SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark one)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2004
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File No. 0-23911

 

Fog Cutter Capital Group Inc.

(Exact name of registrant as specified in its charter)

 

Maryland	52-2081138
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

 

1410 SW Jefferson Street

Portland, OR  97201

(Address of principal executive offices) (Zip Code)

 

(503) 721-6500

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yesý Noo.

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). 
Yes  o   No ý.

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class	Outstanding at September 30, 2004
Common Stock, par value $0.0001 per share	8,380,673 shares

 

 

FOG CUTTER CAPITAL GROUP INC.

 

FORM 10-Q

 

I N D E X

 

PART I–FINANCIAL INFORMATION
Item 1.	Interim Financial Statements (Unaudited):
	Consolidated Statements of Financial Condition
	Consolidated Statements of Operations
	Consolidated Statement of Changes in Stockholders’ Equity
	Consolidated Statements of Cash Flows
	Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II–OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Changes in Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits and Reports on Form 8-K
Signatures

 

Available information

 

Our website is www.fccgi.com.  We make our annual report on Form 10-K, as well as other reports filed with the Securities and Exchange Commission, available free of charge through our website as soon as reasonably practicable after they are filed.  A copy of these reports may also be obtained by writing to us at 1410 SW Jefferson Street, Portland, Oregon 97201, Attn:  Investor Reporting.

 

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PART I — FINANCIAL INFORMATION

 

ITEM 1.  INTERIM FINANCIAL STATEMENTS

 

FOG CUTTER CAPITAL GROUP INC.

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(dollars in thousands, except share data)

 

		September 30 2004				December 31 2003
		(Unaudited)
Assets
Cash and cash equivalents		$	7,103			$		19,607
Securities available for sale, pledged under repurchase agreements, at estimated fair value		—				35,010
Securities available for sale, at estimated fair value		10				500
Loans held for investment		10,417				3,744
Investments in real estate, net		28,009				22,577
Loans to senior executives		2,975				2,964
Investment in Bourne End		1,969				2,141
Restaurant property, plant and equipment, net		6,036				5,897
Intangible assets, net		5,456				5,640
Goodwill		7,541				7,300
Other assets		3,960				3,596
Total assets		$	73,476			$	108,976
Liabilities and Stockholders’ Equity
Liabilities:
Repurchase agreements		$		—		$	25,318
Borrowings and notes payable		7,699				7,804
Obligations under capital leases		12,684				12,942
Obligation under leave of absence agreement		2,358				—
Dividends payable		41				1,216
Deferred income		4,426				3,700
Deferred income taxes		5,880				6,980
Accrued expenses and other liabilities		6,018				5,635
Total liabilities		39,106				63,595
Commitments and contingencies
Stockholders’ Equity:
Preferred stock, $.0001 par value; 25,000,000 shares authorized; no shares issued and outstanding		—				—
Common stock, $.0001 par value; 200,000,000 shares authorized; 11,757,073 shares issued as of September 30, 2004 and 11,716,600 shares issued as of December 31, 2003; 8,380,673 shares outstanding as of September 30, 2004 and 8,670,700 shares outstanding as of December 31, 2003		168,191				168,018
Accumulated deficit		(123,776			)	(115,588			)
Option to purchase common stock		(592			)	—
Accumulated other comprehensive income		274				968
Treasury stock; 3,376,400 common shares as of September 30, 2004, and 3,045,900 common shares as of December 31, 2003, at cost		(9,727			)	(8,017			)
Total stockholders’ equity		34,370				45,381
Total liabilities and stockholders’ equity		$		73,476		$	108,976

 

The accompanying notes are an integral part of these consolidated financial statements.

 

3

 

FOG CUTTER CAPITAL GROUP INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(dollars in thousands, except share data)

 

		Quarter Ended September 30,						Nine months Ended September 30,
		2004			2003			2004			2003
Net Interest Income:
Loans		$	456		$	534		$	1,431		$	850
Loans to senior executives		51			54			138			162
Securities		11			509			616			1,983
Other investments		14			36			85			127
Total interest income		532			1,133			2,270			3,122
Interest expense		—			160			112			578
Net interest income		532			973			2,158			2,544
Real Estate Operations:
Operating income		1,106			1,034			3,083			2,965
Gain on sale of real estate		154			—			159			279
Operating expense		(454		)	(498		)	(1,330		)	(1,564		)
Interest expense		(281		)	(320		)	(843		)	(1,040		)
Depreciation		(166		)	(155		)	(489		)	(461		)
Total real estate operations		359			61			580			179
Restaurant Operations:
Operating revenue		5,673			2,472			16,424			2,472
Cost of goods sold		(3,274		)	(1,515		)	(9,812		)	(1,515		)
Franchise and royalty fee		349			152			998			152
General and administrative cost		(2,530		)	(901		)	(7,946		)	(901		)
Interest expense		(97		)	(112		)	(442		)	(112		)
Depreciation and amortization		(377		)	(141		)	(1,121		)	(141		)
Total restaurant operations		(256		)	(45		)	(1,899		)	(45		)
Other Operating Income:
Gain on sale of loans and securities		—			1,289			2,099			10,672
Gain on sale of prepaid servicing credit		—			—			1,530			—
Equity in income of equity investees		2,719			500			4,231			1,370
Loan brokerage fees		1,839			1,244			4,213			3,497
Other revenue		476			725			1,349			1,318
Total other operating income		5,034			3,758			13,422			16,857
Operating Expenses:
Compensation and employee benefits		2,443			2,283			7,966			8,101
Leave of absence expense		—			—			4,750			—
Professional fees		794			444			1,963			1,539
Fees paid to related parties		141			121			365			391
Other		1,400			795			4,099			2,444
Total operating expenses		4,778			3,643			19,143			12,475
Net income before provision for income taxes		891			1,104			(4,882		)	7,060
Provision for income taxes		—			550			—			2,260
Net Income		$	891		$	554		$	(4,882	)	$	4,800

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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		Quarter Ended September 30,						Nine months Ended September 30,
		2004			2003			2004			2003
Basic net income (loss) per share		$	0.11		$	0.06		$	(0.57	)	$	0.56
Basic weighted average shares outstanding		8,380,173			8,670,575			8,490,376			8,585,550
Diluted net income (loss) per share		$	0.11		$	0.06		$	(0.57	)	$	0.50
Diluted weighted average shares outstanding		8,385,146			9,746,241			8,490,376			9,661,216
Dividends declared per share		$	0.13		$	0.13		$	0.39		$	0.39

 

The accompanying notes are an integral part of these consolidated financial statements.

 

5

 

FOG CUTTER CAPITAL GROUP INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 

(Unaudited)

 

(dollars in thousands)

 

																		Accumulated
												Common Stock						Other
		Common Stock					Treasury Stock					Subject to Options			Accumulated			Comprehensive
		Shares (1)		Amount			Shares		Amount			Amount			Deficit			Income			Total
Balance at January 1, 2004		8,670,700		$	168,018		3,045,900		$	(8,017	)	$	—		$	(115,588	)	$	968		$	45,381
Comprehensive income (loss):
Net loss		—		—			—		—			—			(4,882		)	—			(4,882		)
Other comprehensive income:
Foreign currency translation		—		—			—		—			—			—			97			97
Unrealized holding gains on securities available for sale		—		—			—		—			—			—			1,362			1,362
Reclassification adjustment for gains on securities and foreign currency translation included in net income		—		—			—		—			—			—			(2,153		)	(2,153		)
Total comprehensive loss		—		—			—		—			—			—			—			(5,576		)
Purchase of treasury stock		(330,500	)	—			330,500		(1,710		)	—			—			—			(1,710		)
Common stock issued pursuant to exercise of stock options		40,473		173			—		—			—			—			—			173
Dividends declared		—		—			—		—			—			(3,306		)	—			(3,306		)
Purchase of call options		—		—			—		—			(592		)	—			—			(592		)
Balance at September 30, 2004		8,380,673		$	168,191		3,376,400		$	(9,727	)	$	(592	)	$	(123,776	)	$	274		$	34,370

 

(1)          Issued and outstanding

 

The accompanying notes are an integral part of these consolidated financial statements.

 

6

 

FOG CUTTER CAPITAL GROUP INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(dollars in thousands)

 

		Quarter Ended September 30,						Nine months Ended September 30,
		2004			2003			2004			2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	891		$	554		$	(4,882	)	$	4,800
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization		509			241			1,611			613
Gain on foreign currency translation		(31		)	(491		)	(51		)	(728		)
Gain on sale of securities and loans		—			(1,289		)	(2,099		)	(10,672		)
Gain on sale of real estate		(154		)	—			(159		)	—
Gain on sale of prepaid servicing credit		—			—			(1,530		)	—
Equity in income of equity investees		(2,719		)	(500		)	(4,231		)	(1,370		)
Other		(237		)	32			(882		)	(253		)
Change in:
Deferred income		417			980			726			980
Accrued interest receivable		16			(19		)	64			57
Other assets		1,657			(325		)	456			333
Accounts payable and accrued liabilities		(436		)	(266		)	2,616			946
Net cash used in operating activities		(87		)	(1,083		)	(8,361		)	(5,294		)
CASH FLOWS FROM INVESTING ACTIVITIES:
Repayments of securities available for sale		—			7,178			6,818			14,486
Investment in real estate		(799		)	(1,987		)	(2,433		)	(1,987		)
Investment in variable interest entity		(1,601		)	—			(2,229		)	—
Proceeds from sale of securities available for sale		—			1,844			29,090			13,835
Purchase of loans and discounted loans		(935		)	—			(8,008		)	(1,486		)
Principal repayments on loans and discounted loans		115			289			1,169			782
Proceeds from sale of real estate		362			—			536			—
Proceeds from sale of prepaid servicing credit		—			—			1,530			—
Investment in and loans to equity investees		—			—			—			(3,000		)
Payments made in connection with the acquisition of subsidiary, net of cash acquired		—			(4,965		)	—			(4,965		)
Proceeds from investments in and loans to equity investees		4,429			3,042			4,429			5,942
Purchase of restaurant property plant and equipment		(293		)	—			(1,077		)	—
Other		(9		)	54			18			(194		)
Net cash provided by investing activities		1,269			5,455			29,843			23,413
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments under capital leases		(117		)	(2,891		)	(378		)	(3,184		)
Repayments on borrowings		(1,324		)	(953		)	(27,136		)	(9,173		)
Payment of obligation to purchase treasury stock		—			—			—			(1,399		)
Proceeds from issuance of common stock		9			2			173			877
Investment in option to purchase stock		—			—			(592		)	—
Investment in treasury stock		—			—			(1,710		)	—
Dividend payments on common stock		(1,080		)	(1,127		)	(4,480		)	(4,610		)
Other		197			—			121			—
Net cash used in financing activities		(2,315		)	(4,969		)	(34,002		)	(17,489		)
EFFECT OF EXCHANGE RATE CHANGES ON CASH		(1		)	2			16			(3		)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(1,134		)	(595		)	(12,504		)	627
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		8,237			15,727			19,607			14,505
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	7,103		$	15,132		$	7,103		$	15,132
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest		$	380		$	523		$	1,355		$	1,722
Notes payable issued to settle obligation to purchase treasury stock		$	—		$	331		$	—		$	3,131
Cash paid for income taxes		$	71		$	232		$	203		$	361
Non-cash assets acquired		$	—		$	19,502		$	—		$	19,502
Non-cash liabilities assumed		$	—		$	14,537		$	—		$	14,537

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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FOG CUTTER CAPITAL GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1 - BASIS OF PRESENTATION

 

The accompanying interim consolidated financial statements of Fog Cutter Capital Group Inc. and Subsidiaries (“FCCG” or the “Company”) are unaudited and have been prepared in conformity with the requirements of Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), particularly Rule 10-01 thereof, which governs the presentation of interim financial statements.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  The accompanying interim consolidated financial statements should be read in conjunction with the Company’s 2003 Annual Report on Form 10-K/A.  A summary of the Company’s significant accounting policies is set forth in Note 2 to the consolidated financial statements in the 2003 Annual Report on Form 10-K/A.

 

In the Company’s opinion, all adjustments, comprised of normal recurring accruals necessary for the fair presentation of the interim financial statements, have been included in the accompanying consolidated financial statements.  Operating results for the nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Certain items in the previously reported consolidated financial statements were reclassified to conform to the September 30, 2004 presentation, none of which affected previously reported results of operations.

 

At September 30, 2004, certain Company officers and directors had, directly or indirectly, majority voting control of the Company.

 

NOTE 2 - SIGNIFICANT TRANSACTIONS

 

Fatburger Holdings, Inc.

 

On August 15, 2003, the Company acquired a controlling interest in Fatburger Holdings, Inc. (“Fatburger”), and began reporting the operations of Fatburger on a consolidated basis as of that date.  Fatburger operates or franchises 60 hamburger restaurants located in California, Nevada, Arizona, New Jersey, Colorado, Florida and Washington.  Franchisees currently own and operate 35 of the Fatburger locations and Fatburger has agreements for approximately 240 new franchise restaurants.  The terms of the original acquisition by the Company were amended on January 12, 2004 and May 12, 2004.  Initially, the Company made a $5.4 million investment and acquired approximately 83% of the voting control of Fatburger.  However, all but 15% of the ownership investment was redeemable by Fatburger.  On May 12, 2004, the Company contributed an additional $3.0 million, bringing its total investment to $8.4 million.  As a result of this transaction, the Company’s voting control of Fatburger was reduced to approximately 71%, but the Company retained a non-redeemable, fully diluted 47% ownership interest in Fatburger.  The Company’s investment consists of the purchase of convertible preferred stock (the “Series A Preferred”) and redeemable preferred stock (the “Series D Preferred”).

 

The Series A Preferred is convertible into a 50% ownership interest of the common stock of Fatburger on a fully diluted basis.  The Company owns approximately 93% of the issued and outstanding Series A Preferred, and currently holds voting rights equal to 71% of the voting control of Fatburger.  The Series A Preferred is not redeemable and does not pay dividends.

 

The Series D Preferred has a liquidation preference and is redeemable by Fatburger for $10.1 million plus accrued but unpaid dividends.  Dividends accrue at a rate of 20% of the redemption value,

 

8

 

compounded annually.  The Series D Preferred does not have any voting rights.  The Company owns all of the issued and outstanding Series D Preferred.

 

Mortgage-Backed Securities

 

During the nine months ended September 30, 2004, the Company sold four mortgage-backed securities for $29.1 million in cash.  As a result of these transactions, the Company recognized gains on the sale of securities of $2.1 million in the accompanying consolidated statement of operations.  As of September 30, 2004, the Company’s investment in mortgage-backed securities had decreased to less than $0.1 million.

 

Loans

 

During the nine months ended September 30, 2004, the Company purchased or funded four loans secured by real estate for a total of $8.0 million.  The current yield to the Company on these loans is approximately 17.6%.

 

Dividends

 

The Company has declared and paid a $0.13 per share dividend for each quarter of 2004.  The first quarter dividend was paid on March 1, 2004 to stockholders of record on February 20, 2004.  The second quarter dividend was paid on June 1, 2004 to stockholders of record on May 21, 2004.  The third quarter dividend was paid on September 1, 2004 to stockholders of record on August 18, 2004.  On October 20, 2004, the Company announced the declaration of a $0.13 per share fourth quarter dividend, payable on November 15, 2004 to stockholders of record on November 1, 2004.

 

Call Option

 

On April 26, 2004, the Company purchased a three year call option (the “Call Option”) from Andrew A. Wiederhorn.  At the time, Mr. Wiederhorn was the Company’s Chairman and Chief Executive Officer.  Currently, Mr. Wiederhorn is a director and Chief Strategic Officer under a leave of absence agreement.  The Call Option gives the Company the right, but not the obligation, to purchase 423,245 of the Company’s outstanding common stock (the “Option Shares”) from Mr. Wiederhorn for a purchase price of $3.99 per share.   The option may be exercised at any time during the three year option period.  The Company paid $750,000 ($1.77 per option share) for the Call Option.   The premium paid for the Call Option, together with the strike price, represented a premium to the Company’s book value per share and market price per share at the time the option was purchased.  In purchasing the Call Option, the Company and its directors considered the following factors:  (1) the potentially negative impact on the Company’s share price if the Option Shares were disposed of publicly; (2) the Company’s favorable liquidity position; (3) the potential reduction in the risk that shares are transferred in a transaction which would have an adverse impact on its NOL position; and (4) the reduction in the future expenditure of cash dividends by the Company once the Company exercises the Call Option.  The Board of Directors reviewed and approved the transaction to confirm that the transaction was in the best interest of the Company and its other stockholders.  As a result of the purchase of the Call Option, the Company recorded a direct reduction to stockholders’ equity of $592,000 and compensation expense of $158,000.

 

Treasury Stock Purchase

 

On April 28, 2004, the Company purchased 330,500 shares of its common stock from Clarence B. Coleman, who at the time was a greater than 10% shareholder.  The purchase price was $5.40 per share ($1.8 million) and the shares were added to treasury stock.  At the time, the purchase price represented a small premium to the Company’s book value per share and market price per share.  The Company and its directors considered the following factors:  (1) the potentially negative impact on the Company’s share price if the shares were disposed of publicly; (2) the Company’s favorable liquidity position; (3) the potential reduction in the risk that shares are transferred in a transaction which would have an adverse impact on its NOL position; and (4) the reduction in the future expenditure of cash dividends by the Company.  The Board of Directors reviewed and approved the transaction to confirm that the transaction was in the best interest of the Company

 

9

 

and its other stockholders.  As a result of this transaction, the Company recorded treasury stock of $1.7 million and a charge to earnings of $0.1 million.

 

Leave of Absence Agreement

 

As the Company has previously disclosed, the Company’s former Chairman and Chief Executive Officer, Andrew Wiederhorn, and former President, Lawrence Mendelsohn, received letters from the United States Attorney’s Office for the District of Oregon (“USAODO”) in March 2001 advising them that they were targets of a grand jury investigation (the “CCL Investigation”) into the failure of Capital Consultants, L.L.C (“CCL”).

 

In August 2002, Mr. Mendelsohn resigned as President and Director of the Company. In November 2003, Mr. Mendelsohn entered into an agreement with the USAODO pursuant to which he plead guilty to filing a false 1998 personal tax return and agreed to cooperate in the CCL Investigation.

 

On June 3, 2004, the Company announced that Chief Executive Officer and Chairman of the Board Andrew Wiederhorn had entered into a settlement with the USAODO regarding its investigation into CCL (the “Settlement”) and would take a leave of absence from his corporate positions at FCCG.  Under the Settlement’s terms, Mr. Wiederhorn pled guilty on June 3, 2004 to two federal counts and was sentenced to 18-months incarceration and fined $2.0 million.  The charges to which Mr. Wiederhorn has pled guilty pursuant to the Settlement are not based upon any acts or omission to the Company or of Mr. Wiederhorn in his capacity as an officer or director of the Company.

 

On June 2, 2004, the Company and Mr. Wiederhorn entered into a leave of absence agreement.  In entering into Mr. Wiederhorn’s leave of absence agreement, the Board of Directors considered the nature of the statutes to which Mr. Wiederhorn pled and the fact that he relied on the advice of expert legal counsel and a national accounting firm.  The Board also believed it was important to assure Mr. Wiederhorn’s return to active involvement with the Company because of his expertise and knowledge and to preserve a significant business relationship and the value of the Company’s investments.

 

Mr. Wiederhorn is currently a director and Chief Strategic Officer of the Company.  Under the terms of the leave of absence agreement, Mr. Wiederhorn will continue to receive his regular salary and bonus pursuant to and as set forth in his employment agreement.  In addition, for the reasons stated in the agreement, the Company made a leave of absence payment to Mr. Wiederhorn in the amount of $2.0 million on June, 2, 2004.

 

Mr. Wiederhorn began his leave of absence on August 2, 2004 and is expected to remain in that status for a period of 14 to 18 months.  The accompanying consolidated financial statements reflect a charge to earnings of $4.8 million for the nine month period ending September 30, 2004.  This is comprised of the $2.0 million payment made on June 2, 2004 and the accrual of the expected salary and bonus relating to the leave of absence period.

 

Change in Auditor

 

On July 16, 2004, Ernst & Young LLP advised the Company that the firm would resign as the Company’s auditors upon completion of its review of the interim financial information for the second quarter of 2004 and filing of the Company’s quarterly report on Form 10-Q for the quarter ending June 30, 2004.  The resignation was not the result of disagreements with Ernst & Young LLP on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure. On September 7, 2004, the Company appointed UHY LLP as its independent auditor.  The decision to appoint UHY LLP was approved by the Audit Committee and the Board of Directors.

 

10

 

Nasdaq Delisting

 

Effective October 14, 2004, the Company’s Common Stock began trading in the over-the-counter (“OTC”) market on the OTC “pink sheets.”  Prior to that, the Company’s Common Stock was quoted on the Nasdaq National Market.  On July 20, 2004, the Company was notified by Nasdaq of a staff determination to delist the Company’s Common Stock effective July 29, 2004.  The Company challenged the staff determination and requested an oral hearing by a Listing Qualifications Panel to review the staff’s conclusions.  A hearing was held on September 9, 2004 and, on October 12, 2004, the Company was notified by Nasdaq that the Listing Qualifications Panel upheld the staff determination and the Company’s Common Stock was delisted from the Nasdaq National Market on October 14, 2004.  The Company has requested a review of the Listing Qualifications Panel’s decision by Nasdaq’s Listing and Hearing Review Council.  There can be no assurance that the Company’s appeal will be successful.

 

Bourne End

 

On August 6, 2004, an equity investee of the Company, Bourne End sold its Southend Shopping Center for approximately 28.0 million Great Britain pounds (“GBP”).  The Company’s share of the net gain on this transaction was $2.8 million.

 

George Elkins Mortgage Banking Company

 

On August 11, 2004 the Company received a notice from the Class B Holders of Fog Cap GEMB Holdings LLC (“Holdings”), a 51% owned subsidiary of the Company which owns trade names and certain assets relating to the operation of George Elkins Mortgage Banking Company.  The notice was to inform the Company that the Class B Holders believe that a Change in Control Transaction (as defined in the Holdings Operating Agreement) has occurred as a result of the leave of absence of Mr. Wiederhorn.  The notice also indicates that unless the Change in Control Transaction is corrected within 120 days, the Class B Holders intend to exercise their rights to purchase the Class A Interests held by the Company in accordance with the formula outlined in the Operating Agreement.

 

The Company disputes the claim that a Change in Control Transaction has occurred as a result of the leave of absence of Mr. Wiederhorn.  The Company believes that the market value of its investment is greater than the amount of the buyback formula and intends to vigorously defend against these claims.  However, if the Company is unsuccessful in defending this position, an analysis of the economic effect of the buyback formula indicates that the Company would not incur a loss on the transaction.  As a result, no reserves are required due to the receipt of the notice.

 

NOTE 3 – COMMITMENTS, CONTINGENCIES & OFF-BALANCE SHEET RISK

 

CCL Investigation

 

The Company’s former Chief Executive Officer and current Chief Strategic Officer, Andrew Wiederhorn, and former President, Lawrence Mendelsohn, pursuant to the terms of their respective employment agreements, may have been entitled to indemnity from the Company for litigation expenses and personal losses in connection with the CCL investigations and any related litigation.  Messrs. Wiederhorn and Mendelsohn had notified the Company that, although they believed they were entitled to primary indemnification from other sources, they were reserving their rights to seek indemnity from the Company.  The Company did not agree to any indemnity requests.  Mr. Wiederhorn released the Company from any and all claims he may have had relating to the CCL matter as partial consideration for the leave of absence agreement in June 2004.   The USAODO has settled the CCL matter as it relates to both Mr. Wiederhorn and Mr. Mendelsohn.  As a result, the Company believes that the contingencies relating to the potential indemnification of these officers or former officers have now been resolved.

 

Strouds Acquisition Corporation

 

On October 6, 2003, the Official Committee of Unsecured Creditors of Strouds Acquisition Corporation (“Strouds”) filed a lawsuit in the United States Bankruptcy Court which named the Company,

 

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among others, as a defendant.  The lawsuit was amended on November 10, 2003 and limited the complaint against the Company solely in its capacity as collateral agent for certain secured creditors of Strouds Acquisition Corporation.  The lawsuit, as it pertained to the Company, sought reimbursement of the proceeds from approximately $3.0 million in funds received in October 2003, which the Company was holding as collateral agent for other secured creditors.  These funds were not included in the assets of the Company, but were being held in trust.  On July 1, 2004, the lawsuit was settled and the Company distributed the trust funds, net of legal reimbursements of $0.3 million, in accordance with the settlement agreement.  The Company received a general release from the parties and considers the matter closed.

 

Shareholder Derivative Complaint

 

On July 6, 2004, Jeff Allen McCoon, derivatively on behalf of the Company, filed a lawsuit in the Circuit Court for the State of Oregon (Multnomah County) which named the Company and all of its directors as defendants.  The lawsuit alleges that members of the Company’s Board of Directors breached their duties to the Company by entering into the leave of absence agreement with Andrew Wiederhorn.  The lawsuit generally seeks restitution of payments made under the leave of absence agreement plus attorney fees and costs.  The individual defendants have indemnity agreements with the Company and have asserted the right to indemnification from the Company under those indemnity agreements. This case is in the very early pleading stages and motions are pending against the complaint. The Company may incur expenses under the indemnity agreements and also may derive benefits if the plaintiff’s claims are successful. At this stage of the case, it is too early to predict the outcome with any certainty. The complaint is not specific as to the amount of damages it is seeking against the individual defendants, but it appears to seek at least the return of $2 million paid to Mr. Wiederhorn under the Leave of Absence Agreement.

 

Other

 

The Company is involved in various other legal proceedings occurring in the ordinary course of business which the Company believes will not have a material adverse effect on the consolidated financial condition or operations of the Company.

 

The Company may utilize a wide variety of off-balance sheet financial techniques to manage its risk.  In hedging the interest rate and/or exchange rate exposure of a foreign currency denominated asset or liability, the Company may enter into hedge transactions to counter movements in interest rates and foreign currencies.  These hedges may be in the form of currency and interest rate swaps, options, and forwards, or combinations thereof.

 

At September 30, 2004, the Company had no outstanding derivative instruments held for trading or hedging purposes.

 

The Company has operating leases for office and retail space which expire through 2012.  The leases provide for varying minimum annual rental payments including rent increases and free rent periods.

 

Future minimum rental payments, by year and in the aggregate, under noncancelable operating leases with initial or remaining terms of one year or more, consisted approximately of the following at September 30, 2004 (dollars in thousands):

 

2004		$	722
2005		2,787
2006		2,329
2007		1,808
2008		1,273
Thereafter		3,308
Total minimum lease payments		$	12,227

 

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In order to facilitate the development of franchise locations, as of September 30, 2004, Fatburger had guaranteed the annual minimum lease payments of three restaurant sites owned and operated by franchisees.  The amount of the guarantees total approximately $1.9 million plus certain contingent rental payments as defined in the respective leases.  These leases expire at various times through 2008.

 

The Company did not have any other off balance sheet arrangements in place as of September 30, 2004.

 

NOTE 4 - GOODWILL AND OTHER INTANGIBLE ASSETS

 

Primarily due to the acquisition of Fatburger, the Company has goodwill in the amount of $7.5 million and other intangible assets in the amount of $5.5 million. In accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, goodwill is not amortized, but is subject to an annual impairment test, which is being performed as of August 15, 2004.  Since the acquisition of Fatburger by the Company, Fatburger has experienced operating losses and has funded its operations and expansion with limited liquidity.  The Company believes that these conditions are temporary in nature, however, should these conditions not be corrected, the Company may be required to recognize impairment losses on its recorded goodwill.  As of September 30, 2004, the Company was not aware of any events or changes in circumstances that would require the impairment of the recorded goodwill.

 

Summarized information for the Company’s acquired intangible assets as of September 30, 2004 is as follows (dollars in thousands):

 

Amortized intangible assets:

 

Franchise Agreements		$			983
Other		503
Total amortized intangible assets		$		1,486
Unamortized intangible assets:
Trademarks		$	3,970

 

Trademarks, which have indefinite lives, are not subject to amortization.  All other intangible assets are amortized using the straight-line method over the estimated useful lives of the assets of five to fifteen years.  Estimated amortization expense for the remainder of 2004 and the five succeeding years is as follows (dollars in thousands):

 

2004		$	60
2005		241
2006		239
2007		236
2008		236
2009		236

 

The recorded values of goodwill and other intangible assets may become impaired in the future. The determination of the value of such intangible assets requires management to make estimates and assumptions that affect the consolidated financial statements.  Potential impairments to intangible assets are assessed when there is evidence that events or changes in circumstances indicate that the carrying amount of an asset may not be recovered.  This assessment is based on the operational performance of acquired businesses, market conditions and other factors including future events.   Any resulting impairment loss could have an adverse impact on the results of operations of the Company.

 

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NOTE 5 – RECENTLY ISSUED ACCOUNTING STANDARDS

 

In December 2003, the Accounting Standards Executive Committee (“AcSEC”) issued Statement of Position 03-3 (“SOP 03-3”), “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” SOP 03-3 requires that the excess of contractual cash flows over cash flows expected to be collected not be recognized as an adjustment of yield, loss accrual, or valuation allowance. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan’s yield over its remaining life and decreases in cash flows expected to be collected should be recognized as impairment. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004 and is not expected to have a material effect on the Company’s consolidated financial position or results of operations

 

In March 2004, the FASB issued an exposure draft, “Share-Based Payment - An Amendment to FASB Statements No. 123 and 95,” which changes the requirements of stock option accounting. The exposure draft requires expense recognition of stock options and certain employee stock purchase plans in the statement of operations. A final standard is expected to be effective relative to the Company during the year ending December 31, 2005. Such stock option expensing would require the Company to value its employee stock option grants pursuant to an option valuation formula and then amortize that value against its earnings over the vesting period in effect for those options. The Company currently accounts for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and have adopted the disclosure-only alternative of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” If the Company is required to expense employee stock options in the future, the change in accounting treatment may adversely affect the Company’s future reported results of operations.

 

NOTE 6 – STOCK OPTIONS AND RIGHTS

 

The Company has adopted a non-qualified stock option plan (the “Option Plan”) which provides for options to purchase shares of the Company’s common stock.  The maximum number of shares of common stock that may be issued pursuant to options granted under the Option Plan is 3,500,000 shares.

 

The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for the Option Plan. Accordingly, no compensation expense has been recognized in the Consolidated Statements of Operations for grants under the Option Plan.  Had compensation expense for the Company’s Option Plan been determined based on the fair value at the grant date consistent with the methods of FASB Statement No. 123 “Accounting for Stock Based Compensation,” the Company’s net income and income per share for the nine months ended September 30, 2004 and 2003 would have been decreased to the pro forma amounts indicated below:

 

 

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There were no options granted with exercise prices below the market value of the stock at the grant date. Fair values for 2004 were estimated using the Black-Scholes option-pricing model with the following weighted average assumptions used: 10% dividend yield, expected volatility of 86%, risk-free interest rate of 2.5% and expected lives of five years.

 

NOTE 7 – VARIABLE INTEREST ENTITIES

 

During the nine months ended September 30, 2004, the Company funded $2.3 million to two related Spanish entities formed to purchase, reposition and sell two apartment buildings in Barcelona, Spain.  Under the terms of the loan, the Company receives a preferred 30% return on its investment plus an 80% share in additional profits generated by the investment.  The investment meets the definition of a Variable Interest Entity (“VIE”)  under FASB Interpretation 46 (“FIN 46”) and the Company is the primary beneficiary of the VIE.  As a result, the assets and liabilities of the VIE have been consolidated into the accompanying consolidated financial statements as of September 30, 2004.

 

The VIE purchased the apartment buildings for $4.2 million.  The purchase was funded with bank loans totaling $1.4 million, the Company’s $2.3 million investment and a $0.4 million contribution from the project managers.  Neither the creditors nor the other beneficial interest holders have recourse to the Company with regard to this investment and, as a result, the maximum limit of the Company’s exposure to loss on this investment is $2.3 million.

 

As of September 30, 2004, the following assets and liabilities of the VIE were included in the accompanying consolidated statements of financial condition:

 

Investment in real estate, net		$	4,198,000
Other assets		21,000
Borrowings and notes payable		1,467,000
Accrued expense and other liabilities		129,000
Minority interest		406,000

 

NOTE 8 – OPERATING SEGMENTS

 

The Company’s operating segments consist of (i) restaurant operations conducted through Fatburger Holdings, Inc. (“Fatburger”), (ii) commercial real estate mortgage brokerage activities conducted through George Elkins Mortgage Banking Company (“George Elkins”) and (iii) real estate, merchant banking and financing activities.  The following is a summary of each of the operating segments:

 

Restaurant Operations

 

Fatburger operates or franchises 60 hamburger restaurants located in California, Nevada, Arizona, New Jersey, Florida, Colorado and Washington.  The Company provided an investment and financing package for Fatburger which involved the acquisition of the 93% of the entire class of the Series A Preferred and the entire class of the Series D Preferred stock of Fatburger.  Currently, the Company owns approximately 71% of the voting control of Fatburger.  Fatburger has plans to open additional restaurants including expansion into Oregon, Louisiana, Georgia, New York, Ohio, Texas, Missouri, Kansas, Pennsylvania, West Virginia, Virginia, North Carolina, South Carolina, Washington D.C., British Columbia, Minnesota and Michigan.   Franchisees currently own and operate about 35 of the Fatburger locations.

 

Revenue from the operation of Fatburger company-owned restaurants is recognized when sales occur.  Franchise fee revenue from the sale of individual Fatburger franchises is recognized only when all material services or conditions relating to the sales have been substantially performed or satisfied.  The completion of training and the opening of a location by the franchisee constitute substantial performance on the part of Fatburger.  Nonrefundable deposits collected in relation to the sale of franchises are recorded as deferred franchise fees until the completion of training and the opening of the restaurant, at which time the franchise fee revenue is recognized.  In addition to franchise fee revenue, Fatburger collects a royalty

 

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ranging from 5% to 6% of gross sales from restaurants operated by franchisees.  Fatburger recognizes royalty fees as the related sales are made by the franchisees.  Costs relating to continuing franchise support are expensed as incurred.

 

During the nine months ended September 30, 2004, thirty-one individual Fatburger franchises were sold.  Five new restaurants were opened during the period, including two company-owned locations.  Royalty revenues were approximately $0.3 million and $0.9 million, respectively, for the three and nine month periods ended September 30, 2004.

 

Commercial Real Estate Mortgage Brokerage Operations

 

In May 2002, the Company purchased a 51% ownership interest in George Elkins, a California mortgage banking operation, which, in 2003, provided brokerage services related to the production of over $600 million in commercial real estate mortgages. George Elkins is headquartered in Los Angeles, with satellite offices located throughout the southern California area. As of September 30, 2004, the mortgage brokerage operation also manages a commercial loan servicing portfolio in excess of $700 million for various investors.  The Company earned mortgage servicing fees of $0.5 million during both the nine month periods ended September 30, 2004 and September 30, 2003, which are included in other revenue in the accompanying consolidated statements of operations.

 

Real Estate, Merchant Banking and Financing Operations

 

The Company invests in or finances real estate, mortgage-backed securities and other real estate related or finance related assets.  The merchant banking and financing operations focus on the acquisition of controlling interests in businesses in the process of restructuring.  This can take the form of assisting in a management buy-out, refinancing corporate debt or acquiring the “non-core” assets of a business.

 

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Segment data for the nine months ended September 30, 2004, and 2003 are as follows (dollars in thousands):

 

		Merchant Banking, Real Estate and Finance						Mortgage Brokerage						Restaurant						Total
		2004			2003			2004			2003			2004			2003			2004			2003
Net Interest Income:
Loans		$	1,431		$	850		$	—		$	—		$	—		$	—		$	1,431		$	850
Loans to senior executives		138			162			—			—			—			—			138			162
Securities		616			1,983			—			—			—			—			616			1,983
Other investments		83			125			2			2			—			—			85			127
Total interest income		2,268			3,120			2			2			—			—			2,270			3,122
Interest expense		112			578			—			—			—			—			112			578
Net interest income		2,156			2,542			2			2			—			—			2,158			2,544
Real estate operations:
Operating revenue		3,083			2,965			—			—			—			—			3,083			2,965
Operating expense		(1,330		)	(1,564		)	—			—			—			—			(1,330		)	(1,564		)
Gain on sale of real estate		159			279			—			—			—			—			159			279
Interest expense		(843		)	(1,040		)	—			—			—			—			(843		)	(1,040		)
Depreciation		(489		)	(461		)	—			—			—			—			(489		)	(461		)
Total real estate operations		580			179			—			—			—			—			580			179
Restaurant operations:
Operating income		—			—			—			—			16,424			2,472			16,424			2,472
Cost of goods sold		—			—			—			—			(9,812		)	(1,515		)	(9,812		)	(1,515		)
Franchise and royalty fees		—			—			—			—			998			152			998			152
General and administrative costs		—			—			—			—			(7,946		)	(901		)	(7,946		)	(901		)
Interest Expense		—			—			—			—			(442		)	(112		)	(442		)	(112		)
Depreciation and amortization		—			—			—			—			(1,121		)	(141		)	(1,121		)	(141		)
Total restaurant operations		—			—			—			—			(1,899		)	(45		)	(1,899		)	(45		)
Other operating income:
Market valuations loss / impairment		—			—			—			—			—			—			—			—
Gain on sale of prepaid servicing credit		1,530			—			—			—			—			—			1,530			—
Equity in income of equity investees		4,231			1,370			—			—			—			—			4,231			1,370
Gain on sale of loans and securities		2,099			10,672			—			—			—			—			2,099			10,672
Loan origination fees		—			—			4,213			3,497			—			—			4,213			3,497
Other revenue		1,088			951			261			367			—			—			1,349			1,318
Total other operating income		8,948			12,993			4,474			3,864			—			—			13,422			16,857
Operating expenses:
Compensation and employee benefits		4,185			4,908			3,781			3,193			—			—			7,966			8,101
Leave of absence expense		4,750			—			—			—			—			—			4,750			—
Professional fees		1,934			1,415			29			124			—			—			1,963			1,539
Fees paid to related parties		365			—			—			—			—			—			365			—
Other		3,442			2,198			657			637			—			—			4,099			2,835
Total operating expenses		14,676			8,521			4,467			3,954			—			—			19,143			12,475
Net income (loss) before provisions		(2,992		)	7,193			9			(88		)	(1,899		)	(45		)	(4,882		)	7,060
Provision for income taxes		—			2,152			—			—			—			108			—			2,260
Net income (loss)		$	(2,992	)	$	5,041		$	9		$	(88	)	$	(1,899	)	$	(153	)	$	(4,882	)	$	4,800
Segment assets		$	51,204		$	91,557		$	1,778		$	2,989		$	20,494		$	20,260		$	73,476		$	114,806

 

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