Item 1. Business.
General
The following discussion relates to The FINOVA Group Inc. and its subsidiaries (collectively “FINOVA” or the “Company”), including FINOVA Capital Corporation and its subsidiaries (“FINOVA Capital”). FINOVA is a financial services holding company. Through its principal operating subsidiary, FINOVA Capital, the Company has provided a broad range of financing and capital markets products, primarily to mid-size businesses.
The Company’s business activities are limited to maximizing the value of its portfolio through the orderly collection of its assets. These activities include collection efforts pursuant to underlying contractual terms, negotiation of prepayments, sales of assets or collateral and may include efforts to retain certain customer relationships and restructure or terminate other relationships. The Company has sold portions of asset portfolios and will consider future sales of any asset if buyers can be found at acceptable prices; however, there can be no assurance that the Company will be successful in efforts to sell additional assets. The Company is offering to sell its remaining assets both by portfolio and individual asset. The Company is prohibited by the Indenture governing its Senior Notes (terms defined below) from engaging in any new lending activities, except to honor existing customer commitments and in certain instances, to restructure financing relationships to maximize value. Any funds generated in excess of cash reserves permitted by the Company’s debt agreement are used to reduce FINOVA’s obligations to its creditors.
FINOVA is a Delaware corporation incorporated in 1991. FINOVA’s principal executive offices are located at 4800 North Scottsdale Road, Scottsdale, Arizona 85251-7623, telephone (480) 636-4800.
2001 Restructuring
On March 7, 2001, FINOVA, FINOVA Capital and seven of their subsidiaries (the “Debtors”) filed for protection pursuant to chapter 11, title 11, of the United States Code in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) to enable them to restructure their debt. On August 10, 2001, the Bankruptcy Court entered an order confirming FINOVA’s Third Amended and Restated Joint Plan of Reorganization (the “Plan”), pursuant to which the Debtors restructured their debt, effective August 21, 2001, when the Company emerged from bankruptcy.
Pursuant to the Plan, Berkadia LLC (“Berkadia”), an entity jointly owned by Berkshire Hathaway Inc. (“Berkshire”) and Leucadia National Corporation (“Leucadia”), loaned $5.6 billion to FINOVA Capital on a senior secured basis (the “Berkadia Loan”). The Berkadia Loan was scheduled to mature in 2006, but was repaid earlier than anticipated (first quarter of 2004) due to accelerated runoff and collection of the portfolio. An affiliate of Berkadia continues to hold 61,020,581 shares of common stock issued in conjunction with the Plan, representing 50% of FINOVA’s outstanding shares.
As of December 31, 2005, FINOVA remains obligated to repay $1.7 billion of principal on its 7.5% Senior Secured Notes (the “Senior Notes”) issued in conjunction with the Plan. In accordance with the terms of the Indenture governing the Senior Notes (the “Indenture”), the Company is required to use any excess cash, as defined in the Indenture, to make semi-annual interest and principal payments on the Senior Notes. Additionally, the Indenture permits voluntary prepayments at the Company’s option. Although FINOVA has repaid approximately 45% of the Senior Notes as of the date of this report, the Company does not believe that it has sufficient assets to fully repay the Senior Notes.
FINOVA’s business continues to be operated under a Management Services Agreement with Leucadia that expires in 2011. Pursuant to that agreement, Leucadia has designated its employees to act as Chairman of the Board (Ian M. Cumming), President (Joseph S. Steinberg) and Chief Executive Officer (Thomas E. Mara).
High Investment Risk
As previously stated, FINOVA believes that it will be unable to fully repay its Senior Notes and that it is unlikely that it will be able to make distributions to its stockholders, absent a court order. Consequently, investing in the Senior Notes and common stock involves a high level of risk. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operation for a further discussion of the Senior Notes and restrictions on distributions to stockholders.
Because substantially all (except for a few assets that could not be pledged because those assets already secured other obligations) of the Company’s assets are pledged to secure its obligations under the Intercompany Notes (as defined in Management’s Discussion and Analysis of Financial Condition and Results of Operations) securing the Senior Notes, FINOVA’s ability to obtain additional or alternate financing is severely restricted. Berkadia has no obligation to lend additional sums to or to further invest in the Company. Accordingly, FINOVA intends to rely on internally generated cash flows from the liquidation of its assets as its only meaningful source of liquidity.
Portfolio Descriptions
The asset liquidation process has resulted in significant reductions in the size of many of the Company’s niche portfolios. To facilitate the orderly collection of its remaining asset portfolios, FINOVA has combined its former operating segments into one operating unit; however, its assets continue to be concentrated in certain specific market niches, which are described below.
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Transportation - is primarily comprised of older vintage aircraft, often of class and configuration with limited demand in the aircraft market. FINOVA has a number of aircraft that are off-lease and anticipates that additional aircraft will be returned to the Company as leases expire or operators are unable or unwilling to continue making payments. The Company’s portfolio of aircraft generally is not as desirable to domestic commercial airlines, and as a result, off-lease aircraft are primarily marketed in whole or part to carriers in developing countries.
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Real Estate - represents the combined remaining assets of the Company’s resort and specialty real estate portfolios. Transactions included senior term acquisition loans on hotel and resort properties, receivables financing for timeshare resorts and fractional interest resorts. FINOVA also provided equity investments in credit-oriented real estate sale-leasebacks. Due to continued prepayments and assets sales, this shrinking portfolio will be combined with all other portfolios in future filings. At December 31, 2005, the entire real estate portfolio consisted of resort and timeshare assets.
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All Other Portfolios - is comprised of the remnants of several former portfolios (commercial equipment, communications, corporate finance, franchise, healthcare, mezzanine, public and rediscount) that for various reasons have not been sold or collected. The portfolio generally contains assets that are more difficult and work intensive to liquidate. Approximately 77% of these assets were impaired or nonaccruing at December 31, 2005. Many of the borrowers have missed payments, including balloon obligations, or are otherwise in default.
Portfolio Composition
The following details the composition and carrying amounts of FINOVA’s total financial assets at December 31:
Refer to Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a detailed discussion of the changes to the Company’s portfolio.
At December 31, the Company’s transportation portfolio consisted of the following aircraft:
The aircraft presented in the tables represent owned assets and collateral supporting financing arrangements. The Company continues to monitor all of these aircraft due to the level of prior defaults and returned aircraft.
At December 31, 2005, 33 aircraft with a carrying value of $105.5 million were operated by domestic carriers and 45 aircraft with a carrying value of $38.6 million were operated by foreign carriers. Additionally, 11 aircraft with a carrying value of $7.1 million were off-lease, classified as assets held for the production of income and parked at various storage facilities in the United States and Europe, including 2 aircraft which were identified for potential dismantling or sale at scrap values.
At December 31, 2004, 50 aircraft with a carrying value of $156.3 million were operated by domestic carriers and 61 aircraft with a carrying value of $108.9 million were operated by foreign carriers. Additionally, 19 aircraft with a carrying value of $14.2 million were off-lease, classified as assets held for the production of income and parked at various storage facilities in the United States and Europe, including 5 aircraft which were identified for potential dismantling or sale at scrap values.
Some of the off-lease aircraft are periodically placed in rental agreements with payments based on aircraft usage, commonly known as power-by-the-hour agreements. Often under these agreements there are no minimum rents due, and future cash flows are difficult to project. Additionally, FINOVA has been maximizing the value of the portfolio by using the remaining air-time of aircraft and engines, while minimizing the maintenance investment in those assets. As remaining air-time was exhausted, numerous aircraft and engines were identified for potential dismantling or sale at scrap values; however, the reemergence of the aircraft-financing market during late 2004 caused a change in the Company’s approach to maximize value. In certain instances, the Company believes it can achieve better returns in the current market of improved aircraft values by investing in the maintenance of certain types of aircraft and engines. As a result, the number of aircraft being identified for potential dismantling or sale at scrap values has declined. The Company will continue to invest in aircraft maintenance as long as it makes economic sense to do so.
The Company’s transportation portfolio also includes aircraft engines, domestic railroad and other transportation equipment. The carrying value of this equipment was $12.3 million and $14.7 million at December 31, 2005 and 2004, respectively.
In addition to the concentrated exposures within the transportation portfolio, the Company had certain concentrations within its real estate portfolio. At December 31, the carrying amount of the real estate portfolio by industry was as follows:
Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations for a further discussion of portfolio activity.
Customer Requirements
FINOVA Capital’s financing contracts and leases generally require the customer to pay taxes, license fees and insurance premiums and to perform maintenance and repairs at the customer’s expense. Contract payment rates for existing customers are based on several factors, including the cost of borrowed funds, term of the contract, creditworthiness of the customer, type and nature of collateral and other security and, in leasing transactions, the timing of tax effects and estimated residual values. In true lease transactions, lessees are granted an option to purchase the equipment at the end of the lease term at its then fair market value and, in some cases, are granted an option to renew the lease at its then fair rental value. The extent to which lessees exercise their options to purchase leased equipment varies from year to year, depending on, among other factors, the state of the economy, the financial condition of the lessee, interest rates, and technological developments.
Portfolio Management
FINOVA Capital’s portfolio management personnel generally perform detailed reviews and assessments of customer financial statements to analyze financial performance and trends, conduct periodic assessments, appraisals and/or verification of the underlying collateral, seek to identify issues concerning strengths, weaknesses and vulnerabilities of the customer, seek to resolve outstanding issues with the customer, and periodically review and address covenant compliance issues.
Evaluations of borrower performance are an important aspect of the portfolio management review process. In conjunction with this process, portfolio managers update anticipated portfolio cash flows. These evaluations and cash flows serve as a significant component in the determination of portfolio impairment.
Delinquencies and Workouts
FINOVA Capital monitors the timing of payments on its accounts and has established policies and procedures for collection of delinquencies. These policies and procedures are generally employed, unless in the opinion of management, an alternate course is warranted. Generally, for term loans and leases, when an invoice is past due, the customer is contacted and a determination is made as to the extent of the problem, if any. A commitment for immediate payment is pursued and the account is observed closely. If an invoice for principal or interest becomes 31 days past due, it is reported as delinquent. A notice of default is generally sent prior to an invoice becoming 45 days past due if satisfactory discussions are not in progress. Between 60 and 90 days past the due date, if satisfactory negotiations are not underway, outside counsel may be retained to help protect FINOVA Capital’s rights and to pursue its remedies. If satisfactory results are not obtained as a result of communication with the customer, guarantors, if any, are usually contacted to advise them of the situation and their potential obligation under the guarantee agreement.
Accounts are generally classified as “nonaccruing” when the earlier of the following events occur: (a) the borrower becomes 90 days past due on the payment of principal or interest or (b) when, in the opinion of management, a full recovery of contractual income and
principal becomes doubtful. Impairment reserves may be required even when payments are current, if it is probable that the borrower will not be able to make all payments pursuant to the terms of its contract. When an account is classified as nonaccruing, all accrued and unpaid interest is reversed and future income recognition is suspended. In certain instances, accounts may be returned to accruing status if sustained contractual performance is demonstrated. Changes in borrower performance, assumptions, or estimates could result in a material change in nonaccruing account classification and income recognition. While pursuing collateral and obligors, FINOVA Capital generally continues to negotiate the restructuring or other settlement of the debt, as it believes appropriate.
Governmental Regulation
FINOVA Capital’s activities, including the financing of its operations, are subject to a variety of federal and state regulations, such as those imposed by the Federal Trade Commission, the Securities and Exchange Commission, the Internal Revenue Service, the Consumer Credit Protection Act, the Equal Credit Opportunity Act and the Interstate Land Sales Full Disclosure Act. Additionally, a majority of states have ceilings on interest rates that are charged to customers in financing transactions. Some of FINOVA Capital’s financing transactions and servicing activities are subject to additional government regulation. For example, aircraft financing is regulated by the Federal Aviation Administration and communications financing is regulated by the Federal Communication Commission. FINOVA Capital’s international activities are also subject to a variety of laws and regulations of the countries in which business is conducted. FINOVA’s operations during the reorganization proceedings were also subject to oversight by the bankruptcy court, which has retained jurisdiction to resolve claims resulting from that restructuring.
Employees
At December 31, 2005, the Company had 60 employees compared to 101 and 213 at December 31, 2004 and 2003, respectively. The decrease is primarily attributable to the continued liquidation and sale of assets, the Company’s efforts to trim operating expenses and attrition caused by the events of the past several years. FINOVA believes it continues to retain sufficient personnel to operate in the ordinary course. None of these employees are covered by collective bargaining agreements. FINOVA believes its employee relations remain satisfactory.
The Company continues to review its organizational structure and additional reductions in force are anticipated to occur as the portfolio declines, but sufficient employees will be retained to provide appropriate oversight of the smaller operation in a more efficient manner.
Employees are covered by a severance program, which has been approved by the Board of Directors and continues with no fixed expiration date. The Company has also developed an annual performance-based incentive program for employees. In an effort to maintain the stability of its workforce through the remainder of the liquidation, FINOVA’s Board of Directors approved the establishment of two grantor trusts to secure the Company’s obligations under the severance and bonus programs. These trusts, which do not increase the Company’s obligations to its employees, were funded during 2003 with a combined total of approximately $24.0 million.
Investor Information
FINOVA is subject to the informational requirements of the Securities Exchange Act of 1934 (the “Exchange Act”). Accordingly, FINOVA files periodic reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). Those reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, D.C. 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.
You can access financial and other information on FINOVA’s website. The address is www.finova.com. FINOVA also makes available on its website, free of charge, copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act within two business days after filing that material with the SEC.
FINOVA has a Code of Conduct applicable to all FINOVA employees, including FINOVA’s Chairman, President, Chief Executive Officer and Chief Financial Officer. A copy of the Code of Conduct is available on FINOVA’s website. FINOVA intends to post any amendments to, or waivers from, the Code of Conduct applicable to the senior officers listed above.
Item 1A.
Item 1A. Risk Factors
The risks, uncertainties and other factors that could cause our financial condition, results of operations and cash flows to differ materially from those suggested by this filing or which may materially and adversely affect our performance and the amount repaid to the Senior Note holders include, but are not limited to, those discussed below or identified elsewhere in this Report or from time to time in our public filings.
We may not be successful in implementing our business strategy. The carrying amounts and impairment of our portfolio are based on estimates of asset value and the estimation and timing of future cash flows. Actual results may differ from the estimated amounts. If we fail to fully implement our business strategy to maximize the value of our portfolio through orderly collection or sales of assets, our ability to repay our outstanding debt and other obligations could be impaired and could have a materially adverse impact on our financial position and results of operations.
Our results of operations and financial condition are greatly affected by economic conditions and the performance of our borrowers. Economic conditions in general or in particular market segments could impair the ability of our borrowers to operate or expand their businesses, which might result in decreased performance, adversely affecting their ability to repay their obligations to us. If this were to occur, the rate of borrower defaults or bankruptcies may increase. A worsening of economic conditions could adversely affect our ability to realize estimated cash flows.
We may not be able to retain our employees. We must retain a sufficient number of employees with relevant knowledge and skills to continue to monitor, collect and sell our portfolio. Our failure to do so could result in additional losses. Retention incentives intended to retain that employee base may not be successful in the future. In addition, as staff is reduced, internal controls and procedures must be readjusted to help assure proper handling and reporting of financial and other matters. Doing so becomes more difficult as our staff is reduced, and the loss of key personnel could have a significant impact on our ability to monitor, collect and manage our portfolio.
Continued instability and uncertainty in the airline industry could adversely affect the value of our aircraft portfolio, lease rates and demand. Conditions affecting our aircraft portfolio, including changes in Federal Aviation Administration directives and demand for used aircraft and spare parts. Our aircraft are often of older vintage and contain configurations of engines, avionics, fuel tanks and other components that may not be as high in demand as other available aircraft in that class. Future demand for those aircraft may decrease as newer or more desirable aircraft and components become available. High fuel prices may adversely affect the demand for less fuel-efficient aircraft, including many of those in our portfolio.
It is unlikely we will be able to utilize our tax attributes. We have not recorded a benefit in our financial statements for existing tax attributes and estimated future tax deductions since we do not expect to generate the future taxable income needed to use those tax benefits. We may never be able to use those tax attributes, including most of our net operating loss carryforwards.
It is becoming more difficult to offset the costs of collecting the remaining portfolio. As we continue to liquidate assets and change our portfolio composition, it becomes increasingly more difficult to offset the costs associated with collecting the remaining portfolio and being a public company. Additionally, we incur the risks of potential liabilities that are associated with dispositions of assets, in the form of indemnifications, representations and warranties.
We rely on information from third parties, which may not be accurate. Third party information is supplied by our borrowers or prepared by appraisers. Inaccuracies in that information could lead to inaccuracies in our estimates, including asset valuations and cash flow projections.
We are increasingly subject to concentrations of credit risk. As our portfolio declines, increasing concentrations of financial assets in certain industries such as transportation could make our overall portfolio more sensitive to changes in performance in that industry. Additionally, we previously completed multiple financial transactions with individual borrowers and their affiliates. As a result, we are subject to greater total exposure to those borrowers beyond the typical transaction size and increased concentration risk to economic events affecting the industries (including transportation) of such borrowers and their affiliates.
Current and future legal and administrative claims and proceedings against us may result in increased costs and diversion of management’s attention. We are party either as plaintiff or defendant to various actions, proceedings and pending claims, including legal actions, some of which involve claims for compensatory, punitive or other damages in significant amounts. Litigation often results from our attempts to enforce our lending agreements against borrowers and other parties to those transactions.
Litigation is subject to many uncertainties. It is possible that some of the legal actions, proceedings or claims could be decided against us. Legal matters decided against us could have a material adverse impact on our financial position, results of operations or cash flows. See Item 3. “Legal Proceedings,” for a discussion of specific claims outstanding against us.
Item 1B.
Item 1B. Unresolved Staff Comments.
Not applicable.
Item 2.
Item 2. Properties.
FINOVA’s principal executive offices are located at 4800 North Scottsdale Road, Scottsdale, Arizona 85251-7623, telephone (480) 636-4800. FINOVA Capital operates additional offices in the United States and one in Europe. All of these properties are leased.
As a result of the continued liquidation and sale of assets, FINOVA has consolidated operations and reduced staff, resulting in the need for less office space. FINOVA continues to negotiate its operating lease contracts in an effort to reduce costs. FINOVA has terminated all or a portion of multiple operating lease contracts and ceased using significant portions of other office locations. While the Company pursues subleasing opportunities, it continues to incur costs under these operating lease contracts without receiving economic benefit. The Company maintains a liability for lease termination damages and the estimated fair value of future rental payments, net of anticipated subrentals on office space the Company is no longer using. See Annex A, Notes to Consolidated Financial Statements, Note M. “Costs Associated with Exit or Disposal Activities” for more information.
Item 3.
Item 3. Legal Proceedings.
Legal Proceedings
FINOVA is party either as plaintiff or defendant to various actions, proceedings and pending claims, including legal actions, some of which involve claims for compensatory, punitive or other damages in significant amounts. Litigation often results from FINOVA’s attempts to enforce its lending agreements against borrowers and other parties to those transactions. Litigation is subject to many uncertainties. It is possible that some of the legal actions, proceedings or claims could be decided against FINOVA. Other than the matters described below, FINOVA believes that any resulting liability from its legal proceedings should not materially affect FINOVA’s financial position, results of operations or cash flows. The following matters could have a material adverse impact on FINOVA’s financial position, results of operations or cash flows.
If any legal proceedings result in a significant adverse judgment against the Company, which is not anticipated, it is unlikely that FINOVA would be able to satisfy that liability due to its financial condition. As previously noted, due to the Company’s financial condition, it does not expect that it can satisfy all of its secured debt obligations at maturity. Attempts to collect on those judgments could lead to future reorganization proceedings of either a voluntary or involuntary nature.
Litigation Related to Loans to The Thaxton Group Inc. and Related Companies
Between October 17, 2003 and January 13, 2004, FINOVA Capital Corporation was served with and named as a defendant (with other parties) in five lawsuits that relate to its loan to The Thaxton Group Inc. and several related entities (collectively the “Thaxton Entities”). Under its loan agreement, FINOVA has a senior secured loan to the Thaxton Entities of approximately $108 million at December 31, 2005. The Thaxton Entities were declared in default under their loan agreement with FINOVA after they advised FINOVA that they would have to restate earnings for the first two fiscal quarters of 2003, and had suspended payments on their subordinated notes. As a result of the default, FINOVA exercised its rights under the loan agreement, and accelerated the indebtedness. The Thaxton Entities then filed a petition for bankruptcy protection under chapter 11 of the federal bankruptcy code in the United States Bankruptcy Court for the District of Delaware on October 17, 2003, listing assets of approximately $206 million and debts of $242 million. The Thaxton Group had approximately 6,800 holders of its subordinated notes that were issued in several states, with a total subordinated indebtedness of approximately $122 million.
The first lawsuit, a complaint captioned Earle B. Gregory, et al, v. FINOVA Capital Corporation, James T. Garrett, et al., (the “Gregory action”) was filed in the Court of Common Pleas of Lancaster County, South Carolina, case no. 2003-CP-29-967, and was served on FINOVA on October 17, 2003. An amended complaint was served on November 5, 2003, prior to the deadline for FINOVA to answer, plead, or otherwise respond to the original complaint. The Gregory action was properly removed to the United States District Court for the District of South Carolina on November 17, 2003, pursuant to 28 U.S.C. §§ 1334 and 1452. The plaintiffs filed a motion to remand the case to state court, but the United States District Court denied this motion in an order dated December 18, 2003.
The second Thaxton-related complaint, captioned Tom Moore, Anna Nunnery, et al., v. FINOVA Capital Corporation, Moore & Van Allen PLLC, and Cherry, Bekaert & Holland LLP, case no. 8:03-372413 (“Moore”), was filed in the United States District Court for the District of South Carolina on November 25, 2003, and was served on FINOVA on December 2, 2003. The third complaint, captioned Sam Jones Wood and Kathy Annette Wood, et al., v. FINOVA Capital Corporation, Moore & Van Allen PLLC, and Cherry, Bekaert & Holland LLP, (“Wood”) was filed in the Superior Court for Gwinnett County, Georgia, case no. 03-A13343-B, and was served on FINOVA on December 9, 2003. FINOVA properly removed the Wood action to the United States District Court for the Northern District of Georgia (Atlanta Division) on January 5, 2004. The fourth complaint, captioned Grant Hall and Ruth Ann Hall, et al., v. FINOVA Capital Corporation, Moore & Van Allen PLLC, and Cherry, Bekaert & Holland LLP, case no. 03CVS20572, (“Hall”) was filed in the Mecklenberg County, North Carolina, Superior Court, and was also served on FINOVA on December 9, 2003. FINOVA properly removed the Hall action to the United States District Court for the Western District of North Carolina (Charlotte Division) on January 5, 2004. The fifth complaint, captioned Charles Shope, et al., v. FINOVA Capital Corporation, Moore & Van Allen PLLC, and Cherry, Bekaert & Holland LLP, case no. C204022 (“Shope”), was filed in the United States District Court for the Southern District of Ohio, Eastern Division, and was served on FINOVA on January 13, 2004.
Each of the five Thaxton-related lawsuits are styled as class actions, purportedly brought on behalf of certain defined classes of people who had purchased subordinated notes from the Thaxton Entities. The complaints by the subordinated note holders allege claims of fraud, securities fraud, and various other civil conspiracy and business torts in the sale of the subordinated notes. Each of the complaints seeks an unspecified amount of damages, among other remedies.
Upon motion by FINOVA to the United States Judicial Panel for MultiDistrict Litigation (Docket 1612), all five Thaxton-related actions were transferred on June 18, 2004 to the United States District Court for the District of South Carolina for coordinated pre-trial proceedings (the “MDL Litigation”). In June 2005, the South Carolina District Court certified the MDL Litigation as a class action (collectively, the “Class Action”).
On October 6, 2005, the United States Court of Appeals for the Fourth Circuit issued an order granting the Company’s petition for permission to appeal the order of the South Carolina District Court certifying the class action cases and staying further proceedings in the South Carolina District Court during the pendency of the appeal or until the further order of the Court of Appeals. Oral arguments on the petition were heard by the Fourth Circuit on February 2, 2006. On March 14, 2006, the Fourth Circuit issued its ruling, reversing the South Carolina District Court’s class certification, stating, that in light of the Adversary Proceeding addressed below, class certification is not the superior method for the fair and efficient adjudication of the controversy.
In addition to the MDL Litigation, Thaxton’s unsecured creditors committee (the “Thaxton Committee”) has an action against FINOVA in the bankruptcy proceedings of the Thaxton Entities (the “Adversary Proceeding”) seeking on various grounds, among other things to avoid and/or equitably subordinate the liens and claims of FINOVA against the Thaxton Entities and to recover payments previously collected due to alleged securities fraud, violations of banking regulations, preference payments and similar claims. The Adversary Proceeding was filed in the United States Bankruptcy Court for the District of Delaware and was consolidated with the MDL Litigation for pre-trial proceedings.
The Company was notified on September 21, 2005, that the South Carolina District Court had denied the Company’s motion to transfer the Adversary Proceeding back to the United States District Court for the District of Delaware at this time, denied the Company’s motion for partial summary judgment on certain claims in the Adversary Proceeding, and granted the Thaxton Committee’s motion for partial summary judgment on the Committee’s claim for equitable subordination. The court has not yet issued this opinion.
As Thaxton has liquidated assets, portions of the payments collected by Thaxton have been deposited into a reserve account (approximately $72 million at December 31, 2005) in the name of FINOVA and the Thaxton Entities bankruptcy estates rather than being paid to FINOVA in respect of FINOVA’s outstanding loan. During the third quarter of 2005, FINOVA and Thaxton also agreed to deposit future interest payments and legal expense reimbursement that FINOVA alleges are due from Thaxton to FINOVA into two additional reserve accounts (an aggregate of approximately $5.0 million at December 31, 2005), each in the name of FINOVA and the Thaxton Entities bankruptcy estates. These reserve accounts are expected to be maintained until the Adversary Proceeding is resolved. These amounts are not reflected in FINOVA’s balance sheet. As a result of these reserve accounts, the amount of cash flow being paid by the Thaxton Entities to FINOVA has decreased from prior periods.
If the South Carolina District Court’s equitable subordination finding is not overturned or otherwise modified, the Company’s ability to recover on its claims in the Thaxton Entities bankruptcy cases may be materially and negatively affected, depending upon the exact
nature of that ruling, as well as the results of other rulings in this litigation that may substantially limit the effect and importance of the equitable subordination ruling. Among the other rulings that could affect the Company’s ability to recover its claims, either positively or negatively, is the Delaware bankruptcy court’s ruling on a pending request seeking substantive consolidation of the Thaxton Entities. The Delaware bankruptcy court held a hearing on that issue, but has not yet ruled on the matter. A material and negative impact on the Company’s ability to recover on its claims in the Thaxton Entities bankruptcy cases would have a material adverse impact on the Company’s financial position, results of operations and/or cash flow.
If the Adversary Proceeding results in a significant adverse final determination against the Company, it is unlikely that the Company would be able to satisfy that liability due to its financial condition. As previously disclosed, due to the Company’s financial condition, it does not expect that it can satisfy all of its secured debt obligations at maturity. Attempts to collect on those judgments could lead to future reorganization proceedings of either a voluntary or involuntary nature.
The Company believes all the claims against FINOVA are without merit. FINOVA intends to vigorously defend the claims asserted against it in connection with the Thaxton Entities, whether in the MDL Litigation, or in the Adversary Proceeding, and to protect its senior secured position in the bankruptcy proceedings for the Thaxton Entities, including without limitation with respect to the pending substantive consolidation request.
Motion Regarding Distributions to Stockholders
As discussed more fully in the Notes to the Consolidated Financial Statements, Note F. “Debt”, the Indenture contemplates that as principal payments are made on the Senior Notes, FINOVA stockholders will receive a distribution equal to 5.263% of each principal prepayment. The Indenture prohibits distribution of those amounts due to FINOVA’s financial condition. Those amounts are held in a restricted account, and totaled $70.3 million as of February 15, 2006. Because FINOVA will not be able to repay the Senior Notes in full, on April 1, 2005, it filed a motion in the United States Bankruptcy Court for the District of Delaware seeking an order (1) to cease directing funds into a restricted account and (2) to allow FINOVA to use the funds in the restricted account to satisfy its obligations to creditors. In June 2005, the Bankruptcy Court ordered that the former Equity Committee (the “Equity Committee”) be reconstituted. As of July 14, 2005, the Equity Committee was reconstituted with three members.
A hearing was held on November 29, 2005, and on February 1, 2006, the Bankruptcy Court issued its Order approving FINOVA’s April 1, 2005 motion to the extent that FINOVA will be forever insolvent. The Bankruptcy Court did not find that FINOVA is presently or will be forever insolvent. As a result, FINOVA will continue to direct funds into a restricted account until such time that FINOVA is deemed to be forever insolvent and the funds will then be distributed to FINOVA’s creditors. On February 10, 2006, the Equity Committee filed a Notice of Appeal of the Bankruptcy Court Order to the United States District Court for the District of Delaware.
Litigation Related to FINOVA v. Richard Arledge; Arledge v. FINOVA
FINOVA filed a collection action against Richard Arledge and Arledge Motor Company (collectively “Arledge”) in June 2002 in the United States District Court, District of Arizona (the “Court”), case number CIV02-1277-PHX-RCB. On or about October 1, 2002, Arledge responded in the Arizona action with a counterclaim, alleging various lender liability claims against FINOVA.
Arledge filed an Application for Temporary Restraining Order (“TRO”) and Order to Show Cause, Alternatively Application for Prejudgment Writ of Attachment against FINOVA on August 24, 2005 in an attempt to prevent FINOVA from liquidating part or all of its assets pending trial. The Court denied the motion for TRO. The Court, however, granted Arledge’s request for a prejudgment attachment, but conditioned the issuance of any resulting writ of attachment on Arledge posting a $4.5 million bond (which has not occurred). An evidentiary hearing was held on October 24, 2005 on Arledge’s request for a preliminary injunction; and on January 6, 2006, the Court issued an order denying Arledge’s application for a preliminary injunction. The Court ruled, among other things, that a preliminary injunction would be futile because all of FINOVA’s assets are encumbered. The Company continues to believe that all of the claims against it in this matter are without merit. The Company intends to vigorously defend the claims asserted against it.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders during the fourth quarter of 2005.
Optional Item. Executive Officers of Registrant.
Set forth below is information with respect to those individuals who serve as executive officers of FINOVA. Messrs. Cumming, Steinberg and Mara serve pursuant to the Management Services Agreement with Leucadia that expires in 2011. Messrs. Weiss, Ross, Donnelly and Wifler are “at will” employees and may be terminated at any time.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.
FINOVA’s common stock trades over-the-counter (“OTC”) under the symbol “FNVG.” At December 31, 2005 and 2004, FINOVA had approximately 122,041,000 shares of common stock outstanding, 50% of which are held by an affiliate of Berkadia. The following table summarizes the high and low bid prices as reported on the OTC by Commodity Systems Inc. The OTC market quotations reflect inter-dealer prices, without retail markup, markdown or commission, and may not represent actual transactions.
Stockholders should not expect any payments or distributions from FINOVA. Refer to Item 3. “Legal Proceedings” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a further discussion of stockholder payments and the Company’s motion regarding distributions to stockholders.
FINOVA’s Certificate of Incorporation prohibits persons (except Berkadia and its affiliates) from acquiring 5% or more of Corporation Securities (as defined) unless the purchase is approved by the Board of Directors. Those restrictions did not apply to the acquisition of shares in connection with the reorganization proceedings. The restrictions will remain in effect until the earlier of (a) the repeal of Section 382 of the Internal Revenue Code (or any comparable successor provision) or (b) the beginning of the taxable year of the Company to which certain tax benefits may no longer be carried forward.
As of March 13, 2006, there were approximately 14,660 holders of record of The FINOVA Group Inc.’s common stock. The closing price of the common stock on that date was $0.06.
Item 6.
Item 6. Selected Financial Data.
The following table summarizes selected financial data obtained or derived from the audited consolidated financial statements of FINOVA for each of the years ended December 31, 2005, 2004, 2003 and 2002, the four months ended December 31, 2001 and the eight months ended August 31, 2001. The information set forth below should be read in conjunction with Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following section should be read in conjunction with Item 1. “Business,” Item 6. “Selected Financial Data” and Item 8. “Financial Statements and Supplemental Data.” The discussion relates to The FINOVA Group Inc. and its subsidiaries (collectively “FINOVA” or the “Company”), including FINOVA Capital Corporation and its subsidiaries (“FINOVA Capital”).
OVERVIEW
Prior Bankruptcy Reorganization. On March 7, 2001, FINOVA, FINOVA Capital and seven of their subsidiaries (the “Debtors”) filed for protection pursuant to chapter 11, title 11, of the United States Code in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) to enable them to restructure their debt. On August 10, 2001, the Bankruptcy Court entered an order confirming FINOVA’s Third Amended and Restated Joint Plan of Reorganization (the “Plan”), pursuant to which the Debtors restructured their debt, effective August 21, 2001, when the Company emerged from bankruptcy.
Restrictions on Business Activities. The Company’s business activities are limited to maximizing the value of its portfolio through the orderly collection of its assets. These activities include collection efforts pursuant to underlying contractual terms, negotiation of prepayments, sales of assets or collateral and may include efforts to retain certain customer relationships and restructure or terminate other relationships. The Company has sold portions of asset portfolios and will consider future sales of any asset if buyers can be found at acceptable prices; however, there can be no assurance that the Company will be successful in efforts to sell additional assets. The Company is offering to sell its remaining assets both by portfolio and individual asset. The Company is prohibited by the Indenture governing its Senior Notes (the “Indenture”) from engaging in any new lending activities, except to honor existing customer commitments and in certain instances, to restructure financing relationships to maximize value. Any funds generated in excess of cash reserves permitted by the Company’s debt agreements are used to reduce FINOVA’s obligations to its creditors.
To change the restrictions in the Indenture to permit new business would require the consent of 75% of the Senior Note holders. Absent a further restructuring of its debt through bankruptcy, which could lift those restrictions, the current controlled liquidation of its assets is the only business activity the Company is permitted to conduct. Any restructuring of its debt obligations through a bankruptcy proceeding could require an infusion of new capital and/or the approval of the holders of two-thirds of the amount of the Senior Notes and more than half of the number of holders. No assurance can be given that any bankruptcy restructuring effort will commence, or if begun, what the timing or outcome would be.
Collection / Liquidation of Assets. During the year ended December 31, 2005, net cash flows from the portfolio totaled $312.5 million. These net cash flows together with existing cash on hand at year-end were used to fund operations and service the Company’s debt obligations.
Total financial assets, net of the reserve for credit losses, declined to $326.6 million at December 31, 2005, down from $604.7 million at December 31, 2004. The asset decline was primarily attributable to customer prepayments, scheduled collections and individual asset sales. The Company’s transportation portfolio continued to experience a high level of activity and in certain instances had generated cash in excess of recorded carrying amounts (net of reserves); however, the Company continues to believe that any future gains will not be sufficient to fully offset the Company’s deficit. The Company is also concerned about the stability of the aircraft-financing market due to uncertainty in the airline industry. For a further discussion of industry trends, see Results of Operations below.
The decline in net financial assets was partially offset by $34.4 million of non-cash activity, primarily the reversal of reserve for credit losses. Reserve reversals are down from the prior year, but FINOVA’s overall portfolio realization continues to be better than expected. The majority of the reserve reversals resulted from prepayments and asset sales in excess of recorded carrying amounts (net of reserves) and improved collection experience.
During 2005, the non-cash reversal of reserve for credit losses and cash gains realized from asset sales were not sufficient to fully offset the Company’s negative interest margin, operating costs and the recognition of a loss on the final settlement of the Company’s pension plan. As a result, the Company posted a $94.4 million net loss for the year.
A-1
THE FINOVA GROUP INC.
Asset Shortfall. The following illustrates that the carrying value of the Company’s assets is less than the face amount of its Senior Debt Obligations as of December 31:
As reflected in the table, unless the actual cash flows from the collection of FINOVA’s asset portfolio are substantially greater than the amount assumed to determine the carrying amounts of its assets, FINOVA will not have sufficient assets to fully repay its Senior Debt Obligations. The Company has been successful in its efforts to maximize the value of the portfolio as evidenced by the decline in the asset shortfall; however, to eliminate the shortfall, FINOVA would have to liquidate all of its remaining financial assets for more than four times their book value. Despite the progress that has been made liquidating assets, the required recovery rate to eliminate the shortfall has continued to grow. While the net asset liquidation and collection efforts to date have been in excess of their recorded book values on average, those recoveries have been far below the rate of return necessary to fully repay the Senior Debt Obligations. The Company does not believe that the future asset realization will increase sufficiently to fully offset the shortfall since many of the more attractive assets within the portfolio have been liquidated and the Company continues to have significant exposure in its portfolio to non-performing assets and used aircraft.
Liquidity. Because substantially all (except for a few assets that could not be pledged because those assets already secured other obligations) of the Company’s assets are pledged to secure its obligations under the Intercompany Notes securing the Senior Notes (collectively “Senior Debt Obligations”), FINOVA’s ability to obtain additional or alternate financing is severely restricted. Berkadia has no obligation to lend additional sums to or to further invest in the Company. Accordingly, FINOVA intends to rely on internally generated cash flows from the liquidation of its assets as its only meaningful source of liquidity.
Partial Prepayment of Senior Notes. During 2005 and 2004, the Company made $474.9 million and $801.3 million, respectively, of partial principal prepayments on the Senior Notes, which reduced the outstanding principal to $1.7 billion as of December 31, 2005. FINOVA announced two additional partial prepayments totaling $59.4 million that were made in the first quarter of 2006. Following these prepayments, cumulative prepayments through the first quarter of 2006 totaled $1.3 billion or 45% of the face amount ($2.97 billion) of the Senior Notes. A summary of prepayment activity on the Senior Notes is as follows:
A-2
THE FINOVA GROUP INC.
In accordance with the terms of the Indenture, the Company is required to use any excess cash, as defined in the Indenture, to make semi-annual interest and principal payments on the Senior Notes. Additionally, the Indenture permits voluntary prepayments at the Company’s option. Refer to the Financial Condition, Liquidity and Capital Resources section for a further discussion of the Senior Notes.
No Stockholder Payments Anticipated. Stockholders should not expect any payments or distributions from FINOVA. The Indenture contemplates that as principal payments are made on the Senior Notes, FINOVA’s stockholders will receive a distribution equal to 5.263% of each principal prepayment. However, the Indenture prohibits FINOVA from making distributions to and/or repurchases from stockholders if the payments would render the Company insolvent, would be a fraudulent conveyance or would not be permitted to be made under applicable law. Any such distribution and/or repurchase would be considered an impermissible restricted payment under the Indenture. Given the Company’s significant negative net worth and its belief that the Senior Notes will not be fully repaid, FINOVA is required to retain impermissible restricted payments until such time, if ever, that it is no longer restricted from making a distribution to its stockholders or until it is necessary to use the cash to satisfy its debt obligations.
During 2005, FINOVA filed a motion in the United States Bankruptcy Court for the District of Delaware seeking an order that (1) FINOVA no longer needs to direct funds into a restricted account, and (2) FINOVA may use the funds in the restricted account to satisfy its obligations to creditors. The Bankruptcy Court ordered that the former Equity Committee (the “Equity Committee”) be reconstituted and have the opportunity to independently review FINOVA’s state of solvency before the Bankruptcy Court would rule on FINOVA’s motion. A hearing was held on November 29, 2005, and on February 1, 2006, the Bankruptcy Court issued its Order approving FINOVA’s motion to the extent that FINOVA will be forever insolvent. The Bankruptcy Court did not find that FINOVA is presently or will be forever insolvent. As a result, FINOVA will continue to direct funds into a restricted account until such time that FINOVA is deemed to be forever insolvent and the funds will then be distributed to FINOVA’s creditors. On February 10, 2006, the Equity Committee filed a Notice of Appeal of the Bankruptcy Court Order to the United States District Court for the District of Delaware. Refer to Item 3. “Legal Proceedings” and the Financial Condition, Liquidity and Capital Resources section for a further discussion of the restricted payments and FINOVA’s motion.
Since FINOVA does not believe it has sufficient assets to fully repay the Senior Notes, the Company anticipates that the retained amounts will eventually be paid to the creditors, not the stockholders. If the funds were to be paid to the stockholders, affiliates of Berkadia, which own 50% of FINOVA’s common stock, would receive half of the retained amounts.
Company Direction. The Company expects to continue its present course by seeking to maximize the value of the remaining portfolio through the orderly collection or sale of financial assets. FINOVA continues to actively market individual assets for sale and periodically will consider bulk sales of all or substantially all of the remaining portfolio, if one or more buyers can be found at acceptable prices; however, there can be no assurance that FINOVA will be successful in efforts to sell additional assets. The Company anticipates that when all or substantially all of the assets have been liquidated that the Company’s affairs will need to be wound-up. The Company continues to analyze the potential methods of wind-up, which might involve a sale of the remaining assets, an assignment for the benefit of the creditors, or some other proceeding, any of which may or may not be in conjunction with bankruptcy or state law liquidation proceedings. The Company cannot predict with certainty the timing or nature of that final wind-up, but the Company continues working towards accomplishing that end in a prudent manner. The portfolio has declined considerably and the remaining portfolio has become more concentrated in a small number of accounts, while certain fixed costs and the cost of maintaining a public company have not declined at the same rate as the portfolio. Refer to Note Q “Subsequent Events” for a discussion of sales activity since year-end.
HIGH INVESTMENT RISK OF SECURITIES. As previously stated, FINOVA believes that it will be unable to fully repay its Senior Notes and that it is unlikely that it will be able to make distributions to its stockholders. Consequently, investing in the Senior Notes and common stock involves a high level of risk.
CRITICAL ACCOUNTING POLICIES
The Company’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires FINOVA to use estimates and assumptions that affect reported amounts of assets and liabilities, revenues and expenses and disclosure of contingent liabilities. These estimates are subject to known and unknown risks, uncertainties and other factors that could materially impact the amounts reported and disclosed in the financial statements. See Item 1A. “Risk Factors” and “Special Note Regarding Forward-Looking Statements” for more information on these risks and uncertainties. The Company believes the following to be among the most critical judgment areas in the application of its accounting policies.
A-3
THE FINOVA GROUP INC.
Significant Use of Estimates
Several of the Company’s most critical accounting policies pertain to the ongoing determination of impairment reserves on financing assets and the carrying amount valuation of other financial assets. Determination of impairment reserves and carrying amounts rely, to a great extent, on the estimation and timing of future cash flows. FINOVA’s cash flow estimates assume that its asset portfolios are collected in an orderly fashion over time. These cash flows do not represent estimated recoverable amounts if FINOVA were to liquidate its asset portfolios over a short period of time. Management believes that a short-term asset liquidation could have a material negative impact on the Company’s ability to recover recorded amounts.
FINOVA’s process of determining impairment reserves and carrying amounts includes a periodic assessment of its portfolios on a transaction-by-transaction basis. Cash flow estimates are based on current information and numerous assumptions concerning future general economic conditions, specific market segments, the financial condition of the Company’s customers and FINOVA’s collateral. In addition, assumptions are sometimes necessary concerning the customer’s ability to obtain full refinancing of balloon obligations or residuals at maturity. As a result, the Company’s cash flow estimates assume FINOVA incurs refinancing discounts for certain transactions.
Changes in facts and assumptions have resulted in, and may in the future result in, significant positive or negative changes to estimated cash flows and therefore, impairment reserves and carrying amounts.
Impairment of financing assets (subsequent to implementation of fresh-start reporting) is recorded through the Company’s reserve for credit losses, and accounting rules permit the reserve for credit losses to be increased or decreased as facts and assumptions change. However, certain financing assets were previously marked down for impairments that existed at the time fresh-start reporting was implemented. These marked down values became the Company’s cost basis in those assets, and accounting rules do not permit the carrying value of these assets to be increased above that fresh-start cost basis if subsequent facts and assumptions result in a projected increase in value. Recoveries of amounts in excess of the fresh-start cost basis are recorded through operations when collected.
Impairment of other financial assets is marked down directly against the asset’s carrying amount. Accounting rules permit further markdown if changes in facts and assumptions result in additional impairment; however, most of these assets (except certain investments and assets held for sale, which may be marked up for subsequent events) may not be marked up even if subsequent facts and assumptions result in a projected increase in value. Recoveries of previous markdowns are recorded through operations when collected.
Because of these accounting restrictions, FINOVA is not permitted to fully reflect some anticipated improvements in the portfolio until they are actually realized.
The carrying amounts and reserve for credit losses recorded on FINOVA’s financial statements reflect the Company’s expectation of collecting less than the full contractual amounts owed by some of its customers and recovering less than its original investment in certain owned assets. The Company continues to pursue collection of full contractual amounts and original investments, where appropriate, in an effort to maximize the value of its asset portfolios.
FINOVA has a number of aircraft that are off-lease and anticipates that additional aircraft will be returned to the Company as leases expire or operators are unable or unwilling to continue making payments. In accordance with the provisions of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” FINOVA has recorded impairment losses on owned aircraft by calculating the present value of estimated cash flows. For many of these aircraft, scrap value was assumed, but for certain aircraft, the Company elected (or anticipates electing upon return of the aircraft) to park and maintain the aircraft under the assumption that they will be re-leased or sold in the future despite limited demand for certain of these aircraft today. While the current market makes it difficult to quantify, the Company believes that the recorded values determined under this methodology may significantly exceed the values that the Company would realize if it was required to liquidate those aircraft today; however, actual amounts recovered from these aircraft may differ from recorded amounts and will be significantly impacted by the used aircraft market in the future, which is difficult to predict.
The process of determining appropriate carrying amounts for these aircraft is particularly difficult and subjective, as it requires the Company to estimate future demand, lease rates and scrap values for assets for which there is limited demand. The Company re-assesses its estimates and assumptions each quarter. In particular, the Company assesses market activity and the likelihood that certain aircraft types, which are forecast to go back on lease in the future, will in fact be re-leased.
Due to the numerous assumptions affecting the estimation of cash flows and the accounting restrictions noted above, a traditional sensitivity analysis is not considered to be practical and has not been completed.
A-4
THE FINOVA GROUP INC.
Reserve for Credit Losses. The reserve for credit losses represents FINOVA’s estimate of losses inherent in the portfolio and includes reserves on impaired assets and on assets that are not impaired. Impairment reserves are created if the carrying amount of an asset exceeds its estimated recovery, which is measured by estimating the present value of expected future cash flows (discounted at contractual rates), market value or the fair value of collateral. These methodologies include the use of significant estimates and assumptions regarding future customer performance (which are inherently dependent upon assumptions about general economic conditions and those affecting the customer’s business), amount and timing of future cash flows and collateral value. Reserves on assets that are not impaired are based upon assumptions including general economic conditions, overall portfolio performance, including loss experience, delinquencies and other inherent portfolio characteristics. Actual results have in the past and could in the future, differ from these estimates, resulting in an increase or reversal of reserves. As of December 31, 2005 and 2004, the reserve for credit losses totaled $29.0 million and $101.3 million, respectively.
Owned Assets. Assets held for the production of income and operating leases are carried at amortized cost with impairment adjustments, if any, recorded as permanent markdowns through operations. An owned asset is considered impaired if anticipated undiscounted cash flows are less than the carrying amount of the asset. Once the asset has been deemed impaired, accounting rules allow for several acceptable methods for measuring the amount of impairment. FINOVA’s typical method of measuring impairment is based on the comparison of the carrying amount of those assets to the present value of estimated future cash flows, using risk adjusted discount rates. These estimates include assumptions regarding lessee performance, the amount and timing of future cash flows, selection of risk-adjusted discount rates for net present value calculations and residual value assumptions for leases. If future portfolio assessments indicate additional impairment, additional markdowns may be necessary. Recoveries of previous markdowns are recorded through operations when collected. As of December 31, 2005 and 2004, owned assets totaled $77.4 million and $84.2 million, or 21.7% and 11.9% of total financial assets (before reserves), respectively.
Assets Held for Sale. Assets held for sale are comprised of assets previously classified as financing transactions and other financial assets that management does not have the intent and/or the expected ability to hold to maturity. These assets are revalued quarterly and are carried at the lower of cost or market less anticipated selling expenses, with adjustment, if any, recorded as a gain or loss on financial assets. Market value is often determined by the estimation of anticipated future cash flows discounted at risk adjusted market rates to determine net present value. Valuation of assets held for sale includes estimates regarding market conditions and ultimate sales prices. Actual sales prices could differ from estimates, impacting results from operations. During 2005, the Company sold the majority of these assets and the few assets remaining in held for sale have no value. Refer to Annex A-Notes to the Consolidated Financial Statements, Note C. “Total Financial Assets” for a detailed discussion of sales activity and valuation of the remaining assets. As of December 31, 2004, assets held for sale totaled $42.5 million or 6.0% of total financial assets (before reserves).
Nonaccruing Assets. Accounts are generally classified as nonaccruing and recognition of income is suspended when a customer becomes 90 days past due on the payment of principal or interest, or earlier, if in the opinion of management, full recovery of contractual income and principal becomes doubtful. The decision to classify accounts as nonaccruing on the basis of criteria other than delinquency, is based on certain assumptions and estimates including current and future general economic conditions, industry specific economic conditions, customer financial performance, the ability of customers to obtain full refinancing of balloons or residuals due to FINOVA at maturity and FINOVA’s ability or willingness to provide such refinancing. In certain instances, accounts may be returned to accruing status if sustained performance is demonstrated. Changes in borrower performance, assumptions, or estimates could result in a material change in nonaccruing account classification and income recognition. As of December 31, 2005 and 2004, $131.9 million and $259.4 million, or 37.1% and 36.7% of total financial assets (before reserves), were classified as nonaccruing, respectively.
New Accounting Standards. There were no new accounting standards issued during 2005 that impacted FINOVA.
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THE FINOVA GROUP INC.
RESULTS OF OPERATIONS
As a result of the Company’s continued asset liquidation and shrinking operations, the consolidated financial statements are not necessarily comparable from year to year. Trends during any given year may not be indicative of future trends; however, the following discussion of results for the years ended December 31, may provide useful information regarding the current status of the Company.
Years Ended December 31, 2005 and 2004
Net (Loss) Income. In general, the net loss for the year ended December 31, 2005 was primarily attributable to a lower level of asset realization in excess of recorded carrying amounts and the Company recognizing a loss on the final settlement of its pension plan. Asset realization in excess of recorded carrying amounts is primarily reflected in the financial statements as reversals of excess reserve for credit losses, net gains from the sales of financial assets and the recognition of suspended income upon the payoff of assets.
Even though asset realization in 2005 was less than 2004, the Company still experienced substantially better than anticipated realization and performance of asset portfolios. The Company has been cautioning investors that asset realization trends were not expected to continue at the same level as prior years. Many of our more desirable and marketable assets have been liquidated and the remaining portfolio is becoming more concentrated in non-performing assets and used aircraft, both of which have been more work intensive and difficult to liquidate at acceptable prices. However, during 2005, the aircraft-financing market displayed a high level of activity and in certain instances improved aircraft values. As a result, the Company’s transportation portfolio continued to generate cash in excess of recorded carrying amounts, but the total level of realization was lower than 2004.
The Company has seen an increase in demand for certain types of aircraft; however, this demand may decline due to continued uncertainty in the airline industry and the bankruptcy filings of Delta Airlines and Northwest Airlines. FINOVA has direct exposure to Northwest Airlines, but both carriers are in the process of rejecting or restructuring the terms of numerous financing transactions. In addition, many major domestic carriers continue to post substantial losses due in part to high fuel costs coupled with a high cost structure. If the high fuel costs continue to exist for an extended period of time or airlines are not able to efficiently compete with low-cost carriers, additional airlines may experience financial difficulties. A number of prominent domestic airlines are in bankruptcy and others threatening to file if certain cost reductions cannot be realized. As a result of the current status of the industry and airline bankruptcies, FINOVA anticipates excess aircraft will be parked and forced into the market. FINOVA’s ability to realize the recorded values of its aircraft portfolio will depend upon future aircraft lease rates and values, both of which are greatly impacted by the instability of the airline industry.
Opportunities for recoveries in excess of recorded values continue to exist and are expected to occur, however, the Company remains concerned about the fragile nature of the airline industry.
Interest Margin. The decline in interest margin was primarily attributable to the recognition of a lower level of suspended and deferred income ($15.4 million and $82.9 million for the years ended December 31, 2005 and 2004, respectively), which was generated from payoffs of certain assets in excess of their carrying amounts and the return to earning status of certain assets following demonstration of sustained performance. Income recognition is suspended when an account is classified as a nonaccruing asset and any subsequent interest payments received are applied against its carrying amount to mitigate the Company’s exposure. In certain instances, suspended income is recognized upon payoff, if proceeds realized are in excess of the carrying amount, or if after sustained performance is demonstrated, the account is returned to accruing status.
The Company believes that further instances where it will recognize suspended income may occur; however, any income recognition in future periods will be more comparable to 2005 than 2004. The portfolio is considerably smaller and the Company is currently monitoring only a few accounts with suspended income for potential stabilization and demonstration of sustained performance.
A-6
THE FINOVA GROUP INC.
Additionally, the Company’s interest margin was significantly impacted by a lower level of earning assets ($123.9 million and $332.8 million at December 31, 2005 and 2004, respectively) than the face amount of outstanding debt ($1.7 billion and $2.2 billion at December 31, 2005 and 2004, respectively) and the Company’s high aggregate cost of funds (aggregate effective rate of 13.5% and 11.9% for the years ended December 31, 2005 and 2004, respectively). The increase in the aggregate effective rate was primarily due to the acceleration of fresh-start discount amortization following principal prepayment of the Senior Notes earlier than originally anticipated when fresh-start guidelines were applied upon emergence.
Reversal of Provision for Credit Losses. The Company recorded reversals of provision for credit losses to reduce its overall reserve for credit losses. The reserve reductions were primarily due to recoveries ($11.1 million and $37.2 million for the years ended December 31, 2005 and 2004, respectively) of amounts previously written off, proceeds received from prepayments and asset sales exceeding recorded carrying amounts (net of reserves), collections and the Company’s detailed assessment of estimated inherent losses in its portfolio.
In addition, the Company’s income recognition policy for nonaccruing accounts can result in periodic reserve reductions. In accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” impairment reserves are recorded if the carrying amount of a loan exceeds the net present value of expected cash flows. For nonaccruing accounts, any cash received is applied against the carrying amount of the transaction. As a result, carrying amounts decline at a faster pace than net present value, thus reducing the impairment reserves. This policy had a greater impact on the reversal of provision for credit losses in 2004 than in 2005 due to the reinstatement of a number of accounts to accruing status in 2004.
The pace of collections and account payoffs has continued to be faster than expected. Amounts collected have often exceeded anticipated cash flows, resulting in a partial reversal of previously established reserves. However, as expected, asset realization trends declined from the prior year. During 2004, the Company had experienced substantially better than anticipated realization and performance of asset portfolios. The Company believes it is unlikely that those asset realization trends will materialize again. While 2005 has shown continued accelerated collections, the volume and realization has not kept pace with 2004. The Company does not expect a significant reversal of provision for credit losses in future periods. The Company has already seen a significant decline in realized recoveries of amounts previously written off and expects that declining trend to continue.
The measurement of credit impairment and asset valuation is dependent upon the significant use of estimates and management discretion when predicting expected cash flows. These estimates are subject to known and unknown risks, uncertainties and other factors that could materially impact the amounts reported and disclosed herein. See Item 1A. “Risk Factors,” “Special Note Regarding Forward-Looking Statements” and “Critical Accounting Policies” for a discussion of these and additional factors impacting the use of estimates.
Net Gain on Financial Assets. Gains are sporadic in nature and not necessarily comparable from one period to the next; however, the decrease over the prior year was primarily attributable to the prior year including a one-time gain from the sale of a substantial portion of the Company’s timeshare portfolio, a decrease in the overall realization during 2005 from the Company’s transportation portfolio and valuation markdowns taken in 2005 on the Company’s transportation leveraged lease portfolio.
The net gain during 2005 was primarily attributable to sales of owned assets and financing contracts in excess of carrying amounts, the most significant of which were comprised of $45.7 million of net gains realized from sales of aircraft, including the forfeiture by aircraft operators of security deposits and maintenance reserves ($10.5 million), $4.5 million of net gains realized from the sale and valuation of private and public investments and $5.3 million of net gains from the valuation and sale of the Company’s last two real estate leveraged leases.
Partially offsetting the gain activity for 2005 were $19.1 million of net valuation markdowns and losses on the Company’s transportation leveraged lease portfolio. In conjunction with the Northwest Airlines’ bankruptcy filing, the airline notified FINOVA of its intent to renegotiate the terms of eight leveraged leases or possibly reject the transactions. Two Boeing 757 aircraft and six regional jets secure the Northwest leveraged leases. The outstanding senior debt on these leveraged leases is significantly in excess of the underlying aircraft values. As a result, the assets, which have a contractual balance of $86.4 million, have virtually no remaining value to FINOVA and their remaining carrying value was fully written-off. During 2005, FINOVA recognized total valuation markdowns of $14.4 million on the Northwest leveraged leases, while the remainder of the net markdowns and losses on the transportation leveraged lease portfolio were primarily associated with the American Trans Air bankruptcy and a $0.7 million loss recognized on the sale of FINOVA’s last transportation leveraged lease (excluding the Northwest leases).
A-7
THE FINOVA GROUP INC.
The Company entered into a number of transactions to sell assets over the last couple of years and expects asset sales to continue. However, barring continued strong activity in the aircraft-financing market, the Company generally does not expect to maintain aggregate gain realization levels comparable to those years in future asset sales, due to the fact that many of its more attractive and marketable assets within the portfolio have already been liquidated. The Company’s remaining portfolio of assets is concentrated in owned aircraft and impaired loans and financing leases. As previously discussed, improvements within the aircraft-financing market have generated increased volume and realization from the Company’s transportation portfolio, but the Company is skeptical about whether this improved trend will be sustained and for how long.
FINOVA will continue to consider future sales of the remaining portfolio or individual assets, if buyers can be found at acceptable prices; however, there can be no assurance that the Company will be successful in efforts to sell additional assets or that realization will reach prior year levels. In evaluating offers, FINOVA will generally compare offers against FINOVA’s internal net present value of estimated future cash flows projected to be collected from those assets less the net present value of FINOVA’s operating costs to collect those assets.
Portfolio Expenses. Portfolio expenses include all costs relating to the maintenance and collection of both performing and non-performing financial transactions. In addition, within the transportation portfolio, portfolio costs include storage, maintenance and costs for potential return to service of aircraft. In most cases, the Company experienced a decline in the level of problem account and workout expenses as assets have declined.
The transportation portfolio continues to incur the majority of the Company’s portfolio costs ($14.8 million and $21.0 million for the years ended December 31, 2005 and 2004, respectively). In certain instances, the Company believes it can achieve better returns in the current market of improved aircraft values by investing in the maintenance of certain types of aircraft and engines. As a result, portfolio expenses within the transportation portfolio have not declined as fast as the decline in assets. Portfolio costs within the transportation portfolio will fluctuate with the timing and number of maintenance reinvestment projects. The Company will continue to invest in aircraft maintenance as long as it makes economic sense to do so.
Partially offsetting the decline in transportation expenses was an increase in legal costs associated with the Thaxton litigation ($4.8 million and $0.6 million for the years ended December 31, 2005 and 2004, respectively). The increase in Thaxton related expenses was primarily due to amounts previously reimbursed from the Thaxton bankruptcy being deposited into a reserve account beginning in the third quarter of 2005. Refer to Item 3. “Legal Proceedings” for a further discussion of the Thaxton litigation.
General and Administrative Expenses. The increase in general and administrative expenses was primarily the result of the prior year including a one-time $5.8 million reversal of excess accruals related to bankruptcy claims that were settled for amounts less than what had originally been accrued, higher severance accruals ($2.6 million) related to current year and future staffing reductions and $1.8 million of accruals related to anticipated office lease termination costs, partially offset by $8.5 million of cost savings resulting from staffing and office occupancy reductions (60 employees at December 31, 2005 compared to 101 and 213 employees at December 31, 2004 and 2003, respectively). The Company expects the dollar level of general and administrative expenses to continue to decrease as portfolio and staffing levels decrease; however, general and administrative expenses as a percentage of assets or revenues will likely increase as a result of certain fixed costs, the costs of being a public company and the high level of work intensive assets in the portfolio.
During 2005, the Company had additional and accelerated staff reductions, which were designed to more closely align FINOVA’s operating costs with the size of the remaining portfolio. Total staff reductions included approximately 41% of the workforce (including seven members of senior management). The cost savings from these reductions began during the second half of 2005 and their full benefit will not be realized until 2006. A portion of the savings in 2005 was offset by increased severance costs.
Loss from Settlement of Pension Plan. During 2005, the Company finalized the termination of a trusteed, noncontributory pension plan that covered substantially all of its employees. The Company terminated the pension plan effective December 31, 2004 and received final regulatory approvals in late 2005. Upon final distribution of participant benefits, the Company recognized all remaining unrecognized net actuarial amounts under the plan, which totaled $24.7 million.
Income Tax Expense. No income tax expense or benefit was recorded during the years ended December 31, 2005 and 2004. Any pre-tax book income or loss has been entirely offset by a decrease or increase in valuation allowances against deferred tax assets, which were previously established due to the Company’s concern regarding its ability to utilize income tax benefits generated from losses in prior periods. As of December 31, 2005 and 2004, the Company had federal net operating loss carryforwards of $1.2 billion and $1.1 billion, respectively, none of which expire prior to 2009. For a further discussion of taxes see Note H. “Income Taxes.”
A-8
THE FINOVA GROUP INC.
Years Ended December 31, 2004 and 2003
Net Income. In general, the decrease in net income was primarily attributable to the year ended December 31, 2004 containing a lower level of asset realization in excess of recorded carrying amounts, and the Company not generating any gains from repurchases of debt in 2004. Asset realization in excess of recorded carrying amounts was primarily reflected in the financial statements as net gains from the sale of assets, reversals of excess reserve for credit losses and the recognition of suspended income upon the payoff of assets.
Interest Margin. The negative margin was primarily due to a significantly lower level of earning assets ($332.8 million and $1.0 billion at December 31, 2004 and 2003, respectively) than the face amount of outstanding debt ($2.2 billion and $3.5 billion at December 31, 2004 and 2003, respectively) and the Company’s high aggregate cost of funds (aggregate effective rate of 11.9% and 8.3% for the years ended December 31, 2004 and 2003, respectively), which continued to increase as the lower cost Berkadia Loan was repaid and higher cost Senior Notes became a higher percentage of the outstanding debt. Additionally, the aggregate effective rate increased, to a lesser extent, due to the acceleration of fresh-start discount amortization following principal prepayment of the Senior Notes earlier than originally anticipated when fresh-start guidelines were applied upon emergence.
Also contributing to the decline in interest margin was the recognition of a lower level of suspended and deferred income ($82.9 million and $134.1 million for the years ended December 31, 2004 and 2003, respectively), which was generated from payoffs of certain assets in excess of their carrying amounts and the return to earning status of certain assets following demonstration of sustained performance. In certain instances, suspended income was recognized upon payoff, when proceeds realized were in excess of the carrying amount or when after sustained performance was demonstrated, the account was returned to accruing status.
Reversals of Provision for Credit Losses. The Company recorded reversals of provision for credit losses to reduce its reserve for credit losses. The reserve reductions were primarily due to recoveries ($37.2 million and $109.6 million for the years ended December 31, 2004 and 2003, respectively) of amounts previously written off, proceeds received from prepayments and asset sales exceeding recorded carrying amounts (net of reserves), collections and the Company’s detailed assessment of estimated inherent losses in its portfolio.
In addition, the Company’s income recognition policy for nonaccruing accounts can result in periodic reserve reductions. In accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” impairment reserves are recorded if the carrying amount of a loan exceeds the net present value of expected cash flows. For nonaccruing accounts, any cash received was applied against the carrying amount of the transaction. As a result, carrying amounts declined at a faster pace than net present value, thus reducing the impairment reserve. This policy had a greater impact on the reversal of provision for credit losses in 2003 than in 2004 due to the continued reinstatement of accounts to accruing status over the last two years.
The pace of collections and account payoffs has continued to be faster than expected. In most portfolios, amounts collected have often exceeded anticipated cash flows, resulting in a partial reversal of previously established reserves. However, as expected, asset realization trends declined from the prior year. During 2003, the Company had experienced substantially better than anticipated realization and performance of asset portfolios.
The measurement of credit impairment and asset valuation is dependent upon the significant use of estimates and management discretion when predicting expected cash flows. These estimates are subject to known and unknown risks, uncertainties and other factors that could materially impact the amounts reported and disclosed herein. See the Item 1A. “Risk Factors,” “Special Note Regarding Forward-Looking Statements” and “Critical Accounting Policies” for a discussion of these and additional factors impacting the use of estimates.
Net Gain on Financial Assets. Gains are sporadic in nature and not necessarily comparable from one period to the next; however, the increase over the prior year was primarily attributable to the sale of substantially all of the Company’s timeshare resort portfolio and increased activity and realization from the Company’s transportation portfolio.
The net gain during 2004 was attributable to sales of owned assets and financing contracts in excess of carrying amounts, the most significant of which included a $21.4 million gain realized on the sale of a portion of the Company’s timeshare resort portfolio, $7.8 million of net gains realized from the sale of private and public investments, $9.0 million of net gains realized from multiple transactions to sell a portion of the Company’s real estate leveraged lease portfolio and $62.8 million of net gains realized primarily from numerous aircraft sales, including the forfeiture by aircraft operators of security deposits and maintenance reserves ($10.6 million). The net gains from the sale of transportation assets included a $22.0 million gain realized on an aircraft that was destroyed in a crash by its operator and a $4.9 million gain realized on the sale of 17 off-lease engines.
A-9
THE FINOVA GROUP INC.
The net gain during 2003 primarily included $31.8 million of gains realized from the sale of two equity investments in timeshare resort development companies, $12.1 million of net gains from the sale of the Company’s position in seven real estate leveraged leases, a $6.9 million gain related to the settlement and restructure of an operating lease including the recognition of forfeited maintenance reserves and security deposits, a $5.8 million gain realized from the sale of nine healthcare related loans and a $4.4 million gain realized on the rediscount asset sale. Partially offsetting these net gains were $48.0 million of impairment markdowns within the transportation portfolio and an $11.1 million markdown to the Company’s remaining real estate leveraged leases in association with their classification as assets held for sale. The impairment losses on the transportation portfolio resulted from the Company’s revised estimate of future cash flows expected to be realized through the operation or sale of its predominately older vintage owned aircraft portfolio. The remainder of the 2003 net gain activity was attributable to over 200 individual asset sales (including repossessed assets, loans, residual positions and investments) spread across the portfolio.
Portfolio Expenses. Portfolio expenses include all costs relating to the maintenance and collection of both performing and non-performing financial transactions. In addition, within the transportation portfolio, portfolio costs include storage, maintenance and costs for potential return to service of aircraft. The decrease over 2003 was primarily due to a decline in the level of problem account and workout expenses for most portfolios with the exception of transportation.
The transportation portfolio continued to incur the majority of the Company’s portfolio costs ($21.0 million and $16.4 million for the years ended December 31, 2004 and 2003, respectively). Even though the portfolio has shrunk, portfolio expenses have not declined. Portfolio expenses within the transportation portfolio were trending downward during 2003. FINOVA had been maximizing the value of the portfolio by using the remaining air-time of aircraft and engines, while minimizing the maintenance investment in those assets. As remaining air-time was exhausted, numerous aircraft and engines were identified for potential dismantling or sale at scrap values; however, the reemergence of the aircraft-financing market during late 2004 has altered the Company’s approach to maximize value. In certain instances, the Company believes it can achieve better returns in the current market of improved aircraft values by investing in the maintenance of certain types of aircraft and engines. As a result, portfolio expenses for the transportation portfolio increased during 2004, even though the portfolio is considerably smaller. The Company will continue to invest in aircraft maintenance as long as it makes economic sense to do so.
General and Administrative Expenses. The decrease was primarily due to 2003 including charges of $13.0 million to accrue for settlement of outstanding litigation, bankruptcy claims and other legal matters, a $5.8 million reversal in 2004 of excess accruals, which resulted from the settlement and payment of bankruptcy claims for amounts less than what had originally been accrued and $8.0 million of cost savings resulting from staffing and office occupancy reductions (101 employees at December 31, 2004 compared to 213 and 319 at December 31, 2003 and 2002, respectively), partially offset by higher severance costs ($4.5 million) related to those individuals notified of their pending termination. The remainder of the decrease was the result of an overall decline in general and administrative expenses caused by decreases in portfolio and staffing levels.
Gain from Extinguishment of Debt, Net. During 2003, the Company repurchased $100.0 million (face amount) of Senior Notes at a price of 49.875% or $49.9 million, plus accrued interest. The repurchase generated a net gain of $28.5 million ($50.1 million repurchase discount, partially offset by $21.6 million of unamortized fresh-start discount). The Company continues to evaluate opportunities to repurchase bonds rather than repay debt, but during 2004, bond prices exceeded internal analysis that would support the decision to repurchase bonds.
Income Tax Expense. For the years ended December 31, 2004 and 2003, income tax expense related to pre-tax book income was entirely offset by a decrease in valuation allowances against deferred tax assets, which were previously established due to the Company’s concern regarding its ability to utilize income tax benefits generated from losses in prior periods. As of December 31, 2004 and 2003, the Company had federal net operating loss carryforwards of $1.1 billion and $851.6 million, respectively, none of which expire prior to 2009. For a further discussion of taxes see Note H. “Income Taxes.”
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Because substantially all (except for a few assets that could not be pledged because those assets already secured other obligations) of the Company’s assets are pledged to secure its obligations under the Intercompany Notes securing the Senior Notes, FINOVA’s ability to obtain additional or alternate financing is severely restricted. Berkadia has no obligation to lend additional sums to or to further invest in the Company. Accordingly, FINOVA intends to rely on internally generated cash flows from the liquidation of its assets as its only meaningful source of liquidity.
A-10
THE FINOVA GROUP INC.
The terms of the Indenture prohibit the Company from using available funds (after certain permitted uses) for any purpose other than to satisfy its obligations to creditors and to make limited payments to stockholders in certain circumstances. Under the terms of the Indenture, the Company is permitted to establish a cash reserve in an amount not to exceed certain defined criteria. Due to the Company’s limited sources of liquidity, the estimation of cash reserves is critical to the overall liquidity of the Company. Cash reserve estimations are subject to known and unknown risks, uncertainties, and other factors that could materially impact the amounts determined. Failure to adequately estimate a cash reserve in one period could result in insufficient liquidity to meet obligations in that period, or in a subsequent period, if actual cash requirements exceed the cash reserve estimates. Generally speaking, cash reserves typically equal anticipated cash flows to cover operating costs, tax payments, fundings under existing customer commitments, interest payments and any other necessary cash flows expected to occur during the next six month period. The Company has the discretion to and has from time to time adjusted its cash reserve methodology.
During 2005 and 2004, the Company made $474.9 million and $801.3 million, respectively, of partial principal prepayments on the Senior Notes, which reduced the outstanding principal to $1.7 billion as of December 31, 2005. FINOVA announced two additional partial prepayments totaling $59.4 million that were made in the first quarter of 2006. Following these prepayments, cumulative prepayments through the first quarter of 2006 totaled $1.3 billion or 45% of the face amount ($2.97 billion) of the Senior Notes.
In accordance with the terms of the Indenture, the Company is required to use any excess cash, as defined in the Indenture, to make semi-annual interest and principal payments on the Senior Notes. Additionally, the Indenture permits voluntary prepayments at the Company’s option.
The Company does not believe that it has sufficient assets to fully repay the Senior Notes, and the Indenture prohibits the Company from engaging in new business. Therefore, FINOVA intends to rely on the liquidation of its remaining assets as its only meaningful source of liquidity. The Senior Notes have a first priority security interest in substantially all of FINOVA’s remaining assets.
Stockholders should not expect any payments or distributions from FINOVA. The Indenture contemplates that as principal payments are made on the Senior Notes, FINOVA stockholders will receive a distribution equal to 5.263% of each principal prepayment. However, the Indenture prohibits FINOVA from making distributions to and/or repurchases from stockholders if the payments would render the Company insolvent, would be a fraudulent conveyance or would not be permitted to be made under applicable law. Any such distribution and/or repurchase would be considered an impermissible restricted payment under the Indenture. Given the Company’s significant negative net worth and its belief that the Senior Notes will not be fully repaid, FINOVA is required to retain impermissible restricted payments until such time, if ever, that it is no longer restricted from making a distribution to its stockholders or until it is necessary to use the cash to satisfy its debt obligations. In conjunction with the prepayments of Senior Notes noted above, the Company has retained a total of $70.3 million as of February 15, 2006. Retained amounts are segregated and reflected as restricted cash on the balance sheet, pending their final disposition. The Company anticipates that the retained amounts will eventually be paid to the creditors, not the stockholders. If the funds were to be paid to the stockholders, affiliates of Berkadia (jointly owned by Berkshire Hathaway and Leucadia), which own 50% of FINOVA common stock, would receive half of the retained amounts. Berkadia had advised the Company that it does not believe that stockholders are entitled to the retained amounts since FINOVA cannot fully satisfy its creditor obligations.
In April 2005, FINOVA filed a motion in the United States Bankruptcy Court for the District of Delaware seeking an order that (1) FINOVA no longer needs to direct funds into a restricted account, and (2) FINOVA may use the funds in the restricted account to satisfy its obligations to creditors.
In June 2005, the Bankruptcy Court ordered that the former Equity Committee (the “Equity Committee”) be reconstituted. The Equity Committee was reconstituted with three members on July 14, 2005. As a precursor to the Bankruptcy Court ruling upon FINOVA’s motion, the Equity Committee shall have the opportunity to independently review FINOVA’s state of solvency.
A hearing was held on November 29, 2005, and on February 1, 2006, the Bankruptcy Court issued its Order approving FINOVA’s April 2005 motion to the extent that FINOVA will be forever insolvent. The Bankruptcy Court did not find that FINOVA is presently or will be forever insolvent. As a result, FINOVA will continue to direct funds into a restricted account until such time that FINOVA is deemed to be forever insolvent and the funds will then be distributed to FINOVA’s creditors. On February 10, 2006, the Equity Committee filed a Notice of Appeal of the Bankruptcy Court Order to the United States District Court for the District of Delaware.
A-11
THE FINOVA GROUP INC.
The Company has a negative net worth of $611.7 million as of December 31, 2005 ($1.2 billion if the Senior Notes are considered at their principal amount due). Based on the Company’s current financial condition (including having only $326.6 million of net financial assets), it is highly unlikely there will be funds available to fully repay the outstanding principal on the Senior Notes at maturity or make any 5% distribution to common stockholders, absent a court order. As a result, there would not be a return to the Company’s stockholders. Consequently, investing in the Senior Notes and common stock involves a high level of risk.
In accordance with the Plan, Berkshire Hathaway and its direct and indirect subsidiaries had agreed to retain ownership of all Senior Notes received by Berkshire Hathaway pursuant to the Plan for a period of four years from the effective date (August 21, 2001) of the Plan. As of August 21, 2005, this four-year period had expired and Berkshire Hathaway is no longer restricted from selling its Senior Notes.
Obligations and Commitments
The following is a listing of FINOVA’s significant contractual obligations and contingent commitments at December 31, 2005 and 2004. A detailed repayment schedule has not been provided because the Company’s most significant obligations are contractual as to amount, but contingent regarding the timing of repayment. The listing is not intended to be all encompassing and excludes normal recurring trade and other accounts payable obligations.
The Senior Notes mature in November 2009 and bear interest, payable semi-annually, to the extent that cash is available, at a fixed interest rate of 7.5% per annum. Principal prepayments of the Senior Notes are contingent on the availability of excess cash. FINOVA’s obligations with respect to the payment of interest and principal under the Senior Notes are secured by a first priority security interest in (a) all capital stock of FINOVA Capital, (b) secured promissory notes of FINOVA Capital issued to FINOVA in the aggregate principal amount of the Senior Notes (the “Intercompany Notes”) and (c) certain other property of FINOVA that may be acquired from its subsidiaries in the future. As noted above, the Company made $474.9 million and $801.3 million of partial principal prepayments on the Senior Notes in 2005 and 2004, respectively, and announced two additional partial prepayments totaling $59.4 million that were made in the first quarter of 2006.
FINOVA’s business continues to be operated under a Management Services Agreement with Leucadia that expires in 2011. FINOVA pays Leucadia an annual management fee of $8.0 million and reimburses it for expenses incurred.
Permitted uses of cash are specified in the Indenture. Generally, the Company is permitted to use its cash in the following order: first to fund its operating expenses, including payment of taxes and funding customer commitments; then to pay interest on the Senior Notes; then to make optional purchases of the Senior Notes in accordance with the terms of the Indenture in an amount not to exceed $150 million per year. Ninety-five percent (95%) of the remaining available cash after establishment of cash reserves as defined in the Indenture will be used to make prepayments of principal on the Senior Notes and five percent (5%) is identified for distributions to and/or repurchases of stock from common stockholders. However, the Indenture prohibits FINOVA from making distributions to and/or repurchases from stockholders if the payments would render the Company insolvent, would be a fraudulent conveyance or would not be permitted under applicable law. Any such distribution and/or repurchase would be considered an impermissible restricted payment under the Indenture. Given the Company’s significant negative net worth (approximately $611.7 million at December 31, 2005 or $1.2 billion if the Senior Notes are considered at their principal amount due) and its belief that the Senior Notes will not be fully repaid, FINOVA is required to retain impermissible restricted payments until such time, if ever, that it is no longer restricted from making a distribution to its stockholders or until it is necessary to use the cash to satisfy its debt obligations. As of December 31, 2005, the Company retained a total of $67.2 million. The retained amount increased to $70.3 million during the first quarter of 2006, following the aforementioned additional Senior Note prepayments. Refer to Item 3. “Legal Proceedings” for a discussion of the Company’s motion to the Bankruptcy Court regarding the restricted payments.
A-12
THE FINOVA GROUP INC.
The Indenture provides that if payment in full is made of the outstanding principal of the Senior Notes and payments are made to FINOVA common stockholders in an aggregate amount equal to 5.263% (i.e., 5%/95% as noted above) of the aggregate principal amount of the Senior Notes, ninety-five percent (95%) of any available cash will be used to pay contingent interest to holders of Senior Notes in an aggregate amount of up to $91.2 million (reflecting Senior Notes that have been repurchased by the Company) and five percent (5%) of remaining available cash will be used for distributions to and/or repurchases of stock from common stockholders, if those distributions can be made to stockholders, as noted above. FINOVA’s obligation for the contingent interest payments is not secured. Based on the Company’s current financial condition, it is highly unlikely that there will be funds available to fully repay the outstanding principal on the Senior Notes at maturity, to make any distributions to common stockholders or to pay any contingent interest through its expiration in 2016.
Unfunded customer commitments are primarily unused contractual lines of credit and to a lesser extent, contractual term financing commitments. Funding is typically dependent upon certain conditions precedent and the availability of eligible collateral. Typically, in the event of a contractual customer default, FINOVA has the legal right to cease funding. In these circumstances, decisions to continue or cease funding are made on a case-by-case basis following an evaluation as to what management believes is in the Company’s best interest. Commitments generally have a fixed expiration and at the Company’s discretion, may be extended. As of December 31, 2005, the Company’s unfunded commitments included only a few existing accounts, with the majority of the commitment related to one real estate customer. Because of the primarily revolving nature of its commitments, the Company is unable to estimate with certainty what portion of the commitments will be funded.
Lease obligations represent total contractual obligations (rent and operating costs) due under operating leases (primarily leased office space), as well as commitments made for tenant improvements and lease damages related to the resolution of previously rejected lease space. Lease obligations declined to $7.7 million at December 31, 2005, primarily due to scheduled rent payments. See Notes to the Consolidated Financial Statements, Note L. “Operating Leases” for a schedule of future minimum rental payments by year.
Not included in the table above is nonrecourse debt associated leveraged leases. Nonrecourse debt associated with leveraged leases totaled $125.4 million and $313.1 million at December 31, 2005 and 2004, respectively. The balances represent principal amounts due to third party lenders under lease arrangements. The Company has no direct obligation for repayment of the nonrecourse debt. Accounting rules require that leases financed by nonrecourse borrowings and meeting certain other criteria be classified as leveraged leases. For balance sheet classification purposes, aggregate leveraged lease rental receivables are reduced by the related nonrecourse debt service obligations to determine the Company’s investment in the leveraged leases. At December 31, 2005 and 2004, all of the Company’s leveraged leases were classified and accounted for as assets held for sale. Typically, the debt has a first priority lien against the leased equipment or property with no additional recourse to FINOVA. FINOVA’s exposure is limited to its investment in the transaction and the Company is not contractually obligated or committed to make repayments of this debt. Nonrecourse debt declined to $125.4 million at December 31, 2005, primarily due to the elimination of $124.9 million of nonrecourse debt in conjunction with the sale of FINOVA’s position in three leases, the elimination of $44.7 million of nonrecourse debt as a result of the senior debt holders restructuring contractual obligations and proceeding against the underlying assets in two separate transactions, principal prepayment of $11.5 million of debt and scheduled principal payments of $6.6 million. The entire remaining amount of nonrecourse debt at December 31, 2005 relates to the Company’s leveraged leases with Northwest Airlines. As previously mentioned, in conjunction with the Northwest Airlines’ bankruptcy filing, the airline notified FINOVA of its intent to renegotiate the terms of eight leveraged leases or possibly reject the transactions. Two Boeing 757 aircraft and six regional jets secure the Northwest leveraged leases. The nonrecourse senior debt on these leveraged leases is significantly in excess of the underlying aircraft values. As noted above, FINOVA has no direct obligation for repayment of the nonrecourse debt.
Collection of the Portfolio
As noted previously, the Company’s current business activities are limited to maximizing the value of its portfolio through the orderly collection of its assets. These activities include collection efforts pursuant to underlying contractual terms, negotiation of prepayments, sales of assets or collateral and may include efforts to retain certain customer relationships and restructure or terminate other relationships. The Company has sold portions of asset portfolios and will consider future sales of any asset if buyers can be found at acceptable prices. The Company is offering to sell its remaining assets both by portfolio and individual asset. Due to restrictions contained in the Indenture as well as its general inability to access capital in the public and private markets, the Company’s only viable source of cash flow is from the collection of its portfolio.
A-13
THE FINOVA GROUP INC.
The following table presents the activity in total financial assets, net of the reserve for credit losses:
Total financial assets, net of the reserve for credit losses, declined to $326.6 million at December 31, 2005, down from $604.7 million at December 31, 2004. During 2005, net cash flows from the portfolio totaled $312.4 million, down from $1.1 billion in 2004, while non-cash activity resulted in a $34.4 million increase in net financial assets as compared to $153.2 million for 2004. Components of net cash flow for 2005 included $260.4 million of collections from financial assets (including recoveries) and $66.2 million from the sale of assets (excluding cash gains), offset by $14.2 million of fundings under existing customer commitments. Collections from financial assets included a significant level of prepayments (customer payments in advance of scheduled due dates). Non-cash activity included a $51.8 million reversal of reserves, partially offset by a $12.5 million net decrease related to the valuation of assets held for sale and owned assets and other non-cash activity of $4.9 million.
During 2004, net cash flows from the portfolio totaled $1.1 billion, while non-cash activity resulted in a $153.2 million increase in net financial assets. Components of net cash flow included $749.6 million of collections from financial assets (including reserves) and $386.4 million from the sale of assets (excluding cash gains), offset by $56.3 million of fundings under existing customer commitments. Non-cash activity included a $148.5 million reversal of reserves and other non-cash activity of $15.2 million, partially offset by a $10.5 million reduction related to markdowns of owned assets.
The real estate portfolio (combined remaining resort and specialty real estate portfolios) declined to a carrying amount of $29.2 million or 8.2% of the Company’s total financial assets (before reserves) at December 31, 2005 as compared to $156.1 million or 22.1% of total financial assets (before reserves) at December 31, 2004. The decline was primarily attributable to prepayments, asset sales and scheduled amortization. During 2005, the Company completed the sale of its last two real estate leveraged leases for net proceeds of $14.1 million, while prepayment activity was in excess of $105 million. The remainder of the real estate portfolio is expected to have a slower rate of runoff. The remaining portfolio is primarily comprised of impaired or nonperforming assets that have been marked down and/or reserved due to certain issues or uncertainties with the customers or the underlying collateral. These assets have the potential for recoveries in excess of their carrying amounts. Due to the size of the real estate portfolio at December 31, 2005, the remaining assets will be combined with all other portfolios in future filings.
The carrying amount of the Company’s transportation portfolio declined $130.5 million since December 31, 2004 to $163.5 million at December 31, 2005, which represents 46.0% of the Company’s total financial assets (before reserves). The decline was primarily attributable to asset sales, prepayments, scheduled amortization, write-offs ($21.8 million) and valuation adjustments ($19.1 million) to the transportation leveraged lease portfolio. The decline was partially offset by the prepayment of $12.5 million (including penalties) of nonrecourse debt associated with two leveraged leases to American Trans Air. FINOVA repossessed the underlying collateral (an aircraft and a spare engine) related to these leveraged leases in 2005. During 2005, the Company completed over 60 asset sales with a total carrying amount of $34.9 million, while prepayment activity represented $24.7 million of carrying amount. The transportation portfolio is primarily comprised of older vintage aircraft, often of class and configuration with limited demand in the aircraft market. FINOVA has a number of aircraft that are off-lease and anticipates that additional aircraft will be returned to the Company as leases expire or operators
A-14
THE FINOVA GROUP INC.
are unable or unwilling to continue making payments. The Company’s portfolio of older aircraft generally is not as desirable to domestic commercial airlines and as a result, owned and off-lease aircraft are primarily marketed in whole or part to carriers in developing countries. FINOVA continues to reassess the likelihood of certain off-lease assets being re-leased or sold. The potential for substantial recoveries on these accounts continues to be hampered by the uncertainty in the airline industry. A market for many of these aircraft may never fully return, but the Company believes the course of action to maximize their value is to patiently work these assets and wait for opportune moments to sell or lease the assets that have the potential to return to service, and scrap those assets that are not likely to return to service. As previously discussed, the aircraft-financing market continued to display a high level of activity and in certain instances improved aircraft values. As a result, the Company’s transportation portfolio continued to generate cash in excess of recorded carrying amounts during 2005. Additionally, the Company had a number of aircraft that were under letters of intent to sell as of December 31, 2005 or were sold in early 2006, including the majority of the Company’s off-lease assets and a direct financing lease on a Boeing 747 with Northwest Airlines. In the first quarter of 2006, Northwest exercised a purchase option on the Boeing 747 for $17.0 million, which approximated the fair value of the asset. The Company has seen an increase in demand for certain types of aircraft; however, this demand may decline due to continued uncertainty in the airline industry and the bankruptcy filings of Delta Airlines and Northwest Airlines.
All other portfolios (carrying amount of $162.9 million at December 31, 2005) is comprised of the remnants of former portfolios (commercial equipment, communications, corporate finance, franchise, healthcare, mezzanine, public and rediscount) that for various reasons have not been sold or collected. The decline in the portfolio was primarily attributable to numerous prepayments, asset sales and scheduled amortization. This portfolio represents 45.8% of the Company’s total financial assets (before reserves) and generally contains assets that are more difficult and work intensive to liquidate. Approximately 77% of these assets are impaired or nonaccruing. Many of the borrowers have missed payments, including balloon obligations, or are otherwise in default. The Company expects runoff within this portfolio to begin to slow from the pace in 2005; however, the pace of runoff will be largely dependent on the resolution of a few significant accounts within the portfolio, including the litigation related to loans to The Thaxton Group Inc. and related companies described in Item 3. “Legal Proceedings”. Because this portfolio has been significantly marked down and reserved, the potential exists for recoveries in excess of carrying amounts; however, there can be no assurance that the Company will be successful in recovering amounts in excess of its carrying amounts.
The Company anticipates that when all or substantially all of the assets have been liquidated that the Company’s affairs will need to be wound-up. The Company is analyzing the potential methods of wind-up, which might involve a sale of the remaining assets, an assignment for the benefit of the creditors, or some other proceeding, any of which may or may not be in conjunction with bankruptcy or state law liquidation proceedings. We cannot predict the timing or nature of that final wind-up, but the Company is working towards accomplishing that end in a prudent manner. The portfolio has declined considerably and the remaining value has become more concentrated in a small number of accounts, while certain fixed costs and the cost of maintaining a public company have not declined at the same rate as the portfolio.
FINOVA’s reserve for credit losses decreased to $29.0 million at December 31, 2005 from $101.3 million at December 31, 2004. At December 31, 2005, the total carrying amount of impaired loans and leases was $241.1 million, of which $109.1 million were revenue accruing. The Company has established impairment reserves of $28.3 million related to $85.4 million of impaired assets. At December 31, 2004, the total carrying amount of impaired loans and leases was $458.8 million, of which $202.4 million were revenue accruing. Impairment reserves at December 31, 2004 totaled $96.2 million related to $169.2 million of impaired assets.
Reserves on impaired assets decreased primarily due to write-offs ($31.6 million and $62.2 million for the years ended December 31, 2005 and 2004, respectively), an improvement in pay-off and collection experience on certain assets previously reserved and the Company’s application of cash received on nonaccruing assets, thus reducing impairment reserves required on those assets. Partially offsetting these reductions were new impairment reserves established for assets reclassified to nonaccruing or impaired status during 2005 and additional reserves recorded on certain existing impaired assets.
Other reserves related to estimated inherent losses on unimpaired assets decreased to $0.7 million at December 31, 2005 from $5.0 million at December 31, 2004, as a result of prepayments, collections and the migration of certain accounts to impaired assets.
Accounts classified as nonaccruing were $131.9 million or 37.1% of total financial assets (before reserves) at December 31, 2005 as compared to $259.4 million or 36.7% at December 31, 2004. The decline in nonaccruing assets was primarily attributed to collections and asset sales of $59.2 million and write-offs and net valuation markdowns of $49.2 million. Also contributing to the decline was the return of certain assets to accruing status following demonstration of sustained performance and the classification of newly repossessed aircraft as assets held for the production of income, which are excluded from nonaccruing assets. During 2005, the Company returned a small number of accounts to accruing status. Certain of these accounts were previously restructured and the Company was monitoring the accounts for demonstration of sustained performance under the restructured terms before they would be returned to accruing status.
A-15
THE FINOVA GROUP INC.
The Company continues to be concerned regarding its ability to fully collect principal and interest on certain nonaccruing assets that have significant balloon payments or residual values due to FINOVA at maturity, because those customers may not have the ability to obtain refinancing at maturity for the full amount of these residual/balloon payments. FINOVA’s ability or willingness to continue to extend credit to these borrowers may be affected by its own capital resources and its assessment of the costs and benefits of doing so. In certain of these cases, FINOVA has classified transactions as nonaccruing even though principal and interest payments are current. If necessary, impairment reserves on these transactions are established in accordance with SFAS No. 114.
Special Note Regarding Forward-Looking Statements
Certain statements in this report are “forward-looking,” in that they do not discuss historical fact, but instead reflect future expectations, projections, intentions, or other items. Forward-looking statements are made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include assumptions, estimates and valuations implicit in the financial statements and related notes as well as matters discussed throughout this report including sections captioned Item 1. “Business,” Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 7A.