-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, J+pCCajkIyM40Ct6xagpWoPuZivT4aG2y3Zzl7n2E3V97SfDgRfuSZZQYHRfgVeF zqgY/iCf7piV1NuzGOJmPQ== 0000950116-03-002723.txt : 20030515 0000950116-03-002723.hdr.sgml : 20030515 20030515164411 ACCESSION NUMBER: 0000950116-03-002723 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20030331 FILED AS OF DATE: 20030515 FILER: COMPANY DATA: COMPANY CONFORMED NAME: AMERICAN BUSINESS FINANCIAL SERVICES INC /DE/ CENTRAL INDEX KEY: 0000772349 STANDARD INDUSTRIAL CLASSIFICATION: MORTGAGE BANKERS & LOAN CORRESPONDENTS [6162] IRS NUMBER: 870418807 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-14268 FILM NUMBER: 03705596 BUSINESS ADDRESS: STREET 1: 111 PRESIDENTIAL BLVD STREET 2: STE 215 CITY: BALA CYNWYD STATE: PA ZIP: 19004 BUSINESS PHONE: 6106682440 MAIL ADDRESS: STREET 1: 111 PRESIDENTIAL BLVD STE 215 CITY: BALA CYNWYD STATE: PA ZIP: 19004 FORMER COMPANY: FORMER CONFORMED NAME: GERIACO INTERNATIONAL INC /DE/ DATE OF NAME CHANGE: 19930308 FORMER COMPANY: FORMER CONFORMED NAME: KINGSWAY ENTERPRISES INC DATE OF NAME CHANGE: 19860327 10-Q 1 form10-q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2003 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________ to ________________ Commission File No. 000-22474 AMERICAN BUSINESS FINANCIAL SERVICES, INC. ------------------------------------------------ (Name of registrant as specified in its charter) Delaware 87-0418807 -------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 111 Presidential Boulevard, Bala Cynwyd, PA 19004 --------------------------------------------------- (Address of principal executive offices) (zip code) (610) 668-2440 -------------- (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the 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. [X] YES [ ] NO Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [ ] YES [ X] NO The number of shares outstanding of the Registrant's sole class of common stock as of May 12, 2003 was 2,942,764 shares. American Business Financial Services, Inc. and Subsidiaries INDEX
Page ---- PART I FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets as of March 31, 2003 and June 30, 2002...............................................1 Consolidated Statements of Income for the three and nine months ended March 31, 2003 and 2002....................2 Consolidated Statement of Stockholders' Equity for the nine months ended March 31, 2003..........................3 Consolidated Statements of Cash Flow for the nine months ended March 31, 2003 and 2002...........................4 Notes to Consolidated Financial Statements.......................................................................6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................23 Item 3. Quantitative and Qualitative Disclosure about Market Risk..............................................80 Item 4. Controls and Procedures................................................................................80 PART II OTHER INFORMATION Item 1. Legal Proceedings......................................................................................81 Item 2. Changes in Securities..................................................................................82 Item 3. Defaults Upon Senior Securities........................................................................82 Item 4. Submission of Matters to a Vote of Security Holders....................................................82 Item 5. Other Information......................................................................................82 Item 6. Exhibits and Reports on Form 8-K.......................................................................82
Part I FINANCIAL INFORMATION Item 1. Financial Statements American Business Financial Services, Inc. and Subsidiaries Consolidated Balance Sheets (dollars in thousands)
March 31, June 30, 2003 2002 ----------- ----------- (Unaudited) (Note) Assets Cash and cash equivalents $ 87,232 $ 108,599 Loan and lease receivables, net Available for sale 52,651 52,622 Interest and fees 14,154 12,292 Other 21,254 9,028 Interest-only strips (includes the fair value of overcollateralization related cash flows of $290,650 and $236,629 at March 31, 2003 and June 30, 2002) 609,891 512,611 Servicing rights 132,925 125,288 Prepaid expenses 3,584 3,640 Receivable for sold loans - 5,055 Property and equipment, net 18,092 18,446 Other assets 33,156 28,794 ----------- ----------- Total assets $ 972,939 $ 876,375 =========== =========== Liabilities Subordinated debt $ 710,218 $ 655,720 Warehouse lines and other notes payable 6,782 8,486 Accrued interest payable 45,513 43,069 Accounts payable and accrued expenses 21,268 13,690 Deferred income taxes 38,898 35,124 Other liabilities 73,033 50,908 ----------- ----------- Total liabilities 895,712 806,997 ----------- ----------- Stockholders' equity Preferred stock, par value $.001, authorized, 3,000,000 shares at March 31, 2003 and 1,000,000 shares at June 30, 2002, issued and outstanding, none - - Common stock, par value $.001, authorized, 9,000,000 shares, issued: 3,653,037 shares at March 31, 2003 and 3,645,192 shares at June 30, 2002 (including Treasury shares of 710,273 at March 31, 2003 and 801,823 at June 30, 2002) 4 4 Additional paid-in capital 23,985 23,985 Accumulated other comprehensive income 15,442 11,479 Retained earnings 47,411 47,968 Treasury stock, at cost (9,015) (13,458) ----------- ----------- 77,827 69,978 Note receivable (600) (600) ----------- ----------- Total stockholders' equity 77,227 69,378 ----------- ----------- Total liabilities and stockholders' equity $ 972,939 $ 876,375 =========== ===========
Note: The balance sheet at June 30, 2002 has been derived from the audited financial statements at that date. See accompanying notes to consolidated financial statements. 1 American Business Financial Services, Inc. and Subsidiaries Consolidated Statements of Income (amounts in thousands, except per share data) (unaudited)
Three Months Ended Nine Months Ended March 31, March 31, ---------------------------- ----------------------------- 2003 2002 2003 2002 ----------- ------------ ------------ ---------- Revenues Gain on sale of loans $ 54,504 $ 49,220 $ 170,394 $ 129,139 Interest and fees 4,661 5,292 13,422 16,759 Interest accretion on interest-only strips 12,114 9,538 34,361 25,920 Servicing income 486 1,282 2,667 4,216 Other income 1 103 7 107 ----------- ------------ ------------ ---------- Total revenues 71,766 65,435 220,851 176,141 ----------- ------------ ------------ ---------- Expenses Interest 16,824 17,191 51,057 51,467 Provision for credit losses 1,718 1,728 4,692 4,434 Employee related costs 9,418 9,467 29,965 25,953 Sales and marketing 6,963 6,498 20,136 18,937 General and administrative 26,157 18,824 74,890 52,589 Securitization assets valuation adjustment 10,657 8,691 33,303 13,153 ----------- ------------ ------------ ---------- Total expenses 71,737 62,399 214,043 166,533 ----------- ------------ ------------ ---------- Income before provision for income taxes 29 3,036 6,808 9,608 Provision (benefit) for income taxes (192) 1,275 2,655 4,035 ----------- ------------ ------------ ---------- Net Income $ 221 $ 1,761 $ 4,153 $ 5,573 =========== ============ ============ ========== Earnings per common share: Basic $ 0.07 $ 0.58 $ 1.43 $ 1.88 =========== ============ ============ ========== Diluted $ 0.06 $ 0.55 $ 1.36 $ 1.74 =========== ============ ============ ========== Average common shares: Basic 2,941 2,844 2,909 2,963 =========== ============ ============ ========== Diluted 3,103 3,034 3,043 3,202 =========== ============ ============ ==========
See accompanying notes to consolidated financial statements. 2 American Business Financial Services, Inc. and Subsidiaries Consolidated Statement of Stockholders' Equity (amounts in thousands, except per share data) (unaudited)
Common Stock ------------------- Accumulated Number of Additional Other Total For the nine months ended Shares Paid-In Comprehensive Retained Treasury Note Stockholders' March 31, 2003: Outstanding Amount Capital Income Earnings Stock Receivable Equity ----------- ------ ---------- ------------- -------- -------- ---------- ------------- Balance June 30, 2002 2,844 $ 4 $ 23,985 $ 11,479 $ 47,968 $ (13,458) $ (600) $ 69,378 Comprehensive income: Net income -- -- -- -- 4,153 -- -- 4,153 Net unrealized gain on interest-only strips -- -- -- 3,963 -- -- -- 3,963 ----- ----- --------- --------- -------- --------- ------- --------- Total comprehensive income -- -- -- 3,963 4,153 -- -- 8,116 Exercise of non-employee stock options 57 -- -- -- (569) 619 -- 50 Shares issued to employees 38 -- -- -- (119) 492 -- 373 Shares issued to directors 4 -- -- -- (42) 51 -- 9 Stock dividend (10% of outstanding shares) -- -- -- -- (3,281) 3,281 -- -- Cash dividends ($0.24 per share) -- -- -- -- (699) -- -- (699) ----- ----- --------- --------- -------- --------- ------- --------- Balance March 31, 2003 2,943 $ 4 $ 23,985 $ 15,442 $ 47,411 $ (9,015) $ (600) $ 77,227 ===== ===== ========= ========= ======== ========= ======= =========
See accompanying notes to consolidated financial statements. 3 American Business Financial Services, Inc. and Subsidiaries Consolidated Statements of Cash Flow (dollars in thousands) (unaudited)
Nine Months Ended March 31, ----------------------------------- 2003 2002 ------------- ------------ Cash flows from operating activities Net income $ 4,153 $ 5,573 Adjustments to reconcile net income to net cash used in operating activities: Gain on sales of loans (170,394) (129,139) Depreciation and amortization 38,085 29,806 Interest accretion on interest-only strips (34,361) (25,920) Securitization assets valuation adjustment 33,303 13,153 Provision for credit losses 4,692 4,434 Loans originated for sale (1,226,712) (1,048,706) Proceeds from sale of loans 1,208,940 1,049,999 Principal payments on loans and leases 14,626 8,098 (Increase) decrease in accrued interest and fees on loan and lease receivables (1,862) 3,216 Purchase of initial overcollateralization on securitized loans (3,800) - Required purchase of additional overcollateralization on securitized loans (53,496) (35,468) Cash flow from interest-only strips 109,849 70,729 Decrease in prepaid expenses 56 50 Increase in accrued interest payable 2,444 11,589 Increase in accounts payable and accrued expenses 7,953 2,254 Accrued interest payable reinvested in subordinated debt 28,174 20,545 (Decrease) increase in deferred income taxes (549) 2,738 Increase in loans in process 1,884 762 Other, net (4,493) (4,697) ------------- ------------ Net cash used in operating activities (41,508) (20,984) ------------- ------------ Cash flows from investing activities Purchase of property and equipment, net (4,277) (3,090) Principal receipts and maturity of investments 25 19 ------------- ------------ Net cash used in investing activities (4,252) (3,071) ------------- ------------
4 American Business Financial Services, Inc. and Subsidiaries Consolidated Statements of Cash Flow (continued) (dollars in thousands) (unaudited)
Nine Months Ended March 31, ----------------------------------- 2003 2002 ------------- ------------ Cash flows from financing activities Proceeds from issuance of subordinated debt $ 136,977 $ 177,820 Redemptions of subordinated debt (110,653) (95,579) Net borrowings on revolving lines of credit (495) (7,311) Principal payments on lease funding facility (2,091) (2,474) Principal payments under capital lease obligations (138) - Net repayments of other notes payable - (156) Financing costs incurred (688) (1,497) Lease incentive receipts 2,123 - Exercise of employee stock options (2) - Exercise of non-employee stock options 50 - Grant of restricted stock option 9 - Cash dividends paid (699) (628) Repurchase of treasury stock - (5,652) ------------- ------------ Net cash provided by financing activities 24,393 64,523 ------------- ------------ Net (decrease) increase in cash and cash equivalents (21,367) 40,468 Cash and cash equivalents at beginning of year 108,599 91,092 ------------- ------------ Cash and cash equivalents at end of year $ 87,232 $ 131,560 ============= ============ Supplemental disclosures: Noncash transaction recorded for capitalized lease agreement: Increase in property and equipment $ (1,020) $ - Increase in warehouse lines and other notes payable $ 1,020 $ - Cash paid during the period for: Interest $ 20,439 $ 19,324 Income taxes $ 759 $ 1,086
See accompanying notes to consolidated financial statements. 5 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements March 31, 2003 1. Basis of Financial Statement Presentation American Business Financial Services, Inc. ("ABFS"), together with its subsidiaries (the "Company"), is a diversified financial services organization operating predominantly in the eastern and central portions of the United States. The Company originates, sells and services business purpose loans and home equity loans through its principal direct and indirect subsidiaries. The Company also processes and purchases home equity loans from other financial institutions through the Bank Alliance Services program. The Company's loans primarily consist of fixed interest rate loans secured by first or second mortgages on single family residences. The Company's customers are primarily credit-impaired borrowers who are generally unable to obtain financing from banks or savings and loan associations and who are attracted to its products and services. The Company originates loans through a combination of channels including a national processing center located at a centralized operating office in Bala Cynwyd, Pennsylvania, a regional processing center in Roseland, New Jersey and several retail branch offices. In addition, the Company offers subordinated debt securities to the public, the proceeds of which are used for repayment of existing debt, loan originations, the Company's operations (including repurchases of delinquent assets from securitization trusts), investments in systems and technology and for general corporate purposes. Effective December 31, 1999, the Company de-emphasized and subsequent to that date, discontinued the equipment leasing origination business but continues to service the remaining portfolio of leases. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals and the elimination of intercompany balances) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended March 31, 2003 are not necessarily indicative of financial results that may be expected for the full year ended June 30, 2003. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 2002. On August 21, 2002, the Company's Board of Directors declared a 10% stock dividend, which was paid on September 13, 2002 to shareholders of record on September 3, 2002. As a result of the stock dividend, all outstanding stock options and the related exercise prices were adjusted. Accordingly, all outstanding common shares, earnings per common share, dividends per share, average common shares and stock option amounts for all periods presented have been retroactively adjusted to reflect the effect of this stock dividend. 6 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 1. Basis of Financial Statement Presentation (continued) In December 2002, the Company's shareholders approved an increase in the number of shares of authorized preferred stock from 1.0 million shares to 3.0 million shares. The preferred shares may be used to raise equity capital, redeem outstanding debt or acquire other companies, although no such acquisitions are currently contemplated. The Board of Directors has discretion with respect to designating and establishing the terms of each series of preferred stock prior to issuance. Certain prior period financial statement balances have been reclassified to conform to current period presentation. Recent Accounting Pronouncements In November 2002, the Financial Accounting Standards Board ("FASB") issued Financial Interpretation No. ("FIN") 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45 standardizes practices related to the recognition of a liability for the fair value of a guarantor's obligation. The rule requires companies to record a liability for the fair value of its guarantee to provide or stand ready to provide services, cash or other assets. The rule applies to contracts that require a guarantor to make payments based on an underlying factor such as change in market value of an asset, collection of the scheduled contractual cash flows from individual financial assets held by an SPE, non-performance of a third party, for indemnification agreements, or for guarantees of the indebtedness of others among other things. The provisions of FIN 45 are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The disclosure requirements were effective for statements of annual or interim periods ending after December 15, 2002. Based on the requirements of this guidance for the quarter ended March 31, 2003, the Company has recorded a $0.7 million liability in conjunction with the sale of mortgage loans to the ABFS 2003-1 securitization trust which occurred in March 2003. This liability represents the fair value of periodic interest advances that the Company, as servicer of the securitized loans, is obligated to pay on behalf of delinquent loans in the trust. Recording of this liability reduces the gain on sale recorded for the securitization. The Company would expect to record a similar liability for each subsequent securitization, which generally occurs on a quarterly basis. The amount of the liability that will be recorded is dependent mainly on the volume of loans the Company securitizes, the expected performance of those loans and the interest rate of the loans. In the quarter ended March 31, 2003, the adoption of FIN 45 reduced net income by approximately $0.3 million and diluted earnings per share by $0.11. See Note 8 for further detail of this obligation. In December 2002, the FASB issued Statement of Financial Accounting Standard ("SFAS") No. 148 "Accounting for Stock-Based Compensation - Transition and Disclosure." SFAS No. 148 amends SFAS No. 123 "Accounting for Stock-Based Compensation." SFAS No. 148 provides alternative methods of transition 7 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 1. Basis of Financial Statement Presentation (continued) Recent Accounting Pronouncements (continued) for a voluntary change to the fair value method of accounting for stock-based compensation and requires pro forma disclosures of the effect on net income and earnings per share had the fair value method been used to be included in annual and interim reports and disclosure of the effect of the transition method used if the accounting method was changed, among other things. SFAS No. 148 is effective for annual reports of fiscal years beginning after December 15, 2002 and interim reports for periods beginning after December 15, 2002. The Company plans to continue using the intrinsic value method of accounting for stock-based compensation and therefore the new rule will have no effect on the Company's financial condition or results of operations. The Company has adopted the new standard related to disclosure in the interim period beginning January 1, 2003. See Note 11 for further detail of the adoption of this rule. In April 2003, the FASB began reconsidering the current alternatives available for accounting for stock-based compensation. The Company cannot predict whether the guidance will change the Company's current accounting for stock-based compensation, or what effect, if any, changes may have on the Company's current financial condition or results of operations. In January 2003, the FASB issued FIN 46 "Consolidation of Variable Interest Entities." FIN 46 provides guidance on the identification of variable interest entities that are subject to consolidation requirements by a business enterprise. A variable interest entity subject to consolidation requirements is an entity that does not have sufficient equity at risk to finance its operations without additional support from third parties and the equity investors in the entity lack certain characteristics of a controlling financial interest as defined in the guidance. Special purpose entities ("SPEs") are one type of entity, which under certain circumstances may qualify as a variable interest entity. Although the Company uses unconsolidated SPEs extensively in its loan securitization activities, the guidance will not affect the Company's current consolidation policies for SPEs as the guidance does not change the guidance incorporated in SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities" which precludes consolidation of a qualifying SPE by a transferor of assets to that SPE. FIN 46 will therefore have no effect on the Company's financial condition or results of operations and would not be expected to affect it in the future. In March 2003, the FASB announced that it is reconsidering the permitted activities of a qualifying SPE. The Company cannot predict whether the guidance will change or what effect, if any, changes may have on the Company's current consolidation policies for SPEs. Restricted Cash Balances The Company held restricted cash balances of $9.4 million and $9.0 million related to borrower escrow accounts at March 31, 2003 and June 30, 2002, respectively, and $3.4 million at March 31, 2003 related to deposits for future settlement of interest rate swap contracts. There was no restricted cash related to interest rate swap contracts at June 30, 2002. 8 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 2. Loan and Lease Receivables Loan and lease receivables - Available for sale - were comprised of the following (in thousands):
March 31, June 30, 2003 2002 --------- --------- Real estate secured loans (a) $ 49,121 $ 48,116 Leases, net of unearned income of $806 and $668 (b) 5,483 8,211 --------- --------- 54,604 56,327 Less: allowance for credit losses on loan and lease receivables available for sale 1,953 3,705 --------- --------- $ 52,651 $ 52,622 ========= =========
(a) Includes deferred direct loan origination costs of $1.4 million at March 31, 2003 and June 30, 2002. (b) Includes deferred direct lease origination costs of $0.1 million and $0.4 million at March 31, 2003 and June 30, 2002, respectively. Real estate secured loans have contractual maturities of up to 30 years. At March 31, 2003 and June 30, 2002, the accrual of interest income was suspended on real estate secured loans of $5.9 million and $7.0 million, respectively. The allowance for loan losses includes reserves established for expected losses on these loans in the amount of $1.3 million and $2.9 million at March 31, 2003 and June 30, 2002, respectively. Substantially all leases are direct finance-type leases whereby the lessee has the right to purchase the leased equipment at the lease expiration for a nominal amount. Loan and lease receivables - Interest and fees - are comprised mainly of accrued interest and fees on loans and leases that are less than 90 days delinquent. Additionally, Interest and fees include forbearance and deferment advances. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Managed Portfolio Quality" for a further description of these agreements. These amounts are carried at their estimated net recoverable value. Loan and lease receivables - Other - is comprised of receivables for securitized loans. In accordance with the Company's securitization agreements, the Company has the right, but not the obligation, to repurchase a limited amount of delinquent loans from securitization trusts. In accordance with the provisions of SFAS No. 140, the Company has recorded an obligation for the repurchase of loans subject to these removal of accounts provisions, whether or not the Company plans to repurchase the loans. The obligation for the loans' purchase price is recorded in Other liabilities. A corresponding receivable is recorded at the lower of the loans' cost basis or fair value. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Off-Balance Sheet Arrangements - Trigger Management" for more detail of removal of accounts provisions for securitized loans. 9 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 3. Interest-Only Strips Activity for interest-only strip receivables for the nine months ended March 31, 2003 and 2002 were as follows (in thousands):
March 31, 2003 2002 --------------------------------- Balance at beginning of period $ 512,611 $ 398,519 Initial recognition of interest-only strips, including initial overcollateralization of $3.8 million and $0 141,511 112,869 Cash flow from interest-only strips (109,849) (70,729) Required purchases of additional overcollateralization 53,496 35,468 Interest accretion 34,361 25,920 Termination of lease securitization (a) (1,741) - Net temporary adjustments to fair value (b) 8,286 1,253 Other than temporary fair value adjustment (b) (28,784) (13,153) --------------------------------- Balance at end of period $ 609,891 $ 490,147 =================================
(a) Reflects release of lease collateral from a lease securitization trust which was terminated in accordance with the trust documents after the full payout of trust note certificates. Lease receivables of $1.6 million were recorded on the balance sheet as a result of the termination. (b) Net temporary adjustments to fair value are recorded through other comprehensive income, which is a component of equity. Other than temporary adjustments to decrease the fair value of interest-only strips are recorded through the income statement. Interest-only strips include overcollateralization balances that represent the excess of the principal balance of loans in a securitized pool over investor interests. Overcollateralization is established to provide credit enhancement to investors in securitization trusts. At March 31, 2003 and 2002, the fair value of overcollateralization related cash flows were $290.6 million and $223.1 million, respectively. After a two-year period during which management's estimates required no valuation adjustments to its interest-only strips and servicing rights, declining interest rates and high prepayment rates over the last six quarters have required revisions to management's estimates of the value of these retained interests. Beginning in the second quarter of fiscal 2002 and on a quarterly basis thereafter, the Company increased the prepayment rate assumptions used to value its securitization assets, thereby lowering the fair value of these assets. However, because the Company's prepayment rates as well as those throughout the mortgage industry continued to remain at higher than expected levels due to continuous declines in interest rates during this period to 40-year lows, the Company's prepayment experience exceeded even management's revised assumptions. As a result, over the last six quarters the Company has recorded cumulative write downs to its interest-only strips in the aggregate amount of $89.5 million and 10 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 3. Interest-Only Strips (continued) an adjustment to the value of servicing rights of $4.5 million, for total adjustments of $94.0 million mainly due to its higher than expected prepayment experience. Of this amount, $55.3 million was expensed through the income statement and $38.7 million resulted in a write down through other comprehensive income, a component of stockholders' equity. During the first nine months of fiscal 2003, write downs of $50.0 million were recorded on the Company's securitization assets, including $45.5 million on interest-only strips and $4.5 million on servicing rights. Within the $50.0 million write down was a charge of $58.3 million mainly due to increases in prepayment experience, offset by $8.3 million of favorable fair value adjustments. The income statement impact on interest-only strips for the first nine months of fiscal 2003 was a write down of $33.3 million while the remaining $16.7 million was written down through other comprehensive income in accordance with the provisions of SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" and Emerging Issues Task Force Issue No. 99-20. The long duration of historically low interest rates has given borrowers an extended opportunity to engage in mortgage refinancing activities which resulted in elevated prepayment experience. The persistence of historically low interest rate levels, unprecedented in the last 40 years, has made the forecasting of prepayment levels in future fiscal periods difficult. The Company had assumed that the decline in interest rates had stopped and a rise in interest rates would occur in the near term. Consistent with this view, the Company had utilized derivative financial instruments to manage interest rate risk exposure on the Company's loan production and loan pipeline to protect the fair value of these fixed rate items against potential increases in market interest rates. Based on current economic conditions and published mortgage industry surveys including the Mortgage Bankers Association's Refinance Indexes available at the time of the Company's quarterly revaluation of its interest-only strips and servicing rights, and the Company's own prepayment experience, the Company believes prepayments will continue to remain at higher than normal levels for the near term before returning to average historical levels. The Mortgage Bankers Association of America has forecast as of April 8, 2003 that mortgage refinancings as a percentage share of total mortgage originations will decline from 71% in the first quarter to 33% in the fourth quarter of calendar 2003. The Mortgage Bankers Association of America has also projected in its April 2003 economic forecast that the 10-year treasury rate (which generally affects mortgage rates) will increase over the next three quarters. As a result of the analysis of these factors, the Company has increased its prepayment rate assumptions for home equity loans for the near term, but at a declining rate, before returning to its historical levels. However, the Company cannot predict with certainty what its prepayment experience will be in the future. Any unfavorable difference between the assumptions used to value the Company's securitization assets and its actual experience may have a significant adverse impact on the value of these assets. 11 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 3. Interest-Only Strips (continued) The following table details the pre-tax write downs of the securitization assets (in thousands): Income Other Total Statement Comprehensive Quarter Ended Write down Impact Income Impact - ---------------------- ---------- --------- ------------- September 30, 2002 $ 16,739 $ 12,078 $ 4,661 December 31, 2002 (a) 16,346 10,568 5,778 March 31, 2003 (b) 16,877 10,657 6,220 --------- -------- --------- Total Fiscal 2003 $ 49,962 $ 33,303 $ 16,659 ========= ======== ========= (a) includes a write down of $2.6 million to the carrying value of servicing rights through the income statement. (b) Includes a write down of $1.9 million to the carrying value of servicing rights through the income statement. 4. Servicing Rights Activity for the loan servicing rights asset for the nine months ended March 31, 2003 and 2002 were as follows (in thousands): March 31, 2003 2002 ------------------------- Balance at beginning of period $ 125,288 $ 102,437 Initial recognition of servicing rights 42,171 37,371 Amortization (30,015) (21,614) Write down (4,519) - ------------------------- Balance at end of period $ 132,925 $ 118,194 ========================= A write down of $4.5 million was recorded for the nine-month period ended March 31, 2003 on the value of servicing rights mainly due to the impact of increases in prepayment experience. This adjustment was recorded on the income statement for the nine months ended March 31, 2003 in accordance with SFAS No. 140, as a component of the securitization assets valuation adjustment. 12 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 5. Other Assets and Other Liabilities Other assets were comprised of the following (in thousands):
March 31, June 30, 2003 2002 ----------- ------------ Goodwill $ 15,121 $ 15,121 Real estate owned 6,348 3,784 Financing costs, debt offerings 4,424 5,849 Due from securitization trusts for servicing related activities 2,805 1,616 Investments held to maturity 892 917 Other 3,566 1,507 ----------- ------------ $ 33,156 $ 28,794 =========== ============
Other liabilities were comprised of the following (in thousands):
March 31, June 30, 2003 2002 ----------- ------------ Commitments to fund closed loans $ 31,750 $ 29,866 Obligation for repurchase of securitized loans 25,005 10,621 Escrow deposits held 9,460 9,011 Hedging liabilities, at fair value 2,809 - Unearned lease incentives 2,123 - Periodic advance guarantee 667 - Trading liabilities, at fair value 562 461 Other 657 949 ----------- ------------ $ 73,033 $ 50,908 =========== ============
See Note 2 for an explanation of the obligation for the repurchase of securitized loans and Note 9 for an explanation of the Company's hedging and trading activities. Unearned lease incentives represent reimbursements received in conjunction with the lease agreement for the Company's new corporate office space. These funds represent reimbursement from the landlord for leasehold improvements and furniture and equipment in the rented space and will be recognized as an offset to rent expense over the term of the lease. 13 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 6. Subordinated Debt and Warehouse Lines and Other Notes Payable Subordinated debt was comprised of the following (in thousands): March 31, June 30, 2003 2002 --------- --------- Subordinated debt (a) $ 690,781 $ 640,411 Subordinated debt - money market notes (b) 19,437 15,309 --------- --------- Total subordinated debt (a) $ 710,218 $ 655,720 ========= ========= Warehouse lines and other notes payable were comprised of the following (in thousands): March 31, June 30, 2003 2002 ---------- --------- Warehouse and operating revolving line of credit (c) $ 5,862 $ 6,171 Lease funding facility (d) 38 2,128 Warehouse revolving line of credit (e) - 187 Capitalized leases (f) 882 - --------- --------- Total warehouse lines and other notes payable $ 6,782 $ 8,486 ========= ========= (a) Subordinated debt due April 2003 through March 2012, interest rates ranging from 4.00% to 13.00%; average rate at March 31, 2003 was 9.05%, average remaining maturity was 18 months, subordinated to all of the Company's senior indebtedness. The average rate on subordinated debt including money market notes was 8.91% at March 31, 2003. (b) Subordinated debt-money market notes due upon demand, interest rate at 4.00%; subordinated to all of the Company's senior indebtedness. (c) $50 million warehouse and operating revolving line of credit expiring December 2003, which includes a sublimit for a letter of credit that expires in December 2003 to secure lease obligations for corporate office space, collateralized by certain pledged loans, advances to securitization trusts, real estate owned and certain interest-only strips. The amount of the letter of credit was $8.0 million at March 31, 2003 and will vary over the term of the office lease. (d) Lease funding facility matures through May 2003, collateralized by certain lease receivables. (e) $25 million warehouse revolving line of credit expiring October 2003, collateralized by certain pledged loans. (f) Capitalized leases, maturing through January 2006, imputed interest rate of 8.0%, collateralized by computer equipment. At March 31, 2003, warehouse lines and other notes payable were collateralized by $8.2 million of loan and lease receivables and $1.0 million of computer equipment. 14 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 6. Subordinated Debt and Warehouse Lines and Other Notes Payable (continued) In addition to the above, the Company had available to it the following credit facilities: o $1.2 million operating line of credit expiring January 2004, fundings to be collateralized by an investment in the 99-A lease securitization trust. This line was unused at March 31, 2003. o $200 million warehouse revolving line of credit expiring November 2003, collateralized by certain pledged loans. This line was unused at March 31, 2003. o $300.0 million facility, expiring July 2003, which provides for the sale of mortgage loans into an off-balance sheet funding facility. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Off-Balance Sheet Arrangements" for further discussion of the off-balance sheet features of this facility. At March 31, 2003, $29.5 million of this facility was utilized. Interest rates paid on the revolving credit facilities range from London Inter-Bank Offered Rate ("LIBOR") plus 1.25% to LIBOR plus 2.50%. The weighted-average interest rate paid on the revolving credit facilities was 2.80% and 3.35% at March 31, 2003 and June 30, 2002, respectively. The terms of the warehouse lines and operating lines of credit require the Company to meet specific financial covenants and other standards. Each agreement has multiple individualized financial covenant thresholds and ratio limits that the Company must meet as a condition to drawing on a particular line of credit. At March 31, 2003, the Company was in compliance with the terms of all debt agreements. Under a registration statement declared effective by the Securities and Exchange Commission on October 3, 2002, the Company registered $315.0 million of subordinated debt. Of the $315.0 million, $187.5 million of debt from this registration statement was available for future issuance as of March 31, 2003. The Company's subordinated debt securities are subordinated in right of payment to, or subordinate to, the payment in full of all senior debt as defined in the indentures related to such debt, whether outstanding on the date of the applicable indenture or incurred following the date of the indenture. The Company's assets, including the stock it holds in its subsidiaries, are available to repay the subordinated debt in the event of default following payment to holders of the senior debt. In the event of the Company's default and liquidation of its subsidiaries to repay the debt holders, creditors of the subsidiaries must be paid or provision made for their payment from the assets of the subsidiaries before the remaining assets of the subsidiaries can be used to repay the holders of the subordinated debt securities. 15 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 7. Legal Proceedings On February 26, 2002, a purported class action titled Calvin Hale v. HomeAmerican Credit, Inc., No. 02 C 1606, United States District Court for the Northern District of Illinois, was filed in the Circuit Court of Cook County, Illinois (subsequently removed by Upland Mortgage to the captioned federal court) against the Company's subsidiary, HomeAmerican Credit, Inc., which does business as Upland Mortgage, on behalf of borrowers in Illinois, Indiana, Michigan and Wisconsin who paid a document preparation fee on loans originated since February 4, 1997. The plaintiff alleges that the charging of, and the failure to properly disclose the nature of, a document preparation fee were improper under applicable state law. The plaintiff seeks restitution, compensatory and punitive damages and attorney's fees and costs, in unspecified amounts. The Company believes that its imposition of this fee is permissible under applicable law and is vigorously defending the case. The Hale case consists of five separate counts - three purported class action counts and two individual counts. On November 22, 2002 the Illinois Federal District Court granted Upland Mortgage's motion to dismiss the three class action counts, but a judgment erroneously dismissing all five counts of the case was entered in the docket. The plaintiff appealed the dismissal to the United States Court of Appeals for the Seventh Circuit but, on February 14, 2003, the Court of Appeals dismissed the appeal for lack of jurisdiction, on the grounds that the judgment entered by the Illinois Federal District Court was erroneous and did not constitute a final disposition of all counts of the case. Action on the two remaining individual counts in the Illinois Federal District Court has resumed and discovery has been scheduled. The Company's lending subsidiaries, including HomeAmerican Credit, Inc. which does business as Upland Mortgage, are involved, from time to time, in class action lawsuits, other litigation, claims, investigations by governmental authorities, and legal proceedings arising out of their lending activities from time to time including the purported class action entitled, Calvin Hale v. HomeAmerican Credit, Inc., d/b/a Upland Mortgage, described above. Due to the Company's current expectation regarding the ultimate resolution of these actions, management believes that the liabilities resulting from these actions will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Company maintains a reserve which management believes is sufficient to cover these matters. However, due to the inherent uncertainty in litigation and since the ultimate resolutions of these proceedings are influenced by factors outside of the Company's control, it is possible that the Company's estimated liability under these proceedings may change or that actual results will differ from its estimates. In addition, from time to time, the Company is involved as plaintiff or defendant in various legal proceedings arising in the normal course of business. While the Company cannot predict the ultimate outcome of these various legal proceedings, it is management's opinion that the resolution of these legal actions should not have a material effect on the Company's financial position, results of operations or liquidity. 16 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 8. Commitments Lease Agreements In December 2002, the Company entered into a new lease for an office space for the relocation of the Company's corporate headquarters into Philadelphia, Pennsylvania. The eleven-year operating lease is expected to commence in fiscal 2004. The terms of the rental agreement require increased payments annually for the term of the lease with average minimum annual rental payments of $4.2 million. The Company has entered into contracts, or may engage parties in the future, related to the relocation of the corporate headquarters such as contracts for building improvements to the leased space, office furniture and equipment and moving services. As of March 31, 2003, the Company has contracted for services and equipment totaling $10.5 million related to the office relocation. The provisions of the lease and local and state grants will provide the Company with reimbursement of a substantial amount of these costs related to the relocation, subject to certain conditions and limitations. The Company does not believe that its unreimbursed expenses or unreimbursed cash outlay related to the relocation will be material to its operations. The lease requires the Company to maintain a letter of credit in favor of the landlord to secure the Company's obligations to the landlord throughout the term of the lease. The amount of the letter of credit is currently $8.0 million and will decline over time to $4.0 million. The letter of credit is currently issued by JPMorgan Chase under the Company's current lending facility with JPMorgan Chase. In March 2003, the Company entered into a new lease agreement for office space in Roseland, New Jersey for the relocation of the Company's regional processing center presently located in Roseland, New Jersey. The nine-year lease is expected to commence in May 2003. The terms of the rental agreement require increased payments periodically for the term of the lease with average minimum annual rental payments of $0.8 million. The provisions of the lease require the landlord to assume the costs to ready the premises for occupancy, subject to certain conditions and limitations. The Company does not believe that its expenses or cash outlay related to the relocation will be material to its operations. Periodic Advance Guarantees As the servicer of securitized loans, the Company is obligated to advance interest payments for delinquent loans if we deem that the advances will ultimately be recoverable. These advances can first be made out of funds available in a trust's collection account. If the funds available from the trust's collection account are insufficient to make the required interest advances, then the Company is required to make the advance from its operating cash. The advances made from a trust's collection account, if not recovered from the borrower or proceeds from the liquidation of the loan, require reimbursement from the Company. However, the Company can recover any advances the Company makes from its operating cash from the subsequent month's mortgage loan 17 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 8. Commitments (continued) Periodic Advance Guarantees (continued) payments to the applicable trust prior to any distributions to the certificate holders. The Company adopted FIN 45 on a prospective basis for guarantees that are issued or modified after December 31, 2002. Based on the requirements of this guidance for the quarter ended March 31, 2003, the Company has recorded a $0.7 million liability in conjunction with the sale of mortgage loans to the ABFS 2003-1 securitization trust which occurred in March 2003. This liability represents its estimate of the fair value of periodic interest advances that the Company as servicer of the securitized loans, is obligated to pay to the trust on behalf of delinquent loans. The fair value of the liability was estimated based on an analysis of historical periodic interest advances and recoveries from securitization trusts. 9. Derivative Financial Instruments See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Interest Rate Risk Management" for a detailed discussion of the Company's use of derivative financial instruments. Hedging activity A primary market risk exposure that the Company faces is interest rate risk. Interest rate risk occurs due to potential changes in interest rates between the date fixed rate loans are originated and the date of securitization. The Company may, from time to time, utilize hedging strategies to mitigate the effect of changes in interest rates between the date loans are originated and the date the fixed rate pass-through certificates to be issued by a securitization trust are priced, a period typically less than 90 days. 18 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 9. Derivative Financial Instruments (continued) The Company recorded the following gains and losses on the fair value of derivative financial instruments accounted for as hedges for the three and nine-month periods ended March 31, 2003 and 2002. Any ineffectiveness related to hedging transactions during the period was immaterial. Ineffectiveness is a measure of the difference in the change in fair value of the derivative financial instrument as compared to the change in the fair value of the item hedged (in thousands):
Three Months Ended Nine Months Ended March 31, March 31, ---------------------------- -------------------------- 2003 2002 2003 2002 ---------------------------- -------------------------- Offset by gains and losses recorded on securitizations: Losses on derivative financial instruments $ (2,071) $ (135) $ (3,806) $ (4,923) Offset by gains and losses recorded on the fair value of hedged items: Losses on derivative financial instruments (16) -- (3,070) -- Amount settled in cash - paid (2,619) (135) (5,041) (4,923)
At March 31, 2003 outstanding forward starting interest rate swap contracts accounted for as hedges and unrealized losses recorded as liabilities on the balance sheet were as follows (in thousands): Notional Unrealized Amount Loss -------- ---------- Forward starting interest rate swaps $47,497 $ 2,809 Trading activity The Company recorded the following losses on forward starting interest rate swap contracts, which were used to manage interest rate risk on loans in the Company's pipeline and were therefore classified as trading for the three and nine-month periods ended March 31, 2003 and 2002 (in thousands):
Three Months Ended Nine Months Ended March 31, March 31, ---------------------------- -------------------------- 2003 2002 2003 2002 ---------------------------- -------------------------- Trading losses on forward starting interest rate swaps $ (784) $ -- $ (3,708) $ -- Amount settled in cash - paid -- -- (2,671) --
At March 31, 2003 outstanding forward starting interest rate swap contracts used to manage interest rate risk on loans in the Company's pipeline and associated unrealized losses recorded as liabilities on the balance sheet were as follows (in thousands): Notional Unrealized Amount Loss -------- ---------- Forward starting interest rate swaps $72,503 $ 22 19 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 9. Derivative Financial Instruments (continued) In addition, for the three and nine-month periods ended March 31, 2003, respectively, the Company recorded losses of $0.1 million and $1.1 million on an interest rate swap contract which is not designated as an accounting hedge, and gains of $0.5 million for the three and nine-month periods ended March 31, 2002. This contract was designed to reduce the exposure to changes in the fair value of certain interest-only strips due to changes in one-month LIBOR. The loss on the swap contract was due to decreases in the interest rate swap yield curve during the period the contract was in place. Of the losses recognized during the nine-month period, $0.3 million were unrealized losses representing the net change in the fair value of the contract during the period and $0.8 million were cash losses. The cumulative net unrealized loss of $0.5 million is included as a trading liability in Other liabilities at March 31, 2003. 10. Earnings Per Share Following is a reconciliation of the Company's basic and diluted earnings per share calculations (in thousands, except per share data):
Three Months Ended Nine Months Ended March 31, March 31, ------------------------- ------------------------ 2003 2002 2003 2002 --------- --------- --------- --------- Earnings (a) Net Income $ 221 $ 1,761 $ 4,153 $ 5,573 ========= ========= ========= ======== Average Common Shares (b) Average common shares outstanding 2,941 2,844 2,909 2,963 Average potentially dilutive shares 162 190 134 239 --------- --------- --------- -------- (c) Average common and potentially dilutive shares 3,103 3,034 3,043 3,202 ========= ========= ========= ======== Earnings Per Common Share Basic (a/b) $ 0.07 $ 0.58 $ 1.43 $ 1.88 Diluted (a/c) $ 0.06 $ 0.55 $ 1.36 $ 1.74
11. Stock Option and Stock Incentive Plans The Company has stock option plans that provide for the periodic granting of options to key employees and non-employee directors. These plans have been approved by the Company's shareholders. Options are generally granted to key employees at the market price of the Company's stock on the date of grant and expire five to ten years from date of grant. Options either fully vest when granted or over periods of up to five years. The Company accounts for stock options issued under these plans using the intrinsic value method, and accordingly, no expense is recognized where the exercise price equals or exceeds the fair value of the common stock at the date of grant. Had the Company accounted for stock options granted under these plans using the fair value method, pro forma net income and earnings per share would have been as follows (in thousands, except per share data): 20 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 11. Stock Option and Stock Incentive Plans (continued)
Three Months Ended Nine Months Ended March 31, March 31, ------------------------------- ----------------------------- 2003 2002 2003 2002 ------------------------------- ----------------------------- Net income As reported $ 221 $ 1,761 $ 4,153 $ 5,573 Pro forma $ 285 $ 1,694 $ 4,101 $ 5,488 Earnings per share - basic As reported $ 0.07 $ 0.58 $ 1.43 $ 1.88 Pro forma $ 0.10 $ 0.60 $ 1.41 $ 1.85 Earnings per share - diluted As reported $ 0.06 $ 0.55 $ 1.36 $ 1.74 Pro forma $ 0.09 $ 0.56 $ 1.35 $ 1.71
12. Segment Information The Company has three operating segments: Loan Origination, Servicing and Treasury and Funding. The Loan Origination segment originates business purpose loans secured by real estate and other business assets, home equity loans typically to credit-impaired borrowers and loans secured by one to four family residential real estate. The Servicing segment services the loans originated by the Company both while held as available for sale by the Company and subsequent to securitization. Servicing activities include billing and collecting payments from borrowers, transmitting payments to securitization trust investors, accounting for principal and interest, collections and foreclosure activities and disposing of real estate owned. The Treasury and Funding segment offers the Company's subordinated debt securities pursuant to a registered public offering and obtains other sources of funding for the Company's general operating and lending activities. The All Other caption on the following tables mainly represents segments that do not meet the SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" defined thresholds for determining reportable segments, financial assets not related to operating segments and is mainly comprised of interest-only strips, unallocated overhead and other expenses of the Company unrelated to the reportable segments identified. The reporting segments follow the same accounting policies used for the Company's consolidated financial statements as described in the summary of significant accounting policies. Management evaluates a segment's performance based upon profit or loss from operations before income taxes. 21 American Business Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) March 31, 2003 12. Segment Information (continued) Reconciling items represent elimination of inter-segment income and expense items, and are included to reconcile segment data to the consolidated financial statements (in thousands):
Treasury Nine months ended Loan and Reconciling March 31, 2003: Origination Funding Servicing All Other Items Consolidated ----------- ------- --------- --------- ----------- ------------ External revenues: Gain on sale of loans........... $ 170,394 $ - $ - $ - $ - $ 170,394 Interest income................. 5,930 322 590 34,361 - 41,203 Non-interest income............. 6,169 3 33,031 - (29,949) 9,254 Inter-segment revenues - 56,681 - 57,673 (114,354) - Operating expenses: Interest expense................ 17,263 50,025 (247) 40,697 (56,681) 51,057 Non-interest expense............ 37,621 7,068 30,221 49,087 - 123,997 Depreciation and amortization... 2,467 84 885 2,250 - 5,686 Securitization assets valuation adjustment.................... - - - 33,303 - 33,303 Inter-segment expense........... 87,622 - - - (87,622) - Income tax expense (credit)........ 14,633 (67) 1,077 (12,988) - 2,655 --------- --------- --------- --------- --------- --------- Net income (loss).................. $ 22,887 $ (104) $ 1,685 $ (20,315) $ - $ 4,153 ========= ========= ========= ========= ========= ========= Segment assets..................... $ 100,636 $ 192,470 $ 126,763 $ 647,729 $ (94,659) $ 972,939 ========= ========= ========= ========= ========= ========= Treasury Nine months ended Loan and Reconciling March 31, 2002: Origination Funding Servicing All Other Items Consolidated ----------- ------- --------- --------- ----------- ------------ External revenues: Gain on sale of loans........... $ 129,139 $ - $ - $ - $ - $ 129,139 Interest income................. 5,705 738 1,041 25,920 - 33,404 Non-interest income............. 9,222 1 25,762 102 (21,489) 13,598 Inter-segment revenues - 56,028 - 53,754 (109,782) - Operating expenses: Interest expense................ 14,485 50,417 99 42,494 (56,028) 51,467 Non-interest expense............ 30,005 8,297 22,883 35,537 - 96,722 Depreciation and amortization... 2,518 105 823 1,745 - 5,191 Securitization assets valuation adjustment.................... - - - 13,153 - 13,153 Inter-segment expense........... 75,243 - - - (75,243) - Income tax expense (credit)........ 9,162 (862) 1,259 (5,524) - 4,035 --------- --------- --------- --------- --------- --------- Net income (loss).................. $ 12,653 $ (1,190) $ 1,739 $ (7,629) $ - $ 5,573 ========= ========= ========= ========= ========= ========= Segment assets..................... $ 87,211 $ 204,993 $ 119,069 $ 551,845 $ (77,772) $ 885,346 ========= ========= ========= ========= ========= =========
22 American Business Financial Services, Inc. and Subsidiaries PART I FINANCIAL INFORMATION (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Our consolidated financial information set forth below should be read in conjunction with the consolidated financial statements and the accompanying notes to consolidated financial statements included in Item 1 of this Quarterly Report on Form 10-Q, and the consolidated financial statements, notes to consolidated financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations and the risk factors contained in our Annual Report on Form 10-K for the year ended June 30, 2002. Forward Looking Statements Some of the information in this Quarterly Report on Form 10-Q may contain forward-looking statements. You can identify these statements by words or phrases such as "will likely result," "may," "are expected to," "will continue to," "is anticipated," "estimate," "believe," "projected," "intends to" or other similar words. These forward-looking statements regarding our business and prospects are based upon numerous assumptions about future conditions, which may ultimately prove to be inaccurate. Factors that could affect our assumptions include, but are not limited to, general economic conditions, including interest rate risk, future residential real estate values, regulatory changes (legislative or otherwise) affecting the real estate market and mortgage lending activities, competition, demand for American Business Financial Services, Inc. and its subsidiaries' services, availability of funding, loan payment rates, delinquency and default rates, changes in factors influencing the loan securitization market and other risks identified in our Securities and Exchange Commission filings. Actual events and results may materially differ from anticipated results described in those statements. Forward-looking statements involve risks and uncertainties which could cause our actual results to differ materially from historical earnings and those presently anticipated. When considering forward-looking statements, you should keep these risk factors in mind as well as the other cautionary statements in this document. You should not place undue reliance on any forward-looking statement. GENERAL We are a diversified financial services organization operating predominantly in the eastern and central portions of the United States. We originate, sell and service business purpose loans and home equity loans through our principal direct and indirect subsidiaries. We also process and purchase home equity loans from other financial institutions through the Bank Alliance Services program. Our loans primarily consist of fixed interest rate loans secured by first or second mortgages on single family residences. Our customers are primarily credit-impaired borrowers who are generally unable to obtain financing from banks or savings and loan associations and who are attracted to our products and services. We originate loans through a combination of channels including a national processing center located at our centralized operating office in Bala Cynwyd, Pennsylvania, a regional processing center in Roseland, New Jersey and several retail branch offices. In addition, we offer subordinated debt securities to the public, the proceeds of which are used for repayment of existing debt, loan originations, our operations (including repurchases of delinquent assets from securitization trusts), investments in systems and technology and for general corporate purposes. 23 Initially, we finance our loans under several secured and committed credit facilities. These credit facilities are generally revolving lines of credit, which we have with several financial institutions that enable us to borrow on a short-term basis against our loans. We then securitize or sell our loans to unrelated third parties on a whole loan basis to generate the cash to pay off these revolving credit facilities. We also have a committed mortgage conduit facility with a financial institution that enables us to sell our loans into an off-balance sheet facility. Additionally, we rely upon funds generated by the sale of subordinated debt and other borrowings to fund our operations and to repay our debt as it matures. At March 31, 2003, $710.2 million of subordinated debt was outstanding and revolving credit and conduit facilities totaling $576.2 million were available, of which $35.4 million was drawn upon on that date. We expect to continue to rely on the borrowings to fund our operations and to repay maturing subordinated debt. For a description of our credit facilities and subordinated debt see "-- Liquidity and Capital Resources." For a description of our securitization activity see "-- Off-Balance Sheet Arrangements." Our business strategy is dependent on our ability to emphasize lending related activities that provide us with the most economic value. The implementation of this strategy will depend in large part on a variety of factors outside of our control, including, but not limited to, our ability to obtain adequate financing on favorable terms and to profitably securitize our loans on a regular basis. Our failure with respect to any of these factors could impair our ability to successfully implement our strategy, which could adversely affect our results of operations and financial condition. Local, state and federal legislatures, state and federal banking regulatory agencies, state attorneys general offices, the Federal Trade Commission, the U.S. Department of Justice, the U.S. Department of Housing and Urban Development and state and local governmental authorities have increased their focus on lending practices by companies in the subprime lending industry, more commonly referred to as "predatory lending" practices. State, local and federal governmental agencies have imposed sanctions for practices including, but not limited to, charging borrowers excessive fees, imposing higher interest rates than the borrower's credit risk warrants, failing to adequately disclose the material terms of loans to the borrowers and abusive servicing and collections practices. As a result of initiatives such as these, we are unable to predict whether state, local or federal authorities will require changes in our lending practices in the future, including the reimbursement of borrowers as a result of fees charged or the imposition of fines, or the impact of those changes on our profitability. These laws and regulations may limit our ability to securitize loans originated in certain states or localities due to rating agency, investor or market restrictions. As a result, we have limited the types of loans we offer in some states and may discontinue originating loans in other states or localities. 24 Additionally, the United States Congress is currently considering a number of proposed bills or proposed amendments to existing laws, such as the "Ney - Lucas Responsible Lending Act of 2003" introduced February 11, 2003 into the U.S. House of Representatives, which could affect our lending activities and make our business less profitable. These bills and amendments, if adopted as proposed, could reduce our profitability by limiting the fees we are allowed to charge, including prepayment fees, restricting the terms we are allowed to include in our loan agreements and increasing the amount of disclosure we are required to give to potential borrowers. While we cannot predict whether or in what form Congress may adopt these bills or amendments, we are currently evaluating the potential impact of these bills and amendments, if adopted, on our lending practices and results of operations. In addition to new regulatory initiatives with respect to so-called "predatory lending" practices, current laws or regulations in some states restrict our ability to charge prepayment penalties and late fees. We have used the Federal Alternative Mortgage Transactions Parity Act of 1982, which we refer to as the Parity Act, to preempt these state laws for loans which meet the definition of alternative mortgage transactions under the Parity Act. However, the Office of Thrift Supervision has adopted a rule effective in July 2003, which will preclude us and other non-bank, non-thrift creditors from using the Parity Act to preempt state prepayment penalty and late fee laws on new loan originations. Under the provisions of this rule, we will be required to modify or eliminate the practice of charging prepayment and other fees in some of the states where we originate loans. Additionally, in a recent decision, the Appellate Division of the Superior Court of New Jersey determined that the Parity Act's preemption of state law was invalid and that the state laws precluding some lenders from imposing prepayment fees are applicable to loans made in New Jersey, including alternative mortgage transactions. We are currently evaluating the impact of the adoption of the new rule by the Office of Thrift Supervision and of the recent court decision in New Jersey on our future lending activities and results of operations. We are also subject, from time to time, to private litigation, including actual and purported class action suits. See Note 7 of the Consolidated Financial Statements for a description of one purported class action suit currently pending. We expect that, as a result of the publicity surrounding predatory lending practices and the recent New Jersey court decision regarding the Parity Act, we may be subject to other class action suits in the future. Although we are licensed to originate loans in 44 states, our loan originations are concentrated in the eastern half of the United States. The concentration of loans in a specific geographic region subjects us to the risk that a downturn in the economy or recession in the eastern half of the country would more greatly affect us than if our lending business were more geographically diversified. As a result, an economic downturn or recession in this region could result in reduced profitability. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The accounting policies discussed below are considered by management to be critical to understanding our financial condition and results of operations. The application of these accounting policies requires significant judgment and assumptions by management, which are based upon historical experience and future expectations. The nature of our business and our accounting methods make our financial condition, changes in financial condition and results of operations highly dependent on management's estimates. The line items on our income statement and balance sheet impacted by management's estimates are described below. Revenue Recognition. Revenue recognition is highly dependent on the application of Statement of Financial Accounting Standards, referred to as SFAS in this document, No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" and "gain-on-sale" accounting to our quarterly loan securitizations. Gains on sales of loans through securitizations for the nine months ended March 31, 2003 were 77.2% of total revenues. Securitization gains represent the difference between the net proceeds to us, including retained interests in the securitization, and the allocated cost of loans securitized. The allocated cost of loans securitized is determined by allocating their net carrying value between the loans, the interest-only strips and the servicing rights we retain based upon their relative fair values. Estimates of the fair values of the interest-only strips and the servicing rights we retain are discussed below. We believe the accounting estimates related to gain on sale are critical accounting estimates because more than 80% in the first nine months of fiscal 2003 and 2002 of the securitization gains were based on estimates of the fair value of retained interests. The amount recognized as gain on sale for the retained interests we receive as proceeds in a securitization, in accordance with accounting principles generally accepted in the United States of America, is highly dependent on management's estimates. 25 Interest-Only Strips. Interest-only strips, which represent the right to receive future cash flows from securitized loans, represented 62.7% of our total assets at March 31, 2003 and are carried at their fair values. Fair value is based on a discounted cash flow analysis which estimates the present value of the future expected residual cash flows and overcollateralization cash flows utilizing assumptions made by management at the time the loans are sold. These assumptions include the rates used to calculate the present value of expected future residual cash flows and overcollateralization cash flows, referred to as the discount rates, and expected prepayment and credit loss rates on pools of loans sold through securitizations. We believe the accounting estimates used in determining the fair value of interest-only strips are critical accounting estimates because estimates of prepayment and credit loss rates are made based on management's expectation of future experience, which is based in part, on historical experience, current and expected economic conditions and in the case of prepayment rate assumptions, consideration of the impact of changes in market interest rates. The actual loan prepayment rate may be affected by a variety of economic and other factors, including prevailing interest rates, the availability of alternative financing to borrowers and the type of loan. Our expected future cash flows from our interest-only strips are re-evaluated on a quarterly basis. The current assumptions for prepayment and credit loss rates are monitored against actual experience and other economic and market conditions and are changed if deemed appropriate. Even a small unfavorable change in our assumptions made as a result of unfavorable actual experience or other considerations could have a significant adverse impact on our estimate of residual cash flows and on the value of these assets. In the event of an unfavorable change in these assumptions, the fair value of these assets would be overstated, requiring an accounting adjustment. In accordance with the provisions of Emerging Issues Task Force guidance, referred to as EITF 99-20 in this document, changes in the fair value of interest-only strips that are deemed to be temporary changes are recorded through other comprehensive income, a component of stockholders' equity. Other than temporary adjustments to decrease the fair value of interest-only strips are recorded through the income statement which would adversely affect our income in the period of adjustment. See "-- Off-Balance Sheet Arrangements -- Securitizations" for more detail on the estimation of the fair value of interest-only strips and the sensitivities of these balances to changes in assumptions and the impact on our financial statements of changes in assumptions. Interest accretion income represents the yield component of cash flows received on interest-only strips. We use a prospective approach to estimate interest accretion. As previously discussed, we update estimates of residual cash flow from our securitizations on a quarterly basis. Under the prospective approach, when it is probable that there is a favorable or unfavorable change in estimated residual cash flow from the cash flow previously projected, we recognize a larger or smaller percentage of the cash flow as interest accretion. Any change in value of the underlying interest-only strip could impact our current estimate of residual cash flow earned from the securitizations. For example, a significant change in market interest rates could increase or decrease the level of prepayments, thereby changing the size of the total managed loan portfolio and related projected cash flows. The managed portfolio includes loans held as available for sale on our balance sheet and loans serviced for others. 26 Servicing Rights. Servicing rights, which represent the rights to receive contractual servicing fees from securitization trusts and ancillary fees from borrowers, net of estimated compensation that would be required by a substitute servicer, represented 13.7% of our total assets at March 31, 2003. Servicing rights are carried at the lower of cost or fair value. The fair value of servicing rights is determined by computing the benefits of servicing in excess of adequate compensation, which would be required by a substitute servicer. The benefits of servicing are the present value of projected net cash flows from contractual servicing fees and ancillary servicing fees. We believe the accounting estimates used in determining the fair value of servicing rights are critical accounting estimates because the projected cash flows from servicing fees incorporate assumptions made by management, including prepayment rates, credit loss rates and discount rates. These assumptions are similar to those used to value the interest-only strips retained in a securitization. The current assumptions for prepayment and credit loss rates are monitored against actual experience and other economic and market conditions and are changed if deemed appropriate. Even a small unfavorable change in our assumptions, made as a result of unfavorable actual experience or other considerations could have a significant adverse impact on the value of these assets. In the event of an unfavorable change in these assumptions, the fair value of these assets would be overstated, requiring an adjustment, which would adversely affect our income in the period of adjustment. See "-- Off-Balance Sheet Arrangements -- Securitizations" for more detail on the estimation of the fair value of servicing rights and the sensitivities of these balances to changes in assumptions and the impact on our financial statements of changes in assumptions. Amortization of the servicing rights asset for securitized loans is calculated individually for each securitized loan pool and is recognized in proportion to, and over the period of estimated future servicing income on that particular pool of loans. A review for impairment is performed on a quarterly basis by stratifying the serviced loans by loan type, which is considered to be the predominant risk characteristic. If our analysis indicates the carrying value of servicing rights is not recoverable through future cash flows from contractual servicing and other ancillary fees, a valuation allowance or write down would be required. During the nine months ended March 31, 2003, our valuation analysis indicated that valuation adjustments of $4.5 million were required for impairment due to higher than expected prepayment experience. The write downs were recorded in the income statement in the second and third quarters of fiscal 2003. Impairment is measured as the excess of carrying value over fair value. Allowance for Loan and Lease Losses. The allowance for loan and lease losses is maintained primarily to account for loans and leases that are delinquent and are expected to be ineligible for sale into a future securitization and for delinquent loans that have been repurchased from securitization trusts. The allowance is calculated based upon management's estimate of our ability to collect on outstanding loans and leases based upon a variety of factors, including, periodic analysis of the available for sale loans and leases, economic conditions and trends, historical credit loss experience, borrowers' ability to repay, and collateral considerations. Additions to the allowance arise from the provision for credit losses charged to operations or from the recovery of amounts previously charged-off. Loan and lease charge-offs reduce the allowance. If the actual collection of outstanding loans and leases is less than we anticipate, further write downs would be required which would reduce our net income in the period the write down was required. 27 Development of Critical Accounting Estimates. On a quarterly basis, senior management reviews the estimates used in our critical accounting policies. As a group, senior management discusses the development and selection of the assumptions used to perform its estimates described above. Management has discussed the development and selection of the estimates used in our critical accounting policies as of March 31, 2003 with the Audit Committee of our Board of Directors. In addition, management has reviewed its disclosure of the estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations with the Audit Committee. Impact of Changes in Critical Accounting Estimates. For a description of the impacts of changes in critical accounting estimates in the nine months ended March 31, 2003, see "-- Off-Balance Sheet Arrangements -- Securitizations." Initial Adoption of Accounting Policies. In conjunction with the relocation of our corporate headquarters to new leased office space, we have entered into a lease agreement and are in the process of finalizing certain governmental grant agreements that will provide us with reimbursement for certain expenditures related to our office relocation. The reimbursable expenditures include both capitalizable items for leasehold improvements, furniture and equipment and expense items such as legal costs, moving costs and employee communication programs. Amounts reimbursed to us in accordance with our lease agreement will be initially recorded as a liability on our balance sheet and will be recognized in the income statement on a straight-line basis over the term of the lease as a reduction of rent expense. Amounts received from government grants will be initially recorded as a liability. Grant funds received to offset expenditures for capitalizable items will be reclassified as a reduction of the related fixed asset and amortized to income over the depreciation period of the related asset as an offset to depreciation expense. Amounts received to offset expense items will be recognized in the income statement as an offset to the expense item. OFF-BALANCE SHEET ARRANGEMENTS We use off-balance sheet arrangements extensively in our business activities. The types of off-balance sheet arrangements we use include special purpose entities for the securitization of loans, obligations we incur as the servicer of securitized loans and other contractual obligations such as operating leases for corporate office space. See "-- Liquidity and Capital Resources" for additional information regarding our off-balance sheet contractual obligations. Special purpose entities and off-balance sheet facilities are used in our mortgage loan securitizations. Asset securitizations are one of the most common off-balance sheet arrangements in which a company transfers assets off of its balance sheet by selling them to a special purpose entity. We sell our loans into off-balance sheet facilities to generate the cash to pay off revolving credit facilities and to generate revenue through securitization gains. The special purpose entities described below meet our objectives for mortgage loan securitization structures and comply with accounting principles generally accepted in the United States of America. 28 Our securitizations involve a two-step transfer that qualifies for sale accounting under SFAS No. 140. First, we sell the loans to a special purpose entity, which has been established for the limited purpose of buying and reselling the loans and establishing a true sale under legal standards. Next, the special purpose entity sells the loans to a qualified special purpose entity, which we refer to as the trust. The trust is a distinct legal entity, independent from us. By transferring title of the loans to the trust, we isolate those assets from our assets. Finally, the trust issues certificates to investors to raise the cash purchase price for the loans we have sold. Cash from the sale of certificates to third party investors is returned to us in exchange for our loan receivables and we use this cash to repay any borrowings under warehouse and credit facilities. The off-balance sheet trusts' activities are restricted to holding title to the loan collateral, issuing certificates to investors and distributing loan payments to the investors and us in accordance with the agreement. We also retain the right to service the loans. We have no additional obligations to the off-balance sheet facilities other than those required as servicer of the loans and for breach of warranty obligations. We are not required to make any additional investments in the trusts. Under current accounting rules, the trusts do not qualify for consolidation in our financial statements. The trusts carry the loan collateral as assets and the certificates issued to investors as liabilities. Residual cash from the loans after required principal and interest payments are made to the investors provide us with cash flows from our interest-only strips. We expect that future cash flows from our interest-only strips and servicing rights will generate more of the cash flows required to meet maturities of our subordinated debt and our operating cash needs. We retain the rights to service the loans we sell through securitizations. As the servicer of securitized loans, we are obligated to advance interest payments for delinquent loans if we deem that the advances will ultimately be recoverable. These advances can first be made out of funds available in a trust's collection account. If the funds available from the collection account are insufficient to make the required interest advances, then we are required to make the advance from our operating cash. The advances made from a trust's collection account, if not recovered from the borrower or proceeds from the liquidation of the loan, require reimbursement from us. These advances may require funding from our capital resources and may create greater demands on our cash flow than either selling loans with servicing released or maintaining a portfolio of loans on our balance sheet. However, any advances we make from our operating cash can be recovered from the subsequent month's mortgage loan payments to the applicable trust prior to any distributions to the certificate holders. At March 31, 2003 and June 30, 2002, the mortgage securitization trusts held loans with an aggregate principal balance due of $3.4 billion and $2.9 billion as assets and owed $3.2 billion and $2.8 billion to third party investors, respectively. Revenues from the sale of loans to securitization trusts were $170.4 million, or 77.2% of total revenues for the nine months ended March 31, 2003 and $129.1 million, or 73.3% of total revenues for the nine months ended March 31, 2002. These amounts are net of $5.1 million of expenses for underwriting fees, legal fees and other expenses associated with securitization transactions during the periods. We have interest-only strips and servicing rights with fair values of $609.9 million and $132.9 million, respectively at March 31, 2003, which represent 76.3% of our total assets. Cash flows received from interest-only strips and servicing rights were $140.1 million for the nine months ended March 31, 2003. These amounts are included in our operating cash flows. 29 We also use special purpose entities in our sales of loans to a $300 million off-balance sheet mortgage conduit facility. Sales into the off-balance sheet facility involve a two-step transfer that qualifies for sale accounting under SFAS No. 140, similar to the process described above. This facility has a revolving feature and can be directed by the third party sponsor to dispose of the loans. Typically the loans are disposed of by securitizing the loans in a term securitization. The third party note purchaser also has the right to have the loans sold. Under this off-balance sheet facility arrangement, the loans have been isolated from us and our subsidiaries and as a result, transfers to the facility are treated as sales for financial reporting purposes. When loans are sold to this facility, we assess the likelihood that the sponsor will transfer the loans into a term securitization. As the sponsor has typically transferred the loans to a term securitization in the past, the amount of gain on sale we have recognized for loans sold to this facility is estimated based on the terms we would obtain in a term securitization rather than the terms of this facility. At March 31, 2003, the off-balance sheet mortgage conduit facility held loans with principal balances due of $29.4 million as assets and owed $29.5 million to third parties. Securitizations In our mortgage loan securitizations, pools of mortgage loans are sold to a trust. The trust then issues certificates or notes, which we refer to as certificates in this document, to third-party investors, representing the right to receive a pass-through interest rate and principal collected on the mortgage loans each month. These certificates, which are senior in right to our interest-only strips in the trusts, are sold to public or private offerings. The difference between the average interest rate that is charged to borrowers on the fixed interest rate pools of mortgage loans and the weighted-average pass-through interest rate paid to investors is referred to as the interest rate spread. The interest rate spread is distributed from the trust to us and is the basis of the value of our interest-only strips. In addition, when we securitize our loans we retain the right to service the loans for a fee, which is the basis for our servicing rights. Servicing includes processing of mortgage payments, processing of disbursements for tax and insurance payments, maintenance of mortgage loan records, performance of collection efforts, including disposition of delinquent loans, foreclosure activities and disposition of real estate owned, referred to as REO, and performance of investor accounting and reporting processes. Since fiscal 2000, declines in securitization pass-through interest rates resulted in interest rate spreads improving by approximately 235 basis points at March 31, 2003 compared to the fourth quarter of fiscal 2000. Increased interest rate spreads result in increases in the residual cash flow we will receive on securitized loans, the amount we received at the closing of a securitization from the sale of notional bonds or premiums on bonds and corresponding increases in the gains we recognized on the sale of loans in a securitization. No assurances can be made that market interest rates will remain at current levels. However, in a rising interest rate environment we would expect our ability to originate loans at interest rates that will maintain our current level of securitization gain profitability to become more difficult than during a stable or falling interest rate environment. This situation occurred during the period from our September 1998 mortgage loan securitization through the June 2000 mortgage loan securitization when the pass-through interest rates on the asset-backed securities issued in our securitizations had increased by approximately 155 basis points. During the same period, the average interest rate on our loans securitized increased by only 71 basis points. We would seek to address the challenge presented by a rising interest rate environment by carefully monitoring our product pricing, the actions of our competition, market trends and the use of hedging strategies in order to continue to originate loans in as profitable a manner as possible. See "-- Strategies for Use of Derivative Financial Instruments" for a discussion of our hedging strategies. 30 A rising interest rate environment could also unfavorably impact our liquidity and capital resources. Rising interest rates could impact our short-term liquidity by widening investor interest rate spread requirements in pricing future securitizations as described above, increasing the levels of overcollateralization required in future securitizations, limiting our access to borrowings in the capital markets and limiting our ability to sell our subordinated debt securities at favorable interest rates. These effects may be offset by the positive effect of a decline in prepayment activity that we would expect in a rising interest rate environment. See "-- Liquidity and Capital Resources" for a discussion of both long and short-term liquidity. Conversely, a declining interest rate environment could unfavorably impact the valuation of our interest-only strips. In a declining interest rate environment the level of mortgage refinancing activity tends to increase, which could result in an increase in loan prepayment experience and may require increases in assumptions for prepayments for future periods. After a two-year period during which management's estimates required no valuation adjustments to our interest-only strips and servicing rights, declining interest rates and high prepayment rates over the last six quarters have required revisions to management's estimates of the value of these retained interests. Beginning in the second quarter of fiscal 2002 and on a quarterly basis thereafter, we increased the prepayment rate assumptions used to value our securitization assets, thereby decreasing the fair value of these assets. However, because our prepayment rates as well as those throughout the mortgage industry continued to remain at higher than expected levels due to continuous declines in interest rates during this period to 40-year lows, our prepayment experience exceeded even our revised assumptions. As a result, over the last six quarters we have recorded cumulative write downs to our interest-only strips in the aggregate amount of $89.5 million and an adjustment to the value of servicing rights of $4.5 million, for total adjustments of $94.0 million mainly due to our higher than expected prepayment experience. Of this amount, $55.3 million was expensed through the income statement and $38.7 million resulted in a write down through other comprehensive income, a component of stockholders' equity. During the first nine months of fiscal 2003, write downs of $50.0 million were recorded on our securitization assets, including $45.5 million on interest-only strips and $4.5 million servicing rights. Within the $50.0 million write down was a charge of $58.3 million mainly due to increases in prepayment experience, offset by $8.3 million of favorable fair value adjustments in the second quarter. The long duration of historically low interest rates has given borrowers an extended opportunity to engage in mortgage refinancing activities which resulted in elevated prepayment experience. The persistence of historically low interest rate levels, unprecedented in the last 40 years, has made the forecasting of prepayment levels in future fiscal periods difficult. We had assumed that the decline in interest rates had stopped and a rise in interest rates would occur in the near term. Consistent with this view, we had utilized derivative financial instruments to manage interest rate risk exposure on our loan production and loan pipeline to protect the fair value of these fixed rate items against potential increases in market interest rates. Based on current economic conditions and published mortgage industry surveys including the Mortgage Bankers Association's Refinance Indexes available at the time of our quarterly revaluation of our interest-only strips and servicing rights, and our own prepayment experience, we believe prepayments will continue to remain at higher than normal levels for the near term before returning to average historical levels. The Mortgage Bankers Association of America has forecast as of April 8, 2003 that mortgage refinancings as a percentage share of total mortgage originations will decline from 71% in the first quarter to 33% in the fourth quarter of calendar 2003. The Mortgage Bankers Association of America has also projected in its April 2003 economic forecast that the 10-year treasury rate (which generally affects mortgage rates) will increase over the next three quarters. As a result of our analysis of these factors, we have increased our prepayment rate assumptions for home equity loans for the near term, but at a declining rate, before returning to our historical levels. However, we cannot predict with certainty what our prepayment experience will be in the future. Any unfavorable difference between the assumptions used to value our securitization assets and our actual experience may have a significant adverse impact on the value of these assets. 31 The following tables detail the pre-tax write downs of the securitization assets by quarter and details the impact to the income statement and to other comprehensive income in accordance with the provisions of SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" and EITF 99-20 as they relate to interest-only strips and SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities" as it relates to servicing rights (in thousands):
Fiscal Year 2003: Income Other Total Statement Comprehensive Quarter Ended Write down Impact Income Impact - ----------------------------------------- ---------- --------- ------------- September 30, 2002....................... $ 16,739 $ 12,078 $ 4,661 December 31, 2002........................ 16,346 10,568 5,778 March 31, 2003........................... 16,877 10,657 6,220 --------- -------- -------- Total Fiscal 2003........................ $ 49,962 $ 33,303 $ 16,659 ========= ======== ======== Fiscal Year 2002: Income Other Total Statement Comprehensive Quarter Ended Write down Impact Income Impact - ----------------------------------------- ---------- --------- ------------- December 31, 2001........................ $ 11,322 $ 4,462 $ 6,860 March 31, 2002........................... 15,513 8,691 6,822 June 30, 2002............................ 17,244 8,900 8,344 --------- -------- -------- Total Fiscal 2002........................ $ 44,079 $ 22,053 $ 22,026 ========= ======== ========
Note: The impacts of prepayments on our securitization assets in the quarter ended September 30, 2001 were not significant. 32 The following table summarizes the volume of loan securitizations and whole loan sales for the three months and nine months ended March 31, 2003 and 2002 (dollars in thousands):
Three Months Ended Nine Months Ended March 31, March 31, --------------------------- --------------------------- Securitizations: 2003 2002 2003 2002 ----------- ----------- ----------- ------------ Business loans................................. $ 33,748 $ 34,423 $ 93,267 $ 93,709 Home equity loans.............................. 369,881 306,411 1,083,676 879,434 ----------- ----------- ----------- ------------ Total....................................... $ 403,629 $ 340,834 $ 1,176,943 $ 973,143 =========== =========== =========== ============ Gain on sale of loans through securitization.. $ 54,504 $ 49,220 $ 170,394 $ 129,139 Securitization gains as a percentage of total Revenue...................................... 75.9% 75.2% 77.2% 73.3% Whole loan sales............................... $ 702 $ 12,220 $ 2,239 $ 55,943 (Discount) premiums on whole loan sales........ $ (3) $ 540 $ 29 $ 2,374
Our quarterly revenues and net income may fluctuate in the future principally as a result of the timing, size and profitability of our securitizations. The strategy of selling loans through securitizations requires building an inventory of loans over time, during which time we incur costs and expenses. Since a gain on sale is not recognized until a securitization is closed, which may not occur until a subsequent quarter, operating results for a given quarter can fluctuate significantly. If securitizations do not close when expected, we could experience a material adverse effect on our results of operations for a quarter. See "-- Liquidity and Capital Resources" for a discussion of the impact of securitizations on our cash flow. Several factors affect our ability to complete securitizations on a profitable basis. These factors include conditions in the securities markets, such as fluctuations in interest rates described below, conditions in the asset-backed securities markets relating to the loans we originate, credit quality of the managed portfolio of loans or potential changes to the legal and accounting principles underlying securitization transactions. Any substantial reduction in the size or availability of the securitization market for loans could have a material adverse effect on our results of operations and financial condition. Interest-Only Strips. As the holder of the interest-only strips, we are entitled to receive excess (or residual) cash flows and cash flows from overcollateralization. These cash flows are the difference between the payments made by the borrowers on securitized loans and the sum of the scheduled and prepaid principal and pass-through interest paid to trust investors, servicing fees, trustee fees and, if applicable, surety fees. In most of our securitizations, surety fees are paid to an unrelated insurance entity to provide protection for the trust investors. Generally, all residual cash flows are initially retained by the trust to establish required overcollateralization levels in the trust. Overcollateralization is the excess of the aggregate principal balances of loans in a securitized pool over the investor interests. Overcollateralization requirements are established to provide credit enhancement for the trust investors. The overcollateralization requirements for a mortgage loan securitization are different for each securitization and include: (1) The initial requirement, if any, is a percentage of the original balance of loans securitized and is paid in cash at the time of sale; 33 (2) The final target is a percentage of the original balance of loans securitized and is funded from the monthly excess cash flow. Specific securitizations contain provisions requiring an increase above the final target overcollateralization levels during periods in which delinquencies exceed specified limits. The overcollateralization levels return to the target levels when delinquencies fall below the specified limits; and (3) The stepdown requirement is a percentage of the remaining balance of securitized loans. During the stepdown period, the overcollateralization amount is gradually reduced through cash payments to us until the overcollateralization balance declines to a specific floor. The stepdown period generally begins at the later of 30 to 36 months after the initial securitization of the loans or when the remaining balance of securitized loans is less than 50% of the original balance of securitized loans. The fair value of our interest-only strips is a combination of the fair values of our residual cash flows and our overcollateralization cash flows. At March 31, 2003, investments in interest-only strips totaled $609.9 million, including the fair value of overcollateralization related cash flows of $290.6 million. Trigger Management. Repurchasing loans benefits us by allowing us to limit the level of delinquencies and losses in the securitization trusts and as a result, we can avoid exceeding specified limits on delinquencies and losses that trigger a temporary reduction or discontinuation of cash flow from our interest-only strips until the delinquency or loss triggers are no longer exceeded. We have the right, but are not obligated, to repurchase a limited amount of delinquent loans from securitization trusts. In addition, we elect to repurchase loans in situations requiring more flexibility for the administration and collection of these loans. The purchase price of a delinquent loan is at the loan's outstanding contractual balance. A foreclosed loan is one where we, as servicer, have initiated formal foreclosure proceedings against the borrower and a delinquent loan is one that is 31 days or more past due. The foreclosed and delinquent loans we typically elect to repurchase are usually 90 days or more delinquent and the subject of foreclosure proceedings, or where a completed foreclosure is imminent. The related allowance for loan losses on these repurchased loans is included in our provision for credit losses in the period of repurchase. Our ability to repurchase these loans does not disqualify us for sale accounting under SFAS No. 140, which was adopted on a prospective basis in the fourth quarter of fiscal 2001, or other relevant accounting literature because we are not required to repurchase any loan and our ability to repurchase a loan is limited by contract. At March 31, 2003, three of our 25 mortgage securitization trusts were under a triggering event, a decrease from seven at December 31, 2002. See the "Summary of Selected Mortgage Loan Securitization Trust Information" for details of trusts under triggering events. As a result, these three trusts are retaining all or a portion of the cash flow that would normally be available to us had delinquencies or losses not exceeded specified limits in these trusts. We have a plan to manage the repurchase of delinquent loans in order to more effectively limit delinquencies and losses in the trusts and recover the cash flow held in trusts where triggers have been exceeded, as well as to avoid exceeding trigger limits in the other securitization trusts. The goal of this plan is to maximize net cash receipts by eliminating reductions or discontinuations of cash flow from our interest-only strips. For the nine months ended March 31, 2003, we repurchased $42.5 million in principal of delinquent loans from securitization trusts primarily for trigger management. We expect that the three trusts currently exceeding triggers will again be below trigger limits within the next two months. During that period, we anticipate that approximately $4.4 million of excess overcollateralization now being held by the three trusts will be reduced and cash flow from the related interest-only strips will resume at normal levels. If, however, delinquencies increase and we cannot cure the delinquency or liquidate the loans in the mortgage securitization trusts without exceeding loss triggers, the levels of repurchases required to manage triggers may increase. Our ability to continue to manage triggers in our securitization trusts in the future is affected by our availability of cash from operations or through the sale of subordinated debt to fund these repurchases. Additionally, our repurchase activity increases prepayments which may result in unfavorable prepayment experience. See "-- Securitizations" for more detail of the effect prepayments have on our financial statements. Also see "Managed Portfolio Quality -- Delinquent Loans and Leases" for further discussion of the impact of delinquencies. 34 The following table summarizes the principal balances of loans and REO we have repurchased from the mortgage loan securitization trusts for the nine months ended March 31, 2003 and fiscal years 2002 and 2001. We received $27.4 million of proceeds from the liquidation of repurchased loans and REO for the nine months ended March 31, 2003 and $19.2 million and $10.9 million for the fiscal years 2002 and 2001, respectively. We had repurchased loans and REO remaining on our balance sheet in the amounts of $11.4 million, $9.4 million and $4.8 million at March 31, 2003 and June 30, 2002 and 2001, respectively. All loans and REO were repurchased at the contractual outstanding balances at the time of repurchase and are carried at the lower of their cost basis or fair value. Because the contractual outstanding balance is typically greater than the fair value, the Company generally incurs a loss on these repurchases. Mortgage loan securitization trusts are listed only if repurchases have occurred. 35 Summary of Loans and REO Repurchased from Mortgage Loan Securitization Trusts (dollars in thousands)
2001-3 2001-1 2000-4 2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 ------ ------ ------ ------ ------ ------ ------ ------ ------- ------ Nine months ended March 31, 2003: Business loans................. $ 349 $ 267 $ 223 $ 145 $1,086 $1,410 $2,371 $1,963 $ 1,807 $1,200 Home equity loans.............. 853 2,236 276 839 1,453 3,170 4,224 3,574 2,336 4,272 ------ ------ ------ ------ ------ ------ ------ ------ ------- ------ Total........................ $1,202 $2,503 $ 499 $ 984 $2,539 $4,580 $6,595 $5,537 $ 4,143 $5,472 ====== ====== ====== ====== ====== ====== ====== ====== ======= ====== Number of loans repurchased.... 11 27 6 11 26 42 79 79 47 58 Year ended June 30, 2002: Business loans................. $ -- $ -- $ -- $ -- $ -- $ -- $ 194 $1,006 $ 341 $ 438 Home equity loans.............. -- -- -- -- -- 84 944 3,249 2,688 2,419 ------ ------ ------ ------ ------ ------ ------ ------ ------- ------ Total........................ $ -- $ -- $ -- $ -- $ -- $ 84 $1,138 $4,255 $ 3,029 $2,857 ====== ====== ====== ====== ====== ====== ====== ====== ======= ====== Number of loans repurchased.... -- -- -- -- -- 2 18 47 31 33 Year ended June 30, 2001: Business loans................. $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- Home equity loans.............. -- -- -- 88 330 -- -- -- -- -- ------ ------ ------ ------ ------ ------ ------ ------ ------- ------ Total....................... $ -- $ -- $ -- $ 88 $ 330 $ -- $ -- $ -- $ -- $ -- ====== ====== ====== ====== ====== ====== ====== ====== ======= ====== Number of loans repurchased.... -- -- -- 1 2 -- -- -- -- -- (Continued) 1998-4 1998-3 1998-2 1998-1 1997-2 1997-1 1996-2 1996-1 Total ------ ------ ------ ------ ------ ------ ------ ------ ------- Nine months ended March 31, 2003: Business loans................. $ -- $1,455 $ 206 $ 147 $ -- $ 714 $ 313 $ 138 $13,794 Home equity loans.............. 549 2,828 1,205 381 -- 157 355 -- 28,708 ------ ------ ------ ------ ------ ------ ------ ------ ------- Total........................ $ 549 $4,283 $1,411 $ 528 $ -- $ 871 $ 668 $ 138 $42,502 ====== ====== ====== ====== ====== ====== ====== ====== ======= Number of loans repurchased.... 6 53 20 8 -- 12 12 1 498 Year ended June 30, 2002: Business loans................. $ 632 $ 260 $ 516 $1,266 $1,729 $ 183 $ -- $ 104 $ 6,669 Home equity loans.............. 4,649 5,575 1,548 1,770 223 239 60 123 23,571 ------ ------ ------ ------ ------ ------ ------ ------ ------- Total........................ $5,281 $5,835 $2,064 $3,036 $1,952 $ 422 $ 60 $ 227 $30,240 ====== ====== ====== ====== ====== ====== ====== ====== ======= Number of loans repurchased.... 58 61 24 37 18 8 1 3 341 Year ended June 30, 2001: Business loans................. $ 173 $ 803 $ 215 $ 428 $2,252 $ -- $ 380 $ 250 $ 4,501 Home equity loans.............. 1,310 3,886 1,284 1,686 1,764 -- 92 109 10,549 ------ ------ ------ ------ ------ ------ ------ ------ ------- Total....................... $1,483 $4,689 $1,499 $2,114 $4,016 $ -- $ 472 $ 359 $15,050 ====== ====== ====== ====== ====== ====== ====== ====== ======= Number of loans repurchased.... 10 48 13 31 37 -- 8 4 154
SFAS No. 140 was effective on a prospective basis for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. SFAS No. 140 requires that we record an obligation to repurchase loans from securitization trusts at the time we have the contractual right to repurchase the loans, whether or not we actually repurchase them. For securitization trusts 2001-2 and forward, to which this rule applies, we have the contractual right to repurchase a limited amount of loans greater than 180 days past due. In accordance with the provisions of SFAS No. 140, we have recorded on our March 31, 2003 balance sheet a liability of $25.0 million for the repurchase of loans subject to these removal of accounts provisions. A corresponding asset for the loans, at the lower of their cost basis or fair value, has also been recorded. 36 Mortgage Loan Securitization Trust Information. The following tables provide information regarding the nature and principal balances of mortgage loans securitized in each trust, the securities issued by each trust, and the overcollateralization requirements of each trust. Summary of Selected Mortgage Loan Securitization Trust Information Current Balances as of March 31, 2003 (dollars in millions)
2003-1 2002-4 2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Original balance of loans securitized: Business loans.....................$ 33 $ 30 $ 34 $ 34 $ 32 $ 29 $ 31 $ 35 $ 29 $ 27 Home equity loans.................. 417 350 336 346 288 287 269 320 246 248 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total..............................$ 450 $ 380 $ 370 $ 380 $ 320 $ 316 $ 300 $ 355 $ 275 $ 275 ====== ====== ====== ====== ====== ====== ====== ====== ====== ====== Current balance of loans securitized: Business loans.....................$ 33 $ 29 $ 32 $ 32 $ 28 $ 24 $ 23 $ 27 $ 21 $ 17 Home equity loans.................. 416 343 311 296 220 189 158 169 117 103 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total..............................$ 449 $ 372 $ 343 $ 328 $ 248 $ 213 $ 181 $ 196 $ 138 $ 120 ====== ====== ====== ====== ====== ====== ====== ====== ====== ====== Weighted-average interest rate on loans securitized: Business loans.....................15.85% 16.01% 15.91% 16.01% 15.84% 15.81% 15.94% 15.94% 16.05% 16.07% Home equity loans.................. 9.78% 10.55% 10.87% 10.94% 10.84% 10.71% 11.10% 11.23% 11.43% 11.61% Total..............................10.23% 10.98% 11.35% 11.42% 11.42% 11.29% 11.72% 11.88% 12.13% 12.23% Percentage of first mortgage loans.... 86% 85% 86% 85% 90% 89% 88% 89% 89% 85% Weighted-average loan-to-value........ 77% 77% 77% 77% 76% 77% 76% 76% 75% 76% Weighted-average remaining term (months) on loans securitized....... 270 262 257 245 238 237 227 225 222 212 Original balance of Trust Certificates........................$ 450 $ 376 $ 370 $ 380 $ 320 $ 322 $ 306 $ 355 $ 275 $ 275 Current balance of Trust Certificates........................$ 449 $ 364 $ 336 $ 317 $ 234 $ 201 $ 169 $ 180 $ 126 $ 108 Weighted-average pass-through interest rate to Trust Certificate holders(a).......................... 4.69% 5.82% 6.79% 7.25% 6.11% 5.35% 5.72% 7.92% 7.52% 7.05% Highest Trust Certificate pass-through interest rate..................... 3.78% 8.61% 6.86% 7.39% 6.51% 5.35% 6.14% 6.99% 6.28% 7.05% Overcollateralization requirements: Required percentages: Initial............................. -- 1.00% -- -- -- -- -- -- -- -- Final target........................ 5.50% 5.75% 3.50% 3.50% 4.50% 4.25% 4.00% 4.40% 4.10% 4.50% Stepdown overcollateralization......11.00% 11.50% 7.00% 7.00% 9.00% 8.50% 8.00% 8.80% 8.20% 9.00% Required dollar amounts: Initial............................. -- $ 4 -- -- -- -- -- -- -- -- Final target........................$ 25 $ 22 $ 13 $ 13 $ 14 $ 13 $ 12 $ 16 $ 11 $ 12 Current status: Overcollateralization amount........ -- $ 8 $ 7 $ 10 $ 14 $ 11 $ 12 $ 16 $ 12 $ 12 Final target reached or anticipated date to reach.........9/2004 3/2004 10/2003 8/2003 Yes 7/2003 Yes Yes Yes (c) Yes Stepdown reached or anticipated date to reach....................10/2006 7/2006 1/2006 8/2005 1/2005 7/2004 4/2004 1/2004 10/2003 1/2004 Annual surety wrap fee................ 0.20% (b) (b) (b) 0.21% 0.20% 0.20% 0.20% 0.20% 0.21% Servicing rights: Original balance....................$ 16 $ 14 $ 13 $ 15 $ 13 $ 13 $ 12 $ 15 $ 11 $ 14 Current balance.....................$ 16 $ 14 $ 12 $ 13 $ 10 $ 8 $ 7 $ 8 $ 6 $ 6
- ---------------------------- (a) Rates for securitizations 2001-1 and forward include rates on notional bonds, or the impact of premiums received on certificates, included in securitization structure. The sale of notional bonds allows us to receive more cash at the closing of a securitization. See "-- Nine Months Ended March 31, 2003 Compared to Nine Months Ended March 31, 2002 -- Gain on Sale of Loans" for further description of the notional bonds. (b) Credit enhancement was provided through a senior / subordinate certificate structure. (c) Although the final target has been reached, this trust is exceeding delinquency limits, and the trust is retaining additional overcollateralization. We expect normal residual cash flow to resume within two months. See "-- Trigger Management" for further detail. 37 Summary of Selected Mortgage Loan Securitization Trust Information (Continued) Current Balances as of March 31, 2003 (dollars in millions)
2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 1998(a) 1997(a) 1996(a) ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Original balance of loans securitized: Business loans.....................$ 16 $ 28 $ 25 $ 25 $ 28 $ 30 $ 16 $ 57 $ 45 $ 29 Home equity loans.................. 134 275 212 197 194 190 169 448 130 33 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total..............................$ 150 $ 303 $ 237 $ 222 $ 222 $ 220 $ 185 $ 505 $ 175 $ 62 ====== ====== ====== ====== ====== ====== ====== ====== ====== ====== Current balance of loans securitized: Business loans.....................$ 9 $ 16 $ 13 $ 12 $ 11 $ 12 $ 6 $ 15 $ 11 $ 5 Home equity loans.................. 55 110 80 78 74 79 60 124 23 5 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total..............................$ 64 $ 126 $ 93 $ 90 $ 85 $ 91 $ 66 $ 139 $ 34 $ 10 ====== ====== ====== ====== ====== ====== ====== ====== ====== ====== Weighted-average interest rate on loans securitized: Business loans.....................16.06% 16.06% 16.02% 16.06% 15.79% 15.68% 15.96% 15.95% 15.91% 15.89% Home equity loans..................11.43% 11.42% 11.36% 11.06% 10.84% 10.44% 10.65% 10.78% 11.54% 11.00% Total..............................12.07% 12.02% 12.00% 11.73% 11.50% 11.15% 11.14% 11.35% 12.89% 13.66% Percentage of first mortgage loans.... 88% 81% 81% 85% 86% 89% 92% 90% 76% 74% Weighted-average loan-to-value........ 77% 77% 77% 76% 77% 76% 77% 77% 74% 66% Weighted-average remaining term (months) on loans securitized....... 210 219 208 204 207 216 210 195 153 112 Original balance of Trust Certificates........................$ 150 $ 300 $ 235 $ 220 $ 219 $ 219 $ 184 $ 498 $ 171 $ 61 Current balance of Trust Certificates........................$ 56 $ 108 $ 82 $ 78 $ 76 $ 80 $ 60 $ 125 $ 29 $ 7 Weighted-average pass-through interest rate to Trust Certificate holders............................. 7.61% 7.07% 7.11% 6.86% 6.77% 6.61% 6.56% 6.29% 7.17% 7.68% Highest Trust Certificate pass-through interest rate....................... 7.61% 8.04% 7.93% 7.68% 7.49% 7.13% 6.58% 6.86% 7.53% 7.95% Overcollateralization requirements: Required percentages: Initial............................. -- 0.90% 0.75% 1.00% 1.00% 0.50% 0.50% 1.50% 2.43% 1.94% Final target........................ 4.75% 5.95% 5.95% 5.50% 5.00% 5.00% 5.00% 5.10% 7.43% 8.94% Stepdown overcollateralization...... 9.50% 11.90% 11.90% 11.00% 10.00% 10.00% 10.00% 10.21% 14.86% 12.90% Required dollar amounts: Initial............................. -- $ 3 $ 2 $ 2 $ 2 $ 1 $ 1 $ 7 $ 4 $ 1 Final target........................$ 7 $ 18 $ 14 $ 12 $ 11 $ 11 $ 9 $ 26 $ 13 $ 6 Current status: Overcollateralization amount........$ 7 $ 18 $ 11 $ 12 $ 9 $ 11 $ 6 $ 14 $ 5 $ 3 Final target reached or anticipated date to reach......... Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Stepdown reached or anticipated date to reach....................10/2003 7/2003 Yes Yes (b) Yes Yes (b) Yes Yes Yes Yes Annual surety wrap fee................ 0.21% 0.21% 0.19% 0.21% 0.21% 0.19% 0.19% 0.22% 0.26% 0.18% Servicing rights: Original balance...................$ 7 $ 14 $ 10 $ 10 $ 10 $ 10 $ 8 $ 18 $ 7 $ 4 Current balance....................$ 3 $ 5 $ 4 $ 3 $ 3 $ 3 $ 2 $ 5 $ 1 $ 1
- ---------------------------- (a) Amounts represent combined balances and weighted-average percentages for four 1998 securitization pools, two 1997 securitization pools and two 1996 securitization pools. (b) Although stepdown date has been reached, these trusts are temporarily ineligible to reduce excess overcollateralization levels due to their exceeding delinquency or loss limits. We expect normal cash flow from overcollateralization to resume within two months. See "-- Trigger Management" for further detail. Discounted Cash Flow Analysis. The estimation of the fair value of interest-only strips is based upon a discounted cash flow analysis which estimates the present value of the future expected residual cash flows and overcollateralization cash flows utilizing assumptions made by management at the time loans are sold. These assumptions include the rates used to calculate the present value of expected future residual cash flows and overcollateralization cash flows, referred to as the discount rates, prepayment rates and credit loss rates on the pool of loans. These assumptions are monitored against actual experience and other economic and market conditions and are changed if deemed appropriate. Our methodology for determining the discount rates, prepayment rates and credit loss rates used to calculate the fair value of our interest-only strips is described below. 38 Discount rates. We use discount rates, which we believe are commensurate with the risks involved in our securitization assets. While quoted market prices on comparable interest-only strips are not available, we have performed comparisons of our valuation assumptions and performance experience to others in the non-conforming mortgage industry. We quantify the risks in our securitization assets by comparing the asset quality and performance experience of the underlying securitized mortgage pools to comparable industry performance. In determining the discount rate applied to residual cash flows, we believe that the practice of many companies in the non-conforming mortgage industry has been to add an interest rate spread for risk to the all-in cost of securitizations to determine their discount rates. The all-in cost of the securitization trusts' investor certificates includes the highest trust certificate pass-through interest rate in each mortgage securitization, trustee fees, and surety fees, which generally, in total, range from 19 to 22 basis points. From industry experience comparisons, we have determined an interest rate spread, which is added to the all-in cost of our mortgage loan securitization trusts' investor certificates. The 13% discount rate that we apply to our residual cash flow portion of our interest-only strips compared to rates used by others in the industry reflects our higher asset quality and performance of our securitized assets compared to industry asset quality and performance and the other characteristics of our securitized loans described below: o Underlying loan collateral with fixed interest rates, which are higher than others in the non-conforming mortgage industry. Average interest rate of securitized loans exceeds the industry average by 100 basis points or more. All of the securitized loans have fixed interest rates, which are more predictable than adjustable rate loans. o Approximately 90% to 95% of securitized business purpose loans have prepayment fees. Approximately 85% to 90% of securitized home equity loans have prepayment fees. Our historical experience indicates that prepayment fees lengthen the prepayment ramp periods and slow annual prepayment speeds, which have the effect of increasing the life of the securitized loans. o A portfolio mix of first and second mortgage loans of 80-85% and 15-20%, respectively. Historically, the high proportion of first mortgages has resulted in lower delinquencies and losses. o A portfolio credit grade mix comprised of 60% A credits, 23% B credits, 14% C credits, and 3% D credits. In addition, our historical loss experience is below what is experienced by others in the non-conforming mortgage industry. Although market interest rates have declined from fiscal years 2001 through the third quarter of fiscal 2003, no reduction to the discount rate used to value the residual portion of our interest-only strips has been made. We do not believe a decrease in the discount rate is warranted as the current market interest rate decline was mainly due to actions taken by the Federal Reserve Board in an attempt to prevent the potential adverse effect of uncertain economic conditions and to stimulate economic growth. Additionally, the non-conforming mortgage lending industry generally has taken no actions to reduce discount rates. 39 We apply a second discount rate to projected cash flows from the overcollateralization portion of our interest-only strips. The discount rate applied to projected overcollateralization cash flows in each mortgage securitization is based on the highest trust certificate pass-through interest rate in the mortgage securitization. In fiscal 2001, we instituted the use of a minimum discount rate of 6.5%. At March 31, 2003, the average discount rate applied to projected overcollateralization cash flows was 7%. The risk characteristics of the projected overcollateralization cash flows do not include prepayment risk and have minimal credit risk. For example, if the entire unpaid principal balance in a securitized pool of loans was prepaid by borrowers, we would fully recover the overcollateralization portion of the interest-only strips. In addition, historically, these overcollateralization balances have not been impacted by credit losses as the residual cash flow portion of our interest-only strips has always been sufficient to absorb credit losses and stepdowns of overcollateralization have generally occurred as scheduled. See "-- Trigger Management" for further detail of trusts that have not stepped down as scheduled. Overcollateralization represents our investment in the excess collateral in a securitized pool of mortgage loans. The blended discount rate used to value the interest-only strips, including the overcollateralization cash flows, was 10% at March 31, 2003. Prepayment rates. The assumptions we use to estimate future prepayment rates are regularly compared to actual prepayment experience of the individual securitization pools of mortgage loans and an average of the actual experience of other similar pools of mortgage loans at the same number of months after their inception. It is our practice to use an average historical prepayment rate of similar pools for the expected constant prepayment rate assumption while a pool of mortgage loans is less than a year old even though actual experience may be different. During this period, before a pool of mortgage loans reaches its expected constant prepayment rate, actual experience both quantitatively and qualitatively is generally not sufficient to conclude that final actual experience for an individual pool of mortgage loans would be materially different from the average. For pools of mortgage loans greater than one year old, prepayment experience trends for an individual pool is considered to be more significant. For these pools, adjustments to prepayment assumptions may be made to more closely conform the assumptions to actual experience if the variance from average experience is significant and is expected to continue. Current economic conditions, current interest rates and other factors are also considered in our analysis. As was previously discussed, for the past six quarters, our actual prepayment experience was generally higher, most significantly on home equity loans, than our historical averages for prepayments. See "-- Securitizations" for further detail of our recent prepayment experience. In addition to the use of prepayment fees on our loans, we have implemented programs and strategies in an attempt to reduce loan prepayments in the future. These programs and strategies may include providing information to a borrower regarding costs and benefits of refinancing, which at times may demonstrate a refinancing option is not in the best economic interest of the borrower. Other strategies include offering second mortgages to existing qualified borrowers or offering financial incentives to qualified borrowers to deter prepayment of their loan. We cannot predict with certainty what the impact these efforts will have on our future prepayment experience. 40 Credit loss rates. Credit loss rates are analyzed in a similar manner to prepayment rates. Credit loss assumptions are compared to actual loss experience averages for similar mortgage loan pools and for individual mortgage loan pools. Delinquency trends and economic conditions are also considered. If our analysis indicates that loss experience may be different from our assumptions, we would adjust our assumptions as necessary. Floating interest rate certificates. Some of the securitization trusts have issued floating interest rate certificates supported by fixed interest rate mortgages. The fair value of the excess cash flow we will receive may be affected by any changes in the interest rates paid on the floating interest rate certificates. The interest rates paid on the floating interest rate certificates are based on one-month LIBOR. The assumption used to estimate the fair value of the excess cash flows received from these securitization trusts is based on a forward yield curve. See "Interest Rate Risk Management -- Strategies for Use of Derivative Financial Instruments" for further detail of our management of the risk of changes in interest rates paid on floating interest rate certificates. Sensitivity analysis. The table below outlines the sensitivity of the current fair value of our interest-only strips and servicing rights to 10% and 20% adverse changes in the key assumptions used in determining the fair value of those assets. Our base prepayment, loss and discount rates are described in the table "Summary of Material Mortgage Loan Securitization Valuation Assumptions and Actual Experience." (dollars in thousands): Securitized collateral balance...........................$ 3,417,041 Balance sheet carrying value of retained interests (a)...$ 742,816 Weighted-average collateral life (in years).............. 4.0 - ---------------------------- (a) Amount includes interest-only strips and servicing rights. Sensitivity of assumptions used to determine the fair value of retained interests (dollars in thousands): Impact of Adverse Change -------------------------------- 10% Change 20% Change --------------- --------------- Prepayment speed........................... $ 30,456 $ 55,684 Credit loss rate........................... 5,151 10,302 Floating interest rate certificates (a).... 1,005 1,910 Discount rate.............................. 24,248 47,072 - ---------------------------- (a) The floating interest rate certificates are indexed to one-month LIBOR plus a trust specific interest rate spread. The base one-month LIBOR assumption used in this sensitivity analysis was derived from a forward yield curve incorporating the effect of rate caps where applicable to the individual deals. 41 The sensitivity analysis in the table above is hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% or 20% variation in management's assumptions generally cannot easily be extrapolated because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, in this table, the effect that a change in a particular assumption may have on the fair value is calculated without changing any other assumption. Changes in one assumption may result in changes in other assumptions, which might magnify or counteract the impact of the intended change. These sensitivities reflect the approximate amount of the fair values that our interest-only strips and servicing rights would be reduced for the indicated adverse changes. These reductions would result in a charge to expense in the income statement in the period incurred and a resulting reduction of stockholders' equity, net of income taxes. The effect on our liquidity of changes in the fair values of our interest-only strips and servicing rights are discussed in "-- Liquidity and Capital Resources." 42 The following tables provide information regarding the initial and current assumptions applied in determining the fair values of mortgage loan related interest-only strips and servicing rights for each securitization trust. Summary of Material Mortgage Loan Securitization Valuation Assumptions and Actual Experience at March 31, 2003
2003-1 2002-4 2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Interest-only strip residual discount rate: Initial valuation....................... 13% 13% 13% 13% 13% 13% 13% 13% 13% 13% Current valuation....................... 13% 13% 13% 13% 13% 13% 13% 13% 13% 13% Interest-only strip overcollateralization discount rate........................... 7% 9% 7% 7% 7% 7% 7% 7% 6% 7% Servicing rights discount rate: Initial valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11% Current valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11% Prepayment rates: Initial assumption (a): Expected Constant Prepayment Rate (CPR): Business loans........................ 11% 11% 11% 11% 11% 11% 11% 11% 11% 10% Home equity loans..................... 22% 22% 22% 22% 22% 22% 22% 22% 22% 24% Ramp period (months): Business loans........................ 27 27 27 27 27 27 24 24 24 24 Home equity loans..................... 30 30 30 30 30 30 30 30 30 24 Current assumptions (b): Expected Constant Prepayment Rate (CPR): Business loans ....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11% Home equity loans .................... 22% 22% 22% 22% 22% 22% 22% 22% 22% 22% Ramp period (months): Business loans........................ 27 27 27 27 27 27 27 27 27 27 Home equity loans..................... 30 30 30 30 30 30 30 30 30 30 CPR adjusted to reflect ramp: Business loans........................ 3% 5% 8% 10% 12% 15% 17% 20% 22% 22% Home equity loans..................... 2% 9% 20% 28% 30% 30% 30% 30% 32% 36% Current prepayment experience (c): Business loans........................ -- -- 5% 8% 9% 19% 19% 11% 14% 27% Home equity loans..................... -- -- 10% 21% 25% 36% 40% 38% 28% 35% Annual credit loss rates: Initial assumption...................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% Current assumption...................... 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% 0.40% Actual experience....................... -- -- -- 0.02% 0.02% 0.06% 0.23% 0.12% 0.26% 0.25% Servicing fees: Contractual fees........................ 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.70% Ancillary fees.......................... 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25%
- ---------------------------- (a) The prepayment ramp is the length of time before a pool of mortgage loans reaches its expected Constant Prepayment Rate. The business loan prepayment ramp begins at 3% in month one ramps to an expected peak rate over 27 months then declines to the final expected CPR by month 40. The home equity loan prepayment ramp begins at 2% in month one and ramps to an expected rate over 30 months. (b) Current assumptions for business loans are the estimated expected weighted-average prepayment rates over the securitization's estimated remaining life. The majority of the home equity loan prepayment rate ramps have been increased for the next 6 months to provide for the expected near term continuation of higher than average prepayment. Generally, trusts for both business and home equity loans that are out of the ramping period are based on historical averages. (c) Current experience is a six-month historical average. 43 Summary of Material Mortgage Loan Securitization Valuation Assumptions and Actual Experience at March 31, 2003 (Continued)
2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 1999-1 1998(d) 1997(d) 1996(d) ------ ------ ------ ------ ------ ------ ------ ------ ------ ------- Interest-only strip residual discount rate: Initial valuation....................... 13% 13% 11% 11% 11% 11% 11% 11% 11% 11% Current valuation....................... 13% 13% 13% 13% 13% 13% 13% 13% 13% 13% Interest-only strip overcollateralization 8% 8% 8% 8% 7% 7% 7% 7% 7% 8% discount rate........................... Servicing rights discount rate: Initial valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11% Current valuation....................... 11% 11% 11% 11% 11% 11% 11% 11% 11% 11% Prepayment rates: Initial assumption (a): Expected Constant Prepayment Rate (CPR): Business loans ....................... 10% 10% 10% 10% 10% 10% 10% 13% 13% 13% Home equity loans..................... 24% 24% 24% 24% 24% 24% 24% 24% 24% 24% Ramp period (months): Business loans........................ 24 24 24 24 24 24 24 24 24 24 Home equity loans..................... 24 24 18 18 18 18 18 12 12 12 Current assumptions (b): Expected Constant Prepayment Rate (CPR): Business loans ....................... 11% 11% 11% 11% 10% 10% 10% 10% 22% 14% Home equity loans..................... 22% 22% 22% 22% 22% 22% 22% 23% 25% 25% Ramp period (months): Business loans........................ 27 Na Na Na Na Na Na Na Na Na Home equity loans..................... 30 30 Na Na Na Na Na Na Na Na CPR adjusted to reflect ramp: Business loans........................ 19% 16% 13% 32% 30% 26% 20% 28% 22% 14% Home equity loans..................... 22% 22% 22% 29% 32% 27% 26% 27% 25% 25% Current prepayment experience (c): Business loans........................ 33% 23% 29% 32% 30% 26% 20% 28% 22% 10% Home equity loans..................... 33% 33% 36% 29% 32% 27% 26% 27% 18% 12% Annual credit loss rates: Initial assumption...................... 0.40% 0.40% 0.40% 0.30% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% Current assumption...................... 0.40% 0.40% 0.65% 0.60% 0.55% 0.35% 0.53% 0.60% 0.40% 0.45% Actual experience....................... 0.39% 0.37% 0.61% 0.59% 0.54% 0.35% 0.51% 0.57% 0.37% 0.42% Servicing fees: Contractual fees........................ 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% Ancillary fees.......................... 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 1.25% 0.75% 0.75% 0.75%
- ----------------------------- (a) The prepayment ramp is the length of time before a pool of mortgage loans reaches its expected Constant Prepayment Rate. The business loan prepayment ramp begins at 3% in month one ramps to an expected peak rate over 27 months then declines to the final expected CPR by month 40. The home equity loan prepayment ramp begins at 2% in month one and ramps to an expected rate over 30 months. (b) Current assumptions for business loans are the estimated expected weighted-average prepayment rates over the securitization's estimated remaining life. The majority of the home equity loan prepayment rate ramps have been increased for the next 6 months to provide for the expected near term continuation of higher than average prepayment. Generally, trusts for both business and home equity loans that are out of the ramping period are based on historical averages. (c) Current experience is a six-month historical average. (d) Amounts represent weighted-average percentages for four 1998 securitization pools, two 1997 securitization pools and two 1996 securitization pools. Na = not applicable 44 Servicing Rights. As the holder of servicing rights on securitized loans, we are entitled to receive annual contractual servicing fees of 50 to 70 basis points on the aggregate outstanding loan balance. These fees are paid out of accumulated mortgage loan payments before payments of principal and interest are made to trust certificate holders. In addition, ancillary fees such as prepayment fees, late charges, nonsufficient fund fees and other fees are retained directly by us, as servicer, as payments are collected from the borrowers. We also retain the interest paid on funds held in a trust's collection account until these funds are distributed from a trust. The fair value of servicing rights is determined by computing the benefits of servicing in excess of adequate compensation, which would be required by a substitute servicer. The benefits of servicing are the present value of projected net cash flows from contractual servicing fees and ancillary servicing fees. These projections incorporate assumptions, including prepayment rates, credit loss rates and discount rates. These assumptions are similar to those used to value the interest-only strips retained in a securitization. On a quarterly basis, capitalized servicing rights are evaluated for impairment, which is measured as the excess of unamortized cost over fair value. Servicing rights can be terminated under certain circumstances, such as our failure to make required servicer payments, defined change in control and reaching specified loss levels on underlying mortgage pools. The origination of a high percentage of loans with prepayment fees impacts our servicing rights and income in two ways. Prepayment fees reduce the likelihood of a borrower prepaying their loan. This results in prolonging the length of time a loan is outstanding, which increases the contractual servicing fees to be collected over the life of the loan. Additionally, the terms of our servicing agreements with the securitization trusts allow us to retain prepayment fees collected from borrowers as part of our compensation for servicing loans. In addition, although prepayments increased in recent periods compared to our historical averages, we have generally found that the non-conforming mortgage market is less sensitive to prepayments due to changes in interest rates than the conforming mortgage market where borrowers have more favorable credit history for the following reasons. First, there are relatively few lenders willing to supply credit to non-conforming borrowers which limits those borrowers' opportunities to refinance. Second, interest rates available to non-conforming borrowers tend to adjust much slower than conforming mortgage interest rates which reduces the non-conforming borrowers' opportunity to capture economic value from refinancing. As a result of the use of prepayment fees and the reduced sensitivity to interest rate changes in the non-conforming mortgage market, we believe the prepayment experience on our managed portfolio is more stable than the mortgage market in general. We believe this stability has favorably impacted our ability to value the future cash flows from our servicing rights and interest-only strips because it increased the predictability of future cash flows. However, for the past six quarters, our prepayment experience has exceeded our expectations for prepayments on our managed portfolio and as a result we have written down the value of our securitization assets. See "-- Off-Balance Sheet Arrangements -- Securitizations" for further detail of the effects prepayments that were above our expectations have had on the value of our securitization assets. 45 Whole Loan Sales We also sell loans with servicing released, which we refer to as whole loan sales. Gains on whole loan sales equal the difference between the net proceeds from such sales and the net carrying value of the loans. The net carrying value of a loan is equal to its principal balance plus its unamortized origination costs and fees. Gains from these sales are recorded as fee income. See "-- Off Balance Sheet Arrangements -- Securitizations" for information on the volume of whole loan sales and premiums recorded for the nine months ended March 31, 2003 and 2002. Loans reported as sold on a whole loan basis are generally loans that were originated specifically for a whole loan sale and exclude impaired loans, which may be liquidated by selling the loan with servicing released. RESULTS OF OPERATIONS Overview For the third quarter of fiscal 2003, net income decreased $1.5 million, or 87.5%, to $0.2 million compared to $1.8 million in the third quarter of fiscal 2002. Diluted earnings per common share were $0.06 on average common shares of 3,103,000 compared to $0.55 per share on average common shares of 3,034,000 for the third quarter of fiscal 2002. Dividends of $0.08 and $0.07 per share were paid for the quarters ended March 31, 2003 and 2002, respectively. The common dividend payout ratio based on diluted earnings per share was 133.3% for the third quarter of fiscal 2003 compared to 13.3% for the third quarter of fiscal 2002. Increases in the gain on sale and interest accretion on the interest-only strips recorded during the third quarter of fiscal 2003 were offset by increases in general and administrative expenses and a higher valuation adjustment on securitization assets recorded during the third quarter ended March 31, 2003 compared to the third quarter of fiscal 2002. For the nine months ended March 31, 2003, net income decreased $1.4 million, or 25.5%, to $4.2 million compared to $5.6 million for the same period in fiscal 2002. Diluted earnings per common share decreased to $1.36 on average common shares of 3,043,000 compared to $1.74 per share on average common shares of 3,202,000 for the nine months ended March 31, 2002. Dividends of $0.24 and $0.21 per share were paid for the nine months ended March 31, 2003 and 2002, respectively. The common dividend payout ratio based on diluted earnings per share was 17.6% for the first nine months ended March 31, 2003 compared to 12.1% for the first nine months ended March 31, 2002. Increases in the gain on sale recorded during the first nine months of fiscal 2003 were partially offset by increases in general and administrative expenses, employee related expenses and a $33.3 million valuation adjustment on securitization assets recorded during the nine-month period ended March 31, 2003. See below for further discussion of gain on sale, general and administrative expenses, other expenses and the securitization assets valuation adjustment recorded during the period. In fiscal 1999, the Board of Directors initiated a stock repurchase program in view of the price level of our common stock, which was at the time and has continued to, trade at below book value. In addition, our consistent earnings growth at that time did not result in a corresponding increase in the market value of our common stock. The repurchase program was extended in fiscal 2000, 2001 and 2002. The total number of shares repurchased under the stock repurchase program was: 117,000 shares in fiscal 1999; 327,000 shares in fiscal 2000; 627,000 shares in fiscal 2001; and 352,000 shares in fiscal 2002. The cumulative effect of the stock repurchase program was an increase in diluted net earnings per share of $0.20 and $0.35 for the nine months ended March 31, 2003 and 2002. We currently have no plans to continue to repurchase additional shares or extend the repurchase program. 46 On August 21, 2002, the Board of Directors declared a 10% stock dividend, which was paid on September 13, 2002 to shareholders of record on September 3, 2002. As a result of the stock dividend, all outstanding stock options and related exercise prices were adjusted. Accordingly, all outstanding common shares, earnings per common share, average common share and stock option amounts presented in this document have been adjusted to reflect the effect of this stock dividend. In December 2002, the Company's shareholders approved an increase in the number of shares of authorized preferred stock from 1.0 million shares to 3.0 million shares. The preferred shares may be used to raise equity capital, redeem outstanding debt or acquire other companies, although no such acquisitions are currently contemplated. The Board of Directors has discretion with respect to designating and establishing the terms of each series of preferred stock prior to issuance. Loan Originations The following schedule details our loan originations (in thousands):
Three Months Ended Nine Months Ended March 31, March 31, --------------------------- --------------------------- 2003 2002 2003 2002 --------- --------- ---------- ---------- Business purpose loans....... $ 32,119 $ 37,143 $ 93,170 $ 99,035 Home equity loans............ 371,554 291,631 1,084,170 907,594 --------- --------- ---------- ---------- $ 403,673 $ 328,774 $1,177,340 $1,006,629 ========= ========= ========== ==========
Loan originations for our subsidiary, American Business Credit, Inc., which offers business purpose loans secured by real estate, decreased $5.9 million, or 5.9%, for the nine months ended March 31, 2003, to $93.2 million from $99.0 million for the nine months ended March 31, 2002. Current economic conditions have had an adverse impact on smaller businesses and our ability to find qualified borrowers has become more difficult. In order to increase business purpose loan originations while maintaining our underwriting standards for business purpose loans, American Business Credit is in the process of expanding its marketing efforts into new geographic areas, including the addition of personnel to serve the new areas. American Business Credit is also beginning to build relationships with loan brokers, which it believes will provide an additional source for loan originations in the future. In addition, our business loan subsidiary is focusing on cost control by identifying efficiencies and streamlining the business purpose loan origination process. 47 Home equity loans originated by our subsidiaries, HomeAmerican Credit, doing business as Upland Mortgage and American Business Mortgage Services, Inc., and purchased through the Bank Alliance Services program, increased $176.6 million, or 19.5%, for the nine months ended March 31, 2003, to $1.1 billion from $907.6 million for the nine months ended March 31, 2002. Our home equity loan origination subsidiaries continue to focus on increasing efficiencies and productivity gains by refining marketing techniques and integrating technological improvements into the loan origination process. Expansion in the central and western portions of the United States is also planned to potentially increase loan origination volume. In addition, American Business Mortgage Services, Inc. is in the process of expanding its network of loan brokers to include a larger geographical area in order to reduce concentrations of loans in specific states. As a result of these efforts, as well as the favorable environment for originating home equity loans due to low interest rates, American Business Mortgage Services, Inc. loan originations for the nine months ended March 31, 2003 increased by $92.0 million, or 26.3%, over the prior year period. In addition, the historically low interest rate environment and productivity gains in our Upland Mortgage branch operations have resulted in an increase in loan originations of $39.6 million, or 47.1%, over the prior year period. The remaining increase in originations is primarily attributable to our Upland Mortgage direct retail originations. If interest rates remain level or increase, our ability to make home equity loans may become more difficult and may result in increased costs to originate loans as a result of increasing advertising or geographic expansion or result in a lower volume of loan originations. Summary Financial Results (dollars in thousands, except per share data)
Three Months Ended Nine Months Ended March 31, March 31, ------------------------- Percentage ------------------------- Percentage 2003 2002 Increase/(Decrease) 2003 2002 Increase/(Decrease) -------- -------- ------------------ --------- --------- ------------------- Total revenues.............. $ 71,766 $ 65,435 9.7% $ 220,851 $ 176,141 25.4% Total expenses.............. 71,737 62,399 15.0% 214,043 166,533 28.5% Net income.................. 221 1,761 (87.5)% 4,153 5,573 (25.5)% Return on average equity.... 1.17% 10.75% 7.47% 11.20% Return on average assets.... 0.09% 0.82% 0.60% 0.90% Earnings per share: Basic..................... $0.07 $0.58 (87.9)% $1.43 $ 1.88 (23.9)% Diluted................... $0.06 $0.55 (89.1)% $1.36 $ 1.74 (21.8)% Dividends declared per share..................... $0.08 $0.07 14.3% $0.24 $ 0.21 14.3%
Total Revenues. For the third quarter of fiscal 2003, total revenues increased $6.3 million, or 9.7%, to $71.8 million from $65.4 million for fiscal 2002. For the first nine months of fiscal 2003, total revenues increased $44.7 million, or 25.4%, to $220.9 million from $176.1 million for the first nine months of fiscal 2002. Growth in total revenues for both periods was the result of increases in gains on the securitization of mortgage loans and increases in interest accretion earned on our interest-only strips. Gain on Sale of Loans. For the third quarter of fiscal 2003, gains of $54.5 million were recorded on the securitization of $403.6 million of loans. This represents an increase of $5.3 million, or 10.7%, over gains of $49.2 million recorded on securitizations of $340.8 million of loans for the third quarter of fiscal 2002. For the nine months ended March 31, 2003, gains of $170.4 million were recorded on the securitization of $1.2 billion of loans. This was an increase of $41.3 million, or 31.9% over gains of $129.1 million recorded on securitizations of $1.0 billion of loans for the nine months ended March 31, 2002. 48 The increase in securitization gains for the three and nine months ended March 31, 2003 was due to both an increase in interest rate spreads earned in our securitizations and an increase in the volume of loans securitized. The securitization gain as a percentage of loans securitized increased to 14.5% for the nine months ended March 31, 2003 from 13.3% on loans securitized for the nine months ended March 31, 2002. Increases in interest rate spreads increase residual cash flows to us and the amount of cash we receive at the closing of a securitization from notional bonds or premiums on the sale of trust certificates. Increases in the cash received at the closing of a securitization and residual cash results in increases in the gains we recognize on the sale of loans into securitizations. See "-- Off-Balance Sheet Arrangements -- Securitizations" for further detail of how securitization gains are calculated. The increase in interest rate spread for the nine months ended March 31, 2003 compared to the nine months ended March 31, 2002 resulted from decreases in pass-through interest rates on investor certificates issued by securitization trusts. For loans securitized during the nine months ended March 31, 2003, the weighted average loan interest rate was 10.82%, a 4.9% decrease from 11.38% on loans securitized during the nine months ended March 31, 2002. However, the weighted average interest rate on trust certificates issued in mortgage loan securitizations during the nine months ended March 31, 2003 was 4.47%, a 19.7% decrease from 5.57% during the nine months ended March 31, 2002. The resulting net improvement in interest rate spread was approximately 54 basis points. Also contributing to the increase in the securitization gain percentages for the nine months ended March 31, 2003, was the increase in the amount of cash received at the closing of our securitizations. The improvement in the interest rate spread through fiscal 2002 to the present has enabled us to enter into securitization transactions structured to provide cash at the closing of the securitization through the sale of notional bonds, sometimes referred to as interest-only bonds or the sale of trust certificates at a premium. During the nine months ended March 31, 2003 we received additional cash at the closing of our securitizations, due to these modified structures, of $30.2 million compared to $19.4 million for the first nine months of fiscal 2002. Securitization gains and cash received at the closing of securitizations were partially offset by initial overcollateralization requirements of $3.8 million in fiscal 2003. There was no initial overcollateralization requirement in fiscal 2002. The Office of Thrift Supervision has adopted a rule effective in July 2003, which will preclude us and other non-bank, non-thrift creditors from using the Parity Act to preempt state prepayment penalty and late fee laws and regulations on new loan originations. Under the provisions of this rule we will be required to modify or eliminate the practice of charging a prepayment fee in some of the states where we originate loans and other fees we normally charge will also be modified or eliminated. This new rule will potentially reduce the gain on sale recorded in new securitizations in two ways. First, because the percentage of loans with prepayment fees will be reduced, the prepayment rates on securitized loan pools may increase and therefore the value of our interest-only strips will decrease due to the shorter average life of the securitized loan pool. Second, the value of our servicing rights retained in a securitization may decrease due a reduction in our ability to charge certain fees. We are currently evaluating the impact of the adoption of this rule on our future lending activities and results of operations. 49 Interest and Fees. For the third quarter of fiscal 2003, interest and fee income decreased $0.6 million, or 11.9%, to $4.7 million compared to $5.3 million for the third quarter of fiscal 2002. For the nine months ended March 31, 2003, interest and fee income decreased $3.3 million, or 19.9%, to $13.4 million compared to $16.8 million in the same period of fiscal 2002. Interest and fee income consists primarily of interest income earned on available for sale loans, premiums earned on whole loan sales and other ancillary fees collected in connection with loan and lease originations. During the third quarter of fiscal 2003, interest income increased $0.3 million, or 11.2%, to $2.7 million from $2.4 million for the third quarter of fiscal 2002. This is primarily caused by the increased loans held on our balance sheet prior to securitization in the comparable periods due to higher levels of loan originations during the period. During the nine months ended March 31, 2002, interest income decreased $0.6 million, or 8.7%, to $6.8 million from $7.5 million for the nine months ended March 31, 2002. The year to date decrease was due to a lower weighted-average interest rate on loans available for sale from the prior fiscal year and lower interest rates earned on invested cash balances due to general decreases in market interest rates. Premiums on whole loan sales decreased $2.3 million, to $29 thousand for the nine months ended March 31, 2003 from $2.4 million for the nine months ended March 31, 2002. The volume of whole loan sales decreased 96.0%, to $2.2 million for the nine months ended March 31, 2003 from $55.9 million for the nine months ended March 31, 2002. The decrease in the volume of whole loan sales for the nine months ended March 31, 2003 resulted from management's decision to securitize additional loans as the securitization market's experience during the past year was more favorable than the whole loan sale market. Other fees decreased $0.4 million for the third quarter and nine months of fiscal 2003 compared to the same periods in fiscal 2002. The decrease is mainly due to a decrease in leasing income, which resulted from our decision in fiscal 2000 to discontinue the origination of new leases. The ability to collect certain fees on loans we originate in the future may be impacted by proposed laws and regulations by various authorities. Interest Accretion on Interest-Only Strips. Interest accretion of $12.1 million and $34.4 million were earned in the three and nine months ended March 31, 2003 compared to $9.5 million and $25.9 million in the three and nine months ended March 31, 2002. The increase reflects the growth in the balance of our interest-only strips of $119.7 million, or 24.4%, to $609.9 million at March 31, 2003 from $490.1 million at March 31, 2002. In addition, cash flows from interest-only strips for the nine months ended March 31, 2003 totaled $109.8 million, an increase of $39.1 million, or 55.3%, from the nine months ended March 31, 2002 due to the larger size of our more recent securitizations and additional securitizations reaching final target overcollateralization levels and stepdown overcollateralization levels. Servicing Income. Servicing income is comprised of contractual and ancillary fees collected on securitized loans less amortization of the servicing rights assets that are recorded at the time loans are securitized. Ancillary fees include prepayment fees, late fees and other servicing fee compensation. For the three months ended March 31, 2003, servicing income decreased $0.8 million, or 62.1%, to $0.5 million from $1.3 million for the three months ended March 31, 2002. For the nine months ended March 31, 2003, servicing income decreased $1.5 million, or 36.7%, to $2.7 million from $4.2 million for the nine months ended March 31, 2002. 50 The following table summarizes the components of servicing income for the three and nine months ended March 31, 2003 and 2002 (in thousands):
Three Months Ended Nine Months Ended March 31, March 31, ------------------------ ---------------------- 2003 2002 2003 2002 -------- -------- -------- --------- Contractual and ancillary fees...............$ 11,232 $ 9,150 $ 32,682 $ 25,830 Amortization of servicing rights............. (10,746) (7,868) (30,015) (21,614) -------- -------- -------- --------- $ 486 $ 1,282 $ 2,667 $ 4,216 ======== ======== ======== =========
Because loan prepayment levels in fiscal 2003 increased from fiscal 2002, the amortization of servicing rights has also increased. Amortization is recognized in proportion to servicing income. Therefore the collection of additional prepayment fees in fiscal 2003 has resulted in higher levels of amortization. Total Expenses. Total expenses increased $9.3 million, or 15.0%, to $71.7 million for the three months ended March 31, 2003 compared to $62.4 million for the three months ended March 31, 2002. Total expenses increased $47.5 million, or 28.5%, to $214.0 million for the nine months ended March 31, 2003 compared to $166.5 million for the nine months ended March 31, 2002. As described in more detail below, this increase was mainly a result of increases in securitization asset valuation adjustments recorded during the nine months ended March 31, 2003, increases in employee related costs and increases in general and administrative expenses. Interest Expense. For the third quarter of fiscal 2003, interest expense decreased $0.4 million, or 2.1%, to $16.8 million from $17.2 million for the third quarter of fiscal 2002. Average subordinated debt outstanding during the three months ended March 31, 2003 was $704.3 million compared to $628.9 million during the three months ended March 31, 2002. The effect of the increase in outstanding debt was offset by a decrease in the average interest rates paid on subordinated debt. Average interest rates paid on subordinated debt outstanding decreased to 9.09% during the three months ended March 31, 2003 from 10.50% during the three months ended March 31, 2002. During the first nine months of fiscal 2003, interest expense decreased $0.4 million, or 0.8%, to $51.1 million compared to $51.5 million for the nine months ended March 31, 2002. Average subordinated debt outstanding during the nine months ended March 31, 2003 was $684.2 million compared to $603.2 million during the nine months ended March 31, 2002. Average interest rates paid on subordinated debt outstanding decreased to 9.42% during the nine months ended March 31, 2003 from 10.80% during the nine months ended March 31, 2002. Rates offered on subordinated debt were reduced beginning in the fourth quarter of fiscal 2001 and have continued downward through the third quarter of fiscal 2003 in response to decreases in market interest rates as well as our lower cash needs. The average interest rate of subordinated debt issued at its peak rate, which was the month of February 2001, was 11.85% compared to the average interest rate of subordinated debt issued in the month of March 2003 of 7.78%. As the higher rate notes mature, we expect the average interest rate paid on subordinated debt to decline provided that market rates do not significantly increase. 51 The average outstanding balances under warehouse lines of credit were $51.4 million during the three months ended March 31, 2003, compared to $22.3 million during the three months ended March 31, 2002. The average outstanding balances under warehouse lines of credit were $42.3 million during the nine months ended March 31, 2003, compared to $26.7 million during the nine months ended March 31, 2002. The increases in the average balances on warehouse lines were due to a higher volume of loans originated and lower average cash balances available for loan funding during the periods. Interest rates paid on warehouse lines are generally based on one-month LIBOR plus an interest rate spread ranging from 1.25% to 2.5%. One-month LIBOR has decreased from approximately 1.9% at March 31, 2002 to 1.3% at March 31, 2003. Provision for Credit Losses. The provision for credit losses on available for sale loans and leases was $1.7 million for both the three months ended March 31, 2003 and March 31, 2002. The provision for credit losses on available for sale loans and leases for the nine months ended March 31, 2003 increased $0.3 million, or 5.8%, to $4.7 million, compared to $4.4 million for the nine months ended March 31, 2002. The increase in the provision for credit losses for the nine-month period was primarily due to increases in the average balance of loans in non-accrual status, which were generally repurchased from securitization trusts. The related allowance for loan losses on these repurchased loans is included in our provision for credit losses in the period of repurchase. See "Off-Balance Sheet Arrangements -- Securitizations -- Trigger Management" for further discussion of repurchases from securitization trusts. Non-accrual loans were $5.9 million and $8.8 million at March 31, 2003 and 2002, respectively. See "-- Managed Portfolio Quality" for further detail. The allowance for credit losses was $2.0 million, or 3.6% of gross receivables at March 31, 2003 compared to $3.7 million, or 6.6% of gross receivables at June 30, 2002 and $3.3 million, or 5.1% of gross receivables at March 31, 2002. The allowance for credit losses as a percentage of gross receivables decreased from June 30, 2002 and March 31, 2002 due to the decrease of the non-accrual loan balance being carried on the Company's books at March 31, 2003. Although we maintain an allowance for credit losses at the level we consider adequate to provide for potential losses, there can be no assurances that actual losses will not exceed the estimated amounts or that an additional provision will not be required. 52 The following table summarizes changes in the allowance for credit losses for the three and nine months ended March 31, 2003 and 2002 (in thousands):
Three Months Ended Nine Months Ended March 31, March 31, ------------------------ ------------------------- 2003 2002 2003 2002 ------------ ----------- ------------ ------------ Balance at beginning of period...............$ 3,581 $ 2,878 $ 3,705 $ 2,480 Provision for credit losses.................. 1,718 1,728 4,692 4,434 (Charge-offs) recoveries, net................ (3,346) (1,309) (6,444) (3,617) ----------- ---------- ----------- ------------ $ 1,953 $ 3,297 $ 1,953 $ 3,297 =========== ========== =========== ============
The following table summarizes the changes in the allowance for credit losses by loan and lease type (in thousands):
Business Home Purpose Equity Equipment Three Months Ended March 31, 2003: Loans Loans Leases Total - ---------------------------------- -------- ------- --------- ------- Balance at beginning of period........... $ 1,387 $ 1,898 $ 296 $ 3,581 Provision for credit losses.............. 229 1,392 97 1,718 (Charge-offs) recoveries, net............ (1,016) (2,153) (177) (3,346) -------- -------- ------- ------- Balance at end of period................. $ 600 $ 1,137 $ 216 $ 1,953 ======== ======== ======= ======= Business Home Purpose Equity Equipment Nine Months Ended March 31, 2003: Loans Loans Leases Total - --------------------------------- -------- ------- --------- ------- Balance at beginning of period........... $ 1,388 $ 1,998 $ 319 $ 3,705 Provision for credit losses.............. 1,079 3,257 356 4,692 (Charge-offs) recoveries, net............ (1,867) (4,118) (459) (6,444) -------- -------- ------- ------- Balance at end of period................. $ 600 $ 1,137 $ 216 $ 1,953 ======== ======== ======= ======= Business Home Purpose Equity Equipment Three Months Ended March 31, 2002: Loans Loans Leases Total - ---------------------------------- -------- ------- --------- ------- Balance at beginning of period........... $ 801 $ 1,739 $ 338 $ 2,878 Provision for credit losses.............. 242 823 663 1,728 (Charge-offs) recoveries, net............ (140) (493) (676) (1,309) -------- -------- ------- ------- Balance at end of period................. $ 903 $ 2,069 $ 325 $ 3,297 ======== ======== ======= ======= Business Home Purpose Equity Equipment Nine Months Ended March 31, 2002: Loans Loans Leases Total - --------------------------------- -------- ------- --------- ------- Balance at beginning of period........... $ 591 $ 1,473 $ 416 $ 2,480 Provision for credit losses.............. 1,134 2,368 932 4,434 (Charge-offs) recoveries, net............ (822) (1,772) (1,023) (3,617) -------- -------- ------- ------- Balance at end of period................. $ 903 $ 2,069 $ 325 $ 3,297 ======== ======== ======= =======
The increase in charge-offs for the first nine-month period of fiscal 2003 compared to the same nine-month period of fiscal 2002 was due to increases in the liquidation of loans repurchased from securitization trusts. 53 Employee Related Costs. For the third quarter of fiscal 2003, employee related costs decreased $0.1 million, or 0.5%, to $9.4 million from $9.5 million in the third quarter of fiscal 2002. For the nine months ended March 31, 2003, employee related costs increased $4.0 million, or 15.5%, to $30.0 million from $26.0 million in the prior year. Total employees at March 31, 2003 were 1,093 compared to 968 at March 31, 2002. Increases in payroll and benefits expenses for the increased number of employees were offset in the third quarter of fiscal 2003 compared to the third quarter of fiscal 2002 by reductions of management bonus accruals due to the overall financial performance of the Company in the third quarter of fiscal 2003. The increase in employee related costs in fiscal 2003 for the nine-month comparative period was primarily attributable to additions of personnel to originate, service and collect loans. The remaining increase was attributable to annual salary increases as well as increases in the costs of providing insurance benefits to employees. Sales and Marketing Expenses. For the third quarter of fiscal 2003, sales and marketing expenses increased $0.5 million, or 7.2%, to $7.0 million from $6.5 million for the third quarter of fiscal 2002. For the nine months ended March 31, 2003, sales and marketing expenses increased $1.2 million, or 6.3%, to $20.1 million from $18.9 million for the nine months ended March 31, 2002. These increases were primarily due to increases in expenses for direct mail advertising for home equity and business loan originations offset by decreases in newspaper advertisements for subordinated debt. General and Administrative Expenses. For the third quarter of fiscal 2003, general and administrative expenses increased $7.3 million, or 39.0%, to $26.2 million from $18.8 million for the third quarter of fiscal 2002 mainly due to increases of $3.6 million in costs associated with servicing and collecting our larger total managed portfolio, $2.9 million in costs associated with customer retention incentives to help mitigate loan prepayments and $1.3 million in losses on interest rate swaps. For the nine months ended March 31, 2003, general and administrative expenses increased $22.3 million, or 42.4%, to $74.9 million from $52.6 million for the nine months ended March 31, 2002. This increase for the nine months ended March 31, 2003 compared to the same period in fiscal 2002 was primarily attributable to increases of approximately $12.8 million in costs associated with servicing and collecting our larger total managed portfolio including expenses associated with REO and delinquent loans, $6.8 million increase in costs associated with customer retention incentives in addition to increases of $5.6 million in losses on interest rate swaps. We expect general and administrative expenses to continue to increase as the size of our managed portfolio increases. Securitization Assets Valuation Adjustment. During the three months ended March 31, 2003, a write down through the Statement of Income of $10.7 million was recorded on our securitization assets compared to $8.7 million during the third quarter of fiscal 2002. Of the adjustments, $8.8 million and $8.7 million were write downs of our interest-only strips in fiscal 2003 and 2002, respectively. The remaining $1.9 million in fiscal 2003 was a write down of our servicing rights. These adjustments reflect the impact of higher prepayment experience on home equity loans than anticipated during the period. This portion of the impact of increased prepayments was considered to be other than temporary and was therefore recorded as an adjustment to earnings in the current period in accordance with SFAS No. 115 and EITF 99-20 as they relate to interest-only strips and SFAS No. 140 as it relates to servicing rights. During the nine months ended March 31, 2003, write downs through the Statement of Income of $33.3 million were recorded compared to $13.2 million for the same period in fiscal 2002. Of these adjustments, $28.8 million and $13.2 million were write downs of our interest-only strips in fiscal 2003 and 2002, respectively. The remaining $4.5 million in fiscal 2003 was a write down of our servicing rights. See "-- Off-Balance Sheet Arrangements -- Securitizations" for further detail of these adjustments. 54 Provision for Income Taxes. For the nine months ended March 31, 2003, the provision for income taxes decreased $1.4 million as a result of a $2.8 million decline in pre-tax income and a reduction in our effective tax rate from 42% to 39%. The change in the effective tax rate was made due to an anticipated decrease in any future interest costs on federal tax deficiencies. In the third quarter of fiscal 2003, we recorded a tax benefit of $0.2 million as the cumulative effect of the change in the effective tax rate for fiscal 2003 was recorded in the third quarter. BALANCE SHEET INFORMATION Balance Sheet Data: See "-- Reconciliation of Non-GAAP Financial Measures" for a reconciliation of the below four ratios to the most directly comparable financial measure prepared in accordance with GAAP. (Dollars in thousands, except per share data) March 31, June 30, 2003 2002 -------- --------- Cash and cash equivalents................ $ 87,232 $ 108,599 Loan and lease receivables, net: Available for sale.................... 52,651 52,622 Interest and fees..................... 14,154 12,292 Other................................. 21,254 9,028 Interest-only strips..................... 609,891 512,611 Servicing rights......................... 132,925 125,288 Receivable for sold loans................ -- 5,055 Total assets............................. 972,939 876,375 Subordinated debt........................ 710,218 655,720 Warehouse lines and other notes payable.. 6,782 8,486 Accrued interest payable................. 45,513 43,069 Deferred income taxes.................... 38,898 35,124 Total liabilities........................ 895,712 806,997 Total stockholders' equity............... 77,227 69,378 Book value per common share.............. $ 26.31 $ 24.40 Total liabilities to tangible equity(c).. 14.4x 14.9x Adjusted debt to tangible equity (a)(c).. 12.4x 12.2x Subordinated debt to tangible equity(c).. 11.4x 12.1x Interest-only strips to adjusted tangible equity (b)(c)................ 4.6x 4.3x - ----------------------------- (a) Total liabilities less cash and secured borrowings to tangible equity. (b) Interest-only strips less overcollateralization interests to tangible equity plus subordinated debt with a remaining maturity greater than five years. (c) Tangible equity is calculated as total stockholders' equity less goodwill. Total assets increased $96.6 million, or 11.0%, to $972.9 million at March 31, 2003 from $876.4 million at June 30, 2002 primarily due to increases in interest-only strips, servicing rights and loan and lease receivables - Other, offset by a decrease in cash and cash equivalents. 55 Cash and cash equivalents decreased mainly due to higher levels of loan receivables funded with cash and cash paid on settlements of hedging activities during the period as well as a planned leveling in the issuance of subordinated debt during the nine-month period. Loan and lease receivables - Other increased $12.2 million or 135.4% due to increases in delinquent loans eligible for repurchase from securitization trusts. See Note 2 of the Consolidated Financial Statements for an explanation of these loan receivables. Activity of our interest-only strips for the nine months ended March 31, 2003 and 2002 were as follows (in thousands):
Nine Months Ended March 31, ------------------------ 2003 2002 --------- --------- Balance at beginning of period............................ $ 512,611 $ 398,519 Initial recognition of interest-only strips, including initial overcollateralization of $3.8 million and $0.... 141,511 112,869 Cash flow from interest-only strips....................... (109,849) (70,729) Required purchases of additional overcollateralization.... 53,496 35,468 Interest accretion........................................ 34,361 25,920 Termination of lease securitization (a)................... (1,741) -- Net temporary adjustments to fair value (b)............... 8,286 1,253 Other than temporary adjustments to fair value (b)........ (28,784) (13,153) --------- --------- Balance at end of period.................................. $ 609,891 $ 490,147 ========= =========
- ----------------- (a) Reflects release of lease collateral from a lease securitization trust which was terminated in accordance with the trust documents after the full payout of trust note certificates. Lease receivables of $1.6 million were recorded on our balance sheet as a result of the termination. (b) Net temporary adjustments to fair value are recorded through other comprehensive income, which is a component of equity. Other than temporary adjustments to decrease the fair value of interest-only strips are recorded through the income statement. The following table summarizes the purchases of overcollateralization by trust for the nine months ended March 31, 2003, and the years ended June 30, 2002 and 2001. See "-- Off-Balance Sheet Arrangements -- Securitizations" for a discussion of overcollateralization requirements. 56 Summary of Mortgage Loan Securitization Overcollateralization Purchases (in thousands)
2002-4 2002-3 2002-2 2002-1 2001-4 2001-3 2001-2 Other Total ------ ------ ------ ------ ------ ------ ------ ----- ----- Nine months ended March 31, 2003: Initial overcollateralization.... $3,800 $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 3,800 Required purchases of additional overcollateralization.......... 4,300 7,263 10,241 10,586 10,525 7,645 3,007 (71) $53,496 ------ ------ ------- ------- ------- ------ ------ ------ ------- Total............................ $8,100 $7,263 $10,241 $10,586 $10,525 $7,645 $3,007 $ (71) 57,296 ====== ====== ======= ======= ======= ====== ====== ====== ======= 2002-1 2001-4 2001-3 2001-2 2001-1 2000-4 2000-3 2000-2 2000-1 Other Total ------ ------ ------ ------ ------ ------ ------ ------ ------ ----- ----- Year Ended June 30, 2002: Required purchases of additional overcollateralization.......... $3,814 $ 908 $ 4,354 $11,654 $ 8,700 $6,326 $3,074 $4,978 $ 2,490 $ 973 $47,271 2001-2 2001-1 2000-4 2000-3 2000-2 2000-1 1999-4 1999-3 1999-2 Other Total ------ ------ ------ ------ ------ ------ ------ ------ ------ ----- ----- Year Ended June 30, 2001: Initial overcollateralization $ -- $ -- $ -- $ -- $ 611 $ -- $ -- $ -- $ -- $ -- $ 611 Required purchases of additional overcollateralization.......... 959 2,574 6,049 4,051 10,160 7,519 5,960 3,719 2,316 638 43,945 ------ ------ ------- ------- ------- ------ ------ ------ ------- ------ ------- Total............................ $ 959 $2,574 $ 6,049 $ 4,051 $10,771 $7,519 $5,960 $3,719 $ 2,316 $ 638 $44,556 ====== ====== ======= ======= ======= ====== ====== ====== ======= ====== =======
Servicing rights increased $7.6 million, or 6.1%, to $132.9 million at March 31, 2003 from $125.3 million at June 30, 2002, due to the securitization of $1.2 billion of loans during the nine months ended March 31, 2003, partially offset by amortization of the servicing asset for fees collected during the same period and a $4.5 million write down of the servicing asset mainly due to the impact of higher than expected prepayment experience. Total liabilities increased $88.7 million, or 11.0%, to $895.7 million from $807.0 million at June 30, 2002 primarily due to increases in subordinated debt outstanding, increases in accounts payable and accrued expenses and increases in obligations to repurchase securitized loans recorded in other liabilities. See Note 2 of the Consolidated Financial Statements for further detail of this obligation. Accounts payable and accrued expenses increased $7.6 million, or 55.4%, primarily due to accruals for costs associated with customer retention incentives to help mitigate loan repayments and liabilities to securitization trust collection accounts for periodic interest advances. During the nine months ended March 31, 2003, subordinated debt increased $54.5 million, or 8.3%, to $710.2 million due to sales of subordinated debt used to repay existing debt, to fund loan originations and our operations and for general corporate purposes. Approximately $28.2 million of the increase in subordinated debt was due to the reinvestment of accrued interest on the subordinated debt at maturity. Subordinated debt was 11.4 times tangible equity at March 31, 2003, compared to 12.1 times as of June 30, 2002. See "-- Liquidity and Capital Resources" for further information regarding outstanding debt. 57 Managed Portfolio Quality The following table provides data concerning delinquency experience, real estate owned and loss experience for the managed loan and lease portfolio. See "-- Reconciliation of Non-GAAP Financial Measures" for a reconciliation of total managed portfolio and managed REO measures to our balance sheet. See "-- Deferment and Forebearance Arrangements" for the amounts of loans whose contractual status have been reset to current as a result of these arrangements. (Dollars in thousands):
March 31, 2003 December 31, 2002 September 30, 2002 ------------------------ -------------------- --------------------- Delinquency by Type Amount % Amount % Amount % -------------- ------- ------------- ------ ------------- ------- Business Purpose Loans Total managed portfolio............. $ 392,228 $ 385,139 $ 369,148 ============ =========== =========== Period of delinquency: 31-60 days...................... $ 5,526 1.41% $ 3,966 1.03% $ 3,852 1.04% 61-90 days...................... 2,718 0.69 4,040 1.05 4,025 1.09 Over 90 days.................... 35,286 9.00 35,708 9.27 34,467 9.34 ------------ ----- ----------- ----- ----------- ----- Total delinquencies............. $ 43,530 11.10% $ 43,714 11.35% $ 42,344 11.47% ============ ===== =========== ===== =========== ===== Managed REO......................... $ 4,506 $ 6,021 $ 8,267 ============ =========== =========== Home Equity Loans Total managed portfolio............. $ 3,073,392 $ 2,933,492 $ 2,806,490 ============ =========== =========== Period of delinquency: 31-60 days...................... $ 47,809 1.56% $ 46,746 1.59% $ 50,578 1.80% 61-90 days...................... 23,261 0.76 29,610 1.01 26,065 0.93 Over 90 days.................... 104,939 3.41 100,044 3.41 89,971 3.21 ------------ ----- ----------- ----- ----------- ----- Total delinquencies............. $ 176,009 5.73% $ 176,400 6.01% $ 166,614 5.94% ============ ===== =========== ===== =========== ===== Managed REO......................... $ 30,704 $ 28,403 $ 24,167 ============ =========== =========== Equipment Leases Total managed portfolio............. $ 12,185 $ 16,907 $ 22,523 ============ =========== =========== Period of delinquency: 31-60 days...................... $ 379 3.11% $ 359 2.12% $ 338 1.50% 61-90 days...................... 89 0.73 46 0.27 181 0.80 Over 90 days.................... 85 0.70 358 2.12 389 1.73 ------------ ----- ----------- ----- ----------- ----- Total delinquencies............. $ 553 4.54% $ 763 4.51% $ 908 4.03% ============ ===== =========== ===== =========== ===== Combined Total managed portfolio............. $ 3,477,805 $ 3,335,538 $ 3,198,161 ============ =========== =========== Period of delinquency: 31-60 days...................... $ 53,714 1.55% $ 51,071 1.53% $ 54,768 1.71% 61-90 days...................... 26,068 0.75 33,696 1.01 30,271 0.95 Over 90 days.................... 140,310 4.03 136,110 4.08 124,827 3.90 ------------ ----- ----------- ----- ----------- ----- Total delinquencies............. $ 220,092 6.33% $ 220,877 6.62% $ 209,866 6.56% ============ ===== =========== ===== =========== ===== Managed REO......................... $ 35,210 1.01% $ 34,424 1.03% $ 32,434 1.01% ============ ===== =========== ===== =========== ===== Losses experienced during the three month period(a)(b): Loans........................... $ 8,405 0.99% $ 5,849 0.72% $ 7,863 1.01% ===== ===== ===== Leases.......................... 176 4.82% 65 1.33% 201 3.13% ------------ ===== ----------- ===== ----------- ===== Total managed portfolio......... $ 8,581 1.01% $ 5,914 0.72% $ 8,064 1.03% ============ ===== =========== ===== =========== =====
(a) Percentage based on annualized losses and average managed portfolio. (b) Losses recorded on our books were $6.1 million ($3.1 million from charge-offs through the provision for loan losses and $3.0 million for write downs of real estate owned) and losses absorbed by loan securitization trusts were $2.5 million for the three months ended March 31, 2003. Losses recorded on our books were $2.4 million ($0.9 million from charge-offs through the provision for loan losses and $1.5 million for write downs of real estate owned) and losses absorbed by loan securitization trusts were $3.5 million for the three months ended December 31, 2002. Losses recorded on our books were $4.2 million ($1.9 million from charge-offs through the provision for loan losses and $2.3 million for write downs of real estate owned) and losses absorbed by loan securitization trusts were $3.9 million for the three months ended September 30, 2002. Losses recorded on our books include losses for loans we hold as available for sale or real estate owned and loans repurchased from securitization trusts. 58 The following table summarizes key delinquency statistics related to loans, leases and REO recorded on our balance sheet and their related percentage of our available for sale portfolio (dollars in thousands):
March 31, December 31, September 30, 2003 2002 2002 ------------ ------------ ------------ Delinquencies held as available for sale (a)..... $ 5,992 $ 9,494 $ 6,658 11.7% 16.2% 11.5% Available for sale loans and leases in non-accrual status (b)........................ $ 5,905 $ 9,886 $ 6,991 11.5% 16.9% 12.1% Allowance for losses on available for sale loans and leases............................. $ 1,953 $ 3,581 $ 3,184 3.6% 5.8% 5.7% Real estate owned on balance sheet............... $ 6,348 $ 7,215 $ 3,784
- ---------------------------- (a) Included in total delinquencies are loans in non-accrual status of $5.6 million, $8.6 million and $6.2 million at March 31, 2003, December 31, 2002 and September 30, 2002, respectively. (b) It is our policy to suspend the accrual of interest income when a loan is contractually delinquent for 90 days or more. Non-accrual loans and leases are included in total delinquencies in the previously presented "Managed Portfolio Quality" table. Deferment and Forbearance Arrangements. Our policies and practices regarding deferment and forbearance arrangements, like all of our collections policies and practices, are designed to manage customer relationships, maximize collections and avoid foreclosure or repossession if reasonably possible. From time to time, borrowers are confronted with events, usually involving hardship circumstances or temporary financial setbacks that adversely affect their ability to continue payments on their loan for some period of time. To assist borrowers during a hardship period, we may agree to enter into a deferment or forbearance arrangement. When economic conditions, such as those that exist at the present time, cause the value of the real estate securing our loans to rise, thereby lowering loan-to-value ratios, we are able to be more accommodating to borrowers who request a deferment or forbearance arrangement as relief from their temporary financial hardship. These arrangements permit us to reset the contractual status of a loan in our managed portfolio from delinquent to current based upon evidence, which in our judgment indicates a significant potential for eventual resumption of contractual payments. In a deferment arrangement, which is initiated solely at the request of the borrower, we make advances to a securitization trust on behalf of the borrower in amounts equal to the delinquent loan payments. The borrower must repay the advances either at the termination of the loan or on a monthly payment plan. Borrowers must provide written documentation outlining their hardship and requesting deferment. Other principal guidelines applicable to the deferment process are: (i) the borrower may have up to six payments deferred during the life of the loan and must have a history demonstrating the ability to repay in post-deferment periods; (ii) no more than three payments may be deferred during a twelve-month period; and (iii) the borrower must have made a minimum of six timely payments on the loan and twelve months must have passed since the last deferment in order to qualify for a new deferment request. In a forbearance arrangement, which also is initiated solely at the request of a borrower, we also make advances to a securitization trust on behalf of the borrower in amounts equal to the delinquent loan payments and we also advance any unpaid taxes, insurance premiums or similar assessments. The borrower must repay the advances in addition to their regular monthly payment until the advances are paid in full and the borrower must exhibit the ability to remit post-forbearance payments in a timely manner. A forbearance is part of a formal agreement in which the borrower must execute a deed in lieu of foreclosure, subject to exceptions based on local laws and regulations and individual borrower circumstances. We retain the unrecorded deed in safekeeping until such time as the entire advance amount is repaid. If the borrower subsequently defaults before repaying the advances in full, we have the option to record the deed after providing proper notification to the borrower and a reasonable period of time to cure. The recording of the deed allows us to proceed with a deed in lieu of foreclosure action, which is typically less complex and less costly than a foreclosure action. Other principal guidelines applicable to the forbearance process are: (i) the subject loan must be at least nine months old; (ii) the loan must be a minimum of two payments delinquent and it is preferred that the deferment option be exhausted prior to the initiation of a forbearance process; and (iii) the borrower must not have excessive liens against the real estate collateralizing the loan. 59 We do not enter into a deferment or forbearance arrangement based solely on the fact that a loan meets the criteria for one of the arrangements. Our use of the arrangements depends upon a new credit decision, our view of prevailing economic conditions and an individual's circumstances, which vary from borrower to borrower. Because deferral and forbearance arrangements are account management tools which help us to manage customer relationships, maximize collection opportunities and increase the value of our account relationships, the application of these tools generally is subject to constantly shifting complexities and variations in the marketplace. We continually review and assess the policies and practices to make sure they are in alignment with the goals we have set for them. We modify or permit exceptions to the policies and practices from time to time and from one reporting period to another. In most cases, a loan is considered current if the borrower immediately begins payment under the terms of the deferment or forbearance arrangement and we do not reflect it as a delinquent loan in our delinquency statistics, although if the agreed terms are not adhered to by the borrower, the account status may be reversed and collection actions resumed. The following table presents information regarding loans under deferment and forbearance arrangements, which are reported as current loans and thus not included in delinquencies as of the end of our last four quarters (dollars in thousands):
Cumulative Unpaid Principal Balance --------------------------------------------- % of Under Under Managed Deferment Forbearance Total Portfolio ----------- ------------- ---------- ------------ June 30, 2002........................... $64,958 $73,705 $138,662 4.52% September 30, 2002...................... 67,282 76,649 143,931 4.50 December 31, 2002....................... 70,028 81,585 151,613 4.55 March 31, 2003(a)....................... 85,205 84,751 169,955 4.89
- ---------------------- (a) Included in cumulative unpaid principal balance are loans with arrangements that were entered into longer than twelve months ago. At March 31, 2003, there was $35.5 million of cumulative unpaid principal balance under deferment arrangements and $30.2 million of cumulative unpaid principal balance under forbearance arrangements that were entered into prior to April 2002. Additionally, there are loans under deferment and forbearance arrangements which return to delinquent status. At March 31, 2003 there was $22.6 million of cumulative unpaid principal balance under deferment arrangements and $48.8 million of cumulative unpaid principal balance under forbearance arrangements that are reported as delinquent 31 days or more. During the quarter ended March 31, 2003 we experienced a pronounced increase in the number of borrowers requesting a deferment or forbearance arrangement and in light of the weakened economic environment we made use of deferment arrangements to a greater degree than in prior periods. We currently expect this condition to be temporary and will actively attempt to manage the loan accounts under deferment arrangement to maximize our chances for full recovery of the borrowed amount while still accommodating borrower needs during their period of hardship. The following table presents the amount of unpaid principal balance of loans that entered into a deferment or forbearance arrangement in the first three quarters of fiscal 2003 (dollars in thousands):
Unpaid Principal Balance Impacted by Arrangements --------------------------------------------- % of Under Under Managed Quarter Ended: Deferment Forbearance Total Portfolio ----------- ------------- ---------- ------------ September 30, 2002...................... $11,619 $23,564 $35,183 1.10% December 31, 2002....................... 17,015 27,004 44,018 1.32 March 31, 2003.......................... 37,117 28,051 65,168 1.87
Delinquent loans and leases. Total delinquencies (loans and leases with payments past due greater than 30 days, excluding REO) in the total managed portfolio were $220.1 million at March 31, 2003 compared to $220.9 million and $209.9 million at December 31, 2002 and September 30, 2002, respectively. Total delinquencies as a percentage of the total managed portfolio were 6.33% at March 31, 2003 compared to 6.62% and 6.56% at December 31, 2002 and September 30, 2002, respectively. Delinquencies at June 30, 2002 were $170.8 million or 5.57% of the managed portfolio. Although delinquencies at March 31, 2003 have declined, increases in percentages in fiscal 2003 from fiscal 2002 were mainly due to the impact on our borrowers of continued uncertain economic conditions, which may include the reduction in other sources of credit to our borrowers, and the seasoning of the managed portfolio. These factors have also resulted in a significant increase in the usage of deferment and forbearance arrangements, which impact the aging status of loans for purposes of delinquency reporting described above. In addition, the delinquency percentage had increased due to increased prepayment rates resulting from refinancing activities. Refinancing is not typically available to delinquent borrowers, and therefore the remaining portfolio is experiencing a higher delinquency rate. A leveling in the growth of the managed portfolio as a result of higher prepayment rates and decreases in the growth of the origination of new loans also contributed to the increase in the delinquency percentage in fiscal 2003 from June 30, 2002. As the managed portfolio continues to season, and if economic conditions continue to lag or worsen, the delinquency rate may continue to increase. Delinquent loans and leases held as available for sale on our balance sheet increased slightly from $5.9 million at June 30, 2002 to $6.0 million at March 31, 2003. Compared to December 31, 2002 and September 30, 2002 delinquencies decreased primarily due to liquidations through sales of loans repurchased from our mortgage securitization trusts. See "Results of Operations -- Provision for Credit Losses" for further detail of the impact of delinquencies. 60 Real estate owned. Total REO, comprising foreclosed properties and deeds acquired in lieu of foreclosure, increased to $35.2 million, or 1.01%, of the total managed portfolio at March 31, 2003 compared to $34.4 million, or 1.03% and $32.4 million, or 1.01%, at December 31, 2002 and September 30, 2002, respectively. REO at June 30, 2002 was $34.0 million, or 1.11%. As our portfolio seasons and if economic conditions continue to lag or worsen, REO as a percentage of the portfolio may increase. Although the disposition of REO is affected by court processes, seasonality of the real estate market and other factors beyond our control, management has been making a concerted effort to reduce the time a loan remains in seriously delinquent status until the sale of an REO property. This effort includes adding additional personnel to the process and has included bulk sales of REO. Reducing the time properties are carried reduces carrying costs for interest on funding the cost of the property, legal fees, taxes, insurance and maintenance related to these properties. We believe the results of this effort are evident in the fact that REO as a percentage of the managed portfolio has remained level. REO held by us on our balance sheet increased from $3.8 million at June 30, 2002 to $6.3 million at March 31, 2003 primarily due to repurchases of foreclosed loans from our mortgage securitization trusts. Loss experience. During the third quarter of fiscal 2003, we experienced net loan and lease charge-offs in our total managed portfolio of $8.6 million. On an annualized basis, during the third quarter of fiscal 2003, net loan and lease charge-offs were 1.01% of the total managed portfolio. For the three months ended December 31, 2003, net loan and lease charge-offs in our total managed portfolio were $5.9 million, or 0.72% of the average total managed portfolio. For the three months ended September 30, 2002, net loan and lease charge-offs in our total managed portfolio were $8.1 million, or 1.03% of the average total managed portfolio. Principal loss severity experience on delinquent loans generally has ranged from 10% to 30% of principal and loss severity experience on REO generally has ranged from 25% to 40% of principal. As noted above, we have attempted to reduce the time a loan remains in seriously delinquent status until the sale of an REO property in order to reduce carrying costs on the property. See "-- Summary of Loans and REO Repurchased from Mortgage Loan Securitization Trusts" for further detail of loan repurchase activity. See "-- Off-Balance Sheet Arrangements -- Securitizations" for more detail on credit loss assumptions used to estimate the fair value of our interest-only strips and servicing rights compared to actual loss experience. Real estate values have generally continued to increase in recent periods and their increases have exceeded the rate of increase of many other types of investments in the current economy. If in the future this trend reverses and real estate values begin to decline, our loss severity rates could increase. INTEREST RATE RISK MANAGEMENT A primary market risk exposure that we face is interest rate risk. Profitability and financial performance is sensitive to changes in interest rate swap yields, U.S. Treasury yields, one-month LIBOR yields and the interest rate spread between the effective rate of interest received on loans available for sale or securitized (all fixed interest rates) and the interest rates paid pursuant to credit facilities or the pass-through interest rate to investors for interests issued in connection with securitizations. A substantial and sustained increase in market interest rates could adversely affect our ability to originate and purchase loans and maintain our profitability. The overall objective of our interest rate risk management strategy is to mitigate the effects of changing interest rates on profitability and the fair value of interest rate sensitive balances (primarily loans available for sale, interest-only strips, servicing rights and subordinated debt). We would address this challenge by carefully monitoring our product pricing, the actions of our competition and market trends and the use of hedging strategies in order to continue to originate loans in as profitable a manner as possible. 61 A component of our interest rate risk exposure relates to changes in the fair value of certain interest-only strips due to changes in one-month LIBOR. The structure of certain securitization trusts includes a floating interest rate certificate, which pays interest based on one-month LIBOR plus an interest rate spread. Floating interest rate certificates in a securitization expose us to gains or losses due to changes in the fair value of the interest-only strip from changes in the floating interest rate paid to the certificate holders. A rising interest rate environment could unfavorably impact our liquidity and capital resources. Rising interest rates could impact our short-term liquidity by widening investor interest rate spread requirements in pricing future securitizations, increasing the levels of overcollateralization in future securitizations, limiting our access to borrowings in the capital markets and limiting our ability to sell our subordinated debt securities at favorable interest rates. In a rising interest rate environment, short-term and long-term liquidity could also be impacted by increased interest costs on all sources of borrowed funds, including the subordinated debt, and by reducing interest rate spreads on our securitized loans, which would reduce our cash flows. See "-- Liquidity and Capital Resources" for a discussion of both long and short-term liquidity. Interest Rate Sensitivity. The following table provides information about financial instruments that are sensitive to changes in interest rates. For interest-only strips and servicing rights, the table presents projected principal cash flows utilizing assumptions including prepayment and credit loss rates. See "-- Off-Balance Sheet Arrangements -- Securitizations" for more information on these assumptions. For debt obligations, the table presents principal cash flows and related average interest rates by expected maturity dates (dollars in thousands):
Amount Maturing After March 31, 2003 ------------------------------------------------------------------------------ Months Months Months Months Months There- Fair 1 to 12 13 to 24 25 to 36 37 to 48 49 to 60 after Total Value ------- -------- -------- -------- -------- --------- -------- -------- Rate Sensitive Assets: Loans and leases available for sale (a).$ 46,986 $ 73 $ 80 $ 88 $ 97 $ 5,327 $ 52,651 $ 53,265 Interest-only strips.................... 127,407 130,263 125,011 109,418 90,043 317,028 899,170 609,891 Servicing rights........................ 42,754 33,970 26,764 20,948 16,402 53,101 193,939 132,925 Investments held to maturity............ 215 253 424 - - - 892 935 Rate Sensitive Liabilities: Fixed interest rate borrowings..........$365,866 $146,685 $130,361 $ 27,097 $ 14,685 $ 26,406 $711,100 $710,051 Average interest rate................... 9.32% 9.19% 9.34% 9.84% 9.88% 11.32% 9.82% Variable interest rate borrowings.......$ 5,862 $ 3 $ 30 $ - $ 5 $ - $ 5,900 $ 5,900 Average interest rate................... 2.80% 3.08% 3.08% 3.08% 3.08% 3.08% 2.80%
- ---------------------------- (a) For purposes of this table, all loans and leases which qualify for securitization are reflected as maturing within twelve months, since loans and leases available for sale are generally held for less than three months prior to securitization. 62 Loans Available for Sale. Gain on sale of loans may be unfavorably impacted to the extent we hold fixed interest rate available for sale mortgage loans prior to securitization. A significant variable affecting the gain on sale of loans in a securitization is the interest rate spread between the average interest rate on fixed interest rate loans and the weighted-average pass-through interest rate to investors for interests issued in connection with the securitization. Although the average loan interest rate is fixed at the time the loan is originated, the pass-through interest rate to investors is not fixed until the pricing of the securitization which occurs just prior to the sale of the loans. Generally, the period between loan origination and pricing of the pass-through interest rate is less than three months. If market interest rates required by investors increase prior to securitization of the loans, the interest rate spread between the average interest rate on the loans and the pass-through interest rate to investors may be reduced or eliminated. This factor could have a material adverse effect on our results of operations and financial condition. We estimate that each 0.1% reduction in the interest rate spread reduces the gain on sale of loans as a percentage of loans securitized by approximately 0.22%. See "-- Strategies for Use of Derivative Financial Instruments" for further detail of our interest rate risk management for available for sale loans. Interest-Only Strips and Servicing Rights. A portion of the certificates issued to investors by certain securitization trusts are floating interest rate certificates based on one-month LIBOR plus an interest rate spread. The fair value of the excess cash flow we will receive from these trusts would be affected by any changes in interest rates paid on the floating interest rate certificates. At March 31, 2003, $142.1 million of debt issued by loan securitization trusts was floating interest rate certificates based on one-month LIBOR, representing 4.4% of total debt issued by loan securitization trusts. In accordance with accounting principles generally accepted in the United States of America, the changes in fair value are generally recognized as part of net adjustments to other comprehensive income, which is a component of retained earnings. As of March 31, 2003, the interest rate sensitivity for $60.8 million of floating interest rate certificates issued by securitization trusts is managed with an interest rate swap contract effectively fixing our cost for this debt. In addition, the interest rate sensitivity for $63.0 million of floating interest rate certificates issued from the 2003-1 Trust is managed using an interest rate cap which limits the one-month LIBOR to a maximum rate of 4%. See "-- Strategies for Use of Derivative Financial Instruments" for further detail. A significant change in market interest rates could increase or decrease the level of loan prepayments, thereby changing the size of the total managed loan portfolio and the related projected cash flows. We attempt to minimize prepayment risk on interest-only strips and servicing rights by requiring prepayment fees on business loans and home equity loans, where permitted by law. Currently, approximately 90-95% of business loans and 85-90% of home equity loans in the total managed portfolio are subject to prepayment fees. However, higher than anticipated rates of loan prepayments could result in a write down of the fair value of related interest-only strips and servicing rights, adversely impacting earnings during the period of adjustment. Revaluation of our interest-only strips and servicing rights is performed on a quarterly basis. As part of the revaluation process, assumptions used for prepayment rates are monitored against actual experience, economic conditions and other factors and adjusted if warranted. See "-- Off-Balance Sheet Arrangements -- Securitizations" for further information regarding these assumptions and the impact of prepayments during this period. Subordinated Debt. We also experience interest rate risk to the extent that as of March 31, 2003 approximately $345.2 million of our liabilities were comprised of fixed interest rate subordinated debt with scheduled maturities of greater than one year. To the extent that market interest rates demanded on subordinated debt increase in the future, the interest rates paid on replacement debt could exceed interest rates currently paid thereby increasing interest expense and reducing net income. 63 Strategies for Use of Derivative Financial Instruments. All derivative financial instruments are recorded on the balance sheet at fair value with realized and unrealized gains and losses included in the statement of income in the period incurred. Hedging activity From time to time derivative financial instruments are utilized in an attempt to mitigate the effect of changes in interest rates between the date loans are originated and the date the fixed interest rate pass-through certificates to be issued by a securitization trust are priced. Generally, the period between loan origination and pricing of the pass-through interest rate is less than three months. Derivative financial instruments we use for hedging changes in fair value due to interest rate changes may include interest rate swaps, futures and forward contracts. The nature and quantity of hedging transactions are determined based on various factors, including market conditions and the expected volume of mortgage loan originations and purchases. At the time the contract is executed, derivative contracts are specifically designated as hedges of mortgage loans or our residual interests in mortgage loans in our mortgage conduit facility, which we would expect to be included in a term securitization at a future date. The mortgage loans and mortgage loans underlying residual interests in mortgage pools consist of essentially similar pools of fixed interest rate loans, collateralized by real estate (primarily residential real estate) with similar maturities and similar credit characteristics. Fixed interest rate pass-through certificates issued by securitization trusts are generally priced to yield an interest rate spread above interest rate swap yield curves with maturities to match the maturities of the interest rate pass-through certificates. We may hedge potential interest rate changes in interest rate swap yield curves with interest rate swaps, Eurodollar futures, forward treasury sales or derivative contracts of similar underlying securities. This practice has provided strong correlation between our hedge contracts and the ultimate pricing we will receive on the subsequent securitization. The unrealized gain or loss derived from these derivative financial instruments, which are designated as fair value hedges, is reported in earnings as it occurs with an offsetting adjustment to the fair value of the item hedged. The fair value of derivative financial instruments is based on quoted market prices. The fair value of the items hedged is based on current pricing of these assets in a securitization. Cash flow related to hedging activities is reported as it occurs. The effectiveness of our hedges are continuously monitored. If correlation did not exist, the related gain or loss on the hedged item would no longer be recognized as an adjustment to income. 64 We recorded the following gains and losses on the fair value of derivative financial instruments accounted for as hedges for the three and nine-month periods ended March 31, 2003 and 2002. Any ineffectiveness related to hedging transactions during the period was immaterial. Ineffectiveness is a measure of the difference in the change in fair value of the derivative financial instrument as compared to the change in the fair value of the item hedged (in thousands):
Three Months Ended Nine Months Ended March 31, March 31, --------------------------- --------------------------- 2003 2002 2003 2002 --------- ----------- --------- ----------- Offset by gains and losses recorded on securitizations: Losses on derivative financial instruments... $ (2,071) $ (135) $ (3,806) $ (4,923) Offset by gains and losses recorded on the fair value of hedged items: Losses on derivative financial instruments... (16) -- (3,070) -- Amount settled in cash - paid................ (2,619) (135) (5,041) (4,923)
At March 31, 2003 outstanding forward starting interest rate swap contracts accounted for as hedges and unrealized losses recorded as liabilities on the balance sheet were as follows (in thousands): Notional Unrealized Amount Loss -------- ---------- Forward starting interest rate swaps............................. $47,497 $ 2,809 The sensitivity of forward starting interest rate swap contracts held as hedges as of March 31, 2003 to a 0.1% change in market interest rates is $0.1 million. Trading activity Generally, we do not enter into derivative financial instrument contracts for trading purposes. However, we have entered into derivative financial instrument contracts which we have not designated as hedges in accordance with accounting principles generally accepted in the United States of America and were therefore accounted for as trading assets or liabilities. During the three and nine months ended March 31, 2003, we used interest rate swap contracts to protect the future securitization spreads on loans in our pipeline. Loans in the pipeline represent loan applications for which we are in the process of obtaining all the documentation required for a loan approval or approved loans, which have not been accepted by the borrower and are not considered to be firm commitments. We believed there was a greater chance that market interest rates we would obtain on the subsequent securitization of these loans would increase rather than decline, and chose to protect the spread we could earn in the event of rising rates. However due to a decline in market interest rates during the period the contracts were in place, we recorded the following losses on forward starting interest rate swap contracts, which were used to manage interest rate risk on loans in our pipeline and were therefore classified as trading for the three and nine-month periods ended March 31, 2003 and 2002 (in thousands):
Three Months Ended Nine Months Ended March 31, March 31, ---------------------------- -------------------------- 2003 2002 2003 2002 ------------ ----------- ----------- ----------- Trading losses on forward starting interest rate swaps............................... $ (784) $ -- $ (3,708) $ -- Amount settled in cash - paid.............. -- -- (2,671) --
65 At March 31, 2003 outstanding forward starting interest rate swap contracts used to manage interest rate risk on loans in the Company's pipeline and associated unrealized losses recorded as liabilities on the balance sheet were as follows (in thousands): Notional Unrealized Amount Loss -------- ---------- Forward starting interest rate swaps........................... $72,503 $ 22 The sensitivity of the forward starting interest rate swap contracts held as trading as of March 31, 2003 to a 0.1% change in market interest rates is $0.3 million. In addition, for the three and nine-month periods ended March 31, 2003, respectively, the Company recorded losses of $0.1 million and $1.1 million on an interest rate swap contract which is not designated as an accounting hedge, and gains of $0.5 million for the three and nine-month periods ended March 31, 2002. This contract was designed to reduce the exposure to changes in the fair value of certain interest-only strips due to changes in one-month LIBOR. The loss on the swap contract was due to decreases in the interest rate swap yield curve during the period the contract was in place. Of the losses recognized during the nine-month period, $0.3 million were unrealized losses representing the net change in the fair value of the contract during the period and $0.8 million were cash losses. The cumulative net unrealized loss of $0.5 million is included as a trading liability in Other liabilities at March 31, 2003. Terms of the interest rate swap agreement at March 31, 2003 were as follows (dollars in thousands): Notional amount.................................$ 66,412 Rate received - Floating (a)..................... 1.34% Rate paid - Fixed................................ 2.89% Maturity date....................................April 2004 Unrealized loss.................................$ 755 Sensitivity to 0.1% change in interest rates....$ 30 - ------------------ (a) Rate represents the spot rate for one-month LIBOR paid on the securitized floating interest rate certificate at the end of the period. Derivative transactions are measured in terms of a notional amount, but this notional amount is not carried on the balance sheet. The notional amount is not exchanged between counterparties to the derivative financial instrument, but is only used as a basis to determine fair value, which is recorded on the balance sheet and to determine interest and other payments between the counterparties. Our exposure to credit risk in a derivative transaction is represented by the fair value of those derivative financial instruments in a gain position. We attempt to manage this exposure by limiting our derivative financial instruments to those traded on major exchanges and where our counterparties are major financial institutions. At March 31, 2003, we held no derivative financial instruments in a gain position. 66 In the future, we may expand the types of derivative financial instruments we use to hedge interest rate risk to include other types of derivative contracts. However, an effective interest rate risk management strategy is complex and no such strategy can completely insulate us from interest rate changes. Poorly designed strategies or improperly executed transactions may increase rather than mitigate risk. Hedging involves transaction and other costs that could increase as the period covered by the hedging protection increases. Although it is expected that such costs would be offset by income realized from securitizations in that period or in future periods, we may be prevented from effectively hedging fixed interest rate loans held for sale without reducing income in current or future periods. In addition, while Eurodollar rates, interest rate swap yield curves and the pass-through interest rate of securitizations are generally strongly correlated, this correlation has not held in periods of financial market disruptions (e.g., the so-called Russian Crisis in the later part of 1998). LIQUIDITY AND CAPITAL RESOURCES Liquidity and capital resource management is a process focused on providing the funding to meet our short and long-term cash needs. We have used a substantial portion of our funding sources to build our managed portfolio and investments in securitization residual assets with the expectation that they will generate sufficient cash flows in the future to cover our operating requirements, including repayment of maturing subordinated debt. Our cash needs change as the managed portfolio grows, as our interest-only strips grow and release more cash, as subordinated debt matures, as operating expenses change and as revenues increase. Because we have historically experienced negative cash flows from operations, our business requires continual access to short and long-term sources of debt to generate the cash required to fund our operations. Our cash requirements include funding loan originations and capital expenditures, repaying existing subordinated debt, paying interest expense and operating expenses, and in connection with our securitizations, funding overcollateralization requirements and servicer obligations. At times, we have used cash to repurchase our common stock and could in the future use cash for unspecified acquisitions of related businesses or assets (although no acquisitions are currently contemplated). 67 Following is a summary of future payments required on our contractual obligations as of March 31, 2003 (in thousands):
Payments Due by Period ----------------------------------------------------------------------- Less than 1 to 3 4 to 5 More than Contractual Obligations Total 1 year years years 5 years - ---------------------------------- ----------- ----------- ----------- --------- ---------- Subordinated debt ................ $710,218 $364,984 $277,046 $ 41,782 $ 26,406 Accrued interest - subordinated debt (a) ...................... 45,450 23,776 15,923 2,240 3,511 Warehouse and operating lines of credit ..................... 5,900 5,900 -- -- -- Capitalized lease (b) ............ 882 311 571 -- -- Operating leases (c) ............. 55,406 2,104 9,422 10,499 33,381 Services and equipment (d) ....... 10,542 10,542 -- -- -- -------- -------- -------- -------- -------- Total obligations ................ $828,398 $407,617 $302,962 $ 54,521 $ 63,298 ======== ======== ======== ======== ========
(a) This table reflects interest payment terms elected by subordinated debt holders as of March 31, 2003. In accordance with the terms of the subordinated debt offering, subordinated debt holders have the right to change the timing of the interest payment on their notes once during the term of their investment. (b) Amounts include principal and interest. (c) Amounts include lease for office space assuming a July 1, 2003 start date. Actual start date is dependent upon various factors and may be different from assumed date. (d) Amounts related to the relocation of our corporate headquarters. The provisions of the lease, local and state grants will provide us with reimbursement of a substantial amount of these payments. The following discussion of liquidity and capital resources should be read in conjunction with the discussion contained in "Application of Critical Accounting Policies." When loans are sold through a securitization, we retain the rights to service the loans. Servicing loans obligates us to advance interest payments for delinquent loans under certain circumstances and allows us to repurchase a limited amount of delinquent loans from securitization trusts. See "Off-Balance Sheet Arrangements" and "Off-Balance Sheet Arrangements -- Securitizations -- Trigger Management" for more information on how the servicing of securitized loans effects requirements on our capital resources and cash flow. Cash flow from operations, the issuance of subordinated debt and lines of credit fund our operating cash needs. Loan originations are funded through borrowings against warehouse credit facilities and sales into an off-balance sheet facility. Each funding source is described in more detail below. Cash flow from operations. One of our corporate goals is to achieve positive cash flow from operations. However, we cannot be certain that we will achieve our projections regarding declining negative cash flow or positive cash flow from operations. The achievement of this goal is dependent on our ability to: o Manage levels of securitizations to maximize cash flows received at closing and subsequently from interest-only strips and servicing rights; o Continue to grow a portfolio of mortgage loans which will generate income and cash flows through our servicing activities and the residual interests we hold in the securitized loans; o Build on our established approaches to underwriting loans, servicing and collecting loans and managing credit risks in order to control delinquency and losses; o Continue to invest in technology and other efficiencies to reduce per unit costs in our loan originations and servicing process; and o Control overall expense increases. 68 Our cash flow from operations is negatively impacted by a number of factors. The growth of our loan originations negatively impacts our cash flow from operations because we must bear the expenses of the origination, but generally do not recover the cash outflow from these expenses until we securitize or sell the underlying loans. With respect to loans securitized, we may be required to wait more than one year to begin recovering the cash outflow from loan origination expenses through cash inflows from our residual assets retained in securitization. A second factor, which negatively impacts our cash flow, is an increase in market interest rates. If market interest rates increase, the interest rates that investors demand on the certificates issued by securitization trusts will also increase. The increase in interest rates paid to investors reduces the cash we will receive from our interest-only strips. Although we may have the ability in a rising interest rate market to charge higher loan interest rates to our borrowers, competition, laws and regulations and other factors may limit or delay our ability to do so. Cash flow from operations for the nine months ended March 31, 2003 was a negative $41.5 million compared to negative $21.0 million for the first nine months of fiscal 2002. Negative cash flow from operations increased $20.5 million, or 97.8%, for the nine months ended March 31, 2003 from the nine months ended March 31, 2002 mainly due to increases in the repurchases of securitized loans to avoid delinquency triggers, the funding of $3.8 million in initial overcollateralization from the proceeds of our December 2002 securitization and $2.8 million for the settlement of derivative contracts. Increases in the proceeds from our securitizations from the sale of notional bonds and increases in the cash flow from interest-only strips in the first nine months of fiscal 2003 were offset by increases in operating expenses, mainly general and administrative expenses to service and collect the larger managed portfolio. Negative cash flow from operations was $0.2 million for the third quarter of fiscal 2003, compared to negative cash flow from operations of $32.8 million the second quarter of fiscal 2003, a decrease of $32.5 million. This decrease was mainly due to the receipt of $13.8 million of proceeds during the third quarter from the liquidation of impaired loans and REO that we had repurchased from securitization trusts in prior periods. Also contributing was a $5.1 million increase in the amount of cash we received at the closing of our third quarter securitization resulting from a $1.3 million increase in the proceeds from the sale of notional bonds over the second quarter and reduced initial overcollateralization from the second quarter when we were required to fund $3.8 million of overcollateralization from the proceeds of that quarter's securitization. The amount of cash that we received in the third quarter's securitization was also higher because the larger size of that securitization required us to reduce the amount of securitizable loans available for sale on our balance sheet by approximately $8.3 million. The amount of cash we receive and the amount of overcollateralization we are required to fund at the closing of our securitizations is dependent upon a number of factors including market factors over which we have no control. Although we expect negative cash flow from operations to continue and fluctuate in the foreseeable future, our goal is to continue to reduce our negative cash flow from operations from historical levels. We believe that if our business projections prove accurate, our cash flow from operations will become positive. However, negative cash flow from operations in the current fiscal year may continue to increase from fiscal 2002 levels because due to the nature of our operations, we generally expect the level of cash flow from operations to fluctuate. 69 As was previously discussed, during the six quarters ended March 31, 2003, our actual prepayment experience on our managed portfolio was generally higher than our average historical levels for prepayments. Prepayments result in decreases in the size of our managed portfolio and decreases in the expected future cash flows to us from our interest-only strips and servicing rights. However, due to the favorable interest rate spreads, favorable initial overcollateralization requirements and levels of cash received at closing on our more recent securitizations we do not believe our recent increase in prepayment experience will have a significant impact on our expected cash flows from operations in the future. Other factors could negatively affect our cash flow and liquidity such as increases in mortgage interest rates legislation or other economic conditions which may make our ability to originate loans more difficult. As a result, our costs to originate loans could increase or our volume of loan originations could decrease. Credit facilities. Borrowings against warehouse credit facilities represent cash advanced to us for a limited duration, generally no more than 270 days, and are secured by the loans we pledge to the lender. These credit facilities provide the primary funding source for loan originations. The ultimate sale of the loans through securitization or whole loan sale generates the cash proceeds necessary to repay the borrowings under the warehouse facilities. We also have a committed mortgage conduit facility, which enables us to sell our loans into an off-balance sheet facility. In addition, we have the availability of revolving credit facilities, which may be used to fund our operations. These credit facilities are generally extended for a one-year term before the renewal of the facility must be re-approved by the lender. We periodically review our expected future credit needs and negotiate credit commitments for those needs as well as excess capacity in order to allow us flexibility in the timing of the securitization of our loans. 70 The following is a description of the warehouse and operating lines of credit and mortgage conduit facilities, which were available to us at March 31, 2003 (in thousands):
Amount Amount Facility Utilized On- Utilized Off- Amount Balance Sheet Balance Sheet ------ ------------- ------------- Revolving credit and conduit facilities: Mortgage conduit facility, expiring July 2003 (a)................... $300,000 $ Na $29,528 Warehouse revolving line of credit, expiring November 2003 (b) ..... 200,000 -- Na Warehouse and operating revolving line of credit, expiring December 2003 (c)................................................. 50,000 5,862 Na Warehouse revolving line of credit, expiring October 2003 (d) ...... 25,000 -- Na Operating revolving line of credit, expiring January 2004 (e) ...... 1,200 -- Na -------- ------- ------- Total revolving credit facilities...................................... 576,200 5,862 29,528 Other facilities: Commercial paper conduit for lease production, maturity matches underlying leases (f)..................................... 199 38 161 Capitalized leases, maturing January 2006 (g) ...................... 882 882 Na -------- ------- ------- Total credit facilities................................................ $577,281 $ 6,782 $29,689 ======== ======= =======
- ---------------------------- Na - not applicable for facility (a) $300.0 million mortgage conduit facility. The facility provides for the sale of loans into an off-balance sheet facility with UBS Principal Finance, LLC, an affiliate of UBS Warburg. See "-- Application of Critical Accounting Policies" for further discussion of the off-balance sheet features of this facility. (b) $200.0 million warehouse line of credit with Credit Suisse First Boston Mortgage Capital, LLC. $100.0 million of this facility is continuously committed for the term of the facility while the remaining $100.0 million of the facility is available at Credit Suisse's discretion. The interest rate on the facility is based on one-month LIBOR plus a margin. Advances under this facility are collateralized by pledged loans. (c) $50.0 million warehouse and operating credit facility which includes a sublimit for a letter of credit to secure lease obligations for corporate office space with JPMorgan Chase Bank. Interest rates on the advances under this facility are based upon one-month LIBOR plus a margin. The amount of the letter of credit was $8.0 million at March 31, 2003 and will vary over the term of the lease. Obligations under the facility are collateralized by pledged loans, REO, and advances to securitization trusts. Advances on this line for general operating purposes are limited to $5.0 million and are collateralized by our Class R Certificate of the ABFS Mortgage Loan Trusts 1997-2, 1998-1 and 1998-3. (d) $25.0 million warehouse line of credit facility from Residential Funding Corporation. Under this warehouse facility, advances may be obtained, subject to specific conditions described in the agreements. Interest rates on the advances are based on one-month LIBOR plus a margin. The obligations under this agreement are collateralized by pledged loans. (e) $1.2 million revolving line of credit facility from Firstrust Savings Bank. The obligations under this facility are collateralized by the cash flows from our investment in the ABFS 99-A lease securitization trust. The interest rate on the advances from this facility is one-month LIBOR plus a margin. (f) The commercial paper conduit for lease production provided for sale of equipment leases using a pooled securitization. After January 2000, the facility was no longer available for sales of equipment leases. (g) Capitalized leases, imputed interest rate of 8.0%, collateralized by computer equipment. The warehouse credit agreements require that we maintain specific financial covenants regarding net worth, leverage, net income, liquidity, total debt and other standards. Each agreement has multiple individualized financial covenant thresholds and ratio limits that we must meet as a condition to drawing on a particular line of credit. At March 31, 2003, we were in compliance with the terms of all financial covenants. Some of our financial covenants have minimal flexibility and we cannot say with certainty that we will continue to comply with the terms of all debt covenants. If we do not comply with the debt covenants in one of our credit facilities, we can utilize excess capacity in our other credit facilities for loan funding, request a waiver from our lender or request a renegotiation of the terms of the agreement in order to allow us to continue to draw down on the facility. There can be no assurance that a waiver or modification of terms would be granted us should one be requested in the future. 71 Subordinated debt securities. The issuance of subordinated debt funds the majority of our remaining operating cash requirements. We rely significantly on our ability to issue subordinated debt since our cash flow from operations is not sufficient to meet these requirements. In order to expand our businesses we have issued subordinated debt to partially fund growth and to partially fund maturities of subordinated debt. In addition, at times we may elect to utilize proceeds from the issuance of subordinated debt to fund loans instead of using our warehouse credit facilities, depending on our determination of liquidity needs. During the nine months ended March 31, 2003, subordinated debt increased by $54.5 million, net of redemptions compared to an increase of $102.8 million in the first nine months of fiscal 2002. The reduction in the level of subordinated debt sold was a result of our focus on becoming cash flow positive and reducing our reliance on subordinated debt. We registered $315.0 million of subordinated debt under a registration statement, which was declared effective by the Securities and Exchange Commission on October 3, 2002. Of the $315.0 million, $187.5 million of this debt was available for future issuance as of March 31, 2003. We intend to meet our obligation to repay such debt and interest as it matures with cash flow from operations, cash flows from interest-only strips and cash generated from additional debt financing. The utilization of funds for the repayment of such obligations should not adversely affect operations. Our unrestricted cash balances are sufficient to cover approximately 19.1% of the $388.8 million of subordinated debt and accrued interest maturities due within one year. Unrestricted cash balances were $74.4 million at March 31, 2003, compared to $99.6 million at June 30, 2002 and $122.9 million at March 31, 2002. The current low interest rate environment has provided an opportunity to reduce the interest rates offered on our subordinated debt. The weighted-average interest rate of our subordinated debt issued in the month of March 2003 was 7.27%, compared to debt issued in March 2002, which had a weighted-average interest rate of 7.85%. Debt issued at our peak rate, which was in February 2001, was at a rate of 11.85%. Our ability to further decrease the rates offered on subordinated debt, or maintain the current rates, depends on market interest rates and competitive factors among other circumstances. The weighted average remaining maturity of our subordinated debt at March 2003 was 18 months compared to 17 months at March 2002. Sales into special purpose entities and off-balance sheet facilities. We rely significantly on access to the asset-backed securities market through securitizations to provide permanent funding of our loan production. We also retain the right to service the loans. Residual cash from the loans after required principal and interest payments are made to the investors provide us with cash flows from our interest-only strips. It is our expectation that future cash flows from our interest-only strips and servicing rights will generate more of the cash flows required to meet maturities of our subordinated debt and our operating cash needs. See "-- Off-Balance Sheet Arrangements" for further detail of our securitization activity and effect of securitizations on our liquidity and capital resources. 72 Other liquidity considerations. In December 2002, our shareholders approved an amendment to our Certificate of Incorporation to increase the number of shares of authorized preferred stock from 1.0 million shares to 3.0 million shares. The preferred shares may be used to raise equity capital, redeem outstanding debt or acquire other companies, although no such acquisitions are currently contemplated. The Board of Directors has discretion with respect to designating and establishing the terms of each series of preferred stock prior to issuance. A failure to renew or obtain adequate funding under a warehouse credit facility, offerings of subordinated debt, or any substantial reduction in the size or pricing in the markets for loans, could have a material adverse effect on our results of operations and financial condition. To the extent we are not successful in maintaining or replacing existing financing, we may have to curtail loan production activities or sell loans rather than securitize them, thereby having a material adverse effect on our results of operations and financial condition. A significant portion of our loan originations are non-conforming mortgages to subprime borrowers. Some participants in the non-conforming mortgage industry have experienced greater than anticipated losses on their securitization interest-only strips and servicing rights due to the effects of increased delinquencies, increased credit losses and increased prepayment rates. As a result, some competitors have exited the business or have recorded valuation allowances or write downs for these conditions. Due to these circumstances, some participants experienced restricted access to capital required to fund loan originations and have been precluded from participation in the asset-backed securitization market. However, we have maintained our ability to obtain funding and to securitize loans. Factors that have minimized the effect of adverse market conditions on our business include our ability to originate loans through established retail channels, focus on credit underwriting, assessment of prepayment fees on loans, diversification of lending in the home equity and business loan markets and the ability to raise capital through sales of subordinated debt securities pursuant to a registered public offering. Subject to economic, market and interest rate conditions, we intend to continue to transact additional securitizations for future loan originations. Any delay or impairment in our ability to securitize loans, as a result of market conditions or otherwise, could adversely affect our liquidity and results of operations. A further decline in economic conditions, continued instability in financial markets or further acts of terrorism in the United States may cause disruption in our business and operations including reductions in demand for our loan products and our subordinated debt securities, increases in delinquencies and credit losses in our managed loan portfolio, changes in historical prepayment patterns and declines in real estate collateral values. To the extent the United States experiences an economic downturn, unusual economic patterns and unprecedented behaviors in financial markets, these developments may affect our ability to originate loans at profitable interest rates, to price future loan securitizations profitably and to hedge our loan portfolio effectively against market interest rate changes which could cause reduced profitability. Should these disruptions and unusual activities occur, our profitability and cash flow could be reduced and our ability to make principal and interest payments on our subordinated debt could be impaired. Additionally, under the Soldiers' and Sailors' Civil Relief Act of 1940, members of all branches of the military on active duty, including draftees and reservists in military service and state national guard called to federal duty are entitled to have interest rates reduced and capped at 6% per annum, on obligations (including mortgage loans) incurred prior to the commencement of military service for the duration of military service and may be entitled to other forms of relief from mortgage obligations. To date, compliance with the Act has not had a material effect on our business. 73 RELATED PARTY TRANSACTIONS We have a loan receivable from our Chairman and Chief Executive Officer, Anthony J. Santilli, for $0.6 million, which was an advance for the exercise of stock options to purchase 247,513 shares of our common stock in 1995. The loan is due in September 2005 (earlier if the stock is disposed of). Interest at 6.46% is payable annually. The loan is secured by 247,513 shares of our common stock, and is shown as a reduction of stockholders' equity in our financial statements. On April 2, 2001, we awarded 2,500 shares (3,025 shares after the effect of stock dividends) of our common stock to Richard Kaufman, our director, as a result of services rendered in connection with our stock repurchases. In February 2003, we awarded 2,000 shares of our common stock to both Warren E. Palitz and Jeffrey S. Steinberg, respectively, as newly appointed members of our Board of Directors. We employ members of the immediate family of some of our directors and executive officers in various positions. We believe that the salaries we pay these individuals are competitive with salaries paid to other employees in similar positions in our organization and in our industry. In fiscal 2003, Lanard & Axilbund, Inc., a real estate brokerage and management firm in which our Director, Mr. Sussman, was a partner and is now Chairman Emeritus, acted as our agent in connection with the lease of our new corporate office space. As a result of this transaction, Lanard & Axilbund, Inc. has, and will receive, when our lease begins, a commission from the owner of the building where we will be leasing office space. We believe that the commission to be received by Lanard & Axilbund, Inc. as a result of this transaction is consistent with market and industry standards. Additionally, as part of our agreement with Lanard & Axilbund, Inc., they reimbursed us for some of our costs related to finding new office space including some of our expenses related to legal services, feasibility studies and space design. An additional reimbursement payment will be made to us when our lease begins. Additionally, we have business relationships with other related parties, including family members of directors and officers, through which we have purchased appraisal services, office equipment and real estate advisory services. None of our related party transactions, individually or collectively, are material to our results of operations. 74 RECONCILIATION OF NON-GAAP FINANCIAL MEASURES This quarterly report contains non-GAAP financial measures. For purposes of the Securities and Exchange Commission Regulation G, a non-GAAP financial measure is a numerical measure of a registrant's historical or future financial performance, financial position or cash flow that excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that were included in the most directly comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows (or equivalent statement) of the Company; or includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented. In this regard, GAAP refers to generally accepted accounting principles in the United States of America. Pursuant to the requirements of Regulation G, following is a reconciliation of the non-GAAP financial measures to the most directly comparable financial measure. The Company presents certain financial ratios to measure balance sheet leverage relationships that include or exclude items from GAAP based financial ratios consistent with common industry practices. Additionally, some ratios are adjusted in order to isolate secured items such as secured debt or overcollateralization, which is secured by loan principal in securitization trusts, from unsecured items. Management believes these measures enhance the users' overall understanding of the Company's current financial performance and prospects for the future and that these measures help in understanding the risk characteristics of certain significant balance sheet amounts and how their proportions to equity changes over time. The following tables reconcile the ratios presented in "Balance Sheet Information -- Balance Sheet Data" to GAAP basis measures (dollars in thousands):
Total liabilities to tangible equity: March 31, 2003 June 30, 2002 -------------- ------------- Total liabilities ................. $ 895,712 $ 806,997 Equity ............................ 77,227 69,378 Less: Goodwill .................... (15,121) (15,121) --------- --------- Tangible equity ............... $ 62,106 $ 54,257 ========= ========= Total liabilities to tangible equity.......................... 14.4x 14.9x ========= ========= Liabilities/equity ................ 11.6x 11.6x ========= =========
75
Adjusted debt to tangible equity: March 31, 2003 June 30, 2002 -------------- ------------- Total liabilities................. $ 895,712 $ 806,997 Less: Cash........................ (87,232) (108,599) Less: Warehouse lines............. (6,782) (8,486) Less: Loans in process............ (31,750) (29,866) --------- ---------- 769,948 660,046 Equity............................ 77,227 69,378 Less: Goodwill.................... (15,121) (15,121) --------- ---------- Tangible equity............... $ 62,106 $ 54,257 ========= ========== Adjusted debt to tangible equity......................... 12.4x 12.2x ========= ========== Liabilities/equity................ 11.6x 11.6x ========= ========== Subordinated debt to tangible equity: March 31, 2003 June 30, 2002 -------------- ------------- Subordinated debt................. $ 710,218 $ 655,720 Equity............................ 77,227 69,378 Less: Goodwill.................... (15,121) (15,121) --------- ---------- Tangible equity............... $ 62,106 $ 54,257 ========= ========== Subordinated debt to tangible equity......................... 11.4x 12.1x ========= ========== Liabilities/equity................ 11.6x 11.6x ========= ========== Interest-only strips to adjusted tangible equity: March 31, 2003 June 30, 2002 -------------- ------------- Interest-only strips.............. $ 609,891 $ 512,611 Less: Overcollateralization....... (201,258) (160,079) --------- ---------- 408,633 352,532 Equity............................ 77,227 69,378 Less: Goodwill.................... (15,121) (15,121) --------- ---------- Tangible equity............... 62,106 54,257 Plus: Subordinated debt with remaining maturity >5 years..... 26,406 27,629 --------- ---------- $ 88,512 $ 81,886 ========= ========== Interest-only strips to adjusted tangible equity................ 4.6x 4.3x ========= ========= Interest-only strips/equity....... 7.9x 7.4x ========= =========
76 The Company presents Managed Portfolio and Managed REO information. Management believes these measures enhance the users' overall understanding of the Company's current financial performance and prospects for the future because the volume and credit characteristics of off-balance sheet securitized loan and lease receivables have a significant effect on the financial performance of the Company as a result of the Company's retained interests in the securitized loans. Retained interests included interest-only strips and servicing rights. In addition, because the servicing and collection of the Company's off-balance sheet securitized loan and lease receivables are performed in the same manner and according to the same standards as the servicing and collection of its on-balance sheet loan and lease receivables, certain Company resources, such as personnel and technology, are allocated based on the total Managed Portfolio and total Managed REO. The following tables reconcile the managed portfolio measures presented in "Managed Portfolio Quality." (Dollars in thousands):
March 31, 2003: Delinquencies - -------------------------------------------------------------------------- Amount % ----------------------- On-balance sheet loan and lease receivables...................... $ 51,347 $ 5,992 11.67% Securitized loan and lease receivables...................... 3,426,458 214,100 6.25% ---------- -------- ------- Total Managed Portfolio........... $3,477,805 $220,092 6.33% ========== ======== ======= On-balance sheet REO.............. $ 6,348 Securitized REO................... 28,862 ---------- Total Managed REO................. $ 35,210 ========== December 31, 2002: Delinquencies - -------------------------------------------------------------------------- Amount % ----------------------- On-balance sheet loan and lease receivables...................... $ 58,582 $ 9,494 16.21% Securitized loan and lease receivables...................... 3,276,956 211,383 6.45% ---------- -------- ------- Total Managed Portfolio........... $3,335,538 $220,877 6.62% ========== ======== ======= On-balance sheet REO.............. $ 7,215 Securitized REO................... 27,209 ---------- Total Managed REO................. $ 34,424 ========== September 30, 2002: Delinquencies - -------------------------------------------------------------------------- Amount % ----------------------- On-balance sheet loan and lease receivables...................... $ 57,884 $ 6,658 11.50% Securitized loan and lease receivables...................... 3,140,277 203,208 6.47% ---------- -------- ------- Total Managed Portfolio........... $3,198,161 $209,866 6.56% ========== ======== ======= On-balance sheet REO.............. $ 4,508 Securitized REO................... 27,926 ---------- Total Managed REO................. $ 32,434 ==========
77
June 30, 2002: Delinquencies - ----------------------------------------------------------------------------- Amount % --------------------- On-balance sheet loan and lease receivables..................... $ 56,625 $ 5,918 10.45% Securitized loan and lease receivables..................... 3,009,564 164,855 5.48% ---------- --------- ------- Total Managed Portfolio.......... $3,066,189 $170,773 5.57% ========== ========= ======= On-balance sheet REO............. $ 3,784 Securitized REO.................. 30,261 ---------- Total Managed REO................ $ 34,045 ==========
RECENT ACCOUNTING PRONOUNCEMENTS Set forth below are proposed accounting pronouncements that may have a future effect on operations. The following description should be read in conjunction with the significant accounting policies, which have been adopted that are set forth in Note 1 of the notes to the June 30, 2002 consolidated financial statements. In November 2002, the Financial Accounting Standards Board ("FASB") issued Financial Interpretation No. ("FIN") 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45 standardizes practices related to the recognition of a liability for the fair value of a guarantor's obligation. The rule requires companies to record a liability for the fair value of its guarantee to provide or stand ready to provide services, cash or other assets. The rule applies to contracts that require a guarantor to make payments based on an underlying factor such as change in market value of an asset, collection of the scheduled contractual cash flows from individual financial assets held by a special purpose entity, non-performance of a third party, for indemnification agreements, or for guarantees of the indebtedness of others among other things. The provisions of FIN 45 are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The disclosure requirements were effective for statements of annual or interim periods ending after December 15, 2002. Based on the requirements of this guidance for the quarter ended March 31, 2003, we have recorded a $0.7 million liability in conjunction with the sale of mortgage loans to the ABFS 2003-1 securitization trust which occurred in March 2003. This liability represents the fair value of periodic interest advances that we, as servicer of the securitized loans, are obligated to pay on behalf of delinquent loans in the trust. Recording of this liability reduces the gain on sale recorded for the securitization. We would expect to record a similar liability for each subsequent securitization, which generally occurs on a quarterly basis. The amount of the liability that will be recorded is dependent mainly on the volume of loans we securitize, the expected performance of those loans and the interest rate of the loans. In the quarter ended March 31, 2003, the adoption of FIN 45 reduced net income by approximately $0.3 million and diluted earnings per share by $0.11. See Note 8 of the Consolidated Financial Statements for further detail of this obligation. 78 In December 2002, the FASB issued SFAS No. 148 "Accounting for Stock-Based Compensation - Transition and Disclosure." SFAS No. 148 amends SFAS No. 123 "Accounting for Stock-Based Compensation." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based compensation and requires pro forma disclosures of the effect on net income and earnings per share had the fair value method been used to be included in annual and interim reports and disclosure of the effect of the method used if the accounting method was changed, among other things. SFAS No. 148 is effective for annual reports of fiscal years beginning after December 15, 2002 and interim reports for periods beginning after December 15, 2002. We plan to continue using the intrinsic value method of accounting for stock-based compensation and therefore the new rule will have no effect on our financial condition or results of operations. We adopted the new standard related to disclosure in the interim period beginning January 1, 2003. See Note 11 of the Consolidated Financial Statements for further detail of the adoption of this rule. In April 2003, the FASB began reconsidering the current alternatives for accounting for stock-based compensation. We cannot predict whether the guidance will change our current accounting for stock-based compensation, or what effect, if any, changes may have on our current financial condition or results of operations. In January 2003, the FASB issued FIN 46 "Consolidation of Variable Interest Entities." FIN 46 provides guidance on the identification of variable interest entities that are subject to consolidation requirements by a business enterprise. A variable interest entity subject to consolidation requirements is an entity that does not have sufficient equity at risk to finance its operations without additional support from third parties and the equity investors in the entity lack certain characteristics of a controlling financial interest as defined in the guidance. Special purpose entities ("SPEs") are one type of entity, which under certain circumstances may qualify as a variable interest entity. Although we use unconsolidated SPEs extensively in our loan securitization activities, the guidance will not affect our current consolidation policies for SPEs as the guidance does not change the guidance incorporated in SFAS No. 140 which precludes consolidation of a qualifying SPE by a transferor of assets to that SPE. FIN 46 will therefore have no effect on our financial condition or results of operations and would not be expected to affect it in the future. In March 2003, the FASB announced that it is reconsidering the permitted activities of a qualifying SPE. We cannot predict whether the guidance will change or what effect, if any, changes may have on our current consolidation policies for SPEs. PROPERTY We lease our corporate headquarters facilities in Bala Cynwyd, Pennsylvania under a five-year operating lease expiring in July 2003 at a minimum annual rental of approximately $2.9 million. We lease additional space in Bala Cynwyd under a five-year lease expiring November 2004 at an annual rental of approximately $0.7 million. We also lease a facility in Roseland, New Jersey under an operating lease expiring July 2003 at an annual rental of $0.8 million. In addition, branch offices are leased on a short-term basis in various cities throughout the United States. The leases for the branch offices are not material to operations. In December 2002, we entered into a new lease for office space for the relocation of our corporate headquarters into Philadelphia, Pennsylvania. The eleven-year operating lease is expected to commence in fiscal 2004. The terms of the rental agreement require increased payments annually for the term of the lease with average minimum annual rental payments of $4.2 million. We have entered into contracts, or may engage parties in the future, related to the relocation of our corporate headquarters such as contracts for building improvements to the leased space, office furniture and equipment and moving services. The provisions of the lease and local and state grants will provide us with reimbursement of a substantial amount of the costs related to the relocation, subject to certain conditions and limitations. We do not believe our unreimbursed expenses or unreimbursed cash outlay related to the relocation will be material to our operations. 79 The lease requires us to maintain a letter of credit in favor of the landlord to secure our obligations to the landlord throughout the term of the lease. The amount of the letter of credit is currently $8.0 million and declines over time to $4.0 million. The letter of credit is currently issued by JPMorgan Chase under our current lending facility with JPMorgan Chase. In March 2003, we entered into a new lease agreement for office space in Roseland, New Jersey for the relocation of the our regional processing center presently located in Roseland, New Jersey. The nine-year lease is expected to commence in May 2003. The terms of the rental agreement require increased payments periodically for the term of the lease with average minimum annual rental payments of $0.8 million. The provisions of the lease require the landlord to assume the costs to ready the premises for occupancy, subject to certain conditions and limitations. We do not believe that our expenses or cash outlay related to the relocation will be material to our operations. 80 AVAILABILITY OF REPORTS We make our annual and quarterly reports and other filings with the SEC available free of charge on our web site, www.abfsonline.com, as soon as reasonably practicable after filing with the SEC. We will provide, at no cost, paper or electronic copies of our reports and other filings made with the SEC. Requests should be directed to: Stephen M. Giroux, Esquire American Business Financial Services, Inc. BalaPointe Office Centre 111 Presidential Boulevard Bala Cynwyd, PA 19004 (610) 668-2440 The information on the web site listed above, is not and should not be considered part of this Quarterly Report on Form 10-Q and is not incorporated by reference in this document. This web site is only intended to be an inactive textual reference. Item 3. Quantitative and Qualitative Disclosure about Market Risk See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Risk Management." Item 4. Controls and Procedures Quarterly Evaluation of Disclosure Controls and Internal Controls. Within the 90 days prior to the date of this Quarterly Report on Form 10-Q, we evaluated the effectiveness of the design and operation of the Company's disclosure controls and procedures ("Disclosure Controls"). This evaluation ("Controls Evaluation") was done under the supervision and with the participation of management, including the Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"). Limitations on the Effectiveness of Controls. Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal controls and procedures for financial reporting ("Internal Controls") will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, but not absolute assurance that the objectives of a control system are met. Further, any control system reflects limitations on resources, and the benefits of a control system must be considered relative to its costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of a control. As design of a control system is also based upon certain assumptions about the likelihood of future events, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected. 81 Conclusions. Based upon the Controls Evaluation, the CEO and CFO have concluded that, subject to the limitations noted above, the Disclosure Controls are effective to timely alert management to material information relating to our Company during the period when the Company's periodic reports are being prepared. In accordance with SEC requirements, the CEO and CFO note that, since the date of the Controls Evaluation to the date of this Quarterly Report, there have been no significant changes in Internal Controls or in other factors that could significantly affect Internal Controls, including any corrective actions with regard to significant deficiencies and material weaknesses. PART II OTHER INFORMATION Item 1. Legal Proceedings On February 26, 2002, a purported class action titled Calvin Hale v. HomeAmerican Credit, Inc., No. 02 C 1606, United States District Court for the Northern District of Illinois, was filed in the Circuit Court of Cook County, Illinois (subsequently removed by Upland Mortgage to the captioned federal court) against our subsidiary, HomeAmerican Credit, Inc., which does business as Upland Mortgage, on behalf of borrowers in Illinois, Indiana, Michigan and Wisconsin who paid a document preparation fee on loans originated since February 4, 1997. The plaintiff alleges that the charging of, and the failure to properly disclose the nature of, a document preparation fee were improper under applicable state law. The plaintiff seeks restitution, compensatory and punitive damages and attorney's fees and costs, in unspecified amounts. We believe that our imposition of this fee is permissible under applicable law and we are vigorously defending the case. The Hale case consists of five separate counts - three purported class action counts and two individual counts. On November 22, 2002 the Illinois Federal District Court granted Upland Mortgage's motion to dismiss the three class action counts, but a judgment erroneously dismissing all five counts of the case was entered in the docket. The plaintiff appealed the dismissal to the United States Court of Appeals for the Seventh Circuit but, on February 14, 2003, the Court of Appeals dismissed the appeal for lack of jurisdiction, on the grounds that the judgment entered by the Illinois Federal District Court was erroneous and did not constitute a final disposition of all counts of the case. Action on the two remaining individual counts in the Illinois Federal District Court has resumed and discovery has been scheduled. 82 Our lending subsidiaries, including HomeAmerican Credit, Inc. which does business as Upland Mortgage, are involved, from time to time, in class action lawsuits, other litigation, claims, investigations by governmental authorities, and legal proceedings arising out of their lending activities, including the purported class action entitled, Calvin Hale v. HomeAmerican Credit, Inc., d/b/a Upland Mortgage, described above. Due to our current expectation regarding the ultimate resolution of these actions, management believes that the liabilities resulting from these actions will not have a material adverse effect on our consolidated financial position or results of operations. However, due to the inherent uncertainty in litigation and because the ultimate resolutions of these proceedings are influenced by factors outside of our control, our estimated liability under these proceedings may change or actual results may differ from our estimates. We expect that, as a result of the publicity surrounding predatory lending practices and a recent New Jersey court decision regarding the Federal Parity Act and state laws which preclude the imposition of prepayment and other fees, we may be subject to other class action suits in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - General" for more detail. In addition, from time to time, we are involved as plaintiff or defendant in various other legal proceedings arising in the normal course of our business. While we cannot predict the ultimate outcome of these various legal proceedings, it is management's opinion that the resolution of these legal actions should not have a material effect on our financial position, results of operations or liquidity. Item 2. Changes in Securities - None Item 3. Defaults Upon Senior Securities - None Item 4. Submission of Matters to a Vote of Security Holders - None Item 5. Other Information - None Item 6. Exhibits and Reports on Form 8-K Exhibits
Exhibit Number Description -------- ----------------------------------------------------------------------------------------------- 10.1 Amendment No. 3 of Letter of Credit Agreement with JPMorgan Chase 10.2 Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business Financial Services, Inc., Lessee for 105 Eisenhower Parkway, Roseland, New Jersey 10.3 First Amendment to Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business Financial Services, Inc., Lessee. 99.1 Chief Executive Officer's Certificate 99.2 Chief Financial Officer's Certificate
Reports on Form 8-K - None 83 SIGNATURE Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AMERICAN BUSINESS FINANCIAL SERVICES, INC. DATE: May 14, 2003 By: Albert W. Mandia ------------ ----------------------------- Albert W. Mandia Executive Vice President and Chief Financial Officer 84 CERTIFICATIONS I, Anthony J. Santilli, certify that: 1. I have reviewed the quarterly report on Form 10-Q of American Business Financial Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered in this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors: a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 Anthony J. Santilli --------------------------------------------- Anthony J. Santilli Chairman, President, Chief Executive Officer, Chief Operating Officer, and Director (principal executive officer) 85 I, Albert W. Mandia, certify that: 1. I have reviewed the quarterly report on Form 10-Q of American Business Financial Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered in this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors: a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 Albert W. Mandia ------------------------------ Albert W. Mandia Executive Vice President and Chief Financial Officer (principal financial officer) 86 EXHIBIT INDEX
Exhibit Number Description ------- ----------------------------------------------------------------------------------------------- 10.1 Amendment No. 3 of Letter of Credit Agreement with JPMorgan Chase 10.2 Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business Financial Services, Inc., Lessee for 105 Eisenhower Parkway, Roseland, New Jersey 10.3 First Amendment to Lease between CWLT Roseland Exchange L.L.C., Lessor, and American Business Financial Services, Inc., Lessee. 99.1 Chief Executive Officer's Certificate 99.2 Chief Financial Officer's Certificate
86 EX-10 3 ex10-1.txt EX10-1.TXT JPMorgan JPMorgan Chase Bank Global Trade Services March 28, 2003 L/C NO.: D-233079 AMENDMENT NO: 3 Advising Bank ********* DIRECT ********* APPLICANT: AMERICAN BUSINESS FINANCIAL SERVICES, INC. 111 PRESIDENTIAL BLVD., STE 215 BALA CYNWYD, PA 19004 Beneficiary WANAMAKER, L.L.C. C/O AMERIMAR WANAMAKER MANAGEMENT CO. 210 W. RITTENHOUSE SQUARE, STE 1900 PHILADELPHIA, PA 19103 IN ACCORDANCE WITH INSTRUCTIONS RECEIVED, THE ABOVE-REFERENCED LETTER OF CREDIT HAS BEEN AMENDED AS FOLLOWS: 1 - LETTER OF CREDIT AMOUNT IS INCREASED BY USD 2,000,000.00 (TWO MILLION AND 00/100 UNITED STATES DOLLARS). 2 - THE AGGREGATE AMOUNT NOW AVAILABLE UNDER THIS LETTER OF CREDIT IS USD 8,000,000.00 (EIGHT MILLION AND 00/100 UNITED STATES DOLLARS). ALL OTHER TERMS AND CONDITIONS OF THE CREDIT REMAIN UNCHANGED. ---------------------------------------- Authorized Signature EX-10 4 ex10-2.txt EXHIBIT 10.2 LEASE from: CWLT ROSELAND EXCHANGE L.L.C. Lessor to: AMERICAN BUSINESS FINANCIAL SERVICES, INC. Lessee Building: 105 Eisenhower Parkway Roseland, New Jersey
TABLE OF CONTENTS ----------------- 1. DESCRIPTION:.............................................................................................4 ----------- 2. TERM:....................................................................................................4 ---- 3. BASIC RENT:..............................................................................................4 ---------- 4. USE AND OCCUPANCY:.......................................................................................4 ----------------- 5. CARE AND REPAIR OF PREMISES/ENVIRONMENTAL:...............................................................4 ----------------------------------------- 6. ALTERATIONS, ADDITIONS OR IMPROVEMENTS:..................................................................7 -------------------------------------- 7. ACTIVITIES INCREASING FIRE INSURANCE RATES:..............................................................7 ------------------------------------------ 8. ASSIGNMENT AND SUBLEASE:.................................................................................7 ----------------------- 9. COMPLIANCE WITH RULES AND REGULATIONS:..................................................................11 ------------------------------------- 10. DAMAGES TO BUILDING:....................................................................................11 ------------------- 11. EMINENT DOMAIN:.........................................................................................12 -------------- 12. INSOLVENCY OF LESSEE:...................................................................................12 -------------------- 13. LESSOR'S REMEDIES ON DEFAULT:...........................................................................12 ---------------------------- 14. DEFICIENCY:.............................................................................................12 ---------- 15. SUBORDINATION OF LEASE:.................................................................................13 ---------------------- 16. SECURITY DEPOSIT:.......................................................................................14 ---------------- 17. RIGHT TO CURE LESSEE'S BREACH:..........................................................................14 ----------------------------- 18. MECHANIC'S LIENS:.......................................................................................14 ---------------- 19. RIGHT TO INSPECT AND REPAIR:............................................................................14 --------------------------- 20. SERVICES TO BE PROVIDED BY LESSOR/LESSOR'S EXCULPATION:.................................................15 ------------------------------------------------------ 21. INTERRUPTION OF SERVICES OR USE:........................................................................15 ------------------------------- 22. BUILDING STANDARD OFFICE ELECTRICAL SERVICE:............................................................16 ------------------------------------------- 23. ADDITIONAL RENT:........................................................................................18 --------------- 24. LESSEE'S ESTOPPEL:......................................................................................23 ----------------- 25. HOLDOVER TENANCY:.......................................................................................23 ---------------- 26. RIGHT TO SHOW PREMISES:.................................................................................24 ---------------------- 27. LESSOR'S WORK - LESSEE'S DRAWINGS:......................................................................24 --------------------------------- 28. WAIVER OF TRIAL BY JURY:................................................................................24 ----------------------- 29. LATE CHARGE:............................................................................................24 ----------- 30. LESSEE'S INSURANCE:.....................................................................................24 ------------------
i
31. NO OTHER REPRESENTATIONS:...............................................................................26 ------------------------ 32. QUIET ENJOYMENT:........................................................................................27 --------------- 33. INDEMNITY:..............................................................................................27 --------- 34. ARTICLE HEADINGS:.......................................................................................27 ---------------- 35. APPLICABILITY TO HEIRS AND ASSIGNS:.....................................................................27 ---------------------------------- 36. OUTSIDE PARKING SPACES:.................................................................................27 ---------------------- 37. LESSOR'S LIABILITY FOR LOSS OF PROPERTY:................................................................28 --------------------------------------- 38. PARTIAL INVALIDITY:.....................................................................................28 ------------------ 39. LESSEE'S BROKER:........................................................................................29 --------------- 40. PERSONAL LIABILITY:.....................................................................................29 ------------------ 41. NO OPTION:..............................................................................................29 --------- 42. DEFINITIONS:............................................................................................29 ----------- 43. LEASE COMMENCEMENT:.....................................................................................30 ------------------ 44. NOTICES:................................................................................................31 ------- 45. ACCORD AND SATISFACTION:................................................................................31 ----------------------- 46. EFFECT OF WAIVERS:......................................................................................31 ----------------- 47. LEASE CONDITION:........................................................................................32 --------------- 48. MORTGAGEE'S NOTICE AND OPPORTUNITY TO CURE:.............................................................32 ------------------------------------------ 49. LESSOR'S RESERVED RIGHT:................................................................................32 ----------------------- 50. CORPORATE AUTHORITY:....................................................................................32 ------------------- 51. AFTER-HOURS USE:........................................................................................32 --------------- 52. LESSEE'S EXPANSION/RELOCATION:..........................................................................33 ----------------------------- 53. BUILDING PERMIT:........................................................................................33 --------------- 54. RIGHT OF FIRST OFFER:...................................................................................34 -------------------- 55. TERMINATION OPTION:.....................................................................................36 ------------------ 56. FOOD SERVICE:...........................................................................................37 ------------ 57. FURNITURE AND PHONE SYSTEM:.............................................................................38 --------------------------
ii LEASE, is made the _____ day of _________, 2003 between CWLT ROSELAND EXCHANGE L.L.C. (herein referred to as "Lessor") whose address is c/o Mack-Cali Realty Corporation, 11 Commerce Drive, Cranford, New Jersey 07016 and AMERICAN BUSINESS FINANCIAL SERVICES, INC. (herein referred to as "Lessee") whose address is 111 Presidential Boulevard, Bala Cynwyd, Pennsylvania 19004. PREAMBLE -------- BASIC LEASE PROVISIONS AND DEFINITIONS In addition to other terms elsewhere defined in this Lease, the following terms whenever used in this Lease shall have only the meanings set forth in this section, unless such meanings are expressly modified, limited or expanded elsewhere herein. 1. ADDITIONAL RENT shall mean all sums in addition to Fixed Basic Rent payable by Lessee to Lessor pursuant to the provisions of the Lease. 2. BASE PERIOD COSTS shall mean the following: A. Base Operating Costs: Those Operating Costs incurred during Calendar Year 2003. B. Base Real Estate Taxes: Those Real Estate Taxes incurred during Calendar Year 2003. C. Insurance Cost Expense Stop: $39,600.00 D. Utility and Energy Costs Expense Stop: $220,000.00 3. BUILDING shall mean 105 Eisenhower Parkway, Roseland, New Jersey. 4. BUILDING HOLIDAYS shall be those shown on Exhibit E. 5. BUILDING HOURS shall be Monday through Friday, 8:00 a.m. to 7:00 p.m., and Saturdays 8:00 a.m. to 1:00 p.m., but excluding those holidays as set forth on Exhibit E attached hereto and made a part hereof, except that Common Facilities, lighting in the Building and Office Building Area shall be maintained for such additional hours as, in Lessor's sole judgement, is necessary or desirable to insure proper operating of the Building and Office Building Area. 6. COMMENCEMENT DATE is May 27, 2003 and shall for purposes hereof be subject to Articles 27 and 43 hereof. In no event shall the Commencement Date be earlier than May 27, 2003. In any event, the Commencement Date shall not occur until the Monday following the date of Lessor's substantial completion of the Premises (as more fully set forth in Article 27 and Exhibit C hereof). If such Monday is a Building Holiday set forth on Exhibit E, then the Commencement Date shall be on the Tuesday immediately following such Building Holiday. Lessor shall give Lessee not less than three (3) weeks prior notice of Lessor's substantial completion of the Premises. 7. DEMISED PREMISES OR PREMISES shall be deemed to be 31,160 gross rentable square feet on the fourth (4th) floor of the Building as shown on Exhibit A attached hereto, which includes an allocable share of the Common Facilities as defined in Article 42(b). The parties acknowledge that the gross rentable area of the Premises is still subject to the approval of the plans for such space by both parties. Upon the approval of the plans for such space by both parties, the parties shall enter into a supplement to this Lease confirming the gross rentable area of the Premises and any adjustments to the Fixed Basic Rent payable by Lessee, Lessee's Percentage, the Termination Fee and Lessor's Allowance. 1 8. EXHIBITS shall be the following, attached to this Lease and incorporated herein and made a part hereof. Exhibit A Location of Premises Exhibit A-1 Office Building Area Exhibit B Rules and Regulations Exhibit C Lessor's Work Exhibit C-1 Air Conditioning & Heating Design Standards Exhibit D Cleaning Services Exhibit E Building Holidays Exhibit F Tenant Estoppel Certificate Exhibit G Commencement Date Agreement Exhibit H Letter of Credit 9. EXPIRATION DATE shall be the last day of the month in which the day before the eight (8) year and eight (8) month anniversary of the Commencement Date occurs, subject to Article 55 hereof. 10. FIXED BASIC RENT shall be payable as follows: Month Yearly Rate Monthly Installment ----- ----------- ------------------- 1-8 $0.00 $0.00 9-36 $763,420.00 $63,618.33 37-60 $825,740.00 $68,811.67 61-104 $888,060.00 $74,005.00 11. LESSEE'S BROKER shall mean none. 12. LESSEE'S PERCENTAGE shall be 14.16% subject to adjustment as provided for in Article 42(d). 13. OFFICE BUILDING AREA is as set forth on Exhibit A-1. 14. PARKING SPACES shall mean a total of 133 spaces. Reserved: 8 (such spaces to be designated for Lessee's sole use) Unassigned: 125 15. PERMITTED USE Lessee shall use and occupy the Premises as an office for general office and administrative purposes, data processing, training and for all lawful functions and purposes ancillary to general office and administrative purposes and for no other purpose. 16. SECURITY DEPOSIT shall be $206,435.01. Lessee may deliver to Lessor, in lieu of the cash deposit set forth in this Article an irrevocable negotiable letter of credit issued by and drawn upon such commercial bank selected by Lessee and acceptable to Lessor (at its sole discretion) and in form and content acceptable to Lessor (also at its sole discretion) (the form attached hereto as Exhibit H shall be deemed acceptable to Lessor) for the account of Lessor, in the sum of $206,435.01. Said letter of credit shall be for a term of not less than one (l) year and shall be renewed by Lessee (without notice from Lessor) no later than thirty (30) days prior to its expiration, and the expiration of each replacement thereof, until Lessor shall be required to return the security to Lessee pursuant to the terms of this Lease but in no event earlier than thirty (30) days after the Expiration Date, and each such renewed letter of credit shall be delivered to Lessor no later than sixty (60) days prior to the expiration of the letter of credit then held by Lessor. If any portion of the security deposit shall be utilized by Lessor in the manner permitted by this Lease, Lessee shall, within five (5) business days after request by Lessor, replenish the security account by depositing with Lessor, in cash or by letter of credit, an amount equal to that utilized by Lessor. Failure of Lessee to comply strictly with the provisions of this Article shall constitute a material breach of this Lease and Lessor shall be entitled to present the letter of credit then held by it for payment (without notice to Lessee). If the cash security is converted into a letter of credit, the provisions with respect to letters of credit shall apply (with the necessary changes in points of detail) to such letter of credit deposit. In the event of a bank failure or insolvency affecting the letter of credit, Lessee shall replace same within twenty (20) days after being requested to do so by Lessor. Lessee shall pay all reasonable transfer fees required by the bank issuing the letter of credit in connection with a transfer of the letter of credit by Lessor. 2 Provided that (i) this Lease is in full force and effect and (ii) Lessee is not in and has not been in default hereunder, Lessee, upon request to Lessor, shall reduce the Security Deposit to $68,811.67 on the fifth (5th) anniversary of the Commencement Date. In the event Lessee provides all or a part of the security deposit in the form of cash, Lessor shall, if such cash amount exceeds $25,000, hold such sums in an interest bearing, fully FDIC or FSLIC insured money market account (the "Account"). Any interest from the Account shall be returned to Lessee on an annual basis, subject to Lessor's right to apply same. The unapplied portion of any cash Security Deposit will be returned to Lessee together with any interest in the Account no later than thirty (30) days after the termination of the Lease. Lessee shall pay Lessor a reasonable administrative fee for maintaining the Account. 17. TERM shall mean eight (8) years and eight (8) months from the Commencement Date, plus the number of days, if any, to have the Lease expire on the last day of a calendar month, unless extended pursuant to any option contained herein. -- End of Preamble -- 3 W I T N E S S E T H - - - - - - - - - - For and in consideration of the covenants herein contained, and upon the terms and conditions herein set forth, Lessor and Lessee agree as follows: 1. DESCRIPTION: ----------- Lessor hereby leases to Lessee, and Lessee hereby hires from Lessor, the Premises as defined in the Preamble which includes an allocable share of the Common Facilities, as shown on the plan or plans, initialed by the parties hereto, marked Exhibit A attached hereto and made part of this Lease in the Building as defined in the Preamble, (hereinafter called the "Building") which is situated on that certain parcel of land (hereinafter called "Office Building Area") as described on Exhibit A-1 attached hereto and made part of this Lease, together, with the right to use in common with other lessees of the Building, their invitees, customers and employees, those public areas of the Common Facilities as hereinafter defined. 2. TERM: ---- The Premises are leased for a term to commence on the Commencement Date, and to end at 12:00 midnight on the Expiration Date, all as defined in the Preamble. 3. BASIC RENT: ---------- The Lessee shall pay to the Lessor during the Term, the Fixed Basic Rent as defined in the Preamble (hereinafter called "Fixed Basic Rent") payable in such coin or currency of the United States of America as at the time of payment shall be legal tender for the payment of public and private debts. The Fixed Basic Rent shall accrue at the Yearly Rate as defined in the Preamble and shall be payable, in advance, on the first day of each calendar month during the Term at the Monthly Installments as defined in the Preamble, except that a proportionately lesser sum may be paid for the first and last months of the Term of this Lease if the Term commences on a day other than the first day of the month, in accordance with the provisions of this Lease herein set forth. Lessor acknowledges receipt from Lessee of the first monthly installment by check, subject to collection, for Fixed Basic Rent for the first month of the Lease Term. Lessee shall pay Fixed Basic Rent, and any Additional Rent as hereinafter provided, to Lessor at Lessor's above stated address, or at such other place as Lessor may designate in writing, without demand and without counterclaim, deduction or set off. 4. USE AND OCCUPANCY: ----------------- Lessee shall use and occupy the Premises for the Permitted Use as defined in the Preamble. Lessee hereby acknowledges "no smoking" is permitted in the Common Facilities. If at any time during the Term of this Lease, Lessee adopts a policy prohibiting Lessee, its employees, agents or invitees from smoking within the Premises, Lessee shall use its best efforts to enforce Lessor's policy prohibiting its employees, agents or invitees from smoking within the Common Facilities including the areas outside the Building's main entrance. 5. CARE AND REPAIR OF PREMISES/ENVIRONMENTAL: ----------------------------------------- (a) Lessee shall commit no act of waste and shall take good care of the Premises and the fixtures and appurtenances therein, and shall, in the use and occupancy of the Premises, conform to all laws, orders and regulations of the federal, state and municipal governments or any of their departments affecting the Premises and with any and all environmental requirements resulting from the Lessee's use of the Premises, this covenant to survive the expiration or sooner termination of the Lease. 4 Lessor shall, subject to the same being included in Operating Costs, make all necessary repairs to the Premises, Common Facilities and to the assigned parking areas, if any, except where the repair has been made necessary by misuse or neglect by Lessee or Lessee's agents, servants, visitors or licensees, in which event Lessor shall nevertheless make the repair but Lessee shall pay to Lessor, as Additional Rent, immediately upon demand, the costs therefor. All improvements made by Lessee to the Premises, which are so attached to the Premises, shall become the property of Lessor upon installation. Not later than the last day of the Term, Lessee shall, at Lessee's expense, remove all Lessee's personal property and those improvements made by Lessee which have not become the property of Lessor, including trade fixtures, cabinetwork, movable paneling, partitions and the like; repair all injury done by or in connection with the installation or removal of said property and improvements; and surrender the Premises in as good condition as they were at the beginning of the Term, reasonable wear and tear and damage by fire, the elements, casualty or other cause not due to the misuse or neglect by Lessee, Lessee's agents, servants, visitors or licensees excepted. All other property of Lessee remaining on the Premises after the last day of the Term of this Lease shall be conclusively deemed abandoned and may be removed by Lessor, and Lessee shall reimburse Lessor for the cost of such removal. Lessor may have any such property stored at Lessee's risk and expense. ENVIRONMENTAL ------------- (b) Compliance with Environmental Laws. Lessee shall, at Lessee's own expense, promptly comply with each and every federal, state, county and municipal environmental law, ordinance, rule, regulation, order, directive and requirement, now or hereafter existing ("Environmental Laws"), applicable to the Premises, Lessee, Lessee's operations at the Premises, or all of them. Notwithstanding the preceding, Lessee shall be entitled to use office cleaning products and other such items that are typically used in connection with general office maintenance. (c) ISRA Compliance. Lessee shall, at Lessee's own expense, comply with the Industrial Site Recovery Act, N.J.S.A. 13:1K-6 et seq., the regulations promulgated thereunder and any amending and successor legislation and regulations ("ISRA"). (d) Information to Lessor. At no expense to Lessor, Lessee shall promptly provide all information and sign all documents requested by Lessor with respect to compliance with Environmental Laws. (e) Lessor Audit. Lessee shall permit Lessor and its representatives access to the Premises, from time to time, to conduct an environmental assessment, investigation and sampling, all at Lessee's own expense. When entering the Premises, Lessor shall use reasonable efforts to minimize interference with Lessee's use of the Premises. (f) Lessee Remediation. Should any assessment, investigation or sampling reveal the existence of any spill, discharge or placement of Contaminants in, on, under, or about, or migrating from or onto the Premises, the Building or the Office Building Area, to the extent resulting from the action or omission of Lessee or a "Lessee Representative", then, in addition to being in default under this Lease and Lessor having all rights available to Lessor under this Lease and by law by reason of such default, Lessee shall, at Lessee's own expense, in accordance with Environmental Laws, undertake all action required by Lessor and any governmental authority, including, without limitation, promptly obtaining and delivering to Lessor an unconditional No Further Action Letter. For purposes of this Article, the term "Lessee's Representative" shall mean any shareholder, officer, director, member, partner, employee, agent, contractor, licensee, assignee, sublessee or invitee of Lessee. In no event shall any of Lessee's remedial action involve engineering or institutional controls, a groundwater classification exception area or well restriction area, and Lessee's remedial action shall meet the legally required remediation standards for soil, surface water, groundwater and drinking water. Promptly upon completion of all required investigatory and remedial activities, Lessee shall, at Lessee's own expense, to Lessor's satisfaction, restore the affected areas of the Premises, the Building or the Office Building Area, as the case may be, from any damage or condition caused by the investigatory or remedial work. 5 (g) Environmental Questionnaire. Upon Lessor's request, contemporaneously with the signing and delivery of this Lease, and thereafter upon renewal of the lease, if at all, Lessee shall complete, execute and deliver to Lessor an environmental questionnaire in form and substance satisfactory to Lessor. (h) Environmental Documents and Conditions. For purposes of this Article, the term "Environmental Documents" shall mean all environmental documentation concerning the Building or the Office Building Area, of which the Premises is a part, or its environs, in the possession or under the control of Lessee, including, without limitation, plans, reports, correspondence and submissions. During the term of this Lease and subsequently, promptly upon receipt by Lessee or Lessee's Representatives, Lessee shall deliver to Lessor all Environmental Documents concerning or generated by or on behalf of Lessee, whether currently or hereafter existing. In addition, Lessee shall promptly notify Lessor of any environmental condition of which Lessee has knowledge, which may exist in, on, under, or about, or may be migrating from or onto the Building or the Office Building Area. (i) Lessor's Right to Perform Lessee's Obligations. Notwithstanding anything to the contrary set forth in this Lease, in the event, pursuant to this Lease, Lessee is required to undertake any sampling, assessment, investigation or remediation with respect to the Premises, the Building or the Office Building Area, as the case may be, then, at Lessor's discretion, Lessor shall have the right, upon notice to Lessee, from time to time, to perform such activities at Lessee's expense, and all sums incurred by Lessor shall be paid by Lessee, as Additional Rent, upon demand. (j) Indemnity. Lessee shall indemnify, defend and hold harmless Lessor, Lessor's officers, directors, shareholders, employees and personal or legal representatives from and against any and all claims, liabilities, losses, damages, penalties and costs, foreseen or unforeseen, including, without limitation, counsel, engineering and other professional or expert fees, which an indemnified party may incur resulting directly or indirectly, wholly or partly from Lessee's actions or omissions with regard to Lessee's obligations under this Article. (k) Survival. This Article shall survive the expiration or earlier termination of this lease. Lessee's failure to abide by the terms of this Article shall be restrainable or enforceable, as the case may be, by injunction. (l) Interpretation. The obligations imposed upon Lessee under subparagraphs (a) through (j) above are in addition to and are not intended to limit, but to expand upon, the obligations imposed upon Lessee under this Article 5. As used in this Article, the term "Contaminants" shall include, without limitation, any regulated substance, toxic substance, hazardous substance, hazardous waste, pollution, pollutant, contaminant, petroleum, asbestos or polychlorinated biphenyls, as defined or referred to in any Environmental Laws. Where a law or regulation defines any of these terms more broadly then another, the broader definition shall apply. (m) Lessor represents to Lessee that, to the best of its actual knowledge, the Premises and Building shall on the date of delivery thereof to Lessee be free from unlawful quantities of Contaminants and in compliance with all State, Federal and local laws, codes, regulations and requirements relating to environmental matters. Lessor shall indemnify and hold Lessee harmless from and against any and all damage, loss or liability (excluding consequential and punitive damages) actually incurred by Lessee directly resulting from the breach by Lessor of the foregoing representation and warranty, and shall be responsible for the remediation (in accordance with applicable laws) of Contaminants unlawfully located in the Premises and the Building on the date Lessor delivers the same to Lessee, unless presence or release of such unlawful Contaminants results from any act and/or omission of Lessee or a Lessee Representative. In no event shall Lessee be responsible for the remediation of Contaminants, unless the presence or release of such Contaminants results from any act and/or omission of Lessee or a Lessee Representative. 6 6. ALTERATIONS, ADDITIONS OR IMPROVEMENTS: -------------------------------------- Lessee shall not, without first obtaining the written consent of Lessor, make any alterations, additions or improvements in, to or about the Premises. Notwithstanding the foregoing, Lessor's consent shall not be unreasonably withheld, conditioned or delayed for the following non-structural, interior alterations which do not affect the systems of the Building (such as electrical, water and HVAC) or does not require a building permit: carpeting, wallcovering, painting or other similar work of a decorative nature, the installation of built-ins, or the installation and reconfiguration of interior partitions which do not penetrate the finished ceiling, and reconfiguration and supplementing of cabling and wiring. If Lessor consents to any alterations, improvements or additions, it may impose such reasonable conditions with respect thereto as Lessor deems appropriate, including, without limitation, Lessor's reasonable approval of the contractors to perform the work, contractor's lien waivers, insurance against liabilities which may arise out of such work, plans, and specifications and permits necessary for such work. All work done by Lessee or its contractors pursuant to and in accordance with this Article 6, or otherwise shall be done in a first-class workmanlike manner, using only good grades of materials and without unreasonably disturbing other lessees, shall be done in compliance with all insurance requirements and all applicable laws or ordinances and rules and regulations of governmental departments or agencies, and all landmark or historical designation requirements, and shall be done by responsible contractors and subcontractors approved by Lessor in advance whose engagement will not in Lessor's reasonable opinion, and in fact does not, result in any labor dispute at the Building, whether in connection with any construction at the Building, the operation of the Building or otherwise. 7. ACTIVITIES INCREASING FIRE INSURANCE RATES: ------------------------------------------ Lessee shall not do or suffer anything to be done on the Premises which will increase the rate of fire insurance on the Building. Provided that no activity consistent with a Permitted Use may result in a breach of this obligation. 8. ASSIGNMENT AND SUBLEASE: ----------------------- Provided Lessee is not in default of any provisions of this Lease, Lessee may assign or sublease the within Lease to any party subject to the following: a. In the event Lessee desires to assign this Lease or sublease all or part of the Premises to any other party, the terms and conditions of such assignment or sublease shall be communicated to the Lessor in writing no less than ninety (90) days prior to the effective date of any such sublease or assignment, and, prior to such effective date, the Lessor shall have the option, exercisable in writing to the Lessee, to: (i) sublease such space from Lessee at the lower rate of (a) the rental rate per rentable square foot of Fixed Basic Rent and Additional Rent then payable pursuant to this Lease or (b) the terms set forth in the proposed sublease, (ii) recapture in the case of subletting, that portion of the Premises to be sublet or all of the Premises in the case of an assignment ("Recapture Space") so that such prospective sublessee or assignee shall then become the sole Lessee of Lessor hereunder, or (iii) recapture the Recapture Space for Lessor's own use and the within Lessee shall be fully released from any and all obligations hereunder with respect to the Recapture Space. Notwithstanding the foregoing, Lessor shall have no right to exercise its rights pursuant to clauses (i), (ii) or (iii) above, if the space that Lessee proposes to sublet is less than thirty-three and one-third percent (33 1/3%) of the Premises and the term of such subletting including renewal options, if any, is to expire at any time prior to the end of the seventh (7th) Lease Year. 7 b. In the event that the Lessor elects not to recapture the Lease or relet the Premises as hereinabove provided, the Lessee may nevertheless assign this Lease or sublet the whole or any portion of the Premises, subject to the Lessor's prior written consent, which consent shall not be unreasonably withheld, conditioned or delayed, on the basis of the following terms and conditions: i. The Lessee shall provide to the Lessor the name and address of the assignee or sublessee. ii. The assignee shall assume, by written instrument, all of the obligations of this Lease, and a copy of such assumption agreement shall be furnished to the Lessor within ten (10) days of its execution. Any sublease shall expressly acknowledge that said sublessee's rights against Lessor shall be no greater than those of Lessee. Lessee further agrees that notwithstanding any such subletting, no other and further subletting of the Premises by Lessee or any person claiming through or under Lessee shall or will be made except upon compliance with and subject to the provisions of this Article 8. iii. Each sublease shall provide that it is subject and subordinate to this Lease and to the matters to which this Lease is or shall be subordinate, and that in the event of default by Lessee under this Lease, Lessor may, at its option, take over all of the right, title and interest of Lessee, as sublessor, under such sublease, and such sublessee shall, at Lessor's option, attorn to Lessor pursuant to the then executory provisions of such sublease, except that Lessor shall not (i) be liable for any previous act or omission of Lessee under such sublease or, (ii) be subject to any offset not expressly provided in such sublease which theretofore accrued to such sublease to which Lessor has not specifically consented in writing or by any previous prepayment of more than one month's rent. iv. The Lessee and each assignee shall be and remain liable for the observance of all the covenants and provisions of this Lease, including, but not limited to, the payment of Fixed Basic Rent and Additional Rent reserved herein, through the entire Term of this Lease, as the same may be renewed, extended or otherwise modified. v. The Lessee and any assignee shall promptly pay to Lessor fifty percent (50%) of any consideration received for any assignment and/or fifty percent (50%) of the rent, as and when received, in excess of the Rent required to be paid by Lessee for the area sublet computed on the basis of an average square foot rent for the gross square footage Lessee has leased. vi. In any event, the acceptance by the Lessor of any rent from the assignee or from any of the subtenants or the failure of the Lessor to insist upon a strict performance of any of the terms, conditions and covenants herein shall not release the Lessee herein, nor any assignee assuming this Lease, from any and all of the obligations herein during and for the entire Term of this Lease. vii. In Lessor's reasonable judgment, the proposed assignee or subtenant is engaged in a business or activity, and the Premises, or the relevant part thereof, will be used in a manner, which (a) is in keeping with the then standard of the Building as a first class office building and (b) is limited to the use of the Premises as general offices. viii. The proposed assignee or subtenant shall be an entity which has existed for at least one (1) year and is not then an occupant of any part of the Building or any other building then owned by Lessor or its affiliates within Roseland, New Jersey. ix. The proposed assignee or subtenant is not an entity or a person with whom Lessor is or has been, within the preceding six (6) month period, negotiating to lease space in the Building or any other building owned by Lessor or its affiliates within Roseland, New Jersey. 8 x. There shall not be more than one (1) subtenant in the Premises. xi. Lessee shall not advertise the subtenancy for less than the then current market rent per rentable square foot for the Premises as though the Premises were vacant. xii. Lessee shall not have (a) publicly advertised the availability of the Premises without prior notice to Lessor, nor shall any advertisement state the name (as distinguished from the address) of the Building or (b) listed the Premises for subletting or assignment with other than a broker, agent or representative who waives any entitlement to a commission or other fee from Lessor in the event of a recapturing of the Premises; xiii. The proposed occupancy shall not, in Lessor's reasonable opinion, increase the density of population using the Demised Premises to exceed one (1) person per 250 gross rentable square feet of space or exceed the parking allocation presently provided for in this Lease; xiv. The proposed assignee or subtenant shall only use the Premises for the Permitted Use and shall not be engaged in any of the following: (a) educational, including but not limited to, instructional facilities and correspondence schools; (b) employment agencies; (c) model agencies; (d) photographic studios or laboratories; (e) spas, health, physical fitness or exercise salons; (f) small loan offices; (g) real estate brokerage or real estate sales offices open to the general public or construction offices; (h) medical or dental facilities, including professional offices, treatment facilities, dispensaries or laboratories; (i) federal, state or local government offices; (j) so-called boiler room operations; (k) retail stock brokerage offices; and (l) religious organizations making facilities available to congregations for uses other than business purposes; and (m) executive office suite use. xv. The proposed assignee or subtenant shall not be entitled, directly or indirectly, to diplomatic or sovereign immunity and shall be subject to the service of process in, and the jurisdiction of, the state courts of New Jersey. xvi. Lessor shall require a FIVE HUNDRED AND 00/100 DOLLAR ($500.00) payment to cover its handling charges for each request for consent to any sublet or assignment prior to its consideration of the same. Lessee acknowledges that its sole remedy with respect to any assertion that Lessor's failure to consent to any sublet or assignment is unreasonable shall be the remedy of specific performance and Lessee shall have no other claim or cause of action against Lessor as a result of Lessor's actions in refusing to consent thereto. c. If Lessee is a corporation other than a corporation whose stock is listed and traded on a nationally recognized stock exchange, the provisions of Sub-section a. shall apply to a transfer (however accomplished, whether in a single transaction or in a series of related or unrelated transactions) of stock (or any other mechanism such as, by way of example, the issuance of additional stock, a stock voting agreement or change in class(es) of stock) which results in a change of control of Lessee as if such transfer of stock (or other mechanism) which results in a change of control of Lessee were an assignment of this Lease, and if Lessee is a partnership or joint venture, said provisions shall apply with respect to a transfer (by one or more transfers) of an 9 interest in the distributions of profits and losses of such partnership or joint venture (or other mechanism, such as, by way of example, the creation of additional general partnership or limited partnership interests) which results in a change of control of such a partnership or joint venture, as if such transfer of an interest in the distributions of profits and losses of such partnership or joint venture which results in a change of control of such partnership or joint venture were an assignment of this Lease; but said provisions shall not apply to transactions with a corporation into or with which Lessee is merged or consolidated or to which all or substantially all of Lessee's assets are transferred or to any corporation which controls or is controlled by Lessee or is under common control with Lessee, provided that in the event of such merger, consolidation or transfer of all or substantially all of Lessee's assets (i) the successor to Lessee has a net worth computed in accordance with generally accepted accounting principles at least equal to the greater of (1) the net worth of Lessee immediately prior to such merger, consolidation or transfer, or (2) the net worth of Lessee herein named on the date of this Lease, and (ii) proof satisfactory to Lessor of such net worth shall have been delivered to Lessor at least 10 days prior to the effective date of any such transaction. d. In the event that any or all of Lessee's interest in the Premises and/or this Lease is transferred by operation of law to any trustee, receiver, or other representative or agent of Lessee, or to Lessee as a debtor in possession, and subsequently any or all of Lessee's interest in the Premises and/or this Lease is offered or to be offered by Lessee or any trustee, receiver, or other representative or agent of Lessee as to its estate or property (such person, firm or entity being hereinafter referred to as the "Grantor"), for assignment, conveyance, lease, or other disposition to a person, firm or entity other than Lessor (each such transaction being hereinafter referred to as a "Disposition"), it is agreed that Lessor has and shall have a right of first refusal to purchase, take, or otherwise acquire, the same upon the same terms and conditions as the Grantor thereof shall accept upon such Disposition to such other person, firm, or entity; and as to each such Disposition the Grantor shall give written notice to Lessor in reasonable detail of all of the terms and conditions of such Disposition within thirty (30) days next following its determination to accept the same but prior to accepting the same, and Grantor shall not make the Disposition until and unless Lessor has failed or refused to accept such right of first refusal as to the Disposition, as set forth herein. Lessor shall have thirty (30) days next following its receipt of the written notice as to such Disposition in which to exercise the option to acquire Lessee's interest by such Disposition, and the exercise of the option by Lessor shall be effected by notice to that effect sent to the Grantor; but nothing herein shall require Lessor to accept a particular Disposition or any Disposition, nor does the rejection of any one such offer of first refusal constitute a waiver or release of the obligation of the Grantor to submit other offers hereunder to Lessor. In the event Lessor accept such offer of first refusal, the transaction shall be consummated pursuant to the terms and conditions of the Disposition described in the notice to Lessor. In the event Lessor rejects such offer of first refusal, Grantor may consummate the Disposition with such other person, firm, or entity; but any decrease in price of more than two percent (2%) of the price sought from Lessor or any change in the terms of payment for such Disposition shall constitute a new transaction requiring a further option of first refusal to be given to Lessor hereunder. e. Without limiting any of the provisions of Articles 12 and 13, if pursuant to the Federal Bankruptcy Code (herein referred to as the "Code"), or any similar law hereafter enacted having the same general purpose, Lessee is permitted to assign this Lease notwithstanding the restrictions contained in this Lease, adequate assurance of future performance by an assignee expressly permitted under such Code shall be deemed to mean the deposit of cash security in an amount equal to a sum as is commercially reasonable under the circumstances, which deposit shall be held by Lessor for the balance of the Term, without interest, as security for the full performance of all of Lessee's obligations under this Lease, to be held and applied in the manner specified for security in Article 16. 10 f. Except as specifically set forth above, no portion of the Premises or of Lessee's interest in this Lease may be acquired by any other person or entity, whether by assignment, mortgage, sublease, transfer, operation of law or act of the Lessee, nor shall Lessee pledge its interest in this Lease or in any security deposit required hereunder. 9. COMPLIANCE WITH RULES AND REGULATIONS: ------------------------------------- Lessee shall observe and comply with the rules and regulations hereinafter set forth in Exhibit B attached hereto and made a part hereof and with such further reasonable rules and regulations as Lessor may prescribe, on written notice to the Lessee, for the safety, care and cleanliness of the Building and the comfort, quiet and convenience of other occupants of the Building. Lessee shall not place a load upon any floor of the Premises exceeding the floor load per square foot area which it was designed to carry and which is allowed by law; it being understood and agreed, however, that Lessor architect is designing floor supports to accommodate Lessee's load requirements. Lessor reserves the right to prescribe the weight and position of all safes, business machines and mechanical equipment. Such installations shall be placed and maintained by Lessee, at Lessee's expense, in settings sufficient, in Lessor's reasonable judgement, to absorb and prevent vibration, noise and annoyance. 10. DAMAGES TO BUILDING: ------------------- If the Building is damaged by fire or any other cause to such extent the cost of restoration, as reasonably estimated by Lessor, will equal or exceed twenty-five percent (25%) of the replacement value of the Building (exclusive of foundations) just prior to the occurrence of the damage, then Lessor may, no later than the sixtieth (60th) day following the date of damage, give Lessee a notice of election to terminate this Lease, or if the cost of restoration will equal or exceed fifty percent (50%) of such replacement value and if the Premises shall not be reasonably usable for the purpose for which they are leased hereunder, or if restoration of the damage will require more than one hundred eighty (180) days to complete or if such damage is not fully repaired and reasonable access to the Premises restored within one hundred (180) days from the date of damage, then, in any such event, Lessee may, no later than the sixtieth (60th) day following the date of damage or following the end of said one hundred eighty (180) day period, give Lessor a notice of election to terminate this Lease. In either said event of election, this Lease shall be deemed to terminate on the thirtieth (30th) day after the giving of said notice, and Lessee shall surrender possession of the Premises within a reasonable time thereafter, and the Fixed Basic Rent, and any Additional Rent, shall be apportioned as of the date of said casualty and any Fixed Basic Rent or Additional Rent paid for any period beyond said date shall be repaid to Lessee. If the cost of restoration shall not entitle Lessor to terminate this Lease, or if, despite the cost, Lessor does not elect to terminate this Lease, Lessor shall restore the Building and the Premises with reasonable promptness, subject to Force Majeure, and Lessee shall have no right to terminate this Lease, except as set forth above. Lessor need not restore fixtures and improvements owned by Lessee. In any case in which use of the Premises is affected by any damage to the Building, there shall be either an abatement or an equitable reduction in Fixed Basic Rent, depending on the period for which and the extent to which the Premises are not reasonably usable for the purpose for which they are leased hereunder. The words "restoration" and "restore" as used in this Article 10 shall include repairs. To the extent the damage results from the fault of the Lessee, Lessee's agents, servants, visitors or licensees, Lessee shall not be entitled to any abatement or reduction in Fixed Basic Rent, except to the extent of any rent insurance received by Lessor Any termination of this Lease as set forth in this Paragraph 10 shall be without further liability or obligation of Lessor or Lessee except for those obligations that survive such termination as otherwise expressly set forth in this Lease, and except for such obligations as shall have accrued, as of the date of and attributable solely to periods of time prior to, the date of termination. For such purposes no rent or additional rent attributable to any period of time after the date of termination (whether by reason of acceleration or otherwise) shall be due or payable by Lessee. 11 11. EMINENT DOMAIN: -------------- If Lessee's use of the Premises is materially affected due to the taking by eminent domain of (a) the Premises or any part thereof or any estate therein; or (b) any other part of the Building; then, in either event, this Lease shall terminate on the date when title vests pursuant to such taking. The Fixed Basic Rent, and any Additional Rent, shall be apportioned as of said termination date and any Fixed Basic Rent or Additional Rent paid for any period beyond said date, shall be repaid to Lessee. Lessee shall not be entitled to any part of the award for such taking or any payment in lieu thereof, but Lessee may file a separate claim for any taking of fixtures and improvements owned by Lessee which have not become the Lessor's property, and for relocation expenses, provided the same shall, in no way, affect or diminish Lessor's award. In the event of a partial taking which does not effect a termination of this Lease but does deprive Lessee of the use of a portion of the Premises, there shall either be an abatement or an equitable reduction of the Fixed Basic Rent, and an equitable adjustment reducing the Base Period Costs as hereinafter defined depending on the period for which and the extent to which the Premises so taken are not reasonably usable for the purpose for which they are leased hereunder. 12. INSOLVENCY OF LESSEE: -------------------- Either (a) the appointment of a receiver to take possession of all or substantially all of the assets of Lessee, or, (b) a general assignment by Lessee for the benefit of creditors, or, (c) any action taken or suffered by Lessee under any insolvency or bankruptcy act, shall constitute a default of this Lease by Lessee, and Lessor may terminate this Lease forthwith and upon notice of such termination Lessee's right to possession of the Premises shall cease, and Lessee shall then quit and surrender the Premises to Lessor but Lessee shall remain liable as hereinafter provided in Article 14 hereof, provided, however, that if any involuntary petition in bankruptcy shall be filed against Lessee under any federal or state bankruptcy or insolvency act, such shall not be a default hereunder, if such involuntary petition is dismissed within sixty (60) days after filing. 13. LESSOR'S REMEDIES ON DEFAULT: ---------------------------- If Lessee defaults in the payment of Fixed Basic Rent, or any Additional Rent, or defaults in the performance of any of the other covenants and conditions hereof or permits the Premises to become deserted, abandoned or vacated, Lessor may give Lessee notice of such default, and if Lessee does not cure any Fixed Basic Rent or Additional Rent default within ten (10) days or other default within thirty (30) days after giving of such notice (or if such other default is of such nature that it cannot be completely cured within such period, if Lessee does not commence such curing within such thirty (30) days and thereafter proceed with reasonable diligence and in good faith to cure such default), then Lessor may terminate this Lease on not less than ten (10) days notice to Lessee, and on the date specified in said notice, Lessee's right to possession of the Premises shall cease but Lessee shall remain liable as hereinafter provided. If this Lease shall have been so terminated by Lessor pursuant to Articles 12 or 13 hereof, Lessor may at any time thereafter resume possession of the Premises by any lawful means and remove Lessee or other occupants and their effects. Lessee shall pay to Lessor, on demand, such expenses as Lessor may incur, including, without limitation, court costs and reasonable attorney's fees and disbursements, in enforcing the performance of any obligation of Lessee under this Lease. 14. DEFICIENCY: ---------- In any case where Lessor has recovered possession of the Premises by reason of Lessee's default, Lessor may, at Lessor's option, occupy the Premises or cause the Premises to be redecorated, altered, divided, consolidated with other adjoining premises or otherwise changed or prepared for reletting, and may relet the Premises or any part thereof, as agent of Lessee or otherwise, for a term or terms to expire prior 12 to, at the same time as or subsequent to, the original Expiration Date of this Lease, at Lessor's option and receive the rent therefor. Rent so received shall be applied first to the payment of such expenses as Lessor may have incurred in connection with the recovery of possession, redecorating, altering, dividing, consolidating with other adjoining premises, or otherwise changing or preparing for reletting, and the reletting, including brokerage and reasonable attorney's fees, and then to the payment of damages in amounts equal to the Fixed Basic Rent and Additional Rent hereunder and to the costs and expenses of performance of the other covenants of Lessee as herein provided. Lessee agrees, in any such case, whether or not Lessor has relet, to pay to Lessor damages equal to the Fixed Basic Rent and Additional Rent from the date of such default to the date of expiration of the term demised and other sums herein agreed to be paid by Lessee, less the net proceeds of the reletting, if any, received by Lessor during the remainder of the unexpired term hereof, as ascertained from time to time, and the same shall be payable by Lessee on the several rent days above specified. Lessee shall not be entitled to any surplus accruing as a result of any such reletting. In reletting the Premises as aforesaid, Lessor may grant rent concessions, and Lessee shall not be credited therewith. No such reletting shall constitute a surrender and acceptance or be deemed evidence thereof. If Lessor elects, pursuant hereto, actually to occupy and use the Premises or any part thereof during any part of the balance of the Term as originally fixed or since extended, there shall be allowed against Lessee's obligation for rent or damages as herein defined, during the period of Lessor's occupancy, the reasonable value of such occupancy, not to exceed, in any event, the Fixed Basic Rent and Additional Rent herein reserved and such occupancy shall not be construed as a release of Lessee's liability hereunder. Alternatively, in any case where Lessor has recovered possession of the Premises by reason of Lessee's default, Lessor may at Lessor's option, and at any time thereafter, and without notice or other action by Lessor, and without prejudice to any other rights or remedies it might have hereunder or at law or equity, become entitled to recover from Lessee, as Damages for such breach, in addition to such other sums herein agreed to be paid by Lessee, to the date of re-entry, expiration and/or dispossess, an amount equal to the difference between the Fixed Basic Rent and Additional Rent reserved in this Lease from the date of such default to the date of Expiration of the original Term demised and the then fair and reasonable rental value of the Premises for the same period. Said Damages shall become due and payable to Lessor immediately upon such breach of this Lease and without regard to whether this Lease be terminated or not, and if this Lease be terminated, without regard to the manner in which it is terminated. In the computation of such Damages, the difference between an installment of Fixed Basic Rent and Additional Rent thereafter becoming due and the fair and reasonable rental value of the Premises for the period for which such installment was payable shall be discounted to the date of such default at the rate of not more than eight percent (8%) per annum. Lessee hereby waives all right of redemption to which Lessee or any person under Lessee might be entitled by any law now or hereafter in force. Lessor's remedies hereunder are in addition to any remedy allowed by law. 15. SUBORDINATION OF LEASE: ---------------------- This Lease shall, at Lessor's option, or at the option of any holder of any underlying lease or holder of any mortgages or trust deed, be subject and subordinate to any such underlying leases and to any such mortgages or trust deed which may now or hereafter affect the real property of which the Premises form a part, and also to all renewals, modifications, consolidations and replacements of said underlying leases and said mortgages or trust deed provided, that Lessor shall use commercially reasonable efforts to obtain a non-disturbance agreement from the holder of any such underlying lease, mortgage or trust deed. Although no instrument or act on the part of Lessee shall be necessary to effectuate such subordination, Lessee will, nevertheless, execute and deliver such further instruments confirming such subordination of this Lease as may be desired by the holders of said mortgages or trust deed or by any of the lessor's under such underlying leases. If any underlying lease to which this Lease is subject terminates, Lessee shall, on timely request, attorn to the owner of the reversion. 13 16. SECURITY DEPOSIT: ---------------- Lessee shall deposit with Lessor on the signing of this Lease, the Security Deposit as defined in the Preamble for the full and faithful performance of Lessee's obligations under this Lease, including without limitation, the surrender of possession of the Premises to Lessor as herein provided. If Lessor applies any part of said Security Deposit to cure any default of Lessee, Lessee shall, on demand, deposit with Lessor the amount so applied so that Lessor shall have the full Security Deposit on hand at all times during the Term of this Lease. In the event a bona fide sale, subject to this Lease, Lessor shall have the right to transfer the Security Deposit to the vendee, and if duly and fully transferred, Lessor shall be considered released by Lessee from all liability for the return of the Security Deposit; and Lessee agrees to look solely to the new lessor for the return of the Security Deposit, and it is agreed that this shall apply to every transfer or assignment made of the Security Deposit to the new lessor. Provided this Lease is not in default, the Security Deposit (less any portions thereof used, applied or retained by Lessor in accordance with the provisions of this Article 16), shall be returned to Lessee after the expiration or sooner termination of this Lease and after delivery of the entire Premises to Lessor in accordance with the provisions of this Lease. Lessee covenants that it will not assign or encumber or attempt to assign or encumber the Security Deposit and Lessor shall not be bound by any such assignment, encumbrance or attempt thereof. In the event of the insolvency of Lessee, and such is not dismissed within sixty (60) days thereof, or in the event a petition is filed by or against Lessee under any chapter of the bankruptcy laws of the State of New Jersey or the United States of America, then in such event, Lessor may require the Lessee to deposit additional security in an amount which in Lessor's sole judgement would be sufficient to adequately assure Lessee's performance of all of its obligations under this Lease including all payments subsequently accruing. Failure of Lessee to deposit the security required by this Article 16 within ten (10) days after Lessor's written demand shall constitute a material breach of this Lease by Lessee. 17. RIGHT TO CURE LESSEE'S BREACH: ----------------------------- If Lessee breaches any covenant or condition of this Lease, Lessor may, on reasonable written notice to Lessee (except that no notice need be given in case of emergency) and after any applicable grace or cure period, cure such breach at the expense of Lessee and the reasonable amount of all expenses, including attorney's fees, incurred by Lessor in so doing (whether paid by Lessor or not) shall be deemed Additional Rent payable on demand. 18. MECHANIC'S LIENS: ---------------- Lessee shall, within fifteen (15) days after notice from Lessor, discharge or satisfy by bonding or otherwise any mechanic liens for materials or labor furnished to the Premises at the direction of Lessee. 19. RIGHT TO INSPECT AND REPAIR: --------------------------- Lessor may enter the Premises but shall not be obligated to do so (except as required by any specific provision of this Lease) at any reasonable time on reasonable notice to Lessee (except that no notice need be given in case of emergency) for the purpose of inspection or the making of such repairs, replacement or additions in, to, on and about the Premises or the Building, as Lessor deems necessary or desirable. Lessee shall have no claims or cause of action against Lessor by reason thereof. Subject to Article 21 hereof, in no event shall Lessee have any claim against Lessor for interruption of Lessee's business, however occurring, including but not limited to that arising from the negligence of Lessor, its agents, servants or invitees, or from defects, errors or omissions in the construction or design of the Premises and/or the Building, including the structural and non-structural portions thereof. 14 20. SERVICES TO BE PROVIDED BY LESSOR/LESSOR'S EXCULPATION: ------------------------------------------------------ Subject to and in compliance with all laws, ordinances, regulations and executive orders, Lessor agrees to furnish, except on holidays as set forth on Exhibit E attached hereto and made a part hereof: a. The cleaning services, as set forth on Exhibit D attached hereto and made a part hereof, and subject to the conditions therein stated. Except as set forth on Exhibit D, Lessee shall pay the cost of all other cleaning services required by Lessee. Lessor shall not perform such cleaning services prior to 7:00 p.m. on business days. b. Heating, ventilating and air conditioning (herein "HVAC") as appropriate for the season, and as set forth on Exhibit C-1, attached hereto and made a part hereof, together with Common Facilities lighting and electric energy all during Building Hours, as defined in the Preamble. c. Cold and hot water for drinking and lavatory purposes. d. Elevator service at all times, but reduced if not during Building Hours (if the Building contains an elevator or elevators for the use of the occupants thereof). e. Restroom supplies and exterior window cleaning when reasonably required. f. Notwithstanding the requirements of Exhibit C-1 (as to HVAC) or D or any other provision of this Lease, Lessor shall not be liable for failure to furnish any of the aforesaid services when such failure is due to Force Majeure, as hereinafter defined. Lessor shall not be liable, under any circumstances, including, but not limited to, that arising from the negligence of Lessor, its agents, servants or invitees, or from defects, errors or omissions in the construction or design of the Premises and/or the Building, including the structural and non-structural portions thereof, for loss of or injury to Lessee or to property, however occurring, through or in connection with or incidental to the furnishings of, or failure to furnish, any of the aforesaid services or for any interruption to Lessee's business, however occurring. g. Lessor shall provide such Building security as is customary for comparable buildings in the Roseland, New Jersey area. Lessor shall provide Lessee with twenty-five (25) security passes at no charge. Lessee shall be required to compensate Lessor $25.00 per card to the extent that more than twenty-five (25) cards are provided in any calendar year. Lessor shall cooperate with Lessee if Lessee desires to link Lessee's security system servicing the Premises with the security system servicing the Building, provided that any such linkage shall be at Lessee's sole cost and expense. 21. INTERRUPTION OF SERVICES OR USE: ------------------------------- Interruption or curtailment of any service maintained in the Building or at the Office Building Area, if caused by Force Majeure, as hereinafter defined, shall not entitle Lessee to any claim against Lessor or to any abatement in rent, and shall not constitute a constructive or partial eviction, unless Lessor fails to take measures as may be reasonable under the circumstances to restore the service without undue delay. If the Premises are rendered untenantable in whole or in part, for a period of ten (10) consecutive business days, by the making of repairs, replacements or additions, other than those made with Lessee's consent or caused by misuse or neglect by Lessee, or Lessee's agents, servants, or business invitees, there shall be a proportionate abatement of Rent from and after said tenth (10th) consecutive business day and continuing for the period of such untenantability. In no event, shall Lessee be entitled to claim a constructive eviction from the Premises unless Lessee shall first have notified Lessor in writing of the condition or conditions giving rise thereto, and if the complaints be justified, unless Lessor shall have failed, within a reasonable time after receipt of such notice, to remedy, or commence and proceed with due diligence to remedy such condition or conditions, all subject to Force Majeure as hereinafter defined. 15 22. BUILDING STANDARD OFFICE ELECTRICAL SERVICE: (a) Electricity shall be supplied to the Premises during the term in accordance with the provisions of paragraph (c) of this Article. However, at any time and from time to time during the term hereof, provided it is then permissible under the provisions of legal requirements, Lessor shall have the option to have electricity supplied to the Premises in accordance with paragraph (d) of this Article. (b) For the purposes of this Article: (i) The term "Electric Rate" shall mean the Service Classification pursuant to which Lessee would purchase electricity directly from the utility company servicing the Building, provided, however, at no time shall the amount payable by Lessee for electricity be less than Lessor's Cost per Kilowatt and Cost per Kilowatt Hour (as such terms are hereinafter defined), and provided further that in any event, the Electric Rate shall include all applicable surcharges, and demand, energy, fuel adjustment and time of day charges (if any), taxes and other sums payable in respect thereof. (ii) The term "Cost per Kilowatt Hour" shall mean the total cost for electricity incurred by Lessor to service the Building during a particular time period (including all applicable surcharges, and energy, fuel adjustment and time of day charges (if any), taxes and other sums payable in respect thereof) divided by the total kilowatt hours purchased by Lessor during such period. (iii) The term "Cost per Kilowatt" shall mean the total cost for demand incurred by Lessor to service the Building during a particular time period (including all applicable surcharges, demand, and time of day charges (if any), taxes and other sums payable in respect to thereof) divided by the total kilowatts purchased by Lessor during such period. Notwithstanding anything contained herein to the contrary, the rate charged by Lessor to Lessee for electricity hereunder shall not exceed the rate charged to Lessor by the utility company servicing the Building. (c) (i) Lessor shall supply electricity to service the Premises on a "check meter" basis, and Lessee shall pay to Lessor, as Additional Rent, the sum of (y) an amount determined by applying the Electric Rate or, at Lessor's election, the Cost per Kilowatt Hour and Cost per Kilowatt, to Lessee's consumption of and demand for electricity within the Premises as recorded on the meter(s) servicing the Premises, and (z) the actual administrative costs incurred by Lessor in supplying electricity on a "check metered" basis (such combined sum being hereinafter called "Electric Rent"). Except as set forth in the foregoing clause (z), Lessor will not charge Lessee more than the Electric Rate or, at Lessor's election, the Cost per Kilowatt and Cost per Kilowatt Hour for the electricity provided pursuant to this paragraph. All costs incurred by Lessor to install the check meter(s) and any other equipment necessary to enable Lessee to obtain electricity from Lessor on a check meter basis shall be paid by Lessee, as Additional Rent, within thirty (30) days after Lessee's receipt of Lessor's invoice therefor. (ii) Where more than one meter measures the electric service to the Premises, the electric service rendered through each meter shall be computed and billed separately in accordance with the provisions hereinabove set forth. (iii) Lessee shall pay to Lessor, on account of the Electric Rent payable pursuant to this paragraph (c), the annual sum of $1.20 per square foot of Rentable Area ("Estimated Electric Rent"), subject to the adjustments on the first day of each and every calendar month of the term (except that if the first day of the term is other than the first day of a calendar month, the first monthly installment, prorated to the end of said calendar month, shall be payable on the first day of the first full calendar month). (iv) From time to time during the Term, but not more often than two (2) times per year, the Estimated Electric Rent may be adjusted by Lessor on the basis of either Lessor's reasonable estimate of Lessee's electric consumption and demand (if at any time the meter(s) servicing the Premises are 16 inoperative) or Lessee's actual consumption of and demand for electricity as recorded on the meter(s) servicing the Premises, and, in either event, the Electric Rate or Cost per Kilowatt and Cost per Kilowatt Hour then in effect. (v) Subsequent to the end of each calendar year during the Term, or more frequently if Lessor shall elect, Lessor shall submit to Lessee a statement of the Electric Rent for such year or shorter period together with the components thereof, as set forth in clause (i) of this paragraph (c) ("Electric Statement"). To the extent that the Estimated Electric Rent paid by Lessee for the period covered by the Electric Statement shall be less than the Electric Rent as set forth on such Electric Statement, Lessee shall pay Lessor the difference within 30 days after receipt of the Electric Statement. If the Estimated Electric Rent paid by Lessee for the period covered by the Electric Statement shall be greater than the Electric Rent as set forth on the Electric Statement, such difference shall be credited against the next required payment(s) of Estimated Electric Rent. If no Estimated Electric Rent payment(s) shall thereafter be due, Lessor shall pay such difference to Lessee. (vi) For any period during which the meter(s) servicing the Premises are inoperative, the Electric Rent shall be determined by Lessor, based upon its reasonable estimate of Lessee's actual consumption of and demand for electricity, and the Electric Rate or Cost per Kilowatt and Cost per Kilowatt Hour then in effect. (d) If Lessor discontinues furnishing electricity to the Premises pursuant to paragraph (c) of this Article, Lessee shall make its own arrangements to obtain electricity directly from the utility company furnishing electricity to the Building. The cost of such service shall be paid by Lessee directly to such utility company. Lessor shall provide Lessee with at least sixty (60) days prior notice to Lessee of its election to discontinue providing electricity and, in any event, shall not discontinue furnishing electricity to Lessee until Lessee is able to make arrangements to obtain electricity directly from the utility company servicing the Building. Lessee shall use commercially reasonable efforts to make such arrangements promptly after Lessor's request. Lessor shall permit its electric feeders, risers and wiring serving the Premises to be used by Lessee, to the extent available, safe and capable of being used for such purpose. All meters and all additional panel boards, feeders, risers, wiring and other conductors and equipment which may be required to enable Lessee to obtain electricity of substantially the same quality and character, shall be installed by Lessor at Lessee's cost and expense. (e) Bills for electricity supplied pursuant to paragraph (c) of this Article shall be rendered to Lessee at such times as Lessor may elect. Lessee's payments for electricity supplied in accordance with paragraph (c) of this Article shall be due and payable within 30 days after delivery of a statement therefor, by Lessor to Lessee. If such bills are not paid within 30 days after the same are rendered, Lessor may, without further notice, discontinue the service of electricity to the Premises without releasing Lessee from any liability under this lease and without Lessor or Lessor's agents incurring any liability for any damage or loss sustained by Lessee as the result of such discontinuance. If any tax is imposed upon Lessor's receipts from the sale of electricity to Lessee by legal requirements, Lessee agrees that, unless prohibited by such legal requirements, Lessee's Percentage of such taxes shall be included in the bills of, and paid by Lessee to Lessor, as Additional Rent. (f) Lessor's failure during the term to prepare and deliver any statements or bills under this Article, or Lessor's failure to make a demand under this Article, shall not in any way be deemed to be a waiver of, or cause Lessor to forfeit or surrender, its rights to collect any amount of additional rent which may become due pursuant to this Article. Lessee's liability for any amounts due under this Article shall survive the expiration or sooner termination of the Term. (g) Lessee's failure or refusal, for any reason, to utilize the electrical energy provided by Lessor, shall not entitle Lessee to any abatement or diminution of Fixed Basic Rent or Additional Rent, or otherwise relieve Lessee from any of its obligations under this Lease. 17 (h) If either the quantity or character of the electrical service is changed by the utility company supplying electrical service to the Building or is no longer available or suitable for Lessee's requirements, or if there shall be a change, interruption or termination of electrical service due to a failure or defect on the part of the utility company, no such change, unavailability, unsuitability, failure or defect shall constitute an actual or constructive eviction, in whole or in part, or entitle Lessee to any payment from Lessor for any loss, damage or expense, or to abatement or diminution of Fixed Basic Rent or Additional Rent, or otherwise relieve Lessee from any of its obligations under this Lease, or impose any obligation upon Lessor or its agents. Lessor will use reasonable efforts to insure that there is no interruption in electrical service to Lessee, but in no event shall Lessor be responsible for any failures of the utility providing such service or the negligence or other acts of third parties causing any such interruption. (i) Lessee shall not make any electrical installations, alterations, additions or changes to the electrical equipment or appliances in the Premises (other than ordinary office equipment) without prior written consent of Lessor in each such instance. Lessee shall comply with the rules and regulations applicable to the service, equipment, wiring and requirements of Lessor and of the utility company supplying electricity to the Building. Lessee agrees that its use of electricity in the Premises will not exceed the capacity of existing feeders to the Building or the risers or wiring installations therein and Lessee shall not use any electrical equipment which, in Lessor's judgment, will overload such installations or interfere with the use thereof by other lessees in the Building. If, in Lessor's judgment, Lessee's electrical requirements necessitate installation of an additional riser, risers or other proper and necessary equipment or services, including additional ventilating or air-conditioning, the same shall be provided or installed by Lessor at Lessee's expense, which shall be chargeable and collectible as Additional Rent and paid within 30 days after the rendition to Lessee of a bill therefor. (j) If, after Lessor's initial installation work, (i) Lessee shall request the installation of additional risers, feeders or other equipment or service to supply its electrical requirements and Lessor shall determine that the same are necessary and will not cause damage or injury to the Building or the Premises or cause or create a dangerous or hazardous condition or entail excessive or unreasonable alterations, repairs or expense or interfere with or disturb other Lessees or occupants of the Building, or (ii) Lessor shall determine that the installation of additional risers, feeders or other equipment or service to supply Lessee's electrical requirements is necessary, then and in either of such events Lessor shall cause such installations to be made, at Lessee's sole cost and expense and Lessee shall pay Lessor for such installations, as Additional Rent, within 30 days after submission of a statement therefor. (k) Lessor, at Lessee's expense, shall furnish and install all replacement lighting tubes, lamps, ballasts and bulbs required in the Premises. Lessee, however, shall have the right to furnish and/or install any or all of the items mentioned in this Article 22(k). (l) Lessor shall provide an average of seven (7) watts per rentable square foot of the Premises of electrical energy for standard building lighting fixtures provided by Lessor and for the operation of Lessee's equipment, provided that (A) the connected electrical load of such equipment does not exceed an average of seven (7) watts per rentable square foot of the Premises and (B) except to the extent specified in the plans Lessor approves for the Lessee's Work, the electricity so furnished for equipment uses will be at a nominal 120 volts and no electrical circuit for the supply of such use need have a current capacity exceeding 20 amperes. 23. ADDITIONAL RENT: --------------- It is expressly agreed that Lessee will pay in addition to the Fixed Basic Rent provided in Article 3 hereof, an Additional Rent to cover Lessee's Percentage as defined in the Preamble, of the increased cost to Lessor, for each of the categories enumerated herein, over the "Base Period Costs", as defined in the Preamble for said categories. 18 a. Operating Cost Escalation -- If the Operating Costs incurred for the Building in which the Premises are located and Office Building Area for any Lease Year after 2003 or Partial Lease Year during the Lease Term shall be greater than the Base Operating Costs (adjusted proportionately for periods less than a Lease Year), then Lessee shall pay to Lessor, as Additional Rent, Lessee's Percentage of all such excess Operating Costs. Operating Costs shall include, by way of illustration and not of limitation: personal property taxes; management fees; labor, including all wages and salaries; social security taxes, and other taxes which may be levied against Lessor upon such wages and salaries; supplies; repairs and maintenance; maintenance and service contracts; painting; wall and window washing; laundry and towel service; tools and equipment (which are not required to be capitalized for federal income tax purposes); trash removal; lawn care; snow removal and all other items properly constituting direct operating costs according to standard accounting practices (hereinafter collectively referred to as the "Operating Costs"), but not including depreciation of Building or equipment; interest; income or excess profits taxes; costs of maintaining the Lessor's corporate existence; franchise taxes; any expenditures required to be capitalized for federal income tax purposes, unless said expenditures are for the purpose of reducing Operating Costs within the Building and Office Building Area, or those which under generally applied real estate practice are expensed or regarded as deferred expenses or are required under any governmental or quasi-governmental law, statute, ordinance, rule, order, requirements or regulation, in which event the costs thereof shall be included. Notwithstanding anything contained herein to the contrary, any additional costs incurred by Lessor during the 2003 Calendar Year by reason of Lessor or any of its vendors entering into new labor contracts or renewals or modifications of existing labor contracts shall not be included in Base Operating Costs. The Base Operating Costs shall as be as defined in the Preamble. The following, however, will not be included in Operating Expenses: 1. Costs of alterations of any lessee's premises; 2. Principal or interest payments on loans secured by mortgages or trust deeds on the Office Building Area or portions thereof; 3. Expenses incurred in leasing or procuring new lessees or extending, modifying or amending any leases or the space covered by any lease (including without limitation lease commissions, legal, advertising and renovating space); 4. The cost of electricity to any space leased or available for lease (it being understood that electricity for the Premises, other than HVAC, shall be separately paid by Lessee pursuant to Article 22 hereof and that Lessee shall not pay for increased electricity costs except for the Building's common areas, HVAC, base building systems and elevators) or for which Lessor receives reimbursement from Lessee or other lessees (other than reimbursements by way of their proportionate share of Utility and Energy Costs); 5. Except as provided below, depreciation or amortization of the Building or improvements in the Building or expenditures which standard real estate practices treat as capital in nature; 6. Expenses for repairs or other work occasioned by fire, windstorm or other casualty, whether or not insured, provided, however, a commercially reasonable deductible shall be included as part of Operating Costs if such amount is actually paid by Lessor as part of an insured casualty; 7. Legal expenses in enforcing the terms of or analyzing any lease or in connection with any actual or proposed sale or financing of the Building; 8. Fees and expenses paid to Lessor or an affiliate of Lessor for services to the extent such fees and expenses are above a reasonably competitive rate; 9. Costs of environmental investigation or remediation with respect to existing or future conditions in the Building, including without limitation asbestos (reserving to Lessor, however, its rights against Lessee for any violation of Lessee's environmental obligations under this Lease); provided Lessor shall have the right to periodically test the air and water quality in the Building and to perform routine operation and maintenance pursuant to an existing operation and maintenance plan and to treat the costs thereof as an Operating Cost and provided further that any expenses incurred by Lessor to comply with any future environmental law may be included in Operating Costs; 19 10. The cost of material specialized services provided to a lessee or lessees in the Building which are not provided to Lessee; 11. Uninsured judgments, the cost of the defense of claims, settlements, payments or liabilities to third parties, or other costs or expenses, to the extent attributable to or the fault or negligence of Lessor or any other lessee of the Building or their agents or employees or to a failure of Lessor or any other such lessee to comply with the terms of any agreement or lease to which it is a party; 12. The cost of adding capacity to the Building's electric, HVAC or other systems or components or making any repairs, changes, enhancements or upgrades to the Building systems which are necessary to enable Lessor to meet the standards set forth on Exhibit "C-1 " of this Lease; 13. Late fees, penalties or interest on billings payable by Lessor or attributable to a failure by Lessor or any other lessee to comply with legal requirements, or costs to remedy a condition or circumstance which is in violation of, or contrary to, a specific warranty or representation of Lessor in this Lease; 14. Costs which could reasonably have been avoided, by the enforcement of an applicable vendor's, installer's, or manufacturer's warranty which is in effect; 15. Costs of operating, maintaining or repairing any specialty facility provided to a lessee or lessees in the Building which are not provided to and used by Lessee; or 16. Costs of acquiring, leasing, insuring, restoring, removing or replacing sculptures, paintings, and other objects of art located within or outside the Building, except for the cost of routine maintenance and security of such objects in the public areas in the Building. The following items shall be credited against Operating Costs and/or Utility and Energy Costs in the calculation thereof: all cost recoveries by Lessor from lessees in the Building for special services where such costs were included as Operating Costs and/or Utility and Energy Costs (as contrasted to recoveries of a Lessee's percentage of increases in Operating Costs and/or Utility and Energy Costs). Without limiting any other provision of this Lease, Lessor agrees to keep, preserve and maintain the Building and the Common Facilities, and the use thereof, at all times in a manner and condition comparable to other reasonably high quality office buildings located within the Essex County, New Jersey area, and Lessor shall use commercially reasonable efforts to operate, manage and maintain the Building and Common Facilities in an efficient and prudent manner with a view toward keeping increases in Operating Costs and/or Utility and Energy Costs at reasonable and competitive levels. If requested by Lessee, Lessor shall deliver a statement which shall (1) be certified to be accurate and complete to the knowledge of Lessor or Lessor's managing agent responsible for the preparation of such statement (provided that such certification shall not prevent Lessor from correcting errors thereon as allowed by this Lease) and (2) set forth with reasonable detail the assumptions and methodology utilized for making the occupancy adjustment set forth in this Article 23 above for each item of expense which is so adjusted. If any repair, replacement or improvement within the definition of Operating Costs is capitalized under generally accepted accounting principles, then (A) the cost of any such repair, replacement or improvement shall only be included in Operating Costs if such repair, replacement or improvement (i) is necessary to comply with any governmental or quasi-governmental law, statute, ordinance, rule, order, requirements or regulation, which is enacted or promulgated after the date hereof, (ii) is reasonably intended to reduce Operating Costs or (iii) constitutes a replacement which in 20 Lessor's reasonable judgment is economically prudent to make in lieu of repairs, (B) the cost thereof shall be amortized on a straight line basis over the useful life of such repair, the amount so amortized attributable to such repair, replacement or improvement and (C) there shall be included in Operating Costs in each Lease Year for such portion of the amortization period which occurs during the Term, provided, however, that all amounts thereof included in Operating Costs in any Lease Year subsequent to the year paid shall have added thereto interest from the date Lessor incurred such cost. For amortization purposes, applicable interest shall be two (2) percentage point sin excess of the prime rate charged by Chase Manhattan Bank, or its successor, at the time of expenditure. b. Fuel, Utilities and Electric Cost Escalation (hereinafter referred to as "Utility and Energy Costs") - If the Utility and Energy Costs which include any fuel surcharges or adjustments with respect thereto, incurred for water, sewer, gas, electric, other utilities and heating, ventilating and air conditioning for the Building, to include all leased and leasable areas (not separately billed or metered within the Building), and Common Facilities electric, lighting, water, sewer and other utilities for the Building and Office Building Area, for any Lease Year or Partial Lease Year, during the Term, shall be greater than the Utility and Energy Costs Expense Stop (adjusted proportionately for periods less than a Lease Year), then Lessee shall pay to Lessor as Additional Rent, Lessee's Percentage of all such excess Utility and Energy Costs. As used in this Article 23, the Utility and Energy Costs Expense Stop shall be as defined in the Preamble. c. Tax Escalation -- If the Real Estate Taxes for the Building and Office Building Area at which the Premises are located for any Lease Year or Partial Lease Year, during the Lease Term, shall be greater than the Base Real Estate Taxes (adjusted proportionately for periods less than a Lease Year), then Lessee shall pay to Lessor as Additional Rent, Lessee's Percentage as hereinafter defined, of all such excess Real Estate Taxes. As used in this Article 23(c), the words and terms which follow mean and include the following: i. "Base Real Estate Taxes" shall be as defined in the Preamble. ii. "Real Estate Taxes" shall mean the property taxes and assessments imposed upon the Building and Office Building Area, or upon the rent, as such, payable to the Lessor, including, but not limited to, real estate, city, county, village, school and transit taxes, or taxes, assessments, or charges levied, imposed or assessed against the Building and Office Building Area by any other taxing authority, whether general or specific, ordinary or extraordinary, foreseen or unforeseen but excluding taxes for income, profit or personal property ownership. If due to a future change in the method of taxation, any franchise, income or profit tax shall be levied against Lessor in substitution for, or in lieu of, or in addition to, any tax which would otherwise constitute a Real Estate Tax, such franchise, income or profit tax shall be deemed to be a Real Estate Tax for the purposes hereof; conversely, any additional real estate tax hereafter imposed in substitution for, or in lieu of, any franchise, income or profit tax (which is not in substitution for, or in lieu of, or in addition to, a Real Estate Tax as hereinbefore provided) shall not be deemed a Real Estate Tax for the purposes hereof. d. Insurance Cost Escalation - If the Insurance Costs for the Building and Office Building Area for any Lease Year or partial Lease Year during the Term after 2003 shall be greater than the Insurance Cost Expense Stop (adjusted proportionately for periods less than a Lease Year), Lessee shall pay to Lessor as Additional Rent for each Lease Year or partial Lease Year commencing from and after the Commencement Date, Lessee's Percentage of such excess Insurance Costs. As used in this Article 23(d), the words and terms which follow mean and include the following: i. "Insurance Cost Expense Stop" shall be as defined in the Preamble. 21 ii. "Insurance Costs" shall mean all fire and other insurance costs reasonably incurred by Lessor in connection with its operation and maintenance of the Building and Office Building Area, for any Lease Year or Partial Lease Year, during the Term. e. Lease Year -- As used in this Article 23, Lease Year shall mean a calendar year. Any portion of the Term which is less than a Lease Year as hereinbefore defined, that is, from the Commencement Date through the following December 31, and from the last January 1, falling within the Term to the end of the Term, shall be deemed a "Partial Lease Year". Any reference in this Lease to a Lease Year shall, unless the context clearly indicates otherwise, be deemed to be a reference to a Partial Lease Year if the period in question involves a Partial Lease Year. f. Payment -- At any time, and from time to time, after the establishment of the Base Period Costs for each of the categories referred to above, Lessor shall advise Lessee in writing of Lessee's Percentage share with respect to each of the categories as estimated for the next twelve (12) month period (or proportionate part thereof if the last period prior to the Lease's expiration is less than twelve (12) months) as then known to the Lessor, and thereafter, the Lessee shall pay as Additional Rent, Lessee's Percentage share of these costs for the then current period affected by such advice (as the same may be periodically revised by Lessor as additional costs are incurred) in equal monthly installments, such new rates being applied to any months, for which the Fixed Basic Rent shall have already been paid which are affected by the Operating Cost Escalation and/or Utility and Energy Cost Escalation and/or Tax Escalation Costs and/or Insurance Costs above referred to, as well as the unexpired months of the current period, the adjustment for the then expired months to be made at the payment of the next succeeding monthly rental, all subject to final adjustment at the expiration of each Lease Year as defined in Article 23(e) hereof (or Partial Lease Year if the last period prior to the Lease's termination is less than twelve (12) months). In the event the last period prior to the Lease's termination is less than twelve (12) months, the Base Period Costs during said period shall be proportionately reduced to correspond to the duration of said final period. g. Books and Reports -- For the protection of Lessee, Lessor shall maintain books of account which shall be open to Lessee and its representatives at all reasonable times so that Lessee can determine that such Operating, Utility and Energy and Real Estate Tax Costs have, in fact, been paid or incurred. Lessee's representatives shall mean only (i) Lessee's employees or (ii) a Certified Public Accounting firm, and neither Lessee's employees nor any Certified Public Accounting firm shall be permitted to perform such an inspection and/or audit for any other tenant in the Building. Lessee or its representatives shall be entitled to make and retain copies of any materials reviewed in connection with the exercise of such right. If Lessee or its representatives determine that Lessor has overstated Lessee's Percentage of Operating Costs and/or Utility and Energy Costs, or Real Estate Taxes for the applicable Lease Year by more than seven percent (7%), Lessor shall pay all of Lessee's actual and reasonable expenses related to such inspection after Lessee delivers to Lessor reasonable documentation evidencing such expenses. At Lessor's request, Lessee shall execute a confidentiality agreement reasonably acceptable to Lessor prior to any examination of Lessor's books and records. In the event Lessee disputes any one or more of said charges, Lessee shall attempt to resolve such dispute with Lessor, provided that if such dispute shall not be satisfactorily settled between Lessor and Lessee, the dispute shall be referred by either party to an independent certified public accountant to be mutually agreed upon, and if such an accountant cannot be agreed upon, The American Arbitration Association may be asked by either party to select an arbitrator, whose decision on the dispute will be final and binding upon both parties, who shall jointly share any cost of such arbitration. Pending resolution of said dispute the Lessee shall pay to Lessor the sum so billed by Lessor subject to its ultimate resolution as aforesaid. 22 h. Right of Review -- Once Lessor shall have finally determined said Operating, Utility and Energy or Real Estate Tax Costs at the expiration of a Lease Year, then as to the item so established, Lessee shall only be entitled to dispute said charge as finally established for a period of twelve (12) months after Lessee receives Lessor's statement for such charge, and Lessee specifically waives any right to dispute any such charge at the expiration of said twelve (12 month period. i. Occupancy Adjustment -- If, with respect to Operating Cost Escalation, as established in Article 23(a) hereof, and Utility and Energy Cost Escalation, as established in Article 23(b) hereof, and Insurance Cost Escalation, as established in Article 23(d) hereof, the Building is less than ninety-five percent (95%) occupied during the establishment of the respective Base Periods, then the Base Period Costs incurred with respect to said Operating Cost or Utility and Energy Cost or Insurance Cost shall be adjusted during any such period within the Base Period so as to reflect ninety-five percent (95%) occupancy. Similarly, if during any Lease Year or Partial Lease Year, subsequent to the Base Period the Building is less than ninety-five percent (95%) occupied, then the actual costs incurred for Operating Cost and Utility and Energy Cost and Insurance Cost shall be increased during any such period to reflect ninety-five percent (95%) occupancy so that at all times after the Base Period the Operating Cost or Utility and Energy Cost or Insurance Cost shall be actual costs, but in the event less than ninety-five percent (95%) of the Building is occupied during all or part of the Lease Year involved, the Operating Cost or Utility and Energy Cost or Insurance Cost shall not be less than that which would have been incurred had ninety-five percent (95%) of the Building been occupied. The aforesaid adjustment shall only be made with respect to those items that are in fact affected by variations in occupancy levels. 24. LESSEE'S ESTOPPEL: ----------------- Lessee shall, from time to time, on not less that ten business (10) days prior written request by Lessor, execute, acknowledge and deliver to Lessor a written statement certifying that the Lease is unmodified and in full force and effect, or that the Lease is in full force and effect as modified and listing the instruments of modification; the dates to which the rents and charges have been paid; and, to the best of Lessee's knowledge, whether or not Lessor is in default hereunder, and if so, specifying the nature of the default. It is intended that any such statement delivered pursuant to this Article 24 may be relied on by a prospective purchaser of Lessor's interest or mortgagee of Lessor's interest or assignee of any mortgage of Lessor's interest. Lessee shall also execute and deliver the form "Lessee Estoppel Certificate" attached hereto as Exhibit F. 25. HOLDOVER TENANCY: ---------------- If Lessee holds possession of the Premises after the Expiration Date of this Lease, Lessee shall (i) become a tenant from month to month under the provisions herein provided, but at one hundred fifty percent (150%) of the Monthly Fixed Basic Rent for the last month of the term, plus the Additional Rent, for the first two (2) months of Lessee's holding over and two hundred percent (200%) of the monthly Fixed Basic Rent for the last month of the Term, plus the Additional Rent, thereafter, which shall continue as provided in the Lease which sum shall be payable in advance on the first day of each month, and without the requirement for demand or notice by Lessor to Lessee demanding delivery of possession of said Premises, and such tenancy shall continue until terminated by Lessor, or until Lessee shall have given to Lessor, at least sixty (60) days prior to the intended date of termination, a written notice of intent to terminate such tenancy, which termination date must be as of the end of a calendar month; and (ii) indemnify Lessor against loss or liability resulting from the delay by Lessee in so surrendering the Premises including, without limitation, any claims made by any succeeding occupant founded on such delay so long as Lessor provides prompt written notice to Lessee that it has signed a letter of intent or is near signing a lease with a prospective lessee and advises Lessee of what date it must vacate the Premises in order for Lessor to deliver the Premises to the new lessee. Lessee's obligations under this Section shall survive the expiration or sooner termination of the Lease. The time limitations described in this Article 25 shall not be subject to extension for Force Majeure. 23 26. RIGHT TO SHOW PREMISES: ---------------------- Lessor may show the Premises to prospective purchasers and mortgagees; and during the twelve (12) months prior to termination of this Lease, to prospective tenants, during Building Hours on reasonable advance notice to Lessee. When showing the Premises to prospective purchasers, mortgagees or tenants, Lessor shall use commercially reasonable efforts to minimize interference with Lessee's use and occupancy of the Premises 27. LESSOR'S WORK - LESSEE'S DRAWINGS: --------------------------------- a. Lessor agrees that, prior to the commencement of the Term of this Lease, it will do substantially all of the work in the Premises in accordance with Exhibit C attached hereto and made a part hereof. b. Lessee will timely supply such drawings and information to Lessor as set forth in Exhibit C. Any delay occasioned by Lessee's failure to timely supply such drawings and information shall not delay the Commencement Date of the Term and Lessee's obligations hereunder, and the same shall commence on the date the Premises would have been delivered to Lessee pursuant to Article 2, but for Lessee's delay. c. Lease commencement shall occur and the Commencement Date is defined as that date when Lessor has done substantially all of the work to be done by Lessor in accordance with Exhibit C, unless Lessor has been precluded from completing said work as a result of Lessee's acts or omissions including, but not limited to, its failure to comply with Article 27(b) hereof. Occupancy by Lessee or the delivery of a Certificate of Occupancy by Lessor (if required pursuant to local law) shall be prima facie evidence that Lessor has done substantially all of the work. 28. WAIVER OF TRIAL BY JURY: ----------------------- To the extent such waiver is permitted by law, the parties waive trial by jury in any action or proceeding brought in connection with this Lease or the Premises. 29. LATE CHARGE: ----------- If any payment of Fixed Basic Rent, Additional Rent or any other regularly scheduled sum, or any part of any such payment, to be made by Lessee under the terms of this Lease shall become overdue for a period in excess of five (5) business days, Lessee shall pay to Lessor, a "late charge" in an amount which is the lesser of $1,500.00 or 4% of the amount so overdue, for the purpose of defraying Lessor's administrative expense incident to handling such overdue or delinquent payment. In addition, if any payment of rent or any other sum, or any part of any such payment, to be made by Lessee under the terms of this Lease shall become overdue for a period in excess of five (5) business days, Lessee shall pay to Lessor interest on the overdue amount at the Lease Interest Rate (defined below) from the date when such payment was due until the date paid, but in no event more than the amount or rate which is the maximum amount or rate Lessor may lawfully charge in respect of Lessee in such circumstances under applicable law. The "Lease Interest Rate" shall mean the greater of 10% per annum or such variable per annum rate which is from time to time equal to 4% above the base rate as stated by Citibank, N.A. or its successor, or, in the absence of there being a successor to Citibank, N.A. by such other bank having an office in the City of New York as Lessor may from time to time select. 24 30. LESSEE'S INSURANCE: ------------------ a. Lessee covenants to provide at Lessee's cost and expense on or before the earlier of (i) the Commencement Date, or (ii) Lessee's taking actual possession for the purpose of completing any improvement work, and to keep in full force and effect during the entire Term and so long thereafter as Lessee, or anyone claiming by, through or under Lessee, shall occupy the Premises, insurance coverage as follows: i. Commercial General Liability insurance with contractual liability endorsements with respect to the Premises and the business of Lessee in which Lessee shall be adequately covered under limits of liability of not less than FIVE MILLION AND 00/100 DOLLARS ($5,000,000.00) combined single limit per occurrence for bodily or personal injury (including death) and property damage. Such insurance may be carried (x) under a blanket policy covering the Premises and other locations of Lessee, if any, provided that each such policy shall in all respects comply with this Article and shall specify that the portion of the total coverage of such policy that is allocated to the Premises is in the amounts required pursuant to this Article 30 and (y) under a primary liability policy of not less than ONE MILLION AND 00/100 DOLLARS ($1,000,000.00) and the balance under an umbrella policy. Notwithstanding anything to the contrary contained in this Lease, the carrying of insurance by Lessee in compliance with this Article 30 shall not modify, reduce, limit or impair Lessee's obligations and liability under Article 33 hereof. ii. Fire and Extended Coverage, Vandalism, Malicious Mischief, Sprinkler Leakage and Special Extended Coverage Insurance in an amount adequate to cover the cost of replacement of all personal property, decoration, trade fixtures, furnishings, equipment in the Premises and all contents therein. Lessor shall not be liable for any damage to such property of Lessee by fire or other peril includable in the coverage afforded by the standard form of fire insurance policy with extended coverage endorsement attached (whether or not such coverage is in effect), no matter how caused, it being understood that the Lessee will look solely to its insurer for reimbursement. iii. Worker's Compensation Insurance in the minimum statutory amount covering all persons employed by Lessee. iv. Said limits shall be subject to periodic review and Lessor reserves the right to increase said coverage limits if, in the reasonable opinion of Lessor, said coverage becomes inadequate and is less than that commonly maintained by tenants in similar buildings in the area by tenants making similar uses. On or before the Commencement Date, and thereafter at Lessor's request, Lessee shall provide Lessor evidence of the insurance coverage required herein in the form of a duplicate original insurance policy, an insurance binder (countersigned by the insurer), or Evidence of Insurance (in form ACORD 27 with respect to property insurance and ACORD 25-S with respect to liability insurance) for each of the insurance policies Lessee is required to carry in compliance with its obligations under this Lease. b. All of the aforesaid insurance shall (i) name Lessor as an additional insured on a primary basis as to the Premises; (ii) be written by one or more responsible insurance companies licensed in the State of New Jersey satisfactory to Lessor and in form satisfactory to Lessor; (iii) contain endorsements providing thirty (30) days prior written notice of any material change in or cancellation of this policy."; (iv) shall be written on an "occurrence" basis and not on a "claims made" basis. c. Lessee shall be solely responsible for payment of premium and Lessor (or its designee) shall not be required to pay any premium for such insurance. Lessee shall deliver to Lessor at least fifteen (15) days prior to the expiration of such policy, either a duplicate original or a certificate it being the intention of the parties hereto that the insurance required under the terms hereof shall be continuous during the entire Term of this Lease and any other period of time during which pursuant to the Term hereof, said insurance is required. Any insurance carried by Lessee shall be in excess of and will not contribute with the insurance carried by Lessor for injuries or damage arising out of the Premises. 25 d. Lessee agrees that if Lessee, its employees, agents, contractors or licensees, or a result of or in connection, the fire insurance rate(s) applicable to the Premises shall be higher than that which would be applicable for a business office legally permitted therein due solely to the activities of Lessee, Lessee agrees that it will pay to Lessor as Additional Rent, such portion of the premiums for all Lessor's fire insurance policies in force with respect to the building and the contents of any occupant thereof as shall be attributable to such higher rate(s). e. Lessor makes no representation that the limits of liability specified to be carried by Lessee or Lessor under the terms of this Lease are adequate to protect Lessee against Lessee's undertaking under this Article 30, and in the event Lessee believes that any such insurance coverage called for under this Lease is insufficient, Lessee shall provide, at is own expense, such additional insurance as Lessee deems adequate. f. In the event the Premises or its contents are damaged or destroyed by fire or other insured casualty, (i) Lessor, to the extent of the coverage of Lessor's policies of fire insurance, hereby waives its rights, if any, against Lessee with respect to such damage or destruction, even if said fire or other casualty shall have been caused, in whole or in part, by the negligence of Lessee, and (ii) Lessee, to the extent of the coverage of Lessee's policies of fire insurance with extended coverage, hereby waives its rights, if any, against Lessor with respect to such damage, or destruction, even if said fire or other casualty shall have been caused, in whole or in part, by the negligence of Lessor; provided, however, such waivers of subrogation shall only be effective with respect to loss or damage occurring during such time as Lessor's or Lessee's policies of fire insurance (as the case may be) shall contain a clause or endorsement providing in substance that the aforesaid waiver of subrogation shall not prejudice the type and amount of coverage under such policies or the right of Lessor or Lessee (as the case may be) to recover thereunder. If, at any time, Lessor's or Lessee's insurance carrier refuses to write insurance which contains a consent to the foregoing waiver of subrogation, Lessor or Lessee, as the case may be, shall notify the party thereof in writing, and upon the giving of such notice, the provisions of this Section shall be null and void as to any casualty which occurs after such notice. If Lessor's or Lessee's insurance carrier shall make a charge for the incorporation of the aforesaid waiver of subrogation in its policies, then the party requesting the waiver shall promptly pay such charge to the other party upon demand. In the event the party requesting their waiver fails to pay such charge upon demand, the other party shall be released of its obligation to supply such waiver. g. Should Lessee fail to maintain the insurance coverage as set forth in this Article 30, then Lessee shall be in default hereunder and shall be deemed to have breached its covenants as set forth herein. h. LESSOR'S INSURANCE: During the Term, Lessor shall maintain the following insurance, insuring Lessor and any mortgagee, as their respective interests may appear: (x) insurance against damage to the Building and Office Building Area by all risks of direct physical loss in an amount equivalent to the full replacement cost thereof; (y) comprehensive general liability insurance against claims for bodily injury and property damage occurring in or about the Common Facilities in amounts customarily carried by owners of similar buildings in the Essex County, New Jersey area; and (z) insurance against such other hazards as, from time to time, are then commonly insured against for buildings similarly situated in amounts normally carried with respect thereto. All insurance maintained pursuant to this subparagraph h. may be effected by blanket insurance policies. 26 31. NO OTHER REPRESENTATIONS: ------------------------ No representations or promises shall be binding on the parties hereto except those representations and promises contained herein or in some future writing signed by the party making such representation(s) or promise(s). 32. QUIET ENJOYMENT: --------------- Lessor covenants that if, and so long as, Lessee is not in default hereunder beyond applicable notice and cure periods, and performs Lessee's covenants hereof, Lessor shall do nothing to affect Lessee's right to peaceably and quietly have, hold and enjoy the Premises for the Term herein mentioned, subject to the provisions of this Lease. 33. INDEMNITY: --------- Lessee shall defend, indemnify and save harmless Lessor and its agents against and from; (a) any and all claims (i) arising from (x) the conduct or management by Lessee, its subtenants, licensees, its or their employees, agents, contractors or invitees on the Premises or of any business therein, or (y) any work or thing whatsoever done, or any condition created (other than by Lessor for Lessor's or Lessee's account) in or about the Premises during the Term of this Lease, or during the period of time, if any, prior to the Commencement Date that Lessee may have been given access to the Premises, (z) any default by Lessee under the terms, covenants and conditions of this Lease or (ii) arising from any negligent or otherwise wrongful act or omission of Lessee or any of its subtenants or licensees or its or their employees, agents, contractors or invitees, and (b) all costs, expenses and liabilities including attorneys fees and disbursements incurred in or in connection with each such claim, action or proceeding brought thereon. In case any action or proceeding be brought against Lessor by reason of any such claim, Lessee, upon notice from Lessor, shall resist and defend such action or proceeding. Lessor agrees to indemnify, defend and hold Lessee harmless from and against any suits, proceedings, damages, obligations, liabilities, counsel fees, costs, losses, expenses, orders and judgments imposed upon, incurred by or asserted against Lessee by reason of any latent defect in the Building, and any costs or expenses incurred by Lessee hereunder to recover any security deposit not promptly returned to it at the end of the Lease or in connection with the wrongful application of any security deposit. 34. ARTICLE HEADINGS: ---------------- The article headings in this Lease and position of its provisions are intended for convenience only and shall not be taken into consideration in any construction or interpretation of this Lease or any of its provisions. 35. APPLICABILITY TO HEIRS AND ASSIGNS: ---------------------------------- The provisions of this Lease shall apply to, bind and inure to the benefit of Lessor and Lessee, and their respective heirs, successors, legal representatives and assigns. It is understood that the term "Lessor" as used in this Lease means only the owner, a mortgagee in possession or a term lessee of the Building, so that in the event of any sale of the Building or of any lease thereof, or if a mortgagee shall take possession of the Premises, the Lessor herein shall be and hereby is entirely freed and relieved of all covenants and obligations of Lessor hereunder accruing thereafter, and it shall be deemed without further agreement that the purchaser, the term lessee of the Building, or the mortgagee in possession has assumed and agreed to carry out any and all covenants and obligations of Lessor hereunder. 36. OUTSIDE PARKING SPACES: ---------------------- Lessee's occupancy of the Premises shall include the use of the number of outside parking spaces as set forth in the Preamble, all of which 27 will be unassigned. Lessor shall not be responsible for any damage or theft of any vehicle in the parking area and shall not be required to keep parking spaces clear of unauthorized vehicles or to otherwise supervise the use of the parking area. Lessee shall, upon request, promptly furnish to Lessor the license numbers of the cars operated by Lessee and its subtenants, licensees, invitees, concessionaires, officers and employees. If any vehicle of the Lessee, or of any subtenant, licensee, concessionaire, or of their respective officers, agents or employees, is parked in any part of the Common Facilities other than the employee parking area(s) designated therefor by Lessor, Lessee shall pay to Lessor such penalty as may be fixed by Lessor from time to time. All amounts due under the provisions of this Article 36 shall be deemed to be Additional Rent. 37. LESSOR'S LIABILITY FOR LOSS OF PROPERTY: --------------------------------------- Lessor shall not be liable for any loss of property from any cause whatsoever, including but not limited to theft or burglary from the Premises, and any such loss arising from the negligence of Lessor, its agents, servants or invitees, or from defects, errors or omissions in the construction or design of the Premises and/or the Building, including the structural and non-structural portions thereof, and Lessee covenants and agrees to make no claim for any such loss at any time. 38. PARTIAL INVALIDITY: ------------------ If any of the provisions of this Lease, or the application thereof to any person or circumstances, shall to any extent, be invalid or unenforceable, the remainder of this Lease, or the application of such provision or provisions to persons or circumstances other than those as to whom or which it is held invalid or unenforceable, shall not be affected thereby, and every provision of this Lease shall be valid and enforceable to the fullest extent permitted by law. 28 39. LESSEE'S BROKER: --------------- Lessee represents and warrants to Lessor that its broker, as defined in the Preamble is the sole broker with whom Lessee has negotiated in bringing about this Lease and Lessee agrees to indemnify and hold Lessor and its mortgagee(s) harmless from any and all claims of other brokers and expenses in connection therewith arising out of or in connection with the negotiation of or the entering into this Lease by Lessor and Lessee. In no event shall Lessor's mortgagee(s) have any obligation to any broker involved in this transaction. In the event that no broker was involved as aforesaid, then Lessee represents and warrants to the Lessor that no broker brought about this transaction, and Lessee agrees to indemnify and hold Lessor harmless from any and all claims of any broker arising out of or in connection with the negotiations of, or entering into of, this Lease by Lessee and Lessor. 40. PERSONAL LIABILITY: ------------------ Notwithstanding anything to the contrary provided in this Lease, it is specifically understood and agreed, such agreement being a primary consideration for the execution of this Lease by Lessor, that there shall be absolutely no personal liability on the part of Lessor, its constituent members (to include but not be limited to, officers, directors, partners and trustees) their respective successors, assigns or any mortgagee in possession (for the purposes of this Article, collectively referred to as "Lessor"), with respect to any of the terms, covenants and conditions of this Lease, and that Lessee shall look solely to the equity of Lessor in the Building for the satisfaction of each and every remedy of Lessee in the event of any breach by Lessor of any of the terms, covenants and conditions of this Lease to be performed by Lessor, such exculpation of liability to be absolute and without any exceptions whatsoever. 41. NO OPTION: --------- The submission of this Lease Agreement for examination does not constitute a reservation of, or option for, the Premises, and this Lease Agreement becomes effective as a Lease Agreement only upon execution and delivery thereof by Lessor and Lessee. 42. DEFINITIONS: ----------- a. Affiliate -- Affiliate shall mean any corporation related to Lessee as a parent, subsidiary or brother-sister corporation so that such corporation and such party and other corporations constitute a controlled group as determined under Section 1563 of the Internal Revenue Code of 1986, as amended and as elaborated by the Treasury Regulations promulgated thereunder or any business entity in which Lessee has more than a fifty percent (50%) interest. b. Common Facilities -- Common Facilities shall mean the non-assigned parking areas; lobby; elevator(s); fire stairs; public hallways; public lavatories; all other general Building facilities that service all Building tenants; air conditioning rooms; fan rooms; janitors' closets; electrical closets; telephone closets; elevator shafts and machine rooms; flues; stacks; pipe shafts and vertical ducts with their enclosing walls. Lessor may at any time close temporarily any Common Facilities to make repairs or changes therein or to effect construction, repairs or changes within the Building, or to discourage non-tenant parking, and may do such other acts in and to the Common Facilities as in its judgement may be desirable to improve the convenience thereof, but shall always in connection therewith, endeavor to minimize any inconvenience to Lessee. c. Force Majeure -- Force Majeure shall mean and include those situations beyond Lessor's reasonable control, including by way of example and not by way of limitation, acts of God; accidents; repairs; strikes; shortages of labor, supplies or 29 materials; inclement weather; or, where applicable, the passage of time while waiting for an adjustment or insurance proceeds. Any time limits required to be met by either party hereunder, whether specifically made subject to Force Majeure or not, except those related to the payment of Fixed Basic Rent or Additional Rent, shall, unless specifically stated to the contrary elsewhere in this Lease, be automatically extended by the number of days by which any performance called for is delayed due to Force Majeure. d. Lessee's Percentage -- The parties agree that Lessee's Percentage, as defined in the Preamble, reflects and will be continually adjusted to reflect the ratio of the gross square feet of the area rented to Lessee (including an allocable share of all Common Facilities) [the numerator] as compared with the total number of gross square feet of the entire Building (or additional buildings that may be constructed within the Office Building Area) [the denominator] measured outside wall to outside wall, but excluding therefrom any storage areas. Lessor shall have the right to make changes or revisions in the Common Facilities of the Building so as to provide additional leasing area. Lessor shall also have the right to construct additional buildings in the Office Building Area for such purposes as Lessor may deem appropriate, and subdivide the lands for that purpose if necessary, and upon so doing, the Office Building Area shall become the subdivided lot on which the Building in which the Premises is located. However, if any service provided for in Article 23(a) or any utility provided for in Article 23(b) is separately billed or separately metered within the Building, then the square footage so billed or metered shall be subtracted from the denominator and the Lessee's proportionate share for such service and/or utility shall be separately computed, and the Base Costs for such item shall not include any charges attributable to said square footage. Lessee understands that as a result of changes in the layout of the Common Facilities from time to time occurring due to, by way of example and not by way of limitation, the rearrangement of corridors, the aggregate of all Building tenant proportionate shares may be equal to, less than or greater than one hundred percent (100%). 43. LEASE COMMENCEMENT: ------------------ Notwithstanding anything contained herein to the contrary, if Lessor, for any reason whatsoever, including Lessor's negligence except as provided for in Article 27(b), cannot deliver possession of the Premises, as provided for in Article 27(a), to Lessee at the commencement of the agreed Term as set forth in Article 2, this Lease shall not be void or voidable, nor shall Lessor be liable to Lessee for any loss or damage resulting therefrom, but in that event, the Term shall be for the full term as specified above to commence from and after the date Lessor shall have delivered possession of the Premises to Lessee or from the date Lessor would have delivered possession of the Premises to Lessee but for Lessee's failure to timely supply to Lessor such drawings and/or information required by Exhibit C or for any other reason attributable to Lessee (herein the "Commencement Date") and to expire midnight of the day immediately preceding Term anniversary of the Commencement Date, and if requested by Lessor, Lessor and Lessee shall, ratify and confirm said Commencement and Expiration Dates by completing and signing Exhibit G attached hereto and made a part hereof. Notwithstanding anything contained herein to the contrary, if Lessor shall not have delivered possession of the Premises to Lessee on or before May 23, 2003 and provided the reason therefor has not been as a result of Lessee's acts or omissions or Force Majeure and Lessor is able to deliver possession of the Premises on or before July 31, 2003, then, and in such event, Lessor shall reimburse Lessee in an amount not to exceed $24,793.84 for Lessee's cost of relocating to the Premises over a two (2) weekend. Such reimbursement shall be made promptly after Lessor's receipt of paid invoices evidencing the cost of Lessee's relocation. Notwithstanding anything contained herein to the contrary, if Lessor shall not have delivered possession of the Premises to Lessee on or before August 1, 2003 and provided the reason therefor has not been as a result of Lessee's acts or omissions or Force Majeure, then, and in such event, commencing August 1, 2003 through and including the date 30 Lessor shall have delivered possession of the Premises to Lessee, Lessor shall reimburse Lessee in an amount not to exceed $24,793.84 per month for Lessee's holdover rent in Lessee's current premises through October 31, 2003 and thereafter shall not exceed $37,190.75 per month. Such reimbursement shall made promptly after Lessor's receipt of paid invoices evidencing Lessee's payment of such holdover rent. Notwithstanding anything contained in the foregoing paragraphs of this Article to the contrary, any delays in Lessor's substantial completion of the Premises resulting from Lessee's acts or omissions or Force Majeure shall not automatically relieve Lessor of its obligation to timely deliver the Premises as set forth herein. Such delays resulting from Lessee's acts or omissions or Force Majeure must have in fact delayed Lessor's substantial completion of the Premises by more than the number of days between the forty-fifth (45th) day after the date construction drawings for the Premises has been approved by Lessor and Lessee and May 23, 2003. Notwithstanding anything contained herein to the contrary, if Lessor shall not have delivered possession of the Premises to Lessee substantially completed on or before December 31, 2003 and provided the reason therefor has not been as a result of Lessee's acts or omissions or Force Majeure, then, and in such event, Lessor or Lessee may cancel this Lease upon thirty (30) days notice to the other, which notice shall be given on or before January 10, 2004 (time being of the essence in the giving of such notice) and this Lease shall terminate upon the expiration of said thirty (30) day period and the parties shall be released from their respective obligations under this Lease except that Lessor shall reimburse to Lessee any prepaid rent and return security deposit. 44. NOTICES: ------- Any notice by either party to the other shall be in writing and shall be deemed to have been duly given only if (i) delivered personally or (ii) sent by registered mail or certified mail return receipt requested in a postage paid envelope addressed or (iii) sent by nationally recognized overnight delivery service, if to Lessee, at the above described Building; if to Lessor, at Lessor's address as set forth above; or, to either at such other address as Lessee or Lessor, respectively, may designate in writing. Notice shall be deemed to have been duly given, if delivered personally, on delivery thereof, if mailed, upon the tenth (10th) day after the mailing thereof or if sent by overnight delivery service, the next business day. 45. ACCORD AND SATISFACTION: ----------------------- No payment by Lessee or receipt by Lessor of a lesser amount than the rent and additional charges payable hereunder shall be deemed to be other than a payment on account of the earliest stipulated Fixed Basic Rent and Additional Rent, nor shall any endorsement or statement on any check or any letter accompanying any check or payment for Fixed Basic Rent or Additional Rent be deemed an accord and satisfaction, and Lessor may accept such check or payment without prejudice to Lessor's right to recover the balance of such Fixed Basic Rent and Additional Rent or pursue any other remedy provided herein or by law. 46. EFFECT OF WAIVERS: ----------------- No failure by Lessor to insist upon the strict performance of any covenant, agreement, term or condition of this Lease, or to exercise any right or remedy consequent upon a breach thereof, and no acceptance of full or partial rent during the continuance of any such breach, shall constitute a waiver of any such breach or of such covenant, agreement, term or condition. No consent, or waiver, express or implied, by Lessor to or of any breach of any covenant, condition or duty of Lessee shall be construed as a consent or waiver to or of any other breach of the same or any other covenant, condition or duty, unless in writing signed by Lessor. 31 47. LEASE CONDITION: --------------- Intentionally Omitted. 48. MORTGAGEE'S NOTICE AND OPPORTUNITY TO CURE: ------------------------------------------ Lessee agrees to give any mortgagees and/or trust deed holders, by registered mail, a copy of any notice of default served upon Lessor, provided that, prior to such notice, Lessee has been notified in writing (by way of notice of assignment of rents and leases or otherwise) of the address of such mortgagees and/or trust deed holders. Lessee further agrees that, if Lessor shall have failed to cure such default within the time provided for in this Lease, then the mortgagees and/or trust deed holders shall have an additional thirty (30) days within which to cure such default, or if such default cannot be cured within that time, then such additional time as may be necessary, if within such thirty (30) days, any mortgagee and/or trust deed holder has commenced and is diligently pursuing the remedies necessary to cure such default (including but not limited to commencement of foreclosure proceedings if necessary to effect such cure), in which event this Lease shall not be terminated while such remedies are being so diligently pursued. 49. LESSOR'S RESERVED RIGHT: ----------------------- Lessor and Lessee acknowledge that the Premises are in a Building which is not open to the general public. Access to the Building is restricted to Lessor, Lessee, their agents, employees and contractors and to their invited visitors. In the event of a labor dispute including a strike, picketing, informational or associational activities directed at Lessee or any other tenant, Lessor reserves the right unilaterally to alter Lessee's ingress and egress to the Building or make any change in operating conditions to restrict pedestrian, vehicular or delivery ingress and egress to a particular location. 50. CORPORATE AUTHORITY: ------------------- If Lessee is a corporation, Lessee represents and warrants that this Lease has been duly authorized and approved by the corporation. The undersigned officers and representatives of the corporation represent and warrant that they are officers of the corporation with authority to execute this Lease on behalf of the corporation, and within fifteen (15) days of execution hereof, Lessee will provide Lessor with a corporate resolution confirming the aforesaid. 51. AFTER-HOURS USE: --------------- Lessee shall be entitled to make use of said Standard Electric Service and HVAC beyond the Building Hours, at Lessee's sole cost and expense, provided Lessee shall notify the Lessor by 3:00 p.m. on the day that Lessee shall require said overtime use if said overtime use is required on any weekday, and by 3:00 p.m. on Friday for Saturday and/or Sunday overtime use. It is understood and agreed that Lessee shall pay the sum of FORTY-FIVE AND 00/100 DOLLARS ($45.00) per hour per zone for air-conditioning service and THIRTY AND 00/100 DOLLARS ($30.00) per hour per zone for heating services, plus such additional percentage increase of the aforesaid hourly sum computed by measuring the percentage increase between the rate in effect (including fuel surcharges or adjustments) during the month for which such overtime use is requested and the Base Rate. The Base Rate for purposes hereof shall be the average of the rates in effect (including surcharges and/or adjustments) during Calendar Year 2003. In no event shall the Lessee pay less than the sum of FORTY-FIVE AND 00/100 DOLLARS ($45.00) per hour per zone for such overtime air-conditioning service or less than THIRTY AND 00/100 DOLLARS ($30.00) per hour per zone for such overtime heating service. 32 52. LESSEE'S EXPANSION/RELOCATION: ----------------------------- If necessary to accommodate the needs of a lessee leasing more gross rentable area in the Building than Lessee, Lessor, in its sole discretion, shall have the right one time during the Term to change the location of the Premises to other comparable space (the "Substituted Leased Premises") within the Building, subject to the terms and conditions set forth below. a. The Substituted Leased Premises shall contain a minimum floor area of approximately the same number of square feet as are contained in the Premises; the Substituted Leased Premises shall be substantially comparable to the Premises in design, layout and finishes; and the square footage of any Common Facilities attributable to the Substituted Leased Premises shall be approximately the same as that of the Common Facilities attributable to the Premises. b. If the total square footage comprised by the Substituted Leased Premises and its attributable Common Facilities exceed the total of the Premises and its attributable Common Facilities, the Lessee shall not be required to pay any increase in the Fixed Basic Rent and Lessee's Percentage shall not be increased. If, however, such total square footage shall be less, Lessee's Fixed Basic Rent and Lessee's Percentage shall be decreased proportionately. c. The Lessor shall give the Lessee not less than sixty (60) days prior notice of Lessor's decision to relocate the Lessee; and the Lessee agrees that no later than sixty (60) days from the date of its receipt of such notice it shall relocate to the Substituted Leased Premises. d. The Lessor shall bear and pay for the cost and expense of any such relocation; provided, however, that the Lessee shall not be entitled to any compensation for damages for any interference with or interruption of its business during or resulting from such relocation. The Lessor shall make reasonable efforts to minimize such interference by relocating Lessee on days and at times reasonably convenient to Lessee. e. In connection with any such relocation, the Lessor shall, at its own cost and expense, furnish and install in (or, if practicable, relocate to) the Substituted Leased Premises all walls, partitions, floors, floor coverings, ceilings, fixtures, wiring and plumbing, if any, (including relocating trade fixtures, equipment, furniture, furnishings, telecommunications and computer wiring and cabling and other personal property belonging to Lessee) required for the Lessee's proper use and occupancy thereof, all of which items shall be comparable in quality to those situated in the Premises. f. The payments of new monthly minimum rent shall commence on the earlier of ten (10) days after Lessor has completed the physical relocation and installation of permanent improvements in the Substituted Leased Premises or the date that Lessee first opens for business in the Substituted Leased Premises. g. Lessor and Lessee shall promptly execute an amendment to this Lease reciting the relocation of the Premises and any changes in the monthly minimum rent payable hereunder. 53. BUILDING PERMIT: --------------- This Lease is expressly conditioned upon Lessor obtaining a building permit from the appropriate government official for Lessee's Premises. Lessor hereby agrees to make application to said government official within five (5) days following the execution of the construction drawings for the Premises. As used herein, construction drawings shall mean the final plans and specifications required pursuant to Article 27(b). 33 54. RIGHT OF FIRST OFFER: -------------------- a. i. Subject to the provisions of this Article, Lessee shall have the option to lease from Lessor contiguous space on the fourth (4) floor as shown on the attached floor plan, ("Additional Space") at the expiration of the existing space leases for such Additional Space, subject to Lessor's right to renew such leases with the current tenant(s) only. If the Term of this Lease shall be in full force and effect on the expiration or termination date of the existing space leases for the Additional Space, subject to Lessor's right to renew such leases with the current tenant(s) only, and the date upon which Lessee shall exercise the option hereinafter referred to, Lessee shall have the option to lease all, but not less than all of the Additional Space on an as-is basis, provided Lessee gives Lessor written notice of such election within ten (10) days after Lessee shall receive Lessor's notice that such Additional Space is available for leasing to Lessee. If Lessee fails or refuses to exercise this option within the time period set forth above (TIME BEING OF THE ESSENCE), then and in such event Lessee shall have no further rights under this Section with respect to such Additional Space. If Lessee shall elect to lease said Additional Space: (v) said Additional Space shall be deemed incorporated within and part of the Premises on the date that Lessor shall notify Lessee that such Additional Space is ready for occupancy by Lessee subject to any delays relating to the determination of fair market rent and shall expire on the Expiration Date of this Lease, (x) the Fixed Basic Rent payable under this Lease shall be increased by an amount such that during the balance of the term of this Lease the Fixed Basic Rent for said Additional Space shall be the then fair market rent for the Additional Space, as determined in the manner set forth in clause (ii) below, (y) Lessee's Percentage Share shall be proportionately increased, and (z) all other terms and provisions set forth in this Lease shall apply, except that Lessor not be required to perform any work with respect to said Additional Space. The parties shall promptly execute an amendment of this Lease confirming Lessee's election to lease said Additional Space and the incorporation of said Additional Space into the Premises. ii. Lessor and Lessee shall use their best efforts, within thirty (30) days after Lessor receives Lessee's notice of its election to lease said Additional Space, ("Negotiation Period") to agree upon the Fixed Basic Rent to be paid by Lessee for said Additional Space. If Lessor and Lessee shall agree upon the Fixed Basic Rent, the parties shall promptly execute an amendment to this Lease stating the Fixed Basic Rent for the Additional Space. If the parties are unable to agree on the Fixed Basic Rent for said Additional Space during the Negotiation Period, then within fifteen (15) days notice from the other party, given after expiration of the Negotiation Period, each party, at its cost and upon notice to the other party, shall appoint a person to act as an appraiser hereunder, to determine the fair market rent for the Additional Space. Each such person shall be a real estate broker or appraiser with at least ten (10) years' active commercial real estate appraisal or brokerage experience (involving the leasing of similar space as agent for both landlords and tenants) in Essex County, New Jersey. If a party does not appoint a person to act as an appraiser within said fifteen (15) day period, the person appointed by the other party shall be the sole appraiser and shall determine the aforesaid fair market rent. Each notice containing the name of a person to act as appraiser shall contain the person's address. Before proceeding to establish the fair market rent, the appraisers shall subscribe and swear to an oath fairly and impartially to determine such rent. If the two appraisers are appointed by the parties as stated in the immediately preceding paragraph, they shall meet promptly and attempt to determine the fair market rent. If they are unable to agree within forty-five (45) days after the appointment of the second appraiser, they shall attempt to select a third person meeting the qualifications stated in the immediately preceding paragraph within fifteen (15) days after the last day the two appraisers are given to determine the fair market rent. If they are unable 34 to agree on the third person to act as appraiser within said fifteen (15) day period, the third person shall be appointed by the American Arbitration Association, upon the application of Lessor or Lessee to the office of the Association nearest the Building. The person appointed to act as appraiser by the Association shall be required to meet the qualifications stated in the immediately preceding paragraph. Each of the parties shall bear fifty percent (50%) of the cost of appointing the third person and of paying the third person's fees. The third person, however selected, shall be required to take an oath similar to that described above. The three appraisers shall meet and determine the fair market rent. A decision in which two of the three appraisers concur shall be binding and conclusive upon the parties. In deciding the dispute, the appraisers shall act in accordance with the rules then in force of the American Arbitration Association, subject however, to such limitations as may be placed on them by the provisions of this Lease. After the Fixed Basic Rent for the Additional Space has been determined by the appraiser or appraisers and the appraiser or appraisers shall have notified the parties, at the request of either party, both parties shall execute and deliver to each other an amendment of this Lease stating the Fixed Basic Rent for the Additional Space. If the Fixed Basic Rent for said Additional Space has not been agreed to or established prior to the incorporation of said Additional Space in the Premises, then Lessee shall pay to Lessor an annual rent ("Temporary Rent") which Temporary Rent on a per square foot basis shall be equal to the Fixed Basic Rent, on a per square foot basis, then being paid by Lessee for the Premises. Thereafter, if the parties shall agree upon a Fixed Basic Rent, or the Fixed Basic Rent shall be established upon the determination of the fair market rent by the appraiser or appraisers, at a rate at variance with the Temporary Rent (i) if such Fixed Basic Rent is greater than the Temporary Rent, Lessee shall promptly pay to Lessor the difference between the Fixed Basic Rent determined by agreement or the appraisal process and the Temporary Rent, or (ii) if such Fixed Basic Rent is less than the Temporary Rent, Lessor shall credit to Lessee's subsequent monthly installments of Fixed Basic Rent the difference between the Temporary Rent and the Fixed Basic Rent determined by agreement or the appraisal process. In determining the fair market rent for said Additional Space, the appraiser or appraisers shall be required to take into account the rentals at which leases are then being concluded for comparable space in the Building and in comparable buildings in the County of Essex, New Jersey. In no event shall the Fixed Basic Rent for the Additional Space, on a per square foot basis, be less than the Fixed Basic Rent for the Premises, on a per square foot basis. b. The option granted to Lessee under this Article 54 may be exercised only by Lessee, its permitted successors and assigns, and not by any subtenant or any successor to the interest of Lessee by reason of any action under the Bankruptcy Code, or by any public officer, custodian, receiver, United States Trustee, trustee or liquidator of Lessee or substantially all of Lessee's property. Lessee shall have no right to exercise any of such options subsequent to the date Lessor shall have the right to give the notice of termination referred to in Article 13. Notwithstanding the foregoing, Lessee shall have no right to exercise the option granted to Lessee hereunder if, at the time it gives notice of such election (i) Lessee shall not be in occupancy of substantially all of the Premises or (ii) the Premises or any part thereof shall be the subject of a sublease other than with any affiliate of Lessee. If Lessee shall have elected to exercise its option hereunder, such election shall be deemed withdrawn if, at any time after the giving of notice of such election and prior to the occupancy of the Additional Space, Lessee shall sublease all or any part of the Premises except to an affiliate of Lessee. 35 55. TERMINATION OPTION: ------------------ Notwithstanding anything to the contrary contained herein, Lessee shall have a one-time option to surrender the Premises ("Termination Option") in accordance with the following terms and conditions: a. If Lessee desires to exercise the Termination Option, Lessee shall give Lessor irrevocable written notice ("Termination Notice") of Lessee's exercise of this Termination Option, which shall be delivered by certified mail which Termination Notice must be received by Lessor no later than the date that is twelve (12) full months prior to the Termination Date. TIME IS OF THE ESSENCE with respect to Lessor's receipt of the Termination Notice and all other deadlines in this Article. b. If Lessee gives the Termination Notice and complies with all the provisions in this Article, the Lease as it applies to the Premises only shall terminate at 11:59 p.m. on the last day of the month during which the fifth (5th) anniversary of the Commencement Date occurs (the "Termination Date"). c. In consideration for Lessee's termination of this Lease, Lessee shall pay Lessor $323,230.00 ("Termination Fee") simultaneously with the Termination Notice sent by Lessee to Lessor. d. Lessee's obligations to pay Fixed Basic Rent, Additional Rent, and any other costs or charges under this Lease, and to perform all other Lease obligations for the period up to and including the Termination Date, shall survive the termination of this Lease. e. Notwithstanding the foregoing, if at any time during the period on or after the date on which Lessee shall exercise its Termination Option, up to and including the Termination Date, Lessor shall have notified Lessee in writing of a default and Lessee shall remain in default after the expiration of any applicable grace or cure period, then Lessor may elect, but is not obligated, to cancel and declare null and void Lessee's exercise of the Termination Option by notice to Lessee thereof and this Lease shall continue in full force and effect for the full Term hereof unaffected by Lessee's exercise of the Termination Option. If Lessor does not cancel Lessee's exercise of the Termination Option after Lessee's default, Lessee shall cure any default within the period of time specified in this Lease and this obligation shall survive the Termination Date. f. In the event Lessee exercises the Termination Option, Lessee covenants and agrees to surrender full and complete possession of the Premises to Lessor on or before the Termination Date vacant, broom-clean, in good order and condition, and, in accordance with the provisions of this Lease, and thereafter the Premises shall be free and clear of all leases, tenancies, and rights of occupancy of any entity claiming by or through Lessee. g. If Lessee shall fail to deliver possession of the Premises on or before the Termination Date in accordance with the terms hereof, Lessee shall be deemed to be a holdover Lessee from and after the Termination Date, and in such event all covenants and terms of Article 25 shall apply and shall also be liable to Lessor for all costs and expenses incurred by Lessor in securing possession of the Premises. Lessor may accept any such sums from Lessee without prejudice to Lessor's right to evict Lessee from the Premises by any lawful means. h. If Lessee properly and timely exercises the Termination Option and properly and timely satisfies all other monetary and non-monetary obligations under this Lease, the Lease as it applies to the Premises shall cease and expire on the Termination Date with the same force and effect as if said Termination Date were the date originally provided in this Lease as the Expiration Date of the Term hereof. 36 i. If this Lease has been assigned or all or a portion of the Premises has been sublet to other than an Affiliate of Lessee, this Termination Option shall be deemed null and void and neither Lessee nor any assignee or sublessee shall have the right to exercise such option during the term of such assignment or sublease. 56. FOOD SERVICE: ------------ Lessor shall maintain a food service provider to service the Building. If the food service provider ceases operations, Lessor shall not be in default under this Lease, provided that Lessor shall use diligent, good faith efforts to replace the food service provider as expeditiously as is commercially reasonably possible, provided that such period may never exceed three (3) months. 37 57. FURNITURE AND PHONE SYSTEM: -------------------------- As additional security for the faithful performance and observance by Lessee of all of the terms, provisions and conditions of this Lease, Lessee hereby grants to and creates on behalf of Lessor a security interest in the furniture and phone system being purchased by Lessee from Lessor for Lessee's use in the Premises. The security interest herein granted shall be subordinate to the lien of any lender of Lessee. This Lease constitutes a security agreement under the New Jersey Uniform Commercial Code. Lessee agrees from time to time to execute and deliver such security agreements and financing statements as Lessor shall reasonably require to evidence and/or perfect the lien of the security interest granted herein, within five (5) days of Lessor's request therefor. Any recording cost for such financing statements shall be borne by Lessor. Upon the occurrence of any default hereunder by Lessee, beyond applicable notice and cure periods, during the first (1st) Lease Year, Lessor may, at its option, foreclose on said security and apply the proceeds of the sale of the property covered thereby for the payment of all rent owing under this Lease or any other sum owing by Lessee under the terms of Article 14 above, including, but not limited to any damages or deficiencies resulting from any reletting of the Premises, whether said damage or deficiency accrued before or after summary proceedings or other re-entry by Lessor. Lessee covenants that it shall keep and maintain all such furniture and phone system in good, substantial and efficient operating condition at Lessee's sole cost and expense, during the first (1st) Lease Year. Notwithstanding the foregoing, provided that Lessee complies with each of its obligations under this Lease during the first (1st) Lease Year, the security interest granted to Lessor hereunder shall cease and be of further force or effect after the first (1st) Lease Year. Lessor shall execute such termination of any financing statements as shall be required to effectuate such termination of Lessor's security interest. EACH PARTY AGREES that it will not raise or assert as a defense to any obligation under the Lease or this Agreement or make any claim that the Lease or this Agreement is invalid or unenforceable due to any failure of this document to comply with ministerial requirements including, but not limited to, requirements for corporate seals, attestations, witnesses, notarizations, or other similar requirements, and each party hereby waives the right to assert any such defense or make any claim of invalidity or unenforceability due to any of the foregoing. IN WITNESS WHEREOF, the parties hereto have hereunto set their hands and seals the day and year first above written. LESSOR: LESSEE: CWLT ROSELAND EXCHANGE L.L.C. AMERICAN BUSINESS FINANCIAL SERVICES, INC. By: Mack-Cali Texas Property L.P., member By: Mack-Cali Sub XVII, Inc. its general partner By: _____________________________ By: __________________________ Michael K. Nevins Name: Vice President - Leasing Title: 38 EXHIBIT A --------- LOCATION OF PREMISES Exhibit A - Page 1 EXHIBIT A-1 OFFICE BUILDING AREA BEGINNING at a point on the northerly side line of Eisenhower Parkway at the division line between Lots 6 and 7, Tax Maps Borough of Roseland; thence (1) running along said division line, North 51(Degree)-14'-40" West, 966.53 feet to a point on the southerly line of PSE&G right-of-way; thence (2) running along the southerly line of said right-of-way, North 32(Degree)-12'52" East, 534.42 feet to an angle in same; thence (3) still along same, North 37(Degree)-37'-13" East, 303.58 feet to a corner in same; thence (4) still along same, North 51(Degree)-03'-31" West, 28.80 feet to a corner in same; thence (5) still along same, North 32(Degree)-12'-52" East, 418.07 feet to a point on the westerly line of lands of the Borough of Roseland (Lot 2); thence (6) running along the westerly line of said Lot 2 and along the westerly line of Lots 13 and 14 lands of Beechtree Glen Inc., South 51(Degree)-28'01" East, 873.45 feet to a point on the northerly side line of Eisenhower Parkway; thence (7) running along the northerly side line of Eisenhower Parkway, South 3(Degree)-58'-50" West, 56.10 feet to a point; thence (8) still along same, on a curve, curving to the right, having a radius of 905.37 feet, an arc distance of 495.69 feet and a chord of South 19(Degree)-39'-55" West, 489.52 feet to a point; thence (9) still along same, South 35(Degree)-21'-00" West, 745.94 feet to the point and place of BEGINNING. Exhibit A - Page 1 EXHIBIT B --------- RULES AND REGULATIONS 1. OBSTRUCTION OF PASSAGEWAYS: The sidewalks, entrance, passages, courts, elevators, vestibules, stairways, corridors and public parts of the Building shall not be obstructed or encumbered by Lessee or used by Lessee for any purpose other than ingress and egress. If the Premises are situated on the ground floor with direct access to the street, then Lessor shall, at Lessor's expense, keep the sidewalks and curbs directly in front of the Premises clean and free from ice, snow and refuse. 2. WINDOWS: Windows in the Premises shall not be covered or obstructed by Lessee. No bottles, parcels or other articles shall be placed on the window sills, in the halls, or in any other part of the Building other than the Premises. No article shall be thrown out of the doors or windows of the Premises. 3. PROJECTIONS FROM BUILDING: No awnings, air-conditioning units, or other fixtures shall be attached to the outside walls or the window sills of the Building or otherwise affixed so as to project from the Building, without prior written consent of Lessor. 4. SIGNS: No sign or lettering shall be affixed by Lessee to any part of the outside of the Premises, or any part of the inside of the Premises so as to be clearly visible from the outside of the Premises, without the prior written consent of Lessor. However, Lessee shall have the right to place its name on any door leading into the Premises the size, color and style thereof to be subject to the Lessor's approval. Lessee shall not have the right to have additional names placed on the Building directory without Lessor's prior written consent. 5. FLOOR COVERING: Lessee shall not lay linoleum or other similar floor covering so that the same shall come in direct contact with the floor of the Premises. If linoleum or other similar floor covering is desired to be used, an interlining of builder's deadening felt shall first be fixed to the floor by a paste or other material that may easily be removed with water, the use of cement or other similar adhesive material being expressly prohibited. 6. INTERFERENCE WITH OCCUPANTS OF BUILDING: Lessee shall not make, or permit to be made, any unseemly or disturbing noises or odors and shall not interfere with other tenants or those having business with them. Lessee will keep all mechanical apparatus in the Premises free of vibration and noise which may be transmitted beyond the limits of the Premises. 7. LOCK KEYS: No additional locks or bolts of any kind shall be placed on any of the doors or windows by Lessee. Lessee shall, on the termination of Lessee's tenancy, deliver to Lessor all keys to any space within the Building either furnished to or otherwise procured by Lessee, and in the event of the loss of any keys furnished, Lessee shall pay to Lessor the cost thereof. Lessee, before closing and leaving the Premises, shall ensure that all windows are closed and entrance doors locked. Nothing in this Paragraph 7 shall be deemed to prohibit Lessee from installing a burglar alarm within the Premises, provided: (1) Lessee obtains Lessor's consent which will not be unreasonably withheld or delayed; (2) Lessee supplies Lessor with copies of the plans and specifications of the system; (3) such installation shall not damage the Building; and (4) all costs of installation shall be borne solely by Lessee. 8. CONTRACTORS: No contract of any kind with any supplier of towels, water, toilet articles, waxing, rug shampooing, venetian blind washing, furniture polishing, lamp servicing, cleaning of electrical fixtures, removal of waste paper, rubbish, garbage, or other like service shall be entered into by Lessee, nor shall any machine of any kind be installed in the Building or the Office Building Area without the prior written consent of the Lessor. Lessee shall not employ any persons other than Lessor's janitors for the purpose of cleaning the Premises without prior written consent of Lessor. Lessor shall not be responsible to Lessee for any loss of property from the Premises however occurring, or for any damage to the effects of Lessee by such janitors or any of its employees, or by any other person or any other cause. Exhibit B - Page 1 9. PROHIBITED ON PREMISES: Lessee shall not conduct, or permit any other person to conduct, any auction upon the Premises, manufacture or store goods, wares or merchandise upon the Premises without the prior written approval of Lessor, except the storage of usual supplies and inventory to be used by Lessee in the conduct of his business, permit the Premises to be used for gambling, make any unusual noises in the Building, permit to be played musical instrument on the Premises, permit any radio to be played, or television, recorded or wired music in such loud manner as to disturb or annoy other tenants, or permit any unusual odors to be produced on the Premises. Lessee shall not permit any portion of the Premises to be occupied as an office for a public stenographer or typewriter, or for the storage, manufacture, or sale of intoxicating beverages, narcotics, tobacco in any form or as a barber or manicure shop. Canvassing, soliciting and peddling in the Building and the Office Building Area are prohibited and Lessee shall cooperate to prevent the same. No bicycles, vehicles or animals of any kind shall be brought into or kept in or about the Premises. 10. PLUMBING, ELECTRIC AND TELEPHONE WORK: Plumbing facilities shall not be used for any purpose other than those for which they were constructed; and no sweepings, rubbish, ashes, newspaper or other substances of any kind shall be thrown into them. Waste and excessive or unusual amounts of electricity or water is prohibited. When electric wiring of any kind is introduced, it must be connected as directed by Lessor, and no stringing or cutting of wires will be allowed, except by prior written consent of Lessor, and shall be done by contractors approved by Lessor. The number and locations of telephones, telegraph instruments, electrical appliances, call boxes, etc. shall be subject to Lessor's approval. 11. MOVEMENT OF FURNITURE, FREIGHT OR BULKY MATTER: The carrying in or out of freight, furniture or bulky matter of any description must take place during such hours as Lessor may from time to time reasonably determine and only after advance notice to the superintendent of the Building. The persons employed by Lessee for such work must be reasonably acceptable to the Lessor. Lessee may, subject to these provisions, move freight, furniture, bulky matter, and other material into or out of the Premises on Saturdays between the hours of 9:00 a.m. and 1:00 p.m., provided Lessee pays additional costs, if any, incurred by Lessor for elevator operators or security guards, and for any other expenses occasioned by such activity of Lessee. If, at least three (3) days prior to such activity, Lessor requests that Lessee deposit with Lessor, as security of Lessee's obligations to pay such additional costs, a sum of which Lessor reasonably estimates to be the amount of such additional cost, the Lessee shall deposit such sum with Lessor as security of such cost. There shall not be used in the Building or Premises, either by Lessee or by others in the delivery or receipt of merchandise, any hand trucks except those equipped with rubber tires and side guards, and no hand trucks will be allowed in the elevators without the consent of the superintendent of the Building. Notwithstanding the foregoing, Lessee may move into the Premises on a weekend and Lessor shall cooperate with Lessee with respect thereto, including, without limitation, having all elevators operating on the moving date or other appropriate Building Holiday if Lessee shall move into the Premises on such day. 12. SAFES AND OTHER HEAVY EQUIPMENT: Lessor reserves the right to prescribe the weight and position of all safes and other heavy equipment so as to distribute properly the weight thereof and to prevent any unsafe condition from arising. 13. ADVERTISING: Lessor shall have the right to prohibit any advertising by Lessee which in Lessor's reasonable opinion tends to impair the reputation of the Building or its desirability as a building for offices, and upon written notice from Lessor, Lessee shall refrain from or discontinue such advertising. 14. NON-OBSERVANCE OR VIOLATION OF RULES BY OTHER TENANTS: Lessor shall not be responsible to Lessee for non-observance or violation of any of these rules and regulations by any other tenant. 15. AFTER HOURS USE: Lessor reserves the right to exclude from the Building between the hours of 6:00 p.m. and 8:00 a.m. and at all hours on Saturdays, Sundays and Building Holidays, all persons who do not present a pass to the Building signed by the Lessee. Each Lessee shall be responsible for all persons for whom such a pass is issued and shall be liable to the Lessor for the acts of such persons. Exhibit B - Page 2 16. PARKING: Lessee and its employees shall park their cars only in those portions of the parking area designated by Lessor. 17. Lessor hereby reserves to itself any and all rights not granted to Lessee hereunder, including, but not limited to, the following rights which are reserved to Lessor for its purposes in operating the Building: a) the exclusive right to the use of the name of the Building for all purposes, except that Lessee may use the name as its business address and for no other purposes; and b) the right to change the name or address of the Building, without incurring any liability to Lessee for doing so; and c) the right to install and maintain a sign on the exterior of the Building; and d) the exclusive right to use or dispose of the use of the roof of the Building; and e) the right to limit the space on the directory of the Building to be allotted to Lessee; and f) the right to grant to anyone the right to conduct any particular business or undertaking in the Building. 18. The Lessee shall be responsible for initiating, maintaining and supervising all health and safety precautions and/or programs required by Law in connection with the Lessee's use and occupancy of the Premises. 19. The Lessee shall not store, introduce or otherwise permit any material known to be hazardous within the Premises. Any material within the Premises which is determined to be hazardous shall be removed and properly disposed of by the Lessee at the Lessee's sole expense. -- END -- Exhibit B - Page 3 EXHIBIT C --------- NOTES RE: Workletter Agreement for office space on the fourth (4th) floor at 105 Eisenhower Parkway, Roseland, New Jersey. , 2003 LESSEE: AMERICAN BUSINESS FINANCIAL SERVICES, INC. - ------------------------------------------ You ("Lessee") and we ("Lessor") are executing simultaneously with this Workletter Agreement a written lease ("Lease"), covering the space referred to above, as more particularly described in the Lease ("Premises"). To induce Lessee to enter into the Lease (which is hereby incorporated by reference) and in consideration of the covenants hereinafter contained, Lessor and Lessee mutually agree as follows: 1. Lessor shall have its architect prepare the following architectural and mechanical drawings and specifications based upon the sketch layout supplied to Lessor by Lessee, attached hereto and made a part hereof, upon full execution of this Lease. a. Architectural drawings and specifications for Lessee's partition layout, reflected ceiling, placement of electrical outlets and other installations for the work to be done by Lessor. b. Mechanical plans and specifications where necessary for installation of air conditioning systems, ductwork and heating. All such plans and specifications are expressly subject to Lessor's written approval, which Lessor covenants it will not unreasonably withhold. 2. Lessor agrees to cause the partition plan, electrical plan and the reflected ceiling plan to be delivered to Lessee on or before the fifteenth (15th) day after Lease execution. Lessee agrees to approve said plans by initialing and returning same to Lessor within five (5) business days of receipt of each plan. Upon approval of the plans initialed by Lessee, Lessor shall file said plans with the appropriate governmental agencies. 3. Lessor agrees, at its expense and without charge to Lessee (unless otherwise provided), to do the work in the Premises as shown on the plans attached hereto and described on the "Description of Materials" schedule attached hereto which shall hereinafter be referred to as "The Work". The Work shall include Lessor's general conditions and overhead amounts indicated on the Description of Materials. "Building Standard" shall mean the type and grade of material, equipment and/or device designated by Lessor as standard for the Building. All items are Building Standard unless otherwise noted. The provisions of Article 6 of the Lease shall apply to any alterations made to the Premises after the initial work to be performed herein. 4. Against the cost of The Work, Lessor shall credit an allowance of $482,450.00 ("Lessor's Allowance") and the remaining balance, if any, shall be deemed Additional Rent and paid by Lessee as follows: (i) fifty percent (50%) upon Lessee's execution and delivery of this Lease and (ii) fifty percent (50%) upon Lessor's substantial completion of The Work and prior to Lessee's occupancy of the Premises. Notwithstanding the foregoing, Lessee may utilize any portion of Lessor's Allowance toward the cost of connecting, including wiring and cabling, any existing equipment to be utilized by Lessee in the Premises and the cost of relocating the existing furniture and equipment within the Building to be utilized by Lessee in the Premises. 5. All low partitioning, workstation modules, bank screen partitions and prefabricated partition systems shall be furnished and installed by Lessee. Exhibit C - Page 1 6. The installation or wiring of telephone and computer (data) outlets is not part of The Work. Lessee shall bear the responsibility to provide its own telephone and data systems at Lessee's sole cost and expense. Upon expiration or sooner termination of the Lease, Lessee shall remove all telephone and data equipment and wiring from the Premises and the Building risers upon vacation of same. 7. Changes in The Work, if necessary, except if a result of error or omission of Lessor, architect or other agent or employee of Lessor, or requested by the Lessee, shall be accomplished after the execution of the Lease and this Workletter Agreement, and without invalidating any part of the Lease or Workletter Agreement, by written agreement between Lessor and Lessee hereinafter referred to as a Change Order. Each Change Order shall be prepared by Lessor and signed by both Lessee and Lessor stating their agreement upon all of the following: a. The scope of the change in The Work; and b. The cost of the change; and c. Manner in which the cost will be paid or credited; and d. The estimated extent of any adjustment to the Commencement Date (if any) as a result of the change in The Work. Each and every Change Order shall be signed by Lessor's and Lessee's respective construction representatives. In no event shall any Change Order(s) be permitted without such authorizations. A 10% supervision plus 7% overhead charge will be added to the cost of any Change Order and to the cost of any other work to be performed by Lessor in the Premises after Lessor's completion of The Work. If Lessee shall fail to approve any such Change Order within one (1) week, the same shall be deemed disapproved in all respects by Lessee and Lessor shall not be authorized to proceed thereon. Any increase in the cost of The Work or the change in The Work stated in a Change Order which results from Lessee's failure to timely approve and return said Change Order shall be paid by the Lessee. Lessee agrees to pay to Lessor the cost of any Change Order promptly upon receipt of an invoice for same. Similarly, any cost savings resulting from such Change Order(s) shall be credited to the Lessee. 8. If Lessee elects to use the architect suggested by Lessor, this architect becomes the Lessee's agent solely with respect to the plans, specifications and The Work. If any change is made after completion of schematic drawings and prior to completion of final construction documents which result in a Change Order and additional costs, such costs shall be the responsibility of the Lessee. 9. Prior to Lessee's occupancy of the Premises, Lessee shall identify and list any portion of The Work which does not conform to this Workletter Agreement ("Punch List"). The Lessor shall review with the Lessee all of the items so listed and correct or complete any portion of The Work which fails to conform to the requirements of this Workletter Agreement. 10. The terms contained in the Lease (which include all exhibits attached thereto) constitute Lessor's agreement with Lessee with respect to the work to be performed by Lessor on Lessee's behalf. If the architectural drawings are in conflict with the terms of the Lease, then the Lease shall be deemed the controlling document. 11. All materials and installations constructed for the Lessee within the Premises shall become the property of the Lessor upon installation. No refund, credit or removal of said items is to be permitted at the termination of the Lease. Items installed that are not integrated in any such way with other common building materials do not fall under this provision (e.g. shelving, furniture, etc.). 12. It is agreed that notwithstanding the date provided in the Lease for the Commencement Date, the term shall not commence until Lessor has "substantially completed" all work to be performed by Lessor as hereinbefore set forth in Paragraph 3 above and as set forth in the Exhibit C - Page 2 Lease; provided, however, that if Lessor shall be delayed in substantially completing said work as a result of: a. Lessee's failure to approve the plans and specifications in accordance with Paragraph 2 hereof; or b. Lessee's failure to furnish interior finish specifications, i.e., paint colors, carpet selection, etc., to Lessor by the fifth (5th) working day after Lessor has approved the plans and specifications submitted by Lessee referred to in Paragraph 2 hereof; or c. Lessee's request for materials, finishes or installations other than Lessor's Building Standard; or d. Lessee's changes in The Work; or e. The performance of a person, firm, partnership or corporation employed by Lessee and the completion of the said work by said person, firm, partnership or corporation; then the Commencement Date of the term of said Lease shall be accelerated by the number of days of such delay and Lessee's obligation to pay Fixed Basic Rent and Additional Rent shall commence as of such earlier date. 13. Lessor shall permit Lessee and its agents to enter the Premises prior to the Commencement Date in order that Lessee may perform through its own non-union contractors (or union contractor if required by Lessor) such other work and decorations as Lessee may desire at the same time Lessor's contractors are working in the Premises. The foregoing license to enter prior to the Commencement Date, however, is conditioned upon: a. Lessee's workmen and mechanics working in harmony and not interfering with the labor employed by Lessor, Lessor's mechanics or contractors or by any other Lessee or its mechanics or contractors; and b. Lessee providing Lessor with evidence of Lessee's contractors and subcontractors carrying such worker's compensation, general liability, personal and property insurance as required by law and in amounts no less than the amounts set forth in Article 30 of the Lease. If at any time such entry shall cause disharmony or interference therewith, this license may be withdrawn by Lessor upon forty-eight (48) hours written notice to Lessee. Such entry shall be deemed controlled by all of the terms, covenants, provisions and conditions of said Lease, except as to the covenant to pay Fixed Basic Rent and Additional Rent. Lessor shall not be liable in any way for any injury, loss or damage which may occur to any of Lessee's decorations or installations so made prior to the Commencement Date, the same being solely at Lessee's risk. 14. No part of the Premises shall be deemed unavailable for occupancy by the Lessee, or shall any work which the Lessor is obligated to perform in such part of the Premises be deemed incomplete for the purpose of any adjustment of Fixed Basic Rent payable hereunder, solely due to the non-completion of details of construction, decoration or mechanical adjustments which are minor in character and the non-completion of which does not materially interfere with the Lessee's use of such part of the Premises, provided that such adjustments are completed within twenty (20) business days. 15. Lessee is responsible for all costs related to the repairs and maintenance of any additional or supplemental HVAC systems, appliances and equipment installed to meet Lessee's specific requirements. Lessee shall purchase a service contract for this equipment so that the equipment is covered by such service contract each year of the term of the Lease and shall forward a copy of such contract to Lessor. 16. If construction is to occur in a space occupied by Lessee's employees, Lessee shall be liable for all costs associated with a delay if Lessee shall fail to comply with a submitted construction schedule to relocate personnel, furniture, or equipment. These costs shall include, but not be limited to the following: Exhibit C - Page 3 a. cost of construction workers time wasted; and b. cost of any overtime work necessary to meet schedule deadlines; and c. any other costs associated with delays in final completion. 17. This workletter is based on the quantities and specifications listed herein. Any change to these specifications shall require the recalculation of the construction costs. Such recalculation shall not negate any other section of this Lease. 18. All sums payable by Lessee to Lessor in connection with this Exhibit C and any other work to be performed by Lessor within the Premises and billable to Lessee shall be deemed Additional Rent. 19. With respect to the construction work being conducted in or about the Premises, each party agrees to be bound by the approval and actions of their respective construction representatives. Unless changed by written notification, the parties hereby designate the following individuals as their respective construction representatives: FOR LESSOR: FOR LESSEE: _________________________________ ________________________________ c/o Mack-Cali Realty Corporation ________________________________ _________________________________ ________________________________ _________________________________ ________________________________ Exhibit C - Page 4 EXHIBIT C-1 ----------- AIR CONDITIONING & HEATING DESIGN STANDARDS The following are design standards for the building air-conditioning system for cooling and heating in the air in the subject building: 1. During the normal heating season to maintain an average indoor dry bulb temperature of not less than 70 degrees F (21 degrees C) or more than 76 degrees (24.4 degrees C) when the outdoor dry bulb temperature is lower than 65 degrees F (18 degrees C) but not lower than 0 degrees F (-13 degrees C). 2. To maintain comfort cooling for an average indoor dry bulb temperature of not more than 78 degrees F when the outside dry bulb temperature is 95 degrees F (24 degrees C). 3. During the intermediate seasons, when the outside dry bulb temperature is below 55 degrees (13 degrees C), cooling will be provided by outside air usage in conjunction with operating of return air, outside air and exhaust air dampers. 4. To furnish not less than .10 cubic foot of fresh air per minute per square foot of rentable area, and between .20 and 1.0 cubic feet of total air per minute, per square foot of rentable occupied space. 5. Lessor will not be responsible for the failure of the air-conditioning system if such failure results from (i) the occupancy of the Premises with more than an average of one (1) person for each one hundred (100) usable square feet of floor area (ii) the installation or operation by Lessee of machines and appliances, the installed electrical load of which when combined with the load of all lighting fixtures exceeds five (5) watts per square foot of floor area and in any manner exceeding the aforementioned occupancy and electrical load criteria, or (iii) rearrangement of partitioning after the initial preparation of the Premises. If interference with normal operation of the air-conditioning system in the Premises results, necessitating changes in the air conditioning system servicing the Premises, such changes shall be made by Lessor upon written notice to Lessee at Lessee's sole cost and expense. Lessee agrees to lower and close window coverings when necessary because of the sun's position whenever the air conditioning system is in operation, and Lessee agrees at all times to cooperate fully with Lessor and to abide by all the Rules and Regulations attached hereto as well as reasonable rules and regulations which Lessor may hereafter prescribe involving the air-conditioning system. -- END -- Exhibit C-1 - Page 1 EXHIBIT D --------- CLEANING SERVICES (Five Nights Per Week) LESSEE'S PREMISES - ----------------- 1. Vacuum clean all carpeted areas. 2. Sweep and dust mop all non-carpeted areas. Wet mop whenever necessary. 3. All office furniture such as desks, chairs, files, filing cabinets, etc. shall be dusted with a clean treated dust cloth whenever necessary and only if such surfaces are clear of Lessee's personal property including but not limited to plants. 4. Empty and wash ashtrays. 5. Empty wastepaper baskets and remove waste to the designated areas. 6. All vertical surfaces within arms reach shall be spot cleaned to remove finger marks and smudges. Baseboard and window sills are to be spot cleaned whenever necessary. 7. All cleaning of cafeterias, vending areas, kitchen facilities are excluded. Lessee may make necessary arrangements for same directly with Lessor's cleaning maintenance company. 8. Cleaning hours shall be Monday through Friday between 7:00 p.m. and 11:00 p.m. 9. No cleaning service is provided on Saturday, Sunday and Building Holidays. 10. Cartons or refuse in excess which can not be placed in wastebaskets will not be removed. Lessee is responsible to place such unusual refuse in trash dumpster. 11. Cleaning maintenance company will not remove nor clean tea, office cups or similar containers. If such liquids are spilled in waste baskets, the waste baskets will be emptied but not otherwise cleaned. Lessor will not be responsible for any stained carpet caused from liquids leaking or spilling from Lessee's wastepaper receptacles. 12. Upon completion of cleaning, all lights will be turned off and doors locked leaving the Premises in an orderly condition. 13. Glass entrance doors will be cleaned nightly. Interior glass doors or glass partitions are excluded. Lessee may make arrangements for same with Lessor's cleaning maintenance company. COMMON AREAS - ------------ 1. Vacuum all carpeting in entrance lobbies, outdoor mats and all corridors. 2. Wash glass doors in entrance lobby with a clean damp cloth and dry towel. 3. Clean cigarette urns. Sweep and/or wet mop all resilient tile flooring. Hard surface floors such as quarry tile, etc., shall be cleaned nightly. 4. Wash, clean and disinfect water fountains. 5. Clean all elevators and stairwells. 6. Lavatories -- Men and Women. a. Floors in all lavatories shall be wet mopped each evening with a germicidal detergent to ensure a clean and germ free surface. b. Wash and polish all mirrors, shelves, bright work including any piping and toilet seats. c. Wash and disinfect wash basins and sinks using a germicidal detergent. d. Wash and disinfect toilet bowls and urinals. e. Keep lavatory partitions, tiled walls, dispensers and receptacles in a clean condition using a germicidal detergent when necessary. f. Empty and sanitize sanitary disposal receptacles. g. Fill toilet tissue holders, towel dispensers and soap dispensers. Refills to be supplied by Lessor. 7. Clean all air ventilation grill work in ceilings. Exhibit D - Page 1 EXHIBIT E --------- BUILDING HOLIDAYS BUILDING CLOSED * NEW YEAR'S DAY * * MEMORIAL DAY * * INDEPENDENCE DAY * * LABOR DAY * * THANKSGIVING DAY * * CHRISTMAS DAY * -- END -- Exhibit E - Page 1 EXHIBIT F --------- TENANT ESTOPPEL CERTIFICATE TO: MORTGAGEE and/or its affiliates and/or whom else it may concern: 1. The undersigned is the Lessee (Tenant) under that certain Lease dated _______ by and between _______ as Lessor (Landlord) and _______ as Lessee, covering those certain premises commonly known and designated as _______ r.s.f. on the _______ ( ) floor of____________________________, NJ. 2. The Lease has not been modified, changed, altered or amended in any respect (except as indicated following this sentence) and is the only Lease or agreement between the undersigned and the Lessor affecting said premises. If none, state "none". 3. The undersigned has made no agreements with Lessor or its agents or employees concerning free rent, partial rent, rebate of rental payments or any other type of rental concession (except as indicated following this sentence), except as set forth in Paragraph 10 of the Preamble. If none, state "none". 4. The undersigned has accepted and now occupies the premises, and is and has been open for business since _______, 200_. The Lease term began _______, 2003, and the rent for said premises has been paid to and including , 2003 in conformity with this Lease agreement. No rent has been prepaid for more than two (2) months. The fixed minimum rent being paid as above is $ __________ per month. If Lessee is not in full possession, whether Lessee has assigned the Lease, sublet all or any portion of the Premises, or otherwise transferred any interest in the Lease or the Premises, Lessee agrees to provide a copy of such assignment, sublease, or transfer upon request. 5. To the best of Lessee's knowledge, the Lease is not in default and is in full force and effect. As of the date hereof, the undersigned is entitled to no credit, no free rent and no offset or deduction in rent. 6. All alterations, improvements, additions, build-outs, or construction required to be performed under the Lease have been completed in accordance with the terms of the Workletter attached to Lease as Exhibit C. 7. The Lease does not contain and the undersigned doesn't have any outstanding options or rights of first refusal to purchase the premises or any part thereof or the real property of which the premises are a part. 8. No actions, whether voluntary or otherwise, are pending against the undersigned under the bankruptcy laws of the United States or any State thereof. 9. To the best of Lessee's knowledge there are currently no valid defenses, counterclaims, off-sets, credits, deductions in rent, or claims against the enforcement of any of the agreements, terms, or conditions of the Lease. 10. The undersigned acknowledges that all the interest of Lessor in and to the above-mentioned Lease is being duly assigned to MORTGAGEE or one of its affiliates hereunder and that pursuant to the terms thereof (i) all rental payments under said Lease shall continue to be paid to Lessor in accordance with the terms of the Lease unless and until you are otherwise notified in writing by MORTGAGEE, or its successor or assigns and (ii) no modification, revision, or cancellation of the Lease or amendments thereto shall be effective unless a written consent thereto of such mortgagee is first obtained. 11. The undersigned is authorized to execute this Tenant Estoppel Certificate on behalf of the Lessee. Dated this ________ day of __________________ , 2003 LESSEE: ______________________________________ Name: Title: Exhibit F - Page 1 EXHIBIT G --------- COMMENCEMENT DATE AGREEMENT 1.0 PARTIES - --- ------- THIS AGREEMENT made the _________day of ________, 2003 is by and between ________________ (hereinafter "Lessor") whose address is c/o Mack-Cali Realty Corporation, 11 Commerce Drive, Cranford, New Jersey 07016 and _________________________ (hereinafter "Lessee") whose address is _______________________________________________________. 2.0 STATEMENT OF FACTS - --- ------------------ 2.1 Lessor and Lessee entered into a Lease dated ____________, 2003 (hereinafter "Lease") setting forth the terms of occupancy by Lessee of approximately ________ rentable square feet on the _____ (___) floor (hereinafter "Premises") at _____________________________ (hereinafter "Building"); and 2.2 The Term of the Lease is for ____________ (__) months with the Commencement Date of the initial Term being defined in the Preamble to the Lease as being subject to change under Articles 27 and 43 thereof; and 2.3 It has been determined in accordance with the provisions of Articles 27 and 43 of the Lease that ___________, 2003 is the Commencement Date of the Term of the Lease. 3.0 STATEMENT OF TERMS - --- ------------------ NOW, THEREFORE, in consideration of the Premises and the covenants hereinafter set forth, it is agreed: 3.1 The Commencement Date of the Term of the Lease is ___________, 2003 and the Expiration Date thereof is _____________ , 2003 and the Lease Preamble Articles 6 and 9 shall be deemed modified accordingly. 3.2 Article 10 of the Preamble shall be deemed modified as follows: 3.3 This Agreement is executed by the parties hereto for the purpose of providing a record of the Commencement and Expiration Dates of the Lease, adjust the Term of the Lease and Fixed Basic Rent amount accordingly. EXCEPT as modified herein, the Lease covering the Premises shall remain in full force and effect as if the same were set forth in full herein and Lessor and Lessee hereby ratify and confirm all the terms and conditions thereof. THIS AGREEMENT shall be binding upon and inure to the benefit of the parties hereto and their respective legal representatives, successors and permitted assigns. EACH PARTY AGREES that it will not raise or assert as a defense to any obligation under the Lease or this Agreement or make any claim that the Lease or this Agreement is invalid or unenforceable due to any failure of this document to comply with ministerial requirements including, but not limited to, requirements for corporate seals, attestations, witnesses, notarizations, or other similar requirements, and each party hereby waives the right to assert any such defense or make any claim of invalidity or unenforceability due to any of the foregoing. IN WITNESS THEREOF, Lessor and Lessee have hereunto set their hands and seals the date and year first above written and acknowledge one to the other they possess the requisite authority to enter into this transaction and to sign this Agreement. LESSOR LESSEE By: ________________________________ By: ______________________________ Michael K. Nevins Name: Vice President - Leasing Title: Exhibit G - Page 1 EXHIBIT H [Date] Gentlemen: BY ORDER OF OUR CLIENT _______________________, HAVING AN OFFICE AT ___________________, WE HEREBY ESTABLISH OUR IRREVOCABLE LETTER OF CREDIT NO. ________________ IN YOUR FAVOR FOR A SUM OR SUMS NOT TO EXCEED US $__________________ (Write Out Sum___________________) IN THE AGGREGATE, EFFECTIVE IMMEDIATELY. THIS LETTER OF CREDIT SHALL BE PAYABLE IN IMMEDIATELY AVAILABLE FUNDS IN U.S. DOLLARS. FUNDS UNDER THIS LETTER OF CREDIT ARE PAYABLE TO YOU UPON YOUR PRESENTATION TO US OF A SIGHT DRAFT DRAWN ON US IN THE FORM OF EXHIBIT A ATTACHED HERETO. ACCOMPANIED BY THE ORIGINAL LETTER OF CREDIT FOR PROPER ENDORSEMENT. Partial draws under this letter of credit are permissible. WE ARE INFORMED THAT THIS LETTER OF CREDIT MAY BE REDUCED FROM TIME TO TIME PRIOR TO EXPIRATION. SHOULD YOU WISH TO REDUCE THIS LETTER OF CREDIT, WE REQUEST YOU PRESENT THE FOLLOWING STATEMENT ON YOUR LETTERHEAD, PURPORTEDLY SIGNED BY AN AUTHORIZED OFFICER (INDICATING NAME AND TITLE) AS FOLLOWS: "WE AUTHORIZE THE REDUCTION OF _________ BANK, NATIONAL ASSOCIATION, IRREVOCABLE LETTER OF CREDIT NUMBER ______________ BY THE AMOUNT OF US $__________________, THE NEW BALANCE OF THE LETTER OF CREDIT WILL BE US $____________________." IT IS A CONDITION OF THIS LETTER OF CREDIT, THAT IT WILL AUTOMATICALLY BE EXTENDED FOR AN ADDITIONAL PERIOD OF ONE (1) YEAR FROM ITS PRESENT, OR ANY FUTURE EXPIRATION DATE, BUT NOT BEYOND _______________, 20__, UNLESS YOU RECEIVE OUR WRITTEN NOTIFICATION, DELIVERED TO YOU AT THE ABOVE ADDRESS, BY REGISTERED MAIL OR OTHER FORM OF DELIVERY FOR WHICH RECEIPT IS ACKNOWLEDGED, AT LEAST SIXTY (60) DAYS PRIOR TO THE THEN CURRENT EXPIRATION DATE, ADVISING YOU THAT WE HAVE ELECTED NOT TO EXTEND THIS LETTER OF CREDIT FOR AN ADDITIONAL PERIOD OF ONE (1) YEAR. NOTWITHSTANDING THE ABOVE, THIS LETTER OF CREDIT SHALL TERMINATE AND WILL NOT BE EXTENDED BEYOND ____________, 20__. THIS LETTER OF CREDIT IS TRANSFERABLE IN ITS ENTIRETY, BUT NOT IN PART . WE HEREBY AGREE TO HONOR EACH DRAFT DRAWN UNDER AND IN COMPLIANCE WITH THIS LETTER OF CREDIT IF DULY PRESENTED ON OR BEFORE _____________, 20__, OR ANY AUTOMATICALLY EXTENDED PERIOD THEREAFTER, AT OUR OFFICE LOCATED AT _____________________________________________. THIS LETTER OF CREDIT IS SUBJECT TO THE INTERNATIONAL STANDBY PRACTICES 1998, INTERNATIONAL CHAMBER OF COMMERCE PUBLICATION NO. 590. VERY TRULY YOURS, ________________________________ Name: Title: Exhibit H - Page 1 EX-10 5 ex10-3.txt EXHIBIT 10.3 FIRST AMENDMENT TO LEASE ------------------------ 1. PARTIES ------- 1.1 THIS AGREEMENT made the _________ day of _______________, 2003 is between CWLT ROSELAND EXCHANGE L.L.C. ("Lessor") whose address is c/o Mack-Cali Realty Corporation, 11 Commerce Drive, Cranford, New Jersey 07016 and AMERICAN BUSINESS FINANCIAL SERVICES, INC. ("Lessee"), whose address is 111 Presidential Boulevard, Bala Cynwyd, Pennsylvania 19004. 2. STATEMENT OF FACTS ------------------ 2.1 Lessor and Lessee have previously entered into a Lease Agreement dated March 25, 2003 (hereinafter referred to as the "Lease") covering approximately 31,160 gross rentable square feet on the fourth (4th) floor ("Premises") in the building located at 105 Eisenhower Parkway, Roseland, New Jersey ("Building"); and 2.2 The Term of the Lease is eight (8) years and eight (8) months; and 2.3 Lessee desires to perform its own tenant improvement work in the Premises; and 2.4 The parties desire to amend certain terms of the Lease as set forth below. 3. AGREEMENT --------- NOW, THEREFORE, in consideration of the Premises and the covenants hereinafter set forth, Lessor and Lessee agree as follows: 3.1 The above recitals are incorporated herein by reference. 3.2 All capitalized and non-capitalized terms used in this Agreement which are not separately defined herein but are defined in the Lease shall have the meaning given to any such term in the Lease. 3.3 Paragraph 6 of the Preamble to the Lease is hereby amended by deleting it in its entirety and substituting the following in place thereof: "COMMENCEMENT DATE is May 27, 2003 and shall for purposes hereof be subject to Articles 27 and 43 hereof. In no event shall the Commencement Date be earlier than May 27, 2003." 3.4 Article 27 of the Lease is hereby amended by deleting it in its entirety and substituting the following in place thereof: "Lessor hereby leases to Lessee and Lessee hereby hires from Lessor the Premises in its "AS-IS" condition for the Term, under the terms and conditions set forth herein, subject to Sections 5m. and 33 of the Lease. Lessor shall have no obligation to perform any tenant improvement work in the Premises. All initial tenant improvement work to be performed by Lessee under this Lease shall be performed in accordance with Exhibit C hereof." 3.5 Article 43 of the Lease is hereby amended by deleting it in its entirety and substituting the following in place thereof: "Notwithstanding anything contained herein to the contrary, if Lessor, for any reason whatsoever cannot deliver possession of the Premises to Lessee at the commencement of the agreed Term as set forth in Article 2, this Lease shall not be void or voidable, nor shall Lessor be liable to Lessee for any loss or damage resulting therefrom, but in that event, the Term shall be for the full term as specified above to commence from and after the date Lessor shall have delivered possession of the Premises to Lessee or from the date Lessor would have delivered possession of the Premises to Lessee but for any reason attributable to Lessee (herein the "Commencement Date") and to expire midnight of the day immediately preceding Term anniversary of the Commencement Date, and if requested by Lessor, Lessor and Lessee shall, ratify and confirm said Commencement and Expiration Dates by completing and signing Exhibit G attached hereto and made a part hereof. If Lessee is delayed in substantially completing the Premises on or before May 23, 2003 by reason of Lessor's acts and/or omissions or Force Majeure, then the Commencement Date shall be such number of days after May 27, 2003 as shall be equal to the number of days Lessee is delayed in substantially completing the Premises by reason of Lessor's acts and/or omissions or Force Majeure. Notwithstanding the foregoing, if 1 Lessee is delayed by Force Majeure in substantially completing the Premises for more than thirty (30) days, Lessor shall have the right, but not the obligation, to perform the balance of the work set forth in the construction contract between Lessee and Lessee's contractor at the price set forth therein. In such event, the Commencement Date shall be the earlier of (i) the date Lessee or anyone claiming under or through Lessee shall occupy the Premises for purposes other than constructing tenant improvements in the Premises or (ii) the date Lessor shall substantially complete the Premises. Notwithstanding anything contained in the foregoing paragraphs of this Article to the contrary, any delays in Lessee's substantial completion of the Premises resulting from Lessor's acts or omissions or Force Majeure shall not automatically relieve Lessee of its obligation to commence paying Fixed Basic Rent on the eighth (8th) month anniversary of the Commencement Date. Such delays resulting from Lessor's acts or omissions or Force Majeure must have in fact delayed Lessee's substantial completion of the Premises by more than the number of days between the forty-fifth (45th) day after the date construction drawings for the Premises has been approved by Lessor and Lessee and May 23, 2003. 3.6 Article 53 is hereby deleted in its entirety. 3.7 Exhibit C is hereby amended by deleting it in its entirety and substituting the attached Exhibit C in place thereof. 3.8 Lessee hereby represents to Lessor that (i) there exists no default under the Lease either by Lessee or Lessor; (ii) Lessee is entitled to no credit, free rent or other offset or abatement of the rents due under the Lease; and (iii) there exists no offset, defense or counterclaim to Lessee's obligation under the Lease. 3.9 Lessee represents to Lessor that no broker brought about this transaction, and agrees to indemnify and hold Lessor harmless from any and all claims of any broker arising out of or in connection with negotiations of, or entering into of, this Agreement. 3.10 Except as expressly amended herein, the Lease, as amended, shall remain in full force and effect as if the same had been set forth in full herein, and Lessor and Lessee hereby ratify and confirm all of the terms and conditions thereof. 3.11 This Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective legal representatives, successors and permitted assigns. 3.12 Each party agrees that it will not raise or assert as a defense to any obligation under the Lease or this Agreement or make any claim that the Lease or this Agreement is invalid or unenforceable due to any failure of this document to comply with ministerial requirements including, but not limited to, requirements for corporate seals, attestations, witnesses, notarizations, or other similar requirements, and each party hereby waives the right to assert any such defense or make any claim of invalidity or unenforceability due to any of the foregoing. IN WITNESS WHEREOF, Lessor and Lessee have hereunto set their hands and seals the date and year first above written, and acknowledge one to the other that they possess the requisite authority to enter into this transaction and to sign this Agreement. LESSOR: LESSEE: CWLT ROSELAND EXCHANGE L.L.C. AMERICAN BUSINESS FINANCIAL SERVICES, INC. By: Mack-Cali Texas Property L.P., member By: Mack-Cali Sub XVII, Inc. its general partner By: _____________________________ By: ___________________________ Michael K. Nevins Name: Vice President - Leasing Title: 2 EXHIBIT C --------- LESSEE'S WORK AND ALTERATIONS Lessee may make the alterations required for Lessee's use of the Premises (hereinafter the "Work") after the commencement of the Term subject to the following: 1. a. Lessee, at its sole cost and expense, shall prepare and submit to Lessor, for Lessor's and governmental approval, the following descriptive information, detailed architectural and engineering drawings and specifications (hereinafter the "Plans") for the Work. The Plans shall be as complete and finished as required to completely describe the Work and shall include, but not be limited to, the following: i. Demolition Plans depicting all existing conditions to be removed, abandoned or cut patched. ii. Architectural floor plans depicting partition locations and types; door location, size, and hardware types. iii. Structural plans, if required, depicting new structural components and their connections to existing elements. iv. Electrical plans depicting all new and existing electrical wiring, devices, fixtures and equipment. v. Mechanical plans depicting all new plumbing, piping, heating, ventilating, air conditioning equipment, and duct work and its connections to existing elements. vi. Life Safety System plans depicting all new or altered alarm system fixtures, devices, detectors and wiring within the Premises and their connection to existing systems. vii. Coordinated reflected ceiling plan showing ceiling systems and materials and all of the above items and their proximity to one another. viii. Finish plans showing locations and types of all interior finishes with a schedule of all proposed materials and manufacturers. The Plans shall provide for all systems and construction components complying with the requirements of all governmental authorities and insurance bodies having jurisdiction over the Building. b. The Plans for the Work are subject to Lessor's prior written approval which shall not be unreasonably withheld, provided, however, that Lessor may in any event disapprove the Plans if they are incomplete, inadequate or inconsistent with the terms of the Lease or with the quality and architecture of the Building. Lessor agrees to approve or disapprove the Plans within three (3) business days of receipt of same (the "Lessor's Approval Period"). If Lessor disapproves the Plans or any portion thereof, Lessor shall promptly notify Lessee thereof and of the revisions which Lessor reasonably requires in order to obtain Lessor's approval. Lessee shall, at its sole cost and expense and within five (5) days after approval of the Plans by Lessor and Lessee, submit the Plans, in such form as may be necessary, with the appropriate governmental agencies for obtaining required permits and certificates. Any changes required by any governmental agency affecting the Work or the Plans shall be complied with by Lessee in completing said Work at Lessee's sole cost and expense. Lessee shall submit completed Plans to Lessor simultaneously with Lessee's submission of said plans to the local building department. Exhibit C - Page 1 2. Lessor shall permit Lessee to solicit competitive pricing and select its own general and/or individual subcontractors to perform the Work at its sole cost. Lessee's use of its own contractor and/or individual subcontractors shall be subject to the following: a. All general contractors shall be subject to Lessor's prior written approval, which shall not be unreasonably withheld, conditioned or delayed. b. Lessee shall instruct all approved general contractors to use Lessor's Base Building Sub-Contractors for heating, ventilation, air conditioning, electrical, fire suppression and life safety systems (hereinafter "Building Systems"). and other subcontractors may be used only when specifically approved in writing by Lessor, which approval shall not be unreasonably withheld, conditioned or delayed. c. The Base Building Sub-Contractors and their respective trades are set forth in Paragraph 6 below. d. Lessee notifies Lessor in writing of Lessee's selection of general and subcontractors. e. All costs associated with the bidding process soliciting competitive pricing will be at the sole cost and expense of the Lessee. f. Lessee's workmen and mechanics shall work in harmony and not interfere with the labor employed by Lessor, Lessor's mechanics or contractors or by any other occupant of the Building or their mechanic or contractors, if any. If at any time Lessee and/or its contractors cause disharmony or interference with the operation of the Building, Lessor shall give forty-eight (48) hours written notice to Lessee and within twenty-four (24) hours Lessee shall resolve any dispute so that the tenor of the construction process and the operation of the Building is returned to that which existed prior to Lessor's notice. Such entry by Lessee's contractors shall be deemed controlled by all of the terms, covenants, provisions and conditions of the Lease. g. Prior to the commencement of the Work, Lessee shall provide Lessor with evidence of Lessee's contractors and sub-contractors carrying such worker's compensation, general liability, personal and property insurance required by law and in amounts no less than the amounts set forth in Paragraph 7 herein. Lessor shall not be liable in any way for any injury, loss or damage which may occur to any portion of the Work, Lessee's decorations, or installments so made, the same being solely at Lessee's risk. h. In the event Lessor approves the use of subcontractors other than Lessor's Base Building sub-contractors, all proposed Building System work, including the preparation of the plans and specifications identified herein, shall be approved by Lessor's engineers (the "Engineering Review"), and any cost thereof shall be Lessee's responsibility. i. Lessor shall afford Lessee and its contractors the opportunity to use the Building facilities in order to enable Lessee and its contractors to perform the Work, provided however, that Lessee and its contractors shall remain responsible for the scheduling and transportation of materials and equipment used in the performance of such work. Lessee shall give Lessor adequate prior notice with regard to the scheduling and transportation of materials in and out of the Building. Lessor shall furnish, at Lessor's expense, water, electricity, heat and ventilation during the performance of the Work during regular construction trade hours of 8:00 a.m. to 5:00 p.m., Monday through Friday, exclusive of trade holidays. Any services required by Lessee during other hours shall be paid by Lessee at Lessor's customary charge therefor. Exhibit C - Page 2 j. All work installed by Lessee and its sub-contractors shall require inspections to be made by Lessor's Base Building Sub-Contractors at Lessee's or Lessee's contractors expense, such fees to be reasonable and customary, (the "Inspection Fees"). The Base Building Sub-Contractors shall supply Lessor with certification that work so preformed has been completed in accordance with the Plans which have been previously approved by Lessor. If a Base Building Sub-Contractor is selected and actually installs the work, the Inspection Fees described in this paragraph with respect to such work shall not be required. The Inspection Fees together with the Building Manager's fees shall not exceed $4,000.00. k. Lessee shall be responsible for all cleaning and removal of debris necessitated by the performance of the Work. If Lessee fails to provide such cleaning and removal, the same may be performed by Lessor on Lessee's behalf and Lessee will pay Lessor an amount equal to the contractor's charge therefore. l. Neither the outside appearance nor the strength of the Building or of any of its structural parts shall be affected by the Work. m. The proper functioning of any of the Building Systems shall not be adversely affected or the usage of such systems by Lessee shall not be materially increased above the projected usage of such systems indicated by the current plans and specifications of the Building. n. Lessee and its general and sub-contractors shall be bound by and observe all of the conditions and covenants contained in the Lease and this Exhibit C. o. Lessor shall designate a "Project Manager" as its representative in the Building who shall be responsible for coordination and supervision of the Work as it pertains to the daily operation of the Building. The Project Manager and his subordinates shall be granted access to the Premises at all times during the construction period. Lessee shall pay to Lessor, with the fifteen (15) business days of billing, all reasonable costs applicable to Lessor's supervisory and coordination work during the construction period, at a rate of $75.00 per hour, such charges, together with the Inspection Fees, shall not exceed $4,000.00. 3. Intentionally Omitted. 4. Any part of the Work within the Premises shall become the property of the Lessor upon installation. Furthermore, with respect to any material and installation which is part of the Work, Lessee shall not be entitled to remove, pledge or sell same unless otherwise agreed to in writing by Lessor and Lessee. No refund, credit, or removal of said items shall be permitted at the termination of the Lease. Items installed that are not integrated in any such way with other common building materials do not fall under this provision (Example: shelving, furniture, trade fixtures). 5. Lessor shall provide a cash contribution of FOUR HUNDRED EIGHTY-TWO THOUSAND FOUR HUNDRED FIFTY AND DOLLARS ($482,450.00) ("Lessor's Construction Allowance") for payment of the costs associated with the completion of the Work. Lessor shall make progress payments to Lessee on a monthly basis, for the Work performed to date and/or for materials delivered to the Premises during the previous month, less a retainage of ten percent (10%) of each progress payment ("Retainage"). Each of Lessor's progress payments shall be limited to that fraction of the total amount of such payment, the numerator of which shall be the amount of Lessor's Construction Allowance, and the denominator of which shall be the total contract (or estimated) price for the performance of all of the Work shown on all plans and specifications approved by Landlord. Provided that Lessee delivers requisitions to Lessor on or prior to the 10th day of any month, such progress payments shall be made within 20 days next following the delivery to Lessor of requisitions therefor, signed by a financial officer of Lessee, which requisitions shall set forth the names of each contractor and subcontractor to whom payment is due, and the amount thereof, and shall be accompanied by (i) copies of partial waivers of lien from all contractors, subcontractors and materialman covering all work and Exhibit C - Page 3 materials which were the subject of previous progress payments by Lessor and Lessee, (ii) a written certification from Lessee's architect that the work for which the requisition is being made has been completed substantially in accordance with the plans and specifications approved by Lessor and (iii) such other documents and information as Lessor may reasonably request. Any such requisition made following the 10th day of any month shall be paid no later than the last day of the month following the month in which such requisition is made. If Lessee does not pay any contractor as required by this provision, Lessor shall have the right upon notice to Lessee, but not the obligation, to promptly pay to such contractor all sums so due from Lessee, and Lessee agrees the same shall be deemed Additional Rent and Lessor shall have all remedies available under this Lease, at law or in equity for collection from Lessee of all sums so paid by Lessor. The Retainage of Lessor's Construction Allowance shall be payable within ten (10) business days of Lessor's receipt of the following: a. Copy of the Certificate of Occupancy (temporary and permanent) issued by the local construction official; b. AIA Document G704, Certificate of substantial completion issued and signed by Lessee's Architect; c. Release of Lien statements from the general and all sub-contractors associated with the Work; d. Lessee shall provide Lessor a set of reproducible drawings of the Plans and a "CAD" file (in .DWG or .DXF format) of the "As-Built" Plans; and e. Lessee has paid all sums due and owing Lessor under the Lease and this Exhibit C. If Lessor fails to make such payment(s) of Lessor's Construction Allowance that is due and payable hereunder within the time periods set forth above, Lessee shall so notify Lessor ("Lessee's Notice"). Lessee's Notice shall state the following in bold and capital letters: "IF LESSOR FAILS TO PAY LESSOR'S CONTRUCTION ALLOWANCE DUE AND PAYABLE PURSUANT TO EXHIBIT C OF THE LEASE WITHIN FIVE (5) BUSINESS DAYS OF YOUR RECEIPT OF THIS NOTICE, LESSEE MAY DEDUCT SUCH SUM(S) FROM THE FIXED BASIC RENT DUE AND PAYABLE UNDER THE LEASE." If Lessor shall fail to make such payment of Lessor's Construction Allowance within such five (5) business day period, Lessee shall have the right to deduct such sums from the Fixed Basic Rent due and payable by Lessee under the Lease. 6. The Base Building Sub-Contractors are: Fire Sprinkler Contractor See Attached Exhibit A Electrical Contractor See Attached Exhibit A Plumbing Contractor See Attached Exhibit A HVAC Contractor See Attached Exhibit A 7. Lessee's Contractor's Insurance: a. The Lessee shall require any and all contractors of the Lessee performing work on or about the Premises to obtain and/or maintain specific insurance coverage for events which could occur while operations are being performed and which could occur after the completion of the work. The insurance coverage of the contractor shall be at least equal to the coverage required by Article 30 of the Lease and the contractor shall name Lessor and, if requested, Mortgagee as additional insureds on all policies of liability insurance. Exhibit C - Page 4 b. The contractor shall purchase and maintain such insurance as will protect itself and Lessor and Lessee from claims set forth below which may arise out of or result from its operations under the contract and after contract completion with Lessee, whether such operations are performed by the contractor or by any subcontractor or by anyone directly or indirectly employed by any of them or by anyone for whose acts any of them may be liable. The insurance coverage shall include but not be limited to protection for: i. Claims under Workers or Workmens Compensation, Disability Benefits, and other Employee Benefit Acts; ii. Claims for damages because of bodily injury, occupational sickness, disease or death of its employees; iii. Claims for damages because of bodily injury, sickness, disease, or death of any person other than its employees; iv. Claims for damages insured by the usual personal injury liability coverages which are sustained by (i) any person as a result of an offense directly or indirectly related to the employment of such person by the contractor, or (ii) by any other person; v. Claims for damages, other than to the work itself, because of injury to or destruction of tangible property, including loss of use resulting therefrom; vi. Claims for damages because of bodily injury or death of any person and/or property damage arising out of the ownership, maintenance, or use of any motor vehicle; and vii. Claims which include the foregoing, but not limited thereto, which may occur while operations are being performed and claims which may occur after operations are completed. c. Lessee shall secure evidence of Lessee's contractor's insurance coverage adequate to protect Lessor and Lessee. d. The contract between the Lessee and its contractor shall require that the Lessee's contractor hold the Lessor harmless in a form and manner equal to the indemnity agreement in Article 33, "Indemnity" of the Lease agreement. e. Lessee shall cause to be executed a waiver of all rights their contractors have or may have against Lessor and any Mortgagee involved in the Premises in any way, for damages caused by fire or other perils so insured. 8. All sums payable by Lessee to Lessor in connection with this Exhibit C and any other work to be performed by Lessor within the Premises and billable to Lessee shall be deemed Additional Rent. -END- Exhibit C - Page 5 EX-99 6 ex99-1.txt EXHIBIT 99-1 Exhibit 99.1 AMERICAN BUSINESS FINANCIAL SERVICES, INC. CERTIFICATION PURSUANT TO 18 U.S.C. ss. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 This certification is intended to accompany American Business Financial Services, Inc.'s (the "Company") Quarterly Report on Form 10-Q for the three months ending March 31, 2003 with the Securities and Exchange Commission on the date hereof (the "Report"), and is given solely for the purpose of satisfying the requirements of 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. To the best of my knowledge, I, Anthony J. Santilli, hereby certify in my capacity as the Chief Executive Officer of the Company, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. Anthony J. Santilli ----------------------- Anthony J. Santilli Chief Executive Officer Date: May 14, 2003 EX-99 7 ex99-2.txt EXHIBIT 99-2 Exhibit 99.2 AMERICAN BUSINESS FINANCIAL SERVICES, INC. CERTIFICATION PURSUANT TO 18 U.S.C. ss. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 This certification is intended to accompany American Business Financial Services, Inc.'s (the "Company") Quarterly Report on Form 10-Q for the three months ending March 31, 2003 with the Securities and Exchange Commission on the date hereof (the "Report"), and is given solely for the purpose of satisfying the requirements of 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. To the best of my knowledge, I, Albert W. Mandia, hereby certify in my capacity as the Chief Financial Officer of the Company, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. Albert W. Mandia -------------------- Albert W. Mandia Chief Financial Officer Date: May 14, 2003 -----END PRIVACY-ENHANCED MESSAGE-----