------------------
The Company's Automotive segment designs, develops, markets and acts as a third party administrator for vehicle service contract ("VSC") Programs and other related automotive after-sale products, all of which enhance the dealer's profitability from the sale of automobiles, light trucks, recreational vehicles, personal watercraft and automotive components. These products are sold principally by franchised and independent automobile dealers, leasing companies, repair facilities, retail stores, financial institutions and other specialty marketers.
As a result of the Company's leadership in the use of advanced technology for processing and adjudicating of claims, Warrantech has also become a supplier of choice for several Insurance Companies for their claims runoff projects and for providing administrative services to the provider companies of automotive products. VSCOnline, a complete front-end business rating and processing system, teams with VSC Claims Online to make available a totally paperless environment for all of Warrantech Automotive's clients.
Warrantech Automotive utilizes the services of approximately one hundred fifty (150) independent sales representatives to call on clients to solicit their use of the VSC Programs. At this time, VSC's are being sold in forty-nine (49) states
The VSC is a contract between the dealer/lessor or third party obligor (except in California and Florida, where the contract is between Warrantech Automotive and the vehicle purchaser/lessee) and the vehicle purchaser/lessee that offers coverage for a term extending up to one hundred twenty (120) months or, in the case of mileage based VSC's, up to one hundred fifty thousand (150,000) miles. Coverage is available in the event of the failure of a broad range of mechanical components occurring during the term of the VSC, other than failures covered by a manufacturer's warranty.
Although each VSC sold or issued under a Program designates an obligor that is legally responsible for the cost of valid repairs or replacements made thereunder, those liabilities are fully insured by an independent insurance company that is ultimately responsible for such costs. Currently, Great American Insurance Company ("GAIC") is the primary insurer of Warrantech Automotive's VSC Programs. On reinsurance Programs offered to automobile dealerships and other specialty marketers, the Company has an agreement with Heritage Warranty Insurance Risk Retention Group, Inc. ("Heritage") and an agreement with Automotive Underwritwers Insurance Company, Inc., a Risk Retention Group ("AUIC"). During the immediately preceding five-year period, a portion of the Warrantech VSC Programs were insured by either Reliance (see "Management's Discussion and Analysis - Insurer in Liquidation" below), the New Hampshire Insurance Company or other American International Group, Inc. companies
In 2006, 2005 and 2004 the Automotive segment received $0, $0 million and $7.6 million, respectively in gross revenues from one significant client, which accounted for 0%, 0% and 7% of the Automotive segment's total gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the Automotive segment received from a second client, gross revenues of $4.9 million, $5.8 million and $12.1 million, respectively, which accounted for 6%, 8% and 12% of the Automotive segment's total gross revenues. Additionally, in 2006, 2005 and 2004 the Automotive segment received from a third client, gross revenues of $7.3 million, $7.1 million and $9.6 million, respectively, which accounted for 9%, 10% and 9% of the Automotive segment's total gross revenues. Additionally, in 2006, 2005 and 2004 the Automotive segment received from a fourth client, gross revenues of $11.1 million, $7.1 million and $0, respectively, which accounted for 14%, 10% and 0% of the Automotive segment's total gross revenues.
Warrantech Consumer Products Segment - ------------------------------------
The Company's Consumer Products segment develops, markets and administers extended warranties and product replacement plans on household appliances, consumer electronics, televisions, computers and home office equipment, which are sold principally through retailers, distributors, manufacturers, utility companies, financial institutions and other specialty marketers. Warrantech also markets these warranties and plans directly to the ultimate consumer on behalf of the retailer/dealer and/or the manufacturer through telemarketing and direct mail campaigns. It also offers call center and technical computer services. The extended warranties and product replacement plans administered by Warrantech Consumer Products are service contracts between the purchaser and the retailer/dealer and/or the insurance company that typically offers coverage ranging from twelve (12) to sixty (60) months.
The Consumer Products segment also develops, markets and administers service contract programs in the United States and Canada covering mechanical breakdowns of the working systems and components in homes. These programs protect homeowners against the cost of repairs in case of a breakdown of one or more of the major home systems including heating and air conditioning, plumbing, electrical and built-in appliances.
The programs marketed and administered by Warrantech Consumer Products require that the selling dealer, distributor or manufacturer enter into an agreement outlining the duties of each party. Those duties specifically assumed by Warrantech Consumer Products include the development and distribution of marketing materials, sales and motivational training, processing of service contracts, operating a call center and the adjustment and payment of claims. It has also entered into service center agreements with independent third party, authorized repair facilities located throughout the United States and Canada. These service center agreements bind the amount of reimbursement the repair facility will receive for performance on a repair claim.
Effective June 1, 2006 the Company entered into an agreement on consumer products with Amtrust North America, Inc pursuant to which Amtrust will insure any new service contracts. Insurance for service contracts issued between February 12, 2000 until May 31, 2006 are covered by GAIC. Insurance for service contracts issued between August 1, 1997 until February 12, 2000 are covered by Cigna Insurance Company. On September 1, 2004, the Company began offering one-year extended home product warranties which will not be insured by third party insurance companies, but will be obligations solely of the Company.
In 2006, 2005 and 2004 the Consumer Products segment received $14.7 million, $11.8 million and $9.1 million, respectively, in gross revenues from a significant client which accounted for 42%, 32% and 29% of the segment's gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the Consumer Products segment received from a second client, gross revenues of $4.5 million, $3.2 million and $2.5 million, respectively, which accounted for 13%, 8% and 8% of the Consumer Products segment's total gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the Consumer Products segment received from a third client, gross revenues of $3.6 million, $1.7 million and $0.8 million, respectively, which accounted for 10%, 5% and 3% of the Consumer Products segment's total gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the Consumer Products segment received from a fourth client, that did not renew its agreement with the Company during fiscal 2005, gross revenues of $1.2 million, $3.4 million and $4.7 million, respectively, which accounted for 4%, 9% and 15% of the Consumer Products segment's total gross revenues, respectively. Finally, in 2006, 2005 and 2004 the Consumer Products segment received from a fifth client, gross revenues of $3.9 million, $12.5 million and $14.6 million, respectively, which accounted for 11%, 33% and 46% of the Consumer Products segment's total gross revenues. In 2005, this client filed for bankruptcy. The Company's business relationship with this Client has terminated. The Company has extended its contracts with two of its significant clients through 2006.
Warrantech Direct Segment - -------------------------
The Company's Direct segment, markets vehicle service contracts on automobiles and light trucks and extended warranties and product replacement plans on household appliances, consumer electronics, televisions, computers and home office equipment. The vehicle service contracts and extended warranties are sold directly to the ultimate consumer on behalf of the retailer/dealer and/or the manufacturer through telemarketing and direct mail campaigns. It also offers call center and technical computer services.
The consumer product extended warranties and product replacement plans are service contracts between the purchaser and the retailer/dealer and/or the insurance company that typically offers coverage ranging from twelve (12) to sixty (60) months. The VSC is a contract between the dealer/lessor or third party obligor (except in California and Florida, where the contract is between Warrantech Automotive and the vehicle purchaser/lessee) and the vehicle purchaser/lessee that offers coverage for a term extending up to one hundred twenty (120) months or, in the case of mileage based VSC's, up to one hundred fifty thousand (150,000) miles. Coverage is available in the event of the failure of a broad range of mechanical components occurring during the term of the VSC, other than failures covered by a manufacturer's warranty.
In 2006, 2005 and 2004 the Direct segment received $2.2 million, $2.0 million and $2.1 million, respectively, in gross revenues from a significant client which accounted for 20%, 25% and 29% of the segment's gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the Direct segment received from a second client, gross revenues of $0.7 million, $0.7 million and $1.1 million, respectively, which accounted for 7%, 10% and 15% of the Direct segment's total gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the Direct segment received from a third client, gross revenues of $0.7 million, $0.8 million and $0.7 million, respectively, which accounted for 6%, 10% and 10% of the Direct segment's total gross revenues, respectively.
Warrantech International Segment - --------------------------------
Warrantech International designs, develops, markets and acts as a third party administrator for many of the same Programs and services outside the United States that Warrantech Automotive and Warrantech Consumer Products market and administer in the United States and Canada.
Warrantech International conducts its efforts on a direct basis and has developed relationships with retailers and distributors throughout the Caribbean, Central America and South America. It is currently doing business in Puerto Rico, Guatemala, El Salvador, and until April 1, 2006 Warrantech International was conducting business in Chile and Peru. The Company believes its strategic alliance with Atento, a multi-national call center owned by Spain's Grupo Telefonica, should allow Warrantech International to readily enter markets in Latin America where Atento has existing call center operations. It is actively pursuing leads in other Latin American markets, such as Mexico.
The Programs administered by Warrantech International consist of Plans between the purchaser and the retailer/dealer or the insurance company and typically offer coverage similar to that offered by Warrantech Automotive and Warrantech Consumer Products. Coverage is available in the event of the failure of a broad range of mechanical components occurring during the term of the Plan, other than failures covered by a manufacturer's warranty.
Although a Plan sold or issued under a Program may designate an obligor, other than the applicable insurance company, that is legally responsible for the cost of valid repairs or replacements made thereunder, those liabilities, are fully insured by an independent insurance company that is ultimately responsible for such costs. Insurance coverage has been and/or continues to be provided by Cruz del Sur in Chile, La Positiva in Peru, Universal Insurance Company and GAIC in Puerto Rico and GAIC in Guatemala and El Salvador. Effective September 2003, as a result of terminating its relationship with Universal Insurance Company, the Company suspended its Automotive program in Puerto Rico. The Company is in the process initiating a new automotive warranty plan in Puerto Rico in which the Company will self insure automotive warranties. On June 30, 2004, the
Company terminated its policy with Cruz del Sur, its primary insurance carrier in Chile, effective December 31, 2004. To arrange for continuity of coverage, the Company has been issued a policy with Penta Seguros, effective with contracts written January 1, 2005.
Effective April 1, 2006, Warrantech International ceased operations in Chile and Peru, resulting from various clients not renewing their contracts. The Company recognized that it was no longer profitable to participate in the warranty business in those countries, ceased operations and will focus its future efforts expanding its business domestically and in Mexico. Effective June 1, 2006, Edge Company is in contractual discussions with Warrantech International to help manage the run-off for contracts sold through April 1, 2006 in Chile and Peru. Edge Company is owned by Richard Rodriguez, former President of Warrantech International, who is also a Company Director.
In 2006, 2005 and 2004 the International segment received $1.4 million, $2.9 million and $2.9 million, respectively, in gross revenues from one significant client, that did not renew its agreement with the Company during fiscal 2006, which accounted for 39%, 69% and 22% of the International segment's total gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the International segment received from a second client, that did not renew its agreement with the Company during fiscal 2005, gross revenues of $0.0 million, $1.7 million and $1.7 million, respectively, which accounted for 0%, 22% and 22% of the segment's gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the International segment received from a third client, gross revenues of $0.5 million, $0.4 million and $0.3 million, respectively, which accounted for 14%, 9% and 4% of the segment's gross revenues, respectively. Additionally, in 2006, 2005 and 2004 the International segment received from a fourth client, gross revenues of $0.7 million, $0.5 million and $0.5 million, respectively, which accounted for 20%, 12% and 7% of the segment's gross revenues, respectively. Finally, in 2006, 2005 and 2004 the International segment received from a sixth client, that did not renew its agreement with the Company during fiscal 2004, gross revenues of $0, $0 and $1.0 million, respectively, which accounted for 0%, 0% and 14% of the International segment's total gross revenues.
Sales and Marketing - -------------------
Each business segment is responsible for its own sales and marketing activities. These activities are managed by the segment's own personnel. In certain circumstances, the business segments have entered into marketing agreements with independent organizations that solicit clients at their own expense, and receive a commission on all Plans sold by such clients.
The Warrantech business segments endeavor to improve Program performance through participation in cooperative marketing programs that may be jointly funded by Warrantech and the client or independent sales representatives.
Training and motivational programs are an important form of the specialized assistance provided by the Company to increase the effectiveness and profitability of Program sales efforts. The Company also develops informational and promotional materials and conducts informational meetings either at the client's place of business or an offsite facility with the goal of improving Program effectiveness. The Company also uses its modern training facility, located at its Bedford, Texas corporate offices, to provide a variety of training and educational programs to its internal personnel, thereby increasing their effectiveness and efficiency.
Warrantech also markets directly to the ultimate consumer on behalf of the retailer and for manufacturer's programs through telemarketing and direct mail campaigns. These direct marketing campaigns generate sales through renewals of expiring Plans and initiating sales to customers who did not buy a Plan at the time of product purchase.
Significant Customers - ---------------------
During the fiscal year ended March 31, 2006, the Company had one customer which accounted for more than 10% of the Company's consolidated gross revenues. In 2006, 2005 and 2004 gross revenues from this significant customer were $16.9 million, $13.8 million and $11.2 million, respectively, which accounted for 13%, 12% and 8% of the Company's total gross revenues, respectively.
Competition - -----------
Although accurate information on private companies is difficult to obtain, the Company believes it is among the ten (10) largest independent third party administrators in the United States. All of the Company's business segments compete with subsidiaries and/or divisions of major financial institutions and insurance companies such as Aon and American International Group. The segments also compete against programs offered by product manufacturers. This is particularly true for the Automotive segment which competes against VSC programs offered by major manufacturers such as General Motors, Ford and Daimler Chrysler. The Company acknowledges that a number of these competitors have significantly more employees, greater financial resources and more immediate name recognition than the Company. It believes, however, that its broad client base and the competitive strengths and advantages described above have allowed it to compete effectively and will enable it to grow its business in the future.
Contract Obligors - -----------------
Each Plan contains the name of a designated obligor that is legally responsible for the cost of any valid claim submitted under the Plan. The Company, however, arranges for an independent insurance company to issue a policy on behalf of the named obligor that covers all of the obligor's liabilities under the Plan for the Automotive and Consumer Products segments. As a result, the insurance company is then ultimately responsible for paying the cost of any and all valid claims submitted under these Plans. In the event, however, that the insurance company refuses or is unable to pay a covered claim, the designated obligor will be responsible for the payment and it will have recourse against the insurance company or its estate (in the event of an insolvency or liquidation) to recover the payment.
Prior to April 1, 2000, one of the Company's subsidiaries or a retailer/dealer would routinely be named the obligor under the Plans. Since April 1, 2000, however, Butler Financial Services, LLC ("Butler"), a company unrelated to Warrantech but included in the Company's financial results due to its close transactional ties with the Company, has served as the obligor under all Plans sold or issued under a Program in exchange for a fee payable by the seller or issuer of the Plan. Notwithstanding the forgoing, however, a Company subsidiary continues to act as the designated obligor for Plans sold in the States of California and Florida due to regulatory considerations. Furthermore, Butler has contractually assumed the liabilities of the obligor under all pre-existing Plans in which one of the Company's subsidiaries was named as the designated obligor. The liabilities of the designated obligor under these pre-existing Plans were insured by an independent insurance company and, as a result of this assumption by Butler, the coverage afforded by these insurance policies now benefits Butler as the named obligor.
Certain of the Plans under which Butler is the designated obligor were insured by Reliance. The liquidation of Reliance (see "Management's Discussion and Analysis - Insurer in Liquidation" below) has eliminated Butler's insurance coverage under those Plans. Warrantech Automotive is the obligor, as well as the administrator, under some of the VSC's that were insured by Reliance. As the obligor, Warrantech Automotive is ultimately responsible for paying the valid claims submitted under those VSC's in which Warrantech Automotive is the designated obligor. Prior to Reliance's liquidation, Reliance paid the cost of such covered claims under the insurance policies it provided. Subsequent to the liquidation of Reliance, however, insurance coverage for Warrantech Automotive's obligations under those VSC's was no longer available
Funding to cover these uninsured claims is provided by a special surcharge, which is payable on certain VSC's sold after November 19, 2001. This surcharge will be paid by clients through which Reliance-insured VSC's were sold. These funds will be used to pay valid claims submitted under VSC's previously insured by Reliance.
For financial reporting purposes, for the reasons stated in Footnote 2 of the Financial Statements annexed to this Report, the Company has adopted a policy to treat the Butler-obligor contracts as if they were contracts in which Warrantech was the legal obligor. As a result, the Company recognizes revenues under such contracts pursuant to FASB Technical Bulletin 90-1. The Company also includes, as its own liabilities, liabilities of Butler relating to such contracts. Additionally, because the Company is treating the Butler-obligor contracts as Warrantech obligor contracts for financial purposes, the Company excludes from its financial statements the transactions between Warrantech and Butler. Adopting these policies for accounting reporting purposes does not alter the legal obligations under the applicable agreements in which the Company is not responsible for, and has not assumed, the obligations of Butler. Butler remains legally obligated under such agreements and the service contracts in which it is the named obligor.
Butler is not deemed a "consolidated subsidiary" of the Company, as that term is used in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report. Butler's income, expenses, assets and liabilities have not been consolidated with those of the Company. Butler is an independent entity owned by parties unrelated to the Company and, except for the transactions between Butler and Warrantech as described in this Report, Warrantech does not have knowledge of, or control over, Butler's affairs or financial reporting. Warrantech also has no knowledge of, nor has it established or evaluated, Butler's internal controls or disclosure controls or procedures. Any reference to "consolidated subsidiary," internal controls or disclosure controls and procedures in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report, do not pertain to Butler.
Insurance Coverage - ------------------
Each Plan contains the name of a designated obligor that is legally responsible for the cost of any valid claim submitted under the Plan. The Company, however, arranges for an independent insurance company to issue a policy on behalf of the named obligor that covers all of the obligor's liabilities under the Plan. As a result, the insurance company is ultimately responsible for paying the cost of any and all valid claims submitted under the Plan.
For each Plan sold or issued, the insurance company is entitled to receive a contractually fixed amount that is included in the selling price of the Plan. Generally, this amount is collected by the retailer/dealer at the time of sale and forwarded to the Company at contractually agreed intervals. The Company then holds this amount until required to remit it to the insurance company at contractually agreed intervals. The Company's obligations with respect to such amounts are purely administrative and it acquires no rights in or to such amounts by the performance of its obligations. The calculation of these amounts is based upon the insurance company's actuarial analysis of claims data collected and maintained for each type of coverage and Plan term. Once the retailer/dealer has remitted such contractually fixed amount to the Company, the insurer is fully liable for all valid claims submitted under the applicable Plan, even if such contractually fixed amount is insufficient to cover the cost of such claims.
Currently, GAIC is the primary insurer of Warrantech Automotive's VSC Programs. On reinsurance Programs offered to automobile dealerships and other specialty marketers, the Company also has an agreement with Heritage, a risk retention group that is not rated by any nationally recognized rating agency; Automotive Underwriters Insurance Company, Inc., another non rated risk retention group, Capital Assurance Risk Retention Group, another non rated risk retention group, Western Insurance and American Resources Insurance Company, Inc., a B rated risk retention group. One or more reinsurance companies, contracted by Heritage, participate in this Program as well. During the immediately preceding five-year period, portions of the Warrantech VSC Programs
were insured by Reliance (see "Management's Discussion and Analysis - Insurer in Liquidation" below), the New Hampshire Insurance Company and other member companies of American International Group, Inc. ("AIG").
GAIC also insured Plans issued under Programs marketed and administered by Warrantech Consumer Products after February 12, 2000 until May 31, 2006. During the immediately preceding five-year period, insurance for Plans issued under such Programs was provided by Reliance (see "Management's Discussion and Analysis - Insurer in Liquidation" below) and CIGNA Insurance Company. Effective June 1, 2006 the Company entered into an agreement on consumer products with Amtrust North America, Inc pursuant to which Amtrust will insure any new service contracts.
Except as otherwise noted herein, current insurance coverage is provided by highly rated independent insurance companies. As noted above, in the United States and Canada providers include GAIC Amtrust and ARIC which are rated A (Excellent) and Heritage and AUIC which are unrated risk retention groups. Certain Programs have been or are currently insured by (i) New Hampshire Insurance Company and/or other AIG member companies and Tokio Marine & Fire Insurance Company, each of which is rated A++ (Superior) and (ii) CIGNA Insurance Company (acquired by ACE Insurance Company) which is rated A (Excellent). Internationally, insurance coverage was provided by Universal Insurance Company in Puerto Rico on non-automotive programs through August 2004, rated A - (Excellent), ING beginning January 1, 2005 and Cruz del Sur prior to January 1, 2005 in Chile, and La Positiva in Peru. All ratings for the United States, Canada and Puerto Rico are made by A.M. Best Company. The Home warranty program is self insured by the Company.
Agreements between the Company and the insurers may contain profit-sharing features that permit the Company to share in underwriting profits earned under the Programs. The amounts to be received, if any, are determined in accordance with certain specified formulas based upon the type of program and the policy year. Certain of these agreements require interim calculations and distributions for various Programs, with final calculations being made as Plan terms expire. The Company recognized $0, $41,920 and $173,610 in profit sharing through its International segment in the fiscal years-ended March 31, 2006, 2005 and 2004, respectively.
Federal and State Regulation - ----------------------------
The Programs designed, developed and marketed by the Company's subsidiaries and their related operations are regulated by federal law and the statutes of a significant number of states. The Company continually reviews all existing and proposed statutes and regulations to ascertain their applicability to its existing operations, as well as to new Programs that the Company is developing.
Generally, these statutes apply to the scope of service contract coverage and the content of the service contract or limited warranty document. Statutes typically require specific wording that expressly states the consumer's rights in the event of a claim, how the service contract may be canceled, and identification of the insurance company that insures the named obligors against the cost of valid claims submitted under the service contract.
Insurance departments in some states have sought to interpret the consumer product service contract, or certain specific items covered under such contract, as a form of insurance requiring that the issuer be a duly licensed and chartered insurance company. The Company does not believe that it or any of its subsidiaries is an insurer and has no intention of filing the documents or meeting the capital and surplus requirements that are necessary to obtain a license as an insurance company.
There are instances where the applicability of statutes and regulations to Programs and/or compliance therewith, involve issues of interpretation. The Company uses its best efforts including, but not limited to, consultation with legal and regulatory professionals to comply with applicable statutes and regulations. It cannot, however, be certain that its interpretations, if
challenged, would be upheld by a court or regulatory body. In any situation in which the Company has been specifically notified by a regulatory body that its methods of doing business were not in compliance with applicable laws or regulations, the Company has taken the steps necessary to comply.
If the Company's right to operate in a state is challenged successfully, the Company may be required to cease operations in such state and, in certain circumstances, financial sanctions may be imposed against the Company. These actions, should they occur, could have an adverse impact on the Company's operations. Within the framework of currently known statutes and regulations, however, the Company does not believe that this is a material concern at this time.
In order to reduce its operating costs, the Company has reorganized its corporate structure that involves the transfer of some of the Company's operations from corporate entities to limited partnerships. This reorganization had no effect on the Company or its operations other than a reduction of its franchise tax obligations and other operating costs.
Intellectual Property - ---------------------
The Company holds numerous registered United States trademarks, the most important of which are the "Warrantech" and its stylized "W" logo service marks. Additional service marks are registered covering subsidiary and Program names and descriptions such as "Repairmaster(R)," "RepairGuard(R)," "Xchange Card(R)," "WCPSOnline(R)", "OneWorld(R)" and "VSCOnline(R)." The Company has kept, and intends to keep, the registration for all service marks current.
The Company has developed proprietary computer software that consists of custom designed relational databases with interactive capabilities. Essential to the success of the Company is its ability to maintain all relevant data regarding the Plans administered by the Company's business segments. Development costs associated with this proprietary software have been capitalized and are being amortized over the expected useful life of the software.
The Company has deployed, and continues to refine, Speech Recognition IVR telephone applications to speed the claims process. These telephone applications allow a caller to speak their input, such as a VIN or contract number, rather than key the entry on their phone. Additionally, the Fast-Track Automotive claims telephone application has the capability to establish a claim, issue a reference number, and read back payment information to the repair facility so the caller does not need to hold for, or speak to, a call center representative. Both of these advances help the Company continue to provide better service to its customers and reduce time and costs involved with handling claims while providing the better service.
Employees - ---------
As of March 31, 2006 the Company and its subsidiaries had approximately 349 employees, a decrease of approximately 17 employees from the preceding fiscal year. None of the Company's employees are covered by a collective bargaining agreement. The Company considers its relations with its employees to be good.
Item 2.
Item 2. Properties ----------
The Company's executive office is located at 2200 Highway 121 Airport Centre II, Bedford, Texas. The premises, consisting of approximately 67,800 square feet, is leased pursuant to a lease agreement expiring February 28, 2013, which provides for an annual base rent of $1.2 million. These premises also accommodate the Company's Automotive, Consumer Products, Home, International and Direct Marketing operations.
Warrantech International's Puerto Rico operations are located in leased premises at 1225 Ponce de Leon Avenue, Santurce, Puerto Rico pursuant to a month to month lease. The lease provides for annual base rent payments of $75,526 for 3,433 square feet.
Warrantech International's Chile operations are located in leased premises at Avenida 11 de Septembre No. 1881 Officia No. 1619 Providencia, Santiago, Chile. On May 31, 2006 the company gave its required 60 notice of termination regarding this office and it will close July 31, 2006. The lease provides for annual base rent payments of $23,983 for 145 square meters.
Warrantech International's Peru operations are located in leased premises at Avenida Paseo de la Republica #3691 Officina No 501 San Isidro Peru. Effective May 1, 2006 the landlord released Warrantech from any further rent as Edge Company owned by Rick Rodriguez a director signed a new lease for the premises. The lease provides for annual base rent payments of $6,150 for 323 square feet.
Item 3.
Item 3. Legal Proceedings -----------------
Information regarding legal proceedings is set forth in Note 11 in the Notes to Consolidated Financial Statements set forth in "Item 8. - Consolidated Financial Statements and Supplementary Data" under the subheading "Litigation," which is hereby incorporated by reference.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders ---------------------------------------------------
No matters were submitted to a vote of the Company's Stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of the Company's fiscal year ended March 31, 2006.
PART II
Item 5.
Item 5. Market for Warrantech's Common Equity and Related Stockholder ------------------------------------------------------------- Matters - -------
The Company's common stock, $.007 par value per share (the "Common Stock") trades under the symbol "WTECE.OB." Trades are reported on the Over-The-Counter ("OTC") electronic quotation service of the National Association of Securities Dealers Market Makers.
As of March 31, 2006, there were 13,967,568 shares of outstanding Common Stock and approximately 828 stockholders of record. On that date, the closing bid price for the Common Stock, as reported on the OTC was $0.41.
Following is a summary of the price range of the Company's Common Stock during fiscal years 2006 and 2005:
Fiscal 2006 Fiscal 2005 Quarter High & Low Bid High & Low Bid First $ 0.69 $ 0.55 $ 1.05 $ 0.76 Second $ 0.63 $ 0.45 $ 0.87 $ 0.63 Third $ 0.60 $ 0.37 $ 0.82 $ 0.61 Fourth $ 0.45 $ 0.33 $ 0.78 $ 0.57
No cash dividends have been paid to holders of Common Stock since inception of the Company. The Company anticipates that earnings, if any, will be retained for use in the business or for other corporate purposes and it is not anticipated that cash dividends will be paid in the foreseeable future.
Purchase of Equity Securities for the Twelve Months Ended March 31, 2006
--------------------------------------------------------------------- Total Number of Average Shares Price Paid Period purchased Cost per Share --------------------------------------------------------------------- 1/1/06 - 1/31/06 -- -- -- 2/1/06 - 2/28/06 -- -- -- 3/1/06 - 3/31/06 1,519,425 $ 1,161,610 $ 0.7645
---------------------------- Total 1,519,425 $ 1,161,610 $ 0.7645 ============================
These shares were not purchased pursuant to a publicly announced plan or program regarding stock repurchases in as much as the Company has no such plan or program. The shares were tendered by stockholders in conjunction with debt obligations due to the company that were settled, in whole or in part, in Company common stock.
Item 6.
Item 6. Selected Financial Data -----------------------
The Selected Financial Data should be read in conjunction with the consolidated financial statements and related notes as of and for the years ended March 31, 2006, 2005 and 2004.
WARRANTECH CORPORATION AND SUBSIDIARIES
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations - -------------------------
Cautionary Statement Regarding Risks and Uncertainties That May Affect Future - ----------------------------------------------------------------------------- Results - -------
Except for the historical information contained herein, the matters discussed below or elsewhere in this Quarterly Report on Form 10-K may contain forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those contemplated by the forward-looking statements. The Company makes such forward-looking statements under the provisions of the "safe harbor" section of the Private Securities Litigation Reform Act of 1995. Forward-looking statements reflect the Company's views and assumptions, based on information currently available to management, including, among other things, the Company's operating and financial performance over recent years and its expectations about its business for the current and future fiscal years. When used in this Quarterly Report on Form 10-K, the words "believes," "estimates," "plans," "expects," and "anticipates" and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements.
Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it can give no assurance that its expectations will prove to be correct. These statements are subject to certain risks, uncertainties and assumptions, including, but not limited to,
o changes in the terms or availability of insurance coverage for the Company's programs, o regulatory or legal changes affecting the Company's business, o loss of business from, or significant change in relationships with, any major customer, o the inability of any of the insurance companies which insure the service contracts marketed and administered by the Company to pay claims under the service contracts, o the termination of extended credit terms being provided by the Company's current insurance company, o prevailing economic conditions which may significantly deteriorate, thereby reducing the demand for the Company's products and services, o availability of technical support personnel or increases in the rate of turnover of such personnel, resulting from increased demand for such qualified personnel, o the Company's ability to replace lost revenues in its Consumer Products or International segments, o the ability to successfully identify and contract new business opportunities, both domestically and internationally, o the ability to secure necessary capital for general operating or expansion purposes, o the adverse outcomes of litigation, o the outcome of the bankruptcy proceedings involving Ultimate Electronics, Inc. (discussed below), o the non-payment of notes due from an officer and one former director of the Company in 2007, which would result in a charge against earnings in the period in which the event occurred, o the consummation of the recently announced, proposed agreement for HIG to buyout the Company and the inherent risks associated if the purchase is not completed, o the inability for recourse against the former audit firm, which ceased operations in 2005, and o the illiquidity of the Company's stock.
Should one or more of these or any other risks or uncertainties materialize or develop in a manner adverse to the Company, or should the Company's underlying assumptions prove incorrect, actual results of operations, cash flows and/or the Company's financial condition may vary materially from those anticipated, estimated or expected.
SEC Review of the Company's Filings - -----------------------------------
In March of 2005, the staff of the Division of Corporation Finance of the Securities and Exchange Commission selected the Company's periodic reports for review. The reports reviewed were the Annual Report on Form 10-K for the fiscal year ended March 31, 2005 and the Quarterly Reports on Form 10-Q for the periods ended June 30, 2005, September 30, 2005 and December 31, 2005. The SEC Staff informed the Company that the purpose of the review was to assist the Company in its compliance with applicable disclosure requirements and to enhance the overall disclosure in the Company's reports. In the course of its review, the SEC Staff notified the Company that the wording in the certification documents did not conform with require wording. On April 7, 2006 the Company subsequently revised the certification exhibits and filed an amended Form 10-K/A with this one change.
Additionally on May 30, 2006, the SEC Staff informed the Company that the Annual Report on Form 10-K/A for the fiscal year ended March 31, 2005 must be amended to reflect the risk resulting from the former audit firm's discontinuation of business and therefore the inability of shareholders to have recourse, if any, against the audit firm.
In March of 2003, the staff of the Division of Corporation Finance of the Securities and Exchange Commission selected the Company's periodic reports for review. The reports reviewed were the Annual Report on Form 10-K for the fiscal year ended March 31, 2002 and the Quarterly Reports on Form 10-Q for the periods ended June 30, 2002, September 30, 2002 and December 31, 2002. The SEC Staff informed the Company that the purpose of the review was to assist the Company in its compliance with applicable disclosure requirements and to enhance the overall disclosure in the Company's reports. In the course of its review, the SEC Staff requested clarification of certain of the Company's disclosures and items in its financial statements.
Butler Contracts - ----------------
As a result of discussions with the SEC's Division of Corporation Finance, the Company requested guidance from the SEC's Office of the Chief Accountant ("SEC Staff") concerning, the appropriate revenue recognition policy which should be applied by the Company with respect to the Butler-obligor contracts. After considering the guidance received from the SEC Staff, the Company has restated its financial statements for the fiscal years ending on March 31, 2001, 2002 and 2003 in order to change the method of recognizing revenue from service contracts in which Butler is the named obligor and to give effect to certain transactions which relate to Butler. These changes which are reflected in Footnote 2 to the Financial Statements in this Annual Report include the following:
o The Company has recognized revenues from contracts in which Butler was the obligor on a straight-line basis over the life of the service contracts. o The Company has set up a loss reserve for the estimated cost of all claims under service contracts previously insured by Reliance. o The Company has eliminated any contractual obligations recorded with Butler. o Additionally, the Company now presents line items for Gross Revenue, Direct Costs and Gross Profit in its financial statements. Previously, the Company had only recognized revenue on a net basis.
The Company, with the concurrence of its outside auditors, had previously accounted for the Butler-related transactions based upon the legal obligations of the parties and the regulatory requirements which applied to the transactions. The changes which the Company has adopted are solely for financial reporting purposes. Butler will remain responsible for the same obligations under the service contracts which existed prior to the change in financial presentation. The obligations of Butler under all service contracts sold after July 25, 2000 were, and continue to be, assumed by an A-rated insurance carrier which is a subsidiary of a New York Stock Exchange Company with over $19 billion in assets. Butler also remains the licensed entity which is recognized as the obligor under the service contracts regulated by the insurance departments in all the states in which Butler does business.
Dealer-Obligor Contracts - ------------------------
Historically, the Company has recognized the major portion of the revenues from the dealer-obligor contracts upon a sale to the consumer by the dealer/retailer and has deferred a minor portion of those revenues.
With the issuance of EITF 00-21, the Company and its accountants, with the guidance of the SEC Staff in early 2004, have determined that, in order to continue to recognize income under the dealer-obligor contracts in the same manner as it has done historically, the Company must develop adequate evidence of the fair value of the two elements of its services - the sale and structuring of the contracts and the claims adjudication services. Without this evidence, the Company would be required to recognize all of the income associated with the dealer-obligor contracts over the life of the contracts. This would have the effect of deferring to later periods the substantial portion of these revenues which the Company has previously recognized up front. This would then have the further effect of substantially deferring the current year's income to future periods and may in fact cause the Company to recognize a current net loss.
The SEC Staff offered its guidance that the Company's evidence to date has not been sufficient to meet the standards of EITF Abstracts Issue No. 00-21 "Revenue Arrangements with Multiple Deliverables".
Based on the SEC Staff's 2004 guidance, the Company recognizes all of the income from the Dealer-Obligor Contracts over the life of the contracts.
These accounting changes do not have an impact on Warrantech's cash flows or its cash balances which the Company believes drives its business. The deferral of revenues to future periods results in a significant negative net worth and a corresponding increase in Deferred Income on the Balance Sheet. However, the revenue recognition accounting change will also have a positive effect on the results for future periods.
Warrantech, through its wholly owned subsidiaries, designs, develops, markets and acts as a third party administrator for programs ("Programs") for service contracts, limited warranties and replacement plans (collectively, "Plans"). The Company provides these services to a variety of clients in selected industries. On a Program by Program basis in the Automotive and Consumer Products segments, the Company contracts with highly rated independent insurance companies or risk retention groups to provide coverage for the Plans to be sold or issued under the Programs. This coverage obligates the insurer to pay the cost of repairs or replacements of the products covered by the Plans. In the Home segment, the Company is self insured.
Plans issued under the Company's Programs provide consumers with expanded and/or extended product breakdown coverage for a specified period of time (and/or mileage in the case of automobiles and recreational vehicles), similar to that provided by manufacturers under the terms of their product warranties. Coverage generally provides for the repair or replacement of the product, or a component thereof, in the event of its failure. The Company's Programs provide clients with the opportunity for increased revenue and income without incurring the costs and responsibilities of operating their own programs.
The Plans for the Automotive and Consumer Products segments generally have terms extending up to one hundred twenty (120) months or, in the case of mileage based Plans, up to one hundred fifty thousand (150,000) miles. All repairs and/or replacements required under these Plans are performed by independent third party repair facilities or dealers. The cost of any repair or replacement under these plans is generally paid by the insurance company. Notwithstanding the forgoing, however, certain Plans were insured by Reliance which was placed in liquidation in 2002. For a more detailed discussion of claims handling under
Plans insured by Reliance, see "Management's Discussion and Analysis-Insurer in Liquidation" below. For a more detailed discussion of the responsibilities of obligors and insurers under the Plans, see "Contract Obligors" and "Insurance" in Item I of this Annual Report on Form 10 K. Plans for the Home segment are generally for twelve months. The cost of any repair or replacement for plans in the Home segment is paid for by the Company.
The Company operates in four major business segments: Automotive, Consumer Products, International and Direct. The Automotive segment designs, develops, markets and acts as a third party administrator for vehicle service contract ("VSC") Programs and other related automotive after-sale products, all of which enhance the dealer's profitability from the sale of automobiles, light trucks, recreational vehicles, personal watercraft and automotive components. These products are sold principally by franchised and independent automobile and motorcycle dealers, leasing companies, repair facilities, retail stores, financial institutions and other specialty marketers.
The Consumer Products segment develops, markets and administers extended warranties and product replacement plans on household appliances, consumer electronics, televisions, computers and home office equipment, which are sold principally through retailers, distributors, manufacturers, utility companies, financial institutions and other specialty marketers.
The International segment designs, develops, markets and acts as a third party administrator for many of the same Programs and services outside the United States that Warrantech Automotive and Warrantech Consumer Products market and administer in the United States and Canada.
The Direct segment markets these warranties and plans directly to the ultimate consumer on behalf of the retailer/dealer and/or the manufacturer through telemarketing and direct mail campaigns. It also offers call center and technical computer services.
Insurer in Liquidation - ----------------------
During the second fiscal quarter of 2002, the Pennsylvania Insurance Commissioner informed the Company that Reliance would be liquidated and cease making payments on claims. The Pennsylvania Insurance Commissioner determined that Reliance was not likely to be able to satisfy all of the claims that would be submitted to it due to the circumstances arising out of the September 11, 2001 terrorist attacks on the World Trade Center. Reliance underwrote approximately 48% of the automotive service contracts that were sold by Warrantech Automotive during approximately one and one-half years ending in November 2001. Approximately 52% of the automotive service contracts sold by Warrantech Automotive during that period are not affected by the Reliance liquidation. Service contracts sold before and after that period are not affected because they are underwritten by other insurance companies.
Warrantech Automotive was the named obligor, as well as the administrator, under some of the vehicle service contracts insured by Reliance. As the obligor, Warrantech Automotive would ultimately be responsible for paying for the repairs under such contracts. Additionally, for financial reporting purposes only, Warrantech is treated as the obligor under the service contracts in which Butler is the named obligor. While Warrantech is not obligated to pay claims under such service contracts, it has treated the claims obligations under the Butler-obligor contracts, including the service contracts which were insured by Reliance, as obligations of the Company for accounting purposes.
Prior to Reliance's liquidation, Reliance covered the cost of the repairs under the insurance policies it provided. Because of Reliance's liquidation, insurance coverage for the Company's obligations under those service contracts ceased to exist. However, a non-insurance affiliate of Reliance, Reliance Warranty Company ("RWC"), which was not placed in liquidation, held premiums totaling approximately $15,892,635 relating to a portion of the service contracts in which Butler, the retailer/dealers and Warrantech Automotive were
the named obligors. The Company received $15,892,635 from RWC during the fourth quarter of fiscal 2004, as part of a settlement for claims paid by the Company on behalf of RWC
Funding to cover these uninsured claims is provided by a special surcharge, which is payable on applicable VSC's sold under a Program after November 19, 2001. This surcharge will be paid by clients through which Reliance-insured VSC's were sold. These funds will be used to pay valid claims submitted under VSC's previously insured by Reliance.
To mitigate its claims liability expense resulting from Reliance's liquidation, the Company is attempting to ascertain if any recovery is available on Federal subsidies as a result of the terrorist attacks to the insurance industry in general or Reliance specifically, to pay vehicle service contract claims. If such subsidies are available, it could take years before recovery, if any, is obtained. In February 2005, the Company also began legal proceedings for recovery of approximately $3 million against certain state guaranty funds. In June 2005, the Company made its first state guaranty settlement with one of the defendants in its action. In March 2006, the Company settled with all remaining state guaranty agencies for $996,000.
Butler Financial Services, LLC - ------------------------------
Each Plan contains the name of a designated obligor that is legally responsible for the cost of any valid claim submitted under the Plan. The Company, however, arranges for an independent insurance company to issue a policy on behalf of the named obligor that covers all of the obligor's liabilities under the Plan for the Automotive and Consumer Products segments. As a result, the insurance company is ultimately responsible for paying the cost of any and all valid claims submitted under the Plans. In the event, however, that the insurance company refuses or is unable to pay a covered claim, the designated obligor will be responsible for the payment and it will have recourse against the insurance company or its estate (in the event of an insolvency or liquidation) to recover the payment.
Prior to April 1, 2000, one of the Company's subsidiaries or a retailer/dealer would routinely be named the obligor under the Plans. Since April 1, 2000, however, Butler, a company unrelated to Warrantech but included in the Company's financial results due to its close transactional ties with the Company, has served as the obligor under all Plans sold or issued under a Program in exchange for a fee payable by the seller or issuer of the Plan. Notwithstanding the forgoing, however, a Company subsidiary continues to act as the designated obligor for Plans sold in the States of California and Florida due to regulatory considerations. Furthermore, Butler has contractually assumed the liabilities of the obligor under all pre-existing Plans in which one of the Company's subsidiaries was named as the designated obligor. The liabilities of the designated obligor under these pre-existing Plans were insured by an independent insurance company and, as a result of this assumption by Butler, the coverage afforded by these insurance policies now benefits Butler as the named obligor.
Certain of the Plans under which Butler is the designated obligor were insured by Reliance. The liquidation of Reliance (see "Management's Discussion and Analysis - Insurer in Liquidation" above) has eliminated Butler's insurance coverage under those Plans. As the obligor, Warrantech Automotive is ultimately responsible for paying the valid claims submitted under those VSC's in which Warrantech Automotive is the designated obligor. Prior to Reliance's liquidation, Reliance paid the cost of such covered claims under the insurance policies it provided. Subsequent to the liquidation of Reliance, however, insurance coverage for Warrantech Automotive's obligations under those VSC's was no longer available.
While the Company had provided Butler notice of termination of the Obligor Agreement between the two Companies effective Oct 22, 2004, it subsequently amended the termination notice and Butler remains the obligor on certain service contracts.
For financial reporting purposes, for the reasons stated in Footnote 2 of the Financial Statements annexed to this Report, the Company has adopted a policy to treat the Butler-obligor contracts as if they were
administrator-obligor contracts and recognizes revenues under such contracts pursuant to TB 90-1. The Company also includes, as its own liabilities, liabilities of Butler relating to such contracts. Additionally, because the Company is treating the Butler-obligor contracts as Warrantech-obligor contracts for financial purposes only, the Company eliminated the transactions between Warrantech and Butler from its financial statements.
Reflecting these transactions for financial reporting purposes does not alter the legal obligations under the applicable agreements in which the Company is not responsible for, and has not assumed, the obligations of Butler. Butler remains legally obligated under such agreements and the service contracts in which it is the named obligor.
Butler is not deemed a "consolidated subsidiary" of the Company, as that term is used in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report. Butler's income, expenses, assets and liabilities have not been consolidated with those of the Company. Butler is an independent entity owned by parties unrelated to the Company and, except for the transactions between Butler and Warrantech as described in this Report, Warrantech does not have knowledge of, or control over, Butler's affairs or financial reporting. Warrantech also has no knowledge of, nor has it established or evaluated, Butler's internal controls or disclosure controls or procedures. Any reference to "consolidated subsidiary," internal controls or disclosure controls and procedures in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report, do not pertain to Butler.
Significant Customer In Bankruptcy - ----------------------------------
On January 11, 2005, Ultimate Electronics, Inc. and six of its subsidiaries ("Ultimate") filed individual voluntary petitions for relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. Sales to Ultimate represented 10% and 32% of the Company's and its Consumer Products segment's total gross revenues during fiscal 2005. Pursuant to the provisions of Chapter 11, Warrantech was obligated to honor its existing contract with Ultimate and Ultimate continued to sell service contracts during this period of reorganization. Ultimate has made all its payments to Warrantech with respect to sales subsequent to January 11, 2005 ("post-petition sales)." At the time of filing, however, Warrantech believes that Ultimate owed it approximately $3.27 million for sales up to January 11, 2005 ("pre-petition sales") and Warrantech has filed a "proof of claim" in this amount with the Court. At this time, although Warrantech's proof of claim has been reviewed and approved, Warrantech does not know what it will recover on its claim. No provision for bad debts has been recorded as of March 31, 2006, as there are offsetting liabilities and reserves. The Plan of Reorganization has been approved by the Bankruptcy Court and Ultimate's creditors. Ultimate and its advisors have reviewed filed claims and have made initial determinations regarding preference payments and other amounts that may be recoverable from creditors. They are now contacting those creditors who appear to have the largest potential obligations to the bankruptcy estate in an effort to negotiate settlements. These discussions are expected to continue for a number of months. The first distributions to creditors could occur as early as the 3rd quarter of calendar 2006 although they are more likely to begin during the 4th quarter of calendar year 2006.
In separate orders dated April 19, 2005, the Court approved actions to close thirty (30) of Ultimate's stores and retain a liquidator to dispose of existing inventory. The liquidator was authorized by the Court to sell Warrantech service contracts during the liquidation period in accordance with the terms of the existing Ultimate contract. The liquidation period has been completed. The remaining stores were purchased by Mark Wattles, the principal shareholder of Ultimate, through an entity named Ultimate Acquisition Partners, L.P. ("Acquisition"). As part of the Purchase Agreement, Acquisition was given until August 31, 2005, to decide if it wanted to assume Ultimate's contract with Warrantech. On November 1, 2005, Acquisition notified Warrantech that it had elected not to continue selling warranties administered by Warrantech effective November 15, 2005. Acquisition has made all of its payments to Warrantech with respect to its sales.
At March 31, 2006, the Company was owed $3.7 million by Ultimate, in which the Company has filed a proof of claim for $3.27 million with the bankruptcy court. The remaining balance has subsequently been paid. No provision for bad debts has been recorded with respect to Ultimate as of the fiscal year ended March 31, 2006.
Insurance Relationships - -----------------------
As of November 1, 2005, Great American and Warrantech mutually agreed to modify their current arrangement to provide for a final extension of the administration agreement through November 27, 2005. Under this extension, Great American agreed to continue writing new business for existing clients through December 31, 2005. This mutual agreement was based on certain changes in Great American's strategic direction and Warrantech's resulting belief that it would be in the best interests of Warrantech and its customers to establish new insurance relationships. Since entering into this agreement, both parties have acknowledged that the required transitions have taken longer than originally anticipated. Therefore, Great American and Warrantech have verbally agreed to several extensions of the initial deadline to allow these transitions to occur in an orderly manner. As of the date hereof, Great American has agreed to continue writing business for existing clients through March 12, 2006. On June 7, 2006, in conjunction with the Merger Agreement, GAIC has agreed to continue writing new automotive business for existing clients through December 31, 2006. Effective June 1, 2006 the Company entered into an agreement on consumer products with Amtrust North America, Inc pursuant to which Amtrust will insure any new service contracts.
Results of Operations - ---------------------
The following information should be read in conjunction with the information contained in the Consolidated Financial Statements and the Notes thereto included in "Item 8 - Financial Statements and Supplementary Data" of this Annual Report.
Gross Revenues --------------
For the Years Ended March 31, ------------------------------------------ 2006 2005 2004 ------------ ------------ ------------ Automotive segment $ 78,154,529 $ 69,374,933 $103,494,113 Consumer Products segment 33,193,512 35,781,604 31,594,250 Direct segment 10,959,404 7,988,206 7,318,032 International segment 987,205 759,659 1,923,047 ------------ ------------ ------------ Total gross revenues $123,294,650 $113,904,402 $144,329,442 ============ ============ ============
Gross revenues for the year ended March 31, 2006 increased $9,390,248 or 8% over fiscal 2005. The Automotive segment reported an increase in gross revenue during the period resulting from several new clients. The Consumer Products segment reported a slight decrease in gross revenue as most major clients had increased their volumes and there was an increase from home warranty revenue but it did not fully offset the revenue lost from Ultimate Acquisition which elected not to continue effective November 15, 2005 and Microcenter whose contract expired June 28, 2005. Direct segment revenues continue to increase as the segment continues to expand operations into other regions. International segment gross revenues decreased as a result of the loss of customers. The Peru and Chile operations were closed April 1, 2006 and the financial impact shown under gain (loss) for discontinued operations.
Gross revenues for the year ended March 31, 2005 decreased $30,425,040 or 21% over fiscal 2004. The Consumer Products segment reported increased gross revenues of 13% in the year ended March 31, 2005 over 2004, while the Automotive segment reported a decrease in gross revenues of 33%, during the same period. The decrease in gross revenues in the Automotive segment was due to the downturn in sales of new cars and a reduction in volume arising from premium rate
increases. The increase in the Consumer Products segment was due to the opening of additional stores by one of the Company's top dealers. The International segment decrease in gross revenues during fiscal year 2005, resulted from lower sales volumes in Puerto Rico due to the suspension of auto warranty sales.
Direct Costs ------------
For the Years Ended March 31, ------------------------------------------ 2006 2005 2004 ------------ ------------ ------------
Direct costs $ 96,391,032 $ 84,547,374 $ 85,240,347 ============ ============ ============
Direct costs are those costs directly related to the production and acquisition of service contracts. These costs consist primarily of insurance premiums and commission expenses. Direct costs for the fiscal year ended March 31, 2006 of $96,391,032 increased $11,843,658 or 14% as compared with $84,547,374 during the fiscal year ended March 31, 2005.
Direct costs for the fiscal year ended March 31, 2005 of $84,547,374, decreased $692,973 or 10% as compared with $85,240,347 during the fiscal year ended March 31, 2004.
Service, selling and general and administrative expenses ("SG&A") for 2006 increased $1,661,635 or 7% compared to 2005. Legal expenses decreased $244,346 for the year ended March 31, 2006 compared to 2005, primarily due to legal costs recovered from the state guaranty funds. Employee costs increased $245,617 from $16,381,966 in fiscal 2005 to $16,627,583 for the year ended March 31, 2005, primarily due to the addition of sales personnel in the Home segment. Travel and Entertainment also increased $204,850 from $956,115 in 2005 to $1,160,965 in 2006 as a result of the addition of sales personnel in the Home segment. Lastly, sales related costs increased $282,863 from $935,676 in 2005 to $1,218,539 in 2006 mainly as a result of the addition of sales personnel in the Home segment.
Service, selling and general and administrative expenses ("SG&A") for 2005 decreased $3,312,934 or 12% compared to 2004. Legal expenses increased $369,750 for the year ended March 31, 2005 compared to 2004, primarily due to legal costs associated with the SEC review in early 2005. Employee costs decreased $1,461,171 from $17,843,137 in fiscal 2004 to $16,381,966 for the year ended March 31, 2005, primarily due to the deferral of employee sales related compensation to future years. Rent and related costs expense decreased $528,720 from $2,174,973 for the year ended March 31, 2004 to $1,646,253 for the year ended March 31, 2005, reflecting lower deferred rent charges as a result of the Company's move to its new corporate headquarters in Bedford, Texas.
Depreciation and amortization -----------------------------
For the Years Ended March 31, ------------------------------------------ 2006 2005 2004 ------------ ------------ ------------
Depreciation and amortization $ 1,619,941 $ 2,537,117 $ 3,268,593 ============ ============ ============
Depreciation and amortization expenses were reduced by $917,176 or 36% during 2006 compared to 2005 and by $730,634 or 22% during 2005 compared to 2004. The decrease in depreciation and amortization is the result of the Company's assets maturing and a reduced requirement for capital expenditures for the past few years.
Provision for bad debts -----------------------
For the Years Ended March 31, ------------------------------------------ 2006 2005 2004 ------------ ------------ ------------
Provision for bad debts $ 1,098,222 $ 4,045,271 $ 590,000 ============ ============ ============
Provision for bad debts decreased $2,947,049 during the fiscal year 2006. As a result of a negotiated settlement with the estate of Jeff White, former Company director, for the repayment of his outstanding loan to the Company, the Company forgave $1,098,222 of the debt. Provision for bad debts increased $3,455,271 during the fiscal year 2005.
During fiscal year ending March 31, 2005 and March 31, 2004, the Company incurred $1,865,399 and $1,853,555, respectively, in legal expenses related to the Lloyd's litigation. The Company, in anticipation of receiving reimbursement for these expenses from its insurance company under a professional liability insurance policy, deferred the legal fees. In January 2005, as a result of a summary judgment, the court ruled that the insurance company was not responsible for payment of the Company's legal costs. The Company has appealed the court's decision. As a result of the lower court's ruling, the Company has provided for this potential bad debt of $3,718,954 during the year ended March 31, 2005.
Other Income ------------
Other income for 2006 decreased $576,776 compared to 2005, an increase in interest expense due to the Company's extended payment terms for its insurance premium payable to Great American.
Other income for 2005 increased $281,918 or 50% compared to 2004, primarily due to higher rebates from usage by the Company of its credit card transactions.
Gain (Loss) for Discontinued Operations ---------------------------------------
On April 1, 2006 the Company closed its operations in Peru and Chile as several customers did not renew their agreements. These countries showed a loss of $888,778 and $1,640,014 for March 31, 2006 and 2005, respectively, and a gain of $35,664 for the fiscal year ended March 31, 2004.
The net deferred tax asset as of March 31, 2006, 2005 and 2004 contained a benefit of $1,121,051, $725,544, and $137,456, respectively, related to foreign losses. Management does not believe the amount of this benefit is more likely than not to be realized. Accordingly, management has reserved the amount of this benefit.
Comprehensive Income --------------------
Other comprehensive income for the year ended 2006 was materially flat compared to the year ended March 31, 2005. Gains from foreign currency translation adjustments decreased $277,949 for the year ended March 31, 2005 compared to 2004 and foreign currency translation adjustments gains were $364,858 for the year-ended March 31, 2004 compared to losses of $158,659 for 2003, primarily due to Peru and Chile foreign currency translation fluctuations.
Agreements - ----------
The Company entered into agreements with Butler and GAIC to arrange for the coverage of claims filed under the service contracts previously insured by Reliance. Under these agreements, Butler agreed to assume all the obligations to pay the claims under the service contracts which were covered by the premiums being held by RWC. The Company executed an agreement with GAIC that provides the Company with extended payment terms and a $3 million line of credit ("GAIC Agreement"). All of the Company's obligations to GAIC pursuant to the GAIC Agreement are secured by all of the Company Automotive and Consumer Products segment's accounts receivable, which were $23,537,597 and $19,118,161 at March 31, 2006 and 2005, respectively. Further, GAIC received options to purchase up to 1,650,000 shares of Warrantech's common stock at an exercise price of $1.00 per share subject to certain adjustments. In the event that GAIC exercises all of these options, it would own approximately 11.8% of the Company's outstanding shares, net of shares held in the treasury.
Under an agreement between Butler and RWC that was finalized in the fourth quarter of 2004, $15,892,635 of funds held by RWC were remitted to the Company in repayment of the money which the Company had advanced to pay claims on certain service contracts that had been insured by Reliance and its affiliates. The Company agreed, as a condition of RWC remitting the $15,892,635, to guarantee certain indemnification obligations of Butler under its agreement with Reliance.
Funding to cover the uninsured claims is provided by a special surcharge, which is payable on applicable VSC's sold under a Program after November 19, 2001. This surcharge will be paid by clients through which Reliance-insured VSC's were sold. These funds will be used to pay valid claims submitted under VSC's previously insured by Reliance.
During the years ended March 31, 2006, 2005, 2004, 2003 and 2002, the Company paid $1,303,782, $4,727,643, $9,262,407, $10,959,364 and $5,770,999, respectively, in claims related to Reliance obligations. Remaining amounts are expected to be paid out as set forth in the following table.
Liquidity and Capital Resources - -------------------------------
As of March 31, 2006, total cash and short-term investments totaled $5,064,089, a decrease of $966,003 or 16% from $6,030,092 at March 31, 2005. During the fiscal year ended March 31, 2006, the Company used net cash from operations totaling $866,210, compared to generating net cash from operations of $280,170 for the fiscal year ended March 31, 2005. The change in net cash from operations is due to an increase in insurance premiums payable, mainly because of the increase in revenue. The negative change in its working capital from a negative $15.4 million at March 31, 2005 to a negative $17.1 million at March 31, 2006 was due primarily due to an increase in premium payable. During fiscal year 2006, the Company increased its accounts receivable by $4.7 million as a result of higher sales from its automotive business. The Company offset the use of those funds with a $6.0 million increase in its insurance premiums payable and $1.7 million increase in its accounts and commissions payable.
The Company believes that it will have sufficient funds to finance its current operations for at least the next twelve months from internally generated funds and from extended terms and the $3 million line of credit from Great American Insurance Company ("GAIC"). Additional potential sources of liquidity include the possibility of potential reduced litigation expenditures in the event of either a successful appeal pending in the 5th circuit regarding the LLoyds Underwriters litigation, described in the "Legal Proceedings" section of this Report ("Lloyds Matter") or a successful appeal also pending in the 5th circuit regarding Steadfast Insurance Company's defense in the Lloyds Matter. Furthermore, the merger (see: Merger Agreement), if approved, will positively impact the Company's active search for additional lines of credit to fund working capital. The Company is aggressively pursuing new business domestically to fund future working capital. The Company plans to continue to contain its SG&A costs and utilize technologies for operational efficiencies to further enhance both its operating income and cash flows from operating activities.
With the loss of several major customers in the Consumer Products segment, revenues in the Consumer Product and Direct segments are expected to continue to remain flat compared to the previous year. The Consumer Products segment expects to replace a portion of its business by the end of the fiscal year and continues to expand operations in its Home warranty business. Losses in the Company's International operations should be significantly reduced with the closing of operations in South America and the commencement of operations in Mexico with minimal SG&A costs. The Automotive segment plans to restart its auto warranty operations in Puerto Rico during the 2nd fiscal quarter. Additionally, Automotive segment revenues are expected to continue to increase due to the acquisition of new clients. Stable insurance premium costs have allowed the Company's automotive warranties to be more competitive than in the previous year and the Company has expanded into other distribution channels.
During the fiscal year ended March 31, 2006, the Company used $562,011 in cash in investing activities compared to the use of $239,443 in investing activities in the prior year. This increase in use of funds of $322,568 is primarily due to an decrease in proceeds from the sale of marketable securities. The Company used slightly more funds from the purchase of property and equipment during the current fiscal year. The Company has ongoing relationships with equipment financing companies and intends to continue financing certain future equipment needs through leasing transactions. The total amount financed through leasing transactions during the fiscal year ended March 31, 2006 amounted to $205,345 compared to $538,609 during the fiscal year ended March 31, 2005. At fiscal year end 2006, the Company had $1,093,328 in debt from capital lease obligations compared to $1,465,610 at fiscal year-end 2005.
During the fiscal year ended March 31, 2006, the Company provided $712,371 in cash from financing activities compared to uses of ($678,754) in fiscal year 2005. The variance was primarily due to the reduction of $3,549,000 in loans by Company directors (see: Loans to Directors) and their tendering of shares back into treasury of $1,161,111.
During the fiscal year ended March 31, 2006 the Company obtained 1,519,425 shares of its common stock for an aggregate amount of $1,161,611 compared to the 32,500 shares of its common stock for an aggregate of $23,956 in the fiscal year ended March 31, 2005.
As a result of restricted cash requirements in the State of Florida for the Home warranty business, the Company increased its restricted cash balance by $100,000 during fiscal year 2005.
Loans to Directors - ------------------
On July 6, 1998, Joel San Antonio, Warrantech's Chairman and Chief Executive Officer, and William Tweed and Jeff J. White, members of Warrantech's Board of Directors, exercised an aggregate of 3,000,000 of their vested options to purchase Warrantech common stock. Promissory notes totaling $8,062,500 were signed with interest payable over three years at an annual rate of 6%. The promissory notes, which were with recourse and secured by the stock certificates issued, matured July 5, 2001. The value of the collateral for the Notes, which consists of a total of 3,040,000 shares of the Company's common stock, is currently $1,824,000, as of May 31, 2005, based upon the market price of the stock on that date. Under the loan documents, the Company does not have a right to require the payors to increase the loan collateral. On March 22, 1999, Joel San Antonio delivered an additional promissory note for $595,634, payable to the Company, representing the amounts funded by the Company for the payroll taxes payable by him upon the exercise of these options. The exercise of these stock options and the anticipated tax benefit from this transaction represented approximately $10 million.
In February 2000, the Company agreed to restructure the loans to Mr. Tweed and Mr. White by capitalizing the interest due and extending the loan maturity from July 5, 2001 until January 31, 2005. Interest on the restructured loans accrued annually at the applicable federal rate of 6.2%. Under the restructuring, interest first became payable on the third anniversary of the restructuring and was payable annually thereafter. In July 2002, the Company extended the loan maturity dates until February 1, 2007 (the "loan extension"). The interest, which accrued on the notes up to the time of the loan extension, was added to the principal of the notes. The new principal amount of Mr. Tweed's note is $3,189,675 and of Mr. White's note is $2,912,430. The applicable federal interest rate on the notes following the loan extension is 4.6%. Under the loan extension, interest on the notes will accrue until February 1, 2005 and, at that time, the accrued interest will be added to the principal of the notes. Commencing on February 1, 2005, interest on the new principal amount of the loans to Mssr. Tweed and White is payable annually in arrears, with the first interest payment becoming due on February 1, 2006. On January 31, 2006, in lieu of a cash payment for the $148,033 in interest due by Mr. Tweed, the Company agreed to accept 211,476 shares of its Common Stock.
In February 2000, the Company also agreed to restructure the two existing loans to Mr. San Antonio (as restructured, the "Combined Loan"). The Combined Loan, finalized in March 2001, was due on January 31, 2005 and accrued interest annually at 5.2%. In July 2002, the Company extended the loan maturity date until February 1, 2007 and the interest rate was changed to the then applicable federal rate of 4.6%. The principal amount of Mr. San Antonio's note is $4,165,062. Interest will be forgiven as long as Mr. San Antonio continues to be employed by the Company. The $194,254, $194,254, 194,786 and $133,050 of interest which accrued on the note during fiscal years 2006, 2005, 2004 and 2003, respectively has been forgiven. The interest was charged to operations as additional compensation in the respective fiscal years the interest income was accrued.
Mr. White passed away on November 30, 2005. Pursuant to a promissory note given by Mr. White to the Company in connection with his exercise of stock options, Mr. White's estate owed the Company $3,401,799 as of February 28, 2006. His death triggered an acceleration provision of the promissory note, which provides that if the note is not paid within 90 days after his death (March 1, 2006), the Company is entitled to declare all amounts owed under the note due and payable. An interest payment per the terms of the note was due on February 1, 2006. The Company's Board of Directors agreed to extend the due date of the interest payment until Feb 28, 2006. In consideration for the note, the Estate
of Mr. White ("Estate") and the Company agreed that the Estate would transfer $1,290,000 in cash and 1,322,048 shares of the Company's Common Stock valued at $1,013,577 and in exchange the Company would forgive $1,098,222 of the remaining amount of Mr. White's loan with the Company.
The total amount of the restructured loans to Mr. Tweed and Mr. San Antonio at March 31, 2006, including the capitalized interest of $400,556, is $7,755,292. For a discussion and the impact on these loans based on the Merger see : Merger Agreement.
The total amount of the restructured loans to Mr. Tweed, Mr. White and Mr. San Antonio at March 31, 2005, including the capitalized interest of $764,899, is $11,032,065.
Commitments - -----------
Set forth below is information about the Company's commitments outstanding at March 31, 2006.
The effect of inflation has not been significant to the Company.
Subsequent Event - Merger - -------------------------
On June 7, 2006, the Company, entered into an Agreement and Plan of Merger (the "Merger Agreement") with WT Acquisition Holdings, LLC, a Delaware limited liability company ("Parent") and WT Acquisition Corp., a Nevada corporation and direct wholly-owned subsidiary of Parent ("Merger Sub"). The Merger Agreement contemplates that, subject to the terms and conditions of the Merger Agreement, Merger Sub will be merged with and into the Company, with the Company continuing after the Merger as the surviving corporation (the "Merger").
Pursuant to the Merger Agreement, at the effective time of the Merger (the "Effective Time"), each issued and outstanding share of common stock of the Company will be converted into the right to receive $0.75 in cash, without interest (the "Cash Consideration"). As of the Effective Time, all shares of the Company's common stock issued and outstanding prior to such Effective Time shall no longer be outstanding and shall automatically be cancelled and retired and shall cease to exist, and each holder of a certificate representing any such shares of common stock shall cease to have any rights with respect thereto, except the right to receive the Cash Consideration or the fair value of the shares pursuant to the appraisal rights available under Nevada law. Each outstanding Company stock option at the time of closing will be cancelled in the Merger and the holder thereof shall be entitled to an amount of cash, without interest, equal to the excess, if any, of $0.75 over the exercise price of such stock option with respect to each share of stock issuable upon exercise of such stock option.
Following the recommendations of the Special Committee of disinterested directors, the Boards of Directors of the Company and Merger Sub have, and the Board of Managers of Parent has, approved the Merger Agreement. Completion of the Merger is subject to customary closing conditions, including, among other things, (i) adoption of the Merger Agreement by the Company's stockholders, (ii) absence of any injunction prohibiting the consummation of the Merger, (iii) the accuracy of the representations and warranties of each party, and (v) compliance of the Company with its covenants.
The Merger Agreement contains certain termination rights for both the Company and Parent, and further provides that, upon termination of the Merger Agreement under specified circumstances, the Company may be required to pay Parent a termination fee of $1,250,000.
THE COMPANY STOCKHOLDER AGREEMENTS
In connection with the execution of the Merger Agreement, certain of the Company's principal stockholders holding in the aggregate 35.5% of the Company's issued and outstanding common stock entered into stockholder voting agreements with Parent and/or Parent and the Company (the "Company Stockholder Agreements"), pursuant to which, among other things, such stockholders agreed to vote their shares of common stock in favor of the Merger and against any other acquisition proposal for a period of twelve months following termination of the Merger Agreement. In addition, Joel San Antonio, the Company's Chairman of the Board and Chief Executive Officer entered into an agreement with Parent and the Company which contains the terms of the Company Stockholder Agreements, grants an option to Parent to purchase Mr. San Antonio's shares for $0.75 per share exercisable for a period of twelve months following termination of the Merger Agreement, and also provides for the application of amounts paid to Mr. San Antonio for his shares and stock options to reduce his outstanding indebtedness to the Company, the termination of the outstanding obligations under Mr. San Antonio's employment agreement with the Company in exchange for a cash payment of $1,700,000 and the grant to Mr. San Antonio of a common equity award equal to 22.5% of the common equity interests in Parent. In addition, the Company is aware of a letter agreement between Parent and Mr. San Antonio relating to (i) the forgiveness of accrued and unpaid interest owed on Mr. San Antonio's indebtedness to the Company through the Effective Time, (ii) the forgiveness of approximately $600,000 of outstanding principal on such indebtedness, and the extension of the maturity date of the promissory note, evidencing the remaining indebtedness of approximately $1,050,000, until the second anniversary of the closing of the Merger. William Tweed, a former director of the Company also entered into an agreement with Parent and the Company which contains the terms of the Company Stockholder Agreements, grants an option to Parent to purchase Mr. Tweed's shares for $0.75 per share exercisable for a period of twelve months following termination of the Merger Agreement, and also provides for the application of amounts paid to Mr. Tweed for his shares to reduce his outstanding indebtedness to the Company and the extension of the maturity date of the promissory note evidencing the remaining indebtedness of approximately $2,394,796, until December 31, 2013.
CONSOLIDATION AND SALE OF CERTAIN COMPANY DEBT
In connection with the Merger, the outstanding indebtedness of the Company and its subsidiaries to Great American Insurance Company, GAI Warranty Company, GAI Warranty Company of Florida and GAI Warranty Company of Canada (collectively, "GAI") through March 1, 2006 is being consolidated under a single term promissory note between GAI, the Company and such subsidiaries (the "Term Note"), which is secured by a first priority, continuing security interest in and to all of the tangible and intangible assets of the Company and its subsidiaries granted to GAI under the terms of a security agreement by and between GAI, the Company and its subsidiaries (the "Security Agreement"). All principal and interest under the Term Note is due and payable in 120 days. The Term Note is in full novation of any and all other debt instruments and obligations to repay indebtedness between GAI and the Company and its subsidiaries through March 1, 2006. The Term Note and Security Agreement contain customary representations and warranties, affirmative and negative covenants and events of default.
Contemporaneously with the execution of the Merger Agreement, GAI sold to Wtech Holdings, LLC ("Wtech"), an affiliate of Parent, all of its rights and obligations under the Term Note and Security Agreement, whereupon Wtech became the primary secured lender to, and creditor of, the Company and its subsidiaries. The Company is not a party to the agreement providing for the sale and transfer of GAI's rights under the Term Note and the Security Agreement, although the Company granted its consent with respect thereto.
Critical Accounting Policies - ----------------------------
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Note 1 to the Company's Consolidated Financial Statements set forth in the "Item 8. - Financial Statements and Supplementary Data," in the Company's Annual Report on Form 10-K for the year ended March 31, 2005, describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. The following lists some of the Company's critical accounting policies affected by judgments, assumptions and estimates.
Revenue Recognition Policy
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Note 1 to the Company's Consolidated Financial Statements set forth in the "Item 8. - Financial Statements and Supplementary Data," describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. The following lists some of the Company's critical accounting policies affected by judgments, assumptions and estimates.
Revenue from administrator-obligor contracts is recognized in accordance with Financial Accounting Standards Board Technical Bulletin 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts, ("TB 90-1"). The Company recognizes such revenue over the life of the contract on a straight-line basis. In addition the Company charges the costs of contracts to operations over the life of the contracts on a straight-line basis.
Historically, through June 30, 2003, the Company recognized revenues from dealer-obligor service contracts, in which the retailer/dealer or a third party is designated as the obligor, in direct proportion to the costs incurred in providing the service contract programs to the Company's clients. Revenues in
amounts sufficient to meet future administrative costs and a reasonable gross profit were deferred. With the issuance of EITF Abstracts Issue No. 00-21 (EITF No. 00-21), "Revenue Arrangements with Multiple Deliverables", as of July 1, 2003, the Company recognizes revenue from these dealer-obligor contracts on a straight-line basis over the life of the service contract, pursuant to Staff Accounting Bulletin 101.
Since Butler has been determined to be a nominally capitalized entity, all transactions concerning Butler obligor-contracts are treated in a manner similar to the accounting principles discussed in Financial Accounting Standards Board Emerging Issues Task Force Topic No. D-14, "Transactions Involving Special-Purpose Entities." The Company treats the Butler-obligor contracts as if they were administrator-obligor contracts and recognizes revenues under such contracts pursuant to TB 90-1. Additionally, because the Company is treating the Butler-obligor contracts as Warrantech-obligor contracts for financial reporting purposes only, the Company eliminated the transactions between Warrantech and Butler from its financial statements.
Reflecting these transactions for financial reporting purposes does not alter the legal obligations under the applicable agreements in which the Company is not responsible for, and has not assumed the obligations of Butler. Butler remains legally obligated under such agreements and the service contracts in which it is the named obligor. Butler is not deemed a "consolidated subsidiary" of the Company, as that term is used in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report. Butler's income, expenses, assets and liabilities have not been consolidated with those of the Company. Butler is an independent entity owned by parties unrelated to the Company and, except for the transactions between Butler and Warrantech as described in this Report, Warrantech does not have knowledge of, or control over, Butler's affairs or financial reporting. Warrantech also has no knowledge of, nor has it established or evaluated, Butler's internal controls or disclosure controls or procedures. Any reference to "consolidated subsidiary," internal controls or disclosure controls and procedures in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report, do not pertain to Butler.
Now that the Company is required to recognize revenues from all service contracts over the life of the service contracts, the Company believes that it is unlikely that the Company will be able to report operating profits until at least 2008 when the Company expects that the revenues recognized from prior periods will begin to equal the revenue being deferred to future periods. However, there can be no assurance that the Company will be profitable at that time. In the meantime, the revenue recognition policies adopted by the Company do not have an impact on the Company's cash flows which are an important measure of the Company's financial condition and are reflected in the Statements of Cash Flows which are part of these financial statements.
Direct Costs
Direct costs, consisting primarily of insurance premiums and commissions, are costs directly related to the production and acquisition of service contracts. Effective with the application of the revenue recognition policy(s) described above on all service contracts, the Company recognizes direct costs according to Statement of Financial Accounting Standards No. 113 ("SFAS 113"), "Accounting and Reporting for Reinsurance of Short-Duration and Long Duration Contracts" which requires that insurance premium costs be ratably expensed over the life of the service contract.
Impairment of Long-Lived Assets
The Company assesses potential impairment of its long-lived assets, which include its property and equipment and its identifiable intangibles such as software development costs, goodwill and deferred charges under the guidance of SFAS 144 "Accounting for the Impairment or Disposal of Long-Lived Assets." Once annually, or as events or circumstances indicate that an asset may be impaired, the Company assesses potential impairment of its long-lived assets. The Company
determines impairment by measuring the undiscounted future cash flows generated by the assets, comparing the result to the assets' carrying value and adjusting the assets to the lower of their carrying value or fair value and charging current operations for any measured impairment. At 2005, the Company found no impairment to its property and equipment or its other identifiable intangibles. At March 31, 2006 the Company provided for the impairment of its assets in Chile and Peru for $23,464.
Income Taxes
Deferred tax assets and liabilities are determined using enacted tax rates for the effects of net operating losses and temporary differences between the book and tax bases of assets and liabilities. The Company records a valuation allowance on deferred tax assets when appropriate to reflect the expected future tax benefits to be realized. In determining the appropriate valuation allowance, certain judgments are made relating to recoverability of deferred tax assets, use of tax loss carryforwards, level of expected future taxable income and available tax planning strategies. These judgments are routinely reviewed by management. At March 31, 2006, the Company had deferred tax assets of $24,376,209, net of a valuation allowance of $1,385,529.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ----------------------------------------------------------
As of March 31, 2006, the Company did not have any derivatives, debt or hedges outstanding. Therefore, the Company was not subject to interest rate risk. In addition, the risk of foreign currency fluctuation was and is not material to the Company's financial position or results of operations.
Short-term marketable securities and long-term investments are comprised of municipal bonds which bear interest at fixed rates. Interest income from these securities is generally affected by changes in the U.S. interest rates. The following tables provide information about the Company's financial instruments that are sensitive to changes in interest rates. The tables present principal cash flows and weighted-average interest rates by expected maturity dates. All of the investments are considered "available for sale." The resultant differences between amortized cost and fair value, net of taxes, have been reflected as a separate component of accumulated other comprehensive income.
Principal amounts by expected maturity as of March 31, 2006 of marketable securities are as follows:
The following table sets forth the carrying amounts and fair values of the Company's other receivables at March 31, 2006.
Item 8.
Item 8. Financial Statements and Supplementary Data -------------------------------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
Page No. --------
Report of Independent Registered Public Accounting Firm................ 35-37
Consolidated Financial Statements: Statements of Operations and Comprehensive Income For the Fiscal Years Ended March 31, 2006, 2005 and 2004........... 38
Balance Sheets as of March 31, 2006 and 2005....................... 39-40
Statements of Common Stockholders' Equity (Capital Deficiency) For the Fiscal Years Ended March 31, 2006, 2005 and 2004........... 41
Statements of Cash Flows For the Fiscal Years Ended March 31, 2006, 2005 and 2004........... 42
Notes to Consolidated Financial Statements............................. 43
Consolidated Financial Statement Schedules: Schedule VIII - Valuation and Qualifying Accounts...................... 67
All other schedules for which provision is made in applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted or the information is presented in the consolidated financial statements or accompanying notes.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Warrantech Corporation
We have audited the accompanying consolidated balance sheet of Warrantech Corporation and Subsidiaries as of March 31, 2006 and its related consolidated statements of operations and comprehensive income, common stockholders equity (capital deficiency) and cash flows for the fiscal year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether 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 audit provides a reasonable basis for our opinion.
The financial statements of Warrantech Corporation and Subsidiaries as of March 31 J 2005 and 2004 and for the fiscal years then end d were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report dated June 15, 2005.
In our opinion, the 2006 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Warrantech Corporation and Subsidiaries at March 31, 2006 and the consolidated results of their operations and comprehensive income and their cash flows for the fiscal year then ended, in conformity with accounting principles generally accepted in the United States of America.
Our 2006 audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The 2006 consolidated financial statement schedule of valuation and qualifying accounts is presented for purpose of additional analysis and is not a required part of the basic financial statements. Such 2006 information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic 2006 financial statements taken as a whole.
/s/ RAICH ENDE MALTER & CO. LLP
New York, New York June 23, 2006
Information Regarding Consent of Weinick Sanders Leventhal & Co., LLP - ---------------------------------------------------------------------
In its Annual Report on Form 10-K for the year ended March 31, 2005 filed with the Securities and Exchange Commission (the "SEC") on June 15, 2005 (the "Original Filing"), Warrantech Corporation ("the Company"), pursuant to disclosure requirements of Item 8 included the previously issued audit report from Weinick Sanders Leventhal & Co., LLP ("WSL") on the consolidated financial statements of the Company for the fiscal years ended March 31, 2005, 2004 and 2003, which are covered under the WSL audit report dated June 15, 2005. The Company is no longer able to obtain the reissued audit report covering the 2005, 2004 and 2003 consolidated financial statements of the Company because WSL is no longer practicing public accounting. Consistent with the SEC's guidance in paragraph 65 of AU 9508.15, in filing its Annual Report on Form 10-K for the year ended March 31, 2006, the Company is including a previously issued audit report of WSL and is disclosing that (a) the report is a copy of the previously issued WSL report dated June 15, 2005 and (b) the report has not been reissued by WSL. WSL is thus unable to consent to the incorporation by reference to its audit report with respect to the consolidated financial statements as of and for the fiscal years ended March 31 2005, 2004 and 2003. Under these circumstances, Rule 437(a) under the Securities act permits the Company to file its Annual Report on Form 10K, which is incorporated by reference into the Form 10-K, without a written consent from WSL.
[GRAPHIC OMITTED] WEINICK SANDERS 1375 BROADWAY LEVENTHAL & CO. LLP NEW YORK, N.Y. 10018-7010 ------------------------------------------------------------ CERTIFIED PUBLIC ACCOUNTANTS 212-869-3333 FAX: 212-764-3060 WWW.WSLCO.COM
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of Warrantech Corporation
We have audited the accompanying consolidated balance sheets of Warrantech Corporation and Subsidiaries as of March 31, 2005 and 2004 and its related consolidated statements of operations and comprehensive income, common stockholders equity (capital deficiency) and cash flows for the fiscal years ended March 31, 2005, 2004 and 2003. Our audits also included the financial statement schedules listed in the index. These consolidated financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (Unites 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 consolidated financial position of Warrantech Corporation and Subsidiaries at March 31, 2005 and 2004 and the consolidated results of their operations and comprehensive income and their cash flows for the years ended March 31, 2005, 2004 and 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion,' the related consolidated financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
/s/ Weinick Sanders Leventhal & Co., LLP ----------------------------------------
New York, NY June 15, 2005
THIS IS A COPY OF THE AUDIT REPORT PREVIOUSLY ISSUED BY WEINICK SANDERS LEVENTHAL & CO., LLP IN CONNECTION WITH WARRANTECH CORPORATION'S FILING ON FORM10-K FOR THE YEAR ENDED MARCH 31, 2005. THIS AUDIT REPORT HAS NOT BEEN REISSUED BY WEINICK SANDERS LEVENTHAL & CO., LLP IN CONNECTION WITH THIS FILING ON FORM 10-K.
WARRANTECH CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
WARRANTECH CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
(*) Reclassified for comparability
See accompanying notes to consolidated financial statements.
WARRANTECH CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
(*) Reclassified for comparability
See accompanying notes to consolidated financial statements.
WARRANTECH CORPORATION AND SUBSIDIARIES --------------------------------------- CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY)
See accompanying notes to consolidated financial statements.
WARRANTECH CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
* Reclassified for comparability
WARRANTECH CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business - Warrantech, through its wholly owned subsidiaries, designs, develops, markets and acts as a third party administrator for programs ("Programs") for service contracts, limited warranties and replacement plans (collectively, "Plans"). The Company provides these services to a variety of clients in selected industries. On a Program by Program basis in the Automotive and Consumer Products segments, the Company contracts with highly rated independent insurance companies or risk retention groups to provide coverage for the Plans to be sold or issued under the Programs. This coverage obligates the insurer to pay the cost of repairs or replacements of the products covered by the Plans. In the Home segment, the Company is self insured.
Plans issued under the Company's Programs provide consumers with expanded and/or extended product breakdown coverage for a specified period of time (and/or mileage in the case of automobiles and recreational vehicles), similar to that provided by manufacturers under the terms of their product warranties. Coverage generally provides for the repair or replacement of the product, or a component thereof, in the event of its failure. The Company's Programs provide clients with the opportunity for increased revenue and income without incurring the costs and responsibilities of operating their own programs.
The Plans for the Automotive and Consumer Products segments generally have terms extending up to one hundred twenty (120) months or, in the case of mileage based Plans, up to one hundred fifty thousand (150,000) miles. All repairs and/or replacements required under these Plans are performed by independent third party repair facilities or dealers. The cost of any repair or replacement under these plans is generally paid by the insurance company or retention group with which the Company has contracted to provide coverage for the Plan. Plans for the Home segment are generally for twelve months. The cost of any repair or replacement for plans in the Home segment is paid for by the Company.
Contract Obligors - Each Plan contains the name of a designated obligor that is legally responsible for the cost of any valid claim submitted under the Plan. The Company, however, arranges for an independent insurance company to issue a policy on behalf of the named obligor that covers all of the obligor's liabilities under the Plan for the Automotive and Consumer Products segments. As a result, the insurance company is then ultimately responsible for paying the cost of any and all valid claims submitted under these Plans. In the event, however, that the insurance company refuses or is unable to pay a covered claim, the designated obligor will be responsible for the payment and it will have recourse against the insurance company or its estate (in the event of an insolvency or liquidation) to recover the payment.
Prior to April 1, 2000, one of the Company's subsidiaries or a retailer/dealer would routinely be named the obligor under the Plans. Since April 1, 2000, however, Butler Financial Services, LLC ("Butler"), a company unrelated to Warrantech but included in the Company's financial results due to its close transactional ties with the Company, has served as the obligor under all Plans sold or issued under a Program in exchange for a fee payable by the seller or issuer of the Plan. Notwithstanding the forgoing, however, a Company subsidiary continues to act as the designated obligor for Plans sold in the States of California and Florida due to regulatory considerations. Furthermore, Butler had contractually assumed the liabilities of the obligor under all pre-existing Plans in which one of the Company's subsidiaries was named as the designated obligor. The liabilities of
the designated obligor under these pre-existing Plans were insured by an independent insurance company and, as a result of this assumption by Butler, the coverage afforded by these insurance policies now benefits Butler as the named obligor.
Certain of the Plans under which Butler is the designated obligor were insured by Reliance. The liquidation of Reliance has eliminated Butler's insurance coverage under those Plans. Warrantech Automotive is the obligor, as well as the administrator, under some of the VSC's that were insured by Reliance. As the obligor, Warrantech Automotive is ultimately responsible for paying the valid claims submitted under those VSC's in which Warrantech Automotive is the designated obligor. Prior to Reliance's liquidation, Reliance paid the cost of such covered claims under the insurance policies it provided. Subsequent to the liquidation of Reliance, however, insurance coverage for Warrantech Automotive's obligations under those VSC's was no longer available.
While the Company had provided Butler notice of termination of the Obligor Agreement between the two Companies effective Oct 22, 2004, it subsequently amended the termination notice and Butler remains the obligor on certain service contracts.
Basis of Presentation and Principles of Consolidation - The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These consolidated financial statements include the accounts of Warrantech Corporation, its subsidiaries, all of which are wholly owned, and certain transactions involving Butler due to its related interest to the Company. All intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions which affect the reporting of assets and liabilities as of the dates of the financial statements and revenues and expenses during the reporting period. Actual results could differ from these estimates.
Revenue Recognition Policy - Revenue from administrator-obligor contracts is recognized in accordance with Financial Accounting Standards Board Technical Bulletin 90-1, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts," ("TB 90-1"). The Company recognizes such revenue over the life of the contract on a straight-line basis. In addition the Company charges the costs of contracts to operations over the life of the contracts on a straight-line basis.
Historically, through June 30, 2003, the Company recognized revenues from dealer-obligor service contracts, in which the retailer/dealer or a third party is designated as the obligor, in direct proportion to the costs incurred in providing the service contract programs to the Company's clients. Revenues in amounts sufficient to meet future administrative costs and a reasonable gross profit were deferred. With the issuance of EITF Abstracts Issue No. 00-21 (EITF No. 00-21), "Revenue Arrangements with Multiple Deliverables", as of July 1, 2003, the Company recognizes revenue from these dealer-obligor contracts on a straight-line basis over the life of the service contract, pursuant to Staff Accounting Bulletin 101.
Since Butler has been determined to be a nominally capitalized entity, all transactions concerning Butler obligor-contracts are treated in a manner similar to the accounting principles discussed in Financial Accounting Standards Board Emerging Issues Task Force Topic No. D-14, "Transactions Involving Special-Purpose Entities." The Company treats the Butler-obligor contracts as if they were administrator-obligor contracts and recognizes revenues under such contracts pursuant to TB 90-1. Additionally, because the Company is treating the Butler-obligor
contracts as Warrantech-obligor contracts for financial reporting purposes only, the Company eliminated the transactions between Warrantech and Butler from its financial statements.
Reflecting these transactions for financial reporting purposes does not alter the legal obligations under the applicable agreements in which the Company is not responsible, and has not assumed the obligations of Butler. Butler remains legally obligated under such agreements and the service contracts in which it is the named obligor. Butler is not deemed a "consolidated subsidiary" of the Company, as that term is used in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report. Butler's income, expenses, assets and liabilities have not been consolidated with those of the Company. Butler is an independent entity owned by parties unrelated to the Company and, except for the transactions between Butler and Warrantech as described in this Report, Warrantech does not have knowledge of, or control over, Butler's affairs or financial reporting. Warrantech also has no knowledge of, nor has it established or evaluated, Butler's internal controls or disclosure controls or procedures. Any reference to "consolidated subsidiary," internal controls or disclosure controls and procedures in this Report, including, but not limited to, the Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 which are annexed to this Report, do not pertain to Butler.
Now that the Company is required to recognize revenues from all service contracts over the life of the service contracts, the Company believes that it is unlikely that the Company will be able to report operating profits until at least 2008 when the Company expects that the revenues recognized from prior periods will begin to equal the revenue being deferred to future periods. However, there can be no assurance that the Company will be profitable at that time. In the meantime, the revenue recognition policies adopted by the Company do not have an impact on the Company's cash flows which are an important measure of the Company's financial condition and are reflected in the Statements of Cash Flows which are part of these financial statements.
Direct Costs - Direct costs, which consist primarily of insurance premiums and commissions, are those costs directly related to the production and acquisition of service contracts. Effective with the application of the revenue recognition policy described above on all service contracts, the Company recognizes direct costs according to Statement of Financial Accounting Standards No. 113 ("SFAS 113"), "Accounting and Reporting for Reinsurance of Short-Duration and Long Duration Contracts". This requires that insurance premium costs be ratably expensed over the life of the service contract.
Profit Sharing Arrangement - Pursuant to certain agreements with its insurers, the Company may be eligible to share a portion of the insurers' profits on the Company's service contract programs. The amounts to be received, if any, are determined based upon the residual value of the premiums set aside by the insurer to pay losses (the "Loss Fund"). The residual value is comprised of underwriting profits and investment income earned on the monies in the Loss Fund. Subsequent adjustments to original estimates are solely changes in estimates based upon current information, affording the Company better determination of ultimate profit sharing revenues and are reflected in income when known. The Company recognized $0, $41,920 and $173,610 in profit sharing on its International business in the fiscal years ended March 31, 2006, 2005 and 2004, respectively.
Provision for Bad Debt Expense - The Company's policy is to record an allowance for doubtful accounts when it is established that receivables are uncollectible or are otherwise impaired.
Earnings Per Share - The Company has adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share", which modified the calculation of earnings per share ("EPS".) This Statement replaced the previous presentation of primary and fully diluted EPS to basic and diluted EPS. Basic EPS is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS includes the dilution of common stock equivalents, and is computed similarly to fully diluted EPS pursuant to Accounting Principle Board ("APB") Opinion 15. All prior periods presented have been restated to reflect this adoption.
Cash and Cash Equivalents - Cash and cash equivalents for the purpose of reporting cash flows for all periods presented include cash on deposit and certificates of deposit. There were no other cash equivalents at March 31, 2006 and 2005.
At March 31, 2006 and 2005, respectively, the Company had cash on deposit in excess of federally insured limits of $0 and $376,818. Additionally, at March 31, 2006 and 2005, the Company had cash on deposit in foreign bank accounts not covered by United States insurance limits of $252,152 and $1,893,013, respectively.
Included in the cash and cash equivalent balances as reported at March 31, 2006 and 2005, respectively, is $1,388,671 and $1,354,497 of cash related to Butler. Since Butler is a private company, the Company has no means to determine the disposition of this cash, if any, and, accordingly management disclaims any knowledge of the existence of this cash or related assets, liabilities or expenses. As part of its agreement to receive monies received from RIC, Butler agreed to restrict its cash received from RWC related to such settlement to be used to pay future Reliance claims. At March 31, 2006 and March 31, 2005, of the $1,982,012 received from RWC, Butler had $0 in such restricted cash on deposit.
Investments in Marketable Securities - All investments in marketable securities have been classified as available-for-sale and are carried at fair value with changes in unrealized gains and losses being reflected as a separate component of accumulated other comprehensive income, net of tax. At March 31, 2006 and March 31, 2005, $923,655 and $853,475 of the marketable securities are pledged as collateral for long-term letters of credit and accordingly are classified as long-term assets in the financial statements.
Property and Equipment - Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the related assets ranging between 3 and 7 years.
Capitalization Policy - In accordance with Statement of Position 98-1, the Company capitalizes purchased software or software development and implementation costs incurred internally or through independent consultants related to the Company's state of the art proprietary relational database and interactive operating software for warranty tracking and sales. These systems are only available for internal uses and are not available for purchase by outside parties. All direct implementation costs and purchased software costs are capitalized and amortized using the straight-line method over their estimated useful lives not to exceed a five-year period. Of the $1,266,923 and $1,793,937 of net unamortized software development costs at March 31, 2006 and March 31, 2005, respectively, the Company capitalized $300,861 and $540,388 during these periods, respectively.
Once annually or as events or circumstances indicate that an asset may be impaired, the Company assesses potential impairment of its long-lived assets, which include its property and equipment and its identifiable intangibles such as software development costs, goodwill and deferred charges. The Company determines such impairment by
measuring the undiscounted future cash flow generated by the assets, comparing the result to the assets carrying value and adjusting the asset to the lower of its carrying value or fair value and charging current operations for the measured impairment. At years ended March 31, 2006 and 2005, the Company found no impairment to its property and equipment or its other identifiable intangibles.
Excess of Cost Over Fair Value of Assets Acquired - The excess of cost over fair value of the assets acquired ("Goodwill") is a result of the purchases of Dealer Based Services, Inc. in 1989, and certain assets of Distributors & Dealers Service Co., Inc. in October 1997. Prior to the early adoption of Statement of Financial Accounting Standard No. 142 "Goodwill and Intangible Assets" on April 1, 2001, the excess of cost over fair value of assets acquired was being amortized on a straight-line basis over 15, 10 and 4.5 years, respectively.
Reclassification - Certain reclassifications were made to prior year amounts to conform to the current presentation. The Company has separately disclosed the operating, investing and financing portions of the cash flows attributable to its discontinued operations which in prior periods were reported on a combined basis as a single amount.
Impairment of Long-lived Assets - The Company assesses potential impairment of its long-lived assets, which include its property and equipment and its identifiable intangibles such as software development costs, goodwill and deferred charges under the guidance of SFAS 144 "Accounting for the Impairment or Disposal of Long-Lived Assets." Once annually, or as events or circumstances indicate that an asset may be impaired, the Company assesses potential impairment of its long-lived assets. The Company determines impairment by measuring the undiscounted future cash flows generated by the assets, comparing the result to the assets' carrying value and adjusting the assets to the lower of their carrying value or fair value and charging current operations for any measured impairment. At March 31, 2006 the Company provided for the impairment of its assets in Chile and Peru for $23,464.
Advertising Costs - The Company expenses advertising costs as incurred. Advertising expenses for the years ended March 31, 2006, 2005 and 2004 were $301,849, $216,737 and $197,833, respectively.
Stock Based Compensation - The Company applies FASB Statement No. 123 R, "Share Based Payment" in accounting for its stock-based compensation plans. Under this method, compensation of any unvested awards at January 1, 2006, is recognized over the remaining service period and any new and modified awards are expensed prospectively. In addition, Statement 123 R requires all share payments to employees, including grants of employee stock options, to be recognized as an expense based on fair values measured on award grant dates. No restatement of prior periods is required.
Income Taxes - Deferred tax assets and liabilities are determined using enacted tax rates for the effects of net operating losses and temporary differences between the book and tax bases of assets and liabilities. The Company records a valuation allowance on deferred tax assets when appropriate to reflect the expected future tax benefits to be realized. In determining the appropriate valuation allowance, certain judgments are made relating to recoverability of deferred tax assets, use of tax loss carryforwards, level of expected future taxable income and available tax planning strategies. These judgments are routinely reviewed by management.
Foreign Currency Translation - Financial statement accounts expressed in foreign currencies are translated into United States dollars in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52 "Foreign Currency Translation". The functional currency for the Company's Chilean and Peruvian operations are their respective local currencies. Transaction gains and losses are reflected in operations, while translation gains and losses are reflected as a separate component of accumulated other comprehensive income, net of tax.
Comprehensive Income - The Company has adopted SFAS No. 130 "Reporting Comprehensive Income". SFAS No. 130 establishes rules for the reporting and display of comprehensive income and its components; however, the adoption of this Statement had minimal impact on the Company's net income or stockholders' equity. SFAS No. 130 requires unrealized gains or losses to be recorded on the Company's available for sale securities and foreign currency translation adjustments, which prior to the adoption were reported separately in stockholders' equity, to be included in other comprehensive income.
Contingent Liability Policy - In accordance with SFAS No. 5 and Financial Accounting Standards Interpretation ("FIN") 14, the Company may have certain contingent liabilities with respect to material existing or potential claims, lawsuits and other proceedings. The Company accrues liabilities when it is probable that future costs will be incurred and such costs can be reasonably estimated and measured.
2. CLAIMS LOSS LIABILITY
During the second fiscal quarter of 2002, the Pennsylvania Insurance Commissioner informed the Company that Reliance would be liquidated and cease making payments on claims. The Pennsylvania Insurance Commissioner determined that Reliance was not likely to be able to satisfy all of the claims that would be submitted to it due to the circumstances arising out of the September 11, 2001 terrorist attacks on the World Trade Center. Reliance underwrote approximately 48% of the automotive service contracts that were sold by Warrantech Automotive during approximately one and one-half years ending in November 2001. Approximately 52% of the automotive service contracts sold by Warrantech Automotive during that period are not affected by the Reliance liquidation. Service contracts sold before and after that period are not affected because they are underwritten by other insurance companies.
Warrantech Automotive was the named obligor, as well as the administrator, under some of the vehicle service contracts insured by Reliance. As the obligor, Warrantech Automotive would ultimately be responsible for paying for the repairs under such contracts. Additionally, for financial reporting purposes only, Warrantech is treated as the obligor under the service contracts in which Butler is the named obligor. While Warrantech is not obligated to pay claims under such service contracts, it has treated the claims obligations under the Butler-obligor contracts, including the service contracts which were insured by Reliance, as obligations of the Company for accounting purposes. Prior to Reliance's liquidation, Reliance covered the cost of the repairs under the insurance policies it provided. Because of Reliance's liquidation, insurance coverage for the Company's obligations under those service contracts ceased to exist. However, a non-insurance affiliate of Reliance, Reliance Warranty Company ("RWC"), which was not placed in liquidation, held premiums totaling approximately $15,892,635 relating to a portion of the service contracts in which Butler, the retailer/dealers and Warrantech Automotive were the named obligors. The Company received $15,892,635 from RWC during the fourth quarter of fiscal 2004, as part of a settlement for claims paid by the Company on behalf of RWC. As a result of the Reliance liquidation, the Company recorded a claims liability expense for $19,591,713 during fiscal 2002, which was net of the $15,892,632 receivable from RWC.
To mitigate its claims liability expense resulting from Reliance's liquidation, the Company is attempting to ascertain if any recovery is available on Federal subsidies to the insurance industry in general or Reliance specifically, as a result of the terrorist attacks to pay vehicle service contract claims. If such subsidies are available, it could take years before recovery, if any, is obtained. In February 2005, the Company also began legal proceedings for recovery of approximately $3 million against certain state guaranty funds. In June
2005 the Company made its first state guaranty settlement with one of the defendants in its action. In March 2006, the Company settled with all remaining state guarantee agencies for $996,000.
During the years ended March 31, 2006, 2005, 2004, 2003 and 2002, the Company paid $1,303,782, $4,727,643, $9,262,407, $10,959,364 and $5,770,999, respectively, in claims related to Reliance obligations. Remaining amounts are expected to be paid out as set forth in the following table.
3. RESTRICTED CASH
At March 31, 2006 and 2005, respectively, cash in the amount of $800,000, was on deposit with Florida and Ohio regulatory agencies to comply with their state insurance laws. Butler had $0, at March 31, 2006 and 2005, which was restricted, and held in trust by the Company, for use to pay Reliance claims.
4. INVESTMENTS IN MARKETABLE SECURITIES
Short-term marketable securities and long-term investments are comprised of municipal bonds which bear interest at fixed rates. Interest income from these securities is generally affected by changes in the U.S. interest rates. The following tables provide information about the Company's financial instruments that are sensitive to changes in interest rates. The tables present principal cash flows and weighted-average interest rates by expected maturity dates. All of the investments are considered "available for sale." The resultant differences between amortized cost and fair value, net of taxes, have been reflected as a separate component of accumulated other comprehensive income.
Principal amounts by expected maturity as of March 31, 2006 of marketable securities are as follows:
Principal amounts by expected maturity as of March 31, 2005 of marketable securities are as follows:
JP Morgan has issued two letters of credit in the amounts of $750,000 and $200,000 as security respectively for the Bedford lease and for the credit card processor. As security against these letters of credit the Company has pledges its securities held by JP Morgan in the amount of $923,665 at March 31, 2006 and $853,475 at March 31, 2005.
5. ACCOUNTS RECEIVABLE
On January 11, 2005, Ultimate Electronics, Inc. and six of its subsidiaries ("Ultimate") filed individual voluntary petitions for relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. Sales to Ultimate represented 10% and 32% of the Company's and its Consumer Products segment's total gross revenues during fiscal 2005. Pursuant to the provisions of Chapter 11, Warrantech was obligated to honor its existing contract with Ultimate and Ultimate continued to sell service contracts during this period of reorganization. Ultimate has made all its payments to Warrantech with respect to sales subsequent to January 11, 2005 ("post-petition sales)." At the time of filing, however, Warrantech believes that Ultimate owed it approximately $3.27 million for sales up to January 11, 2005 ("pre-petition sales") and Warrantech has filed a "proof of claim" in this amount with the Court. At this time, although Warrantech's proof of claim has been reviewed and approved, Warrantech does not know what it will recover on its claim. No provision for bad debts has been recorded as of March 31, 2006, as there are offsetting liabilities and reserves. The Plan of Reorganization has been approved by the Bankruptcy Court and Ultimate's creditors. Ultimate and its advisors have reviewed filed claims and have made initial determinations regarding preference payments and other amounts that may be recoverable from creditors. They are now contacting those creditors who appear to have the largest potential obligations to the bankruptcy estate in an effort to negotiate settlements. These discussions are expected to continue for a number of months. The first distributions to creditors could occur as early as the 3rd quarter of calendar 2006 although they are more likely to begin during the 4th quarter of calendar year 2006.
In separate orders dated April 19, 2005, the Court approved actions to close thirty (30) of Ultimate's stores and retain a liquidator to dispose of existing inventory. The liquidator was authorized by the Court to sell Warrantech service contracts during the liquidation period in accordance with the terms of the existing Ultimate contract. The liquidation period has been completed. The remaining stores were purchased by Mark Wattles, the principal shareholder of Ultimate, through an entity named Ultimate Acquisition Partners, L.P. ("Acquisition"). As part of the Purchase Agreement, Acquisition was given until August 31, 2005, to decide if it wanted to assume Ultimate's contract with Warrantech. On November 1, 2005, Acquisition notified Warrantech that it had elected not to continue selling warranties administered by Warrantech effective November 15, 2005. Acquisition has made all of its payments to Warrantech with respect to its sales subsequent to January 11, 2005.
At March 31, 2006, the Company was owed $3.7 million by Ultimate, in which the Company has filed a proof of claim for $3.27 million with the bankruptcy court. The remaining balance has subsequently been paid. No provision for bad debts has been recorded as of the fiscal year ended March 31, 2006.
Accounts Receivable Security - The Company has executed an agreement with Great American Insurance Company ("GAIC") that provides the Company with extended premium payment terms and a $3 million line of credit ("GAIC Agreement"). All of the Company's obligations to GAIC pursuant to the GAIC Agreement are secured by all of the Company's
Automotive and Consumer Products segment's accounts receivable, which were $23,537,597 and $19,118,161 at March 31, 2006 and 2005, respectively.
6. OTHER RECEIVABLES
During fiscal year ending March 31, 2006, 2005 and 2004, the Company incurred $948,822, $1,865,399 and $1,853,555, respectively, in legal expenses related to the Lloyd's litigation. The Company, in anticipation of receiving reimbursement for these expenses from its insurance company under a professional liability insurance policy, deferred the legal fees. In January 2005, as a result of a summary judgment, the court ruled that the insurance company was not responsible for payment of the Company's legal costs. The Company has appealed the court's decision. As a result of the lower court's ruling, the Company has provided for this potential bad debt of $3,718,954 during the year ended March 31, 2005. Some future legal expenses are expected to be covered under the Company's Director's and Officer's liability insurance policy.
The nature and amounts of Other Receivables as of March 31, 2006 and 2005 are as follows. :
The following table sets forth the carrying amounts and fair values of the Company's other receivables at March 31, 2006.
7. PROPERTY AND EQUIPMENT
Property and equipment consists of the following at March 31
The aggregate amounts of maturities at March 31, 2006 were as follows:
Minimum Future Fiscal Year Lease Payments -------------- 2007 $ 513,724 2008 451,347 2009 202,877 2010 93,877 2011 3,196 2012 and thereafter -- -------------- 1,265,021 Less: amount representing interest 167,873 -------------- Net $ 1,093,328 ==============
The capital lease obligations are collateralized by the capitalized property and equipment related to the underlying leases.
9. SPLIT DOLLAR LIFE INSURANCE POLICIES
Through April 2003, the Company made payments on split dollar life insurance policies on the lives of six officers of the Company, respectively. The Company suspended payment of premiums under these policies until the permissibility of making such payments under the Sarbanes-Oxley Act of 2002 is clarified. In lieu of these premium payments, beginning in September of 2004 and going forward, the Company provides cash bonuses for the premium amount to these officers. The cash surrender value of these policies was $900,145 as of March 31, 2006 and 2005, respectively. The Company is the beneficiary of any proceeds from the policies up to the amount of premiums paid.
10. INCOME TAXES
A reconciliation of the income tax provision to the amount computed using the federal statutory rate is as follows:
Deferred tax assets and liabilities reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income taxes. The components of the net deferred tax asset are as follows:
As of March 31, 2006, the Company had a United States net operating loss carryforward of approximately $15.45 million, which is available to reduce future regular federal taxable income. If not used, the entire carryover will expire in the years 2020 to 2025. As of March 31, 2006, the Company also had a foreign net operating loss carryforward of approximately $2.1 million. Due to the uncertainty of the realization of these foreign tax carryforwards, the Company established a valuation allowance against these carryforward benefits of $1,493,437 and $1,255,462 at March 31, 2006 and 2005, respectively.
Section 174 expense represents research and experimental expenses related to the development of a proprietary relational database and interactive software.
11. COMMITMENTS AND CONTINGENCIES
Operating Lease Commitments - The Company leases office and warehouse space under noncancellable operating leases expiring through 2013. These leases include scheduled rent increases over their respective terms. The accompanying consolidated statements of operations reflect rent expense on a straight-line basis over the lease terms, which differ from the cash payments required. Rent expense, net of sub-lease income, charged to operations for the years ended March 31, 2006, 2005 and 2004 was $1,490,273, $1,646,252 and $2,101,971, respectively.
Future minimum commitments under these leases that have initial or remaining lease terms in excess of one year at March 31, 2006, are as follows:
Fiscal Year Amount ----------- ----------- 2007 $ 1,307,236 2008 1,291,125 2009 1,308,241 2010 1,288,409 2011 1,288,409 Thereafter through 2013 2,469,451 ----------- Total future minimum lease payments $ 8,952,871 ===========
Employment Contracts - The Company has employment contracts with its officers and certain key employees. These employment contracts, expiring on various dates through 2008, provide for aggregate minimum annual base compensation of $2,088,333. Certain agreements also call for (i) annual increases, (ii) cost of living increases, (iii) automobile allowances, (iv) medical insurance, and (v) additional compensation if certain defined performance levels are attained. This additional compensation is to be paid in the form of cash and/or Company common stock. The Company also agreed to forgive interest which has accrued annually on a note between the Company and its CEO, for as long as the CEO remains in the Company's employ.
Line of Credit and Extended Payment Terms - The Company executed an agreement with GAIC on October 9, 2002, whereby GAIC agreed to provide funding by extending a favorable change of its credit terms to the Company. GAIC agreed to allow a 30 day extension to its normal payment terms as set forth in the service agreement. Interest is charged on amounts within the extended payment term at 3% per annum, calculated on a daily basis. GAIC also agreed to a separate line of credit for an amount up to $3 million through further extensions of terms, subject to certain adjustments. Funds provided by the line of credit are made available by GAIC by further extending its premium payment terms. Interest is charged on funds advanced from the line of credit at an annual rate equal to the prime interest rate plus 2%. As of March 31, 2006, the $3 million available line of credit from GAIC has been drawn down by the Company and is reflected in premium payable.
Letters of Credit - The Company maintains a $750,000 letter of credit for the benefit of the landlord of its headquarters office building. This letter of credit is automatically renewed annually through January 31, 2013.
The Company also maintains a $200,000 letter of credit for the benefit of its credit card processor. This letter of credit is automatically renewed annually, as long as the agreement with the credit card company is in place.
As security against these letters of credit the Company has pledges its securities held by JP Morgan in the amount of $923,665 at March 31, 2006 and $853,475 at March 31, 2005.
Equipment Financing - The Company has ongoing relationships with equipment financing companies and intends to continue financing certain future equipment needs through leasing transactions. The total amount financed through leasing transactions during the fiscal year ended March 31, 2006 amounted to $205,345 compared to $538,609 during the fiscal year ended March 31, 2005. At fiscal year end 2006, the Company had $1,093,328 in debt outstanding from capital lease obligations compared to $1,465,609 at fiscal year end 2005.
Litigation - The Company is from time to time involved in litigation incidental to the conduct of its business.
Lloyd's Underwriters Certain Underwriters at Lloyd's, London and Other Reinsurers Subscribing to Reinsurance Agreements/2992/00 and No./2992/00 v. Warrantech Corporation, Warrantech Consumer Product Services, Inc., Warrantech Help Desk, Inc., and Joel San Antonio, in United States District Court, Northern District of Texas, Fort Worth Division.
During the period that Houston General was the underwriter of certain of Warrantech's programs, it reinsured certain of the underwritten risks with one or more Lloyd's insurance syndicates. At some point thereafter, Houston General commenced an arbitration against the Lloyd's syndicates seeking to recover approximately $46,000,000 under the reinsurance treaties with respect to claims previously paid by Houston General on warranty claims submitted by customers under Warrantech programs. The Warrantech entities were not parties in the
arbitration but were the subject of extensive discovery by each of Houston General and the Lloyd's syndicates. The arbitration concluded in August 2002 with an award of approximately $39,000,000 in favor of Houston General.
The award supports the assertions of Houston General with respect to the validity of the claims that it paid. Warrantech was not involved in the selection of these re-insurers, has no contractual relationship with them, and has had no reporting or other obligation to them. Despite these facts, the Lloyd's syndicates now seek to recover some portion of the arbitration award from the Warrantech entities on two theories of liability. The first is that, at the time certain claims were presented to Houston General for payment, the Warrantech entities either fraudulently or negligently represented to Houston General that such claims were valid. The second is that the Warrantech entities intentionally failed to comply with their legal obligations to cooperate with the parties during the discovery process for the arbitration. The complaint seeks ordinary, punitive and exemplary damages although no specific amount is requested. On January 6, 2004, the plaintiff filed an amended complaint that added Joel San Antonio, Chairman and Chief Executive Officer of Warrantech Corporation, as a party defendant in his individual capacity.
Warrantech has filed a counterclaim against Lloyd's arising out of the same set of facts that underlie the original litigation. Warrantech alleges fraud, unfair claim settlement practices and bad faith and is seeking damages of approximately $46 million. Warrantech is also asking that treble damages for $138 million be awarded as permitted under applicable Texas law.
This case was originally brought in the District Court of Tarrant County, Texas, 17th Judicial District. On March 19, 2004, Defendant San Antonio filed a notice of removal to the United States District Court which motion was joined by all other defendants. Following removal, Lloyd's filed a motion to remand the case to state court. Although the motion was originally denied, the matter was subsequently returned to state court by Judge McBryde. Warrantech appealed this and several other rulings to the 5th Circuit Court of Appeals. Oral argument was heard on August 29, 2005 and, although a decision was expected before the end of 2005, the Court has yet to announce its decision. If the Court determines that jurisdiction properly lies with the federal courts, it will also rule on defendant's motions with respect to collateral estoppel and res judicata. A ruling favorable to the defendants on either of these issues could ultimately lead to a successful pre-trial resolution of the entire litigation. The Court is also considering the reinstatement of Warrantech's counterclaim against Lloyds for damages and attorneys' fees. As the parties await the ruling of the 5th Circuit they are continuing with preparation for trial in state court, currently scheduled for October 9, 2006. The defendants have filed several motions for summary judgment based on lack of jurisdiction and the running of the statute of limitations. Both motions are currently being briefed and will be argued in late June. As with the pending federal appeal, a favorable ruling on either motion could result in a successful pre-trial resolution of the entire litigation.
Management continues to believe that the Lloyd's case is without merit. At this time, however, it is not able to predict the outcome of the litigation. For this reason, the Company is unable to determine its potential liability, if any, and as such, the accompanying financial statements do not reflect any estimate for losses.
Universal Insurance Company --------------------------- In the Matter of Arbitration between Universal Insurance Company and Warrantech Consumer Product Services, Inc.; Jane Doe; and ABC Corporation
Universal Insurance Company ("Universal") provided insurance for the vehicle service contracts marketed and administered by Warrantech International in Puerto Rico pursuant to an Administrative Agreement that was effective as of April 1, 1998. On October 16, 2003, Universal, claiming a material breach of the agreement by Warrantech, terminated the agreement and assumed responsibility for administering the applicable service contracts.
Universal served Warrantech with a Demand for Arbitration, dated October 15, 2004, seeking to recover a portion of the fees Warrantech received to provide administrative services under the contracts, approximating $2,155,000, together with interest thereon from the effective date of termination. Subsequent to receipt of Universal's Demand for Arbitration, Warrantech commenced an action against Universal in the State of Connecticut to recover fees owed to Warrantech pursuant to the terms of a certain Fee Agreement. Although it is difficult at this time to determine the exact amount owed to Warrantech, it is believed that the amount will be in excess of $1,000,000. Universal has moved in local court to have the Connecticut action combined with the arbitration in Puerto Rico. In response to that motion, Warrantech has moved to have the Connecticut action remanded to federal court in Connecticut. The parties are currently contesting a number of procedural issues. Minimal discovery has taken place as of the date hereof.
Management believes Universal's case is without merit. At this time, however, it is not able to predict the outcome of either the arbitration or the Connecticut action. For this reason, the Company is unable to determine its potential liability, if any, and as such, the accompanying financial statements do not reflect any estimate for losses.
12. SHARE BASED COMPENSATION AND OTHER BENEFIT PLANS
Stock Incentive Plans - Under the Company's 1998 Employee Incentive Stock Option Plan, as amended (the "1998 amended Plan"), 1,041,987 shares of the Company's common stock are reserved for issuance to employees (including officers) upon exercise of options granted under the 1998 amended plan. Options are to be granted at an exercise price not less than 100% of the fair market value of the Company's common stock at date of grant. The number of shares granted, terms of exercise, and expiration dates are to be decided at the date of grant of each option by the Company's Board of Directors. The 1998 Amended Plan will terminate in August 2008 unless sooner terminated by the Board of Directors.
Stock Awards - Restricted common stock of the Company may be awarded to officers, key employees, non-employee directors and certain other non-employees. Shares granted are subject to certain restrictions on ownership and transferability. Such restrictions on current restricted stock awards typically lapse one to three years after the award. The deferred compensation expense related to restricted stock grants is amortized to expense on a straight-line basis over the period of time the restrictions are in place. Restricted common stock awards to employees reduce stock options otherwise available for future grants. The common stock awards are valued based on the opening price of the Company's stock on the date the award is approved by the Board of Directors. During the year end March 31, 2006 and 2005, 88,334 and 32,500 restricted shares were awarded to directors and employees, respectively.
The Company recognized costs of $61,875, $73,850 and $100,000 for the years ended March 31, 2006, 2005 and 2004, respectively, for stock-based compensation to employees and directors. The Company had no costs for the years ended March 31, 2006, 2005 and 2004, respectively, for stock-based compensation to non-employees.
Stock Option Plans - At March 31, 2005, the Company had one stock option plan, which is described above. SFAS No. 123, "Accounting for Stock-based Compensation," defines a fair value method of accounting for an employee stock option. SFAS No. 123 allows a company to continue to measure compensation costs for these plans using APB No. 25 and related interpretations. The Company has elected to continue using APB No. 25 for accounting for its employee stock compensation plan. Accordingly, no compensation cost has been recognized for its fixed stock option plan. If Warrantech had determined compensation cost for its stock option plan based on the fair value at the grant dates for awards under the plan, consistent with the method prescribed by SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts as follows:
In December 2004, the FASB issued Statement 123(R), "Share-Based Payment," to be effective, in the case of Warrantech, for interim periods beginning after December 15, 2005; thereby, becoming effective for Warrantech in the fourth quarter of fiscal 2006. Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized as an operating expense in the income statement. The cost is recognized over the requisite service period based on fair values measured on grant dates. The new standard may be adopted using either the modified prospective transition method or the modified retrospective method. The Company is currently evaluating its share-based employee compensation programs, the potential impact of this statement on the consolidated financial position and results of operations. The Company has adopted the modified prospective method for its options issued and recognizes compensation expense under their requisite vesting periods.
Presented below is a summary of the status of the stock options in the plan and the related transactions for the years ended March 31, 2006, 2005 and 2004.
The weighted average fair value of stock options at date of grant, calculated using the Black-Scholes option-pricing model, granted during the years ended March 31, 2006, 2005 and 2004 was $0.38, $0.38 and $0.56, respectively.
The following table summarizes the status of all Warrantech's stock options outstanding and exercisable at March 31, 2006.
Other Stock Options - The Company may issue options to purchase its common stock to officers, non-employees, non-employee directors or others as part of settlements in disputes and/or incentives to perform services for the Company. The Company accounts for stock options issued to vendors and non-employees of the Company under SFAS No. 123 "Accounting for Stock-based Compensation." The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with weighted average assumptions identical to those used for options granted to employees.
No stock options have been issued to vendors or non-employees during fiscal 2006, 2005 or 2004.
The fair value of Warrantech stock options used to compute pro forma net income and earnings per share disclosures is the estimated value at grant date using the Black-Scholes option-pricing model with the following weighted average assumptions for the years ended March 31, 2006, 2005 and 2004, respectively: expected dividend yield of 0%; expected volatility of 30% - 50%; a risk free interest rate of 4.5% - 5.0%; and expected option life of 3 to 5 years.
On October 1, 2002, as part of an agreement between the Company and GAIC to provide extended credit terms, GAIC received options to purchase up to 1,650,000 shares of common stock. The GAIC options are exercisable no earlier than January 1, 2006 nor later than December 31, 2006. Per the terms of the agreement, since Warrantech's stock did not trade above $2 per share for ten consecutive trading days prior to January 1, 2004, the exercise price of the option was automatically reduced to $1 per share from $2 per share. The GAIC options are each exercisable for a period of five years. Warrantech has the right to redeem these options at any time if its shares trade at a price of $3.00 per share or more on any five consecutive trading days. The redemption price is $.001 per share. However, if Warrantech elects
to redeem the options, GAIC will have the right to exercise their respective options immediately prior to the redemption. If GAIC exercises all of these options, it would own approximately 9.7% of the Company's outstanding shares. As the options had no value under the Black-Scholes option pricing model, no compensation expense was recorded in the Company's results of operations for the fiscal year ended March 31, 2006.
On July 6, 1998, Joel San Antonio, Warrantech's Chairman and Chief Executive Officer, and William Tweed and Jeff J. White, members of Warrantech's Board of Directors, exercised an aggregate of 3,000,000 of their vested options to purchase Warrantech common stock. Promissory notes totaling $8,062,500 were signed with interest payable over three years at an annual rate of 6%. The promissory notes, which were with recourse and secured by the stock certificates issued, matured July 5, 2001. On March 14, 2006, there was a settlement of Mr. White's note with his estate (see below). The value of the remaining collateral for Mr. Tweed and Mr. San Antonio's Notes, which consists of a total of 2,183,000 shares of the Company's common stock, is currently $1,026,000, as of May 31, 2006, based upon the market price of the stock on that date. Under the loan documents, the Company does not have a right to require the payors to increase the loan collateral. On March 22, 1999, Joel San Antonio delivered an additional promissory note for $595,634, payable to the Company, representing the amounts funded by the Company for the payroll taxes payable by him upon the exercise of these options. The exercise of these stock options and the anticipated tax benefit from this transaction represented approximately $10 million. .
In February 2000, the Company agreed to restructure the loans to Mr. Tweed and Mr. White by capitalizing the interest due and extending the loan maturity from July 5, 2001 until January 31, 2005. Interest on the restructured loans accrued annually at the applicable federal rate of 6.2%. Under the restructuring, interest first became payable on the third anniversary of the restructuring and was payable annually thereafter. In July 2002, the Company extended the loan maturity dates until February 1, 2007 (the "loan extension"). The interest, which accrued on the notes up to the time of the loan extension, was added to the principal of the notes. The new principal amount of Mr. Tweed's note is $3,189,675 and of Mr. White's note is $2,912,430. The applicable federal interest rate on the notes following the loan extension is 4.6%. Under the loan extension, interest on the notes will accrue until February 1, 2005 and, at that time, the accrued interest will be added to the principal of the notes. Commencing on February 1, 2005, interest on the new principal amount of the loans to Mr. Tweed and Mr. White is payable annually in arrears, with the first interest payment becoming due on February 1, 2006. On January 31, 2006, in lieu of a cash payment for the $148,033 in interest due by Mr. Tweed, the Company agreed to accept 211,476 shares of its Common Stock.
In February 2000, the Company also agreed to restructure the two existing loans to Mr. San Antonio (as restructured, the "Combined Loan"). The Combined Loan, finalized in March 2001, was due on January 31, 2005 and accrued interest annually at 5.2%. In July 2002, the Company extended the loan maturity date until February 1, 2007 and the interest rate was changed to the then applicable federal rate of 4.6%. The principal amount of Mr. San Antonio's note is $4,165,062. Interest will be forgiven as long as Mr. San Antonio continues to be employed by the Company. The $194,254, $194,254, 194,786 and $133,050 of interest which accrued on the note during fiscal years 2006, 2005, 2004 and 2003, respectively has been forgiven. The interest was charged to operations as additional compensation in the respective fiscal years the interest income was accrued.
Mr. White passed away on November 30, 2005. Pursuant to a promissory note given by Mr. White to the Company in connection with his exercise of stock options, Mr. White's estate owed the Company $3,401,799 as of February 28, 2006. His death triggered an acceleration provision of the promissory note, which provides that if the note is not paid within 90 days after his death (March 1, 2006), the Company is entitled to declare all amounts owed under the note due and payable. An interest payment per the terms of the note, was due on February 1, 2006. The Company's Board of Directors agreed to extend the due date of the interest payment until Feb 28, 2006. In settlement of the note, the Estate of Mr. White ("Estate") and the Company agreed that the Estate would transfer $1,290,000 in cash and 1,322,048 shares of the Company's Common Stock valued at $1,013,577, and in exchange the Company forgave and charged $1,098,222 of the remaining amount of Mr. White's loan with the Company to operations. The transaction took place on March 14, 2006.
The total amount of the restructured loans to Mr. Tweed and Mr. San Antonio at March 31, 2006, including the capitalized interest of $400,556, is $7,755,292. The total amount of the restructured loans to Mr. Tweed, Mr. White and Mr. San Antonio at March 31, 2005, including the capitalized interest of $764,899, is $11,032,065.
Savings and Retirement Plan
The Company and its qualified employees also participate in a Savings and Retirement Plan also known as the 401(k) Plan (the "Plan"). All of the Company's domestic employees are eligible to participate in the Plan at the first quarterly enrollment period following their date of employment. All Plan participants who have completed one year of service with the Company are eligible for the Company contribution. The Company contributes 66% of an eligible employee's contribution to the Plan, with a maximum up to 4% of the employee's compensation. The Company's contribution, for the benefit of the employee, vests after an employee has been employed by the Company for three years. The Company contributed $203,973, $197,265 and $217,159 to the Plan during the fiscal years ended March 31, 2006 2005 and 2004, respectively.
13. OTHER INCOME (EXPENSE)
Other income (expense) consists of the following:
14. GAIN (LOSS) FOR DISCONTINUED OPERATIONS
On April 1, 2006 the Company closed its operations in Peru and Chile as several customers did not renew their agreements. These countries showed a loss for 2006 of $888,778, a loss of $1,640,014 for 2005 and a gain for 2004 of $35,664.
15. SIGNIFICANT CUSTOMERS
During the fiscal year ended March 31, 2006, the Company had one customer which accounted for more than 10% of the Company's consolidated gross revenues. In 2006, 2005 and 2004 gross revenues from this significant customer were $16.9 million, $13.8 million and $11.2 million, respectively, which accounted for 13%, 12% and 8% of the Company's total gross revenues, respectively.
16. EARNINGS PER SHARE
The computations of loss per share for the years ended March 31, 2006, 2005 and 2004 are as follows:
17. ACCUMULATED OTHER COMPREHENSIVE INCOME
The components of accumulated other comprehensive income, net of related tax, for the years ended March 31, 2006, 2005 and 2004 are as follows:
March 31, March 31, 2006 2005 ----------- ----------- Unrealized gain/ (loss) on investments $ 198 $ (4,291) Accumulated translation adjustments 300,969 236,747 ----------- ----------- Accumulated other comprehensive income $ 301,157 $ 232,456 =========== ===========
18. SEGMENT INFORMATION
Until April 2006, the Company operated in four major business segments: Automotive, Consumer Products, Direct and International, each of which is discussed below. Effective with April 2006, the Company ceased operations in Chile and Peru in its International segment. The Automotive segment markets and administers extended warranties on automobiles, light trucks, motorcycles, recreational vehicles and automotive components, which are sold principally by franchised and independent automobile and motorcycle dealers, leasing companies, repair facilities, retail stores, financial institutions and other specialty marketers. The Consumer Products segment develops, markets and administers extended warranties and product replacement plans on household appliances, consumer electronics, televisions, computers, home office equipment and homes which are sold principally through retailers, distributors, manufacturers, utility companies, financial institutions and other specialty marketers. The International segment is currently operating in Central America, Puerto Rico and the Caribbean and operated in Chile and Peru until April 2006. The International segment markets and administers outside the United States and Canada predominately the same products and services of the other business segments. The Direct segment markets these warranties and plans directly to the ultimate consumer on behalf of the retailer/dealer and/or the manufacturer through telemarketing and direct mail campaigns. Other includes intersegment eliminations of revenues and receivables and net unallocated Corporate expenses and Butler.
19. SUBSEQUENT EVENT - MERGER
THE MERGER AGREEMENT - --------------------
On June 7, 2006, the Company, entered into an Agreement and Plan of Merger (the "Merger Agreement") with WT Acquisition Holdings, LLC, a Delaware limited liability company ("Parent") and WT Acquisition Corp., a Nevada corporation and direct wholly-owned subsidiary of Parent ("Merger Sub"). The Merger Agreement contemplates that, subject to the terms and conditions of the Merger Agreement, Merger Sub will be merged with and into the Company, with the Company continuing after the Merger as the surviving corporation (the "Merger").
Pursuant to the Merger Agreement, at the effective time of the Merger (the "Effective Time"), each issued and outstanding share of common stock of the Company will be converted into the right to receive $0.75 in cash, without interest (the "Cash Consideration"). As of the Effective Time, all shares of the Company's common stock issued and outstanding prior to such Effective Time shall no longer be outstanding and shall automatically be cancelled and retired and shall cease to exist, and each holder of a certificate representing any such shares of common stock shall cease to have any rights with respect thereto, except the right to receive the Cash Consideration or the fair value of the shares pursuant to the appraisal rights available under Nevada law. Each outstanding Company stock option at the time of closing will be cancelled in the Merger and the holder thereof shall be entitled to an amount of cash, without interest, equal to the excess, if any, of $0.75 over the exercise price of such stock option with respect to each share of stock issuable upon exercise of such stock option.
Following the recommendations of the Special Committee of disinterested directors, the Boards of Directors of the Company and Merger Sub have, and the Board of Managers of Parent has, approved the Merger Agreement. Completion of the Merger is subject to customary closing conditions, including, among other things, (i) adoption of the Merger Agreement by the Company's stockholders, (ii) absence of any injunction prohibiting the consummation of the Merger, (iii) the accuracy of the representations and warranties of each party, and (iv) compliance of the Company with its covenants.
The Merger Agreement contains certain termination rights for both the Company and Parent, and further provides that, upon termination of the Merger Agreement under specified circumstances, the Company may be required to pay Parent a termination fee of $1,250,000.
THE COMPANY STOCKHOLDER AGREEMENTS - ----------------------------------
In connection with the execution of the Merger Agreement, certain of the Company's principal stockholders holding in the aggregate 35.5% of the Company's issued and outstanding common stock entered into stockholder voting agreements with Parent and/or Parent and the Company (the "Company Stockholder Agreements"), pursuant to which, among other things, such stockholders agreed to vote their shares of common stock in favor of the Merger and against any other acquisition proposal for a period of twelve months following termination of the Merger Agreement. In addition, Joel San Antonio, the Company's Chairman of the Board and Chief Executive Officer entered into an agreement with Parent and the Company which contains the terms of the Company Stockholder Agreements, grants an option to Parent to purchase Mr. San Antonio's shares for $0.75 per share exercisable for a period of twelve months following termination of the Merger Agreement, and also provides for the application of amounts paid to Mr. San Antonio for his shares and stock options to reduce his outstanding indebtedness to the Company, the termination of the outstanding obligations under Mr. San Antonio's employment agreement with the Company in exchange for a cash payment of $1,700,000 and the grant to Mr. San Antonio of a common equity award equal to 22.5% of the common equity interests in Parent. In addition, the Company is aware of a letter agreement between Parent and Mr. San Antonio relating to (i) the forgiveness of accrued and unpaid interest owed on Mr. San Antonio's indebtedness to the Company through the Effective Time, (ii) the forgiveness of approximately $600,000 of outstanding principal on such indebtedness, and (iii) the extension of the maturity date of the promissory note, evidencing the remaining indebtedness of approximately $1,050,000, until the second anniversary of the closing of the Merger. William Tweed, a former director of the Company also entered into an agreement with Parent and the Company which contains the terms of the Company Stockholder Agreements, grants an option to Parent to purchase Mr. Tweed's shares for $0.75 per share exercisable for a period of twelve months following termination of the Merger Agreement, provides for the application of amounts paid to Mr. Tweed for his shares to reduce his outstanding indebtedness to the Company and the extension of the maturity date of the promissory note evidencing the remaining indebtedness of approximately $2,394,796, until December 31, 2013.
CONSOLIDATION AND SALE OF CERTAIN COMPANY DEBT - ----------------------------------------------
In connection with the Merger, the outstanding indebtedness of the Company and its subsidiaries to Great American Insurance Company, GAI Warranty Company, GAI Warranty Company of Florida and GAI Warranty Company of Canada (collectively, "GAI") through March 1, 2006 is being consolidated under a single term promissory note between GAI, the Company and such subsidiaries (the "Term Note"), which is secured by a first priority, continuing security interest in and to all of the tangible and intangible assets of the Company and its subsidiaries granted to GAI under the terms of a security agreement by and between GAI, the Company and its subsidiaries (the "Security Agreement"). All principal and interest under the Term Note is due and payable 120 days from June 7, 2006. The Term Note is in full novation of any and all other debt instruments and obligations to repay indebtedness between GAI and the Company and its subsidiaries through March 1, 2006. The Term Note and Security Agreement contain customary representations and warranties, affirmative and negative covenants and events of default.
Contemporaneously with the execution of the Merger Agreement, GAI sold to Wtech Holdings, LLC ("Wtech"), an affiliate of Parent, all of its rights and obligations under the Term Note and Security Agreement, whereupon Wtech became the primary secured lender to, and creditor of, the Company and its subsidiaries. The Company is not a party to the agreement providing for the sale and transfer of GAI's rights under the Term Note and the Security Agreement, although the Company granted its consent with respect thereto.
WARRANTECH CORPORATION AND SUBSIDIARIES SUPPLEMENTAL QUARTERLY FINANCIAL DATA (Unaudited)
The following fiscal 2006 and 2005 quarterly financial information for each of the three month periods ended June 30, September 30, December 31, 2005 and 2004 and March 31, 2006 and 2005 is unaudited. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary to present fairly the results of operations for such periods have been made for a fair presentation of the results shown.
WARRANTECH CORPORATION AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULE SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS
(a) Amount of receivables charged to the allowance during the year. (b) Recovery of prior year bad debts resulted in credit amount for the year ended March 31, 2006.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosures - ---------------------
None.
Item 9A.
Item 9A. Controls and Procedures -----------------------
Disclosure Controls and Procedures The Company's Chief Executive Officer (CEO) and Chief Financial Officer (CFO) are primarily responsible for the accuracy of the financial information that is presented in this Annual Report on Form 10-K. Each of them has, within 90 days of the filing date of this report, evaluated the Company's disclosure controls and procedures, as defined in the rules of the SEC and have determined that such controls and procedures were effective in ensuring that material information relating to the Company and its consolidated subsidiaries was made known to them during the period covered by this Annual Report.
Internal Controls To meet their responsibility for financial reporting, the CEO and CFO have established internal controls and procedures, which they believe, are adequate to provide reasonable assurance that the Company's assets are protected from loss. These internal controls are reviewed by the independent accountants to support their audit work
THERE WERE NO SIGNIFICANT CHANGES IN COMPANY'S INTERNAL CONTROLS OR IN OTHER FACTORS THAT COULD SIGNIFICANTLY AFFECT INTERNAL CONTROLS SUBSEQUENT TO THE DATE OF THE CEO'S AND CFO'S MOST RECENT EVALUATION.
Item 9B.
Item 9B. Other Information -----------------
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant --------------------------------------------------
Set forth below is certain information concerning the nominees for the Board of Directors of the Company.
While the Company has not formally adopted a policy regarding Board members' attendance at annual meetings of stockholders, it has been the consistent past practice of all directors who are standing for re-election to attend the meetings. The Company anticipates that this practice will continue in the future.
No family relationships exist among any of the Company's directors or executive officers, except that Randall San Antonio, President of Warrantech Direct, Inc., a wholly-owned subsidiary of the Company, is Joel San Antonio's brother.
The business experience of each of the Company's directors and other executive officers and key employees follows.
Joel San Antonio has served as the Company's Chairman and Chief Executive Officer since February 1988, and President of the Company since June 15, 2005. He began his business career as co-founder of a women's sportswear manufacturer. Exiting the fashion industry, Mr. San Antonio and his partner established the Company in 1983. He is presently Chairman of the Board of Directors of Marc Pharmaceuticals, Inc., a company engaged in the development and commercialization of innovative products for the treatment of cancer and other life threatening diseases. He is also Chairman of the Board of Directors of MedStrong International Corporation and a member of the Board of Directors of SearchHelp, Inc. Mr. San Antonio is engaged in a variety of philanthropic and charitable activities.
Robert M. Cohen has been a director since October 2005. Mr. Cohen is president, chief executive officer, chief financial officer and a director of Marc Pharmaceuticals, Inc. He has been president of Marc Pharmaceuticals, Inc. since its inception in 2001. Mr. Cohen is Chairman of the Board of Directors of Home Run USA, Inc., a chain of indoor batting cages he founded in 2001. In 1987, Mr. Cohen founded Robert M. Cohen & Co. Inc., a full-service stock brokerage firm that emphasized trading and investment banking and served its president from 1987 to December 2003.
Richard Rodriguez has been a director since 2002. Mr. Rodriguez joined the Company in 1987 and was the Executive Vice President of the Company and President of Warrantech International, Inc. since May 1999. From April 1998 until May 1999, Mr. Rodriguez was President of Warrantech Consumer Product Services, Inc. and, from December 1996 until March 1998, he was Vice President and Managing Director of Warrantech International.
Donald Senderowitz has been a director since January 2005. Mr. Senderowitz is a real estate developer and is licensed as a real estate broker and a broker appraiser in the state of Pennsylvania. He has been a real estate Associate Broker with Re/Max Real Estate in Allentown, Pennsylvania since 1994. He has been a member of the Board of the Allentown Housing Authority for the past twelve years and its Chairman for the past two years. He has served as the treasurer of the Jewish Federation of the Lehigh Valley since 2000 and, since in or about 1990, as a member of the Board of Directors of the Jewish Day School of Allentown.
Charles G. Stiene, Esq. has been a director since October 2005. Mr. Stiene is an attorney and member of the law firm of Stiene & Edwards, LLP located in Huntington, New York. Mr. Stiene has been engaged in the practice of law since 1985. His practice is based primarily in representing financial institutions in connection with loan transactions and in real estate.
Other Executive Officers and Key Employees ------------------------------------------
Jeanine M. Folz, 41, has been the Senior Vice President of Insurance Services since April 1998 and has been Assistant Secretary of the Company since January 1995. Ms. Folz has held various positions since joining the Company in 1987, serving as the Vice President of Insurance Services from October 1995 until March 1998. She is a member of the Risk and Insurance Management Society and the National Association for Female Executives. Ms. Folz also renders consulting services for a fee, to Butler Financial Solutions, Inc. which serves, in some instances, as the obligor under service contracts administered by the Company.
Christopher Ford, 58, has been President of Warrantech Automotive, Inc. since joining the Company in May 1999. From December 1996 until April 1999, he was Regional Vice President for the Warranty Products Division of AIU, based in Australia which is an international subsidiary of American International Group, Inc. From 1979 until 1996, Mr. Ford held several key marketing and management positions within the vehicle service contract industry.
Richard F. Gavino, 59, has been Executive Vice President, and the Company's Chief Financial Officer, Chief Accounting Officer and Treasurer since April 1998. From 1995 until March 1998, Mr. Gavino was Chief Financial Officer of Maxon Auto Group, one of the largest automobile retailers in New Jersey. From 1978 until 1993 Mr. Gavino held several Chief Financial Officer positions within the consumer electronics industry.
James F. Morganteen, 56, has been General Counsel since joining the Company in April 1997 and Senior Vice President since February 1998. Prior to joining the Company, Mr. Morganteen served as Senior Counsel of Xerox Corporation, responsible for provision of legal services to Xerox Credit Corporation, and as a Vice President of Bankers Trust Corporation.
Evan Rothman, 39, has been President of Warrantech Home Service Company since joining the Company in March 2004. From March 2003 until February 2004, he was National Director for the 2-10 Resale Home Warranty Company. From November 2000 until February 2003, Mr. Rothman was a division director for RHI Management Resources and MSI Consulting, both management consulting firms. From August 1999 until November 2000, Mr. Rothman was President of Global Internet Group, an internet consulting group and prior to August 1999, Mr. Rothman was Vice President of Cross Country Home Services, parent company of HMS, Inc., a home national warranty company.
Randall San Antonio, 52, has been President of Warrantech Direct, Inc., since June 1996, having joined the Company in May 1994.
Laurence Tutt, 41, has been Senior Vice President and Chief Operating Officer of Warrantech Corporation since April 2005, From September 2000 until March 2005, he served as Vice President of MIS/Telecommunication and Operations. He held various managerial positions within the MIS Department since joining the Company in 1994, having become Vice President-MIS in 1999.
Stephen R. Williams, 58, joined the Company in June 1990. Mr. Williams has been Senior Vice President Retail Sales of Warrantech Consumer Products since 1994.
Item 11.
Item 11. Executive Compensation ----------------------
The following table provides information for the years ended March 31, 2006, 2005 and 2004 concerning the annual and long-term compensation of the Company's Chief Executive Officer and the Company's next four highest paid executive officers.
- ---------------
(1) For purposes of this Summary Compensation Table and this purpose only, the 1998 Employee Incentive Stock Option Plan is being treated as a long-term incentive plan.
(2) Included in Other Annual Compensation are auto allowances, the Company's 401K Plan matching contributions and other perquisites given to each officer in fiscal 2006, 2005 and 2004; forgiveness of $194,254, $178,288 and $194,254 in interest, in 2006, 2005 and 2004, respectively, on a loan to Mr. San Antonio and $128,674, $19,862 and $100,134, amounts which covered the personal income taxes which Mr. San Antonio incurred in the 2003 and 2002 calendar years, respectively, in connection with the forgiveness of interest on his loan.
Stock-Based Compensation Grants in Last Fiscal Year
The following table sets forth information with respect to individual grants of stock options during the fiscal year ended March 31, 2006 to the Company's Chief Executive Officer and the other four most highly compensated executive officers.
- ------------- (1) The exercise price equals the fair market value of a share of Common Stock on the date of grant.
Options Exercised and Holdings
The following table sets forth information with respect to the individuals listed in the Summary Compensation Table above concerning unexercised options held as of the end of the 2006 fiscal year.
----------------
(1) Based upon the Company's price per share of $0.40, as reported on the NASDAQ National Market System on March 31, 2006.
Employment Agreements
Joel San Antonio - Chief Executive Officer
Mr. San Antonio's employment agreement was renewed as of July 1, 2003 for a five year term. His annual compensation consists of a base salary of $595,026 and an incentive bonus equal to 2% of the Company's net after-tax profits. The Company provides Mr. San Antonio with an annual automobile allowance of $12,000 and comprehensive medical, dental and disability coverage and reimbursement for all ordinary, reasonable and necessary expenses incurred by him in the performance of his duties. Through April 2002, the Company made payments on a split dollar life insurance death benefit policy of $4,000,000 covering Mr. San Antonio, in which the Company is the beneficiary of any proceeds from the policies up to the amount of premiums paid. The Company suspended payment of premiums for the policy until the permissibility of making such payments under the Sarbanes-Oxley Act of 2002 is clarified. In lieu of these premium payments, beginning in September 2004 and going forward the Company provides $56,000 cash bonus for the premium amount. Upon execution of his agreement, Mr. San Antonio was granted options, which vest over three years, to purchase an aggregate of 150,000 shares of Common Stock at an exercise price of $1.595 (110% of the fair market value on the date of grant) per share.
Richard F. Gavino - Executive Vice President, Chief Financial Officer and Treasurer
Mr. Gavino's employment agreement was renewed as of April 1, 2004 for a five year term. His annual compensation consists of a base salary of $285,000 and a cash bonus equal to 0.5% percent of the Company's net after tax income. While Mr. Gavino's base salary was increased from $265,254 in fiscal 2003, he does not automatically receive annual cost of living increases. The Company provides Mr. Gavino with medical and dental insurance and an annual automobile allowance of $12,000. Through April 2002, the Company made payments on a split dollar life insurance death benefit policy of $376,304 covering Mr. Gavino, in which the Company is the beneficiary of any proceeds from the policies up to the amount of premiums paid. The Company suspended payment of premiums for the policy until the permissibility of making such payments under the Sarbanes-Oxley Act of 2002 is clarified. In lieu of such split dollar life insurance payment, the Company awarded Mr. Gavino a $15,918 bonus. In accordance with the terms of his agreement, Mr. Gavino was granted options, which vest over five years, to purchase an aggregate of 147,060 shares of Common Stock at an exercise price of $0.68 per share.
Christopher Ford - President Warrantech Automotive, Inc.
Mr. Ford's employment agreement has a five year term which commenced as of July 1, 2003. His annual compensation consists of a base salary, currently $230,000 with 5% increases if certain operating goals for Warrantech Automotive are attained, and a cash bonus equal to 30% of his then base salary. The Company provides Mr. Ford with medical and dental insurance, an annual automobile allowance of $6,000 and club memberships. The Company plans to make payments of premiums for a split-dollar life insurance policy of $150,000, however, until the permissibility of making such payments under the Sarbanes-Oxley Act of 2002 is clarified, the Company will not make the payments. The Company will be the
beneficiary of any proceeds from the policies up to the amount of premiums paid. In accordance with the terms of the agreement, Mr. Ford was granted options, which vest over three years, to purchase an aggregate of 98,040 shares of Common Stock at an exercise price of $1.02 per share.
Richard Rodriguez - Executive Vice President of the Company and President of Warrantech International, Inc.
Mr. Rodriguez's employment agreement was renewed as of April 1, 2004 for a three year term. His base salary, which is subject to annual 5% increases, is currently $192,398 in fiscal 2005. Mr. Rodriguez is also entitled to receive an annual bonus of $50,000, half of which is contingent upon the Company achieving certain financial objectives and the balance of which is contingent on Warrantech International achieving its financial objectives. The Company provides Mr. Rodriguez with medical and dental insurance, an annual automobile allowance of $6,000 and life insurance benefits similar to that provided by the Company to certain of its other executives. Through April 2002, the Company made payments on a split dollar life insurance life insurance death benefit policy of $721,369 covering Mr. Rodriguez, in which the Company is the beneficiary of any proceeds from the policies up to the amount of premiums paid. The Company suspended payment of premiums for the policy until the permissibility of making such payments under the Sarbanes-Oxley Act of 2002 is clarified. In lieu of such split dollar life insurance payment, the Company awarded Mr. Rodriguez a $10,000 bonus.
Stephen R. Williams - Senior Vice President Warrantech Consumer Product Services, Inc.
Effective June 1, 2004, Stephen R. Williams entered into a three-year employment agreement to serve as Senior Vice President of Warrantech Consumer Product Services, Inc. Mr. Williams' base salary was $175,000 in fiscal 2005. He is entitled to receive an annual cash bonus up to $50,000 if certain operating goals for Warrantech Consumer Products Services are attained. The Company provides Mr. Williams with life, medical and dental insurance, an automobile allowance of $6,000 per annum and club memberships. During 2005, in accordance with the terms of his employment agreement, Mr. Williams was granted options to purchase an aggregate of 88,236 shares of common stock at an exercise price of $0.68 per share, which vest over three years.
Other Incentives and Compensation
Employee Incentive Stock Option Plan
The Company has provided executives equity-based long-term incentives through its 1998 Employee Incentive Stock Option Plan, which was designed to award key management personnel and other employees of the Company with bonuses and stock options based on the Company's and the employee's performance.
During the fiscal year ended March 31, 2006, all decisions regarding the Company's 1998 Employee Incentive Stock Option Plan (the "Plan"), including the granting of options thereunder, were made by the full Board of Directors.
As of March 31, 2006, options to purchase an aggregate of 1,473,033shares of Common Stock were issued under the Plan, of which options to purchase 300,000 shares were granted under the Plan during the fiscal year ended March 31, 2006.
Incentive Bonuses
The Company's Bonus Incentive Plan is designed to reward key executive officers if the Company attains its operating goals. Under the Bonus Incentive Plan, if the Company's net operating revenues and/or operating income goals are met, each eligible participant is entitled to a bonus, payable in cash and/or stock options, equal to an agreed upon percentage of his then current salary base, adjusted proportionately.
The Company provides an incentive bonus to all employees for referring job candidates who are hired by the Company. The amount of the bonus is predicated on the skill and professional level of the new employee.
Additionally, the Company provides incentive bonuses to employees who are claims adjusters for obtaining and maintaining certification as professionals in their field.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management --------------------------------------------------------------
The following table sets forth certain information, as of June 7, 2006, with respect to the number of shares of Warrantech common stock beneficially owned by individual directors and officers, by all directors and officers of Warrantech as a group, and by persons known to Warrantech to own more than 5% of Warrantech common stock. Unless otherwise indicated below, to Warrantech's knowledge, all persons below have sole voting and investment power with respect to their shares, except to the extent authority is shared by spouses under applicable law. This information is based upon Warrantech's records and the persons' filings with the SEC.
(1) Beneficial ownership is determined in accordance with the rules of the SEC and includes voting and investment power with respect to shares. Unless otherwise indicated, the persons named in the table have sole voting and sole investment control with respect to all shares beneficially owned by them.
(2) The number and percentage of shares beneficially owned are based on 13,967,586 shares of common stock issued and outstanding as of June 7, 2006, after deducting shares held in treasury. Certain of the above listed persons have the right to acquire beneficial ownership of shares of Warrantech common stock within 60 days after the date of this proxy statement. Each of their
percentages of ownership is determined by assuming that all of their respective options have been exercised and that the shares acquired upon exercise are outstanding.
(3) The 3,753,095 shares held by Mr. San Antonio do not include (i) 46,908 shares owned by his brother, sister-in-law and mother, (ii) 5,000 held by two of Mr. San Antonio's adult children, (iii) an aggregate of 200,000 shares held in trusts for his children for which Mr. San Antonio's ex-wife is trustee and (iv) 100,800 shares owned by his ex-wife. Mr. San Antonio disclaims the beneficial ownership of shares listed in (i) through (iv) above. Such 3,753,095 shares include 48,215 shares held in his 401(k) account and 570,000 shares subject to stock options exercisable within 60 days.
(4) Includes (i) 23,000 shares held by Mr. Tweed as custodian for his daughter, (ii) 1,500 shares held by Mr. Tweed's wife, and (iii) 55,000 shares held in trust, as to which he disclaims any beneficial interest. Does not include an aggregate of 7,500 shares held by Mr. Tweed's sister and 60,000 shares held by Mr. Tweed's daughter as to which Mr. Tweed also disclaims beneficial ownership.
(5) Includes 200 shares owned by Mr. Cohen's wife as custodian for Mr. Cohen's son, as to which he disclaims any beneficial interest.
(6) Less than 1% of the outstanding shares of Common Stock.
Security Ownership of Certain Beneficial Owners
The following table describes, as of June 7, 2006, each person who is known by the Company to beneficially own more than 5% of the Company's outstanding voting securities.
Beneficial ownership, and the calculation of the number of shares owned, is determined in accordance with the rules of the SEC. The person named in the table has the right to acquire beneficial ownership of the reported shares within 60 days after the date of this Proxy Statement. The percentage of ownership reported is determined by assuming that all of the reported options have been exercised and that the shares acquired upon exercise are outstanding. The percentage reported, as adjusted, is based on 13,967,586 shares of Common Stock issued and outstanding as of June 7, 2006.
Item 13.
Item 13. Certain Relationships and Related Transactions ----------------------------------------------
Receipt of Rent Payments from Companies Affiliated with Directors
During the last fiscal year, MedStrong International Corp. ("MedStrong") and Marc Pharmaceuticals, Inc. ("Marc") each paid rent in the amount of $350.00 per month to the Company for the use of a portion of office space maintained by the Company at 350 Bedford Street, Stamford, Connecticut 06901. Joel San Antonio, who is the Company's Chief Executive Officer and Chairman of the board of directors, is Chairman of the board of directors of MedStrong and Marc. Robert M. Cohen, who is a director of the Company, is Chief Executive Officer, President, Chief Financial Officer and a director of Marc.
Item 14.
Item 14. Principal Accountants Fees and Services ---------------------------------------
On July 21, 2005, the Company engaged Raich Ende Malter & Co. LLP ("Raich") as its new independent accountants, effective on August 1, 2005, replacing Weinick Sanders Leventhal & Co., LLP ("Weinick"), due to the fact that Weinick resigned, effective July 31, 2005, because it ceased doing business. Since the Company does not have an Audit Committee, the full Board of Directors approved the engagement of Raich on July 21, 2005.
The reports of Weinick on the financial statements of the Company for the past two fiscal years contained no adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principles. In connection with its audits for the two most recent fiscal years and through June 30, 2005, there have been no disagreements with Weinick on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Weinick would have caused them to make reference thereto in their report on the financial statements for such years.
It is expected that representatives of Raich will be present at the annual meeting and will have the opportunity to make a statement if they so desire and will be available to respond to appropriate questions.
Scope of Services. During fiscal 2006, the Company engaged Raich to provide audit services only. It did not engage Raich for any other services. Specifically, it did not engage Raich to provide: (a) bookkeeping or other services related to the accounting records or financial statements; (b) financial information systems design and implementation; (c) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (d) actuarial services; (e) internal audit outsourcing services; (f) management functions or human resources; (g) broker or dealer, investment adviser, or investment banking services; (h) legal services and expert services unrelated to the audit; or (i) tax preparation and compliance services.
Audit Fees. Raich's audit services during fiscal 2006 included the examination of the Company's annual consolidated financial statements for fiscal 2006, the reviews of the consolidated financial statements included in the Company's Forms 10-Q for fiscal 2006 and assistance with correspondence related to the SEC's review of the Company's consolidated financial statements. The aggregate fees for professional audit services rendered by Raich during fiscal year 2006 were $278,468.
Item 15.
Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ---------------------------------------------------------------
(a) 1. and 2. Financial Statements and Financial Statement Schedule: see accompanying Index to Financial Statements and Financial Statement Schedule, page.
(b) Reports on Form 8-K during the last quarter:
(c) Exhibits
Exhibits not incorporated herein by reference to a prior filing are designated by an asterisk (*) and are filed herewith; all exhibits not so designated are incorporated herein by reference as indicated. Management contracts or compensatory plans, contracts or arrangements with directors and executive officers of the Company appear in Exhibits 10(p) through 10(bb).
EXHIBITS
Exhibit Description - ------- -----------
3(a) Certificate of Nevada Incorporation filed February 28, 2005.
*3(b) Amended and Restated By-laws of Warrantech Corporation in the State of Nevada.
3(c) Amendment to the Bylaws and Article of Incorporation, Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005.
10(a) Form of Sales Distributor Agreement. Incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1985, file no. 0-13084.
10(b) Form of Service Center Agreement. Incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1985, file no. 0-13084.
10(c) Form of Dealer Agreement. Incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1985, file no. 0-13084.
10(d) Form of Sales Agent Agreement. Incorporated by reference to the Company's Registration Statement on Form S-1, filed on September 5, 1986, Registration No. 3-8517.
10(e) Amendment and supplement number one, dated January 16, 2004 to certain Warrantech and Butler agreements. Incorporated by reference to Exhibit 10(2) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2004, file no. 0-13084.
10(f) Warrantech Corp. Guaranty of Payment and Performance by RWC Corp. Incorporated by reference to Exhibit 10(3) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2004, file no. 0-13084.
10(g) Security Agreement dated as of January 16, 2004, by Reliance Warranty Company, in favor of Warrantech Corporation. Incorporated by reference to Exhibit 10(4) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2004, file no. 0-13084.
10(h) Indemnity Agreement by and between Warrantech Corporation (the "Indemnitor") and Butler Financial Solutions, LLC, Reliance Warranty Company, SPG Financial Corp., the current members and officers of Butler, RWC and SPG, Harris Miller, Karen Parker and Paula Graff, (collectively and individually, the "Indemnitee(s)"). Incorporated by reference to Exhibit 10(5) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2004, file no. 0-13084.
10(i) General Agency Agreement between American International Group, Inc. and Warrantech Automotive, Inc. Incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1996, file no. 0-13084.
10(j) Master Agreement between American International Group, Inc. and Warrantech Corporation. Incorporated by reference to Exhibit 10(q) to the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1996, file no. 0-13084.
10(k) Stock Option Agreement dated June 4, 2002, by and between Warrantech Corporation and Staples, Inc. Incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002, file no. 0-13084.
10(l) Warrantech Corporation 1998 Employee Incentive Stock Option Plan, as amended and restated, effective September 25, 2001. Incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2001, file no. 0-13084.
10(m) Amendment No. 2 dated October 8, 2002, to the Warrantech Corporation 1998 Employee Incentive Stock Option Plan, as amended and restated, effective September 25, 2001. Incorporated by reference to Exhibit 4(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, file no. 0-13084.
10(n) Amendment No. 3, dated September 8, 2003, to the Warrantech Corporation 1998 Employee Incentive Stock Option Plan, as amended and restated, effective June 12, 2003. Incorporated by reference to Exhibit 4(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, file no. 0-13084.
10(o) Amendment No. 3, dated October 7, 2003, to the Warrantech 401K plan. Incorporated by reference to Exhibit 4(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, file no. 0-13084.
10(p) Employment Agreement dated April 1, 2003 between Warrantech Corporation and Joel San Antonio. Incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, file no. 0-13084.
10(q) Employment Agreement dated April 1, 2004, between Warrantech Corporation and Richard F. Gavino. Incorporated by reference to Exhibit 10(x) to the Company's Annual Report on Form 10-K for the year ended March 31, 2004, file no. 0-13084.
10(r) Schedule 10(u) identifying contracts that are substantially similar to Exhibit 10(t), the Employment Agreement between Warrantech Corporation and James F. Morganteen, in all material respects except as to the parties thereto, the dates of execution, or other details, incorporated by reference to Exhibit 10(h) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, file no. 0-13084.
10(s) Employment Agreement dated March 15, 2004, between Warrantech Corporation and Evan Rothman. Incorporated by reference to Exhibit 10(aa) to the Company's Annual Report on Form 10-K for the year ended March 31, 2004, file no. 0-13084.
10(t) Employment Agreement dated June 1, 2004, between Warrantech Corporation and Stephen R. Williams. Incorporated by reference to Exhibit 10(bb) to the Company's Annual Report on Form 10-K for the year ended March 31, 2004, file no. 0-13084.
10(u) Amendment #1, dated April 1, 2004 to the Employment Agreement dated April 1, 2000 between Warrantech Corporation and Richard Rodriguez.
10(v) Employment Agreement dated July 9, 2003, between Warrantech Corporation and Christopher L. Ford. Incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, file no. 0-13084.
10(w) Employment Agreement dated April 1, 2003 between Warrantech Corporation and Randall San Antonio. Incorporated by reference to Exhibit 10(w) to the Company's Annual Report on Form 10-K for the year ended March 31, 2003, file no. 0-13084.
10(x) Employment Agreement dated December 1, 2004, between Warrantech Corporation and Laurence Tutt. Incorporated by reference to Exhibit 10(1) to the Company's Quarterly Report on Form 10-Q for the quarter ended December 31, 2004, file no. 0-13084.
10(y) Amendment #1, dated October 1, 2004 to the Employment Agreement dated April 1, 2002 between Warrantech Corporation and Jeanine Folz.
10(z) Promissory Note, as amended July 24, 2002,between Warrantech Corporation and William Tweed, incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, file no. 0-13084.
10(aa) Promissory Note, as amended, July 24, 2002, between Warrantech Corporation and Joel San Antonio, incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, file no. 0-13084.
10(bb) Promissory Note, as amended July 24, 2002, between Warrantech Corporation and Jeff J. White. Incorporated by reference to Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, file no. 0-13084.
10(cc) Code of Business Conduct and Ethics. Incorporated by reference to Exhibit 10(ii) to the Company's Annual Report on Form 10-K for the year ended March 31, 2004, file no. 0-13084.
*10(dd) Agreement dated May 2006, between Warrantech Corporation and William Tweed to exchange shares of Company Common Stock for the interest due on the Note from Mr. Tweed.
10(ee) Filed as exhibit to 8-K filed March 14, 2006.
*21 Subsidiaries of the Company.
*31.1 Certification by the Chief Executive Officer pursuant to Rule13a-14(a) of the Securities Exchange Act of 1934, as amended.
*31.2 Certification by the Chief Financial Officer pursuant to Rule13a-14(a) of the Securities Exchange Act of 1934, as amended.
*32.1 Statement by the Chief Executive Officer and the Chief Financial Officer furnished pursuant to Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended.
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 thereto duly authorized.
WARRANTECH CORPORATION
Dated: June 29, 2006 By: /s/ JOEL SAN ANTONIO ------------------------------------- Joel San Antonio, Chairman of the Board and Chief Executive Officer
Dated: June 29, 2006 By: /s/ RICHARD F. GAVINO ------------------------------------- Richard F. Gavino, Executive Vice President and Chief Financial Officer
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 indicated on June 29, 2006.
/s/ JOEL SAN ANTONIO Chairman, Chief Executive Officer and Director - ------------------------ (Principal Executive Officer) Joel San Antonio
/s/ RICHARD F. GAVINO Executive Vice President and Chief Financial Officer - ------------------------ (Principal Accounting and Financial Officer) Richard F. Gavino
/s/ ROBERT M. COHEN Director - ------------------------ Robert M. Cohen
/s/ CHARLES G. STIENE, ESQ. Director - ------------------------ Charles G. Stiene, Esq
/s/ DONALD SENDEROWITZ Director - ------------------------ Donald Senderowitz
/s/ RICHARD RODRIGUEZ Director - ------------------------ Richard Rodriguez