Monday, September 13, 2010 7:32:52 PM
JFGI News, from 10-k:
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Edgar Online "Glimpses "
During fiscal 2010, the Company has focused its primary efforts on the development and marketing of its surety business in West Virginia and Ohio , arranging reinsurance and other potential strategic relationships that will accelerate the progression of the Company's business plan, and, raising additional capital to increase the capital base of its insurance subsidiary, First Surety Corporation (FSC), to facilitate entry into other state markets. RESULTS OF OPERATIONS AND FINANCIAL CONDITION AS OF AND FOR THE YEAR ENDED MAY 31, 2010 RESULTS OF OPERATIONS The Company experienced a loss (after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock and equity preferred stock) of $2,713,193 in fiscal 2010 as compared with a loss (after accretion of mandatorily redeemable convertible preferred stock, including accrued dividends) of $3,057,687 in fiscal 2009. While total revenues increased from approximately $1,194,000 in fiscal 2009 to approximately $1,372,000 in fiscal 2010, total operating expenses decreased from approximately $2,039,000 in fiscal 2009 to approximately $1,830,000 in fiscal 2010, resulting in a decrease in the loss from operations of approximately $386,000 . The increase in revenues is largely attributable to new business acquired by FSC and increased investment holdings and the gain on sales of investments of FSC. The decrease in expenses is attributable to decreased general and administrative expense related to reduction in professional legal fees incurred in the Company's pending acquisition agreements and ongoing efforts to raise additional capital to expand its business and penetrate new markets. Interest expense increased from approximately $605,000 in fiscal 2009 to approximately $957,000 in fiscal 2010. This was mainly due to additional borrowings incurred in relation to the Company's efforts to raise additional capital financing and to provide financing of current operations, as well as the increased expense of common shares issued in connection with bridge loans and other financing arrangements, and the higher interest rate on bridge loans due to the forbearance agreement. In the twelve-month period ending May 31, 2010 , the Company, upon advice of legal counsel, removed certain dormant accounts payable in the aggregate amount of $200,240 based upon the conclusion that none of the accounts represented an obligation that is legally enforceable against the Company. Such removal was recorded as a gain on debt extinguishment. -8-
CAPITAL RESOURCES AND FINANCIAL CONDITION
MANDATORILY REDEEMABLE PREFERRED STOCK
In conjunction with the acquisition of FSC at December 31, 2005 , a restructuring of the Company's financing was accomplished through the private placement of 350 shares of Series A Preferred stock and 3,980 shares of Series B Preferred stock, each accompanied by warrants to acquire common stock of the Company in exchange for cash totaling $3,335,000 . $2,860,000 was used in the acquisition and funding of the insurance subsidiary, with the remaining funds used to pay expenses attributable to the acquisition and the funding of on-going operations. Additionally, approximately $3,668,000 of indebtedness of the Company
was
converted into preferred stock and warrants reducing the Company's borrowings under short-term financing arrangements to approximately $167,000 as of December 30, 2005 . The Series A designation was designed for issuance to principals desiring surety bonds under FSC's partially collateralized bonding programs. As designed, proceeds from the sale of Series A preferred stock is down-streamed to FSC to increase its capital and insurance capacity, although to the extent that proceeds from the sale of Series B preferred shares was used in the initial acquisition and funding of FSC, the Company was allowed to use such proceeds to redeem Series B preferred stock (Company option to redeem) or for funding of on-going operations. Effective June 1, 2007 , the Company agreed to
the
requirement of the West Virginia Insurance Department to downstream all future proceeds from sales of Series A preferred stock in order to increase capital and reserves of the insurance subsidiary to more substantial levels. The Series A designation contains a conditional redemption feature providing for the redemption of the Series A shares at any time after the seventh (7th) anniversary of the Issue Date, provided that the principal no longer requires surety bonds issued by FSC. Furthermore, once redeemed, the principal will no longer be eligible to participate in partially collateralized bonding programs offered by FSC. Surety bonds currently being issued by FSC are primarily for coal mining and reclamation permits, which are long-term in nature
and
continually evolving whereby outstanding bonds are periodically released as properties are mined and reclaimed and new bonds issued for properties to be mined in the future. Accordingly, this source of financing was designed to be long-term by nature. The Series B designation was designed for issuance to investors in JFG and contains both conversion rights to common stock and redemption features. Each share of the Series B preferred stock is convertible, at the option of the holder, into 1,000 shares of JFG common stock and can be converted at any time. Additionally, the Series B preferred stock can be redeemed, at the option of the holder, at full-face value plus accrued and unpaid cumulative dividends, commencing with the fifth (5th) anniversary of the original issue date.
The
Company has the option to redeem the Series B preferred shares at any time after the first (1st) anniversary of the original issue date, subject to the holder choosing to exercise conversion privileges prior to the stated redemption date. Management's ability to execute its business plan and increase the market value of its common stock will largely determine whether the Series B preferred shares are converted to common shares or eventually redeemed. As an inducement to the initial preferred stock shareholders, warrants to purchase 45,402,996 shares of common stock at an exercise price of one-tenth of one cent ($.001) per share were issued with a five-year expiration period. Such warrants were valued at approximately $533,000 using the Black-Scholes pricing model. Additionally, the Series B preferred shares were issued at a twenty-five -9- percent (25%) discount to the stated face value of $1,000 per share or approximately $2,217,650 in total. Additional shares of the Series B were subsequently sold at a discount of approximately four and one-half percent (4.5%) or approximately $36,000 . In November 2009 , as a means of alleviating obligations associated with the Company's Series B Preferred Stock, which by its terms matures at the end of 2010, management proposed a recapitalization to assist in stabilizing
the
financial position of the Company. The Board deemed it advisable to designate a Series C Preferred Stock, with 10,000 authorized shares. The Recapitalization consisted of the exchange of 6,804.936 Series B Shares for a combination of Series C Shares and Common Stock Shares. For each Series B Share,
the
participating holder received (i) one Series C Share and (ii) 2,000 shares of JFG Common Stock. The accumulated dividend rights and preferences associated with the Series B Shares transferred undiminished to the corresponding Series C Shares. This exchange amounted to $6,269,051 of carrying value of Series B stock being exchanged for Series C and Common Stock. 13,609,872 shares of Common Stock were issued to the Series C Stock holders at the rate of 2,000 Common shares for each exchanged Series B Stock, with the related cost associated with the Common issuance offsetting the Series C carrying value by $265,120 . The shares were valued at approximately $.01948 per share based on the average quoted closing price of the Company's stock for the 20-day period proceeding the date of the transaction. Series C stock may be redeemed by the Company but does not have a fixed maturity date and is considered permanent equity. Holders of over 70% of the outstanding Series B Preferred Shares elected to participate in the recapitalization. The carrying value of the Series B Preferred Shares that did not convert are listed in the Liabilities section of the Balance Sheet,
and
therefore the accretion and dividends associated with the Series B stock after November 30, 2009 are deductions from net income. The remaining Series B shares are continuing to be accreted from carrying value to the face amount for the 5 year period from the date of issuance. Series C stock has no accretion.
The
recorded values of the Series A preferred stock is being increased to their stated liquidation values using the interest method over a period of five years and such amounts are categorized as accretion of mandatorily redeemable preferred stock in the consolidated statement of operations. The Series A designation is entitled to receive cumulative dividends at the rate of 4.00% per annum and the Series B and Series C designations are entitled to receive cumulative dividends at the rate of 8.00% per annum, with the Series A, B and C designations having equal ranking and preference as to dividends and liquidation rights and in priority to the Company's common stockholders.
The
accrued (but undeclared) dividends associated with the Series C exchange amounted to $2,295,624 and are included in the total amount exchanged for Series C Shares. Unlike the Series B Shares with their fixed maturity date, the Series C Shares are permanent equity, with accruing dividends only increasing the preference amount that must be satisfied before junior securities may participate in dividends or on liquidation. Accordingly, the effect of the accrual of dividends with respect to the Series C Shares on the Company's balance sheet is to increase the aggregate claim of the Series C Shares on the equity of the corporation and to increase the deficit in common equity, while having no effect on the net equity of the corporation as a whole. The entitlement of the Series C Shares to a priority in relation to junior securities with respect to dividends and on liquidation does not create an obligation by the Company and therefore no liability is recorded until the dividends are declared by the Board of the Company. The Series C Shares are pari passu with the Series A Shares and Series B Shares and no dividends or other distributions will be paid upon Common Shares or any other class of Shares that is junior in priority to the Series C Shares while dividends are in arrears. At this time, management has chosen to
defer -10-
payment of dividends to the holders of the Series A, B and C Preferred Shares until the Company has sufficient cash flow from operations to service
the obligation.
BRIDGE-FINANCING, COMMITMENTS AND MATERIAL AGREEMENTS
Of primary importance to the Company's ability to fully implement its business plan is the expansion of that business into additional states. Regulatory approval and licensing is required for each state where FSC seeks to conduct business. Management found entry into additional states (as a surety)
was
proving difficult without the benefit of more substantial capital and reserves due to FSC's status as a recent entry into this market. Accordingly, management began pursuing avenues that would provide additional capital to facilitate such expansion. Beginning in fiscal 2008 and completed during the first quarter of fiscal 2009, the Company obtained two rounds of bridge financing totaling an aggregate of $3,500,000 . The purpose of the financing was to pay expenses of operations
and
to pay fees and expenses incurred or expected to be incurred in connection with a larger permanent financing and, in addition, to increase the capital surplus of FSC to make possible the reactivation of FSC's surety license in the state of Ohio . The terms of the bridge-financing arrangement provide for payment in full upon consummation by the Company of a qualified equity offering providing net proceeds of at least $15 million on or before September 10, 2013 ; and because such a qualified equity offering was not consummated by September 10, 2008 , accrued interest-to-date was payable, and quarterly installments of principal and interest became payable over five years commencing in December 2008 . The interest rates on such notes were fixed at 10.00%. Payments due December 2008 and March 2009 were not made by the Company as scheduled, but a forbearance agreement was subsequently entered into with the bridge lenders on June 5, 2009 , modifying payment terms to cure the default (including increasing the interest rate on the loans to 17%), issuing additional common stock to the loan holders, and pledging the stock of the Company's subsidiary, CMW, as security
for
repayment of the loans. The modification required the Company to pay interest of $224,515 on june 10, 2009 and increase the quarterly payments by $67,185 (to a total of $291,700 ) for eight consecutive quarters beginning September 10, 2009 to satisfy the arrearage. Although the Company has failed to make the payment that was due September 10, 2009 and the payments that were due in the ensuing quarters, management has remained in close contact with the bridge lenders, providing reports regarding its efforts to refinance or otherwise repay the bridge loans. To date, none of the bridge lenders has elected to pursue legal remedies. Certain equity inducements in the form of common stock of the Company were provided under the terms of the bridge loan documents. Upon issuance of the bridge notes, an aggregate of 7% of the outstanding common stock of the Company was issued to the bridge lenders. Upon retirement of the notes upon consummation of a qualified equity offering, the Company will issue to the bridge lenders a percentage of the outstanding common stock of the Company which, when added to the stock initially issued, may equal as much as 28% of the common stock of the Company that would otherwise have been retained by the holders of the Company's common shares immediately prior to the financing. Finally, because a qualified financing was not completed by September 10, 2008 , the Company was required to issue to the bridge lenders under the terms of the loan documents a total of 2.8% of the Company's outstanding common shares at such date. An additional 2.8% of the Company's outstanding common shares are required to be issued upon each six-month anniversary date thereof until retirement of the notes. -11- RESTRICTIONS ON USE OF ASSETS Regulatory approval of the acquisition of FSC by JFG was provided under the condition that no dividends or monies are to be paid to JFG from FSC without regulatory approval. Accordingly, cash, marketable investments, and other receivables held by FSC are restricted from use to fund operations or meet cash needs outside of the insurance company's domain. As of May 31, 2010 , such assets amounted to approximately $6.96 million .
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
INVESTMENTS
Management believes the Company has the ability to hold all fixed income securities to maturity. However, during the current fiscal year, the Company determined it may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company reclassified all of its fixed income securities (bonds) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders' equity as a separate component of accumulated other comprehensive income. INSURANCE PREMIUMS Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis. Insurance premium receivables are presented net of an estimated allowance for doubtful accounts, which is based on a periodic evaluation of the aging and collectability of premium receivables.
DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, are deferred and amortized as a charge to income as the related premiums are earned. The Company periodically tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to income is taken and the deferred policy acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs.
INTANGIBLE ASSETS
In exchange for the purchase price of $2.9 million for the acquisition of FSC, the Company received cash and investments held by FSC totaling $2.75 million , with the difference being attributed to the property and casualty licenses of FSC in the states of West Virginia, Ohio and Indiana . Such licenses have indefinite lives and are evaluated annually for recoverability and impairment loss. Impairment loss, if any, is measured by estimating future cash flows -12- attributable to such assets based on forecasts and projections and comparing such discounted cash flow amounts to the carrying value of the asset. Should actual results differ from such forecasts and projections, such assets may be subject to future impairment charges.
RESERVE FOR LOSSES AND LOSS EXPENSES
Reserves for unpaid losses and loss adjustment expenses of the insurance subsidiary are estimated using individual case-basis valuations in conjunction with estimates derived from industry and company experience. FSC has experienced no claims for losses as of May 31, 2010 . FSC is currently licensed to write coal permit and miscellaneous fixed-liability limit surety bonds in West Virginia and Ohio . Coal permit bonds are required by regulatory agencies to assure the reclamation of land that has been disturbed by mining operations, and accordingly, is a highly regulated process by federal and state agencies. Such bonds are generally long-term in nature with mining operations and reclamation work being conducted in unison as the property is mined. Additionally, no two principals and properties are alike due to varied company structures and unique geography and geology of each site. In underwriting coal reclamation bonds, management obtains estimates of costs to reclaim the properties in accordance with the specifications of the mining permit, prepared by independent outside professionals experienced in this field of work. Such estimates are then periodically updated and compared with marketable securities pledged, and held for the benefit of FSC as collateral for the surety bond, to mitigate the exposure to significant loss. Should the principal default in its obligation to reclaim the property as specified in the mining permit, FSC would then use the funds held in the collateral account to reclaim the property or forfeit the face amount of the surety bond. Losses can occur if the costs of reclamation exceed the estimates obtained at the time the bond was underwritten or upon subsequent re-evaluations, if sufficient collateral is not obtained, or if the collateral held has experienced significant deterioration in value and if FSC is not otherwise able to recover under its contractual rights to indemnification. Miscellaneous fixed-liability limit surety bonds are generally fully collateralized by the principal's cash investment into a collateral investment account, managed by the Company's investment advisory subsidiary ( Jacobs & Co. ) that mitigates FSC's exposure to loss. Losses can occur should the principal default on the performance required by the bond and the collateral held in the investment account experience deterioration in value. In establishing its reserves for losses and loss adjustment expense, management continually reviews its exposure to loss based on reports provided in conjunction with the periodic monitoring and inspections performed along with industry averages and historical experience. Management has estimated such losses based on industry experience, adjusted for factors that are unique to the Company's approach, and in consultation with consulting actuaries experienced in the surety field. LIQUIDITY AND GOING CONCERN The Company has experienced operating losses (after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock and equity preferred stock) of approximately $2,713,000 and $3,058,000 for the fiscal years ended May 31, 2010 and 2009, respectively. Despite increased revenue and the continued decline of operating -13- expenses, the Company has not been able to pay certain amounts due to
professionals and others and continues to be unable to pay its preferred stock dividend obligation, certain payroll taxes and withholdings from 2009, and to cure its defaults in certain quarterly payments due its bridge-financing lenders. A substantial portion of the Company's cash flow is generated by its
insurance subsidiary and is subject to certain withdrawal restrictions. While management expects revenue growth and cash flow to increase significantly as its business plan is fully implemented, it is anticipated that losses will continue and the Company will be cash constrained until FSC is able to develop a substantial book of business. Effective April 1, 2009 , FSC entered into a reinsurance agreement with Lloyd's of London for its coal reclamation surety bonding programs. This agreement has provided additional bonding capacity to FSC and has enabled FSC to write more bonds and of greater size for its coal reclamation bonding clients. Management expects this reinsurance arrangement to continue FSC's expansion of market share and to result in increased cash flow for each of the Company's operating subsidiaries. Expansion of FSC's business to other states is a key component to fully
implementing the Company's business plan. In fiscal 2009, the Company was able to increase the capital of FSC and reactivate FSC's insurance license in Ohio and obtain authority to issue surety bonds in that state. However, management has found that entry into other states (as a surety) has been difficult without the benefit of more substantial capital and reserves due to FSC's status as a recent entry into this market and the financial condition of the Company. This is the case notwithstanding the reinsurance agreement entered into by FSC with Lloyd's of London and the resulting increase in bonding capacity. Management believes that if FSC's capital and surplus reserves were significantly more substantial and the financial condition of the Company was stabilized, entry into other states would be less challenging. Accordingly, management continues to pursue avenues that can provide additional capital to increase the capacity of its insurance subsidiary and to fund continuing operations as the business is being fully developed. In addition, as an alternative means of addressing access to markets, management is seeking to establish a relationship with any one of several possible sureties that are licensed in those states other than West Virginia and Ohio that comprise significant markets for the bonding programs of FSC and could issue surety bonds that are underwritten and reinsured by FSC. Under such a "fronting" arrangement, the need for additional capital at the level of FSC to facilitate entry to other state markets would become secondary, since the payment of a fronting fee to the insurance company with active licenses would provide access to the state market without formal entry. As a means of alleviating obligations associated with the Company's Series B Preferred Stock, which by its terms matures at the end of 2010, management proposed a recapitalization to assist in stabilizing the financial position of the Company. Holders of the Series B Preferred Stock were offered
the
opportunity to exchange their Series B Shares for an equal number of shares of a new series of JFG preferred stock designated as Series C Preferred Stock plus 2,000 shares of JFG Common Stock. Series C Preferred Stock is equal in priority to the Series B Preferred Stock, is entitled to dividends at the same rate as Series B Preferred Stock, is entitled to convert to common stock of the Company at a conversion rate of $.10 per common share (in contrast to $1.00 per share for Series B Preferred) and may be redeemed by the Company but does not have a fixed maturity date and, thus, is classified as permanent equity. Holders of over 70% of the outstanding Series B Preferred Shares elected to participate in the recapitalization. Management believes the recapitalization will improve the -14-
Company's prospects for engaging in a larger financing, will assist FSC
as it applies to enter other state markets, and will be an impetus to the growth of the Company's business. Through the sharing of resources (primarily personnel) to minimize operating costs, the Company and its subsidiaries attempt to minimize operating expenses and preserve resources. Although FSC is now cash flow positive, the use of its assets and profits are restricted to its stand-alone operation by regulatory authority until its capital and surplus reserves reach more substantial levels. And while growth of the FSC business continues to provide additional cash flow to the Company's other subsidiaries, Jacobs and Triangle Surety, it is anticipated that working capital deficiencies will continue and will need to be met either through the raising of additional capital or borrowings. However, there can be no assurance that additional capital (or debt financing) will be available when and to the extent required or, if available, on terms acceptable to the Company. Accordingly, concerns as to the Company's ability to continue as a going concern are substantial. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
COMPARISON OF RESULTS OF OPERATIONS FOR FISCAL 2010 WITH 2009
The Company experienced a loss (after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock and equity preferred stock) of $2,713,193 in fiscal 2010 as compared with a loss of $3,057,687 (after accretion of mandatorily redeemable convertible preferred stock, including accrued dividends) in fiscal 2009.
REVENUES
Revenues in fiscal 2010 amounted to $1,371,783 as compared with $1,194,077 in fiscal 2009. The increase in revenues is largely attributable to new business acquired by FSC and increased investment holdings of FSC and gains on sales of those investment holdings. Revenue from the investment management segment, net of advisory referral fees,
was $262,635 in fiscal 2010 as compared with $233,297 in fiscal 2009, representing an increase of $29,337 . As investment advisory fees are based on the market value of assets under management, some fluctuation will occur due to overall market conditions. For the most part, however, such revenues will remain relatively constant from year to year with any large fluctuations being attributable to the growth or loss of assets under management. The increase in revenues is primarily attributable to growth in individually managed funds...
Revenue from the surety insurance segment, consisting of FSC and TSA,
was
$1,095,213 for fiscal 2010 as compared with $957,067 for fiscal 2009. Revenues attributable to the insurance segment are as follows:
Year Ended May 31, 2010 2009 --------------- --------------- Premiums and commissions $ 780,808 $ 660,222 Net investment income 273,577 288,747 Net realized investment gains 40,828 8,098 --------------- --------------- Total $ 1,095,213 $ 957,067 =============== =============== -15- Premium revenue is recognized ratably over the term of the policy period and thus is relatively stable from period to period with fluctuations for comparable periods generally reflecting the overall growth or loss of business. Whereas, commission revenue, which is dependent on the timing of issuance or renewal of bonds, is expected to be somewhat more "seasonable" from quarter-to-quarter with fluctuations for comparable periods largely reflecting the overall growth or loss of business. Commission income for the year ending 2010 was $11,900 compared to $13,349 for 2009. Investment income is expected to remain relatively consistent from period to period, but can fluctuate based on interest rates, market conditions, growth or loss of business, and investment funds expended in the payment of claims. The increase in revenues reflected above is attributable to increased surety business that has been secured in fiscal 2010. Gross premium written in fiscal 2010 amounted to $1,114,197 as compared to $905,519 and is reflective of the growth experienced in this segment of the business for the comparable periods. However, net premium written (written premium less deductions ceded reinsurance) in fiscal 2010 amounted to $728,938 as compared with $813,345 in fiscal 2009, due to a full year of ceded premium in 2010 compared to 2 months in 2009. Commission income earned for the placement of bonds with outside insurers has remained relatively stagnant. FSC's investment holdings in fiscal 2010 averaged $6.553 million as compared with $5.986 million for fiscal 2009, with investment yields decreasing slightly from 5.0% to 4.1%. EXPENSES Incurred policy losses represent the provision for loss and loss adjustment expense for "incurred but not reported" (IBNR) losses attributable to surety bonds issued by FSC. Incurred policy losses for fiscal 2010 have been recorded as $178,531 or 23.2% of earned premium as compared to $186,007 or 28.5% of earned premium for fiscal 2009. IBNR loss estimates have been based on industry averages adjusted for factors that are unique to the FSC's underwriting approach. As of May 31, 2010 FSC has not received any claims for losses on any bonds underwritten since business began in 2006, therefore its actuaries
have approved reducing the percentage of premiums reserved for IBNR due to this historical pattern.
Insurance policy acquisition costs represent charges to operations
for
underwriting, commissions and premium tax attributable to surety polices issued by FSC and are recognized ratably over the period in which premiums are earned. In fiscal 2010 such costs amounted to $249,478 or 32.4% of earned premium as compared with $152,964 or 23.5% in fiscal 2009. The increase of $96,514 in expenses is attributable to costs associated to the increase in gross premium written, while the increase as a percentage is attributable to reduced net premium earned after ceding of premium to reinsurers. General and administrative expenses for fiscal 2010 were $1,316,211 as compared with $1,564,224 for fiscal 2009, representing a decrease of $248,013 and are comprised of the following: -16- Year Ended May 31, 2010 2009 Difference ----------------
----------------- ------------
Salaries and related costs $ 710,750 $ 550,646 $ 160,104 General office expense 111,203 103,830 7,373 Legal and other professional fees 171,535 486,878 (315,343) Audit, accounting and related services 110,431 126,359 (15.928) Travel, meals and entertainment 49,214 58,589 (9,375) Other general and administrative 163,078
237,922 (74,844)
----------------
----------------- -------------
Total general and administrative $ 1,316,211 $
1,564,224 $ (248,013)
================
================= =============
Salaries and related costs, net of deferred internal policy acquisition costs, increased approximately $160,104 and are comprised of the following:
Year Ended May 31, 2010 2009 Difference ------------------ ------------------ --------------- Salaries and wages $ 469,341 $ 528,699 $ (59,358) Commissions 44,374 26,131 18,243 Payroll taxes 42,372 45,262 (2,890) Stock option expense 251,631 11,462 240,169 Fringe benefits 54,027 63,531 (9,504)
Key-man life insurance 54,994 57,522 (2,528) Deferred policy acquisition costs (205,989) (181,961) (24,028) ------------------
------------------ ----------------
Total salaries and related costs $ 710,750 $
550,646 $ 160,104
==================
================== ================
Decreases in salaries and wages relate to decreased staff and lower salary for staff replaced during the last month of 2009. The increase in stock option expense is attributable to the awarding of 10,000,000 shares of incentive stock options on June 30, 2009 . Group health benefits decreased slightly due to less employees being covered in 2010. Commissions increase due to a large number of new bonds being written in 2010.
The decrease in legal and professional fees of $315,343 is due to fewer resources expended in 2010 in the areas of acquisition and expansion.
Other less significant decreases were experienced in audit, travel and other general administrative expenses categories in fiscal 2010 as compared to fiscal 2009, also due to fewer resources expended in acquisition efforts.
Jacobs & Co. was the investment advisor to the Jacobs & Company Mutual Fund (the "Fund"). The Fund was initially established by Jacobs & Co. to provide
the ability to manage smaller accounts in a more efficient and diversified manner and provide an investment vehicle that would fit within the Company's broader business plan of issuing smaller bonds under its collateralized surety programs. The delays incurred by the Company in accomplishing a financing that would make possible the full implementation of the Company's business plan coupled with the -17- Fund's lackluster performance during the interim period contributed to a gradual decline in assets and the fixed cost maintenance of the Fund was a significant expense to the Company. The Fund's independent Board of Trustees had determined that unless the Fund experienced a significant growth in assets it would be necessary to liquidate the Fund. Growth in assets was not accomplished. As a result, the Board of Trustees directed the liquidation of the Fund's assets in November and the distribution of the proceeds to the Fund's shareholders on December 1, 2009 . While the Fund was responsible for its own operating expenses, Jacobs & Co. , as the investment advisor, had agreed to limit the Fund's aggregate annual operating expenses to 2% of the average net assets. Under this expense limitation agreement, Jacobs & Co. absorbed $75,038 of the Fund's operating expenses in 2010 as compared to $122,758 in 2009. Due to the Fund's liquidation, there were no revenues and minimal expenses attributable to the fund subsequent to December 1, 2009 . The cumulative reimbursement due the Fund by J&C as of May 31, 2010 was $54,866 .
GAIN ON EXTINGUISHMENT OF DEBT
During the year ended May 31, 2010 , the Company, upon advice of legal counsel, removed certain dormant accounts payable in the aggregate amount of $200,240 , based upon the conclusion that none of accounts represented an obligation that is legally enforceable against the Company. Such removal was recorded as a gain on debt extinguishment.
INTEREST EXPENSE AND INTEREST INCOME
Interest expense for fiscal 2010 was $956,973 as compared with $605,045 in fiscal 2009. The increase in interest expense is primarily attributable to the bridge-financing arrangement forbearance agreement and increased debt and stock issued as incentive for debt in 2010. Components of interest expense are comprised of the following: Year Ended May 31, 2010 2009 Difference
------------------ ------------------ --------------
Interest expense on bridge financing $ 583,829
$ 349,016 $ 234,813 Expense of common shares issued or to be issued in connection with bridge financing arrangements
233,683 149,738 83,945
Expense of common shares issued or to be issued in connection with issued debt
28,275 14,733 13,542 Interest expense on demand and term notes 102,046 77,460 24,586 Other finance charges 9,140 14,098 (4,958)
------------------ ------------------ ---------------
Total interest expense $ 956,973
$ 605,045 $ 351,928
================== ================== ===============
-18-
PREFERRED STOCK ACCRETION AND DIVIDENDS
Accretion of mandatorily redeemable convertible preferred stock is comprised of accretion of discount and accrued but unpaid dividends on preferred stock as follows: Year Ended May 31, 2010 2009 ----------------- ---------------- Accretion of discount $ 273,369 $ 567,811
Accrued dividends - mandatorily redeemable
preferred stock 607,706
1,041,499
Accrued dividends - equity preferred stock 374,662
- ----------------- ---------------- $ 1,255,737 $ 1,609,310 ================= ================
The Series B class of stock is treated as a liability as of November 30, 2009 when the majority was exchanged for Series C equity stock. Therefore, accretion of $86,932 and dividends of $155,708 associated with the Series B after that date are deductions from net income and not included in the table above.
The
decrease in the accretion of discount results from this exclusion of Series B subsequent to November 30, 2009 as well as the application of the interest or constant yield method to the initial discount recorded with respect to the mandatorily redeemable preferred stock over a period of five years from the date of issuance of the stock. Series C equity stock accrues dividends at the same rate as the Series B it was exchanged for, however it is separated in the
table above due to Series C not being mandatorily redeemable. Series C does not accrete.
OFF BALANCE SHEET ARRANGEMENTS
The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Edgar Online "Glimpses "
During fiscal 2010, the Company has focused its primary efforts on the development and marketing of its surety business in West Virginia and Ohio , arranging reinsurance and other potential strategic relationships that will accelerate the progression of the Company's business plan, and, raising additional capital to increase the capital base of its insurance subsidiary, First Surety Corporation (FSC), to facilitate entry into other state markets. RESULTS OF OPERATIONS AND FINANCIAL CONDITION AS OF AND FOR THE YEAR ENDED MAY 31, 2010 RESULTS OF OPERATIONS The Company experienced a loss (after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock and equity preferred stock) of $2,713,193 in fiscal 2010 as compared with a loss (after accretion of mandatorily redeemable convertible preferred stock, including accrued dividends) of $3,057,687 in fiscal 2009. While total revenues increased from approximately $1,194,000 in fiscal 2009 to approximately $1,372,000 in fiscal 2010, total operating expenses decreased from approximately $2,039,000 in fiscal 2009 to approximately $1,830,000 in fiscal 2010, resulting in a decrease in the loss from operations of approximately $386,000 . The increase in revenues is largely attributable to new business acquired by FSC and increased investment holdings and the gain on sales of investments of FSC. The decrease in expenses is attributable to decreased general and administrative expense related to reduction in professional legal fees incurred in the Company's pending acquisition agreements and ongoing efforts to raise additional capital to expand its business and penetrate new markets. Interest expense increased from approximately $605,000 in fiscal 2009 to approximately $957,000 in fiscal 2010. This was mainly due to additional borrowings incurred in relation to the Company's efforts to raise additional capital financing and to provide financing of current operations, as well as the increased expense of common shares issued in connection with bridge loans and other financing arrangements, and the higher interest rate on bridge loans due to the forbearance agreement. In the twelve-month period ending May 31, 2010 , the Company, upon advice of legal counsel, removed certain dormant accounts payable in the aggregate amount of $200,240 based upon the conclusion that none of the accounts represented an obligation that is legally enforceable against the Company. Such removal was recorded as a gain on debt extinguishment. -8-
CAPITAL RESOURCES AND FINANCIAL CONDITION
MANDATORILY REDEEMABLE PREFERRED STOCK
In conjunction with the acquisition of FSC at December 31, 2005 , a restructuring of the Company's financing was accomplished through the private placement of 350 shares of Series A Preferred stock and 3,980 shares of Series B Preferred stock, each accompanied by warrants to acquire common stock of the Company in exchange for cash totaling $3,335,000 . $2,860,000 was used in the acquisition and funding of the insurance subsidiary, with the remaining funds used to pay expenses attributable to the acquisition and the funding of on-going operations. Additionally, approximately $3,668,000 of indebtedness of the Company
was
converted into preferred stock and warrants reducing the Company's borrowings under short-term financing arrangements to approximately $167,000 as of December 30, 2005 . The Series A designation was designed for issuance to principals desiring surety bonds under FSC's partially collateralized bonding programs. As designed, proceeds from the sale of Series A preferred stock is down-streamed to FSC to increase its capital and insurance capacity, although to the extent that proceeds from the sale of Series B preferred shares was used in the initial acquisition and funding of FSC, the Company was allowed to use such proceeds to redeem Series B preferred stock (Company option to redeem) or for funding of on-going operations. Effective June 1, 2007 , the Company agreed to
the
requirement of the West Virginia Insurance Department to downstream all future proceeds from sales of Series A preferred stock in order to increase capital and reserves of the insurance subsidiary to more substantial levels. The Series A designation contains a conditional redemption feature providing for the redemption of the Series A shares at any time after the seventh (7th) anniversary of the Issue Date, provided that the principal no longer requires surety bonds issued by FSC. Furthermore, once redeemed, the principal will no longer be eligible to participate in partially collateralized bonding programs offered by FSC. Surety bonds currently being issued by FSC are primarily for coal mining and reclamation permits, which are long-term in nature
and
continually evolving whereby outstanding bonds are periodically released as properties are mined and reclaimed and new bonds issued for properties to be mined in the future. Accordingly, this source of financing was designed to be long-term by nature. The Series B designation was designed for issuance to investors in JFG and contains both conversion rights to common stock and redemption features. Each share of the Series B preferred stock is convertible, at the option of the holder, into 1,000 shares of JFG common stock and can be converted at any time. Additionally, the Series B preferred stock can be redeemed, at the option of the holder, at full-face value plus accrued and unpaid cumulative dividends, commencing with the fifth (5th) anniversary of the original issue date.
The
Company has the option to redeem the Series B preferred shares at any time after the first (1st) anniversary of the original issue date, subject to the holder choosing to exercise conversion privileges prior to the stated redemption date. Management's ability to execute its business plan and increase the market value of its common stock will largely determine whether the Series B preferred shares are converted to common shares or eventually redeemed. As an inducement to the initial preferred stock shareholders, warrants to purchase 45,402,996 shares of common stock at an exercise price of one-tenth of one cent ($.001) per share were issued with a five-year expiration period. Such warrants were valued at approximately $533,000 using the Black-Scholes pricing model. Additionally, the Series B preferred shares were issued at a twenty-five -9- percent (25%) discount to the stated face value of $1,000 per share or approximately $2,217,650 in total. Additional shares of the Series B were subsequently sold at a discount of approximately four and one-half percent (4.5%) or approximately $36,000 . In November 2009 , as a means of alleviating obligations associated with the Company's Series B Preferred Stock, which by its terms matures at the end of 2010, management proposed a recapitalization to assist in stabilizing
the
financial position of the Company. The Board deemed it advisable to designate a Series C Preferred Stock, with 10,000 authorized shares. The Recapitalization consisted of the exchange of 6,804.936 Series B Shares for a combination of Series C Shares and Common Stock Shares. For each Series B Share,
the
participating holder received (i) one Series C Share and (ii) 2,000 shares of JFG Common Stock. The accumulated dividend rights and preferences associated with the Series B Shares transferred undiminished to the corresponding Series C Shares. This exchange amounted to $6,269,051 of carrying value of Series B stock being exchanged for Series C and Common Stock. 13,609,872 shares of Common Stock were issued to the Series C Stock holders at the rate of 2,000 Common shares for each exchanged Series B Stock, with the related cost associated with the Common issuance offsetting the Series C carrying value by $265,120 . The shares were valued at approximately $.01948 per share based on the average quoted closing price of the Company's stock for the 20-day period proceeding the date of the transaction. Series C stock may be redeemed by the Company but does not have a fixed maturity date and is considered permanent equity. Holders of over 70% of the outstanding Series B Preferred Shares elected to participate in the recapitalization. The carrying value of the Series B Preferred Shares that did not convert are listed in the Liabilities section of the Balance Sheet,
and
therefore the accretion and dividends associated with the Series B stock after November 30, 2009 are deductions from net income. The remaining Series B shares are continuing to be accreted from carrying value to the face amount for the 5 year period from the date of issuance. Series C stock has no accretion.
The
recorded values of the Series A preferred stock is being increased to their stated liquidation values using the interest method over a period of five years and such amounts are categorized as accretion of mandatorily redeemable preferred stock in the consolidated statement of operations. The Series A designation is entitled to receive cumulative dividends at the rate of 4.00% per annum and the Series B and Series C designations are entitled to receive cumulative dividends at the rate of 8.00% per annum, with the Series A, B and C designations having equal ranking and preference as to dividends and liquidation rights and in priority to the Company's common stockholders.
The
accrued (but undeclared) dividends associated with the Series C exchange amounted to $2,295,624 and are included in the total amount exchanged for Series C Shares. Unlike the Series B Shares with their fixed maturity date, the Series C Shares are permanent equity, with accruing dividends only increasing the preference amount that must be satisfied before junior securities may participate in dividends or on liquidation. Accordingly, the effect of the accrual of dividends with respect to the Series C Shares on the Company's balance sheet is to increase the aggregate claim of the Series C Shares on the equity of the corporation and to increase the deficit in common equity, while having no effect on the net equity of the corporation as a whole. The entitlement of the Series C Shares to a priority in relation to junior securities with respect to dividends and on liquidation does not create an obligation by the Company and therefore no liability is recorded until the dividends are declared by the Board of the Company. The Series C Shares are pari passu with the Series A Shares and Series B Shares and no dividends or other distributions will be paid upon Common Shares or any other class of Shares that is junior in priority to the Series C Shares while dividends are in arrears. At this time, management has chosen to
defer -10-
payment of dividends to the holders of the Series A, B and C Preferred Shares until the Company has sufficient cash flow from operations to service
the obligation.
BRIDGE-FINANCING, COMMITMENTS AND MATERIAL AGREEMENTS
Of primary importance to the Company's ability to fully implement its business plan is the expansion of that business into additional states. Regulatory approval and licensing is required for each state where FSC seeks to conduct business. Management found entry into additional states (as a surety)
was
proving difficult without the benefit of more substantial capital and reserves due to FSC's status as a recent entry into this market. Accordingly, management began pursuing avenues that would provide additional capital to facilitate such expansion. Beginning in fiscal 2008 and completed during the first quarter of fiscal 2009, the Company obtained two rounds of bridge financing totaling an aggregate of $3,500,000 . The purpose of the financing was to pay expenses of operations
and
to pay fees and expenses incurred or expected to be incurred in connection with a larger permanent financing and, in addition, to increase the capital surplus of FSC to make possible the reactivation of FSC's surety license in the state of Ohio . The terms of the bridge-financing arrangement provide for payment in full upon consummation by the Company of a qualified equity offering providing net proceeds of at least $15 million on or before September 10, 2013 ; and because such a qualified equity offering was not consummated by September 10, 2008 , accrued interest-to-date was payable, and quarterly installments of principal and interest became payable over five years commencing in December 2008 . The interest rates on such notes were fixed at 10.00%. Payments due December 2008 and March 2009 were not made by the Company as scheduled, but a forbearance agreement was subsequently entered into with the bridge lenders on June 5, 2009 , modifying payment terms to cure the default (including increasing the interest rate on the loans to 17%), issuing additional common stock to the loan holders, and pledging the stock of the Company's subsidiary, CMW, as security
for
repayment of the loans. The modification required the Company to pay interest of $224,515 on june 10, 2009 and increase the quarterly payments by $67,185 (to a total of $291,700 ) for eight consecutive quarters beginning September 10, 2009 to satisfy the arrearage. Although the Company has failed to make the payment that was due September 10, 2009 and the payments that were due in the ensuing quarters, management has remained in close contact with the bridge lenders, providing reports regarding its efforts to refinance or otherwise repay the bridge loans. To date, none of the bridge lenders has elected to pursue legal remedies. Certain equity inducements in the form of common stock of the Company were provided under the terms of the bridge loan documents. Upon issuance of the bridge notes, an aggregate of 7% of the outstanding common stock of the Company was issued to the bridge lenders. Upon retirement of the notes upon consummation of a qualified equity offering, the Company will issue to the bridge lenders a percentage of the outstanding common stock of the Company which, when added to the stock initially issued, may equal as much as 28% of the common stock of the Company that would otherwise have been retained by the holders of the Company's common shares immediately prior to the financing. Finally, because a qualified financing was not completed by September 10, 2008 , the Company was required to issue to the bridge lenders under the terms of the loan documents a total of 2.8% of the Company's outstanding common shares at such date. An additional 2.8% of the Company's outstanding common shares are required to be issued upon each six-month anniversary date thereof until retirement of the notes. -11- RESTRICTIONS ON USE OF ASSETS Regulatory approval of the acquisition of FSC by JFG was provided under the condition that no dividends or monies are to be paid to JFG from FSC without regulatory approval. Accordingly, cash, marketable investments, and other receivables held by FSC are restricted from use to fund operations or meet cash needs outside of the insurance company's domain. As of May 31, 2010 , such assets amounted to approximately $6.96 million .
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
INVESTMENTS
Management believes the Company has the ability to hold all fixed income securities to maturity. However, during the current fiscal year, the Company determined it may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company reclassified all of its fixed income securities (bonds) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders' equity as a separate component of accumulated other comprehensive income. INSURANCE PREMIUMS Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis. Insurance premium receivables are presented net of an estimated allowance for doubtful accounts, which is based on a periodic evaluation of the aging and collectability of premium receivables.
DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, are deferred and amortized as a charge to income as the related premiums are earned. The Company periodically tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to income is taken and the deferred policy acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs.
INTANGIBLE ASSETS
In exchange for the purchase price of $2.9 million for the acquisition of FSC, the Company received cash and investments held by FSC totaling $2.75 million , with the difference being attributed to the property and casualty licenses of FSC in the states of West Virginia, Ohio and Indiana . Such licenses have indefinite lives and are evaluated annually for recoverability and impairment loss. Impairment loss, if any, is measured by estimating future cash flows -12- attributable to such assets based on forecasts and projections and comparing such discounted cash flow amounts to the carrying value of the asset. Should actual results differ from such forecasts and projections, such assets may be subject to future impairment charges.
RESERVE FOR LOSSES AND LOSS EXPENSES
Reserves for unpaid losses and loss adjustment expenses of the insurance subsidiary are estimated using individual case-basis valuations in conjunction with estimates derived from industry and company experience. FSC has experienced no claims for losses as of May 31, 2010 . FSC is currently licensed to write coal permit and miscellaneous fixed-liability limit surety bonds in West Virginia and Ohio . Coal permit bonds are required by regulatory agencies to assure the reclamation of land that has been disturbed by mining operations, and accordingly, is a highly regulated process by federal and state agencies. Such bonds are generally long-term in nature with mining operations and reclamation work being conducted in unison as the property is mined. Additionally, no two principals and properties are alike due to varied company structures and unique geography and geology of each site. In underwriting coal reclamation bonds, management obtains estimates of costs to reclaim the properties in accordance with the specifications of the mining permit, prepared by independent outside professionals experienced in this field of work. Such estimates are then periodically updated and compared with marketable securities pledged, and held for the benefit of FSC as collateral for the surety bond, to mitigate the exposure to significant loss. Should the principal default in its obligation to reclaim the property as specified in the mining permit, FSC would then use the funds held in the collateral account to reclaim the property or forfeit the face amount of the surety bond. Losses can occur if the costs of reclamation exceed the estimates obtained at the time the bond was underwritten or upon subsequent re-evaluations, if sufficient collateral is not obtained, or if the collateral held has experienced significant deterioration in value and if FSC is not otherwise able to recover under its contractual rights to indemnification. Miscellaneous fixed-liability limit surety bonds are generally fully collateralized by the principal's cash investment into a collateral investment account, managed by the Company's investment advisory subsidiary ( Jacobs & Co. ) that mitigates FSC's exposure to loss. Losses can occur should the principal default on the performance required by the bond and the collateral held in the investment account experience deterioration in value. In establishing its reserves for losses and loss adjustment expense, management continually reviews its exposure to loss based on reports provided in conjunction with the periodic monitoring and inspections performed along with industry averages and historical experience. Management has estimated such losses based on industry experience, adjusted for factors that are unique to the Company's approach, and in consultation with consulting actuaries experienced in the surety field. LIQUIDITY AND GOING CONCERN The Company has experienced operating losses (after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock and equity preferred stock) of approximately $2,713,000 and $3,058,000 for the fiscal years ended May 31, 2010 and 2009, respectively. Despite increased revenue and the continued decline of operating -13- expenses, the Company has not been able to pay certain amounts due to
professionals and others and continues to be unable to pay its preferred stock dividend obligation, certain payroll taxes and withholdings from 2009, and to cure its defaults in certain quarterly payments due its bridge-financing lenders. A substantial portion of the Company's cash flow is generated by its
insurance subsidiary and is subject to certain withdrawal restrictions. While management expects revenue growth and cash flow to increase significantly as its business plan is fully implemented, it is anticipated that losses will continue and the Company will be cash constrained until FSC is able to develop a substantial book of business. Effective April 1, 2009 , FSC entered into a reinsurance agreement with Lloyd's of London for its coal reclamation surety bonding programs. This agreement has provided additional bonding capacity to FSC and has enabled FSC to write more bonds and of greater size for its coal reclamation bonding clients. Management expects this reinsurance arrangement to continue FSC's expansion of market share and to result in increased cash flow for each of the Company's operating subsidiaries. Expansion of FSC's business to other states is a key component to fully
implementing the Company's business plan. In fiscal 2009, the Company was able to increase the capital of FSC and reactivate FSC's insurance license in Ohio and obtain authority to issue surety bonds in that state. However, management has found that entry into other states (as a surety) has been difficult without the benefit of more substantial capital and reserves due to FSC's status as a recent entry into this market and the financial condition of the Company. This is the case notwithstanding the reinsurance agreement entered into by FSC with Lloyd's of London and the resulting increase in bonding capacity. Management believes that if FSC's capital and surplus reserves were significantly more substantial and the financial condition of the Company was stabilized, entry into other states would be less challenging. Accordingly, management continues to pursue avenues that can provide additional capital to increase the capacity of its insurance subsidiary and to fund continuing operations as the business is being fully developed. In addition, as an alternative means of addressing access to markets, management is seeking to establish a relationship with any one of several possible sureties that are licensed in those states other than West Virginia and Ohio that comprise significant markets for the bonding programs of FSC and could issue surety bonds that are underwritten and reinsured by FSC. Under such a "fronting" arrangement, the need for additional capital at the level of FSC to facilitate entry to other state markets would become secondary, since the payment of a fronting fee to the insurance company with active licenses would provide access to the state market without formal entry. As a means of alleviating obligations associated with the Company's Series B Preferred Stock, which by its terms matures at the end of 2010, management proposed a recapitalization to assist in stabilizing the financial position of the Company. Holders of the Series B Preferred Stock were offered
the
opportunity to exchange their Series B Shares for an equal number of shares of a new series of JFG preferred stock designated as Series C Preferred Stock plus 2,000 shares of JFG Common Stock. Series C Preferred Stock is equal in priority to the Series B Preferred Stock, is entitled to dividends at the same rate as Series B Preferred Stock, is entitled to convert to common stock of the Company at a conversion rate of $.10 per common share (in contrast to $1.00 per share for Series B Preferred) and may be redeemed by the Company but does not have a fixed maturity date and, thus, is classified as permanent equity. Holders of over 70% of the outstanding Series B Preferred Shares elected to participate in the recapitalization. Management believes the recapitalization will improve the -14-
Company's prospects for engaging in a larger financing, will assist FSC
as it applies to enter other state markets, and will be an impetus to the growth of the Company's business. Through the sharing of resources (primarily personnel) to minimize operating costs, the Company and its subsidiaries attempt to minimize operating expenses and preserve resources. Although FSC is now cash flow positive, the use of its assets and profits are restricted to its stand-alone operation by regulatory authority until its capital and surplus reserves reach more substantial levels. And while growth of the FSC business continues to provide additional cash flow to the Company's other subsidiaries, Jacobs and Triangle Surety, it is anticipated that working capital deficiencies will continue and will need to be met either through the raising of additional capital or borrowings. However, there can be no assurance that additional capital (or debt financing) will be available when and to the extent required or, if available, on terms acceptable to the Company. Accordingly, concerns as to the Company's ability to continue as a going concern are substantial. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
COMPARISON OF RESULTS OF OPERATIONS FOR FISCAL 2010 WITH 2009
The Company experienced a loss (after accretion of mandatorily redeemable convertible preferred stock, and accrued dividends on mandatorily redeemable preferred stock and equity preferred stock) of $2,713,193 in fiscal 2010 as compared with a loss of $3,057,687 (after accretion of mandatorily redeemable convertible preferred stock, including accrued dividends) in fiscal 2009.
REVENUES
Revenues in fiscal 2010 amounted to $1,371,783 as compared with $1,194,077 in fiscal 2009. The increase in revenues is largely attributable to new business acquired by FSC and increased investment holdings of FSC and gains on sales of those investment holdings. Revenue from the investment management segment, net of advisory referral fees,
was $262,635 in fiscal 2010 as compared with $233,297 in fiscal 2009, representing an increase of $29,337 . As investment advisory fees are based on the market value of assets under management, some fluctuation will occur due to overall market conditions. For the most part, however, such revenues will remain relatively constant from year to year with any large fluctuations being attributable to the growth or loss of assets under management. The increase in revenues is primarily attributable to growth in individually managed funds...
Revenue from the surety insurance segment, consisting of FSC and TSA,
was
$1,095,213 for fiscal 2010 as compared with $957,067 for fiscal 2009. Revenues attributable to the insurance segment are as follows:
Year Ended May 31, 2010 2009 --------------- --------------- Premiums and commissions $ 780,808 $ 660,222 Net investment income 273,577 288,747 Net realized investment gains 40,828 8,098 --------------- --------------- Total $ 1,095,213 $ 957,067 =============== =============== -15- Premium revenue is recognized ratably over the term of the policy period and thus is relatively stable from period to period with fluctuations for comparable periods generally reflecting the overall growth or loss of business. Whereas, commission revenue, which is dependent on the timing of issuance or renewal of bonds, is expected to be somewhat more "seasonable" from quarter-to-quarter with fluctuations for comparable periods largely reflecting the overall growth or loss of business. Commission income for the year ending 2010 was $11,900 compared to $13,349 for 2009. Investment income is expected to remain relatively consistent from period to period, but can fluctuate based on interest rates, market conditions, growth or loss of business, and investment funds expended in the payment of claims. The increase in revenues reflected above is attributable to increased surety business that has been secured in fiscal 2010. Gross premium written in fiscal 2010 amounted to $1,114,197 as compared to $905,519 and is reflective of the growth experienced in this segment of the business for the comparable periods. However, net premium written (written premium less deductions ceded reinsurance) in fiscal 2010 amounted to $728,938 as compared with $813,345 in fiscal 2009, due to a full year of ceded premium in 2010 compared to 2 months in 2009. Commission income earned for the placement of bonds with outside insurers has remained relatively stagnant. FSC's investment holdings in fiscal 2010 averaged $6.553 million as compared with $5.986 million for fiscal 2009, with investment yields decreasing slightly from 5.0% to 4.1%. EXPENSES Incurred policy losses represent the provision for loss and loss adjustment expense for "incurred but not reported" (IBNR) losses attributable to surety bonds issued by FSC. Incurred policy losses for fiscal 2010 have been recorded as $178,531 or 23.2% of earned premium as compared to $186,007 or 28.5% of earned premium for fiscal 2009. IBNR loss estimates have been based on industry averages adjusted for factors that are unique to the FSC's underwriting approach. As of May 31, 2010 FSC has not received any claims for losses on any bonds underwritten since business began in 2006, therefore its actuaries
have approved reducing the percentage of premiums reserved for IBNR due to this historical pattern.
Insurance policy acquisition costs represent charges to operations
for
underwriting, commissions and premium tax attributable to surety polices issued by FSC and are recognized ratably over the period in which premiums are earned. In fiscal 2010 such costs amounted to $249,478 or 32.4% of earned premium as compared with $152,964 or 23.5% in fiscal 2009. The increase of $96,514 in expenses is attributable to costs associated to the increase in gross premium written, while the increase as a percentage is attributable to reduced net premium earned after ceding of premium to reinsurers. General and administrative expenses for fiscal 2010 were $1,316,211 as compared with $1,564,224 for fiscal 2009, representing a decrease of $248,013 and are comprised of the following: -16- Year Ended May 31, 2010 2009 Difference ----------------
----------------- ------------
Salaries and related costs $ 710,750 $ 550,646 $ 160,104 General office expense 111,203 103,830 7,373 Legal and other professional fees 171,535 486,878 (315,343) Audit, accounting and related services 110,431 126,359 (15.928) Travel, meals and entertainment 49,214 58,589 (9,375) Other general and administrative 163,078
237,922 (74,844)
----------------
----------------- -------------
Total general and administrative $ 1,316,211 $
1,564,224 $ (248,013)
================
================= =============
Salaries and related costs, net of deferred internal policy acquisition costs, increased approximately $160,104 and are comprised of the following:
Year Ended May 31, 2010 2009 Difference ------------------ ------------------ --------------- Salaries and wages $ 469,341 $ 528,699 $ (59,358) Commissions 44,374 26,131 18,243 Payroll taxes 42,372 45,262 (2,890) Stock option expense 251,631 11,462 240,169 Fringe benefits 54,027 63,531 (9,504)
Key-man life insurance 54,994 57,522 (2,528) Deferred policy acquisition costs (205,989) (181,961) (24,028) ------------------
------------------ ----------------
Total salaries and related costs $ 710,750 $
550,646 $ 160,104
==================
================== ================
Decreases in salaries and wages relate to decreased staff and lower salary for staff replaced during the last month of 2009. The increase in stock option expense is attributable to the awarding of 10,000,000 shares of incentive stock options on June 30, 2009 . Group health benefits decreased slightly due to less employees being covered in 2010. Commissions increase due to a large number of new bonds being written in 2010.
The decrease in legal and professional fees of $315,343 is due to fewer resources expended in 2010 in the areas of acquisition and expansion.
Other less significant decreases were experienced in audit, travel and other general administrative expenses categories in fiscal 2010 as compared to fiscal 2009, also due to fewer resources expended in acquisition efforts.
Jacobs & Co. was the investment advisor to the Jacobs & Company Mutual Fund (the "Fund"). The Fund was initially established by Jacobs & Co. to provide
the ability to manage smaller accounts in a more efficient and diversified manner and provide an investment vehicle that would fit within the Company's broader business plan of issuing smaller bonds under its collateralized surety programs. The delays incurred by the Company in accomplishing a financing that would make possible the full implementation of the Company's business plan coupled with the -17- Fund's lackluster performance during the interim period contributed to a gradual decline in assets and the fixed cost maintenance of the Fund was a significant expense to the Company. The Fund's independent Board of Trustees had determined that unless the Fund experienced a significant growth in assets it would be necessary to liquidate the Fund. Growth in assets was not accomplished. As a result, the Board of Trustees directed the liquidation of the Fund's assets in November and the distribution of the proceeds to the Fund's shareholders on December 1, 2009 . While the Fund was responsible for its own operating expenses, Jacobs & Co. , as the investment advisor, had agreed to limit the Fund's aggregate annual operating expenses to 2% of the average net assets. Under this expense limitation agreement, Jacobs & Co. absorbed $75,038 of the Fund's operating expenses in 2010 as compared to $122,758 in 2009. Due to the Fund's liquidation, there were no revenues and minimal expenses attributable to the fund subsequent to December 1, 2009 . The cumulative reimbursement due the Fund by J&C as of May 31, 2010 was $54,866 .
GAIN ON EXTINGUISHMENT OF DEBT
During the year ended May 31, 2010 , the Company, upon advice of legal counsel, removed certain dormant accounts payable in the aggregate amount of $200,240 , based upon the conclusion that none of accounts represented an obligation that is legally enforceable against the Company. Such removal was recorded as a gain on debt extinguishment.
INTEREST EXPENSE AND INTEREST INCOME
Interest expense for fiscal 2010 was $956,973 as compared with $605,045 in fiscal 2009. The increase in interest expense is primarily attributable to the bridge-financing arrangement forbearance agreement and increased debt and stock issued as incentive for debt in 2010. Components of interest expense are comprised of the following: Year Ended May 31, 2010 2009 Difference
------------------ ------------------ --------------
Interest expense on bridge financing $ 583,829
$ 349,016 $ 234,813 Expense of common shares issued or to be issued in connection with bridge financing arrangements
233,683 149,738 83,945
Expense of common shares issued or to be issued in connection with issued debt
28,275 14,733 13,542 Interest expense on demand and term notes 102,046 77,460 24,586 Other finance charges 9,140 14,098 (4,958)
------------------ ------------------ ---------------
Total interest expense $ 956,973
$ 605,045 $ 351,928
================== ================== ===============
-18-
PREFERRED STOCK ACCRETION AND DIVIDENDS
Accretion of mandatorily redeemable convertible preferred stock is comprised of accretion of discount and accrued but unpaid dividends on preferred stock as follows: Year Ended May 31, 2010 2009 ----------------- ---------------- Accretion of discount $ 273,369 $ 567,811
Accrued dividends - mandatorily redeemable
preferred stock 607,706
1,041,499
Accrued dividends - equity preferred stock 374,662
- ----------------- ---------------- $ 1,255,737 $ 1,609,310 ================= ================
The Series B class of stock is treated as a liability as of November 30, 2009 when the majority was exchanged for Series C equity stock. Therefore, accretion of $86,932 and dividends of $155,708 associated with the Series B after that date are deductions from net income and not included in the table above.
The
decrease in the accretion of discount results from this exclusion of Series B subsequent to November 30, 2009 as well as the application of the interest or constant yield method to the initial discount recorded with respect to the mandatorily redeemable preferred stock over a period of five years from the date of issuance of the stock. Series C equity stock accrues dividends at the same rate as the Series B it was exchanged for, however it is separated in the
table above due to Series C not being mandatorily redeemable. Series C does not accrete.
OFF BALANCE SHEET ARRANGEMENTS
The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
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