-----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, JFECFgQbbUbacGjmtt2pn+VALGE+e9fLLVBhWKdhNpgtVnFeD1zpbNX3B7EFrMOm mxmRKhSQW/idw8/fq6PlQA== 0000950144-01-505664.txt : 20010814 0000950144-01-505664.hdr.sgml : 20010814 ACCESSION NUMBER: 0000950144-01-505664 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20010701 FILED AS OF DATE: 20010813 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SERVICE MERCHANDISE CO INC CENTRAL INDEX KEY: 0000089107 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-MISC GENERAL MERCHANDISE STORES [5399] IRS NUMBER: 620816060 STATE OF INCORPORATION: TN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-09223 FILM NUMBER: 1707201 BUSINESS ADDRESS: STREET 1: 7100 SERVICE MERCHANDISE BLVD CITY: BRENTWOOD STATE: TN ZIP: 37027 BUSINESS PHONE: 6156606000 MAIL ADDRESS: STREET 1: PO BOX 24600 CITY: NASHVILLE STATE: TN ZIP: 37202 10-Q 1 g71130e10-q.txt SERVICE MERCHANDISE COMPANY, INC. 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------- FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JULY 1, 2001. Commission File No.1-9223 SERVICE MERCHANDISE COMPANY, INC. (Debtor-in-Possession as of March 27, 1999) (Exact Name of Registrant as Specified In Its Charter) TENNESSEE 62-0816060 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) P.O. BOX 24600, NASHVILLE, TN 37202-4600 (mailing address) (Zip Code) 7100 SERVICE MERCHANDISE DRIVE, BRENTWOOD, TN 37027 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (615) 660-6000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]. As of July 1, 2001, there were 99,871,123 shares of the Registrant's common stock, $.50 par value, outstanding. 2 TABLE OF CONTENTS
Page No. ---- PART I FINANCIAL INFORMATION Consolidated Statements of Operations (Unaudited) - Three and Six Periods Ended July 1, 2001 and July 2, 2000 ..........................................................................3 Consolidated Balance Sheets - July 1, 2001 (Unaudited), July 2, 2000 (Unaudited) and December 31, 2000 ..............................................................................4 Consolidated Statements of Cash Flows (Unaudited) - Six Periods Ended July 1, 2001 and July 2, 2000 ...................................................................................5 Notes to Consolidated Financial Statements (Unaudited) ............................................6 Management's Discussion and Analysis of Financial Condition and Results of Operations.............14 Quantitative and Qualitative Disclosure about Market Risk.........................................24 PART II OTHER INFORMATION Legal Proceedings ................................................................................25 Defaults Upon Senior Securities ..................................................................26 Exhibits and Reports on Form 8-K .................................................................26 SIGNATURES ................................................................................................27
2 3 PART 1-FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE PERIODS ENDED SIX PERIODS ENDED ----------------------- ------------------------- JULY 1, JULY 2, JULY 1, JULY 2, 2001 2001 2001 2001 ---------- --------- ---------- ---------- Net Sales: Operations excluding exiting categories and closed facilities $ 258,570 $ 315,784 $ 457,634 $ 617,525 Exiting categories and closed facilities -- 101,764 65 143,052 ---------- ---------- ---------- ---------- 258,570 417,548 457,699 760,577 ---------- ---------- ---------- ---------- Costs of merchandise sold and buying and occupancy expenses: Operations excluding exiting categories and closed facilities 183,058 222,858 327,166 441,556 Exiting categories and closed facilities -- 113,347 382 150,544 ---------- ---------- ---------- ---------- 183,058 336,205 327,548 592,100 ---------- ---------- ---------- ---------- Gross margin (loss) after cost of merchandise sold and buying and occupancy expenses: Operations excluding exiting categories and closed facilities 75,512 92,926 130,468 175,969 Exiting categories and closed facilities -- (11,583) (317) (7,492) ---------- ---------- ---------- ---------- 75,512 81,343 130,151 168,477 ---------- ---------- ---------- ---------- Selling, general and administrative expenses: Operations excluding exiting categories and closed facilities 75,264 86,298 145,531 170,491 Exiting categories and closed facilities 851 43,063 5,539 58,265 ---------- ---------- ---------- ---------- 76,115 129,361 151,070 228,756 ---------- ---------- ---------- ---------- Other (income) expense, net 669 (971) 1,380 (13,267) Restructuring charge (income) -- (838) -- (1,747) Depreciation and amortization: Operations excluding exiting categories and closed facilities 10,509 9,678 20,904 19,243 Exiting categories and closed facilities 24 334 48 513 ---------- ---------- ---------- ---------- 10,533 10,012 20,952 19,756 ---------- ---------- ---------- ---------- Reorganization items 10,101 12,217 17,128 30,911 ---------- ---------- ---------- ---------- Loss before interest and income tax (21,906) (68,438) (60,379) (95,932) Interest expense (contractual interest $17,759, $34,951, $16,673 and $34,604 for the three and six periods ended July 1, 2001 and July 2, 2000, respectively) 10,720 9,634 20,873 20,526 ---------- ---------- ---------- ---------- Loss before income tax (32,626) (78,072) (81,252) (116,458) Income tax -- -- -- -- ---------- ---------- ---------- ---------- Net loss $ (32,626) $ (78,072) $ (81,252) $ (116,458) ========== ========== ========== ========== Weighted average common shares - basic and diluted 99,723 99,723 99,723 99,723 ========== ========== ========== ========== Net loss per common share - basic and diluted $ (0.33) $ (0.78) $ (0.81) $ (1.17) ========== ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 3 4 SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED) -------------------------- JULY 1, JULY 2, DECEMBER 31, 2000 2000 2000 ---------- ---------- ------------ ASSETS CURRENT ASSETS: Cash and cash equivalents $ 19,535 $ 29,719 $ 31,838 Accounts receivable, net of allowance of $18,107, $17,496 and $18,542, respectively 6,834 8,268 7,061 Inventories 431,746 513,592 440,324 Prepaid expenses and other assets 12,889 16,968 11,025 ---------- ---------- ------------ TOTAL CURRENT ASSETS 471,004 568,547 490,248 PROPERTY AND EQUIPMENT: Net property and equipment - owned 353,893 348,189 364,898 Net property and equipment - leased 11,193 13,410 12,330 Other assets and deferred charges 49,066 61,138 58,376 ---------- ---------- ------------ TOTAL ASSETS $ 885,156 $ 991,284 $ 925,852 ========== ========== ============ LIABILITIES AND SHAREHOLDERS' DEFICIT LIABILITIES NOT SUBJECT TO COMPROMISE: CURRENT LIABILITIES Notes payable $ 194,844 $ 76,192 $ 89,143 Accounts payable 31,001 54,753 48,570 Accrued expenses 123,127 162,643 158,843 State and local sales taxes 8,290 14,985 16,300 Current maturities of capitalized lease obligations 97 305 93 ---------- ---------- ------------ TOTAL CURRENT LIABILITIES 357,359 308,878 312,949 LONG-TERM LIABILITIES: Long-term debt 60,000 60,000 60,000 Capitalized lease obligations 2,346 1,639 2,396 ---------- ---------- ------------ TOTAL LONG-TERM LIABILITIES 62,346 61,639 62,396 LIABILITIES SUBJECT TO COMPROMISE 745,928 754,285 747,251 ---------- ---------- ------------ TOTAL LIABILITIES 1,165,633 1,124,802 1,122,596 ---------- ---------- ------------ COMMITMENTS AND CONTINGENCIES SHAREHOLDERS' DEFICIT: Preferred stock, $1 par value, authorized 4,600 shares, undesignated as to rate and other rights, none issued Series A Junior Preferred Stock, $1 par value, authorized 1,100 shares, none issued Common stock, $.50 par value, authorized 500,000 shares, issued and outstanding 99,871, 99,956 and 99,871 shares, respectively 49,935 49,979 49,935 Additional paid-in capital 5,881 6,211 5,881 Deferred compensation (157) (467) (221) Accumulated other comprehensive loss (2,545) -- -- Retained deficit (333,591) (189,241) (252,339) ---------- ---------- ------------ TOTAL SHAREHOLDERS' DEFICIT (280,477) (133,518) (196,744) ---------- ---------- ------------ TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT $ 885,156 $ 991,284 $ 925,852 ========== ========== ============
The accompanying notes are an integral part of these consolidated financial statements. 4 5 SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)
SIX PERIODS ENDED --------------------- JULY 1, JULY 2, 2001 2000 --------- --------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (81,252) $(116,458) Adjustments to reconcile net loss to net cash provided (used by operating activities: Depreciation and amortization 22,973 23,694 Net loss (gain) on sale of property and equipment 1,380 (3,809) Reorganization items 17,128 30,911 Changes in assets and liabilities: Accounts receivable, net 227 4,903 Inventories 8,578 129,405 Prepaid expenses and other assets (1,864) 3,440 Accounts payable (16,687) (6,904) Accrued expenses and state and local sales taxes (58,098) (60,719) Accrued restructuring costs (110) (7,406) --------- --------- NET CASH USED BY OPERATING ACTIVITIES (107,725) (2,943) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property and equipment -- owned (9,638) (17,790) Proceeds from sale of property and equipment 134 8,613 Proceeds from sale of property and equipment -- reorganization 142 4,059 Restricted cash and other assets, net 6,134 (1,267) --------- --------- NET CASH USED BY INVESTING ACTIVITIES (3,228) (6,385) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Short-term borrowings, net 105,701 33,215 Repayment of long-term debt (5,301) (45,004) Repayment of capitalized lease obligations (1,750) (2,194) Debt issuance cost -- (8,500) Forfeiture of restricted stock -- (61) --------- --------- NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES 98,650 (22,544) --------- --------- NET DECREASE IN CASH AND CASH EQUIVALENTS (12,303) (31,872) CASH AND CASH EQUIVALENTS -- BEGINNING OF PERIOD 31,838 61,591 --------- --------- CASH AND CASH EQUIVALENTS -- END OF PERIOD $ 19,535 $ 29,719 ========= ========= SUPPLEMENTAL DATA: Cash paid (received) during the period for: Interest $ 13,322 $ 11,525 Income taxes $ 462 $ (315) Reorganization items $ 10,468 $ 7,658 Non-cash financing activities: Other comprehensive loss $ 2,545 $ --
The accompanying notes are an integral part of these consolidated financial statements. 5 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) A. FINANCIAL STATEMENT PRESENTATION AND GOING CONCERN MATTERS The consolidated financial statements except for the consolidated balance sheet as of December 31, 2000, have been prepared by the Company without audit. In management's opinion, the information and amounts furnished in this report reflect all adjustments (consisting of normal recurring adjustments) considered necessary for the fair presentation of the consolidated financial position and consolidated results of operations for the interim periods presented. Certain prior period amounts have been reclassified to conform to the current period presentation. The accompanying consolidated financial statements have been prepared on a going concern basis of accounting and in accordance with AICPA Statement of Position ("SOP") 90-7 "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." The line item "Exiting categories and closed facilities" represents activity specifically identifiable to closed facilities and inventory liquidations conducted in conjunction with the Company's 2000 and 2001 Business Plans. Prior year amounts reflect operating results for these same facilities and merchandise classifications. Selling, general and administrative expenses for closed facilities do not include any allocation of corporate overhead. The Company's recent losses and the Chapter 11 Cases (defined herein) raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements do not include any adjustments relating to recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The ability of the Company to continue as a going concern and the appropriateness of using the going concern basis are dependent upon, among other things, (i) the Company's ability to comply with the DIP to Exit Facility (defined herein), (ii) the Company's ability to revise and implement its business plan, (iii) confirmation of a plan of reorganization under the Bankruptcy Code, (iv) the Company's ability to achieve profitable operations after such confirmation, and (v) the Company's ability to generate sufficient cash from operations to meet its obligations. As described in Note B, the Company has an exclusive right to submit a plan of reorganization to the Bankruptcy Court through January 31, 2002. Management believes that the anticipated plan of reorganization, as it is being developed and subject to approval of the Bankruptcy Court, along with cash provided by the DIP to Exit Facility and operations, will provide sufficient liquidity to allow the Company to continue as a going concern; however, there can be no assurance that the sources of liquidity will be available or sufficient to meet the Company's needs. A plan of reorganization could materially change the amounts currently recorded in the consolidated financial statements. The consolidated financial statements do not give effect to any adjustment to the carrying value of assets or amounts and classifications of liabilities that might be necessary as a result of the Chapter 11 Cases. On February 21, 2000, the Company's Board of Directors approved its 2000 Business Plan, which emphasized: (i) an expansion of jewelry and jewelry related products; (ii) an exit of certain unprofitable home good categories; (iii) the reducing of selling and warehouse spaces within the Company's stores to adjust for the new merchandise mix, which allows for potential subleasing of excess space; and (iv) cost saving initiatives. The 2001 Business Plan advances the initiatives of the 2000 Business Plan and refines the business model to include: focusing on the Company's core competency in jewelry; refining home assortments and jewelry merchandising; developing a "key item" program; advertising with an emphasis on quality, value and assortment; aligning sublease and remodel programs; consolidating space at the corporate headquarters; reconfiguring the jewelry repair organization; and implementing initiatives to reduce the Company's corporate staffing levels and overall expense structure. The execution and success of the Company's business plan is subject to numerous known and unknown risks and uncertainties. See "Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995." The Company continues to review its business strategy, which may include additional store closings, changes in merchandise assortments, changes in distribution networks and overhead costs. The Company is also 6 7 considering various options with respect to its Executive Security Plan and its Savings and Investment Plan, which may include reinstatement, amendments, termination or substitution of such plans, among other things. The Company has historically incurred a net loss for the first three quarters of the year because of the seasonality of its business. The results of operations for the six periods ended July 1, 2001 and July 2, 2000 are not necessarily indicative of the operating results for an entire fiscal year. These consolidated financial statements should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. B. PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE As a result of the Company's decreased net sales in the fourth quarter of fiscal 1998 and the resulting negative cash flows from operations, in January 1999 the Company began an effort to effect an out-of-court restructuring plan. As part of this out-of-court restructuring plan, the Company developed the Rationalization Plan (defined herein) to close up to 132 stores, up to four distribution centers and to reduce corporate overhead. In March 1999, as part of the Rationalization Plan, the Company announced the closing of the Dallas, Texas distribution center and the reduction of its workforce at its Nashville, Tennessee corporate offices by 150 employees. On March 15, 1999, five of the Company's vendors filed an involuntary petition for reorganization under Chapter 11 ("Chapter 11") of Title 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Middle District of Tennessee (the "Bankruptcy Court") seeking court supervision of the Company's restructuring efforts. On March 27, 1999, the Company and 31 of its subsidiaries (collectively, the "Debtors") filed voluntary petitions with the Bankruptcy Court for reorganization under Chapter 11 under case numbers 399-02649 through 399-02680 (the "Chapter 11 Cases") and orders for relief were entered by the Bankruptcy Court. The Chapter 11 Cases have been consolidated for the purpose of joint administration under Case No. 399-02649. The Debtors are currently operating their businesses as debtors-in-possession pursuant to the Bankruptcy Code. Under the Bankruptcy Code, actions to collect pre-petition indebtedness are stayed and other contractual obligations against the Debtors may not be enforced. In addition, under the Bankruptcy Code the Debtors may assume or reject executory contracts, including lease obligations. Parties affected by these rejections may file claims with the Bankruptcy Court in accordance with the reorganization process. Substantially all pre-petition liabilities are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders of the Company and approved by the Bankruptcy Court. Although the Debtors expect to file a reorganization plan or plans that provide for emergence from bankruptcy in 2002, there can be no assurance that a reorganization plan or plans will be proposed by the Debtors or confirmed by the Bankruptcy Court, or that any plan will be consummated. As provided by the Bankruptcy Code, the Debtors initially had the exclusive right to submit a plan of reorganization for 120 days. On May 25, 1999, the Company received Bankruptcy Court approval to extend the period in which the Company had the exclusive right to file or advance a plan of reorganization in the Chapter 11 Cases. The order extended the Company's exclusive right to file a plan from July 23, 1999 to February 29, 2000, and extended the Company's exclusive right to solicit acceptances of its plan from September 21, 1999 to May 1, 2000. On February 2, 2000, the Company received Bankruptcy Court approval to extend the period in which the Company had the exclusive right to file or advance a plan from February 29, 2000 to April 30, 2001 and extend the Company's right to solicit acceptances of its plan from May 1, 2000 to June 30, 2001. On February 27, 2001, the Bankruptcy Court again extended the period in which the Company has the exclusive right to file or advance a plan until January 31, 2002, and extended the Company's right to solicit acceptances of its plan until April 1, 2002. If the Debtors fail to file a plan of reorganization during such period or extension thereof, or if such plan is not accepted by the required number of creditors and equity holders, any party in interest may subsequently file its own plan of reorganization for the Debtors. A plan of reorganization must be confirmed by the Bankruptcy Court upon certain findings required by the Bankruptcy Code. The Bankruptcy Court may also confirm a plan notwithstanding the non-acceptance of the plan by an impaired class of creditors or equity security holders if 7 8 certain requirements of the Bankruptcy Code are met. The plan or plans currently being considered by the Company involve a debt conversion of the Company's pre-petition unsecured claims into new common equity of the reorganized Company. Under such circumstances, the existing common stock of the Company would be cancelled and would result in existing holders of the common stock receiving no value for their interests. The Company believes the value of the common stock is highly speculative since it is probable that it will be cancelled, and therefore, will be worthless if the expected plan of reorganization is consummated. At this time, it is not possible to predict the outcome of the Chapter 11 Cases, their effect on the Company's business or the ability of the Company to exit Chapter 11 on a timely basis. C. RESTRUCTURING PLANS Restructuring Plan On March 25, 1997, the Company adopted a restructuring plan (the "Restructuring Plan"), a plan to close up to 60 under performing stores and one distribution center. As a result, a pre-tax charge of $129.5 million for restructuring costs was recorded in the first quarter of fiscal 1997. The remaining components of the restructuring charge accrual and an analysis of the change in the accrual for the six periods ended July 1, 2001 are outlined in the following table:
2001 ACTIVITY -------------------------- ACCRUED ACCRUED RESTRUCTURING RESTRUCTURING COSTS AS OF RESTRUCTURING CHANGE IN COSTS AS OF DECEMBER 31, 2000 COSTS PAID ESTIMATE JULY 1, 2001 ----------------- ------------- --------- ------------- (in thousands) Lease termination and other real estate costs $ 7,715 $ -- $ -- $7,715 ======= ==== ==== ======
Note: The accrued restructuring costs are included in Liabilities Subject to Compromise. The closing of nine stores during the first half of fiscal 1998 brought the total number of closures, in accordance with the Restructuring Plan, to 53 stores and one distribution center. Store closures were completed as of May 1998. The Company closed less than 60 stores primarily because it was unable to negotiate acceptable exit terms with the related lessors. Lease terminations and other real estate costs primarily consist of contractual rent payments and other real estate costs. These amounts have been accrued according to the remaining leasehold obligations under Section 502(b)(6) of the Bankruptcy Code. Section 502(b)(6) limits a lessor's claim to the rent reserved by such lease, without acceleration, to the greater of one year or 15 percent, not to exceed three years, of the remaining term of the lease. Any unpaid rent is included in the claim. Rationalization Plan In February 1999, the Company announced a rationalization plan (the "Rationalization Plan") to close up to 132 stores and four distribution centers and to reduce corporate overhead. On March 8, 1999, as part of the Rationalization Plan and prior to the filing of the involuntary bankruptcy petition, the Board of Directors approved the adoption of a business restructuring plan to close 106 stores, to close the Dallas, Texas distribution center and to reduce the Company's workforce at its Nashville, Tennessee corporate offices by 150 employees. As a result, a pre-tax charge of $99.5 million for restructuring costs was recorded in the first quarter of 1999. On March 29, 1999 in connection with the Chapter 11 Cases, store leases under this plan were approved for rejection by the Bankruptcy Court. The remaining components of the restructuring charge accrual and an analysis of the change in the accrual for the six periods ended July 1, 2001 are outlined in the following table: 8 9
2001 ACTIVITY ---------------------- ACCRUED ACCRUED COSTS AS OF CHANGE IN COSTS AS OF DECEMBER 31, 2000 COSTS PAID ESTIMATE JULY 1, 2001 ----------------- ---------- --------- ------------ (in thousands) Lease termination and other real estate costs $ 34,127 $(110) $ -- $ 34,017 ======== ===== ==== ========
Note: The accrued restructuring costs are included in Liabilities Subject to Compromise. Lease terminations and other real estate costs primarily consists of contractual rent payments. These amounts have been accrued according to the remaining leasehold obligations under Section 502(b)(6) of the Bankruptcy Code. Section 502(b)(6) limits a lessor's claim to the rent reserved by such lease, without acceleration, to the greater of one year or 15 percent, not to exceed three years, of the remaining term of the lease. Any unpaid rent is included in the claim. As of July 1, 2001, leases remaining on locations closed in connection with the restructuring plans vary in length with expiration dates ranging from September 2001 to February 2020. D. LIABILITIES SUBJECT TO COMPROMISE "Liabilities Subject to Compromise" refers to liabilities incurred prior to the commencement of the Chapter 11 Cases. These liabilities consist primarily of amounts outstanding under long-term debt and also include accounts payable, accrued interest, accrued restructuring costs, and other accrued expenses. These amounts represent the Company's estimate of known or potential claims to be resolved in connection with the Chapter 11 Cases. Such claims remain subject to future adjustments. Adjustments may result from (1) negotiations; (2) actions of the Bankruptcy Court; (3) further development with respect to disputed claims; (4) future rejection of additional executory contracts or unexpired leases; (5) the determination as to the value of any collateral securing claims; (6) proofs of claim; or (7) other events. Payment terms for these amounts, which are considered long-term liabilities at this time, will be established in connection with the Chapter 11 Cases. Pursuant to order of the Bankruptcy Court, on or about March 15, 2000, the Company mailed notices to all known creditors that the deadline for filing proofs of claim with the Bankruptcy Court was May 15, 2000. Differences between amounts recorded by the Company and claims filed by creditors are continuing to be investigated and resolved. Accordingly, the ultimate number and amount of allowed claims is not presently known and, because the settlement terms of such allowed claims is subject to a confirmed plan of reorganization, the ultimate distribution with respect to allowed claims is not presently ascertainable. The Company has received approval from the Bankruptcy Court to pay pre-petition and post-petition employee wages, salaries, benefits and other employee obligations, to pay vendors and other providers in the ordinary course for goods and services received after March 15, 1999, and to honor customer service programs, including warranties, returns, layaways and gift certificates. In mid-March 2001, the Company filed approximately 1,250 complaints seeking recovery of debit balances owed by third parties to the Company and preference payments made by the Company to third parties during the 90-day period prior to the Company's filing for reorganization relief under Chapter 11 of the Bankruptcy Code. At July 1, 2001, the Company has settled approximately 51 of these debit balance and preference actions and received approximately $0.6 million in settlement payments. The principal categories of claims classified as Liabilities Subject to Compromise under reorganization proceedings are identified below. 9 10
JULY 1, 2001 JULY 2, 2000 ------------ ------------ (in thousands) Accounts payable $198,712 $195,538 Accrued expenses 73,492 66,954 Accrued restructuring costs: 1997 Restructuring Plan 7,715 7,720 1999 Rationalization Plan 34,017 35,272 Long-term debt 411,408 424,003 Capitalized lease obligations 20,584 24,798 -------- -------- Total $745,928 $754,285 ======== ========
Contractual interest expense not accrued or recorded on certain pre-petition debt totaled $7.0 million for each of the three periods ended July 1, 2001 and July 2, 2000, and $14.1 million for each of the six periods ended July 1, 2001 and July 2, 2000. E. REORGANIZATION ITEMS Expenses and income directly incurred or realized as a result of the Chapter 11 Cases have been segregated from the normal operations and are disclosed separately. The major components are as follows:
THREE PERIODS THREE PERIODS ENDED ENDED JULY 1, 2001 JULY 2, 2000 ------------- ------------- (in thousands) Professional fees and administrative items $ 8,427 $ 8,776 Loss on disposal of assets 642 3,474 Store closing costs -- (33) Severance 1,032 -- -------- -------- Total reorganization items expense (income) $ 10,101 $ 12,217 ======== ======== SIX PERIODS ENDED SIX PERIODS ENDED (in thousands) JULY 1, 2001 JULY 2, 2000 ----------------- ----------------- (in thousands) Professional fees and administrative items $ 15,027 $ 15,764 Loss on disposal of assets 1,048 1,960 Store closing costs 21 3,764 Severance 1,032 9,423 -------- -------- Total reorganization items expense (income) $ 17,128 $ 30,911 ======== ========
PROFESSIONAL FEES AND OTHER ADMINISTRATIVE ITEMS: Professional fees and administrative items relate to legal, accounting and other professional costs directly attributable to the Chapter 11 Cases. LOSS ON DISPOSAL OF ASSETS: Loss on disposal of assets primarily consists of gains and losses associated with the sale of real property, the rejection of real estate leases and disposition of fixtures and equipment. STORE CLOSING COSTS: Store closing costs include rent, common area maintenance, utilities, asset write-downs and real estate 10 11 taxes offset by other income resulting from store dispositions. Rent amounts have been adjusted to reflect the reduction allowed under Section 502(b)(6) of the Bankruptcy Code. SEVERANCE: Severance costs arise from workforce reductions at the corporate offices, distribution centers and stores. F. BORROWINGS This note contains information regarding the Company's short-term borrowings and long-term debt as of July 1, 2001. As a result of the filing of the Chapter 11 Cases, no principal or interest payments were made on any pre-petition unsecured debt after March 15, 1999. Repayment terms for pre-petition unsecured debt must be set forth in a plan of reorganization and approved by the Bankruptcy Court. From March 29, 1999 through April 14, 2000, the Company had a 27-month, $750.0 million fully committed asset-based debtor-in-possession credit facility (the "DIP Facility"). The Bankruptcy Court approved the DIP Facility on an interim basis on March 29, 1999 and granted final approval on April 27, 1999. The DIP Facility included $100.0 million in term loans and up to a maximum of $650.0 million in revolving loans including a $200.0 million sub-facility for letters of credit. Interest rate spreads on the DIP Facility were LIBOR plus 2.25% on Eurodollar loans and Prime Rate plus 1.25% on Alternate Base Rate loans. The DIP Facility was secured by all material unencumbered assets of the Company and its subsidiaries, including inventory, but excluding previously mortgaged property. Borrowings under the DIP Facility were limited based on a borrowing base formula which considered eligible inventories, eligible accounts receivable, mortgage values on eligible real properties, eligible leasehold interests, available cash equivalents and in-transit cash. On April 14, 2000, the Company entered into a four year, $600.0 million fully committed asset-based debtor-in-possession and emergence credit facility (the "DIP to Exit Facility") which replaced the DIP Facility. The Bankruptcy Court approved the DIP to Exit Facility on April 4, 2000. The DIP to Exit Facility matures on April 14, 2004, and includes $60.0 million in term loans and up to a maximum of $540.0 million in revolving loans including a $150.0 million sub-facility for letters of credit. Interest rate spreads on the DIP to Exit Facility were initially LIBOR plus 2.50% on Eurodollar loans and Prime Rate plus 0.75% on Alternate Base Rate loans. Beginning with the second quarter of 2001, these spreads are subject to quarterly adjustment pursuant to a pricing grid based on availability and financial performance, with ranges of 200 to 275 basis points over LIBOR and 25 to 100 basis points over Prime Rate. Short-term borrowings outstanding under the revolver of the DIP to Exit Facility were $194.8 million as of July 1, 2001. Outstanding borrowings under the term loan of the DIP to Exit Facility were $60.0 million as of July 1, 2001. Short-term borrowings related to the DIP to Exit Facility were $76.2 million as of July 2, 2000. Outstanding borrowings under the term loan of the DIP to Exit Facility were $60.0 million as of July 2, 2000. There is a commitment fee of 0.375% on the undrawn portion of the revolving loans under the DIP to Exit Facility. Borrowings under the DIP to Exit Facility are secured by all material unencumbered assets of the Company and its subsidiaries, including inventory, but excluding previously mortgaged property. Borrowings under the DIP to Exit Facility are limited based on a borrowing base formula, which considers eligible inventories, eligible accounts receivable, mortgage values on eligible real properties, eligible leasehold interests, available cash equivalents and in-transit cash. Availability under the facility continues unless the Company breaches the financial covenants for the DIP to Exit Facility. As of July 1, 2001, the Company was in compliance with the financial covenants under the DIP to Exit Facility. 11 12 G. EARNINGS (LOSS) PER SHARE Basic earnings (loss) per common share is computed by dividing net earnings (loss) by the weighted-average number of common shares outstanding during the reported period. Diluted net earnings (loss) per common share is computed by dividing net earnings (loss) by the weighted-average number of common shares outstanding during the period plus incremental shares that would have been outstanding upon the assumed vesting of dilutive restricted stock and the assumed exercise of dilutive stock options. For the three and six periods ended July 1, 2001 and July 2, 2000 all outstanding restricted stock and stock options are considered anti-dilutive. H. BENEFIT PLANS On January 23, 2001, the U. S. Bankruptcy Court issued an order authorizing the Company to take all steps necessary and appropriate to effectuate the termination of the Company's Restated Retirement Plan and to implement procedures for distributions thereunder. I. OTHER COMMITMENTS AND CONTINGENCIES On January 28, 1997, the Company and Service Credit Corp. (the "Subsidiary"), a wholly-owned subsidiary, entered into an agreement with World Financial Network National Bank ("WFNNB") for the purpose of providing a private label credit card to the Company's customers. The contract requires the Subsidiary to maintain a 3.0% credit risk reserve for the outstanding balances, which are owned by WFNNB. The purpose of this reserve is to offset future potential negative spreads and portfolio losses. The negative spreads or losses may result from potential increased reimbursable contractual program costs. The 3.0% credit risk reserve is held by the Subsidiary, which is not in Chapter 11, in the form of cash and cash-equivalents. On April 28, 1999, WFNNB advised the Company that WFNNB has projected that such portfolio losses and negative spreads will be at least approximately $9.0 million. The Company does not have in its possession sufficient information to determine the accuracy or validity of WFNNB's projection. Pending confirmation of the accuracy of WFNNB's projection and a resolution of the Company's rights and remedies, the Company has made provision for such potential liability during fiscal 1999 by maintaining an allowance on the 3.0% credit risk reserve of $9.0 million. On July 16, 1999, the Company filed a complaint against WFNNB in the Bankruptcy Court alleging, among other things, breach of contract and violation of the automatic stay provisions of the Bankruptcy Code by WFNNB with respect to and in connection with the January 1997 private label credit card program agreement between the Company, the Subsidiary and WFNNB (the "World Financial Agreement"). Under the World Financial Agreement, a program was established pursuant to which, among other things, WFNNB agreed to issue credit cards to qualifying Company customers for the purchase of goods and services from the Company. While the ultimate result of this litigation cannot be determined or predicted with any accuracy at this time, the Company intends to pursue available remedies against WFNNB. On August 20, 1999, over the objection of WFNNB, the Bankruptcy Court authorized the Company to enter into an agreement with Household Bank (SB), N.A. ("Household") for the purpose of offering new private label credit cards to those customers of the Company who meet Household's credit standards. The Company's prior private label credit card program with WFNNB was suspended in March 1999, and the rights and liabilities of WFNNB, the Company and the Subsidiary are the subject of the litigation referred to in the preceding paragraph. On September 23, 1999, WFNNB filed a motion to dismiss the Company's complaint and a separate motion seeking to have the complaint litigated in the United States District Court for the Middle District of Tennessee (the "District Court"), rather than the Bankruptcy Court. The Company filed timely oppositions to both motions, and, on October 27, 1999, the District Court denied WFNNB's motion to have the complaint litigated in the District Court. The Bankruptcy Court scheduled a hearing on December 6, 1999, to consider WFNNB's motion to dismiss and the Company's opposition thereto. 12 13 On December 6, 1999, the Bankruptcy Court entered an order dismissing the Company's complaint. On December 16, 1999, the Company filed a motion asking the Court to clarify the order issued on December 6, 1999, and to grant the Company leave to file an amended complaint (the "Company's Motion"). On January 11, 2000, WFNNB responded with an objection to the Company's Motion. On February 22, 2000, the Bankruptcy Court entered an order granting the Company's Motion and the Company filed an amended complaint. On April 24, 2000, WFNNB filed a motion to dismiss this amended complaint. The Company responded to the motion to dismiss and filed a cross-motion seeking to treat its amended complaint as an objection to WFNNB's proof of claim. On November 9, 2000, the Court granted in part and denied in part WFNNB's motion to dismiss the Company's amended complaint. The Court denied WFNNB's motion to dismiss the Company's claims for breach of contract, anticipatory repudiation and violation of the automatic stay. The Court granted WFNNB's motion to dismiss the Company's claims for breach of the duty of good faith and fair dealing and indemnification. On January 5, 2001, WFNNB answered the remaining parts of the Company's amended complaint. On the same day, WFNNB filed a motion to lift the automatic stay so they could file counter claims against the Company. On April 6, 2001, the Bankruptcy Court, with the consent of the Company, lifted the automatic stay and permitted the claims to proceed. The Company was involved in litigation, investigations and various legal matters during the six periods ended July 1, 2001, which are being defended and handled in the ordinary course of business. While the ultimate results of these matters cannot be determined or predicted, management believes that they will not have a material adverse effect on the Company's results of operations or financial position. Any potential liability may be affected by the Chapter 11 Cases. J. SEGMENT REPORTING The Company manages its business on the basis of one reportable segment. As of July 1, 2001, all of the Company's operations were located within the United States. The following data is presented in accordance with SFAS No. 131 for all periods presented.
CLASSES OF SIMILAR PRODUCTS: THREE PERIODS ENDED SIX PERIODS ENDED ---------------------------- ------------------------ ------------------------ JULY 1, JULY 2, JULY 1, JULY 2, 2001 2000 2001 2000 -------- -------- -------- -------- Net Sales (in thousands): Home products $137,677 $271,364 $229,667 $486,855 Jewelry 120,893 146,184 228,032 273,722 -------- -------- -------- -------- Total Net Sales $258,570 $417,548 $457,699 $760,577 ======== ======== ======== ========
The decline in home products sales was primarily due to the inclusion in July 2, 2000 sales of certain categories including electronics, toys and sporting goods that were discontinued in fiscal 2000. The decline in jewelry products is primarily due to a weak economic environment and cross shop loss from exiting of certain home good categories. K. OTHER COMPREHENSIVE LOSS As part of the Company's risk management program, the Company uses interest rate swap agreements. The Company does not hold or issue derivative financial instruments for trading purposes. Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is immediately recognized in earnings. 13 14 The adoption of SFAS No. 133 on January 1, 2001, did not have a material impact on results of operations but resulted in the cumulative effect of an accounting change of $1.6 million being recognized as expense in other comprehensive income. The Company entered into interest rate swap agreements to reduce the impact of potential increases on floating rate debt. The interest rate swaps vary in notional amount from $110 million to $155 million and expire January 2, 2002. The Company accounts for the interest rate swaps as cash flow hedges whereby the fair values of the interest rate swaps are reflected as liabilities in the accompanying consolidated balance sheet with the offset, net of any hedge ineffectiveness (which is not material) recorded as interest expense, to other comprehensive loss. The fair values of the interest rate swaps was $(2.5) million as of July 1, 2001. As interest expense on the underlying hedged debt is recognized, corresponding amounts are removed from other comprehensive income and charged to interest expense. Such amounts were not material during the quarter ended July 1, 2001. The balance in other comprehensive income related to derivative instruments as of July 1, 2001 is expected to be recognized in earnings over the next six months. The following table summarizes activity in other comprehensive income related to derivatives classified as cash flow hedges held by the Company during the period January 1 (the date of the Company's adoption of SFAS No. 133) through July 1, 2001 (in thousands):
Three Periods Six Periods Ended Ended ------------ ------------ July 1, 2001 July 1, 2001 ------------ ------------ Accumulated derivative loss included in other comprehensive income at the beginning of the period, net $(2,697) $ 0 Cumulative effect of adopting SFAS 133, net 0 (1,606) (Gains)/losses reclassified into earnings from other comprehensive income, net 736 1,067 Change in fair value of derivatives, net (584) (2,006) ------- ------- Accumulated derivative loss included in other Comprehensive income at the end of the period, net $(2,545) $(2,545) ======= =======
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For comparative purposes, interim balance sheets are more meaningful when compared to the balance sheets at the same point in time of the prior year. Comparisons to balance sheets of the most recent fiscal year end may not be meaningful due to the seasonal nature of the Company's business. Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 This report includes certain forward-looking statements (any statement other than those made solely with respect to historical fact) based upon management's beliefs, as well as assumptions made by and data currently available to management. This information has been, or in the future may be, included in reliance on the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on a variety of assumptions that may not be realized and are subject to significant business, economic, judicial and competitive uncertainties and potential contingencies, including those set forth below, many of which are beyond the Company's control. Actual results may differ materially from those anticipated in any such forward-looking statements. The Company undertakes no obligation to update or revise any such forward-looking statements. The forward-looking statements and the Company's liquidity, capital resources and results of operations are subject to a number of risks and uncertainties including, but not limited to, the following: the ability of the Company to continue as a going concern; the ability of the Company to operate pursuant to the terms of and access liquidity from the DIP to Exit Facility and the vendor credit facility; the ability of the Company to develop, prosecute, confirm and consummate on a timely basis one or more plans of reorganization with respect to the Chapter 11 Cases and to exit Chapter 11; trends in the economy as a whole which may affect consumer confidence and consumer demand for the types of goods sold by the Company; the ability of the Company to successfully implement the 2001 Business Plan initiatives; risks associated with third parties seeking and obtaining court approval to terminate or shorten the exclusivity period for the Company to propose and confirm 14 15 one or more plans of reorganization, for the appointment of a Chapter 11 trustee or to convert the Company's cases to Chapter 7 cases; the ability of the Company to reduce its workforce and related expenses and to achieve anticipated cost savings; the ability of the Company to obtain trade credit and shipments and terms with vendors and service providers for current orders; the ability of the Company to sublease successfully additional portions of its real estate and to consummate the sale/leaseback of its headquarters; the successful consolidation of its distribution centers; the ability of the Company to access liquidity from the DIP to Exit Facility upon its anticipated emergence from Chapter 11; potential adverse developments with respect to the Company's liquidity or results of operations; competitive pressures from other retailers, including specialty retailers and discount stores, which may affect the nature and viability of the Company's business strategy; the seasonal nature of the Company's business and the ability of the Company to predict consumer demand as a whole, as well as demand for specific goods; the ability to fund and execute its business plan; the ability of the Company to attract, retain and compensate key executives and associates; the ability of the Company to attract and retain customers; potential adverse publicity; and uncertainties regarding real estate occupancy and development costs, including the substantial fixed investment costs associated with opening, maintaining or closing a Company store. Overview The Company, with 218 stores in 31 states at July 1, 2001, is one of the nation's largest retailers of jewelry and offers a selection of brand-name home products and other product lines. During the year ended December 31, 2000 ("fiscal 2000"), the Company repositioned its product offerings to focus on value pricing and a broad selection of jewelry and home products. These remerchandising efforts were based on perceived customer expectations of entry level price points and a large selection within each product assortment. The Company also revised its media strategy during fiscal 2000 to employ TV, radio and print (including a seasonal sourcebook) campaigns in a coordinated effort to build awareness, prospect for new customers and drive customer traffic. On February 21, 2000, the Company's Board of Directors approved its 2000 Business Plan, which emphasized: (i) an expansion of jewelry and jewelry related products; (ii) an exit of certain unprofitable home good categories; (iii) the reducing of selling and warehouse spaces within the Company's stores to adjust for the new merchandise mix, which allows for potential subleasing of excess space; and (iv) cost saving initiatives. The 2001 Business Plan advances the initiatives of the 2000 Business Plan and refines the business model to include: focusing on the Company's core competency in jewelry; refining home assortments and jewelry merchandising; developing a "key item" program; advertising with an emphasis on quality, value and assortment; aligning sublease and remodel programs; consolidating space at the corporate headquarters; reconfiguring the jewelry repair organization; and implementing initiatives to reduce the Company's corporate staffing levels and overall expense structure. The execution and success of the Company's business plan is subject to numerous known and unknown risks and uncertainties. See "-Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995." Proceedings Under Chapter 11 of the Bankruptcy Code On March 15, 1999, five of the Company's vendors filed an involuntary petition for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Middle District of Tennessee seeking court supervision of the Company's restructuring efforts. On March 27, 1999, the Debtors filed voluntary petitions with the Bankruptcy Court for reorganization under Chapter 11 and orders for relief were entered by the Bankruptcy Court. The Chapter 11 Cases have been consolidated for the purpose of joint administration under Case No. 399-02649. The Debtors are currently operating their businesses as debtors-in-possession pursuant to the Bankruptcy Code. Actions to collect pre-petition indebtedness are stayed and other contractual obligations against the Debtors may not be enforced. In addition, under the Bankruptcy Code, the Debtors may assume or reject executory contracts, including lease obligations. Parties affected by these rejections may file claims with the Bankruptcy Court in accordance with the reorganization process. Substantially all pre-petition liabilities are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders and approved by the Bankruptcy Court. Although the Debtors expect to file a reorganization plan or plans that provide for 15 16 emergence from bankruptcy in 2002, there can be no assurance that a reorganization plan or plans will be proposed by the Debtors or confirmed by the Bankruptcy Court, or that any such plan(s) will be consummated. As provided by the Bankruptcy Code, the Debtors initially had the exclusive right to submit a plan of reorganization for 120 days. On May 25, 1999, the Bankruptcy Court extended the period in which the Company had the exclusive right to file or advance a plan of reorganization to February 29, 2000. On February 2, 2000, the Bankruptcy Court extended the period in which the Company had the exclusive right to file or advance a plan of reorganization to April 30, 2001 and extended the right to solicit acceptance of its plan to June 30, 2001. On February 27, 2001, the Bankruptcy Court again extended the period in which the Company has the exclusive right to file or advance a plan of reorganization until January 31, 2002, and extended the Company's right to solicit acceptances of its plan until April 1, 2002. If the Debtors fail to file a plan of reorganization during such period or if such plan is not accepted by the required number of creditors and equity holders, any party in interest may subsequently file its own plan of reorganization for the Debtors. A plan of reorganization must be confirmed by the Bankruptcy Court, upon certain findings being made by the Bankruptcy Court, which are required by the Bankruptcy Code. The Bankruptcy Court may confirm a plan notwithstanding the non-acceptance of the plan by an impaired class of creditors or equity security holders if certain requirements of the Bankruptcy Code are met. The plan or plans currently being considered by the Company involve a debt conversion of the Company's pre-petition unsecured claims into new common equity of the reorganized company. Under such circumstances the existing common stock of the Company would be cancelled and would result in existing holders of the common stock receiving no value for their interests. The Company believes the value of the common stock is highly speculative since it is highly probable that it will be cancelled, and therefore, will be worthless if the expected plan of reorganization is consummated. At the first day hearing held on March 29, 1999 before Judge George C. Paine, the Bankruptcy Court entered first day orders granting authority to the Debtors, among other things, to pay pre-petition and post-petition employee wages, salaries, benefits and other employee obligations, and to pay vendors and other providers in the ordinary course for goods and services received after March 15, 1999, and to honor customer service programs, including warranties, returns, layaways and gift certificates. On March 29, 1999, the Company entered into the DIP Facility, a 27-month, $750.0 million fully committed asset-based debtor-in-possession credit facility which replaced the Second Amended and Restated Credit Facility. The Bankruptcy Court approved the DIP Facility on an interim basis on March 29, 1999 and granted final approval on April 27, 1999. The DIP Facility included $100.0 million in term loans and up to a maximum of $650.0 million in revolving loans including a $200.0 million sub-facility for letters of credit. Interest rate spreads on the DIP Facility were LIBOR plus 2.25% on Eurodollar loans and Prime Rate plus 1.25% on Alternate Base Rate loans. The DIP Facility was secured by all material unencumbered assets of the Company and its subsidiaries, including inventory, but excluding previously mortgaged property. Borrowings under the DIP Facility were limited based on a borrowing base formula which considered eligible inventories, eligible accounts receivable, mortgage values on eligible real properties, eligible leasehold interests, available cash equivalents and in-transit cash. On April 14, 2000, the Company entered into the DIP to Exit Facility, a four year, $600.0 million fully committed asset-based debtor-in-possession and emergence credit facility, which replaced the DIP Facility. The Bankruptcy Court approved the DIP to Exit Facility on April 4, 2000. The DIP to Exit Facility matures on April 14, 2004, and includes $60.0 million in term loans and up to a maximum of $540.0 million in revolving loans including a $150.0 million sub-facility for letters of credit. Interest rate spreads on the DIP to Exit Facility were initially LIBOR plus 2.50% on Eurodollar loans and Prime Rate plus 0.75% on Alternate Base Rate loans. Beginning with the second quarter of 2001, these spreads are subject to quarterly adjustment pursuant to a pricing grid based on availability and financial performance, with ranges of 200 to 275 basis points over LIBOR and 25 to 100 basis points over prime rate. Short-term borrowings outstanding under the revolver of the DIP to Exit Facility were $194.8 million as of July 1, 2001. Outstanding borrowings under the term loan of the DIP to Exit Facility were $60.0 million as of July 1, 2001. Short-term borrowings related to the DIP to Exit Facility were $76.2 16 17 million as of July 2, 2000. Outstanding borrowings under the term loan of the DIP to Exit Facility were $60.0 million as of July 2, 2000. There is a commitment fee of 0.375% on the undrawn portion of the revolving loans under the DIP to Exit Facility. Borrowings under the DIP to Exit Facility are secured by all material unencumbered assets of the Company and its subsidiaries, including inventory, but excluding previously mortgaged property. Borrowings under the DIP to Exit Facility are limited based on a borrowing base formula, which considers eligible inventories, eligible accounts receivable, mortgage values on eligible real properties, eligible leasehold interests, available cash equivalents and in-transit cash. Availability under the facility continues unless the Company breaches the financial covenants for the DIP to Exit Facility. As of July 1, 2001, the Company was in compliance with the financial covenants under the DIP to Exit Facility. Conversion of the DIP to Exit Facility to an exit financing upon the Company's anticipated emergence from Chapter 11 is subject to closing conditions, including the collateral and administrative agent's reasonable satisfaction with the Company's capital structure, plan of reorganization and any materially revised projections, as well as the achievement by the Company of a specified trailing 12-month earnings level (which varies depending on time of exit) and certain minimum availability (which varies from $50.0 to $100.0 million depending on the time of exit.) There can be no assurance that the Company will be able to access liquidity from the DIP to Exit Facility, or from any other source, or that such liquidity will be sufficient to meet the Company's needs. Moreover, there can be no assurance that the Company will exit Chapter 11 or convert the DIP to Exit Facility to an exit financing facility. See "-Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995." The Company's Consolidated Financial Statements have been prepared on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities and commitments in the normal course of business. The Company's recent losses and the Chapter 11 Cases (defined herein) raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements do not include any adjustments relating to recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The ability of the Company to continue as a going concern and the appropriateness of using the going concern basis are dependent upon, among other things, (i) the Company's ability to comply with the DIP to Exit Facility, (ii) the Company's ability to revise and implement its business plan, (iii) confirmation of a plan of reorganization under the Bankruptcy Code, (iv) the Company's ability to achieve profitable operations after such confirmation, and (v) the Company's ability to generate sufficient cash from operations to meet its obligations. As a result of the filing of the Chapter 11 Cases and related circumstances, realization of assets and liquidation of liabilities is subject to significant uncertainty. While under the protection of Chapter 11, the Debtors may sell or otherwise dispose of assets, and liquidate or settle liabilities, for amounts other than those reflected in the Consolidated Financial Statements. Further, a plan or plans of reorganization could materially change the amounts reported in the accompanying Consolidated Financial Statements. The Consolidated Financial Statements do not include any adjustments relating to recoverability of the value of recorded asset amounts or the amounts and classification of liabilities that might be necessary as a consequence of a plan of reorganization. At this time, it is not possible to predict the outcome of the Chapter 11 Cases or their effect on the Company's business. Additional information regarding the Chapter 11 Cases is set forth in Note B of Notes to Consolidated Financial Statements. If it is determined that the liabilities subject to compromise in the Chapter 11 Cases exceed the fair value of the assets available therefor, unsecured claims may be satisfied at less than 100% of their face value and the equity interests of the Company's current shareholders may have no value. The Company believes the DIP to Exit Facility should provide the Company with adequate liquidity to conduct its business while it prepares a reorganization plan. However, the Company's liquidity, capital resources, results of operations and ability to continue as a going concern are subject to known and unknown risks and uncertainties, including those set forth above under "Safe Harbor Statement Under The Private Securities Litigation Reform Act of 1995." 17 18 2001 Business Plan In February 2001, the Company's Board of Directors approved its 2001 Business Plan. The 2001 Business Plan initiatives include: focusing on the Company's core competency in jewelry; refining home assortments and jewelry merchandising; developing a "key item" program; advertising with an emphasis on quality, value and assortment; aligning sublease and remodel programs; consolidating space at the corporate headquarters; reconfiguring the jewelry repair organization; and implementing initiatives to reduce the Company's corporate staffing levels and overall expense structure. Approximately 1,750 full time positions, including 1,630 positions in the store and field organizations and approximately 120 positions at the corporate office, were eliminated in January 2001. RESULTS OF OPERATIONS THREE PERIODS ENDED JULY 1, 2001 COMPARED TO THREE PERIODS ENDED JULY 2, 2000 The line item "Exiting categories and closed facilities" represents activity specifically identifiable to closed facilities and inventory liquidations conducted in conjunction with the Company's 2000 and 2001 Business Plans. Prior year amounts reflect operating results for these same facilities and merchandise classifications. Selling, general and administrative expenses for closed facilities do not include any allocation of corporate overhead. The Company's business is highly seasonal with a significant portion of its sales occurring in the fourth quarter. Fourth quarter net sales accounted for 33.2% and 37.5% of total net sales in fiscal 2000 and 1999, respectively. Net Sales Net sales for the Company were $258.6 million for the three periods ended July 1, 2001 compared to $417.5 million for the three periods ended July 2, 2000. The decline in net sales was primarily due to the increased restructuring and remerchandising activities in fiscal 2000, cross shop loss from exiting of certain home good categories and a weak economic environment. Net sales from operations excluding exiting categories and closed facilities were $258.6 million for the three periods ended July 1, 2001 compared to $315.8 million for the three periods ended July 2, 2000. Comparable store sales for jewelry were down 16.6% and home products comparable store sales were down 21.7% compared to the three periods ended July 2, 2000. The jewelry comparable stores sales decrease was led by declines in watches/accessories and diamonds/stones. The home products comparable store sales performance was driven by declines in seasonal, personal care, photo, and housewares. The Company believes that the decline in net sales was primarily due to cross shop loss from exiting of certain home good categories and a weak economic environment. There were no net sales from exiting categories and closed facilities for the three periods ended July 1, 2001 compared to $101.8 million for the three periods ended July 2, 2000. Sales from exiting categories and closed facilities decreased primarily due to the fact that the three periods ended July 2, 2000 reflects the sales of discontinued product lines that were primarily completed by December 31, 2000. Gross Margin Gross margin was $75.5 million for the three periods ended July 1, 2001 as compared to $81.3 million for the three periods ended July 2, 2000. The decrease in gross margin was primarily due to a decrease in sales. Gross margin after costs and expenses and excluding exiting categories and closed facilities was $75.5 million or 29.2% of net sales for the three periods ended July 1, 2001, compared to $92.9 million or 29.4% of net 18 19 sales for the three periods ended July 2, 2000. The margin decrease was primarily due to a decrease in sales with approximately the same occupancy costs as the prior year. There was no gross loss after costs and expenses for exiting categories and closed facilities for the three periods ended July 1, 2001 compared to $(11.6) million for the three periods ended July 2, 2000. The margin increase was primarily due to the fact that the three periods ended July 2, 2000 reflects the sales of discontinued product lines that were primarily completed by December 31, 2000. Selling, General and Administrative Expenses Selling, general and administrative expenses declined $53.3 million in the three periods ended July 1, 2001 to $76.1 million from $129.4 million in the three periods ended July 2, 2000. The decline was primarily due to store closures, corporate downsizing and overhead reduction efforts. Selling, general and administrative expenses were $75.3 million or 29.1% of net sales from operations excluding exiting categories and closed facilities for the three periods ended July 1, 2001 compared to $86.3 million or 27.3% of net sales from operations excluding exiting categories and closed facilities for the three periods ended July 2, 2000. The decrease in expenses was attributable to a decrease in employment costs and other selling, general and administrative expenses primarily due to the corporate downsizing and overhead reduction efforts. Selling, general and administrative expenses for exiting categories and closed facilities were $0.9 million for the three periods ended July 1, 2001 compared to $43.1 million for the three periods ended July 2, 2000. The decrease in selling, general and administrative expenses was attributable to lower sales efforts for discontinuing merchandise and closed facilities. Other Expense (Income), net The net (gain) loss on dispositions of property and leases recorded for the three periods ended July 1, 2001 was $0.7 million, as compared to $(1.0) million for the three periods ended July 2, 2000. The loss for the three periods ended July 1, 2001 included the disposition of fixtures at the corporate office compared to a gain realized from the completion of the auction property sale of 20 properties for the three periods ended July 2, 2000. Depreciation and Amortization Depreciation and amortization on owned and leased property and equipment was $10.5 million for the three periods ended July 1, 2001 as compared to $10.0 million for the three periods ended July 2, 2000. The increase was primarily attributable to fixture additions for the remodeled stores. Interest Expense Interest expense for the three periods ended July 1, 2001 was $10.7 million as compared to $9.6 million for the three periods ended July 2, 2000. The increase in interest expense primarily relates to higher average borrowings and higher interest rates. Income Taxes The Company did not recognize an income tax benefit due to the recording of a deferred tax asset valuation allowance. Deferred taxes are recognized to reflect the estimated future utilization of temporary book/tax differences. The Company has recorded a full valuation allowance on net deferred tax assets as realization of such assets in future years is uncertain. Management does not believe it is more likely than not that the Company will realize the deferred tax asset. 19 20 SIX PERIODS ENDED JULY 1, 2001 COMPARED TO SIX PERIODS ENDED JULY 2, 2000 NET SALES Net sales for the Company were $457.7 million for the first half of 2001 compared to $760.6 million for the first half of 2000. The decline in net sales was primarily due to the increased restructuring and remerchandising activities in fiscal 2000, cross shop loss from exiting of certain home good categories and a weak economic environment. Net sales from operations excluding exiting categories and closed facilities were $457.6 million for the first half of 2001 compared to $617.5 million for the first half of 2000. Comparable store sales for jewelry were down 15.7% and comparable store sales for home products was down 22.4% as compared to the first half of 2000. The jewelry comparable store sales decrease was driven by declines in watches/accessories and diamond/stones. Home products comparable sales performance was driven by declines in personal care, photo and housewares. The Company believes that the decline in net sales was primarily due to cross shop loss from exiting of certain home good categories and a weak economic environment. Net sales from exiting categories and closed facilities were $0.1 million for the first half of 2001 compared to $143.1 million for the first half of 2000. Sales from exiting categories and closed facilities decreased primarily due to the fact that the first half of 2000 reflects the sales of discontinued product lines that were primarily completed by December 31, 2000 and were not reflected in the first half of 2001. GROSS MARGIN Gross margin was $130.2 million for the first half of 2001 compared to $168.5 million in the first half of 2000. The decrease was primarily due to a $302.9 million decline in sales, partially offset by a $264.6 million decrease in cost of goods sold. Gross margin after costs and expenses and excluding exiting categories and closed facilities was $130.5 million or 28.5% of net sales for the first half of 2001, compared to $176.0 million or 28.5% of net sales for the first half of 2000. The margin decrease was primarily due to decreased sales. Gross (loss) after costs and expenses for exiting categories and closed facilities was $(0.3) million, compared to $(7.5) million for the first half of 2000. The margin increase was primarily a result of decreased inventory clearance sales for the first half of 2001. SELLING GENERAL AND ADMINISTRATIVE Selling, general and administrative expenses decreased $77.7 million in the first half of 2001, to $151.1 million from $228.8 million in the first half of 2000. The decline was primarily due to store closures, corporate downsizing and overhead reduction efforts. Selling, general and administrative expenses were $145.5 million or 31.8% of net sales from operations excluding exiting categories and closed facilities for the first half of 2001, compared to $170.5 million or 27.6% of net sales from operations excluding exiting categories and closed facilities for the first half of 2000. The decrease in expenses was attributable to a decrease in employment costs and other selling, general and administrative expenses primarily due to corporate downsizing and overhead reduction efforts. Selling, general and administrative expenses for exiting categories and closed facilities were $5.5 million for the first half of 2001, compared to $58.3 million for the first half of 2000. The decrease in expenses was attributable to decreases in employment costs and other selling, general and administrative expenses primarily due to store closures. 20 21 OTHER (INCOME) EXPENSE, NET The net (gain) loss on dispositions of property and leases recorded for the first half of 2001 was $1.4 million, as compared to $(13.3) million in 2000. The loss for the first half of 2001 is primarily related to the disposition of corporate fixtures, compared to a gain in the first half of 2000 for amounts realized from the completion of the auction property sale of 10 owned and 13 leased properties. DEPRECIATION AND AMORTIZATION Depreciation and amortization on owned and leased property and equipment was $21.0 million for the first half of 2001 as compared to $19.8 million for the first half of 2000. The increase was primarily attributable to new fixtures for remodeled stores. INTEREST EXPENSE Interest expense for the first half of 2001 was $20.9 million as compared to $20.5 million for the first half of 2000. Interest expense increased due to higher average borrowings and higher interest rates. INCOME TAXES The Company did not recognize an income tax benefit due to the recording of a deferred tax asset valuation allowance. Deferred taxes are recognized to reflect the estimated future utilization of temporary book/tax differences. The Company has recorded a full valuation allowance on net deferred tax assets as realization of such assets in future years is uncertain. Management does not believe it is more likely than not that the Company will realize the deferred tax asset. RESTRUCTURING PLAN On March 25, 1997, the Company adopted the Restructuring Plan to close up to 60 under performing stores and one distribution center. As a result, a pre-tax charge of $129.5 million for restructuring costs was recorded in the first quarter of fiscal 1997. The remaining components of the restructuring charge accrual and an analysis of the change in the accrual for the six periods ended July 1, 2001 are outlined in the following table:
2001 ACTIVITY -------------------------- ACCRUED ACCRUED RESTRUCTURING RESTRUCTURING COSTS AS OF RESTRUCTURING CHANGE IN COSTS AS OF DECEMBER 31, 2000 COSTS PAID ESTIMATE JULY 1, 2001 ----------------- ------------- --------- ------------- (in thousands) Lease termination and other real estate costs $ 7,715 $ -- $ -- $ 7,715 ======= ==== ==== =======
Note: The accrued restructuring costs are included in Liabilities Subject to Compromise. The closing of nine stores during the first half of fiscal 1998 brought the total number of closures, in accordance with the Restructuring Plan, to 53 stores and one distribution center. Store closures were completed as of May 1998. The Company closed less than 60 stores primarily because it was unable to negotiate acceptable exit terms with the related lessors. Lease terminations and other real estate costs primarily consist of contractual rent payments and other real estate costs. These amounts have been accrued according to the remaining leasehold obligations under Section 502(b)(6) of the Bankruptcy Code. Section 502(b)(6) limits a lessor's claim to the rent reserved by such lease, without acceleration, to the greater of one year or 15 percent, not to exceed three years, of the remaining term of the lease. Any unpaid rent is included in the claim. 21 22 RATIONALIZATION PLAN In February 1999, the Company announced its Rationalization Plan to close up to 132 stores, up to four distribution centers and to reduce corporate overhead. On March 8, 1999, as part of the Rationalization Plan and prior to the filing of the involuntary bankruptcy petition, the Board of Directors approved the adoption of a business restructuring plan to close 106 stores, to close the Dallas, Texas distribution center and to reduce the Company's workforce at its Nashville, Tennessee corporate offices by 150 employees. As a result, a pre-tax charge of $99.5 million for restructuring costs was recorded in the first quarter of 1999. On March 29, 1999 in connection with the Chapter 11 Cases, store leases under this plan were approved for rejection by the Bankruptcy Court. The remaining components of the restructuring charge accrual and an analysis of the change in the accrual for the six periods ended July 1, 2001 are outlined in the following table:
2001 ACTIVITY ----------------------- ACCRUED ACCRUED COSTS AS OF CHANGE IN COSTS AS OF DECEMBER 31, 2000 COSTS PAID ESTIMATE JULY 1, 2001 -------------------- ---------- --------- ------------ (in thousands) Lease termination and other real estate costs $34,127 $ (110) $ -- $ 34,017 ======= ====== ==== ========
Note: The accrued restructuring costs are included in Liabilities Subject to Compromise. Lease terminations and other real estate costs primarily consists of contractual rent payments. These amounts have been accrued according to the remaining leasehold obligations under Section 502(b)(6) of the Bankruptcy Code. Section 502(b)(6) limits a lessor's claim to the rent reserved by such lease, without acceleration, to the greater of one year or 15 percent, not to exceed three years, of the remaining term of the lease. Any unpaid rent is included in the claim. As of July 1, 2001, leases remaining on locations closed in connection with the restructuring plans vary in length with expiration dates ranging from September 2001 to February 2020. LIQUIDITY AND CAPITAL RESOURCES On March 27, 1999, the Debtors filed the Chapter 11 Cases, which affect the Company's liquidity and capital resources. See Note B "Proceedings Under Chapter 11 of the Bankruptcy Code." Availability under the DIP to Exit Facility, trade credit and terms from vendors provided the resources required to support operations, seasonal working capital requirements and capital expenditures during the six periods ended July 1, 2001. The Company's business is highly seasonal with the Company's inventory investment and related short-term borrowing requirements reaching a peak prior to the Christmas season. Historically, positive cash flow from operations has been generated principally in the latter part of the fourth quarter of each fiscal year, in line with the seasonal nature of the Company's business. Net cash used by operations was $107.7 million for six periods ended July 1, 2001 as compared to $2.9 million for six periods ended July 2, 2000. The increase in net cash used by operations was primarily a result of higher proceeds from liquidation of exiting merchandise categories in the six periods ended July 2, 2000. Net cash used by investing activities was $3.2 million for the six periods ended July 1, 2001 and $6.4 million for the six periods ended July 2, 2000. Cash used by investing activities for the six periods ended July 1, 2001 resulted primarily from capital spending for store remodeling. Cash used by investing activities for the six periods ended July 2, 2000 resulted primarily from capital expenditures partially offset by proceeds from the sale of real estate. 22 23 Net cash provided (used) by financing activities was $98.7 million for the six periods ended July 1, 2001 and $(22.5) million for the six periods ended July 2, 2000. For the six periods ended July 1, 2001, cash provided by financing activities reflected a $105.7 million net increase in short-term borrowings. For the six periods ended July 2, 2000, cash provided by financing activities reflected a $33.2 million net increase in short-term borrowings, offset by repayments of long-term debt. Capital Expenditures Capital expenditures for the six periods ended July 1, 2001 and July 2, 2000, respectively, related primarily to store remodeling and preparing the stores for subleasing. Planned capital expenditures for fiscal 2001 are expected to be approximately $27.0 million and are expected to be directed primarily to store remodels, capital maintenance and information systems improvements. The Company expects to fund these planned expenditures primarily with borrowings under the DIP to Exit Facility. Capital Structure The Company's principal sources of liquidity during the six periods ended July 1, 2001 and July 2, 2000 were borrowings under the DIP to Exit Facility. At July 1, 2001, the Company had $194.8 million in revolving loans outstanding under the DIP to Exit Facility. The Company had $97.1 million in revolving loans outstanding under the DIP to Exit Facility on July 2, 2000. Average short-term borrowings for the six periods ended July 1, 2001 increased to $182.2 million compared to $100.1 million for the six periods ended July 2, 2000, due primarily to a decline in sales from liquidations of merchandise in toys, electronics and sporting goods categories and a decline in sales of property and equipment. Short-term borrowings under the revolver portion of the DIP to Exit Facility reached a maximum of $240.3 million during the six periods ended July 1, 2001 as compared to short-term borrowings under the revolver portions of the DIP to Exit Facility of $176.3 million during the six periods ended July 2, 2000. On April 14, 2000, the Company entered into the DIP to Exit Facility, which replaced the DIP Facility. The Bankruptcy Court approved the DIP to Exit Facility on April 4, 2000. The DIP to Exit Facility matures on April 14, 2004, and includes $60.0 million in term loans and up to a maximum of $540.0 million in revolving loans including a $150.0 million sub-facility for letters of credit. Interest rate spreads on the DIP to Exit Facility were initially LIBOR plus 2.50% on Eurodollar loans and Prime Rate plus 0.75% on Alternate Base Rate loans. Beginning with the second quarter of 2001, these spreads are subject to quarterly adjustment pursuant to a pricing grid based on availability and financial performance, with ranges of 200 to 275 basis points over LIBOR and 25 to 100 basis points over Prime Rate. There is a commitment fee of 0.375% on the undrawn portion of the revolving loans under the DIP to Exit Facility. Borrowings under the DIP to Exit Facility are secured by all material unencumbered assets of the Company and its subsidiaries, including inventory, but excluding previously mortgaged property. Borrowings under the DIP to Exit Facility are limited based on a borrowing base formula, which considers eligible inventories, eligible accounts receivable, mortgage values on eligible real properties, eligible leasehold interests, available cash equivalents and in-transit cash. Availability under the facility continues unless the Company breaches the financial covenants for the DIP to Exit Facility. As of July 1, 2001, the Company was in compliance with the financial covenants under the DIP to Exit Facility. To fund capital expenditures in 2001, the DIP to Exit Facility permits capital expenditures up to $105.9 million. During 2002 and 2003, the Company may invest up to $50.0 million each year with 100 percent carryover of unexpended amounts from prior years. Conversion of the DIP to Exit Facility to an exit financing upon the Company's anticipated emergence from Chapter 11 is subject to customary closing conditions, including the collateral and administrative agent's 23 24 reasonable satisfaction with the Company's capital structure, plan of reorganization and any materially revised projections, as well as the achievement by the Company of a specified trailing 12-month earnings level (which varies depending on time of exit) and certain minimum availability (which varies from $50.0 to $100.0 million) depending on the time of exit. There can be no assurance that the Company will be able to access liquidity from the DIP to Exit Facility, or from any other source, or that such liquidity will be sufficient to meet the Company's needs. Moreover, there can be no assurance that the Company will exit Chapter 11 or convert the DIP to Exit Facility to an exit financing facility. See "- Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995." EFFECT OF NEW ACCOUNTING PRONOUNCEMENTS The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and No. 142 "Goodwill and Other Intangible Assets". SFAS No. 141 will require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and that the use of the pooling-of-interest method is no longer allowed. SFAS No. 142 requires that upon adoption, amortization of goodwill will cease and instead, the carrying value of goodwill will be evaluated for impairment on an annual basis. Identifiable intangible assets will continue to be amortized over their useful lives and reviewed for impairment in accordance with SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of". SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. The Company is evaluating the impact of the adoption of these standards and has not yet determined the effect of adoption on its financial position and results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The Company's operations are subject to market risks primarily from changes in interest rates. The Company has immaterial exposure to exchange rate risk. The Company manages its interest rate risk by entering into interest rate swap agreements and balancing its debt portfolio with both fixed and floating rate borrowings. As of July 1, 2001, the Company was party to interest rate swaps covering a portion of its short-term borrowings and term loan, which vary seasonally. These swaps, which vary in notional amount from $110 million to $155 million and expire January 2, 2002, exchange floating interest rate exposure for fixed interest rate exposure. The Company will pay a weighted average fixed rate of 6.97%, rather than the one-month LIBOR, which was 5.08% as of July 1, 2001. The fair values of interest rate swap agreements is estimated based on quotes from dealers of these instruments and represents the estimated amounts the Company could expect to pay or receive to terminate the agreements. The fair value of the Company's interest rate swap agreements was ($2.5) million as of July 1, 2001. 24 25 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. On March 15, 1999, five of the Company's vendors filed an involuntary petition for reorganization under Chapter 11 in the Bankruptcy Court seeking court supervision of the Company's restructuring efforts. On March 27, 1999, the Company and 31 of its subsidiaries (the " Debtors") filed voluntary petitions with the Bankruptcy Court for reorganization under Chapter 11 of the Bankruptcy Code. The Debtors are currently operating their businesses as debtors-in-possession. The Chapter 11 Cases have been consolidated for the purpose of joint administration under Case No. 399-02649. On January 28, 1997, the Company and Service Credit Corp. ("Subsidiary"), a wholly owned subsidiary, entered into an agreement with World Financial Network National Bank ("WFNNB") for the purpose of providing a private label credit card to the Company's customers. The contract requires the Subsidiary to maintain a 3.0% credit risk reserve for the outstanding balances, which are owned by WFNNB. The purpose of this reserve is to offset future potential negative spreads and portfolio losses. The negative spreads or losses may result from potential increased reimbursable contractual program costs. The 3.0% credit risk reserve is held by the Subsidiary, which is not in Chapter 11, in the form of cash and cash equivalents. On April 28, 1999, WFNNB advised the Company that WFNNB has projected that such portfolio losses and negative spreads will be at least approximately $9.0 million. The Company does not have in its possession sufficient information to determine the accuracy or validity of WFNNB's projection. Pending confirmation of the accuracy of WFNNB's projection and a resolution of the Company's rights and remedies, the Company made provision for such potential liability during fiscal 1999 by maintaining an allowance on the 3.0% credit risk reserve of approximately $9.0 million. On July 16, 1999, the Company filed a complaint against WFNNB in the Bankruptcy Court alleging, among other things, breach of contract and violation of the automatic stay provisions of the Bankruptcy Code by WFNNB with respect to and in connection with the January 1997 private label credit card program agreement between the Company, the Subsidiary and WFNNB (the "World Financial Agreement"). Under the World Financial Agreement, a program was established pursuant to which, among other things, WFNNB agreed to issue credit cards to qualifying Company customers for the purchase of goods and services from the Company. On August 20, 1999, over the objection of WFNNB, the Bankruptcy Court authorized the Company to enter into an agreement with Household Bank (SB), N.A. ("Household") for the purpose of offering new private label credit cards to those customers of the Company who meet Household's credit standards. The Company's prior private label credit card program with WFNNB was suspended in March of 1999, and the rights and liabilities of WFNNB, the Company and the Subsidiary are the subject of the litigation referred to in the preceding paragraph. On September 23, 1999, WFNNB filed a motion to dismiss the Company's complaint and a separate motion seeking to have the complaint litigated in the United States District Court for the Middle District of Tennessee (the "District Court"), rather than the Bankruptcy Court. The Company filed timely oppositions to both motions, and, on October 27, 1999, the District Court denied WFNNB's motion to have the complaint litigated in the District Court. The Bankruptcy Court scheduled a hearing on December 6, 1999, to consider WFNNB's motion to dismiss and the Company's opposition thereto. On December 6, 1999, the Bankruptcy Court entered an order dismissing the Company's complaint. On December 16, 1999, the Company filed a motion asking the Court to clarify the order issued on December 6, 1999, and to grant the Company leave to file an amended complaint (the "Company's Motion"). On January 11, 2000, WFNNB responded with an objection to the Company's Motion. On February 22, 2000, the Bankruptcy Court entered an order granting the Company's Motion and the Company filed the amended complaint. On April 24, 2000, WFNNB filed a motion to dismiss this amended complaint. The Company responded to the motion to dismiss and filed a cross-motion seeking to treat its amended complaint as an objection to WFNNB's proof of claim. On November 9, 2000, the Court granted in part and denied in part WFNNB's motion to dismiss the Company's amended complaint. The Court denied WFNNB's motion to dismiss the Company's claims for breach 25 26 of contract, anticipatory repudiation and violation of the automatic stay. The Court granted WFNNB's motion to dismiss the Company's claims for breach of the duty of good faith and fair dealing and indemnification. On January 5, 2001, WFNNB answered the remaining parts of the Company's amended complaint. On the same day, WFNNB filed a motion to lift the automatic stay so they could file counter claims against the Company. On April 6, 2001, the Bankruptcy Court, with the consent of the Company, lifted the automatic stay and permitted the claims to proceed. At this time, it is not possible to predict the outcome of the Chapter 11 Cases or their effect on the Company's business. Additional information regarding the Chapter 11 Cases is set forth elsewhere in this Quarterly report on Form 10-Q and in Item 1. "Business - Proceedings Under Chapter 11 of the Bankruptcy Code", Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations," Note B of Notes to Consolidated Financial Statements, and the Report of Independent Auditors included in the Company's Annual Report on Form 10-K filed on March 16, 2001, which includes an explanatory paragraph concerning a substantial doubt as to the Company's ability to continue as a going concern. If it is determined that the liabilities subject to compromise in the Chapter 11 Cases exceed the fair value of the assets available to satisfy them, unsecured claims may be satisfied at less than 100% of their face value and the equity interests of the Company's shareholders may have no value. ITEM 2. DEFAULTS UPON SENIOR SECURITIES. The Company commenced the Chapter 11 Cases on March 27, 1999. As a result of filing the Chapter 11 Cases, no principal or interest payments will be made on certain indebtedness incurred by the Company prior to March 27, 1999, including the 9% Senior Subordinated Debentures and 8 3/8% Senior Notes, until a plan of reorganization defining the payment terms has been approved by the Bankruptcy Court. ITEM 3. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits filed with this Form 10-Q 10.1 Employment Agreement between Registrant and Jane Gilmartin dated May 14, 2001. (b) Reports on Form 8-K. During the three periods ended July 1, 2001, the Company filed the following reports on Form 8-K: (i) dated April 20, 2001, announcing the Company's 2001 business plan; (ii) dated April 30, 2001, announcing the filing with the Bankruptcy Court of the Company's monthly operating report for the period commencing February 26, 2001 and ending April 1, 2001; (iii) dated June 1, 2001, announcing the filing with the Bankruptcy Court of the Company's monthly operating report for the period commencing April 2, 2001 and ending April 29, 2001; and (iv) dated June 22, 2001, announcing the filing with the Bankruptcy Court of the Company's monthly operating report for the period commencing April 30, 2001 and ending May 27, 2001. 26 27 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ S. Cusano - ------------------------------------------------------- S. Cusano Chairman, President and Chief Executive Officer (Principal Executive Officer) August 13, 2001 /s/ Michael E. Hogrefe - ------------------------------------------------------- Michael E. Hogrefe Senior Vice President and Chief Financial Officer (Principal Financial Officer) August 13, 2001 /s/ Kenneth A. Conway - ------------------------------------------------------- Kenneth A. Conway Vice President Controller and Chief Accounting Officer (Principal Accounting Officer) August 13, 2001 27 EX-10.1 3 g71130ex10-1.txt EMPLOYMENT AGREEMENT 1 EXHIBIT 10.1 EMPLOYMENT AGREEMENT This Employment Agreement is made as of the 14th day of May, 2001 (the "Agreement") by and between Service Merchandise Company, Inc., a Tennessee corporation (the "Company"), and Jane F. Gilmartin (the "Executive"). RECITALS WHEREAS, the Company desires to provide for the employment of the Executive in accordance with the terms and conditions provided herein; and WHEREAS, the Executive wishes to perform services for the Company in accordance with the terms and conditions provided herein. NOW, THEREFORE, in consideration of the premises hereof and of the mutual promises and agreements contained herein, the parties hereto, intending to be legally bound, hereby agree as follows: 1. Employment. The Company hereby agrees to employ the Executive, and the Executive hereby agrees to perform services for the Company, on the terms and conditions set forth herein. 2. Term. The term of employment of the Executive by the Company hereunder shall commence effective as of May 14, 2001 (the "Effective Date"), and shall end on May 13, 2003 (the "Initial Term"), unless further extended or sooner terminated as hereinafter provided. Commencing on May 14, 2003 and on each anniversary thereafter (each such date, an "Anniversary Date"), the term of the Executive's employment shall automatically be extended for one additional year unless, not later than the December 31, immediately preceding an Anniversary Date, either party shall have given notice to the other party that it does not wish to extend this Agreement (a "Notice of Non-Renewal"). References herein to the "Term" of this Agreement shall refer to both the Initial Term and any extended term of the Executive's employment hereunder. Notwithstanding the foregoing, if a Change of Control (as defined in Section 6) occurs during the 2 Term, in no event shall the Term end prior to the end of the twenty-fourth (24th) month following the month in which such Change of Control occurs. 3. Position and Duties. (a) The Executive shall serve as President and Chief Merchandising Officer of the Company and shall have such responsibilities, duties and authority as are generally consistent and customary with such position. Executive shall report solely to the Chief Executive Officer of the Company. The Executive shall also serve, if requested by the Board of Directors (the "Board"), as a director or officer of any of the Company's present or future direct or indirect subsidiaries. (b) During the Term, and excluding any periods of vacation and sick leave to which the Executive is entitled, the Executive shall devote reasonable attention and time during normal business hours to the business and affairs of the Company and, to the extent necessary to discharge the responsibilities assigned to the Executive under this Agreement, use the Executive's reasonable best efforts to carry out such responsibilities faithfully and efficiently. It shall not be considered a violation of the foregoing for the Executive to serve on corporate, industry, civic or charitable boards or committees, so long as such activities do not significantly interfere with the performance of the Executive's responsibilities as an employee of the Company in accordance with this Agreement. 4. Compensation. (a) Base Salary. During the Term, the Executive shall receive an annual base salary ("Annual Base Salary") of $520,000. The Annual Base Salary shall be payable in accordance with the Company's regular payroll practice for its senior executives, as in effect from time to time. During the Term, the Annual Base Salary shall be reviewed by the Compensation Committee of the Board for possible 2 3 increase at least annually. Any increase in the Annual Base Salary shall not limit or reduce any other obligation of the Company under this Agreement. The Annual Base Salary shall not be reduced after any such increase, and the term "Annual Base Salary" shall thereafter refer to the Annual Base Salary as so increased. (b) Annual Bonus; Retention Program. During the Term, the Executive shall be entitled to receive an annual bonus ("Annual Bonus") pursuant to the Company's annual bonus plan, as in effect from time to time, and shall be entitled to participate as a Tier II Employee in the Company's 2001 Retention Program for Key Employees (the "Program"), which Program was approved by order (the "Order") of the U.S. Bankruptcy Court for the Middle District of Tennessee (the "Court") entered on March 28, 2001, respectively, in connection with the Company's Chapter 11 case (the "Case"). (c) Make-Whole Payment. Executive shall be entitled to receive a payment equal to $2,500,000 (the "Make-Whole Payment"). $1,250,000 of the Make-Whole Payment shall be paid to the Executive in cash, by wire transfer at the first available time for wire transfers following approval of this Agreement by the Court and receipt of this Agreement, fully-executed by the Executive. The remaining portion of the Make-Whole Payment shall be paid pursuant to draws by the Executive under an irrevocable letter of credit in accordance with the terms thereof, including the credit draw certificate (the letter of credit and draw certificate are referred to herein as the "Letter of Credit"). The Make-Whole Payment, or any portion thereof, will not be included in any salary continuation calculation under sections 5 or 6 of this Agreement. In the event the Executive voluntarily terminates her employment, or is duly terminated for Cause (as hereinafter defined in Section 5) prior to the expiration of the Initial Term, any portion of the Make-Whole Payment previously received by the Executive will be paid back to the Company. Notwithstanding the foregoing, any remaining portions of the Make-Whole Payment, not yet paid, shall be due in full upon the termination, for any reason, of the employment of Sam Cusano as Chief Executive Officer of the Company. 3 4 (d) Other Benefits. During the Term, the Executive shall be entitled to participate in other employee benefit plans, programs and arrangements of the Company, other than Annual Bonus plans (covered by Section 4(b) above) (the "Benefit Plans"), now or hereinafter in effect, that are applicable to the Company's employees generally or to its executive officers, as the case may be, subject to and on a basis consistent with the terms, conditions and overall administration of the Benefit Plans. During the Term, the Company shall provide to the Executive all of the fringe benefits and perquisites that are provided to senior executives of the Company, and the Executive shall be entitled to participate in and receive any other fringe benefits or perquisites that become available to the Company's senior executives. The Company shall provide to the Executive a car allowance in the amount of $10,000 per annum. The value of the benefit received by the Executive pursuant to the previous sentence shall be subject to applicable withholding pursuant to Section 13. (e) Vacation and Other Leaves. The Executive shall be entitled to vacation in an amount equal to the greater of three (3) weeks or that provided in accordance with the Company's vacation policy (and to compensation in respect of earned but unused vacation days) and all paid holidays and personal leave days that are available generally to executive officers of the Company. (f) Expenses; Attorneys' Fees. During the Term, the Executive shall be entitled to receive prompt reimbursement for all reasonable and customary expenses incurred by the Executive in performing his services hereunder, including all expenses of travel and accommodations while engaged in business of the Company, provided that such expenses are incurred and accounted for in accordance with the policies and procedures established by the Company. Until the end of the Initial Term, and any extension thereof resulting from a Change of Control (as defined in Section 6), the Company shall provide to the Executive, at the Company's expense, a furnished two-bedroom apartment with housekeeping services, and shall reimburse the Executive for all reasonable travel incurred by the Executive for travel between New York City and Nashville. The Company shall reimburse the Executive for legal fees and expenses in the amount of $15,000 incurred in connection with the negotiation and execution of 4 5 this Agreement. The value of the benefit received by the Executive pursuant to the previous two sentences shall be subject to applicable withholding pursuant to Section 13. (g) Services Furnished. During the Term, the Company shall furnish the Executive with office space, secretarial and/or administrative assistance, office supplies, support services and such other facilities and services as shall be suitable to the Executive's position and adequate for the performance of his duties hereunder. 5. Compensation on Termination of Employment (Except Within Two Years Following a Change of Control). This Section 5 shall apply to termination of the Executive's employment during the Term and prior to a Change of Control (as hereinafter defined in Section 6) and to termination of the Executive's employment more than two (2) years following a Change of Control. This Section 5 shall not apply to termination of Executive's employment during the Change of Control Period (as hereinafter defined in Section 6): (a) Disability. If the Executive's employment with the Company is terminated by the Executive or the Company due to the Executive's inability to perform Executive's duties as a result of physical or mental incapacity as defined in the Company's long-term disability insurance policy ("Disability"), the Executive shall be paid such amounts, if any, as the Executive is entitled to receive under the Company's disability insurance policies then in effect for Company officers, but shall be entitled to no further compensation or benefits (unless previously accrued under the Company's benefit plans). (b) Other Termination Not Giving Rise to Salary Continuation. If the Executive's employment shall be terminated for Cause (as hereinafter defined) or if the Executive dies or if the Executive terminates Executive's employment for any reason other than for a material breach of this Agreement by the Company, the Company shall pay the Executive any installments of Executive's Annual Base Salary as then in effect that would otherwise be due through the date 5 6 on which Executive's employment is terminated. The Company shall then have no further obligations to the Executive under this Agreement except that in the event of termination by death, the Executive's estate or beneficiaries, as the case may be, shall be paid such amounts as may be payable to the Executive under the Company's insurance policies and/or other benefit plans. For the purposes of this Agreement, the Company shall have "Cause" to terminate the Executive's employment upon (i) the willful engaging by the Executive in misconduct materially injurious to the Company, (ii) acts of dishonesty or fraud by the Executive, or (iii) the willful violation by the Executive of the provisions of Section 8 or Section 9 hereof (c) Termination Giving Rise to Salary Continuation. If the Company shall terminate the Executive's employment with the Company or shall provide a Notice of Non-Renewal for any reason other than due to the Executive's death or Disability or for Cause, or if the Executive terminates this Agreement because of a material breach of this Agreement by the Company, then, subject to the compliance by the Executive with the provisions of Sections 8 and 9 hereof, the Company shall pay, as salary continuation, to the Executive an amount equal to two (2) times the Executive's maximum Annual Base Salary paid during the prior five (5) year period (inclusive of the highest Annual Bonus paid or payable to the Executive during the prior five (5) year period, but excluding unearned bonuses negotiated by Executive at the time of the Executive's employment with the Company), payable in a lump sum, but no other compensation or benefits (unless accrued under the Company's benefit plans prior to the date of termination of employment or as provided in Section 4(e) hereof) shall be paid to the Executive. (d) Healthcare Coverage. If the Executive's employment with the Company is terminated by the Company for any reason other than due to the Executive's death or Disability or for Cause, the Company will reimburse the Executive for the premium paid by the Executive for continued coverage for the Executive (and any dependents of the Executive covered by the Company's healthcare plans at the time the Executive's employment was terminated) under the Company's healthcare plan pursuant to "COBRA" (or any other mandatory healthcare continuation law then in effect), such coverage then being 6 7 substantially similar to that provided by the Company to its senior executives and their eligible dependents. The Executive will be entitled to reimbursement for such coverage for the period commencing with the date of termination of employment and ending on the earlier of (i) the second anniversary of termination of employment, or (ii) the date the Executive becomes eligible to receive any healthcare coverage from another employer of the Executive or Executive's spouse, or any governmental entity, that does not contain any exclusion or limitation with respect to any pre-existing condition of the Executive or Executive's covered dependents. If the Executive (or Executive's dependents covered at the time of termination of employment) elects not to continue coverage under COBRA (or any other mandatory healthcare continuation law then in effect) or is not eligible to continue coverage under such healthcare continuation law, and is otherwise eligible under this Section 5(d), the Company will reimburse the Executive for the cost of purchasing substantially similar coverage or a supplement required to achieve substantially similar coverage under another arrangement approved by the Company for the same period; however, such reimbursement shall be limited to the then current premium charged to others by the Company for substantially similar coverage under COBRA (or other mandatory healthcare continuation law then in effect). Any amount payable to the Executive shall be subject to withholding of applicable taxes as provided in Section 13 hereof. In the event of Executive's death following termination giving rise to the benefit described in this Section 5(d), but before the expiration of such benefits, Executive's dependents shall be entitled to such benefits. 6. Compensation on Termination of Employment Within Two Years Following A Change of Control. This Section 6 shall apply to termination of Executive's employment during the "Change of Control Period" (as defined in this Section 6). This Section 6 shall not apply to termination of Executive's employment prior to a Change of Control or more than two (2) years following a Change of Control: (a) Definition of Certain Terms. 7 8 (i) "Good Reason" shall mean the occurrence or continuation, without consent of Executive, after a Change of Control, of any of the following events within the Change of Control Period: (A) the assignment to Executive of any duties inconsistent with the customary powers and duties that Executive held immediately prior to the Change of Control, or an adverse change in the status, position or conditions of Executive's employment or the nature of Executive's responsibilities in effect immediately prior to such Change of Control, or any removal of Executive from, or any failure to re-elect Executive to, any of such positions; (B) a reduction by the Company in Executive's Annual Base Salary as in effect immediately prior to such Change of Control; (C) the relocation of Executive's principal office to a location outside a 35 mile radius from Executive's principal office immediately prior to such Change of Control, except for required travel on the Company's business to an extent substantially consistent with Executive's business travel obligations immediately prior to such Change of Control; (D) the failure by the Company to continue in effect any benefit or compensation plan in which Executive participates immediately prior to the Change of Control which is material to Executive's total compensation, including but not limited to any stock or stock option, employee stock ownership, bonus, insurance, disability and vacation plans which the Company currently has or any substitute or additional plans adopted prior to the Change of Control, unless an equitable arrangement (embodied in an ongoing substi- 8 9 tute or alternative plan or plans) has been made with respect to such plan, or the failure by the Company to continue Executive's participation therein (or in such substitute or alternative plan) on a basis not materially less favorable, both in terms of the amount of benefits provided and the level of Executive's participation relative to other participants, as in existence immediately prior to such Change of Control; (E) the termination, for any reason, of the employment of Sam Cusano as Chief Executive Officer of the Company; or (F) the failure of the Company to obtain an agreement from any successor to assume and agree to perform this Agreement as contemplated herein. (ii) A "Change of Control" shall be deemed to have taken place if (i) any person or entity, including a "group" as defined in Section 13(d)(3) of the Securities and Exchange Act of 1934, other than Company or a wholly-owned subsidiary thereof or any employee benefit plan of Company or any of its it subsidiaries, becomes the beneficial owner of the Company securities having 20% or more of the combined voting power of the then outstanding securities of the Company that may be cast for the election of directors of the Company (other than as a result of an in issuance of securities initiated by the Company in the ordinary course of business); or (ii) as the result of, or in connection with, any cash tender or exchange offer, merger or other business combination, sale of assets or contested election, or any combination of the foregoing transactions, less than a majority of the combined voting power of the then outstanding securities of the Company or any successor corporation or entity entitled to vote generally in the election of the directors of the Company or such other corporation or entity after such transaction is held in the aggregate by the holders of the Company's securities entitled to vote generally in the election of directors of the Company immediately prior 9 10 to such transaction; or (iii) the following individuals cease for any reason to constitute a majority of the number of directors then serving: individuals who, as of the Effective Date, constitute the Board and any new director (other than a director whose initial assumption of office is in connection with an actual or threatened election contest, including but not limited to, a consent solicitation, relating to the election of directors of the Company) whose appointment or election by the Board or nomination for election by the Company's shareholders, was approved or recommended by a vote of at least two-thirds of the directors of the Company then still in office who were directors of the Company on the Effective Date or whose appointment, election or nomination for election was previously so approved or recommended; provided, however, that a "Change of Control" shall not be deemed to have taken place if any of the events specified (i), (ii) or (iii) of this paragraph occur in connection with the substantial consummation of a confirmed plan of reorganization under Chapter 11 of the Bankruptcy Code prosecuted by the Company. (iii) "Change of Control Period" shall mean the two (2) year period following a Change of Control. (iv) "Change of Control Severance Benefits" shall mean all of the following payments: (A) any installments of Executive's Annual Base Salary through the date of termination of employment at the rate in effect at the time the Notice of Termination is given, (B) the Special Termination Payment; and (C) the Medical Benefits. 10 11 (v) "Change of Control Date" shall mean the date on which a Change of Control occurs. (vi) "Medical Benefits" shall mean the reimbursement for continued medical coverage for Executive and Executive's dependents described in Section 5(d) hereof. (vii) "Notice of Termination" shall refer to written notice described in Section 6(d) indicating the specific termination provision of this Agreement relied upon, setting forth in reasonable detail the facts and circumstances claimed to provide the basis for termination of Executive's employment under the provision so indicated and stating the date of termination. (viii) "Special Termination Payment" shall mean an amount payable in a single lump sum equal to the product of (x) an amount equal to the Executive's maximum Annual Base Salary paid in any year of the five (5) year period preceding the date of termination (inclusive of the Annual Bonus paid to Executive during the 12-month period preceding the date of termination or the Annual Bonus earned by the Executive with respect to the fiscal year immediately preceding the date of termination, whichever Annual Bonus is higher, but excluding unearned bonuses negotiated by Executive at the time of Executive's employment with the Company), multiplied by (y) the number three (3), except that in the event that the Change in Control is the result of a liquidation of the Company, the amount specified in (x) will be multiplied by (y) the number two (2) instead of the number three (3). (b) Termination Not Giving Rise To Special Termination Payments or Medical Benefits. If Executive's employment is terminated during the Change of Control Period for Cause (as defined in Section 5(b), or on account of Disability (as defined in Section 5(a)), or if Executive dies during the Change of Control Period, or if Executive terminates Executive's employment during the Change of Control 11 12 Period without Good Reason, the Company shall pay to Executive any installments of Executive's Annual Base Salary as then in effect that would otherwise be due through the date on which Executive's employment is terminated. The Company shall then have no further obligations to the Executive under this Agreement (unless accrued under the Company's benefit plans) except that in the event of termination by death, the Executive's estate or beneficiaries, as the case may be, shall be paid such amounts as may be payable to the Executive under the Company's insurance policies and/or other benefit plans, and except that in the event of termination by Disability, the Executive shall be paid such amounts as Executive is entitled to receive under the Company's disability insurance policies and plans then in effect covering the Executive. (c) Termination Giving Rise to Change of Control Severance Benefits. If the Executive's employment is terminated or a Notice of Non-Renewal is given by the Company during the Change of Control Period for any reason other than Cause, death of the Executive or Disability, or if the Executive terminates his employment during the Change of Control Period for Good Reason, then Executive shall be entitled to receive the Change of Control Severance Benefits, all of which (except the Medical Benefits) shall be paid to Executive within ten (10) days following the date of termination. (d) Notice of Termination. Any termination of Executive's employment by the Company or by Executive pursuant to this Section 6 shall be communicated by written notice of termination (the "Notice of Termination") to the other party hereto, which shall indicate the specific termination provision in the Agreement relied upon, shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of Executive's employment and shall state the date of termination. 7. Certain Reduction in Payments by the Company. 12 13 (a) Definition of Certain Terms. (i) A "Payment" shall mean any payment or distribution in the nature of compensation to or for the benefit of Executive, whether paid or payable pursuant to this Agreement or otherwise. (ii) An "Agreement Payment" shall mean a Payment paid or payable on account of termination of employment during the Change in Control Period pursuant to Section 6 of this Agreement (disregarding the reduction provided by Section 7(b)). (iii) "Net After Tax Receipt" shall mean the Present Value (as defined below) of all Payments that are contingent on a Change of Control within the meaning of Section 280G of the Internal Revenue Code of 1986, as amended (the "Code"), net of all taxes imposed on Executive with respect thereto under Sections I and 4999 of the Code, determined by applying the highest marginal rate under Section I of the Code which applied to Executive's taxable income for the immediately preceding taxable year. (iv) "Present Value" shall mean such value determined in accordance with Section 280G(d)(4) of the Code. (b) Limitation on Agreement Payments. It is intended that all Agreement Payments hereunder, together with all other Payments to Executive contingent upon or in connection with a Change of Control, are reasonable compensation for Executive's service to Company and its subsidiaries. Notwithstanding the foregoing, should Company determine, based upon the opinion of the independent accounting advisors of Company immediately prior to the Change of Control ("Accounting Firm"), which opinion shall be based on generally accepted accounting principles ("GAAP"), that the Agreement Payments and other Payments, together with any other amounts 13 14 received by Employee that must be included in such determination, would result in the payment of an "excess parachute payment" as defined in Section 280G of the Code, then Company will reduce the Agreement Payments to the minimum extent necessary so that no portion of the aggregate Payments would result in the payment of an "excess parachute payment;" provided, however, that such reduction will be made if, but only if, the value of all such Payments (without regard to the foregoing reduction) would result in Net After Tax Receipts which are less than the Net After Tax Receipts that would result after taking into account any such reduction. (c) Opinion of Accounting Firm. Company may reduce the Agreement Payments pursuant to this Section 7 only if within thirty (30) days of Executive's termination it provides Executive with an opinion of the Accounting Firm, which opinion shall be based on GAAP, that Executive will be considered to have received "excess parachute payments" as defined in Section 280G of the Code if Executive were to receive the full amounts owing pursuant to the terms of this Agreement and that the reduced amount proposed to be paid by the Company will result in Net After Tax Receipts that are equal to or greater than the Net After Tax Receipts which would result from reduction in the Agreement Payments by any other amount. 8. Unauthorized Disclosure. (a) During the period in which the Executive is employed by the Company, the Executive shall not, without the prior written consent of the Board, or a person authorized thereby, disclose to any person, other than a person to whom disclosure is necessary or appropriate in connection with the performance by the Executive of Executive's duties as an officer of the Company, or its subsidiaries or its affiliates, any confidential information obtained by Executive while in the employ of the Company with respect to any of the Company's products, improvements, formulae, designs or styles, processes, customers, methods of marketing or distribution, systems, procedures, plans, proposals, policies or methods of manufacture, the disclosure of which Executive knows, or should have reason to know, will be 14 15 materially damaging to the Company or its subsidiaries or its affiliates, nor shall Executive intentionally make any materially false statements regarding the Company or its subsidiaries or its affiliates or take any unreasonable action which Executive knows, or should have reason to know, will be materially damaging to the Company or its subsidiaries or its affiliates; provided, however, that confidential information shall not include any information known generally to the public (other than as a result of unauthorized disclosures by the Executive) or any information of a type not otherwise considered confidential by persons engaged in the same business or a business similar to that conducted by the Company. Following the termination of the Executive's employment with the Company for any reason, the Executive shall not disclose any confidential information of the type described above or take any action of type described above except as may be required in the opinion of the Executive's counsel in connection with any judicial or administrative proceeding or inquiry. The provisions of this Section 8 shall be binding upon the Executive's heirs, successors and legal representatives. (b) Company agrees to refrain from making derogatory or defamatory statements about or concerning Executive. 9. Non-Competition. During the period in which the Executive is employed by the Company and for a period of two (2) years following any termination giving rise to salary continuation payments pursuant to Section 5(c) or to Change of Control Severance Benefits pursuant to Section 6(c), the Executive will not (a) directly or indirectly own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director or otherwise with, or have any financial interest in, or aid or assist anyone else in the conduct of, any business which is in substantial competition with any business conducted by the Company or by any group, division or subsidiary of the Company in any area where such business is being conducted at the time of such termination (provided that ownership of five percent (5%) or less of the voting stock of any publicly held corporation shall not constitute a violation hereof) or (b) directly or indirectly employ, solicit for employment, or advise or recommend to any other persons that they 15 16 employ or solicit for employment any employee of the Company or any of its subsidiaries or affiliates. 10. Specific Performance. The Executive acknowledges and agrees that, in the event of a breach of Section 8 or Section 9 hereof by the Executive, the Company would be irreparably harmed and that monetary damages would be an inadequate remedy in favor of the Company. Accordingly, the Executive and the Company agree that in the event of such a breach, the Company shall be entitled to injunctive relief against the Executive. 11. Binding Agreement. This Agreement and all obligations of the Company hereunder shall be binding upon the successors and assigns of the Company. This Agreement and all rights of the Executive hereunder shall inure to the benefit of and be enforceable by the Executive's personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. 12. Notice. For the purposes of this Agreement, notices and all other communications provided for in the Agreement shall be in writing and shall be deemed to have been duly given when delivered or mailed by United States registered mail, return receipt requested, postage prepaid, addressed as follows: If to the Executive: Ms. Jane F. Gilmartin 631 The Plain Road Westbury, New York 11590 with a copy to: Steven G. Leventhal 15 Remsen Avenue Roslyn, New York 11576 16 17 If to the Company: Service Merchandise Company, Inc. 7100 Service Merchandise Drive Brentwood, Tennessee 37027 Attn: General Counsel or to such other address as any party may have furnished to the other in writing in accordance herewith, except that notices of change of address shall be effective only upon receipt. 13. Withholding of Taxes. The Company may withhold from any amounts payable under this Agreement, all federal, state, city or other taxes as shall be required pursuant to any law or government regulation or ruling. 14. Governing Law. This Agreement shall be construed according to the laws of Tennessee, without giving effect to the principles of conflicts of laws of such State. 15. Amendment, Modification, Waiver. This Agreement may not be amended except by the written agreement of the parties hereto. No provisions of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by Executive and the Company. No waiver by either party hereto at any time of any breach by the other party hereto or compliance with any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. However, notwithstanding anything in this Agreement to the contrary, if in the opinion of the Company's accountants, which opinion shall be in accordance with GAAP, any provision of this Agreement would preclude the use of "pooling of interest" accounting treatment for a Change of Control transaction that (i) would otherwise qualify for such accounting treatment and (ii) is contingent upon qualifying for such accounting treatment, then to 17 18 the extent any provision of this Agreement disqualifies the transaction as a "pooling of interest" transaction (including, if applicable, the entire Agreement), such provision(s) shall be null and void as of the date hereof. 16. Binding Effect. This Agreement is personal in nature and neither of the parties hereto shall, without the consent of the other, assign, transfer or delegate this Agreement or any rights or obligations hereunder except as expressly provided for herein. Without limiting the generality of the foregoing, Executive's right to receive payments hereunder shall not be assignable, transferable or delegable, whether by pledge, creation of a security interest or other-wise, other than by a transfer by his will or by the laws of descent and distribution and, in the event of any attempted assignment or transfer contrary to this paragraph, the Company shall have no liability to pay any amount so attempted to be assigned, transferred or delegated. 17. Entire Contract. This Agreement, together with the Letter of Credit and the Company's Employee Policy Manual, constitutes the entire agreement and supersedes all other prior agreements, employment contracts and understandings, both written and oral, express or implied with respect to the subject matter of this Agreement, including, without limitation, any employment agreement or any severance or indemnification, by and between the Company and the Executive, all of such agreements being rendered null and void by this Agreement. 18. Termination. This Agreement shall be terminable only upon the occurrence of any one of the following events: (a) expiration of the Term without Executive's employment having been previously terminated; (b) the termination of Executive with payment in full of all the payments/benefits described in Sections 5 or 6 hereof as appropriate; or (c) the Company (or its successor in interest) and Executive so agree in writing; provided, however, that the provisions of Sections 8 and 9 hereof shall survive without limitation. 18 19 IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first above written. SERVICE MERCHANDISE COMPANY, INC. By: /s/ C. Steven Moore -------------------------------------- Its: Chief Administrative Officer Accepted and Agreed: /s/ Jane F. Gilmartin - ----------------------------- May 16, 2001 - ------------------ Jane F. Gilmartin 19 20 LETTER OF CREDIT PROVISIONS This Irrevocable Letter of Credit is established, at the request of Service Merchandise Company, Inc. (the "Company"), in favor of Jane F. Gilmartin (the "Beneficiary") in the amount of $1,250,000.00 (such amount, as it may be reduced from time to time pursuant to the terms hereof, the "Stated Amount") pursuant to the Employment Agreement dated as of May 14, 2001 between the Company and the Beneficiary (the "Employment Agreement"). The term "beneficiary" includes any successor by operation of law of the named beneficiary, including without limitation, any heirs and assigns. We hereby undertake to promptly honor your sight draft(s) drawn on us, including our credit number, for all or any part of this credit, subject to the terms specified in this Letter of Credit, if presented at our office specified below on or before the expiry date or any automatically extended expiry date. Except as expressly stated herein, this undertaking is not subject to any agreement, condition or qualification. The obligation of the Fleet National Bank under this Letter of Credit is the individual obligation of Fleet National Bank and is no way contingent upon reimbursement with respect thereto. Subject to the other terms hereof, the Beneficiary may draw upon this Letter of Credit prior to its Expiry Date (as defined below) in accordance with the following schedule:
From and After -------------- June 1, 2001 $156,250.00 July 1, 2001 $312,500.00, less amounts previously drawn August 1, 2001 $468,750.00, less amounts previously drawn September 1, 2001 $625,000.00, less amounts previously drawn October 1, 2001 $781,250.00, less amounts previously drawn November 1, 2001 $937,500.00, less amounts previously drawn December 1, 2001 $1,093,750.00, less amounts previously drawn January 1, 2002 $1,250,000.00, less amounts previously drawn.
Notwithstanding the foregoing, if, prior to the Expiry Date, either (i) the Company is liquidated; (ii) the Beneficiary is terminated by the Company, other than for Cause; or (iii) the employment of Sam Cusano as Chief Executive Officer of the Company is terminated, for any reason, any amounts remaining under this Letter 21 of Credit may be immediately drawn by the Beneficiary. In the event of the foregoing, the Beneficiary shall note the event giving rise to the draw in the Sight Draft, as further defined below. A draw on this Letter of Credit may only be made by the Beneficiary by the presentment to us at our offices located at One Fleet Way, Attn: Letter of Credit Dept., Scranton, PA 18507 of your sight draft, drawn on us and referencing Irrevocable Letter of Credit Number 151270967 and setting forth the amount being drawn, accompanied by a executed and dated statement of the Beneficiary stating that the Beneficiary has not voluntarily terminated the Beneficiary's employment with or been duly terminated for Cause by Service Merchandise Company, Inc. on the draw date (the "Sight Draft"). Each draw upon this Letter of Credit shall reduce the then Stated Amount by the amount of such draw. If the Beneficiary so requests, we will wire transfer amounts drawn under the Letter of Credit to a bank account designated by the Beneficiary. This Letter of Credit shall expire at 5:00 p.m., New York City time, on January 31, 2002 to the extent not fully drawn prior to then. This credit is subject to and governed by the laws of the State of New York and the 1993 Revision of the Uniform Customs and Practice for Documentary Credits of the International Chamber of Commerce (Publication No. 500). Very truly yours, Fleet National Bank /s/ Mark Forti -------------------------------- Authorized Signature -----END PRIVACY-ENHANCED MESSAGE-----