-----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, SfcErxU9G181CmWZn3ARQLnDlvPZzooL2qaAC7TwSORxEWAXFbW5Wbd1YtA9z3Ly agelVwZtgCYIHG6bKd0U1A== 0000912057-00-004780.txt : 20000210 0000912057-00-004780.hdr.sgml : 20000210 ACCESSION NUMBER: 0000912057-00-004780 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990831 FILED AS OF DATE: 20000209 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ILM II LEASE CORP CENTRAL INDEX KEY: 0000932092 STANDARD INDUSTRIAL CLASSIFICATION: REAL ESTATE INVESTMENT TRUSTS [6798] IRS NUMBER: 043248639 STATE OF INCORPORATION: VA FISCAL YEAR END: 0831 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 000-25880 FILM NUMBER: 529459 BUSINESS ADDRESS: STREET 1: 28 STATE STREET SUITE 1100 CITY: BOSTON STATE: MA ZIP: 02109 BUSINESS PHONE: 8882573550 MAIL ADDRESS: STREET 1: 28 STATE STREET SUITE 1100 CITY: BOSTON STATE: MA ZIP: 02109 10-K/A 1 FORM 10-K/A UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR FISCAL YEAR ENDED: AUGUST 31, 1999 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from _____ to _____. Commission File Number: 0-25880 ILM II LEASE CORPORATION (Exact name of registrant as specified in its charter) Virginia 04-3248639 -------- ---------- (State of organization) (I.R.S. Employer Identification No.) 1750 Tysons Boulevard, Suite 1200, Tysons Corner, VA 22102 - ---------------------------------------------------- ----- (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (888) 257-3550 -------------- Securities registered pursuant to Section 12(b) of the Act: Name of each exchange Title of each class on which registered - ------------------- ------------------- None None Securities registered pursuant to Section 12(g) of the Act: SHARES OF COMMON STOCK, $.01 PAR VALUE (Title of class) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X Indicate by check mark whether the registrant (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 No X . Shares of common stock outstanding as of August 31, 1999: 5,180,952. The aggregate sales price of the shares sold was $500,000. This does not reflect market value. There is no current market for these shares. DOCUMENTS INCORPORATED BY REFERENCE Documents Form 10-K Reference - ----------------------------------------------- ------------------- Registration Statement on Form 10 of registrant Part III, Part IV dated July 20, 1995, as supplemented Part IV ================================================================================ ILM II LEASE CORPORATION 1999 FORM 10-K TABLE OF CONTENTS
PART I PAGE - ------ ---- Item 1 Business.............................................................I-1 Item 2 Properties...........................................................I-5 Item 3 Legal Proceedings....................................................I-6 Item 4 Submission of Matters to a Vote of Security Holders..................I-6 PART II - ------- Item 5 Market for the Registrant's Shares and Related Stockholder Matters.................................................II-1 Item 6 Selected Financial Data.............................................II-2 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................II-3 Item 8 Financial Statements and Supplementary Data.........................II-9 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................................II-9 PART III - -------- Item 10 Directors and Executive Officers of the Registrant.................III-1 Item 11 Executive Compensation.............................................III-4 Item 12 Security Ownership of Certain Beneficial Owners and Management.....III-4 Item 13 Certain Relationships and Related Transactions.....................III-4 PART IV - ------- Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K.....IV-1 Signatures...............................................................................IV-2 Index to Exhibits........................................................................IV-3 Financial Statements and Supplementary Data............................................F1-F16
ILM II LEASE CORPORATION PART I ITEM 1. BUSINESS ILM II Lease Corporation (the "Company") was incorporated on September 12, 1994, under the laws of the State of Virginia by ILM II Senior Living, Inc., a Virginia finite-life corporation ("ILM II"), formerly PaineWebber Independent Living Mortgage Inc. II, to operate six rental housing projects that provide independent-living and assisted-living services for senior citizens (the "Senior Housing Facilities") under the terms of a facilities lease agreement dated September 1, 1995 (the "Facilities Lease Agreement"), between the Company, as lessee, and ILM II Holding, Inc. ("ILM II Holding"), as lessor, and a direct subsidiary of ILM II. The Company's sole business is the operation of the Senior Housing Facilities. ILM II contributed $500,000 to the Company in return for all of the issued and outstanding shares of the Company's common stock. ILM II had originally made mortgage loans secured by the Senior Housing Facilities to Angeles Housing Concepts, Inc. ("AHC") between July 1990 and July 1992. In March 1993, AHC defaulted under the terms of such mortgage loans and in connection with the settlement of such default, title to the Senior Housing Facilities was transferred, effective April 1, 1994, to certain majority-owned, indirect subsidiaries of ILM II, subject to the mortgage loans. Subsequently, the indirect subsidiaries of ILM II were merged into ILM II Holding. As part of the fiscal 1994 settlement agreement with AHC (the "Settlement Agreement"), ILM II Holding retained AHC as the property manager for all of the Senior Housing Facilities pursuant to the terms of a management agreement which was assigned to the Company as of September 1, 1995. As discussed further in Item 7, the agreement with AHC was terminated in July 1996. ILM II is a public company subject to the reporting obligations of the Securities and Exchange Commission. ILM II has elected to qualify and be taxed as a REIT under the Internal Revenue Code of 1986, as amended ("the Code"), for each taxable year of operations. In order to maintain its status as a REIT, 75% of ILM II's annual gross income must be Qualified Rental Income as defined by the Code. The rent paid by the residents of the Senior Housing Facilities likely would not be deemed to be Qualified Rental Income because of the extent of services provided to residents. Consequently, the operation of the Senior Housing Facilities by ILM II or its subsidiaries over an extended period of time could adversely affect ILM II's status as a REIT. Therefore, ILM II formed the Company to operate the Senior Housing Facilities, and by means of a distribution, transferred the ownership of the common stock of the Company to the holders of ILM II common stock on September 1, 1995. Because the Company, which is taxed as a so-called "C" corporation, is no longer a subsidiary of ILM II, it can receive service-related income without endangering the REIT status of ILM II. On September 1, 1995, after ILM II received the required regulatory approval, it distributed all of the outstanding shares of capital stock of the Company to the holders of record of ILM II's common stock. One share of common stock of the Company was issued for each full share of ILM II's common stock held. No fractional shares were issued. Holders of ILM II's common stock were not required to pay any cash or other consideration or to exchange their common stock of ILM II for the common stock of the Company. Prior to the distribution of the Company's stock, ILM II's shareholders received an information statement fully describing the Company and the distribution of its capital stock. ILM II Holding (the "Lessor"), a majority-owned subsidiary of ILM II, leases the Senior Housing Facilities to the Company (the "Lessee"), pursuant to the Facilities Lease Agreement. Such lease is scheduled to expire on December 31, 2000 (December 31, 1999 with respect to the Santa Barbara Facility) unless terminated earlier at the election of the Lessor in connection with the sale by the Lessor of the Senior Housing Facilities to a non-affiliated third party, upon 30 days' notice to the Company. ILM II has entered into an agreement and plan of merger with Capital Senior Living Corporation and certain affiliates of Capital, and has agreed to cause ILM II Holding to cancel and terminate the Facilities Lease Agreement immediately prior to the effective time of the merger. While there can be no assurance, consummation of the merger is presently anticipated in the first quarter of calendar year 2000. The lease is accounted for as an operating lease in the Company's financial statements. I-1 ILM II LEASE CORPORATION ITEM 1. BUSINESS (CONTINUED) In July 1996, the Company terminated the property management agreement with AHC, and the Company entered into a property management agreement (the "Management Agreement") with Capital Senior Management 2, Inc. ("Capital") to handle the day-to-day operations of the Senior Housing Facilities. Lawrence A. Cohen, who served through July 28, 1998 as a Director of the Company and President, Chief Executive Officer and Director of ILM II, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive Officer of Capital Senior Living Corporation. As a result, the Management Agreement with Capital was considered a related party transaction through July 28, 1998. Pursuant to the Facilities Lease Agreement, the Company pays annual base rent for the use of all of the Senior Housing Facilities in the aggregate amount of $4,035,600. The facilities lease is a "triple-net" lease whereby the Lessee pays all operating expenses, governmental taxes and assessments, utility charges and insurance premiums, as well as the costs of all required maintenance, personal property and non-structural repairs in connection with the operation of the Senior Housing Facilities. ILM II Holding, as the Lessor, is responsible for all major capital improvements and structural repairs to the Senior Housing Facilities. Also, any fixed assets of the Company at a Senior Housing Facility would remain with the Senior Housing Facility at the termination of the lease. The Company also pays variable rent, on a quarterly basis, for each Senior Housing Facility in an amount equal to 40% of the excess of the aggregate total revenues for the Senior Housing Facilities, on an annualized basis, over $13,021,000. For the fiscal years ended August 31, 1999 and 1998, variable rent expense was $1,261,000 and $984,000, respectively. On February 7, 1999, ILM I entered into an agreement and plan of merger with Capital Senior Living Corporation, the corporate parent of Capital, and certain affiliates of Capital. Although there can be no assurance as to whether the merger will be consummated or, if consummated, as to the timing thereof, the Company's operations would not be expected to continue beyond the effective time of the merger. I-2 ILM II LEASE CORPORATION ITEM 1. BUSINESS (CONTINUED) Descriptions of the properties covered by the Facilities Lease Agreement between the Company and ILM II Holding as of August 31, 1999 are summarized as follows:
Year Facility Rentable Resident Property Name and Location (1) Type of Property Built Units (3) Capacities (3) - ------------------------------ ---------------- ----- --------- -------------- The Palms Fort Myers, FL Senior Housing Facility 1988 205 255 Crown Villa Omaha, NE Senior Housing Facility 1992 73 73 Overland Park Place Overland Park, KS Senior Housing Facility 1994 141 153 Rio Las Palmas Stockton, CA Senior Housing Facility 1988 164 190 The Villa at Riverwood St. Louis County, MO Senior Housing Facility 1986 120 140 Villa Santa Barbara (2) Santa Barbara, CA Senior Housing Facility 1979 125 125
(1) See Notes to the financial statements filed with this annual report for a description of the agreements through which the Company has leased these facilities. (2) The Company operates Villa Santa Barbara under a co-tenancy arrangement with an affiliated company, ILM I Lease Corporation ("Lease I"). The Company has entered into an agreement with Lease I regarding such joint tenancy. Lease I was formed for similar purposes as the Company by an affiliated company, ILM Senior Living, Inc. ("ILM I"), a subsidiary of which owns 25% of the Villa Santa Barbara property. The portion of the Senior Housing Facility leased by the Company represents 75% of the total project. Villa Santa Barbara is 25% owned by ILM Holding Inc. and 75% by ILM II Holding, Inc., a direct subsidiary of ILM II, as tenants in common. Upon the sale of ILM I or ILM II, arrangements would be made to transfer the Santa Barbara facility to the non-selling joint tenant (or one of its subsidiaries). The property was extensively renovated in 1995. (3) Rentable units represent the number of apartment units and is a measure commonly used in the real estate industry. Resident capacity equals the number of bedrooms contained within the apartment units and corresponds to measures commonly used in the healthcare industry. The Senior Housing Facilities are subject to competition from similar properties in the vicinities in which they are located. The properties are located in areas with significant senior citizen populations and, as a result there are, and will likely continue to be, a variety of competing projects aimed at attracting senior residents. Such projects will generally compete on the basis of rental rates, services, amenities and location. The Company has no real estate investments located outside the United States. The Company's sole business is the operation of the Senior Housing Facilities. Therefore, presentation of information about industry segments is not applicable. I-3 ILM II LEASE CORPORATION ITEM 1. BUSINESS (CONTINUED) The Company's use of the properties is limited to use as Senior Housing Facilities. The Company has responsibility to obtain and maintain all licenses, certificates and consents needed to use and operate each Senior Housing Facility, and to use and maintain each Senior Housing Facility in compliance with all local board of health and other applicable governmental and insurance regulations. The Senior Housing Facilities located in California, Florida and Kansas are licensed by such states to provide assisted living services. In addition, various health and safety regulations and standards, which are enforced by state and local authorities, apply to the operation of all the Senior Housing Facilities. Violations of such health and safety standards could result in fines, penalties, closure of a Senior Housing Facility, or other sanctions. Through June 18, 1997, and subject to the supervision of and pursuant to the general policies set by the Company's Board of Directors, assistance in managing the business of the Company was provided by PaineWebber Lease Advisors, L.P. ("PaineWebber"). For discussion purposes, PaineWebber will refer to PaineWebber Lease Advisors, L.P. and all affiliates of PaineWebber that provided services to the Company in the past. PaineWebber resigned from this position effective as of June 18, 1997. PaineWebber agreed to perform certain administrative services for the Company and its affiliates through August 31, 1997. Through the date of its resignation, PaineWebber performed the day-to-day operations of the Company and acted as the investment advisor and consultant for the Company. PaineWebber provided cash management, accounting, tax preparation, financial reporting, investor communications and relations as well as asset management services to the Company. These services are now being provided to the Company, subject to the supervision of the Company's Board of Directors, by various companies and consultants including Greenberg Traurig, Fleet Bank, Ernst & Young LLP, and MAVRICC Management Systems, Inc. There are currently three Directors of the Company, none of whom are affiliates of PaineWebber or the property management company. The Directors are subject to removal by the vote of the holders of a majority of the outstanding shares of the Company's common stock. The terms of transactions between the Company and PaineWebber and similar disclosures with respect to relationships of other related parties which provide services to the Company are set forth in Items 11 and 13 below to which reference is hereby made for a description of such terms and transactions. As discussed further in Item 7, on July 29, 1996, the Company terminated the property management agreement with AHC and retained Capital to be the property manager of the Senior Housing Facilities, and ILM II has guaranteed the payment of all fees due to Capital under the terms of the Management Agreement. Lawrence A. Cohen, who served through July 28, 1998 as a Director of the Company and President, Chief Executive Officer and Director of ILM II, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive Officer of Capital Senior Living Corporation. As a result, through July 28, 1998, Capital was considered a related party (see Item 13). Capital earned property management fees from Lease II of $980,000 and $899,000 for the years ended August 31, 1999 and 1998, respectively. I-4 ILM II LEASE CORPORATION ITEM 2. PROPERTIES As of August 31, 1999, the Company has leased the six operating properties referred to under Item 1 to which reference is made for the description, name and location of such properties. Average occupancy levels for each fiscal quarter during 1999, along with an average for the year, are presented below for each property:
Average Quarterly Occupancy --------------------------------------------------------------------------- Fiscal 1999 11/30/98 2/28/99 5/31/99 8/31/99 Average The Palms 94% 93% 91% 89% 92% Crown Villa 96% 97% 93% 94% 95% Overland Park Place 98% 97% 95% 95% 96% Rio Las Palmas 92% 92% 91% 92% 92% The Villa at Riverwood 97% 93% 86% 87% 91% Villa Santa Barbara 97% 99% 97% 97% 98%
ITEM 3. LEGAL PROCEEDINGS On July 29, 1996, the Company and ILM II Holding (collectively for this Item 3, the "Companies") terminated a property management agreement with AHC which covered the six Senior Housing Facilities leased by the Company from ILM II Holding. The management agreement with AHC was terminated for cause pursuant to the contract. Simultaneously, with the termination of the management agreement, the Companies, together with certain affiliated entities, filed suit against AHC in the United States District Court for the Eastern District of Virginia for breach of contract, breach of fiduciary duty and fraud. The Companies alleged, among other things, that AHC willfully performed actions specifically in violation of the agreement and that such actions caused damages to the Companies. Due to the termination of the management agreement for cause, no termination fee was paid to AHC. Subsequent to the termination of the management agreement, AHC filed for protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic State of California. The filing was challenged by the Companies, and the Bankruptcy Court dismissed AHC's case effective October 15, 1996. In November 1996, AHC filed with the Virginia District Court an answer in response to the litigation initiated by the Companies and a counterclaim against ILM II Holding. The counterclaim alleged that the management agreement was wrongfully terminated for cause and requested damages which included the payment of the termination fee in the amount of $750,000, payment of management fees pursuant to the contract from August 1, 1996 through October 15, 1996, which is the earliest date that the management agreement could have been terminated without cause, and recovery of attorneys' fees and expenses. I-5 ITEM 3. LEGAL PROCEEDINGS (CONTINUED) The aggregate amount of damages against all parties as requested in AHC's counterclaim exceeded $2,000,000. On June 13, 1997 and July 8, 1997, the court issued orders to enter judgment against ILM I and ILM II in the amount of $1,000,000. The orders do not contain any findings of fact or conclusions of law. On July 10, 1997, the Company, ILM I, ILM II and Lease I filed a notice of appeal to the United States Court of Appeals for the Fourth Circuit from the orders. On February 4, 1997, AHC filed a complaint in the Superior Court of the State of California against Capital, the new property manager; Lawrence A. Cohen, who, through July 28, 1998, was a Director of the Company and President, Chief Executive Officer and Director of ILM II, and others alleging that the defendants intentionally interfered with AHC's agreement (the "California litigation"). The complaint sought damages of at least $2,000,000. On March 4, 1997, the defendants removed the case to Federal District Court in the Central District of California. At a Board meeting on February 26, 1997, the Company's Board of Directors concluded that since all of Mr. Cohen's actions relating to the California litigation were taken either on behalf of the Company under the direction of the Board or as a PaineWebber employee, the Company or its affiliates should indemnify Mr. Cohen with respect to any expenses arising from the California litigation, subject to any insurance recoveries for those expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen totaled $229,000 as of August 31, 1999. The Company's Board also concluded that, subject to certain conditions, the Company or its affiliates should pay reasonable legal fees and expenses incurred by Capital in the California litigation. At August 31, 1999, the amount advanced to Capital by the Company and Lease I for Capital's California litigation costs totaled approximately $563,000. On August 18, 1998, the Company and its affiliates along with Capital and its affiliates entered into a Settlement Agreement with AHC. The Company and Lease I agreed to pay $1,625,000 and Capital and its affiliates agreed to pay $625,000 to AHC in settlement of all claims including those related to the Virginia litigation and the California litigation. The Company and its affiliates also entered into an agreement with Capital and its affiliates to mutually release each other from all claims that any such parties may have against each other, other than any claims under the property management agreements. On September 4, 1998, the full settlement amounts were paid to AHC and its affiliates with the Company paying $650,000 and Lease I paying $975,000. The Company has pending claims incurred in the normal course of business which, in the opinion of the Company's Board of Directors, will not have a material effect on the financial statements of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-6 ILM II LEASE CORPORATION PART II ITEM 5. MARKET FOR THE REGISTRANT'S SHARES AND RELATED STOCKHOLDER MATTERS Prior to September 1, 1995, the Company was a wholly-owned subsidiary of ILM II. Pursuant to a reorganization and distribution agreement, ILM II capitalized the Company with $500,000, an amount estimated to provide the Company with necessary working capital. On September 1, 1995, MAVRICC Management Systems, Inc., as the distribution agent, caused to be issued on the stock records of the Company the distributed common stock of the Company, in uncertificated form, to the holders of record of ILM II common stock at the close of business on July 14, 1995. One share of the Company's common stock was distributed for each outstanding share of ILM II common stock. No certificates or scrip representing fractional shares of the Company's common stock were issued to holders of ILM II common stock as part of the distribution. In lieu of receiving fractional shares, each holder of ILM II common stock who would otherwise have been entitled to receive a fractional share of the Company's common stock received a cash payment equivalent to $0.14 per share for such fractional interest. At August 31, 1999, there were 3,282 record holders of the Company's shares. The shares do not trade on an established exchange and the only market that has developed is a secondary market; therefore, little resale activity occurs. Although PaineWebber and others may endeavor to assist Shareholders desiring to sell their shares by attempting to match requests to sell shares with requests to purchase shares, such transfers are not expected to be frequent. The Company did not pay cash dividends in fiscal years 1999, 1998 and 1997, and may or may not determine to pay cash dividends in the future. On February 7, 1999, ILM II entered into an agreement and plan of merger with Capital Senior Living Corporation, the corporate parent of Capital, and certain affiliates of Capital. While there can be no assurance, consummation of the merger is presently anticipated in the first quarter of calendar year 2000. In connection with the merger, ILM II has agreed to cause ILM II Holding to cancel and terminate the Facilities Lease Agreement immediately prior to the effective time of the merger. As noted above, the Facilities Lease Agreement, which is scheduled to expire on December 31, 2000, may be terminated earlier at the election of the Lessor in connection with the sale by the Lessor of the Senior Housing Facilities to a non-affiliated third party, upon 30 days' notice to the Company. Although there can be no assurance as to whether the merger will be consummated or, if consummated, as to the timing thereof, the Company's operations would not be expected to continue beyond the effective time of the merger. II-1 ILM II LEASE CORPORATION ITEM 6. SELECTED FINANCIAL DATA ILM II LEASE CORPORATION (Dollars in thousands, except per share data)
For the year ended August 31, 1999 1998 1997 ------------- ------------ ------------ Revenues $ 16,250 $ 15,524 $ 14,433 Income (loss) before income taxes 911 (36) (67) Income tax expense (benefit) 342 (14) (27) ----------- ----------- ----------- Net income (loss) $ 569 $ (22) $ (40) =========== =========== =========== Net income (loss) per share of common stock $ 0.10 $ 0.00 $ (0.01) =========== =========== =========== Total assets $ 2,770 $ 2,733 $ 2,126 =========== =========== =========== Shares outstanding 5,180,952 5,180,952 5,180,952
The above selected financial data should be read in conjunction with the financial statements and related notes appearing in Item 14 in this annual report. II-2 ILM II LEASE CORPORATION ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES The Company was formed in 1995 by ILM II, a publicly-held, non-traded REIT, for the purpose of operating six Senior Housing Facilities under the terms of a Facilities Lease Agreement. ILM II contributed $500,000 in return for all of the issued and outstanding shares of the Company's common stock. ILM II had originally made mortgage loans secured by the Senior Housing Facilities to AHC between July 1990 and July 1992. In March 1993, AHC defaulted under the terms of such mortgage loans and in connection with the settlement of such default, title to the Senior Housing Facilities was transferred, effective April 1, 1994, to certain majority-owned, indirect subsidiaries of ILM II, subject to the mortgage loans. Subsequently, these property-owning subsidiaries of ILM II were merged into ILM II Holding, which is also a majority-owned subsidiary of ILM II. As part of the fiscal 1994 Settlement Agreement with AHC, ILM II Holding retained AHC as the property manager for the Senior Housing Facilities pursuant to the terms of a management agreement which was assigned to the Company as of September 1, 1995. As discussed further below, the management agreement with AHC was terminated in July 1996. ILM II has elected to qualify and be taxed as a REIT under the Internal Revenue Code of 1986, as amended ("the Code"), for each taxable year of operations. In order to maintain its status as a REIT, 75% of ILM II's annual gross income must be Qualified Rental Income as defined by the Code. The rent paid by the residents of the Senior Housing Facilities likely would not be deemed to be Qualified Rental Income because of the extent of services provided to residents. Consequently, the operation of the Senior Housing Facilities by ILM II or its subsidiaries over an extended period of time could adversely affect ILM II's status as a REIT. Therefore, ILM II formed the Company to operate the Senior Housing Facilities, and by means of a distribution, transferred the ownership of the common stock of the Company to the holders of ILM II common stock. Because the Company, which is taxed as a so-called "C" corporation, is no longer a subsidiary of ILM II, it can receive service-related income without endangering the REIT status of ILM II. On September 1, 1995, after ILM II received the required regulatory approval, it distributed all of the outstanding shares of capital stock of the Company to the holders of record of ILM II's common stock. One share of common stock of the Company was issued for each full share of ILM II's common stock held. No fractional shares were issued. Holders of ILM II's common stock were not required to pay any cash or other consideration or to exchange their common stock of ILM II for the common stock of the Company. Prior to the distribution of the Company's stock, ILM II's Shareholders received an information statement fully describing the Company and the distribution of its capital stock. Pursuant to the Facilities Lease Agreement, the Company pays base rent for the use of the Senior Housing Facilities in the aggregate amount of $4,035,600. The facilities lease is a "triple-net" lease whereby the Company, as Lessee, pays all operating expenses, governmental taxes and assessments, utility charges and insurance premiums, as well as the costs of all required maintenance, personal property and non-structural repairs in connection with the operation of the Senior Housing Facilities. ILM II Holding, as Lessor, is responsible for all major capital improvements and structural repairs to the Senior Housing Facilities. Also, any fixed assets of the Company at a Senior Housing Facility would remain with the Senior Housing Facility at the termination of the lease. The Company also pays variable rent, on a quarterly basis, for each Senior Housing Facility in an amount equal to 40% of the excess of the aggregate total revenues for the Senior Housing Facilities, on an annualized basis, over $13,021,000. For the fiscal years ended August 31, 1999 and 1998, variable rent expense was $1,261,000 and $984,000, respectively. As noted above, the Company's Facilities Lease Agreement is scheduled to expire on December 31, 2000. Accordingly, since the Company does not have any current plans to operate or own any other facilities or engage in any other business outside of its relationship with ILM II, there is no assurance that the Company's operations will continue beyond December 2000. The Facilities Lease Agreement may be terminated earlier, however, by ILM II Holding upon 30 days' notice to the Company in connection with a sale to a non-affiliated third party of the Senior Housing Facilities. II-3 ILM II LEASE CORPORATION ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) On July 29, 1996, the Company terminated the management agreement with AHC covering six Senior Housing Facilities leased by the Company (see "Item 3. Legal Proceedings") and retained Capital to be the manager of the Senior Housing Facilities. ILM II has guaranteed payment of all fees due to Capital under the terms of the Management Agreement. Lawrence A. Cohen, who served through July 28, 1998 as a Director of the Company and President, Chief Executive Officer and Director of ILM II, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive Officer and Acting Chief Financial Officer of Capital Senior Living Corporation. As a result, the Management Agreement with Capital was considered a related party transaction through July 28, 1998. Under the terms of the management agreement, Capital earns a base management fee equal to 4% of the gross operating revenues of the Senior Housing Facilities, as defined, as well as an incentive management fee equal to 25% of the amount by which net cash flow of the Senior Housing Facilities, as defined, exceeds a specified base amount. Each August 31, beginning on August 31, 1997, the base amount is increased based on the percentage increase in the Consumer Price Index as well as 15% of facility expansion costs. On February 4, 1997, AHC filed a complaint in the Superior Court of the State of California against Capital, the new property manager; Lawrence A. Cohen, who, through July 28, 1998, was a Director of the Company and President, Chief Executive Officer and Director of ILM II, and others alleging that the defendants intentionally interfered with AHC's agreement (the "California litigation"). The complaint sought damages of at least $2,000,000. On March 4, 1997, the defendants removed the case to Federal District Court in the Central District of California. At a Board meeting on February 26, 1997, the Company's Board of Directors concluded that since all of Mr. Cohen's actions relating to the California litigation were taken either on behalf of the Company under the direction of the Board or as a PaineWebber employee, the Company or its affiliates should indemnify Mr. Cohen with respect to any expenses arising from the California litigation, subject to any insurance recoveries for those expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen totaled $229,000 as of August 31, 1999. The Company's Board also concluded that, subject to certain conditions, the Company or its affiliates should pay reasonable legal fees and expenses incurred by Capital in the California litigation. At August 31, 1999, the amount advanced to Capital by the Company and Lease I for Capital's California litigation costs totaled approximately $563,000. Occupancy levels for the six properties which the Company leases from ILM II Holding averaged 94% and 96% for the years ended August 31, 1999 and 1998, respectively. The Senior Housing Facilities have generated sufficient net cash flow to cover the base rent payments at their current level of $4,035,600 per year since the inception of the Company's operations. Base rent payments of $4,035,600 will remain in effect throughout the remaining term of the lease. As noted above, the Facilities Lease Agreement also provides for the payment of variable rent beginning in January 1997. The Senior Housing Facilities are currently generating gross revenues which are in excess of the specified threshold in the variable rent calculation. Current annualized operating income levels are sufficient to cover the Company's base and variable rent obligations to ILM II Holding. In fiscal years ended August 31, 1999 and 1998, the Company had variable rent expense of $1,261,000 and $984,000, respectively. At August 31, 1999, the Company had cash and cash equivalents of $1,487,000 compared to $1,497,000 at August 31, 1998. This decrease of $10,000 is primarily attributable to the September 4, 1998, payment of the AHC litigation settlement of $650,000 and increased investment in capital improvements, offset by other cash flows provided by operating activities. As noted above, under the terms of the Facilities Lease Agreement, the Lessor is responsible for major capital improvements and structural repairs to the Senior Housing Facilities. Consequently, the company does not have any material commitments for capital expenditures. Furthermore, the Company does not currently anticipate the need to engage in any borrowing activities. As a result, substantially all of the Company's cash flow will be generated from operating activities. The Company did not pay cash dividends in fiscal years 1999, 1998 and 1997. The Company may or may not determine to pay cash dividends in the future. Payment of dividends, if any, will be at the discretion of the Company's Board of Directors and will depend upon II-4 ILM II LEASE CORPORATION ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) such factors as the Company's financial condition, earnings, anticipated investments and other relevant factors. The source of future liquidity is expected to be from operating cash flow from the Senior Housing Facilities, net of the Facilities Lease Agreement payments to ILM II Holding, and interest income earned on invested cash reserves. Such sources of liquidity are expected to be adequate to meet the Company's operating requirements on both a short-term and long-term basis. YEAR 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs or hardware that have date-sensitive software or embedded chips may recognize the year 2000 as a date other than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Based on ongoing assessments, the Company, through Capital, its property manager, has developed a program to modify or replace portions of its software and certain hardware, which are generally PC-based systems, so that those systems will properly recognize and utilize dates beyond December 31, 1999. The Company has completed software upgrades and software and hardware replacement. The Company presently believes that these modifications and replacements of existing software and certain hardware will result in its systems being Year 2000 compliant. The costs of Year 2000 remediation have not been material based on the Company's operations. The Company has assessed its exposure to operating equipment, and such exposure is not significant due to the nature of the Company's business. The Company is not aware of any external agent with a Year 2000 issue that would materially impact the Company's results of operations, liquidity or capital resources. The Company has contacted its only material external agent (Capital) and has received assurances from Capital that it is Year 2000 compliant. Management of the Company believes it has an effective program in place to resolve the Year 2000 issue in a timely manner. As noted above, the Company has substantially completed all necessary phases of its Year 2000 program. However, disruptions in the economy generally resulting from Year 2000 issues could also adversely affect the Company. Although the amount of potential liability and lost revenue cannot be reasonably estimated at this time, in a worst case situation, if Capital, the Company's most significant third party contractor, were to experience a Year 2000 problem, it is likely that the Company would not receive rental income as it became due from Senior Living Facility residents. The Company in turn would fail to pay ILM II Holding lease payments as they arise under the master lease, and ILM II Holding in turn would fail to pay ILM II mortgage payments due it. However, if this were to occur, the Company believes that given the nature of its business, such problem would be temporary and is easily remedied with a simple accounting. II-5 ILM II LEASE CORPORATION ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) RESULTS OF OPERATIONS 1999 COMPARED TO 1998 REVENUES. Total revenues were $16,250,000 for the year ended August 31, 1999 compared to $15,524,000 for the year ended August 31, 1998, representing an increase of $726,000, or 4.7%. Rental and other income from the Company's senior housing operations increased $751,000 or 4.9%, primarily as a result of increases in rental rates at certain other facilities located in strong markets. Interest income decreased $25,000 or 58.1%, to $18,000 in fiscal year 1999, compared to $43,000 in fiscal year 1998, primarily due to a decrease in cash and cash equivalents experienced throughout most of fiscal year 1999. EXPENSES. Total expenses were $15,339,000 in fiscal 1999 compared to $15,560,000 in fiscal 1998, representing a decrease of $221,000 or 1.4%. Although overall expenses remained generally comparable, depreciation expense increased $139,000 or 90.3% due to recognition of changes in remaining useful lives for certain assets purchased in 1999 and prior to conform to the lease expiration date, as such assets are not subject to repurchase by ILM II Holding. Facilities Lease Agreement rent expense increased $277,000 or 5.6% as the result of the increase in variable rents due under the Facilities Lease Agreement. Other increases in expense included administrative salaries, wages and expenses of $106,000 or 9.7%; repairs and maintenance of $82,000 or 14.8%; property management fees of $81,000 or 9.0%; and minor increases in certain other expenses. These increases were offset by a $250,000 or 100% decrease in Termination fee expense and a $655,000 or 74.6% decrease in Professional fees as a result of reduced legal fees subsequent to the AHC litigation settlement. General and administrative costs decreased $95,000 or 29.4% while Director's Compensation decreased $24,000 or 32.0% as a result of fewer Board of Directors meetings. INCOME TAX EXPENSE. Income tax expense increased $356,000 from a benefit of $14,000 in fiscal 1998 to expense of $342,000 in fiscal 1999. NET INCOME (LOSS). Primarily as a result of the factors discussed above, net income increased $591,000 or to net income of $569,000 in fiscal 1999 from a net loss of $22,000 in fiscal 1998. II-6 ILM II LEASE CORPORATION ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 1998 COMPARED TO 1997 REVENUES. Total revenues were $15,524,000 for the year ended August 31, 1998 compared to $14,433,000 for the year ended August 31, 1997, representing an increase of $1,091,000, or 7.6%. Rental and other income from the Company's senior housing operations increased $1,087,000 primarily as a result of improved occupancies in all markets and increases in rental rates at certain other facilities located in strong markets. EXPENSES. Total expenses were $15,560,000 in fiscal 1998 compared to $14,500,000 in fiscal 1997, representing an increase of $1,060,000, or 7.3%. This increase was principally comprised of increases in Facilities Lease Agreement rent expense of $572,000; marketing salaries, wages and expenses of $31,000; repairs and maintenance of $23,000; property management fees of $192,000; and general and administrative expenses of $701,000. These increases in expenses were offset by decreases in dietary and food service salaries, wages and expenses of $25,000; administrative salaries, wages and expenses of $138,000; other property operating expenses of $175,000; termination fee expense of $150,000 (see "Item 3, Legal Proceedings"); advisory fees of $58,000; and minor decreases in certain other expenses. The increase in Facilities Lease Agreement expense is the result of the increase in variable rents due under the Facilities Lease Agreement. General and administrative expense increased as a result of higher AHC litigation expenses in fiscal 1998. The increases in other operating costs cited above were the result of higher operating levels associated with improved occupancies. In addition, total charges to depreciation expense in fiscal 1998 include additional depreciation expense of $36,000 in recognition of changes in the remaining useful life for certain assets purchased in fiscal 1997 and prior to conform to the lease termination date, as such assets are not subject to repurchase by ILM II Holding. INCOME TAX EXPENSE. Income tax benefit decreased from $27,000 in fiscal 1997 to a $14,000 benefit in fiscal 1998. The fiscal 1997 deferred tax provision reflects a reclassification of $160,000 of current tax expense in fiscal 1997, which was ultimately determined to be deductible in fiscal 1998. NET INCOME (LOSS). Primarily as a result of the factors discussed above, net loss decreased from a net loss of $40,000 in fiscal 1997 to a net loss of $22,000 in fiscal 1998. INFLATION The Company completed its fourth full year of operations in fiscal 1999. The effects of inflation and changes in prices on the Company's operating results to date have not been significant. Inflation in future periods is likely to cause increases in the Company's expenses, which may be partially offset by increases in revenues from the tenant leases at the Senior Housing Facilities. Rental revenues may tend to rise with inflation since the rental rates on the tenant leases, which are short-term in nature, can be adjusted to keep pace with inflation as market conditions allow. As noted above, under the terms of the Facilities Lease Agreement between the Company and ILM II Holding, the Company is obligated to pay variable rent, in addition to the base rent owed, in an amount equal to 40% of the excess of total revenues from the Senior Housing Facilities over a specified base amount. Accordingly, to the extent that the total revenues are in excess of this threshold, a portion of the increase in revenues would be payable to ILM II Holding. II-7 ILM II LEASE CORPORATION ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) FORWARD-LOOKING INFORMATION CERTAIN STATEMENTS INCLUDED IN THIS ANNUAL REPORT ON FORM 10-K ("ANNUAL REPORT") CONSTITUTE "FORWARD-LOOKING STATEMENTS" INTENDED TO QUALIFY FOR THE SAFE HARBORS FROM LIABILITY ESTABLISHED BY SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"), AND SECTION 21E OF THE SECURITIES ACT OF 1934, AS AMENDED (THE "EXCHANGE ACT"). THESE FORWARD-LOOKING STATEMENTS GENERALLY CAN BE IDENTIFIED AS SUCH BECAUSE THE CONTEXT OF THE STATEMENT WILL INCLUDE WORDS SUCH AS "BELIEVES," "COULD," "MAY," "SHOULD," "ENABLE," "LIKELY," "PROSPECTS," "SEEK," "PREDICTS," "POSSIBLE," "FORECASTS," "PROJECTS," "ANTICIPATES," "EXPECTS" AND WORDS OF ANALOGOUS IMPORT AND CORRELATIVE EXPRESSIONS THEREOF, AS WELL AS STATEMENTS PRECEDED OR OTHERWISE QUALIFIED BY: "THERE CAN BE NO ASSURANCE" OR "NO ASSURANCE CAN BE GIVEN." SIMILARLY, STATEMENTS THAT DESCRIBE THE COMPANY'S FUTURE PLANS, OBJECTIVES, STRATEGIES OR GOALS ALSO ARE FORWARD-LOOKING STATEMENTS. SUCH STATEMENTS MAY ADDRESS FUTURE EVENTS AND CONDITIONS CONCERNING, AMONG OTHER THINGS, THE COMPANY'S CASH FLOWS, RESULTS OF OPERATIONS AND FINANCIAL CONDITION; THE CONSUMMATION OF ACQUISITION AND FINANCING TRANSACTIONS AND THE EFFECT THEREOF ON THE COMPANY'S BUSINESS, ANTICIPATED CAPITAL EXPENDITURES, PROPOSED OPERATING BUDGETS AND ACCOUNTING RESERVES; LITIGATION; PROPERTY EXPANSION AND DEVELOPMENT PROGRAMS OR PLANS; REGULATORY MATTERS; AND THE COMPANY'S PLANS, GOALS, STRATEGIES AND OBJECTIVES FOR FUTURE OPERATIONS AND PERFORMANCE. ANY SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN SUCH FORWARD-LOOKING STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO A NUMBER OF ASSUMPTIONS REGARDING, AMONG OTHER THINGS, GENERAL ECONOMIC, COMPETITIVE AND MARKET CONDITIONS. SUCH ASSUMPTIONS NECESSARILY ARE BASED ON FACTS AND CONDITIONS AS THEY EXIST AT THE TIME SUCH STATEMENTS ARE MADE, THE PREDICTION OR ASSESSMENT OF WHICH MAY BE DIFFICULT OR IMPOSSIBLE AND, IN ANY CASE, BEYOND THE COMPANY'S CONTROL. FURTHER, THE COMPANY'S BUSINESS IS SUBJECT TO A NUMBER OF RISKS THAT MAY AFFECT ANY SUCH FORWARD-LOOKING STATEMENTS AND ALSO COULD CAUSE ACTUAL RESULTS OF THE COMPANY TO DIFFER MATERIALLY FROM THOSE PROJECTED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. ALL FORWARD-LOOKING STATEMENTS CONTAINED IN THIS ANNUAL REPORT ARE EXPRESSLY QUALIFIED IN THEIR ENTIRETY BY THE CAUTIONARY STATEMENTS IN THIS PARAGRAPH. MOREOVER, THE COMPANY DOES NOT INTEND TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS TO REFLECT ANY CHANGES IN GENERAL ECONOMIC, COMPETITIVE OR MARKET CONDITIONS AND DEVELOPMENTS BEYOND ITS CONTROL. READERS OF THIS ANNUAL REPORT ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON ANY OF THE FORWARD-LOOKING STATEMENTS SET FORTH HEREIN AND THAT ACTUAL RESULTS MAY DIFFER. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data are included under Item 14 of this annual report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-8 ILM II LEASE CORPORATION PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There currently are three Directors of the Company. The Directors are subject to removal by the vote of the holders of a majority of the outstanding shares of the Company's common stock. The Directors are responsible for the general policies of the Company, but they are not required to personally conduct the business of the Company in their capacities as Directors. (a) and (b) The names and ages of the Directors and Executive Officers of the Company during fiscal 1999 are as follows:
Dates NAME OFFICE AGE OF OFFICE Jeffry R. Dwyer President, Secretary and Director 53 9/13/94*-present Julien G. Redele Director 64 7/28/98-present J. William Sharman, Jr. Director 59 9/18/97-present
* The date of incorporation of the Company. (c) There is no family relationship among any of the foregoing Directors or Officers. All of the foregoing Directors and Officers of the Company have been elected to serve until the Company's next annual meeting. (d) The business experience of each of the Directors and Executive Officers of the Company is as follows: JEFFRY R. DWYER is President, Secretary and Director of the Company. Mr. Dwyer has served as President of the Company since March 9, 1999. Mr. Dwyer has been a shareholder of Greenberg Traurig, which has provided legal services to the Company and its affiliates since June 1997. From 1993 to 1997 Mr. Dwyer was a partner with the law firm of Akin, Gump, Strauss, Hauer & Feld in the District of Columbia. Prior to joining Akin, Gump, Strauss, Hauer & Feld, Mr. Dwyer was a partner with the law firm of Morrison & Foerster from 1989 to 1993. Mr. Dwyer also presently serves as Secretary and a Director of ILM I and ILM II and also serves as President, Secretary and Director of Lease I. Mr. Dwyer has written several law review articles and a major treatise on real estate financing and taught Real Estate Planning as an Adjunct Professor at the Georgetown UniversityLaw Center. Mr. Dwyer graduated from Georgetown University and received his law degree from the Georgetown University Law Center. JULIEN G. REDELE is a Director and served as President of the Company from July 28, 1998 through March 9, 1999. Mr. Redele' is one of the original founders ofSFRE, Inc., a Dutch owned real estate investment and development firm which has served since 1963 as advisor to Dutch institutional, corporate and individual investors active in the United States. Mr. Redele serves as a Director of the Island Preservation Partnership. Mr. Redele attended Westersingel Business School, Rotterdam, where he studied economics, law and finance. Mr. Redele' also presently serves as Director of Lease I. J. WILLIAM SHARMAN, JR. is a Director and served as President of the Company from September 18, 1997 through July 28, 1998. Mr. Sharman also presently serves as a Director of Lease I. Mr. Sharman is the Chairman of the Board and CEO of Lancaster Hotels and Resorts, Inc., a hotel management company. Mr. Sharman served for ten years as Chairman of the Board and President of the Lancaster Group, Inc., a real estate development firm based III-1 ILM II LEASE CORPORATION ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (CONTINUED) in Houston, Texas, which is the predecessor of Lancaster Hotel Management, L.C. and Bayou Equities, Inc. Mr. Sharman serves as a Director of Small Luxury Hotels, Ltd. of the United Kingdom, an international hotel marketing and reservations firm, and also serves on the Board of Trustees of St. Edwards University in Austin, Texas. Mr. Sharman also presently serves as President and Director of ILM I and ILM II. He has a Bachelor of Science degree from the University of Notre Dame. (e) Except for the Feldman litigation as discussed below, none of the current Directors and Officers was involved in legal proceedings which are material to an evaluation of his or her ability or integrity as a Director or Officer. On May 8, 1998, Andrew A. Feldman and Jeri Feldman, as Trustees for the Andrew A. & Jeri Feldman Revocable Trust dated September 18, 1990, commenced a purported class action on behalf of that trust and all other shareholders of ILM I and ILM II (affiliates of the Company, as previously discussed) in the Supreme Court of the State of New York, County of New York, naming as defendants ILM I, ILM II and Lawrence A. Cohen, Jeffry R. Dwyer, Julien G. Redele, Carl J. Schramm and J. William Sharman, Jr. as the directors of both corporations. The class action complaint alleged that the directors engaged in wasteful and oppressive conduct and breached fiduciary duties in preventing the sale or liquidation of the assets of ILM I and ILM II, diverting certain of their assets. The complaint sought compensatory damages in an unspecified amount, punitive damages, the judicial dissolution of ILM I and ILM II, an order requiring the directors to take all steps to maximize shareholder value, including either an auction or liquidation, and rescinding certain agreements, and attorney's fees. On July 8, 1998, the defendants moved to dismiss the complaint on all counts. On December 8, 1998, the Court granted the defendants' dismissal motion in part but afforded the plaintiffs leave to amend their complaint. In doing so, the Court accepted the defendants' position that all claims relating to the derivative actions were filed improperly. In addition, the Court dismissed common law claims for punitive damages, but allowed plaintiffs to amend their claims to assert claims alleging that the defendants injured shareholders without injuring ILM I and ILM II as a whole. On January 22, 1999, the Feldman plaintiffs filed an amended complaint, again purporting to commence a class action, and adding claims under Section 10(b) and 20(a) of the Securities and Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Even before the defendants responded to that amended complaint, the Feldman plaintiffs moved for leave to file a second amended complaint to add claims directed at enjoining the announced potential merger on ILM I and ILM II with Capital Senior Living Corporation and, alternatively, for compensatory and punitive damages. At a hearing held on March 4, 1999 relating to the motion for leave to file that second amended complaint and to expedite discovery, the Court granted leave to amend and set a schedule for discovery leading to a trial (if necessary) in the summer of 1999. On March 9, 1999, the Feldman plaintiffs filed a second amended complaint, which included claims for injunctive relief and, in the alternative, damages in an unspecified amount. In response to the defendants' motion to dismiss the second amended complaint, on June 7, 1999 the Court issued an order dismissing the plaintiffs' federal security claims but denying the motion to dismiss plaintiffs' claims for breach of fiduciary duty and judicial dissolution, which motion was addressed to the pleadings and not to the merits of the action. III-2 4 ILM II LEASE CORPORATION ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (CONTINUED) On June 21, 1999, the defendants answered the second amended complaint and denied any and all liability and moved for reconsideration of the portion of the Court's June 7, 1999 order denying their motion to dismiss. In response to discovery requests, ILM I, ILM II and others produced documents to the plaintiffs and depositions of current and former directors and others were taken. Discovery was completed as of July 1, 1999. On July 2, 1999, the parties to this action came to an agreement-in-principle to settle the action. On August 3, 1999, the parties entered into a Stipulation of Settlement and on August 11, 1999, the Court signed an order preliminarily approving the Stipulation and providing for notice of the Stipulation to the proposed settlement class. On September 30, 1999, the Court conducted a hearing and on October 4, 1999 issued an order certifying a settlement class and approving the proposed settlement as fair, reasonable and adequate, subject to the condition that certain modifications be made to the Stipulation of Settlement and any related documents filed with the Court on or before October 15, 1999. On October 15, 1999, the parties entered into a revised Stipulation of Settlement and filed it with the Court, which approved the settlement, by order dated October 21, 1999. In issuing that order the Court entered a final judgement dismissing the action and all non-derivative claims of the settlement class against the defendants with prejudice. In its October 4th order, the Court also denied the application by plaintiffs' counsel for payment of attorneys' fees and expenses, without prejudice to renewal within 14 days upon reapplication therefor. On or about October 14, 1999, plaintiffs' counsel reapplied to the Court for fees and expenses. A hearing was held November 5, 1999, in which the Court granted the application for attorney's fees in the amount of $950,000 and costs in the amount of $182,000. Under the Stipulation, if the proposed merger is consummated, Capital Senior Living Corporation is responsible for payment of such attorney's fees and expenses sought under this application, and if the proposed merger with Capital Senior Living Corporation is not consummated and if ILM I and ILM II enter into a transaction having similar effect to the merger with a third party, then ILM I and ILM II are responsible for such fees and expenses. (f) Compliance With Exchange Act Filing Requirements: The Securities Exchange Act of 1934 requires the Officers and Directors of the Company, and persons who own more than ten percent of the Company's outstanding common stock, to file certain reports of ownership and changes in ownership with the Securities and Exchange Commission. Officers, Directors and ten-percent beneficial holders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms received by it, the Company believes that, during the year ended August 31, 1999, there was compliance with all filing requirements applicable to its Officers and Directors and ten-percent beneficial holders. III-3 ILM II LEASE CORPORATION ITEM 11. EXECUTIVE COMPENSATION The Company's Directors each receive annual compensation of $12,000 plus $500 for attending each Board of Directors meeting and reimbursement for expenses incurred in attending meetings and as a result of other work performed for the Company. Officers of the Company are not compensated. Jeffry R. Dwyer receives compensation from and is a shareholder of Greenberg Traurig, which acts as Counsel to the Company and its affiliates. The former Officers of the Company who were also Officers of PaineWebber received compensation from PaineWebber which indirectly related to services to the Company because the Company was required to pay certain fees to PaineWebber as described in Item 13. When PaineWebber resigned as advisor to the Company, the former officers resigned effective the same date, therefore no services were provided by such persons subsequent to June 18, 1997. Lawrence A. Cohen, who was a Director of the Company until July 28, 1998, received compensation from and was an employee of Capital Senior Living Corporation, an affiliate of Capital, a related party through July 28, 1998. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) As of the date hereof, no person of record owns or is known by the Company to own beneficially more than five percent of the outstanding shares of common stock of the Company. (b) The Directors and Officers of the Company do not have any direct or indirect ownership of shares of the Company's common stock as of the date hereof. (c) There exists no arrangement, known to the Company, the operation of which may at a subsequent date result in a change in control of the Company. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Subject to the supervision of the Company's Board of Directors, assistance in managing the business of the Company was provided by PaineWebber. As previously discussed in Item 1, PaineWebber resigned effective June 18, 1997. Under the advisory agreement, PaineWebber had specific management responsibilities; to perform day-to-day operations of the Company and to act as the investment advisor and consultant for the Company in connection with general policy and investment decisions. PaineWebber received a fee in an amount equal to 0.5% of the gross operating revenue of the facilities. For the years ended August 31, 1999, 1998 and 1997, PaineWebber earned management fees totaling $0, $0 and $58,000, respectively. PaineWebber was reimbursed for direct expenses relating to the administration of the Company. PaineWebber performed certain accounting, tax preparation, securities law compliance and investor communications and relations services for the Company. Included in general and administrative expenses on the accompanying statements of income for the years ended August 31, 1999, 1998 and 1997 are $0, $0 and $59,000, respectively, representing reimbursements to PaineWebber for providing such services to the Company. As discussed in Items 1 and 7, the Company, ILM I, ILM II, and their affiliates accepted the resignation of PaineWebber effective as of June 18, 1997. The Company, ILM I, ILM II, and their affiliates and PaineWebber entered into a transition services agreement pursuant to which PaineWebber would continue to provide certain administrative services to the Company, ILM I, ILM II, and their affiliates through August 31, 1997. III-4 ILM II LEASE CORPORATION ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED) The advisory relationship with PaineWebber ceased on June 18, 1997; therefore, the payment of advisory fees ceased as of that date. Other services, such as accounting, compliance, investor communications and relations, and cash management services ceased on August 31, 1997; therefore, the Company was not obligated to pay service fees past August 31, 1997 to PaineWebber. The Company retained Capital to be the property manager of the Senior Housing Facilities pursuant to a Management Agreement which commenced on July 29, 1996. As discussed in Note 1, Lawrence A. Cohen, who served through July 28, 1998 as a Director of the Company and President, Chief Executive Officer and Director of ILM II, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive Officer and Acting Chief Financial Officer of Capital Senior Living Corporation. Under the Management Agreement, Capital generally is required to perform all operational functions necessary to operate the Senior Housing Facilities other than certain administrative functions. The functions performed by Capital include periodic reporting to and coordination with the Company, leasing the individual units in the Senior Housing Facilities maintaining bank accounts, maintaining books and records, advertising and marketing the Senior Housing Facilities, hiring and supervising on-site personnel, and performing maintenance. Under the terms of the Management Agreement, Capital earns a base management fee equal to 4% of the gross operating revenues of the Senior Housing Facilities, as defined. Capital also earns an incentive management fee equal to 25% of the amount by which the net cash flow of the Senior Housing Facilities, as defined, exceeds a specified base amount. Each August 31, beginning on August 31, 1997, the base amount is increased based on the percentage increase in the Consumer Price Index as well as 15% of Facility expansion costs. ILM II has guaranteed the payment of all fees due to Capital under the terms of the Management Agreement. For the years ended August 31, 1999 and 1998, Capital earned property management fees from the Company of $980,000 and $899,000, respectively. On February 4, 1997, AHC filed a complaint in the Superior Court of the State of California against Capital, the new property manager; Lawrence A. Cohen, who, through July 28, 1998, was a Director of the Company and President, Chief Executive Officer and Director of ILM II, and others alleging that the defendants intentionally interfered with AHC's agreement (the "California litigation"). The complaint sought damages of at least $2,000,000. On March 4, 1997, the defendants removed the case to Federal District Court in the Central District of California. At a Board meeting on February 26, 1997, the Company's Board of Directors concluded that since all of Mr. Cohen's actions relating to the California litigation were taken either on behalf of the Company under the direction of the Board or as a PaineWebber employee, the Company or its affiliates should indemnify Mr. Cohen with respect to any expenses arising from the California litigation, subject to any insurance recoveries for those expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen totaled $229,000 as of August 31, 1999. The Company's Board also concluded that, subject to certain conditions, the Company or its affiliates should pay reasonable legal fees and expenses incurred by Capital in the California litigation. At August 31, 1999, the amount advanced to Capital by the Company and Lease I for Capital's California litigation costs totaled approximately $563,000. III-5 ILM II LEASE CORPORATION ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED) On September 18, 1997, the Company entered into an agreement with Capital Senior Development, Inc., an affiliate of Capital, to manage the development process for the potential expansions of the Senior Housing Facilities. Capital Senior Development, Inc. will receive a fee equal to 7% of the total development costs of these expansions if they are pursued. ILM II Holding will reimburse the Company for all costs related to these potential expansions including fees to Capital Senior Development, Inc. For the years ended August 31, 1999 and 1998, Capital Senior Development, Inc. earned fees from the Company of $15,000 and $73,000, respectively, for managing pre-construction development activities for potential expansions of the Senior Housing Facilities. Jeffry R. Dwyer, President, Secretary and Director of the Company, is a shareholder of Greenberg Traurig, Counsel to the Company and its affiliates since 1997. For the years ended August 31, 1999 and 1998, Greenberg Traurig earned fees from the Company of $54,000 and $153,000, respectively. III-6 ILM II LEASE CORPORATION PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) and (2) FINANCIAL STATEMENTS AND SCHEDULES: The response to this portion of Item 14 is submitted as a separate section of this report. See Index to Financial Statements and Financial Statement Schedules at page F-1. (3) EXHIBITS: The exhibits listed on the accompanying index to exhibits at page IV-3 are filed as part of this Report. (b) Exhibits: See (a)(3) above. (c) Financial Statement Schedules: The response to this portion of Item 14 is submitted as a separate section of this report. See Index to Financial Statements and Financial Statement Schedules at page F-1. IV-1 ILM II LEASE CORPORATION SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ILM II LEASE CORPORATION By: /s/ JEFFRY R. DWYER ------------------------------ Jeffry R. Dwyer President (Principal Accounting Officer) Dated: NOVEMBER 23, 1999 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 Company in the capacity and on the dates indicated. By: /s/ JEFFRY R. DWYER Date: NOVEMBER 23, 1999 -------------------------------- ------------------------------ Jeffry R. Dwyer Director By: /s/ JULIEN G. REDELE Date: NOVEMBER 22, 1999 ------------------------------ ------------------------------ Julien G. Redele Director By: /s/ J. WILLIAM SHARMAN, JR. Date: NOVEMBER 23, 1999 ------------------------------- ------------------------------ J. William Sharman, Jr. Director IV-2 ILM II LEASE CORPORATION ANNUAL REPORT ON FORM 10-K ITEM 14(A)(3) ILM II LEASE CORPORATION INDEX TO EXHIBITS
PAGE NUMBER IN THE REPORT EXHIBIT NO. DESCRIPTION OF DOCUMENT OR OTHER REFERENCE (3) and (4) Registration Statement on Form 10 Filed with the Commission of the Registrant dated July 20, 1995, pursuant to Rule 424(c) and as supplemented incorporated herein by reference (13) Annual Reports to Shareholders No Annual Report for the year ended August 31, 1999 has been sent to the Shareholders. An Annual Report will be sent to the Shareholders subsequent to this filing. (27) Financial Data Schedule Filed as last page of EDGAR submission following the Financial Statements and Financial Statement Schedule required by Item 14.
IV-3 ILM II LEASE CORPORATION ANNUAL REPORT ON FORM 10-K ITEM 14(A)(1) AND (2) AND 14(D) ILM II LEASE CORPORATION INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
REFERENCE --------- ILM II LEASE CORPORATION: Report of Ernst & Young LLP, Independent Auditors F-2 Balance Sheets as of August 31, 1999 and 1998 F-3 Statements of Operations for the years ended August 31, 1999, 1998 and 1997 F-4 Statements of Changes in Shareholders' Equity for the years ended August 31, F-5 1999, 1998 and 1997 Statements of Cash Flows for the years ended August 31, 1999, 1998 and 1997 F-6 Notes to Financial Statements F-7
Financial statement schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements, including the notes thereto. F-1 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Shareholders of ILM II Lease Corporation: We have audited the accompanying balance sheets of ILM II Lease Corporation as of August 31, 1999 and 1998, and the related statements of operations, changes in shareholders' equity, and cash flows for each of the three years in the period ended August 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assisting the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ILM II Lease Corporation at August 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended August 31, 1999, in conformity with generally accepted accounting principles. ERNST & YOUNG LLP Dallas, Texas October 22, 1999 F-2 ILM II LEASE CORPORATION BALANCE SHEETS August 31, 1999 and 1998 (Dollars in thousands, except per share data)
1999 1998 ------- ------- ASSETS Cash and cash equivalents $ 1,487 $ 1,497 Accounts receivables, net 80 89 Accounts receivable - related party 50 102 Prepaid taxes and other assets 352 50 Tax refund receivable 21 158 ------- ------- Total current assets 1,990 1,896 Furniture, fixtures and equipment 1,135 783 Less: accumulated depreciation (518) (225) ------- ------- 617 558 Deposits 9 9 Deferred tax asset, net 154 270 ------- ------- $ 2,770 $ 2,733 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Accounts payable and accrued expenses $ 625 $ 789 Income taxes payable 226 -- Termination fee payable -- 650 Real estate taxes payable 230 209 Accounts payable - related party 337 287 Security deposits 49 25 ------- ------- Total current liabilities 1,467 1,960 Deferred rent payable 37 76 ------- ------- Total liabilities 1,504 2,036 Commitments and contingencies Shareholders' equity: Common stock, $0.01 par value, 20,000,000 shares authorized, 5,180,952 shares issued and outstanding 52 52 Additional paid-in capital 448 448 Retained earnings 766 197 ------- ------- Total shareholders' equity 1,266 697 ------- ------- $ 2,770 $ 2,733 ======= =======
See accompanying notes. F-3 ILM II LEASE CORPORATION STATEMENTS OF OPERATIONS For the years ended August 31, 1999, 1998 and 1997 (Dollars in thousands, except per share data)
1999 1998 1997 --------- --------- -------- REVENUES: Rental and other income $ 16,232 $ 15,481 $ 14,394 Interest income 18 43 39 -------- -------- -------- 16,250 15,524 14,433 EXPENSES: Facilities lease rent expense 5,265 4,988 4,416 Dietary, salaries, wages and food service expenses 2,740 2,677 2,702 Administrative salaries, wages and expenses 1,196 1,090 1,228 Marketing salaries, wages and expenses 705 688 657 Utilities 1,062 1,045 1,051 Repairs and maintenance 636 554 531 Real estate taxes 527 506 511 Property management fees 980 899 707 Other property operating expenses 1,433 1,433 1,389 General and administrative 228 323 216 Directors compensation 51 75 31 Professional fees 223 878 547 Termination fee expense -- 250 400 Advisory fees -- -- 58 Depreciation expense 293 154 56 -------- -------- -------- 15,339 15,560 14,500 -------- -------- -------- Income (loss) before income taxes 911 (36) (67) Income tax expense (benefit): Current 226 -- 191 Deferred 116 (14) (218) -------- -------- -------- 342 (14) (27) -------- -------- -------- NET INCOME (LOSS) $ 569 $ (22) $ (40) ======== ======== ======== NET INCOME (LOSS) PER SHARE OF COMMON STOCK $ 0.10 $ 0.00 $ (0.01) ======== ======== ========
The above net income (loss) per share of common stock is based upon the weighted average number of shares outstanding for the year ended August 31, 1999, 1998 and 1997, of 5,180,952. See accompanying notes. F-4 ILM II LEASE CORPORATION STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended August 31, 1999, 1998 and 1997 (Dollars in thousands, except per share data)
Common Stock $.01 Par Value ---------------------- Additional Paid-in Retained Shares Amount Capital Earning Total ---------- --------- --------- --------- ---------- BALANCE AT AUGUST 31, 1996 5,180,952 $ 52 $ 448 $ 259 $ 759 Net loss -- -- -- (40) (40) --------- --------- --------- --------- --------- BALANCE AT AUGUST 31, 1997 5,180,952 52 448 219 719 Net loss -- -- -- (22) (22) --------- --------- --------- --------- --------- BALANCE AT AUGUST 31, 1998 5,180,952 52 448 197 697 Net income -- -- -- 569 569 --------- --------- --------- --------- --------- BALANCE AT AUGUST 31, 1999 5,180,952 $ 52 $ 448 $ 766 $ 1,266 ========= ========= ========= ========= =========
See accompanying notes. F-5 ILM II LEASE CORPORATION STATEMENTS OF CASH FLOWS For the years ended August 31, 1999, 1998 and 1997 (In thousands)
1999 1998 1997 -------- -------- -------- Cash flows from operating activities: Net income (loss) $ 569 $ (22) $ (40) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities Depreciation expense 293 154 56 Deferred tax expense (benefit), net 116 (14) (218) Changes in assets and liabilities: Accounts receivable, net 9 (34) 5 Accounts receivable - related party 52 (102) (55) Tax refund receivable 137 (158) -- Prepaid taxes and other assets (302) 193 (125) Accounts payable and accrued expenses (164) 242 196 Income taxes payable 226 Accounts payable - related party 50 135 (327) Termination fee payable (650) 250 400 Real estate taxes payable 21 10 (4) Security deposits 24 8 (3) Deferred rent payable (39) (24) (31) ------- ------- ------- Net cash provided by (used in) operating activities 342 638 (146) ------- ------- ------- Cash flows from investing activity: Additions to furniture, fixtures and equipment (352) (297) (289) ------- ------- ------- Net cash used in investing activities (352) (297) (289) ------- ------- ------- Net (decrease) increase in cash and cash equivalents (10) 341 (435) Cash and cash equivalents, beginning of period 1,497 1,156 1,591 ------- ------- ------- Cash and cash equivalents, end of period $ 1,487 $ 1,497 $ 1,156 ======= ======= ======= SUPPLEMENTAL DISCLOSURE: Cash paid during the period for state income taxes $ 5 $ 116 $ 288 ======= ======= =======
See accompanying notes. F-6 ILM II LEASE CORPORATION Notes to Financial Statements 1. ORGANIZATION, RESTRUCTURING, AND NATURE OF OPERATIONS ILM II Lease Corporation ("the Company") was organized as a corporation on September 12, 1994 under the laws of the state of Virginia. Through August 31, 1995, the Company had no significant operations. The Company was formed by ILM II Senior Living, Inc. ("ILM II"), formerly PaineWebber Independent Living Mortgage Inc. II, to operate six rental housing projects that provide independent-living and assisted-living services for independent senior citizens ("the Senior Housing Facilities") under a Facilities Lease Agreement. ILM II initially made mortgage loans to Angeles Housing Concepts, Inc. ("AHC") secured by the Senior Housing Facilities between July 1990 and July 1992. In March 1993, AHC defaulted under the terms of such mortgage loans and in connection with the settlement of such default, title to the Senior Housing Facilities was transferred, effective April 1, 1994, to certain majority-owned, indirect subsidiaries of ILM II, subject to the mortgage loans. Subsequently, the indirect subsidiaries of ILM II were merged into ILM II Holding, Inc. ("ILM II Holding"). As part of the fiscal 1994 settlement agreement with AHC, AHC was retained as the property manager for all of the Senior Housing Facilities pursuant to the terms of a management agreement which was assigned to the Company as of September 1, 1995. As discussed further in Note 6, the management agreement with AHC was terminated in July 1996. ILM II has elected to qualify and be taxed as a Real Estate Investment Trust ("REIT") under the Internal Revenue Code of 1986, as amended ("the Code"), for each taxable year of operations. In order to maintain its status as a REIT, 75% of ILM II's annual gross income must be Qualified Rental Income as defined by the Code. The rent paid by the residents of the Senior Housing Facilities likely would not be deemed to be Qualified Rental Income because of the extent of services provided to residents. Consequently, the operation of the Senior Housing Facilities by ILM II or its subsidiaries over an extended period of time could adversely affect ILM II's status as a REIT. Therefore, ILM II formed the Company to operate the Senior Housing Facilities, and by means of a distribution, transferred the ownership of the common stock of the Company to the holders of ILM II common stock on September 1, 1995 (see Note 4). Because the Company, which is taxed as a so-called "C" corporation, is no longer a subsidiary of ILM II, it can receive service-related income without endangering the REIT status of ILM II. The Company's sole business is the operations of the Senior Housing Facilities. The Company leases the Senior Housing Facilities from ILM II Holding, which is now a subsidiary of ILM II that holds title to the Senior Housing Facilities, pursuant to a Facilities Lease Agreement. Such lease is scheduled to expire on December 31, 2000 (December 31, 1999 with respect to the Santa Barbara Facility) (see Note 5), unless terminated earlier at the election of the Lessor in connection with the sale of the Senior Housing Facilities to a non-affiliated third party, upon 30 days' notice to the Company. ILM II has entered into an agreement and plan of merger with Capital Senior Living Corporation and certain affiliates of Capital, and has agreed to cause ILM II Holding to cancel and terminate the Facilities Lease Agreement immediately prior to the effective time of the merger. While there can be no assurance, consummation of the merger is presently anticipated in the first quarter of calendar year 2000. The lease is accounted for as an operating lease in the Company's financial statements. In July 1996, following the termination of the property management agreement with AHC, the Company entered into a property management agreement (the "Management Agreement") with Capital Senior Management 2, Inc. ("Capital") to handle the day-to-day operations of the Senior Housing Facilities. Lawrence A. Cohen, who served through July 28, 1998 as a Director of the Company and President, Chief Executive Officer and Director of ILM II, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive Officer and Acting Chief Financial Officer of Capital Senior Living Corporation. As a result, the Management Agreement with Capital was considered a related party transaction through July 28, 1998 (see Note 3). F-7 ILM II LEASE CORPORATION Notes to Financial Statements (continued) 1. ORGANIZATION, RESTRUCTURING, AND NATURE OF OPERATIONS (CONTINUED) On February 7, 1999, ILM I entered into an agreement and plan of merger with Capital Senior Living Corporation, the corporate parent of Capital, and certain affiliates of Capital. Although there can be no assurance as to whether the merger will be consummated or, if consummated, as to the timing thereof, the Company's operations would not be expected to continue beyond the effective time of the merger. 2 USE OF ESTIMATES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of August 31, 1999 and 1998 and revenues and expenses for the years ended August 31, 1999, 1998 and 1997. Actual results could differ from the estimates and assumptions used. Furniture, fixtures and equipment are carried at the lower of cost, reduced by accumulated depreciation, or fair value in accordance with FAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets To Be Disposed Of." Depreciation expense was provided on a straight-line basis using an estimated useful life of 3 to 5 years through fiscal year 1997. In 1998, the Company changed the estimated useful lives of its assets to the lease termination date of December 31, 2000, as such assets are not subject to repurchase by ILM II Holding. For fiscal year 1998, this increased depreciation expense by $36,000. Units at the Senior Housing Facilities are generally rented for terms of twelve months or less. The base rent charged varies depending on the unit size, with added fees collected for more than one occupant per unit and for assisted living services. Included in the amount of base rent charged are certain meals, housekeeping, medical and social services provided to the residents of each Senior Housing Facility. The Company rents the Senior Housing Facilities from ILM II Holding pursuant to a multi-year operating lease. Rent expense is recognized on a straight-line basis over the term of the lease agreement. Deferred rent payable represents the difference between rent expense recognized on a straight-line basis and cash paid for rent pursuant to the terms of the lease agreement. The Company's policy is to expense all advertising costs as incurred. For the years ended August 31, 1999, 1998 and 1997, advertising expenses were $705,000, $688,000 and $657,000, respectively. The cash and cash equivalents, receivables, accounts payable and accrued liabilities appearing on the accompanying balance sheets represent financial instruments for purposes of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments." The carrying amount of these assets and liabilities approximates their fair value as of August 31, 1999 due to the short-term nature of these instruments. Income tax expense is provided for using the liability method as prescribed by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." For purposes of reporting cash flows, cash and cash equivalents include all highly liquid investments with original maturities of 90 days or less. F-8 ILM II LEASE CORPORATION Notes to Financial Statements (continued) 3. RELATED PARTY TRANSACTIONS The Company entered into an advisory agreement (the "Advisory Agreement") with PaineWebber Lease Advisor, L.P. For discussion purposes, PaineWebber Lease Advisors L.P. and all affiliates of PaineWebber will be collectively referred to as PaineWebber ("PaineWebber"). PaineWebber served in this capacity through June 18, 1997. Subject to the supervision of and pursuant to the general policies set by the Company's Board of Directors, assistance in the managing of the business of the Company was provided by PaineWebber. Under the Advisory Agreement, the Company engaged PaineWebber and PaineWebber agreed to use its best efforts to manage the day-to-day affairs and operations of the Company and to provide administrative services and facilities appropriate for such management. The specific duties of PaineWebber under the Advisory Agreement included recommending selections of providers of professional and specialized services and handling other managerial functions with respect to the Senior Housing Facilities. PaineWebber was also obligated to provide office and clerical facilities adequate for the Company's operations and to provide, or obtain others to provide, accounting, custodial, funds collection and payment, stockholder communications, legal and other services necessary in connection with the Company's operations. The Advisory Agreement also obligated PaineWebber to handle or arrange for the handling of the Company's financial and other records. PaineWebber received a base fee in an amount equal to 0.5% of the gross operating revenues of the Senior Housing Facilities operated by the Company as compensation for its services. This fee amounted to $0, $0 and $58,000 for the years ended August 31, 1999, 1998 and 1997, respectively. In addition, PaineWebber is entitled to reimbursement for expenses incurred in providing certain financial, accounting and investor communication services to the Company. Included in general and administrative expense for the year ended August 31, 1999, 1998 and 1997, are $0, $0 and $59,000, respectively, representing reimbursements to PaineWebber for providing such services to the Company. In performing its services under the Advisory Agreement, PaineWebber was required to pay certain employment expenses of its personnel, certain expenses of employees and agents of PaineWebber and of directors, officers and employees of the Company who are also employees of PaineWebber or its affiliates, and certain of its overhead and miscellaneous administrative expenses relating to performance of its functions under the Advisory Agreement. The Company was responsible for reimbursing out-of-pocket expenses of directors, officers and employees of the Company incurred by them exclusively in such capacity and for all other costs of its operations. The Company retained Capital to be the property manager of the Senior Housing Facilities pursuant to a Management Agreement which commenced on July 29, 1996. As discussed in Note 1, Lawrence A. Cohen, who served through July 28, 1998 as a Director of the Company and President, Chief Executive Officer and Director of ILM II, has also served in various management capacities at Capital Senior Living Corporation, an affiliate of Capital, since 1996. Mr. Cohen currently serves as Chief Executive of Capital Senior Living Corporation. Under the Management Agreement, Capital generally is required to perform all operational functions necessary to operate the Senior Housing Facilities other than certain administrative functions. The functions performed by Capital include periodic reporting to and coordinating with the Company, leasing the individual units in the Senior Housing Facilities, maintaining bank accounts, maintaining books and records, advertising and marketing the Senior Housing Facilities, hiring and supervising on-site personnel, and performing maintenance. Under the terms of the Management Agreement, Capital earns a base management fee equal to 4% of the gross operating revenues of the Senior Housing Facilities, as defined. Capital also earns an incentive management fee equal to 25% of the amount by which the net cash flow of the Senior Housing Facilities, as defined, exceeds a specified base amount. Each August 31, beginning on August 31, 1997, the base amount is increased based on the percentage increase in the Consumer Price Index as well as 15% of Facility expansion costs. ILM II has guaranteed the payment of all fees due to Capital under the terms of the Management Agreement. For the years ended August 31, 1999, 1998 and 1997, Capital earned property management fees from the Company of $980,000, $899,000 and $707,000, respectively. F-9 ILM II LEASE CORPORATION Notes to Financial Statements (continued) 3. RELATED PARTY TRANSACTIONS (CONTINUED) On February 4, 1997, AHC filed a complaint in the Superior Court of the State of California against Capital, the new property manager; Lawrence A. Cohen, who, through July 28, 1998, was a Director of the Company and President, Chief Executive Officer and Director of ILM II, and others alleging that the defendants intentionally interfered with AHC's agreement (the "California litigation"). The complaint sought damages of at least $2,000,000. On March 4, 1997, the defendants removed the case to Federal District Court in the Central District of California. At a Board meeting on February 26, 1997, the Company's Board of Directors concluded that since all of Mr. Cohen's actions relating to the California litigation were taken either on behalf of the Company under the direction of the Board or as a PaineWebber employee, the Company or its affiliates should indemnify Mr. Cohen with respect to any expenses arising from the California litigation, subject to any insurance recoveries for those expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen totaled $229,000 as of August 31, 1999. The Company's Board also concluded that, subject to certain conditions, the Company or its affiliates should pay reasonable legal fees and expenses incurred by Capital in the California litigation. At August 31, 1999, the amount advanced to Capital by the Company and Lease I for Capital's California litigation costs totaled approximately $563,000. On September 18, 1997, the Company entered into an agreement with Capital Senior Development, Inc., an affiliate of Capital, to manage the development process for the potential expansions of the Senior Housing Facilities. Capital Senior Development, Inc. will receive a fee equal to 7% of the total development costs of these expansions if they are pursued. ILM II Holding will reimburse the Company for all costs related to these potential expansions including fees to Capital Senior Development, Inc. For the years ended August 31, 1999 and 1998, Capital Senior Development, Inc. earned fees from the Company of $15,000 and $73,000, respectively, for managing pre-construction development activities for potential expansions of the Senior Housing Facilities. Jeffry R. Dwyer, President, Secretary and Director of the Company, is a shareholder of Greenberg Traurig, Counsel to the Company and its affiliates since 1997. For the years ended August 31, 1999 and 1998, Greenberg Traurig earned fees from the Company of $54,000 and $153,000, respectively. Accounts receivable - related party at August 31, 1999 includes $30,349 expense reimbursement due from ILM II Holding for the balance of the Ft. Myers roof replacement and $20,000 in other reimbursable costs due from ILM II Holding. Accounts receivable - related party at August 31, 1998 is an insurance refund due to the Company from Lease I in the amount of $102,000 which was reimbursed to the Company during fiscal 1999. Accounts payable - related party at August 31, 1999 and 1998 includes $337,000 and $287,000, respectively, for variable rent due to ILM II Holding. 4. CAPITAL STOCK Prior to September 1, 1995, the Company was a wholly-owned subsidiary of ILM II. Pursuant to a reorganization and distribution agreement, ILM II capitalized the Company with $500,000, an amount estimated to provide the Company with necessary working capital. On September 1, 1995, MAVRICC Management Systems, Inc., as the distribution agent, caused to be issued on the stock records of the Company the distributed Common Stock of the Company, in uncertificated form, to the holders of record of ILM II Common Stock at the close of business on July 14, 1995. One share of the Company's Common Stock was distributed for each outstanding share of ILM II Common Stock. No certificates or scrip representing fractional shares of the Company's Common Stock were issued to holders of ILM II Common Stock as part of the distribution. In lieu of receiving fractional shares, each holder of ILM II Common Stock who would otherwise have been entitled to receive a fractional share of the Company's Common Stock received a cash payment equivalent to $0.14 per share for such fractional interest. F-10 ILM II LEASE CORPORATION Notes to Financial Statements (continued) 5. THE FACILITIES LEASE AGREEMENT ILM II Holding (the "Lessor"), a majority-owned subsidiary of ILM II, leases the Senior Housing Facilities to the Company (the "Lessee"), pursuant to a Facilities Lease Agreement. Such lease is scheduled to expire on December 31, 2000 (December 31, 1999 with respect to the Santa Barbara Facility) unless terminated earlier at the election of the Lessor in connection with the sale of the Senior Housing Facilities to a non-affiliated third party, upon 30 days' notice to the Company. ILM II has entered into an agreement and plan of merger with Capital Senior Living Corporation and certain affiliates of Capital, and has agreed to cause ILM II Holding to cancel and terminate the Facilities Lease Agreement immediately prior to the effective time of the merger. While there can be no assurance, consummation of the merger is presently anticipated in the first quarter of calendar year 2000. The lease is accounted for as an operating lease in the Company's financial statements. Descriptions of the properties covered by the Facilities Lease Agreement between the Company and ILM II Holding are summarized as follows:
Year Facility Rentable Resident Name Location Built Units (2) Capacity (2) ---- -------- ----- --------- ------------ The Palms Fort Myers, FL 1988 205 255 Crown Villa Omaha, NE 1992 73 73 Overland Park Place Overland Park, KS 1984 141 153 Rio Las Palmas Stockton, CA 1988 164 190 The Villa at Riverwood St. Louis County, MO 1986 120 140 Villa Santa Barbara (1) Santa Barbara, CA 1979 125 125
(1) The Company operates Villa Santa Barbara under a co-tenancy arrangement with an affiliated company, ILM I Lease Corporation ("Lease I"). The Company has entered into an agreement with Lease I regarding such joint tenancy. Lease I was formed for similar purposes as the Company by an affiliated company, ILM Senior Living, Inc. ("ILM I"), a subsidiary of which owns 25% of the Villa Santa Barbara property. The portion of the Senior Housing Facility leased by the Company represents 75% of the total project. Villa Santa Barbara is 25% owned by ILM Holding Inc. and 75% by ILM II Holding, Inc., a direct subsidiary of ILM II, as tenants in common. Upon the sale of ILM I or ILM II, arrangements would be made to transfer the Santa Barbara facility to the non-selling joint tenant (or one of its subsidiaries). The property was extensively renovated in 1995. (2) Rentable units represent the number of apartment units and is a measure commonly used in the real estate industry. Resident capacity equals the number of bedrooms contained within the apartment units and corresponds to measures commonly used in the healthcare industry. F-11 ILM II LEASE CORPORATION Notes to Financial Statements (continued) 5. THE FACILITIES LEASE AGREEMENT (CONTINUED) Pursuant to the Facilities Lease Agreement, the Company pays annual base rent for the use of all of the Senior Housing Facilities in the aggregate amount of $4,035,600. The facilities lease is a "triple-net" lease whereby the Lessee pays all operating expenses, governmental taxes and assessments, utility charges and insurance premiums, as well as the costs of all required maintenance, personal property and non-structural repairs in connection with the operation of the Senior Housing Facilities. ILM II Holding, as the Lessor, is responsible for all major capital improvements and structural repairs to the Senior Housing Facilities. Also, any fixed assets of the Company at a Senior Housing Facility would remain with the Senior Housing Facility at the termination of the lease. The Company also pays variable rent, on a quarterly basis, for each Senior Housing Facility in an amount equal to 40% of the excess of the aggregate total revenues for the Senior Housing Facilities, on an annualized basis, over $13,021,000. For the fiscal years ended August 31, 1999 and 1998, variable rent expense was $1,261,000 and $984,000, respectively. The Company's use of the properties is limited to use as a Senior Housing Facility. The Company has responsibility to obtain and maintain all licenses, certificates and consents needed to use and operate each Facility, and to use and maintain each Senior Housing Facility in compliance with all local board of health and other applicable governmental and insurance regulations. The Senior Housing Facilities located in California, Florida and Kansas are licensed by such states to provide assisted living services. Also, various health and safety regulations and standards which are enforced by state and local authorities apply to the operation of all of the Senior Housing Facilities. Violations of such health and safety standards could result in fines, penalties, closure of a Senior Housing Facility or other sanctions. 6. LEGAL PROCEEDINGS AND CONTINGENCIES A management agreement between ILM II Holding and AHC which covered the management of all six Senior Housing Facilities was assigned to the Company effective September 1, 1995. On July 29, 1996, the Company and ILM II Holding ("the Companies") terminated the property management agreement with AHC. The management agreement was terminated for "cause" pursuant to the terms of the contract. Simultaneously with the termination of the management agreement, the Companies, together with certain affiliated entities, filed suit against AHC in the United States District Court for the Eastern District of Virginia for breach of contract, breach of fiduciary duty and fraud. The Company and ILM II Holding alleged, among other things, that AHC willfully performed actions specifically in violation of the agreement and that such actions caused damages to the Companies. Due to the termination of the management agreement for cause, no termination fee was paid to AHC. Subsequent to the termination of the agreement, AHC filed for protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic State of California. The filing was challenged by the Companies, and the Bankruptcy Court dismissed AHC's case effective October 15, 1996. In November 1996, AHC filed with the Virginia District Court an Answer in response to the litigation initiated by the Companies and a counterclaim against ILM II Holding. The counterclaim alleged that the agreement was wrongfully terminated for cause and requested damages which include the payment of the termination fee in the amount of $750,000, payment of management fees pursuant to the contract from August 1, 1996 through October 15, 1996, which is the earliest date that the management agreement could have been terminated without cause, and recovery of attorney's fees and expenses. F-12 ILM II LEASE CORPORATION Notes to Financial Statements (continued) 6. LEGAL PROCEEDINGS AND CONTINGENCIES (CONTINUED) The aggregate amount of damages against all parties as requested in AHC's counterclaim exceeded $2,000,000. On June 13, 1997 and July 8, 1997, the court issued orders to enter judgment against ILM I and ILM II in the amount of $1,000,000. The orders do not contain any findings of fact or conclusions of law. On July 10, 1997, the Company, ILM I, ILM II and Lease I filed a notice of appeal to the United States Court of Appeals for the Fourth Circuit from the orders. On February 4, 1997, AHC filed a complaint in the Superior Court of the State of California against Capital, the new property manager; Lawrence A. Cohen, who, through July 28, 1998, was a Director of the Company and President, Chief Executive Officer and Director of ILM II, and others alleging that the defendants intentionally interfered with AHC's agreement (the "California litigation"). The complaint sought damages of at least $2,000,000. On March 4, 1997, the defendants removed the case to Federal District Court in the Central District of California. At a Board meeting on February 26, 1997, the Company's Board of Directors concluded that since all of Mr. Cohen's actions relating to the California litigation were taken either on behalf of the Company under the direction of the Board or as a PaineWebber employee, the Company or its affiliates should indemnify Mr. Cohen with respect to any expenses arising from the California litigation, subject to any insurance recoveries for those expenses. Legal fees paid by the Company and Lease I on behalf of Mr. Cohen totaled $229,000 as of August 31, 1999. The Company's Board also concluded that, subject to certain conditions, the Company or its affiliates should pay reasonable legal fees and expenses incurred by Capital in the California litigation. At August 31, 1999, the amount advanced to Capital by the Company and Lease I for Capital's California litigation costs totaled approximately $563,000. On August 18, 1998, the Company and its affiliates along with Capital and its affiliates entered into a Settlement Agreement with AHC. The Company and Lease I agreed to pay $1,625,000 and Capital and its affiliates agreed to pay $625,000 to AHC in settlement of all claims including those related to the Virginia litigation and the California litigation. The Company and its affiliates also entered into an agreement with Capital and its affiliates to mutually release each other from all claims that any such parties may have against each other, other than any claims under the property management agreements. On September 4, 1998, the full settlement amounts were paid to AHC and its affiliates with the Company paying $650,000 and Lease I paying $975,000. The Company has pending claims incurred in the normal course of business which, in the opinion of the Company's management, will not have a material effect on the financial statements of the Company. F-13 ILM II LEASE CORPORATION Notes to Financial Statements (continued) 7. FEDERAL INCOME TAXES The Company is taxable as a so-called "C" corporation and, therefore, its income is subject to tax at the federal and state levels. The Company reports on a calendar year for tax purposes. Income taxes at the appropriate statutory rates have been provided for in the accompanying financial statements. Deferred income tax benefit reflects the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company's deferred tax assets and liabilities as of August 31, 1999 and 1998, are comprised of the following amounts (in thousands):
1999 1998 ---- ---- Deferred tax asset - straight-line rent expense $ 15 $ 28 Deferred tax asset - book over tax depreciation 124 44 Deferred tax asset - book over tax amortization 15 30 Net operating loss carryforward -- 168 ---- ---- ---- Net deferred tax asset $154 $270 ==== ====
The components of income tax expense (benefit) for fiscal 1999, 1998 and 1997 are as follows (in thousands):
1999 1998 1997 --------- --------- --------- Current: Federal $ -- $ -- $ 162 State -- -- 29 ----- ----- ----- Total current -- -- 191 ----- ----- ----- Deferred: Federal 293 (12) (185) State 49 (2) (33) ----- ---- ----- Total deferred 342 (14) (218) ----- ------ ----- $ 342 $ (14) $ (27) ===== ====== ======
The reconciliation of income tax computed for fiscal 1999, 1998 and 1997, at U.S. federal statutory rates to income tax expense (benefit) is as follows (in thousands):
1999 1998 1997 ---------------- ---------------- ----------------- Tax at U.S. statutory rates $ 293 34% (12) (34%) $ (23) (34%) State income taxes, net of federal tax benefit 49 6% (2) (6%) (4) (6%) ----- ----- ----- ----- ----- ----- $ 342 40% $ (14) (40%) $ (27) (40%) ===== ===== ===== ===== ===== =====
F-14 EX-27 2 EXHIBIT 27
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE BALANCE SHEET AS OF AUGUST 31, 1999 AND THE STATEMENT OF INCOME FOR THE PERIOD ENDED AUGUST 31, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS AUG-31-1999 AUG-31-1999 1,487 0 503 5 0 1,990 1,135 518 2,770 1,467 0 0 0 52 1,214 2,770 0 16,250 0 15,339 0 0 0 911 342 569 0 0 0 569 .10 .10
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