ITEM 1. BUSINESS.
THE COMPANY
WMS was incorporated in Delaware on November 20, 1974 under the name Williams Electronics, Inc. The Company's principal executive offices are located at 3401 North California Avenue, Chicago, Illinois 60618, telephone number (773) 961-1111. During fiscal year 1998 the Company, through its subsidiaries and affiliates, was engaged in the design, manufacture and sale of slot/video gaming machines and video lottery terminals ("Gaming"), coin-operated pinball and novelty games and wooden cabinets for coin-operated games ("Pinball, Novelty and Cabinets") and the contract manufacture of video games ("Contract Manufacturing").
Until April 6, 1998, the Company also engaged in the design, distribution and sale of interactive entertainment software played in both the coin-operated and home markets through its subsidiary, Midway Games Inc. ("Midway"). On such date, the Company distributed to its stockholders through a dividend (the "Distribution") all of the shares of common stock of Midway owned by the Company, which shares constituted 86.8% of the outstanding stock of Midway. On October 29, 1996, Midway completed an initial public offering of 5,100,000 shares of Midway common stock (the "Offering"), which comprised the remaining 13.2% of Midway shares. The Distribution provided the Company's stockholders with 1.19773 shares of Midway common stock for each owned share of the Company's common stock, par value $.50 ("Common Stock"). Fractional shares were sold and the net proceeds thereof paid in cash. The distribution ratio reflected 27,886,021 shares of Common Stock outstanding on the record date for the Distribution. On the date of the Distribution, the Company's rights plan became effective. See "The Distribution" below.
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Distribution, which was proposed during 1997, split the Company and Midway into two independent public corporations. Accordingly, the financial position, results of operations and cash flows of the Company's video games business segment are reported as discontinued operations in the 1998 Annual Report. The Company's businesses are reported in the following three industry segments: (i) Gaming; (ii) Pinball, Novelty and Cabinets; and (iii) Contract Manufacturing. Financial information for the years ended June 30, 1998,
1997 and 1996 with respect to these segments appears at Note 16 of the Notes to Consolidated Financial Statements in the 1998 Annual Report, which information is incorporated herein by reference.
OPERATIONS
GENERAL
During the fiscal year ended June 30, 1998, the Company was a designer, manufacturer and marketer of gaming equipment, pinball and novelty games and wooden cabinets for coin-operated games and a contract manufacturer of coin-operated video games. The Gaming business segment is conducted through the Company's subsidiary, WMS Gaming Inc. ("WGI") which markets its products under the Williams(TM) and WMS Gaming(TM) trademarks. The Pinball, Novelty and Cabinets business segment is conducted through its subsidiaries Williams Electronics Games, Inc. ("Williams" or "WEG") and Fun House Games Inc. ("Fun House Games") which market products under the Bally(R), FunHouse(R) and Williams(R) trademarks and the Company's subsidiary, Lenc-Smith Inc. ("Lenc-Smith"). The Contract Manufacturing business segment is conducted through WEG.
GAMING
Slot/Video Gaming Machines: The Company has designed, developed and manufactured a series of gaming machines for casinos located in established gaming jurisdictions, including jurisdictions permitting land based casinos and casino gaming on riverboats and in casinos owned by Native American nations, as well as in government sponsored gaming jurisdictions such as Canada. The Company's newest generation of slot machines integrates video or dotmatrix animation with traditional games to create a "game within a game" for longer, more exciting play. As they play the primary slot game and achieve certain milestones, players move on to play a secondary game for additional bonus credits. The secondary game gives players a sense of "investment" in the game which contributes to player interest and extended play. The Company's newest reel machines include Jackpot Party, X-Factor, Top Cat, Pharaoh's Fortune, Big Bang Piggy Bankin' and Winning Streak. Each of these games features engaging and entertaining themes. With the special Dotmation dotmatrix animation features, a player's game experience is enhanced with animated sequences of mermaids diving into the ocean or genies emerging from magic lamps to present the top awards. Like all Williams games, these reel slots feature high-end sound, utilizing the Company's proprietary Digital Compression System ("DCS"), and exciting glass designs and visuals. At the September 1998 World Gaming Congress Exposition, the Company expects to introduce at least eight new reel spinning games and six new video gaming devices -- all with new themes and graphics.
The Company's innovations in video technology have given rise to some of the industry's leading video gaming device concepts which utilize second-screen bonusing features, including Reel 'Em In, Filthy Rich, Boom!, Jackpot Party and Life of Luxury. These games are designed to attract players with greater visual excitement through state-of-the art graphics and bigger monitors, high-end DCS sound and engaging game themes. With the Company's multi-game Multi-Pay Plus, the Company premiered an innovative cabinet design that accommodates a bigger, high-resolution monitor in the same footprint of games with smaller, low resolution monitors. Both the upright 17" and slant-top 19" versions of the game incorporate this new cabinet design. Multi-Pay Plus offers the player a varied menu of games on a single machine, including video poker, keno, blackjack and video reel games. The Williams video gaming devices feature enhanced viewing through high-resolution 19" or 17" monitors which vividly display digitized images in up to 256 colors simultaneously as well as compact-disc quality digitally produced sound effects and music. These devices accept both coins and bills in varying denominations via an electronic coin validator or high-security bill validator to ensure a high-level of fraud protection. Reel 'Em In, Filthy Rich, Boom!, Jackpot Party and Life of Luxury also utilize the same superior cabinet design with a clever recreational fishing theme, farming theme, Fourth of July picnic theme, festive party theme and material extravagance theme, respectively.
The Company is authorized to sell its gaming machines in Arizona, Colorado, Connecticut, Delaware, Illinois, Indiana, Iowa, Kansas, Louisiana, Michigan, Missouri, Minnesota, Mississippi, Montana, Nevada,
New Jersey, New Mexico, North Dakota, Oregon, Rhode Island, South Dakota, West Virginia and Wisconsin. The Company is also authorized to sell its gaming machines directly or through distributors in certain foreign jurisdictions and to several Native American nations.
See "Item 3. Legal Proceedings" with respect to certain patent litigation between the Company and International Game Technology involving reel-type slot machines.
Video Lottery Terminals: WGI markets video lottery terminals ("VLT" or "VLTs") under the Williams(TM) and WMS Gaming(TM) trademarks. VLTs, purchased, leased or operated on a revenue sharing basis by state lottery agencies to increase lottery revenues, offer a wide selection of exciting, menu-driven games, including poker, keno, blackjack and video slot games. The Williams VLTs feature enhanced viewing through high-resolution 19" or 17" monitors which vividly display digitized images in up to 256 colors simultaneously as well as compact-disc quality digitally produced sound effects and music. Game selection and play are initiated by lightly touching a touch screen attached to the monitor. VLTs accept both coins and bills in varying denominations via an electronic coin validator or high-security bill validator to ensure a high-level of fraud protection. All money handling and storage compartments, as well as the long-life, programmable printer, are secured with heavy duty, multiple barrel locks which are accessed separately. A heavy gauge steel cabinet and innovative drip system protect internal components. Williams VLTs are equipped with built-in, self diagnostic software to identify problem areas and to record electronically all aspects of machine operation, including game play, wagering/payout data and physical breaches such as opening doors, removing currency, accessing the central processor and disconnecting the power source. Extensive information storage capacity allows for periodic telephone polling by the central computer or on-line, real time monitoring. Williams VLTs communicate with mainframe central site computers and retail validation terminals through internal modems, master/slave configurations and fiber optic connections.
The Williams Multi-Magic VLT, successor to the popular Midas Touch VLT, is available in three different model configurations -- one of which provides unique player comfort through a combination of a slant-top playing surface and built-in seating. VLTs represent a source of revenue for jurisdictions in addition to taxes and may be operated as stand-alone units or may interface with central monitoring computers operated by governmental agencies. WGI is currently approved as a manufacturer of VLTs in Delaware, Oregon, Rhode Island and West Virginia, and the Canadian Provinces of Alberta, New Brunswick, New Foundland and Nova Scotia.
PINBALL, NOVELTY AND CABINETS
Pinball Games: Based on industry awards with respect to the Company's coin-operated pinball games and the number of such games sold in comparison to its competitors, the Company believes it is the world's leading manufacturer of pinball games, producing pinball games under both the Williams and Bally trade names. Coin-operated pinball games utilize electromechanical devices such as flippers to propel steel balls on an intricately designed playing field. These games are generally designed by members of the Company's internal design staff but may be designed by outside consultants. During fiscal 1998, the Company introduced four new pinball game models -- two for the Williams product line and two for the Bally product line. In fiscal 1998, four of the Company's pinball games received American Amusement Machine Association ("AAMA") Silver and Gold Sales Achievement Awards. In addition, the Amusement and Music Operators Association ("AMOA") named the Company's The Adams Family Most Played Pinball Game at its Fall 1997 trade show. Williams and Bally pinball games have received three nominations for Most Played Pinball Game to be decided at the Fall 1998 trade show.
Shuffle-Alley and Novelty Games: Shuffle-alley games offer a simulation of bowling with varied scoring options. During fiscal 1996, the Company introduced League Champs, its most recent version of shuffle alley. Coin-operated novelty redemption games dispense tickets when a certain level of skill is achieved. Such games comprise a large proportion of games located in family entertainment centers. Tickets won may be redeemed by the player for merchandise of nominal value. The Company did not introduce any new novelty games in fiscal 1998. In fiscal 1997, the Company introduced Aaahh!! Real Monsters based on the popular children's
cartoon. During fiscal 1996, the Company established Fun House Games to develop and market novelty games. Additional novelty games introduced in fiscal 1996 were Safecracker and Ticket-Tac-Toe.
Cabinets: Lenc-Smith sells wooden pinball cabinets to WEG and wooden cabinets and other wooden products to Midway, pursuant to a Cabinet Supply Agreement, and to other companies from time to time, primarily for coin-operated video games. See "Item 13. Certain Relationships and Related Transactions -- Relationship with Midway -- Cabinet Supply Agreement."
Due to an industry wide decline in demand for pinball games in recent years, the Company determined to downsize its Pinball, Novelty and Cabinets segment operations in fiscal 1996. See Note 4 to the Notes to Consolidated Financial Statements contained in the 1998 Annual Report.
CONTRACT MANUFACTURING
The Company manufactures coin-operated video games and kits for Midway pursuant to the Manufacturing Agreement described under the heading "Item 13. Certain Relationships and Related Transactions -- Relationship with Midway -- Manufacturing Agreement." From time to time, the Company may also perform contract manufacturing for other parties.
BUSINESS STRATEGY
GENERAL
The Company's overall business strategy is to increase both market share and profitability by offering an expanding library of high-earning games for each key segment of the market. The Company intends to accomplish this by building on the Company's track record of creating the most innovative, entertaining games available and by increasing sales penetration in major markets. The Company utilizes the creative talents of 89 experienced game designers organized in teams comprised of programmers, artists and mechanical and electrical engineers.
GAMING
The Williams slot machine and video gaming device lines offer casinos a variety of game themes, all with original soundtracks, art and varying paytables. The Company's Gaming machines emphasize innovation, reliability, price and player appeal all of which are expected to translate into substantial earnings for casino owners. The Company's new gaming machines have more advanced technological features than its existing machines which are expected to elevate excitement for end-users.
PINBALL, NOVELTY AND CABINETS
During fiscal 1997, the Company completed a downsizing of its pinball design and manufacturing operations as a result of the industry-wide decline in demand for pinball games. Notwithstanding this market contraction, the Company believes it will be able to maintain its share of the worldwide pinball games market as a result of its leadership in design and engineering which is evidenced by the continued annual achievement awards bestowed by the AMOA and AAMA. Such leadership enables the Company to offer its distributors a variety of innovative pinball games which result in greater operator profit through increased player interest, mechanical reliability and serviceability. The Company's design and engineering staff has been the industry leader in innovations such as music and other sound effects, multi-level playing fields, multi-ball releases and in reliability improvements such as solid state technology and sophisticated diagnostic testing to quickly locate any malfunction. In the past, the Company has generally introduced eight new pinball machines per year in order to sustain player interest while spreading research, development and manufacturing expenses to maintain competitive pricing. However, as a result of the Company's decision to downsize the Pinball, Novelty and Cabinets segment, the Company introduced four models during fiscal 1997, four models in fiscal 1998 and expects to introduce four games in fiscal 1999.
CONTRACT MANUFACTURING
Contract manufacturing for Midway is conducted pursuant to the Manufacturing Agreement. The Company does not currently plan to seek additional manufacturing contracts. From time to time, however, the Company may perform contract manufacturing for other parties.
MARKETING AND DISTRIBUTION
Slot/Video Gaming Machines. The slot/video machine market is composed of casinos located in hotels and other establishments, riverboats, in Native American nations and on cruise ships. Casinos feature gaming as their primary attraction. Gaming machines designed for the casino market are normally sold directly to the casino and on occasion they may be sold to or through casino management companies or through specialized gaming machine distributors. Sales may be made in return for full payment or financed through machine revenue as well as provided on a revenue-sharing basis. The Company employs 12 sales personnel in offices in several United States locations and retains two sales/service consultants for the Canadian market.
Video Lottery Terminals. The VLT market is different from both the casino market and the traditional lottery market. Most VLTs are located in places where gaming is not the principal attraction. In certain jurisdictions, VLTs are privately owned either by the owners of the establishments in which the terminals are placed or by route operators or distributors who contract with establishment owners to install, service and maintain the terminals. In other jurisdictions, VLTs may be owned by or leased to the government or its appointed agent or may be provided by the Company to the governmental agency on a revenue-sharing basis.
Pinball and Novelty Games. Coin-operated pinball and novelty games are sold under the Williams, Bally and Fun House trademarks. Pinball and novelty games are marketed through approximately 53 independent distributors worldwide. Distributors sell these products to operators who own and operate the machines and place them in amusement arcades, restaurants, taverns, convenience stores and movie theaters. Distributors are primarily responsible for the sale and distribution of these products in designated territories and are generally expected to provide replacement parts and service and to arrange for installment financing. It is customary for distributors of the Company's novelty games also to distribute games produced by other manufacturers. However, the appointment of distributors of the Company's pinball games are generally made on an exclusive basis. Pinball and novelty games are marketed through trade shows, promotional videotapes and advertising in trade publications.
Export Sales. Export sales of the Company's products, primarily of pinball games to Western Europe, were approximately $24.4 million (25.0% of total revenues) for the fiscal year ended June 30, 1998 compared with $33.7 million (44.0% of total revenues) for the fiscal year ended June 30, 1997 and $41.4 million (44.0% of total revenues) for the fiscal year ended June 30, 1996. Substantially all foreign sales are made in United States dollars and, therefore, the Company is not generally subject to the risk of fluctuation of the value of foreign currencies in relation to the dollar.
Customers/Distributors. In the fiscal year ended June 30, 1998, no one customer accounted for greater than 10% of revenues of the Company. However, Nova Games Import-Export GmbH & Co. KG and affiliates accounted for approximately 16.0% ($12.1 million) of the Company's total revenues for fiscal 1997 and 15.0% ($14.0 million) of the Company's total revenues for fiscal 1996. In the opinion of the Company, while the loss of a single distributor could temporarily affect the distribution of a particular model, it would not have a material adverse effect on the business of the Company. In any such event, the Company believes it could make arrangements with alternate distributors for the distribution of the Company's products.
MANUFACTURING
The Company's products are manufactured in its factories in Illinois. Effective as of July 1, 1996 and in connection with the Offering, Midway and the Company entered into a Manufacturing and Services Agreement dated as of July 1, 1996 (the "Manufacturing and Services Agreement") pursuant to which,
among other things, the Company continued to manufacture Midway's coin-operated video games. Effective as of April 6, 1998, in connection with the Distribution, Midway and the Company and/or certain of its subsidiaries entered into various agreements, including, among others, the Manufacturing Agreement and a Cabinet Supply Agreement dated as of April 6, 1998 (the "Cabinet Supply Agreement") pursuant to which the Company continues to manufacture Midway's coin-operated video games and cabinets therefor. Effective April 6, 1998, the Manufacturing Agreement superseded the Manufacturing and Services Agreement. For a description of the Manufacturing and Services Agreement, the Manufacturing Agreement and the Cabinet Supply Agreement, see "Item 13. Certain Relationships and Related Transactions". The Company believes its facilities are adequate for its current and planned production needs. Production is generally based on advance purchase orders from Midway with respect to Contract Manufacturing, from governmental agencies with respect to VLT's and from distributors or Midway with respect to Pinball, Novelty and Cabinets.
As a result of the patent litigation, the Company was enjoined from manufacturing or selling certain older models of its reel-type slot machines. Consequently, the Company has a significant inventory of potentially excess and unusable slot machines of such particular models that are written down to the cost of salvageable parts therein. See "Item 3. Litigation" and "Note 13: Litigation" contained in the Company's Consolidated Financial Statements in the 1998 Annual Report.
The Company believes that it is not meaningful to compare backlog orders at the end of fiscal years since the amount of backlog orders varies from the beginning to the end of a normal two- to three-month production process of a coin-operated game and during the on-going production process for certain models of gaming equipment which can extend over a period of years.
Slot machines are warranted for a period of 90 days; VLTs are warranted for a period of up to one year; and most pinball and novelty games are warranted for a period of 60 to 90 days. No substantial costs have been incurred by the Company in connection with such warranties.
The raw materials used in manufacturing the Company's products include various metals, plastics, wood and glass obtained from numerous sources of supply. In addition, numerous component parts, including electronic subassemblies and video monitors, are purchased from suppliers. Wood cabinets for amusement games are manufactured by the Company's subsidiary, Lenc-Smith, as well as by outside suppliers. The Company believes that the sources of supply of component parts and raw materials are adequate and that substitute sources of materials are available.
The Company has a long cycle from purchase of inventory to collection of cash on the sale of its gaming machines which is typical in the industry. Component parts are purchased and assembled into finished goods which are inventoried in order to be able to quickly fulfill customer orders. Finished gaming machines are often installed in casinos on a "trial" basis and, only after a successful trial period, the machines are sold to the casinos. The sale may have extended payment terms if competitive forces so require.
INTELLECTUAL PROPERTY LICENSES
While the Company primarily seeks to develop original proprietary games, certain of the Company's games and gaming devices are based on properties licensed from third parties, such as Hasbro, Inc. and the National Basketball Association. Typically, the Company is obligated to make certain minimum guaranteed royalty payments over the term of the license and to advance payment against such guarantees. License agreements generally extend for a term of two to three years, are terminable in the event of material breach (including failure to pay any amounts owing to the licensor in a timely manner) by the Company and certain other events, and, in some cases, are renewable upon payment of certain minimum guarantees or the attainment of specified sales levels during the term of the license. Certain licenses are limited to specific territories. Each license typically provides that the licensor retains the right to exploit the licensed property for all other purposes, including the right to license the property for use with other products.
PATENT, TRADEMARK, COPYRIGHT AND PRODUCT PROTECTION
Each slot/video gaming machine and pinball and novelty game title may embody a number of separately-protected intellectual property rights, including trademarks, copyrights and patents. See "Item 3. Legal Proceedings" with respect to certain patent litigation between the Company and International Game Technology involving certain older models of reel-type slot machines.
GOVERNMENT REGULATION
GENERAL
The manufacture and distribution of gaming equipment is subject to extensive Federal, state, local and foreign regulation. Although the laws and regulations of the various jurisdictions in which the Company operates vary in their technical requirements and are subject to amendment from time to time, virtually all of these jurisdictions require licenses, permits, documentation of qualification, including evidence of financial stability, and other forms of approval for companies engaged in the manufacture and distribution of gaming devices as well as for the officers, directors, major stockholders and key personnel of such companies.
WGI has obtained the required regulatory licenses to manufacture and sell its products to land based casinos, riverboats, racetracks, lotteries and Native American casinos in the following domestic gaming jurisdictions: Arizona, Colorado, Connecticut, Delaware, Illinois, Indiana, Iowa, Kansas, Louisiana, Minnesota, Mississippi, Missouri, Montana, Nevada, New Jersey, New Mexico, North Dakota, Oregon, Rhode Island, South Dakota, West Virginia, Wisconsin, Bad River Band of Chippewa, Bay Mills Indian Community, Chitimacha Tribe of Louisiana, Coushatta Tribe of Louisiana, Fond du Lac Band of Lake Superior Chippewa, Fort McDowell Mohave-Apache Indian Community, Grand Portage Band of Chippewa, Grand Traverse Band of Ottawa & Chippewa Indians, Hannahville Indian Community, Ho-Chunk Nation, Lac du Flambeau Band of Lake Superior Chippewa Indians, Lac Vieux Desert Band of Lake Superior Chippewa Indians, Leech Lake Band of Chippewa, Lower Sioux Indian Community, Mashantucket Pequot Tribe, Menominee Indian Tribe of Wisconsin, Mille Lacs Band of Ojibwe Indians, Mississippi Band of Choctaw Indians, Mohegan Tribe of Indians, Omaha Tribe of Nebraska, Oneida Tribe of Indians of Wisconsin, Prairie Band of Potawatomi Nation, Prairie Island Indian Community, Pueblo of Isleta, Pueblo of Santa Ana, Pueblo of Tesuque, Red Cliff Band of Lake Superior Chippewa, Red Lake Band of Chippewa Indians, Sac & Fox Tribe of Mississippi in Iowa, Sault Ste. Marie Tribe of Chippewa Indians, Shakopee Mdewakanton Sioux (Dakota) Community, Sisseton Wahpeton Sioux Tribe, Spirit Lake Sioux Tribe, St. Croix Chippewa Indians of Wisconsin, Standing Rock Sioux Tribe, Tunica-Biloxi Tribe of Louisiana, Upper Sioux Community, Ute Mountain Ute Tribe, White Earth Nation, White Mountain Apache Tribe, Yavapai-Apache Nation.
WGI is also licensed in the Canadian provinces of Alberta, British Columbia, Manitoba, New Brunswick, Newfoundland, Nova Scotia, Ontario, Quebec and Saskatchewan, and in the Bahamas, Greece and Puerto Rico.
NEVADA REGULATIONS
The manufacture, sale and distribution of gaming devices for use or play in Nevada or for distribution outside of Nevada are subject to the Nevada Gaming Control Act and the regulations promulgated thereunder (collectively, the "Nevada Act"). The Company's manufacturing and distribution of gaming devices are subject to licensing and regulatory control of the Nevada Gaming Commission (the "Nevada Commission") and the Nevada State Gaming Control Board (the "Nevada Board"). The Nevada Commission and the Nevada Board are collectively referred to as the "Nevada Gaming Authorities."
The laws, regulations and supervisory procedures of the Nevada Gaming Authorities are based upon declarations of public policy which are concerned with, among other things: (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity; (ii) the establishment and maintenance of responsible accounting practices and procedures; (iii) the maintenance of effective controls over the financial practices of licensees, including the establishment of
minimum procedures for internal fiscal affairs, and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada Gaming Authorities; (iv) the prevention of cheating and fraudulent practices; and (v) providing a source of state and local revenues through taxation and licensing fees. A change in such laws, regulations and procedures could have an adverse effect on the Company's future Nevada operations.
Certain of the Company's subsidiaries (each a "Gaming Subsidiary" and collectively the "Gaming Subsidiaries"), which manufacture and distribute gaming devices or which hold stock of a Company subsidiary which does so, are required to be licensed or registered by the Nevada Gaming Authorities. The licenses require periodic payments of fees and taxes and are not transferable. No person may become a stockholder of, or receive any percentage of profits from, the Gaming Subsidiaries without first obtaining licenses and approvals from the Nevada Gaming Authorities. The Company is registered by the Nevada Commission as a publicly traded corporation ("Registered Corporation") and as such, it is required periodically to submit detailed financial and operating reports to the Nevada Commission and to furnish any other information which the Nevada Commission may require. On August 21, 1997, the Nevada Commission approved the Company's application for an amendment to its Order of Registration by removing the limitation which, if not removed, would have caused the Order of Registration to expire in August 1997. Also on that date, the Gaming Subsidiaries and Mr. Louis J. Nicastro, Mr. Neil D. Nicastro and Mr. Harold H. Bach, Jr. were registered, licensed or found suitable by the Nevada Commission, as applicable, as a Registered Corporation, as registered holding companies, for licensure as a manufacturer and distributor of gaming devices, as an operator of a slot machine route and as directors, officers and stockholders of such entities. There can be no assurance that such registrations, findings of suitability and licenses will not be revoked, suspended, limited or conditioned or that such persons will continue to be found suitable as licensees.
All gaming devices that are manufactured, sold or distributed for use or play in Nevada, or for distribution outside of Nevada, must be manufactured by licensed manufacturers and distributed or sold by licensed distributors. All gaming devices manufactured for use or play in Nevada must be approved by the Nevada Commission before distribution or exposure for play. The approval process for gaming devices includes rigorous testing by the Nevada Board, a field trial and a determination as to whether the gaming device meets strict technical standards that are set forth in the regulations of the Nevada Commission. Associated equipment must be administratively approved by the Chairman of the Nevada Board before it is distributed for use in Nevada.
The Nevada Commission may investigate any individual who has a material relationship to, or material involvement with, the Company or the Gaming Subsidiaries in order to determine whether such individual is suitable or should be licensed as a business associate of a licensee. Officers, directors and certain key employees of the Gaming Subsidiaries must file license applications with the Nevada Gaming Authorities. Officers, directors and key employees of the Company who are actively and directly involved in activities of the Gaming Subsidiaries may be required to be licensed or found suitable by the Nevada Gaming Authorities. The Nevada Gaming Authorities may deny an application for licensing for any cause which they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal financial information followed by a thorough investigation. The applicant for licensing or a finding of suitability must pay all the costs of the investigation. Changes in licensed positions must be reported to the Nevada Gaming Authorities and, in addition to their authority to deny an application for a finding of suitability or license, the Nevada Commission has jurisdiction to disapprove a change in a corporate position.
If the Nevada Gaming Authorities were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with the Company or the Gaming Subsidiaries, the companies involved would have to sever all relationships with such person. In addition, the Nevada Commission may require the Company or any of the Gaming Subsidiaries to terminate the employment of any person who refuses to file appropriate applications. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada.
The Company and the Gaming Subsidiaries are required to submit detailed financial and operating reports to the Nevada Commission. Substantially all material loans, leases, sales of securities and similar
financing transactions by the Gaming Subsidiaries must be reported to, and approved by, the Nevada Commission.
If it were determined that the Nevada Act was violated by the Gaming Subsidiaries, the licenses they hold could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, the Gaming Subsidiaries, the Company and the persons involved could be subject to substantial fines for each separate violation of the Nevada Act at the discretion of the Nevada Commission. The limitation, conditioning or suspension of any gaming license or the appointment of a supervisor could and the revocation of any license would materially adversely affect the Company's future operations in Nevada.
Any beneficial holder of the voting securities of the Company, regardless of the number of shares owned, may be required to file applications, be investigated and have his, her or its suitability as a beneficial holder of the Company's voting securities determined if the Nevada Commission has reason to believe that such ownership would otherwise be inconsistent with the declared policies of the State of Nevada. The applicant must pay all costs of investigation incurred by the Nevada Gaming Authorities in conducting any such investigation.
The Nevada Act requires any person who acquires beneficial ownership of more than 5% of the Company's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires that beneficial owners of more than 10% of the Company's voting securities apply to the Nevada Commission for a finding of suitability within 30 days after the Chairman of the Nevada Board mails the written notice requiring such filing. Under certain circumstances, an "institutional investor," as defined in the Nevada Act, which acquires more than 10% but not more than 15% of the Company's voting securities may apply to the Nevada Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of the Board of Directors of the Company, any change in the Company's corporate charter, bylaws, management, policies or operations, or those of any of its gaming affiliates, or any other action which the Nevada Commission finds to be inconsistent with holding the Company's voting securities for investment purposes only. Activities which are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by stockholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in its management policies or operations; and (iii) such other activities as the Nevada Commission may determine to be consistent with such investment intent. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of investigation.
Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Nevada Commission or the Chairman of the Nevada Board may be found unsuitable. The same restrictions apply to a record owner if the record owner, after request by the Nevada Commission or the Chairman of the Nevada Board, fails to identify the beneficial owner. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the common stock of a Registered Corporation beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a criminal offense. The Company is subject to disciplinary action if, after it receives notice that a person is unsuitable to be a stockholder or to have any other relationship with the Company or the Gaming Subsidiaries, the Company: (i) pays that unsuitable person any dividend or interest upon voting securities of the Company; (ii) allows that person to exercise, directly or indirectly, any voting rights conferred through securities held by that person; (iii) pays remuneration in any form to that person for services rendered or otherwise; or (iv) fails to pursue all lawful efforts to require the unsuitable person to relinquish voting securities including, if necessary, the immediate repurchase of such voting securities for cash at fair market value.
The Nevada Commission may in its discretion, require holders of any debt security of a Registered Corporation to file applications, be investigated and be found suitable to own the debt security of a Registered Corporation if the Nevada Commission has reason to believe that such ownership would otherwise be inconsistent with the declared policies of the State of Nevada. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the Nevada Act, the Registered Corporation can be sanctioned, including with the loss of its approvals, if, without the prior approval of the Nevada Commission, it: (i) pays to the unsuitable person any dividend, interest or any distribution whatsoever; (ii) recognizes any voting right by such unsuitable person in connection with such securities; (iii) pays the unsuitable person remuneration in any form; or (iv) makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation or similar transaction.
The Company is required to maintain a current stock ledger in the State of Nevada which may be examined by the Nevada Gaming Authorities at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Gaming Authorities. A failure to make such disclosure may be grounds for finding the record holder unsuitable. The Company is also required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power to require that the Company's stock certificates bear a legend indicating that the securities are subject to the Nevada Act. However, to date, the Nevada Commission has not imposed such a requirement on the Company.
The Company may not make a public offering of its securities without the prior approval of the Nevada Commission if the securities or the proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Nevada, or to retire or extend obligations incurred for such purposes. Such approval, if given, does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities. Any representation to the contrary is unlawful.
Changes in control of the Company through merger, consolidation, stock or asset acquisitions, management or consulting agreements, or any act or conduct by a person whereby he or she obtains control, may not occur without the prior approval of the Nevada Commission. Entities seeking to acquire control of a Registered Corporation must satisfy the Nevada Board and the Nevada Commission in a variety of stringent standards prior to assuming control of such Registered Corporation. The Nevada Commission may also require controlling stockholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process relating to the transaction.
The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defense tactics affecting Nevada gaming licenses and Registered Corporations that are affiliated with those operations may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to: (i) assure the financial stability of corporate licensees and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the Company can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. The Nevada Act also requires prior approval of a plan of recapitalization proposed by the Company's Board of Directors in response to a tender offer made directly to the Registered Corporation's stockholders for the purpose of acquiring control of the Registered Corporation.
License fees and taxes computed in various ways depending on the type of gaming or activity involved are payable to the State of Nevada and to the counties and cities in which the Nevada licensee's respective operations are conducted. Depending upon the particular fee or tax involved, these fees and taxes are payable either quarterly or annually. Annual fees are also payable to the State of Nevada for renewal of licenses as a manufacturer and distributor.
Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming venture outside of Nevada is required to deposit with the Nevada Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation by the Nevada Board of their participation in such foreign gaming operations. The revolving fund is subject to increase or decrease in the discretion of the Nevada Commission. Thereafter, Licensees are required to comply with certain reporting requirements imposed by the Nevada Act. The Nevada Board may require a Licensee to file an application for a finding of suitability to be made by the Nevada Commission concerning an actual or intended activity or association of the Licensee in a foreign gaming operation. A Licensee is also subject to disciplinary action by the Nevada Commission if any such licensee knowingly violates any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fails to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engages in activities that are harmful to the State of Nevada or its ability to collect gaming taxes and fees, or employs a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability.
NEW JERSEY REGULATION
The manufacture, distribution, and operation of gaming machines in New Jersey are regulated by the New Jersey Casino Control Commission (the "New Jersey Commission") pursuant to the New Jersey Casino Control Act and the regulations of the New Jersey Commission promulgated thereunder (collectively, the "New Jersey Act"). Under the New Jersey Act, a company must be licensed as a gaming related casino service industry ("CSI"), or fulfill other requirements, in order to manufacture or distribute gaming machines. In order for a CSI license to be issued or maintained, certain directors, officers, key employees and owners of a company must be found by the New Jersey Commission to possess by clear and convincing evidence good character, honesty, integrity and financial stability.
WGI has been issued a CSI license by the New Jersey Commission. This license was issued for a two-year period and, upon proper application and satisfaction of the same requirements for the initial issuance of a license, may be renewed for four-year periods. However, the New Jersey Commission has the discretion to suspend, revoke, or refuse to renew a license if a licensee fails to continue to satisfy the requirements for licensure or violates the New Jersey Act.
In addition, all gaming machines used in New Jersey casinos must be approved by the New Jersey Commission. In determining whether to approve gaming machines, the New Jersey Commission will consider various factors, including design, integrity, fairness, and honesty and may require a field test of the machine.
MISSISSIPPI
The manufacture, sale and distribution of gaming devises for use or play in Mississippi are subject to the Mississippi Gaming Control Act and the regulations promulgated thereunder (collectively, the "Mississippi Act"). Such activities are subject to the licensing and regulatory control of the Mississippi Gaming Commission (the "Mississippi Commission") and the Mississippi State Tax Commission (collectively referred to as the "Mississippi Gaming Authorities"). Although not identical, the Mississippi Act is similar to the Nevada Act.
The Company and the Gaming Subsidiaries have received the various registrations, approvals, permits and licenses in order to engage in manufacturing and distribution of gaming equipment in Mississippi. The license to manufacture and distribute gaming equipment in Mississippi is not transferable, is issued for a two-year period and must be renewed every two years thereafter.
Similar to Nevada, the Mississippi Commission may investigate and find suitable any individual who has a material relationship to, or material involvement with, the Company or the Gaming Subsidiaries, including, but not limited to, record or beneficial holders of any of the voting securities of the Company or the Gaming Subsidiaries and any other person whom the Mississippi Commission determines exercises a significant influence upon the management or affairs of the Company. The Company and the Gaming Subsidiaries are
required to maintain a current stock ledger in Mississippi which may be examined by the Mississippi Commission at any time. The Company believes that all required findings of suitability currently required have been applied for or obtained. Any applicant for a finding of suitability must pay all investigative fees and costs of the Mississippi Commission in connection with such an investigation.
The Mississippi Act requires any person who acquires beneficial ownership of more than 5% of a Registered Corporation's voting securities to report the acquisition to the Mississippi Commission and such person may be required to be found suitable. The Mississippi Act requires that beneficial owners of more than 10% of a Registered Corporation's voting securities apply to the Mississippi Commission for a finding of suitability. The Mississippi Commission exercises its discretion to require a finding of suitability of any beneficial owner of more than 5% of a Registered Corporation's common stock. Under certain circumstances, an "institutional investor," which acquires more than 5%, but not more than 10%, of the Registered Corporation's voting securities may apply to the Mississippi Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only and otherwise meets the regulatory requirements of the institutional investor waiver provisions.
The Company may not make a public offering of its securities without the approval of the Mississippi Commission if the securities or proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Mississippi, or to retire or extend obligations incurred for such purposes. All loans by the Company must be reported to the Mississippi Commission and certain loans and other stock transactions must be approved in advance.
If it were determined that the Mississippi Act was violated by the Company or the Gaming Subsidiaries, the licenses they hold could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures, which action, if taken, could materially adversely affect the Company's manufacturing and distribution of gaming devices.
FEDERAL REGISTRATION
Any subsidiaries of the Company that are involved in gaming activities are required to register annually with the United States Department of Justice, Criminal Division, in connection with the sale, distribution or operation of Gaming. The Federal Gambling Devices Act of 1962 (the "Federal Act") makes it unlawful, in general, for a person to manufacture, deliver or receive gaming machines, gaming machine type devices and components across state lines or to operate gaming machines unless that person has first registered with the Attorney General of the United States. The Company is required to register and renew its registration annually. The Company has complied with such registration requirements. In addition, various record keeping and equipment identification requirements are imposed by the Federal Act. Violation of the Federal Act may result in seizure and forfeiture of the equipment, as well as other penalties.
REGULATION IN FOREIGN JURISDICTIONS
Certain foreign countries permit the importation, sale and/or operation of gaming equipment. Where importation is permitted, some countries prohibit or restrict the payout feature of the traditional slot machine or limit the operation of slot machines to a controlled number of casinos or casino-like locations. Certain jurisdictions in which the Company operates require the licensing of gaming devices, gaming device operators and manufacturers. The Company and its gaming machines have been properly licensed and approved or have applied for licensure and approval in all jurisdictions where the Company's operations require such licensure and approval.
NATIVE AMERICAN GAMING REGULATION
Numerous Native American tribes have become engaged in or have licensed gaming activities on Indian lands as a means of generating tribal governmental revenue. The Company manufactures and supplies gaming equipment for Native American tribes. Gaming on Native American lands, including the terms and conditions under which gaming equipment can be sold or leased to Native American tribes, is or may be subject to regulation under the laws of the tribes, the laws of the host state, the Indian Gaming Regulatory Act of 1988
("IGRA"), which is administered by the National Indian Gaming Commission (the "NIGC") and the Secretary of the U.S. Department of the Interior (the "Secretary"), and also may be subject to the provisions of certain statutes relating to contracts with Native American tribes, which are administered by the Secretary. As a precondition to gaming involving gaming machines, IGRA requires that the tribe and the state enter into a written agreement (a "tribal-state compact") that specifically authorizes such gaming, and that has been approved by the Secretary, with notice of such approval published in the Federal Register. Tribal-state compacts vary from state to state. Many require that equipment suppliers meet ongoing registration and licensing requirements of the state and/or the tribe and some impose background check requirements on the officers, directors and shareholders of gaming equipment suppliers. Under IGRA, tribes are required to regulate all commercial gaming under ordinances approved by the NIGC. Such ordinances may impose standards and technical requirements on main hardware and software and may impose registration, licensing and background check requirements on gaming equipment suppliers and their officers, directors and shareholders.
REGULATORY CHANGES AND LICENSE STATUS
The laws and regulations of the numerous jurisdictions, foreign and domestic, in which the Company and its Gaming Subsidiaries do business are subject to change from time to time. In addition, the license status of the Company and its Gaming Subsidiaries with respect to these jurisdictions is subject to change. The information set forth in this Annual Report on Form 10-K represents the most current available at the time of filing. Thus far the Company has never been denied any such necessary governmental licenses, permits or approvals. No assurances, however, can be given that such required licenses, permits or approvals will be given or renewed in the future.
COMPETITION
The Gaming and Pinball, Novelty and Cabinets businesses are intensely competitive and are characterized by the continuous introduction of new titles and the development of new technologies. The ability of the Company to compete successfully in these markets is based, in large part, upon its ability to select and develop new products, to identify and obtain rights to commercially marketable intellectual properties and to adapt its products for use with new technologies. In addition, successful competition is also based upon price, product enhancements, new product introductions, marketing support and distribution systems. The Company's competitors vary in size from very small companies with limited resources to very large corporations with greater financial, marketing and product development than those of the Company.
The Company believes that it is a leading manufacturer of slot/video gaming machines and VLTs and the world's leading manufacturer of coin-operated pinball games. In the slot/video gaming machine market, the Company competes with International Game Technology, Alliance Gaming Corp., Sigma Game, Inc., Casino Data Systems, Inc., Video Lottery Consultants, Inc., Silicon Gaming, Inc., Atronics, Inc. and Aristocrat, Inc. In the VLT market, the Company competes primarily with International Game Technology, G-Tech and Video Lottery Consultants, Inc., each based in the United States, and Spielo, based in Canada. See "Item 3. Legal Proceedings" with respect to certain patent litigation between the Company and International Game Technology involving certain older models of reel-type slot machines. In the coin-operated pinball game market, the Company competes with Sega Pinball. See "Factors Affecting Future Performance -- Competition" below.
During the term of the Manufacturing Agreement, WMS will not experience competition for the manufacture of Midway's coin-operated video games; however, the Manufacturing Agreement may be terminated on six months' notice. Midway may, at any time, seek and accept superior competing third-party bids for cabinets under the Cabinet Supply Agreement. No assurance can be given that Midway will continue to employ the Company's services and keep these agreements in effect.
DESIGN, RESEARCH AND PRODUCT DEVELOPMENT
The gaming equipment and pinball and novelty games which are sold by the Company may be designed by members of its internal design staff or by independent designers under contract to the Company. Cabinets are made to customer specifications, and manufacturing under the Manufacturing Agreement is based on Midway's designs and specifications. The Company also evaluates coin-operated games designed by others with a view toward obtaining licenses authorizing it to manufacture and sell such games as well as for purposes of performing the contract manufacture of such games for sale under the trademarks of others. The Company currently employs approximately 89 persons in its research and product development departments. During the fiscal years ended June 30, 1998, 1997, and 1996, approximately $12,908,000, $12,882,000 and $13,436,000, respectively, were expended on research and development with respect to the Company's Gaming and Pinball, Novelty and Cabinets businesses.
SEASONALITY
None of the Company's business segments has historically been seasonal, but quarterly revenues and net income usually increase when a coin-operated gaming machine, pinball game or novelty game that achieves significant player appeal is introduced.
EMPLOYEES
At June 30, 1998, the Company employed approximately 1,100 persons. Approximately 550 of such employees were represented by the International Brotherhood of Electrical Workers (the "IBEW") and approximately 145 of such employees were represented by the United Furniture Workers union (the "UFW"). Collective bargaining agreements with the IBEW relating to the Chicago and Waukegan, Illinois manufacturing facilities both expire June 30, 2000. The collective bargaining agreement with the UFW relating to the Cicero, Illinois manufacturing facility owned by Lenc-Smith expired June 30, 1998, and the Company is currently in negotiations with the UFW to renew such agreement. Non-salaried Lenc-Smith employees are currently on strike, but the Company does not believe that the strike will have an adverse effect on the Company's business, as the Company has been purchasing cabinets from alternative suppliers. The Company believes that its relations with its other employees are satisfactory.
THE DISTRIBUTION
In addition to the Company's businesses, the Company previously, through Midway and Midway's subsidiaries and affiliates, designed, published and marketed interactive entertainment software played in both the coin-operated and home markets. On April 6, 1998, the Company distributed to its stockholders through a dividend all of the Midway common stock which it owned, which stock represented 86.8% of the outstanding common stock of Midway. The Distribution provided the Company's stockholders with 1.19773 shares of Midway common stock for each share of Common Stock held by such stockholders on the Distribution record date of March 31, 1998. Fractional shares were sold and the net proceeds thereof paid in cash. The distribution ratio reflected 27,886,021 shares of Common Stock outstanding on March 31, 1998. The Company first announced its intentions to complete the Distribution on August 11, 1997. On the date of the Distribution, pursuant to the Company's Stock Option Plans, the stock options held by directors, officers and other employees of the Company were adjusted, and adjustment payments were made to holders of such options. See "Item 11. Executive Compensation."
The financial position, results of operations and cash flows of Midway are reported as discontinued operations in the 1998 Annual Report.
In November 1997, the Board of Directors adopted a rights plan pursuant to the Rights Agreement dated as of March 5, 1998 between the Company and The Bank of New York, as Rights Agent, which became effective on the date of the Distribution. The Rights Agreement provides that one preferred stock purchase right (a "Right") will attach to each share of the Common Stock issued. The Rights will expire at the close of
business on April 6, 2007 unless previously redeemed by the Company for nominal consideration prior to exercisability. The Rights will not be exercisable, transferable separately or trade separately from the shares of Common Stock, until (a) the tenth business day after the date of a public announcement that a person or group is an "Acquiring Person" or (b) the tenth business day (or such later day as the Board, with the concurrence of a majority of Continuing Directors (as defined), determines) after a person or group announces a tender or exchange offer, which, if consummated, would result in such person or group beneficially owning 15% or more of the Common Stock. In general, any person or group of affiliated persons who, after the date of adoption of the Rights Agreement, acquires beneficial ownership of 15% or more of the Common Stock will be considered an "Acquiring Person." If a person or group of affiliated persons becomes an Acquiring Person, then each Right (other than Rights owned by such Acquiring Person and its affiliates and associates) will entitle the holder thereof to purchase, for the exercise price, a number of shares of the Common Stock having a then current market value of twice the exercise price. Accordingly, at the original exercise price, each Right would entitle its registered holder to purchase $200.00 worth of Common Stock for $100.00. A more complete summary of the terms of the Rights Agreement is hereby incorporated herein by reference to Exhibit 1 to the Company's Registration Statement on Form 8-A (File No. 1-8300) filed March 25, 1998.
The Distribution was also accompanied by certain director and executive officer changes. Prior to the Distribution, in June 1996, Mr. Louis J. Nicastro had resigned from his position with WMS and certain amusement game subsidiaries of the Company in order to assume, at the request of the Board of Directors of the Company, the position of Chief Executive Officer of WHG Resorts & Casinos Inc. ("WHG") in contemplation of the distribution by the Company of all the common stock of WHG to the Company's stockholders. In early January 1998, WHG was merged with a large resort and casino company. The Board of Directors, in view of Mr. Nicastro's experience with the Company and in the industry, invited him to return as Chief Executive Officer and President, effective on the date of the Distribution, when the former Chief Executive Officer and President, Mr. Neil D. Nicastro, was scheduled to resign from the Company in order to devote substantially all of his business time to Midway. See "Item 11. Executive Compensation -- Employment Contracts." In addition, Mr. Kenneth J. Fedesna resigned as a director of the Company, David M. Satz, Jr. joined the Board of Directors and Kevin L. Verner became Vice President and Chief Operating Officer shortly after the Distribution.
FACTORS AFFECTING FUTURE PERFORMANCE
Some of the risks and uncertainties that may cause the Company's operating results to vary from anticipated results or that may that adversely affect its operating results are as follows:
LOSSES FROM CONTINUING OPERATIONS
The Company, apart from its discontinued operations, has not generated net income during its last three fiscal years and may not generate net income for the current fiscal year.
GAMING
Patent Litigation. WGI is party to certain patent litigation between WGI and International Game Technology with respect to certain older model reel-type slot machines. In the event that it is ultimately determined in these actions that the Company's older model slot machines infringe on International Game Technology's patent and if the Company is unable to develop or acquire non-infringing alternative devices or obtain licenses to use the patent, the development of the Company's reel-type slot machine business may be adversely affected. For a description of the patent litigation, see "Item 3. Legal Proceedings."
Ability to Maintain Regulatory Approvals. The manufacture and distribution of gaming equipment is subject to extensive Federal, state, local and foreign regulation. Although the laws and regulations of the various jurisdictions in which the Company operates vary in their technical requirements and are subject to amendment from time to time, virtually all of these jurisdictions require licenses, permits, documentation of qualification, including evidence of financial stability, and other forms of approval for companies engaged in the manufacture and distribution of gaming devices as well as for the officers, directors, major stockholders and key personnel of such companies. The Company is authorized to sell its gaming machines in Arizona, Colorado, Connecticut, Delaware, Illinois, Indiana, Iowa, Kansas, Louisiana, Michigan, Missouri, Minnesota, Mississippi, Nevada, New Jersey, New Mexico, North Dakota, Oregon, Rhode Island, South Dakota, West Virginia and Wisconsin, as well as to cruise ships operating in international waters. The Company is also authorized to sell its gaming machines directly or through distributors in several international jurisdictions and to many Native American nations. Thus far, the Company has never been denied any such necessary governmental licenses, permits or approvals. No assurances, however, can be given that such required licenses, permits or approvals will be given or renewed in the future.
Application of Future or Additional Regulatory Requirements. In the future the Company intends to seek the necessary registrations, licenses, approvals and findings of suitability for the Company, its products and its personnel in other U.S. and foreign jurisdictions in which the Company identifies significant sales potential for its products. However, there can be no assurance that such registrations, licenses, approvals or findings of suitability will be obtained and will not be revoked, suspended or conditioned or that the Company will be able to obtain the necessary approvals for its future products as they are developed in a timely manner, or at all. If a registration, license, approval or finding of suitability is required by a regulatory authority and the Company fails to seek or does not receive the necessary registration, license, approval or finding of suitability, the Company may be prohibited from selling its products for use in the respective jurisdiction or may be required to sell its products through other licensed entities at a reduced profit to the Company.
PINBALL, NOVELTY AND CABINETS
During fiscal 1997, the Company completed a downsizing of its pinball design and manufacturing operations as a result of the industry-wide decline in demand for pinball games. Notwithstanding this market contraction, the Company believes it will be able to maintain its share of the worldwide pinball games market, and it expects to introduce a new generation of pinball games in late 1998, tentatively entitled "Pinball 2000." However, no assurance can be given as to the likelihood of success and consumer acceptance of Pinball 2000 nor whether the decline in demand for pinball games generally will abate.
CONTRACT MANUFACTURING
The Manufacturing Agreement may be terminated on six months' notice. No assurance can be given that Midway will continue to employ the Company's services and keep this agreement in effect. In the event that Midway terminates the Manufacturing Agreement, the Company's business and financial condition could be adversely affected.
GENERAL
Conflicts of Interest With Midway. Certain of WMS' officers and directors are also officers, directors and stockholders of Midway, and may be subject to various conflicts of interest including, among others, the performance by the two companies under their existing agreements with each other as well as the negotiation of any agreements required to be entered into in the future between these two parties. Additionally, WMS may be subject to various conflicts of interest arising from the relationship among it and Midway and their respective affiliates.
Mr. Louis J. Nicastro, the President, Chief Executive Officer and Chairman of the Board of WMS is also a Director of Midway. Mr. Neil D. Nicastro, the son of Louis J. Nicastro and a Director of and a consultant to WMS, is also the Chairman of the Board, President, Chief Executive Officer and Chief Operating Officer of Midway. Mr. Harold H. Bach, Jr., Mr. Kenneth J. Fedesna and Mr. Orrin J. Edidin, officers and employees of WMS and/or various of its affiliates, are also officers of Midway. Mr. Bach and Mr. Fedesna are also Directors of Midway. Each of these key employees will devote such time to the business and affairs of the Company as the Board of Directors deems appropriate. However, each such person has other duties and responsibilities with Midway that may conflict with time which might otherwise be devoted to his duties with WMS. The Company anticipates that Messrs. Bach, Fedesna and Edidin will resign their positions with the Company by the end of fiscal 1999.
Competition. The Gaming and Pinball, Novelty and Cabinets businesses are intensely competitive and are characterized by the continuous introduction of new titles and the development of new technologies. The ability of the Company to compete successfully in these markets is based, in large part, upon its ability to select and develop new products, to identify and obtain rights to commercially marketable intellectual properties and to adapt its products for use with new technologies. In addition, successful competition is also based upon price, product enhancements, new product introductions, marketing support and distribution systems. The Company's competitors vary in size from very small companies with limited resources to very large corporations with greater financial, marketing and product development than those of the Company. See "Operations -- Competition" above. There can be no assurance that the Company will be able to compete successfully against current or future competitors or that competitive pressures faced by the Company will not adversely affect its business and financial condition.
ITEM 2.
ITEM 2. PROPERTIES.
The following table sets forth the Company's principal properties, principal use, approximate floor space and the annual rental and lease expiration date, where leased by the Company, at June 30, 1998.
- ------------------------- (1) Under leases that contain renewal options, additional amounts may be payable for taxes, insurance, utilities and maintenance.
Management believes that all of the facilities listed in the foregoing table are in good repair and are adequate for their respective purposes. The manufacturing facilities used by the Company are suitable and adequate for the design and production of the Company's products and for its contract manufacturing. Except during the July vacation shutdown, the manufacturing facilities are generally operated on a one-shift basis; however, during periods of increased production, certain portions of the facilities are operated on multiple shifts. The production levels can be increased or decreased on a periodic basis to match the level of incoming customer orders.
The Company owns substantially all of the machinery, equipment, tools and dies, furnishings and fixtures used in its businesses, all of which are well maintained and satisfactory for the purposes intended.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
In May 1994, WGI instituted a declaratory judgment action (the "Model 400 Action") against International Game Technology ("IGT"), in the United States District Court for the Northern District of Illinois. The action sought a declaration that a certain patent issued in 1984 and owned by IGT (the "Telnaes Patent") was invalid, and that certain reel-type slot machines then made by WGI did not infringe the Telnaes Patent. IGT counterclaimed alleging that the Telnaes Patent was infringed by WGI's reel-type slot machines. The Telnaes Patent relates to a particular method of assigning the probability of selecting particular reel stop positions in a computer-controlled reel-type gaming machine, which increases or decreases the probabilities of winning by means of the computer's software, not the mechanical reels themselves.
On September 19, 1996, the trial court rendered a decision in favor of IGT, finding the Telnaes Patent valid, finding WGI's Model 400 slot machine to infringe the Telnaes Patent, and enjoining WGI from further infringement of the Telnaes Patent. On February 28, 1997, after a hearing on IGT's alleged damages, the Court awarded judgment in favor of IGT and against WGI in the amount of $32,845,189. Subsequently, the Court granted WGI's motion for a stay of proceedings to enforce the money judgment pending disposition of WGI's motion for a new trial and a similar stay pending appeal. On March 14, 1997, WGI filed a motion seeking a new trial based on newly discovered evidence. A hearing on the motion and the newly discovered evidence was concluded on September 18, 1997 and the Court disposed of this post-judgment motion on October 1, 1997 by denying WGI's request for a new trial. WGI filed a notice of appeal on October 20, 1997. A bond having been previously filed by WGI, enforcement of the money judgment has been stayed pending the disposition of the appeal. The appeal is now pending before the United States Court of Appeals for the Federal Circuit.
On November 26, 1996, IGT commenced an action against WGI in the United States District Court for the Northern District of Illinois (the "Model 401 Action"). In this action, IGT seeks a judgment declaring that WGI's Model 401 slot machine also infringes the Telnaes Patent. The complaint seeks a preliminary and permanent injunction and treble damages. On December 18, 1996, the Court granted IGT's motion for a preliminary injunction and enjoined WGI from the manufacture, use and sale of the Model 401 slot machine. On April 10, 1997, WGI filed a motion to vacate the previously entered preliminary injunction based upon the newly discovered evidence. On May 5, 1998, the Court denied the motion to vacate the preliminary injunction. WGI filed a notice of appeal on May 7, 1998. The appeal of the preliminary injunction order is now pending before the United States Court of Appeals for the Federal Circuit.
In the event that it is ultimately determined in the Model 400 Action and in the Model 401 Action that such slot machines infringe upon the Telnaes Patent and if WGI is unable to develop or acquire non-infringing alternative devices or obtain a license to use the Telnaes Patent, the development of WGI's reel-type slot machines business may be adversely affected. The Telnaes Patent relates only to reel spinning slot machines and does not relate to VLTs, video poker machines and other video gaming devices.
Other than set forth above, the Company currently and from time to time is involved in litigation incidental to the conduct of its business, none of which, in the opinion of the Company, is likely to have a material adverse effect on the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Reference is made to "Market for the Company's Common Stock and Related Security-Holder Matters" set forth in the 1998 Annual Report, which information is incorporated by reference herein.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Reference is made to "Selected Five-Year Financial Data" set forth in the 1998 Annual Report, which information is incorporated by reference herein.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations" set forth in the 1998 Annual Report, which information is incorporated by reference herein.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Reference is made to the Consolidated Financial Statements and Notes thereto and Report of Independent Auditors set forth in the 1998 Annual Report, which information is incorporated by reference herein.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
(a) Identification of Directors. Except as set forth below, the directors listed in the following table were elected at the January 1998 Annual Meeting of Stockholders to serve until the 1999 Annual Meeting of Stockholders and until their respective successors are duly elected and qualify. All are present directors of the Company. Mr. Kenneth J. Fedesna, who was also elected as a director of the Company at the January 1998 Annual Meeting of Stockholders, resigned as a director on April 6, 1998. On April 6, 1998, Mr. David M. Satz, Jr. was elected as a director of the Company to serve until the 1999 Annual Meeting of Stockholders and until his successor has been duly elected and qualifies. Mr. Satz was elected to fill the vacancy resulting from the resignation of Mr. Fedesna. Mr. Neil D. Nicastro is the son of Mr. Louis J. Nicastro; otherwise, there is no family relationship between any of the directors or executive officers of the Company.
- ------------------------- * Less than 1% of the number of outstanding shares of Common Stock on September 15, 1998.
(1) Pursuant to Rule 13d-3(d)(1) of the Securities Exchange Act of 1934, as amended, shares underlying options are deemed to be beneficially owned if the holder of the option has the right to acquire beneficial ownership of such shares within 60 days.
(2) For purposes of calculating the percentage of outstanding Common Stock owned by each director, shares issuable upon the exercise of options exercisable within 60 days have been deemed to be outstanding.
(3) The number of shares reported as beneficially owned includes 7,155,200 shares owned by Sumner M. Redstone and National Amusements, Inc. for which the reporting person has shared voting power but no dispositive power. Additionally, the number of shares reported as beneficially owned includes 504,632 shares for which the reporting person has sole voting and sole dispositive power, 500,000 of which may be acquired upon the exercise of options. For a discussion concerning the shared voting power with respect to the 7,155,200 shares of Common Stock referred to above, see "Item 12. Security Ownership of Certain Beneficial Owners and Management -- Voting Proxy Agreement."
(4) The number of shares reported as beneficially owned includes 7,155,200 shares owned by Sumner M. Redstone and National Amusements, Inc. for which the reporting person has shared voting power but no dispositive power. Additionally, the number of shares reported as beneficially owned includes 1,282,300 shares for which the reporting person has sole voting and sole dispositive power, 1,257,286 of which may be acquired pursuant to stock options. For a discussion concerning the shared voting power with respect to the 7,155,200 shares of Common Stock referred to above, see "Item 12. Security Ownership of Certain Beneficial Owners and Management -- Voting Proxy Agreement."
(5) Includes 62,955 shares of Common Stock which such person has the right to acquire upon the exercise of stock options.
(6) Includes 100,728 shares of Common Stock which Mr. Sheinfeld has the right to acquire upon the exercise of stock options.
(7) Includes 50,000 shares of Common Stock which Mr. Satz has the right to acquire upon the exercise of stock options.
LOUIS J. NICASTRO has been the President and Chief Executive Officer of the Company since April 6, 1998 and was Chief Operating Officer of the Company from April 6, 1998 to May 14, 1998. He has served as Chairman of the Board of Directors of the Company since its incorporation in 1974. Mr. Nicastro also served as Co-Chief Executive Officer of the Company (1994-1996), Chief Executive Officer (1974-1994), President (1985-1988 and 1990-1991) and Chief Operating Officer (1985-1986 and 1998). Mr. Nicastro is also a Director of Midway, and he held various executive positions for Midway from 1988 until 1996.
NEIL D. NICASTRO is a Director of and a consultant to the Company and he was the President, Chief Executive Officer and Chief Operating Officer of the Company until his resignation from such positions on April 6, 1998. Mr. Nicastro became a Director of the Company in 1986 and was elected President of the Company June 18, 1991, sole Chief Executive Officer June 26, 1996, Co-Chief Executive Officer August 29, 1994 and Chief Operating Officer September 30, 1990. He served as Treasurer (1986-1994), Executive Vice President (1988-1991), Senior Vice President (1987-1988), Vice President (1986-1987) and Director of Stockholder Relations (1981-1986). Mr. Nicastro is Chairman of the Board, President, Chief Executive Officer and Chief Operating Officer of Midway. Mr. Nicastro has held various other executive positions for Midway since 1988.
NORMAN J. MENELL has been Vice Chairman of the Board of Directors since 1990 and a Director of the Company since 1980. He also served as President (1988-1990), Chief Operating Officer (1986-1990) and Executive Vice President (1981-1988) of the Company. Mr. Menell is also a Director of Midway.
WILLIAM C. BARTHOLOMAY is President of Near North National Group, Chicago, Illinois (insurance brokers) and Chairman of the Board of the Atlanta Braves (National League Baseball). He has served as Vice Chairman of Turner Broadcasting System, Inc., a division of Time Warner Inc., since April 1994 having also held that office during the period 1976-1992 and having served as a Director (1976-1994). He also served as Vice Chairman of the Board of Directors of Frank B. Hall & Co. Inc. (1974-1990). Mr. Bartholomay was elected a Director of the Company in 1981. Mr. Bartholomay is also a Director of Midway.
WILLIAM E. MCKENNA has served as a General Partner of MCK Investment Company, Beverly Hills, California for in excess of five years. He also is a Director of Midway, California Amplifier, Inc., Drexler Technology Corporation and Safeguard Health Enterprises, Inc. Mr. McKenna has served as a Director of the Company since 1981.
HARVEY REICH was a member of the law firm of Robinson Brog Leinwand Greene Genovese & Gluck, P.C., New York, New York and its predecessor firms for in excess of five years until his retirement in July 1998. Mr. Reich was elected a Director of the Company in 1983. Mr. Reich is also a Director of Midway.
IRA S. SHEINFELD became a director of the Company in 1993. He has been a member of the law firm of Squadron, Ellenoff, Plesent & Sheinfeld LLP, New York, New York, for in excess of five years. Mr. Sheinfeld is also a Director of Midway.
DAVID M. SATZ JR. became a Director of the Company on April 6, 1998. Mr. Satz has been a member of the law firm Saiber Schlesinger Satz & Goldstein, Newark, New Jersey, for in excess of five years. Mr. Satz is also a Director of the Atlantic City Racing Association.
(b) Identification of Executive Officers. The following officers will serve until the 1999 Annual Meeting of the Board of Directors and until their respective successors are duly elected and qualify.
The principal occupation or employment of Mr. Louis J. Nicastro during the last five years is set forth in Item 10(a) above. See also "Item 11.
ITEM 11. EXECUTIVE COMPENSATION.
The Summary Compensation Table below sets forth the compensation paid by the Company and Midway for service in all capacities during the fiscal years ended June 30, 1998, 1997 and 1996 to each of the Company's executive officers who served during such periods and whose compensation exceeded $100,000. Pursuant to the Manufacturing and Services Agreement, after the Offering and until the Distribution the compensation paid by the Company to the executive officers of the Company (other than Mr. Neil D. Nicastro) was allocated to Midway based upon estimates by management of the Company and by management of Midway of the percentage of time devoted to Midway. After the Distribution, compensation paid by WMS to the executive officers of the Company is reimbursed by Midway in amounts equal to the Company's allocated cost pursuant to the Temporary Support Services Agreement dated as of April 6, 1998 between the Company and Midway (the "Temporary Support Services Agreement"). Management of the Company believes that such executive officers devoted 40% to 70% of their time to Midway during fiscal 1998. See "Item 13. Certain Relationships and Related Transactions" for a description of the Manufacturing and Services Agreement and the Temporary Support Services Agreement.
SUMMARY COMPENSATION TABLE
- ------------------------- (1) Does not include Midway stock options, all of which were granted at an exercise price equal to market value on the date of grant. In fiscal 1998, Mr. Louis J. Nicastro received options to purchase 10,000 shares of Midway common stock, Mr. Neil D. Nicastro received options to purchase 150,000 shares of Midway common stock, Mr. Bach received options to purchase 50,000 shares of Midway common stock and Mr. Edidin received options to purchase 35,000 shares of Midway common stock. In fiscal 1997, Mr. Neil D. Nicastro received options to purchase 500,000 shares of Midway common stock, Mr. Louis J. Nicastro received an option to purchase 25,000 shares of Midway common stock and Mr. Bach received options to purchase 100,000 shares of Midway common stock.
(2) Represents a payment made to Mr. Louis J. Nicastro to compensate him in lieu of adjusting his WMS stock options in connection with the Distribution. See "Adjustment to Options Resulting from the Distribution" below.
(3) Reflects the adjusted amount (total number) of stock options previously granted by the Company, which number of options and the exercise price thereof were adjusted pursuant to the distribution of the WHG common stock.
(4) Represents a termination payment received in fiscal 1997. See "Item 1. Business -- The Distribution" and Note 3 to the Notes to Consolidated Financial Statements.
(5) Mr. Louis J. Nicastro was elected President, Chief Executive Officer and Chief Operating Officer of the Company on April 6, 1998 and resigned from the position of Chief Operating Officer on May 14, 1998. Mr. Louis J. Nicastro has been Chairman of the Board of Directors since 1974. He also served as Co-Chief Executive Officer in fiscal 1996 until June 26, 1996. See "Item 1. Business -- The Distribution."
(6) Represents tax gross-up payments.
(7) Represents the accrual for contractual retirement benefits for Mr. Louis J. Nicastro.
(8) Excludes the value of adjustments to stock options of these holders pursuant to the Distribution. These amounts are found under "Adjustment to Options Resulting from the Distribution" below.
(9) Includes Mr. Nicastro's termination payment in the amount of $2,500,000. He also received an option to purchase 250,000 shares of Common Stock and a WMS consulting agreement. See "Employment Contracts" below.
(10) Includes life insurance premiums of $1,571, $1,467 and $691 for fiscal 1998, 1997 and 1996, respectively, and accrual for contractual retirement benefits of $45,503, $53,165 and $35,100 for fiscal 1998, 1997 and 1996, respectively.
(11) Mr. Nicastro served as President, Chief Executive Officer and Chief Operating Officer of the Company during fiscal 1998 until his resignation from such positions on April 6, 1998.
(12) Includes $50,100 paid to Mr. Verner in consideration of his forfeiture of performance units granted by his previous employer.
(13) Mr. Verner was elected Vice President and Chief Operating Officer of the Company on May 14, 1998.
(14) Mr. Edidin joined the Company as Vice President, Secretary and General Counsel on May 30, 1997.
The following table sets forth certain information with respect to options to purchase Common Stock granted in fiscal 1998 under the Company's stock option plans to persons named in the Summary Compensation Table.
OPTION GRANTS IN LAST FISCAL YEAR
- ------------------------- (1) The assumed appreciation rates are set pursuant to the rules and regulations promulgated under the Securities Exchange Act of 1934, as amended, and are not derived from the historical or projected prices of the Company's Common Stock. Total potential stock price appreciation from April 6, 1998 to April 6, 2008 for all stockholders, based on the price of $5.4375 per share of Common Stock on April 6, 1998 and
a total of 27,886,021 shares of Common Stock outstanding, would be $95,359,000 and $241,660,000 at assumed rates of stock appreciation of 5% and 10%, respectively.
(2) This option become exercisable for up to 10%, 30%, 60% and 100% of the option grant upon the first, second, third and fourth anniversaries, respectively, of the date of the grant.
The following table sets forth certain information with respect to the exercise of options to purchase Common Stock and the number and value of outstanding options owned by persons named in the Summary Compensation Table.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL-YEAR-END OPTION VALUES
- ------------------------- (1) Based on the closing price of Common Stock on the New York Stock Exchange on June 30, 1998, which was $4.1875.
(2) Excludes a $4,956,640 payment to compensate Mr. Louis J. Nicastro for the full amount to which he would otherwise have been entitled under the Adjustment Plan described below under the heading "Adjustment to Options Resulting from the Distribution."
ADJUSTMENT TO OPTIONS RESULTING FROM THE DISTRIBUTION
As of the date of the Distribution, Midway had 38,500,000 shares outstanding of which the Company owned 33,400,000 shares, representing approximately 86.8% of the outstanding shares of Midway common stock.
In August 1997, the Company announced that its Board of Directors had approved the Distribution in principle. The Distribution was conditioned upon several requirements, including the receipt of a ruling from the Internal Revenue Service that the transaction be tax free to the Company and its stockholders. The Company completed the Distribution on April 6, 1998.
Each of the Company's four Stock Option Plans in effect prior to the Distribution provided that in the event of a dividend or other distribution, such as the Distribution, outstanding options were to be adjusted so as to prevent dilution of the benefits or potential benefits intended to be made available by the options in such manner as the Board of Directors deems equitable. Several adjustment method alternatives were considered by the Board. Some companies that have implemented a spin-off of a subsidiary have followed a strategy where existing option holders were given replacement options in both the parent and the subsidiary. However, since Midway was already a public company with 13.2% of its stock held by stockholders other than the Company, the Board concluded that it would not be appropriate for the Company to cause Midway to issue options to satisfy the Company's obligations to its option holders.
The Board also considered adjusting the number and exercise price of the options so that their intrinsic value after the Distribution would equal the intrinsic value of the options before the Distribution. Such an adjustment would be accompanied by both reducing the exercise price of the options and increasing the
number of shares issuable upon exercise of the options. However, in light of the significant value of Midway to the Company as a whole, such an approach would have resulted in the issuance of options to acquire more than twice the number the shares of Common Stock outstanding, which the Board believed would not be in the best interests of stockholders.
Instead, the Board adopted an approach that would give option holders the same number of options to acquire shares of Common Stock after the Distribution (at the exercise price described below) as such holders held at the time of the Distribution and to compensate option holders for the lost opportunity value represented by the shares of common stock of Midway being distributed in the Distribution to stockholders of the Company which option holders would not participate in. In order to preserve the Company's cash resources, the Board also provided that such compensation be paid through a combination of cash and shares of Common Stock and would be capped.
The Board also believed it was desirable to advise the Company's stockholders at the earliest time of the minimum number of Midway shares they would receive as a result of the Distribution. Such number would have varied by reason of the exercise of any options prior to the completion of the Distribution. The Board believed that it was therefore in the interest of stockholders to obtain an undertaking from each option holder not to exercise his or her options prior to the completion of the Distribution.
After considering all of the foregoing and in consultation with its financial advisors, the Board approved and proposed to option holders the plan described below (the "Adjustment Plan"). The Adjustment Plan was accepted by holders of all outstanding options under the Company's four Stock Option Plans then in effect, including each of the persons listed in the Summary Compensation Table. The implementation of the Distribution was subject to the receipt of an opinion from the Company's financial advisors, CIBC Oppenheimer Corp., that the Distribution, including the adjustments to stock options resulting from the Distribution, was fair to the Company and its stockholders.
Pursuant to the Adjustment Plan, each option holder agreed not to exercise his or her outstanding options until the earliest of (i) the record date of the Distribution which was March 31, 1998, (ii) the date the Company publicly announces that is has abandoned its plan to complete the Distribution, (iii) the termination of employment of such holder by the Company for any reason, or (iv) June 30, 1998. In consideration for such agreement, each option holder was afforded one of two choices, at their election, which election was made shortly before the Distribution, in the event the Distribution was completed:
(1) Each option holder became entitled to receive a guaranteed minimum payment for all of his or her options in an amount equal to the spread between the trading price of shares of Common Stock on September 22, 1997 ($30.00), the date the Adjustment Plan was approved by the Board, and the exercise price of the option, plus a premium which represented the value of the option holder's commitment not to exercise the options, determined using the Black-Scholes method of determining option values; or
(2) At the time of the Distribution, the option holder could elect to receive: (a) an ongoing option (the "Surviving Option") to purchase the same number of shares of Common Stock as they then held at an exercise price determined by multiplying the exercise price of the applicable options by a fraction, the numerator of which was the projected value of shares of Common Stock after the date on which shares of Common Stock traded ex-dividend (i.e. without entitlement to the Midway shares being spun off), as determined by the Board upon advice of its financial advisors, and the denominator of which was the average closing price of shares of Common Stock on the New York Stock Exchange for a period of time prior to the Distribution determined by the Board and (b) payment for the lost opportunity value of options to purchase the number of shares of common stock of Midway that such optionee would have received prior to the Distribution (the "Phantom Midway Options"). The number of shares subject to the Phantom Midway Options was determined by multiplying the number of options by the ratio of shares of Common Stock (the "Distribution Ratio"). The exercise price of the Phantom Midway Options was determined by subtracting the exercise price of the applicable Surviving Option from the exercise price of the applicable option and dividing the result by the Distribution Ratio. The Phantom
Midway Options were then valued using the Black-Scholes methodology, utilizing such assumptions approved by the Board and its financial advisors, and were purchased by the Company.
Payments by the Company for either the minimum guarantee or the Phantom Midway Options was initially approved by the Board to be paid in cash up to maximum of $30.0 million and in shares of Common Stock up to a maximum of 2,000,000 shares. Shortly before the Distribution, the Board became concerned that, after payment of taxes, optionees would have little cash remaining and might be inclined, for investment concentration or other reasons, to sell shares of Midway common stock received in the Distribution, which sales might have a depressive effect on the market price of such stock. The Board believed that this concern would be alleviated if $5.0 million of additional cash were available to pay to optionees so that optionees would receive at least 70% of their adjustment payments in cash.
In order to raise the additional $5.0 million in cash as well as additional cash of approximately $8.5 million used to pay expenses of the Distribution and for additional working capital, the Company requested that Mr. Louis J. Nicastro, Chairman of the Board of the Company, forego his entitlement under the Adjustment Plan, to receive payments valued at $10,406,059 and an adjustment of the exercise price of his stock options to $3.519 per share. Instead, at the request of the Board, shortly before the Distribution, Mr. Nicastro exercised his options to purchase 629,554 shares of Common Stock, sold such shares in the public market and received from the Company a payment of $4,956,640 representing the difference between $10,406,059 and the net amount he received from the exercise and sale. When Mr. Nicastro exercised his options, the Company received an aggregate exercise price of $13,437,200. The Company used $5.0 million of the proceeds from the aforementioned exercise, together with $30.0 million, to pay the 1998 cash portion of the adjustment to the other option holders. In consideration of the Company making increased cash available to holders, each of Messrs. Neil D. Nicastro, Harold H. Bach, Jr., Kenneth J. Fedesna, officers and/or directors of the Company and/or Midway, agreed to refrain from selling or disposing of shares of Midway common stock received by them in the Distribution for a period of six months after the Distribution.
The consideration paid under the Adjustment Plan in fiscal 1998 to the persons named in the Summary Compensation Table is in addition to the amounts set forth therein and is as follows: Mr. Neil D. Nicastro received $12,428,476 in cash and Common Stock valued at $6,079,497. Mr. Kevin L. Verner received $175,615 in cash and Common Stock valued at $85,904. Mr. Verner will receive additional cash adjustment payments, up to a total of $2,256,605 if he is still serving the Company through the end of the vesting period, on the dates that his options would have vested. Mr. Harold H. Bach, Jr. received $1,093,193 in cash and Common Stock valued at $534,722. Mr. Orrin J. Edidin received $49,442 in cash. He will receive additional cash adjustment payments, up to a total of $441,335 if he is still serving the Company or Midway through the end of the vesting period, on the dates that his options would have vested. The Common Stock was valued at the average of the high and low sale prices on the New York Stock Exchange on April 3, 1998, the last day of trading prior to the Distribution.
COMPENSATION OF DIRECTORS
The Company pays a fee of $40,000 per annum to each director who is not also an employee of the Company or its subsidiaries. Each such director who serves as the chairman of any committee of the Board of Directors receives a further fee of $5,000 per annum for his services in such capacity and each member of the Company's Audit and Ethics Committee receives an additional fee of $5,000 per annum.
Each Director of the Company who was not also an employee of the Company or its subsidiaries prior to the Distribution (which at that time included Mr. Louis J. Nicastro) was also a non-employee Director of Midway. All such persons continue to serve on the Midway Board of Directors. During the 1998 fiscal year, Midway paid a fee of $22,500 per annum to each such Midway Director. Each such Director who serves as the chairman of any committee of the Midway Board of Directors receives a further fee of $2,500 per annum for his services in such capacity and each other member of Midway's Audit Committee receives an additional fee of $2,500 per annum. Each such director was also eligible to receive, and has received, options to purchase Midway common stock.
The Company's 1991 and 1993 Stock Option Plans and 1998 Non-Qualified Stock Option Plan (each, a "Plan") provide for the issuance of shares of Common Stock of the Company pursuant to non-qualified stock options which may be granted to non-employee directors of the Company, generally at not less than 100% of the fair market value of such shares on the date of grant. Under the 1991 Plan, Mr. Sheinfeld holds options to purchase 37,773 shares (as adjusted) of Common Stock at an average exercise price of $3.26 (as adjusted). Under the 1993 Plan, the following non-employee directors each hold options to purchase 62,955 shares (as adjusted) of Common Stock at an exercise price of $3.519 per share (as adjusted): Messrs. Bartholomay, McKenna, Menell, Reich and Sheinfeld. Under the 1998 Plan, Mr. Satz holds options to purchase 50,000 shares of Common Stock at an exercise price of $4.4375 per share.
Directors also are entitled to participate at the Company's expense in a medical reimbursement plan which is supplementary to the primary medical insurance maintained by such individual and in certain stock option plans of the Company. See "Stock Option Plans" below.
Pursuant to the Adjustment Plan described above, Mr. Sheinfeld received 18,202 shares of Common Stock valued at $604,648 and cash in the amount of $1,236,277, and Messrs. Reich, Menell, McKenna and Bartholomay each received 10,731 shares of Common Stock valued at $356,470 and cash in the amount of $728,799.
STOCK OPTION PLANS
The Company currently has the following five stock option plans in effect: the 1982 Employee Stock Option Plan; the 1991 Stock Option Plan; the 1993 Stock Option Plan; the 1994 Stock Option Plan; and the 1998 Non-Qualified Stock Option Plan (collectively, the "Stock Option Plans" or "Plans"). The Plans provide for the issuance of shares of Common Stock pursuant to options which may be granted thereunder. Options granted under the Plans may be in the form of options meeting the requirements of Section 422 of the Internal Revenue Code, as amended ("incentive stock option", except in the case of the 1998 Plan), or options not meeting the requirements of such section ("non-qualified stock options").
The purpose of each of the Plans is to encourage employees of the Company and its subsidiaries and, under certain of the Plans, non-employee directors, consultants and advisers of the Company to acquire a proprietary interest in the Company and to enable such individuals to realize benefits from an increase in the value of the Common Stock, to provide such individuals with greater incentive and to encourage their continued provision of services to the Company and, generally, to promote the interests of the Company and all of its stockholders.
Under the 1982 Plan, there are 220,270 options outstanding, and no further options are available for grant. Under the 1991 Plan, there are 963,217 options outstanding and 88,445 options available for grant through September 6, 2001. Under the 1993 Plan, there are 1,474,905 outstanding options, and no further options are available for grant. Under the 1994 Plan, there are 1,450,326 options outstanding and 191,296 options available for grant through June 20, 2004. Under the 1998 Plan, there are 291,000 options outstanding and 709,000 options available for grant through May 13, 2008. The average exercise price of the outstanding exercisable options at September 15, 1998, was approximately $3.66. Of the 4,399,718 options outstanding, 2,430,178 were held by officers and directors of the Company (including 500,000 held by Mr. Louis J. Nicastro and 1,257,286 held by Mr. Neil D. Nicastro).
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
No member of the Company's Compensation Committee or Stock Option Committee is an employee or officer of the Company, and no officer, director or other person had any relationship required to be disclosed here.
EMPLOYMENT CONTRACTS
Mr. Louis J. Nicastro is employed by the Company under the terms of an Employment Agreement dated as of April 6, 1998. The employment agreement provides for salaried compensation at the rate of $450,000 per
annum, or such greater amount as may be determined by the Board of Directors. The agreement expires June 30, 2000, subject to automatic extensions in order that the term of Mr. Nicastro's employment shall at no time be less than two years; provided that either party may terminate the agreement effective upon expiration of the original term or the extended term upon written notice from the terminating party to the other party dated and received at least two years prior to the respective termination date.
The employment agreement of Mr. Louis J. Nicastro provides for, among other things, full participation in all benefit plans and perquisites generally available to senior executives and for reimbursement of all medical and dental expenses incurred by him or his spouse during their lives to the extent such expenses are not otherwise reimbursed by insurance provided by the Company. Additionally, Mr. Nicastro is entitled to receive such special bonuses as may be determined from time to time by the Board of Directors. The employment agreement may be terminated at the election of Mr. Nicastro upon the occurrence without his prior written consent of any one or more of the following events: (i) the placement of Mr. Nicastro in a position of lesser status, the assignment to Mr. Nicastro of duties inconsistent with his positions with the Company or duties which, if performed, would result in a significant change in the nature or scope of powers, authority, functions or duties inherent in such positions presently in effect, the assignment to Mr. Nicastro of performance requirements or working conditions which are at variance with the performance requirements or working conditions presently in effect, or the treatment of Mr. Nicastro in a manner which is in deregation of his status as a senior executive; (ii) the cessation of service of Mr. Nicastro as a member of the Board of Directors of the Company; (iii) the discontinuance or reduction (from the highest level in effect during the term of the employment agreement) of amounts payable for base salary payable to Mr. Nicastro pursuant to the agreement; and (iv) the discontinuance or reduction (from the level in effect on the date of the employment agreement) of the perquisites or fringe benefits inherent in Mr. Nicastro's position on the date of the employment agreement. In such event, and in the event the Company is deemed to have wrongfully terminated Mr. Nicastro's employment agreement under the terms thereof, the Company is obligated (a) to pay Mr. Nicastro a lump sum payment equal in amount to three times Mr. Nicastro's base salary at the highest annual rate in effect during the one-year period immediately preceding termination and (b) to purchase at the election of Mr. Nicastro all stock options held by him with respect to the Company's Common Stock and options to purchase the securities of any other company at least 20% of the voting securities of which are owned by the Company at a price equal to the spread between the option price and the fair market price of such stock as defined in the employment agreement. The employment agreement may also be terminated at the election of Mr. Nicastro if individuals who presently constitute the Board of Directors, or successors approved by such Board members, cease for any reason to constitute at least a majority of the Board. Upon such an event, the Company will be required to make payments and purchase the stock options held by Mr. Nicastro as set forth above.
If payments made to Mr. Nicastro pursuant to the employment agreement after a change of control are considered "excess parachute payments" under Section 280G of the Internal Revenue Code of 1986, as amended, additional compensation is required to be paid to Mr. Nicastro to the extent necessary to eliminate the economic effect on him of the resulting excise tax. Pursuant to Section 280G, in addition to income taxes, the recipient is subject to a 20% nondeductible excise tax on excess parachute payments. An excess parachute payment is a payment in the nature of compensation which is contingent on a change of ownership or effective control and which exceeds the portion of the base amount (i.e., the average compensation for the five-year period prior to the change of control) allocable to the payment. These rules apply only if the present value of all payments of compensation (including non-taxable fringe benefits) at the time of a change of control is at least equal to three times the base amount. Excess parachute payments are not deductible by the Company.
In contemplation of the Offering of common stock of Midway, the Company and Midway each entered into separate employment agreements (the "1996 Agreements") with Mr. Neil D. Nicastro effective as of July 1, 1996. On March 5, 1998 in connection with the Distribution and at the request of the Board of Directors of the Company, the Company and Mr. Nicastro entered into an agreement (the "Termination Agreement") pursuant to which Mr. Nicastro's employment with the Company terminated effective at the time of the Distribution. Pursuant to the Termination Agreement, at the time of the Distribution,
Mr. Nicastro resigned as President, Chief Executive Officer and Chief Operating Officer of the Company to devote his full time to Midway.
Each of the 1996 Agreements provided that Mr. Nicastro would receive salaried compensation at the rate of $300,000 per annum, or such greater amount as may have been determined by the Board of Directors of the Company or Midway, as applicable. Mr. Nicastro's 1996 Agreement with Midway provided for bonus compensation in an amount equal to two percent of the pre-tax income of Midway multiplied by the percentage of Midway common stock outstanding which was not owned by the Company (which was 13.2%). Mr. Nicastro's 1996 Agreement with the Company also provided for bonus compensation in an amount equal to two percent of the pre-tax income of the Company. The portion of Mr. Nicastro's bonus from the Company that was attributable to the pre-tax income of Midway was charged to Midway pursuant to the Manufacturing and Services Agreement between the Company and Midway. The 1996 Agreement with the Company provided for, among other things, full participation in all benefit plans available to senior executives and for reimbursement of all medical and dental expenses incurred by Mr. Nicastro or his spouse and incurred by his children under the age of twenty-one. Additionally, the Company and Midway each provided Mr. Nicastro with $1,000,000 of life insurance coverage in addition to the standard amount provided to Company employees. Each of the 1996 Agreements provided that Mr. Nicastro could divide his attention between the business of the Company and the business of Midway as he would consider appropriate. The 1996 Agreements further provided for certain benefits upon the termination of Mr. Nicastro's employment.
Pursuant to the Termination Agreement, as full consideration for payments that would otherwise have been made to Mr. Nicastro under the 1996 Agreement with the Company with respect to base salary, bonus, retirement and death benefits, Mr. Nicastro was paid a lump sum of $2,500,000, and he was granted a 10-year option to purchase 250,000 shares of Common Stock at an exercise price of $5.4375. Additionally, the $1,000,000 of life insurance coverage provided by the Company under such 1996 Agreement was transferred to Midway at the time of the Distribution.
In connection with the Distribution, the Company also entered into a consulting agreement (the "Consulting Agreement") with Mr. Nicastro pursuant to which Mr. Nicastro agreed to make himself reasonably available at the Company's request, to render such services concerning the Company as the Board of Directors or the Chairman of the Board and Chief Executive Officer of the Company may reasonably request. The term of the Consulting Agreement is for five years from the date of the Distribution, and is automatically renewable for successive one year terms unless either party shall give notice of termination not less than six months prior to the end of the term then in effect. The Company pays Mr. Nicastro $1,000 per month for his services under the Consulting Agreement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
VOTING PROXY AGREEMENT
In order for the Company to be permitted to manufacture and sell slot machines in Nevada, the Company and its Gaming Subsidiaries and Mr. Louis J. Nicastro and Mr. Neil D. Nicastro were required to be registered, licensed or found suitable and have been registered, licensed or found suitable by the Nevada Board and the Nevada Commission, as applicable, as a Registered Corporation, as registered holding companies, for licensure as a manufacturer and distributor of gaming devices and as directors, officers and stockholders of such entities, as applicable. Under applicable Nevada law and administrative procedure, as a greater than 10% stockholder of the Company, Mr. Sumner M. Redstone ("SMR") was required to apply and has an application pending with the Nevada Gaming Authorities for a finding of suitability as a stockholder of the Company. Pending completion of the processing of SMR's application, SMR and National Amusements, Inc. ("NAI") have voluntarily granted to Mr. Louis J. Nicastro and, if he is unable to perform his duties under the Proxy Agreement (as defined below), Mr. Neil D. Nicastro, individually, a voting proxy for all of the shares of Common Stock which they own beneficially or of record.
On September 21, 1995, Mr. Louis J. Nicastro and Mr. Neil D. Nicastro entered into a Voting Proxy Agreement (the "Proxy Agreement") with the Company, SMR and NAI, pursuant to which Mr. Louis J. Nicastro and, if he is unable to perform his duties under the Proxy Agreement, Mr. Neil D. Nicastro have
been appointed, individually, as proxy holder with full power of substitution during and for the term of the voting proxy, to vote all shares of the Company's Common Stock as the proxy of SMR and NAI at any annual, special or adjourned meeting of the stockholders of the Company, including the right to execute consents, certificates or other documents relating to the Company that the law of the State of Delaware may permit or require on any and all matters which may be presented to the stockholders of the Company. The term of the Proxy Agreement is for 10 years commencing August 25, 1995, unless sooner terminated upon 30 days' written notice. The Proxy Agreement will be deemed terminated as to any subject matter that will be presented for approval, consent or ratification to the stockholders of the Company if the Company fails to give SMR and NAI 45 days' notice of such subject matter. The Proxy Agreement will also terminate if SMR and NAI are found suitable as stockholders of the Company by the Nevada Gaming Authorities or are no longer subject to the provisions of Nevada gaming laws applicable to holders of more than 10% of the Company's Common Stock. The Proxy Agreement is not applicable to any shares of the Company's Common Stock sold or otherwise disposed of by SMR or NAI to any person who is not an affiliate of SMR or NAI. SMR and NAI have agreed to give notice of any sale or disposition to the Chairman of the Nevada Board within 10 days after such sale or disposition. The Proxy Agreement was entered into to assure that the passive investment position of SMR and NAI relative to the Company will not change without prior notification to the Nevada Gaming Authorities.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information as of September 15, 1998 (except as otherwise footnoted) with respect to persons known to be the beneficial owner of more than five percent of the Company's Common Stock, each Executive Officer of the Company who is not also a Director of the Company, and Directors and Executive Officers of the Company as a group. Security ownership of the individual Directors of the Company is set forth under the heading "Identification of Directors" in Item 10(a) above.
- ------------------------- * Less than 1% of the number of outstanding shares of Common Stock on September 15, 1998.
(1) Pursuant to Rule 13d-3(d)(1) of the Securities Exchange Act of 1934, as amended, shares underlying options are deemed to be beneficially owned if the holder of the option has the right to acquire beneficial ownership of such shares within 60 days.
(2) For purposes of calculating the percentage of outstanding Common Stock, shares issuable upon the exercise of options within 60 days have been deemed to be outstanding.
(3) The number of shares reported is based upon information contained in Amendment No. 20, dated January 7, 1997, to the Schedule 13D filed by Mr. Sumner M. Redstone with the Securities and Exchange Commission and a Form 4, dated July 9, 1998, filed by Mr. Redstone with the Securities and Exchange Commission. Pursuant to such filings, Mr. Redstone and National Amusements, Inc., a Maryland corporation, reported beneficial ownership of and sole investment power with respect to 3,671,300 and 3,483,900 shares, respectively, of the Common Stock and shared voting power with respect to such shares pursuant to a Proxy Agreement entered into with the Company, and Messrs. Louis J. and Neil D. Nicastro (see "Voting Proxy Agreement" above). As a result of his stock ownership in National Amusements, Inc. Mr. Redstone is deemed the beneficial owner of the shares of Common Stock owned by National Amusement, Inc.
(4) The number of shares reported is based upon information contained in Schedule 13G, dated February 9, 1998, filed by Boston Partners Asset Management, L.P. ("BPAM"), Boston Partners, Inc. ("Boston Partners") and Desmond John Heathwood ("Heathwood", and collectively with BPAM and Boston Partners, the "Reporting Persons"). Each of the Reporting Persons may be deemed to own beneficially 1,633,700 shares of Common Stock. As sole general partner of BPAM, Boston Partners may be deemed to own beneficially all of the shares of Common Stock that BPAM may be deemed to own. As principal stockholder of Boston Partners, Heathwood may be deemed to own beneficially all of the Common Stock that Boston Partners may be deemed to own beneficially. BPAM holds all the above 1,633,700 shares under management for its clients, who have the right to direct the receipt of dividends, to receive dividends from such shares and to receive the proceeds from the sale of such shares. Boston Partners and Heathwood expressly disclaimed beneficial ownership of any shares of Common Stock in the Schedule 13G.
(5) The number of shares reported is based upon a written certification delivered by Fidelity Management & Research Company, a wholly-owned subsidiary of FMR Corp., stating that it is the beneficial owner of the shares as a result of acting as investment adviser to various investment companies registered under Section 8 of the Investment Company Act of 1940 and that Fidelity Advisor Strategic Opportunities Fund, one of such investment companies, is the beneficial owner of 1,825,100 shares or 6.5% of the Common Stock. FMR Corp. reported that it has sole power to dispose of or direct the disposition of all such shares.
(6) The number of shares reported as beneficially owned includes 7,155,200 shares of Common Stock owned by Sumner M. Redstone and National Amusements, Inc. for which the reporting person has
shared voting power but no dispositive power. Additionally, the number of shares reported as beneficially owned includes 1,282,300 shares for which the reporting person has sole voting and sole dispositive power, 1,257,286 of which may be acquired upon the exercise of stock options. For a discussion concerning the shared voting power with respect to the 7,155,200 shares of Common Stock referred to above, see "Voting Proxy Agreement" above.
(7) The number of shares reported as beneficially owned includes 7,155,200 shares owned by Sumner M. Redstone and National Amusements, Inc. for which the reporting person has shared voting power but no dispositive power. Additionally, the number of shares reported as beneficially owned includes 504,632 shares for which the reporting person has sole voting and sole dispositive power, 500,000 of which may be acquired upon the exercise of stock options. For a discussion concerning the shared voting power with respect to the 7,155,200 shares of Common Stock referred to above, see "Voting Proxy Agreement" above.
(8) Includes 94,433 shares of Common Stock which Mr. Harold H. Bach, Jr. has the right to acquire upon the exercise of stock options.
(9) Includes 12,591 shares of Common Stock which Mr. Kevin L. Verner has the right to acquire upon the exercise of stock options.
(10) Includes 2,500 shares of Common Stock which Mr. Orrin J. Edidin has the right to acquire upon the exercise of stock options.
(11) Includes 2,269,358 shares of Common Stock which directors and executive officers have the right to acquire upon the exercise of stock options. Additionally, includes 7,155,200 shares of Common Stock owned by Sumner M. Redstone and National Amusements, Inc. with respect to which Mr. Louis J. Nicastro and Mr. Neil D. Nicastro both have shared voting power but no dispositive power. For a discussion concerning the shared voting power with respect to the 7,155,200 shares of Common Stock referred to above, see "Voting Proxy Agreement" above.
(12) For purposes of this calculation, the 7,155,200 shares of Common Stock owned by Sumner M. Redstone and National Amusements, Inc. with respect to which Mr. Louis J. Nicastro and Mr. Neil D. Nicastro have shared voting power but no dispositive power have only been counted once. For a discussion concerning the shared voting power with respect to the 7,155,200 shares of Common Stock referred to above, see "Voting Proxy Agreement" above.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
RELATIONSHIP WITH MIDWAY
Prior to the Offering, Midway was a wholly-owned subsidiary of WMS. As a result of the Offering, WMS' beneficial ownership of Midway common stock was reduced from 100.0% to 86.8%. As a result of the Distribution, WMS does not own any Midway common stock. A majority of Midway's directors are also directors and/or officers of WMS. Additionally, several of the executive officers of Midway are officers and/or directors of WMS. See "Item 10 -- Directors and Executive Officers of the Registrant."
In connection with the Distribution, WMS and Midway entered into the following agreements:
Manufacturing Agreement. WEG and Midway entered into the Manufacturing Agreement with respect to the manufacture of coin-operated video games and kits. The Manufacturing Agreement became effective as of April 6, 1998 and will continue in effect for a period of three years and for successive renewal periods of six months each unless terminated (a) by either party for any reason upon six months' notice or (b) in the event of a material default under the Manufacturing Agreement or under the Confidentiality provisions of the Confidentiality and Non-Competition Agreement discussed below, immediately at the election of the non-defaulting party. Pursuant to this Agreement, all of Midway's coin-operated video games are manufactured by WEG at its facility in Waukegan, Illinois.
WEG is required to allocate 65% of its combined production and storeroom square footage at the Waukegan plant to perform its obligations under the Manufacturing Agreement. Midway conducts its own design and engineering of coin-operated video games, including programming, graphic design, electrical
engineering, sound engineering and model shop engineering. Certain production engineering activities, such as the design process for the assembly of each game, creating work station profiles and quality control of incoming parts and the assembly process are provided to Midway by WEG. Materials used in the manufacture of coin-operated video games which are unique to such games are purchased by Midway from third party vendors. Materials used in the manufacture of coin-operated video games which are common with materials used in the production of pinball and novelty games sold by WEG are purchased by WEG (estimated to be 5% of materials costs) and charged to Midway at actual cost plus 9.0%. All labor costs, including fringe benefits, directly associated with the manufacturing of coin-operated video games are charged to Midway at WEG's actual cost plus 9.0%. The Waukegan plant's operating costs are either identified as Midway costs and charged to Midway or allocated as agreed between the parties. Such identified or allocated costs include, without limitation, manufacturing costs, materials management costs, quality assurance costs and administration costs. Plant operating costs of WEG paid by Midway under the Manufacturing Agreement are increased by 9.0%. The obligations of WEG under the Manufacturing Agreement are guaranteed by WMS.
Cabinet Supply Agreement. Lenc-Smith and Midway entered into the Cabinet Supply Agreement with respect to the supply of cabinets for coin-operated video games. The Cabinet Supply Agreement became effective as of April 6, 1998 and will continue in effect for a period of three years and for successive renewal periods of six months each unless terminated (a) by either party for any reason upon six months' notice or (b) in the event of a material default, immediately at the election of the non-defaulting party.
The Cabinet Supply Agreement provides that to initiate the purchase of video game cabinets, Midway shall issue a pricing inquiry to Lenc-Smith specifying the number of cabinets to be ordered and the cabinet specifications. Lenc-Smith then provides a formal quote on the pricing inquiry, and, upon agreement on a final price, a purchase order will be issued. Lenc-Smith ships all cabinets to WEG's Waukegan, Illinois plant for use in the manufacture of coin-operated video games. Midway may purchase cabinets from manufacturers other than Lenc-Smith if Lenc-Smith does not meet competitive bona-fide quotes.
Spare Parts Sales and Service Agreement. WEG entered into the Spare Parts and Sales Service Agreement with Midway and Atari Games Corporation, a wholly-owned subsidiary of Midway ("Atari Games"), pursuant to which WEG sells spare parts for coin-operated video games produced on behalf of Midway and Atari Games. The agreement became effective as of April 6, 1998 and has the same term and is terminable in the same manner as the Cabinet Supply Agreement. Pursuant to the agreement, WEG must purchase and maintain an adequate inventory of spare parts needed by end-users of coin-operated video games of Midway and Atari Games. To the extent any parts are proprietary to Midway, Midway will sell or arrange for the sale of such parts to WEG. WEG will purchase all non-proprietary parts through its usual vendor sources or through Midway at negotiated prices. Midway and Atari Games are required to refer their customers to WEG for spare parts purchases during the term of the agreement. The agreement does not include warranty services, which services Midway is required to provide to its customers.
Sales Agreement. WEG entered into the Sales Agreement with Midway effective April 6, 1998. The term of the agreement is the same as the term of the Cabinet Supply Agreement. During the term of the agreement, Midway will supply WEG with certain sales services, including sales testing for all new products developed by WEG, coordinating and negotiating print advertising and video presentations with third-party advertising and media firms, and negotiating distribution and sales agency agreements with third-party distributors. In consideration for such services, WEG will pay Midway $500,000 per annum plus a commission of 1.5% on the first $25.0 million of annual net sales of WEG products made by Midway and 1.0% on annual net sales of WEG products made by Midway in excess of $25.0 million. The commission for the period April 6, 1998 through June 30, 1998 was 1.5% of the first $6,250,000 of net sales made by Midway and 1.0% thereafter. An annual budget for marketing and testing will be developed and agreed upon in advance between the parties annually and modified quarterly upon mutual agreement. To extent additional services are provided which were not included in the budget, certain additional charges will be applicable for payroll, overhead and expense at Midway's cost plus 8.0%.
Information Systems Service Agreement. WEG and Midway entered into an Information Systems Service Agreement effective as of April 6, 1998 for a term of three years with successive renewal periods of
18 months. The agreement is terminable by either party (a) upon 18 months' notice or (b) upon a material default, immediately by the non-defaulting party. Pursuant to the agreement, WEG provides Midway with access to its computer systems for business applications, including, without limitation, order entry, financial and manufacturing modules, marketing and sales and engineering (including electronic engineering documentation and blueprint systems) as well as support for the computer system. The agreement also provides that WEG will coordinate the provision and maintenance of cabling, wiring, switching components, routers and gateway and the purchasing, maintaining and upgrading of network services for Midway. These services include purchasing of desktop computers and related hardware as well as providing certain telecommunications service to Midway. Midway may also request WEG to provide services to develop the communications networking, operating and computer system of Midway and other related services. Midway pays WEG an amount equal to the cost to WEG for all services provided plus 6.6% of such cost.
Confidentiality and Non-Competition Agreement. WMS entered into the Confidentiality and Non-Competition Agreement with Midway effective as of April 6, 1998. Pursuant to the agreement, either party may designate information regarding its business as confidential, which each party will use its best efforts to keep confidential. For a period of five years from the date of the agreement, neither party shall engage, directly or indirectly, in the business currently conducted by the other party (except that Midway may engage in any business related to coin-operated video game manufacturing, cabinet supply, spare parts sales and video-simulated non-mechanical pinball games). Additionally, for the greater of (i) the period from the date of the agreement until April 5, 2000 or (ii) a period ending one year after the date that any particular employee of Midway or WMS no longer is providing services to the other party pursuant to any of the agreements entered into in connection with the Distribution, such other party shall not, directly or indirectly, hire or solicit the employment of such employee or encourage such employee to leave his or her employment or induce any such employee to seek, accept or obtain employment by any person other than such employer.
Right of First Refusal Agreement. WMS and Midway entered into the Right of First Refusal Agreement as of April 6, 1998 pursuant to which Midway was granted the right of first refusal with respect to any offer to WMS to purchase the Waukegan plant, or any material part thereof, which offer is not made in connection with the sale of substantially all of WMS' assets and business as a going concern or a sale of substantially all of the capital stock of WMS, and which WMS intends to accept. The term of the agreement is for 10 years expiring April 5, 2008.
Third Parties Agreement. WMS entered into the Third Parties Agreement with Midway on April 6, 1998. The agreement governs the treatment of the numerous arrangements with third parties that WMS and Midway are party to with respect to game development, the obtaining or grant of licenses and other matters, which provide for, among other matters, the receipt of payments, the obligation or guaranty of an obligation to make payments to third parties, recoupment of prior advances, rights of first refusal and reporting and monitoring of intellectual property rights. The parties will allocate all other rights and obligations under third party arrangements so that the party receiving the benefit will bear the burden of such agreements. The agreement shall remain in effect so long as any third party arrangements remain outstanding.
Temporary Support Services Agreement. WMS and Midway entered into a Temporary Support Services Agreement which provides, among other things, that WMS will supply all or a portion of Midway's administrative, legal and accounting, information services, and janitorial and other agreed upon services, including the use of space by Midway in any WMS facility, as requested from time to time by Midway. In consideration for the services provided by WMS, Midway will pay WMS an amount equal to its direct or allocated cost (including, without limitation, wages, salaries, fringe benefits and materials), as indicated on monthly invoices supplied by WMS. The agreement was effective as of April 6, 1998 and will continue for a period of 18 months and for successive renewal periods of three months each; provided, however, that the agreement may be terminated by either party upon six months' notice, and each party may, upon 60 days' notice, terminate any one or more of the services provided, except the use of space by Midway in any WMS facility.
Tax Separation Agreement. Midway has been a member of the consolidated group of corporations of which WMS was the common parent for federal income tax purposes (the "WMS Group") since 1988.
Therefore, Midway is jointly and severally liable for any federal tax liability incurred by the WMS Group. Midway and WMS entered into the Tax Separation Agreement as of April 6, 1998. The agreement sets forth the parties respective liabilities for federal, state and local taxes as well as their agreements as a result of Midway and its subsidiaries ceasing to be members of the WMS Group. The Tax Separation Agreement governs, among other things, (i) the filing of tax returns with federal, state and local authorities, (ii) the carryover of any tax benefits of Midway, (iii) the treatment of the deduction attributable to the exercise of stock options to purchase Common Stock which are held by employees or former employees of Midway and any other similar compensation related tax deductions, (iv) the treatment of certain net operating loss carrybacks, (v) the treatment of audit adjustments, (vi) procedures with respect to any proposed audit adjustment or other claim made by any taxing authority with respect to a tax liability of Midway or any of its subsidiaries. Certain other tax matters are addressed in the Tax Sharing Agreement which was entered into in connection with the Offering and which remains in full force and effect. See "Tax Sharing Agreement" below.
Tax Indemnification Agreement. WMS entered into the Tax Indemnification Agreement with Midway effective as of April 6, 1998 providing for indemnifications in the event the Distribution fails to qualify under Section 355 of the Internal Revenue Code of 1986, as amended (the "Code"). Each of the parties agreed that for a period of two years after the Distribution, each would continue active conduct of its historic trade or business as conducted by it during the five-year period prior to the Distribution. Midway also agreed that, to fund an acquisition, within one year after the Distribution, it would either (i) raise cash through an offering of shares of its common stock or debentures with detachable warrants to purchase shares of its common stock or (ii) use shares of its common stock as acquisition consideration. Additionally, each party agreed not to: (i) merge or consolidate with another entity; (ii) liquidate or partially liquidate; (iii) sell or transfer all or substantially all its assets in a single transaction or a series of transactions; (iv) redeem or otherwise repurchase any of its capital stock in a manner contrary to certain Internal Revenue Service ("IRS") revenue procedures; (v) enter into any transaction or make any change in its equity structure which may cause the Distribution to be treated as a plan pursuant to which one or more persons acquire directly or indirectly its common stock representing a "50 percent or greater interest" within the meaning of Section 355(d)(4) of the Code; or (vi) in the case of Midway except in connection with stock issued pursuant to an employee benefit or compensation plan and except as described in the private letter ruling issued in connection with the Distribution issue additional shares of its capital stock, unless such party first obtains the consent of the other party and, if applicable, the person or persons acquiring a "50 percent or greater interest" in such party have agreed to become jointly or severally liable for payments required to be made by such party pursuant to the Tax Indemnification Agreement.
Midway will indemnify WMS with respect to any action referred to above which it takes or if it fails to issue Midway common stock as set forth above which causes the Distribution to fail to qualify under Section 355 of the Code, against any federal, state and local taxes, interest, penalties and additions to tax imposed upon or incurred by the WMS Group or any member thereof. WMS will indemnify Midway and its subsidiaries against any and all federal, state and local taxes, interest, penalties and additions to tax resulting from the Distribution, other than any such liabilities for which Midway is required to indemnify WMS. The agreement also governs the procedures for indemnification, calculation of the amount of indemnified liability for income taxes and reduction of indemnity by income tax benefits from indemnified liabilities.
In connection with the Offering, WMS and Midway entered into the following agreements:
Manufacturing and Services Agreement. WMS and Midway entered into the Manufacturing and Services Agreement with respect to various aspects of their relationship after the Offering. As of the Distribution, the Manufacturing Agreement referred to above superseded and replaced the Manufacturing and Services Agreement. The Manufacturing and Services Agreement became effective as of July 1, 1996. The Manufacturing and Services Agreement provided, among other things, for WMS to provide Midway with management, legal and administrative services and certain services for its coin-operated video games including, without limitation: (i) manufacturing; (ii) engineering support; (iii) sales and marketing; (iv) warranty and field services; and (v) creative services.
Materials used in the manufacture of coin-operated video games were purchased by Midway at its expense. Certain other manufacturing costs were allocated based upon units produced for Midway and the other amusement games businesses of WMS. All labor costs associated with the manufacturing of coin- operated video games were charged to Midway at actual cost to WMS. Certain management, legal and administrative expenses and sales and marketing expenses were allocated based upon the revenues of and/or units produced for Midway and the other amusement games businesses of WMS or other methods appropriate for the allocation of the particular expense.
Tax Sharing Agreement. WMS and Midway entered into a Tax Sharing Agreement (the "Tax Sharing Agreement") (which remains in effect, except as provided in the Tax Separation Agreement referred to above) whereby WMS and Midway have agreed upon a method for: (i) determining the amount which Midway must pay to WMS in respect of federal income taxes; (ii) compensating any member of the WMS Group for use of its net operating losses, tax credits and other tax benefits in arriving at the WMS Group tax liability as determined under the federal consolidated return regulations; and (iii) providing for the receipt of any refund arising from a carryback of net operating losses or tax credits from subsequent taxable years and for payments upon subsequent adjustments. The amount Midway is required to pay to WMS in respect of federal income taxes is determined as if Midway was filing a separate tax return. If any two or more members of the WMS Group are required to elect, or WMS elects to cause two or more members of the WMS Group to file combined or consolidated income tax returns under state or local income tax law, the financial consequences of such filings among such members shall be determined in a manner as similar as practicable to those provided for under the Tax Sharing Agreement for federal taxes. The Tax Sharing Agreement is not binding on the IRS or upon state, local or foreign taxing authorities. The effectiveness of the Tax Sharing Agreement is therefore dependent on each member of the WMS Group having the ability to pay its relative share of taxes. Because the IRS or other taxing authorities can be expected to seek payment from WMS prior to seeking payment from the individual group members, it is likely that Midway would seek to enforce any rights it may have against WMS for sharing at a time when WMS was unable to pay its proportionate share of taxes.
Patent License Agreement. WMS and Midway entered into a patent license agreement which remains in effect, pursuant to which WMS and Midway each licensed to the other, on a perpetual, royalty-free basis, certain patents used in the development and manufacture of both coin-operated video games and video lottery terminals and other gaming machines.
OTHER RELATED PARTY TRANSACTIONS
Mr. Ira S. Sheinfeld, a Director of the Company, is a member of the law firm of Squadron, Ellenoff, Plesent & Sheinfeld LLP which the Company has retained to provide tax services during the last fiscal year and proposes to retain for such services during the current fiscal year.
The Company pays Mr. Neil D. Nicastro $1,000 per month for his services under the Consulting Agreement. See "Item 11. Executive Compensation -- Employment Contracts."
Pursuant to the Termination Agreement, as full consideration for payments that would otherwise have been made to Mr. Neil D. Nicastro under the 1996 Agreement with the Company with respect to base salary, bonus, retirement and death benefits, Mr. Nicastro was paid a lump sum of $2,500,000, and he was granted a 10-year option to purchase 250,000 shares of Common Stock at an exercise price of $5.4375. See "Item 11. Executive Compensation -- Employment Contracts."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1) Financial Statements of the Company. See "Index to Financial Information" on page.
(2) Financial Statement Schedule of the Company. See "Index to Financial Information" on page.
(3) Exhibits.
A Report on Form 8-K was filed by the Company on April 17, 1998, reporting completion of the Distribution and certain related matters under Items 2 and 7.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 24th day of September, 1998.
WMS INDUSTRIES INC.
By: /s/ LOUIS J. NICASTRO ------------------------------------ Louis J. Nicastro Chairman of the Board, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been duly signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
WMS INDUSTRIES INC.
INDEX TO FINANCIAL INFORMATION
------------------------- * Incorporated by reference to the portions of the Company's 1998 Annual Report filed as Exhibit 13 to this Form 10-K.
All other schedules are omitted since the required information is not present in amounts sufficient to require submission of the schedule or because the information required is included in the consolidated financial statements and notes thereto.
REPORT OF INDEPENDENT AUDITORS
To the Stockholders and Board of Directors WMS Industries Inc.
We have audited the consolidated financial statements of WMS Industries Inc. and subsidiaries listed in Item 14(a)(1) of the Annual Report on Form 10-K of WMS Industries Inc. for the year ended June 30, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a)(2). The financial statements and related schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and related schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and related schedule are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of WMS Industries Inc. and subsidiaries at June 30, 1998 and 1997, and the consolidated results of their operations and cash flows for each of the three years in the period ended June 30, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ ERNST & YOUNG LLP
Chicago, Illinois August 17, 1998
SCHEDULE II
WMS INDUSTRIES INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED JUNE 30, 1998, 1997 AND 1996
- ------------------------- (1) Included as a direct reduction of stockholders' equity.
EXHIBIT INDEX