UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K

 

 

Commission File Number 333-133253

 

HARLAND CLARKE HOLDINGS CORP.

(Exact name of registrant as specified in its charter)

 

(210) 697-8888

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No x

 

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.  Yes x     No o*

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No x

 

As of March 4, 2011, there were 100 shares of the registrant’s common stock outstanding, with a par value of $0.01 per share. All outstanding shares are owned by a subsidiary of M & F Worldwide Corp.

 

 

 

HARLAND CLARKE HOLDINGS CORP.

 

INDEX TO ANNUAL REPORT ON FORM 10-K

 

For the Year Ended December 31, 2010

 

 

 

Harland Clarke Holdings Corp. (“Harland Clarke Holdings” and, together with its subsidiaries, the “Company”) is a holding company that conducts its operations through its direct and indirect, wholly owned operating subsidiaries and was incorporated in Delaware on October 19, 2005. On December 15, 2005, CA Investment Corp., an indirect wholly owned subsidiary of M & F Worldwide Corp. (“M & F Worldwide”) purchased 100% of the capital stock of Novar USA Inc. (“Novar”) (the “Clarke American Acquisition”) and was renamed Clarke American Corp. (“Clarke American”) which was the successor by merger to Novar, which indirectly wholly owned the operating subsidiaries of the Clarke American business. On May 1, 2007, the Company completed the acquisition of John H. Harland Company (“Harland”), and a subsidiary of the Company was merged with and into Harland, with Harland continuing after the merger as the surviving corporation and as a wholly owned subsidiary of the Company (the “Harland Acquisition”). After the closing of the Harland Acquisition, the Company changed its name on May 2, 2007 from Clarke American to Harland Clarke Holdings.

 

The Company has organized its business and corporate structure along the following three business segments: Harland Clarke, Harland Financial Solutions and Scantron.

 

The Harland Clarke segment offers checks and related products, forms and treasury supplies, and related delivery and fraud prevention products to financial services, retail and software providers. It also provides direct marketing services to their clients including direct marketing campaigns, direct mail, database marketing, telemarketing and e-mail marketing. In addition to these products and services, the Harland Clarke segment offers stationery, business cards and other business and home office products to consumers and small businesses.

 

During December 2009, Harland Clarke Corp., a wholly owned subsidiary of the Company, acquired in separate transactions SubscriberMail and Protocol Integrated Marketing Services (“Protocol IMS”), a division of Protocol Global Solutions. SubscriberMail is a leading email marketing service provider that offers patented tools to develop and deliver professional email communications. Protocol IMS focuses on direct marketing services with solutions that include business to business strategic services, business to consumer strategic services, database marketing and analytics, outbound business to business teleservices, production and fulfillment (see Note 3 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

The Harland Financial Solutions segment provides technology products and services to financial services clients worldwide including lending and mortgage compliance and origination applications, risk management solutions, business intelligence solutions, Internet and mobile banking applications, branch automation solutions, self-service solutions, electronic payment solutions and core processing systems.

 

On December 6, 2010, Harland Financial Solutions, Inc. (“HFS”), a wholly owned subsidiary of the Company, acquired all of the outstanding membership interests of Parsam Technologies, LLC and the equity of SRC Software Private Limited (collectively referred to as “Parsam”). Parsam’s solutions allow financial institutions to provide services online, in branches and at call centers, from new account opening and funding to account-to-account money transfers, person-to-person payments, account and adviser-client relationship management, and bill presentment and payment. HFS is integrating Parsam’s solutions into its existing solution offerings (see Note 3 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

The Scantron segment provides data management solutions and related services to educational, commercial, healthcare and governmental entities worldwide including testing and assessment solutions, patient information collection and tracking, and survey services. Scantron’s solutions combine a variety of data collection, analysis, and management tools, including web-based solutions, software, scanning equipment, forms, and related field maintenance services.

On July 21, 2010, Scantron Corporation (“Scantron”), a wholly owned subsidiary of the Company, acquired 100% of the equity of Spectrum K12 School Solutions, Inc. (“Spectrum K12”). Spectrum K12 develops, markets and sells student achievement management, response to intervention and special education software solutions. Spectrum K12’s software solutions complement Scantron’s software solutions for education assessments, content and data management (see Note 3 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

On December 15, 2010, Scantron entered into a securities purchase agreement with KUE Digital International LLC pursuant to which Scantron would purchase all of the outstanding capital stock or membership interests of KUE Digital Inc., KUED Sub I LLC and KUED Sub II LLC (collectively referred to as “GlobalScholar”). GlobalScholar’s instructional management platform supports all aspects of managing education at K-12 schools, including student information systems; performance-based scheduler; gradebook; learning management system; longitudinal data collection, analysis and reporting; teacher development and performance tracking; and online communication and tutoring portals. GlobalScholar’s instructional management platform complements Scantron’s testing and assessment, response to intervention, student achievement management and special education software solutions thereby expanding Scantron’s web-based education solutions. Scantron completed the acquisition of GlobalScholar on January 3, 2011 (see Note 20 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

Company Overview

 

Harland Clarke

 

Harland Clarke provides checks and related products, direct marketing services and customized business and home office products to financial services, retail and software providers as well as consumers and small business. In 2010, Harland Clarke generated revenues of $1,191.2 million (71% of the Company’s 2010 consolidated net revenues).

 

Products and Services

 

Checks and Related Products

 

In addition to offering basic consumer and small business checks, Harland Clarke also offers checks customized with licensed designs and characters, such as cartoon characters, collegiate designs and photographs. Harland Clarke also offers a variety of financial documents in conjunction with consumer and small business financial software packages. Accessory products include leather checkbook covers, endorsement stamps, address labels, recording registers and other bill paying accessories. In addition, Harland Clarke also offers its clients a variety of fraud prevention solutions.

 

Harland Clarke offers various delivery options, including expedited and trackable delivery. Check users often prefer expedited delivery to both receive their order sooner and for the security and tracking features that these expedited methods provide. These delivery services represent an important component of the range of value-added service offerings.

 

Harland Clarke also offers a wide variety of standard financial forms and flexible formats to suit clients’ needs, and the products are also compatible with image processing systems. Harland Clarke also provides treasury management supplies, such as integrated cash deposit products, customized deposit tickets and security bags.

 

Marketing Services

 

Harland Clarke also offers integrated, multi-channel marketing services that help clients measure, understand, manage and optimize their business-to-consumer and business-to-business relationships as well as their returns on marketing investments. These services include:

 

 

 

Customized Business and Home Office Products

 

In addition to a wide variety of checks and related products, Harland Clarke offers consumers and small businesses customized products including stationery, business cards, notepads, invitations, announcements, labels, rubber stamps and envelopes.

 

Sales and Marketing

 

Harland Clarke manages relationships with large and complex financial and commercial institutions through dedicated account management teams composed of relationship management, marketing, operations and service oriented skill sets. In addition, Harland Clarke has a national sales force targeting distinct financial institution segments ranging from major nationwide and large regional banks and securities firms to community banks and credit unions. Hosted websites, contact center services and mail order forms enable clients to offer convenient ordering options to their customers.

 

Harland Clarke also markets its products directly to consumers and small businesses through advertising inserts in newspapers, advertisements sent directly to residences, and online and e-mail advertising. Online shopping, contact center access and mail order forms enable consumers to order at their convenience.

 

Clients

 

The clients of Harland Clarke range from major national and large regional banks and securities firms to community banks, credit unions, brokerage houses, retailers and software companies. In addition, Harland Clarke clients include consumers and small businesses.

 

Harland Clarke contracts with its clients are generally sole-source contracts for the sale of its checks and related products to the clients’ customers. The initial terms of the agreements generally range from three to five years and generally are terminable for cause, although some of its financial institution clients can terminate their contracts for convenience.

 

Competition

 

Harland Clarke’s primary competition comes from alternative payment methods such as debit cards, credit cards, ACH, and other electronic and online payment options. Harland Clarke also competes with large providers that offer a wide variety of products and services including Deluxe Corporation, Harte-Hanks, Inc., and R.R. Donnelley & Sons Company. There are also many other competitors that specialize in providing one or more of the products and services Harland Clarke offers to its clients. Harland Clarke competes on the basis of service, convenience, quality, product range and price.

 

Environmental Matters

 

Harland Clarke’s current check printing operations use hazardous materials in the printing process and generate solid wastes, wastewater and air emissions. Consequently, its facilities are subject to many existing and proposed federal, state and local laws and regulations designed to protect human health and the environment. While enforcement of these laws may require the expenditure of material amounts for environmental compliance or cleanup, Harland Clarke believes that its facilities are currently in material compliance with such laws and regulations.

Historic check printing operations at Harland Clarke’s current and former facilities used hazardous materials and generated regulated wastes in greater quantities than Harland Clarke’s current operations. In some instances Harland Clarke has sold these facilities and agreed to indemnify the buyer of the facility for potential environmental liabilities. Harland Clarke may also be subject to liability under environmental laws for environmental conditions at these current or former facilities or in connection with the disposal of waste generated at these facilities. Harland Clarke is not aware of any fact or circumstance that would require the expenditure of material amounts for environmental cleanup or indemnification in connection with its historic operations. However, if environmental contamination is discovered at any of these former facilities or at locations where wastes were disposed, Harland Clarke could be required to spend material amounts for environmental cleanup.

 

It is generally not possible to predict the ultimate total costs relating to any remediation that may be demanded at any environmental site due to, among other factors, uncertainty regarding the extent of prior pollution, the complexity of applicable environmental laws and regulations and their interpretations, uncertainty regarding future changes to such laws and regulations or their enforcement, the varying costs and effectiveness of alternative cleanup technologies and methods, and the questionable and varying degrees of responsibility and/or involvement by Harland Clarke.

 

Harland Financial Solutions

 

Harland Financial Solutions provides technology products and services to financial services clients worldwide including lending and mortgage applications, risk management solutions, business intelligence solutions, Internet and mobile banking applications, branch automation solutions, self-service solutions, electronic payment solutions and core processing systems. In 2010, Harland Financial Solutions generated revenues of $282.7 million (17% of the Company’s 2010 consolidated net revenues).

 

Products and Services

 

Harland Financial Solutions provides host processing systems on both an in-house and outsourced basis to financial institutions, including banks, credit unions and thrifts. Its products centralize customer information and facilitate high speed and reliable processing of transactions from every delivery channel. Harland Financial Solutions has integrated its compliance, branch automation, Internet banking, mobile banking and business intelligence products into its core processing solutions. Management believes that this integration capability differentiates Harland Financial Solutions from other providers. Harland Financial Solutions helps financial institutions increase the profitability of customer relationships through business intelligence and branch automation software. Harland Financial Solutions offers Internet banking, mobile banking and branch automation systems designed to enhance the customer experience through integrated teller, platform, call center and self-service tools from new account opening and funding to account-to-account money transfers, person-to-person payments, account and adviser-client relationship management, and bill presentment and payment.

 

Harland Financial Solutions also sells loan and deposit origination and compliance software to financial institutions. Harland Financial Solutions offers a complete product suite, Pro Suite, including solutions for lending, account opening, sales management and loan underwriting. Harland Financial Solutions also offers a commercial lending risk management, underwriting and portfolio management product suite marketed as CreditQuest. Harland Financial Solutions provides mortgage loan origination, production and servicing solutions through its various products.

 

As a result of the Parsam acquisition in December 2010, Harland Financial Solutions has a software development and support operation consisting of approximately 40 information technology professionals located in Thiruvananthapuram, India.

 

Backlog

 

Harland Financial Solutions’ backlog was estimated to be $366.1 million at December 31, 2010. Backlog consists of contracted products, maintenance, outsourced services and professional services prior to delivery.

The Company expects to deliver approximately 36% of this backlog during 2011. Due to the long-term nature of certain service contracts, primarily in the service bureau business, the remainder of the backlog will be delivered in 2012 and beyond. During 2010, Harland Financial Solutions updated its definition of backlog to include contracted maintenance and contractual adjustments to prices during the term of the agreement and refined its calculation to eliminate a seasonal bias at year end. Under this definition and calculation, the value of Harland Financial Solutions backlog was estimated to be $347.8 million at December 31, 2009.

 

Sales and Marketing

 

Harland Financial Solutions predominately sells its products and services directly to financial institutions through its own national sales organization supported by dedicated product management, marketing, and client support organizations.

 

Clients

 

Harland Financial Solutions is a leading supplier of financial software and services to financial institutions, including banks, credit unions and thrifts. Harland Financial Solutions contracts generally provide for a license with ongoing maintenance or a term-based service arrangement.

 

Competition

 

Providing technological solutions to financial institutions is highly competitive and fragmented. Harland Financial Solutions competes with several large and diversified financial technology providers, including, among others, Fidelity National Information Services, Inc., Fiserv, Inc., Jack Henry & Associates, Inc., Open Solutions Inc., Computer Services Inc. and many regional providers. Many multi-national and international providers of technological solutions to financial institutions also compete with products or services offered by Harland Financial Solutions both domestically and internationally, including Temenos Group AG, Misys plc, Infosys Technologies Limited, Tata Consultancy and Oracle Financial Services. There are also many other competitors that offer one or more specialized products or services that compete with products and services offered by Harland Financial Solutions. Management believes that competitive factors influencing buying decisions include product features and functionality, client support, price and vendor financial stability.

 

Scantron

 

Scantron provides data management solutions and related services to educational, commercial, healthcare and governmental entities worldwide. Scantron’s solutions combine a variety of data collection, analysis and management tools, including web-based software tools, scanning equipment, forms, and related field maintenance services. For the year ended December 31, 2010, Scantron generated revenue of $203.7 million (12% of the Company’s 2010 consolidated net revenues).

 

Products and Services

 

Education-Related Products

 

Scantron’s sales to K-12 educational institutions have historically represented the largest portion of Scantron’s revenues, although it also generates revenues from sales to higher education, healthcare, government and commercial institutions. In 2010, Scantron derived approximately 30% of its revenues from sales to K-12 educational institutions.

 

Scantron’s Achievement Series is a set of web-based testing solutions that provide schools and other enterprises with a content-neutral platform for measuring achievement, with real-time reporting. Scantron also offers solutions for managing and centralizing the data generated by the testing process to measure progress against state and national standards. Scantron’s Performance Series is an Internet-delivered, standards-based, computer adaptive assessment that provides valid and reliable diagnostic and placement assessment data. Each assessment is adapted for each student, is aligned to individual state standards, and links to instructional applications that can help educators design formative assessment-based instruction.

Scantron has integrated Achievement Series and Performance Series to provide an overall diagnostic, achievement testing, monitoring and data reporting solution. These solutions also allow the easy integration of disparate technologies and content. Scantron’s Achievement Series and Performance Series solutions generate subscription revenues and the opportunity for the sale of associated products, including forms and scanner solutions, testing content, testing-based instruction applications and data management tools.

 

EXCEED^® is a web-based solution acquired in 2010 in the Spectrum K12 acquisition that manages, administers and prescribes the personalized learning process and data required for all K-12 students. Information about each student is gathered from any assessments to conduct universal screening and ongoing progress monitoring. This instructional outcome data is integrated with other student data like attendance, discipline, and grades to give teachers, principals and school district administrators a centralized, 360 degree view of each student and the data to inform and individualize instruction for every student.

 

As a result of the GlobalScholar acquisition in January 2011, Scantron provides a comprehensive software platform through GlobalScholar’s Pinnacle System, that supports standards-based student, classroom, and program grading and evaluation, enabling schools to identify deficiencies in student performance and comply with government-mandated standards. The Pinnacle System provides databases of attendance, grades, and student proficiencies that is available over the Internet and through other devices to students, parents, teachers and administrators. Additionally, users worldwide, through a series of websites, can obtain tutoring services and access directories of educational institutions; access lectures and full courses on many topics; obtain educational administrative support and assistance in developing interactive educational websites; and store curriculum, testing, and evaluation information. With the GlobalScholar acquisition, Scantron acquired operations located in Chennai, India consisting of approximately 200 employees. Approximately 100 of these employees are information technology professionals who provide software development and support services.

 

Scantron provides educational institutions with a patented forms and scanner solution for standardized and classroom-based testing needs. The Scantron forms and scanner solution has achieved widespread acceptance among educational institutions. Scantron generates forms and scanner solutions revenues by charging for the purchase or lease of scanners and the purchase of forms by the client. In addition, Scantron has a loan marketing program, under which a scanner is loaned to a client in exchange for a minimum annual forms purchase.

 

Scantron also offers custom form and scanner solutions, course evaluations and classroom testing software packages, and student response devices.

 

Commercial, Healthcare, and Government — Related Products

 

Scantron provides data management outsourcing services for clients using web-based, telephone and paper-based methods for data collection, processing, analysis and reporting. These services include customer and employee surveys, patient information tracking, and a wide variety of other data collection, analysis and management applications.

 

Scantron provides custom form and scanner solutions for a wide variety of data collection applications such as patient information collection, safety assessments and employee testing or information collection. Scantron offers scanners with both optical mark and full image capabilities. The scanners range in size and speed for various customer applications. Scantron also provides software that converts optical marks and images into digital data for delivery to third-party applications.

 

In addition, Scantron offers software packages for client-managed survey and general data collection.

 

Field Maintenance Services

 

Scantron provides field maintenance services including installation, maintenance and repairs for computers and other third-party equipment as well as Scantron scanners.

Backlog

 

Scantron’s backlog, which consists primarily of contracted products and services prior to delivery, was estimated to be $60.4 million and $65.3 million at December 31, 2010 and 2009, respectively. The Company expects to deliver approximately 81% of the 2010 backlog during 2011.

 

Sales, Marketing and Product Support

 

Scantron sells its products and services directly through sales organizations segmented by industry vertical or product category. Scantron provides comprehensive product support to its clients directly with telephone and online support and provides on-site and depot support for scanner products.

 

Clients

 

Clients for Scantron’s educational products range from K-12 institutions and districts to higher education institutions. Clients for Scantron’s other data management products include commercial, healthcare and government organizations.

 

Competition

 

Scantron competes with many education software providers at the K-12 and higher education levels. Scantron also faces significant competition from a number of local and regional education competitors. Scantron faces competition with respect to its forms and scanners from large international and regional printers and manufacturers. The business landscape for commercial, healthcare and governmental data management is highly fragmented, and Scantron faces competition for its products and services from many large and small companies.

 

The Company’s Suppliers

 

The main supplies used in check and form printing are paper, print ink, binders, boxes, packaging and delivery services. For all critical supplies, Harland Clarke has at least two qualified suppliers or multiple qualified production sites in order to ensure that supplies are available as needed. Using alternative suppliers may, however, result in increased costs. Harland Clarke has not historically experienced any material shortages and management believes Harland Clarke has redundancy in its supplier network for each of its key inputs.

 

Scantron purchases a majority of the paper for its business from a single supplier. It purchases scanner components from various equipment manufacturers and supply firms. Scantron historically has not experienced shortages of materials and believes it will continue to be able to obtain such materials or suitable substitutes in acceptable quantities and at acceptable prices.

 

The Company’s Foreign Sales

 

The Company conducts business outside the United States in Canada, India, Ireland and Israel. Its foreign sales totaled $20.6 million in 2010, $18.1 million in 2009 and $19.1 million in 2008.

 

The Company’s Employees

 

As of December 31, 2010, the Company had approximately 7,900 employees. No employees of the Company are represented by a labor union. The Company considers its employee relations to be good.

 

The Company’s Intellectual Property

 

The Company relies on a combination of trademark, copyright and patent laws, trade secret protection and confidentiality and license agreements to protect its trademarks, copyrights, software, inventions, trade secrets, know-how and other intellectual property. The sale of products bearing trademarks or designs licensed from third parties accounts for a significant portion of the Company’s revenue. Typically, such license agreements are effective for a two- to three-year period, provide for the retention of ownership of the

tradename, know-how or other intellectual property by the licensor and require the payment of a royalty to the licensor. There can be no guarantee that such licenses will be renewed or will continue to be available on terms that would allow the Company to sell the licensed products profitably.

 

Governmental Regulation Related to the Company

 

The Company is subject to the federal financial modernization law known as the Gramm-Leach-Bliley Act and the regulations implementing its privacy and information security requirements, as well as other privacy and data security federal and state laws and regulations. The Company is also subject to additional privacy and information security requirements in many of its contracts with financial institution clients, which are often more restrictive than the laws or regulations. These laws, regulations and agreements require the Company to develop and implement policies to protect the security and confidentiality of consumers’ nonpublic personal information and to disclose these policies to consumers before a customer relationship is established and periodically thereafter.

 

These laws and regulations require some of the Company’s businesses to provide a notice to consumers to allow them the opportunity to have their nonpublic personal information removed from the Company’s files before the Company shares their information with certain third parties. These laws and regulations may limit the Company’s ability to use its direct-to-consumer data in its businesses. Current laws and regulations allow the Company to transfer consumer information to process a consumer-initiated transaction, but also require the Company to protect the confidentiality of a consumer’s records or to protect against actual or potential fraud, unauthorized transactions, claims or other liabilities. The Company is also allowed to transfer consumer information for required institutional risk control and for resolving customer disputes or inquiries. The Company may also contribute consumer information to a consumer-reporting agency under the Fair Credit Reporting Act. Some of the Company’s financial institution clients request various contractual provisions in their agreements that are intended to comply with their obligations under the Gramm-Leach-Bliley Act and other laws and regulations.

 

Congress and many states have passed and are considering additional laws or regulations that, among other things, restrict the use, purchase, sale or sharing of nonpublic personal information about consumers and business customers. New laws and regulations may be adopted in the future with respect to the Internet, e-commerce or marketing practices generally relating to consumer privacy. Such laws or regulations may impede the growth of the Internet and/or use of other sales or marketing vehicles. For example, new privacy laws could decrease traffic to the Company’s websites, decrease telemarketing opportunities and decrease the demand for its products and services. Additionally, the applicability to the Internet of existing laws governing property ownership, taxation and personal privacy is uncertain and may remain uncertain for a considerable length of time.

 

Non-Operating Contingent Claims, Indemnification and Insurance Matters

 

Honeywell Indemnification

 

Certain of the intermediate holding companies of the predecessor of the Company had issued guarantees on behalf of operating companies formerly owned by these intermediate holding companies, which operating companies are not part of the Company’s businesses. In the stock purchase agreement executed in connection with the 2005 acquisition of the Company by M & F Worldwide, Honeywell International Inc. agreed to use its commercially reasonable efforts to assume, replace or terminate such guarantees and indemnify M & F Worldwide and its affiliates, including the Company and its subsidiaries, with respect to all liabilities arising under such guarantees.

 

Other

 

A series of commercial borrowers in eight states that allegedly obtained loans from banks employing HFS’s LaserPro software have commenced individual or class actions against their banks alleging that the loans were deceptive or usurious in that they failed to disclose properly the effect of the “365/360” method of calculating interest. In some cases, the banks have made warranty claims against HFS related to these actions.

Some of these actions have already been dismissed, and many of the remainder, and the related warranty claims, are at early stages, so that the likely progress of the matters still pending is not yet clear. HFS settled one warranty claim in 2009 for an immaterial amount without any admission of liability. The Company has not accepted any of the remaining warranty claims and does not believe that any of these claims will result in material liability for the Company, but there can be no assurance.

 

Various other legal proceedings, claims and investigations are pending against the Company, including those relating to commercial transactions, product liability, environmental, safety and health matters, employment matters and other matters. The Company is also involved in various stages of legal proceedings claims, investigations and cleanup relating to environmental matters, some of which relate to waste disposal sites. Most of these matters are covered by insurance, subject to deductibles and maximum limits, and by third-party indemnities. In the opinion of management, based upon the information available at this time, the outcome of the matters referred to above will not have a material adverse effect on the Company’s financial position or results of operations.

 

Availability of Reports

 

Copies of the Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports filed or furnished pursuant to the Securities Exchange Act of 1934, are available without charge as soon as reasonably practicable after the Company files such materials with or furnishes such materials to the Securities and Exchange Commission upon request to the Chief Financial Officer, Harland Clarke Holdings Corp., 10931 Laureate Drive, San Antonio, TX 78249.

 

 

Risks Related to Our Substantial Indebtedness

 

We have substantial indebtedness, which may adversely affect our ability to operate our business and prevent us from fulfilling our obligations under our debt agreements.

 

As of December 31, 2010, we had total indebtedness of $2,219.7 million (including $4.6 million of capital lease obligations and other indebtedness), and $91.8 million of additional availability under our revolving credit facility (after giving effect to the issuance of $8.2 million of letters of credit). In addition, under certain circumstances, we are permitted to incur additional term loan and/or revolving credit facility indebtedness in an aggregate principal amount of up to $250.0 million, and the terms of our senior secured credit facilities and notes allow us to borrow substantial additional debt, including additional secured debt. Our substantial level of indebtedness could have important consequences. For example, it could:

 

 

Our ability to make payments on our indebtedness depends on our ability to generate sufficient cash in the future.

 

Our ability to make payments on our indebtedness and to fund planned capital expenditures will depend on our ability to generate cash in the future. This is subject to general economic, financial, competitive, legislative, regulatory and other factors beyond our control.

We are required to make scheduled payments of principal on our senior secured term loan in the amount of $18.0 million per year in equal quarterly installments. In addition, our term loan facility requires that a portion of our excess cash flow be applied to prepay amounts borrowed under that facility. An excess cash flow payment of approximately $3.5 million will be paid in 2011 with respect to 2010 and will be applied against other mandatory payments due in 2011 under the terms of the facility. No such excess cash flow payment was paid in 2010 with respect to 2009 and no such excess cash flow payment was paid in 2009 with respect to 2008. We are required to repay our senior secured term loan in full in 2014 and are required to repay our senior notes in 2015. Our revolving credit facility will mature in 2013.

 

We may not be able to generate sufficient cash flow from operations and future borrowings may not be available to us under our senior secured credit facilities in an amount sufficient to enable us to repay our debt or to fund our other liquidity needs. If our future cash flow from operations and other capital resources are insufficient to pay our obligations as they mature or to fund our liquidity needs, we may be forced to reduce or delay our business activities and capital expenditures, sell assets, obtain additional debt or equity capital or restructure or refinance all or a portion of our debt on or before maturity. We may not be able to accomplish any of these alternatives on a timely basis or on satisfactory terms, if at all. In addition, the terms of our existing and future indebtedness, including the notes and our senior secured credit facilities, may limit our ability to pursue any of these alternatives.

 

Despite our current indebtedness levels, we may still be able to incur substantially more debt. Additional indebtedness could exacerbate the risks associated with our substantial leverage.

 

We may be able to incur substantial additional indebtedness in the future. The terms of our senior secured credit facilities and the indenture governing our senior notes do not fully prohibit us from doing so. In addition, as of December 31, 2010, there was $91.8 million of additional availability under our $100.0 million revolving credit facility (after giving effect to the issuance of $8.2 million of letters of credit). Under certain circumstances, we are permitted to incur additional term loan and/or revolving credit facility indebtedness under our senior secured credit facilities in an aggregate principal amount of up to $250.0 million. In addition, the terms of our senior secured credit facilities and senior notes allow us to borrow substantial additional debt, including additional secured debt. If new indebtedness is added to our current debt levels, the related risks that we now face could intensify.

 

Covenant restrictions under our indebtedness may limit our ability to operate our business.

 

The indenture governing the notes and the agreement governing our senior secured credit facilities contain, among other things, covenants that restrict our ability to finance future operations or capital needs or to engage in other business activities. The indenture restricts, among other things, our ability to:

 

 

Our senior secured credit facilities contain customary affirmative and negative covenants including, among other things, restrictions on indebtedness, liens, mergers and consolidations, sales of assets, loans, investments, acquisitions, restricted payments, transactions with affiliates, dividends and other payment restrictions affecting subsidiaries and sale-leaseback transactions.

 

In addition, our credit agreement requires us to maintain a maximum consolidated leverage ratio for the benefit of the lenders under our revolving credit facility only. These restrictions may limit our ability to

operate our businesses and may prohibit or limit our ability to enhance our operations or take advantage of potential business opportunities as they arise.

 

Risks Related to Our Business

 

Weak economic conditions and further acceleration of check unit declines may continue to have an adverse effect on the Company’s revenues and profitability and could result in additional impairment charges.

 

The Company has substantial intangible assets, including substantial goodwill arising from previous acquisitions. Goodwill and other intangible assets determined to have an indefinite life are not amortized, but are tested for impairment annually in the fourth quarter, or when events or changes in circumstances indicate that the assets might be impaired. The Company also has a significant amount of property, plant and equipment and amortizable intangible assets, such as customer relationships, which are tested for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The impairment test processes are more fully described in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates” included elsewhere in this Annual Report on Form 10-K.

 

The annual impairment evaluations for goodwill and indefinite-lived intangible assets involve significant estimates and assumptions made by management regarding specific business and operating factors as well as discount rates. Changes in estimates and assumptions, as well as the occurrence of various events or changes in circumstances could have a material impact on the fair value of goodwill or indefinite-lived intangible assets in future periods, which in turn may result in material asset impairments. Similar considerations apply to any impairment evaluation of our property, plant and equipment and amortizable intangible assets as well as our determinations as to whether interim impairment tests are necessary.

 

The Company periodically updates its long-range business plans and forecasts, which include financial projections that are incorporated in the annual impairment tests. Estimated revenue growth rates for all reporting units may be lower than past projections due to the various factors discussed in this report, including, but not limited to, the following:

 

 

Depending on the nature of these factors and the expected relative magnitude and permanency of their effects, the Company’s businesses may not be able to achieve previous levels of performance even when overall economic conditions improve. During the 2009 annual impairment test for goodwill and indefinite-lived tradenames, the Company determined the fair value of the Harland Clarke tradename was less than its carrying value due to declines in revenues from check unit volumes that are projected to decline at rates that are higher than recent years and also due to the continuing economic downturn. As a result of this impairment, the useful life of the Harland Clarke tradename was reassessed and determined to no longer be indefinite. Based on an analysis of future cash flows attributable to the Harland Clarke tradename, the Company determined the economic life for the Harland Clarke tradename is 25 years. A non-cash impairment charge of $44.2 million was recorded in the fourth quarter of 2009 based on the current fair value of the Harland Clarke tradename being less than its carrying value and the useful life was reclassified from an indefinite life to a life of 25 years. The annual impairment test for goodwill and indefinite-lived tradenames performed in the fourth quarter of 2010 did not result in further impairments of goodwill and indefinite-lived tradenames.

 

Future impairment tests may result in a determination that there have been additional material asset impairments. Any asset impairment would be reported as a non-cash operating loss, would have a negative effect on the Company’s earnings and total assets, and could have a negative impact on the market prices of the Company’s outstanding securities. Impairment charges in the future would not impact the Company’s consolidated cash flows, current liquidity, capital resources and covenants under its existing credit facilities.

Difficult conditions in the financial markets and a general economic downturn may adversely affect the business and results of operations of the Company and we cannot determine if these conditions will improve or worsen in the near future.

 

The economic conditions since late 2008 and the volatility in the financial markets during this period have contributed and may continue to contribute to high unemployment levels, decreased consumer spending, reduced credit availability and/or declining business and consumer confidence. During this period, a number of financial institutions have taken significant write-downs of asset values. These write-downs have caused many financial institutions to seek additional capital, to merge with other institutions and, in some cases, to fail. We cannot determine whether the difficult conditions in the economy in general and/or the financial markets will improve or worsen in the near future. Our businesses have been and may continue to be adversely affected by these difficult conditions. Harland Clarke may experience reduced revenues due to losses of customers in the event the financial institutions upon which it depends either merge with or are sold to other institutions, or fail, or in the event that consumer spending continues to decline, or checking account openings continue to decrease, resulting in further acceleration in the decline of check usage and the use of Harland Clarke’s other products. Similarly, Harland Financial Solutions, which also depends on its financial institution customers, may be adversely affected due to losses of financial institution customers from mergers, consolidations or failures. Reductions in financial institution information technology budgets in response to market difficulties could continue to result in further delays or cancellations of Harland Financial Solutions client purchases, as well as potential pricing pressure on Harland Financial Solutions products. Economic slowdown and liquidity constraints may also cause state and local public and private education budgets to be further reduced, which could continue to result in reduced revenues at Scantron, as well as pricing pressure on Scantron products. In addition, further disruptions in the credit and other financial markets could, among other things, impair the financial condition of suppliers of the Company, thereby increasing the risk of supplier performance.

 

Account data breaches involving stored client data or misuse of such data could adversely affect our reputation, revenues, profits and growth.

 

We, our clients, and other third parties store customer account information relating to our Harland Clarke segment’s checks. In addition, a number of clients use our Harland Financial Solutions products and Scantron products to store and manage sensitive customer and student information. Scantron also provides services which involve the storage of non-public customer information. Any breach of the systems on which sensitive customer data and account information are stored or archived and any misuse by our own employees, by employees of data archiving services or by other unauthorized users of such data could lead to fraudulent activity involving our clients and our financial institution clients’ customers’ information and/or funds, damage the reputation of our brands and result in claims against us. If we are unsuccessful in defending any lawsuit involving such data security breaches or misuse, we may be forced to pay damages, which could materially and adversely affect our profitability and could have a material adverse impact on our transaction volumes, revenue and future growth prospects. In addition, such breaches could adversely affect our financial institution clients’ perception as to our reliability, and could lead to the termination of client contracts.

 

Legislation and contracts relating to protection of personal data could limit or harm our future business.

 

We are subject to state and federal laws and regulations regarding the protection of consumer information commonly referred to as “non-public personal information.” Examples include the federal financial modernization law known as the Gramm-Leach-Bliley Act and the regulations implementing its privacy and information security requirements, as well as other privacy and data security federal and state laws and regulations. We are also subject to additional requirements in many of our contracts with financial institution clients, which are often more restrictive than the regulations. These laws, regulations and agreements require us to develop and implement policies to protect non-public personal information and to disclose these policies to consumers before a customer relationship is established and periodically thereafter. The laws, regulations, and agreements limit our ability to use or disclose non-public personal information for other than the purposes originally intended.

Where not preempted by the provisions of the Gramm-Leach-Bliley Act, states may enact legislation or regulations that are more restrictive on our use of data. In addition, more restrictive legislation or regulations have been introduced in the past and could be introduced in the future in Congress and the states and could have a negative impact on our business, results of operations or prospects. Additionally, future contracts may impose even more stringent requirements on us which could increase our operating costs, as well as interfere with the cost savings we are trying to achieve.

 

We market certain products and services through various distribution media, including direct mail, telemarketing, online marketing, and other methods. These media are subject to increasing regulation, both at the federal and state levels, particularly in the area of consumer privacy. Our ability to solicit or sign up new customers may be affected.

 

The financial services sector is also subject to various federal and state regulations and oversight. As a supplier of services to financial institutions, certain operations of our Harland Clarke and Harland Financial Solutions segments are examined by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, among other agencies, to confirm our ability to maintain data security. These agencies regulate and audit services we provide and the manner in which we operate, and we are required to comply with a broad range of applicable laws and regulations. Adverse audit findings could impact our ability to continue to render services or require investment in corrective measures. Moreover, current laws and regulations may be amended in the future or interpreted by regulators in a manner which could negatively affect the operations of our Harland Clarke or Harland Financial Solutions segments or limit their future growth.

 

The use of our Scantron products and services to store and manage student and other educational data may be subject to The Family Education Rights and Privacy Act of 1974, commonly known as FERPA, which is a federal law that protects the privacy of student education records in connection with Scantron’s web-based assessment services. Many states have enacted similar laws to protect the privacy of student data. The operation of websites by Scantron that are accessed by children under the age of 13 may be subject to the Children’s Online Privacy Protection Act of 1998, commonly known as COPPA. The collection of patient data through Scantron’s survey services is subject to the Health Insurance Portability and Accountability Act of 1996, commonly known as HIPAA, which protects the privacy of patient data. Scantron is also subject to the Gramm-Leach-Bliley Act.

 

New laws and regulations may be adopted in the future with respect to the Internet, e-commerce or marketing practices generally relating to consumer privacy. Such laws or regulations may impede the growth of the Internet and/or use of other sales or marketing vehicles. As an example, new privacy laws could decrease traffic to our websites, decrease telemarketing opportunities and decrease the demand for our products and services. Additionally, the applicability to the Internet of existing laws governing property ownership, taxation, libel and personal privacy is uncertain and may remain uncertain for a considerable length of time.

 

We may experience processing errors or software defects that could harm our business and reputation.

 

We use sophisticated software and computing systems in our Harland Clarke, Harland Financial Solutions and Scantron segments. We may experience difficulties in installing or integrating our technologies on platforms used by our clients. Furthermore, certain financial institution clients of our Harland Clarke segment have integrated certain components of their systems with ours, permitting our operators to effect certain operations directly into our financial institution clients’ customers’ accounts. Errors or delays in the processing of check orders, software defects or other difficulties could result in:

 

 

We may not successfully implement any or all components of our business strategies or realize all of our continued cost savings, which could reduce our revenues and profitability.

 

Important components of our business strategies are to cross-sell between business segments, capitalize on complementary offerings across the client base of our Harland Clarke segment, cross-sell software products into our combined client base, continue focusing on software-enabled testing and assessment products while expanding the offering of survey services to financial institutions, and continue to reduce costs and generate strong cash flow.

 

We may not be able to fully implement any or all components of our business strategies or realize, in whole or in part or within the timeframes anticipated, the efficiency improvements or cost savings from these strategies. These strategies are subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. Financial industry turmoil and the general economic slowdown may continue to adversely affect our ability to implement our business strategies. Additionally, our business strategies may change from time to time. As a result, we may not be able to achieve our expected results of operations.

 

We may be unable to protect our rights in intellectual property, and third-party infringement or misappropriation may materially adversely affect our profitability.

 

We rely on a combination of measures to protect our intellectual property, among them, contract provisions, registering trademarks and copyrights, patenting inventions, implementing procedures that afford trade secret status and protection to our proprietary information, such as entering into third-party non-disclosure and intellectual property assignment agreements, and maintaining our intellectual property by entering into licenses that grant only limited rights to third parties. We may be required to spend significant resources to protect, monitor and police our trade secrets, proprietary know-how trademarks and other intellectual property rights. Despite our efforts to protect our intellectual property, third parties or licensees may infringe or misappropriate our intellectual property. The confidentiality agreements that are designed to protect our trade secrets and proprietary know-how could be breached, or our trade secrets and proprietary know-how might otherwise become known by others. We may not have adequate remedies for infringement or misappropriation of our intellectual property rights or for breach of our confidentiality agreements. The loss of intellectual property protection or the inability to enforce our intellectual property rights could harm our business and ability to compete.

 

We may be unable to maintain our licenses to use third-party intellectual property on favorable terms.

 

A significant portion of our revenues are derived from the sale of products by our Harland Clarke segment bearing third-party trademarks or designs pursuant to royalty-bearing licenses. Typically, these licenses are for a term of between two and three years, and some licenses may be terminated at the licensor’s option upon a change of control. There can be no guarantee that such licenses will be renewed or will continue to be available to us on terms that would allow us to continue to sell the licensed products profitably.

 

Third parties may claim we infringe on their intellectual property rights.

 

Third parties may assert intellectual property infringement claims against us in the future. In particular, there has been a substantial increase in the issuance of patents for Internet-related systems and business methods, which may have broad implications for participants in technology and service sectors. Claims for infringement of these patents are increasingly becoming a subject of litigation. Because patent application information may not always be readily available, there is also a risk that we could adopt a technology without knowledge of a pending patent application, which technology would infringe a third-party patent once that patent is issued. Responding to these infringement claims may require us to enter into royalty-bearing license agreements, to stop selling or to redesign affected products, services and technologies, to pay damages, and/or to satisfy indemnification commitments under agreements with our licensees. In the event that our trademarks are successfully challenged by third parties, we could be forced to rebrand our products, which could result in the loss of brand recognition. Future litigation relating to infringement claims could also result in substantial

costs to us and a diversion of management resources. Adverse determinations in any litigation or proceeding could also subject us to significant liabilities and could prevent us from using some of our products, services or technologies.

 

We are dependent upon third-party providers for significant information technology needs, and an interruption of services from these providers could materially and adversely affect our operations.

 

We have entered into agreements with third-party providers for the licensing of certain software and the provision of information technology services, including software development and support services, and personal computer, telecommunications, network server and help desk services. In the event that one or more of these providers is not able to provide adequate information technology services or terminates a license or service, we would be adversely affected. Although we believe that information technology services and substantially equivalent software and services are available from numerous sources, a failure to perform or a termination by one or more of our service providers could cause a disruption in our business while we obtain an alternative source of supply and we may not be able to find such an alternative source on commercially reasonable terms, or at all.

 

We depend upon the talents and contributions of a limited number of individuals, many of whom would be difficult to replace, and the loss or interruption of their services could materially and adversely affect our business, financial condition and results of operations.

 

Our business is largely driven by the personal relationships of our senior management teams. Despite executing employment agreements with certain members of our senior management teams, these individuals may discontinue service with us and we may not be able to find individuals to replace them at the same cost, or at all. We have not obtained “key person” insurance for any member of our senior management teams. The loss or interruption of the services of these executives could have a material adverse effect on our business, financial condition and results of operations.

 

We face uncertainty with respect to future acquisitions, and unsuitable or unsuccessful acquisitions could materially and adversely affect our business, prospects, results of operations and financial condition.

 

We have acquired complementary businesses in the past, and we may pursue acquisitions of complementary businesses in the future. We cannot predict whether suitable acquisition candidates can be acquired on acceptable terms or whether future acquisitions, even if completed, will be successful. Future acquisitions by us could result in the incurrence of contingent liabilities, debt or amortization expenses relating to intangible assets which could materially adversely affect our business, results of operations and financial condition. Moreover, the success of any past or future acquisition will depend upon our ability to integrate effectively the acquired businesses.

 

We also cannot predict whether any acquired products, technology or business will contribute to our revenues or earnings to any material extent or whether cost savings and synergies we expect at the time of an acquisition can be realized once the acquisition has been completed. Furthermore, if we incur additional indebtedness to finance an acquisition, we cannot predict whether the acquired business will be able to generate sufficient cash flow to service that additional indebtedness.

 

Unsuitable or unsuccessful acquisitions could therefore have a material and adverse effect on our business, prospects, financial condition and results of operations.

 

Our business is exposed to changes in interest rates.

 

We are exposed to changes in interest rates on our variable-rate debt. A hypothetical increase of 1 percentage point in the variable component of interest rates applicable to floating rate debt outstanding as of December 31, 2010 would have resulted in an increase to interest expense of approximately $8.8 million per year including the effect of interest rate swaps outstanding at December 31, 2010. Adverse interest rate changes could have a material adverse effect on our business, results of operations and financial condition.

We are dependent on the success of our research and development and the failure to develop new and improved products could adversely affect our business.

 

We have in the past made, and intend to continue in the future to make, investments in research and development in order to enable us to identify and develop new products. The development process for new products can be lengthy. Despite investments in this area, our research and development may not result in the discovery or successful development of new products. The success of our new product offerings will depend on several factors, including our ability to:

 

 

The continuous introduction of new products is important to our growth. Our financial condition could deteriorate if we cannot timely and cost effectively develop and commercialize new products.

 

We may be subject to sales and other taxes, which could have adverse effects on our business.

 

In accordance with current federal, state and local tax laws, and the constitutional limitations thereon, we currently collect sales, use or other similar taxes in state and local jurisdictions where we have a physical presence. One or more state or local jurisdictions may seek to impose sales tax collection obligations on us and other out-of-state companies which engage in remote or online commerce. Several states in the United States have taken various initiatives to prompt retailers to collect local and state sales taxes on purchases made over the Internet. Furthermore, tax law and the interpretation of constitutional limitations thereon is subject to change. In addition, any new operations of these businesses in states where they do not currently have a physical presence could subject shipments of goods by these businesses into such states to sales tax under current or future laws. If one or more state or local jurisdictions successfully asserts that we must collect sales or other taxes beyond our current practices, it could have a material, adverse affect on our business.

 

We may be subject to environmental risks, and liabilities for environmental compliance or cleanup could have a material, adverse effect on our profitability.

 

Our operations are subject to many existing and proposed federal, state, local and foreign laws and regulations pertaining to pollution and protection of human health and the environment, the violation of which can result in substantial costs and liabilities, including material civil and criminal fines and penalties. Such requirements include those pertaining to air emissions; wastewater discharges; occupational safety and health; the generation, handling, treatment, remediation, use, storage, transport, release, and exposure to hazardous substances and wastes. Under certain of these laws and regulations, such as the federal Superfund statute, the obligation to investigate and remediate contamination at a facility may be imposed on current and former owners or operators or on persons who may have sent waste to that facility for disposal. In addition, environmental laws and regulations, and interpretation or enforcement thereof, are constantly evolving and any such changes could affect the business, financial condition or results of operations. Enforcement of these laws and regulations may require the expenditure of material amounts for environmental compliance or cleanup.

 

The operations of our Harland Clarke segment use hazardous materials in the printing process and generate wastewater and air emissions. Some of our historic check and form printing operations at current and former facilities used hazardous materials in greater quantities. In some instances, we have sold these facilities and agreed to indemnify the buyer of the facility for certain environmental liabilities. We may also be subject to liability under environmental laws and regulations for environmental conditions at our current or former facilities or in connection with the disposal of waste generated at these facilities. Although we are not aware

of any fact or circumstance that would require the expenditure of material amounts for environmental compliance or cleanup, if environmental liabilities are discovered at our current or former facilities or at locations where our wastes were disposed, we could be required to spend material amounts for environmental compliance or cleanup.

 

It is generally not possible to predict the ultimate total costs relating to any remediation that may be demanded at any environmental site due to, among other factors, uncertainty regarding the extent of prior pollution, the complexity of applicable environmental laws and regulations and their interpretations, uncertainty regarding future changes to such laws and regulations or their enforcement, the varying costs and effectiveness of alternative cleanup technologies and methods, and the questionable and varying degrees of responsibility and/or involvement by us.

 

M & F Worldwide, our indirect parent company, and its principal stockholder have significant influence over us.

 

MacAndrews & Forbes Holdings Inc. is a corporation wholly owned by Mr. Ronald O. Perelman. Mr. Perelman, directly and through MacAndrews & Forbes Holdings Inc., beneficially owned, as of December 31, 2010, approximately 43.4% of the outstanding common stock of M & F Worldwide, which beneficially owns 100% of our stock. In addition, two of our directors and three of M & F Worldwide’s directors, as well as M & F Worldwide’s senior executives, are affiliated with MacAndrews & Forbes Holdings Inc. As a result, MacAndrews & Forbes Holdings Inc. and its sole stockholder possess significant influence over our business decisions.

 

Risks Related to our Harland Clarke Segment

 

The paper check industry overall is a mature industry and check usage is declining. Our business will be harmed if check usage declines faster than expected.

 

Check and related products and services, including delivery services, account for most of our revenues. The check industry overall is a mature industry. The number of checks written in the United States has declined in recent years, and we believe that it will continue to decline due to the increasing use of alternative payment methods, including credit cards, debit cards, smart cards, automated teller machines, direct deposit, wire transfers, electronic, home banking applications, Internet based payment services and other bill paying services. The actual rate and extent to which alternative payment methods will achieve consumer acceptance and replace checks, whether as a result of legislative developments, personal preference or otherwise, cannot be predicted with certainty and could decline at a more rapid rate. Changes in technology or the widespread adoption of current technologies may also make alternative payment methods more popular. An increase in the use of any of these alternative payment methods could have a material adverse effect on the demand for checks and a material adverse effect on our business, results of operations and prospects. In recent years, Harland Clarke has experienced check unit declines at a higher rate than in the past, as evidenced by recent period-over-period declines in Harland Clarke revenue. Harland Clarke is unable to determine at this time whether these higher rates of decline are attributable to economic and financial market difficulties, the depth and length of the economic recession, higher unemployment, decreased openings of checking accounts, changing business strategies of our financial institution clients, decreased consumer spending and/or a further acceleration in the use of alternative non-cash payments. Harland Clarke expects that check unit volume will continue to decline at rates that are higher than it had previously experienced in recent years, resulting in a corresponding decrease in check revenues and depending on the nature and relative magnitude of the causes for the decreases, such decreases may not be mitigated when overall economic conditions improve. Harland Clarke is focused on growing its non-check related products and services, including marketing services, and optimizing its existing catalog of offerings to better serve its clients, as well as managing its costs, overhead and facilities to reflect the decline in check unit volumes. Harland Clarke does not believe that revenues from non-check related products and services will fully offset revenue declines from declining check unit volumes. In the future, Harland Clarke may not be able to mitigate the revenue declines from declining check unit volumes through cost management, which could negatively affect Harland Clarke’s margins.

Consolidation among financial institutions may adversely affect our relationships with our clients and our ability to sell our products and may therefore result in lower revenues and profitability.

 

Mergers, acquisitions and personnel changes at financial institutions, as well as failures or liquidations of such financial institutions, may adversely affect our business, financial condition and results of operations. For the year ended December 31, 2010, financial institutions accounted for approximately 83% of revenues for our Harland Clarke segment. In recent years, the number of financial institutions has declined due to consolidation. Consolidation among financial institutions could cause us to lose current and potential clients as such clients are, for example, acquired by financial institutions with pre-existing relationships with other providers. The increase in general negotiating strength possessed by such consolidated entities also presents a risk that new and/or renewed contracts with these institutions may not be secured on terms as favorable as those historically negotiated with these clients. Consolidation among or failure of financial institutions could therefore decrease our revenues and profitability.

 

We are dependent on a few large clients, and adverse changes in our relationships with these highly concentrated clients may adversely affect our revenues and profitability.

 

The majority of sales from our Harland Clarke segment has been, and very likely will continue to be, concentrated among a small group of clients. For the year ended December 31, 2010, the top 20 clients of our Harland Clarke segment represented approximately 43% of its revenues, with sales to Bank of America and Wells Fargo representing a significant portion of revenues. A number of contracts with Harland Clarke segment clients may be terminated by the client for convenience upon written notice or “for cause.” A significant decrease or interruption in business from any of our Harland Clarke segment significant clients, or the termination of our contracts with any of our most significant clients could have a material adverse effect on our revenues and profitability.

 

Our financial results can also be adversely affected by the business practices and actions of our large clients in a number of ways, including timing, size and mix of product orders and supply chain management. Several contracts with our significant clients expire over the next several years. We may not be able to renew them on terms favorable to us, or at all. The loss of one or more of these clients or a shift in the demand by, distribution methods of, pricing to, or terms of sale to, one or more of these clients could materially adversely affect us. The write-off of any significant receivable due from delays in payment or return of products by any of our significant clients could also adversely impact our revenues and profitability.

 

We face intense competition and pricing pressures in certain areas of our business, which could result in lower revenues, higher costs and lower profitability.

 

The check printing industry is intensely competitive. In addition to competition from alternative payment methods, we also face considerable competition from other check printers and other similar providers of printed products. The principal factors on which we compete are service, convenience, quality, product range and price. We may not be able to compete effectively against current and future competitors, which could result in lower revenues, higher costs and lower profitability.

 

Interruptions or adverse changes in our vendor or supplier relationships or delivery services could have a material adverse effect on our business.

 

We have strong relationships with many of the country’s largest paper mills and ink suppliers. These relationships afford us certain purchasing advantages, including stable supply and favorable pricing arrangements. Our supplier arrangements are by purchase order and terminable at will at the option of either party. While we have been able to obtain sufficient paper supplies during recent paper shortages and otherwise, in part through purchases from foreign suppliers, we are subject to the risk that we will be unable to purchase sufficient quantities of paper to meet our production requirements during times of tight supply. An interruption in our relationship with service providers for our digital printers could compromise our ability to fulfill pending orders for checks and related products. In addition, disruptions in the credit and other financial markets could, among other things, impair the financial condition of suppliers of the Company, thereby

increasing the risk of supplier performance. Any interruption in supplies or service from these or other vendors or suppliers or delivery services could result in a disruption to our business if we are unable to readily find alternative service providers at comparable rates.

 

Increased production and delivery costs, such as fluctuations in paper costs, could materially adversely affect our profitability.

 

Increases in production costs such as paper and labor could adversely affect our profitability, our business, our financial condition and results of operations. For example, the principal raw material used by our Harland Clarke segment is paper. Rising inflation may cause our material and delivery costs to rise. Any significant increase in paper prices as a result of a short supply or otherwise would adversely affect our costs. In addition, disruptions in parcel deliveries or increases in delivery rates, which are often tied to fuel prices, could also increase our costs. Our contracts with clients in our Harland Clarke segment may contain certain restrictions on our ability to pass on to clients increased production costs or price increases. In addition, competitive pressures in the check industry may have the effect of inhibiting our ability to reflect these increased costs in the prices of our products and services.

 

Softness in direct mail response rates could have an adverse impact on our operating results.

 

The direct-to-consumer business of our Harland Clarke segment has experienced declines in response and retention rates related to direct mail promotional materials. We believe that these declines are attributable to a number of factors, including the decline in check usage, the overall increase in direct mail solicitations received by our target customers, and the multi-box promotional strategies employed by us and our competitors. To offset these factors, we may have to modify and/or increase our marketing efforts, which could result in increased expense.

 

The profitability of the direct-to-consumer business of our Harland Clarke segment depends in large part on our ability to secure adequate advertising media placements at acceptable rates, as well as the consumer response rates generated by such advertising. Suitable advertising media may not be available at a reasonable cost, or available at all. Furthermore, the advertising we utilize may not be effective. Competitive pricing pressure may inhibit our ability to reflect any of these increased costs in the prices of our products. We may not be able to sustain our current levels of profitability as a result.

 

Risks Related to our Harland Financial Solutions and Scantron Segments

 

If we fail to continually improve our Harland Financial Solutions and Scantron products, effectively manage our product offerings and introduce new products and service offerings, our business may suffer.

 

Harland Financial Solutions’ and Scantron’s businesses are affected by technological change, evolving industry standards, changes in client requirements and frequent new product introductions and enhancements. The businesses of providing technological solutions to financial institutions, educational organizations and other enterprises have been and continue to be intensely competitive, requiring us to continually improve our existing products and create new products while at the same time controlling our costs. We face intense competition from a number of multi-national, international, national, regional and local providers of software and services, some of whom may have greater financial and other resources than we have, greater familiarity with our prospective clients than we do, or the ability to offer more attractive products and services than we do. Our future success will depend in part upon our ability to:

 

 

 

We may not successfully anticipate and develop product enhancements or new products and services to adequately address changing technologies and client requirements. Any such products, solutions or services may not be successful or may not generate expected revenues or cash flow, and the business and results of operations of our Harland Financial Solutions and Scantron businesses may be materially and adversely affected as a result.

 

The revenues, cash flows and results of operations of our Harland Financial Solutions segment may be reduced if we need to lower prices or offer other favorable terms on our products and services to meet competitive pressures in the software industry.

 

Providing technological solutions to financial institutions has been and continues to be intensely competitive. Some of our competitors have advantages over Harland Financial Solutions due to their significant worldwide presence, longer operating and product development history, larger installed client base, and substantially greater financial, technical and marketing resources. In response to competition, Harland Financial Solutions has been required in the past, and may be required in the future, to furnish additional discounts to clients, otherwise modify pricing practices or offer more favorable payment terms or more favorable contractual implementation terms. These developments have and may increasingly negatively affect the revenues, cash flows and results of operations of the Harland Financial Solutions business.

 

Consolidation among financial institutions may adversely affect our relationships with Harland Financial Solutions clients and our ability to sell our products and may therefore result in lower revenues and profitability.

 

Mergers, acquisitions and personnel changes at financial institutions, as well as failures or liquidations of such financial institutions, may adversely affect our Harland Financial Solutions business, financial condition and results of operations. For the year ended December 31, 2010, financial institutions accounted for substantially all of our Harland Financial Solutions segment revenues. In recent years, the number of financial institutions has declined due to consolidation. Consolidation among financial institutions could cause us to lose current and potential clients as such clients are, for example, acquired by financial institutions with pre-existing relationships with other providers. The increase in general negotiating strength possessed by such consolidated entities also presents a risk that new and/or renewed contracts with these institutions may not be secured on terms as favorable as those historically negotiated with these clients. Consolidation among or failure of financial institutions could therefore decrease our revenues and profitability.

 

Downturns in general economic and industry conditions, enhanced regulatory burdens and reductions in information technology budgets could cause decreases in demand for our software and related services which could negatively affect our revenues, cash flows and results of operations.

 

Our revenues, cash flows and results of operations depend on the overall demand for our products, software and related services. Economic downturns in one or more of the countries in which we do business and enhanced regulatory burdens, including through increased fees and assessments charged to financial institutions by the Federal Deposit Insurance Corporation (“FDIC”) and National Credit Union Administration (“NCUA”) or due to recently enacted federal legislation for additional taxes on certain financial institutions, could result in reductions in the information technology budgets for some portion of our clients and potentially longer lead-times for acquiring Harland Financial Solutions products and services. Such reductions and longer lead times could result in delays or cancellations of client purchases and could have a material adverse effect on our business, financial position, results of operations and cash flows. Recent financial industry turmoil and the general economic slowdown may adversely affect our financial institution clients’ ability or willingness to commit financial resources to our products, and spending decisions by these clients may continue to be delayed. Prolonged economic slowdowns may result in clients requiring us to renegotiate existing contracts on less advantageous terms than those currently in place or default on payments due on existing contracts.

As our software offerings increase in number, scope and complexity, our need to prevent any undetected errors and to correct any identified errors may increase our costs, slow the introduction of new products and we may become subject to warranty or product liability claims which could be costly to resolve and result in negative publicity.

 

Although our Harland Financial Solutions and Scantron businesses test each of their new products and product enhancement releases and evaluate and test the products obtained through acquisition before introducing them to customers, significant errors may be found in existing or future releases of our software products, and vulnerability to cyber attacks may arise, with the possible result that significant resources and expenditures may be required in order to correct such errors or otherwise satisfy client demands. In addition, defects in our products or difficulty integrating our products with our clients’ systems could result in delayed or lost revenues, warranty or other claims against us by clients or third parties, adverse client reaction and negative publicity about us or our products and services or reduced acceptance of our products and services in the marketplace, any of which could have a material adverse effect on our business, financial position, results of operations and cash flows.

 

Errors, defects or other performance problems of our products could result in harm or damage to our clients and expose us to liability, which may adversely affect our business and operating results.

 

Because our clients may use our products for mission critical applications, errors, defects or other performance problems may cause financial or other damages to our clients and result in claims for substantial damages against us, regardless of our responsibility for such errors, defects or other performance problems. For example, Harland Financial Solutions has been named in at least one lawsuit challenging certain provisions in Harland Financial Solutions’ lending products.

 

The terms of our contracts with our clients are generally designed to limit our liability for errors, defects or other performance problems and damages relating to such errors, defects or other performance problems, but these provisions may not be enforced by a court or otherwise effectively protect us from legal claims. Our liability insurance may not be adequate to cover all of the costs resulting from these legal claims. Our current liability insurance coverage may not continue to be available on acceptable terms and insurers may deny coverage as to any future claim. The successful assertion against us of one or more large claims that exceed available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or coinsurance requirements, could have a material adverse effect on our business, financial position, results of operations and cash flows. Furthermore, even if we succeed in the litigation, we are likely to incur additional costs and our management’s attention might be diverted from our normal operations.

 

Failure to hire and retain a sufficient number of qualified information technology professionals could have a material adverse effect on our business, results of operations and financial condition.

 

Our business of delivering professional information technology services is labor intensive, and, accordingly, our success depends upon our ability to attract, develop, motivate, retain and effectively utilize highly skilled information technology professionals. We believe that there is a growing shortage of, and significant competition for, information technology professionals in the United States who possess the technical skills and experience necessary to deliver our services, and that such information technology professionals are likely to remain a limited resource for the foreseeable future. We also plan to manage and grow software development operations internationally related to Harland Financial Solutions and Scantron. We believe that, as a result of these factors, we operate within an industry that experiences a significant rate of annual turnover of information technology personnel. Our business plans are based on hiring and training a significant number of additional information technology professionals each year to meet anticipated turnover and increased staffing needs. Our ability to maintain and renew existing engagements and to obtain new business depends, in large part, on our ability to hire and retain qualified information technology professionals. We may not be able to recruit and train a sufficient number of qualified information technology professionals, and we may not be successful in retaining current or future employees. Increased hiring by technology companies and increasing worldwide competition for skilled technology professionals may lead to a shortage in the availability of

qualified personnel in the markets in which we operate and hire. Failure to hire and train or retain qualified information technology professionals in sufficient numbers could have a material adverse effect on our business, results of operations and financial condition.

 

We may not receive significant revenues from our current research and development efforts.

 

Developing and localizing software is expensive, and the investment in product development may involve a long payback cycle. Our future plans include significant investments in software research and development and related product opportunities. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position, but future revenues from these investments are not fully predictable. Therefore, we may not realize any benefits from our research and development efforts in a timely fashion or at all.

 

Our Harland Financial Solutions segment provides services to clients that are subject to government regulations that could constrain its operations.

 

The financial services sector is subject to various federal and state regulations and oversight. As a supplier of services to financial institutions, certain Harland Financial Solutions operations are examined by the Office of the Comptroller of the Currency, the FDIC and the NCUA, among other agencies. These agencies regulate services we provide and the manner in which we operate, and we are required to comply with a broad range of applicable laws and regulations. Current laws and regulations may be amended in the future or interpreted by regulators in a manner which could negatively affect our current Harland Financial Solutions’ operations or limit its future growth.

 

We may not be able to successfully develop new products and services for our Scantron segment, and those products and services may not receive widespread acceptance. As a result, the business, prospects, results of operations and financial condition of Scantron could be materially and adversely affected.

 

The data collection and educational testing industry has also changed significantly during recent years due to technological advances and regulatory changes, and we must successfully develop new products and solutions in our Scantron segment to respond to those changes. Scantron must continue to keep pace with changes in testing and data collection technology and the needs of its clients. The development of new testing methods and technologies depends on the timing and costs of the development effort, product performance, functionality, customer acceptance, adoption rates and competition, all of which could have a negative effect on our business. If we are not able to adopt new electronic data collection solutions at a rate that keeps pace with other technological advances, the business, business prospects, results of operations and financial condition of Scantron could be materially and adversely affected.

 

Budget deficits may reduce funding available for Scantron products and services and have a negative effect on our revenue.

 

Our Scantron segment derives a significant portion of its revenues from public schools and colleges, which are heavily dependent on local, state and federal governments for financial support. Government budget deficits, including deficits arising from the current economic slowdown, may have a negative effect on the availability of funding for Scantron products. Budget deficits experienced by schools or colleges may also cause those institutions to react negatively to future price increases for Scantron products. If budget deficits significantly reduce funding available for Scantron products and services, our revenue could be adversely affected.

 

If we are not able to obtain paper and other supplies at acceptable quantities and prices, our revenue could be adversely affected.

 

Our Scantron segment purchases a majority of its paper from one supplier. Scantron purchases scanner components from equipment manufacturers, supply firms and others. Scantron may not be able to purchase those supplies in adequate quantities or at acceptable prices. Rising inflation will also cause Scantron’s material and delivery costs to rise. If Scantron is forced to obtain paper and other supplies at higher prices or lower quantities, our profitability could be adversely affected.

 

 

None

 

 

Harland Clarke is headquartered in San Antonio, Texas, Harland Financial Solutions is headquartered in Lake Mary, Florida and Scantron is headquartered in Eagan, Minnesota. The principal properties for each segment are as follows:

 

Harland Clarke

 

 

 

 

Harland Financial Solutions

 

 

Scantron

 

 

A series of commercial borrowers in eight states that allegedly obtained loans from banks employing HFS’s LaserPro software have commenced individual or class actions against their banks alleging that the loans were deceptive or usurious in that they failed to disclose properly the effect of the “365/360” method of calculating interest. In some cases, the banks have made warranty claims against HFS related to these actions. Some of these actions have already been dismissed, and many of the remainder, and the related warranty claims, are at early stages, so that the likely progress of the matters still pending is not yet clear. HFS settled one warranty claim in 2009 for an immaterial amount without any admission of liability. The Company has not accepted any of the remaining warranty claims and does not believe that any of these claims will result in material liability for the Company, but there can be no assurance.

 

Various legal proceedings, claims and investigations are pending against the Company, including those relating to commercial transactions, product liability, safety and health matters, employment matters and other matters. The Company is also involved in various stages of legal proceedings, claims, investigations and cleanup relating to environmental matters, some of which relate to waste disposal sites. Most of these matters are covered by insurance, subject to deductibles and maximum limits, and by third-party indemnities.

 

The Company believes that the outcome of all pending legal proceedings in the aggregate will not have a material adverse effect on its consolidated financial position or results of operations.

 

 

 

We are an indirect, wholly owned subsidiary of M & F Worldwide. As such, our common stock is not listed on any stock exchange or traded in any over-the-counter market and is held by only one holder.

 

 

The table below reflects historical financial data, which are derived from the audited consolidated financial statements for each of the years in the five-year period ended December 31, 2010.

 

The selected financial data are not necessarily indicative of results of future operations, and should be read in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.

 

 

 

 

 

 

 

The following discussion should be read in conjunction with Item 6. “Selected Financial Data” and the Harland Clarke Holdings consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.

 

Overview of Business

 

Harland Clarke Holdings Corp. (“Harland Clarke Holdings” and, together with its subsidiaries, the “Company”) is a holding company that conducts its operations through its direct and indirect wholly owned subsidiaries and was incorporated in Delaware on October 19, 2005. On December 15, 2005, CA Investment Corp., an indirect wholly owned operating subsidiary of M & F Worldwide Corp. (“M & F Worldwide”), purchased 100% of the capital stock of Novar USA Inc. (“Novar”) (the “Clarke American Acquisition”). Novar was renamed Clarke American Corp., which was the successor by merger to Novar, which indirectly wholly owned the operating subsidiaries of the Clarke American Corp. business. On May 1, 2007, the Company completed the acquisition of John H. Harland Company (“Harland”) and changed its name on May 2, 2007 from Clarke American Corp. to Harland Clarke Holdings. The Company’s businesses are organized along three business segments together with a corporate group for certain support services.

 

The Harland Clarke segment offers checks and related products, forms and treasury supplies, and related delivery and fraud prevention products to financial services, retail and software providers. It also provides direct marketing services to their clients including direct marketing campaigns, direct mail, database marketing, telemarketing and e-mail marketing. In addition to these products and services, the Harland Clarke segment offers stationery, business cards and other business and home office products to consumers and small businesses.

 

The Harland Financial Solutions segment provides technology products and services to financial services clients worldwide including lending and mortgage compliance and origination applications, risk management solutions, business intelligence solutions, Internet and mobile banking applications, branch automation solutions, self-service solutions, electronic payment solutions and core processing systems.

 

The Scantron segment provides data management solutions and related services to educational, commercial, healthcare and governmental entities worldwide including testing and assessment solutions, patient information collection and tracking, and survey services. Scantron’s solutions combine a variety of data collection, analysis, and management tools including web-based solutions, software, scanning equipment, forms, and related field maintenance services.

 

Recent Development

 

On December 15, 2010, Scantron Corporation (“Scantron”), a wholly owned subsidiary of the Company, entered into a securities purchase agreement with KUE Digital International LLC pursuant to which Scantron would purchase all of the outstanding capital stock or membership interests of KUE Digital Inc., KUED Sub I LLC and KUED Sub II LLC (collectively referred to as “GlobalScholar”) for $140.0 million in cash, subject to post-closing adjustments, and a contingent payment of up to $20.0 million in cash, which would be dependent upon the achievement of certain revenue targets during calendar year 2011. GlobalScholar’s instructional management platform supports all aspects of managing education at K-12 schools, including

student information systems; performance-based scheduler; gradebook; learning management system; longitudinal data collection, analysis and reporting; teacher development and performance tracking; and online communication and tutoring portals. GlobalScholar’s instructional management platform complements Scantron’s testing and assessment, response to intervention, student achievement management and special education software solutions thereby expanding Scantron’s web-based education solutions. Scantron completed the acquisition of GlobalScholar on January 3, 2011 for $135.4 million in cash, net of cash acquired, and subject to post-closing adjustments. The Company financed the acquisition and related fees and expenses with cash on hand. Due to the timing of the acquisition, preliminary accounting for the business combination is not complete. Financial results for GlobalScholar will be included in the Company’s results of operations beginning in the first quarter of 2011.

 

The Parsam Acquisition

 

On December 6, 2010, Harland Financial Solutions, Inc. (“HFS”), a wholly owned subsidiary of the Company, acquired all of the outstanding membership interests of Parsam Technologies, LLC and the equity of SRC Software Private Limited (collectively referred to as “Parsam”). Parsam’s solutions allow financial institutions to provide services online, in branches and at call centers, from new account opening and funding to account-to-account money transfers, person-to-person payments, account and adviser-client relationship management and bill presentment and payment. HFS is integrating Parsam’s solutions into its existing solution offerings. The acquisition-date purchase price was $32.6 million in cash, net of cash acquired, and subject to post-closing adjustments. In addition, the Company recorded the fair value of contingent consideration of $2.7 million, which resulted in total consideration of $35.3 million. Contingent consideration would be payable upon achievement of certain revenue targets of Parsam during calendar years 2011 and 2012 with a maximum contingent consideration of $25.0 million if the revenue targets are met (see Note 3 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K). The Company financed the acquisition and related fees and expenses with cash on hand.

 

The Spectrum K12 Acquisition

 

On July 21, 2010, Scantron acquired Spectrum K12 School Solutions, Inc. (“Spectrum K12”). Spectrum K12 develops, markets and sells student achievement management, response to intervention and special education software solutions. Spectrum K12’s software solutions complement Scantron’s software solutions for education assessments, content and data management. The acquisition-date purchase price was $28.6 million in cash, net of cash acquired and after giving effect to working capital adjustments. In addition, the Company recorded the fair value of contingent consideration of $4.0 million, which resulted in total consideration of $32.7 million. Contingent consideration would be payable upon achievement of certain revenue targets of Spectrum K12 during the twelve-month periods ending June 30, 2011 and 2012 with a maximum aggregate contingent consideration of $20.0 million if the revenue targets are met (see Note 3 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K). The Company financed the acquisition and related fees and expenses with cash on hand.

 

The SubscriberMail and Protocol IMS Acquisitions

 

During December 2009, Harland Clarke Corp., a wholly owned subsidiary of the Company, acquired in separate transactions SubscriberMail and Protocol Integrated Marketing Services (“Protocol IMS”), a division of Protocol Global Solutions. SubscriberMail is a leading email marketing service provider that offers patented tools to develop and deliver professional email communications. Protocol IMS focuses on direct marketing services with solutions that include business to business strategic services, business to consumer strategic services, database marketing and analytics, outbound business to business teleservices, production and fulfillment. The acquisition-date aggregate consideration of $13.1 million for these transactions includes contingent consideration of $1.8 million for SubscriberMail upon the achievement of certain revenue targets in 2010 and 2011, with a maximum aggregate contingent consideration of $2.0 million if the revenue targets are met (see Note 3 to the Company’s consolidated financial statements included elsewhere in this Annual Report

on Form 10-K). The Protocol IMS and SubscriberMail acquisitions are collectively referred to as the “2009 Acquisitions.”

 

The Transaction Holdings Acquisition

 

In December 2008, Harland Clarke Corp. acquired Transaction Holdings Inc. (“Transaction Holdings”) for total cash consideration of $8.2 million (the “Transaction Holdings Acquisition”). Transaction Holdings produces personal and business checks, payment coupon books and promotional checks and provides direct marketing services to financial institutions as well as individual consumers and small businesses.

 

The Data Management Acquisition

 

In February 2008, Scantron purchased all of the limited liability membership interests of Data Management I LLC (“Data Management”) from NCS Pearson, for $218.7 million in cash after giving effect to working capital adjustments of $1.6 million (the “Data Management Acquisition”). Data Management designed, manufactured and serviced scannable data collection products, including printed forms, scanning equipment and related software, and provided survey consulting and tracking services, including medical device tracking, as well as field maintenance services to corporate and governmental clients. The Company financed the Data Management Acquisition and related fees and expenses with cash on hand.

 

Economic and Other Factors Affecting the Businesses of the Company

 

Harland Clarke

 

While total non-cash payments — including checks, credit cards, debit cards and other electronic forms of payment — are growing, the number of checks written has declined and is expected to continue to decline. Harland Clarke believes the number of checks printed is driven by the number of checks written, the number of new checking accounts opened and reorders reflecting changes in consumers’ personal situations, such as name or address changes. In recent years, Harland Clarke has experienced check unit declines at a higher rate than in the past, as evidenced by recent period-over-period declines in Harland Clarke revenue which are discussed in more detail elsewhere in this report. Harland Clarke is unable to determine at this time whether these higher rates of decline are attributable to recent economic and financial market difficulties, the depth and length of the economic downturn, higher unemployment, decreased openings of checking accounts, changing business strategies of our financial institution clients, decreased consumer spending and/or a further acceleration in the use of alternative non-cash payments. Harland Clarke expects that check unit volume will continue to decline at rates that are higher than it had previously experienced in recent years, resulting in a corresponding decrease in check revenues and depending on the nature and relative magnitude of the causes for the decreases, such decreases may not be mitigated when overall economic conditions improve. Harland Clarke is focused on growing its non-check related products and services, including marketing services, and optimizing its existing catalog of offerings to better serve its clients, as well as managing its costs, overhead and facilities to reflect the decline in check unit volumes. Harland Clarke does not believe that revenues from non-check related products and services will fully offset revenue declines from declining check unit volumes. In the future, Harland Clarke may not be able to mitigate the revenue declines from declining check unit volumes through cost management, which could negatively affect Harland Clarke’s margins.

 

Harland Clarke’s primary competition comes from alternative payment methods such as debit cards, credit cards, ACH, and other electronic and online payment options. Harland Clarke also competes with large providers that offer a wide variety of products and services including Deluxe Corporation, Harte-Hanks, Inc., and R.R. Donnelley & Sons Company. There are also many other competitors that specialize in providing one or more of the products and services Harland Clarke offers to its clients. Harland Clarke competes on the basis of service, convenience, quality, product range and price.

 

The Harland Clarke segment’s operating results are also affected by consumer confidence and employment. Consumer confidence directly correlates with consumer spending, while employment also affects revenues through the number of new checking accounts being opened. The Harland Clarke segment’s operating results may be negatively affected by slow or negative growth of, or downturns in, the United States economy.

Business confidence affects a portion of the Harland Clarke segment. In addition, if Harland Clarke’s financial institution customers fail or merge with other financial institutions, Harland Clarke may lose any or all revenue from such financial institutions and/or experience further pricing pressure, which would negatively affect Harland Clarke’s operating results.

 

Harland Financial Solutions

 

Harland Financial Solutions’ operating results are affected by the overall demand for our products, software and related services which is based upon the technology budgets of our clients and prospects. Economic downturns in one or more of the countries in which we do business and enhanced regulatory burdens, including through increased fees and assessments charged to financial institutions by the Federal Deposit Insurance Corporation and National Credit Union Association or due to recently enacted federal legislation for additional taxes on certain financial institutions, could result in reductions in the information technology budgets for some portion of our clients and potentially longer lead-times for acquiring Harland Financial Solutions products and services. In addition, if Harland Financial Solutions’ financial institution customers fail or merge with other financial institutions, Harland Financial Solutions may lose any or all revenue from such financial institutions and/or experience further pricing pressure, which would negatively affect Harland Financial Solutions’ operating results.

 

Harland Financial Solutions’ business is affected by technological change, evolving industry standards, regulatory changes in client requirements and frequent new product introductions and enhancements. The business of providing technological solutions to financial institutions and other enterprises requires that we continually improve our existing products and create new products while at the same time controlling our costs to remain price competitive.

 

Providing technological solutions to financial institutions is highly competitive and fragmented. Harland Financial Solutions competes with several large and diversified financial technology providers, including, among others, Fidelity National Information Services, Inc., Fiserv, Inc., Jack Henry & Associates, Inc., Open Solutions Inc., Computer Services Inc. and many regional providers. Many multi-national and international providers of technological solutions to financial institutions also compete with Harland Financial Solutions both domestically and internationally, including Temenos Group AG, Misys plc, Infosys Technologies Limited, Tata Consultancy and Oracle Financial Services. There are also many other competitors that offer one or more specialized products or services that compete with products and services offered by Harland Financial Solutions. Management believes that competitive factors influencing buying decisions include product features and functionality, client support, price and vendor financial stability.

 

Scantron

 

While the number of tests given annually in K-12 and higher education continues to grow, the demand for optical mark reader paper-based testing has declined and is expected to continue to decline. Changes in educational funding can affect the rate at which schools adopt new technology thus slowing the decline for paper-based testing but also slowing the demand for Scantron’s on-line testing products. Educational funding changes may also reduce the rate of consumption of Scantron’s forms and purchase of additional hardware to process these forms. Scantron’s education-based customers may turn to lower cost solutions for paper-based forms and hardware in furtherance of addressing their budget needs. A weak economy in the United States may negatively affect education budgets and spending, which would have an adverse effect on Scantron’s operating results. Data collection is also experiencing a conversion to non-paper based methods of collection. Scantron believes this trend will also continue as the availability of these alternative technologies becomes more widespread. While Scantron’s non-paper data collection business could benefit from this trend, Scantron’s paper-based data collection business could be negatively affected by this trend. Changes in the overall economy can affect the demand for data collection to the extent that Scantron’s customers adjust their research or testing expenditures.

Critical Accounting Policies and Estimates

 

The Company reviews its accounting policies on a regular basis. The Company makes estimates and judgments as part of its financial reporting that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to accounts receivable, investments, intangible assets, other postretirement benefits, income taxes, contingencies and litigation, as well as other assets and liabilities. The Company bases its estimates on historical experience and on various other assumptions that it believes reasonable under the circumstances. These estimates form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Results may differ from these estimates due to actual outcomes being different from the assumed outcomes. The Company believes the following critical accounting policies affect its more significant judgments and estimates.

 

Revenue Recognition – The Company considers its revenue recognition policy as critical to its reported results of operations primarily in its Harland Financial Solutions and Scantron segments. Revenue recognition requires judgment, including amongst other things, whether a software arrangement includes multiple elements, whether any elements are essential to the functionality of any other elements, and whether vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. Customers receive certain elements of the Company’s products and services over time.

 

Changes to the elements in a software arrangement or in the Company’s ability to identify VSOE for those elements could materially affect the amount of earned and unearned revenue reflected in the financial statements.

 

For software license agreements that do not require significant modification or customization of the software, the Company recognizes software license revenue when persuasive evidence of an arrangement exists, delivery of the product has occurred, the license fee is fixed and determinable and collection is probable. The Company’s software license agreements include multiple products and services or “elements.” None of these elements are deemed to be essential to the functionality of the other elements. The accounting guidance generally requires revenue earned on software arrangements involving multiple elements to be allocated proportionally to each element based on VSOE of fair value. Fair value is determined for license fees based upon the price charged when sold separately. In the event that the Company determines that VSOE does not exist for one or more of the delivered elements of a software arrangement, but does exist for all of the undelivered elements, revenue is recognized using the residual method. Under the residual method, a residual amount of the total arrangement fee is recognized as revenue for the delivered elements after the established fair value of all undelivered elements has been deducted. In the event the Company determines that VSOE is not achieved for any of the elements of a software arrangement, the entire arrangement is bundled as a single unit and revenue is recognized ratably over the initial term of the arrangement commencing upon the delivery of the software.

 

Implementation services are generally for installation, training, implementation and configuration. These services are not considered essential to the functionality of the related software. VSOE of fair value is established by pricing used when these services are sold separately. Generally revenue is recognized when services are completed. On implementations for outsourced data processing services, revenue is deferred and recognized over the life of the outsourcing arrangement. On certain larger implementations, revenue is recognized based on milestones during the implementation. Milestones are triggered by tasks completed or based on labor hours. Estimates of efforts to complete a project are used in the percentage-of-completion calculation. Due to uncertainties inherent in these estimates, actual results could differ from these estimates. Revenue from arrangements that are subject to substantive customer acceptance provisions is deferred until the acceptance conditions have been met.

 

Maintenance fees are deferred and recognized ratably over the maintenance period, which is usually twelve months. VSOE of fair value is determined based on contract renewal rates.

 

Outsourced data processing services and other transaction processing services are recognized in the month the transactions are processed or the services are rendered.

The Company recognizes product and service revenue when persuasive evidence of a non-cancelable arrangement exists, products have been shipped and/or services have been rendered, the price is fixed or determinable, collectability is reasonably assured, legal title and economic risk is transferred to the customer and an economic exchange has taken place. Revenues are recorded net of any applicable discounts, contract acquisition payments amortization, accrued incentives and allowances for sales returns. Deferred revenues represent amounts billed to the customer in excess of amounts earned.

 

Revenues for direct response marketing services are recognized from the Company’s fixed price direct mail and marketing contracts based on the proportional performance method for specific projects.

 

Income Taxes – The Company estimates its actual current tax liability together with temporary differences resulting from differing treatment of items, such as net operating losses and depreciation, for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities. The Company must assess the likelihood that it will recover deferred tax assets from future taxable income and, to the extent it believes that recovery is not likely, establish a valuation allowance. To the extent the Company establishes a valuation allowance or increases this allowance in a period, it must include and expense the allowance within the tax provision in the consolidated statement of income. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets.

 

As part of the process of preparing its consolidated financial statements, the Company is required to calculate the amount of income tax in each of the jurisdictions in which it operates. On a regular basis the amount of taxable income is reviewed by various federal, state and foreign taxing authorities. As such, the Company routinely provides reserves for unrecognized tax benefits for items that it believes could be challenged by these taxing authorities.

 

Long-Lived Assets – The Company assesses the impairment of property, plant and equipment and amortizable intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors the Company considers important that could trigger an impairment review include the following:

 

 

When the Company determines that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more indicators of impairment, it measures the impairment based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with current market expectations. Significant assumptions requiring judgment are required to determine future cash flows, including but not limited to the estimated remaining useful life of the asset, future revenue streams and future expenditures to maintain the existing service potential of the asset. The Company re-evaluates the useful life of these assets at least annually to determine if events and circumstances continue to support their recorded useful lives. Assets held for sale are carried at the lower of carrying amount or fair value, less estimated costs to sell such assets.

 

Goodwill and Acquired Intangible Assets – Goodwill represents the excess of consideration transferred over the fair value of identifiable net assets acquired. Acquired intangibles are recorded at fair value as of the date acquired. Goodwill and other intangibles determined to have an indefinite life are not amortized, but are tested for impairment annually in the fourth quarter, or when events or changes in circumstances indicate that the assets might be impaired, such as a significant adverse change in the business climate.

 

The goodwill impairment test is a two-step process, which requires management to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of the Company’s reporting units. In 2009, the Company reduced the number of reporting units from five to four as a result of an organizational realignment and the integration of two former reporting units into

a single reporting unit. In 2010, the Company further reduced the number of reporting units from four to three as a result of the integration of two former reporting units into a single reporting unit. The Company’s reporting units are now the same as its reportable segments.

 

The Company utilizes both the income and market approaches to estimate the fair value of the reporting units. The income approach involves discounting future estimated cash flows. The discount rate used is the value-weighted average of the reporting unit’s estimated cost of equity and debt (“cost of capital”) derived using, both known and estimated, customary market metrics. The Company performs sensitivity tests with respect to growth rates and discount rates used in the income approach. In applying the market approach, valuation multiples are derived from historical and projected operating data of selected guideline companies; evaluated and adjusted, if necessary, based on the strengths and weaknesses of the reporting unit relative to the selected guideline companies; and applied to the appropriate historical and/or projected operating data of the reporting unit to arrive at an indication of fair value. The Company weights the results of the income and market approaches equally, except where guideline companies are not similar enough to provide a reasonable value using the market approach. When that occurs, the market approach is weighted less than the income approach.

 

If the estimated fair value of a reporting unit is less than the carrying value, a second step is performed to compute the amount of the impairment by determining an “implied fair value” of goodwill. The determination of the Company’s “implied fair value” requires the Company to allocate the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the “implied fair value” of goodwill, which is compared to the corresponding carrying value.

 

The Company measures impairment of its indefinite-lived tradename based on the relief-from-royalty-method. Under the relief-from-royalty method of the income approach, the value of an intangible asset is determined by quantifying the cost savings a company obtains by owning, as opposed to licensing, the intangible asset. Assumptions about royalty rates are based on the rates at which similar tradenames are licensed in the marketplace. The Company also re-evaluates the useful life of this asset to determine whether events and circumstances continue to support an indefinite useful life.

 

The annual impairment evaluations for goodwill and the indefinite-lived intangible asset involve significant estimates made by management. The discounted cash flow analyses require various judgmental assumptions about sales, operating margins, growth rates and discount rates. Assumptions about sales, operating margins and growth rates are based on the Company’s budgets, business plans, economic projections, anticipated future cash flows and marketplace data. Changes in estimates could have a material impact in the carrying amount of goodwill and the indefinite-lived intangible asset in future periods.

 

Intangible assets that are deemed to have a finite life are amortized over their estimated useful life generally using accelerated methods that are based on expected cash flows. They are also evaluated for impairment as discussed above in “Long-Lived Assets.”

 

Contingent Consideration Arrangements – The Company has entered into contingent consideration arrangements in conjunction with recent acquisitions. These arrangements are in the form of earn-out agreements with payments based on the achievement of certain revenue targets over specified time periods after the date of the acquisition. The fair value of these contingent consideration arrangements is recorded as a liability on the date of the acquisition, except for arrangements that are considered to be employee compensation for services rendered. In those cases, the fair value is recorded as a liability and compensation expense ratably over the requisite service period. The fair value of these arrangements is subject to remeasurement as of each balance sheet date.

 

The fair value of each arrangement is estimated utilizing a discounted cash flow analysis. The analysis considers, among other things, estimates of future revenues which involve significant estimates by management. Changes in estimates of revenues could have a material effect on the fair value of liabilities for contingent consideration arrangements with any changes in fair value being recognized in net income.

 

Contingencies and Indemnification Agreements – The Company records the estimated impacts of various conditions, situations or circumstances involving uncertain outcomes. These events are “contingencies,” and the accounting for such events follows accounting guidance for contingencies.

The accrual of a contingency involves considerable judgment by management. The Company uses internal expertise and consults with outside experts, as necessary, to help estimate the probability that the Company has incurred a loss and the amount (or range) of the loss. When evaluating the need for an accrual or a change in an existing accrual, the Company considers whether it is reasonably probable to estimate an outcome for the contingency based on its experience, any experience of others facing similar contingencies of which the Company is aware and the particulars of the circumstances creating the contingency. See Item 3. Legal Proceedings; and Note 16 — Commitments and Contingencies to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

 

Postretirement Benefits – The Company sponsors unfunded defined benefit postretirement plans that cover certain former salaried and non-salaried employees. One postretirement benefit plan provides healthcare benefits and the other provides life insurance benefits. The Company consults with outside actuaries who use several statistical and other factors that attempt to estimate future events to calculate the expense and liability related to the plans. These factors include assumptions about the discount rate within certain guidelines. In addition, the Company’s actuarial consultants also use subjective factors such as withdrawal and mortality rates and the expected healthcare cost trend rate to estimate these factors.

 

The actuarial assumptions used by the Company may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates, higher or lower healthcare inflation rates or longer or shorter life spans of participants, among other things. Differences from these assumptions may result in a significant difference with the amount of postretirement benefits expense and liability that the Company recorded.

 

Derivative Financial Instruments – The Company uses derivative financial instruments to manage interest rate risk related to a portion of its long-term debt. The Company recognizes all derivatives at fair value as either assets or liabilities on the consolidated balance sheets and changes in the fair values of such instruments are recognized in earnings unless specific hedge accounting criteria are met. If specific cash flow hedge accounting criteria are met, the Company recognizes the changes in fair value of these instruments in other comprehensive income (loss) until the underlying debt instrument being hedged is settled or the Company determines that the specific hedge accounting criteria are no longer met.

 

On the date the interest rate derivative contract is entered into, the Company designates the derivative as either a fair value hedge or a cash flow hedge. The Company formally documents the relationship between hedging instruments and the hedged items, as well as its risk-management objectives and strategy for undertaking various hedge transactions. The Company links all hedges that are designated as fair value hedges to specific assets or liabilities on the balance sheet or to specific firm commitments. The Company links all hedges that are designated as cash flow hedges to forecasted transactions or to liabilities on the balance sheet. The Company also assesses, both at the inception of the hedge and on an on-going basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. If an existing derivative were to become not highly effective as a hedge, the Company would discontinue hedge accounting prospectively. The Company assesses the effectiveness of the hedge based on total changes in the hedge’s cash flows at each payment date as compared to the change in the expected future cash flows on the long-term debt.

 

Accounting Guidance

 

See Note 2 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K regarding the impact of recently issued accounting guidance on the Company’s financial condition and results of operations.

 

Off-Balance Sheet Arrangements

 

It has not been the Company’s practice to enter into off-balance sheet arrangements. In the normal course of business the Company periodically enters into agreements that incorporate general indemnification language. These indemnifications encompass such items as intellectual property rights, governmental regulations and/or employment-related matters. Performance under these indemnities would generally be triggered

by a breach of terms of the contract or by a third-party claim. There has historically been no material losses related to such indemnifications, and the Company does not expect any material adverse claims in the future.

 

The Company is not engaged in any transactions, arrangements or other relationships with any unconsolidated entity or other third party that is reasonably likely to have a material effect on its consolidated results of operations, financial position or liquidity. In addition, the Company has not established any special purpose entity.

 

Asset Impairments

 

Changes in estimates and assumptions used in the Company’s financial projections resulting from the factors discussed above for any of the Company’s business segments could have a material impact on the fair value of goodwill, indefinite-lived intangible assets or other long-lived assets in future periods, which may result in material asset impairments, as more fully described in Item 1A, “Risk Factors — Weak economic conditions and further acceleration of check unit declines may continue to have an adverse effect on the Company’s revenues and profitability and could result in additional impairment charges.”

 

Restructuring

 

The Company has taken restructuring actions in the past in an effort to achieve manufacturing and contact center efficiencies and other cost savings. Past restructuring actions have related to both acquisitions and ongoing cost reduction initiatives and have included manufacturing plant closures, contact center closures and workforce rationalization. The Company anticipates future restructuring actions, where appropriate, to realize process efficiencies, to continue to align our cost structure with business needs and remain competitive in the marketplace. The Company expects to incur severance and severance-related costs, facilities closures costs and other costs such as inventory write-offs, training, hiring and travel in connection with future restructuring actions.

 

Consolidated Operating Results

 

The Company has organized its business along three reportable segments together with a corporate group for certain support services. The Company’s operations are aligned on the basis of products, services and industry. Management measures and evaluates the reportable segments based on operating income.

 

In the tables below, dollars are in millions.

 

Year Ended December 31, 2010 Compared to Year Ended December 31, 2009

 

The operating results for the years ended December 31, 2010 and 2009, as reflected in the accompanying consolidated statements of income and described below, include the acquired Parsam, Spectrum K12, SubscriberMail and Protocol IMS businesses from the respective dates of acquisition (see Note 3 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

Net Revenues:

 

Net revenues decreased by $41.1 million, or 2.4%, to $1,671.2 million in 2010 from $1,712.3 million in 2009.

Net revenues for the Harland Clarke segment decreased by $34.8 million, or 2.8%, to $1,191.2 million in 2010 from $1,226.0 million in 2009. The decrease was primarily due to volume declines in check and related products, the loss of a client and a decrease in revenues per unit, partially offset by a $27.0 million increase in revenues from the businesses acquired in the 2009 Acquisitions, the addition of new clients, and a one-time payment received as a result of the loss of a client. Revenues from new client additions more than offset lost revenues from client losses. Net revenues in the 2010 period included charges of $0.6 million for non-cash fair value acquisition accounting adjustments to deferred revenue related to the SubscriberMail acquisition.

 

Net revenues for the Harland Financial Solutions segment increased by $3.8 million, or 1.4%, to $282.7 million in 2010 from $278.9 million in 2009. Increases in term license, maintenance, outsourced host processing revenues and early termination fees as well as revenues from the Parsam acquisition were partially offset by decreases in other license revenues and hardware sales.

 

Net revenues for the Scantron segment decreased by $4.3 million, or 2.1%, to $203.7 million in 2010 from $208.0 million in 2009. The decrease was primarily due to declines in forms, hardware and service maintenance revenues, partially offset by increases in revenues from web-based products and services for the education market, sales of a solution that assists financial institutions with the implementation of changes to federal regulations during 2010 regarding overdraft services provided to financial institution customers and revenues from the Spectrum K12 acquisition. Net revenues in the 2010 period included charges of $2.1 million for non-cash fair value acquisition accounting adjustments to deferred revenue primarily related to the Spectrum K12 acquisition.

 

Elimination of net revenues increased to $6.4 million in the 2010 period from $0.6 million in the 2009 period primarily due to intersegment sales from the Scantron segment to the Harland Clarke segment. These intersegment sales are related to solutions that assist financial institutions with the implementation of changes to federal regulations during 2010.

 

Cost of Revenues:

 

 

Cost of revenues decreased by $39.1 million, or 3.9%, to $958.6 million in 2010 from $997.7 million in 2009.

 

Cost of revenues for the Harland Clarke segment decreased by $33.4 million, or 4.4%, to $730.9 million in 2010 from $764.3 million in 2009. The decrease in cost of revenues was primarily due to labor cost reductions and decreases in depreciation and occupancy expenses, primarily resulting from restructuring activities. Additionally, lower volumes resulted in lower delivery, materials, and other variable overhead expenses. Decreases in cost of revenues were partially offset by increases resulting from the businesses acquired in the 2009 Acquisitions and by a $4.6 million increase in amortization expense resulting from the reclassification of the Harland Clarke tradename from an indefinite-lived to a definite-lived intangible asset in the fourth quarter of 2009. Cost of revenues as a percentage of revenues for the Harland Clarke segment was 61.4% in 2010 as compared to 62.3% in 2009.

 

Cost of revenues for the Harland Financial Solutions segment increased by $2.1 million, or 1.8%, to $121.7 million in 2010 from $119.6 million in 2009. The increase in cost of revenues was primarily due to a $1.7 million increase in amortization expense resulting from the reclassification of the Harland Clarke tradename from an indefinite-lived to a definite-lived intangible asset in the fourth quarter of 2009. Additional

increases due to labor and related expenses and costs associated with the business acquired in the Parsam acquisition were offset by lower hardware and third-party license costs. Cost of revenues as a percentage of revenues for the Harland Financial Solutions segment was 43.0% in 2010 as compared to 42.9% in 2009.

 

Cost of revenues for the Scantron segment decreased by $2.0 million, or 1.7%, to $112.4 million in 2010 from $114.4 million in 2009. The decrease was primarily due to volume declines and labor cost reductions resulting from restructuring activities, partially offset by costs associated with the business acquired in the Spectrum K12 acquisition and an increase in delivery costs related to the Company’s solution that assists financial institutions with the implementation of changes to federal regulations during 2010. Cost of revenues as a percentage of revenues for the Scantron segment was 55.2% in 2010 as compared to 55.0% in 2009.

 

Elimination of cost of revenues increased to $6.4 million in the 2010 period from $0.6 million in the 2009 period primarily due to intersegment costs from the Scantron segment to the Harland Clarke segment. These intersegment costs are related to solutions that assist financial institutions with the implementation of changes to federal regulations during 2010.

 

Selling, General and Administrative Expenses:

 

 

Selling, general and administrative expenses increased by $2.5 million, or 0.6%, to $389.9 million in 2010 from $387.4 million in 2009.

 

Selling, general and administrative expenses for the Harland Clarke segment decreased by $0.3 million, or 0.1%, to $206.3 million in 2010 from $206.6 million in 2009. The decrease was primarily due to labor cost reductions resulting from restructuring activities and reductions in advertising and selling expenses, substantially offset by costs of the businesses acquired in the 2009 Acquisitions, investments in growth initiatives and an increase in travel expenses. Selling, general and administrative expenses as a percentage of revenues for the Harland Clarke segment was 17.3% in 2010 as compared to 16.9% in 2009.

 

Selling, general and administrative expenses for the Harland Financial Solutions segment decreased by $2.5 million, or 2.2%, to $109.6 million in 2010 from $112.1 million in 2009. The decrease was primarily due to labor cost reductions resulting from restructuring activities, a reduction in compensation expense related to an incentive agreement, and decreases in general overhead expenses and depreciation, partially offset by an increase in selling expenses, an increase in occupancy costs and costs associated with the business acquired in the Parsam acquisition. Selling, general and administrative expenses in the 2010 and 2009 periods included charges of $1.1 million and $3.5 million, respectively, for compensation expense related to an incentive agreement for an acquisition in 2007. Selling, general and administrative expenses as a percentage of revenues for the Harland Financial Solutions segment was 38.8% in 2010 as compared to 40.2% in 2009.

 

Selling, general and administrative expenses for the Scantron segment increased $2.9 million, or 5.2%, to $58.8 million in 2010 from $55.9 million in 2009. The increase was primarily due to costs associated with the business acquired in the Spectrum K12 acquisition and increases in management, sales and product development personnel in connection with investments in growth initiatives, partially offset by cost reductions resulting from restructuring activities and a decrease in integration expenses. Selling, general and administrative expenses as a percentage of revenues for the Scantron segment was 28.9% in 2010 as compared to 26.9% in 2009.

Corporate selling, general and administrative expenses increased $2.4 million, or 18.8%, to $15.2 million in 2010 from $12.8 million in 2009, primarily due to $2.2 million in transaction expenses related to merger and acquisition activities and increases in general overhead costs.

 

Asset Impairment Charges

 

During the 2010 period, the Company recorded non-cash impairment charges of $3.7 million for the Harland Clarke segment primarily related to the abandonment of a development project, an adjustment to the carrying value of certain held for sale facilities to reflect an updated estimate for the fair values less costs to sell and restructuring related impairments of property, plant and equipment. During 2009, the Company recorded non-cash asset impairment charges of $33.6 million for the Harland Clarke segment, $10.6 million for the Harland Financial Solutions segment and $0.2 million for the Scantron segment, of which $44.2 million related to an impairment of the Harland Clarke tradename. This impairment resulted from the 2009 annual impairment test for indefinite-lived tradenames and the Company’s decision to reclassify the Harland Clarke tradename to a definite life.

 

See Notes 6, 7 and 15 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding these asset impairment charges.

 

Restructuring Costs

 

The Company adopted plans during 2008, 2009 and 2010 to strengthen operating margins and leverage incremental synergies within the printing plants, contact centers and selling, general and administrative areas by relying on the Company’s shared services capabilities and reorganizing certain operations and sales and support functions.

 

During 2010, the Company recorded restructuring costs of $12.3 million for the Harland Clarke segment and Corporate, $2.8 million for the Harland Financial Solutions segment and $7.2 million for the Scantron segment related to these plans. During 2009, the Company recorded restructuring costs of $25.7 million for the Harland Clarke segment and Corporate, $3.8 million for the Harland Financial Solutions segment and $3.0 million for the Scantron segment related to these plans (see Note 15 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

Interest Income

 

Interest income was $0.7 million in 2010 as compared to $1.0 million in 2009. The decrease in interest income was primarily due to decreased interest on notes receivable from a related party (see Note 17 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

Interest Expense

 

Interest expense was $115.5 million in 2010 as compared to $136.9 million in 2009. The decrease in interest expense was primarily due to lower effective interest rates as well as a decrease in total debt outstanding.

 

Gain on Early Extinguishment of Debt

 

During 2009, the Company extinguished debt with a total principal amount of $136.9 million by purchasing 2015 Senior Notes in individually negotiated transactions for an aggregate purchase price of $67.6 million, resulting in a gain of $65.0 million after the write-off of $4.3 million of unamortized deferred financing fees related to the extinguished debt. The Company did not purchase any 2015 Senior Notes during the 2010 period (see Note 11 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

Other Income (Expense), Net

 

Other income (expense), net was income of $0.1 million in 2010 and 2009 primarily due to non-recurring miscellaneous income.

 

Provision for Income Taxes

 

The Company’s effective tax rate was 37.3% in 2010 and 37.5% in 2009. The decrease was primarily due to an increased benefit from the domestic production activities deduction, partially offset by a charge in 2010 for the change in federal tax law relating to the deductibility of retiree prescription drug subsidies and the release of a reserve for uncertain tax positions in 2010 that was less than a similar release in 2009.

 

Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

 

The operating results for the years ended December 31, 2009 and 2008, as reflected in the accompanying consolidated statements of income and described below, include the acquired Protocol IMS, Transaction Holdings and Data Management businesses from the respective dates of acquisition (see Note 3 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

Net Revenues:

 

 

Net revenues decreased by $82.3 million, or 4.6%, to $1,712.3 million in 2009 from $1,794.6 million in 2008.

 

Net revenues for the Harland Clarke segment decreased by $64.4 million, or 5.0%, to $1,226.0 million in 2009 from $1,290.4 million in 2008. The decrease was primarily due to volume declines from check and related products, which the Company believes was partially affected by the economic downturn. Declines in volumes were partially offset by increased revenues per unit.

 

Net revenues for the Harland Financial Solutions segment decreased by $14.8 million, or 5.0%, to $278.9 million in 2009 from $293.7 million in 2008. The decrease was primarily due to declines in license, hardware and professional services revenues as well as in mortgage products, partially offset by increases in lending products. The Company believes the declines were partially affected by the economic downturn, which has negatively affected financial institution purchases.

 

Net revenues for the Scantron segment decreased by $3.3 million, or 1.6%, to $208.0 million in 2009 from $211.3 million in 2008. The Data Management Acquisition accounted for an increase of $14.6 million. The remaining $17.9 million decrease was a result of volume declines in hardware and forms products, partially offset by organic growth in software products. The Company believes transactions related to hardware and forms product lines were partially affected by the economic downturn.

Cost of Revenues:

 

 

Cost of revenues decreased by $69.2 million, or 6.5%, to $997.7 million in 2009 from $1,066.9 million in 2008.

 

Cost of revenues for the Harland Clarke segment decreased by $58.2 million, or 7.1%, to $764.3 million in 2009 from $822.5 million in 2008. The decrease was primarily due to lower volumes, which resulted in decreases in delivery, materials, and other variable overhead expenses. Labor costs decreased due to cost reduction and restructuring activities. Decreases in travel expenses and depreciation also contributed to the decrease in cost of revenues. These decreases were partially offset by inflation in delivery and materials expenses, as well as an increase in the amortization of intangible assets of $5.1 million. Cost of revenues as a percentage of revenues for the Harland Clarke segment was 62.3% in 2009 as compared to 63.7% in 2008.

 

Cost of revenues for the Harland Financial Solutions segment decreased by $4.5 million, or 3.6%, to $119.6 million in 2009 from $124.1 million in 2008. The decrease was primarily due to lower hardware and third-party license costs related to volume declines, as well as reductions in labor and related expenses due to cost reduction activities. Decreases in depreciation and amortization also contributed to the decrease in cost of revenues. Cost of revenues as a percentage of revenues for the Harland Financial Solutions segment was 42.9% in 2009 as compared to 42.3% in 2008.

 

Cost of revenues for the Scantron segment decreased by $6.7 million, or 5.5%, to $114.4 million in 2009 from $121.1 million in 2008. The Data Management Acquisition accounted for an increase of $9.4 million. The remaining $16.1 million decrease was primarily due to volume declines and cost reductions related to the Data Management Acquisition, in addition to other restructuring activities. Cost of revenues as a percentage of revenues for the Scantron segment was 55.0% in 2009 as compared to 57.3% in 2008.

 

Selling, General and Administrative Expenses:

 

 

Selling, general and administrative expenses decreased by $58.5 million, or 13.1%, to $387.4 million in 2009 from $445.9 million in 2008.

 

Selling, general and administrative expenses for the Harland Clarke segment decreased by $33.5 million, or 14.0%, to $206.6 million in 2009 from $240.1 million in 2008. The decrease was primarily due to labor cost reductions and lower integration-related and travel expenses. Selling, general and administrative expenses as a percentage of revenues for the Harland Clarke segment was 16.9% in 2009 as compared to 18.6% in 2008.

Selling, general and administrative expenses for the Harland Financial Solutions segment decreased by $19.5 million, or 14.8%, to $112.1 million in 2009 from $131.6 million in 2008. The decrease was primarily due to labor cost reductions, a reduction in compensation expense related to an incentive agreement for an acquisition and reductions in occupancy, travel and depreciation expenses. Selling, general and administrative expenses in 2009 and 2008 included charges of $3.5 million and $8.1 million, respectively, for compensation expense related to an incentive agreement for an acquisition. Selling, general and administrative expenses as a percentage of revenues for the Harland Financial Solutions segment was 40.2% in 2009 as compared to 44.8% in 2008.

 

Selling, general and administrative expenses for the Scantron segment decreased $3.5 million, or 5.9%, to $55.9 million in 2009 from $59.4 million in 2008. The Data Management Acquisition accounted for an increase of $3.3 million, which was more than offset by a $6.8 million decrease, primarily due to cost reductions related to the Data Management Acquisition, in addition to other restructuring activities, and a decrease in integration-related expenses. In 2009, the Scantron segment incurred approximately $1.3 million in one-time expenses related to a contractual obligation owing to a former employee upon termination of employment. Selling, general and administrative expenses as a percentage of revenues for the Scantron segment was 26.9% in 2009 as compared to 28.1% in 2008.

 

Corporate selling, general and administrative expenses decreased $2.0 million, or 13.5%, to $12.8 million in 2009 from $14.8 million in 2008, primarily due to lower professional fees.

 

Asset Impairment Charges

 

During 2009, the Company recorded non-cash asset impairment charges of $33.6 million for the Harland Clarke segment, $10.6 million for the Harland Financial Solutions segment and $0.2 million for the Scantron segment, of which $44.2 million related to an impairment of the Harland Clarke tradename. This impairment resulted from the 2009 annual impairment test for indefinite-lived tradenames and the Company’s decision to reclassify the Harland Clarke tradename to a definite life.

 

During 2008, the Company recorded non-cash asset impairment charges of $2.4 million for the Harland Clarke segment. The charges consisted of $1.9 million primarily related to the Company’s decision to consolidate facilities as a result of the Harland acquisition. In addition, the Company experienced declines in customer revenues from Alcott Routon operations in 2008 and assessed the customer relationship intangible asset for impairment resulting in an impairment charge of $0.5 million.

 

See Notes 6, 7 and 15 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding these asset impairment charges.

 

Restructuring Costs

 

During 2007 and 2008, as a result of acquisition activity, the Company adopted plans to restructure its businesses. These plans focused on improving operating margins through consolidating facilities and reducing duplicative expenses, such as selling, general and administrative, executive and shared services expenses. As a result of the economic downturn and the sales decline experienced in recent periods, the Company adopted further restructuring plans during 2008 and 2009 to strengthen operating margins and leverage incremental synergies within the printing plants, contact centers and selling, general and administrative areas by relying on the Company’s shared services capabilities and reorganizing certain operations and sales and support functions.

 

During 2009, the Company recorded restructuring costs of $25.7 million for the Harland Clarke segment and Corporate, $3.8 million for the Harland Financial Solutions segment and $3.0 million for the Scantron segment related to these plans. During 2008, the Company recorded restructuring costs of $8.3 million for the Harland Clarke segment and Corporate, $3.9 million for the Harland Financial Solutions segment and $2.4 million for the Scantron segment related to these plans (see Notes 3 and 15 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

Interest Income

 

Interest income was $1.0 million in 2009 as compared to $2.2 million in 2008. The decrease in interest income was primarily due to lower average cash equivalents balances in 2009 as compared to 2008 and lower interest rates on investments in cash equivalents in 2009 as compared to 2008, partially offset by higher interest income on notes receivable from a related party in 2009.

 

Interest Expense

 

Interest expense was $136.9 million in 2009 as compared to $186.4 million in 2008. The decrease in interest expense was primarily due to lower effective interest rates and also a decrease in total debt outstanding.

 

Gain on Early Extinguishment of Debt

 

During 2009, the Company extinguished debt with a total principal amount of $136.9 million by purchasing 2015 Senior Notes in individually negotiated transactions for an aggregate purchase price of $67.6 million, resulting in a gain of $65.0 million after the write-off of $4.3 million of unamortized deferred financing fees related to the extinguished debt (see Note 11 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K).

 

Other Income (Expense), Net

 

Other income (expense), net was income of $0.1 million in 2009 as compared to an expense of $0.4 million in 2008. The income in 2009 was due to non-recurring miscellaneous income. The expense in 2008 was attributable to a $0.8 million write-down of an equity investment due to an other-than-temporary decline in its market value, partially offset by non-recurring miscellaneous income.

 

Provision for Income Taxes

 

The Company’s effective tax rate was 37.5% in 2009 and 41.1% in 2008. The change was primarily due to the effects of a net reduction in reserves for uncertain tax positions in 2009 and a reduction in foreign rate differential from 2008.

 

Related Party Transactions

 

Notes Receivable

 

In 2008, the Company acquired the senior secured credit facility and outstanding note of Delphax Technologies, Inc. (“Delphax”), the supplier of Imaggia printing machines and related supplies and service for the Harland Clarke segment. The senior secured credit facility is comprised of a revolving credit facility of up to $14.0 million, subject to borrowing limitations set forth therein, that mature in September 2011. The senior secured credit facility is collateralized by a perfected security interest in substantially all of Delphax’s assets. The revolving facility has a borrowing base calculated based on Delphax’s eligible accounts receivable and inventory. The senior secured credit facility has an interest rate equal to the sum of Wells Fargo N. A. prime rate plus 2.5%, with accrued interest payable quarterly. The note had an original principal amount of $7.0 million, matures in September 2012 and originally bore interest at an annual rate of 12%, payable quarterly either in cash, or in a combination of cash and up to 25% Delphax stock. Contemporaneous with its acquisition of the facility and note, the Company also acquired 250,000 shares of Delphax common stock from the previous holder of the Delphax note. In January 2010, the note was restated to reduce the interest rate to 9%, payable solely in cash, effective October 1, 2009, and to require the repayment of $3.0 million of principal in 2010.

 

During 2010, the Company received $3.0 million in payments and released no draws on the revolver, bringing the principal balance of the note and the senior secured credit facility to $4.0 million and $0.0 million, respectively, at December 31, 2010. During 2009, the Company received $15.0 million in payments and released $9.8 million in draws on the revolver, bringing the principal balance of the note and the senior

secured credit facility to $7.0 million and $0.0 million, respectively, at December 31, 2009. The outstanding balance on the note is included in other assets in the consolidated balance sheets included elsewhere in this Annual Report on Form 10-K. Interest income of $0.4 million, $0.8 million and $0.4 million was recorded in 2010, 2009 and 2008, respectively.

 

Other

 

The Company expensed $2.7 million annually during 2010, 2009 and 2008 for services provided to the Company by M & F Worldwide. This amount is reflected in selling, general and administrative expenses and accrued expenses.

 

During 2010 and 2009, the Company paid cash dividends of $31.2 million and $41.3 million, respectively to M & F Worldwide as permitted by restricted payment baskets within the Company’s debt agreements.

 

As discussed in Note 8 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K, the Company made net payments to and had net receivables with M&F Worldwide related to a tax sharing agreement.

 

As discussed in Note 3 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K, the Company paid $2.0 million in February 2008 to MacAndrews & Forbes Holdings Inc. for its services related to sourcing, analyzing, negotiating and executing the Data Management Acquisition.

 

The Company participates in MacAndrews & Forbes Holdings Inc.’s directors and officer’s insurance program, which covers the Company as well as MacAndrews & Forbes Holdings Inc. and its other affiliates. MacAndrews & Forbes Holdings Inc. directly and indirectly beneficially owned, as of December 31, 2010, approximately 43.4% of outstanding common stock of M & F Worldwide. The limits of coverage are available on aggregate losses to any or all of the participating companies and their respective directors and officers. The Company reimburses MacAndrews & Forbes Holdings Inc. for its allocable portion of the premiums for such coverage, which the Company believes is more favorable than the premiums the Company could secure were it to secure its own coverage. At December 31, 2010 and 2009, the Company recorded prepaid expenses of $0.1 million and $0.4 million, respectively, relating to the directors and officers insurance program in the accompanying consolidated balance sheets. The Company paid $0.0 million, $0.1 million and $0.3 million to MacAndrews & Forbes Holdings Inc. in 2010, 2009 and 2008, respectively, under the insurance program.

 

Liquidity and Capital Resources

 

Cash Flow Analysis

 

The Company’s net cash provided by operating activities for the year ended December 31, 2010 was $273.0 million as compared to $205.3 million during the year ended December 31, 2009. The increase in net cash provided by operating activities of $67.7 million was due to changes in working capital and an increase in cash flow from operations. The changes in working capital were primarily due to the timing of payments related to other accrued expenses and prepaid expenses during 2010 compared to 2009.

 

The Company’s net cash used in investing activities was $73.9 million for year ended December 31, 2010 as compared to $76.8 million for the year ended December 31, 2009. In 2010, the Company expended $61.2 million for the acquisition of businesses, net of cash acquired from these acquisitions, compared to $11.4 million for the acquisition of businesses, net of cash acquired in the acquisitions in 2009. In 2010, the Company sold marketable securities for net proceeds of $24.7 million. The Company had invested $24.6 million in those marketable securities in 2009. The Company also had lower capital expenditures in 2010 compared to 2009.

 

The Company’s net cash used in financing activities was $51.5 million for the year ended December 31, 2010 as compared to $129.2 million for the year ended December 31, 2009. The decrease in net cash used in financing activities in 2010 was primarily due to cash used during 2009 to extinguish $136.9 million principal

amount of 2015 Senior Notes for an aggregate purchase price of $67.6 million. The Company also had a lower dividend paid to parent in 2010 compared to 2009.

 

The Company’s Consolidated Contractual Obligations

 

The Company has certain cash obligations and other commercial commitments which will affect its short-term liquidity. At December 31, 2010, such obligations and commitments, which do not include options for renewal, were as follows:

 

 

 

 

At December 31, 2010, the Company had a net deferred tax liability of $369.6 million. Deferred tax liabilities are temporary differences between tax and financial statement basis of assets and do not directly relate to income taxes to be paid in the future. At December 31, 2010, the Company had unrecognized tax benefits of $12.0 million for which the Company is unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authority. Thus, these liabilities have not been included in the contractual obligations table.

 

The Company’s Credit Agreement

 

On April 4, 2007, the Company and substantially all of its subsidiaries as co-borrowers entered into senior secured credit facilities, which provided for a revolving credit facility of $100.0 million maturing on June 28, 2013 and a $1,800.0 million term loan maturing on June 30, 2014. Portions of the Company’s revolving credit facility are available for the issuance of letters of credit and swing line loans.

 

All obligations under the credit facilities are guaranteed by the Company’s direct parent and by each of the Company’s direct and indirect present domestic subsidiaries and future wholly-owned domestic subsidiaries. The credit facilities are secured by a perfected first priority security interest in substantially all of the Company and the guarantors’ assets, other than voting stock in excess of 65.0% of the outstanding voting stock of each direct foreign subsidiary and certain other excluded property.

 

The term loan facility has an aggregate principal amount of $1,800.0 million which was drawn in full on May 1, 2007. The term loan facility is required to be repaid in quarterly installments of $4.5 million until maturity. The term loan facility requires that a portion of the Company’s excess cash flow (as defined in the senior secured credit facilities) be applied to prepay amounts borrowed thereunder, beginning in 2009 with respect to 2008. An excess cash flow payment of approximately $3.5 million will be paid in 2011 with respect to 2010 and will be applied against other mandatory payments due in 2011 under the terms of the facility. No such excess cash flow payment was paid in 2010 with respect to 2009 and no such excess cash flow payment was paid in 2009 with respect to 2008. The balance of the term loan facility is due in full in 2014.

 

Loans under the credit facilities bear, at the Company’s option, interest at:

 

 

The credit facilities have a commitment fee of 0.50% for the unused portion of the revolver and a weighted average commitment fee of 2.52% for issued letters of credit. Interest rate margins and commitment fees under the revolver are subject to reduction in increments based upon the Company achieving certain consolidated leverage ratios.

 

The credit facilities contain representations and warranties customary for a senior secured credit facility. They also contain affirmative and negative covenants customary for a senior secured credit facility, including, among other things, restrictions on indebtedness, liens, mergers and consolidations, sales of assets, loans, acquisitions, restricted payments, transactions with affiliates, dividends and other payment restrictions affecting subsidiaries and sale leaseback transactions. The credit facilities also require the Company to maintain a certain maximum consolidated leverage ratio for the benefit of the lenders under the revolver only.

As of December 31, 2010, $1,737.0 million principal amount was outstanding under the term loan facility. As of December 31, 2010, no amounts were drawn under the Company’s $100.0 million revolving credit facility, and the Company had $91.8 million available for borrowing (giving effect to the issuance of $8.2 million of letters of credit).

 

During 2009 and 2010, the Company entered into interest derivative transactions in the form of three-year interest rate swaps with notional amounts totaling $855.0 million currently outstanding, which swap the underlying variable rate for fixed rates ranging from 1.264% to 2.353%. Those derivatives are being accounted for as cash flow hedges. The purpose of the transactions is to limit the Company’s risk on a portion of its variable rate term loan.

 

The Company’s Senior Notes

 

On May 1, 2007, the Company issued $305.0 million aggregate principal amount of Senior Floating Rate Notes due 2015 (the “Floating Rate Notes”) and $310.0 million aggregate principal amount of 9.50% Senior Fixed Rate Notes due 2015 (the “Fixed Rate Notes” and, together with the Floating Rate Notes, the “2015 Senior Notes”). The 2015 Senior Notes mature on May 15, 2015. The Fixed Rate Notes bear interest at a rate per annum of 9.50%. The Floating Rate Notes bear interest at a rate per annum equal to the Applicable LIBOR Rate (as defined in the indenture governing the 2015 Senior Notes (the “Indenture”)), subject to a floor of 1.25%, plus 4.75%. The Senior Notes are unsecured and are therefore effectively subordinated to all of the Company’s senior secured indebtedness, including outstanding borrowings under the senior secured credit facilities. The Indenture contains customary restrictive covenants, including, among other things, restrictions on the Company’s ability to incur additional debt, pay dividends and make distributions, make certain investments, repurchase stock, incur liens, enter into transactions with affiliates, enter into sale and lease back transactions, merge or consolidate and transfer or sell assets. The Company must offer to repurchase all of the 2015 Senior Notes upon the occurrence of a “change of control,” as defined in the Indenture, at a purchase price equal to 101% of their aggregate principal amount, plus accrued and unpaid interest. The Company must also offer to repurchase the 2015 Senior Notes with the proceeds from certain sales of assets, if it does not apply those proceeds within a specified time period after the sale, at a purchase price equal to 100% of their aggregate principal amount, plus accrued and unpaid interest.

 

The Senior Notes are guaranteed fully and unconditionally, jointly and severally by each of the Company’s existing subsidiaries other than unrestricted and certain immaterial subsidiaries, all of which are wholly owned by the Company.

 

During 2009, the Company extinguished $136.9 million principal amount of debt by purchasing 2015 Senior Notes in individually negotiated transactions for an aggregate purchase price of $67.6 million. The Company did not purchase any 2015 Senior Notes during 2010.

 

Impact of Inflation

 

The Company presents its results of operations and financial condition based upon historical cost. While it is difficult to measure accurately the impact of inflation due to the imprecise nature of the estimates required, the Company believes that, for the three most recent fiscal years, the effects of inflation, if any, on its results of operations and financial condition have been minor.

 

Liquidity Assessment

 

The Company believes that its cash and cash equivalents, borrowings available under its credit agreements (as further discussed in Note 11 to the Company’s consolidated financial statements included elsewhere in this Annual Report on Form 10-K) and anticipated cash flow from operating activities will be sufficient to meet the Company’s expected operating needs, investment and capital spending requirements and debt service requirements for the foreseeable future.

In addition to normal operating cash, working capital requirements and service of indebtedness, the Company also requires cash to fund capital expenditures, make contract acquisition payments to financial institution clients and enable cost reductions through restructuring projects as follows:

 

 

The Company may also, from time to time, seek to use its cash to make acquisitions or investments, and also to retire or purchase its outstanding debt in open market purchases, in privately negotiated transactions, or otherwise. Such retirement or purchase of debt may be funded from the operating cash flows of the business or other sources and will depend upon prevailing market conditions, liquidity requirements, contractual restrictions and other factors, and the amounts involved may be material. During 2009, the Company extinguished $136.9 million principal amount of debt by purchasing 2015 Senior Notes in individually negotiated transactions for an aggregate purchase price of $67.6 million. The Company did not purchase any 2015 Senior Notes during 2010. The Company also used cash on hand to fund the aggregate $61.2 million, net of cash acquired, expended for both the Spectrum K12 and Parsam acquisitions in 2010 and the $135.4 million, net of cash acquired, expended for the GlobalScholar acquisition on January 3, 2011.

 

Cash Flow Risks

 

The Company’s ability to meet its debt service obligations and reduce its total debt will depend upon its ability to generate cash in the future which, in turn, will be subject to general economic, financial, business, competitive, legislative, regulatory and other conditions, many of which are beyond the Company’s control. The Company may not be able to generate sufficient cash flow from operations or borrow under its credit facility in an amount sufficient to repay its debt or to fund other liquidity needs. As of December 31, 2010, the Company had $91.8 million of availability under its revolving credit facility (after giving effect to the issuance of $8.2 million of letters of credit). The Company may also use its revolving credit facility to fund potential future acquisitions or investments. If future cash flow from operations and other capital resources is insufficient to pay the Company’s obligations as they mature or to fund its liquidity needs, the Company may be forced to reduce or delay business activities and capital expenditures, sell assets, obtain additional debt or equity capital or restructure or refinance all or a portion of its debt on or before maturity. The Company may not be able to accomplish any of these alternatives on a timely basis or on satisfactory terms, if at all. In addition, the terms of the Company’s existing and future indebtedness may limit its ability to pursue any of these alternatives.

 

Honeywell Indemnification

 

Certain of the intermediate holding companies of the predecessor of the Company had issued guarantees on behalf of operating companies formerly owned by these intermediate holding companies, which operating

companies are not part of the Company’s businesses. In the stock purchase agreement executed in connection with the 2005 acquisition of Clarke American Corp. by M & F Worldwide, Honeywell International Inc. agreed to use its commercially reasonable efforts to assume, replace or terminate such guarantees and indemnify M & F Worldwide and its affiliates, including Harland Clarke Holdings and its subsidiaries, with respect to all liabilities arising under such guarantees.

 

Other

 

A series of commercial borrowers in eight states that allegedly obtained loans from banks employing HFS’s LaserPro software have commenced individual or class actions against their banks alleging that the loans were deceptive or usurious in that they failed to disclose properly the effect of the “365/360” method of calculating interest. In some cases, the banks have made warranty claims against HFS related to these actions. Some of these actions have already been dismissed, and many of the remainder, and the related warranty claims, are at early stages, so that the likely progress of the matters still pending is not yet clear. HFS settled one warranty claim in 2009 for an immaterial amount without any admission of liability. The Company has not accepted any of the remaining warranty claims and does not believe that any of these claims will result in material liability for the Company, but there can be no assurance.

 

Various other legal proceedings, claims and investigations are pending against the Company, including those relating to commercial transactions, product liability, environmental, safety and health matters, employment matters and other matters. The Company is also involved in various stages of legal proceedings, claims, investigations and cleanup relating to environmental matters, some of which relate to waste disposal sites. Most of these matters are covered by insurance, subject to deductibles and maximum limits, and by third-party indemnities. In the opinion of management, based upon the information available at this time, the outcome of the matters referred to above will not have a material adverse effect on the Company’s financial position or results of operations.

 

Forward-Looking Statements

 

This Annual Report on Form 10-K for the year ended December 31, 2010, as well as certain of the Company’s other public documents and statements and oral statements, contains forward-looking statements that reflect management’s current assumptions and estimates of future performance and economic conditions. When used in this Annual Report on Form 10-K, the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “estimates” or similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. All forward-looking statements speak only as of the date of this Annual Report on Form 10-K. Although the Company believes that its plans, intentions and expectations reflected in or suggested by the forward-looking statements are reasonable, such plans, intentions or expectations may not be achieved. Such forward-looking statements are made in reliance upon the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company cautions investors that any forward-looking statements are subject to risks and uncertainties that may cause actual results and future trends to differ materially from those projected, stated or implied by the forward-looking statements. In addition, the Company encourages investors to read the summary of the Company’s critical accounting policies and estimates included in this Annual Report on Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates.”

 

In addition to factors described in the Company’s SEC filings and others, the following factors could cause the Company’s actual results to differ materially from those expressed in any forward-looking statements made by the Company:

 

 

 

 

The Company encourages investors to read carefully the risk factors in the section entitled “Risk Factors” for a description of certain risks that could, among other things, cause actual results to differ from these forward-looking statements.

 

 

The Company has exposure to market risk from changes in interest rates and foreign currency exchange rates, which could affect its business, results of operations and financial condition. The Company manages its exposure to these market risks through its regular operating and financing activities.

 

At December 31, 2010, the Company had $1,737.0 million of term loans outstanding under its credit agreement, $8.2 million of letters of credit outstanding under its revolving credit facility, $206.8 million of floating rate senior notes and $271.3 million of 9.50% fixed rate senior notes. All of these outstanding loans bear interest at variable rates, with the exception of the $271.3 million of fixed rate senior notes. Accordingly, the Company is subject to risk due to changes in interest rates. The Company believes that a hypothetical increase of 1 percentage point in the variable component of interest rates applicable to its floating rate debt outstanding as of December 31, 2010 would have resulted in an increase in its annual interest expense of approximately $8.8 million, including the effect of the interest rate derivative transactions discussed below.

 

In order to manage its exposure to fluctuations in interest rates on a portion of the outstanding variable rate debt, the Company entered into interest rate derivative transactions in 2009 and 2010 in the form of swaps with notional amounts totaling $855.0 million currently outstanding as further described in the notes to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K. These derivatives currently swap the underlying variable rates for fixed rates ranging from 1.264% to 2.353%.

 

As of December 31, 2010, the Company’s net foreign currency market exposures were $18.0 million. This is the value of the equity of the investments in the foreign subsidiaries in Canada, India, Ireland and Israel. Since the exposures are not material, the Company does not generally hedge against foreign currency fluctuations.

 

A 10% appreciation in foreign currency exchange rates from the prevailing market rates would result in a $1.8 million increase in the related assets or liabilities. Conversely, a 10% depreciation in these currencies from the prevailing market rates would result in a $1.8 million decrease in the related assets or liabilities.

 

 

See the financial statements and supplementary data listed in the accompanying Index to Consolidated Financial Statements and Financial Statement Schedules on page F-1 herein. Information required by other schedules called for under Regulation S-X is either not applicable or is included in the consolidated financial statements or notes thereto included elsewhere in this Annual Report on Form 10-K.

 

None.

 

 

The Company’s management, with the participation of the Company’s Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13(a)-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of December 31, 2010. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2010.

 

There were no material changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter of 2010 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Management’s Report on Internal Control over Financial Reporting

 

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

 

The Company’s internal control over financial reporting includes those policies and procedures that:

 

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework.

 

Based on its assessment, management believes that, as of December 31, 2010, the Company’s internal control over financial reporting was effective.

 

 

Not applicable.

 

 

Organizational Structure

 

Harland Clarke Holdings is organized along the following three business segments: Harland Clarke, Harland Financial Solutions and Scantron.

 

The following table sets forth information regarding our directors and executive officers as of March 3, 2011:

 

 

Charles T. Dawson was appointed President and Chief Executive Officer of Harland Clarke Holdings on September 27, 2007. Mr. Dawson was elected as a Director of Harland Clarke Holdings and appointed Chief Executive Officer of Harland Clarke on May 1, 2007. Mr. Dawson has over 30 years of experience in the security printing industry. Mr. Dawson also served as President of Harland Clarke from May, 2007 to August 2009 and before that as President of Clarke American Corp. (“Clarke American”) from April 2005 to May 2007. Previous roles at Clarke American included Executive Vice President/General Manager of Partnership Development from February 2003 to April 2005 and Senior Vice President/General Manager of the National Account/Securities/Business Development divisions from July 2000 to February 2003. Mr. Dawson was the Chief Executive Officer for Rocky Mountain Bank Note Company before joining Clarke American in 1992. Mr. Dawson is also a director of M & F Worldwide, which is required to file reports under the Securities Exchange Act of 1934.

 

Peter A. Fera, Jr. was appointed Executive Vice President and Chief Financial Officer of Harland Clarke Holdings on September 27, 2007. Mr. Fera was appointed Executive Vice President and Chief Financial Officer of Harland Clarke on May 1, 2007 and also served as Senior Vice President and Chief Financial Officer of Clarke American from April 2005 to April 2007. Previously, Mr. Fera was employed by Honeywell International, Inc. (“Honeywell”) for seven years and held a variety of leadership positions in finance and marketing. Most recently he served as Chief Financial Officer for the Aircraft Landing Systems business of Honeywell from October 2003 to April 2005. At Honeywell, he also served as Director of Finance — Business Analysis and Planning from February 2002 to October 2003 and Global Marketing Manager from October 2000 to February 2002. Earlier in his career he held operational and engineering roles at General Electric Co.

 

James D. Singleton was appointed President of Harland Clarke on August 14, 2009 and Chief Operating Officer of Harland Clarke on October 5, 2008. Mr. Singleton previously served as Executive Vice President of Harland Clarke from May 2007 until October 2008 with responsibility for Sales, Marketing, and Customer Service and Sales Contact Centers. Mr. Singleton previously held other roles at Clarke American including Senior Vice President Partnership Development from January 2006 to May 2007, as well as a variety of positions in Sales and Marketing. Previous roles at Indalex Aluminum Solutions Inc. from November 2000 to January 2006 included Vice President and General Manager, Specialty Products, Business Unit President South, and Senior Vice President Sales Marketing and International.

Raju M. Shivdasani was appointed President of Harland Financial Solutions on August 31, 2009. Mr. Shivdasani previously served as President of Enterprise Solutions for Harland Financial Solutions since August 2001. Prior to joining Harland Financial Solutions, Mr. Shivdasani was with Phoenix International, Inc. where he served as President and Chief Operating Officer from 1998 to 2001, and as Senior Vice President and President of the International Division from July 1996 to January 1998. Mr. Shivdasani was previously employed as the Group Executive Vice President for Fiserv, Inc. and with Citicorp Information Resources as President of CBS Worldwide. He also served on the IBM AS/400 Strategic Advisory Board from 1992 to 1994.

 

William D. Hansen was appointed President of Scantron on July 13, 2009 and served in that role until January 2011, when he became Chairman of Scantron. Prior to joining Scantron, Mr. Hansen served as President and Chief Executive Officer of Chartwell Education Group, LLC, an education-related consulting firm. Prior to joining Chartwell in 2005, he served as the Senior Vice President and Managing Director of Affiliated Computer Services’ Educational Service business. From May 2001 to July 2003, Mr. Hansen served as the Deputy Secretary of the United States Department of Education, functioning as its Chief Operating Officer. Mr. Hansen also served as President of the Education Finance Council, Inc. from 1993 to 2001.

 

Paul G. Savas has been one of our directors since May 1, 2007 and served as Harland Clarke Holdings’ Executive Vice President and Chief Financial Officer from May 1, 2007 to September 27, 2007. Mr. Savas has been Executive Vice President and Chief Financial Officer of M & F Worldwide since May 2006 and previously served as the Senior Vice President of Finance of M & F Worldwide since 2002. He has been Executive Vice President and Chief Financial Officer of MacAndrews & Forbes Holdings Inc. and various affiliates since May 2007, and previously served as Executive Vice President — Finance from April 2006 until May 2007 and was Senior Vice President — Finance of MacAndrews & Forbes Holdings Inc. and various affiliates from 2002 until April 2006. Mr. Savas joined MacAndrews & Forbes Holdings Inc. in 1994 as Director of Corporate Finance and was appointed Vice President — Finance in 1998. Mr. Savas is also a director of SIGA Technologies Inc., which is required to file reports under the Securities Exchange Act of 1934.

 

Barry F. Schwartz has been one of our directors since the Clarke American acquisition by M & F Worldwide in 2005, has acted as Chairman of our Board since September 2007, and served as Harland Clarke Holdings’ President and Chief Executive Officer from May 1, 2007 to September 27, 2007. Mr. Schwartz has been President and Chief Executive Officer of M & F Worldwide since September 2007 and prior to that time he served as Executive Vice President and General Counsel of M & F Worldwide since 1996. Mr. Schwartz has been Executive Vice Chairman and Chief Administrative Officer of MacAndrews & Forbes Holdings Inc. and various affiliates since October 2007 and previously served as Executive Vice President and General Counsel of MacAndrews & Forbes Holdings Inc. and various affiliates since 1993 and was Senior Vice President of MacAndrews & Forbes Holdings Inc. and various affiliates from 1989 to 1993. Mr. Schwartz is also a Director of the following organizations which are required to file reports under the Securities Exchange Act of 1934: Scientific Games Corporation, Revlon Consumer Products Corporation, Revlon Inc. and M & F Worldwide.

 

Code of Ethics

 

Harland Clarke Holdings does not have a separate code of ethics because we are a wholly-owned subsidiary of M & F Worldwide. All of our employees, including our principal executive officer, principal financial officer and principal accounting officer, are subject to the M & F Worldwide Code of Business Conduct. The Code is available on M & F Worldwide’s website at www.mandfworldwide.com.

 

Board of Directors

 

Harland Clarke Holdings is an indirect wholly-owned subsidiary of M & F Worldwide. Our board of directors is currently composed of three individuals, Charles T. Dawson, Paul G. Savas and Barry F. Schwartz. We believe this structure effectively combines the involvement of our parent, M & F Worldwide, and our CEO in the oversight of the Company’s operations.

The Board is responsible for risk oversight. The Board’s role in the Company’s risk oversight process includes receiving periodic reports from members of senior management on areas of material risk to the Company, including operational, financial, legal and regulatory, and strategic and reputational risks. The Company does not have a separate risk committee or chief risk officer as risk functions are performed throughout the organization and reviewed by the Board and senior management of the Company and M & F Worldwide, providing what we believe to be an appropriate level of accountability, as well as separation of duties.

 

As a wholly-owned subsidiary of M & F Worldwide, we are not required to have a nominating committee and we do not have a formal policy on diversity in identifying board nominees. The exact number of members of our Board is to be determined from time to time by resolution of a majority of our full Board of Directors.

 

Board Committees

 

We do not have standing audit, nominating or compensation committees because we are a wholly-owned subsidiary of M & F Worldwide. M & F Worldwide’s Audit Committee serves as our audit committee. The Audit Committee operates under a written charter which is available on M & F Worldwide’s website at http://www.mandfworldwide.com/Corporate_Charter/audit_committee_charter.htm. The Board of Directors of M & F Worldwide has determined that each of the members of the Audit Committee is “independent” within the meaning of the NYSE listing standards applicable to audit committee members.

 

Compensation Committee Interlocks and Insider Participation

 

There are no interlocking relationships between any member of M & F Worldwide’s Compensation Committee and any of our executive officers that would require disclosure under the rules of the United States Securities and Exchange Commission. No member of M & F Worldwide’s Compensation Committee is a current or former officer or employee of the Company.

 

Compensation Risk Assessment

 

The Company conducted a risk assessment of the various compensation policies and practices at the Harland Clarke Holdings level and across its three business segments. The Company evaluated whether any of its compensation programs, policies, and practices are reasonably likely to have a material adverse effect on the Company.

 

The following summarizes the Company’s evaluation of our compensation programs, policies, and practices with respect to the assessment of risk:

 

 

 

Based on this evaluation and the currently known facts and circumstances, the Company concluded that its compensation programs, policies, and practices are not reasonably likely to have a material adverse effect on the Company.

 

 

Compensation Discussion & Analysis

 

Named Executive Officers

 

This Compensation Discussion & Analysis (“CD&A”) describes the compensation programs applicable for our named executive officers and the basis for decisions regarding their compensation for 2010. Our named executive officers (“NEOs”) for 2010 are:

 

 

Compensation Decision Makers

 

Our Compensation Committee

 

The Compensation Committee of the Board of Directors of M & F Worldwide serves as our Compensation Committee. The Compensation Committee operates under a written charter which is available on M & F Worldwide’s website at http://www.mandfworldwide.com/Corporate_Charter/compensation_committee_charter.htm.

 

The Compensation Committee and management of M & F Worldwide supervised the design and drafting of the long-term incentive compensation plans for each NEO. Mr. Dawson reviews his recommendations on base pay, long-term incentive plans and performance targets with the management of M & F Worldwide, and the Compensation Committee, where applicable. The Compensation Committee of M & F Worldwide reviews and approves major changes to NEO compensation and the design, structure and amounts of compensation and incentive plans.

 

Role of Executive Officers in the Compensation Process

 

Mr. Dawson recommends business performance targets and objectives to management of M & F Worldwide and to the Compensation Committee, where applicable, in his role as CEO. He further evaluates the performances of and recommends compensation for the executive officers reporting to him, which includes all NEOs other than himself for 2010. Targets are set consistent with annual budgets presented to the Compensation Committee and the Board of Directors of M & F Worldwide.

Compensation Consultants

 

In 2010, the Compensation Committee engaged Compensation Advisory Partners, LLC to advise on the structure of the 2011-2013 LTIP as well as other changes to senior executives’ compensation.

 

Market Data

 

The Company subscribes to various compensation surveys to provide general market data for executive positions. Further, in determining the structure of the 2011-2013 LTIP as well as other changes to senior executives’ total compensation in 2011, the Compensation Committee reviewed data for peer groups and companies with revenues within a comparable range of the Company’s revenue, provided by the Committee’s compensation consultant, Compensation Advisory Partners, LLC.

 

Compensation Philosophy

 

The objectives of the Company’s compensation programs are to enable the Company to attract, retain, and motivate key talent and to reward achievement of short-term and long-term strategic business objectives and financial goals.

 

The material principles underlying the Company’s executive compensation policies and decisions include recognizing that quality talent is attracted and retained with quality pay packages and that our executives recognize through their pay structure that their personal success with the Company is subject to and conditioned on the success of the Company’s business segments. We set pay in a way we think best drives our executives to promote the growth of our three principal business segments, Harland Clarke, Harland Financial Solutions and Scantron.

 

We use cash compensation, not equity compensation. The Compensation Committee has determined that our cash-based compensation programs are an appropriate means by which to link compensation with performance measures. Equity compensation can be volatile based on market effects not necessarily tied to Company and individual performance. Equity compensation could also dilute shareholder interests. In addition, the Compensation Committee prefers cash-based compensation programs because of its greater simplicity in design and its ability to be understood by our executives and other employees as well as shareholders.

 

Compensation can increase or decrease materially in the event of a change in scope of position responsibilities, in light of individual and/or Company performance, and in response to business need. We generally do not take one element of pay into account when setting another pay element for the same executive, but we have designed target total compensation opportunities to be competitive. We do calculate bonus as a percentage of base pay as we explain below. We view base plus bonus as an executive’s core pay, and we deliberately set the mix of base and bonus based on the responsibility the executive has for our financial performance.

Overview of Compensation Components

 

Our executive compensation program includes the following elements:

 

Elements of Compensation

 

Base Salary

 

Mr. Dawson determines an NEO’s recommended base pay by evaluating the NEO’s individual leadership competencies, achievement of personal goals in support of the Company objectives and position-critical skills. Management of M & F Worldwide conducts this evaluation together with Mr. Dawson, and, where appropriate, discusses it with the NEO. Management of M & F Worldwide recommends a pay level to the Compensation Committee in the case of major changes to compensation or changes in the design or structure of a compensation plan. The Compensation Committee then decides the base pay level, where applicable. Mr. Dawson’s base salary is determined by his employment agreement.

 

We feel that a substantial portion of an executive’s core pay (base and bonus) should be subject to risk to the extent that the executive is partially responsible for below-target financial performance. The analysis of how much direct responsibility our executives have for our performance targets determines how much of the executive’s core pay should be at risk.

 

Annual Executive Bonus Plan

 

The amount of bonus paid to our NEOs is tied directly to the Company’s performance and the NEO’s individual performance. The Company wants our annual bonus program to properly reward our NEOs for their individual performances and contributions to the Company. Each NEO’s bonus targets were set based on the performance of the principal business segment for which the NEO is responsible. These Adjusted EBITDA for Compensation Purposes targets vary for each of our business segments, reflecting the appropriate adjustments we make to financial performance. We discuss these Adjusted EBITDA for Compensation Purposes targets in more detail in “Adjusted EBITDA for Compensation Purposes Targets” below.

 

We base the bonus plan on achievement of the annual Adjusted EBITDA for Compensation Purposes target for each business segment. As illustrated in the chart below, the amount of bonus opportunity is tied to a percentage of salary increasing incrementally as performance against goal increases incrementally, up to a maximum amount. If at least 90% of target is not achieved, then no bonus will be paid. The differences in percentages listed in the “Bonus as a Percentage of Base Salary” column are due to differences in each NEO’s responsibility and the size of the NEO’s relevant business segment. The bonuses generally were designed to be compliant with the performance-based exception of Section 162(m) of the Internal Revenue Code (the “Code”), if applicable. Each NEO earned a bonus from the Company during 2008, 2009, and 2010. Bonuses are generally paid by March 15th of the year following the year for which the bonuses are earned.

 

The chart below sets forth the base salary, bonus potential and actual bonus paid for 2009 and anticipated to be paid for 2010 for each of our NEOs.

 

 

Long-Term Incentive Compensation

 

We believe in linking compensation to Company and individual performance. We tie long-term incentive compensation to our overall financial goals and, where appropriate, to the goals of individual business units. A NEO’s compensation varies with our financial and operating performance so that they are rewarded when performance meets or exceeds objectives and receive lower compensation when performance objectives are not met. We apply objective measures of performance in setting pay levels. The Company has a strong history of

achieving performance at and above target levels, and the Compensation Committee has determined that linking NEOs’ compensation to certain individual and collective performance objectives can help our Company to achieve its targets.

 

The Company maintained a three-year cash-based plan tied to multiyear Company and business segment performance for the performance period from 2008 to 2010, and the Compensation Committee approved a new long-term incentive plan covering the period from 2011 to 2013, which will be submitted for shareholder approval in connection with the next Annual Meeting of Stockholders of M & F Worldwide. Each of these long-term incentive plans are described below, followed by additional detail on the determinations of performance measures and targets established pursuant to these plans.

 

The 2008-2010 M & F Worldwide Long-Term Incentive Compensation Plan (“2008-2010 LTIP”)

 

The 2008-2010 LTIP is a three-year cash-based plan tied to multiyear Company and business segment performance. It became effective on January 1, 2008 and covers fiscal years 2008 through 2010. All payouts to the executives will be made subsequent to the end of the three-year performance cycle, which occurred on December 31, 2010, but no later than March 15, 2011. All of the NEOs participated in the 2008-2010 LTIP in 2010, 2009 and 2008, with the exception of Mr. Hansen who did not participate in the plan during fiscal year 2008. The actual payout amount to our current NEOs for the 2008-2010 LTIP at the end of the three-year cycle will be approximately $8.5 million.

 

With respect to plan design for the 2008-2010 LTIP, we determined that the best approach was to (a) establish Adjusted EBITDA for Compensation Purposes targets within 90 days of the beginning of each year the plan is in effect which demonstrate benefit to shareholders of M & F Worldwide, and (b) compensate executives only if those Adjusted EBITDA for Compensation Purposes targets are achieved on a cumulative basis over a three-year period, thus providing a clear indication of sustained performance. If the executive is terminated without cause during the course of the plan term, he would receive a pro rata payment in respect of the time elapsed, only if Adjusted EBITDA for Compensation Purposes targets are achieved, and the payments, if any, would be paid out at the end of the three-year cycle, not at the time of termination.

 

Under the 2008-2010 LTIP, no payouts would have been made if actual three-year performance was below 90% of the cumulative Adjusted EBITDA for Compensation Purposes targets. If performance was between 90% and 100% of cumulative Adjusted EBITDA for Compensation Purposes target, the 2008-2010 LTIP would pay out a ratable amount between 50% and 100%. The 2008-2010 LTIP participants would also share in 2.3% and 2.7%, respectively, of the cumulative three-year excess over target, up to a maximum of 120% of cumulative performance over target for business segment performance and consolidated performance. Adjusted EBITDA for Compensation Purposes targets under the 2008-2010 LTIP are bifurcated, granting awards with respect to each executive based 50% on performance of the executive’s individual business segment and 50% on consolidated performance. For 2009 only, Mr. Hansen’s Adjusted EBITDA for Compensation Purposes target is based solely on consolidated performance. The Compensation Committee determined that the bifurcated structure was appropriate because there are three separate and distinct business segments, each with their own challenges, risks and opportunities, but there remains the opportunity for the business segments to assist each other in their individual growth.

 

The 2011-2013 M & F Worldwide Long-Term Incentive Compensation Plan

 

The Compensation Committee has approved a new long-term incentive plan covering the period 2011-2013 (“2011-2013 LTIP”) and the 2011-2013 LTIP will be submitted for shareholder approval in connection with the next Annual Meeting of Stockholders of M & F Worldwide. The 2011-2013 LTIP is a three-year cash-based plan tied to Company and business segment performance. The 2011-2013 LTIP became effective January 1, 2011 and covers fiscal years 2011 through 2013.

 

Subject to the approval of the 2011-2013 LTIP by shareholders of M & F Worldwide, the Company has granted awards to certain executives of the Company and its subsidiaries, including each of the NEOs. All payouts to the executives participating will be made, assuming the cumulative performance thresholds are met, at the end of the three-year cycle. While the Company expects the performance targets under the 2011-2013 LTIP to be met, the Company is not certain it will achieve or exceed the performance targets.

The awards will provide for a cash payment at the end of the three-year period ending December 31, 2013 and the executives will be entitled to payments in the amounts set forth in the table below assuming targets are achieved at the end of such three-year period. The performance measures used under the 2011-2013 LTIP includes Adjusted EBITDA and a “non-check revenue” performance measure (as discussed in more detail in “Performance Measures and Performance Targets” below). Each award granted under the 2011-2013 LTIP will be based 75% on cumulative Adjusted EBITDA for Compensation Purposes targets and 25% on cumulative non-check revenue targets. If less than 90% of the target is achieved, then no payment will be made. If between 90% and 100% of the targets are achieved, then the amount of the award in the table below will be adjusted based on linear interpolation between 50% up to 100%, and if between 100% and 110% of the targets are achieved, then the amount of the award in the table below will be adjusted based on linear interpolation between 100% up to a maximum of 150%. For Mr. Dawson and Mr. Fera, the awards and related payments will be based solely on Company results and for Messrs. Singleton, Hansen and Shivdasani, 50% will be based on Company results and 50% will be based on the results of their respective business segment.

 

The 2011-2013 LTIP contains “clawback” provisions, which provide that if a participant is determined by the Compensation Committee to have violated a noncompete, nonsolicit, nondisclosure covenant or other agreement or engaged in activity that was in conflict with or was adverse to the interests of the Company or its affiliates (including fraud) or conduct contributing to any financial restatement or financial irregularities, then the Compensation Committee can cancel the participant’s award. In addition, the Compensation Committee may require the participant to repay any profits or benefit realized by the participant. To the extent required by applicable law (including without limitation Section 302 of the Sarbanes-Oxley Act of 2002 and Section 954 of the Dodd Frank Act), awards shall be subject to clawback, forfeiture or similar requirement.

 

2011-2013 LTIP Aggregate Target Amounts

 

 

Performance Measures and Performance Targets

 

Adjusted EBITDA for Compensation Purposes Targets

 

The Compensation Committee believes that Adjusted EBITDA for Compensation Purposes targets is an appropriate performance measure on which to base long-term incentive compensation payments. Adjusted EBITDA for Compensation Purposes is a non-GAAP measure representing EBITDA (net income before interest expense-net, income taxes, depreciation and amortization) adjusted to reflect the impact of those items the Company does not consider indicative of its ongoing performance such as restructuring costs, certain non-operational items, group management fees, acquisition-related expenses, certain stand-alone costs, and other adjustments relevant to each segment. The Adjusted EBITDA for Compensation Purposes targets are similar to measures of covenant compliance under the Company’s debt agreements, and securities analysts often use similar measures to evaluate the performance of the Company.

 

The Company’s long-term incentive compensation plans have Adjusted EBITDA for Compensation Purposes targets based on both consolidated and segment performance; whereas the annual bonus is based solely on the relevant segment Adjusted EBITDA for Compensation Purposes targets. The 2010, 2009 and 2008 consolidated Adjusted EBITDA for Compensation Purposes targets were $488.0 million, $498.9 million and $470.7 million, respectively. The 2010, 2009 and 2008 segment Adjusted EBITDA for Compensation Purposes performance targets were as follows: Harland Clarke $355.0 million, $358.1 million and $352.0 million, Harland Financial Solutions $80.0 million, $76.5 million and $68.7 million, and Scantron $65.0 million, $76.7 million and $62.8 million, respectively. The Company exceeded its consolidated targets in

2010, 2009 and 2008. The segment targets were met or exceeded in 2008 and 2010, and exceeded in all segments except for Scantron in 2009.

 

Non-Check Revenue Performance Measures Commencing in 2011

 

Commencing in 2011, the Compensation Committee implemented a new performance measure for a portion of its long-term compensation programs. “Non-Check Revenue” is the performance measure that encourages the development of additional revenue sources other than checks and check-related products, which are currently the Company’s largest source of revenue, which have been in decline in recent years and are expected to continue declining. This measure is intended to encourage diversification of the Company’s sources of revenue.

 

Post-Employment Compensation

 

Payments to be made to executives in connection with termination without cause are in the form of severance and the temporary continuation of other benefits that are set forth in an individual’s employment agreement. We want our executives to make business decisions that put the Company’s interests before their own. We encourage them to feel comfortable making difficult decisions for the Company which might not otherwise be in their own long-term best interests by offering severance which would generally replace the income they would have received for the one and a half to two years following their termination of employment if we terminate them without cause.

 

We do not offer change in control protection, and we do not provide tax gross-ups if our NEOs are subject to the so-called “golden parachute excise tax,” a special tax imposed under section 4999 of the Code on unusually large payments (in comparison to historic compensation) made in connection with a change in control.

 

In the event of termination with cause, post-employment compensation is forfeited.

 

Other Benefits and Perquisites

 

Other benefits and perquisites are a minor part of executive compensation offered in order to provide a competitive total compensation and benefits package. Our NEOs participate in benefit plans available to all employees and on the same terms as similarly situated employees, such as group medical insurance and participation in and matching through the Company-sponsored 401(k) plan. Our NEOs may also participate in our non-elective, nonqualified deferred compensation plan known as the “Benefit Equalization Plan,” or “BEP,” which is a supplemental benefit program for employees whose Company contributions to the 401(k) plan are limited due to IRS annual qualified plan compensation limits. In addition, our NEOs receive benefits available to other officers such as a monthly car allowance, life insurance, annual physicals and a cell phone. Certain of our NEOs are provided private country club membership. Mr. Dawson is the only NEO that is provided with a leased company car rather than a car allowance. Mr. Singleton is permitted to travel first class, and Mr. Dawson is permitted to travel first class or by chartered aircraft.

 

Tax Considerations Relating to Executive Compensation

 

Section 162(m) of the Internal Revenue Code

 

The Compensation Committee’s general policy is that compensation should qualify to be tax deductible to the Company for federal income tax purposes. Under Section 162(m) of the Code, compensation paid to certain members of senior management in excess of $1 million per year is not deductible unless the compensation is “performance-based” as described in the regulations under Section 162(m) of the Code. Compensation is generally “performance-based” if it is determined using pre-established objective formulas and criteria approved by stockholders. The compensation awards under our annual bonus program, the 2008-2010 LTIP, and the 2011-2013 LTIP are generally designed to be tax deductible to us under the performance-based compensation exception to Section 162(m) of the Code, if and to the extent we become subject to Section 162(m) of the Code.

Report of the Board of Directors

 

We have reviewed and discussed the foregoing Compensation Discussion and Analysis with management. Based on our review and discussion with management, we have determined to include the Compensation Discussion and Analysis in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

 

 

SUMMARY COMPENSATION TABLE FOR FISCAL YEAR 2010

 

 

 

 

 

All Other Compensation