ITEM 1. BUSINESS
General Development of Business
Epiq Systems, Inc. is a provider of integrated technology solutions for the legal profession. References below to "we," "us" and "our" may refer to Epiq Systems, Inc. exclusively or to one or more of our subsidiaries. Our solutions streamline the administration of bankruptcy, litigation, financial transactions and regulatory compliance matters. We offer innovative technology solutions for electronic discovery, document review, legal notification, claims administration and controlled disbursement of funds. Our clients include law firms, corporate legal departments, bankruptcy trustees, government agencies and other professional advisors who require innovative technology, responsive service and deep subject-matter expertise.
We were incorporated in the State of Missouri on July 13, 1988, and on July 15, 1988 acquired all of the assets of an unrelated predecessor corporation.
As a part of our business strategy, we have made several acquisitions and one disposition over the past five years. During the second quarter of 2008 we acquired all of the equity of Uberdevelopments Limited and its wholly-owned operating subsidiary Pinpoint Global Limited (collectively, "Pinpoint"), an electronic discovery business with operations in the United Kingdom, to expand our market in the United Kingdom. During 2006, we acquired the net assets of Gazes LLC (now Epiq Preference Solutions) to supplement our ability to provide claims preference services for our bankruptcy segment clients. During 2005, we acquired nMatrix (now Epiq eDiscovery Solutions) to expand our offerings to include electronic discovery, and Hilsoft, Inc., which enhanced our expert legal noticing services for clients of our settlement administration segment.
Our trademarks and service marks include Epiq™, Epiq Systems™, Bankruptcy Link®, CasePower®, CasePower 13®, ClaimsMatrix®, ClassMatrix™, CreditorMatrix™, DebtorMatrix™, DocuMatrix™, eDataMatrix®, IQ Review™, IQ ReviewSM, LegalMatrix™, TCMS®, TCMSWeb™, and XFrame™. The trademarks and service marks have been filed but are not yet registered; the registered marks have durations ranging from 2011 through 2019.
Financial Information About Segments
Our business is organized into three reporting segments: electronic discovery, bankruptcy, and settlement administration. Segment information related to revenues, a performance measure of profit or loss, capital expenditures, and total assets is contained in Note 14 of the Notes to Consolidated Financial Statements.
Narrative Description of Business
Electronic Discovery Segment
Our electronic discovery segment provides collections and forensics, processing, search and review, and document review services to companies and the litigation departments of law firms. Our eDataMatrix® software analyzes, filters, deduplicates and produces documents for review. Produced documents are made available primarily through a hosted environment, and our DocuMatrix™ software allows for efficient attorney review and data requests. Our customers are typically large corporations that use our products and services cooperatively with their legal counsel to manage the electronic discovery process for litigation and regulatory matters.
The substantial amount of electronic documents and other data used by businesses has changed the dynamics of how attorneys support discovery in complex litigation matters. Due to the complexity of cases, the volume of data that are maintained electronically, and the volume of documents that are
produced in all types of litigation, law firms have become increasingly reliant on electronic evidence management systems to organize and manage the litigation discovery process.
Following is a description of the significant sources of revenue in our electronic discovery business.
•Consulting, forensics and collection service fees based on the number of hours a professional services team spends providing the requested services.
•Fees related to the conversion of data into an organized, searchable electronic database. The amount we earn varies primarily on the size (number of documents) and complexity of the engagement.
•Hosting fees based on the amount of data stored.
•Document review fees based on the number of hours spent reviewing documents, the number of pages reviewed, or the amount of data reviewed.
In the first half of 2009 we opened new offices in Brussels and Hong Kong, establishing global reach for our offices and data centers in the U.S., Europe and Asia; and expanded our offerings to include data forensics and collections services, as well as document review services. In 2009 we also launched IQ Review™, a revolutionary combination of new intelligent technology and expert services which incorporates new prioritization technology into DocuMatrix™, our flagship document management platform.
Bankruptcy Segment
Bankruptcy is an integral part of the United States' economy. As reported by the Administrative Office of the U.S. Courts for the fiscal years ended September 30, 2009, 2008, and 2007, there were approximately 1.40 million, 1.04 million, and 0.80 million new bankruptcy filings, respectively. Bankruptcy filings for the twelve-month period ended September 30, 2009 increased 34% versus the twelve-month period ended September 30, 2008. During this period, Chapter 7 filings increased 45%, Chapter 11 filings increased 68%, and Chapter 13 filings increased 13%. The quarter ended September 30, 2009 represented the highest quarterly filing period since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was enacted.
Our bankruptcy business provides solutions that address the needs of Chapter 7, Chapter 11, and Chapter 13 bankruptcy trustees to administer bankruptcy proceedings and of debtor corporations that file a plan of reorganization.
•Chapter 7 is a liquidation bankruptcy for individuals or businesses that, as measured by the number of new cases filed in the twelve-month period ended September 30, 2009, accounted for approximately 71% of all bankruptcy filings. In a Chapter 7 case, the debtor's assets are liquidated and the resulting cash proceeds are used by the Chapter 7 bankruptcy trustee to pay creditors. Chapter 7 cases typically last several years.
•Chapter 11 is a reorganization model of bankruptcy for corporations that, as measured by the number of new cases filed in the twelve-month period ended September 30, 2009, accounted for approximately 1% of all bankruptcy filings. Chapter 11 generally allows a company, often referred to as the debtor-in-possession, to continue operating under a plan of reorganization to restructure its business and to modify payment terms of both secured and unsecured obligations. Chapter 11 cases generally last several years.
•Chapter 13 is a reorganization model of bankruptcy for individuals that, as measured by the number of new cases filed in the twelve-month period ended September 30, 2009, accounted for approximately 28% of all bankruptcy filings. In a Chapter 13 case, debtors make periodic cash payments into a reorganization plan and a Chapter 13 bankruptcy trustee uses these cash
payments to make monthly distributions to creditors. Chapter 13 cases typically last between three and five years.
The application of Chapter 7 bankruptcy regulations has the practical effect of discouraging trustee customers from incurring direct administrative costs for computer system expenses. As a result, we provide our Chapter 7 products and services to our trustee customers at no direct charge, and they maintain deposit accounts for bankruptcy cases under their administration at a designated banking institution. We have arrangements with various banks under which we provide the bankruptcy trustee case management software and related services, and the bank provides the bankruptcy trustee with deposit-related banking services. During the years ended December 31, 2009 and 2008, a majority of our Chapter 7 trustee clients' deposits were maintained at Bank of America. See Note 9 of the Notes to Consolidated Financial Statements for additional information on this significant customer.
Chapter 11 bankruptcy engagements are generally long-term, multi-year assignments that provide revenue visibility into future periods. For the Chapter 7 trustee services component of the bankruptcy segment, the increase in filings is expected to translate into growth in client deposit balances related to asset liquidations. Our trustee services deposit portfolio reached $2.0 billion during the fourth quarter of 2009, while pricing was at floor pricing levels under our agreements due to the low short-term interest rate environment.
The key participants in a bankruptcy proceeding include the debtor-in-possession, the debtor's legal counsel, the creditors, the creditors' legal counsel, and the bankruptcy judge. Chapter 7 and Chapter 13 cases also include a professional bankruptcy trustee, who is responsible for administering the bankruptcy case. The end-user customers of our bankruptcy solutions are debtor corporations that file a plan of reorganization and professional bankruptcy trustees. The Executive Office for United States Trustees, a division of the U.S. Department of Justice, appoints all bankruptcy trustees. A United States Trustee is appointed in most federal court districts and generally has responsibility for overseeing the integrity of the bankruptcy system. The bankruptcy trustee's primary responsibilities include liquidating the debtor's assets or collecting funds from the debtor, distributing the collected funds to creditors pursuant to the orders of the bankruptcy court and preparing regular status reports for the Executive Office for United States Trustees and for the bankruptcy court. Trustees manage an entire caseload of bankruptcy cases simultaneously.
Following is a description of the significant sources of revenue in our bankruptcy business.
•Data hosting fees and volume-based fees.
•Case management professional service fees and other support service fees related to the administration of cases, including data conversion, claims processing, claims reconciliation, professional services, and disbursement services.
•Deposit-based fees, earned primarily on a percentage of Chapter 7 total liquidated assets placed on deposit with a designated financial institution by our trustee clients, to whom we provide, at no charge, software licenses, limited hardware and hardware maintenance, and postcontract customer support services. The fees we earn based on total liquidated assets placed on deposit by our trustee clients may vary based on fluctuations in short-term interest rates.
•Legal noticing services to parties of interest in bankruptcy matters, including direct notification and media campaign and advertising management in which we coordinate notification, primarily through print media outlets, to potential parties of interest for a particular client engagement.
•Reimbursement for costs incurred, primarily related to postage on mailing services.
Settlement Administration Segment
Our settlement administration segment provides managed services, including legal notification, claims administration, project administration and controlled disbursement.
The customers of our settlement administration segment are corporations that are administering the settlement or resolution of class action cases or administering projects. We sell our services directly to those customers and other interested parties, including legal counsel, which often provide access to these customers. During the years ended December 31, 2009, 2008 and 2007, approximately 12%, 22%, and less than 1%, respectively, of our consolidated revenue was derived from a large contract with IBM in support of the federal government's analog to digital conversion program. This revenue was recognized in our settlement administration segment. The contract began in the fourth quarter of 2007 and, as expected, wound-down in 2009.
Following is a description of the significant sources of revenue in our settlement administration business.
•Fees contingent upon the month-to-month delivery of case management services such as claims processing, claims reconciliation, project management, professional services, call center support, and controlled disbursements. The amount we earn varies primarily on the size and complexity of the engagement.
•Legal noticing services to parties of interest in class action matters; including media campaign and advertising management, in which we coordinate notification through various media outlets such as print, radio and television, to potential parties of interest for a particular client engagement.
•Reimbursement for costs incurred related to postage on mailing services.
Key participants in this marketplace include law firms that specialize in representing class action and mass tort plaintiffs and other law firms that specialize in representing defendants. Class action and mass tort refer to litigation in which class representatives bring a lawsuit against a defendant company or other persons on behalf of a large group of similarly affected persons. Mass tort refers to class action cases that are particularly large or prominent. Class action and mass tort litigation is often complex and the cases, including administration of any settlement, may last several years.
Competition
Electronic Discovery
The electronic discovery market is highly fragmented, intensely competitive and rapidly evolving. Competitors include Electronic Evidence Discovery, Inc., Fios, Inc., Kroll Ontrack (Marsh & McLennan Companies), Attenex (FTI Consulting, Inc.), Autonomy ZANTAZ, Inc., Stratify, Inc. (Iron Mountain Incorporated), and Clearwell Systems, Inc. Competition is primarily based on the quality of service, technology innovations, and price.
Bankruptcy
Our bankruptcy segment competes in a more mature market. We are one of two primary providers in the Chapter 7 bankruptcy market, along with Bankruptcy Management Solutions, Inc.; and in the Chapter 11 bankruptcy market competitors include Kurtzman Carson Consultants LLC and The Garden City Group, Inc. In both the Chapter 7 and Chapter 11 markets there are also several smaller competitors. Competition is primarily based on quality of service and technology innovations.
Settlement Administration
The primary competitors with our settlement administration segment are The Garden City Group, Inc., Rust Consulting, Inc., and Gilardi & Co LLC, as well as several smaller competitors. Competition is primarily based on the quality of service, technology innovations, and price.
In addition to the competitors mentioned above, certain law firms, accounting firms, management consultant firms, turnaround specialists and crisis management firms offer products and services that compete with our products and services in each of our segments.
Key competitive factors and the relative strength of our products and services versus our competitors are directly and indirectly affected by our technology innovations, the quality of our services, price, ease of use of our technology solutions, quality of our technical support, reliability, and our domain expertise. Our ability to continually innovate and differentiate our product offerings has enabled us to achieve and maintain leadership positions in the various markets that we serve.
Sales and Marketing
Our sales executives market our products and services directly to prospective customers and referral law firms through on-site sales calls and longstanding relationships. We focus on attracting and retaining customers by providing superior integrated technology solutions and exceptional customer service. Our client support specialists are responsible for providing ongoing support services for existing customers. Additionally, we maintain a website that clients and potential clients may access to obtain additional information related to solutions we offer, we attend industry trade shows, we publish articles, and we conduct direct mail campaigns and advertise in trade journals.
Government Regulation
Our products and services are not directly regulated by the government. However, our bankruptcy segment customers are subject to significant regulation under the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and local rules and procedures established by bankruptcy courts. Additionally, the Executive Office for United States Trustees, a division of the United States Department of Justice, oversees the federal bankruptcy system and establishes administrative rules governing our clients' activities. Furthermore, class action and mass tort cases, as well as electronic discovery requirements related to litigation, are subject to various federal and state laws, as well as rules of evidence and rules of procedure established by the courts.
In April 2006, the United States Supreme Court approved certain amendments to the Federal Rules of Civil Procedure regarding the discovery in litigation of certain electronically stored information. These amendments became effective on December 1, 2006. Among other things, these amendments (i) require early attention by parties in litigation to meet and confer regarding discovery issues and to develop a discovery plan that identifies and addresses the parties' electronically stored information, (ii) expand the reach of federal court subpoenas to include electronically stored information, (iii) allow for parties to object to production of electronically stored information that is not reasonably accessible due to the undue burden or cost associated with such retrieval, and (iv) provide a "safe harbor" to parties unable to provide electronically stored information lost or destroyed as a result of the routine, good-faith operation of an electronic information system. While these federal rules do not apply in state court proceedings, the civil procedure rules of many states have been closely modeled on these provisions. We anticipate the federal and state court discovery rules relating to electronic documents and information will continue to evolve and affect the way we develop and implement technology and service solutions to those changing discovery rules.
Employees
As of December 31, 2009, we employed approximately 550 full-time employees, none of whom is covered by a collective bargaining agreement. We believe the relationship with our employees is good.
Financial Information About Geographic Areas
Substantially all of our revenues are generated from services provided within the United States, and substantially all of our assets are located within the United States.
Available Information
Our company internet address is www.epiqsystems.com. We make a variety of information available, free of charge, at our Investor Relations website, www.epiqsystems.com/investors.php, including our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, and any amendments to those reports as soon as reasonably practicable after we electronically file those reports with or furnish them to the SEC, as well as our code of ethics and other governance documents.
The public may read and copy materials filed by us with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. The contents of these websites are not incorporated into this report. Further, our references to the URLs for these websites are intended to be inactive textual references only.
ITEM 1A.
ITEM 1A. RISK FACTORS
This report, other reports to be filed by us with the SEC, press releases made by us and other public statements by our officers, oral and written, contain or will contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, including those relating to the possible or assumed future results of operations and financial condition. Because those statements are subject to a number of uncertainties and risks, actual results may differ materially from those expressed or implied by the forward-looking statements. Listed below are risks associated with an investment in our securities that could cause actual results to differ from those expressed or implied. If any of the following risks occurs, our business, financial condition, results of operations and prospects could be materially adversely affected.
We compete with other third party providers on the basis of the technological features, capabilities and price of our products and services, and we could lose existing customers and fail to attract new business if we do not keep pace with technological changes and offer competitive pricing for our products and services.
The markets for our products and services are competitive, continually evolving and subject to technological change. We believe that key competitive factors in the markets we serve include the breadth and quality of system and software solution offerings, the stability of the information systems provider, the features and capabilities of the product and service offerings, the pricing of our products and services, and the potential for future product and service enhancements. Our success depends upon our ability to keep pace with technological change and to introduce, on a timely and cost-effective basis, new and enhanced software solutions and services that satisfy changing client requirements. If we do not keep pace with technological changes, we could lose existing customers and fail to attract new business. Likewise, technology products and services can become more price sensitive over time, and if we are not able to maintain price competitive products and services we could lose existing customers and fail to attract new customers. The impact of not keeping pace with technological changes or maintaining competitive pricing could adversely affect our results of operations.
Security problems with our software products, systems or services could cause increased service costs and damage to our reputation.
We have included security features in our products and processes that are intended to protect the privacy and integrity of data, including confidential client or consumer data. Security for our products and processes is critical given the confidential nature of the information contained in our systems. Our software products, the systems on which the products are used, and our processes may not be impervious to intentional break-ins ("hacking") or other disruptive disclosures or problems, whether as a result of inadvertent third party action, employee action, malfeasance, or other. Hacking or other disruptive problems could result in the diversion of our development resources, damage to our reputation, increased service costs and impaired market acceptance of our products, any of which could result in higher expenses or lower revenues.
Improper disclosure of personal data could harm our reputation and result in liability and increased expense for litigation and diversion of management time.
We store and process large amounts of personally identifiable information. Our software products also enable our customers to store and process personal data. It is possible that our security controls over personal data, our selection and training of employees, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Such disclosure could harm our reputation and subject us to liability in regulatory proceedings and private litigation under laws that protect personal data, resulting in increased costs or loss of revenue. Perceptions that our products and services do not adequately protect the privacy of personal information could inhibit sales of our products and services. Additionally, improper disclosure of personal data could result in lawsuits or
regulatory proceedings alleging damages. Defending these types of claims could result in increased expenses for litigation and claims settlement and a significant diversion of our management's attention.
Errors or fraud related to our business processes could cause increased expense for litigation and diversion of management attention.
We administer claims, disburse funds, generate and distribute legal notices and provide professional services for third parties. Errors or fraud could occur, for example, in the payment of settlement claims in a case we are administering for a customer. Errors or fraud related to the processing or payment of these claims or errors related to the delivery of professional services could result in the diversion of management resources, damage to our reputation, increased service costs or impaired market acceptance of our services, any of which could result in higher expenses and lower revenues. Additionally, these types of errors or fraud could result in lawsuits alleging damages. Defending these types of claims could result in increased expenses for litigation and claims settlement and a significant diversion of our management's attention.
Any claims or threats of litigation could distract us from business operations and strategic planning, and costs of litigation or settlement could adversely affect our financial condition or results of operations.
Any claims made or litigation commenced against the company, or our officers or directors, may distract our board of directors, management, or other key employees from business operations and strategic planning. There may also be an increase versus prior periods in potential claims or litigation relative to company operational growth. Claims resolution frequently entails a cost/benefit analysis, which would include consideration of the potential risks, expenses and impact to business operations. We may determine to litigate or settle such claims (including threatened claims) even if we believe those claims have little or no merit. The cost of litigation or settlements could adversely affect our financial condition or our results of operations.
Interruptions or delays in service at the data centers we utilize could impair the delivery of our service and harm our business.
We provide certain of our services through computer hardware that is located in data centers operated by unrelated third parties. We do not control the operation of these facilities, which increases our vulnerability to problems with the services they provide, and they are subject to damage or interruption from earthquakes, floods, fires, power loss, terrorist attacks, telecommunications failures and similar events. They are also subject to break-ins, sabotage, intentional acts of vandalism and similar misconduct. The occurrence of any of these events, a decision to close a facility without adequate notice, or other unanticipated problems at a facility could result in interruptions in certain of our services. In addition, the failure by our vendor to provide our required data communications capacity could result in interruptions in our service. Any damage to, or failure of, our systems or services could reduce our revenue, cause us to issue credits or pay penalties, cause customers to terminate their agreements with us and adversely affect our ability to secure business in the future. Our business will be harmed if our customers and potential customers believe our services are unreliable.
Releases of new software products or upgrades to our existing software products may have undetected errors, which could cause litigation claims against us or damage to our reputation.
Certain of our services utilize software solutions developed by us for our customers. We issue new releases of our software products to our customers periodically. Complex software products, such as those we offer, can contain undetected errors when first introduced or as new versions are released. Any introduction of new software products or upgrade to existing software products has a risk of undetected errors. These undetected errors may be discovered only after a product has been installed
and used either in our internal processing or by our customers. Likewise, the software products we acquire in business acquisitions have a risk of undetected errors.
Any undetected errors, as well as any difficulties in installing and maintaining our software products or upgrade releases or difficulties training customers and their staffs on the utilization of new software products or upgrade releases, may result in a delay or loss of revenue, diversion of development resources, damage to our reputation, increased service costs, increased expense for litigation or claims settlement, or impaired market acceptance of our products.
Our software solutions may not achieve our customer's desired objectives, which could cause loss of business and potential litigation claims against us or damage to our reputation.
The software products and solutions we provide our customers are increasingly complex in response to the needs of our customers. While our products and services are designed to meet the needs of our customers, our software products may fail to achieve the customer's desired objectives, which could result in the loss of that customer, loss of future business, potential litigation claims against us and damage to our reputation.
We rely on third-party hardware and software, which could cause errors or failures of our software or services.
We rely on hardware purchased or leased and software licensed from third parties for our service offerings. The hardware is typically standardized hardware from national vendors. The software licenses are generally standardized, commercial software licenses from national software vendors. We are generally able to select from a number of competing hardware and software applications, and, from time to time, we have changed the hardware and software technologies incorporated into our software products and solutions. Any errors or defects in third party hardware or software incorporated into our products could result in a failure of our service or errors in our software, which in turn could adversely affect our customer relationships and result in the loss of customers, the loss of future business, potential litigation claims against us, and damage to our reputation.
Revenue in our bankruptcy segment related to trustee deposits is collected through a few financial institutions, and the adverse modification or termination of any of those arrangements, including a component of pricing tied to prevailing interest rates, could cause uncertainty and adversely affect our future bankruptcy segment revenue and earnings.
The application of Chapter 7 bankruptcy regulations discourages Chapter 7 trustees from incurring direct administrative costs for computer system expenses. As a result, we provide our products and services to these trustee customers at no direct charge, and these trustee customers agree to deposit the cash proceeds from liquidations of debtors' assets with one of the designated financial institutions with which we have an arrangement. We then collect fees from each financial institution which are largely based on a percentage of the total funds on deposit pursuant to contracts with that financial institution. The great majority of our clients' funds are currently deposited at two such financial institutions. Fees we earn for deposits placed with those financial institutions vary, within certain limits, based on fluctuations in short-term interest rates. The significant decline in short-term interest rates, which began in 2008 and continued into 2009, resulted in pricing under those arrangements reaching the low end of the variable fee schedule. Fluctuations in short-term interest rates could affect the fees we earn for the Chapter 7 deposits in the future. These bankruptcy deposit-based fees represent a material percentage of our bankruptcy segment revenues.
Our pricing and terms with the two financial institutions are in the form of agreements that are currently non-cancellable, without cause, prior to June 2012. We have, however, from time to time agreed with the financial institutions to modify the pricing or terms of those agreements and we may
do so again in the future. Any modifications to pricing or terms could adversely affect our bankruptcy segment revenue and earnings. Likewise, a termination of a financial institution arrangement could adversely affect our bankruptcy segment revenue and earnings.
We depend upon our key personnel, and we may not be able to retain them or to attract, assimilate and retain highly qualified employees in the future.
Our future success may depend upon the continued service of our senior management and certain of our key technical personnel and our continuing ability to attract, assimilate and retain highly qualified technical, managerial, and sales and marketing personnel. We do not have employment agreements with our Chief Executive Officer, President, or Chief Financial Officer. We maintain key-man life insurance policies on our Chief Executive Officer and our President. The loss of the services of any of these senior executives or other key personnel, including key sales professionals, or the inability to hire or retain qualified personnel in the future could have a material adverse impact on our results of operations.
The integration of acquired businesses is time consuming, may distract our management from our other operations, and can be expensive, all of which could reduce or eliminate our expected earnings.
We have acquired businesses in the past and we may consider opportunities in the future to acquire other companies, assets or product lines that complement or expand our business. If we are unsuccessful in integrating these companies or product lines with our existing operations, or if integration is more difficult than anticipated, we may experience disruptions to our operations. A difficult or unsuccessful integration of an acquired business could have an adverse effect on our results of operations.
Some of the risks that may affect our ability to integrate or realize any anticipated benefits from companies or businesses we acquire include those associated with:
•unexpected losses of key employees or customers of the acquired business;
•conforming standards, processes, procedures and controls of the acquired business with our operations;
•increasing the scope, geographic diversity and complexity of our operations;
•difficulties in transferring processes and know-how;
•difficulties in the assimilation of acquired operations, technologies or products;
•diversion of management's attention from other business concerns to the acquired business; and
•adverse effects on existing business relationships with customers.
We continue to expand our business internationally, which subjects us to additional risks associated with these international operations.
We have expanded our business internationally with offices in London, Brussels and Hong Kong, primarily related to our electronic discovery business. We could expand other businesses internationally and we could enter other world markets. It requires significant management attention and financial resources to develop successful global markets. In addition, new operations in geographies we may enter may not be immune from possible government monitoring or intrusion.
Global operations are subject to additional inherent risks, including certain risks that are not present with our domestic operations, and our future results could be adversely affected by a variety of uncontrollable and changing factors. These include:
•difficulties and costs in recruiting effective management for international operations;
•foreign certification, licensing and regulatory requirements, which may be substantially more complex or burdensome than our domestic requirements;
•unexpected changes in foreign regulatory requirements;
•risk associated with selecting or terminating partners for foreign expansions, including marketing agents, distributors or other strategic partners for particular markets;
•changes to or reduced protection of intellectual property rights in some countries;
•reduced protection of confidential consumer information in some countries; and
•different or additional functionality requirements for our software and services.
To the extent our revenues are paid in foreign currencies, and currency exchange rates become unfavorable, we may lose some of the economic value of the revenues in U.S. dollar terms.
As we expand our international operations, more of our customers pay us in foreign currencies and we incur more of our expenses in foreign currencies. The revenues recorded and collected in a foreign currency may not match the expenses paid or incurred in that same currency. Conducting business in currencies other than U.S. dollars subjects us to fluctuations in currency exchange rates. Unfavorable changes in currency exchange rates could have a negative impact on our revenues, expenses and earnings.
Our intellectual property is not protected through patents or formal copyright registration. Therefore, we do not have the full benefit of patent or copyright laws to prevent others from replicating our software.
Our intellectual property rights are not protected through patents or formal copyright registration. We may not be able to protect our trade secrets or prevent others from independently developing substantially equivalent proprietary information and techniques or from otherwise gaining access to our trade secrets. In addition, foreign intellectual property laws may not adequately protect our intellectual property rights. Moreover, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringements. Litigation of this nature could result in substantial expense for us and diversion of management and other resources, which could result in a loss of revenue and profits.
We may be sued by third parties for alleged infringement of their proprietary rights.
The software and internet industries are characterized by the existence of a large number of patents, trademarks, and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. We have received in the past, and may receive in the future, communications from third parties claiming that we have infringed on the intellectual property rights of others. Our technologies may not be able to withstand any third party claims or rights against their use. Any intellectual property claims, with or without merit, could be time-consuming and expensive to resolve, could divert management attention from executing our business plan, and could require us to pay monetary damages or enter into royalty or licensing agreements. In addition, certain customer agreements require us to indemnify our customers for third-party intellectual property infringement claims, which would increase the cost to us of an adverse ruling on such a claim. An
adverse determination could also prevent us from offering our service to others, which could result in a loss of revenues and profits.
Compliance with changing regulation of financial reporting, corporate governance and public disclosure may result in additional expenses and diversion of management time and attention from operational activities.
Compliance with changing laws, regulations and standards relating to financial reporting, corporate governance and public disclosure, including new accounting standards, SEC regulations, and The NASDAQ Stock Market and FINRA (Financial Industry Regulatory Authority) rules, are time consuming and expensive. We have spent substantial amounts of management time and have incurred substantial legal and accounting expense in the past complying with these federal securities laws. Complying with these laws and regulations also creates uncertainty for companies such as ours. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity. As a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.
Future government legislation or changes in court rules could adversely affect one or more of our business segments.
Our products and services are not directly regulated by the government. Each of our three reporting segments and the customers served by those businesses are, however, directly or indirectly affected by federal and state laws and regulations and court rules. For example, bankruptcy reform legislation, class action and tort reform legislation and amendments to the Federal Rules of Civil Procedure regarding discovery of "electronically stored information" have all affected our customers, and indirectly, our business segments. Future federal or state legislation or court rules, or court interpretations of those laws and rules, could adversely affect the businesses we serve and thus could have an adverse impact on our revenues and results of operations.
Goodwill comprises a significant portion of our total assets. We assess goodwill for impairment at least annually, which could result in a material, non-cash write-down and could have a material adverse effect on our results of operations and financial condition.
The carrying value of our goodwill was approximately $264.2 million, or approximately 60% of our total assets, as of December 31, 2009. We assess goodwill for impairment on an annual basis at a reporting unit level. Goodwill is assessed between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Our impairment reviews require extensive use of accounting judgment and financial estimates. Application of alternative assumptions and definitions, such as reviewing goodwill for impairment at a different organization level, could produce significantly different results. We may be required to recognize impairment of goodwill based on future economic factors such as unfavorable changes in our stock price and market capitalization or unfavorable changes in the estimated future discounted cash flows of our reporting units. Impairment of goodwill could result in material charges that could, in the future, result in a material, non-cash write-down of goodwill, which could have a material adverse effect on our results of operations and financial condition. As of July 31, 2009, which is the date of our most recent impairment test, the fair value of the bankruptcy trustee management reporting unit had approximately $75.2 million of goodwill allocated to it, and the fair value of this reporting unit exceeded its carrying value by approximately 32%; the fair value of each of our other reporting units was substantially in excess of the carrying value of the reporting unit.
The continuing uncertainty in national and global economic conditions could negatively affect our business, results of operations and financial condition.
The recent financial crisis affecting the banking system and financial markets and the continuing uncertainty in national and global economic conditions resulted in a tightening in the credit markets, a low level of liquidity in many financial markets and extreme volatility in credit, equity and fixed income markets. It is difficult to estimate the exact impact of the economic crisis on our business, but we believe that it adversely affected our electronic discovery segment in 2009, while generally benefitting our bankruptcy segment. There could still be a number of unforeseen or unidentified follow-on effects from these economic developments on our business and our customers. National economic risks that we have considered in our planning processes in the past 12 months include risks associated with the inability or unwillingness of our credit banks to fund draws on our revolving credit facility, our inability to increase or renew our current revolving credit facility, failure of our customers to pay us on a timely basis or at all, and delays in business and litigation-related expenditures by our customers. If the global economy or the U.S. economy remains uncertain or weakens further, the consequences could have an adverse effect on our business, operating results and financial condition.
Our quarterly results have fluctuated in the past and may fluctuate in the future. If they do, our operating results may not meet the expectations of securities analysts or investors. This could cause fluctuations in the market price of our common stock.
Our quarterly results have fluctuated in the past and may fluctuate in the future. Our quarterly revenues and operating results can be difficult to forecast. Our business will continue to be affected by a number of factors, any one of which could substantially affect our results of operations for a particular fiscal quarter. Specifically, our quarterly results from operations can vary due to:
•the initiation or termination of a large engagement;
•the timing, size, cancellation or rescheduling of customer orders;
•fluctuations in short-term interest rates or bankruptcy trustees' deposit balances;
•unanticipated expenses related to software maintenance or customer service; and
•unexpected legal or regulatory expenses.
It is possible that our future quarterly results from operations from time to time will not meet the expectations of securities analysts or investors. This could cause a material decrease in the market price of our common stock.
The market price of our common stock may be volatile even if our quarterly results do not fluctuate significantly.
Even if we report stable or increased earnings, the market price of our common stock may be volatile. There are a number of factors, beyond earnings fluctuations, that can affect the market price of our common stock, including the following:
•a decrease in market demand for our stock;
•downward revisions in securities analysts' estimates;
•announcements of technological innovations or new products developed by us or our competitors;
•legal proceedings;
•the degree of customer acceptance of new products or enhancements offered by us; and
•general market conditions and other economic factors.
In addition, the stock market has experienced significant price and volume fluctuations that have often been unrelated to the operating performance of particular companies. The market price of our common stock has been volatile and this is likely to continue.
We historically have not paid cash dividends on our common stock and our common stock may not appreciate in value or even maintain the price at which it was purchased.
We historically have not paid cash dividends on our common stock. In addition, certain terms of our contingent convertible subordinated notes restrict our payment of dividends while the notes are outstanding, and certain provisions in our credit facility may restrict our ability to pay dividends in the future. The convertible notes mature in June 2010. Subject to any financial covenants in current or future financing agreements that directly or indirectly restrict the payment of dividends, the payment of dividends is within the discretion of our board of directors and will depend upon our future earnings and cash flow from operations, our capital requirements, our financial condition and any other factors that the board of directors may consider. Unless we pay cash dividends on our common stock in the future, the success of an investment in our common stock will depend entirely upon its future appreciation. Our common stock may not appreciate in value or even maintain the price at which it was purchased.
The use of our common stock to fund acquisitions or to refinance debt incurred for acquisitions could dilute existing shares.
We have used our common stock to fund, in part, acquisitions and to refinance debt incurred in connection with acquisitions. During November 2007, we issued 5.0 million shares of common stock and used approximately $74.0 million of the net proceeds to pay debt outstanding under our credit facility. During November 2005, we issued approximately 1.8 million shares of common stock in connection with an electronic discovery business acquisition. During June 2004, we issued $50.0 million of convertible notes, which are convertible at the option of the note holders on or before June 15, 2010, into approximately 4.3 million shares of common stock based upon a conversion price of $11.67 per share, to refinance a portion of the purchase price for an acquisition.
We may consider further opportunities to acquire companies, assets or product lines that complement or expand our business. We expect that future acquisitions, if any, could provide for consideration to be paid in cash, shares of our common stock, or a combination of cash and shares. If the consideration for an acquisition is paid in common stock, existing shareholders' investments could be diluted. Furthermore, we may decide to issue convertible debt or additional shares of common stock and use part or all of the proceeds to finance or refinance the costs of any future acquisitions.
Our articles of incorporation and Missouri law contain provisions that could be used by us to discourage or prevent a takeover of our company.
Some provisions of our articles of incorporation could make it more difficult for a third party to acquire control of our company, even if the change of control would be beneficial to certain shareholders. For example, our articles of incorporation include "blank check" preferred stock provisions, which permit our board of directors to issue one or more series of preferred stock without shareholder approval. In conjunction with the issuance of a series of preferred stock, the board is authorized to fix the rights of that series, including voting rights, liquidation preferences, conversion rights and redemption privileges. The board could issue a series of preferred stock to a friendly investor and use one or more of these features of the preferred stock to discourage or prevent a takeover of the company. Additionally, our articles of incorporation do not permit cumulative voting in the election of directors. Cumulative voting, if available, would enable minority shareholders to elect one or more representatives to the board in certain circumstances, which could be used by third parties to facilitate a takeover of our company that was opposed by our board or management.
In addition, the General and Business Corporation Law of Missouri, under which we are incorporated, provides that any merger involving the company must be approved by the holders of not less than two-thirds of the outstanding shares of capital stock entitled to vote on the merger. Presently, our only outstanding voting securities are our shares of common stock. Accordingly, shareholders with voting power over as little as one-third of our outstanding common stock could block a merger proposal, even if that merger proposal were supported by our board of directors or shareholders holding a majority of our then outstanding shares of common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Our corporate headquarters are located in a 49,000-square-foot facility in Kansas City, Kansas. This owned property serves as collateral under our credit facility. We also have significant leased offices in New York City and in metropolitan Portland, Oregon, and maintain smaller leased offices in Chicago, Miami, Washington, D.C., Los Angeles, London, Brussels, and Hong Kong.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Purported Derivative Shareholder Complaint
On July 29, 2008, the Alaska Electrical Pension Fund filed a putative shareholder derivative action in the U.S. District Court for the District of Kansas (Civil Action No. 08-CV-2344 CM/JPO), alleging that each of our current directors and certain current and former executive officers and directors engaged in misconduct regarding stock option grants.
The complaint asserts, among other things, that the company backdated certain stock options and that the individual defendants either participated in the backdating or permitted it to occur, violations of generally accepted accounting principles as a result of the alleged backdating of options, related claims of false and misleading proxy statements and annual reports filed by the company under the Securities Exchange Act of 1934, also as a result of the alleged backdating of options, and various violations of state law, breaches of fiduciary duty of loyalty and insider trading in company stock. The complaint seeks, among other things, unspecified money damages, an accounting for profits obtained from the alleged backdating of options, specified changes in our corporate governance policies, punitive damages and rescission of the allegedly backdated options.
In October 2008, the company and the individual defendants filed a motion to dismiss the plaintiff's complaint on a variety of grounds. In June 2009, the Court entered an order on defendants' motion to dismiss plaintiff's complaint. In that order, the Court: (i) barred certain of plaintiff's federal securities law claims arising before July 29, 2005, leaving only the claim for the stock option grant dated June 3, 2006; (ii) held that the statute of limitations was tolled on those federal securities law claims; (iii) barred plaintiff's other federal securities law claims arising before December 9, 2003; (iv) declined to rule at that time on defendants' motions to dismiss plaintiff's state law claims based on any statute of repose or statute of limitations; (v) dismissed plaintiff's state law claim for constructive fraud; and (vi) held that plaintiff's complaint stated federal securities law and state law claims with sufficient particularity to avoid dismissal at that stage in the proceedings. The individual defendants and the company have filed an answer denying plaintiff's claims.
The plaintiff, the individual defendants and the company are participating in mediation required by the court. In connection with this on-going mediation, the company has accrued a liability, of approximately $1.0 million at December 31, 2009 in the accompanying Consolidated Financial Statements. The ultimate resolution of this matter may materially differ from the amount recorded as of December 31, 2009 as a result of future court rulings or potential settlement. Any liability relative to this matter may be funded in part, or in whole, by the company's insurance carrier.
We believe the plaintiff's claims are without merit and have been defending against them vigorously.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is traded under the symbol "EPIQ" on the NASDAQ Global Market. The following table shows the reported high and low sales prices for our common stock for the calendar quarters of 2009 and 2008 as reported by NASDAQ.
Holders
As of February 12, 2010, there were approximately 72 owners of record of our common stock and approximately 7,000 beneficial owners of our common stock.
Dividends
We historically have not paid any cash dividends on our common stock. In addition, certain terms of our contingent convertible subordinated notes restrict our payment of dividends while the notes are outstanding, and certain provisions in our credit facility may restrict our ability to pay dividends in the future. The convertible notes mature in June 2010. Subject to any financial covenants in current or future financing agreements that directly or indirectly restrict the payment of dividends, the payment of dividends is within the discretion of our board of directors and will depend upon our future earnings and cash flow from operations, our capital requirements, our financial condition and any other factors that the board of directors may consider. There is no restriction on the ability of our subsidiaries to transfer funds to the parent company in the form of cash dividends, loans or advances.
Equity Compensation Plan Information
The following table sets forth as of December 31, 2009 (a) the number of securities to be issued upon exercise of outstanding options, warrants and rights, (b) the weighted average exercise price of outstanding options, warrants and rights and (c) the number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)).
As of December 31, 2009, equity compensation plans approved by security holders consist of our 1995 Stock Option Plan and our 2004 Equity Incentive Plan, both as amended. Securities remaining available for future issuance under equity compensation plans approved by security holders consist solely of shares available under the 2004 Equity Incentive Plan. Securities remaining available for future issuance under our 2004 Equity Incentive Plan may be issued, in any combination, as incentive stock options, non-qualified stock options, stock appreciation rights or restricted stock.
As of December 31, 2009, equity compensation plans not approved by security shareholders consist of stock options issued in conjunction with acquisitions. Inducement stock options were issued in conjunction with the execution of employment agreements with certain key employees of acquired companies to become employees of our newly acquired subsidiaries. In accordance with the NASDAQ corporate governance rules, shareholder approval was not required for these inducement stock option grants.
The stock options granted under equity compensation plans not approved by security holders were granted at option exercise prices equal to fair market value of the common stock on the date of grant, are non-qualified options, are exercisable for up to 10 years from the date of grant, and otherwise have terms substantially identical to the material terms of the 1995 Stock Option Plan and the 2004 Equity Incentive Plan. Additional information related to the equity compensation plans not approved by security holders is contained in Note 12 of the Notes to Consolidated Financial Statements.
Recent Sales of Unregistered Securities
None.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
We did not purchase any shares of our common stock during the fourth quarter of 2009.
Performance Graph
The following Performance Graphs and related information shall not be deemed "soliciting material" or to be "filed" with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such a filing.
The following graphs show the total shareholder return of an investment of $100 in cash for (i) Epiq's common stock, (ii) the NASDAQ Stock Market Computer & Data Processing Index (the "NASDAQ Computer Index"), and (iii) the Standard & Poor's 500 Total Return Index (the "S&P 500 Index") for our last five fiscal years (December 31, 2004 through December 31, 2009) and for the period beginning on the date of our initial public offering through the end of the last fiscal year (February 4, 1997 through December 31, 2009). All values assume reinvestment of the full amount of any dividends. The NASDAQ Computer Index and the S&P 500 Index are calculated by Standard & Poor's Institutional Market Services.
The five-year graph assumes that $100.00 was invested in our common stock on December 31, 2004, at the price of $9.76 per share, the closing sales price on that date. The second graph assumes that $100.00 was invested in our common stock on February 4, 1997, the date of our initial public offering, at the price of $0.93 per share, the closing sales price on that date (after giving effect to the stock splits and stock dividends paid by Epiq). The closing sales prices were used for each index on December 31, 2004 or February 4, 1997, as applicable, and all dividends were reinvested. No cash dividends have been declared on our common stock. Shareholder returns over the indicated period should not be considered indicative of future shareholder returns.
Five-Year Performance Graph
COMPARISON OF CUMULATIVE TOTAL RETURN
AMONG EPIQ SYSTEMS, INC., S&P 500 TOTAL RETURN INDEX
AND NASDAQ COMPUTER & DATA PROCESSING INDEX
ASSUMES $100 INVESTED ON DEC. 31, 2004
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING DEC. 31, 2009
Performance Graph Since Initial Public Offering
COMPARISON OF CUMULATIVE TOTAL RETURN
AMONG EPIQ SYSTEMS, INC., S&P TOTAL RETURN INDEX
AND NASDAQ COMPUTER & DATA PROCESSING INDEX
ASSUMES $100 INVESTED ON FEB. 4, 1997
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING DEC. 31, 2009
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected historical financial data for the years ended December 31, 2009, 2008, 2007, 2006, and 2005 (in thousands, except per share data).
In October 2003 we entered into a three-year arrangement related to our Chapter 7 bankruptcy trustee business that included various elements which had previously been provided on a standalone basis. As a result, for the final quarter of 2003 and for the years ended December 31, 2004 and 2005 we deferred substantially all of our Chapter 7 bankruptcy trustee revenue. The $59.7 million of revenue deferred during these periods related to this arrangement was recognized during the year ended December 31, 2006. The effect of this was to: (i) reduce revenue recognized for the years ended December 31, 2003, 2004 and 2005 with a corresponding increase in revenue recognized for the year ended December 31, 2006; and (ii) substantially decrease net income for the year ended December 31, 2003 and to incur a net loss for the years ended December 31, 2004 and 2005, with a corresponding increase in net income for the year ended December 31, 2006. Effective October 1, 2006, we entered into a new arrangement with this depository financial institution; this new arrangement does not include provisions related to software upgrades. Accordingly, we now recognize this revenue based on a contingent usage based revenue model and, during the years ended December 31, 2007, 2008 and 2009, we did not defer any bankruptcy trustee revenue or recognize any previously deferred bankruptcy trustee revenue.
In November 2007, we completed a registered offering of 5,000,000 shares of common stock and received net proceeds of approximately $78.6 million.
All per share amounts have been adjusted to reflect the 3-for-2 stock split, effected as 50% stock dividend, paid on June 7, 2007 to holders of record as of May 24, 2007.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our consolidated results of operations and financial condition should be read in conjunction with the "Cautionary Statement Concerning Forward-Looking Statements," our "Risk Factors," "Selected Financial Data," and "Financial Statements and Supplementary Data" included in this Form 10-K.
Management's Overview
Electronic Discovery Segment
Our electronic discovery segment provides collections and forensics, processing, search and review, and document review services to companies and the litigation departments of law firms. Our eDataMatrix® software analyzes, filters, deduplicates and produces documents for review. Produced documents are made available primarily through a hosted environment, and our DocuMatrix™ software allows for efficient attorney review and data requests. Our customers are typically large corporations that use our products and services cooperatively with their legal counsel to manage the electronic discovery process for litigation and regulatory matters.
The substantial amount of electronic documents and other data used by businesses has changed the dynamics of how attorneys support discovery in complex litigation matters. Due to the complexity of cases, the volume of data that are maintained electronically, and the volume of documents that are produced in all types of litigation, law firms have become increasingly reliant on electronic evidence management systems to organize and manage the litigation discovery process.
Following is a description of the significant sources of revenue in our electronic discovery business.
•Consulting, forensics and collection service fees based on the number of hours a professional services team spends providing the requested services.
•Fees related to the conversion of data into an organized, searchable electronic database. The amount we earn varies primarily on the size (number of documents) and complexity of the engagement.
•Hosting fees based on the amount of data stored.
•Document review fees based on the number of hours spent reviewing documents, the number of pages reviewed, or the amount of data reviewed.
In the first half of 2009, we opened new offices in Brussels and Hong Kong, establishing global reach for our offices and data centers in the U.S., Europe and Asia; and expanded our offerings to include data forensics and collections services, as well as document review services. In 2009 we also launched IQ Review™, a revolutionary combination of new intelligent technology and expert services which incorporates new prioritization technology into DocuMatrix™, our flagship document management platform.
Bankruptcy Segment
Bankruptcy is an integral part of the United States' economy. As reported by the Administrative Office of the U.S. Courts for the fiscal years ended September 30, 2009, 2008, and 2007, there were approximately 1.40 million, 1.04 million, and 0.80 million new bankruptcy filings, respectively. Bankruptcy filings for the twelve-month period ended September 30, 2009 increased 34% versus the twelve-month period ended September 30, 2008. During this period, Chapter 7 filings increased 45%, Chapter 11 filings increased 68%, and Chapter 13 filings increased 13%. The quarter ended
September 30, 2009 represented the highest quarterly filing period since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was enacted.
Our bankruptcy business provides solutions that address the needs of Chapter 7, Chapter 11, and Chapter 13 bankruptcy trustees to administer bankruptcy proceedings and of debtor corporations that file a plan of reorganization.
•Chapter 7 is a liquidation bankruptcy for individuals or businesses that, as measured by the number of new cases filed in the twelve-month period ended September 30, 2009, accounted for approximately 71% of all bankruptcy filings. In a Chapter 7 case, the debtor's assets are liquidated and the resulting cash proceeds are used by the Chapter 7 bankruptcy trustee to pay creditors. Chapter 7 cases typically last several years.
•Chapter 11 is a reorganization model of bankruptcy for corporations that, as measured by the number of new cases filed in the twelve-month period ended September 30, 2009, accounted for approximately 1% of all bankruptcy filings. Chapter 11 generally allows a company, often referred to as the debtor-in-possession, to continue operating under a plan of reorganization to restructure its business and to modify payment terms of both secured and unsecured obligations. Chapter 11 cases generally last several years.
•Chapter 13 is a reorganization model of bankruptcy for individuals that, as measured by the number of new cases filed in the twelve-month period ended September 30, 2009, accounted for approximately 28% of all bankruptcy filings. In a Chapter 13 case, debtors make periodic cash payments into a reorganization plan and a Chapter 13 bankruptcy trustee uses these cash payments to make monthly distributions to creditors. Chapter 13 cases typically last between three and five years.
The application of Chapter 7 bankruptcy regulations has the practical effect of discouraging trustee customers from incurring direct administrative costs for computer system expenses. As a result, we provide our Chapter 7 products and services to our trustee customers at no direct charge, and they maintain deposit accounts for bankruptcy cases under their administration at a designated banking institution. We have arrangements with various banks under which we provide the bankruptcy trustee case management software and related services and the bank provides the bankruptcy trustee with deposit-related banking services. During the year ended December 31, 2009 and 2008, a majority of our Chapter 7 trustee clients' deposits were maintained at Bank of America. See Note 9 of the Notes to Consolidated Financial Statements for additional information on this significant customer.
Chapter 11 bankruptcy engagements are generally long-term, multi-year assignments that provide revenue visibility into future periods. For the Chapter 7 trustee services component of the bankruptcy segment, the increase in filings is expected to translate into growth in client deposit balances related to asset liquidations. Our trustee services deposit portfolio reached $2.0 billion during the fourth quarter of 2009, while pricing was at floor pricing levels under our agreements due to the low short-term interest rate environment.
The key participants in a bankruptcy proceeding include the debtor-in-possession, the debtor's legal counsel, the creditors, the creditors' legal counsel, and the bankruptcy judge. Chapter 7 and Chapter 13 cases also include a professional bankruptcy trustee, who is responsible for administering the bankruptcy case. The end-user customers of our bankruptcy solutions are debtor corporations that file a plan of reorganization and professional bankruptcy trustees. The Executive Office for United States Trustees, a division of the U.S. Department of Justice, appoints all bankruptcy trustees. A United States Trustee is appointed in most federal court districts and generally has responsibility for overseeing the integrity of the bankruptcy system. The bankruptcy trustee's primary responsibilities include liquidating the debtor's assets or collecting funds from the debtor, distributing the collected funds to creditors pursuant to the orders of the bankruptcy court and preparing regular status reports
for the Executive Office for United States Trustees and for the bankruptcy court. Trustees manage an entire caseload of bankruptcy cases simultaneously.
Following is a description of the significant sources of revenue in our bankruptcy business.
•Data hosting fees and volume-based fees.
•Case management professional service fees and other support service fees related to the administration of cases, including data conversion, claims processing, claims reconciliation, professional services, and disbursement services.
•Deposit-based fees, earned primarily on a percentage of Chapter 7 total liquidated assets placed on deposit with a designated financial institution by our trustee clients, to whom we provide, at no charge, software licenses, limited hardware and hardware maintenance, and postcontract customer support services. The fees we earn based on total liquidated assets placed on deposit by our trustee clients may vary based on fluctuations in short-term interest rates.
•Legal noticing services to parties of interest in bankruptcy matters, including direct notification and media campaign and advertising management in which we coordinate notification, primarily through print media outlets, to potential parties of interest for a particular client engagement.
•Reimbursement for costs incurred, primarily related to postage on mailing services.
Settlement Administration Segment
Our settlement administration segment provides managed services, including legal notification, claims administration, project administration and controlled disbursement.
The customers of our settlement administration segment are corporations that are administering the settlement or resolution of class action cases or administering projects. We sell our services directly to those customers and other interested parties, including legal counsel, which often provide access to these customers. During the years ended December 31, 2009, 2008 and 2007 approximately 12% and 22%, and less than 1%, respectively, of our consolidated revenue was derived from a large contract with IBM in support of the federal government's analog to digital conversion program. This revenue was recognized in our settlement administration segment. The contract began in the fourth quarter of 2007, and, as expected, wound-down in 2009.
Following is a description of the significant sources of revenue in our settlement administration business.
•Fees contingent upon the month-to-month delivery of case management services such as claims processing, claims reconciliation, project management, professional services, call center support, and controlled disbursements. The amount we earn varies primarily on the size and complexity of the engagement.
•Legal noticing services to parties of interest in class action matters; including media campaign and advertising management, in which we coordinate notification through various media outlets such as print, radio and television, to potential parties of interest for a particular client engagement.
•Reimbursement for costs incurred related to postage on mailing services.
Key participants in this marketplace include law firms that specialize in representing class action and mass tort plaintiffs and other law firms that specialize in representing defendants. Class action and mass tort refer to litigation in which class representatives bring a lawsuit against a defendant company or other persons on behalf of a large group of similarly affected persons. Mass tort refers to class
action cases that are particularly large or prominent. Class action and mass tort litigation is often complex and the cases, including administration of any settlement, may last several years.
Results of Operations for the Year Ended December 31, 2009 Compared with the Year Ended December 31, 2008
Consolidated Results of Operations
Revenue
Total revenue was $239.1 million in 2009, an increase of $3.0 million, or 1%, as compared to $236.1 million in the prior year. A portion of our total revenue consists of reimbursement for direct costs we incur, such as postage related to document management services. We reflect the operating revenue from these reimbursed direct costs as a separate line item on our accompanying Consolidated Statements of Income. Revenue originating from reimbursed direct costs was $30.5 million, an increase of $2.2 million, or 8%, from $28.3 million in the prior year. This increase corresponded to the increase in reimbursed direct costs. Although reimbursed operating revenue may fluctuate significantly from period to period, these fluctuations have a minimal effect on our income from operations as we realize little or no margin from this revenue.
Operating revenue exclusive of revenue originating from reimbursed direct costs, which we refer to as operating revenue before reimbursed direct costs, was $208.5 million in 2009, an increase of $0.6 million as compared to $207.9 million in the prior year. The increase consisted of a $31.2 million increase in the bankruptcy segment, offset by a $28.2 million decrease in the settlement administration segment, and a $2.3 million decrease in the electronic discovery segment. Changes by segment are discussed below.
Operating Expenses
The direct cost of services, exclusive of depreciation and amortization, was $71.9 million in 2009, a decrease of $10.0 million, or 12%, as compared to $81.9 million in the prior year. Contributing to this decrease was a $9.8 million decrease in the cost of outside services, primarily related to telephone, mailing and temporary help services, and a $5.6 million decrease in legal noticing. These declines were partially offset by $4.8 million increase in compensation related expense, and a $0.9 million increase in software maintenance costs. Changes by segment are discussed below.
The direct cost of bundled products and services, exclusive of depreciation and amortization, was $3.5 million in 2009, a decrease of $0.1 million, or 3%, compared to $3.6 million in the prior year. Changes by segment are discussed below.
Reimbursed direct costs increased in 2009 to $30.2 million compared to $28.1 million in the prior year. This increase corresponded to the increase in revenue originating from reimbursed direct costs. Changes by segment are discussed below.
General and administrative costs increased $7.3 million, or 10%, to $78.4 million in 2009 compared to $71.1 million in the prior year. Contributing to this increase was a $6.1 million increase in share-based compensation expense, which was the result of the timing of when certain awards were granted. There were no share-based awards granted to executive management in fiscal year 2008, and awards pertaining to both 2008 and 2009 were granted in fiscal year 2009. Expense related to cash based incentive awards to executive management in 2009 was $0.2 million compared to $2.4 million in the prior year. Compensation, commission and benefits expense increased $0.8 million, primarily resulting from expanded staffing to meet client demands; data line and telephone expense increased $0.8 million, due primarily to data center expansion; expense related to outside services increased $0.6 million; and $0.5 million of expense in 2009 related to a litigation settlement reserve. Partially offsetting these increases were a $1.2 million decrease in professional fees, due primarily to a decline in legal fees; and
a $0.7 million decrease in travel expense, related to expense management measures in 2009. Changes by segment are discussed below.
Depreciation and software and leasehold amortization costs in 2009 were $18.8 million, an increase of $2.5 million, or 15%, compared to $16.3 in the prior year. This increase was primarily the result of increased software amortization expense and increased hardware depreciation largely related to investment in our electronic discovery segment.
Amortization of identifiable intangible assets in 2009 was $7.4 million, a decrease of $1.7 million, or 18%, compared to $9.1 million in the prior year. This decrease was primarily the result of certain non-compete and customer contract intangible assets that were fully amortized during the year.
Other operating expense in 2009 of $0.6 million increased $0.4 million, compared to $0.2 million in the prior year. Expense in 2009 is primarily comprised of acquisition-related expense, and in 2008, other operating expense was comprised of $2.1 million of expense related to potential acquisitions and non-capitalized acquisition related expenses, and a $2.4 million gain related to interest rate floor options purchased during 2007 and recognized in 2008.
Interest Expense, Net
Interest expense was $1.5 million, compared to $1.8 million in the prior year, a decrease of $0.3 million, or 16%. Contributing to the decline was a $0.1 million decrease in loan fee amortization and a $0.1 million decrease in other interest expense.
During April 2007, the holders of the contingent convertible subordinated notes exercised their right to extend the maturity of the convertible notes from June 2007 to June 2010. As a result, we will continue to pay interest, at a rate of 4% per annum, during the extension period on any convertible notes that remain outstanding. The holders of the convertible notes may chose at any time on or prior to June 15, 2010 to convert some or all of the notes into our common shares. See Note 5 of the Notes to Consolidated Financial Statements for additional information regarding this conversion right.
We estimated the fair value of the option to extend immediately prior to the note holders' vote to extend and recorded a final adjustment to the fair value of the option to extend the subordinated convertible notes' maturity. We are currently amortizing the exercise date fair value of the option as a reduction to interest expense over the term of the extension. During both 2009 and 2008 we recognized a reduction to interest expense of approximately $1.6 million related to the amortization of the carrying value of the option to extend the maturity term subsequent to the extension date.
Effective Tax Rate
Our effective tax rate for 2009 was 45.7% compared with an effective rate of 43.2% for the prior year. The increase compared to the prior year was primarily related to non-deductible equity compensation in 2009 for which a comparable expense did not exist in the prior year and approximately $0.9 million of additional state income taxes, offset by $0.9 million of both research credits and benefits related to the domestic production activities deduction. State taxes, non-deductible equity compensation and foreign losses on which we have recorded valuation allowances were the primary reasons our tax rate was higher than the statutory federal rate of 35%. We have significant operations located in New York City that are subject to state and local tax rates that are higher than the tax rates assessed by other jurisdictions where we operate.
Although our income tax returns for 2006 and later are generally subject to exam, it is reasonably possible that we will recognize approximately $0.5 million of previously unrecognized tax benefits as a result of anticipated lapses in the statute of limitations within twelve months of our reporting date. If recognized, the $0.5 million of tax benefits would affect the effective tax rate.
Net Income
We had net income of $14.6 million for 2009 compared to $13.8 million for the prior year, an increase of $0.8 million, or 5%. Strong growth in our bankruptcy segment, driven primarily by an increase in corporate restructuring engagements, was offset in part by declines in our electronic discovery segment, driven by lower revenues related to the current economic climate and lower pricing, as well as an increase in expense related to the expansion of service and geographic expansion of the business; a decline in our settlement administration segment, driven primarily by the wind down of the analog to digital conversion contract in 2009; an increase in share-based compensation expense, the result of there being no share-based awards granted to executive management in fiscal year 2008, while awards pertaining to both 2008 and 2009 were granted in fiscal year 2009; a decline in cash based incentive awards granted to executive management in 2009 compared to the prior year; a decline in other operating income due to the gain on the interest rate floor options recognized in the prior year; and an increase in our 2009 effective tax rate, resulting in higher tax expense, due to the items mentioned above.
Results of Operations by Segment
The following segment discussion is presented on a basis consistent with our segment disclosure contained in Note 14 of our Notes to Consolidated Financial Statements.
Electronic Discovery Segment
Electronic discovery operating revenue before reimbursed direct costs in 2009 was $55.8 million, a decrease of $2.3 million, or 4%, compared to $58.1 million in the prior year. The change from the prior year primarily related to a slower pace in the start-up of litigation matters in 2009, as well as industry pricing pressures, the impact of which was an approximate 16% decline in the average price of services, both of which can be attributed to the current economic climate. While we believe the national financial, banking and economic crisis that began in the fourth quarter of 2008 and that continued in 2009 had a direct effect on the volume of electronic discovery in litigation and regulatory proceedings in 2009, we cannot quantify the impact in 2009 or predict the extent to which continuing economic and financial concerns will affect our electronic discovery business in 2010.
Electronic discovery direct and administrative expenses, including reimbursed direct costs, were $37.7 million in 2009, an increase of $5.7 million, or 18%, compared to $32.0 million in the prior year. This increase was due to a $2.8 million increase in compensation related expense, a $1.1 million increase in building and equipment lease expense and utility expense; a $1.0 million increase in outside services; and a $0.9 million increase in software maintenance costs. The increases in expense were primarily related to the expansion of service offerings and geographic expansion, including certain costs related to data center expansion.
Bankruptcy Segment
Bankruptcy operating revenue before reimbursed direct costs was $91.0 million in 2009, an increase of $31.2 million, or 52%, compared to $59.8 million in the prior year. This increase was primarily attributable to an increase in corporate restructuring engagements, which is the direct result of an increase in Chapter 11 bankruptcy filings. Corporate restructuring engagements are generally long-term, multi-year assignments. This has provided us with a strong inventory of cases in the early stages of administration.
The increase in revenue related to corporate restructuring engagements was slightly offset by a decline in Chapter 7 bankruptcy trustee fees. The Chapter 7 fees reflect year-end deposit portfolio increasing 27% in 2009 compared to 2008, and the impact of lower pricing, resulting from short-term
interest rates lowering our pricing formulas to floor levels. Short-term interest rates began declining in the fourth quarter of 2008 and continued to decline in 2009.
Bankruptcy direct and administrative expenses, including reimbursed direct costs, were $54.2 million in 2009, an increase of $20.1 million, or 59%, compared to $34.1 million in the prior year. The increases in these costs were directly related to the increase in corporate restructuring engagements, as we have expanded our capacity to support increased volumes. Compensation related expense increased $6.7 million, expense related to outside services increased $4.4 million, call center expense increased $1.9 million, legal notification costs increased $0.7 million, and building and equipment lease expense increased $0.3 million. Also contributing to the increase in costs was an increase in reimbursed direct costs of $5.7 million, which directly corresponded to the increase in revenue originating from reimbursed direct costs.
Settlement Administration
Settlement administration operating revenue before reimbursed direct costs was $61.7 million in 2009, a decrease of $28.2 million, or 31%, compared to $89.9 million in the prior year, primarily due to the planned wind down of the major analog to digital conversion contract during 2009, which declined $21.0 million from the prior year, as well as a decrease in legal notification and settlement revenue of $7.7 million.
Settlement administration direct and administrative expenses, including reimbursed direct costs, were $65.2 million in 2009, a decrease of $28.0 million, or 30%, compared to $93.2 million in the prior year, primarily due to the planned wind down of the major analog to digital conversion contract during 2009, which resulted in a $17.8 million decrease in costs from the prior year; as well as a decrease of $9.3 million in legal noticing, outside services and production supplies expenses from the prior year.
Results of Operations for the Year Ended December 31, 2008 Compared with the Year Ended December 31, 2007
Consolidated Results of Operations
Revenue
Total revenue was $236.1 million in 2008, an increase of $61.7 million, or 35%, as compared to $174.4 million in the prior year. A portion of our total revenue consists of reimbursement for direct costs we incur, such as postage related to document management services. We reflect the operating revenue from these reimbursed direct costs as a separate line item on our accompanying Consolidated Statements of Income. Revenue originating from reimbursed direct costs was $28.3 million, an increase of $5.5 million, or 24%, from $22.8 million in the prior year. This increase directly corresponded to the increase in reimbursed direct costs. Although reimbursed operating revenue may fluctuate significantly from period to period, these fluctuations have a minimal effect on our income from operations as we realize little or no margin from this revenue.
Operating revenue exclusive of revenue originating from reimbursed direct costs, which we refer to as operating revenue before reimbursed direct costs, was $207.9 million in 2008, an increase of $56.3 million, or 37%, as compared to the prior year. The increase consists of a $9.1 million increase in the electronic discovery segment and a $47.6 million increase in the settlement administration segment, partially offset by a $0.5 million decrease in the bankruptcy segment. Changes by segment are discussed below.
Operating Expenses
Direct cost of services, exclusive of depreciation and amortization, was $81.9 million in 2008, an increase of $40.4 million, or 98%, as compared to $41.5 million in the prior year. Contributing to this
increase was a $26.2 million increase in the cost of outside services, primarily related to telephone, mailing and temporary help services; a $5.3 million increase in legal noticing; a $1.8 million increase in compensation related expense; and a $4.9 million increase in production supplies. Changes by segment are discussed below.
Direct cost of bundled products and services, exclusive of depreciation and amortization, was $3.6 million in 2008, a decrease of $0.1 million, or 2%, compared to $3.7 million in the prior year. Changes by segment are discussed below.
Reimbursed direct costs increased in 2008 to $28.1 million compared to $22.6 million in the prior year. This increase directly corresponded to the increase in revenue originating from reimbursed direct costs. Changes by segment are discussed below.
General and administrative costs increased $8.6 million, or 14%, to $71.1 million in 2008 compared to $62.5 million in the prior year. Contributing to this increase was a $4.9 million increase in compensation, commission and benefits expense, primarily resulting from expanded staffing to meet client demands; a $1.5 million increase in travel expense; a $1.9 million increase in professional services; and a $1.4 million increase in bad debt expense. These increases were partially offset by a decrease of $2.8 million in share-based compensation expense which was the result of the timing of when certain awards were granted. There were no share-based awards granted to executive management in fiscal year 2008. Changes by segment are discussed below.
Depreciation and software and leasehold amortization costs in 2008 were $16.3 million, an increase of $3.5 million, or 28%, compared to the prior year. This increase was primarily the result of increased software amortization expense and increased hardware depreciation largely related to investment in our electronic discovery segment.
Amortization of identifiable intangible assets in 2008 was $9.1 million, a decrease of $0.5 million, or 5%, compared to the prior year. This decrease was primarily the result of certain customer contracts and trade names that became fully amortized during the year, partially offset by an increase in non-compete amortization resulting from our second quarter acquisition of an electronic discovery business in the United Kingdom.
Other operating expense of $0.2 million in 2008 primarily consists of $0.9 million of non-capitalized acquisition-related expenses related to the acquisition of an electronic discovery business in the United Kingdom in the second quarter of 2008, as well as $1.2 million of expenses incurred throughout 2008 related to potential acquisitions that were not completed. The acquisition-related expenses consisted of legal services, executive compensation, indirect and general costs, accounting services, and valuation services. Partially offsetting these expenses is a $2.4 million gain in 2008 related to interest rate floor options purchased during 2007.
Interest Expense, Net
Interest expense was $1.8 million, compared to $12.0 million in the prior year, a decrease of $10.2 million, or 85%. Contributing to the decline was a $6.3 million decrease in interest expense related to our credit facility, a $3.2 million decrease in expense related to the value of our subordinated convertible note holders' option to extend the maturity of the subordinated convertible notes from June 15, 2007 to June 15, 2010, and a $0.6 million decrease in loan fee amortization.
The $6.3 million decrease in credit facility interest expense resulted from our repayment and termination of the credit facility term loan and the repayment in full of the credit facility revolving loan during 2007 from the proceeds of a common stock offering in November 2007. The $0.6 million decrease in loan fee amortization expense was primarily the result of the completion of the amortization of fees related to the contingent convertible subordinated debt and the credit facility term loan during 2007.
During April 2007, the holders of the contingent convertible subordinated notes exercised their right to extend the maturity of the convertible notes from June 2007 to June 2010. As a result, we will continue to pay interest, at a rate of 4% per annum, during the extension period on any convertible notes that remain outstanding. The holders of the convertible notes may chose at any time to convert some or all of the notes into our common shares. See Note 5 of the Notes to Consolidated Financial Statements for additional information regarding this conversion right.
We estimated the fair value of the option to extend immediately prior to the note holders' vote to extend and recorded a final adjustment to the fair value of the option to extend the subordinated convertible notes' maturity. We are currently amortizing the exercise date fair value of the option as a reduction to interest expense over the term of the extension. During 2008 we recognized a reduction to interest expense of approximately $1.6 million related to the amortization of the carrying value of the option to extend the maturity term subsequent to the extension date.
Effective Tax Rate
Our effective tax rate was 43.2% for 2008 compared with an effective rate of 37.0% for the prior year. Our tax rate is generally higher than the statutory federal rate primarily due to state and local taxes. Several of our subsidiaries operate in New York City and are subject to state and local tax rates which are higher than the tax rates assessed by other jurisdictions where we operate. The increase in the effective tax rate compared with the prior year is primarily due to a larger proportion of our income being taxed in high tax rate jurisdictions and the reversal of a valuation allowance related to our United Kingdom net operating loss carryforward in 2007. During the fourth quarter of 2007, we determined that it was more likely than not that the United Kingdom net operating loss would be fully utilized within the carryforward period. Accordingly, we reversed the valuation allowance related to the remaining net operating loss carryforward asset resulting in a lower effective tax rate in 2007.
Net Income
We had net income of $13.8 million for 2008 compared to $6.9 million for the prior year, an increase of $6.9 million, or 100%. Growth in our settlement administration segment, resulting from a large contract in support of the federal government's analog to digital conversion program; as well as the decline in net interest expense, contributed to the increase in net income. These increases were offset in part by the bankruptcy segment, which declined as a result of reduced short-term interest rates throughout 2008, combined with lower bankruptcy deposits.
Results of Operations by Segment
The following segment discussion is presented on a basis consistent with our segment disclosure contained in Note 14 of our Notes to Consolidated Financial Statements.
Electronic Discovery Segment
Electronic discovery operating revenue before reimbursed direct costs in 2008 was $58.1 million, an increase of $9.1 million, or 18%, compared to the prior year. This increase is attributable to additional projects from existing clients, as well as an expansion of our client base, which resulted in an increase in hosting and processing revenue.
Electronic discovery direct and administrative expenses, including reimbursed direct costs, were $32.0 million in 2008, an increase of $7.2 million, or 29%, compared to the prior year. Factors contributing to this increase include a $4.0 million increase in compensation, commission and benefits expense, resulting from expanded staffing to support increased operating revenue; a $0.2 million increase in bad debt expense; a $0.4 million increase in promotional expense; a $0.2 million increase in professional services; a $0.4 million increase in purchased software; a $0.7 million increase in building
and equipment lease expense, primarily related to data center expansion; and an $0.8 million increase in maintenance expense.
Bankruptcy Segment
Bankruptcy operating revenue before reimbursed direct costs was $59.8 million in 2008, a decrease of $0.5 million, or 1%, compared to the prior year. This slight decrease was the result of an $8.6 million decline in our bankruptcy trustee fees; offset in part by an $8.2 million increase in bankruptcy restructuring engagements.
Bankruptcy direct and administrative expenses, including reimbursed direct costs, were $34.1 million in 2008, an increase of $4.2 million, or 14%, compared to the prior year. This increase was primarily the result of a $0.3 million increase in compensation, commission and benefits expense, primarily due to increased headcount; a $1.3 million increase in bad debt expense, resulting from several clients moving from Chapter 11 to Chapter 7 bankruptcy and additional accruals; and a $1.9 million increase in outside services expense, resulting from several large noticing engagements.
Settlement Administration
Settlement administration operating revenue before reimbursed direct costs was $89.9 million in 2008, an increase of $47.6 million, or 113%, compared to the prior year. This increase was due to a $38.3 million increase in call center and direct mailing revenue, primarily related to the large contract in support of the analog to digital conversion program; a $5.5 million increase in legal notification revenue, resulting from several large class action cases; and an $8.8 million increase in professional services. These increases were partially offset by a $3.4 million decrease in transaction processing revenue.
Settlement administration direct and administrative expenses, including reimbursed direct costs, were $93.2 million in 2008, an increase of $41.9 million, or 82%, compared to the prior year. This increase is primarily the result of a $29.2 million increase in call center, outside service, and mailing supplies costs to support the large contract referenced above. Also contributing to the increase was a $5.3 million increase in the cost of legal noticing that is directly related to the increase in legal notification revenue; and a $5.3 million increase in reimbursable expenses, which is offset directly by an increase in operating revenue from reimbursable costs. Additional staffing requirements to meet client demands resulted in a $1.1 million increase in compensation, commissions and benefits, and a $0.6 million increase in outside services.
Liquidity and Capital Resources
Cash Flows
Fiscal year 2009
Operating Activities
During the year ended December 31, 2009, our operating activities provided net cash of $51.8 million. Contributing to net cash provided by operating activities was net income of $14.6 million; and non-cash expenses, such as depreciation and amortization, bad debt expense and share-based compensation expense, of $36.7 million. The changes in operating assets and liabilities primarily consisted of a $3.5 million decrease in trade accounts receivable and other assets, offset by a decrease of $1.3 million in accounts payable and other liabilities, and a $1.6 million decrease in deferred revenue. Trade accounts receivable will fluctuate from period to period depending on the timing of sales and collections. Accounts payable will fluctuate from period to period depending on the timing of purchases and payments.
Investing Activities
During the year ended December 31, 2009, we used cash of approximately $10.3 million for purchases of property and equipment, including computer hardware, purchased software licenses primarily for our electronic discovery business, and purchased computer hardware primarily for our bankruptcy trustee business. Enhancements to our existing software and the development of new software is essential to our continued growth, and, during 2009, we used cash of $7.6 million to fund internal costs related to the development of software for which technological feasibility had been established. Our property, equipment and third-party software purchases consisted primarily of computer-related hardware, purchased software, and leasehold improvements. We believe that cash generated from operations will be adequate to fund our anticipated property, equipment and software spending over the next year.
Financing Activities
During the year ended December 31, 2009, we used cash to pay approximately $6.1 million as a principal reduction on our deferred acquisition notes and capital lease payments, and $1.8 million to acquire treasury stock related to shares used to satisfy tax withholding upon the vesting of restricted stock awards. This financing use of cash was partially offset by $2.9 million of net proceeds from stock issued in connection with the exercise of employee stock options. We also recognized a portion of the tax benefit related to the exercise of stock options as a financing source of cash.
As of December 31, 2009 and 2008, our borrowings consisted of $50.7 million and $52.3 million, respectively, including the fair value of the embedded option, of contingent convertible subordinated notes, which bear interest at 4% based on the $49.9 million and $50.0 million, respectively, of principal amount outstanding; and approximately $8.1 million and $8.9 million, respectively, of obligations related to capital leases and deferred acquisition price payments. During 2007, the term of our contingent convertible subordinated notes was extended to June 15, 2010. The holders of the contingent convertible subordinated notes have the right to convert at a price of approximately $11.67 per share. The notes will require the use of $49.9 million of cash at the extended maturity date of June 15, 2010 if the remaining note holders do not convert their notes into shares of our common stock. We will use a combination of cash on hand and our revolving credit facility, if necessary, to fund the payment of these notes if the remaining notes are not converted prior to maturity. For any of the notes that are converted into shares of our common stock prior to the scheduled maturity there will be no cash requirements associated with those converted notes, other than the regular payment of interest earned
prior to the conversion date. One holder of the notes converted a nominal principal amount of the notes into shares of common stock in 2009.
As of December 31, 2009 and December 31, 2008, we did not have any borrowings outstanding under our $100.0 million senior revolving loan. During the term of the credit facility, we have the right, subject to compliance with our covenants, to increase the senior revolving loan to $175.0 million. Interest on the credit facility is generally based on a spread, not to exceed 325 basis points over the LIBOR rate. As of December 31, 2009, significant financial covenants, all as defined within our credit facility agreement, include a leverage ratio not to exceed 3.00 to 1.00, a fixed charge coverage ratio of not less than 1.25 to 1.00, and a current ratio of not less than 1.50 to 1.00. As of December 31, 2009 and December 31, 2008, we were in compliance with all financial covenants.
Covenants contained in our credit facility and in our contingent convertible subordinated notes include limitations on acquisitions, should we pursue acquisitions in the future. Pursuant to the terms of our credit facility, we generally cannot incur indebtedness outside the credit facility, with the exceptions of capital leases and subordinated debt, with a limit of $100.0 million of aggregate subordinated debt. Furthermore, for any acquisition we must be able to demonstrate that, on a pro forma basis, we would be in compliance with our covenants during the four quarters prior to the acquisition and bank permission must be obtained for an acquisition for which cash consideration exceeds $80.0 million or total consideration exceeds $125.0 million.
We believe that funds generated from operations, plus our existing cash resources and amounts available under our credit facility, will be sufficient over the next 12 months, and for the foreseeable future thereafter, to finance currently anticipated working capital requirements, internal software development expenditures, property, equipment and third party software expenditures, deferred acquisition price agreements and capital leases, interest payments due on our outstanding borrowings, payments on any of the convertible notes that are not converted prior to maturity, and payments for other contractual obligations.
Fiscal year 2008
Operating Activities
During the year ended December 31, 2008, our operating activities provided net cash of $34.2 million. Contributing to net cash provided by operating activities was net income of $13.8 million and non-cash expenses, such a depreciation and amortization and share-based compensation expense, of $30.5 million. These items were partially offset by a $10.1 million net use of cash resulting from changes in operating assets and liabilities. The most significant change in operating assets and liabilities was a $16.9 million increase in trade accounts receivable, related to a large settlement administration customer and several matters in the bankruptcy segment. Trade accounts receivable will also fluctuate from period to period depending on the timing of sales and collections. Partially offsetting this increase in accounts receivable was an increase in accounts payable and other liabilities of $4.6 million. Accounts payable will fluctuate from period to period depending on timing of purchases and payments.
Investing Activities
During the year ended December 31, 2008, we used cash of approximately $14.5 million for purchases of property and equipment, including computer hardware, purchased software licenses for our electronic discovery business, and purchased computer hardware for our bankruptcy trustee business. Enhancements to our existing software and the development of new software is essential to our continued growth, and, during 2008, we used cash of $6.6 million to fund internal costs related to the development of software for which technological feasibility had been established. We also used cash of $4.8 million to fund the acquisition of an electronic discovery business located in the United Kingdom. Our property, equipment and third-party software purchases consisted primarily of
computer-related hardware, purchased software, and leasehold improvements to support the expansion of our electronic discovery business.
Financing Activities
During the year ended December 31, 2008, we used cash to pay approximately $4.0 million as a principal reduction on our deferred acquisition notes and capital lease payments, and $0.8 million in closing costs as part of our amended credit facility. This financing use of cash was partially offset by $2.5 million of net proceeds from stock issued in connection with the exercise of employee stock options. We also recognized a portion of the tax benefit related to the exercise of stock options as a financing source of cash.
Off-balance Sheet Arrangements
Although we generally do not utilize off-balance sheet arrangements in our operations, we enter into operating leases in the normal course of business. Our operating lease obligations are disclosed below under "Contractual Obligations" and also in Note 6 of the Notes to Consolidated Financial Statements.
Contractual Obligations
As of December 31, 2009, we did not have any borrowings outstanding under our $100.0 million senior revolving loan. To determine the amount that we may borrow, the $100.0 million available under the revolving loan is reduced by $1.8 million in outstanding letters of credit.
The following table sets forth a summary of our contractual obligations and commitments, excluding periodic interest payments for capital lease obligations, as of December 31, 2009.
(1)Approximately $5.3 million of unrecognized tax benefits are not included in this contractual obligations table due to the uncertainty related to the timing of any payments. Settlement of such amounts would require the utilization of working capital.
(2)Convertible debt is included at stated value of the principal redemption and is net of the carrying value of the embedded option, which will not be paid in cash. The holders of the contingent convertible subordinated notes have the right to convert at a price of approximately $11.67 per share. Any conversion to our common stock of part or all of the convertible debt will reduce our cash obligation related to the convertible debt. A portion of the purchase price for acquisitions was paid in the form of non-interest bearing notes or below market rate notes, which were discounted using an appropriate imputed rate. The discounts are accreted over the life of the note and each period's accretion is added to the principal of the respective note. The amount in the above contractual obligation table includes both the notes' principal, as reflected on our December 31, 2009 consolidated balance sheet, and all future accretion.
(3)Represents payments on fixed interest debt and assumes all contingent convertible subordinate notes are held to the extended maturity date.
(4)In conjunction with acquisitions, we have entered into employment agreements with certain key employees of the acquired companies.
Critical Accounting Policies
We consider our accounting policies related to revenue recognition, share-based compensation, business combinations, goodwill, identifiable intangible assets, income taxes and derivative financial instruments to be critical policies in understanding our historical and future performance.
Revenue Recognition
We have agreements with clients pursuant to which we deliver various services each month.
Following is a description of significant sources of our revenue:
•Fees contingent upon the month-to-month delivery of case management services defined by client contracts, such as claims processing, claims reconciliation, professional services, call center support, disbursement services, project management, collection and forensic services, document review services, and conversion of data into an organized, searchable electronic database. The amount we earn varies based primarily on the size and complexity of the engagement.
•Hosting fees based on the amount of data stored.
•Deposit-based fees, earned primarily based on a percentage of Chapter 7 total liquidated assets placed on deposit with a designated financial institution by our trustee clients, to whom we provide, at no charge, software licenses, limited hardware and hardware maintenance, and postcontract customer support services. The fees we earn are based on total liquidated assets placed on deposit by our trustee clients and may vary based on fluctuations in short-term interest rates.
•Legal noticing services to parties of interest in bankruptcy and class action matters, including direct notification, media campaign, and advertising management in which we coordinate notification through various media outlets, such as print, radio and television, to potential parties of interest for a particular client engagement.
•Reimbursement for costs incurred, primarily related to postage on mailing services.
Non-Software Arrangements
Services related to electronic discovery and settlement administration are billed based on volume. For these contractual arrangements, we have identified each deliverable service element. Based on our evaluation of each element, we have determined that each element delivered has standalone value to our customers because we or other vendors sell such services separately from any other services/deliverables. We have also obtained objective and reliable evidence of the fair value of each element based either on the price we charge when we sell an element on a standalone basis or based on third-party evidence of fair value of such similar services. Lastly, our arrangements do not include general rights of return. Accordingly, each of the service elements in our multiple element case and document management arrangements qualifies as a separate unit of accounting. We allocate revenue to the various units of accounting in our arrangements based on the fair value of each unit of accounting, which is generally consistent with the stated prices in our arrangements. As we have evidence of an arrangement, revenue for each separate unit of accounting is recognized each period. Revenue is recognized as the services are rendered, our fee becomes fixed and determinable, and collectability is
reasonably assured. Payments received in advance of satisfaction of the related revenue recognition criteria are recognized as a customer deposit until all revenue recognition criteria have been satisfied.
Software Arrangements
For our Chapter 7 bankruptcy trustee arrangements, we provide our trustee clients with a software license, hardware lease, hardware maintenance, and postcontract customer support services, all at no charge to the trustee. The trustees place their liquidated estate deposits with a financial institution with which we have an arrangement. We earn contingent monthly fees from the financial institutions based on the dollar level of average monthly deposits held by the trustees with that financial institution related to the software license, hardware lease, hardware maintenance, and postcontract customer support services. Since we have not established vendor specific objective evidence ("VSOE") of the fair value of the software license, we do not recognize any revenue on delivery of the software. The software element is deferred and included with the remaining undelivered elements, which are postcontract customer support services. This revenue, when recognized, is included as a component of "Case management services revenue". Revenue related to postcontract customer support is entirely contingent on the placement of liquidated estate deposits by the trustee with the financial institution. Accordingly, we recognize this contingent usage based revenue as the fee becomes fixed or determinable at the time actual usage occurs and collectibility is probable. This occurs monthly as a result of the computation, billing and collection of monthly deposit fees contractually agreed to. At that time, we have also satisfied the other revenue recognition criteria since we have persuasive evidence that an arrangement exists, services have been rendered, the price is fixed and determinable, and collectability is reasonably assured.
We also provide our trustee clients with certain hardware, such as desktop computers, monitors, and printers; and hardware maintenance. We retain ownership of all hardware provided and we account for this hardware as a lease. As the hardware maintenance arrangement is an executory contract similar to an operating lease, we use guidance related to contingent rentals in operating lease arrangements for hardware maintenance as well as for the hardware lease. Since the payments under all of our arrangements are contingent upon the level of trustee deposits and the delivery of upgrades and other services, and there remain important uncertainties regarding the amount of unreimbursable costs yet to be incurred by us, we account for the hardware lease as an operating lease. Therefore, all lease payments, based on the estimated fair value of hardware provided, were accounted for as contingent rentals; which requires that we recognize rental income when the changes in the factor on which the contingent lease payment is based actually occur. This occurs at the end of each period as we achieve our target when deposits are held at the depository financial institution as, at that time, evidence of an arrangement exists, delivery has occurred, the amount has become fixed and determinable, and collection is reasonably assured. This revenue, which is less than ten percent of our total revenue for the years ended December 31, 2009, 2008 and 2007, is included in the Consolidated Statements of Income as a component of "Case management services" revenue.
Reimbursements
We have revenue related to the reimbursement of certain costs, primarily postage. Reimbursed postage and other reimbursable direct costs are recorded gross in the Consolidated Statements of Income as "Operating revenue from reimbursed direct costs" and as "Reimbursed direct costs", respectively.
Share-based compensation
We measure compensation cost for share-based awards at fair value and recognize the expense as compensation expense over the service period for awards expected to vest. To date, the share-based compensation awards we have issued are stock option and nonvested share awards (also referred to as
restricted stock awards). We are required to estimate the share-based awards that we ultimately expect to vest and to reduce share-based compensation expense for the effects of estimated forfeitures of awards over the expense recognition period. Although we estimate forfeitures based on historical experience, actual forfeitures in the future may differ. In addition, to the extent our actual forfeitures are different than our estimates, we record a true-up for the difference in the period that the awards vest, and such true-ups could affect our operating results.
We estimate the fair value of employee stock options using a Black-Scholes valuation model. The fair value of an award is affected by our stock price on the date of grant, as well as other assumptions including the expected volatility of our stock price over the term of the awards, the estimated period of time that we expect the stock options will be held, the expected risk-free interest rate, and the expected dividend rate.
We estimate our expected volatility based on implied volatilities from traded share options on our stock and on our stock's historical volatility based on daily stock prices. We have estimated the expected term of our share options based on the historical exercise pattern of groups of employees that have similar historical exercise behavior. The expected risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant. Historically, we have not paid dividends; accordingly, our expected dividend rate is zero.
The fair value of nonvested share awards is determined based on the number of shares granted and the quoted price of our common stock.
We record deferred tax assets for share-based awards that potentially result in deductions on our income tax returns. We estimate the deferred tax asset based on the amount of share-based compensation recognized and the statutory tax rate in the jurisdictions in which we will receive a tax deduction. Because the deferred tax asset we record is based upon the share-based compensation expense in a particular jurisdiction, the aforementioned inputs that affect the fair value of our stock awards also indirectly affect our income tax expense. In addition, differences between the deferred tax assets recognized for financial reporting purposes and the actual tax deduction reported on our income tax returns are recorded in additional paid-in capital. If the tax deduction is less than the deferred tax asset, such shortfalls reduce our pool of excess tax benefits. If the pool of excess tax benefits is reduced to zero, then subsequent shortfalls would increase our income tax expense.
Recognition of share-based compensation expense has had, and will likely continue to have, a material effect on our"Direct cost of services" and "General and administrative" line items within our Consolidated Statements of Income, and also may have a material effect on our"Deferred income taxes" and "Additional paid-in capital" line items within our Consolidated Balance Sheets. For additional information see Note 12 of the Notes to the Consolidated Financial Statements.
Business combination accounting
We have acquired a number of businesses in the past, and we may acquire additional businesses in the future. Business combination accounting requires us to determine the fair value of all assets acquired, including identifiable intangible assets, and liabilities assumed. The cost of the acquisition is allocated to the assets acquired and liabilities assumed in amounts equal to the estimated fair value of each asset and liability, and any remaining acquisition cost is classified as goodwill. This allocation process requires extensive use of estimates and assumptions, including quoted market prices and estimates of future cash flows to be generated by the acquired assets. Acquisition-related costs for potential and completed acquisitions are expensed, as incurred, and are included in "Other operating expense (income)" in our Consolidated Statements of Income.
Certain identifiable intangible assets, such as customer lists and covenants not to compete, are amortized based on the pattern in which the economic benefits of the intangible assets are consumed
over the intangible asset's estimated economic benefit period, generally from five to ten years. Goodwill is not amortized. Accordingly, the acquisition cost allocation has had, and will continue to have, a significant impact on our current operating results.
Goodwill
Goodwill consists of the excess of cost of acquired enterprises over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed. We assess goodwill for impairment on an annual basis at a reporting unit level. A reporting unit is a component of a segment that constitutes a business, for which discrete financial information is available, and for which the operating results are regularly reviewed by management. We have determined that our reporting units are bankruptcy trustee management, corporate restructuring, electronic discovery, and settlement administration. Goodwill is assessed between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, a change in strategic direction, legal factors, operating performance indicators, a change in the competitive environment, the sale or disposition of a significant portion of a reporting unit, or future economic factors such as unfavorable changes in our stock price and market capitalization or unfavorable changes in the estimated future discounted cash flows of our reporting units. Our annual test is performed as of July 31 each year.
Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. We considered both a market approach and an income approach in order to develop an estimate of the fair value of each reporting unit for purposes of our annual impairment test. When evaluating the market approach, we determined that directly comparable publicly-traded companies did not exist, primarily due to the unique business model characteristics and projected growth of each reporting unit. Instead, we utilized a discounted projected future cash flow analysis (income approach) to determine the fair value of each reporting unit. Potential impairment is indicated when the carrying value of a reporting unit, including goodwill, exceeds its estimated fair value. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. In addition, financial and credit market volatility directly impacts our fair value measurement through our weighted average cost of capital, used to determine our discount rate, and through our stock price, used to determine our market capitalization. We may be required to recognize impairment of goodwill based on future economic factors such as unfavorable changes in our stock price and market capitalization or unfavorable changes in the estimated future discounted cash flows of our reporting units.
If we determine that the estimated fair value of any reporting unit is less than the reporting unit's carrying value, then we proceed to the second step of the goodwill impairment analysis to measure the potential impairment charge. An impairment loss is recognized for any excess of the carrying value of the reporting unit's goodwill over the implied fair value. If goodwill on our consolidated balance sheet becomes impaired during a future period, the resulting impairment charge could have a material impact on our results of operations and financial condition.
Our recognized goodwill totaled $264.2 million as of December 31, 2009. As of July 31, 2009, which is the date of our most recent impairment test, the fair value of each of our reporting units was substantially in excess of the carrying value of the reporting unit, except for the bankruptcy trustee management reporting unit. The bankruptcy trustee management reporting unit had approximately
$75.2 million of goodwill allocated to it and the fair value of this reporting unit exceeded its carrying value by approximately 32%.
Identifiable intangible assets
Each year we evaluate whether events and circumstances warrant a revision to the remaining estimated useful life of each identifiable intangible asset. All of our identifiable intangible assets have finite lives. If we were to determine that events and circumstances warrant a change to the estimate of an identifiable intangible asset's remaining useful life, then the remaining carrying amount of the identifiable intangible asset would be amortized prospectively over that revised remaining useful life. Additionally, information resulting from our annual assessment, or other events and circumstances, may indicate that the carrying value of one or more identifiable intangible assets is not recoverable which would result in recognition of an impairment charge.
A change in the estimate of the remaining life of one or more identifiable intangible assets or the impairment of one or more identifiable intangible assets could have a material impact on our results of operations and financial condition. Our identifiable intangible assets' carrying value, net of amortization, was $19.5 million as of December 31, 2009.
Income Taxes
A deferred tax asset or liability is recognized for the anticipated future tax consequences of temporary differences between the tax basis of assets or liabilities and their reported amounts in the financial statements and for operating loss and tax credit carryforwards. A valuation allowance is provided when, in the opinion of management, it is more likely than not that some portion or all of a deferred tax asset will not be realized. Realization of the deferred tax assets is dependent on our ability to generate sufficient future taxable income and, if necessary, execution of our tax planning strategies. In the event we determine that sufficient future taxable income, taking into consideration tax planning strategies, may not generate sufficient taxable income to fully realize net deferred tax assets, we may be required to establish or increase valuation allowances by a charge to income tax expense in the period such a determination is made. This charge may have a material impact on recognized income tax expense on our Consolidated Statements of Income. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The recognition of a change in enacted tax rates may have a material impact on recognized income tax expense and on our Consolidated Statements of Income.
We follow accounting guidance which prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Under this guidance, tax positions are initially recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. Application of this guidance requires numerous estimates based on available information. We consider many factors when evaluating and estimating our tax positions and tax benefits, and our recognized tax positions and tax benefits may not accurately anticipate actual outcomes. As we obtain additional information, we may need to periodically adjust our recognized tax positions and tax benefits. These periodic adjustments may have a material impact on our Consolidated Statements of Income. The cumulative effect of applying the provisions of this new guidance was reported as an adjustment to the opening balance of retained earnings as of January 1, 2007. The cumulative effect adjustment does not include items that would not be recognized in earnings, such as the effect on tax positions related to business combinations. For
additional information related to uncertain tax positions see Note 10 of the Notes to the Consolidated Financial Statements.
Derivative financial instruments
In August of 2007, in order to limit our economic exposure to market fluctuations in interest rates, we purchased one month LIBOR based interest rate floor options with a total notional amount of $800 million and initial contractual maturity of three years. We recorded this derivative instrument in our Consolidated Balance Sheet at fair value. As the interest rate floor options were not designated as an accounting hedge, changes in the fair value of the derivatives were recorded each period in current earnings. For the year ended December 31, 2007, the change in the fair value of the interest rate floor options was recognized as an unrealized gain of $1.1 million and was included as a component of other operating income on the accompanying Consolidated Statements of Income. During February 2008, we sold the interest rate floor options and realized a $3.5 million gain. The $2.4 million difference between the realized gain of $3.5 million and the previously recognized gain of $1.1 million is included as a component of other operating income on the accompanying Consolidated Statements of Income. As of December 31, 2009 and 2008, we did not hold any interest rate floor options, other derivatives, or auction rate securities.
Recently Adopted Accounting Pronouncements
In December 2007, new guidance was issued for the recognition and measurement of assets, liabilities and equity in business combinations. This guidance was effective for us as of January 1, 2009. Due to these new guidelines, we now expense, as incurred, acquisition-related costs for potential and completed acquisitions. Acquisition-related costs expensed in 2009 were approximately $0.7 million and are included in "Other operating expense (income)" in our Consolidated Statements of Income. This guidance also requires the recognition of changes in an acquirer's income tax valuation allowance on deferred taxes and acquired tax contingencies associated with acquisitions that closed prior to the effective date to be expensed. This new guidance will primarily apply to all future acquisitions.
In December 2007, new guidance was issued that changed the way in which noncontrolling interests in subsidiaries are measured and classified on the balance sheet. These provisions were effective for us as of January 1, 2009. The adoption of these new guidelines had no impact on our consolidated financial position or results of operations.
In March 2008, new guidance was issued that changed the disclosure requirements for derivative instruments and hedging activities. This guidance was effective for us as of January 1, 2009. The adoption of these new guidelines had no impact on our consolidated financial position or results of operations. Disclosures required by this guidance are included in Note 15 to the Consolidated Financial Statements.
In April 2008, new guidance was issued on determining the useful life of a recognized intangible asset. These provisions were effective for us as of January 1, 2009 and had no impact on our consolidated financial position or results of operations as we did not renew or extend the useful lives of any of our intangible assets.
In June 2008, new guidance was issued that clarified that share-based payment awards that entitle their holders to receive non-forfeitable dividends or dividend equivalents before vesting should be considered participating securities, and requires them to be included in the computation of earnings per share pursuant to the two-class method. This guidance was effective for us as of January 1, 2009 with the requirement that all prior period income per share data presented to be adjusted retroactively. We have determined that nonvested share awards that were granted in the first quarter of 2009 are participating securities as defined by this guidance because they have equivalent common stock dividend rights. Accordingly, we have included these shares in our basic and diluted share calculations
as appropriate. There is no prior period impact of this guidance as there were no participating securities outstanding prior to the first quarter of 2009. Details of the income per share calculation are described in Note 11.
In June 2008, the Financial Accounting Standards Board ("FASB") ratified the consensus reached by the Emerging Issues Task Force ("EITF") on three issues discussed at its June 12, 2008 meeting pertaining to how an entity should evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument's contingent exercise and settlement provisions; how the currency in which the strike price of an equity-linked financial instrument (or embedded feature) is denominated affects the determination of whether the instrument is indexed to an entity's own stock; and how the issuer should account for market-based employee stock option valuation. This guidance was effective for us January 1, 2009 and did not have an impact on our consolidated financial position.
In April 2009, new guidance was issued that addressed application issues raised by preparers, auditors, and members of the legal profession on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. This guidance was effective for us for any business combinations completed on or after January 1, 2009. This guidance has not had an impact on our consolidated financial position as we have not completed any business combinations since the date of adoption.
In April 2009, new guidance was issued that required disclosure about the fair value of financial instruments in interim as well as in annual financial statements. These standards were effective for periods ending after June 15, 2009. The disclosures required by this guidance are included in Note 9 to the Consolidated Financial Statements.
In May 2009, new guidance was issued that established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. This guidance was effective for reporting periods ending after June 15, 2009. The disclosures required by this guidance are included in Note 1.
In June 2009, new guidance was issued that identified the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States, commonly referred to as the Accounting Standards Codification. This guidance was effective for periods ending after September 15, 2009, and the appropriate references to accounting guidance have been incorporated into this Form 10-K.
Recently Issued Accounting Pronouncements Not Yet Adopted
In October 2009, the FASB issued new standards for revenue recognition with multiple deliverables. These new standards require entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. These new standards are effective for us beginning in the first quarter of fiscal year 2011, however early adoption is permitted. We are currently evaluating both the timing and the impact of the pending adoption of these standards on our consolidated financial statements.
In October 2009, the FASB issued new standards for the accounting for certain revenue arrangements that include software elements. These new standards amend the scope of pre-existing software revenue guidance by removing from the guidance non-software components of tangible products and certain software components of tangible products. These new standards are effective for
us beginning in the first quarter of fiscal year 2011, however early adoption is permitted. We are currently evaluating both the timing and the impact of the pending adoption of these standards on our consolidated financial statements.
In January 2010, the FASB issued updated guidance that require entities to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. In addition, the update requires entities to present separately information about purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs (Level 3). The disclosures related to Level 1 and Level 2 fair value measurements are effective for us in 2010 and the disclosures related to Level 3 fair value measurements are effective for us in 2011. The update requires new disclosures only, and will have no impact on our consolidated financial position, results of operations, or cash flows.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The principal market risks to which we are exposed include interest rates under our senior revolving credit facility, foreign exchange rates giving rise to translation, and fluctuations in short-term interest rates on a portion of our bankruptcy trustee revenue.
Interest Rate Risk
Interest on our senior revolving credit facility is generally based on a spread, not to exceed 325 basis points over the LIBOR rate. There were no amounts due under our senior revolving credit facility as of December 31, 2009 or 2008, thereby we had no market risk exposure.
As of December 31, 2007, we had market risk exposure to interest rates as we held interest rate floor options with a notional value of $800 million. During February 2008, we sold the interest rate floor options and realized a $3.5 million gain, thereby eliminating our market risk exposure related to these instruments. At December 31, 2009 and 2008, we did not hold any interest rate floor options or other derivatives.
Foreign Currency Risk
We have operations in the United Kingdom, Brussels and Hong Kong; therefore, a portion of our revenues and expenses are incurred in a currency other than U.S. dollars. We do not utilize hedge instruments to manage the exposures associated with fluctuating currency exchange rates. Our operating results are exposed to changes in exchange rates between the U.S. dollar and the appropriate functional currency. When the U.S. dollar weakens against foreign currencies, the dollar value of revenues and expenses denominated in foreign currencies increases. When the U.S. dollar strengthens, the opposite situation occurs.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our Consolidated Financial Statements appear following Item 15 of this Report.
Supplementary Data-Quarterly Financial Information (Unaudited)
The following table sets forth the quarterly financial data for the quarters of the years ended December 31, 2009 and 2008 (in thousands, except per share data):
(1)Gross profit is calculated as total revenue less direct cost of services, direct cost of bundled products and services, reimbursed direct costs, and the portion of depreciation and software amortization attributable to direct costs of services.
(2)The sum of the quarters' net income per share may not equal the total of the respective year's net income per share as each quarter is calculated independently.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. Based on their evaluation as of December 31, 2009, the end of the period covered by this Annual Report on Form 10-K, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level to ensure that the information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, including this Annual Report, were recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and was accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
Management's Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
•Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company;
•Provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
•Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
In connection with the filing of our Annual Report on Form 10-K, our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2009. In making this assessment, our management used the criteria set forth by Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based on our assessment using those criteria, management believes that, as of December 31, 2009, our internal control over financial reporting is effective based on those criteria.
The effectiveness of our internal control over financial reporting as of December 31, 2009 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which appears beginning on page 43.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal controls over financial reporting during the quarter ended December 31, 2009, that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Epiq Systems, Inc.
Kansas City, Kansas
We have audited the internal control over financial reporting of Epiq Systems, Inc. and subsidiaries (the "Company") as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2009 of the Company and our report dated March 1, 2010 expressed an unqualified opinion on those consolidated financial statements and financial statement schedule.
/s/ DELOITTE & TOUCHE LLP
Kansas City, Missouri
March 1, 2010
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Incorporated by reference to our Proxy Statement for our 2010 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2009.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated by reference to our Proxy Statement for our 2010 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2009.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Incorporated by reference to our Proxy Statement for our 2010 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2009.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Incorporated by reference to our Proxy Statement for our 2010 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2009.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Incorporated by reference to our Proxy Statement for our 2010 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2009.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)The following documents are filed as a part of this report:
(1)Financial Statements.
The following Consolidated Financial Statements, contained on pages through of this report, are filed as part of this report under Item 8 "Financial Statements and Supplementary Data."
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets-December 31, 2009 and 2008
Consolidated Statements of Income-Years Ended December 31, 2009, 2008 and 2007
Consolidated Statements of Changes in Stockholders' Equity and Comprehensive Income-Years Ended December 31, 2009, 2008 and 2007
Consolidated Statements of Cash Flows-Years Ended December 31, 2009, 2008 and 2007
Notes to Consolidated Financial Statements
(2)Financial Statement Schedules.
Epiq Systems, Inc. and subsidiaries for each of the years in the three-year period ended December 31, 2009.
Schedule II-Valuation and Qualifying Accounts
(3)Exhibits. Exhibits are listed on the Exhibit Index at the end of this report.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 1, 2010
EPIQ SYSTEMS, INC.
By:
/s/ TOM W. OLOFSON
Tom W. Olofson
Chairman of the Board, Chief Executive Officer and Director
In accordance with the Exchange Act this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the dates indicated.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Epiq Systems, Inc.
Kansas City, Kansas
We have audited the accompanying consolidated balance sheets of Epiq Systems, Inc. and subsidiaries (the "Company") as of December 31, 2009 and 2008, and the related consolidated statements of income, changes in stockholders' equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Epiq Systems, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for uncertainty in income taxes in 2007.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2010 expressed an unqualified opinion on the Company's internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Kansas City, Missouri
March 1, 2010
EPIQ SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands, Except Share Data)
See accompanying Notes to Consolidated Financial Statements.
EPIQ SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, Except Per Share Data)
See accompanying Notes to Consolidated Financial Statements.
EPIQ SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
(In Thousands)
(1)AOCI-Accumulated Other Comprehensive Income (Loss)
See accompanying Notes to Consolidated Financial Statements.
EPIQ SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
See accompanying Notes to Consolidated Financial Statements.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The Consolidated Financial Statements include the accounts of Epiq Systems, Inc. ("Epiq") and its wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated in consolidation.
In preparing these financial statements, we have evaluated events and transactions for potential recognition or disclosure through the date the financial statements were issued.
Nature of Operations
We are a provider of integrated technology solutions for the legal profession. Our solutions streamline the administration of bankruptcy, litigation, financial transactions and regulatory compliance matters. We offer innovative technology solutions for electronic discovery, document review, legal notification, claims administration and controlled disbursement of funds. Our clients include law firms, corporate legal departments, bankruptcy trustees and other professional advisors who require innovative technology, responsive service and deep subject-matter expertise.
Stock Split
On May 17, 2007, the board of directors approved a 3 for 2 stock split, effected in the form of a 50% stock dividend, payable June 7, 2007 to holders of record as of May 24, 2007. The total number of authorized common shares was unchanged by the split. All per share and shares outstanding data in the Consolidated Financial Statements and the accompanying notes have been revised to reflect the stock split.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and in banks and all liquid investments with original maturities of three months or less at the time of purchase.
Accounts Receivable
Accounts receivable are recorded at the invoiced amount and are non-interest bearing. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible receivables. We review accounts receivable by amounts due by customers which are past due to identify specific customers with known disputes or collectibility issues. In determining the amount of the reserve, we make judgments about the creditworthiness of significant customers based on ongoing credit evaluations.
Internally Developed Software Costs
Certain internal software development costs incurred in the creation of computer software products for sale, lease or otherwise to be marketed are capitalized once technological feasibility has been established. Capitalized costs are amortized, beginning in the period the product is available for general release, based on the ratio of current revenue to current and estimated future revenue for each product with minimum annual amortization equal to the straight-line amortization over the remaining estimated economic life of the product. Certain internal software development costs incurred in the
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
creation of computer software products for internal use are capitalized when the preliminary project phase is complete and when management, with the relevant authority, authorizes and commits funding to the project and it is probable the project will be completed and the software will be used to perform the function intended. Capitalized costs are amortized, beginning in the period each module or component of the product is ready for its intended use, on a straight-line basis over the estimated economic life of the product.
Goodwill and Identifiable Intangible Assets
Goodwill consists of the excess of cost of acquired enterprises over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed. We assess goodwill for impairment on an annual basis at a reporting unit level. A reporting unit is a component of a segment that constitutes a business, for which discrete financial information is available, and for which the operating results are regularly reviewed by management. We have determined that our reporting units are bankruptcy trustee management, corporate restructuring, electronic discovery, and settlement administration. Goodwill is assessed between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, a change in strategic direction, legal factors, operating performance indicators, a change in the competitive environment, the sale or disposition of a significant portion of a reporting unit, or future economic factors such as unfavorable changes in our stock price and market capitalization or unfavorable changes in the estimated discounted cash flows of our reporting units. Our annual test is performed as of July 31 each year.
Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. We considered both a market approach and an income approach in order to develop an estimate of the fair value of each reporting unit for purposes of our annual impairment test. When evaluating the market approach, we determined that directly comparable publicly-traded companies did not exist, primarily due to the unique business model characteristics and projected growth of each reporting unit. Instead, we utilized a discounted projected future cash flow analysis (income approach) to determine the fair value of each reporting unit. Potential impairment is indicated when the carrying value of a reporting unit, including goodwill, exceeds its estimated fair value. This analysis requires significant judgments, including estimation of cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. In addition, financial and credit market volatility directly impacts our fair value measurement through our weighted average cost of capital, used to determine our discount rate, and through our stock price, used to determine our market capitalization. We may be required to recognize impairment of goodwill based on future economic factors such as unfavorable changes in our stock price and market capitalization or unfavorable changes in the estimated future discounted cash flows of our reporting units.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
If we determine that the estimated fair value of any reporting unit is less than the reporting unit's carrying value, then we proceed to the second step of the goodwill impairment analysis to measure the potential impairment charge. An impairment loss is recognized for any excess of the carrying value of the reporting unit's goodwill over the implied fair value. If goodwill on our consolidated balance sheet becomes impaired during a future period, the resulting impairment charge could have a material impact on our results of operations and financial condition.
Our recognized goodwill totaled $264.2 million as of December 31, 2009. As of July 31, 2009, which is the date of our most recent impairment test, the fair value of each of our reporting units was substantially in excess of the carrying value of the reporting unit except for the bankruptcy trustee management reporting unit. The bankruptcy trustee management reporting unit had approximately $75.2 million of goodwill allocated to it, and the fair value of this reporting unit exceeded its carrying value by approximately 32%.
Each year we evaluate whether events and circumstances warrant a revision to the remaining estimated useful life of each identifiable intangible asset. If we were to determine that events and circumstances warrant a change to the estimate of an identifiable intangible asset's remaining useful life, then the remaining carrying amount of the identifiable intangible asset would be amortized prospectively over that revised remaining useful life. Additionally, information resulting from our annual assessment, or other events and circumstances, may indicate that the carrying value of one or more identifiable intangible assets is not recoverable which would result in recognition of an impairment charge.
Identifiable intangible assets, resulting from various business acquisitions, consist primarily of customer relationships and agreements not to compete. All of our identifiable intangible assets have finite lives, and are amortized over their estimated economic benefit period, generally from five to ten years. Identifiable intangible assets are reviewed for impairment whenever events or changes in circumstances have indicated that the carrying amount of these assets might not be recoverable.
Impairment of Long-lived Assets
We reduce the carrying amounts of long-lived assets to their fair values when events or changes in circumstances indicate that the fair value of such asset is determined to be less than their carrying amounts (i.e., assets are deemed to be impaired). Fair value is typically estimated using a discounted cash flow analysis, which requires us to estimate the future cash flows anticipated to be generated by the particular asset being tested for impairment as well as to select a discount rate to measure the present value of the anticipated cash flows. When determining future cash flow estimates, we consider historical results adjusted to reflect current and anticipated operating conditions. Estimating future cash flows requires significant judgment by management in such areas as future economic conditions, industry-specific conditions, product pricing, and necessary capital expenditures. The use of different assumptions or estimates for future cash flows could produce different impairment amounts (or none at all) for long-lived assets.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Deferred Loan Fees
Incremental, third party costs related to establishing credit facilities are capitalized and amortized based on the terms of the related debt. The unamortized costs are included as a component of other long-term assets on our Consolidated Balance Sheets. Amortization costs are included as a component of interest expense on our Consolidated Statements of Income.
Share-Based Compensation
We measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize that cost over the period during which an employee is required to provide service in exchange for the award.
We have recognized compensation costs related to share-based compensation beginning in 2006. We recognize this expense on a straight-line basis over the requisite service period of the award.
Income Taxes
A deferred tax asset or liability is recognized for the anticipated future tax consequences of temporary differences between the tax basis of assets or liabilities and their reported amounts in the financial statements and for operating loss and tax credit carryforwards. A valuation allowance is provided when, in the opinion of management, it is more likely than not that some portion or all of a deferred tax asset will not be realized. Realization of the deferred tax assets is dependent on our ability to generate sufficient future taxable income and, if necessary, execution of our tax planning strategies. In the event we determine that sufficient future taxable income, taking into consideration tax planning strategies, may not generate sufficient taxable income to fully realize net deferred tax assets, we may be required to establish or increase valuation allowances by a charge to income tax expense in the period such a determination is made. This charge may have a material impact on recognized income tax expense on our Consolidated Statements of Income. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The recognition of a change in enacted tax rates may have a material impact on recognized income tax expense and on our Consolidated Statements of Income.
We follow accounting guidance which prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Under this guidance, tax positions are initially recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. Application of this guidance requires numerous estimates based on available information. We consider many factors when evaluating and estimating our tax positions and tax benefits, and our recognized tax positions and tax benefits may not accurately anticipate actual outcomes. As we obtain additional information, we may need to periodically adjust our recognized tax positions and tax benefits. These periodic adjustments may have a
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
material impact on our Consolidated Statements of Income. The cumulative effect of applying the provisions of this new guidance was reported as an adjustment to the opening balance of retained earnings as of January 1, 2007. The cumulative effect adjustment does not include items that would not be recognized in earnings, such as the effect on tax positions related to business combinations. For additional information related to uncertain tax positions see Note 10.
Revenue Recognition
We have agreements with clients pursuant to which we deliver various services each month.
Following is a description of significant sources of our revenue:
•Fees contingent upon the month-to-month delivery of case management services defined by client contracts, such as claims processing, claims reconciliation, professional services, call center support, disbursement services, project management, collection and forensic services, document review services, and conversion of data into an organized, searchable electronic database. The amount we earn varies based primarily on the size and complexity of the engagement.
•Hosting fees based on the amount of data stored.
•Deposit-based fees, earned primarily based on a percentage of Chapter 7 total liquidated assets placed on deposit with a designated financial institution by our trustee clients, to whom we provide, at no charge, software licenses, limited hardware and hardware maintenance, and postcontract customer support services. The fees we earn are based on total liquidated assets placed on deposit by our trustee clients and may vary based on fluctuations in short-term interest rates.
•Legal noticing services to parties of interest in bankruptcy and class action matters, including direct notification, media campaign, and advertising management in which we coordinate notification through various media outlets, such as print, radio and television, to potential parties of interest for a particular client engagement.
•Reimbursement for costs incurred, primarily related to postage on mailing services.
Non-Software Arrangements
Services related to electronic discovery and settlement administration are billed based on volume. For these contractual arrangements, we have identified each deliverable service element. Based on our evaluation of each element, we have determined that each element delivered has standalone value to our customers because we or other vendors sell such services separately from any other services/deliverables. We have also obtained objective and reliable evidence of the fair value of each element based either on the price we charge when we sell an element on a standalone basis or based on third-party evidence of fair value of such similar services. Lastly, our arrangements do not include general rights of return. Accordingly, each of the service elements in our multiple element case and document management arrangements qualifies as a separate unit of accounting. We allocate revenue to the various units of accounting in our arrangements based on the fair value of each unit of accounting, which is generally consistent with the stated prices in our arrangements. As we have evidence of an arrangement, revenue for each separate unit of accounting is recognized each period. Revenue is
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
recognized as the services are rendered, our fee becomes fixed and determinable, and collectability is reasonably assured. Payments received in advance of satisfaction of the related revenue recognition criteria are recognized as a customer deposit until all revenue recognition criteria have been satisfied.
Software Arrangements
For our Chapter 7 bankruptcy trustee arrangements, we provide our trustee clients with a software license, hardware lease, hardware maintenance, and postcontract customer support services, all at no charge to the trustee. The trustees place their liquidated estate deposits with a financial institution with which we have an arrangement. We earn contingent monthly fees from the financial institutions based on the dollar level of average monthly deposits held by the trustees with that financial institution related to the software license, hardware lease, hardware maintenance, and postcontract customer support services. Since we have not established vendor specific objective evidence ("VSOE") of the fair value of the software license, we do not recognize any revenue on delivery of the software. The software element is deferred and included with the remaining undelivered elements, which are postcontract customer support services. This revenue, when recognized, is included as a component of "Case management services revenue". Revenue related to postcontract customer support is entirely contingent on the placement of liquidated estate deposits by the trustee with the financial institution. Accordingly, we recognize this contingent usage based revenue as the fee becomes fixed or determinable at the time actual usage occurs and collectibility is probable. This occurs monthly as a result of the computation, billing and collection of monthly deposit fees contractually agreed to. At that time, we have also satisfied the other revenue recognition criteria since we have persuasive evidence that an arrangement exists, services have been rendered, the price is fixed and determinable, and collectability is reasonably assured.
We also provide our trustee clients with certain hardware, such as desktop computers, monitors, and printers; and hardware maintenance. We retain ownership of all hardware provided and we account for this hardware as a lease. As the hardware maintenance arrangement is an executory contract similar to an operating lease, we use guidance related to contingent rentals in operating lease arrangements for hardware maintenance as well as for the hardware lease. Since the payments under all of our arrangements are contingent upon the level of trustee deposits and the delivery of upgrades and other services, and there remain important uncertainties regarding the amount of unreimbursable costs yet to be incurred by us, we account for the hardware lease as an operating lease. Therefore, all lease payments, based on the estimated fair value of hardware provided, were accounted for as contingent rentals; which requires that we recognize rental income when the changes in the factor on which the contingent lease payment is based actually occur. This occurs at the end of each period as we achieve our target when deposits are held at the depository financial institution as, at that time, evidence of an arrangement exists, delivery has occurred, the amount has become fixed and determinable, and collection is reasonably assured. This revenue, which is less than ten percent of our total revenue for the years ended December 31, 2009, 2008 and 2007, is included in the Consolidated Statements of Income as a component of "Case management services" revenue.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Reimbursements
We have revenue related to the reimbursement of certain costs, primarily postage. Reimbursed postage and other reimbursable direct costs are recorded gross in the Consolidated Statements of Income as "Operating revenue from reimbursed direct costs" and as "Reimbursed direct costs", respectively.
Costs Related to Contract Acquisition, Origination, and Set-up
We expense contract acquisition, origination, and set-up costs as incurred.
Depreciation and Software and Leasehold Amortization
The caption "Depreciation and software and leasehold amortization" in the accompanying Consolidated Statements of Income includes costs that are directly related to services of approximately $10.6 million, $9.4 million, and $7.1 million for the years ended December 31, 2009, 2008 and 2007, respectively.
Income Per Share
Basic net income per share is computed on the basis of weighted average outstanding common shares. Diluted net income per share is computed on the basis of basic weighted average outstanding common shares adjusted for the dilutive effect of stock options and convertible debt, if dilutive. The numerator of the diluted net income per share calculation is increased by the amount of interest expense, net of tax, related to outstanding convertible debt, and the allocation of net income to nonvested shares, if the net impact is dilutive.
When calculating incremental shares related to outstanding share options, we have historically applied the treasury stock method. The treasury stock method assumes that proceeds, consisting of the amount the employee must pay on exercise, compensation cost attributed to future services and not yet recognized, and excess tax benefits, net of tax deficiencies, that would be credited to additional paid-in capital on exercise of the awards, are used to repurchase outstanding shares at the average market price for the period.
Based upon new guidance which was effective January 1, 2009, we determined that the nonvested share awards (also referred to as restricted stock awards) that were issued during the first quarter of 2009 were participating securities because they have non-forfeitable rights to dividends. Accordingly, basic net income per share is calculated under the two-class method calculation. In determining the number of diluted shares outstanding, we are required to disclose the more dilutive earnings per share result between the treasury stock method calculation and the two-class method calculation. For the year ended December 31, 2009, the two-class method calculation was more dilutive; therefore, the diluted net income per share calculation for the year ended December 31, 2009 is presented following the two-class method. There was no impact to our calculations for the years ended December 31, 2008 or 2007, as we did not have any participating securities outstanding during those periods.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Segment Information
We consider how we organize our business internally for making operating decisions and assessing business performance to determine our reportable segments.
Foreign Currency Translation
Local currencies are the functional currencies for our operating subsidiaries. Accordingly, assets and liabilities of these subsidiaries are translated at the rate of exchange at the balance sheet date. Adjustments from the translation process are part of accumulated other comprehensive income (loss) and are included as a separate component of stockholders' equity. The changes in foreign currency translation adjustments were not adjusted for income taxes since they relate to indefinite term investments in non-United States subsidiaries. Income and expense items of significant value are translated as of the date of the transactions for these subsidiaries; however, day to day operational transactions are translated at average rates of exchange. As of December 31, 2009, 2008 and 2007, cumulative translation adjustments included in accumulated other comprehensive income (loss) were ($1.8 million), ($2.7 million), and less than $0.1 million, respectively.
Fair Value Measurement
Unless otherwise specified, we believe the carrying value of financial instruments approximates their fair value.
Accounting for Contingencies
We are involved in various legal proceedings that arise from time to time in the ordinary course of business. Except for income tax contingencies, we record accruals for contingencies to the extent that we conclude their occurrence is probable and that the related liabilities are estimable. We record anticipated recoveries under existing insurance contracts when we are assured of recovery. Many factors are considered when making these assessments, including the progress of the case, opinions or views of legal counsel, prior case law, our experience or the experience of other companies with similar cases, and our intent on how to respond. Litigation and other contingencies are inherently unpredictable and excessive damage awards do occur. As such, these assessments can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the periods reported. Actual results may differ from those estimates.
Recently Adopted Accounting Pronouncements
In December 2007, new guidance was issued for the recognition and measurement of assets, liabilities and equity in business combinations. This guidance was effective for us as of January 1, 2009.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Due to these new guidelines, we now expense, as incurred, acquisition-related costs for potential and completed acquisitions. Acquisition-related costs expensed in 2009 were approximately $0.7 million and are included in "Other operating expense (income)" in our Consolidated Statements of Income. This guidance also requires the recognition of changes in an acquirer's income tax valuation allowance on deferred taxes and acquired tax contingencies associated with acquisitions that closed prior to the effective date to be expensed. This new guidance will primarily apply to all future acquisitions.
In December 2007, new guidance was issued that changed the way in which noncontrolling interests in subsidiaries are measured and classified on the balance sheet. These provisions were effective for us as of January 1, 2009. The adoption of these new guidelines had no impact on our consolidated financial position or results of operations.
In March 2008, new guidance was issued that changed the disclosure requirements for derivative instruments and hedging activities. This guidance was effective for us as of January 1, 2009. The adoption of these new guidelines had no impact on our consolidated financial position or results of operations. Disclosures required by this guidance are included in Note 15.
In April 2008, new guidance was issued on determining the useful life of a recognized intangible asset. These provisions were effective for us as of January 1, 2009 and had no impact on our consolidated financial position or results of operations as we did not renew or extend the useful lives of any of our intangible assets.
In June 2008, new guidance was issued that clarified that share-based payment awards that entitle their holders to receive non-forfeitable dividends or dividend equivalents before vesting should be considered participating securities, and requires them to be included in the computation of earnings per share pursuant to the two-class method. This guidance was effective for us as of January 1, 2009 with the requirement that all prior period income per share data presented to be adjusted retroactively. We have determined that nonvested share awards that were granted in the first quarter of 2009 are participating securities as defined by this guidance because they have equivalent common stock dividend rights. Accordingly, we have included these shares in our basic and diluted share calculations as appropriate. There is no prior period impact of this guidance as there were no participating securities outstanding prior to the first quarter of 2009. Details of the income per share calculation are described in Note 11.
In June 2008, the Financial Accounting Standards Board ("FASB") ratified the consensus reached by the Emerging Issues Task Force ("EITF") on three issues discussed at its June 12, 2008 meeting pertaining to how an entity should evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument's contingent exercise and settlement provisions; how the currency in which the strike price of an equity-linked financial instrument (or embedded feature) is denominated affects the determination of whether the instrument is indexed to an entity's own stock; and how the issuer should account for market-based employee stock option valuation. This guidance was effective for us January 1, 2009 and did not have an impact on our consolidated financial position.
In April 2009, new guidance was issued that addressed application issues raised by preparers, auditors, and members of the legal profession on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 1: NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
business combination. This guidance was effective for us for any business combinations completed on or after January 1, 2009. This guidance has not had an impact on our consolidated financial position as we have not completed any business combinations since the date of adoption.
In April 2009, new guidance was issued that required disclosure about the fair value of financial instruments in interim as well as in annual financial statements. These standards were effective for periods ending after June 15, 2009. The disclosures required by this guidance are included in Note 9.
In May 2009, new guidance was issued that established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. This guidance was effective for reporting periods ending after June 15, 2009. The disclosures required by this guidance are included in Note 1.
In June 2009, new guidance was issued that identified the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States, commonly referred to as the Accounting Standards Codification. This guidance was effective for periods ending after September 15, 2009, and the appropriate references to accounting guidance have been incorporated into these financial statements.
Recently Issued Accounting Pronouncements Not Yet Adopted
In October 2009, the FASB issued new standards for revenue recognition with multiple deliverables. These new standards require entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. These new standards are effective for us beginning in the first quarter of fiscal year 2011, however early adoption is permitted. We are currently evaluating both the timing and the impact of the pending adoption of these standards on our consolidated financial statements.
In October 2009, the FASB issued new standards for the accounting for certain revenue arrangements that include software elements. These new standards amend the scope of pre-existing software revenue guidance by removing from the guidance non-software components of tangible products and certain software components of tangible products. These new standards are effective for us beginning in the first quarter of fiscal year 2011, however early adoption is permitted. We are currently evaluating both the timing and the impact of the pending adoption of these standards on our consolidated financial statements.
In January 2010, the FASB issued updated guidance that require entities to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. In addition, the update requires entities to present separately information about purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs (Level 3). The disclosures related to Level 1 and Level 2 fair value measurements are effective for us in 2010 and the disclosures related to Level 3 fair value measurements are effective for us in 2011. The update requires new disclosures only, and will have no impact on our consolidated financial position, results of operations, or cash flows.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 2: PROPERTY AND EQUIPMENT
Property and equipment, including leasehold improvements and purchased software, are stated at cost and depreciated or amortized on a straight-line basis over the estimated useful life of each asset or, for leasehold improvements, the lesser of the lease term or useful life. The classification of property and equipment and the related estimated useful lives is as follows (in thousands):
Computer and purchased software includes property acquired under capital leases. As of December 31, 2009 and 2008, assets acquired under capital leases had a historical cost basis of $10.8 million and $5.6 million, respectively, and accumulated amortization of $4.7 million and $1.4 million, respectively.
NOTE 3: INTERNALLY DEVELOPED SOFTWARE
The following is a summary of internally developed software capitalized (in thousands):
Included in the above are capitalized software development costs for unreleased products of $5.8 million and $4.1 million at December 31, 2009 and 2008, respectively. During the years ended
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 3: INTERNALLY DEVELOPED SOFTWARE (Continued)
December 31, 2009, 2008 and 2007, we recognized amortization expense related to capitalized software development costs of $4.8 million, $5.5 million, and $4.6 million, respectively.
NOTE 4: GOODWILL AND INTANGIBLE ASSETS
The change in the carrying amount of goodwill for 2009 and 2008 was as follows (in thousands):
The net $3.2 million increase in goodwill in 2008 primarily resulted from the April 2008 acquisition of an electronic discovery business in the United Kingdom, partially offset by a reversal of FIN 48 tax liabilities, as certain federal and state tax returns were closed under the statute of limitations.
Amortizing identifiable intangible assets as of December 31, 2009 and December 31, 2008 consisted of the following (in thousands):
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 4: GOODWILL AND INTANGIBLE ASSETS (Continued)
Customer relationships and non-compete agreements both carry a weighted average life of eight years. Amortization expense for each year in the three year period ended December 31, 2009, and estimated amortization expense for each of the next five years is as follows (in thousands):
See Note 1 for further discussion of goodwill and identifiable intangible assets.
NOTE 5: LONG-TERM OBLIGATIONS
The following is a summary of long-term obligations outstanding (in thousands):
Credit Facilities
During July 2008, we amended and restated our credit facility. The amended credit facility, with KeyBank National Association as administrative agent, consists of a $100.0 million senior revolving loan. The facility matures in 2011. During the term of the credit facility, we have the right, subject to compliance with our covenants, to increase the senior revolving loan to $175.0 million. The amended credit facility is secured by liens on our real property and a significant portion of our personal property. Interest on the amended credit facility is generally based on a spread, not to exceed 325 basis points, over the LIBOR rate. There were no amounts due under the senior revolving loan as of December 31, 2009 or as of December 31, 2008. To determine the amount that we may borrow, the
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 5: LONG-TERM OBLIGATIONS (Continued)
$100.0 million available under the revolving loan is reduced by $1.8 million in outstanding letters of credit.
Our amended credit facility contains financial covenants related to earnings before interest, provision for income taxes, depreciation, amortization and other adjustments as defined in the agreements ("EBITDA") and total debt. In addition, our credit facility also contains financial covenants related to senior debt, fixed charges, and working capital. As of December 31, 2009 and 2008, we were in compliance with all financial covenants.
Contingent Convertible Subordinated Notes
During June 2004, we issued $50.0 million of contingent convertible subordinated notes ("convertible notes") with a fixed 4% per annum interest rate and an original maturity of June 15, 2007. The holders of the convertible notes had the right to extend the maturity date by up to three years. In 2007, the holders exercised this right and the maturity date of the convertible notes was extended to June 2010. If we change our capital structure (for example, through a stock dividend or stock split) while the convertible notes are outstanding, the conversion price would be adjusted on a consistent basis and, accordingly, the number of shares of common stock we would issue on conversion would be adjusted. The convertible notes are convertible into 4.3 million shares of our common stock at a price of approximately $11.67 per share, and do not contain the right to any dividends. We have the right to require that the holders of the convertible notes convert to equity if our share price exceeds $23.33 on a weighted average basis for 20 consecutive trading days.
For any of the notes that are converted into shares of our common stock prior to the scheduled maturity there will be no cash requirements associated with those converted notes, other than the regular payment of interest earned prior to the conversion date. One holder of the notes converted a nominal principal amount of the notes into shares of common stock in 2009. If the note holders do not convert the remainder of the notes into shares of our common stock by the extended maturity date of June 2010, the notes will require the use of approximately $49.9 million of cash. If the remaining notes are not converted prior to maturity, we will use a combination of cash on hand and our revolving credit facility, if necessary, to fund the payment of these notes.
The right to extend the maturity of the convertible notes was accounted for as an embedded option subject to bifurcation. The embedded option was initially valued at $1.2 million and the convertible notes balance was reduced by the same amount. During April 2007, the holders of the convertible notes exercised their right to extend and we performed a final valuation to estimate the fair value of the embedded option as of the approximate date of the extension. The estimated fair value of the embedded option at this date, included as a component of the convertible notes, was approximately $4.8 million. The $4.8 million estimated fair value of the embedded option is amortized as a credit to "Interest expense" on the Consolidated Statements of Income over the period to the extended maturity, which is June 15, 2010. The balance of this embedded option is included as a component of "Current maturities of long-term obligations" on the Consolidated Balance Sheet at December 31, 2009 and is a component of "Long-term obligations (excluding current maturities)" at December 31, 2008. During the third quarter of 2009, a nominal principal amount of the notes were converted into shares of common stock. As a result of this conversion, we recognized a nominal gain in the third quarter related to the unamortized embedded option value associated with the converted notes. The above
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 5: LONG-TERM OBLIGATIONS (Continued)
changes related to the carrying value of the convertible notes, the estimated fair value of the embedded option, and the amortization of the fair value of the embedded option do not affect our cash flow.
Capital Leases
We lease certain property and software under capital leases that expire during various years through 2014.
Deferred Acquisition Price
We have made acquisitions for which a portion of the purchase price was deferred. These deferred payments, which are either non-interest bearing or have a below market interest rate, have been discounted using an appropriate imputed interest rate. As of December 31, 2009 and 2008, the discounted value of the remaining note payments, for which the final payment is due in 2011, was approximately $2.9 million and $4.2 million, respectively, of which approximately $2.4 million and $1.5 million, respectively, was classified as a current liability in the Consolidated Balance Sheets as of December 31, 2009 and 2008, respectively.
Scheduled Principal Payments
Our long-term obligations, consisting of contingent convertible subordinated notes (including the carrying value of the embedded option), deferred acquisition price, and capitalized leases, mature as follows for years ending December 31 (in thousands):
NOTE 6: OPERATING LEASES
We have non-cancelable operating leases for office space at various locations expiring at various times through 2015. Each of the leases requires us to pay all executory costs (property taxes, maintenance and insurance). Certain of our lease agreements provide for scheduled rent increases during the lease term. Rent expense is recognized on a straight-line basis over the lease term. Landlord provided tenant improvement allowances are recorded as a liability and amortized as a reduction to rent expense. Additionally, we have non-cancelable operating leases for office equipment and automobiles expiring through 2012.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 6: OPERATING LEASES (Continued)
Future minimum lease payments during the years ending December 31 are as follows (in thousands):
Expense related to operating leases for the years ended December 31, 2009, 2008 and 2007 was approximately $8.7 million, $5.2 million, and $5.7 million, respectively; net of sublease income of $1.0 million, $1.2 million, and $0.6 million, respectively.
NOTE 7: STOCKHOLDERS' EQUITY
Under the terms of our contingent convertible subordinated notes, we are restricted from payment of cash dividends while the notes are outstanding. Thereafter, the payment of cash dividends is within the discretion of our board of directors and will depend upon various factors, including future earnings, capital requirements, financial condition, the terms of our credit facility, and other factors deemed relevant by the board of directors. There is no restriction on the ability of our subsidiaries to transfer funds to Epiq in the form of cash dividends, loans or advances.
On May 17, 2007, the board of directors approved a 3 for 2 stock split, effected in the form of a 50% stock dividend, payable June 7, 2007 to holders of record as of May 24, 2007. The total number of authorized common shares was unchanged by the split. All per share and shares outstanding data in the Consolidated Financial Statements and the accompanying Notes have been revised to reflect the stock split.
During November 2007, we issued 5,000,000 shares of common stock in connection with a registered direct offering. Net proceeds from the offering were approximately $78.6 million.
On February 8, 2008, at a Special Meeting of the Shareholders of Epiq Systems, Inc., the shareholders approved an amendment to our articles of incorporation to increase the authorized number of shares of common stock from 50,000,000 to 100,000,000.
NOTE 8: EMPLOYEE BENEFIT PLANS
Stock Purchase Plan
We have an employee stock purchase plan that allows employees to purchase shares of our common stock through payroll deduction. The purchase prices for all employee participants are based on the closing bid price on the last business day of the month.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 8: EMPLOYEE BENEFIT PLANS (Continued)
Defined Contribution Plan
We have a defined contribution 401(k) plan that covers substantially all employees. We match 60% of the first 10% of employee contributions and also have the option of making discretionary contributions. Our plan expense was approximately $1.2 million, $1.5 million, and $1.3 million for the years ended December 31, 2009, 2008, and 2007, respectively.
NOTE 9: FINANCIAL INSTRUMENTS AND CONCENTRATIONS
Fair Values of Assets and Liabilities
Fair value accounting guidance establishes a three-level fair value hierarchy based upon the assumptions (inputs) used to price assets or liabilities. The hierarchy requires us to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are listed below.
Level 1-Unadjusted quoted prices in active markets for identical assets or liabilities.
Level 2-Observable inputs other than those included in Level 1, such as quoted market prices for similar assets and liabilities in active markets or quoted prices for identical assets in inactive markets.
Level 3-Unobservable inputs reflecting our own assumptions and best estimate of what inputs market participants would use in pricing an asset or liability.
Assets
The carrying value and estimated fair value of our cash equivalents, which consist of short-term money market funds, are classified as Level 1 and are presented in the following table at December 31, 2009 and 2008. As of December 31, 2009 and 2008, the carrying value of our trade accounts receivable approximated fair value.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 9: FINANCIAL INSTRUMENTS AND CONCENTRATIONS (Continued)
Liabilities
As of December 31, 2009 and 2008, the carrying value of accounts payable, deferred acquisition price payments, capital leases, and the embedded option related to our convertible notes approximated fair value. As of both December 31, 2009 and 2008, the carrying value of convertible debt was approximately $50.0 million. The fair value of our convertible debt was estimated at $59.9 million and $71.6 million as of December 31, 2009 and 2008, respectively. This amount was estimated by taking the outstanding convertible debt, divided by the conversion price of $11.67 per share, to arrive at an estimated number of shares that would be issued assuming conversion of all of the notes. The estimated number of shares was then multiplied by the closing price of our common stock on the last day of the respective reporting period to arrive at an estimate of the fair value of our convertible debt.
Significant Customer and Concentration of Credit Risk
During the years ended December 31, 2009, 2008 and 2007, approximately 12%, 22% and 1%, respectively, of our consolidated revenue was derived from a contract with IBM in support of the national analog to digital television conversion program, which was launched in the fourth quarter of 2007. This revenue was recognized in our settlement administration segment. Accounts receivable related to this contract represented approximately 1% and 22% of our accounts receivable balance as of December 31, 2009 and 2008, respectively. The contract was substantially completed in 2009.
Revenues recognized by us from Bank of America, primarily related to our bankruptcy segment, were approximately 5%, 7% and 14% of our total revenues for the years ended December 31, 2009, 2008 and 2007, respectively. Additionally, Bank of America represented approximately 4% and 3% of our accounts receivable balance as of December 31, 2009 and 2008, respectively.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 10: INCOME TAXES
The following table presents the income from operations before income taxes and the provision for income taxes (in thousands):
A reconciliation of the provision for income taxes at the statutory rate of 35% for the year ended December 31, 2009, 35% for the year ended December 31, 2008, and 34% for the year ended December 31, 2007 to the provision for income taxes at our effective rate is shown below (in thousands):
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 10: INCOME TAXES (Continued)
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities on the accompanying Consolidated Balance Sheets are as follows (in thousands):
As of December 31, 2009, we had as filed state and local operating loss carryforwards of $4.7 million. These carryforwards expire in varying amounts in years 2021 through 2029. Management believes that it is more likely than not that we will be able to utilize these carryforwards and, therefore, no valuation allowance is necessary. The state net operating losses for which a deferred tax asset is recognized for financial reporting purposes is smaller than the as filed losses due to unrecognized tax benefits.
As of December 31, 2008, we had state and local capital loss carryforwards of $0.6 million. Prior to filing our 2008 tax return, we determined that the reported $0.6 million capital loss was an ordinary loss. This redetermination allowed us to use this loss to offset taxable income on our 2008 tax return. Therefore, the valuation allowance was reversed as the re-characterized deferred tax asset relating to the capital loss was fully utilized on our 2008 tax return.
During 2009 we recorded a $0.1 million valuation allowance relating to net operating losses generated from our Hong Kong operations. The valuation allowance offset a $0.1 million deferred tax asset associated with a $0.7 million net operating loss carryforward. The valuation allowance will be released when management believes it is more likely than not that based on the available positive and
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 10: INCOME TAXES (Continued)
negative evidence the deferred tax asset will be realizable. Hong Kong net operating losses have an unlimited carryover period.
As a result of certain realization requirements related to share-based compensation, we were unable to realize a $0.1 million excess tax benefit that arose directly from state net operating losses created by equity compensation tax deductions in excess of compensation recognized for financial reporting as of December 31, 2008. In 2009, the related state net operating losses were fully utilized and as a result, we were able to realize the excess tax benefit. Accordingly, equity increased by $0.1 million. We use tax law ordering for the purpose of determining when excess tax benefits have been realized.
The net deferred tax liability is presented on the Consolidated Balance Sheets as follows (in thousands):
U.S. income and foreign withholding taxes have not been recognized on the excess of earnings for financial reporting over the tax basis of investments in foreign subsidiaries that are essentially permanent in duration. Generally, such earnings become subject to U.S. taxation upon the remittance of dividends or a sale or liquidation of the foreign subsidiary. The amount of such excess totaled approximately $1.2 million at December 31, 2009. It is not practicable to estimate the amount of any deferred tax liability related to this amount.
As of December 31, 2009, 2008, and 2007, the gross amount of unrecognized tax benefits, including penalty and interest, was approximately $7.8 million, $6.3 million, and $5.7 million, respectively. If recognized, approximately $6.6 million, $5.7 million, and $4.2 million would have affected our effective tax rate in 2009, 2008, and 2007, respectively.
The following table summarizes the activity related to our gross unrecognized tax benefits excluding interest and penalties (in thousands):
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 10: INCOME TAXES (Continued)
We file income tax returns in the U.S. federal jurisdiction, the United Kingdom, Hong Kong, Belgium, and various state jurisdictions. We have also made an evaluation of the potential impact of assessments by state jurisdictions in which we have not filed tax returns.
In 2007 the State of New York initiated an examination of our 2003 - 2005 New York state income tax returns. During 2009, this examination was expanded to include the years 2006 and 2007. As of December 31, 2009 the examination was not concluded. It is possible that the examination will conclude in 2010 and it is reasonably possible that a change in the unrecognized tax benefits may occur within the next twelve months; however, a quantification of an estimated range cannot be made at this time.
During 2009, lapses in the statute of limitations for certain federal and state tax returns resulted in recognizing $1.0 million of net unrecognized tax benefits, of which $1.0 million reduced tax expense. For statutes closing in 2008 we recognized $1.0 million of net unrecognized tax benefits, of which $0.7 million decreased goodwill and $0.3 million reduced tax expense. For statutes closing in 2007, we recognized $0.9 million of net unrecognized tax benefits, of which $0.5 million decreased goodwill and $0.4 million reduced tax expense.
As of December 31, 2009, the 2006 - 2008 federal, state and foreign tax returns are subject to examination. In addition, the 2005 statute of limitations remains open in certain state and foreign jurisdictions. As of December 31, 2009, it is reasonably possible that approximately $0.5 million of net unrecognized tax benefits would be recognized in the following twelve months due to the closing of 2005 and 2006 years for federal and state jurisdictions, of which $0.5 million would affect our effective tax rate.
We have classified interest and penalties as a component of income tax expense. Estimated interest and penalties classified as a component of income tax expense during 2009, 2008 and 2007 totaled $0.1 million, $0.1 million and $0.2 million, respectively. Accrued interest and penalties, included as a component of "Other long-term liabilities" on the accompanying Consolidated Balance Sheets, totaled $1.0 million and $0.2 million, respectively, as of December 31, 2009. As of December 31, 2008, the accrued interest and penalties were $0.9 million and $0.2 million respectively.
NOTE 11: NET INCOME PER SHARE
Basic net income per share is computed on the basis of weighted average outstanding common shares. Diluted net income per share is computed on the basis of basic weighted average outstanding common shares adjusted for the dilutive effect of stock options and convertible debt, if dilutive. The numerator of the diluted net income per share calculation is increased by the amount of interest expense, net of tax, related to outstanding convertible debt, and the allocation of net income to nonvested shares, if the net impact is dilutive.
Based upon new guidance effective January 1, 2009, we determined that the nonvested share awards (also referred to as restricted stock awards) that were issued during the first quarter of 2009 were participating securities because they have non-forfeitable rights to dividends. Accordingly, basic net income per share is calculated under the two-class method calculation. In determining the number of diluted shares outstanding, we are required to disclose the more dilutive earnings per share result between the treasury stock method calculation and the two-class method calculation. For the year
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 11: NET INCOME PER SHARE (Continued)
ended December 31, 2009, the two-class method calculation was more dilutive; therefore, the diluted net income per share information below is presented following the two-class method. There was no impact to our prior year calculations, which were completed using the treasury stock method, as we did not have any participating securities outstanding during the prior year.
The computation of basic and diluted net income per share for the year ended December 31, 2009 is as follows (in thousands, except per share data):
(1)Net income allocated to holders of nonvested shares is calculated based upon a weighted average percentage of nonvested shares in relation to total shares outstanding.
The computation of basic and diluted net income per share for the year ended December 31, 2008 and 2007 is as follows (in thousands, except per share data):
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 11: NET INCOME PER SHARE (Continued)
For the years ended December 31, 2009, 2008 and 2007 weighted-average outstanding share options totaling approximately 2.4 million, 1.9 million and 0.4 million shares of common stock, respectively, were antidilutive and, therefore not included in the computation of diluted net income per share. For the year ended December 31, 2007, we did not assume conversion of the convertible debt as the effect would be antidilutive.
NOTE 12: SHARE-BASED COMPENSATION
Share-based compensation is measured at grant date, based on the fair value of the award, and is recognized on a straight-line basis over the requisite service period. See Note 1 for additional information.
The following table presents total share-based compensation expense, which is a non-cash charge, included in the Consolidated Statements of Income (in thousands):
Share-based compensation expense was adjusted for share options and awards that we estimate will be forfeited prior to vesting. We use historical information to estimate employee termination and the resulting forfeiture rate. As of December 31, 2009, there was $7.6 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements, which will be recognized over a weighted-average period of 3.0 years. The increase in share-based compensation expense in 2009 was the result of the timing of when certain awards were granted. There were no share-based awards granted to executive management in fiscal year 2008, and awards pertaining to both 2008 and 2009 were granted in fiscal year 2009.
The 2004 Equity Incentive Plan, as amended (the "2004 Plan") limits the combined grant of options to acquire shares of common stock, stock appreciation rights, and nonvested share (commonly referred to as restricted stock) awards stock under the 2004 Plan to 7,500,000 shares. Any grant under the 2004 Plan that expires or terminates unexercised, becomes unexercisable or is forfeited will generally be available for further grants. At December 31, 2009, there were approximately 1,212,000 shares of common stock available for future equity-related grants under the 2004 Plan.
As part of certain acquisitions and as an inducement to key employees, stock options are issued outside of the 2004 Plan from time to time. These options are granted at an option exercise price equal to fair market value of the common stock on the date of grant, are non-qualified options, are exercisable for up to 10 years from the date of grant, and generally vest 25% on the second anniversary of the grant date and continue to vest 25% per year on each anniversary of the grant date until fully
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 12: SHARE-BASED COMPENSATION (Continued)
vested. Although various forms of equity instruments may be issued, through December 31, 2009 we have only issued incentive stock options, nonqualified stock options, and nonvested share awards under this Plan.
Stock Options
Stock options are awards which allow the employee or director to purchase shares of our common stock at prices equal to the fair value at the date of grant. Stock options are issued with an exercise price equal to the grant date closing market price of our common stock. Stock options become exercisable under various vesting schedules, ranging from immediate vesting to a 7 year vesting period, and expire 10 years from the date of grant.
The estimated fair value of stock options is determined using the Black-Scholes valuation model. Key inputs and assumptions to estimate the fair value of stock options include the grant price of the award, the expected option term, the volatility of the company's stock, the risk-free interest rate, and the company's dividend yield. We estimate our expected volatility based on implied volatilities from traded share options on our stock and on our stock's historical volatility. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by individuals who receive equity awards, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the company.
The fair value of each stock option grant was estimated at the date of grant using a Black-Scholes option pricing model. The following table presents the weighted-average assumptions used and the weighted-average fair value per option granted.
We have estimated the expected term of our share options based on the historical exercise pattern of groups of employees that have similar historical exercise behavior. The expected volatility is estimated based upon implied volatilities from traded share options on our stock and on our stock's historical volatility, based on daily stock prices. The expected risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant. Historically, we have not paid dividends; accordingly our expected dividend rate is zero.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 12: SHARE-BASED COMPENSATION (Continued)
A summary of option activity during the year ended December 31, 2009 is presented below (shares and aggregate intrinsic value in thousands):
The aggregate intrinsic value was calculated using the difference between the December 31, 2009 market price and the grant price for only those awards that have a grant price that is less than the December 31, 2009 market price.
The following table summarizes information about stock options outstanding as of December 31, 2009 (in thousands, except contractual life and price data):
Exercises of Stock Options
The total intrinsic value of share options exercised during the years ended December 31, 2009, 2008 and 2007 was $2.7 million, $3.2 million and $6.7 million, respectively. During the years ended December 31, 2009, 2008 and 2007 we received cash for payment of the grant price of exercised share options of approximately $2.9 million, $2.5 million and $9.4 million, respectively, and we anticipate we will realize a tax benefit related to these exercised share options of approximately $2.7 million, $0.4 million and $1.9 million, respectively. The cash received for payment of the grant price is included as a component of cash flows from financing activities. The tax benefit related to the option exercise price in excess of the option fair value at grant date is separately disclosed as a component of cash
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 12: SHARE-BASED COMPENSATION (Continued)
flows from financing activities on the consolidated statement of cash flows, and the remainder of the tax benefit is included as a component of cash flows from operating activities.
We settle stock option exercises and nonvested share awards primarily with newly issued common shares. As a result of the repurchase of shares of common stock to satisfy tax withholdings that result from the vesting of nonvested share awards, we also may have treasury stock. Treasury stock is also used to satisfy option exercises. As of December 31, 2009 we held 56,473 shares of treasury stock. We held no treasury stock as of December 31, 2008. After our treasury shares are exhausted, we will use newly issued shares to satisfy option exercises. We do not anticipate that we will repurchase shares on the open market during the next year for the purpose of satisfying share-based compensation awards.
Nonvested Share Awards
Nonvested share awards entitle the holder to shares of common stock as the award vests. In 2009 we issued 285,000 nonvested share awards at a weighted-average grant date fair value of $14.49 per share, and with a six-month vesting period. The 285,000 awards vested in full in the third quarter of 2009 and the total fair value was $4.1 million. We measure the fair value of nonvested share awards based upon the market price of the underlying common stock as of the date of grant, and amortize the expense over the vesting period using a straight-line method. As of December 31, 2009 there were no nonvested share awards outstanding.
NOTE 13: ACQUISITIONS
Pinpoint Global Limited
On April 4, 2008, our wholly-owned subsidiary, Epiq Systems Holding B.V., acquired all of the equity of Uberdevelopments Limited and its wholly-owned operating subsidiary, Pinpoint Global Limited (collectively, "Pinpoint"), an electronic discovery business with operations in the United Kingdom. The value of the transaction was $7.1 million, consisting of $4.9 million of cash, $1.7 million of deferred payments and $0.5 million of capitalized transaction costs. Certain revenue targets were satisfied as of September 30, 2008, which required an additional payment of $0.6 million in the fourth quarter of 2008; and the accrual of an additional payment of approximately £545,000 (as of December 31, 2009 and 2008 approximately $0.9 million and $0.8 million, respectively, including interest) due in 2010. These additional payments were recorded as purchase price adjustments. If certain other revenue targets are satisfied prior to the second and third anniversary dates of the agreement, we are required to make additional payments. We have determined that it is probable that these targets will be satisfied and have began accruing a liability for total payments of approximately £400,000 (as of both December 31, 2009 and 2008 approximately $0.6 million). These amounts are recorded as compensation expense over the contingency period.
The allocation of the purchase price was as follows: $0.3 million to net assets, $1.1 million to customer contracts, $1.1 million to non-compete agreements, $0.7 million to establish a deferred tax liability related to the acquired intangible assets, and $5.3 million to goodwill. The purchase price in excess of the value of the acquired identifiable net assets reflects the strategic value we placed on Pinpoint as this acquisition facilitated the expansion of our electronic discovery business in the United Kingdom.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 13: ACQUISITIONS (Continued)
The acquisition was accounted for using the purchase method of accounting with the operating results included in the accompanying Consolidated Financial Statements from the date of acquisition. The operating results of the acquired entities are included within our electronic discovery segment. The pro forma results of the acquired entity for the period from January 1, 2008 through the date of acquisition were not material to our consolidated results of operations.
NOTE 14: SEGMENT REPORTING
We have three reporting segments: electronic discovery, bankruptcy, and settlement administration. Our electronic discovery business provides collections and forensics, processing, search and review, and document review services to companies and the litigation departments of law firms. Produced documents are made available primarily through a hosted environment, and our DocuMatrix™ software allows for efficient attorney review and data requests. Our bankruptcy business provides solutions that address the needs of trustees to administer bankruptcy proceedings and of debtor corporations that file a plan of reorganization. Our settlement administration segment provides managed services including legal notification, claims administration, project administration and controlled disbursement.
The segment performance measure is based on earnings before interest, taxes, depreciation and amortization, other operating expense (income), and share-based compensation expense. In management's evaluation of performance, certain costs, such as compensation for administrative staff and executive management, are not allocated by segment and, accordingly, the following reporting segment results do not include such unallocated costs.
Assets reported within a segment are those assets that can be identified to a segment and primarily consist of trade receivables, property, equipment and leasehold improvements, software, identifiable intangible assets and goodwill. Cash, tax-related assets, and certain prepaid assets and other assets are not allocated to our segments. Although we can and do identify long-lived assets such as property, equipment and leasehold improvements, software, and identifiable intangible assets to reporting segments, we do not allocate the related depreciation and amortization to the segment as management evaluates segment performance exclusive of these non-cash charges.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 14: SEGMENT REPORTING (Continued)
Following is a summary of segment information for the year ended December 31, 2009. The intersegment revenues during 2009 related primarily to call center services performed by the settlement administration segment for the bankruptcy segment.
Following is a summary of segment information for the year ended December 31, 2008. Intersegment revenues for this period were not considered material to the segment reporting information.
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 14: SEGMENT REPORTING (Continued)
Following is a summary of segment information for the year ended December 31, 2007. Intersegment revenues for this period were not considered material to the segment reporting information.
Following is a reconciliation of our segment performance measure to income before income taxes (in thousands):
Following are total assets by segment (in thousands):
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 14: SEGMENT REPORTING (Continued)
Following are capital expenditures by segment (in thousands):
Following is revenue, determined by the location providing the services, by geographical area (in thousands):
Following are long-lived assets by geographical area (in thousands):
NOTE 15: DERIVATIVE FINANCIAL INSTRUMENTS
Interest Rate Floors
A portion of our bankruptcy trustee revenue is subject to variability based on fluctuations in short-term interest rates. During 2007, in order to limit our economic exposure to market fluctuations in interest rates, we purchased one-month LIBOR based interest rate floor options with a total notional amount of $800 million and initial contractual maturity of three years. We accounted for this transaction by recording this derivative instrument on our balance sheet at fair value. As the interest rate floor options were not designated as an accounting hedge, changes in the fair values of the derivatives were recorded each period in current earnings. For the year ended December 31, 2007, the change in the fair value of the interest rate floor options was recognized as an unrealized gain of
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 15: DERIVATIVE FINANCIAL INSTRUMENTS (Continued)
$1.1 million and was included as a component of "Other operating expense (income)" in our Consolidated Statements of Income. During February 2008, we sold the interest rate floor options and realized a $3.5 million gain. The $2.4 million difference between the realized gain of $3.5 million and the previously unrealized gain of $1.1 million was included as a component of "Other operating expense (income)" for the year ended December 31, 2008 on the accompanying Consolidated Statements of Income. As of December 31, 2008 and December 31, 2009 we did not hold any interest rate floor options, other derivatives, or auction rate securities.
Contingently Convertible Subordinated Notes
The holders of our convertible notes had the right to extend the maturity of these notes for a period not to exceed three years. The right to extend the maturity of the notes represented an embedded option. The embedded option, which is a derivative financial instrument, was adjusted to estimated fair value at the end of each period, with a final adjustment to an estimated fair value of approximately $4.8 million immediately prior to the April 2007 exercise of the embedded option to extend. This final fair value estimate is being amortized as a credit to interest expense over the period to the extended maturity, which is June 15, 2010. For any convertible notes converted into shares of our common stock prior to the scheduled extended maturity, the unamortized embedded option value related to those shares will be recognized as a gain in the period the conversion occurs. The estimated fair value and the amortized carrying value of our obligation related to the embedded option is included as a component of "Current maturities of long-term obligations" on the Consolidated Balance Sheet at December 31, 2009 and is a component of "Long-term obligations (excluding current maturities)" at December 31, 2008. Changes in the fair value of the embedded option through the final fair value measurement date in April 2007 and the subsequent amortization of the embedded option fair value were recorded each period as a component of interest expense on our accompanying Consolidated Statements of Income.
NOTE 16: SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information is as follows (in thousands):
EPIQ SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2009, 2008 AND 2007
NOTE 17: LEGAL PROCEEDINGS
On July 29, 2008, the Alaska Electrical Pension Fund filed a putative shareholder derivative action in the U.S. District Court for the District of Kansas (Civil Action No. 08-CV-2344 CM/JPO), alleging that each of our current directors and certain current and former executive officers and directors engaged in misconduct regarding stock option grants.
The complaint asserts, among other things, that the company backdated certain stock options and that the individual defendants either participated in the backdating or permitted it to occur, violations of generally accepted accounting principles as a result of the alleged backdating of options, related claims of false and misleading proxy statements and annual reports filed by the company under the Securities Exchange Act of 1934, also as a result of the alleged backdating of options, and various violations of state law, breaches of fiduciary duty of loyalty and insider trading in company stock. The complaint seeks, among other things, unspecified money damages, an accounting for profits obtained from the alleged backdating of options, specified changes in our corporate governance policies, punitive damages and rescission of the allegedly backdated options.
In October 2008, the company and the individual defendants filed a motion to dismiss the plaintiff's complaint on a variety of grounds. In June 2009, the Court entered an order on defendants' motion to dismiss plaintiff's complaint. In that order, the Court: (i) barred certain of plaintiff's federal securities law claims arising before July 29, 2005, leaving only the claim for the stock option grant dated June 3, 2006; (ii) held that the statute of limitations was tolled on those federal securities law claims; (iii) barred plaintiff's other federal securities law claims arising before December 9, 2003; (iv) declined to rule at that time on defendants' motions to dismiss plaintiff's state law claims based on any statute of repose or statute of limitations; (v) dismissed plaintiff's state law claim for constructive fraud; and (vi) held that plaintiff's complaint stated federal securities law and state law claims with sufficient particularity to avoid dismissal at that stage in the proceedings. The individual defendants and the company have filed an answer denying plaintiff's claims.
The plaintiff, the individual defendants and the company are participating in mediation required by the court. In connection with this on-going mediation, the company has accrued a liability, of approximately $1.0 million at December 31, 2009 in the accompanying Consolidated Financial Statements. The ultimate resolution of this matter may materially differ from the amount recorded as of December 31, 2009 as a result of future court rulings or potential settlement. Any liability relative to this matter may be funded in part, or in whole, by the company's insurance carrier.
We believe the plaintiff's claims are without merit and have been defending against them vigorously.
EPIQ SYSTEMS, INC.
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
EXHIBIT INDEX
The following exhibits are filed with this Form 10-K or are incorporated herein by reference:
*Filed herewith.