-----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, HHQDf7jxpY0PsILUxQyhkFvT65qfkXpurD1raeRUdpshv07Be6BvJQfKrpzG8EdJ pBEBHsbEciQdOtEyoHezLg== 0000891618-98-000906.txt : 19980227 0000891618-98-000906.hdr.sgml : 19980227 ACCESSION NUMBER: 0000891618-98-000906 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980226 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: HNC SOFTWARE INC/DE CENTRAL INDEX KEY: 0000945093 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 330248788 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 000-26146 FILM NUMBER: 98549689 BUSINESS ADDRESS: STREET 1: 5930 CORNERSTONE CT W CITY: SAN DIEGO STATE: CA ZIP: 92121-3728 BUSINESS PHONE: 6195468877 MAIL ADDRESS: STREET 1: 5930 CORNERSTONE CT WEST CITY: SAN DIEGO STATE: CA ZIP: 92121-3728 10-K/A 1 AMENDMENT TO FORM 10-K 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K/A-1 (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM __________ TO __________. COMMISSION FILE NUMBER 0-26146 HNC SOFTWARE INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 33-0248788 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
5930 CORNERSTONE COURT WEST, SAN DIEGO, CA 92121 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (619) 546-8877 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, $0.001 PAR VALUE (TITLE OF CLASS) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] 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. [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant, based on the closing price as reported on the Nasdaq Stock Market at January 30, 1998, was approximately $809 million. The number of shares of the Registrant's Common Stock outstanding at January 30, 1998 was 24,570,578 shares. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for Registrant's 1998 Annual Meeting of Stockholders to be filed with the Commission on or before April 30, 1998 are incorporated by reference in Part III of this Annual Report on Form 10-K. With the exception of those portions that are specifically incorporated by reference in this Annual Report on Form 10-K, such Proxy Statement shall not be deemed filed as part of this Report or incorporated by reference herein. ================================================================================ 2 TABLE OF CONTENTS
PAGE NO. -------- PART I Item 1. Business........................................................................... 3 Item 2. Properties......................................................................... 24 Item 3. Legal Proceedings.................................................................. 24 Item 4. Submission of Matters to a Vote of Security Holders................................ 24 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters.......... 24 Item 6. Selected Financial Data............................................................ 25 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations......................................................................... 27 Item 7A. Quantitative and Qualitative Disclosures About Market Risk......................... 34 Item 8. Financial Statements and Supplementary Data........................................ 35 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure......................................................................... 56 PART III Item 10. Directors and Executive Officers of the Registrant................................. 56 Item 11. Executive Compensation............................................................. 57 Item 12. Security Ownership of Certain Beneficial Owners And Management..................... 57 Item 13. Certain Relationships and Related Transactions..................................... 57 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports On Form 8-K.................... 57
ProfitMax(R) is a registered trademark of the Company. CRLink(TM), CompCompare(TM), ProviderCompare(TM), PMA Advisor(TM), VeriComp(TM), MIRA(TM), Falcon(TM), Falcon Export(TM), Falcon Select(TM), Falcon Debit(TM), Falcon Retail(TM ), Falcon Sentry(TM), Eagle(TM), Capstone(TM), Capstone for Payment Cards(TM), Capstone for Consumer Lending(TM), Capstone for Mortgage Lending(TM), ProfitMax Bankruptcy(TM), AREAS(TM), Retek Merchandising System(TM), Retek Data Warehouse(TM), Active Retail Intelligence(TM), Retek Demand Forecasting(TM), Falcon Retail(TM), MatchPlus(TM), SelectCast(TM), SelectResponse(TM) and SelectResource(TM) are trademarks of the Company. All other trademarks or trade names referred to in this Report are the property of their respective owners. The latest news and information about the Company can be found on the HNC Software World Wide Web site: http://www.hncs.com and can also be accessed by calling our Stockholder Information Line at 1-800-396-8052. The Company was founded in 1986 under the laws of California and was reincorporated in June 1995 under the laws of Delaware. The Company's principal executive offices are located at 5930 Cornerstone Court West, San Diego, California 92121-3728, and its telephone number is (619) 546-8877. In this Report, the terms "HNC," the "Company" and the "Registrant" each refer to HNC Software Inc., a Delaware corporation, and its consolidated subsidiaries unless the context otherwise requires. RISK FACTORS This Report (including without limitation the following Risk Factors) contains forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act") regarding the Company and its business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Report. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements. Although forward-looking statements in this Report reflect the good faith judgment of the Company's management, such statements can only be based on facts and factors currently known by the Company. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include without limitation those discussed below as well as those discussed elsewhere in this Report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Report. The Company undertakes no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Report. Readers are urged to carefully review and consider the various disclosures made by the Company in this Report, which attempts to advise interested parties of the risks and factors that may affect the Company's business, financial condition and results of operations and prospects. 2 3 PART I ITEM 1. BUSINESS HNC develops, markets and supports predictive software solutions for leading service industries. These predictive software solutions employ proprietary neural-network predictive decision engines, profiles, traditional statistical modeling, business models, expert rules and context vectors to convert existing data and business experiences into meaningful recommendations and actions. Just as manufacturing organizations have implemented manufacturing resource planning ("MRP") software to automate routine transactions, leading service industries such as the health-care/insurance, financial services and retail industries are using predictive software solutions to improve profitability, competitiveness and customer satisfaction. INDUSTRY BACKGROUND Today's competitive business environment has forced many service companies to increase business efficiency while improving their flexibility and responsiveness to changing market conditions. Businesses continually seek new ways to make better decisions by collecting and analyzing data. Consequently, service companies have made, and continue to make, significant investments in computer systems designed to gather and electronically store ever increasing amounts of data. In most cases, these computerized systems automate manual tasks and activities, resulting in the conversion of significant amounts of corporate data from paper to electronic form. However, these systems generally do not synthesize data in ways that help businesses make better real-time decisions. Historically, the development of predictive software solutions was inhibited by the lack of computing standards and effective computational intelligence techniques. The emergence of client-server standards, including relational database management systems, the Windows operating system and network communications protocols, has fostered the increased transmission and dissemination of electronically stored data within and among businesses. MRP software systems were developed to automate production, accounting, human resources and distribution transactions for primarily manufacturing organizations. These systems manage and store large amounts of diverse business information, providing continuous and simultaneous availability of information to geographically dispersed employees, customers and suppliers. However, MRP systems generally do not provide businesses with the functionality and flexibility needed to utilize this data to simulate operations and make real-time decisions and recommendations in diverse and rapidly changing business environments. Several service industries have a particular need to leverage large volumes of real-time transactional and operational data in order to address systemic issues that have historically affected profitability, competitiveness and customer satisfaction. These industries and issues include: - HEALTHCARE/INSURANCE INDUSTRY. Workers' compensation fraud and abuse is currently receiving widespread attention in the healthcare/insurance industry. Conning & Co. recently estimated that 10%-25% of the dollar amount of filed workers' compensation claims in the United States are fraudulent. This translates to more than $5 billion lost each year to workers' compensation fraud. - FINANCIAL SERVICES INDUSTRY. Based on reports from Visa and Mastercard, Faulkner & Gray estimates that United States credit card credit losses and chargeoffs were $18 billion in 1996. - RETAIL INDUSTRY. Rapid changes in consumer buying patterns have caused merchants to place increased emphasis on predicting consumer demand and managing retail inventories. The change from mass to individual retail marketing has multiplied the number of promotional offers and stock-keeping units ("SKUs") required to address market opportunities. The U.S. Department of Commerce estimates that the inventory carrying costs for retail inventories nationwide were $316 billion at the end of March 1997. Historically, many companies in the healthcare/insurance, financial services and retail industries have developed specialized in-house applications to address these issues. Such applications are generally designed to access large volumes of operational and transactional data stored on mainframe computers. However, such 3 4 systems are expensive, costly to support and maintain, and do not offer flexible and enterprise-wide access to data. Furthermore, most of these systems are not designed to meet the need for real-time recommendations and actions. The widespread adoption of distributed client-server computing has provided organizations with a much greater ability to access and manipulate stored information but also has created the need for third-party vendors of packaged applications software solutions that provide the same degree of functionality and reliability as traditional in-house applications. These vendors are able to provide a higher degree of functionality and reliability than traditional in-house applications by combining the domain knowledge from their customers and partners with expertise in computational intelligence and client-server technologies. THE HNC SOLUTION HNC's predictive software solutions enable leading service industries, such as the healthcare/insurance, financial services and retail industries, to analyze and act upon operational and transactional data in real time. The Company's products provide the following benefits: Core predictive software technology. The Company's software includes a variety of computational intelligence technologies such as proprietary neural-network predictive decision engines, profiles, traditional statistical modeling, business models, expert rules and context vectors, that can be customized to specific business applications. Neural networks can be adapted to changing environments and applications quickly and have proven to be accurate and effective in real-time operating environments. The Company's decision engine also includes a user-defined rule-based technology. The neural networks and rulebases are delivered through software that allows the Company's products to adapt to many customer-specific business needs without extensive custom programming. Adaptable functions include workflow queuing management, policy and procedure guidelines, input data modification, flexible graphical user interface ("GUI") display, decision criteria and report formats. Quick payback for customers. The Company's software solutions are designed for quick customer payback. The Company typically installs its products in two to six months, and customer payback periods for installation and first year usage fees are typically less than one year. Payback is rapid because the software products address applications that have a significant profit impact. HNC personnel focus not only on the technical integration, but also on delivering direct benefits to the customer throughout the service contract period. Transaction-based, real-time decision capability. HNC's software can operate in real time, providing an immediate, situation-specific response to each customer transaction. For example, the Falcon system for credit/debit card fraud detection can monitor millions of transactions each day, identify fraudulent transactions in progress and permit the card issuing bank to withhold an authorization before the perpetrator completes a purchase. The Falcon system differs from traditional modeling implementations, which operate in a batch or off-line mode on a collection of historical transactions. Flexible client-server solutions. HNC's solutions can be integrated into a customer's existing environment or architecture. The Company's products are available on industry-standard, client-server platforms, including Windows and UNIX clients, NetWare, Windows NT, UNIX and CICS servers and IBM, Oracle, Sybase and Informix databases. HNC's application products represent a complete software solution, including decision models, deployment software, communications interfaces and GUIs. The Company also supplies systems integration, ongoing performance analysis, model rebuilding and application consulting services to help ensure ongoing success for the customer. The Company believes that this flexible combination of products, services and deployment platforms represents an advance that enables successful predictive software system deployment in many mission-critical applications. Turnkey, customized and user-developed model options. The choice of data source is important to customers because data are the fundamental building blocks used to create accurate predictive models. HNC provides various models built on industry-specific or customer-specific data to meet individual application requirements. Customers and data suppliers provide the Company with historical transaction data for turnkey models, trend analyses and product updates. This combination of proprietary turnkey (from data and 4 5 individual consumer profiles), customized and user-developed models allows the Company to offer products that solve a broad range of predictive application problems. HNC'S STRATEGY HNC's objective is to be the leading supplier of predictive software solutions by leveraging its core computational intelligence technology across a series of product families targeted at specific service industries. The Company's strategy for achieving this objective contains the following key elements: Maintain and strengthen HNC's position at the core of its customers' applications infrastructure. Customers rely heavily on HNC's predictive software solutions to anticipate and react to rapidly changing business conditions. The Company's core computational intelligence technology serves as a platform upon which service businesses can deploy and combine the Company's products to manage and respond to operational and transactional data in real time. Therefore, HNC attempts to establish a strong position within the applications infrastructure of its customers. For example, the Company's first predictive solution product, Falcon, is a credit/debit card fraud detection system for monitoring individual credit card accounts. By adapting the core technology developed for Falcon, the Company later introduced ProfitMax, a transaction-based, real-time credit authorization system that manages the profitability of credit card portfolios. The Company believes that the opportunity exists for similar penetration within each of its core vertical markets, including opportunities such as retail banking within the financial services industry. As another example, the Company's context vectoring technology could profile visitors to a financial institution's Web site and send proactive direct e-mails regarding financial products. Leverage core predictive technologies to enter new market segments. Historically, the Company has applied its core predictive technology to the domain knowledge of companies it has acquired to introduce new products. For example, in August 1996, HNC acquired Risk Data Corporation ("Risk Data"), a developer of decision systems in the workers' compensation industry. By combining Risk Data's industry expertise with HNC's fraud detection technology, HNC is developing a VeriComp module that applies predictive technology to employer fraud in the workers' compensation industry. In addition, the Company is evaluating opportunities in other data-intensive industries, such as telecommunications, where predictive software may have the ability to improve business performance and profitability. Earn recurring revenues through long-term contracts. The Company markets most of its predictive software solutions as an ongoing service that includes software licenses, decision model updates, application consulting and on-line or on-site support and maintenance. Since many of the Company's applications are enhanced by periodic model updates, customers derive significant value from the Company's ongoing services. In addition, the mission-critical nature of many of HNC's predictive software solutions creates customer demand for long-term support commitments. Accordingly, the Company's customers typically pay for this package of software and service with a monthly usage fee and a three to seven year contract commitment. Use strategic relationships to support direct distribution. In each of its primary markets, the Company uses strategic relationships with system integrators and third-party service providers to support its direct distribution efforts. These partners provide varying levels of distribution support, from lead generation to resale of the Company's products. The Company maintains such strategic relationships with Electronic Data Systems ("EDS"), Intracorp and Marsh McLennan, Inc. in healthcare/insurance, First Data and EDS in financial services, and Andersen Consulting and KPMG Peat Marwick LLP in retail. Growth through acquisitions. The Company acquired Risk Data, Retek Distribution Corporation, now known as Retek Information Systems ("Retek") and CompReview, Inc. ("CompReview") in 1996 and 1997, thereby significantly expanding its product offerings in its target markets. On January 30, 1998, the Company signed a definitive agreement to acquire Practical Control Systems Technologies, Inc. ("PCS"), a distribution center management software vendor based in Cincinnati, Ohio, subject to the satisfaction of certain closing conditions and the approval of PCS' shareholders. The Company expects to continue to review acquisitions of businesses, products and technologies as a means to expand its product offerings for existing and new target markets. 5 6 MARKETS AND PRODUCTS HNC has a broad family of predictive software products that provide specific solutions for each of the healthcare/insurance, financial services and retail markets. Revenues from each of the Company's three target markets accounted for more than one-quarter of the Company's total revenues in 1997. Revenues from three products, CRLink, Retek Merchandising System and Falcon, accounted for 57.9% of the Company's total revenues in 1997. See "Risk Factors -- Product Concentration." Healthcare/Insurance HNC offers and is developing products in the healthcare/insurance market. These products are targeted to insurance carriers, insurance providers, managed care organizations, state insurance funds, third-party administrators and large, self-insured employers. HNC has developed predictive software solutions that address the containment of the medical costs of workers' compensation and automobile accident insurance claims, workers' compensation loss reserving, workers' compensation fraud, managed care effectiveness and provider effectiveness. These solutions, CRLink, MIRA, CompCompare, ProviderCompare, PMAdvisor and VeriComp, allow users the ability to reduce fraud losses and streamline operations. HNC HEALTHCARE/INSURANCE INDUSTRY PRODUCTS ================================================================================
PRODUCT PRODUCT DESCRIPTION - --------------------------------------------------------------------------------------------------------- CRLink CRLink operates as the bill review engine that links all of the critical components of an effective cost containment program to help clients control the cost of workers' compensation, personal injury and other casualty risks. - --------------------------------------------------------------------------------------------------------- MIRA MIRA uses statistical predictive methods to automatically determine workers' compensation loss reserves based on historical data gathered from insurance carriers, third-party administrators and state insurance funds throughout the United States. - --------------------------------------------------------------------------------------------------------- CompCompare CompCompare enables clients to compare claims costs or the effectiveness of managed care programs by using benchmarking data from HNC's proprietary workers' compensation database. - --------------------------------------------------------------------------------------------------------- ProviderCompare ProviderCompare is a physician profiling product that provides on-line access to HNC's proprietary workers' compensation database. ProviderCompare enables clients to generate a detailed comparative analysis, such as treatment costs, among providers within the same specialty. - --------------------------------------------------------------------------------------------------------- PMAdvisor PMAdvisor enables claim payors to verify that the number of visits and type of treatment for claims involving physical medicine (primarily chiropractic and physical therapy) are appropriate for the diagnosis and severity of the injury and to identify chiropractic and physical therapy claims that exceed appropriate treatment guidelines. - --------------------------------------------------------------------------------------------------------- VeriComp VeriComp is a workers' compensation claimant system designed to assist in identifying claimant behavior that is likely to indicate the presence of fraud or abuse. - ---------------------------------------------------------------------------------------------------------
Financial Services The increasing volume of electronic financial transactions requires mission-critical decision-making in real time for applications such as credit card charge authorization, that carry a substantial risk of consumer and merchant fraud. HNC's Falcon and ProfitMax product lines are targeted at bank and private label card issuers and payment processors. Falcon employs a client/server architecture that consists of an interface into the customer's legacy system, a decision engine, a cardholder profile database, a case management database and a fraud workstation. 6 7 HNC estimates that loan underwriting costs in the United States currently exceed $2.5 billion each year. Competitive pressures including cost reduction, rapid loan approval and the growth of on-line banking have compelled lenders to turn to software solutions that can automate loan origination in order to lower costs, improve customer service and provide remote access to lending services. HNC's predictive software solutions for the loan origination markets, Capstone and AREAS, allow lenders such as banks and private label card issuers, home equity lenders, auto lenders and mortgage lenders to automate the loan approval decision process. HNC FINANCIAL SERVICES INDUSTRY PRODUCTS ================================================================================
PRODUCT PRODUCT DESCRIPTION - --------------------------------------------------------------------------------------------------------- Falcon Product Line - ------------------------ Falcon Falcon products are neural network-based solutions that examine Falcon Expert transaction, cardholder and merchant data to detect a wide range of Falcon Select credit and debit card fraud. Using predictive software techniques, Falcon Debit Falcon captures relationships and patterns that often are missed by Falcon Retail traditional methods of detecting suspicious transactions. Falcon Sentry Eagle - --------------------------------------------------------------------------------------------------------- Capstone Product Line - ------------------------ Capstone for Payment Capstone is an intelligent, high-performance new account decision Cards processing solution. Based on expert rules, Capstone allows users to Capstone for automate lending decisions and design, test, implement and track lending Consumer Lending policies. Capstone for Mortgage Lending - --------------------------------------------------------------------------------------------------------- ProfitMax Product Line - ------------------------ ProfitMax ProfitMax provides transaction-based, real-time authorization and action ProfitMax Bankruptcy decisions from within a complete infrastructure for managing the profitability of credit card portfolios. ProfitMax uses neural networks, expert rules and HNC's cardholder behavior profiling technology to analyze the expected profitability of each account in an issuer's portfolio using the issuer's definition of financial profit. ProfitMax Bankruptcy uses the basic ProfitMax structure to predict the likelihood of cardholder bankruptcy even before the cardholder is delinquent. - --------------------------------------------------------------------------------------------------------- AREAS AREAS automated property valuation software uses neural networks and other computational intelligence to provide an objective prediction of the current market value of residential property. - ---------------------------------------------------------------------------------------------------------
Retail Although retailers have made significant investments in customer information, point-of-sale and quick-response ordering systems, these applications often do not include the forecasting ability required to maximize profitability and respond to competition through timely "in-store" replenishment, electronic networking and quick response initiatives. HNC has developed a group of products that effectively addresses inventory control, merchandise management and financial control management. These software solutions allow retailers to build forecasting and marketing models to carry out day-to-day buying and selling activities, thereby reducing carrying costs for inventories and improving purchasing, promotion and logistics efficiencies. The target 7 8 markets for the Company's retail products are department stores, mass merchandisers and specialty retail chains in multi-store and multi-warehouse environments with gross sales in excess of $200 million. HNC RETAIL INDUSTRY PRODUCTS ================================================================================
PRODUCT PRODUCT DESCRIPTION - --------------------------------------------------------------------------------------------------------- Retek Merchandising The Retek Merchandising System provides inventory control, merchandise System management and financial control and addresses the definition and management of merchandise at the SKU level and reporting and financial control through stock ledgers. - --------------------------------------------------------------------------------------------------------- Retek Data Warehouse Retek Data Warehouse provides the transaction infrastructure needed for retailers to plan, buy, move, sell and pay for their merchandise. - --------------------------------------------------------------------------------------------------------- Active Retail Active Retail Intelligence identifies performance exceptions and Intelligence recommends the appropriate corrective action. - --------------------------------------------------------------------------------------------------------- Retek Demand Retek Demand Forecasting provides forecasts to retailers' supply chain Forecasting planning allocation and replenishment functions and uses predictive causal techniques with automated forecasting and multi-dimensional on-line analysis. - --------------------------------------------------------------------------------------------------------- Falcon Retail Falcon Retail provides proactive detection of private label card application and transaction fraud. - ---------------------------------------------------------------------------------------------------------
EMERGING MARKET OPPORTUNITIES The Company's experience and technology capabilities in the healthcare/insurance, financial services and retail markets often lead to new product ideas and concepts. The Company also evaluates new market opportunities that arise through its commercial and government contract work. As contracts are completed, the end products are evaluated for commercialization. For example, contracts for the Advanced Research Projects Agency, United States Army Research Laboratory, United States Air Force, Office of Naval Research, DataTimes Corporation and Tracor Applied Sciences, Inc. generated a context-based text analysis technology called MatchPlus. This core text analysis technology has been under development at HNC for the last four years for Department of Defense applications. During 1996, the Company formed Aptex to commercialize HNC's MatchPlus text analysis technology for emerging markets. Aptex has developed a strategic partnership with InfoSeek Corporation, an Internet search and navigation service, to deliver products using this text analysis technology to the Internet market. To date, three new Internet products have been launched: SelectCast, SelectResponse and SelectResource. Substantially all of the Company's revenues in recent years have been attributable to sales of predictive software solutions and services, and these products and services are currently expected to continue to account for a substantial amount of the Company's future revenues. The market for predictive software solutions is still emerging. The rate at which businesses have adopted the Company's products has varied significantly by market and by product within each market, and the Company expects to continue to experience such variations with respect to its target markets and products in the future. The Company has introduced products for the healthcare/insurance, financial services and retail markets. The Company has recently announced several new products, including PMAdvisor, VeriComp, SelectCast, SelectResponse and SelectResource. To date, none of these products has achieved any significant degree of market acceptance, and there can be no assurance that such products will ever be widely accepted. Although businesses in the Company's target markets have recognized the advantages of using predictive software solutions to automate the decision- making process, many have developed decision automation systems internally rather than licensing them from outside vendors. There can be no assurance that the markets for the Company's products will continue to develop or that the Company's products will be widely accepted, if at all. If the markets for the Company's new or existing products fail to develop, or develop more slowly than anticipated, the Company's sales would be negatively impacted, which would have a material adverse effect on the Company's business, financial condition and results of operations. 8 9 CUSTOMER SERVICE AND SUPPORT A high level of continuing maintenance, service and support is critical to maintaining the performance of the Company's predictive software solutions. Service and support are also essential to the Company's objective of developing long-term relationships with, and obtaining recurring revenues from, customers. The Company's service and support activities are related to system installation, performance validation and ongoing consultation on the optimal use of HNC products. Model and Rule Updates. Most HNC product license agreements include periodic data, model and/or rule updates to maintain system performance. HNC technical personnel generally assist the customer with installation of updates. The Company makes commitments to update models and rules at varying intervals, from fixed times (such as quarterly and annually) to unscheduled times, provided the customer has met its commitments to provide data to HNC. Education. The Company offers comprehensive education and training programs to its customers. The Company provides on-site training services associated with many of its products. Fees for education and training services are generally included in usage-priced products, but may be charged separately in other cases. Consulting. The Company's consultants are available to work with customers' user application groups and information systems organizations. Customers that buy consulting services are usually planning large implementations or want to optimize performance of the Company's products in their operating environments. Fees for consulting are generally included in usage-priced products, but may be charged separately in other cases. PRICING The Company generally establishes prices in one of two ways: usage-based fees and fixed-fee licenses with maintenance. The Company generally employs usage-based pricing for its healthcare/insurance products, Falcon, ProfitMax and AREAS. Under the usage-based pricing structure, HNC generally provides a fixed- term software license, software maintenance, model updates (in the case of HNC-supplied models) and ongoing consulting services in exchange for recurring revenue based on usage. Usage-based term contracts typically include annual price index adjustments. In 1995, 1996 and 1997, annual license and maintenance revenues from these contracts represented 61.2%, 56.1% and 55.2% of the Company's total revenues, respectively. The Company generally employs fixed-fee license pricing for Capstone and all of the Company's retail products except Falcon Retail. Under the fixed-fee license pricing structure, the Company generally licenses the product for the customer's internal use on a perpetual basis. In most cases, the user can separately contract for maintenance services on an annual basis. The Company typically offers early adopter pricing for its usage-based products to customers that agree to be part of pilot or other early product life cycle installations. Early adopter pricing might include reduced-fee perpetual licenses, reduced-fee services or both. The Company often contracts for installation services associated with its predictive software solutions. The Company provides user-specific proposals priced at either fixed-fee levels or on a time and materials basis. In nearly all cases, travel expenses are billed separately at cost. The Company offers contract consulting services. Because of the complexity associated with predictive software solutions, users often request that HNC help them to develop models or analyze problems. Also, the Company from time to time accepts engagements not associated with current product offerings in order to become more familiar with a new application area and determine the potential for new product development. Although consulting services are included with many of the Company's usage-based products, customers may request additional consulting, often associated with custom modeling. SALES AND MARKETING The Company sells and markets its software and services in North America and internationally through its direct sales organization, joint marketing and distribution agreements. The Company's worldwide sales and marketing organization consisted of 125 employees as of December 31, 1997. The domestic sales staff is based at the Company's corporate headquarters in San Diego and in United States field offices in California, 9 10 Colorado, Connecticut, Georgia, Minnesota, New York, Pennsylvania, Texas and Virginia. Internationally, the Company has field sales offices in Australia, Canada, France, Germany, Japan, Singapore, South Africa and the United Kingdom. To support its sales force, the Company conducts comprehensive marketing programs, which include direct mail, public relations, advertising, seminars, trade shows and ongoing customer communication programs. The sales staff is generally product-based, and each representative is assigned a geographic territory. The Company has licensed First Data Resources, Inc. ("First Data") and EDS to act as service bureaus to provide an alternate channel of distribution for end-users to utilize the Falcon product to process credit card receipts for banks and other credit card issuers. The Company generally assists its service bureau partners in the sales effort, often employing the Company's direct sales force in the process. Company sales representatives earn a commission for service bureau sales in their territory. These service bureaus pay the Company monthly usage fees based on the volume of transactions processed for such credit card issuers. Product licenses to First Data, the largest provider of credit card charge receipt processing services to banks, accounted for 8.7%, 8.6% and 7.6% of the Company's total revenues in 1995, 1996 and 1997, respectively. The Company has licensed First Data to provide its customers with access to the Company's ProfitMax product pursuant to a license agreement entered into in January 1996 (the "ProfitMax Contract"). The Company's revenues under the ProfitMax Contract represented approximately one-quarter of the Company's revenues from First Data in 1997. In late January 1998, First Data asserted that certain restrictive covenants under the ProfitMax Contract violated certain intellectual property laws. First Data also asserted that the existence of such restrictions made the ProfitMax Contract at least temporarily unenforceable and that First Data is therefore not obligated to pay the Company license fees due under the ProfitMax Contract. The Company disputed First Data's claim, released and waived the above-mentioned restrictive covenants in the ProfitMax Contract and gave First Data written notice that the Company intended to terminate the ProfitMax Contract pursuant to its terms unless First Data cured its failure to pay the delinquent license fees in a timely manner. Currently, First Data and the Company are working to resolve their dispute regarding the ProfitMax Contract by negotiating a new agreement. First Data has resumed making license fee payments on a delayed basis, and HNC has agreed to extend the date for First Data to pay past due license fees until mid-April 1998. Although HNC expects to reach a new agreement with First Data that will resolve the pending dispute, there can be no assurance that such an agreement will be reached or that the terms of such an agreement would be as favorable to HNC as its existing contractual arrangements with First Data. If no such agreement can be reached and First Data maintains its current position, it is possible that litigation or arbitration could ensue, which would likely result in a loss of anticipated revenue to the Company under the ProfitMax Contract and possibly other agreements between the Company and First Data, which could have a material adverse effect on the Company's business, financial condition and results of operation. The Company also uses representative agents for certain products in certain territories outside of North America. The Company has agents covering Australia, Austria, France, Germany, Italy, New Zealand, Spain and Switzerland. In 1995, 1996 and 1997, international operations and export sales (includes sales in Canada) represented 12.6%, 17.7% and 16.8% of the Company's total revenues, respectively. International sales result primarily from Falcon product sales and sales of retail products. The Company intends to continue to expand its operations outside the United States and to enter additional international markets, including by adding sales and support offices in Europe and Japan, which will require significant management attention and financial resources. The Company has committed and continues to commit significant time and development resources to customizing certain of its products for selected international markets and to developing international sales and support channels. There can be no assurance that the Company's efforts to develop products, databases and models for targeted international markets or to develop additional international sales and support channels will be successful. The failure of such efforts, which can entail considerable expense, could have a material adverse effect on the Company's business, financial condition and results of operations. See "Risk Factors -- Risks Associated with International Sales." International sales are subject to additional inherent risks, including longer payment cycles, unexpected changes in regulatory requirements, import and export restrictions and tariffs, difficulties in staffing and managing foreign operations, the burdens of complying with a variety of foreign laws, greater difficulty or delay 10 11 in accounts receivable collection, potentially adverse tax consequences and political and economic instability. The Company's international sales are currently denominated predominantly in United States dollars and a small portion are denominated in British pounds sterling. An increase in the value of the United States dollar relative to foreign currencies could make the Company's products more expensive, and therefore potentially less competitive, in foreign markets. In the future, to the extent the Company's international sales are denominated in local currencies, foreign currency translations may contribute to significant fluctuations in the Company's business, financial condition and results of operations. If for any reason exchange or price controls or other restrictions on foreign currencies are imposed, the Company's business, financial condition and results of operations could be materially adversely affected. Due in part to the mission-critical nature of certain of the Company's applications, potential customers perceive high risk in connection with adoption of the Company's products. As a result, customers have been cautious in making decisions to acquire the Company's products. In addition, because the purchase of the Company's products typically involves a significant commitment of capital and may involve shifts by the customer to a new software and/or hardware platform, delays in completing sales can arise while customers complete their internal procedures to approve large capital expenditures and test and accept new technologies that affect key operations. For these and other reasons, the sales cycle associated with the purchase of the Company's products is typically lengthy, unpredictable and subject to a number of significant risks over which the Company has little or no control, including customers' budgetary constraints and internal acceptance reviews. The sales cycle associated with the licensing of the Company's products can typically range from 60 days to 18 months. As a result of the length of the sales cycle and the typical size of customers' orders, the Company's ability to forecast the timing and amount of specific sales is limited. A lost or delayed sale could have a material adverse effect on the Company's business, financial condition and results of operations. TECHNOLOGY The Company seeks to develop innovative products by combining industry and application knowledge with its core neural-network technology to address specific market needs. The Company's systems also employ rule-based technology to implement customer strategy, policy and procedures. These technologies are incorporated in computer software and hardware architectures, including client-server hardware, relational databases and object-oriented programming. The Company intends to continue to develop state-of-the-art technologies to enhance its current products and broaden development opportunities. Neural-Network Technology. Neural networks have predictive power that can be improved with experience as the historical database increases in size. The term "neural network" refers to a family of nonlinear, statistical modeling techniques, sometimes called "computational intelligence." These techniques distinguish themselves through a process of automated "learning" or "training" that replaces the time-consuming manual techniques of traditional nonlinear, statistical modeling. The neural-network architecture itself consists of groups of "processing elements," or equations with several inputs and a single output. The output of each element becomes either the input to another element or part of the dependent output. Each input receives a "weight" or value, in the equation, which is adjusted during the training process. The actual result from each training record is compared with the answer from the neural network, and the weights are adjusted to reduce the error between the two. This process can become computationally intensive, as millions of training data records must be processed hundreds or thousands of times. HNC has developed proprietary high-speed and parallel-processor boards to accelerate training and execution of its neural-network software. The Company believes that the rapid model development afforded by its technology provides a competitive advantage in the development of predictive software solutions. Rule-Based Technology. The Company's systems also employ rule-based technology to implement customer strategy, policy and procedures. The rules are implemented as part of predictive processes. The Company believes that its combination of neural networks and rule bases in a single decision engine represents a significant competitive advantage over more traditional approaches to decision automation. Context Vector Technology. Context vector technology that originated at HNC and is being commercialized at Aptex is a way to explore, analyze and model unstructured textual data. Context vector technology 11 12 automatically discovers the underlying structure of free form symbolic data. This structure enables modeling from data elements previously considered impossible to include in predictive software applications. Context vector technology also models behavior. Just as relationships are discovered in unstructured data, observing electronic transaction behavior identifies patterns. Compatibility predictions can be made between information, behavior, people and products. When combined with other HNC technologies, such as neural networks and rule-based systems, the Company believes that context vectors can improve the performance of existing applications while opening new market opportunities. Context vector technology has been demonstrated to increase banner advertising click rates on the Internet, automate e-mail responses and discover unknown relationships in credit card transaction data. The Company's success depends upon its ability to enter new markets by successfully developing new products for such markets on a timely and cost-effective basis. The Company's products often require customer data for decision model development and system installation. As a result, completion of new products (particularly new products for markets not previously served by the Company) may be delayed while the Company extracts sufficient amounts of statistically relevant data and develops the models. During this development process, the Company relies on its potential customers in the new market to provide data and to help train Company personnel in the use and meaning of the data in the specific industry. These relationships also assist the Company in establishing a market presence and credibility in the new market. These potential customers, most of which have significantly greater financial and marketing resources than the Company, may compete with the Company in the future or otherwise discontinue their relationships with or support of the Company, either during development of the Company's products or thereafter. The failure by the Company to obtain adequate third-party support for new product development would have a material adverse effect on the Company's ability to enter new markets and, consequently, on the Company's business, financial condition and results of operations. See "Risk Factors -- Risks Associated with Technological Change and Delays in Developing New Products." RESEARCH AND DEVELOPMENT The Company believes that its future success depends in part on its ability to maintain and improve its core technologies, enhance its existing products and develop new products that meet an expanding range of markets and customer requirements. The Company intends to expand its existing product offerings and to introduce new predictive software solutions. In the development of new products and enhancements to existing products, the Company uses its own tools extensively. Until 1996, the Company relied primarily on internal development of its products. Based on timing and cost considerations, however, the Company has acquired, and in the future may consider acquiring, technology or products from third parties. For example, the Company acquired technology and products in connection with its acquisitions of Risk Data and Retek in 1996 and CompReview in 1997. The Company performs all quality assurance and develops documentation internally. The Company intends to continue to support industry standard operating environments, client-server architectures and network protocols. The Company's specialists in neural network model development, software engineering, user interface design, product documentation and quality improvement are responsible for maintaining and enhancing the performance, quality and usability of all HNC predictive software solutions. The marketing services organization is responsible for authoring and updating all user documentation and other publications. See "Risk Factors -- Risks Associated with Technological Change and Delays in Developing New Products." The Company strategically targets its long-term research projects. In addition to funds allocated by the Company for research, HNC receives research contracts from a range of commercial sources and the United States Government. Government and commercial contract customers have included the Advanced Research Projects Agency, United States Air Force, Office of Naval Research and Tracor Applied Sciences, Inc. The Company believes that these contracts augment its ability to maintain existing technologies and investigate new technologies that may or may not become part of its products. The United States Government typically retains certain intellectual property rights and licenses in the technologies the Company develops under research contracts directly or indirectly sponsored by the government, and in some cases can terminate the Company's rights in such technologies if the Company fails to commercialize them on a timely basis. 12 13 Historically, these contracts have not resulted in development of products contributing to the Company's revenues in the fiscal year in which the research contract is performed, or in the subsequent fiscal year. The market for the Company's predictive software solutions for service industries is characterized by rapidly changing technology and improvements in computer hardware, network operating systems, programming tools, programming languages, operating systems and database technology. The Company's success will depend upon its ability to continue to develop and maintain competitive technologies, enhance its current products and develop, in a timely and cost-effective manner, new products that meet changing market conditions, including evolving customer needs, new competitive product offerings, emerging industry standards and changing technology. For example, the rapid growth of the Internet environment creates new opportunities, risks and uncertainties for businesses, such as the Company, which develop software solutions that now may have to be designed to operate in Internet, intranet and other on-line environments. The Company may not be able to develop and market, on a timely basis, or at all, product enhancements or new products that respond to changing technologies. The Company has previously experienced significant delays in the development and introduction of new products and product enhancements, primarily due to difficulties with model development, which has in the past required multiple iterations, as well as difficulties with acquiring data and adapting to particular operating environments. The length of these delays has varied depending upon the size and scope of the project and the nature of the problems encountered. Any significant delay in the completion of new products, or the failure of such products, if and when installed, to achieve any significant degree of market acceptance, would have a material adverse effect on the Company's business, financial condition and results of operations. Any failure by the Company to anticipate or to respond adequately to changing technologies, or any significant delays in product development or introduction, could cause customers to delay or decide against purchases of the Company's products and would have a material adverse effect on the Company's business, financial condition and results of operations. INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS The Company relies on a combination of patent, copyright, trademark and trade secret laws and confidentiality procedures to protect its proprietary rights. The Company currently owns seven issued United States patents and has four United States patent applications pending. The Company has applied for additional patents for its Falcon technology in Canada, Europe and Japan and for its MIRA product in Australia, Canada and Europe. There can be no assurance that patents will be issued with respect to pending or future patent applications or that the Company's patents will be upheld as valid or will prevent the development of competitive products. The Company seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. As part of its confidentiality procedures, the Company generally enters into invention assignment and proprietary information agreements with its employees and independent contractors and nondisclosure agreements with its distributors, corporate partners and licensees, and limits access to and distribution of its software, documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise to obtain and use the Company's products or technology without authorization, or to develop similar technology independently. In addition, to ensure that customers will not be adversely affected by an interruption in the Company's business, the Company places source code for certain of its products into escrow, which may increase the likelihood of misappropriation or other misuse of the Company's intellectual property. Moreover, effective protection of intellectual property rights may be unavailable or limited in certain foreign countries in which the Company has done and may do business. Also, the Company has developed technologies under research projects conducted under agreements with various United States Government agencies or subcontractors to such agencies. Although the Company has acquired certain commercial rights to such technologies, the United States Government typically retains ownership of certain intellectual property rights and licenses in the technologies developed by the Company under such contracts, and in some cases can terminate the Company's rights in such technologies if the Company fails to commercialize them on a timely basis. In addition, under certain United States Government contracts, the results of the Company's research may be made public by the government, which could limit the Company's competitive advantage with respect to future products based on such research. 13 14 In the past, the Company has received communications from third parties asserting that Company trademarks infringe such other parties' trademarks, none of which has resulted in litigation or losses to the Company. Given the Company's ongoing efforts to develop and market new technologies and products, the Company may receive communications from third parties asserting that the Company's products infringe, or may infringe, their intellectual property rights. If as a result of any such claims the Company were precluded from using certain technologies or intellectual property rights, licenses to such disputed third-party technology or intellectual property rights might not be available on reasonable commercial terms, if at all. Furthermore, the Company may initiate claims or litigation against third parties for infringement of the Company's proprietary rights or to establish the validity of the Company's proprietary rights. Litigation, either as plaintiff or defendant, could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel from productive tasks, whether or not such litigation is resolved in favor of the Company. In the event of an adverse ruling in any such litigation, the Company might be required to pay substantial damages, discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses to infringing technology, and the court might invalidate the Company's patents, trademarks or other proprietary rights. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company's business, financial condition and results of operations would be materially and adversely affected. As the number of software products increases and the functionality of these products further overlaps, the Company believes that software developers may become increasingly subject to infringement claims. Any such claims, with or without merit, can be time consuming and expensive to defend and could materially and adversely affect the Company's business, financial condition and results of operations. COMPETITION The market for predictive software solutions for service industries is intensely competitive and subject to rapid change. Competitors, many of which have substantially greater financial resources than the Company, vary in size and in the scope of the products and services they offer. The Company encounters competition from a number of sources, including (i) other application software companies, (ii) management information systems departments of customers and potential customers, including banks, insurance companies and retailers, (iii) third party professional services organizations, including without limitation, consulting divisions of public accounting firms, (iv) hardware suppliers that bundle or develop complementary software, (v) network and service providers that seek to enhance their value-added services, (vi) neural-network tool suppliers and (vii) managed care organizations. In the healthcare/insurance market, the Company has experienced competition primarily from National Council on Compensation Insurance ("NCCI"), Corporate Systems and CSC Incorporated. In the workers' compensation and medical cost administration market, the Company has experienced competition from MediCode, Inc. ("MediCode"), Medata, Inc. and Embassy Software with regard to software licensing, and Intracorp and Corvel Corporation in the service bureau operations market. Additionally, the Company has faced competition from Automatic Data Processing, Inc. ("ADP") in the automobile accident medical claims market. In the financial services market, the Company has experienced competition from Fair, Isaac & Co., Inc., Cogensys (a subsidiary of Policy Management Systems Corporation), Federal National Mortgage Association ("Fannie Mae"), Federal Home Loan Mortgage Corporation ("Freddie Mac"), International Business Machines Corporation ("IBM"), Nestor, Inc., NeuralTech Inc., Neuralware Inc., PMI Mortgage Services Co., VISA International and others. In the retail market, the Company has experienced competition from JDA Software Group, Inc., SAP AG, PeopleSoft, Inc., IBM, Manugistics Group, Inc. and others. The Company expects to experience additional competition from other established and emerging companies, as well as other technologies. For example, the Company's Falcon product competes against other methods of preventing credit card fraud, such as card activation programs, credit cards that contain the cardholder's photograph, smart cards and other card authorization techniques. Increased competition, whether from other products or new technologies, could result in price reductions, fewer customer orders, reduced gross margins and loss of market share, any of which could materially adversely affect the Company's business, financial condition and results of operations. 14 15 The Company believes that most of its products are currently priced at a premium when compared to its competitors' products. The market for the Company's products is highly competitive, and the Company expects that it will face increasing pricing pressures from its current competitors and new market entrants. In particular, increased competition could reduce or eliminate such premiums and cause further price reductions. In addition, such competition could adversely affect the Company's ability to obtain new long-term contracts and renewals of existing long-term contracts on terms favorable to the Company. Any reduction in the price of the Company's products could materially adversely affect the Company's business, financial condition and results of operations. The Company believes that the principal competitive factors affecting its market include technical performance (for example, accuracy in detecting credit card fraud or evaluating workers' compensation claims), access to unique proprietary databases and product attributes such as adaptability, scalability, ability to integrate with products produced by other vendors, functionality, ease-of-use, product reputation, quality, performance, price, customer service and support, the effectiveness of sales and marketing efforts and Company reputation. Although the Company believes that its products currently compete favorably with respect to such factors, there can be no assurance that the Company can maintain its competitive position against current and potential competitors, especially those with significantly greater financial, marketing, service, support, technical and other resources. Some of the Company's current, and many of the Company's potential, competitors have significantly greater financial, technical, marketing and other resources than the Company. As a result, they may be able to respond more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the development, promotion and sale of their products than the Company. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the Company's prospective customers. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly gain significant market share. Also, the Company relies upon its customers to provide data, expertise and other support for the ongoing updating of the Company's models. The Company's customers, most of which have significantly greater financial and marketing resources than the Company, may compete with the Company in the future or otherwise discontinue their relationships with or support of the Company. There can be no assurance that the Company will be able to compete successfully against current and future competitors or that competitive pressures faced by the Company will not materially adversely affect its business, financial condition and results of operations. EMPLOYEES As of December 31, 1997, the Company had 706 employees, including 316 in product development and support, 87 in customer service, 125 in sales and marketing and 178 in finance, administration and MIS. Most of these employees are located in the United States. None of the Company's employees are represented by a labor union. The Company has experienced no work stoppages and believes that its employee relationships are generally good. The Company's success depends to a significant degree upon the continued service of members of the Company's senior management and other key research, development, sales and marketing personnel. Accordingly, the loss of any of the Company's senior management or key research, development, sales or marketing personnel could have a material adverse effect on the Company's business, financial condition and results of operations. Only a small number of employees have employment agreements with the Company, and there can be no assurance that such agreements will result in the retention of these employees for any significant period of time. In addition, the untimely loss of a member of the management team or a key employee of a business acquired by the Company could have a material adverse effect on the Company's business, financial condition and results of operations, particularly if such loss occurred before the Company has had adequate time to familiarize itself with the operating details of that business. In the past, the Company has experienced difficulty in recruiting a sufficient number of qualified sales and technical employees. In addition, competitors may attempt to recruit the Company's key employees. There can be no assurance that the Company will be successful in attracting, assimilating and retaining such personnel. The 15 16 failure to attract, assimilate and retain key personnel could have a material adverse effect on the Company's business, financial condition and results of operations. See "Risk Factors -- Risks Associated with Managing Growth." POTENTIAL FLUCTUATIONS IN OPERATING RESULTS. The Company's revenues and operating results have varied significantly in the past and may do so in the future. Because the Company's expense levels are based in part on its expectations regarding future revenues and in the short term are fixed to a large extent, the Company may be unable to adjust its spending in time to compensate for any unexpected revenue shortfall. Factors affecting operating results include market acceptance of the Company's products; the relatively large size and small number of customer orders that may be received during a given period; customer cancellation of long-term contracts yielding recurring revenues or customers' ceasing their use of Company products for which the Company's fees are usage based; the length of the Company's sales cycle; the Company's ability to develop, introduce and market new products and product enhancements; the timing of new product announcements and introductions by the Company and its competitors; changes in the mix of distribution channels; changes in the level of operating expenses; the Company's ability to achieve progress on percentage-of-completion contracts; the Company's success in completing certain pilot installations for contracted fees; competitive conditions in the industry; domestic and international economic conditions; and market conditions in the Company's targeted markets. In addition, as a result of recently issued guidance on software revenue recognition, license agreements entered into during a quarter may not meet the Company's revenue recognition criteria. Therefore, even if the Company meets or exceeds its forecast of aggregate licensing and other contracting activity, it is possible that the Company's revenues would not meet expectations. Furthermore, the Company's operating results may be affected by factors unique to certain of its product lines. For example, the Company derives a substantial and increasing portion of its revenues from its retail products, which are generally priced as "perpetual" license transactions in which the Company receives a one-time license fee. The Company recognizes these fees as revenue upon delivery of the software and acceptance by the customer. Thus, failure to complete a perpetual license transaction during a fiscal quarter would have a disproportionate adverse impact on the Company's operating results for that quarter. The Company expects fluctuations in its operating results to continue for the foreseeable future. Accordingly, the Company believes that period-to-period comparisons of its financial results should not be relied upon as an indication of future performance. The Company may not be able to maintain profitability on a quarterly or annual basis in the future. Due to all of the foregoing factors, it is possible that in some future quarter the Company's operating results will be below the expectations of public market analysts and investors. In that event, the price of the Company's Common Stock and, in turn, the market price of the Notes, would likely be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." LENGTHY AND UNPREDICTABLE SALES CYCLE. Due in part to the mission-critical nature of certain of the Company's applications, potential customers perceive high risk in connection with adoption of the Company's products. As a result, customers have been cautious in making decisions to acquire the Company's products. In addition, because the purchase of the Company's products typically involves a significant commitment of capital and may involve shifts by the customer to a new software and/or hardware platform, delays in completing sales can arise while customers complete their internal procedures to approve large capital expenditures and test and accept new technologies that affect key operations. For these and other reasons, the sales cycle associated with the purchase of the Company's products is typically lengthy, unpredictable and subject to a number of significant risks over which the Company has little or no control, including customers' budgetary constraints and internal acceptance reviews. The sales cycle associated with the licensing of the Company's products can typically range from 60 days to 18 months. As a result of the length of the sales cycle and the typical size of customers' orders, the Company's ability to forecast the timing and amount of specific sales is limited. A lost or delayed sale could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business -- Sales and Marketing." ACQUISITIONS. Between August 1996 and November 1997, the Company acquired three businesses. In August 1996, the Company acquired Risk Data, a company that develops, markets and supports proprietary 16 17 software decision products for use in the insurance industry. In November 1996, the Company acquired Retek, a company that develops, markets and supports management decision software products for retailers and their vendors. In November 1997, the Company acquired CompReview, a company that develops, markets and supports a software product and related services designed to assist in the management and containment of the medical costs of workers' compensation and automobile accident medical claims. The Company believes that its future growth depends, in part, upon the success of these and possible future acquisitions. There can be no assurance that the Company will successfully identify, acquire on favorable terms or integrate such businesses, products, services or technologies. The Company may in the future face increased competition for acquisition opportunities, which may inhibit the Company's ability to consummate suitable acquisitions and increase the costs of completing such acquisitions. The acquisitions of Risk Data, Retek and CompReview, as well as other potential future acquisitions, will require the Company to successfully manage and integrate such acquired businesses, which may be located in diverse geographic locations. Acquiring other businesses also requires the Company to successfully develop and market products to new industries and markets with which the Company may not be familiar. It also requires the Company to coordinate (and possibly change) the diverse operating structures, policies and practices of the acquired companies and to integrate the employees of the acquired companies into the Company's organization and culture. Failure of the Company to successfully integrate and manage acquired businesses, to retain their employees, and to successfully address new industries and markets associated with such acquired businesses, would have a material adverse effect on the Company's business, financial condition and results of operations. In addition, although the acquisitions of Risk Data, Retek and CompReview have been accounted for as poolings of interests, future acquisitions may be accounted for as purchases, resulting in potential charges that may adversely affect the Company's earnings. Additional acquisitions may also involve the issuance of shares of the Company's stock to owners of acquired businesses, resulting in dilution in the percentage of the Company's stock owned by other stockholders. See "Business -- HNC's Strategy." RISKS ASSOCIATED WITH MANAGING GROWTH. In recent years, the Company has experienced changes in its operations that have placed significant demands on the Company's administrative, operational and financial resources. The growth in the Company's customer base and expansion of its product functionality, together with its acquisition of other businesses and their employees, have challenged and are expected to continue to challenge the Company's management and operations, including its sales, marketing, customer support, research and development and finance and administrative operations. The Company's future performance will depend in part on its ability to successfully manage change, both in its domestic and international operations, and to adapt its operational and financial control systems, if necessary, to respond to changes in its business and to facilitate the integration of acquired businesses with the Company's operations. The failure of the Company's management to effectively respond to and manage growth could have a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE ON EMERGING TECHNOLOGIES AND MARKETS. The market for predictive software solutions is still emerging. The rate at which businesses have adopted the Company's products has varied significantly by market and by product within each market, and the Company expects to continue to experience such variations with respect to its target markets and products in the future. The Company has introduced products for the healthcare/insurance, financial services and retail markets. The Company has recently announced several new products, including PMAdvisor, VeriComp, SelectCast, SelectResponse and SelectResource. To date, none of these products has achieved any significant degree of market acceptance, and there can be no assurance that such products will ever be widely accepted. Although businesses in the Company's target markets have recognized the advantages of using predictive software solutions to automate the decision- making process, many have developed decision automation systems internally rather than licensing them from outside vendors. There can be no assurance that the markets for the Company's products will continue to develop or that the Company's products will be widely accepted, if at all. If the markets for the Company's new or existing products fail to develop, or develop more slowly than anticipated, the Company's sales would be negatively impacted, which would have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Emerging Market Opportunities." 17 18 RISKS ASSOCIATED WITH TECHNOLOGICAL CHANGE AND DELAYS IN DEVELOPING NEW PRODUCTS. The market for the Company's predictive software solutions for service industries is characterized by rapidly changing technology and improvements in computer hardware, network operating systems, programming tools, programming languages, operating systems and database technology. The Company's success will depend upon its ability to continue to develop and maintain competitive technologies, enhance its current products and develop, in a timely and cost-effective manner, new products that meet changing market conditions, including evolving customer needs, new competitive product offerings, emerging industry standards and changing technology. For example, the rapid growth of the Internet environment creates new opportunities, risks and uncertainties for businesses, such as the Company, which develop software solutions that now may have to be designed to operate in Internet, intranet and other on-line environments. The Company may not be able to develop and market, on a timely basis, or at all, product enhancements or new products that respond to changing technologies. The Company has previously experienced significant delays in the development and introduction of new products and product enhancements, primarily due to difficulties with model development, which has in the past required multiple iterations, as well as difficulties with acquiring data and adapting to particular operating environments. The length of these delays has varied depending upon the size and scope of the project and the nature of the problems encountered. Any significant delay in the completion of new products, or the failure of such products, if and when installed, to achieve any significant degree of market acceptance, would have a material adverse effect on the Company's business, financial condition and results of operations. Any failure by the Company to anticipate or to respond adequately to changing technologies, or any significant delays in product development or introduction, could cause customers to delay or decide against purchases of the Company's products and would have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Technology" and "-- Research and Development." PRODUCT CONCENTRATION. The Company currently has one product or product line in each of its three target markets that accounts for a majority of the Company's total revenues from that market. These products in the aggregate accounted for 60.0%, 59.1% and 57.9% of the Company's total revenues in 1995, 1996 and 1997, respectively. In the healthcare/insurance market, the Company's revenues from its CRLink product accounted for 29.8%, 24.6% and 23.0% of the Company's total revenues in 1995, 1996 and 1997, respectively, and are expected to account for a substantial portion of the Company's total revenues for the foreseeable future. Continued market acceptance of CRLink will be affected by future product enhancements and competition. Decline in demand for, or use of, CRLink, whether as a result of competition, simplification of state workers' compensation fee schedules, changes in the overall payment system or regulatory structure for workers' compensation claims, technological change, an inability to obtain or use state fee schedule or claims data, saturation of market demand, industry consolidation or otherwise, could result in decreased revenues from CRLink, which could have a material adverse effect on the Company's business, financial condition and results of operations. Further, revenues from the Retek Merchandising System ("RMS"), a retail management product, accounted for 2.2%, 13.6% and 18.9% of the Company's total revenues in 1995, 1996 and 1997, respectively, and are expected to continue to account for a substantial portion of the Company's revenues in the foreseeable future. Continued market acceptance of RMS will be affected by the quality and timely introduction of future product enhancements and competition. Decline in demand for, or use of, RMS as a result of continued entry into the retail inventory management market by vendors that may have significantly greater resources and a broader customer base than the Company could result in decreased revenues from RMS, which could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, decline in demand for RMS, as a result of technological change, saturation of market demand, industry consolidation or otherwise would have a material adverse effect on the Company's business, financial condition and results of operations. Revenues from the Company's Falcon product line for credit card fraud detection for financial institutions accounted for 28.0%, 20.9% and 16.0% of the Company's total revenues in 1995, 1996 and 1997, respectively, and are expected to continue to account for a substantial portion of the Company's total revenues in the foreseeable future. Continued market acceptance of the Falcon product line will be affected by the quality and timely introduction of future product enhancements and competition. In addition, it is possible that patterns of credit card fraud may change in a manner that the Falcon product line would not detect and that other methods of credit card fraud prevention may reduce 18 19 customers' needs for the Falcon product line. As a result of increasing saturation of market demand for the Falcon product line, the Company may also need to rely increasingly on international sales to maintain or increase Falcon revenue levels. Furthermore, Falcon customers are banks and related financial institutions. Accordingly, the Company's future success depends upon the capital expenditure budgets of such customers and the continued demand by such customers for Falcon products. The financial services industry tends to be cyclical in nature, which may result in variations in demand for the Company's products. In addition, there has been and continues to be consolidation in the financial services industry, which in some cases has lengthened the sales cycle and may lead to reduced demand for the Company's products. Decline in demand for, or use of, Falcon, whether as a result of competition, technological change, change in fraud patterns, the cyclical nature of the financial services industry, saturation of market demand, fluctuations in interest rates, industry consolidation, reduction in capital spending or otherwise, could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Markets and Products." DEPENDENCE ON DATA. The development, installation and support of the Company's credit card fraud control and profitability management, loan underwriting, home valuation and certain healthcare/insurance products require periodic model updates. The Company must develop or obtain a reliable source of sufficient amounts of current and statistically relevant data to analyze transactions and update its models. For example, in the electronic payments market, the data required by the Company are collected privately and maintained in proprietary databases. As a result, the Company and its Falcon and ProfitMax customers enter into agreements pursuant to which customers agree to provide the data that the Company requires to analyze transactions, report results and build new fraud detection and profitability models. For its AREAS home valuation product, the Company obtains data from commercial databases on available terms and conditions. Many of the Company's healthcare/insurance products use historical workers' compensation claims data obtained from customers. CRLink also uses data from state workers' compensation fee schedules adopted by state regulatory agencies, and certain third parties have asserted copyright interests in such data. In most cases, such data must be periodically updated and refreshed to enable the Company's predictive software products to continue to work effectively. In addition, the development of new and enhanced products also depends to a significant extent on the availability of sufficient amounts of statistically relevant data to enable the Company to develop models. For example, to expand the geographic coverage of its AREAS product, the Company would be required to develop or obtain data on home sales in each county for which AREAS is marketed. There can be no assurance that the Company will be able to continue to obtain adequate amounts of statistically relevant data on a timely basis, in the required formats or on reasonable terms and conditions, whether from customers or commercial suppliers. Any such failure by the Company to obtain required data when it is needed, for a reasonable price and on reasonable terms, could have a significant negative impact on existing product performance, new product development and product pricing which could in turn have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Customer Service and Support." COMPETITION. The market for predictive software solutions for service industries is intensely competitive and subject to rapid change. Competitors, many of which have substantially greater financial resources than the Company, vary in size and in the scope of the products and services they offer. The Company encounters competition from a number of sources, including (i) other application software companies, (ii) management information systems departments of customers and potential customers, including banks, insurance companies and retailers, (iii) third-party professional services organizations, including without limitation, consulting divisions of public accounting firms, (iv) hardware suppliers that bundle or develop complementary software, (v) network and service providers that seek to enhance their value-added services, (vi) neural-network tool suppliers and (vii) managed care organizations. In the healthcare/insurance market, the Company has experienced competition primarily from NCCI, Corporate Systems and CSC Incorporated. In the workers' compensation and medical cost administration market, the Company has experienced competition from MediCode, Medata, Inc. and Embassy Software with regard to software licensing, and Intracorp and Corvel Corporation in the service bureau operations market. Additionally, the Company has faced competition from ADP in the automobile accident medical claims market. In the financial services market, the Company has experienced competition from Fair, Isaac & Co., Inc., Cogensys (a subsidiary of Policy Management Systems Corporation), Fannie Mae, Freddie Mac, IBM, Nestor, Inc., NeuralTech Inc., Neuralware Inc., PMI 19 20 Mortgage Services Co., VISA International and others. In the retail market, the Company has experienced competition from JDA Software Group, Inc., SAP AG, PeopleSoft, Inc., IBM, Manugistics Group, Inc. and others. The Company expects to experience additional competition from other established and emerging companies, as well as other technologies. For example, the Company's Falcon product competes against other methods of preventing credit card fraud, such as card activation programs, credit cards that contain the cardholder's photograph, smart cards and other card authorization techniques. Increased competition, whether from other products or new technologies, could result in price reductions, fewer customer orders, reduced gross margins and loss of market share, any of which could materially adversely affect the Company's business, financial condition and results of operations. The Company believes that most of its products are currently priced at a premium when compared to its competitors' products. The market for the Company's products is highly competitive, and the Company expects that it will face increasing pricing pressures from its current competitors and new market entrants. In particular, increased competition could reduce or eliminate such premiums and cause further price reductions. In addition, such competition could adversely affect the Company's ability to obtain new long-term contracts and renewals of existing long-term contracts on terms favorable to the Company. Any reduction in the price of the Company's products could materially adversely affect the Company's business, financial condition and results of operations. Some of the Company's current, and many of the Company's potential, competitors have significantly greater financial, technical, marketing and other resources than the Company. As a result, they may be able to respond more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the development, promotion and sale of their products than the Company. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the Company's prospective customers. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly gain significant market share. Also, the Company relies upon its customers to provide data, expertise and other support for the ongoing updating of the Company's models. The Company's customers, most of which have significantly greater financial and marketing resources than the Company, may compete with the Company in the future or otherwise discontinue their relationships with or support of the Company. There can be no assurance that the Company will be able to compete successfully against current and future competitors or that competitive pressures faced by the Company will not materially adversely affect its business, financial condition and results of operations. See "Business -- Competition." RISKS ASSOCIATED WITH RECRUITING AND RETAINING QUALIFIED PERSONNEL. The Company's success depends to a significant degree upon the continued service of members of the Company's senior management and other key research, development, sales and marketing personnel. Accordingly, the loss of any of the Company's senior management or key research, development, sales or marketing personnel could have a material adverse effect on the Company's business, financial condition and results of operations. Only a small number of employees have employment agreements with the Company, and there can be no assurance that such agreements will result in the retention of these employees for any significant period of time. In addition, the untimely loss of a member of the management team or a key employee of a business acquired by the Company could have a material adverse effect on the Company's business, financial condition and results of operations, particularly if such loss occurred before the Company has had adequate time to familiarize itself with the operating details of that business. In the past, the Company has experienced difficulty in recruiting a sufficient number of qualified sales and technical employees. In addition, competitors may attempt to recruit the Company's key employees. There can be no assurance that the Company will be successful in attracting, assimilating and retaining such personnel. The failure to attract, assimilate and retain key personnel could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Employees" and "Management." CUSTOMER CONCENTRATION. Product licenses to First Data, the largest provider of credit card charge receipt processing services to banks, accounted for 8.7%, 8.6% and 7.6% of the Company's total revenues in 1995, 1996 and 1997, respectively. The Company has licensed First Data to provide its customers with access to the Company's ProfitMax product pursuant to the ProfitMax Contract entered into in January 1996. The 20 21 Company's revenues under the ProfitMax Contract represented approximately one-quarter of the Company's revenues from First Data in 1997. In late January 1998, First Data asserted that certain restrictive covenants under the ProfitMax Contract violated certain intellectual property laws. First Data also asserted that the existence of such restrictions made the ProfitMax Contract at least temporarily unenforceable and that First Data is therefore not obligated to pay the Company license fees due under the ProfitMax Contract. The Company disputed First Data's claim, released and waived the above-mentioned restrictive covenants in the ProfitMax Contract and gave First Data written notice that the Company intended to terminate the ProfitMax Contract pursuant to its terms unless First Data cured its failure to pay the delinquent license fees in a timely manner. Currently, First Data and the Company are working to resolve their dispute regarding the ProfitMax Contract by negotiating a new agreement; however, there can be no assurance that such an agreement will be reached or that the terms of such an agreement would be as favorable to HNC as its existing contractual arrangements with First Data. If no such agreement can be reached and First Data maintains its current position, it is possible that litigation or arbitration could ensue, which would likely result in a loss of anticipated revenue to the Company under the ProfitMax Contract and possibly other agreements between the Company and First Data, which could have a material adverse effect on the Company's business, financial condition and results of operation. See "Business -- Sales and Marketing." RISKS ASSOCIATED WITH INTERNATIONAL SALES. In 1995, 1996 and 1997, international operations and export sales (including sales in Canada) represented 12.6%, 17.7% and 16.8% of the Company's total revenues, respectively. The Company intends to continue to expand its operations outside the United States and to enter additional international markets, including by adding sales and support offices in Europe and Japan, which will require significant management attention and financial resources. For certain more mature products, such as Falcon, the Company may need to increase international sales in order to continue to expand the product's customer base. The Company has committed and continues to commit significant time and development resources to customizing certain of its products for selected international markets and to developing international sales and support channels. There can be no assurance that the Company's efforts to develop products, databases and models for targeted international markets or to develop additional international sales and support channels will be successful. The failure of such efforts, which can entail considerable expense, could have a material adverse effect on the Company's business, financial condition and results of operations. International sales are subject to additional inherent risks, including longer payment cycles, unexpected changes in regulatory requirements, import and export restrictions and tariffs, difficulties in staffing and managing foreign operations, the burdens of complying with a variety of foreign laws, greater difficulty or delay in accounts receivable collection, potentially adverse tax consequences and political and economic instability. The Company's international sales are currently denominated predominantly in United States dollars and a small portion are denominated in British pounds sterling. An increase in the value of the United States dollar relative to foreign currencies could make the Company's products more expensive, and therefore potentially less competitive, in foreign markets. In the future, to the extent the Company's international sales are denominated in local currencies, foreign currency translations may contribute to significant fluctuations in the Company's business, financial condition and results of operations. If for any reason exchange or price controls or other restrictions on foreign currencies are imposed, the Company's business, financial condition and results of operations could be materially adversely affected. See "Business -- Sales and Marketing." RISKS ASSOCIATED WITH CHANGING REGULATORY ENVIRONMENT. The Company's customers are subject to a number of government regulations and certain other industry standards with which the Company's products must comply. For example, the Company's financial services products are affected by Regulation B promulgated under the Equal Credit Opportunity Act, by regulations governing the extension of credit to consumers and by Regulation E promulgated under the Electronic Fund Transfers Act governing the transfer of funds from and to consumer deposit accounts, as well as VISA and MasterCard electronic payment standards. In the mortgage services market, the Company's products are affected by regulations such as Fannie Mae and Freddie Mac regulations for conforming loans, Uniform Standards of Professional Appraisal Practice and appraisal standards for federally insured institutions under the Financial Institutions Reform, Recovery and Enforcement Act. In addition, recent regulatory initiatives have restricted the availability of bank and credit bureau data, reflecting a consumer privacy trend that could limit the Company's ability to 21 22 obtain or use certain credit-related information. It is also possible that insurance-related regulations may in the future apply to the Company's healthcare/insurance products. In many states, including California, there have been periodic legislative efforts to reform workers' compensation laws in order to reduce the cost of workers' compensation insurance and to curb abuses of the workers' compensation system, and such changes, if adopted, might adversely affect the Company's healthcare/insurance business. In addition, if state- mandated workers' compensation laws or regulations or state workers' compensation fee schedules are simplified, such changes would diminish the need for, and the benefit provided by, the CRLink product. Changes in workers' compensation laws or regulations could also adversely affect the Company's healthcare/ insurance products by making them obsolete, or by requiring extensive changes in these products to reflect new workers' compensation rules. To the extent that the Company sells new products targeted to markets that include regulated industries and businesses, the Company's products will need to comply with these additional regulations. Any failure of the Company's products to comply with existing or new regulations and standards could result in legal action against the Company or its customers by regulatory authorities or by third parties, including actions seeking civil or criminal penalties, injunctions against the Company's use of data or civil damages, any of which could have a material adverse effect on the Company's business, financial condition and results of operations. The Company may also be liable to its customers for failure of its products to comply with such regulatory requirements. Furthermore, changes to these regulations and standards or the adoption of new regulations or standards that affect the Company's products could affect the performance of such products and have a material adverse effect on the Company's business, financial condition and results of operations. PROTECTION OF INTELLECTUAL PROPERTY. The Company relies on a combination of patent, copyright, trademark and trade secret laws and confidentiality procedures to protect its proprietary rights. The Company currently owns seven issued United States patents and has four United States patent applications pending. The Company has applied for additional patents for its Falcon technology in Canada, Europe and Japan and for its MIRA product in Australia, Canada and Europe. There can be no assurance that patents will be issued with respect to pending or future patent applications or that the Company's patents will be upheld as valid or will prevent the development of competitive products. The Company seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. As part of its confidentiality procedures, the Company generally enters into invention assignment and proprietary information agreements with its employees and independent contractors and nondisclosure agreements with its distributors, corporate partners and licensees, and limits access to and distribution of its software, documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise to obtain and use the Company's products or technology without authorization, or to develop similar technology independently. In addition, to ensure that customers will not be adversely affected by an interruption in the Company's business, the Company places source code for certain of its products into escrow, which may increase the likelihood of misappropriation or other misuse of the Company's intellectual property. Moreover, effective protection of intellectual property rights may be unavailable or limited in certain foreign countries in which the Company has done and may do business. Also, the Company has developed technologies under research projects conducted under agreements with various United States Government agencies or subcontractors to such agencies. Although the Company has acquired certain commercial rights to such technologies, the United States Government typically retains ownership of certain intellectual property rights and licenses in the technologies developed by the Company under such contracts, and in some cases can terminate the Company's rights in such technologies if the Company fails to commercialize them on a timely basis. In addition, under certain United States Government contracts, the results of the Company's research may be made public by the government, which could limit the Company's competitive advantage with respect to future products based on such research. See "Business -- Intellectual Property and Other Proprietary Rights." INFRINGEMENT OF PROPRIETARY RIGHTS. In the past, the Company has received communications from third parties asserting that Company trademarks infringed such other parties' trademarks, none of which has resulted in litigation or losses to the Company. Given the Company's ongoing efforts to develop and market new technologies and products, the Company may receive communications from third parties asserting that the Company's products infringe, or may infringe, their intellectual property rights. If as a result of any such 22 23 claims the Company were precluded from using certain technologies or intellectual property rights, licenses to such disputed third-party technology or intellectual property rights might not be available on reasonable commercial terms, if at all. Furthermore, the Company may initiate claims or litigation against third parties for infringement of the Company's proprietary rights or to establish the validity of the Company's proprietary rights. Litigation, either as plaintiff or defendant, could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel from productive tasks, whether or not such litigation is resolved in favor of the Company. In the event of an adverse ruling in any such litigation, the Company might be required to pay substantial damages, discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses to infringing technology, and the court might invalidate the Company's patents, trademarks or other proprietary rights. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company's business, financial condition and results of operations would be materially and adversely affected. As the number of software products increases and the functionality of these products further overlaps, the Company believes that software developers may become increasingly subject to infringement claims. Any such claims, with or without merit, can be time consuming and expensive to defend and could materially and adversely affect the Company's business, financial condition and results of operations. See "Business -- Intellectual Property and Other Proprietary Rights." RISK OF PRODUCT DEFECTS AND PRODUCT LIABILITY. Software products as complex as those offered by the Company often contain undetected errors or failures when first introduced or as new versions are released. In addition, to the extent that the Company may have to develop new products that operate in new environments, such as the Internet, the possibility for program errors and failures may increase due to factors such as the use of new technologies or the need for more rapid product development that is characteristic of the Internet market. Despite pre-release testing by the Company and by current and potential customers, there still may be errors in new products, even after commencement of commercial shipments. The occurrence of such errors could result in delay in, or failure to achieve, market acceptance of the Company's products, which could have a material adverse effect on the Company's business, financial condition and results of operations. Although the Company's license agreements with its customers typically contain provisions designed to limit the Company's exposure to potential product liability claims, it is possible that such limitation of liability provisions may not be effective as a result of existing or future laws or unfavorable judicial decisions. Because the Company's products are used in business-critical applications, any errors or failures in such products may give rise to substantial product liability claims, which could have a material adverse effect on the Company's business, financial condition and results of operations. YEAR 2000 COMPLIANCE. Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. These date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, in less than two years, computer systems and/or software used by many companies may need to be upgraded to comply with such "Year 2000" requirements. Significant uncertainty exists in the software industry concerning the potential effects associated with such compliance. The Company anticipates that it will need to devote resources in the next two years to modify its CRLink product to properly process dates beyond December 31, 1999. The Company expects that the cost of making these modifications and distributing the modified product to existing customers will be approximately $500,000. These modifications and the resources that the Company expects to devote to such modifications may divert management and engineering attention from, or delay the development and introduction of, new products and enhancements to existing products. The inability of the Company to complete such modifications successfully and on a timely basis, or the inability of the Company to devote sufficient resources to continuing updates and enhancements to the CRLink product, could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the Company believes that the purchasing patterns of customers and potential customers may be affected by Year 2000 issues as companies expend significant resources to correct or patch their current software systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase software products such as those offered by the Company, which could result in a material adverse effect on the Company's business, financial condition and results of operations. 23 24 FACTORS INHIBITING TAKEOVER. The Board of Directors is authorized to issue up to 4,000,000 shares of Preferred Stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the stockholders. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. The issuance of Preferred Stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of the outstanding voting stock of the Company. The Company has no current plans to issue shares of Preferred Stock. In addition, Section 203 of the Delaware General Corporation Law restricts certain business combinations with any "interested stockholder" as defined by such statute. The statute may have the effect of delaying, deferring or preventing a change in control of the Company. ITEM 2. PROPERTIES The Company's principal administrative, sales, marketing, support, research and development facilities are located in approximately 85,000 square feet of space in San Diego, California. The Company and its subsidiaries also lease an aggregate of approximately 95,000 square feet of additional office space elsewhere in San Diego and in Atlanta, Georgia; Minneapolis, Minnesota; Costa Mesa, California; and Irvine, California. The Company and its subsidiaries also maintain numerous field offices in the United States and in foreign countries. The Company believes that its current facilities are adequate to meet its needs for the foreseeable future. The Company believes that suitable additional or alternative space will be available in the future on commercially reasonable terms as needed. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any litigation other than ordinary routine litigation incidental to the business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS A Special Meeting of Stockholders was held on November 25, 1997 to approve two proposals: (1) a proposal to approve the issuance by the Company of shares of HNC Common Stock and options to purchase HNC Common Stock to the stockholders and optionholders, respectively, of CompReview; and (2) a proposal to approve an amendment to the Company's 1995 Equity Incentive Plan increasing the number of shares of the Company's Common Stock reserved for issuance thereunder by 750,000 shares. The proposals passed by the following vote:
ABSTENTIONS AND BROKER VOTES FOR VOTES AGAINST NON-VOTES ---------- ------------- ----------- Proposal(1)....................... 15,748,682 80,072 791,746 Proposal(2)....................... 15,578,243 1,026,607 15,650
PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock has been traded on the Nasdaq National Market since June 1995 under the symbol "HNCS." The following table sets forth for the periods indicated the high and low sales prices of the Common Stock. Prior to June 1995, there was no established public trading market for the Common 24 25 Stock. All prices have been adjusted to give effect to a two-for-one stock split effected in the form of a stock dividend paid in April 1996.
HIGH LOW ---- ---- 1996: First Quarter.................................... $38 3/4 $18 1/4 Second Quarter................................... 51 31 1/4 Third Quarter.................................... 47 1/2 20 3/4 Fourth Quarter................................... 45 1/4 26 1/4 1997: First Quarter.................................... $36 3/4 $23 1/4 Second Quarter................................... 42 3/8 18 1/4 Third Quarter.................................... 43 5/8 33 3/4 Fourth Quarter................................... 43 1/2 30
As of February 13, 1998, there were approximately 186 holders of record of the Common Stock. The Company has never declared or paid any cash dividends on its capital stock. The Company currently anticipates that it will retain all future earnings for use in its business and does not anticipate paying any cash dividends in the foreseeable future. The Company's bank credit agreement prohibits the Company from declaring or paying any cash dividends without the bank's consent. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data as of December 31, 1996 and 1997 and for each of the years in the three-year period ended December 31, 1997 have been derived from HNC's audited Consolidated Financial Statements included elsewhere in this Report. The selected consolidated financial data as of December 31, 1994 and 1995 and for the year ended December 31, 1994 have been derived from separate audited financial statements for HNC and CompReview not included herein. The selected consolidated financial data as of and for the year ended December 31, 1993 have been derived from separate financial data for HNC and CompReview not included herein. The data set forth below are qualified in their entirety by reference to, and should be read in conjunction with, "Management's Discussion and Analysis of Financial 25 26 Condition and Results of Operations" and the Consolidated Financial Statements and related notes thereto included elsewhere in this Report.
YEAR ENDED DECEMBER 31, -------------------------------- 1995 1996 1997 -------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF INCOME DATA(1): Revenues: License and maintenance.............................................. $ 24,561 $48,890 $89,643 Installation and implementation...................................... 4,648 6,691 10,702 Contracts and other.................................................. 9,146 11,128 7,772 Service bureau....................................................... 5,349 4,730 5,618 -------- ------- ------- Total revenues................................................ 43,704 71,439 113,735 -------- ------- ------- Operating expenses: License and maintenance.............................................. 7,903 13,725 19,937 Installation and implementation...................................... 1,425 2,714 5,174 Contracts and other.................................................. 6,894 7,694 5,438 Service bureau....................................................... 3,025 3,365 4,320 Research and development............................................. 6,998 13,808 21,151 Sales and marketing.................................................. 7,276 11,923 22,049 General and administrative........................................... 5,101 8,551 12,626 -------- ------- ------- Total operating expenses...................................... 38,622 61,780 90,695 -------- ------- ------- Operating income....................................................... 5,082 9,659 23,040 Interest and other income.............................................. 912 2,178 2,003 Interest expense....................................................... (428) (478) (81) Minority interest in income of consolidated subsidiary................. -- -- (43) -------- ------- ------- Income before income tax (benefit) provision.................. 5,566 11,359 24,919 Income tax (benefit) provision......................................... (511) (534) 7,354 -------- ------- ------- Net income.................................................... $ 6,077 $11,893 $17,565 ======== ======= ======= Earnings per share: Basic net income per common share(2)................................. $ 0.38 $ 0.50 $ 0.72 ======== ======= ======= Diluted net income per common share(2)............................... $ 0.28 $ 0.47 $ 0.68 ======== ======= ======= Unaudited pro forma data(3): Income before income tax provision................................... $ 5,566 $11,359 $24,919 Income tax provision................................................. 1,032 1,628 9,502 -------- ------- ------- Net income.................................................... $ 4,534 $ 9,731 $15,417 ======== ======= ======= Basic pro forma net income per common share(3)....................... $ 0.64 ======= Diluted pro forma net income per common share(3)..................... $ 0.60 ======= Shares used in computing basic net income per common share and unaudited basic pro forma net income per common share................ 15,195 23,552 24,275 ======== ======= ======= Shares used in computing diluted net income per common share and unaudited diluted pro forma net income per common share.............. 21,510 25,363 25,681 ======== ======= =======
26 27
YEAR ENDED DECEMBER 31, ------------------------------------------------ 1993 1994 1995 1996 1997 ------- ------- ------- ------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) ADDITIONAL STATEMENT OF INCOME DATA:(1) Total revenues........................................ $16,167 $29,838 $43,704 $71,439 $113,735 Operating income...................................... 1,034 2,881 5,082 9,659 23,040 Net income............................................ 875 3,142 6,077 11,893 17,565 Basic net income per common share(2).................. 0.02 0.28 0.38 0.50 0.72 Diluted net income per common share(2)................ 0.02 0.17 0.28 0.47 0.68 Pro forma net income(3)............................... 641 2,137 4,534 9,731 15,417 Basic pro forma net income per common share(3)........ 0.64 Diluted pro forma net income per common share(3)...... 0.60 Shares used in computing unaudited basic net income per common share and basic pro forma net income per common share........................................ 8,591 8,642 15,195 23,552 24,275 Shares used in computing unaudited diluted net income per common share and diluted pro forma net income per common share.................................... 9,289 18,142 21,510 25,363 25,681
DECEMBER 31, ------------------------------------------------ 1993 1994 1995 1996 1997 ------- ------- ------- ------- -------- (IN THOUSANDS) BALANCE SHEET DATA: Cash, cash equivalents and investments available for sale................................................ $ 4,679 $ 7,827 $44,975 $34,849 $ 42,946 Total assets.......................................... 10,944 20,663 63,113 98,293 119,877 Long-term obligations, less current portion........... 367 917 1,373 264 63 Mandatorily redeemable convertible preferred stock.... 12,452 13,169 -- -- --
- --------------- (1) The selected consolidated financial data gives retroactive effect to the acquisitions of Risk Data, Retek and CompReview for all periods presented, accounted for as poolings of interests. (2) The computations of basic net income per common share for 1993, 1994 and 1995 include reductions of consolidated net income in the amounts of $717,000, $717,000 and $348,000, respectively, related to the accretion of dividends on mandatorily redeemable convertible Preferred Stock, which converted into Common Stock upon the closing of the Company's initial public offering on June 26, 1995. The computation of diluted net income per common share for 1993 does not include the assumed conversion of all outstanding shares of mandatorily redeemable convertible Preferred Stock into 7,675,000 shares of Common Stock or an increase to net income per common share related to the elimination of dividend accretion on such Preferred Stock as the impact would be antidilutive. (3) Pro forma net income and net income per common share reflect a provision for taxes on the income of CompReview, which was a subchapter S corporation prior to its acquisition by HNC, as if CompReview had been subject to corporate income taxes as a C corporation for all periods presented. ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Report (including without limitation the following section regarding Management's Discussion and Analysis of Financial Condition and Results of Operations) contains forward-looking statements (within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act) regarding the Company and its business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Report. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements. Although forward-looking statements in this Report reflect the good faith judgment of the Company's management, such statements can only be based on facts and factors currently known by the Company. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results 27 28 and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include without limitation those discussed in "Risk Factors" in Item 1 above as well as those discussed elsewhere in this Report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Report. The Company undertakes no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Report. Readers are urged to carefully review and consider the various disclosures made by the Company in this Report, which attempt to advise interested parties of the risks and factors that may affect the Company's business, financial condition, results of operations and prospects. OVERVIEW HNC develops, markets and supports predictive software solutions for leading service industries. These predictive software solutions employ proprietary neural-network predictive decision engines, profiles, traditional statistical modeling, business models, expert rules and context vectors to convert existing data and business experiences into meaningful recommendations and actions. HNC was founded in 1986 to provide software tools and contracted technology services using neural-network technology. In August 1996, HNC completed its acquisition of Risk Data in a transaction accounted for as a pooling of interests. Risk Data is based in Irvine, California and develops, markets and supports proprietary software decision products for use in the insurance industry. In 1996, HNC formed Aptex Software Inc. ("Aptex"), a majority-owned subsidiary located in San Diego, California that develops, markets and supports electronic text analysis technology in products designed for the Internet and other environments. In November 1996, HNC completed its acquisition of Retek in a transaction accounted for as a pooling of interests. Retek is based in Minneapolis, Minnesota and develops, markets and supports software products that provide merchandise management and other management tools to retailers and their vendors. In November 1997, the Company completed its acquisition of CompReview, in a transaction accounted for as a pooling of interests. CompReview is located in Costa Mesa, California and develops, markets and supports a software product and related services designed to assist in the management and containment of the medical costs of workers' compensation and automobile accident medical claims. CompReview provides its product and services primarily to insurance companies, managed care organizations, third party administrators and large self-insured employers. The Company anticipates that from time to time it will consider acquisitions of other businesses in order to expand the markets served by the Company and to acquire complementary technologies, products and personnel. See "Business -- Risk Factors -- Acquisitions" and "Business -- HNC's Strategy." After giving retroactive effect to the Company's acquisitions of Risk Data, Retek and CompReview, HNC experienced compound annual growth in total revenues of 63% from 1993 through 1997. See "Business -- Risk Factors -- Risks Associated with Managing Growth." This revenue growth resulted primarily from increased license fees for the Retek Merchandising System, CRLink, Falcon, MIRA and ProfitMax products and, to a lesser extent, from increased license fees for the Active Retail Intelligence, Retek Data Warehouse, PMAdvisor, CompCompare, Capstone and AREAS products. Because of the long sales and development cycle associated with the Company's products, the Company has not received significant revenues to date from the SelectCast, SelectResponse, SelectResource, VeriComp or PMAdvisor products. See "Business -- Risk Factors -- Lengthy and Unpredictable Sales Cycle." The Company markets most of its predictive software solutions as an ongoing service that includes software licenses, decision model updates, application consulting and on-line or on-site support and maintenance. The Company's pricing for the CRLink, Falcon, MIRA, ProfitMax, AREAS, PMAdvisor, CompCompare and ProviderCompare products typically includes an annual or monthly usage fee and a one to seven year contract commitment. In 1995, 1996 and 1997, annual license and maintenance revenues from these contracts represented 61.2%, 56.1% and 55.2% of the Company's total revenues, respectively. The Company's revenues and operating results have varied significantly in the past and may do so in the future. Because the Company's expense levels are based in part on its expectations regarding future revenues and in the short term are fixed to a large extent, the Company may be unable to adjust its spending in time to 28 29 compensate for any unexpected revenue shortfall. Factors affecting operating results include market acceptance of the Company's products; the relatively large size and small number of customer orders that may be received during a given period; customer cancellation of long-term contracts yielding recurring revenues or customers' ceasing their use of Company products for which the Company's fees are usage based; the length of the Company's sales cycle; the Company's ability to develop, introduce and market new products and product enhancements; the timing of new product announcements and introductions by the Company and its competitors; changes in the mix of distribution channels; changes in the level of operating expenses; the Company's ability to achieve progress on percentage-of-completion contracts; the Company's success in completing certain pilot installations for contracted fees; competitive conditions in the industry; domestic and international economic conditions; and market conditions in the Company's targeted markets. In addition, as a result of recently issued guidance on software revenue recognition, license agreements entered into during a quarter may not meet the Company's revenue recognition criteria. Therefore, even if the Company meets or exceeds its forecast of aggregate licensing and other contracting activity, it is possible that the Company's revenues would not meet expectations. Furthermore, the Company's operating results may be affected by factors unique to certain of its product lines. For example, the Company derives a substantial and increasing portion of its revenues from its retail products, which are generally priced as "perpetual" license transactions in which the Company receives a one-time license fee. The Company recognizes these fees as revenue upon delivery of the software and acceptance by the customer. Thus, failure to complete a perpetual license transaction during a fiscal quarter could have a disproportionate adverse impact on the Company's operating results for that quarter. The Company expects fluctuations in its operating results to continue for the foreseeable future. Accordingly, the Company believes that period-to-period comparisons of its financial results should not be relied upon as an indication of future performance. The Company may not be able to maintain profitability on a quarterly or annual basis in the future. Due to all of the foregoing factors, it is possible that in some future quarter the Company's operating results will be below the expectations of public market analysts and investors. In that event, the price of the Company's Common Stock would likely be materially adversely affected. RESULTS OF OPERATIONS The Company's statements of income for all periods presented give retroactive effect to the acquisitions of Risk Data, Retek and CompReview in August 1996, November 1996 and November 1997, respectively, each of which was accounted for as a pooling of interests. Total Revenues The Company's revenues are comprised of license and maintenance revenues, installation and implementation revenues, contracts and other revenues and service bureau revenues. Total revenues increased by 63.5% to $71.4 million in 1996 and by 59.2% to $113.7 million in 1997. International operations and export sales represented 12.6%, 17.7% and 16.8% of total revenues in 1995, 1996 and 1997, respectively. The retail product line currently has more sales in international markets than the healthcare/insurance and financial services product lines combined. The Company believes that international sales represent a significant opportunity for revenue growth and expects international sales to increase as a percent of total revenue. License and Maintenance Revenues. The Company's license and maintenance revenues are derived from annual license fees, monthly license fees, perpetual license fees and annual maintenance fees. The Company typically licenses many of its products for an annual or monthly usage fee under long-term contracts that include software licenses, decision model updates, application consulting, and on-line or on-site support and maintenance. The Company's revenue from periodic software license and maintenance agreements is generally recognized ratably over the respective license or agreement periods. Revenue from certain short-term periodic software license and maintenance agreements with guaranteed minimum license fees is recognized as related services are performed. Transactional fees are recognized as revenue based on system usage or when fees based on system usage exceed the monthly minimum license fees. Revenue from perpetual licenses of the Company's software for which there are no significant continuing obligations and collection of the related receivables is probable is recognized on 29 30 delivery of the software and acceptance by the customer. Recently issued guidance on software revenue recognition could lead to unanticipated changes in the Company's revenue recognition practices. See "Risk Factors -- Potential Fluctuations in Operating Results" and "New Accounting Pronouncements." License and maintenance revenues increased by 99.1% to $48.9 million in 1996 and by 83.4% to $89.6 million in 1997. The increase from 1995 to 1996 was due primarily to the growth of license fees in all markets, particularly from the Retek Merchandising System, CRLink and Falcon, and, to a lesser extent, MIRA and CompCompare. The increase from 1996 to 1997 was due primarily to the growth of license fee revenues from the Retek Merchandising System and CRLink. Also contributing to the increase were increased license fees from other retail products, such as ARI and Retek Data Warehouse, financial services products such as Falcon, ProfitMax and Capstone, and other healthcare/insurance products, such as PMAdvisor and MIRA. Installation and Implementation Revenues. Revenues from software installations and implementations are generally recognized as the services are performed using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Amounts received in advance of performance under the contracts are recorded as deferred revenue and are generally recognized within one year from receipt. Installation and implementation revenues increased by 44.0% to $6.7 million in 1996 and by 59.9% to $10.7 million in 1997. Substantially all of the increase from 1995 to 1996 was due primarily to growth in the installations of Retek Data Forecasting as this product moved from development into production. The increase from 1996 to 1997 was due primarily to growth in the installations of Capstone and ProfitMax. Contracts and Other Revenues. Contracts and other revenues are derived primarily from new product development contracts with commercial customers and research contracts with the United States Government. The Company typically contracts with one or two commercial partners for pilot development and installation of its new products and with the United States Government for additional research funds. Revenues from contract services are generally recognized as the services are performed using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Revenue from hardware product sales, which is included in contracts and other revenue, is recognized upon shipment to the customer. Contracts and other revenues increased by 21.7% to $11.1 million in 1996 and decreased by 30.2% to $7.8 million in 1997. The increase in 1996 was primarily the result of greater revenues from commercial new product pilot installation contracts with customers in support of the Company's development of ProfitMax, SelectCast, Falcon Sentry and Capstone. The decrease in 1997 was primarily the result of products such as ProfitMax, Retek Data Forecasting and Capstone moving from development into production. During 1997, the Company had fewer new product development projects and new product pilot installations than during 1996. There can be no assurance that any of these product development projects or pilot installations will be successful or be completed within anticipated time schedules or that the customers who serve as pilot installation sites will be satisfied with these products or agree to license them. If the Company's new product development efforts are unsuccessful, are not completed on a timely basis or are not well received by pilot customers, the Company may be compelled to delay or discontinue the release of production versions of these products or bear increased expense to bring these pilot products to market, either of which would have a material adverse effect on the Company's business, financial condition and results of operations. Service Bureau Revenues. Service bureau revenues are derived from the Company's service bureau operations, which provide CRLink's functionality to customers that do not wish to obtain a license, that use this service until they can implement their own internal CRLink operation or that use this service when their volumes peak to high levels. Service bureau customers typically subscribe for services under month-to-month agreements. Service bureau fees are recognized as revenue when the processing services are performed. 30 31 Service bureau revenues decreased by 11.6% to $4.7 million in 1996 and increased by 18.8% to $5.6 million in 1997. The decrease in 1996 was primarily a result of the significant increase in license revenues as the Company's sales efforts were focused on licensing CRLink to customers rather than marketing service bureau services. The increase in 1997 was primarily due to an increase in the number of customers utilizing service bureau operations. Gross Margin The following table sets forth the gross margin for each of the Company's revenue categories for each of the comparison periods.
YEARS ENDED DECEMBER 31, ------------------------ 1995 1996 1997 ---- ---- ---- License and maintenance.............................. 67.8% 71.9% 77.8% Installation and implementation...................... 69.3 59.4 51.7 Contracts and other.................................. 24.6 30.9 30.0 Service bureau....................................... 43.4 28.9 23.1
License and Maintenance Gross Margin. License and maintenance costs primarily represent the Company's expenses for personnel engaged in customer support, travel to customer sites and documentation materials. The Company's gross margin on license and maintenance revenues was 67.8%, 71.9% and 77.8% in 1995, 1996 and 1997, respectively. In 1996, the improvement in gross margin was the result of the Company's ability to move from price discounts for early adopters of its products to full pricing for products sold to subsequent customers as well as a higher volume of international licenses, which generate relatively higher margins than domestic operations due, in part, to lower overhead expenses as a result of less corporate infrastructure. Gross margin improved in 1997 due primarily to license fees increasing at a higher rate than the costs associated with providing these licenses. This increase was primarily attributable to increased pricing producing higher margins in the retail and healthcare/insurance markets. Installation and Implementation Gross Margin. Installation and implementation costs consist primarily of personnel-related costs, travel and equipment. The Company's gross margin on installation and implementation revenues was 69.3%, 59.4% and 51.7% in 1995, 1996 and 1997, respectively. In 1996, the decrease in the gross margin was due primarily to new installations of Retek Data Forecasting, which have substantially lower margins than installations of Falcon products, which represented a majority of installations in 1995. Gross margin decreased in 1997 due primarily to an increase in Capstone implementations, which have substantially lower margins than implementations of Falcon products. Contracts and Other Gross Margin. Contracts and other costs consist primarily of personnel-related costs. The Company's gross margin on contracts and other revenues was 24.6%, 30.9% and 30.0% in 1995, 1996 and 1997, respectively. The improvement in gross margin during 1996 was due primarily to the Company's increased ability to better price its new pilot projects. The slight decrease in gross margin for 1997 was due to the decrease in new product development contracts, while government projects with substantially lower margins remained relatively constant in absolute dollars. Service Bureau Gross Margin. Service bureau costs consist primarily of the personnel and facilities costs of operating the service bureaus. The Company's gross margin on service bureau revenues was 43.4%, 28.9% and 23.1% in 1995, 1996 and 1997, respectively. The decrease in 1996 was a result of the loss of a customer in early 1996 for which the Company was able to recognize higher than usual margins during 1995. The decrease in 1997 was attributable to an increase in fixed costs and in labor costs required to support the service bureau business that outpaced the increase in revenue. This was the result of a more static customer base and higher fixed costs associated with the infrastructure necessary to run the service bureau operation. 31 32 Other Operating Expenses Research and Development Expenses. Research and development expenses consist primarily of salaries and other personnel-related expenses, subcontracted development services, depreciation for development equipment and supplies. Research and development expenses increased from $7.0 million in 1995 to $13.8 million in 1996 and to $21.2 million in 1997, representing 16.0%, 19.3% and 18.6% of total revenues in 1995, 1996 and 1997, respectively. Research and development expenses increased in absolute dollars due to the development costs associated with new releases of several products in the retail and financial services product lines. The increased research and development expenses in absolute dollars and as a percentage of revenues in 1996 was primarily the result of greater staffing to support more new product development programs, primarily for ProfitMax, Capstone, CompCompare, ProviderCompare and the Retek Merchandising System. The 1996 costs also included the initial product development costs of the Company's Aptex business unit, which did not have a significant impact on revenues. Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed," requires capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on the Company's product development process, technological feasibility is not established until completion of a working model. Costs incurred by the Company between completion of the working model and the point at which a product is ready for general release have been insignificant. As a result, no significant software development costs were capitalized through December 31, 1997. The Company anticipates that research and development expenses will increase in dollar amount and could increase as a percentage of total revenues for the foreseeable future. Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries and benefits, commissions, travel, entertainment and promotional expenses. Sales and marketing expenses increased from $7.3 million in 1995 to $11.9 million in 1996 and to $22.0 million in 1997, representing 16.6%, 16.7% and 19.4% of total revenues in 1995, 1996 and 1997, respectively. The increases were primarily a result of increased staffing as the Company built its direct sales and marketing staff, opened sales offices in Japan and in several locations in Europe, and increased expenses for trade shows, advertising and other marketing programs. The Company expects sales and marketing expenses to continue to increase for the foreseeable future. Such expenses could also increase as a percentage of total revenues as the Company continues to develop a direct sales force in Europe and other international markets, expand its domestic sales and marketing organization and increase the breadth of its product lines. General and Administrative Expenses. General and administrative expenses consist primarily of personnel costs for finance, contract administration, human resources and general management, as well as acquisition, insurance and professional services expenses. General and administrative expenses increased from $5.1 million in 1995 to $8.6 million in 1996 and to $12.6 million in 1997, representing 11.7%, 10.3% and 9.8% of total revenues, respectively. General and administrative expenses included $1.2 million of acquisition expenses related to the acquisitions of Risk Data and Retek in 1996 and $1.4 million of acquisition expenses primarily related to the acquisition of CompReview in 1997. Excluding acquisition expenses, general and administrative expenses were $5.1 million, $7.4 million and $11.2 million in 1995, 1996 and 1997, respectively. The primary reason for these increases in absolute dollars was increased staffing to support the Company's growth and additional expenses associated with being a public company. Operating Income The above factors resulted in operating income of $5.1 million, constituting 11.6% of total revenues in 1995, $9.7 million, constituting 13.5% of total revenues in 1996, and $23.0 million, constituting 20.3% of total revenues in 1997. The Company does not expect that operating income will continue to increase significantly as a percentage of total revenues. 32 33 Other Income (Expense) Net Interest and other income, net of interest expense, increased from $484,000 in 1995 to $1.7 million in 1996 and to $1.9 million in 1997. The increase in 1996 was primarily attributable to increased interest income in 1996 from higher cash and investment balances, which consisted primarily of the proceeds from the Company's initial public offering in June 1995 and secondary public offering in December 1995. The increase in 1997 was primarily due to a decrease in interest expense of approximately $397,000 primarily related to the repayment of Risk Data's bank notes payable during the third quarter of 1996, offset by a decrease in interest income of approximately $165,000. Income Tax (Benefit) Provision The income tax benefit of $511,000 in 1995 was primarily attributable to the recognition of a $2.2 million deferred tax asset based on anticipated future utilization of all of the Company's remaining net operating loss carryforwards and research and development credit carryforwards. The income tax benefit of $534,000 in 1996 was primarily attributable to the recognition of a $2.7 million deferred tax asset based on anticipated future utilization of all of the remaining net operating loss carryforwards and research and development credit carryforwards relating to Risk Data and Retek. That deferred tax asset had previously been offset by a valuation allowance. The Company released the valuation allowance during the fourth quarter of 1996, based upon management's assessment that it was more likely than not that the Company would realize the asset in future periods. The 1997 income tax provision of $7.4 million, or 29.5% of pre-tax income, was lower than 1997 taxes at statutory rates primarily as a result of CompReview's subchapter S corporation status prior to the acquisition, which resulted in most of CompReview's tax liability being borne by its former stockholders. As of the date of the acquisition, CompReview's tax status was changed to C corporation. In the future, the Company expects that the effective tax rate will be reflective of the tax rate of other California-based companies. LIQUIDITY AND CAPITAL RESOURCES The $21.0 million of net cash provided by operating activities in 1997 represented net income before depreciation and amortization of approximately $22.4 million, further increased by a decrease in deferred income taxes of $6.9 million and offset by an increase in accounts receivable of $11.1 million. Net cash used in investing activities was $7.7 million in 1997 primarily due to $9.6 million expended for property and equipment during 1997, including $6.0 million for computer equipment to support the increased staffing across the Company, and $1.9 million for furniture and fixtures primarily related to the relocation of the Company's Minneapolis facility, offset by approximately $1.9 million of proceeds from sales and maturities of investments available for sale net of purchases of such investments. Net cash used in financing activities was $3.2 million in 1997 primarily due to $6.8 million in distributions to the former CompReview stockholders offset by $4.0 million in net proceeds from issuances of common stock. As of December 31, 1997, the Company had $42.9 million in cash, cash equivalents and investments. The Company believes that its current cash, cash equivalents and investments available for sale balances, borrowings under its credit facility and net cash provided by operating activities, will be sufficient to meet its working capital and capital expenditure requirements for at least the next 12 months. A portion of the Company's cash could be used to repurchase shares of the Company's Common Stock from time to time in the open market. Management intends to invest the Company's cash in excess of current operating requirements in short-term, interest-bearing, investment-grade securities. A portion of the Company's cash could also be used to acquire or invest in complementary businesses or products or otherwise to obtain the right to use complementary technologies or data. From time to time, in the ordinary course of business, the Company evaluates potential acquisitions of such businesses, products, technologies or data. The Company has no present understandings, commitments or agreements with respect to any material acquisition of businesses, products, technologies or data. 33 34 YEAR 2000 COMPLIANCE The Company anticipates that it will need to devote resources in the next two years to modify its CRLink product to properly process dates beyond December 31, 1999. The Company expects that the cost of making these modifications and distributing the modified product to existing customers will be approximately $500,000. These modifications and the resources that the Company expects to devote to such modifications may divert management and engineering attention from, or delay the development and introduction of, new products and enhancements to existing products. The inability of the Company to complete such modifications successfully and on a timely basis, or the inability of the Company to devote sufficient resources to continuing updates and enhancements to the CRLink product, could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the Company believes that the purchasing patterns of customers and potential customers may be affected by Year 2000 issues as companies expend significant resources to correct or patch their current software systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase software products such as those offered by the Company, which could result in a material adverse effect on the Company's business, financial condition and results of operations. NEW ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 130 ("FAS 130"), "Reporting Comprehensive Income," which the Company is required to adopt for 1998. This statement will require the Company to report in the financial statements, in addition to net income, comprehensive income and its components including foreign currency items and unrealized gains and losses on certain investments in debt and equity securities. Upon adoption of FAS 130, the Company is also required to reclassify financial statements for earlier periods provided for comparative purposes. The adoption of FAS 130 will not have a significant impact on the Company's consolidated financial statement disclosures. In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131 ("FAS 131"), "Disclosures about Segments of an Enterprise and Related Information," which the Company is required to adopt for its 1998 annual financial statements. This statement establishes standards for reporting information about operating segments in annual financial statements and requires selected information about operating segments in interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Under FAS 131, operating segments are to be determined consistent with the way that management organizes and evaluates financial information internally for making operating decisions and assessing performance. The Company has not determined the impact of the adoption of this new accounting standard on its consolidated financial statement disclosures. In October 1997, the American Institute of Certified Public Accountants issued Statement of Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition," which the Company is required to adopt for agreements entered into with customers beginning in 1998. This statement provides guidance for software revenue recognition matters primarily from a conceptual level and does not include specific implementation guidance. Based on its reading and interpretation of SOP 97-2, the Company believes that the adoption of SOP 97-2 will not have a significant impact on its financial statements; however, detailed implementation guidelines for this standard have not yet been issued. Once issued, such detailed implementation guidance could lead to unanticipated changes in the Company's current revenue recognition practices, and such changes could be material to the Company's financial statements. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. 34 35 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following documents are filed as part of this report:
DESCRIPTION PAGE ------------------------------------------------------------------- ------- Report of Independent Accountants.................................. 36 Consolidated Balance Sheet as of December 31, 1996 and 1997........ 37 Consolidated Statement of Income for the years ended December 31, 38 1995, 1996 and 1997........................................... Consolidated Statement of Cash Flows for the years ended 39 December 31, 1995, 1996 and 1997.............................. Consolidated Statement of Changes in Stockholders' Equity for the 40 years ended December 31, 1995, 1996 and 1997.................. Notes to Consolidated Financial Statements......................... 41 Selected Consolidated Quarterly Operating Results (unaudited)...... 56
35 36 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of HNC Software Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of income, of cash flows and of changes in stockholders' equity present fairly, in all material respects, the financial position of HNC Software Inc. and its subsidiaries at December 31, 1996 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE LLP San Diego, California January 29, 1998, except as to Note 11 which is as of February 13, 1998 36 37 HNC SOFTWARE INC. CONSOLIDATED BALANCE SHEET (IN THOUSANDS, EXCEPT PER SHARE DATA) ASSETS
DECEMBER 31, -------------------- 1996 1997 ------- -------- Current assets: Cash and cash equivalents............................................. $ 8,121 $ 18,068 Investments available for sale........................................ 26,728 24,878 Accounts receivable, net.............................................. 21,856 32,980 Current portion of deferred income taxes.............................. 6,383 11,310 Other current assets.................................................. 2,553 2,802 ------- -------- Total current assets.......................................... 65,641 90,038 Deferred income taxes, less current portion............................. 22,966 15,322 Property and equipment, net............................................. 6,339 12,102 Other assets............................................................ 3,330 2,415 ------- -------- $98,276 $119,877 ======= ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable...................................................... $ 4,368 $ 5,728 Accrued liabilities................................................... 4,433 5,933 Deferred revenue...................................................... 3,377 3,883 Other current liabilities............................................. 445 191 ------- -------- Total current liabilities..................................... 12,623 15,735 Non-current liabilities................................................. 683 239 Minority interest in consolidated subsidiary............................ -- 43 Commitments and contingencies (Notes 5 and 10) Stockholders' equity: Preferred stock, $0.001 par value -- 4,000 shares authorized: no shares issued or outstanding.................................... -- -- Common stock, $0.001 par value -- 50,000 shares authorized: 24,012 and 24,538 shares issued and outstanding, respectively...... 24 25 Paid-in capital....................................................... 83,991 95,919 Unrealized loss on investments available for sale..................... (59) (2) Foreign currency translation adjustment............................... 54 (111) Retained earnings..................................................... 960 8,029 ------- -------- Total stockholders' equity.................................... 84,970 103,860 ------- -------- $98,276 $119,877 ======= ========
See accompanying notes to consolidated financial statements 37 38 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31, -------------------------------- 1995 1996 1997 -------- ------- ------- Revenues: License and maintenance.................................... $ 24,561 $48,890 $89,643 Installation and implementation............................ 4,648 6,691 10,702 Contracts and other........................................ 9,146 11,128 7,772 Service bureau............................................. 5,349 4,730 5,618 -------- ------- ------- Total revenues..................................... 43,704 71,439 113,735 -------- ------- ------- Operating expenses: License and maintenance.................................... 7,903 13,725 19,937 Installation and implementation............................ 1,425 2,714 5,174 Contracts and other........................................ 6,894 7,694 5,438 Service bureau............................................. 3,025 3,365 4,320 Research and development................................... 6,998 13,808 21,151 Sales and marketing........................................ 7,276 11,923 22,049 General and administrative................................. 5,101 8,551 12,626 -------- ------- ------- Total operating expenses........................... 38,622 61,780 90,695 -------- ------- ------- Operating income............................................. 5,082 9,659 23,040 Interest and other income.................................... 912 2,178 2,003 Interest expense............................................. (428) (478) (81) Minority interest in income of consolidated subsidiary....... -- -- (43) -------- ------- ------- Income before income tax (benefit) provision....... 5,566 11,359 24,919 Income tax (benefit) provision............................... (511) (534) 7,354 -------- ------- ------- Net income......................................... $ 6,077 $11,893 $17,565 ======== ======= ======= Earnings per share: Basic net income per common share.......................... $ 0.38 $ 0.50 $ 0.72 ======== ======= ======= Diluted net income per common share........................ $ 0.28 $ 0.47 $ 0.68 ======== ======= ======= Unaudited pro forma data (Note 1): Income before income tax provision......................... $ 5,566 $11,359 $24,919 Income tax provision....................................... 1,032 1,628 9,502 -------- ------- ------- Net income......................................... $ 4,534 $ 9,731 $15,417 ======== ======= ======= Basic pro forma net income per common share................ $ 0.64 ======= Diluted pro forma net income per common share.............. $ 0.60 ======= Shares used in computing basic net income per common share and unaudited basic pro forma net income per common share (Notes 1 and 8)............................................ 15,195 23,552 24,275 ======== ======= ======= Shares used in computing diluted net income per common share and unaudited diluted pro forma net income per common share (Notes 1 and 8)............................................ 21,510 25,363 25,681 ======== ======= =======
See accompanying notes to consolidated financial statements. 38 39 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS)
YEAR ENDED DECEMBER 31, ------------------------------ 1995 1996 1997 -------- -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income............................................................. $ 6,077 $ 11,893 $ 17,565 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization........................................ 1,874 3,605 4,833 Tax benefit from stock option transactions........................... 800 896 3,848 Changes in assets and liabilities: Accounts receivable, net........................................... (1,658) (10,978) (11,124) Other assets....................................................... (674) (1,207) (295) Deferred income taxes.............................................. (1,551) (1,324) 6,909 Accounts payable................................................... 1,172 2,167 1,360 Accrued liabilities................................................ 1,756 625 (2,348) Deferred revenue................................................... 1,337 1,472 375 Other liabilities.................................................. 22 (441) (116) -------- -------- -------- Net cash provided by operating activities....................... 9,155 6,708 21,007 -------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of investments available for sale............................. (28,666) (26,113) (26,517) Maturities of investments available for sale........................... 4,182 18,125 24,666 Proceeds from sales of investments available for sale.................. 2,467 3,707 3,716 Acquisitions of property and equipment................................. (2,246) (3,978) (9,593) -------- -------- -------- Net cash used in investing activities........................... (24,263) (8,259) (7,728) -------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from issuances of common stock............................ 33,726 1,935 4,039 Proceeds from issuances of notes payable to stockholders............... 1,000 -- -- Repayments of notes payable to stockholders............................ -- (1,000) -- Proceeds from bank line of credit...................................... 1,085 309 -- Repayments of bank line of credit...................................... (265) (2,504) -- Repayments of debt from asset purchases................................ -- (4,710) -- Capital lease payments................................................. (502) (553) (408) Proceeds from issuances of bank notes payable.......................... -- 1,999 -- Repayments of bank notes payable....................................... (687) (1,999) -- Distributions to CompReview stockholders............................... (3,845) (5,908) (6,798) -------- -------- -------- Net cash provided by (used in) financing activities............. 30,512 (12,431) (3,167) -------- -------- -------- Effect of exchange rate changes on cash.................................. -- 54 (165) -------- -------- -------- Net increase (decrease) in cash and cash equivalents..................... 15,404 (13,928) 9,947 Cash and cash equivalents at beginning of period......................... 6,645 22,049 8,121 -------- -------- -------- Cash and cash equivalents at end of period............................... $ 22,049 $ 8,121 $ 18,068 ======== ======== ======== SIGNIFICANT NON-CASH INVESTING AND FINANCING ACTIVITIES: Assets purchased through issuance of debt.............................. $ -- $ 4,710 $ -- ======== ======== ======== Acquisitions of property and equipment under capital leases............ $ 411 $ 344 $ -- ======== ======== ======== Conversion of preferred stock.......................................... $ 13,518 $ -- $ -- ======== ======== ======== Accretion of dividends on mandatorily redeemable convertible preferred stock................................................................ $ 348 $ -- $ -- ======== ======== ======== SUPPLEMENTAL CASH FLOW DISCLOSURE: Interest paid.......................................................... $ 390 $ 448 $ 101 ======== ======== ======== Income taxes paid...................................................... $ 190 $ 165 $ 547 ======== ======== ========
See accompanying notes to consolidated financial statements 39 40 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS)
CONVERTIBLE PREFERRED STOCK --------------------------------- UNREALIZED GAIN (LOSS) ON SERIES A SERIES E COMMON STOCK INVESTMENTS --------------- --------------- --------------- PAID-IN AVAILABLE SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT CAPITAL FOR SALE ------ ------ ------ ------ ------ ------ ------- -------------- BALANCE AT DECEMBER 31, 1994................... 380 $ -- 1,282 $ 1 8,656 $ 9 $10,980 $ -- Common stock options exercised................. 207 85 Accretion of dividends......................... (348) Issuance of common stock in initial public offering, net of issuance costs............... 2,376 2 14,329 Conversion of convertible preferred stock into common stock.................................. (380) -- (1,282) (1) 8,956 9 10,618 Issuance of common stock in follow-on public offering, net of issuance costs............... 1,116 2 19,184 Issuance of common stock at inception of Retek (Note 1)...................................... 1,367 1 (1) Tax benefit from stock option transactions..... 800 Unrealized gain on investments................. 92 Stock warrant exercised........................ 100 124 Distributions to CompReview stockholders....... Net income..................................... ---- ----- ------ --- ------ --- ------- ----- BALANCE AT DECEMBER 31, 1995................... -- -- -- -- 22,778 23 55,771 92 Common stock options exercised................. 1,140 1 1,095 Common stock issued under Employee Stock Purchase Plan................................. 94 839 Tax benefit from stock option transactions..... 7,889 Tax benefit from Retek taxable pooling (Note 7)............................................ 18,397 Unrealized loss on investments................. (151) Foreign currency translation adjustment........ Distributions to CompReview stockholders....... Net income..................................... ---- ----- ------ --- ------ --- ------- ----- BALANCE AT DECEMBER 31, 1996................... -- -- -- -- 24,012 24 83,991 (59) Common stock options exercised................. 475 1 2,845 Common stock issued under Employee Stock Purchase Plan................................. 51 1,193 Tax benefit from stock option transactions..... 4,192 Unrealized gain on investments................. 57 Foreign currency translation adjustment........ Distributions to CompReview stockholders....... CompReview contribution to capital............. 3,698 Net income..................................... ---- ----- ------ --- ------ --- ------- ----- BALANCE AT DECEMBER 31, 1997................... -- $ -- -- $ -- 24,538 $ 25 $95,919 $ (2) ==== ===== ====== === ====== === ======= ===== FOREIGN (ACCUMULATED CURRENCY DEFICIT) TOTAL TRANSLATION RETAINED STOCKHOLDERS' ADJUSTMENT EARNINGS EQUITY ----------- ------------ ------------- < BALANCE AT DECEMBER 31, 1994................... $ -- $(10,149) $ 841 Common stock options exercised................. 85 Accretion of dividends......................... (348) Issuance of common stock in initial public offering, net of issuance costs............... 14,331 Conversion of convertible preferred stock into common stock.................................. 2,892 13,518 Issuance of common stock in follow-on public offering, net of issuance costs............... 19,186 Issuance of common stock at inception of Retek (Note 1)...................................... -- Tax benefit from stock option transactions..... 800 Unrealized gain on investments................. 92 Stock warrant exercised........................ 124 Distributions to CompReview stockholders....... (3,845) (3,845) Net income..................................... 6,077 6,077 ----- -------- -------- BALANCE AT DECEMBER 31, 1995................... -- (5,025) 50,861 Common stock options exercised................. 1,096 Common stock issued under Employee Stock Purchase Plan................................. 839 Tax benefit from stock option transactions..... 7,889 Tax benefit from Retek taxable pooling (Note 7)............................................ 18,397 Unrealized loss on investments................. (151) Foreign currency translation adjustment........ 54 54 Distributions to CompReview stockholders....... (5,908) (5,908) Net income..................................... 11,893 11,893 ----- -------- -------- BALANCE AT DECEMBER 31, 1996................... 54 960 84,970 Common stock options exercised................. 2,846 Common stock issued under Employee Stock Purchase Plan................................. 1,193 Tax benefit from stock option transactions..... 4,192 Unrealized gain on investments................. 57 Foreign currency translation adjustment........ (165) (165) Distributions to CompReview stockholders....... (6,798) (6,798) CompReview contribution to capital............. (3,698) -- Net income..................................... 17,565 17,565 ----- -------- -------- BALANCE AT DECEMBER 31, 1997................... $(111) $ 8,029 $ 103,860 ===== ======== ========
See accompanying notes to consolidated financial statements 40 41 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) NOTE 1 -- THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES The Company Headquartered in San Diego, California, HNC Software Inc. (the "Company" or "HNC") develops, markets and supports predictive software solutions in client/server environments. HNC provides innovative predictive software systems in the healthcare/insurance, financial services and retail markets. Acquisitions On August 30, 1996, the Company completed an acquisition of all of the outstanding shares of Risk Data Corporation ("Risk Data"). Risk Data is an insurance information technology services firm that develops, markets and supports analytical benchmarking and risk management software products primarily for insurance carriers, state insurance funds and third party administrators primarily in the workers' compensation insurance field. Under the terms of the acquisition, accounted for as a pooling of interests, the Company exchanged 1,891 shares of common stock for all of the then outstanding shares of Risk Data preferred and common stock. On November 29, 1996, the Company completed an acquisition of all of the outstanding shares of Retek Distribution Corporation ("Retek"). Retek develops, markets and supports inventory management system software primarily for customers in the retail industry. Under the terms of the acquisition, accounted for as a pooling of interests, the Company exchanged 1,367 shares of common stock for all of the then outstanding shares of Retek common stock. On November 28, 1997, the Company completed an acquisition of all of the outstanding shares of CompReview, Inc. ("CompReview"). CompReview develops, markets and supports cost containment software for workers' compensation insurance carriers and for insurers that handle automobile accident personal injury claims. Under the terms of the acquisition, accounted for as a pooling of interests, the Company exchanged 4,886 shares of common stock for all of the then outstanding shares of CompReview common stock. The consolidated financial statements and related notes give retroactive effect to all three acquisitions for all of the periods presented. The consolidated balance sheet as of December 31, 1996 and 1997 includes the accounts of Risk Data, Retek and CompReview as of December 31, 1996 and 1997. The consolidated statements of income, of cash flows and of changes in stockholders' equity for each of the three years in the period ended December 31, 1997 include the results of Risk Data, Retek and CompReview for each of the years then ended. The term "Company" as used in these consolidated financial statements refers to HNC and its subsidiaries, including Risk Data, Retek and CompReview. 41 42 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) No adjustments to conform the accounting methods of the acquired companies to the accounting methods of HNC were required. Certain amounts have been reclassified with regard to presentation of the financial information of the acquired companies. Revenues and net income (loss) for each of the previously separate companies for the periods prior to their respective acquisition dates are as follows:
NINE MONTHS ENDED YEAR ENDED DECEMBER 31, SIX MONTHS SEPTEMBER 30, ---------------------------- ENDED ----------------- 1995 1996 1997 JUNE 30, 1996 1997 ------- ------- -------- 1996 ------- ------- ---------- (UNAUDITED) (UNAUDITED) Revenues: HNC......................... $25,174 $53,833 $113,735 $ 16,478 $31,423 $62,683 Risk Data................... 4,577 -- -- 2,600 -- -- Retek....................... 921 -- -- 3,377 5,635 -- CompReview.................. 13,032 17,606 -- 8,119 12,631 18,971 ------- ------- -------- ------- ------- ------- $43,704 $71,439 $113,735 $ 30,574 $49,689 $81,654 ======= ======= ======== ======= ======= ======= Net income (loss): HNC......................... $ 4,457 $ 6,376 $ 17,565 $ 1,780 $ 975 $ 7,597 Risk Data................... (1,952) -- -- (2,184) -- -- Retek....................... (382) -- -- 43 93 -- CompReview.................. 3,954 5,517 -- 2,123 3,679 6,702 ------- ------- -------- ------- ------- ------- $ 6,077 $11,893 $ 17,565 $ 1,762 $ 4,747 $14,299 ======= ======= ======== ======= ======= =======
Transaction costs of $563, $515 and $1,440 were incurred to complete the acquisitions of Risk Data, Retek and CompReview, respectively. Transaction costs were deferred and charged to income when the related transactions were consummated. Transaction costs consisted primarily of investment banker, legal and accounting fees, and printing, mailing and registration expenses. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. During 1996, the Company established Aptex Software Inc. ("Aptex"), a majority owned subsidiary, in order to develop, market and support certain text analysis technology that is being used to develop products for the Internet market. The minority stockholders' interest in Aptex's financial position and results of operations is presented as a minority interest in the Company's consolidated financial statements. Financial Statement Preparation The preparation of financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Cash Equivalents Cash equivalents are highly liquid investments and consist of investments in money market accounts and commercial paper purchased with maturities of three months or less. 42 43 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Investments Management determines the appropriate classification of its investments in marketable debt and equity securities at the time of purchase and re-evaluates such designation as of each balance sheet date. The Company classifies all securities as "available for sale" and carries them at fair value with unrealized gains or losses related to these securities included in stockholders' equity in the Company's consolidated balance sheet. Property and Equipment Property and equipment are recorded at cost. The Company computes depreciation and amortization using either the straight-line method over the estimated useful lives of the assets of three to seven years or an accelerated method over the estimated useful lives of the assets of five to seven years. The Company amortizes leasehold improvements over the shorter of their estimated useful lives or the remaining term of the related lease. Repair and maintenance costs are charged to expense as incurred. Software Costs Software costs are recorded at cost and amortized over their estimated useful lives of 36 to 42 months. Software costs are comprised of purchased software and other rights that are stated at the lower of cost or net realizable value. At December 31, 1996 and 1997, software costs of $2,561 and $2,581, respectively, were included in other assets in the consolidated balance sheet net of accumulated amortization of $642 and $1,451, respectively. Development costs for software to be licensed or sold that are incurred from the time technological feasibility is established until the product is available for general release to customers are capitalized and reported at the lower of cost or net realizable value. Through December 31, 1997, no significant amounts were expended subsequent to reaching technological feasibility. Long-Lived Assets The Company investigates potential impairments of long-lived assets, certain identifiable intangibles and associated goodwill when events or changes in circumstances have made recovery of an asset's carrying value unlikely. An impairment loss would be recognized if the sum of the expected future net cash flows were less than the carrying amount of the asset. No such impairments of long-lived assets existed through December 31, 1997. Stock-Based Compensation The Company measures compensation expense for its stock-based employee compensation plans using the intrinsic value method and provides pro forma disclosures of net income and earnings per share as if the fair value-based method had been applied in measuring compensation expense. Revenue Recognition The Company's revenue from periodic software license and maintenance agreements is generally recognized ratably over the respective license periods. Revenue from certain short-term periodic software license and maintenance agreements with guaranteed minimum license fees is recognized as related services are performed. Transactional fees are recognized as revenue based on system usage or when fees based on system usage exceed the monthly minimum license fees. Revenue from perpetual licenses of the Company's software for which there are no significant continuing obligations and collection of the related receivables is probable is recognized on delivery of the software and acceptance by the customer. Revenue from hardware product sales, which is included in contracts and other revenue, is recognized upon shipment to the customer. 43 44 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The Company's revenue from software installation and implementation and from contract services is generally recognized as the services are performed using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Amounts received under contracts in advance of performance are recorded as deferred revenue and are generally recognized within one year from receipt. Contract losses are recorded as a charge to income in the period such losses are first identified. Unbilled accounts receivable are stated at estimated realizable value. Service bureau fees are from review and repricing of customers' medical bills and are assessed to customers on the basis of volume of bills processed and are recognized as revenue when the processing services are performed. Income Taxes The Company's current income tax expense is the amount of income taxes expected to be payable for the current year. A deferred income tax asset or liability is computed for the expected future impact of differences between the financial reporting and tax bases of assets and liabilities as well as the expected future tax benefit to be derived from tax loss and tax credit carryforwards. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount "more likely than not" to be realized in future tax returns. Tax rate changes are reflected in income during the period such changes are enacted. Net Income Per Common Share The Company adopted Statement of Financial Accounting Standard No. 128 ("FAS 128"), "Earnings per Share," for fiscal 1997 and retroactively restated all prior periods to conform with FAS 128 as required. Basic net income per common share is computed as net income less accretion of dividends on mandatorily redeemable convertible preferred stock divided by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed as net income divided by the weighted average number of common shares and potential common shares, using the treasury stock method, outstanding during the period and assumes conversion into common stock at the beginning of each period of all outstanding shares of convertible preferred stock (Note 8). Unaudited Pro Forma Data Prior to the acquisition of CompReview by HNC on November 28, 1997, CompReview had elected subchapter S corporation status for income tax purposes; therefore, its income was included in the tax returns of its stockholders, and no income tax provision was recorded for CompReview other than certain minimum state taxes on subchapter S corporations. As a result of the acquisition, beginning November 29, 1997, CompReview became subject to corporate income taxes on its taxable income. For comparative purposes, the consolidated statement of income includes unaudited pro forma adjusted data with respect to the merged companies' income tax provision as if CompReview had been subject to corporate income taxes on its taxable income for all periods presented. Foreign Currency Translation The financial statements of the Company's international operations are translated into U.S. dollars using period-end exchange rates for assets and liabilities and average exchange rates during the period for revenues and expenses. Cumulative translation gains and losses are excluded from results of operations and recorded as a separate component of stockholders' equity. Gains and losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's local currency) are included in the consolidated statement of income and are not material. 44 45 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Diversification of Credit Risk The Company's financial instruments that are subject to concentrations of credit risk consist primarily of cash equivalents, investments available for sale and accounts receivable, which are generally not collateralized. The Company's policy is to place its cash, cash equivalents and investments available for sale with high credit quality financial institutions and commercial companies and government agencies in order to limit the amount of its credit exposure. The Company's software license and installation agreements and commercial development contracts are primarily with large customers in the healthcare/insurance, financial services and retail industries. The Company maintains reserves for potential credit losses. The Company has one major product or product line in each of its three target markets. In the healthcare/insurance market, revenues from one product accounted for 29.8%, 24.6% and 23.0% of the Company's total revenues for 1995, 1996 and 1997, respectively. During those same periods, one product in the retail market accounted for 2.2%, 13.6% and 18.9%, respectively, of the Company's total revenues, and one product line in the financial services market accounted for 28.0%, 20.9% and 16.0%, respectively, of the Company's total revenues. Revenues from international operations and export sales, primarily to Western Europe and Canada, represented approximately 12.6%, 17.7% and 16.8% of total revenues in 1995, 1996 and 1997, respectively. Export sales were $4,595, $7,310 and $7,896 in 1995, 1996 and 1997, respectively. Disclosures About Fair Value of Financial Instruments The carrying amounts of cash and cash equivalents and accrued liabilities approximate fair value because of the short-term maturities of these financial instruments. The carrying amounts of capital lease obligations approximate their fair values based on interest rates currently available to the Company for borrowings with similar terms and maturities. Reincorporation and Stock Split In May 1995, the Company's stockholders approved an Agreement and Plan of Merger whereby the Company merged with and into a newly incorporated Delaware corporation ("HNC Delaware"), which is the surviving corporation. In conjunction with the merger, each share of the Company's common stock, preferred stock and options and warrants to purchase the Company's common stock was exchanged for one-half share of HNC Delaware's common stock, preferred stock and options and warrants to purchase HNC Delaware's common stock, at twice the exercise price for options and warrants. In April 1996, the Company consummated a two-for-one stock split effected in the form of a common stock dividend. All references to share and per share amounts of common and preferred stock and other data in these financial statements have been retroactively restated to reflect the reincorporation and stock split. New Accounting Pronouncements In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 130 ("FAS 130"), "Reporting Comprehensive Income," which the Company is required to adopt for 1998. This statement will require the Company to report in the financial statements, in addition to net income, comprehensive income and its components including foreign currency items and unrealized gains and losses on certain investments in debt and equity securities. Upon adoption of FAS 130, the Company is also required to reclassify financial statements for earlier periods provided for comparative purposes. The adoption of FAS 130 will not have a significant impact on the Company's consolidated financial statement disclosures. In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131 ("FAS 131"), "Disclosures about Segments of an Enterprise and Related Information," which the Company is required to 45 46 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) adopt for its 1998 annual financial statements. This statement establishes standards for reporting information about operating segments in annual financial statements and requires selected information about operating segments in interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Under FAS 131, operating segments are to be determined consistent with the way that management organizes and evaluates financial information internally for making operating decisions and assessing performance. The Company has not determined the impact of the adoption of this new accounting standard on its consolidated financial statement disclosures. In October 1997, the American Institute of Certified Public Accountants issued Statement of Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition," which the Company is required to adopt for agreements entered into with customers beginning in 1998. This statement provides guidance for software revenue recognition matters primarily from a conceptual level and does not include specific implementation guidance. Based on its reading and interpretation of SOP 97-2, the Company believes that the adoption of SOP 97-2 will not have a significant impact on its financial statements; however, detailed implementation guidelines for this standard have not yet been issued. Once issued, such detailed implementation guidance could lead to unanticipated changes in the Company's current revenue recognition practices, and such changes could be material to the Company's financial statements. Reclassifications Certain prior year balances have been reclassified to conform to the current year presentation. NOTE 2 -- COMPOSITION OF CERTAIN FINANCIAL STATEMENT CAPTIONS
DECEMBER 31, ------------------- 1996 1997 ------- ------- Accounts receivable, net: Billed................................................. $13,266 $27,812 Unbilled............................................... 9,299 8,368 ------- ------- 22,565 36,180 Less allowance for doubtful accounts..................... (709) (3,200) ------- ------- $21,856 $32,980 ======= =======
Unbilled accounts receivable represent revenue recorded in excess of amounts billable pursuant to contract provisions and generally become billable at contractually specified dates or upon the attainment of milestones. Unbilled amounts are expected to be realized within one year.
DECEMBER 31, ------------------- 1996 1997 ------- ------- Property and equipment, net: Computer equipment..................................... $ 9,302 $15,611 Furniture and fixtures................................. 2,210 4,632 Leasehold improvements................................. 273 1,012 ------- ------- 11,785 21,255 Less accumulated depreciation and amortization........... (5,446) (9,153) ------- ------- $ 6,339 $12,102 ======= =======
46 47 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
DECEMBER 31, ------------------- 1996 1997 ------- ------- Accrued liabilities: Payroll and related benefits........................... $ 1,645 $ 3,456 Vacation............................................... 860 927 Other.................................................. 1,928 1,550 ------- ------- $ 4,433 $ 5,933 ======= =======
NOTE 3 -- INVESTMENTS At December 31, 1996 and 1997, the amortized cost and estimated fair value of investments available for sale were as follows:
DECEMBER 31, 1996 --------------------------------------------- AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ------- U.S. government and federal agencies... $18,212 $ -- $ (38) $18,174 Foreign government debt................ 1,006 -- (2) 1,004 U.S. corporate debt.................... 4,851 -- (14) 4,837 Foreign corporate debt................. 2,718 -- (5) 2,713 ------- ------- ------- ------- $26,787 $ -- $ (59) $26,728 ======= ======= ======= =======
DECEMBER 31, 1997 --------------------------------------------- AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ------- U.S. government and federal agencies... $20,682 $ -- $ (1) $20,681 U.S. corporate debt.................... 1,894 -- (1) 1,893 Foreign corporate debt................. 2,304 -- -- 2,304 ------- ------- ------- ------- $24,880 $ -- $ (2) $24,878 ======= ======= ======= =======
No significant gains or losses were realized during the years ended December 31, 1996 and 1997. The cost of securities sold is determined by the specific identification method. NOTE 4 -- NOTES PAYABLE The Company has a Credit Agreement with a bank which provides for a $15,000 revolving line of credit through July 11, 1999. The agreement requires that the Company maintain certain financial ratios and levels of working capital, tangible net worth and profitability, and also restricts the Company's ability to pay cash dividends and make loans, advances or investments without the bank's consent. At December 31, 1997, the Company had no amounts outstanding under the revolving line of credit. Interest is payable monthly at the bank's prime rate or LIBOR rate plus 1.5%. The applicable interest rate was 7.22% at December 31, 1997. The Risk Data credit facilities were comprised of a revolving line of credit secured by eligible accounts receivable, as well as a bridge loan that was secured by the guarantees of certain stockholders. The revolving line of credit matured on January 5, 1997. The bridge loan matured on September 5, 1996. All outstanding amounts were repaid during 1996, and neither credit facility was renewed. 47 48 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) During 1995, the preferred stockholders of Risk Data loaned the Company $1,000 under subordinated note agreements (secured by the assets of Risk Data but subordinated to borrowings under the Risk Data line of credit) bearing interest at 9%. All outstanding amounts were repaid during 1996. NOTE 5 -- LEASES At December 31, 1997, the Company was obligated through 2004 under noncancelable operating leases for its facilities and certain equipment as follows:
NET FUTURE FUTURE MINIMUM LESS SUBLEASE MINIMUM LEASE LEASE PAYMENTS INCOME PAYMENTS -------------- ------------- ------------- 1998.................................. $2,984 $ 127 $ 2,857 1999.................................. 3,047 -- 3,047 2000.................................. 3,043 -- 3,043 2001.................................. 2,994 -- 2,994 2002.................................. 2,884 -- 2,884 thereafter............................ 1,535 -- 1,535
The lease for the Company's corporate headquarters provides for scheduled rent increases and an option to extend the lease for five years with certain changes to the terms of the lease agreement and a refurbishment allowance. Rent expense under operating leases for the years ended December 31, 1995, 1996 and 1997 was approximately $1,503, $1,623 and $2,687, respectively, net of sublease income of $83, $125 and $477, respectively. Risk Data maintains a lease line of credit with a leasing company for the acquisition of equipment under capital lease arrangements. Future minimum payments are $222 for 1998 and $66 for 1999 with a total of $34 of such amounts representing interest. The gross value of assets under capital leases at December 31, 1996 and 1997 was $1,481 and $714, and accumulated amortization was $599 and $556, respectively. Amortization expense for assets acquired under capital leases is included in depreciation expense. NOTE 6 -- CAPITAL STOCK During June 1995, the Company completed its initial public offering of 5,176 shares of common stock (of which 2,376 shares were sold by the Company and 2,800 shares were sold by certain selling stockholders) at a price to the public of $7.00 per share, which resulted in net proceeds to the Company of $15,461 after the payment of underwriters' commissions but before the deduction of offering expenses. Upon the closing of the Company's initial public offering, all outstanding shares of Series A, B, C, D and E convertible preferred stock were automatically converted into shares of common stock at their then effective conversion prices. Upon conversion, the preferred stockholders were no longer entitled to any undeclared cumulative dividends and all class voting rights terminated. During December 1995, the Company completed a follow-on public offering of 3,000 shares of common stock (of which 1,116 shares were sold by the Company and 1,884 shares were sold by certain selling stockholders) at a price to the public of $18.50 per share, which resulted in net proceeds to the Company of $19,606 after the payment of underwriters' commissions but before the deduction of offering expenses. The Company's Board of Directors is authorized to issue up to 4,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares 48 49 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to the rights of the holders of any preferred stock that may be issued in the future. NOTE 7 -- INCOME TAXES Income (loss) before income tax (benefit) provision was taxed under the following jurisdictions:
YEAR ENDED DECEMBER 31, ------------------------------ 1995 1996 1997 ------ ------- ------- Domestic....................................... $5,764 $ 8,599 $23,907 Foreign........................................ (198) 2,760 1,012 ------ ------- ------- $5,566 $11,359 $24,919 ====== ======= =======
The income tax (benefit) provision is summarized as follows:
YEAR ENDED DECEMBER 31, ------------------------------ 1995 1996 1997 ------ ------- ------- CURRENT: Federal...................................... $ 97 $ 1,132 $ 2,257 State........................................ 143 204 537 Foreign...................................... -- 51 233 DEFERRED: Federal...................................... (521) (1,569) 3,197 State........................................ (186) (56) 985 Foreign...................................... (44) (296) 145 ------ ------- ----- $ (511) $ (534) $ 7,354 ====== ======= =====
Deferred tax assets are summarized as follows:
YEAR ENDED DECEMBER 31, ------------------- 1996 1997 ------- ------- Taxable pooling basis difference......................... $18,397 $16,955 Net operating loss carryforwards......................... 8,587 7,404 Tax credit carryforwards................................. 1,878 2,059 Other.................................................... 487 214 ------- ------- Gross deferred tax assets................................ 29,349 26,632 Deferred tax asset valuation allowance................... -- -- ------- ------- Net deferred tax asset......................... $29,349 $26,632 ======= =======
During 1995, the Company released the valuation allowance related to its deferred tax assets based on management's assessment that it was more likely than not that the Company would realize a portion of those assets in future periods due to improvements in the Company's operating results. During 1996, the Company released the valuation allowances related to Risk Data's and Retek's deferred tax assets based on management's assessment that it was more likely than not that the Company would realize those assets in future periods due to improvements in the operating results of those subsidiaries. 49 50 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) During 1995, 1996 and 1997, the Company realized certain tax benefits related to stock option transactions in the amount of $800, $7,889 and $4,192, respectively. The benefit from the stock option tax deduction is credited directly to paid-in capital. During 1996, in connection with the acquisition of Retek, the Company made an Internal Revenue Code Section 338 election for federal and state tax purposes, resulting in the treatment of the acquisition as a taxable transaction, whereby the tax bases of the acquired assets and liabilities were adjusted to their fair values as of the date of the acquisition. As the purchase price exceeded the carrying value of the net assets acquired by approximately $46,000, the Company recorded a deferred tax asset in the amount of $18,397. A reconciliation of the income tax (benefit) provision to the amount computed by applying the statutory federal income tax rate to income before income tax provision is summarized as follows:
YEAR ENDED DECEMBER 31, ------------------------------- 1995 1996 1997 ------- ------- ------- Amounts computed at statutory federal rate.... $ 1,892 $ 3,862 $ 8,472 State income taxes....................... 465 554 1,407 Subchapter S corporation earnings........ (1,366) (1,901) (2,888) Change in tax status of S corporation.... -- -- 869 Tax credit carryforwards generated....... (68) (334) (284) Release of valuation allowance........... (2,223) (2,717) -- Foreign income taxes..................... (44) (296) 27 Losses without tax benefit............... 794 -- -- Other.................................... 39 298 (249) ------- ------- ------- Income tax (benefit) provision................ $ (511) $ (534) $ 7,354 ======= ======= =======
Prior to the acquisition of CompReview by the Company on November 28, 1997, CompReview had elected subchapter S corporation status and the cash basis of accounting for income tax purposes; therefore, its cash basis income was included in the tax returns of its stockholders, and no income tax provision was recorded for CompReview other than certain minimum state taxes on subchapter S corporations. As of the date of CompReview's acquisition, its tax status was changed to C corporation status with the accrual basis of accounting. As a result of this change in tax status, the Company recorded a deferred tax liability in the amount of $869 based on the cumulative income recognition differences as of the date of acquisition between CompReview's former and prospective tax accounting methods. At December 31, 1997, the Company had federal, state and foreign net operating loss carryforwards of approximately $19,992, $7,785 and $352, respectively. The net operating loss carryforwards expire as follows: 2001....................................... $ 6,982 2003....................................... 84 2005....................................... 123 2006....................................... 1,670 2007....................................... 17 2008....................................... 1,692 2009....................................... 1,370 2010....................................... 1,840 2011....................................... 14,086
The Company also has approximately $1,295 of federal research and development credit carryforwards, which expire from 2000 to 2012, $711 of state research and development credit carryforwards, which have no 50 51 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) expiration date, and $53 of foreign tax credit carryforwards, which expire from 1999 to 2002. Certain of these net operating loss and research and development credit carryforwards generated by Risk Data, Retek and CompReview prior to their acquisitions by HNC are subject to annual limitations on their utilization and also are limited to utilization solely by the company that generated them. Should a substantial change in HNC's ownership occur, as defined by the Tax Reform Act of 1986, there will be an annual limitation on its utilization of net operating loss and research and development credit carryforwards. NOTE 8 -- RECONCILIATION OF NET INCOME AND SHARES USED IN PER SHARE COMPUTATIONS
YEAR ENDED DECEMBER 31, ------------------------------- 1995 1996 1997 ------- ------- ------- NET INCOME USED: Net income used in computing basic net income per common share.......... $ 5,729 $11,893 $17,565 Add back accretion of dividends on mandatorily redeemable convertible preferred stock....................................................... 348 -- -- ------- ------- ------- Net income used in computing diluted net income per common share........ $ 6,077 $11,893 $17,565 ======= ======= ======= SHARES USED: Weighted average common shares outstanding used in computing basic net income per common share............................................... 15,195 23,552 24,275 Weighted average options and warrants to purchase common stock as determined by application of the treasury stock method.............. 1,995 1,796 1,383 Incremental shares for assumed conversion of convertible preferred stock............................................................... 4,265 -- -- Purchase Plan common stock equivalents................................ 55 15 23 ------- ------- ------- Shares used in computing diluted net income per common share............ 21,510 25,363 25,681 ======= ======= =======
All outstanding shares of the Company's preferred stock automatically converted into shares of common stock upon the closing of the Company's initial public offering on June 26, 1995. Shares used in computing diluted net income per common share for 1995 assume conversion of all outstanding shares of convertible preferred stock were converted at the beginning of that year. NOTE 9 -- EMPLOYEE BENEFIT PLANS During 1987, the Company adopted the 1987 Stock Option Plan and reserved 2,500 shares of the Company's common stock for issuance pursuant to nonqualified and incentive stock options to its officers, directors, key employees and consultants. The plan, as amended, is administered by the Board of Directors or its designees and provides generally that, for incentive stock options and nonqualified stock options, the exercise price must not be less than the fair market value of the shares as determined by the Board of Directors at the date of grant. The options expire no later than ten years from the date of grant and may be exercised in installments based upon stipulated timetables (not in excess of seven years). At December 31, 1997, options to purchase 490 shares were exercisable. During 1995, the Company adopted the 1995 Directors Stock Option Plan (the "Directors Plan"), the 1995 Equity Incentive Plan (the "Incentive Plan") and the 1995 Employee Stock Purchase Plan (the "Purchase Plan"). For purposes of the discussion contained in the three paragraphs below, "fair market value" means the closing price of the Company's common stock on the Nasdaq National Market on the grant date. The Directors Plan provides for the issuance of up to 300 nonqualified stock options to the Company's outside directors. Under the provisions of the Directors Plan, options to purchase 25 shares of the Company's common stock are granted to outside directors upon their respective dates of becoming members of the Board of Directors and options to purchase ten shares of such stock will be granted on each anniversary of such dates. 51 52 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Options under the Directors Plan are granted at the fair market value of the stock at the grant date and vest at specific times over a four-year period. At December 31, 1997, options to purchase 72 shares were exercisable. The Incentive Plan provides for the issuance of up to 3,550 shares of the Company's common stock in the form of nonqualified or incentive stock options, restricted stock or stock bonuses. In addition, all shares that remained unissued under the 1987 Stock Option Plan on the effective date of the Incentive Plan, and all shares issuable upon exercise of options granted pursuant to the 1987 Stock Option Plan that expire or become unexercisable for any reason without having been exercised in full are available for issuance under the Incentive Plan. Nonqualified stock options and restricted stock may be awarded at a price not less than 85% of the fair market value of the stock at the date of the award. Incentive stock options must be awarded at a price not less than 100% of the fair market value of the stock at the date of the award. Options granted under the Incentive Plan may have a term of up to ten years. The Company has the discretion to provide for restrictions and the lapse thereof in respect of restricted stock awards. Options typically vest at the rate of 25% of the total grant per year over a four-year period; however, the Company may, at its discretion, implement a different vesting schedule with respect to any new stock option grant. At December 31, 1997, 316 shares were exercisable. The Purchase Plan provides for the issuance of a maximum of 400 shares of common stock. Each purchase period, eligible employees may designate between 2% and 10% of their cash compensation, subject to certain limitations, to be deducted from their compensation for the purchase of common stock under the Purchase Plan. The purchase price of the shares under the Purchase Plan is equal to 85% of the lesser of the fair market value per share on the first day of the twelve-month offering period or the last day of each six-month purchase period. Approximately 60% of eligible employees have participated in the Purchase Plan in the last two years. Risk Data's stock option plan is administered by HNC's Board of Directors. All outstanding Risk Data options were converted into options to purchase HNC common stock and adjusted to give effect to the acquisition exchange ratio in the Risk Data acquisition. No changes were made to the terms of the Risk Data options in connection with the exchange. Options granted under the Risk Data stock option plan generally vest at the rate of 25% of the total grant per year and expire ten years after the date of grant. At December 31, 1997, 30 shares were exercisable under the Risk Data plan. Retek's stock options are administered by HNC's Board of Directors. All outstanding Retek options were converted into options to purchase the Company's common stock and adjusted to give effect to the acquisition exchange ratio in the Retek acquisition. No changes were made to the terms of the Retek options in connection with the exchange. Options granted vest ratably over periods from one to four years and have a term of up to ten years. At December 31, 1997, options to purchase 32 shares were exercisable. The CompReview 1995 Stock Option Plan is administered by HNC's Board of Directors. All outstanding CompReview stock options were converted into options to purchase HNC common stock in the CompReview acquisition and adjusted to give effect to the acquisition exchange ratio. No changes were made to the terms of the CompReview options in connection with the exchange. Options granted under the CompReview Stock Option Plan generally vest ratably over periods from two to four years and expire ten years after the date of grant. At December 31, 1997, options to purchase 156 shares were exercisable. 52 53 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Transactions under the Company's stock option and purchase plans during the years ended December 31, 1995, 1996 and 1997, including options under the Risk Data stock option plan, options under the Retek stock option plan and options under the CompReview Stock Option Plan, but excluding options to purchase stock of Aptex, a subsidiary of the Company, are summarized as follows.
YEAR ENDED DECEMBER 31, ------------------------------------------------------------------------------ 1995 1996 1997 ------------------------ ------------------------ ------------------------ WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE ------ ---------------- ------ ---------------- ------ ---------------- Outstanding at beginning of year.... 2,080 $ 0.49 2,868 $ 2.84 3,215 $15.65 Options granted................... 1,272 6.08 1,645 27.98 2,177 32.61 Options exercised................. (207) 0.52 (1,140) 0.96 (475) 6.16 Options canceled.................. (277) 1.80 (158) 17.62 (326) 26.33 ------ ------ Outstanding at end of year.......... 2,868 2.84 3,215 15.65 4,591 23.92 ====== ====== Options exercisable at end of year.............................. 1,437 841 1,096 Weighted average fair value of options granted during the year... $ 3.10 $14.50 $19.79
The following table summarizes information about employee stock options outstanding at December 31, 1997:
OPTIONS OUTSTANDING ------------------------------------------- OPTIONS EXERCISABLE WEIGHTED ------------------------- NUMBER AVERAGE WEIGHTED NUMBER WEIGHTED OUTSTANDING AT REMAINING AVERAGE OUTSTANDING AT AVERAGE RANGE OF DECEMBER 31, CONTRACTUAL EXERCISE DECEMBER 31, EXERCISE EXERCISE PRICES 1997 LIFE (IN YEARS) PRICE 1997 PRICE ------------------------------ -------------- --------------- -------- -------------- -------- $ 0.02 to $ 3.00.............. 1,002 5.90 $ 1.90 702 $ 1.60 4.50 25.38.............. 793 8.21 19.22 188 15.69 25.60 30.75.............. 791 8.86 29.39 147 30.33 30.81 31.50.............. 944 9.57 31.40 1 30.94 31.88 39.00.............. 774 9.42 36.03 32 34.24 39.09 49.50.............. 287 9.27 41.42 26 42.64 ----- ----- 0.02 49.50.............. 4,591 8.37 23.92 1,096 9.82 ===== =====
During 1996, Aptex adopted the 1996 Equity Incentive Plan (the "Aptex Plan") whereby 2,000 shares of Aptex common stock were reserved for issuance pursuant to nonqualified and incentive stock options and restricted stock awards. The plan is administered by the Board of Directors of Aptex or its designees and provides generally that nonqualified stock options and restricted stock may be awarded at a price not less than 85% of the fair market value, as determined by the Board of Directors, of the stock at the date of the award. Incentive stock options must be awarded at a price not less than 100% of the fair market value of the stock at the date of the award, or 110% of fair market value for awards to more than 10% stockholders. Options granted under the Incentive Plan may have a term of up to ten years. The Company has the discretion to provide for restrictions and the lapse thereof in respect of restricted stock awards, and options typically vest at the rate of 25% of the total grant per year. However, the Company may, at its discretion, implement a different vesting schedule with respect to any new stock option grant. During 1996, Aptex issued 1,000 shares of common stock at fair market value under the Aptex Plan for cash consideration of $0.03 per share. At December 31, 1997, options to purchase 79 shares were exercisable under the Aptex Plan. 53 54 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for its stock-based compensation. No compensation expense has been recognized for its employee stock option grants, which are fixed in nature, as the options have been granted at fair market value. No compensation expense has been recognized for the Purchase Plan. Had compensation cost for the Company's stock-based compensation awards issued during 1997 and 1996 been determined based on the fair value at the grant dates of awards consistent with the method of Financial Accounting Standards Board Statement No. 123 ("FAS 123"), the Company's net income and basic and diluted pro forma net income per common share would have been reduced to the pro forma amounts indicated below:
YEAR ENDED DECEMBER 31, -------------------------- 1995 1996 1997 ------ ------- ------- Net income: As reported...................................... $6,077 $11,893 $17,565 Pro forma........................................ 5,126 6,122 2,232 Basic net income per common share: As reported...................................... 0.38 0.50 0.72 Pro forma........................................ 0.31 0.26 0.09 Diluted net income per common share: As reported...................................... 0.28 0.47 0.68 Pro forma........................................ 0.24 0.24 0.09
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants during the years ended December 31, 1995, 1996 and 1997, respectively: dividend yield of 0.0% for all three years, risk-free interest rates of 6.29%, 6.03% and 6.10%, expected volatilities of 75%, 70% and 65% (0% for 1995 and 1996 options granted by Risk Data, Retek and CompReview prior to their acquisition by HNC), and expected lives of 3.5, 3.5 and 3.0 years. The fair value of the employees' purchase rights pursuant to the Purchase Plan is estimated using the Black-Scholes model with the following assumptions: dividend yield of 0.0% for all three years, risk-free interest rates of 5.66%, 5.36% and 5.32%, expected volatilities of 75%, 70% and 65%, and an expected life of 6 months for all three years. The weighted average fair value of those purchase rights granted in 1995, 1996 and 1997 was $2.75, $9.61 and $14.10, respectively. The fair value of each option granted under the Aptex Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants during the years ended December 31, 1996 and 1997: dividend yield of 0.0% for both years, risk-free interest rates of 6.42% and 6.33%, expected volatility of 90% for both years, and expected lives of 9.25 and 8.0 years. Options to purchase 704 shares and 214 shares were granted during 1996 and 1997, with weighted average exercise prices per share of $0.03 and $0.08, respectively. During 1997, options to purchase 173 shares with a weighted average exercise price of $0.03 per share were exercised. During 1997, options to purchase 58 shares with a weighted average exercise price of $0.03 per share were cancelled. The weighted average fair value per share of options granted during 1996 and 1997 was $0.03 and $0.07, respectively. 54 55 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The following table summarizes information about Aptex employee stock options outstanding at December 31, 1997:
OPTIONS OUTSTANDING ------------------------------------------- OPTIONS EXERCISABLE WEIGHTED ------------------------- NUMBER AVERAGE WEIGHTED NUMBER WEIGHTED OUTSTANDING AT REMAINING AVERAGE OUTSTANDING AT AVERAGE RANGE OF DECEMBER 31, CONTRACTUAL EXERCISE DECEMBER 31, EXERCISE EXERCISE PRICES 1997 LIFE (IN YEARS) PRICE 1997 PRICE --------------------------- -------------- --------------- -------- -------------- -------- $0.03 to $0.03 497 8.75 $ 0.03 79 $ 0.03 0.05 0.05 39 9.40 0.05 -- -- 0.10 0.10 151 9.82 0.10 -- -- --- --- 0.03 0.10 687 9.03 0.05 79 0.03 === ===
NOTE 10 -- CONTINGENCIES Various claims arising in the course of business, seeking monetary damages and other relief, are pending. The amount of the liability, if any, from such claims cannot be determined with certainty; however, in the opinion of management, the ultimate liability for such claims will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows. NOTE 11 -- SUBSEQUENT EVENTS On January 30, 1998, the Company signed a definitive agreement to acquire Practical Control Systems Technologies, Inc. ("PCS"), a distribution center management software vendor based in Cincinnati, Ohio, subject to the satisfaction of certain closing conditions and the approval of PCS' shareholders. If consummated, the acquisition of PCS will be accounted for under the purchase method and will not be considered a "significant" acquisition pursuant to regulations set forth by the Securities and Exchange Commission. On February 13, 1998, the Company adopted the 1998 Stock Option Plan (the "1998 Plan"), under which 1,000,000 shares of HNC Common Stock were reserved for issuance pursuant to nonqualified stock options. The 1998 Plan is administered by the Board of Directors of HNC or a committee appointed by the Board and provides that nonqualified stock options granted under the plan must be awarded at an exercise price of not less than 100% of the fair market value of the stock at the date of grant. Options granted under the 1998 Plan may have a term of up to ten years. No options have been granted under the 1998 Plan to date. 55 56 SELECTED CONSOLIDATED QUARTERLY OPERATING RESULTS (UNAUDITED)
YEAR ENDED DECEMBER 31, 1997 -------------------------------------------------------- FIRST SECOND THIRD FOURTH TOTAL QUARTER QUARTER QUARTER QUARTER YEAR ------- ------- ------- ------- -------- (IN THOUSANDS) REVENUES: As restated for pooling transactions.... $24,072 $27,593 $29,989 $32,081 $113,735 As previously reported.................. 18,481 20,989 23,213 -- -- OPERATING INCOME: As restated for pooling transactions.... 5,120 6,002 6,371 5,547 23,040 As previously reported.................. 3,061 3,464 4,169 -- -- NET INCOME: As restated for pooling transactions.... 4,212 4,959 5,127 3,267 17,565 As previously reported.................. 2,183 2,458 2,956 -- -- PRO FORMA NET INCOME(1): As restated for pooling transactions.... $ 3,434 $ 4,008 $ 4,286 $ 3,689 $ 15,417 As previously reported.................. 2,183 2,458 2,956 -- --
YEAR ENDED DECEMBER 31, 1996 -------------------------------------------------------- FIRST SECOND THIRD FOURTH TOTAL QUARTER QUARTER QUARTER QUARTER YEAR ------- ------- ------- ------- -------- (IN THOUSANDS) REVENUES: As restated for pooling transactions.... $13,877 $16,697 $19,115 $21,750 $ 71,439 As previously reported.................. 9,899 12,556 14,603 16,775 53,833 OPERATING INCOME: As restated for pooling transactions.... 351 1,801 3,117 4,390 9,659 As previously reported.................. (627) 609 1,574 2,562 4,118 NET (LOSS) INCOME: As restated for pooling transactions.... 258 1,504 2,984 7,147 11,893 As previously reported.................. (727) 366 1,429 5,308 6,376 PRO FORMA NET (LOSS) INCOME(1): As restated for pooling transactions.... $ (131) $ 1,088 $ 2,363 $ 6,411 $ 9,731 As previously reported.................. (727) 366 1,429 5,308 6,376
(1) Pro forma net income reflects a provision for taxes on the income of CompReview, which was a subchapter S corporation prior to its acquisition by HNC, as if CompReview had been subject to corporate income taxes as a C corporation for all periods presented. ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item, which will be set forth under the captions "Proposal No. 1 Election of Directors," "Executive Officers" and "Compliance With Section 16(a) of the Securities Exchange Act of 1934" in the Company's Proxy Statement for its 1998 Annual Meeting of Stockholders, is incorporated herein by reference. 56 57 ITEM 11. EXECUTIVE COMPENSATION The information required by this Item, which will be set forth under the captions "Director Compensation," "Executive Compensation" and "Compensation Committee Interlocks and Insider Participation" in the Company's Proxy Statement for its 1998 Annual Meeting of Stockholders, is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item, which will be set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement for its 1998 Annual Meeting of Stockholders, is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item, which will be set forth under the caption "Certain Transactions" in the Company's Proxy Statement for its 1998 Annual Meeting of Stockholders, is incorporated herein by reference. 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. Consolidated Financial Statements: The consolidated financial statements of the Company listed below and the report thereon are included in Item 8 hereof: Report of Independent Accountants Consolidated Balance Sheet as of December 31, 1996 and 1997 Consolidated Statement of Income for the years ended December 31, 1995, 1996 and 1997 Consolidated Statement of Cash Flows for the years ended December 31, 1995, 1996 and 1997 Consolidated Statement of Changes in Stockholders' Equity for the years ended December 31, 1995, 1996 and 1997 Notes to Consolidated Financial Statements 2. Financial Statement Schedule: The financial statement schedule of the Company listed below and the report thereon are included herein: Report of Independent Accountants on Financial Statement Schedule (See page 62.) Schedule II -- Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1995, 1996 and 1997 (See page 63.) All other schedules are omitted because they are not applicable or not required or because the required information is shown in the Consolidated Financial Statements or notes thereto. 57 58 3. Exhibits:
EXHIBIT NUMBER DESCRIPTION --------- ------------------------------------------------------------------------- 2.01 Agreement and Plan of Reorganization dated as of July 19, 1996 by and among the Registrant, HNC Merger Corp. and Risk Data Corporation, as amended. (Incorporated by reference to Exhibit Number 2.01 to Registrant's Current Report on Form 8-K filed on September 12, 1996, as amended (the "Risk Data 8-K").) 2.02 Agreement of Merger dated August 30, 1996 by and between HNC Merger Corp. and Risk Data Corporation. (Incorporated by reference to Exhibit Number 2.02 to the Risk Data 8-K.) 2.03 Exchange Agreement dated as of October 25, 1996 by and among the Registrant, Retek Distribution Corporation and the shareholders of Retek Distribution Corporation. (Incorporated by reference to Exhibit Number 2.01 to Registrant's Current Report on Form 8-K filed on December 12, 1996 (the "Retek 8-K").) 2.04 Form of Option Exchange Agreement between the Registrant and each person who held outstanding options to purchase shares of Retek Distribution Corporation on November 29, 1996. (Incorporated by reference to Exhibit Number 2.02 to the Retek 8-K.) 2.05 Agreement and Plan of Reorganization dated as of July 14, 1997 by and among the Registrant, FW1 Acquisition Corp., CompReview, Inc., Robert L. Kaaren and Mishel E. Munnayer, a.k.a. Michael Munayyer, Trustee of the Michael Munayyer Trust dated August 11, 1995. (Pursuant to Item 601(b)(2) of Regulation S-K, certain schedules have been omitted but will be furnished supplementally to the Commission upon request.) (Incorporated by reference to Exhibit Number 2.01 to Registrant's Current Report on Form 8-K filed on December 15, 1997 (the "CompReview 8-K").) 2.06 Agreement of Merger dated as of November 28, 1997 by and between FW1 Acquisition Corp. and CompReview, Inc. (Incorporated by reference to Exhibit Number 2.02 to the CompReview 8-K.) 3(i).01 Registrant's Restated Certificate of Incorporation filed with the Secretary of State of Delaware on June 13, 1996. (Incorporated by reference to Exhibit Number 3(i).04 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (the "Second Quarter 1996 10-Q").) 3(ii).02 Registrant's Bylaws, as amended. (Incorporated by reference to Exhibit Number 3(ii).05 to the Second Quarter 1996 10-Q.) 4.01 Form of Specimen Certificate for Registrant's Common Stock. (Incorporated by reference to Exhibit Number 4.01 to Registrant's Form S-1 Registration Statement, as amended (File No. 33-91932) (the "IPO S-1").) 4.02 Third Amended Registration Rights Agreement dated March 10, 1993, as amended. (Incorporated by reference to Exhibit Number 4.02 to the IPO S-1.) 4.03 Second Waiver and Amendment to Third Amended Registration Rights Agreement. (Incorporated by reference to Exhibit Number 4.03 to Registrant's Form S-1 Registration Statement, as amended (File No. 33-99980) (the "Second S-1").) 4.04 Registration Rights Agreement dated as of August 30, 1996 by and among the Registrant and the former shareholders of Risk Data Corporation. (Incorporated by reference to Exhibit Number 4.01 to the Risk Data 8-K.) 4.05 Registration Rights Agreement dated as of October 25, 1996 by and among the Registrant and the former shareholders of Retek Distribution Corporation. (Incorporated by reference to Exhibit Number 4.01 to the Retek 8-K.)
58 59
EXHIBIT NUMBER DESCRIPTION --------- ------------------------------------------------------------------------- 4.06 Amendment No. 1 to the Registration Rights Agreement dated as of February 24, 1997 by and between the Registrant and the former shareholders of Retek Distribution Corporation. (Incorporated by reference to Exhibit Number 4.06 to Registrant's Annual Report on Form 10-K, as amended, for the year ended December 31, 1996 (the "1996 10-K").) 4.07 Registration Rights Agreement dated as of November 28, 1997 by and among the Registrant and the former shareholders of CompReview, Inc. (Incorporated by reference to Exhibit Number 4.01 to the CompReview 8-K.) 10.01 Registrant's 1987 Stock Option Plan and related documents. (Incorporated by reference to Exhibit Number 10.01 to the IPO S-1.)(1) 10.02 Registrant's 1995 Equity Incentive Plan and related documents, as amended.(1) 10.03 Registrant's 1995 Directors Stock Option Plan and related documents. (Incorporated by reference to Exhibit Number 10.03 to the IPO S-1.)(1) 10.04 Registrant's 1995 Employee Stock Purchase Plan and related documents. (Incorporated by reference to Exhibit Number 10.04 to the IPO S-1.)(1) 10.05 Registrant's 1998 Stock Option Plan.(1) 10.06 Form of Indemnity Agreement entered into by Registrant with each of its directors and executive officers. (Incorporated by reference to Exhibit Number 10.08 to the IPO S-1.)(1) 10.07 Office Building Lease dated as of December 1, 1993, as amended effective February 1, 1994 and June 1, 1994, between Registrant and PacCor Partners. (Incorporated by reference to Exhibit Number 10.09 to the IPO S-1.) 10.08 Marketing Agreement dated as of June 24, 1993 between Registrant and First Data Resources, Inc. (Incorporated by reference to Exhibit Number 10.11 to the IPO S-1.)(2) 10.09 License Agreement dated as of June 24, 1993, as amended October 18, 1993, September 16, 1994 and by letter amendment, with Addendum dated January 21, 1994, as amended February 15, 1995, between Registrant and First Data Resources, Inc. (Incorporated by reference to Exhibit Number 10.12 to the IPO S-1.)(2) 10.10 Loan and Security Agreement dated as of July 11, 1997, between Registrant and Wells Fargo Bank, National Association. (Incorporated by reference to Exhibit Number 10.01 to Registrant's Quarterly Report on Form 10-Q, as amended, for the quarter ended June 30, 1997 (the "Second Quarter 1997 10-Q").) 10.11 Office Building Lease dated as of May 30, 1997, between Retek Information Systems, Inc. and Midwest Real Estate Holdings, Inc. (Incorporated by reference to Exhibit Number 10.02 to the Second Quarter 1997 10-Q.) 10.12 Office Building Lease dated as of June 17, 1996, between Registrant and Williams Properties I, LLC & Williams Properties II, LLC. (Incorporated by reference to Exhibit Number 10.12 to the 1996 10-K.) 10.13 Employment Agreement dated as of September 10, 1996, by and between Aptex Software Inc. and Michael A. Thiemann. (Incorporated by reference to Exhibit Number 10.13 to the 1996 10-K.)(1) 10.14 Investors' Rights Agreement dated as of September 10, 1996, by and among Aptex Software Inc., HNC Software Inc. and Michael A. Thiemann. (Incorporated by reference to Exhibit Number 10.14 to the 1996 10-K.)(1)
59 60
EXHIBIT NUMBER DESCRIPTION --------- ------------------------------------------------------------------------- 10.15 Restricted Stock Purchase Agreement dated as of September 10, 1996, by and between Aptex Software Inc. and Michael Thiemann. (Incorporated by reference to Exhibit Number 10.15 to the 1996 10-K.)(1) 10.16 Aptex Software Inc.'s 1996 Equity Incentive Plan and related documents. (Incorporated by reference to Exhibit Number 10.16 to the 1996 10-K.)(1) *10.17 Office Building Lease dated June 17, 1993, between Linsco/Private Ledger Corp. and PacCor Partners and Assignment of such lease to the Registrant. 21.01 List of Registrant's subsidiaries. *23.01 Consent of Price Waterhouse LLP, Independent Accountants. 27.01 Financial Data Schedule
- --------------- * Filed herewith. (1) Management contract or compensatory plan or arrangement. (2) Confidential treatment has been granted for certain portions of this document. Such portions have been omitted from the filing and have been filed separately with the Securities and Exchange Commission. (b) Reports on Form 8-K (i) A Report on Form 8-K was filed on October 24, 1997 to report, under Item 5, the earnings press release for the quarter ended September 30, 1997. (ii) A Report on Form 8-K was filed on December 15, 1997 to report, under Items 2 and 7, the acquisition of CompReview (event dated November 28, 1997). Filed therewith were the financial statements of CompReview as of September 30, 1997 and for the nine months ended September 30, 1996 and 1997 and as of December 31, 1995 and 1996 and for the years ended December 31, 1994, 1995 and 1996. Also filed therewith were pro forma consolidated combined condensed financial information at September 30, 1997 and for the nine months ended September 30, 1997 and 1996 and for the years ended December 31, 1994, 1995 and 1996 and historical and supplemental consolidated financial statements of the Company at December 31, 1995 and 1996 and for the years ended December 31, 1994, 1995 and 1996. 60 61 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amendment to report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 25, 1998 HNC SOFTWARE INC. By: /s/ RAYMOND V. THOMAS ------------------------------------ Raymond V. Thomas Vice President, Finance & Administration and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this amendment to report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE - --------------------------------------------- ---------------------------- ------------------- /s/ ROBERT L. NORTH President and Chief February 25, 1998 - --------------------------------------------- Executive Officer (Principal Robert L. North Executive Officer) /s/ RAYMOND V. THOMAS Vice President, Finance & February 25, 1998 - --------------------------------------------- Administration and Chief Raymond V. Thomas Financial Officer (Principal Financial Officer and Principal Accounting Officer) /s/ EDWARD K. CHANDLER Director February 25, 1998 - --------------------------------------------- Edward K. Chandler Director February , 1998 - --------------------------------------------- Oliver D. Curme /s/ THOMAS F. FARB Director February 25, 1998 - --------------------------------------------- Thomas F. Farb Director February , 1998 - --------------------------------------------- Charles H. Gaylord, Jr.
61 62 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of HNC Software Inc. Our audits of the consolidated financial statements referred to in our report dated January 29, 1998, except as to Note 11 which is as of February 13, 1998, appearing on page 36 of this Annual Report on Form 10-K/A-1 of HNC Software Inc. also included an audit of the Financial Statement Schedule listed in Item 14(a) of this Form 10-K/A-1. In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE LLP San Diego, California January 29, 1998 62 63 HNC SOFTWARE INC. SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1997
ALLOWANCE FOR DEFERRED TAX DOUBTFUL ACCOUNTS ASSET VALUATION AND SALES RETURNS ALLOWANCE ----------------- --------------- Balance at December 31, 1994.................................. $ 514,000 $ 4,238,000 Provision................................................... 529,000 702,000 Write-off................................................... (472,000) -- Recovery.................................................... (18,000) (2,223,000) ---------- ----------- Balance at December 31, 1995.................................. 553,000 2,717,000 Provision................................................... 279,000 -- Write-off................................................... (94,000) -- Recovery.................................................... (29,000) (2,717,000) ---------- ----------- Balance at December 31, 1996.................................. 709,000 -- Provision................................................... 3,171,000 -- Write-off................................................... (505,000) -- Recovery.................................................... (175,000) -- ---------- ----------- Balance at December 31, 1997.................................. $ 3,200,000 $ -- ========== ===========
63 64 EXHIBIT INDEX
EXHIBIT NUMBER EXHIBIT TITLE - --------- ----------------------------------------------------------------------------------- 2.01 Agreement and Plan of Reorganization dated as of July 19, 1996 by and among the Registrant, HNC Merger Corp. and Risk Data Corporation, as amended. (Incorporated by reference to Exhibit Number 2.01 to Registrant's Current Report on Form 8-K filed on September 12, 1996, as amended (the "Risk Data 8-K").).................... 2.02 Agreement of Merger dated August 30, 1996 by and between HNC Merger Corp. and Risk Data Corporation. (Incorporated by reference to Exhibit Number 2.02 to the Risk Data 8-K.)......................................................................... 2.03 Exchange Agreement dated as of October 25, 1996 by and among the Registrant, Retek Distribution Corporation and the shareholders of Retek Distribution Corporation. (Incorporated by reference to Exhibit Number 2.01 to Registrant's Current Report on Form 8-K filed on December 12, 1996 (the "Retek 8-K").)............................ 2.04 Form of Option Exchange Agreement between the Registrant and each person who held outstanding options to purchase shares of Retek Distribution Corporation on November 29, 1996. (Incorporated by reference to Exhibit Number 2.02 to the Retek 8-K.).............................................................................. 2.05 Agreement and Plan of Reorganization dated as of July 14, 1997 by and among the Registrant, FW1 Acquisition Corp., CompReview, Inc., Robert L. Kaaren and Mishel E. Munnayer, a.k.a. Michael Munayyer, Trustee of the Michael Munayyer Trust dated August 11, 1995. (Pursuant to Item 601(b)(2) of Regulation S-K, certain schedules have been omitted but will be furnished supplementally to the Commission upon request.) (Incorporated by reference to Exhibit Number 2.01 to Registrant's Current Report on Form 8-K filed on December 15, 1997 (the "CompReview 8-K").)............. 2.06 Agreement of Merger dated as of November 28, 1997 by and between FW1 Acquisition Corp. and CompReview, Inc. (Incorporated by reference to Exhibit Number 2.02 to the CompReview 8-K.)................................................................... 3(i).01 Registrant's Restated Certificate of Incorporation filed with the Secretary of State of Delaware on June 13, 1996. (Incorporated by reference to Exhibit Number 3(i).04 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 (the "Second Quarter 1996 10-Q").)........................................ 3(ii).02 Registrant's Bylaws, as amended. (Incorporated by reference to Exhibit Number 3(ii).05 to the Second Quarter 1996 10-Q.)......................................... 4.01 Form of Specimen Certificate for Registrant's Common Stock. (Incorporated by reference to Exhibit Number 4.01 to Registrant's Form S-1 Registration Statement, as amended (File No. 33-91932) (the "IPO S-1").)................................... 4.02 Third Amended Registration Rights Agreement dated March 10, 1993, as amended. (Incorporated by reference to Exhibit Number 4.02 to the IPO S-1.)................. 4.03 Second Waiver and Amendment to Third Amended Registration Rights Agreement. (Incorporated by reference to Exhibit Number 4.03 to Registrant's Form S-1 Registration Statement, as amended (File No. 33-99980) (the "Second S-1").)........ 4.04 Registration Rights Agreement dated as of August 30, 1996 by and among the Registrant and the former shareholders of Risk Data Corporation. (Incorporated by reference to Exhibit Number 4.01 to the Risk Data 8-K.)............................ 4.05 Registration Rights Agreement dated as of October 25, 1996 by and among the Registrant and the former shareholders of Retek Distribution Corporation. (Incorporated by reference to Exhibit Number 4.01 to the Retek 8-K.)............... 4.06 Amendment No. 1 to the Registration Rights Agreement dated as of February 24, 1997 by and between the Registrant and the former shareholders of Retek Distribution Corporation. (Incorporated by reference to Exhibit Number 4.06 to Registrant's Annual Report on Form 10-K, as amended, for the year ended December 31, 1996 (the "1996 10-K").)..................................................................... 4.07 Registration Rights Agreement dated as of November 28, 1997 by and among the Registrant and the former shareholders of CompReview, Inc. (Incorporated by reference to Exhibit Number 4.01 to the CompReview 8-K.)........................... 10.01 Registrant's 1987 Stock Option Plan and related documents. (Incorporated by reference to Exhibit Number 10.01 to the IPO S-1.)(1).............................. 10.02 Registrant's 1995 Equity Incentive Plan and related documents, as amended.(1)...... 10.03 Registrant's 1995 Directors Stock Option Plan and related documents. (Incorporated by reference to Exhibit Number 10.03 to the IPO S-1.)(1)...........................
65
EXHIBIT NUMBER EXHIBIT TITLE - --------- ----------------------------------------------------------------------------------- 10.04 Registrant's 1995 Employee Stock Purchase Plan and related documents. (Incorporated by reference to Exhibit Number 10.04 to the IPO S-1.)(1)........................... 10.05 Registrant's 1998 Stock Option Plan.(1)............................................ 10.06 Form of Indemnity Agreement entered into by Registrant with each of its directors and executive officers. (Incorporated by reference to Exhibit Number 10.08 to the IPO S-1.)(1)....................................................................... 10.07 Office Building Lease dated as of December 1, 1993, as amended effective February 1, 1994 and June 1, 1994, between Registrant and PacCor Partners. (Incorporated by reference to Exhibit Number 10.09 to the IPO S-1.)................................. 10.08 Marketing Agreement dated as of June 24, 1993 between Registrant and First Data Resources, Inc. (Incorporated by reference to Exhibit Number 10.11 to the IPO S-1.)(2)........................................................................... 10.09 License Agreement dated as of June 24, 1993, as amended October 18, 1993, September 16, 1994 and by letter amendment, with Addendum dated January 21, 1994, as amended February 15, 1995, between Registrant and First Data Resources, Inc. (Incorporated by reference to Exhibit Number 10.12 to the IPO S-1.)(2)........................... 10.10 Loan and Security Agreement dated as of July 11, 1997, between Registrant and Wells Fargo Bank, National Association. (Incorporated by reference to Exhibit Number 10.01 to Registrant's Quarterly Report on Form 10-Q, as amended, for the quarter ended June 30, 1997 (the "Second Quarter 1997 10-Q")).............................. 10.11 Office Building Lease dated as of May 30, 1997, between Retek Information Systems, Inc. and Midwest Real Estate Holdings, Inc. (Incorporated by reference to Exhibit Number 10.02 to the Second Quarter 1997 10-Q.)..................................... 10.12 Office Building Lease dated as of June 17, 1996, between Registrant and Williams Properties I, LLC & Williams Properties II, LLC. (Incorporated by reference to Exhibit Number 10.12 to the 1996 10-K.)............................................ 10.13 Employment Agreement dated as of September 10, 1996, by and between Aptex Software Inc. and Michael A. Thiemann. (Incorporated by reference to Exhibit Number 10.13 to the 1996 10-K.)(1)................................................................. 10.14 Investors' Rights Agreement dated as of September 10, 1996, by and among Aptex Software Inc., HNC Software Inc. and Michael A. Thiemann. (Incorporated by reference to Exhibit Number 10.14 to the 1996 10-K.)(1)............................ 10.15 Restricted Stock Purchase Agreement dated as of September 10, 1996, by and between Aptex Software Inc. and Michael Thiemann. (Incorporated by reference to Exhibit Number 10.15 to the 1996 10-K.)(1)................................................. 10.16 Aptex Software Inc.'s 1996 Equity Incentive Plan and related documents. (Incorporated by reference to Exhibit Number 10.16 to the 1996 10-K.)(1)........... *10.17 Office Building Lease dated June 17, 1993, between Linsco/Private Ledger Corp. and PacCor Partners and Assignment of such lease to the Registrant..................... 21.01 List of Registrant's subsidiaries.................................................. *23.01 Consent of Price Waterhouse LLP, Independent Accountants*.......................... 27.01 Financial Data Schedule............................................................
- --------------- * Filed herewith. (1) Management contract or compensatory plan or arrangement. (2) Confidential treatment has been granted for certain portions of this document. Such portions have been omitted from the filing and have been filed separately with the Securities and Exchange Commission. EX-10.17 2 EXHIBIT 10.17 1 EXHIBIT 10.17 OFFICE BUILDING LEASE BETWEEN PACCOR PARTNERS ("LANDLORD") AND LINSCO/PRIVATE LEDGER CORP. ("TENANT") DATE: JUNE 17, 1993 2 TABLE OF CONTENTS
SECTION 1 BASIC LEASE INFORMATION 1.1 Parties 1.2 Project 1 1.3 Premiss 1.4 Commencement Date 1.5 Term of Lease 1.6 Option to Extend Term 1.7 Base Rent 1.8 Security Deposit Amount 1.9 Tenant's Share of Common Area Operating Expenses and Building Operating Expenses 1.10 Tenant Improvement Allowance 1.11 Additional Insureds 1.12 Notice Address 1.13 Exhibits SECTION 2 PREMISES SECTION 3 TERM 3.1 Term 3.2 Option to Extend Term SECTION 4 RENT 4.1 Definitions 4.2 Base Rent 4.3 Rent for Extended Term 4.4 Fair Market Rental Value 4.5 Security Deposit Amount SECTION 5 TENANT IMPROVEMENTS 5.1 Definitions 5.2 Space Plan Allowance 5.3 Preparation of Premises 5.4 Tenant's Contractor 5.5 Acceptance of Premises 5.6 Relocation Consultant 5.7 Refurbishment Allowance SECTION 6 OPERATING EXPENSES 6.1 Definitions 6.2 Adjustments to Common Area Operating Expenses 6.3 Rent Adjustment 6.4 Lease Expenses Difference Cap 6.5 Operating Expense Records SECTION 7 USE AND MAINTENANCE OF THE PREMISES
3
7.1 Permitted Use 7.2 Insurance 7.3 Compliance with Laws 7.4 Hazardous Waste or Nuisance 7.5 Damage and Overloading 7.6 Access by Landlord 7.7 Signs 7.8 Parking 7.9 Alterations 7.10 Mechanics' Lien 7.11 Indemnity and Exemption of Landlord from Liability 7.12 Premises Changes 7.13 Services and Utilities 7.14 Rules 7.15 Maintenance Obligations 7.16 Building Security 7.17 Tenant to Pay Personal Property Taxes SECTION 8 INSURANCE 8.1 Tenant's Insurance 8.2 Landlord's Insurance SECTION 9 DESTRUCTION 9.1 Risk Covered by Insurance 9.2 Abatement or Reduction of Rent 9.3 Loss During Last Part of Term or Exceeding 25% of Replacement Value 9.4 Limitation on Landlord's Restoration Obligation SECTION 10 CONDEMNATION 10.1 Definitions 10.2 Governed by Lease 10.3 Total Taking 10.4 Partial Taking 10.5 Award 10.6 Temporary Taking 10.7 Waiver of Statute SECTION 11 ASSIGNMENT AND SUBLETTING 11.1 Assignment 11.2 Sublease 11.3 Tenant and Assignee or Sublessee Fully Liable 11.4 Assignment of Rents 11.5 Sublease Assignment Right SECTION 12 DEFAULT AND REMEDIES 12.1 Default 12.2 Landlord's Remedies
4
12.3 Interest and Late Charges 12.4 Quarterly Payments 12.5 Waiver 12.6 Notice of Default SECTION 13 SUBORDINATION, ATTORNMENT, ESTOPPEL AND NON-DISTURBANCE 13.1 Subordination 13.2 Attornment 13.3 Estoppel Certificates 13.4 Non-Disturbance Agreement SECTION 14 SURRENDER OF PREMISES, HOLDING OVER 14.1 Surrender of Premises 14.2 Holding Over SECTION 15 DELAY IN OCCUPANCY 15.1 Definitions 15.2 Delay in Occupancy SECTION 16 GENERAL PROVISIONS 16.1 Brokers 16.2 Notices 16.3 Quitclaim Deed 16.4 Sale or Transfer of Premises 16.5 Attorneys' Fees 16.6 Merger 16.7 Time of Essence 16.8 Successor in Interest 16.9 Easements 16.10 Governing Law 16.11 Integration 16.12 Provisions Are Covenants and Conditions 16.13 Person and Gender 16.14 Severability 16.15 Limitations on Landlord's Liability 16.16 Headings and Exhibits 16.17 Payments in United States Currency 16.18 Tenant's Financial Statements 16.19 No Option 16.20 Recordation of Lease 16.21 No Violation of Other Agreements 16.22 Project Name Change 16.23 Use of Project Name 16.24 Reserved Area SECTION 17 SPECIAL PROVISIONS 17.1 Moving Allowance 17.2 Right of First Negotiation
5
17.3 Satellite Dish Exhibit A Description of Premises Exhibit B Description of Real Property Exhibit C Work Letter Exhibit D Building/Tenant Improvement Standards for Pacific Corporate Park Exhibit E Rules and Regulations Exhibit F Tri-Water System Exhibit F1 Walsh Engineers Letter dated 4/29/93 Exhibit G Building Security Service Agreement Exhibit G1 Pinkerton's Inc. Schedule of Patrol Service Exhibit H Non-Disturbance Agreement Exhibit I Estoppel Certificate Exhibit J Janitorial Specifications GLOSSARY
6 OFFICE LEASE This Office Lease ("Lease") is made and entered into this ______ day of ________, 1993 between PACCOR PARTNERS, a California general partnership ("Landlord"), and LINSCO/PRIVATE LEDGER CORP., a California corporation ("Tenant"), who for valuable consideration, the receipt and sufficiency of which are hereby acknowledged, agree as follows: SECTION 1 BASIC LEASE INFORMATION 1.1 Parties: Landlord and Landlord's Address: PacCor Partners, a California general partnership 11939 Rancho Bernardo Road, Suite 200 San Diego, California 92128 Tenant and Tenant's Address: LINSCO/PRIVATE LEDGER CORP. 5871 Oberlin Drive San Diego, CA 92121 1.2 "Project" shall mean: (i) the Premises; (ii) the building located at 5935 Cornerstone Court West, San Diego, California (the "Building"); (iii) building located at 5930 Cornerstone Court West, San Diego, California ("Adjacent Building"), Building and Adjacent Building are referred to collectively as "Buildings"; (iv) Common Area as defined in Exhibit B and Section 6.1(c); (v) the real property defined in Exhibit B ("Real Property"); and (vi) all other improvements on the Real Property or any future improvements, including additional buildings, to the Real Property. 1.3 "Premises" shall mean all of the interior of the Building. (See Exhibit "A" attached.) (i) "Rentable Square Footage" shall mean 48,984 square feet. (ii) "Usable Square Footage" shall mean 43,568 square feet. 1.4 "Commencement Date" shall mean June 1, 1994 or later as set forth below. (a) "Tenant's Occupancy" shall mean the earlier of (i) the date when fifteen (15) employees of Tenant are occupying the Premises as their primary work place or (ii) the date when Tenant first conducts its business on the Premises. Tenant Occupancy shall not occur solely due to employees of Tenant on the Premises for inspection, testing of equipment or other activities associated with the Work or moving from Tenant's present location to the Premises. (b) Tenant's Occupancy may occur on or after May 1, 1994. (c) If, as of June 1, 1994, Tenant's Occupancy has not occurred and there are fourteen (14) days or fewer of combined Landlord Delay (as defined in Section 10 of the Work Letter) and Unavoidable Delay (as defined in Section 11 of the Work Letter), then the Commencement Date shall be the earlier of (i) Tenant's Occupancy or (ii) the date which is the number of days of Landlord Delay and Unavoidable Delay after June 1, 1994. (d) If, as of June 1, 1994, Tenant's Occupancy has not occurred and there are at least fifteen (15) days but not more than thirty-four (34) days of combined Landlord Delay and Unavoidable Delay, then the Commencement Date shall be the earlier of (i) Tenant's Occupancy or (ii) July 5, 1994. 7 (e) If, as of July 5, 1994, Tenant's Occupancy has not occurred and there are at least thirty-five (35) days but not more than ninety-seven (97) days of combined Landlord Delay and Unavoidable Delay, then the Commencement Date shall be the earlier of (i) Tenant's Occupancy or (ii) September 6, 1994. (f) If, as of September 6, 1994, Tenant's Occupancy has not occurred and there are at least ninety-eight (98) days of combined Landlord Delay and Unavoidable Delay, then the Commencement Date shall be the earlier of (i) Tenant's Occupancy or (ii) November 29, 1994. (g) If, as of November 29, 1994, Tenant's Occupancy or Substantial Completion has not occurred and there are at least one hundred eighty-one (181) days of combined Landlord Delay and Unavoidable Delay, then the Commencement Date shall be the earlier of (i) Tenant's Occupancy or (i) Substantial Completion as defined below. 1.5 "Term of Lease" shall mean One Hundred Twenty (120) full calendar months from and after the Commencement Date or, if the Commencement Date is not the first day of a month, from and after the first day of the month following the Commencement Date. 1.6 "Option to Extend Term" shall mean one (1) option to extend, for a period of five (5) years following the Expiration Date. 1.7 "Base Rent" shall be payable monthly in accordance with the "Schedule of Base Rent" as set forth in Section 4.2, beginning at an initial monthly rent of Forty-eight Thousand Nine Hundred Eighty Four Dollars and 00/100ths ($48,984.00) for months one (1) through sixty (60) and Sixty-four Thousand One Hundred Sixty-nine Dollars and 04/100ths ($64,169.04) for months sixty-one (61) through one hundred twenty (120). Tenant shall receive a rent abatement of Thirty-Three Thousand Four Hundred Ninety-Two Dollars ($33,492.00) for the second (2nd) month and Nine Thousand Dollars ($9,000.00) per month for months three (3) through nineteen (19) ("Rent Abatement"). 1.8 "Security Deposit Amount" shall mean the amount of Forty-eight Thousand Nine Hundred Eighty-four and 00/100ths Dollars ($48,984.00). 1.9 "Tenant's share of Common Area Operating Expenses and Building Operating Expenses" (as defined in Section 6.1) shall mean an amount due Landlord, beginning one year after the Commencement Date, which is a fraction of the increase in Common Area Operating Expenses and all the increase in Building Operating Expenses over the Base Year, as specifically set forth in Sections 6.3 and 6.4. 1.10 "Tenant Improvement Allowance" shall mean the amount of One Million Four Hundred Ninety-four Thousand One Hundred Seventy-six and no/100 Dollars ($1,494,176.00) which Tenant shall receive from Landlord for the cost of Tenant's improvements of the Premises, including the cost of architectural fees and permitting costs. 1.11 Additional Insureds: Tenant shall name as additional insureds the following entities: PacCor Partners, a California general partnership (Landlord) 11939 Rancho Bernardo Road, Suite 200 San Diego, California 92128 (Attn: Marlene Booth) PacCor Management Company, a California corporation (a general partner) 11939 Rancho Bernardo Road, Suite 200 San Diego, California 92128 (Attn: Marlene Booth) PR Land Corp., a Delaware corporation (a general partner) c/o Paul Revere Investment Management Corporation 18 Chestnut Street Worcester, MA 01608 8 1.12 Notice Address (Section 16.2): All notices shall be addressed as follows: Landlord: PacCor Partners 11939 Rancho Bernardo Road, Suite 200 San Diego, California 92128 Attn: Terrence L. Vogel Copy to: PacCor Management Company 11939 Rancho Bernardo Road, #200 San Diego, California 92128 Attn: Marlene Booth To Tenant prior to Tenant's taking possession of the Premises: LINSCO/PRIVATE LEDGER CORP. 5871 Oberlin Drive San Diego, CA 92121 Attn: Andrew J. Micheletti Tenant after Tenant's taking possession of the Premises: LINSCO/PRIVATE LEDGER CORP. 5935 Cornerstone Court West San Diego, CA 92121 Attn: Andrew J. Micheletti Copy of all notices to Tenant to: Solomon, Ward, Seidenwurm & Smith 401 B Street, Suite 1200 San Diego, CA 92101 Attn: Richard L. Seidenwurm, Esq. 1.13 EXHIBITS: Exhibit "A": Description of Premises Exhibit "B": Description of Real Property Exhibit "C": Work Letter Exhibit "D": Building/Tenant Improvement Standards for Pacific Corporate Park Exhibit "E": Rules and Regulations Exhibit "F": Tri-Water System Exhibit "F1": Walsh Engineers Letter dated 4/29/93 Exhibit "G": Building Security Service Agreement Exhibit "G1": Pinkerton's Inc. Schedule of Patrol Service Exhibit "H": Non-Disturbance Agreement Exhibit "I": Estoppel Certificate Exhibit "J": Janitorial Specifications Exhibit "K": Covenants, Conditions & Restrictions Exhibit "L": Signs Exhibit "M": Floor-Bearing Loads Exhibit "N": Amended Planned Industrial Development ("PID") Permit No. 85-0830 Exhibit "O": Insurance Quotes Exhibit "P": List of Comparable Buildings to Determine Fair Market Value SECTION 2 PREMISES Landlord hereby leases to Tenant and Tenant hereby leases from Landlord, subject to the provisions of this Lease, the Premises. 9 SECTION 3 TERM 3.1 TERM: The Term of this Lease is set forth in Section 1.5. "Expiration Date" shall mean the last day of the initial Term. The Commencement Date and Expiration Date shall be confirmed in writing by Landlord and Tenant within fifteen (15) days after the Commencement Date. 3.2 OPTION TO EXTEND TERM: (a) Option to Extend Term: As a material part of the consideration for the execution of this Lease by Tenant, Tenant is hereby granted an option to extend the Term for one (1) five (5) year period ("Extended Term") following the Expiration Date, by giving Landlord written notice of Tenant's exercise of the option and setting forth the agreed upon or arbitrator-determined Base Rent for the Extended Term, ("Option Notice") at least nine (9) months before the Expiration Date or otherwise in accordance with the provisions of Section 4.3 below. The option to extend the Term shall be for all, or any full floor portion, of the Premises. If the option to extend is exercised, the "Option Commencement Date" shall be one day after the Expiration Date and the term of this Lease shall be extended to the fifth anniversary of the Expiration Date ("Option Expiration Date"). (b) Provisions Applicable to the Option: The option to extend set forth in the preceding paragraph may be exercised by Tenant provided that, at the time Landlord receives the Option Notice, Tenant is not in material default under this Lease. Notwithstanding Section 3.2(a), if Tenant is in material default of this Lease on the date Landlord receives the Option Notice, the Option Notice shall be void and the Extended Term shall not commence unless Landlord notifies the Tenant in writing within ten (10) days after receipt of the Option Notice that the Option Notice is accepted and will operate to extend the Term. If Tenant is in material default under this Lease on the date the Extended Term is to commence and Tenant has not commenced any cure of such default within the cure periods set forth in Section 12 below, then, in Landlord's sole election, the Extended Term shall not commence and this Lease shall expire upon the Expiration Date. Tenant shall in no event be deemed in default if curative action has occurred pursuant to Section 12. (c) Provisions Applicable To The Extended Term: The Extended Term shall be upon the same terms and conditions as set forth in this Lease except as follows: (i) The Base Rent for the Extended Term shall be adjusted to ninety-five percent (95%) of the then-fair market rental value as more specifically set forth in Section 4.3 below. (ii) Tenant will have no option to extend the Term of this Lease beyond the Option Expiration Date. (iii) Tenant shall accept the Premises in its then "AS IS" condition at the Option Commencement Date. (iv) If the Lease is extended, then "Term" as used in this Lease shall include the Term and the Extended Term unless specifically provided to the contrary. (v) Within thirty (30) days after Tenant's delivery of an Option Notice setting forth the agreed-upon Base Rent or arbitrator-determined Base Rent for the Extended Term, the parties shall execute an amendment to this Lease stating the new monthly Base Rent for the Extended Term, provided, however, that the execution of such amendment shall not be a condition precedent to Tenant's obligation to pay increased Base Rent. SECTION 4 RENT 4.1 DEFINITIONS: For purposes of this Lease, the following definitions shall apply: (a) "Base Rent" shall mean the minimum monthly base rent set forth in Section 4.2; 10 (b) "Additional Rent" shall mean all Monthly Payments and Lease Expense Difference which Tenant is required to pay under Section 6 below. (c) "Rent" shall mean Base Rent and Additional Rent and any other sum payable by Tenant to Landlord under this Lease. 4.2 BASE RENT: Tenant agrees to pay to Landlord the Base Rent as set forth on the Schedule of Base Rent below, without deduction, setoff, prior notice, or demand (except as specifically set forth in this Lease and except for tenant allowances which Landlord fails to timely pay to Tenant pursuant to this Lease), per month in advance on the first day of each month commencing on the Commencement Date and continuing during the Term of the Lease. Tenant shall receive a Rent Abatement of Thirty-Three Thousand Four Hundred Ninety-Two Dollars ($33,492.00) for the second (2nd) month and Nine Thousand and 00/100ths Dollars ($9,000.00) per month for the third (3rd) through nineteenth (19th) months of the Term of the Lease. All rent shall be paid to Landlord at its address specified in Section 16.2 entitled "Notices." Base Rent in the amount of Forty-eight Thousand Nine Hundred Eighty-four and 00/100ths Dollars ($48,984.00) shall be paid to Landlord concurrent with the execution of this Lease and shall be applied to month one (1) of the Term.
SCHEDULE OF BASE RENT MONTHLY BASE RENT RATE PER RENTABLE RENTABLE MONTHLY MONTHLY RENT MONTHLY NET MONTH SQ. FT. SQ. FT. BASE RENT ABATEMENT AMOUNT ----- ------- ------- --------- --------- ------ Month 1 $ 1.00 48,984 $48,984.00 0 $48,984.00 Month 2 $ 1.00 48,984 $48,984.00 $33,492.00 $15,492.00 Months 3-19 $ 1.00 48,984 $48,984.00 $9,000.00 $39,984.00 Months 20-60 $ 1.00 48,984 $48,984.00 0 $48,984.00 Months 61-120 $ 1.31 48,984 $64,169.04 0 $64,169.04
4.3 RENT FOR EXTENDED TERM: The rent for the Extended Term shall be Ninety-five Percent (95%) of the Fair Market Rental Value of the Premises, as defined in Section 4.4. On or before the date which is Fourteen (14) months prior to the Expiration Date, Landlord shall notify Tenant in writing of Landlord's determination of Fair Market Rental Value. Tenant may, at its election, either accept such determination of Fair Market Rental Value or attempt to reach an alternative determination of Fair Market Rental Value by mutual agreement with Landlord. If Landlord and Tenant are unable to agree on the Fair Market Rental Value within thirty (30) days after Tenant's receipt of the Landlord's Notice, then the Fair Market Rental Value shall be determined in accordance with the following procedure: Within forty (40) days after Tenant's receipt of Landlord's notice, Landlord and Tenant shall jointly appoint an arbitrator and an alternate arbitrator in accordance with the commercial arbitration rules of the American Arbitration Association. Such arbitrator and alternate arbitrator shall be experienced with matters involving real estate appraisals in the area in which the Premises are located. Concurrent with such appointments, Landlord and Tenant shall each submit to such arbitrator their respective determination of the Fair Market Rental Value and such arbitrator shall select the one of such two submitted determinations that is closest to such arbitrator's own appraisal of the Fair Market Rental Value. Such arbitrator shall have no discretion to make any determination other than the selection of either Landlord or Tenant's determination of Fair Market Rental Value. The cost of such arbitrator shall be shared equally by Landlord and Tenant. Landlord and Tenant shall each proceed expeditiously with the arbitration in order to permit the arbitrator's decision to be issued at least Three hundred forty (340) days prior to the Expiration Date. If the arbitrator's decision has not been received by the Tenant and the Landlord three hundred forty (340) days prior to the Expiration Date it shall be void unless the parties agree in writing otherwise, and Landlord and Tenant shall each, three hundred and thirty (330) days prior to the Expiration Date, submit to the alternate arbitrator their respective determination of Fair Market Rental Value and the alternate arbitrator shall select the one of such two submitted determinations that is closest to such alternate arbitrator's own appraisal of the Fair Market 11 Rental Value. Such alternate arbitrator shall have no discretion to make any determination other than the selection of either Landlord or Tenant's determination of Fair Market Rental Value. The cost of such alternate arbitrator shall be shared equally by Landlord and Tenant. Landlord and Tenant shall each proceed expeditiously with the arbitration in order to permit the alternate arbitrator's decision to be issued at least two hundred eighty (280) days prior to the Expiration Date. In the event that the arbitrator's decision is not received by Tenant on or before such date, Tenant shall nevertheless have a period of ten (10) days following such receipt to determine whether to send the Option Notice to Landlord, exercising Tenant's right to extend. If Tenant does not so extend, the Term shall be extended by a number of days equal to Two Hundred Seventy (270), minus the number of days remaining in the Term when the Tenant's right to send the Option Notice expired, divided by two (2). 4.4 "FAIR MARKET RENTAL VALUE" shall mean the effective value on a monthly basis of all expenditures for comparable office space being paid by willing, comparable non-renewal tenants with a credit standing and financial stature equivalent to Tenant, giving appropriate consideration to all relevant economic terms and conditions of the Landlord/Tenant relationship, including without limitation tenant improvement, refurbishment and other allowances, operating expense stops or caps, leasing and other commissions (whether paid to independent parties, to Landlord or to affiliates of Landlord), parking charges or abatements, rental abatements, signing bonuses and similar cash or cash-equivalent tenant concessions. For purposes of determination of Fair Market Rental Value, other comparable space in the Project shall be considered the most comparable space to the Premises and Landlord shall be obligated to furnish to Tenant and any arbitrator copies of all leases of other space in the Project, certified to contain all relevant information with regard to the economic transaction between Landlord and the tenant thereunder. Other than the Project, Landlord and Tenant acknowledge that the most comparable buildings to the Building to be considered in determination of Fair Market Rental Value are set forth in Exhibit "P", however other comparable buildings in the general area may be considered. 4.5 SECURITY DEPOSIT AMOUNT: Upon the execution of this Lease, Tenant shall deposit with Landlord cash or a check in the amount of the Security Deposit Amount to secure the performance by Tenant of its obligations under this Lease, including without limitation Tenant's obligations to (a) pay Rent, (b) repair damages to the Premises caused by Tenant, Tenant's agent(s), employee(s), officer(s) and/or independent contractor(s) of or retained by Tenant ("Tenant's Representatives"), and/or Tenant's guests, visitors, customers, invitees and/or licensees ("Tenant's Invitees"), (c) clean the Premises upon termination of this Lease, and (d) remedy future defaults by Tenant in any obligation under this Lease to restore, replace or return personal property installed or located in or on the Premises including without limitation trade fixtures, furnishings, equipment and inventory, signs, satellite dish ("Personal Property") or appurtenances. If Tenant defaults under this Lease, including without limitation a default described in the preceding sentence, Landlord may use the security deposit to cure such defaults and to compensate Landlord for all or a portion of Landlord's damage resulting from such defaults. Upon demand by Landlord, Tenant shall promptly pay to Landlord a sum equal to the amount so used by Landlord so as to replenish the Security Deposit Amount. Within thirty (30) days after the Expiration Date, Option Expiration Date or earlier termination of this Lease, Landlord shall deliver to Tenant, at Tenant's address, any portion of such Security Deposit Amount not used by Landlord, together with a detailed statement explaining how any portion of the Security Deposit Amount was used. Landlord may commingle such Security Deposit Amount with Landlord's other funds and Landlord shall not pay to Tenant interest on such Security Deposit Amount. In the event of a bankruptcy or other insolvency or a debtor-creditor proceeding against or by Tenant, the Security Deposit Amount shall be deemed applied first to the payment of Rent and other amounts due Landlord for all periods prior to the date of filing or instigating such proceedings. To the extent any debts, liabilities and obligations of Tenant under this Lease have not been satisfied, Tenant shall remain fully liable to Landlord for their payment and/or performance. Provided that Tenant has not been in default under this Lease beyond the cure period set forth in Section 12 below during the first sixty (60) months of the Term, Landlord shall return to Tenant the Security Deposit Amount at the end of such sixty (60) month period. 12 SECTION 5 TENANT IMPROVEMENTS 5.1 DEFINITIONS: For purposes of this Lease, the following definitions shall apply: (i) "Completed Area" shall mean restrooms, elevators, first floor lobby, north and south fire exit corridors, stairwells, exercise room, telephone and utilities equipment room within the Building. (ii) "Space Plan Allowance" shall mean the amount of Ninety-Seven Thousand Nine Hundred Sixty-Eight and no/100 Dollars ($97,968.00). (iii)"Substantial Completion" shall mean that the Premises have been approved for occupancy by the City of San Diego Building Department, and completion of construction of the Work (defined below) in accordance with the approved Construction Documents and Change Orders has occurred with the exception of minor details of construction, installation, decoration, or mechanical adjustments commonly found on a punchlist, none of which materially interferes with Tenant's use or occupancy of the Premises. Substantial Completion of the Work shall be deemed to have occurred notwithstanding the requirement to complete the punchlist items or similar corrective work. (iv) "Work" shall mean the Tenant improvements as set forth in the approved Construction Documents and approved Change Orders as more specifically defined in the Work Letter. (v) "Work Letter" shall mean Exhibit "C" attached to the Lease. 5.2 SPACE PLAN ALLOWANCE: The Landlord shall pay the Space Plan Allowance to Tenant (a) as to costs paid by Tenant prior to the date of this Lease, within thirty (30) days after Lease execution by both parties, and (b) as to other costs, within thirty (30) days after Tenant submits proof of payment to Landlord. Tenant may offset any amounts for Space Plan Allowance not timely paid by Landlord pursuant to this Section 5.2 against Tenant's monetary obligations under this Lease. 5.3 PREPARATION OF PREMISES: Tenant shall timely perform, or arrange for the timely performance, of the Work in accordance with the requirements set forth in the Work Letter and this Lease. Tenant shall cause the Work to be Substantially Completed at least fifteen (15) days prior to the Commencement Date. The Tenant Improvement Allowance shall be payable by Landlord in accordance with the Work Letter. If Substantial Completion has not occurred and possession of the Premises (including without limitation the Work) is not delivered to Tenant on or before May 15, 1994, due solely to Landlord Delays, Landlord's liability for damages incurred by Tenant shall be limited to rent (holdover rent) payable by Tenant at its current location that exceeds the Rent for the Premises and increased moving expenses and storage costs if any. 5.4 TENANT'S CONTRACTOR: Tenant shall enter into construction contracts in accordance with the Work Letter, subject to Landlord's reasonable approval. 5.5 ACCEPTANCE OF PREMISES: Within five (5) days after Substantial Completion, Landlord, Tenant, Tenant's architect and such other of Tenant's Representatives as Tenant deems appropriate shall conduct a walk-through of the Premises. Landlord shall deliver to Tenant at the conclusion of the walk-through a list of any items not completed in accordance with the Lease, Work Letter, construction documents, construction contracts, Building/Tenant Improvement Standard for Pacific Corporate Park as set forth in Exhibit "D" ("Building Standards") and/or other applicable codes, laws, regulations or standards ("Corrections List"). Tenant shall reasonably and promptly complete all items on the Corrections List. Except for latent defects in the Building not reasonably discoverable during construction, Tenant shall be deemed to have accepted the Premises in its then "AS IS" condition upon Substantial Completion. Any such latent defects discovered and reported to Landlord in writing within one (1) year after the Commencement Date shall be repaired by Landlord at Landlord's sole cost and expense. 5.6 RELOCATION CONSULTANT: The Landlord shall provide a Thirty Thousand and 00/100ths Dollars ($30,000.00) allowance (regardless of the actual cost to Tenant) for the Tenant to engage a Tenant improvement build/out Relocation Consultant. Such allowance shall be paid to Tenant within thirty (30) days following the Commencement Date and occupancy by Tenant of the Premises. Tenant may offset any 13 amounts for allowances not timely paid by Landlord pursuant to this Section 5.6 against Tenant's monetary obligations under this Lease. 5.7 REFURBISHMENT ALLOWANCE: Landlord shall provide Tenant an allowance to refurbish the Premises of Eighty-seven Thousand One Hundred Thirty-six and no/100 Dollars ($87,136.00) ($2.00 multiplied by Usable Square Footage) beginning with the sixty-first (61st) month of the Term. Such allowance shall be payable to Tenant within ten (10) days of Tenant's having incurred expenses for such refurbishment. Tenant may offset any amounts for allowances not timely paid by Landlord pursuant to this Section 5.7 against Tenant's monetary obligations under this Lease. Refurbishment and/or alteration shall be in accordance with Section 7.9 of this Lease. SECTION 6 OPERATING EXPENSES 6.1 DEFINITIONS: For purposes of this Lease, the following definitions shall apply: (a) "Base Year" shall mean the twelve (12) month period commencing on the first day of the calendar month immediately following the Commencement Date and ending on the day prior to the first anniversary of such date. (b) "Building Operating Expenses" shall mean all costs and expenses paid or incurred by Landlord or on Landlord's behalf with respect to the maintenance and operation of the Building which belong within the following categories: (i) Real Property Taxes (as defined below) allocable to the land and the Building provided that Real Property Taxes attributable to the Base Year shall be increased, if required, to reflect the full value of the tenant improvements of the Premises provided for hereunder; (ii) painting, interior landscape maintenance, window cleaning, janitorial and other cleaning services for the Building, pest control and security services provided in connection with the Building; (iii) premiums, costs, expenses, deductibles paid or similar costs or charges with respect to insurance Landlord maintains, including without limitation any insurance arranged by Landlord under Section 8.2 below, public liability and property damage insurance, fire and extended coverage insurance, plate glass insurance, rental income insurance, fidelity insurance, and/or any other insurance Landlord maintains under this Lease provided that the decision to carry such insurance is commercially reasonable; (iv) supplies, including without limitation cleaning supplies and other depletable materials, and sales and other taxes on such items; (v) the cost of the rental of equipment including without limitation all applicable sales taxes; (vi) the cost of operating and maintaining the Building security or other system used in connection with life or property protection, (including without limitation all machinery, electronic systems, and other equipment comprising any part of such systems); (vii) direct charges for services of independent contractors who provide services in connection with the maintenance and operation of the Building, to the extent such charges are not in excess of commercially competitive rates; (viii) the cost of operation, maintenance and repairs of cables, fans, pumps, boilers, cooling equipment, wiring, electrical fixtures, metering, control and distribution equipment, component 14 parts of the heating, ventilating and air-conditioning system, electrical systems, plumbing systems, structural items, walls, roofs, elevators, any life and/or property protections including without limitation sprinkler systems, lighting and window washing equipment, signs (other than signs to be maintained by a tenant) and/or any other portions of the Building; (ix) charges for removal of trash from the Building, including the cost of janitorial services provided to tenants of the Building (including without limitation Tenant); (x) whether or not capitalized under generally accepted accounting principles, costs for alterations and improvements to the Building made by reason of the laws and requirements enacted after the Commencement Date of any public authorities or the reasonable requirements of insurance bodies after the Commencement Date or Landlord's insurer after the Commencement Date, which costs shall be amortized over the reasonable useful life of such alterations and improvements, which in no event shall be less than five (5) years; (xi) management fee for the Building, to the extent said management fee does not exceed four percent (4%) of Base Rent, is not increased during the term of this Lease and is otherwise commercially reasonable; (xii) whether or not capitalized under generally accepted accounting principles, costs of capital improvements, equipment, or machinery installed after the Commencement Date for the purpose of reducing energy consumption or reducing other Building Operating Expenses, which costs shall be amortized over the reasonable useful life of such capital improvements, equipment or machinery, which in no event shall be less than five (5) years, provided that the amount of such costs included in Building Operating Expenses for any year shall never exceed the savings in Building Operating Expenses for such year resulting from the capital improvements, equipment or machinery; (xiii) the cost of all charges for water and sewer (together with any taxes on such utilities) used at the Building; (xiv) reasonable accounting fees for the audit and verification of the financial matters relating to the Building; (xv) reasonable labor expenses, including salaries, wages and benefits, for on-site personnel retained by Landlord to manage the Building; (xvi) Pacific Corporate Center, Unit 1 Owners' Association fee with respect to the Building; and (xvii) all other charges properly allocable to the management, repair, operation, and/or maintenance of the Building in accordance with generally accepted accounting practices. Notwithstanding anything to the contrary in this definition of Building Operating Expenses, Building Operating Expenses shall not include, and Tenant shall not be responsible for payment of any share or portion of, the following: (A) Interest, principal, points and fees on debt secured by the Building or the Project; (B) Any ground lease rentals; (C) Costs of capital improvements and equipment, except as specifically permitted above; (D) Costs incurred by Landlord for the repair of damage to the Building, to the extent that Landlord is reimbursed by insurance proceeds; 15 (E) Costs incurred with respect to the installation or rehabilitation of tenant improvements made at any time for other tenants or other occupants of the Building or the Project or otherwise improving, decorating, painting or redecorating vacant space for tenants or other occupants of the Building or the Project; (F) Costs and expenses (including attorney's fees, leasing commissions, brochures and space planning costs) incurred in connection with negotiations or disputes with present or prospective tenants or other occupants of the Building or the Project; (G) Landlord's general corporate overhead and general and administrative expenses; (H) Advertising and promotional expenditures; (I) Tax penalties; (J) Costs and expenses incurred by Landlord by reason of a violation by Landlord of this Lease or a violation of another tenant of the terms and conditions of another lease regarding other space in the Building or the Project; (K) Services provided, taxes attributable to and costs incurred in connection with the operation of any retail or restaurant operations in the Building or the Project; (L) Costs arising from the presence in or about the Building or the Project (including ground water or soil) of hazardous materials or substances as defined by and in contravention of applicable laws in effect on the Commencement Date; (M) Costs arising from Landlord's charitable or political contributions; and (N) Management, overhead and profit increments paid to Landlord or Landlord's affiliates for services in the Building or the Project to the extent they exceed the reasonable costs of such services if rendered by unaffiliated third parties on a competitive basis. (c) "Common Area" (as shown on Exhibit "B") shall mean all areas and facilities within the Project designated from time to time by Landlord for the general use and convenience of Tenant and other users of the Project. Common Area includes, without limitation, walkways, parking lots (as designated by Landlord for non-exclusive tenant parking), landscape areas, sidewalks, and all other areas of the Project intended for use by Tenant in common with the Project tenants, their authorized representatives and invitees. Tenant has the non-exclusive right to use the Common Area along with others so entitled, subject to rules and regulations promulgated from time to time by Landlord. (d) "Common Area Operating Expenses" shall mean all costs and expenses paid or incurred by Landlord or on Landlord's behalf with respect to the maintenance and operation of the Common Area and which include but are not limited to the categories listed in the definition of Building Operating Expenses, but in no event shall Common Area Operating Expenses include any expense attributable to the maintenance and/or operation of any interior portion of any building except Building or a building in which Tenant leases space pursuant to Section 17.2. (e) "Lease Expenses" shall mean the sum of (i) Building Operating Expenses, and (ii) Tenant's proportionate share (defined as a fraction, the numerator of which is the Rentable Square Footage and the denominator of which is the Project Rentable Area as defined below) of Common Area Operating Expenses. (f) "Lease Year" shall mean each twelve (12) month period during the Term after the Base Year. (g) "Project Rentable Area" shall mean 97,968 square feet plus, if applicable, the rentable square footage [calculated in accordance with the standards and methodology set forth in the "Method for Measuring Floor Area in Office Buildings" (Reprinted Aug. 1990) as published by the Building Owners and Managers Association International ("BOMA") as ANSI Z65.1-1980 (Reaffirmed 1989) approved June/July 21, 1989 by American National Standards Institute, Inc. of any future buildings in the Project. 16 (h) "Real Property Taxes" shall mean all real property taxes and general and special assessments levied or assessed against real property, including without limitation any tax, fee or excise on (i) rents, (ii) the square footage, (iii) the act of entering into this Lease, or (iv) the occupancy of Tenant, or any other tax, or excise, however described including without limitation value-added tax, levied or assessed by the United States, the State of California or any political subdivision of the State of California, including without limitation any county, city and county, public corporation, district, or any other political entity or public corporation of the State of California as a direct substitution in whole or in part for, or in addition to, any real property taxes or general or special assessments. Notwithstanding anything to the contrary in the preceding sentence, "Real Property Taxes" shall not mean any municipal, county, state, or federal income, franchise, estate, succession, inheritance or transfer taxes of Landlord. If any Real Property Taxes are assessed or collected on the basis of a fiscal period, a portion of which occurs during the Term and the remainder of which occurs before or after the Term, then the Real Property Taxes payable for such fiscal period shall be apportioned between such periods based upon the number of days during such fiscal period that occur during the Term and the number of days that occur before or after the Term. Real Property Taxes shall also not include, so long as Proposition 13 remains in effect in California, any increase in taxes attributable to any sale or transfer of or change of ownership in the Project (or any part thereof) which occurs during the initial five (5) years of the Term. If Real Property Taxes are assessed in combination with the Adjacent Building, then (for purposes of determining Building Operating Expenses and Common Area Operating Expenses) the Real Property Taxes shall be allocated on the basis of the ratio of the Rentable Square Footage to the Project Rentable Area. 6.2 ADJUSTMENTS TO COMMON AREA OPERATING EXPENSES: Common Area Operating Expenses during the Term (including the Base Year) shall be "grossed up" ("Gross Up") if the Project is less than ninety-five percent (95%) leased and occupied, in accordance with reasonable and generally accepted accounting principles consistently applied to reflect what Common Area Operating Expenses would have been had the Project been ninety-five percent (95%) leased and occupied and fully assessed for tax purposes as leased and occupied buildings. In no event shall the Gross Up result in Landlord receiving payment or reimbursement from Tenant for costs or expenses not actually incurred by Landlord. 6.3 RENT ADJUSTMENT: If Lease Expenses for any Lease Year are greater than Lease Expenses for the Base Year (after the Gross Up of Common Area Operating Expenses), Tenant shall pay such increase in Lease Expenses pursuant to this Section 6.3. Landlord shall deliver to Tenant, at least thirty (30) days prior to the commencement of each subsequent Lease Year during the Term, a written statement ("Estimated Statement") setting forth Landlord's estimate of the amount by which the Lease Expenses for the upcoming Lease Year will be greater or less than the Lease Expenses for the Base Year (the "Lease Expenses Difference"). If the Lease Expenses for the upcoming Lease Year are estimated to be greater than the Lease Expenses for the Base Year, then Tenant shall pay to Landlord, on the first day of each month during the Term, an amount ("Monthly Payment") equal to one-twelfth (1/12th) of the Lease Expenses Difference, as estimated by Landlord in the most recently delivered Estimated Statement. Landlord may, at its election, no more than one (1) time during any Lease Year, deliver to Tenant a revised Estimated Statement, revising Landlord's estimate of the Lease Expenses, in accordance with Landlord's most current estimate. No later than one hundred twenty (120) days after the end of each Lease Year, Landlord shall deliver to Tenant a written statement ("Actual Statement") setting forth the actual Lease Expenses Difference allocable to such Lease Year. If the sum of Monthly Payments actually paid by Tenant during any Lease Year exceeds the actual Lease Expenses Difference allocable to such Lease Year, then such excess shall be refunded to Tenant within thirty (30) days after delivery of the Actual Statement to Tenant. If Tenant has made Monthly Payments and the sum of Monthly Payments actually paid by Tenant during any Lease Year is less than the actual Lease Expenses Difference allocable to such Lease Year, then Tenant shall, within thirty (30) days after receipt of the Actual Statement, pay to Landlord the amount of such deficiency. The payment by Tenant of any Monthly Payment or any year-end deficiency of Lease Expenses Difference shall not be deemed a waiver of Tenant's right to contest Landlord's calculation of Lease Expenses. 6.4 LEASE EXPENSES DIFFERENCE CAP: Notwithstanding anything to the contrary in this Lease, Lease Expenses Difference shall not include more than one hundred eight percent (108%) of Controllable Operating Expenses of the preceding Lease Year, or in the case of the first Lease Year, the Base Year. "Controllable Operating Expenses" shall mean landscaping maintenance, parking lot sweeping, plumbing, Tri-Water System maintenance, janitorial services and supplies, trash removal, security and life safety, pest control, elevator maintenance, parking and walkways, locks and keys, window washing, lighting 17 maintenance, roof maintenance, painting and sealing, general maintenance, paving maintenance, windows, doors and screens, signs, common area maintenance, and management fees. 6.5 OPERATING EXPENSE RECORDS: Landlord shall maintain all operating expense records for a period of five (5) years. Tenant or Tenant's Representative shall have the right to inspect and photocopy any or all of the operating expense records at the office of PacCor Management Company during normal working hours upon twenty-four (24) hours written notice. Tenant shall have the right to require an audit of Lease Expenses. In the event Tenant's audit determines that Lease Expenses Difference for any Lease Year is overstated by Twelve Thousand Five Hundred Dollars ($12,500.00) or more, then Landlord shall pay for the cost of such audit unless the Actual Statement fairly disclosed the facts underlying the overstatement. The $12,500.00 shall be adjusted each Lease Year to reflect the increase, if any, in the cost of living during the previous Lease Year by increasing the $12,500 by the percentage by which the level of the Consumer Price Index (for all urban consumers in San Diego areas as reported for the date of an audit pursuant to this Section 6.5 by the Bureau of Labor Statistics of the United States Department of Labor) has increased over the level as of the date of the execution of this Lease. Any amounts of Lease Expenses Difference overpaid by Tenant shall be immediately refunded or shall be credited against the Base Rent next due by Tenant. SECTION 7 USE AND MAINTENANCE OF THE PREMISES 7.1 PERMITTED USE: Tenant may use the Premises for general office use and for any other legally permitted use compatible with comparable office buildings in the Sorrento Mesa area of San Diego, California. 7.2 INSURANCE: Tenant shall not do, bring or keep anything in or about the Premises which is outside the scope of that which is normally contemplated for the use specified in Section 7.1, that will cause a cancellation of any insurance covering the Premises or the Project. If the rate of any insurance carried by Landlord is increased as a result of Tenant's use (except as contemplated by Section 7.1), Tenant shall pay to Landlord, within ten (10) days after Landlord delivers to Tenant a notice of such increases, the amount of such increase. 7.3 COMPLIANCE WITH LAWS: Tenant shall comply with all laws concerning the Premises and Tenant's use of the Premises, including without limitation the obligation at Tenant's sole cost to alter, maintain, or restore the Premises in compliance with all laws, including without limitation zoning laws, relating to the condition, use, or occupancy of the Premises during the Term. Landlord represents and warrants that, as of the date of this Lease, there are no violations within the Project of the Americans With Disabilities Act 42 U.S.C. Section 1281 et. seq. ("ADA") and any similar state and federal laws. To the extent that the foregoing representation and warranty is inaccurate or untrue, Landlord shall, at its sole expense and not as an expense which shall be added to Building Operating Expenses or Common Area Operating Expenses, be responsible for compliance with the ADA and any similar state or federal law. At Tenant's expense, the Work shall comply with the requirements of the ADA and any similar state and federal laws. If the Premises do not comply with the ADA or similar state or federal law during the Term of the Lease due to the Work, Tenant shall at its sole cost be responsible for compliance with the ADA or other law(s). 7.4 HAZARDOUS WASTE OR NUISANCE: Landlord represents that to its knowledge the Premises is free of asbestos and other hazardous materialS. Tenant shall not use the Premises in any manner that will constitute waste, nuisance or unreasonable annoyance to other tenants of the Project, or to owners or occupants of nearby properties. Tenant shall not use the Premises for sleeping, washing clothes, or the preparation, manufacture, or mixing of anything that might emit any odor or objectionable noises or lights onto the Building or nearby properties. Tenant shall neither bring into the Premises, nor permit the bringing into the Premises of, any animal, motorcycle or other vehicle, except for guide dogs or wheelchairs. Tenant and Landlord shall each strictly comply with all statutes, laws, ordinances, rules, regulations, and precautions now or hereafter mandated or advised by any federal, state or local law, regulation, ordinance or rule or by any governmental agency with respect to the use, generation, treatment, storage, disposal, release or threatened release of hazardous, toxic or radioactive substance, materials or waste (collectively "Hazardous Materials"). As used in this Section 7.4, Hazardous Materials includes without limitation those substances identified in Section 66680 through 66685 of Title 22 of the California Administrative Code, Division 4, Chapter 30, as amended from time to time, and those substances defined as "hazardous substances," "hazardous materials," "hazardous wastes," "pollutants," "contaminants," "chemicals known to 18 the State to cause cancer or reproductive toxicity," "asbestos," "hydrocarbons (including without limitation oil)," "toxic bearing dust" or other similar designations in the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, 42 U.S.C. Sections 9601, et seq., the Hazardous Materials Transportation Act, 49 U.S.C. Sections 1801, et seq., the Hazardous Substance Account Act, Health & Safety Code Sections 25300, et seq., the Safe Drinking Water and Toxic Enforcement Act of 1986, Health & Safety Code Sections 25249.5, et seq., and any other federal, state or local statutes, laws, ordinances, rules, regulations and precautions. Tenant shall not cause or allow any other party or parties to cause any Hazardous Materials to be used, generated, treated, stored, disposed of or released in, on or about the Premises, except as allowed by law. Tenant shall indemnify, protect, defend by counsel acceptable to Landlord, and hold Landlord and its successors, assigns and mortgagees harmless from and against any and all claims, losses, liabilities, costs and expenses, including all foreseeable and unforeseeable consequential damages, except to the extent caused by Landlord's or Landlord's Representative's negligence, willful misconduct or breach of obligations under this Lease, directly or indirectly arising out of the use, generation, treatment, storage, disposal, release or threatened release of Hazardous Materials by Tenant or any party or parties claiming under Tenant of Hazardous Materials at, on, beneath or from the Project based on the Comprehensive Environmental Response, Compensation and Liability Act, 42 U.S.C. Sections 9601, et seq., the Resource Conservation and Recovery Act, 42 U.S.C. Sections 6901, et seq., the California Hazardous Substance Account Act, Health & Safety Code Sections 25300, et seq., the California Hazardous Waste Control Law, Health & Safety Code Sections 25100, et seq., the Porter-Cologne Water Quality Control Act, Water Code Sections 13000, et seq., or any other federal, state or local statute, law, regulation, ordinance or rule. Landlord shall indemnify, protect, defend by counsel acceptable to Tenant, and hold Tenant, Tenant's Representatives (as defined in 4.5) and Tenant's successors, assigns and mortgagees harmless from and against any and all claims, losses, liabilities, costs and expenses, including all foreseeable and unforeseeable consequential damages, except to the extent caused by Tenant or Tenant's Representative's negligence, willful misconduct or breach of its obligations under this Lease, directly or indirectly arising out of the past, present or future use, generation, treatment, storage, disposal, release or threatened release of Hazardous Materials at, on, beneath or from the Project based on the Comprehensive Environmental Response, Compensation and Liability Act, 42 U.S.C. Sections 9601, et seq., the Resource Conservation and Recovery Act, 42 U.S.C. Sections 6901, et seq., the California Hazardous Substance Account Act, Health & Safety Code Sections 25300, et seq., the California Hazardous Waste Control Law, Health & Safety Code Sections 25100, et seq., the Porter-Cologne Water Quality Control Act, Water Code Sections 13000, et seq., or any other federal, state or local statute, law, regulation, ordinance or rule. Neither the written consent by Landlord to the use, generation, storage or disposal of Hazardous Materials nor the strict compliance by Tenant with all statutes, laws, ordinances, rules, regulations and precautions pertaining to Hazardous Materials shall excuse Tenant from Tenant's obligations pursuant to this Section 7.4. Tenant's obligations pursuant to this Section 7.4 shall survive the termination of this Lease. Tenant shall notify Landlord, as required by California Health & Safety Code Section 25359.7, if Tenant knows or has reasonable cause to believe that any Hazardous Material has come to be located on or beneath the Building. On or before January 1, 1995, and each January 1 thereafter during the Term, Tenant shall provide Landlord with a written list of all Hazardous Materials used, generated, treated, stored, disposed of and released in, on or about the Premises by Tenant during the prior calendar year and those Hazardous Materials Tenant proposes to use, generate, treat, store, dispose of and release during the next calendar year, except for substances which are customarily used or found in typical offices, including without limitation copier and printer toner, cleaning supplies, correction fluid and ink. 7.5 DAMAGE AND OVERLOADING: Tenant shall be responsible for any damage to the Premises or the Project caused by Tenant's Invitees and/or Tenant's employees. Landlord represents to Tenant that the correct floor loads for the Building are set forth in Exhibit "M". Neither the floor nor any other portion of the Premises shall be loaded more than set forth in Exhibit "M". No machinery, apparatus, or other appliance shall be used or operated in or on the Premises that will in any manner injure the Premises or Project. If Tenant, Tenant's Representatives or Tenant's Invitees cause damage to the Premises or the Project, then Landlord shall have the right but not the obligation to repair such damage and Tenant shall promptly reimburse Landlord for Landlord's actual costs of such repair (to the extent that such costs exceed available insurance proceeds) as Rent. 7.6 ACCESS BY LANDLORD: (a) Landlord and/or Landlord's agent(s), employee(s), officer(s) or independent contractor(s) of or retained by Landlord ("Landlord's Representatives") shall have the right to enter the Premises at all 19 reasonable times upon twenty-four (24) hour prior written notice (i) to determine whether the Premises are in Good Condition (as defined in Section 7.15) or whether Tenant is complying with its obligations under this Lease, (ii) to do any necessary maintenance or make any restoration to the Premises that the Landlord has the right or obligation to perform, (iii) to serve, post, or keep posted any notices required or allowed under this Lease, (iv) to show the Premises to brokers, agents, buyers, tenants or other persons interested in a listing of, financing, sale or exchange of, or occupancy of the Premises or the Project, and (v) to shore the foundations, footings, and walls of the Premises and other improvements on the Real Property and to erect scaffolding and protective barricades around and about the Premises or the Project, but not so as to prevent entry to or use of the Premises and to do any other act or thing necessary for the safety or preservation of the Premises or the Project if any excavation or other construction is undertaken or is about to be undertaken on any adjacent property or nearby street. Landlord shall have the right at any and all times to enter the Premises for emergency purposes. (b) Landlord shall not be liable for any inconvenience, disturbance, loss of business, nuisance, or other damage arising out of Landlord's entry on the Premises as provided in this Section 7.6, except damage resulting directly from the negligent act or willful misconduct of Landlord or Landlord's Representatives. No provision of this Lease shall be construed as obligating Landlord to perform any repairs, alterations or decorations except as otherwise expressly agreed in writing to be performed by Landlord. Landlord shall have the right to run utility or other services and facilities through the Premises whether to service the Premises or other premises, provided that the use of such space does not have a materially adverse effect on Tenant's use and enjoyment of the Premises. If during the last month of the Term, Tenant shall have removed substantially all of its Personal Property and personnel from the Premises, Landlord may enter the Premises and repair, alter and redecorate the same without abatement of Base Rent or liability to Tenant and such acts shall have no effect on this Lease. Any entry to the Premises obtained by Landlord pursuant to this Section 7.6 shall not under any circumstances be construed or deemed to be a forcible or unlawful entry into of the Premises, or an eviction of Tenant from the Premises or any portion thereof. Tenant shall not be entitled to an abatement or reduction of Base Rent because of the exercise by Landlord of any rights under this Section 7.6. Landlord shall conduct its activities on the Premises as allowed in this Section 7.6 in a manner that will cause as little inconvenience, annoyance, or disturbance to Tenant as reasonably feasible. 7.7 SIGNS: Tenant shall have the right to place, construct and maintain one or more signs, monuments, logos or emblems at the entrance to the Project, near the top of the Building, on the directory, near the entrance to the Building and/or on entrance doors of the Premises, as set forth in Exhibit "L" ("Signs"). Modifications to Signs shall be subject to Landlord's written approval, which approval will not be unreasonably withheld. The design, construction and maintenance of Signs shall be solely at Tenant's expense. Landlord makes no representation with respect to Tenant's ability to obtain such approvals under applicable laws and regulations or pursuant to that certain Declaration of Covenants, Conditions and Restrictions for Unit No. 1 of Pacific Corporate Center, dated May 14, 1985 and recorded as Instrument #85-169398 ("CC&R's"; Exhibit "K"). In any event, Signs shall comply with all laws, regulations, CC&R's, and PID (Exhibit "N"). Tenant shall obtain any approvals required by laws, regulations and CC&R's. All costs to remove all Signs upon the Expiration Date, Option Expiration Date or earlier termination of the Lease shall be the liability of Tenant. 7.8 PARKING: Subject to the terms of this Section 7.8 and so long as Tenant is not in default under this Lease, Landlord grants to Tenant the right to the non-exclusive use in common with other Project tenants of the parking lot adjacent to and serving the Building of One Hundred Eighty Two (182) parking spaces(except that there shall be reserved for the use of Tenant's visitors and executives the twelve (12) parking spaces in front of the Building). Tenant's use of the parking lot shall be subject to such reasonable rules which do not favor other Project tenants to the detriment of Tenant, as Landlord may, in its sole discretion, adopt from time to time with respect to use of the parking lot. Landlord shall cooperate with Tenant, and shall take all reasonable steps necessary, to ensure that Tenant and Tenant's Representatives and Tenant's Invitees shall have access to all one hundred eighty-two (182) parking spaces to which Tenant is entitled. Tenant shall not be charged for the use of the parking lot unless the City of San Diego or other governmental entity after the execution of this Lease assesses a tax, fee and/or excise on the parking of motor vehicles in the parking lot, and then Tenant shall pay to Landlord that portion of the tax, fee and/or excise based on Tenant's right to non-exclusive parking of One Hundred Eighty Two (182) parking spaces, consisting of approximately 50 percent of the Project parking lot capacity. 20 7.9 ALTERATIONS: (a) Tenant shall not make any alterations, improvements, repairs, additions, installations, or changes of any nature in or to the Premises (individually and collectively, "Alterations") without Landlord's prior written consent, which consent shall not be unreasonably withheld or delayed more than ten (10) days after Landlord's receipt of Tenant's request for Landlord's consent. If written consent is obtained from Landlord, any construction undertaken by Tenant in or to the Premises shall comply with all the terms and provisions of Sections 7.9(b) and 7.9(c). All Alterations made by Tenant shall become the property of Landlord and a part of the realty and shall be surrendered to Landlord upon the Expiration Date, Option Expiration Date or sooner termination of the Lease, or, at Landlord's election but only in the event that Landlord's approval of any such Alteration prior to installation specified that such Alteration would be removed upon termination, and shall be removed before the last day of the Term after receiving ninety (90) days prior written notice from Landlord to Tenant or thirty (30) days after notice of Landlord's election is given to Tenant in the event of earlier termination of the Lease. All damage caused by such removal shall be repaired with all due diligence by Tenant at its sole cost and expense. (b) Tenant must utilize only bondable licensed contractors for any Alterations proposed to be made in or to the Premises. Tenant shall promptly provide Landlord with copies of bid solicitations and bids received for all such work. (c) Alterations whether installed by Tenant or Tenant's Representatives at any time prior to or during the Term shall be completed only in compliance with the following: (i) Except as to Alterations which are reasonably expected to cost less than Twenty Thousand Dollars ($20,000.00), no work shall commence without (A) Landlord's prior written approval or written waiver of right to approve Tenant's contractor, (B) certificates of insurance acceptable to Landlord from a company or companies approved by Landlord, furnished to Landlord by Tenant's contractor, for general liability and automobile liability with limits of not less than $500,000.00 combined single limit, builder's risk insurance for the value at risk, workers' compensation as required, endorsed to include Landlord as an additional insured, (C) Landlord's prior written approval of detailed plans and specifications for such work which approval may not be unreasonably withheld or delayed more than ten (10) days after Landlord's receipt of Tenant's request for approval, and (D) with respect to any work estimated to cost more the $50,000.00, procurement by Tenant or its contractor, if required by Landlord, of both a performance and labor and materials payment bond (or a single bond including such coverage) guaranteeing lien-free completion of the work of improvements. (ii) Notwithstanding Section 7.9(c)(i), all work on any Alterations shall be performed in conformity with a valid permit and all other applicable permits or licenses when and where required by cognizant government authority or agency, copies of which shall be furnished to Landlord before the work is commenced, and any work not acceptable to any governmental authority or agency having or exercising jurisdiction over such work, or not reasonably satisfactory to Landlord, shall be promptly corrected at Tenant's sole cost and expense. Notwithstanding any failure by Landlord to object to any such work, Landlord shall have no responsibility thereof either to Tenant or to third parties. (iii) Notwithstanding Section 7.9(c)(i), all work or any Alterations shall be performed at such time and in such manner as Landlord may schedule or designate. Tenant shall pay to Landlord, subject to Tenant's prior written approval, any extraordinary costs incurred for monitoring any substantial changes to the Premises. (iv) Tenant shall reimburse Landlord subject to Tenant's prior written approval, for any extraordinary expense actually incurred by Landlord by reason of faulty work performed by Tenant or its contractors, or by reason of delays caused by such work, or by reason of inadequate cleanup. (v) Tenant or its contractors will in no event be allowed to install plumbing, mechanical equipment, electrical wiring or fixtures, acoustical or integrated ceilings, or partitions, unless such installation is consistent with plans and specifications previously approved in writing by Landlord. (vi) All data processing, photocopying, copying and other special electrical equipment shall have a separate duplex outlet and to the extent such equipment requires electrical power in excess of that allotted to the Premises, such equipment shall be installed only under the supervision of Landlord or its 21 electrical contractor. Tenant assumes the risk of all damage, costs, and expense which is incurred by Landlord or other Premises tenants as the result of Tenant's installation of electrical equipment in the Premises without the supervision of Landlord or its electrical contractor. Tenant shall pay any additional costs on account of any increased support to the floor load necessary thereof or for any other equipment. (vii) Tenant or its contractors shall, before the commencement of any Alterations by Tenant in, on or around the Premises, give sufficient notice thereof to Landlord for Landlord's preparation, posting and recordation of any appropriate notices of non-responsibility as provided in California Civil Code Section 3094 or any related, successor or similar provision of law. Within ten (10) days after substantial completion of any Alterations or repairs, Tenant or its contractor shall file for record in the Office of the County Recorder in and for the county in which the Premises is located, a notice of completion as permitted by law. (viii) All Alterations shall conform to the then applicable Building Standards. The Building Standards may be reasonably amended during the Term of the Lease. 7.10 MECHANICS' LIEN: Tenant shall pay all costs for Alterations and other construction done or caused to be done by it on the Premises. Tenant shall keep the Premises free and clear of all mechanics' liens resulting from such Alterations or other construction. Tenant shall have the right to contest the correctness or validity of any such lien if, immediately on demand by Landlord, Tenant procures and records a lien release bond, issued by a corporation satisfactory to Landlord and authorized to issue surety bonds in California, in an amount equal to one hundred fifty percent (150%) of the amount of the claim of lien. The bond shall meet the requirements of California Civil Code Section 3143, shall indemnify Landlord against liability for such claim of lien and shall hold the Project free from the effect of such claim of lien. In addition, Landlord may require Tenant to pay Landlord's reasonable and necessary attorneys' fees and costs in participating in such an action. 7.11 INDEMNITY AND EXEMPTION OF LANDLORD FROM LIABILITY: (a) Except to the extent caused by the negligence or willful misconduct of Landlord or Landlord's Representatives, Tenant shall indemnify, protect and defend Landlord against all claims arising from (i) the use of the Premises by Tenant, Tenant's Representatives and/or Tenant's Invitees, (ii) the conduct of Tenant's business, (iii) any activity, work or things done, permitted or suffered by Tenant or any of Tenant's Representatives in or about the Premises or elsewhere, (iv) any breach or default in the performance of any obligation to be performed by Tenant under this Lease, or (v) any negligence of Tenant, Tenant's Representatives and/or Tenant's Invitees, and against all costs, attorneys' fees, expenses and liabilities incurred in the defense of any such claim and any action or proceeding brought on such claim. If any action or proceeding is brought against Landlord by reason of any such claim, Tenant upon written notice from Landlord shall defend such action or proceeding at Tenant's sole cost by counsel satisfactory to Landlord. Tenant assumes all risk of damage to property and injury to persons in, upon or about the Premises arising from any cause, and Tenant waives all claims against Landlord in respect of such damage or injury, except to the extent caused by Landlord's or Landlord's Representative's sole and exclusive gross negligent acts or willful misconduct. Tenant's obligations pursuant to this Section 7.11 shall survive the termination of this Lease. (b) Landlord shall not be liable for injury to Tenant's business or any loss of income from such business or for damage or injury to the goods, wares, merchandise, or other property or the person of Tenant, Tenant's Representatives or Tenant's Invitees or any other persons in, upon or about the Premises, whether such damage, loss or injury is caused by or results from criminal acts, fire steam, electricity, gas, water or rain, or from the breakage, leakage, obstruction or other defects of pipes, sprinklers, wires, appliances, plumbing, air conditioning or lighting fixtures, or from any other cause, whether such damage, loss or injury results from conditions arising upon the Premises or from other sources or places and regardless of whether the cause of such damage, loss or injury or the means of repairing such damages, loss or injury is inaccessible to Tenant. 7.12 PREMISES CHANGES: This Lease shall not be affected or impaired by any change to any part of the Project or any sidewalks, streets or improvements nearby the Project, provided that access to the Premises, parking for the Premises and Tenant's use of the Premises are not adversely materially affected by such change. 22 7.13 SERVICES AND UTILITIES: (a) Tri-Water System: (i) Landlord has installed that portion of the water source heat pump system set forth in the first and second paragraphs of Weather Engineering letter to Roel Construction Company dated April 6, 1993 attached as Exhibit "F" and Landlord agrees to install a second circulating pump to operate alternately with the existing pump and flush out all existing piping. The complete water source heat pump system is described in Exhibit "F" ("Tri Water System"). (ii) The parties agree that the adequacy of the existing Tri-Water System cannot be determined until the Final Space Plan (as defined in the Work Letter) has been approved. If the Tri-Water System does not comply with Tenant's specifications as reasonably determined by Tenant's consultant(s), then Landlord shall pay a sum not to exceed Twenty Thousand Dollars ($20,000) to improve the Tri-Water System, or to install an auxiliary system to the Tri-Water System. The method chosen to comply with Tenant's specifications, if necessary, shall be determined by Tenant and approved by Landlord, which approval shall not be unreasonably withheld. Tenant shall pay all costs in excess of $20,000 in the event the improvement of the Tri-Water System or installation of an auxiliary system to the Tri-Water System costs more than Twenty Thousand Dollars ($20,000). The improved or auxiliary system shall become a part of the Building for all purposes except as specifically set forth in this Section 7.13. (iii) Tenant shall install as a component of the Work all portions of the Tri-Water System within the Building which is set forth generally as items 1 through 9 in Exhibit "F" and in that certain letter dated April 29, 1993 from Walsh Engineers (Exhibit "F1"). Tenant shall install as a component of Work the improvement to the Tri-Water System or an auxiliary system if necessary. Tenant shall obtain a twelve (12) month warranty on that portion of the Tri-Water System or auxiliary system installed by Tenant. The warranty shall provide that except for routine scheduled maintenance, all other maintenance and repair work shall be at no cost to Landlord. The cost of the warranty, if any, shall be at Tenant's expense. Tenant shall provide Landlord a copy of the warranty upon Substantial Completion. Tenant shall install at Tenant's cost a monitoring device to measure off-hours use of the Tri-Water System. Tenant shall pay all costs of the Tri-Water System including any improvement or an auxiliary system except as installed by Landlord as set forth in Section 7.13(a). Tenant shall bear the financial responsibility of wear and tear on the Tri-Water System by reason of use of such system during off-hours periods (other than 7:00 a.m. to 7:00 p.m. Monday through Friday and 8:00 a.m. to 2:00 p.m. on Saturday) by payment to Landlord, on a monthly basis, of the sum of One Dollar and Fifty Cents ($1.50) per hour for each hour (or portion thereof) of off-hours use of the Tri-Water System. Tenant shall provide Landlord written documentation to support the off-hour use which shall accompany the monthly payment. (b) Landlord's Responsibility: Landlord shall provide to the Building telephone service and electrical service to the utilities equipment room in the Builiding. Landlord shall install water line(s) to the Building at Landlord's expense. Landlord shall furnish elevator service consisting of non-attended automatic elevators, lighting replacement for exterior standard lights, daily janitor services, and such other services and pursuant to the specifications set forth on attached Exhibit "F". If Tenant uses heat generating machines or equipment in the Premises which affect the temperature otherwise maintained 23 by the Tri-Water System for the Premises, Landlord reserves the right to install supplementary air conditioning units in the Premises and the cost thereof, including the cost of installation, operation and maintenance thereof, shall be paid by Tenant to Landlord upon written demand by Landlord. (c) Interruption of Services: In the event of any interruption of service required to be provided by Landlord hereunder where such interruption is caused by the negligence or willful misconduct of Landlord, Tenant shall be entitled to abatement of Base Rent and Lease Expenses Difference in proportion to the reasonable denial of use caused by the interruption, beginning on the later of the third day after Tenant provides Landlord with notice of the interruption or the actual date when Tenant stops using all or any affected portion of the Premises because of the interruption, and continuing until the restoration of the interrupted service. Notwithstanding the foregoing, Tenant acknowledges that services to be supplied by Landlord hereunder may be interrupted because of accidents, repairs, alterations, improvements or other reasons beyond the reasonable control of Landlord. Except as set forth in the next sentence of this Section 7.13 (c) no such interruption shall (i) be considered an eviction or disturbance of Tenant's use and possession of the Premises; (ii) make Landlord liable to Tenant for damages; (iii) abate Basic Rent or Lease Expenses Difference or (iv) relieve Tenant from performing its obligations hereunder. Notwithstanding the preceding sentence, if any essential services (such as the Tri-Water System, passenger elevators, electricity or water) supplied by Landlord are interrupted and the interruption does not result from the negligence or willful misconduct of Landlord or Landlord's Representatives, Tenant shall be entitled to an abatement of Base Rent and Lease Expenses Difference beginning on the fourth consecutive business day of the interruption and continuing until the interrupted services are restored. (d) Tenant's Responsibility: As part of the Work, Tenant shall install separate utility meters for electrical, gas and water service to the Premises and any monitoring devices required to measure off-hours use of the Tri-Water System. Tenant shall be responsible for the payment for all electrical, gas and water service to the Premises and the Tri-Water System during the Term. (e) Excessive Consumption: Tenant shall not connect any apparatus with electric current except through existing electrical outlets in the Premises, without Landlord's prior written consent which shall not be unreasonably withheld. Tenant shall not consume water in excess of that usually and reasonably furnished or supplied for the use of other tenants in the Project using their premises as general office space, including limited lunchroom facilities (as reasonably determined by Landlord), without first procuring the written consent of Landlord, which will not be unreasonably withheld provided that Tenant shall be responsible to pay for such excess use, and in the event of consent, Landlord may cause to be installed a water meter for the Premises to measure the amount of water consumed. The cost of any such meter and of its installation, maintenance and repair shall be paid for by the Tenant and Tenant agrees to pay Landlord promptly upon demand for all such water consumed as shown by said meter, at the rates charged for such services by the local public utility company plus any additional reasonable and necessary expense incurred by Landlord in keeping account of the water so consumed. If a separate meter is not installed, the excess cost for such water shall be established by an estimate made by a utility company hired by Landlord at Tenant's expense. 7.14 RULES: Tenant and Tenant's Representatives shall observe faithfully and comply strictly with the rules and regulations that are set forth in attached Exhibit "E" and such other rules as Landlord may from time to time reasonably adopt and disclose to Tenant for the Real Property and the Project ("Rules"). 7.15 MAINTENANCE OBLIGATIONS: (a) Tenant at its sole cost shall maintain (except to the extent janitorial services are supplied by Landlord as set forth in the janitorial specifications in Exhibit "J"), and repair, all in neat, clean, broom-clean and good condition, with allowances for reasonable wear and tear ("Good Condition"), all portions of the Premises, except those portions of the Premises to be maintained by Landlord as expressly described in Section 7.15(b). Tenant shall be liable for any damage to the Project resulting from the acts or omissions of Tenant or Tenant's Representatives. If Tenant fails to maintain the Premises as provided above, then after applicable periods of notice and periods to cure as set forth in Section 12.1(b), Landlord shall have the right but not the obligation to maintain the Premises and Tenant shall promptly reimburse Landlord for Landlord's actual cost of such maintenance. 24 (b) Subject to Section 7.15(a), Landlord shall maintain, repair, replace and repaint (i) the structural parts of the Building, which are limited to foundations, bearing and exterior walls (excluding glass doors which are part of Tenant's Premises), subflooring, and roof; (ii) the unexposed electrical, plumbing, sewage systems and mechanical systems, elevators and elevator shafts which are not part of the Work; (iii) windows and window frames, gutters and downspouts on the Building; (iv) the Tri-Water System and any auxiliary system to the Tri-Water System, if any, for the Building; and (v) that portion of the Building not included as part of the Premises and the Common Area. (c) Landlord's failure to perform its obligations set forth in Section 7.15(b) shall not release Tenant of its obligations under this Lease, including without limitation Tenant's obligation to pay Rent. Tenant waives the provisions of California Civil Code Sections 1941 and 1942 with respect to Landlord's obligations for tenantability of the Premises and Tenant's right to make repairs and deduct the expenses of such repairs from rent. 7.16 BUILDING SECURITY: Landlord shall supply building security systems and services as set forth in Exhibit "G" and Exhibit "G1" or the equivalent as reasonably determined by Landlord. Except for the service to be provided as set forth in Exhibits "G" and "G1", Tenant acknowledges (a) that the monthly Base Rent does not include the cost of additional security measures for any portion of the Project, (b) that Landlord shall have no obligation to provide any such additional security measures, and (c) that Landlord has made no representation to Tenant regarding the safety or security of the Project. Tenant assumes all responsibility for the security and safety of Tenant and/or Tenant's Invitees and Tenant's employees. Except to the extent caused by the negligence or intentional misconduct of Landlord or Landlord's Representatives, Tenant releases Landlord from all claims for damage, loss or injury to Tenant, Tenant's Invitees, Tenant's employees and/or to Tenant's Personal Property, even if such damage, loss or injury is caused by or results from the criminal or negligent acts of third parties. Landlord shall have no duty to warn Tenant of any criminal acts or dangerous conduct that has occurred in or near the Premises, unless Landlord has received written notice of such acts or conduct. 7.17 TENANT TO PAY PERSONAL PROPERTY TAXES: Tenant shall pay before delinquent all taxes, assessments, license fees, and other charges levied or assessed against, or based upon the value of Tenant's Personal Property ("Personal Property Taxes") that become payable during the Term. On written demand by Landlord, Tenant shall furnish Landlord with written satisfactory evidence of such payments. If any Personal Property Taxes are levied against Landlord or Landlord's property, or if the assessed value of the Project is increased by the inclusion of a value placed on Tenant's Personal Property, and if Landlord pays such Personal Property Taxes or any taxes based on the increased assessments caused by such Tenant's Personal Property, then Tenant, on demand, shall immediately reimburse Landlord for the sum of the Personal Property Taxes so levied against Landlord, or the proportion of taxes resulting from such increase in Landlord's assessment. Landlord shall have the right to pay such Personal Property Taxes or such proportion, and receive such reimbursement, regardless of the validity of the levy. SECTION 8 INSURANCE 8.1 TENANT'S INSURANCE: (a) Public Liability and Property Damage Insurance: Tenant shall procure at its sole cost and expense and keep in effect from the date of this Lease at all times until the end of the Term, comprehensive general liability insurance insuring against liability of Tenant, Tenant's Representatives, Landlord, and Landlord's Representatives, arising out of or in connection with Tenant's use or occupancy of the Premises or any part thereof, or the Project by Tenant or Tenant's Representative. Such insurance shall include contractual liability insurance coverage insuring Tenant's indemnity obligations under this Lease. Such coverage shall have a minimum combined single limit of liability of not less than $1,000,000 with a minimum general aggregate limit of $1,000,000.00. Such policies shall be written to apply to property damage, bodily injury, personal injury, premises medical payments, fire legal liability, general liability and other covered losses, however occasioned, occurring during the policy term, naming the Landlord and Landlord's lender as additional insureds, providing that such coverage shall be primary and that any insurance maintained by Landlord shall be excess insurance only. Such coverage shall also (i) delete any employee exclusion on personal injury coverage; (ii) include employees as insureds; (iii) include liquor liability and (iv) include employer's automobile non-ownership liability. All such insurance shall provide for severability of interests or contain a cross-liability endorsement and shall provide that an act or omission of one of the named 25 insureds shall not reduce or avoid coverage to the other named insureds; and shall afford coverage for all claims based on acts, omissions, injury and damage, which claims occurred or arose (or the onset of which occurred or arose) in whole or in part during the policy period. (b) Automobile Liability Insurance: Tenant shall procure at its sole cost and expense and keep in effect from the date of this Lease at all times until the end of the Term, if applicable, Comprehensive Automobile Liability insurance covering owned, non-owned and hired vehicles. Such coverage shall have a minimum combined single limit of liability of not less than $1,000,000. (c) Workers Compensation Insurance: Tenant shall, if applicable, maintain Workers' Compensation insurance in accordance with California law, and employer's liability insurance with a limit of not less than $1,000,000. Workers' Compensation insurance shall be endorsed to waive the insurer's right of subrogation against Landlord. (d) Business Personal Property and Loss of Income Insurance: Tenant shall, if applicable, maintain business personal property insurance to pay for damage to or destruction of the Tenant's property from damage to or destruction of the Premises. Such insurance shall insure against losses on an "all-risk" type policy to the extent of at least one hundred percent (100%) of the full replacement value of business personal property. (e) Maintaining Insurance: If Tenant fails during the Term to maintain any insurance required to be maintained by Tenant under this Lease, then Landlord may, at its option and in addition to Landlord's other remedies in the event of default by Tenant, arrange for any such insurance, and Tenant shall reimburse Landlord for any premiums for any such insurance within five (5) business days after Tenant receives a copy of the premium notice. If such premiums are allocable to a period, a portion of which occurs during the Term and the remainder of which occurs before or after the Term, then such premiums shall be apportioned between Landlord and Tenant based upon the number of days during such period that occurred during the Term and the number of days that occurred before or after the Term, such that Tenant pays for the premiums that are allocable to the period during the Term. Insurance required to be maintained by Tenant under this Lease (i) shall be issued as a primary policy by insurance companies authorized to do business in the State of California with a Best's rating of a least "A" and a Best's financial size category rating of at least "VIII", as set forth in the most current edition of Best's insurance reports or such higher rating as may be required by Landlord's lender, (ii) shall name the Additional Insureds as additional named insureds, (iii) shall constitute "occurrence" based coverage, without provision for subsequent conversion to "claims" based coverage, and (iv) shall not be cancelable or subject to reduction of coverage or other modification except after thirty (30) days' prior written notice to Landlord and any lender. Tenant shall, at least thirty (30) days prior to the expiration of any such policy, furnish Landlord with a renewal or binder of such policy. Tenant shall, upon request from Landlord, promptly deliver to Landlord copies of such policy or policies or certificates evidencing the existence and amounts of such insurance together with evidence of payment of premiums. Any policy required to be maintained by Landlord or Tenant under this Lease may be maintained under a so-called "blanket policy" insuring other parties and/or other locations, so long as the amount of insurance and type of coverage required to be provided under this Lease is not thereby diminished, changed or adversely affected. (f) All insurance coverage, terms and conditions described in this Section 8.1 shall be evidenced by a Certificate of Insurance issued to Landlord. A copy of all insurance policies issued to Tenant during the Term shall be forwarded to Landlord within sixty (60) days after the Commencement Date. (g) If at any time during the Term the amount or coverage of insurance which Tenant is required to carry under this Section 8.1 is, in Landlord's reasonable judgment, materially less than that amount or type of insurance coverage typically carried by owners or tenants of properties located in San Diego, California, which are similar in size and used for similar purposes as the Premises, Landlord shall have the right to require Tenant to increase the amount or change the types of insurance coverage required under this Section 8.1. 8.2 Landlord's Insurance: Landlord shall, at its expense, maintain in effect at all times during the Term: a policy or policies of "all risk" fire, general liability and extended coverage insurance, including at least six (6) months rental interruption insurance, with vandalism and malicious mischief endorsements, coverage with respect to increased costs due to building ordinances, demolition coverage, boiler and machinery insurance, sprinkler leakage coverage, in each case to the extent of at least one hundred 26 percent (100%) of the full replacement value of the Building and Adjacent Building and any future building on the Project. Landlord shall notify Tenant of Landlord's obtaining any such insurance. If Landlord fails during the Term to maintain any insurance required to be maintained by Landlord under this Lease, then Tenant may, at its election, arrange for any such insurance, and Tenant may require that Landlord reimburse Tenant for any premiums for any such insurance within five (5) days after Landlord or Tenant's receipt of the premium notice. Insurance required to be maintained by Landlord under this Lease (a) shall be issued as a primary policy by insurance companies authorized to do business in California with a Best's Rating of at least "A" and a Best's Financial Size Category rating of at least "VIII," as set forth in the most current edition of "Best's Insurance Reports," or such higher rating as may be required by any lender, (b) shall name Tenant and any lender or other party as Tenant may elect as additional named insureds, (c) shall constitute "occurrence" based coverage, without provision for subsequent conversion to "claims" based coverage, and (d) shall not be cancelable or subject to reduction of coverage or other modification except after thirty (30) days' prior written notice to Tenant and any lender. Landlord shall, at least thirty (30) days prior to the expiration of each such policy, furnish Tenant with a renewal or "binder" of such policy. Landlord shall, upon request from Tenant, promptly deliver to Tenant copies of such policy or policies or certificates evidencing the existence and amounts of such insurance together with evidence of payment of premiums. The premiums, costs and expenses and deductibles of and/or with respect to any such insurance shall be included in the Building Operating Expenses. Landlord shall not increase the amount or types of insurance coverage beyond that which was in place during the Base Year, other than reasonable increases to reflect inflation or an increase in value of the insured property. Landlord has set forth on Exhibit "O" quotes for any insurance coverage Landlord may reasonably obtain in the future. If Landlord subsequently obtains in any Lease Year insurance coverage which is set forth on Exhibit "O", then Lease Expenses for the Base Year shall include the insurance quotes on Exhibit "O" and Lease Expenses for the Lease Year shall include the cost of insurance to the extent increases over the quotes are a result of reasonable increases for inflation or the value of the insured property. SECTION 9 DESTRUCTION 9.1 RISK COVERED BY INSURANCE: (a) If during the Term the Premises is totally or partially destroyed, rendering the Premises totally or partially inaccessible or unusable, Landlord shall, subject to Sections 9.1(b) and 9.1(c), restore the Premises to substantially the same condition as it was in immediately before the destruction. Such destruction shall not terminate this Lease. If, however, then-existing laws do not permit such restoration, Landlord may terminate this Lease by giving written notice to Tenant. (b) If Landlord determines that the cost of such restoration exceeds the amount of proceeds received by Landlord from any insurance maintained by Landlord, then Landlord may elect to terminate this Lease by giving notice to Tenant within sixty (60) days after such destruction or within sixty (60) days after Landlord's receipt of such proceeds, whichever is later. If Landlord gives such notice of termination, then this Lease shall terminate as of forty-five (45) days after Landlord's notice of termination, unless Tenant provides Landlord with written notice of its election to pay the amount by which the cost of such restoration exceeds the amount of proceeds received by Landlord ("Notice To Restore"), in which event this Lease shall remain in full force and effect. Tenant shall have thirty (30) days after Notice To Restore to pay the excess cost of restoration either to Landlord or to an escrow account to be used for restoration. (c) Within thirty (30) days after such destruction, Landlord shall notify Tenant in writing whether or not, based on Landlord's determination, the Premises can be restored within six (6) months after the date of such destruction. If such restoration cannot be completed within such six (6) month period, either party may terminate this Lease by giving written notice to the other party within twenty (20) days after the date of Landlord's written notice. If Landlord determines that the Premises can be restored within such six (6) month period and neither party terminates this Lease pursuant to this Section 9, Landlord shall use its reasonable efforts to restore the Premises within such six (6) month period to substantially the same condition as it was in immediately before the destruction. 9.2 ABATEMENT OR REDUCTION OF RENT: In case of any destruction to the Premises, all obligations of Tenant under this Lease shall remain in effect, except that Base Rent and Lease Expenses Difference shall be abated or reduced, between the date of such destruction and the date of completion of restoration, by 27 the ratio of (a) the area of the Premises rendered unusable or inaccessible by the destruction to (b) the area of the Premises prior to such destruction. 9.3 LOSS DURING LAST PART OF TERM OR EXCEEDING TWENTY-FIVE PERCENT (25%) OF REPLACEMENT VALUE: Not withstanding any other provision of this Lease, if any destruction to the Premises occurs during the last year of the Term, or if, at any time during the Term, there is any destruction to the Premises that exceeds twenty-five percent (25%) of the then replacement value of the Premises, Landlord or Tenant may terminate this Lease by giving written notice to the other not more than thirty (30) days after such destruction, in which case (a) neither Landlord nor Tenant shall have any obligation to restore the Premises, (b) Landlord shall retain all insurance proceeds relating to such destruction except for insurance proceeds relating to the loss of or damage to Tenant's Personal Property or loss of business, and (c) this Lease shall terminate as of thirty (30) days after such notice of termination. 9.4 LIMITATION ON LANDLORD'S RESTORATION OBLIGATION: If Landlord is required or elects to restore the Premises as provided in Section 9.1, Landlord shall not be required to restore any of Tenant's Alterations which were constructed without Landlord's written consent or any of Tenant's Personal Property, unless they are an integral part of the Premises and specifically covered by insurance proceeds received by Landlord, such excluded items being the sole responsibility of Tenant to restore. SECTION 10 CONDEMNATION 10.1 DEFINITIONS: For purposes of this Lease, the following definitions shall apply: (a) "Condemnation" shall mean the exercise of any governmental power, whether by legal proceedings or otherwise, by a Condemnor (as defined below) or a voluntary sale or transfer by Landlord to any Condemnor, either under threat of condemnation or while legal proceedings for condemnation are pending; (b) "Date of Taking" shall mean the date the Condemnor has a right to possession of the property being condemned; (c) "Award" shall mean all compensation, sums or anything of value awarded, paid, or received on a total or partial Condemnation of the Project; and (d) "Condemnor" shall mean any public or quasi-public authority, or private corporation or individual, having the power of Condemnation. 10.2 GOVERNED BY LEASE: If during the Term, or during the period of time between the execution of this Lease and the Commencement Date, there is any taking of all or any part of the Project or any interest in this Lease by Condemnation, the rights and obligations of Landlord and Tenant shall be determined pursuant to this Section 10. 10.3 TOTAL TAKING: If the Premises are totally taken or more than thirty percent (30%) of the available parking area is taken by Condemnation, this Lease shall terminate on the Date of Taking. 10.4 PARTIAL TAKING: If any portion, but not all, of the Premises is taken by Condemnation, this Lease shall remain in effect, except that Tenant may elect to terminate this Lease if the remaining portion of the Premises is rendered unsuitable for Tenant's continued use of the Premises. If Tenant elects to so terminate this Lease, Tenant must exercise its right to terminate by giving notice to Landlord within sixty (60) days after the date that the nature and the extent of the taking have been determined ("Determination Date"), which notice shall set forth the date of termination. Such termination date shall not be earlier than thirty (30) days nor later than ninety (90) days after Tenant has notified Landlord of its election to terminate; except that this Lease shall terminate on the Date of Taking if the Date of Taking falls on a date before the date of termination as designated by Tenant. If Tenant does not so notify Landlord within sixty (60) days after the Determination Date, all obligations of Tenant under this Lease shall remain in effect, except that Base Rent shall be reduced by the ratio of (a) the area of the Premises taken to (b) the area of the Premises immediately prior to the Date of Taking. 28 10.5 AWARD: The Award shall belong to and be paid to Landlord, Tenant shall have no right to any part of the Award, and Tenant assigns to Landlord all of Tenant's right, title and interest in and to any part of the Award, except that Tenant shall receive from the Award an amount equal to the value of Tenant's leasehold interest and any sum paid expressly to Tenant from the Condemnor for relocation, the cost of tenant improvements which were paid for by Tenant and not part of the Tenant Improvement Allowance, the value of Alterations and loss of goodwill. 10.6 TEMPORARY TAKING: The taking of the Premises or any part of the Premises by military or other public authorities shall constitute a taking of the Premises by Condemnation only when the use and occupancy by the taking authority is continued for longer than one hundred eighty (180) consecutive days. During the one hundred eighty (180) day period, all obligations of Tenant under this Lease shall remain in effect, except that Base Rent shall be abated or reduced during such period of taking by the ratio of (a) the area of the Premises taken to (b) the area of the Premises immediately prior to the Date of Taking, and Landlord shall be entitled to any Award related to such taking. 10.7 WAIVER OF STATUTE: Landlord and Tenant waive the provision of California Code of Civil Procedure Section 1265.130 allowing Landlord or Tenant to petition the superior court to terminate this Lease in the event of a partial taking of the Premises. SECTION 11 ASSIGNMENT AND SUBLETTING 11.1 ASSIGNMENT: (a) Tenant shall not assign, enter into a license or concession agreement for, hypothecate or otherwise divest itself of this Lease or any of its rights under this Lease or permit any third party or parties other than Tenant to occupy the Premises or any portion thereof without Landlord's prior written consent, which consent shall not be unreasonably withheld, but is subject to the terms and conditions contained in this Section 11. (b) For purposes of this Lease, each of the following events shall be deemed to constitute an assignment of this Lease: (i) any assignment or transfer of this Lease, or any interest in this Lease, voluntarily, involuntarily, by operation of law or otherwise; (ii) any mortgage, hypothecation, pledge, or collateral assignment of this Lease or any interest in this Lease; (iii) any sale, transfer, grant of concessions or licenses, or other disposition of this Lease, any interest in this Lease or all or any portion of the Premises; (iv) any assignment, transfer, disposition, sale, or acquisition of a controlling interest in Tenant to or by any person, entity, or group of related persons or affiliated entities, whether in a single transaction or in a series of related or unrelated transactions ("Change of Control"). For purposes of this Lease a "Change of Control" shall mean a change in the identity of the person or persons exercising, or who may exercise, effective control of Tenant, unless such change results from either (A) the acquisition of Tenant by a publicly traded company, (B) the trading of shares listed on a recognized national securities exchange, or (C) the transfer of interests in Tenant for purposes of estate or tax planning; and 29 (v) any issuance of an interest or interests in Tenant (whether stock, partnership interests, or otherwise) to any person, entity, or group of related persons or affiliated entities, whether in a single transaction or in a series of related or unrelated transactions, which results in Change of Control. (c) At least fifteen (15) days prior to entering into any assignment of this Lease of all or any portion of the Premises, Tenant shall submit to Landlord the form of such proposed assignment, and a written notice ("Tenant's Notice") setting forth in reasonable detail (i) the name and address of the proposed assignee, (ii) the terms and conditions of the proposed assignment, including without limitation the proposed effective date of the assignment, which shall be at least thirty (30) days after Tenant's Notice is given, (iii) the nature and character of the business of the proposed assignee, and (iv) current banking, financial, and other credit information, including prior year's federal tax return, if available, (all of which information Landlord agrees to treat as strictly confidential and not disclose or disseminate to third parties) relating to the proposed assignee, in reasonably sufficient detail, to enable Landlord to determine the proposed assignee's financial responsibility. (d) Within thirty (30) days after Landlord's receipt of Tenant's Notice and the form of assignment, Landlord shall notify Tenant whether Landlord has consented to the proposed assignment. Any consent granted by Landlord in any instance shall not constitute a consent with respect to any other instance or request. If Landlord consents to any proposed assignment and Tenant fails to consummate such assignment within one hundred eighty (180) days after such consent, then such consent shall be deemed withdrawn and Tenant shall be required again to comply with this Section 11 before assigning this Lease or any portion of the Premises. (e) Landlord shall not have unreasonably withheld its consent with respect to any assignment if Landlord shall not have received Tenant's Notice as provided above, nor if (i) the nature and character of the proposed assignee and the proposed use and occupancy of the Premises by the proposed assignee is not in keeping with the dignity and character of the Premises and the surrounding area, (ii) the proposed assignment will result in the diminution of the value or marketability of the Premises, (iii) upon review of the information furnished in Tenant's Notice, Landlord is not satisfied that the proposed assignee's use of the Premises will not conflict with other uses in the Premises. Tenant acknowledges that Tenant's Notice shall be ineffective if Tenant is in material default with respect to any provision under this Lease. 11.2 SUBLEASE: If Tenant is not in default of the Lease, Tenant may sublease all or a portion of the Premises upon Landlord's prior written consent, which consent shall not be unreasonably withheld. Any sublease of all or a portion of the Premises shall be in accordance with the terms and conditions of this Section 11 and all other applicable terms and conditions of this Lease. Tenant's request to sublease all or a portion of the Premises shall be in the form of the Tenant's Notice as set forth in Section 11.1(c). (a) Any sublease of all or any portion of the Premises must contain the following provisions, which provisions, whether contained in such sublease nor not, shall apply to such sublessee: (i) Such sublease shall be subject and subordinate to all of the provisions of this Lease (including all exhibits) and any subsequent amendments of this Lease; (ii) At Landlord's option, in the event of cancellation or termination of this Lease for any reason or the surrender of this Lease, whether voluntarily, involuntarily, or by operation of law, prior to the expiration of such sublease, the subtenant shall make full and complete attornment to Landlord for the balance of the term of such sublease, provided that Landlord agrees in writing not to disturb subtenant's right to occupy the subleased area as long as such sublessee is in compliance with its obligations under such sublease. The subtenant shall execute and deliver to Landlord an agreement of attornment satisfactory to Landlord within five (5) days after requested by Landlord; and (iii) No sublessee shall be permitted to further sublet all or any portion of the subleased space without Landlord's prior written consent. 30 (b) Tenant shall submit all subleases to Landlord prior to execution for Landlord's review and approval, which shall not be unreasonably withheld or delayed more than fourteen (14) days after Landlord's receipt of any sublease. 11.3 TENANT AND ASSIGNEE OR SUBLESSEE FULLY LIABLE: No assignment of this Lease nor any sublease of all or any portion of the Premises shall release or discharge Tenant from any liability, whether past, present, or future, under this Lease and Tenant shall continue to remain primarily liable under this Lease. The assignee of any assignment of this Lease, and the sublessee of any sublease of all or any portion of the Premises, shall execute, acknowledge, and deliver to Landlord an agreement satisfactory to Landlord in which the assignee or sublessee assumes and agrees to be bound by all of the provisions of this Lease. 11.4 ASSIGNMENT OF RENTS: Tenant irrevocably assigns to Landlord, as security for Tenant's obligations under this Lease, all rent from any subletting of all or any portion of the Premises, and Landlord, as assignee and as special attorney-in-fact for Tenant, or a receiver for Tenant appointed on Landlord's application, may collect such rent and apply it toward Tenant's obligations under this Lease, except that, unless Tenant defaults under this Lease, Tenant shall have the right to collect such rent. 11.5 SUBLEASE ASSIGNMENT RIGHT: Landlord and Tenant shall share equally any "Premium" (as defined below) arising from the sublease of any portion of the Premises to any entity which is not a subsidiary of Tenant. For purposes of this paragraph "Premium" shall mean all sums received by Tenant under the sublease which exceeds the Rent attributable to the subleased portion of the Premises, after deducting (a) all reasonable expenses of Tenant incurred in connection with such sublease amortized on a straight line basis over the initial term of the sublease, including without limitation legal costs, brokerage commissions, rent abatement and other concessions, lease takeover, subtenant improvement costs, the unamortized value of Tenant's leasehold improvements, downtime, and cash payments, (b) any utility costs paid by Tenant which is attributable to such subleased premises, and (c) any Additional Rent paid by Tenant which is attributable to such subleased premises. The determination of Base Rent attributable to the subleased portion of the Premises shall be made on the basis of the ratio of the rentable square footage in the subleased portion to the Rentable Square Footage. SECTION 12 DEFAULT AND REMEDIES 12.1 DEFAULT: The occurrence of any of the following shall constitute a material default and breach of this Lease by Tenant: (a) the failure by Tenant to pay Rent as and when due, where such failure shall continue for a period of three (3) business days after written notice of such failure from Landlord to Tenant. In the event that Landlord serves Tenant with a Notice to Pay Rent or Quit pursuant to applicable statutes set forth in California Code of Civil Procedure, such Notice to Pay Rent or Quit shall also constitute the notice of such failure; (b) the failure by Tenant to observe or perform any of the provisions of this Lease to be observed or performed by Tenant, other than described in Section 12.1(a), where such failure shall continue for a period of thirty (30) days after written notice of such failure from Landlord to Tenant; provided, however, that if the nature of Tenant's default is such that more than thirty (30) days are required for its cure, then Tenant shall not be deemed to be in default if Tenant commenced such cure within such thirty (30) day period and thereafter diligently prosecutes such cure to completion within sixty (60) days after Landlord's written notice; or (c) the making by Tenant of any general arrangement or assignment for the benefit of creditors; Tenant's becoming bankrupt, insolvent or a "debtor" as defined in 11 U.S.C. Section 101, or any successor statute (unless, in the case of a petition filed against Tenant, such petition is dismissed within sixty (60) days after its original filing); the institution of proceedings under bankruptcy or similar laws in which Tenant is the debtor or bankrupt; the appointing of a trustee or receiver to take possession of substantially all of Tenant's assets located at the Premises or of Tenant's interest in this Lease (unless possession is restored to Tenant within sixty (60) days after such taking); or the attachment, execution of judicial seizure of substantially all of Tenant's assets located at the Premises or Tenant's interest in this Lease (unless such attachment, 31 execution or judicial seizure is discharged within sixty (60) days after such attachment, execution or judicial seizure). 12.2 LANDLORD'S REMEDIES: Landlord shall have the following remedies if Tenant commits a default or breach under this Lease; these remedies are not exclusive, but are cumulative in addition to any remedies provided elsewhere in this Lease or now or later allowed by law. (a) Continuation of Lease: No act by Landlord (including without limitation the acts set forth in this Section 12.2(a)) shall terminate Tenant's right to possession unless Landlord notifies Tenant in writing that Landlord elects to terminate Tenant's right to possession. As long as Landlord does not terminate Tenant's right to possession, Landlord may (i) continue this Lease in effect, (ii) continue to collect rent when due and enforce all the other provisions of this Lease, (iii) enter the Premises and relet them, or any part of them, to third parties for Tenant's account, for a period shorter or longer than the remaining term of this Lease, and (iv) have a receiver appointed to collect rent and conduct Tenant's business. Tenant shall immediately pay to Landlord all costs Landlord incurs in such reletting, including, without limitation, brokers' commissions, attorneys' fees, advertising costs and expenses of remodeling the Premises of such reletting. (b) Rent from Reletting: If Landlord elects to relet all or any portion of the Premises as permitted by Section 12.2(a), rent that Landlord receives from such reletting shall be applied to the payment of, in the following order and priority, (i) any indebtedness due from Tenant to Landlord (other than Base Rent), (ii) all costs incurred by Landlord in such reletting, including without limitation any brokers', finders', or leasing agents' commissions, charges or fees, and (iii) Base Rent due and unpaid under this Lease. After applying such payments as referred to above, any sum remaining from the rent Landlord receives from such reletting shall be held by Landlord and applied in payment of future Base Rent as it becomes due under this Lease. In no event shall Tenant be entitled to any excess rent received by Landlord. (c) Termination of Tenant's Right to Possession: Landlord may terminate Tenant's right to possession of the Premises at any time, by notifying Tenant in writing that Landlord elects to terminate Tenant's right to possession. On termination of this Lease, Landlord has the right to recover from Tenant (i) the worth at the time of the award of the unpaid Base Rent which had been earned at the time of such termination, (ii) the worth at the time of the award of the amount by which the unpaid Base Rent which would have been earned after such termination until the time of award exceeds the amount of such loss of Base Rent that Tenant proves could have been reasonably avoided, (iii) the worth at the time of the award of the amount by which the unpaid Base Rent for the balance of the Term after the time of award (had there been no such termination) exceeds the amount of such loss of Base Rent that Tenant proves could be reasonably avoided, and (iv) any other amount necessary to compensate Landlord for all detriment proximately caused by Tenant's failure to perform Tenant's obligations under this Lease or in the ordinary course of things would be likely to result therefrom. The "worth at the time of the award" of the amounts referred to in Sections 12.2(c)(i) and 12.2(c)(ii) is to be computed by allowing interest at a rate equal to ten percent (10%) per annum, but in no event greater than the maximum rate permitted by applicable law. The "worth at the time of the award" of the amount referred to in Section 12.2(c)(iii) is to be computed by discounting such amount at the discount rate of the Federal Reserve Bank of San Francisco at the time of award plus one percent (1%). (d) Landlord's Right to Cure Default: Landlord, at any time after Tenant commits a default or breach under this Lease, may cure such default or breach at Tenant's sole cost. If Landlord at any time, by reason of Tenant's default or breach, pays any sum or does any act that requires the payment of any sum, such sum shall be due immediately from Tenant to Landlord at the time such sum is paid, and shall be deemed additional rent under this Lease. 12.3 INTEREST AND LATE CHARGES: Rent not paid within five (5) days after its due date shall bear interest from the date due at a rate equal to ten percent (10%) per annum, but in no event greater than the maximum rate permitted by applicable law. Late payment by Tenant to Landlord of Rent will cause Landlord to incur cost not contemplated by this Lease, the exact amount of which would be impracticable or extremely difficult to fix. Such costs include, without limitation, processing, collection and accounting charges, and late charges that may be imposed on Landlord by the terms of any Mortgage covering the Premises. Therefore, if any Rent is not received by Landlord within three (3) business days after notice 32 to the Chief Financial Officer of Tenant of such overdue payment from Landlord to Tenant, Tenant shall pay to Landlord an additional sum of five percent (5%) of such overdue amount as a late charge ("Late Charge"). Landlord and Tenant agree that the Late Charge represents a fair and reasonable estimate of the costs that Landlord will incur by reason of any late payment by Tenant, and therefore this Section 12.3 is reasonable under the circumstances existing at the time this Lease is executed. Acceptance of the Late Charge by Landlord shall not constitute a waiver of Tenant's default with respect to such overdue amount, nor prevent Landlord from exercising any of the other rights and remedies available to Landlord under this Lease. 12.4 QUARTERLY PAYMENTS: In the event that a Late Charge is payable under this Lease, whether or not collected, for three (3) consecutive installments of Rent or in the event Rent is paid more than thirty (30) days late twice due under this Lease during any twelve (12) month period, then Base Rent, and Monthly Payment, shall, at Landlord's election by written notice to Tenant, become due and payable quarterly in advance, rather than monthly, for a period of six (6) months. If a Late Charge is payable under the Lease, whether or not collected, for two (2) installments of Rent during the twelve (12) calendar months following such six (6) month period, then Base Rent and Monthly Payment shall automatically become due and payable quarterly in advance for a period of one (1) year. If any payment is not timely paid during such one year period, then Base Rent and Monthly Payment shall automatically become due and payable quarterly in advance for the remaining Term of the Lease. All monies paid to Landlord under this Section 12.4 may be commingled with other monies of Landlord and shall not bear interest. 12.5 WAIVER: No delay or omission in the exercise of any right or remedy of Landlord in the event of any default by Tenant shall impair such right or remedy or be construed as a waiver. The receipt and acceptance by Landlord of delinquent Rent shall not constitute a waiver of any default other than the particular rent payment accepted. Landlord's receipt and acceptance from Tenant, on any date ("Receipt Date"), of an amount less than rent due on such Receipt Date, or to become due (pursuant to Section 4 or Section 6) at a later date but applicable to a period prior to such Receipt Date, shall not release Tenant of its obligation (a) to pay the full amount of such rent due on such Receipt Date or (b) to pay when due the full amount of such rent to become due at a later date but applicable to a period prior to such Receipt Date. No act or conduct of Landlord, including without limitation, the acceptance of the keys to the Premises, shall constitute an acceptance by Landlord of the surrender of the Premises by Tenant before the Expiration Date or Option Expiration Date. Only a written notice from Landlord to Tenant stating Landlord's election to terminate Tenant's right to possession of the Premises shall constitute acceptance of the surrender of the Premises and accomplish a termination of this Lease. Landlord's consent to or approval of any act by Tenant requiring Landlord's consent or approval shall not be deemed to waive or render unnecessary Landlord's consent to or approval of any other or subsequent act by Tenant. Any waiver by Landlord of any default by Tenant must be in writing and shall not be a waiver of any other default concerning the same or any other provision of this Lease. 12.6 NOTICE OF DEFAULT: Landlord shall not be deemed to be in default in the performance of any obligation required to be performed by Landlord unless and until it has failed to perform such obligation within thirty (30) days after Landlord's receipt of written notice from Tenant specifying Landlord's failure to perform such obligation. However, if the nature of Landlord's obligation is such that more than thirty (30) days are required for its performance, then Landlord shall not be deemed to be in default if it shall commence such performance within such thirty (30) day period and thereafter prosecutes the same to completion. SECTION 13 SUBORDINATION, ATTORNMENT, ESTOPPEL, AND NON-DISTURBANCE 13.1 SUBORDINATION: This Lease and Tenant's rights under this Lease are subject and subordinate to any mortgage, loan secured by a deed of trust, or other written security instrument or agreement affecting the Project that constitutes security for the payment of a debt or performance of an obligation (each, a "Mortgage"), and to all renewals, modifications, consolidations, replacements or extensions thereof, now or hereafter affecting the Premises. The provisions of this Section 13.1 shall be self-operative, and no further instrument of subordination shall be required. Within fifteen (15) days after written notice from Landlord, Tenant shall execute and deliver any instruments that Landlord, the holder of any Mortgage, or the lessor of any ground or underlying lease may reasonably request to evidence 33 such subordination. If Tenant fails to execute and deliver any such instrument(s) within fifteen (15) days after such notice, Tenant agrees that Landlord may then send a second notice and irrevocably constitutes and appoints Landlord as Tenant's special attorney-in-fact to execute and deliver such instruments on behalf of Tenant ten (10) days after Landlord's second written notice to Tenant to execute and deliver requested instrument(s) and Tenant fails to do so. If Landlord executes documents on behalf of Tenant pursuant to the special power-of-attorney, it shall be deemed that Tenant has not waived any rights against Landlord solely due to the use of the special power-of-attorney by Landlord. 13.2 ATTORNMENT: If the holder of any Mortgage shall hereafter succeed to the Landlord under this Lease, Tenant shall attorn to and recognize such successor as the Landlord under this Lease, and shall promptly execute and deliver any instruments that may be necessary to evidence such attornment. If Tenant fails to execute and deliver any such instrument(s) within fifteen (15) days after written notice from Landlord, Tenant agrees that Landlord may then send a second notice and irrevocably appoints Landlord as Tenant's special attorney-in-fact to execute and deliver such instruments on behalf of Tenant ten (10) days after Landlord's second written notice to Tenant to execute and deliver requested instrument(s) and Tenant fails to do so. If Landlord executes documents on behalf of Tenant pursuant to the special power-of-attorney, it shall be deemed that Tenant has not waived any rights against Landlord or such successor solely due to the use of the special power-of-attorney by Landlord. Upon such attornment, this Lease shall continue in effect as a direct lease between such successor landlord and Tenant upon and subject to all of the provisions of this Lease. 13.3 ESTOPPEL CERTIFICATES: Within fifteen (15) days after written notice from Landlord, Tenant shall execute and deliver to Landlord, in recordable form, a certificate in the form of Exhibit "I" stating (i) that this Lease is unmodified and in effect, or in effect as amended, and stating all amendments; (ii) the amount of Base Rent; (iii) the date to which Base Rent has been paid in advance; (iv) the amount of any security deposit, prepaid rent or other payment constituting rent which has been paid; (v) whether or not Tenant or Landlord is in default under this Lease; and (vi) such other matters as Landlord shall reasonably request. Tenant's failure to deliver such estoppel certificate within such fifteen (15) day period shall be conclusive upon Tenant for the benefit of Landlord, and any successor in interest to Landlord, that this Lease is in effect and has not been amended except as may be represented by Landlord, no rent has been paid more than thirty (30) days in advance and neither Landlord nor Tenant is in default under this Lease. If Tenant fails to deliver such estoppel certificate within such fifteen (15) day period, then Tenant agrees that Landlord may then send a second notice and irrevocably constitutes and appoints Landlord as its special attorney-in-fact to execute and deliver such certificate to any third party ten (10) days after Landlord's second written notice to Tenant to execute and deliver an estoppel certificate and Tenant fails to do so. Landlord shall execute and deliver a similar estoppel certificate within fifteen (15) days after written request by Tenant. If Landlord executes documents on behalf of Tenant pursuant to the special power-of-attorney, it shall be deemed that Tenant has not waived any rights against Landlord by reason of the contents of the estoppel certificate signed pursuant to the special power-of-attorney by Landlord. 13.4 NON-DISTURBANCE AGREEMENT: Landlord shall, within ten (10) days after the date of this Lease, obtain from Paul Revere Insurance Company and each other holder of a Mortgage in existence at the time of execution of this Lease a duly executed non-disturbance agreement in the form of Exhibit "H". With respect to any Mortgages which are not in existence at the time of execution of this Lease, Landlord shall obtain a non-disturbance agreement in the form of Exhibit "H" duly executed in recordable form by any holders of any future Mortgage as a condition to this Lease being subordinate and junior to such future Mortgage and as a condition to the recordation of any such future Mortgage. Notwithstanding any other provision in this Section 13, no special power-of-attorney in favor of Landlord or agreement to attorn by Tenant shall have force or effect unless a non-disturbance agreement substantially in the form of Exhibit "H" was previously or concurrently delivered to Tenant. SECTION 14 SURRENDER OF PREMISES, HOLDING OVER 14.1 SURRENDER OF PREMISES: By the Expiration Date, Option Expiration Date or earlier termination of this Lease, (i) Tenant shall surrender to Landlord the Premises, including without limitation all Alterations, in Good Condition (except for destruction to the Premises covered by Section 9) except for Alterations that Tenant is obligated to remove under Section 7.9, (ii) Tenant shall remove all its Personal Property and perform all repairs and restoration required by the removal of any Alterations or Personal 34 Property at its sole cost, and (iii) Tenant shall surrender to Landlord all keys to the Premises (including without limitation any keys to exterior or interior office doors) and all permits, validations, keycards, passes, and similar items with respect to the Premises and parking lot. Landlord may elect to retain or dispose of in any manner any Alterations or Personal Property that Tenant does not remove from the Premises on the Expiration Date, Option Expiration Date or earlier termination of this Lease as required by this Lease by giving written notice to Tenant. Title to any such Alterations or Personal Property that Landlord elects to retain or dispose of shall vest in Landlord. Tenant waives all claims against Landlord for any damage to Tenant resulting from Landlord's retention or disposition of any such Alterations or Personal Property after the Expiration Date or earlier termination of this Lease. Tenant shall be liable to Landlord for Landlord's costs for storing, removing or disposing of any such Alterations or Personal Property. If Tenant fails to surrender the Premises to Landlord on the Expiration Date or earlier termination of this Lease, Tenant shall indemnify and defend Landlord against all liability, loss and claims resulting from such failure including without limitation any claim for damages made by any other tenant or subtenant. 14.2 HOLDING OVER: If Tenant, with Landlord's written consent, remains in possession of the Premises after the Expiration Date, Option Expiration Date or earlier termination of this Lease, such possession by Tenant shall be deemed to be a month-to-month tenancy terminable on thirty (30) days written notice given at any time by Landlord or Tenant. During any such month-to-month tenancy, Tenant shall pay as Base Rent one hundred twenty-five percent (125%) of the Base Rent in effect immediately prior to the Expiration Date or earlier termination of this Lease, as the case may be. All provisions of this Lease except for those pertaining to the Term shall apply to such month-to-month tenancy. SECTION 15 DELAY IN OCCUPANCY 15.1 Definitions: (a) "Landlord Delays" shall have the meaning set forth in Paragraph 10 of the Work Letter (Exhibit "C"). (b) "Unavoidable Delays" shall have the meaning set forth in Paragraph 11 of the Work Letter. 15.2 Delay In Occupancy: (a) If, as of November 29, 1994, Tenant's Occupancy or Substantial Completion has not occurred and there are more than one hundred and eighty-one (181) days of combined Landlord Delay and Unavoidable Delay, this Lease shall, at Tenant's option, terminate. If, as of November 29, 1994, Tenant's Occupancy or Substantial Completion has not occurred and there are more than one hundred and eighty-one (181) days of Unavoidable Delay, this Lease shall, at Landlord's option, terminate. If, as of November 29, 1994, Tenant's Occupancy or Substantial Completion has not occurred and there are more than one hundred and eighty-one (181) days of combined Landlord Delay and Unavoidable Delay and Tenant is not using reasonable efforts to obtain Substantial Completion, this Lease shall, at Landlord's option, terminate. (b) If the Commencement Date is later than June 1, 1994 and there are more than fourteen (14) days of Landlord Delay, Landlord shall pay to Tenant that portion of rent at Tenant's address or other location that exceeds Base Rent ("Reimbursed Rent") and moving and storage costs attributed solely to the delay in the Commencement Date ("Reimbursed Moving and Storage Cost") from June 1, 1994 until the Commencement Date or July 5, 1994 whichever is earlier. If the Commencement Date is later than July 5, 1994 and there are more than thirty-four (34) days of Landlord Delay, Landlord shall pay to Tenant Reimbursed Rent and Reimbursed Moving and Storage Cost from June 1, 1994 until the Commencement Date or September 6, 1994 whichever is earlier. If the Commencement Date is later than September 6, 1994 and there are ninety-seven (97) days of Landlord Delay, Landlord shall pay Tenant Reimbursed Rent and Reimbursed Moving and Storage Cost from June 1, 1994 until the Commencement Date or November 29, 1994 whichever is earlier. If the Commencement Date is later than November 29, 1994 and there are more than one hundred eighty-one (181) days of Landlord Delay, then Landlord shall pay Tenant Reimbursed Rent and Reimbursed Moving and Storage Cost from June 35 1, 1994 until the Lease is terminated as set forth in Section 15.2(a), except that Landlord shall not be obligated to pay Reimbursement Rent and Reimbursed Moving and Storage Costs for any period beyond June 1, 1994 through November 29, 1994. (c) Landlord shall have no liability for Landlord Delay or Unavoidable Delay except as specifically set forth in Sections 1.4 and 15.2 of this Lease. (d) Tenant's occupancy of the Premises at any time shall conclusively be deemed a waiver by Tenant of this Section 15 except for any sums Landlord may owe to Tenant pursuant to this Section 15. SECTION 16 GENERAL PROVISIONS 16.1 BROKERS: Tenant represents that, except as set forth in this Section 16.1, no real estate broker, agent, finder, or other person is responsible for bringing about or negotiating this Lease and that Tenant has not dealt with any real estate broker, agent, finder, or other person with respect to this Lease in any manner. Tenant shall indemnify and defend Landlord against all liability, costs, expenses and charges (including without limitation attorneys' fees and disbursements) arising from any claims that may be made against Landlord by any real estate broker, agent, finder, or other person alleging to have acted on behalf of or to have dealt with Tenant, prior to the Commencement Date and during the Term. Landlord retained CB Commercial Real Estate Group Inc. ("CB Commercial") as a leasing broker and shall be responsible for all commissions paid to CB Commercial regarding this Lease. Tenant retained Cushman Realty Corporation ("Cushman"), as exclusive agent for Tenant. Landlord shall pay to Cushman a real estate brokerage commission ("Commission") of five percent (5%) of the Base Rent (less the Rent Abatement for the first five (5) years of the Term) and two and one-half percent (2 1/2%) of the Base Rent for years six (6) through ten (10) of the Term payable one-half (1/2) upon the complete execution of the Lease and one-half (1/2) upon the Commencement Date and upon the occupancy of the Premises by Tenant. In the event Landlord fails to pay the Commission to Cushman on or before the date(s) due, as specified herein, Cushman may send written notice to each of Landlord and Tenant of such failure. If Landlord fails to pay such amount(s) within thirty (30) days after the date of such notice, Tenant shall have the option, but not the obligation, to pay Cushman any balance due of the Commission and to offset the amount paid, together with interest at the rate of ten percent (10%) per annum, against Tenant's next rent due under this Lease. 16.2 NOTICES: Any notice, demand, request, consent, approval, or communication that either Landlord or Tenant desires or is required under this Lease to give to the other or any other person shall be in writing and either served personally or sent by certified prepaid, first class U.S. Federal Express mail or other overnight delivery service that provides written confirmation of delivery addressed to Tenant or to Landlord at the addresses set forth below: To Landlord: PacCor Partners 11939 Rancho Bernardo Road, #200 San Diego, California 92128 Attn: Terrence L. Vogel Copy of all notices to Landlord to: PacCor Management Company 11939 Rancho Bernardo Road, #200 San Diego, California 92128 Attn: Marlene Booth 36 To Tenant Prior to Tenant's taking possession of the Premises: LINSCO/PRIVATE LEDGER CORP. 5871 Oberlin Drive San Diego, CA 92121 Attn: Andrew G. Micheletti Tenant after Tenant's taking possession of the Premises: LINSCO/PRIVATE LEDGER CORP. 5935 Cornerstone Court San Diego, CA 92121 Attn: Andrew G. Micheletti Copy of all notices to Tenant to: Solomon, Ward, Seidenwurm & Smith 401 B Street, Suite 1200 San Diego, CA 92101 Attn: Richard L. Seidenwurm, Esq. Either Landlord or Tenant may change its address by notifying the other of the change of its address in writing pursuant to this Section 16.2. Notice, if mailed as provided in this Section 16.2, shall be deemed given forty-eight (48) hours after the time of such mailing. 16.3 QUITCLAIM DEED: Tenant shall execute and deliver to Landlord on the Expiration Date or earlier termination of this Lease, promptly on Landlord's request, a quitclaim deed to the Premises, in recordable form, designating Landlord as transferee. 16.4 SALE OR TRANSFER OF PREMISES: If Landlord sells or transfers any portion of the Premises, Landlord, on consummation of the sale or transfer, shall be released from liability under this Lease, except for the actions of Landlord or Landlord's Representatives occurring prior to the date of such consummation. If any security deposit or prepaid rent has been paid by Tenant, Landlord may transfer the security deposit and/or prepaid rent to Landlord's successor-in-interest and on such transfer Landlord shall be discharged from any further liability arising from the security deposit or prepaid rent. 16.5 ATTORNEYS' FEES: If Landlord or Tenant becomes a party to any litigation concerning this Lease, the Premises, or the Project by reason of any act or omission of the other or its agents, employees, officers, independent contractors, licensees, invitees, visitors or customers, (and not by any act or omission of the one that becomes a party to that litigation or its agents, employees, officers, independent contractors, licensees, invitees, visitors or customers), the one that causes the other to become involved in such litigation shall be liable to the other for reasonable attorneys' fees, court costs, and other expenses incurred by it in such litigation. If Landlord or Tenant commences an action against the other arising out of or in connection with this Lease, the prevailing party (as determined by the court) shall be entitled to recover from the losing party reasonable attorneys' fees, court costs, and other expenses incurred by the prevailing party in such litigation. 16.6 MERGER: A voluntary or other surrender of this Lease by Tenant, or a mutual cancellation of this Lease, or a termination by Landlord, shall not work a merger, and shall, at the option of Landlord, terminate any existing subleases or may, at the option of Landlord, operate as an assignment to Landlord of any such subleases. 16.7 TIME OF ESSENCE: Time and strict and punctual performance are of the essence with respect to each provision of this Lease. 16.8 SUCCESSOR IN INTEREST: Subject to Section 11, this Lease shall be binding on and inure to the benefit of Landlord and Tenant and their successors in interest. 37 16.9 EASEMENTS: Landlord may, from time to time, grant such easements, rights and dedications that Landlord deems necessary or desirable, and cause the recordation of parcel maps and restrictions, provided such easements, rights, dedications, maps and restrictions do not unreasonably interfere with the use of the Premises by Tenant. Tenant shall promptly sign any documents or instruments to accomplish the foregoing upon request by Landlord, and failure to do so shall constitute a material breach of this Lease. Tenant irrevocably appoints Landlord as Tenant's special attorney-in-fact to execute and deliver such documents or instruments on behalf of Tenant should Tenant refuse or fail to do so. 16.10 GOVERNING LAW: This Lease shall be interpreted in accordance with the laws of the State of California. 16.11 INTEGRATION: This Lease contains all the agreements between Landlord and Tenant relative to this Lease and cannot be amended or modified except by a written document executed by Landlord and Tenant. This Lease shall be deemed prepared by both parties, and the fact that one party actually drafted this Lease shall not affect the interpretation of any provision thereof. 16.12 PROVISIONS ARE COVENANTS AND CONDITIONS: All provisions, whether covenants or conditions, to be performed or observed by Landlord and Tenant shall be deemed to be both covenants and conditions. 16.13 PERSON AND GENDER: Whenever the singular number is used in this Lease, the same shall include, when appropriate, the plural; and each gender shall include, when appropriate, any other genders; and the word "person" shall include, in addition to a natural person, when appropriate, a corporation, firm, partnership, joint venture, trust, estate or other entity. 16.14 SEVERABILITY: If any provision of this Lease is held by a court to be unenforceable or invalid for any reason, the remaining provisions of this Lease shall be unaffected by such holding. 16.15 LIMITATIONS ON LANDLORD'S LIABILITY: If Landlord is in default under this Lease, and as a consequence, Tenant recovers a money judgment against Landlord, such judgment shall be satisfied only out of the proceeds of sale received upon execution of such judgment and levy against the right, title and interest of Landlord in the Project, and out of rent or other income from the Project receivable by Landlord or out of the consideration received by Landlord from the sale or other disposition of or any part of Landlord's right, title and interest in the Project, except for that portion of the judgment that specifically pertains to Landlord's (i) failure to timely pay taxes or insurance, (ii) failure to refund Tenant's security deposit, (iii) fraudulent, willful or intentional acts or misrepresentations, (iv) failure to apply insurance or condemnation proceeds as required by the Lease, and (v) failure to remit, to the persons entitled thereto, any funds paid by Tenant to Landlord for work or materials on the Premises. Except as specifically provided in this Section, neither Landlord nor the partners comprising Landlord (if any) shall be personally liable for any deficiency. 16.16 HEADINGS AND EXHIBITS: The Section and subsection headings of this Lease shall have no effect on its interpretation. Any exhibits referred to in this Lease are incorporated in it by reference. 16.17 PAYMENTS IN UNITED STATES CURRENCY: All payments to be made by Tenant to Landlord under this Lease shall be in United States currency. 16.18 TENANT'S FINANCIAL STATEMENTS: Within fifteen (15) days of written notice from Landlord, Tenant agrees to deliver to Landlord or any lender or buyer designated by Landlord, at no cost to Tenant, such financial statements of Tenant that have most recently been prepared, as may be reasonably required by Landlord, any lender or buyer. Such financial statements shall include the past three (3) years' financial statements of Tenant if requested in writing by Landlord. Such financial statements shall be kept confidential and Landlord shall take all reasonable steps necessary to ensure such confidentiality. 38 16.19 NO OPTION: The submission of this Lease by Landlord, its agent or representative for examination or execution by Tenant does not constitute an option or offer to lease the Premises upon the terms and conditions contained in this Lease or reservation of the Premises in favor of Tenant, it being intended that this Lease shall only become effective upon the execution of the Lease by Landlord and Tenant and delivery of a fully executed Lease to both parties. 16.20 RECORDATION OF LEASE: Either Landlord or Tenant may, at its election, record a Memorandum of Lease and each party shall cooperate with the other in connection therewith. 16.21 NO VIOLATION OF OTHER AGREEMENTS: Tenant hereby warrants and represents that neither its execution of or performance under this Lease shall cause Tenant to be in violation of any agreement, instrument, contract, law, rule or regulation by which Tenant is bound and, in addition to all other indemnity granted to Tenant in this Lease, Tenant agrees to indemnify Landlord against any loss, cost, damage or liability arising out of Tenant's breach of this Section 16.21. 16.22 PROJECT NAME CHANGE: Landlord reserves the right to change the name of the Project from time to time during the Term, except that so long as Tenant occupies no less than forty thousand (40,000) Rentable Square Footage in the Project, Landlord shall not change the name of the Project to (i) the name of another tenant which is not the owner of the Project, or (ii) the name of any retail securities brokerage company. 16.23 USE OF PROJECT NAME: Tenant shall not be allowed to use the name, picture or representation of the Project or words to that effect, in connection with any business carried on in the Premises or otherwise (except at Tenant's address) without the prior written consent of Landlord. 16.24 RESERVED AREA: Tenant hereby acknowledges and agrees that the exterior walls of the Premises and the area between the finished ceilings of the Premises and the slab of the floor of the Premises have not been demised by this Lease and the use thereof, together with the right to install, maintain, use, repair and replace pipes, ducts, conduits and wires leading through, over or above the Premises in locations which will not materially interfere with Tenant's use of the Premises and serving other parts of the Premises, are hereby excepted and reserved unto Landlord. Notwithstanding the foregoing, Tenant shall have the right, subject to Landlord's right of approval pursuant to Section 7.9 above, to make such Alterations as Tenant deems necessary or desirable to such areas above the finished ceilings and below the slab floor of the Premises. SECTION 17 SPECIAL PROVISIONS 17.1 MOVING ALLOWANCE: Landlord shall pay to Tenant within thirty (30) days after the Commencement Date and Tenant occupies the Premises a moving allowance of Forty Thousand Dollars ($40,000.00) for Tenant's moving costs ("Moving Allowance"), regardless of Tenant's actual moving costs. Tenant may offset any amount of the Moving Allowance not timely paid by Landlord against Tenant's monetary obligations under this Lease. 17.2 RIGHT OF FIRST NEGOTIATION: Landlord shall notify Tenant in writing whenever an Expansion Space (as defined below) becomes, or is expected to become, available ("Availability Notice"). Such notification shall include the rental rate and other terms and conditions upon which Landlord is willing to rent Expansion Space. Tenant shall have the right of first negotiation for such Expansion Space for a period of thirty (30) days after Tenant's receipt of the Availability Notice. Landlord shall negotiate in good faith with Tenant for the Expansion Space and if no agreement as to the terms of a proposed lease can be reached within thirty (30) days after Tenant's receipt of the Availability Notice, then Landlord may lease the Expansion Space during a one (1) year period thereafter (following which this right of first negotiation shall be reinstated) to another party on terms (including the terms included in the definition of Fair Market Rental Value) in the aggregate no less favorable to Landlord than Landlord's last offer to Tenant during such negotiations ("Landlord's Last Offer"). If during such one year period Landlord has received a bonafide offer to lease the Expansion Space which Landlord is prepared to accept and the aggregate terms of such lease are less favorable to Landlord than Landlord's Last Offer, then Landlord shall give notice to Tenant of such terms in writing and Tenant shall thereafter have a right of first refusal, exercisable during a ten (10) business day period following receipt of such notice, to lease such Expansion Space on the terms set forth in such notice. If not timely exercised by Tenant, such right of first refusal shall expire with respect to the particular 39 Expansion Space described in the notice. All rights of first negotiation and first refusal pursuant to this Section shall in any event terminate seven (7) years after the Commencement Date. For purposes of this Section, "Expansion Space" shall mean, during the first eighteen (18) months of the Term, any rentable space in the Adjacent Building which was previously leased and becomes vacant. Commencing in the nineteenth (19th) month of the Lease, Expansion Space shall mean any rentable space in the Adjacent Building. 17.3 SATELLITE DISH: Landlord shall provide Tenant with two hundred (200) square feet, in a location to be mutually agreed upon, on the roof of the Building or other mutually agreed location to accommodate Tenant's satellite dish requirements. The Tenant shall install the dish at its own expense, and shall be liable for any damage to the Building due to the installation of the satellite dish. The installation shall be subject to applicable CC&R's, the PID and governmental regulations. Landlord makes no representations regarding the installation of a satellite dish on the roof of the Building. At the end of the Term, the Tenant shall be responsible for removing the satellite dish from its location and repairing any damage caused by such installation or removal. There shall be no additional rent paid to the Landlord as a result of any satellite dish use and/or installation. 17.4 CONDITION OF TITLE. Landlord represents that the condition of title of the Real Property as of the date of this Lease is substantially the same as title on March 2, 1990 as set forth by the Policy of Title Insurance issued by First American Title Insurance Company, Order No. 1000371-20. 17.5 FLOOR LOADS. To Landlord's reasonable knowledge the floor loads for the Premises are: Dead Load 34 psf (reduceable) Live Load 100 psf (reduceable) Landlord shall provide Exhibit M to Tenant within ten (10) business days from the execution of this Lease. If the floor loads as set forth on Exhibit M are not equal to or greater than those set forth above, Tenant shall have two (2) business days after receipt of such Exhibit M to terminate the Lease by written notice to Landlord. If Tenant does not notify Landlord of the termination of the Lease within the stated time, the floor loads set forth in Exhibit M are deemed accepted. IN WITNESS WHEREOF, the parties hereto have executed this Lease as of the date first hereinabove set forth. Landlord: PACCOR PARTNERS, A CALIFORNIA GENERAL PARTNERSHIP By: PacCor Management Company Its general partner By: _________________________________ Its __________________________ Tenant: LINSCO/PRIVATE LEDGER CORP., A CALIFORNIA CORPORATION By:_______________________________________ Its _________________________________ 40 Exhibit A 1 page map of first floor 1 page map of second floor 1 page map of third floor Exhibit B 1 page map of site plan and Legal Description: Lot 5, of Pacific Corporate Center Unit no. 1, in the City of San Diego, County of San Diego, State of California, According to map Thereof no. 11126, Filed in the Office of the County Recorder of San Diego County, January 18, 1985 Exhibit "C" WORK LETTER This Work Letter is an exhibit to the Lease between Paccar Partners, a California general partnership ("Landlord') and Linsco/Private Ledger Corp., a California Corporation("Tenant") dated with regard to the following: 1. Condition of Premises and Building Delivered (by Landlord 1.1 Premises Shell and Stub-in. Landlord shall provide, at its expense and not as a charge against the Tenant Improvement Allowance, A finished shell for the f 'remises and Building, which shall include: (a) smooth concrete floors; (b) unfinished ceilings in the Premises; finished CORE area, including elevator(s), toilet room(s), electrical room, telephone room(s), janitorial closet(s) and exit stair(s); (d) dry wall (taped and/or finished, but not painted) around surfaces of core walls; (e) existing heating, ventilating and air conditioning service as set forth in Exhibit "F" to the Lease; (f) existing sprinkler service within the Building (not including main loops and branch distribution); (g) main electrical panel; (h) exercise room including existing exercise equipment, and (I) life safety systems as required by the applicable San Diego City Municipal Code for a building shell. 1.2 Building Standards. All improvements in the Building shall BE in accordance with Building/Tenant Improvement Standards for Pacific Corporate Park ("Building Standards") attached as Exhibit D of the Lease. If provisions of this Work Letter conflict with provisions of the Building Standards, the provisions of the Work Letter shall prevail. 1.3 Building Plans. Landlord has delivered to Tenant its best available shell building plans and information ("Building Plans"). 41 1.4 The Work. The installation and construction of the Tenant improvements by Tenant in accordance with the permitted and approved Construction Document. (defined in paragraph 2.4) and Change Orders (defined in paragraph 9) constitutes the work ("Worthy'). 2. Plans and Documents: 2.1 Preliminary Space Plan. Tenant shall provide to Landlord a preliminary schematic drawing depicting the Premises with walls, doors, windows, columns and structural elements, based on site visits, other information obtained by Tenant or Tenant's Representatives, and the best available Building Plans supplied by Landlord ("Preliminary Space Plan"), in accordance with toe schedule set forth in paragraph 6 of this Work Letter ("Schedule") for information only. 2.2 Final Space Plan: Tenant shall furnish to Landlord a final schematic drawing depicting the Premises with walls, doors, windows, columns and structural elements, based on site visits, other information obtained by Tenant or Tenant's Representatives, and the Building Plans ("Final Space Plan"), in accordance with the Schedule. Landlord shall review and approve, which approval shall not be unreasonably withheld, the Final Space Plan with reasonable written conditions, if any, within seven (7) business days of receipt of the Final Space Plan. 2.3 Design/Development Documents. Tenant shall schedule and hold a meeting to present and discuss the design/development plans ("Design Presentation") in accordance with the Schedule. Tenant shall notify Landlord in writing a minimum of two (2) business days prior to the Design Presentation. Landlord shall have the right but not the duty to attend the Design Presentation. If Landlord attends the Design Presentation, Landlord will use reasonable efforts to notify Tenant in writing as to any comments Landlord may have ith regard to the Design Presentation within five (5) business days. 2.4 Construction Documents. Tenant shall cause to be prepared and submitted to Landlord all documents required to obtain a building permit from the city of San DIEGO for the Work, including any corrections or changes requested by the City of San Diego ("Construction Documents"). The Construction Documents shall be consistent with the Final Space Plan, Design Presentation and the Building Standards. 2.4.1 50% Completion. Tenant shall submit the Construction Documents to Landlord when fifty percent (50%) completed in accordance with the Schedule. The Construction Documents are fifty percent (50%) complete when determined by Tenant's architect ("50% Completion"). Landlord shall notify Tenant in writing of Landlord's comments, if any, within seven (7) business days after receipt of the 50% Completion. 2.4.2 Complete Construction Documents. Tenant shall submit Construction Documents including the list of bid alternates, if any, to Landlord in accordance with the Schedule. The Landlord shall review and approve, which approval shall not be unreasonably withheld, the Construction Documents with reasonable conditions, if any, within ten (10) business days of receipt of the Construction Documents. Tenant shall comply with the Landlord's conditions, if any, by modifying the Construction Documents prior to the issuance of a building permit. 42 2.5 Design/Engineering Fees. Tenant shall re responsible for all space planning, design and engineering fees related to the production of Construction Documents in accordance with the Lease. 2.6 Landlord's Review of Plans and Documents. Landlord's review of plans, specifications and documents during design and construction of Work is selective for the benefit of Landlord only. A Building Standard, provision in the Amended Planned Industrial development Permit No. 85-0830 ("PID") or other similar document may only be amended, modified or waived as specifically set forth in writing by Landlord. Any provision of a PID and/or governmental requirement that is amended, modified or waived must be specifically approved by the appropriate government entity prior to final approval by the Landlord. 3. Cost Estimates. 3.1 Preliminary Cost Estimates. If Tenant attains preliminary cost estimates they shall be submitted to Landlord for Landlord's information within ten (10) day after receipt by Tenant. 3.2 Contractors. Tenant shall notify Landlord in writing of the general contractor to be retained for construction of the Work. 3.3 Engineers. Tenant shall notify Landlord in writing of consultants to be retained for design of the Work. 4. Building Permit. Tenant shall submit all Construction Documents required to obtain a Building Permit in accordance with the Schedule. Furthermore, Tenant and Tenant's General Contractor shall conduct all processing and coordination with the City of San Diego required for the issuance of a Building Permit for the Work. Landlord shall have no obligation regarding the issuance of a building permit except Landlord agrees to cooperate as required by the City of San Diego at no cost to Landlord. Tenant shall be responsible for obtaining any required subsequent approvals from the City of San Diego or other governmental entity. 5. CONSTRUCTION CONTRACTS. 5.1 Tenant shall prepare a bid package for distribution to the general contractor(s) and submit to Landlord for review. Landlord shall approve, which approval shall not be unreasonably withheld, the bid package with reasonable conditions, if any, within two (2) business days after receipt of the bid package. 5.2 Tenant shall prepare a contract for the work with the designated general contractor and submit to Landlord for review in accordance with the Schedule. Landlord shall HAVE five (5) business days to approve, which approval shall not be unreasonably withheld, of any objections to the construction contract. 5.3 Tenant shall execute a construction contract ("Construction Contract") with a licensed general contractor ("General Contractor'). Tenant shall deliver to Landlord a copy of the Construction Contract within seven (7) business days of execution and a copy of the construction schedule within seven (7) business days of receipt by Tenant. 43 6. SCHEDULE. Tenant and Landlord shall use reasonable efforts to comply with the Schedule.
SCHEDULE ACTION RESPONSIBIUTY DUE DATE ------ ------------- -------- a) Deliver to Landlord Preliminary Space Plan b) TENANT JUNE 23, 1993 Deliver to Landlord Final Space Plan c) Deliver to Landlord Construction Documents, Tenant August 23, 1993 submit Construction Documents to City of San Diego for permit d) Estimated issuance of building permits by City of Tenant November 8, 1993 San Diego Tenant January 3, 1994 e) Commence construction of Work
NOTE: The documents in the Schedule are deemed deli iered when received in good condition by the following which may be changed upon written notice: To Tenant's Representative: Sandra Clark c/o Space Matte s 5355 Mira Sarrento Place, Suite 100 San Diego, Calif. 92121 To Tenant's Interior Roy Jossy Designer. c/o Howard Sneed Interior Architecture 633 Kettner Boulevard San Diego, Calif. 92101 To Landlord's Representative: Mr. Gary Carter PacCor Management Company 11939 Rancho Bernardo Road, Suite.200 San Diego, Calif. 92128 7. ADMINISTRATION OF CONSTRUCTION. Tenant shall administer the construction of the Work in accordance with the Work LETTER and the Construction Contract. Tenant shall use its best effort to notify Landlord if all regularly scheduled construction meetings during the course of construction of the Work. Landlord shall have the right but not the obligation to attend all construction meetings. 8. Payment of Tenant Improvement Allowance. Landlord shall make monthly progress payments to the Tenant and the General Contractor of the Tenant Improvement Allowance pursuant to the following conditions and computations: 44 8.1 Landlord shal deliver to Tenant copies of Roel's approve monthly payment request("Payment Request"). 8.2 At such time as Landlord has expended the Tenant Improvement Allowance, Tenant shall reimburse landlord for the entire remaining balance of the cost of the Work or the amount due under the Construction Contract, whichever is greater. After the tenant Improvement Allowance has been expended, Tenant shall reimburse Landlord the amount of the Payment Request within fourteen days of receipt of the Payment Request by Tenant. 9.0 Change Orders 9.1 Any deviation from the Construction Contract during the construction of the Work shall be via a change order from the Tenant to the General Contractor except for minor changes that are made by the General Contractor which are within normal construction practices in the San Diego Area ("Change Order'). 9.2 The Tenant shall prepare and submit all change orders to the Landlord for approval. The Change Order shall include the change in the contract price and tlie number of days of delay, if any, in Substantial Completion. 9.3 Within one (1) business day after Landlord receives a Change Order, Landlord shall give Tenant notice of its approval or disapproval including the reason for disapproval. Tenant and Landlord agree to meet and confer within three (3) business days after receipt of the (change Order regarding any Change Order not approved. Tenant shall reimburse Landlord for outside consultants' fees for the review of a Change Order if (i) Landlord does not reasonably have the expertise among its employees to properly review a specific Change Order, and (ii) Tenant consents to the retaining of an outside consultant. 9.4 Landlord agrees not to unreasonably disapprove a Change Order. Both parties agree to use reasonable effort to process a Change Order expeditiously. When a Change Order has been signed by Landlord, General Contractor and Tenant, the contents thereof shall be binding on all parties. 10. Landlord Delay. A day of "Landlord Delay" shall mean each day, or any portion thereof, during which any of the following occur. 10.1 Landlord's failure to approve or disapprove e, in strict compliance with the requirements of this Work Letter and/or the Lease, any design, plan or specification.' submitted to Landlord by Tenant. 10.2 Interruption of elevator service, electrical service or water service due to Landlord negligence or intentional misconduct. 10.3 If after written notice Landlord fails to timely complete any other action which is the responsibility of Landlord under this Work Letter and/or the Lease, and such failure continues more than two (2) business days after Landlord could reasonably complete the action. Tenant shall notify Landlord in writing of the commencement of Landlord Delay and the basis of said Landlord Delay within ten (10) business days after Landlord Delay commences. If Tenant fails to so notify Landlord then that portion of the period of Landlord Delay occurring more than ten (1 0) days prior to notification to Landlord shall be deemed to have been waived by Tenant. 45 11. Unavoidable Delay. A day of "Unavoidable Delay" shall mean each day, or any portion thereof, during which occurs any delays or defaults due to: 11.1 War, insurrection, strikes, lock-outs, riots, floods, earthquakes, fires, casualties, acts of God, acts of public enemy, epidemics, quarantine restrictions, freight embargoes, lack of transportation, governmental restrictions, moratoriums, not caused Tenant; 11.2 Delay caused solely by any latent defect. of the Premises or any material inconsistency between the Premises as actually constructed and any plans and, specifications for the Premises provided to Tenant by Landlord (except to the extent such inconsistency could have been discovered by Tenant after reasonable inspection); and 11.3 Unusually severe weather. 11.4 Interruption of electric service or water service not caused by the negligence or intentional misconduct of Landlord, Tenant or Tenant's Representatives commencing one (1) business day after written notice to Landlord. 11.5 Interruption of both elevators not caused by the negligence or intentional misconduct of Landlord, Tenant or Tenant's Representatives negligence or willful misconduct commencing five (5) business days after written notice to Landlord. Tenant shall notify Landlord in writing of the commencement of Unavoidable Delay and the basis of said Unavoidable Delay within ten (10) business days after Unavoidable Delay commences. If Tenant fails to so notify Landlord then that portion of the period of Unavoidable delay occurring more than ten (10) days prior to notification to Landlord shall be deemed to have been waived. If the Work is commenced on or before January 3, 1994, then all Unavoidable Delay as of January 3, 1994 shall be deemed to have been waived. 12. Specific Landlord Concerns re Construction Documents and Change Orders. 12.1 Landlord has identified below certain areas of intense concern which are most likely to generate condition(s) to acceptance by Landlord during Landlord's review of Construction Documents and Change Orders, and therefore may result in a disapproval or the necessity to retain outside consultants. 12.1.1 Any aspects of the Work that may endanger the structural integrity of the Premises, the Building and/or the Project; 12.1.2 Any aspects of the Work altering l the Project utility services or utilities serving Landlord's other tenants; 12.1.3 Any aspect of the Work which is a material deviation from the Building Standards; 12.1.4 Any aspects of the Work which violate the conditions of the PID, any State or municipal code or public agency ordinance, or regulation and the applicable Declaration of Conditions, Covenants & Restrictions ("CC&R's"). 12.1.5 Any aspects of the Work to the premises which will be isually unattractive from the 46 2.1.6 Penetration or modification of the Building roof or shell. 12.1.7 eduction in the number of parking stalls in the Project. 12.1.8 Increase in rentable areas which may cause a reduction in buildable area available to Landlord with respect to future expansion of the Project. 13. Special Improvements. Landlord understands that included within Work may be special Tenant improvements to the Premises including computer facilities, auditoriums, cafeterias, dining rooms, internal stairwells, one stairwell outside of the Building and other special facilities incidental to Tenant's operations (collectively the "Special Improvements"). All such Special Improvements shall be subject to Landlord's approval, not to be unreasonably withheld. Tenant shall not be required to remove any Work completed prior to the occupancy of the Premises by Tenant. 14. Tenant's Visit to Premises. 14.1 Upon execution of the Lease Tenant shall have access to the Premises for the purpose of constructing the Work seven (7) days a week, twenty-four (24) hours a day, subject to all applicable codes, ordinances, law and governmental restrictions, except that Tenant shall not interrupt or interfere with the activities of Landlord or other tenants of the Project. 14.2 Tenant hereby indemnifies and agrees to hold Landlord, Landlord's Representatives and the Project free and harmless of any and all costs, claims, damages, liens, losses and expenses of any kind or nature, arising out of or resulting from such entry and/or activity upon the Project, Building or Premises by Tenant and Tenant's Representatives, except to the extent caused by Landlord's negligence or intentional misconduct. 14.3 All of Tenant's decorations brought upon or installed in the Premises before the delivery of possession shall be at Tenant's risk, and neither Landlord nor Landlord's Representatives shall be responsible for any damage, losses or destruction thereof, except for Landlord's willful misconduct. All Tenant's installations shall conform with all applicable governmental regulations and codes. 15. Bonds/Guarantee. Tenant may at its election require the contractors to provide for the benefit of Tenant and Landlord from a company acceptable to Tenant and Landlord a performance and completion bond to assure the completion of the Work and the payment of all labor and material costs. For all Work not bonded as set forth in the previous sentence Tenant guarantees completion if all Work in a lien-free manner, except to the extent caused by Landlord's negligence or wrongful failure to eke any payments required to be made by Landlord pursuant to the Lease or this Work Letter. 16. Insurance. 16.1 Tenant's contractors, vendors or any ether party performing work for Tenant (collectively "Tenant's Contractors") shall maintain in effect all times during the full term of any work, insurance coverage's with limits not less than those set forth below, issued by insurers licensed in California and acceptable to Landlord (rated B or better by the most recent edition of Best Key Rating Guide) in policies satisfactory to Landlord and provide evidence thereof, as follows: 47 16.1.1 Worker's Compensation Insurance in accordance with applicable California law and Employer's Liability Insurance, not less than $100,000/500,000/100,000. 16.1.2 Comprehensive Genera/ Liability Insurance, in "occurrence form", including without limitation coverage for bodily injury, property damage, personal injury (employee and contractual liability exclusion deleted), products and completed operation, blanket contractual l' bility, owner's protective liability, and broad form property d-mage, and cross liability and severability of interest clauses, with the following limits of liability, One Million Dollars ($1,000,000.00) each occurrence combined single limit with a not to exceed Teri Thousand Dollars ($10,000.00) deductible and such insurance shall be primary and not contributor to other available insurance. 16.1.3 Comprehensive Automobile Liability Insurance covering all owned, hired and non-owned vehicles in combined single limit not less than $1,000,000.00. Tenant's Contractors shall require all other consultants, subcontractors and suppliers performing work on the Project to comply with the requirements hereof. 16.2 Tenant and Tenant's Contractors shall require its insurance representative(s) to furnish to Landlord, prior to start of any work, A Certificate of Insurance, to include: 16.2.1. Description of Operations to state "All Operations of Named Insured" or "job title"; 16.2.2. Cancellation notice shall state that the issuing company will mail A thirty (30) day written notice. Please delete the words "endeavor to" and "but failure to mail..." in the cancellation paragraph of the certificate. 16.2.3. Certificate holder to be: PacCor Partners c/o PacCor Management Comp any 11939 Rancho Bernardo Road, Suite 200 San Diego. California 92128 Attn: Marlene Booth 16.3. Additional insured endorsement naming Landlord, its partners, agents and representatives, together with the officers, directors, shareholders and employees of each of them as additional insured parties with respect to Paragraphs 16,1.2 and 16.1.3. 17. Utility Services Prior TO Commencement Date. Landlord shall provide at no cost to Tenant elevator service, electrical service and water service prior to Substantial Completion required to complete the Work. 18. Landlord's Review. No fee, charge, out-of-pocket costs, general conditions, overhead or profit shall be chargeable by Landlord to Tenant in connection with Landlord's review or approval of recommendations with respect to, or inspections of, 48 Tenant's plans or the construction of and installation of Tenant's Work, except as provided in Paragraph 9.3 above. 19. Permits and Inspections. Tenant shall comply with all rules and procedures regarding inspections by all appropriate governmental agencies and shall not occupy any portion of the Premises unless and until occupancy is authorized by the City of San Diego. 20. Arbitration of Disputes: If Landlord disapproves any designs, plans and specifications submitted by Tenant pursuant to this Work Letter, Tenant shall as soon thereafter as reasonably possible, submit for Landlord's approval revised designs, plans and specifications. Within three (3) business days after Landlord's receipt of such revised designs, plans and specifications, Landlord shall notify Tenant of Landlord's approval or disapproval of such revisions. If Landlord disapproves such revised designs, plans and specifications, then Tenant may, at its election, notify Landlord in writing of the submission of tlute dispute to arbitration pursuant to this paragraph. Such arbitration shall be settled by binding arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association (the "AAA"). In administering the arbitration, the AAA shall follow the following Procedure: (a) the arbitrator shall be , unless such person is unavailable or is unable to comply with the time constraints set forth in this paragraph, in which case the arbitrator shall be unless such person s unavailable or is unable to comply with the time constraints set forth in this section, in which case the arbitrator shall be _________; (b) the arbitrator shall immediately schedule an arbitration hearing for a date not later than seven m business days after his or her appointment; (c) any filing, including without limitation any answer, required to be made by either party in connection with such arbitration shall be made within three (3) business days after notice from the AAA or the arbitrator, (4) Landlord and Tenant shall respond within two (2) business days to any requests for information from the arbitrator, (e) the arbitrator shall issue his or her decision no more than three (3) business days after the hearing; and (f) the arbitrator's authority to render a decision shall be limited to the resolution of design and construction related disputes and the determination of whether any delay in the construction of the work constituted Landlord delay or unavoidable delay as specifically defined in paragraph 10 and 11 of the Work Letter. Each party shall bear its own costs and expenses relating to any such resolution. The cost of the arbitrator and the fees of the AAA, if any, shall be borne equally by Landlord and Tenant. Within twenty (20) days after execution of the Lease, Landlord and Tenant shall agree on the arbitrators whose names are to be inserted into the blanks set forth above. 21. Defined Terms. All defined terms (capitalized words) shall have same meaning as in the Lease. "Business days" shall mean Monday through Friday, excluding all federal and state holidays. ACCEPTED AND APPROVED: PACCOR PARTNERS By: PACCOR MANAGEMENT COMPANY A general partner BY: ---------------------------------------------------------- ITS: ------------------------------------------------------- LINSCOIPRIVATE LEDGE By: --------------------------------------------- 49 Its: ------------------------------------------- Exhibit D: BUILDING/TENANT IMPROVEMENT STANDARDS FOR PACIFIC: CORPORATE PARK These Building/Tenant Improvement Standards consists of the following Sections: GENERAL LANDLORD'S RESPONSIBILITIES TENANT'S Responsibilities IMPROVEMENTS PROVIDED BY TENANT DESIGN CRITERIA A. Architectural Criteria B. Interior Improvement Criteria C. Signage Criteria D. Electrical Criteria E. Plumbing Criteria F. Mechanical Criteria G. Sprinkler Criteria CONSTRUCTION REGULATIONS TENANT'S CONSTRUCTION DOCUMENT SUBMITTAL TENANT IMPROVEMENT STANDARD SPECIFICATIONS EXHIBIT D All defined terms in this Exhibit D shall have the same meaning as in the Lease. I. GENERAL A. Pacific Corporate Park is designed to be a highly successful office building center. It is expected that tenant improvements and signage may represent a variety of design styles. PacCor Partners ("Landlord") intends to provide Tenant with reasonable latitude with this aspect of design. At the same time, Landlord will discourage tenant it improvements and signage design that would conflict significantly with the general design of these buildings. These matters are more fully addressed in section Vl of these Building/Tenant Improvement Standards For Pacific Corporate Park ("Building Standards"). In providing the Building Standards, it is Landlord's intent to simplify the effort of Tenant in securing Landlord's approval of tenant improvements and/or alterations to be constructed by Tenant through a clear understanding of the responsibility of each party. The Building Standards are intended to aid Tenant in designing its improvements. In the event of any conflict between the Building Standards and the Office Lease (the "Lease"), the provisions of the Lease will govern. II. LANDLORD'S RESPONSIBILITIES A. Responsibilities of Landlord are as follows: 1. Make available to Tenant and Tenant's Representatives a person designated by the Landlord to be responsible for providing information, review of Tenant's drawings, to have final approval authority for all submittals, and to resolve disputes between tenants. 50 2. Meet with Tenant and Tenant's Representatives in a preliminary meeting to clarify details of Tenant's tenant improvement process. 3, 4, Intentionally Left Blank 5, 6, & 7 III. TENANT'S RESPONSIBILITIES A. Intentionally Left Blank B. Intentionally Left Blank C. Intentionally Left Blank D Intentionally Left Blank E. Intentionally Left Blank F. Intentionally Left Blank G. Intentionally Left Blank H. Intentionally Left Blank I. Tenant shall ensure the cooperation of Tenant's Representatives with Landlord and Landlord's agents and other Tenants and their agents while at Pacific Corporate Park. J. Intentionally Left Blank K. Intentionally Left Blank L. Intentionally Left Blank M. Intentionally Left Blank N. Intentionally Left Blank O. Tenant and Tenant's Contractors shall be responsible for the security of the Premises during the period of construction, including re-keying, if required, of Tenant's doors after completion of construction. Landlord shall have no liability for any loss or damage, including theft of building materials, equipment or supplies. P. Tenant shall, within ten (10) working days after the completion of Tenant's Work, execute and file of record, or cause to be filed of record, a notice of completion with respect thereto in a form complying with the applicable provisions of the California Civil Code specifying the names of Tenant's Contractor and the location of the work done. Tenant shall furnish to Landlord a conformed copy thereof after recordation. Q. Tenant shall ensure that Tenant's Contractors exercise caution in matters relating to public safety and to prevent damage to the Common Areas and other leased areas. Tenant shall be responsible for any damage or liability occurring by reason of the acts or omissions of Tenant's Contractors. R. Tenant shall require that Tenant's Contractors and other Representatives cause all supplies, materials, equipment, or trash being delivered to or removed from the Premises across the Common Areas or within the elevators, which requires the use of dollies or hand trucks, to be transported on dollies or hand trucks with soft rubber tires. IV. Intentionally Left Blank V. IMPROVEMENTS PROVIDED BY TENANT A. All items of construction other than described in Section IV shall be performed diligently by Tenant, at Tenant's expense, in a workmanlike manner and in accordance with Tenant's Construction Documents. Tenant's Work will include, but not be limited to, the installation and performance of the following: 51 1. Any modifications, approved in writing by Landlord, to the interior of the Premises as shown Tenant's plans. 2. Drywall and taping of the interior side of walls demising the Premises and the interior side of exterior walls of the Premises. 3. Partitions and walls within the Premises. 4. All ceilings. 5. All interior painting, wallpaper and other finishes. 6. All floor coverings and floor finishes, preparations of surfaces to receive same, special reinforcing and floating of any irregularities or depressions in the concrete floor. 7. Office fixtures and furnishings. 8. Stairways and elevators within the Premises, dumb waiters, chutes, conveyers, pneumatic tubes and their shafts, doors and other components, including required electrical hookups for such equipment and the cost of any engineering and structural changes resulting from penetrations of the slab. 9. Signs and related attachments. The method of attachment including structural calculations, if required, shall be provided to Landlord prior to construction of any such appendages. 10. Electrical work and equipment, including wiring from the meter room to the Premises in conduit provided by Tenant, required transformers, and lighting and time clocks. Electrical requirements are more particularly described in Section Vl. 11. Telephone service and equipment, telephone conduit, cabinets, and outlets within the Premises, including wiring conduit from the terminal board provided by Landlord to the Premises. 12. Internal communications, security, fire and smoke detection, and alarm systems. 13. Any plumbing fixtures and accessories, toilets, water heaters, water treatment systems and drinking fountains, together with plumbing thereto, connected to services stubbed to the Premises as shown in Landlord's plans. Plumbing requirements are more particularly described in Section Vl. 14. All heating, cooling, ventilating equipment, ducting, condensate lines, and hookups within the Premises. Mechanical requirements are more particularly described in Section Vl. 15. All additions and modifications to, and relocation of, the fire sprinkler system installed by Landlord pursuant to Landlord's plans. Sprinkler requirements are more particularly described in Section Vl. 16. Any engineering costs incurred by Landlord for review of structural changes proposed by Tenant shall be paid according to the Lease arid Work Letter. Tenant shall not notch, core, cut or otherwise modify the structure of the Building without Landlord's written approval. VI. DESIGN CRITERIA A. Architectural Criteria: 1. Tenant's Work must be designed and constructed by Tenant's architect and Tenant's Contractors to meet all applicable City, County, State and other governmental ordinances, rules, regulations and codes, and be constructed to the highest standards of quality consistent with the Common Areas of the Premises. Landlord's approval of Tenant's Construction Documents shall not be deemed a certification by Landlord or Landlord's Representatives that Tenant's Construction Documents comply with building codes or other governmental requirements 2. Tenant shall retain, at Tenant's expense. Tenant's architect, along with other consultants for the design of Tenant's Construction Documents. Tenant's Construction 52 Documents shall include interior design, signage, electrical, plumbing, mechanical, and sprinkler systems. The design firm of Harvard-Sneed Interior Architecture ("Tenant's Architect") is approved by Landlord. 3. Tenant's Architect will be provided with a copy of those portions of Landlord's plans reasonably required to complete the Construction Documents. Tenant's Architect shall be responsible for verifying Building drawings and specifications for the Premises delivered to Tenant by Landlord. B. Interior Improvement Criteria: 1. Landlord shall provide a building shell in accordance with Landlord's plans. Construction shall generally be type V, 1 hr. rated (sprinklered in lieu of 1 hr. protection) for B2 occupancies. All structural columns and beams within the Premise are exposed and will not be protected. 2. Tenant shall install at least 2 1/2' X 25 GA (min.) metal studs @ 16" o.c. w/5/8", type X drywall each side, continuous from floor slab to the structure above on Tenant's side of each demising wall. Drywall will be fire-taped, spackled, and sealed air tight in order to achieve a one (1) hour rating of the demising wall. Demising walls between Tenant spaces must be finished with orange peel medium wall texture, R.11 batt insulation in cavities and 1 hr. rated w/STC.50. 3. Tenant shall not penetrate the drywall which encloses any fire corridor or exit stairwell without the prior written approval of Landlord. Any penetrations shall maintain the fire rating of the corridor or stairwell. 4. Tenant's Architect shall indicate on Tenant's Construction Documents, referencing Building grid lines and the structural supporting members, the precise location, size, and weight of all safes, Tri-Water System equipment, and other heavy fixtures or equipment. Any required structural changes to accommodate such equipment or loading, including slab, other structural penetration, or the reinforcing of the Building structure, must have the prior review and approval of the Landlord, Landlord's designer and/or Landlord's structural engineer, with the cost of such review to be paid according to the Lease and Work Letter. 5. The studs provided by Landlord for demising walls or corridors are not designed to accommodate cantilevered or eccentric loads. For such loads, Tenant shall reinforce the wall as required by inserting additional studs or by other appropriate means. Tenant's Construction Documents shall include details of any such reinforcement. 6. Any interior stairwells and/or elevators shall require the prior review and approval of Landlord, Landlord's designer and/or structural engineer. Tenant shall contract directly with Landlord's consultant for such review, with all costs paid as set forth in the Lease and the Work Letter. 7. If Tenant's Construction Documents include Tri-Water System ducts which penetrate through any floor level, such ducts must be enclosed in properly rated shafts and incorporate appropriate fire-dampers. 8. Any roof top penetrations will be sealed by Landlord's roofing contractor. Tenant shall contract directly with Landlord's roofing contractor for such work and pay the reasonable cost of same. 9. Interior finishes within the Premises will be appropriate for the type and quality of Tenant's operation. 10. Tenant shall install proprietary materials, products or assemblies denoted by an asterisk (*) in section IX of the Building Standards. C. Signage Criteria: 1. Tenant shall provide submittals or shop drawings of Tenant's proposed exterior signage for Landlord's review and approval, subject to the Lease and Exhibit L. Tenant shall not proceed with the fabrication or installation of signage without the prior written approval by Landlord of Tenant's final sign plans, which approval shall not be unreasonably withheld. 53 D. Electrical Criteria 1. Prior to the preparation of Tenant's electrical plans and specifications for the Premises, Tenant's electrical engineer shall thoroughly familiarize himself with these Building Standards, Landlord's plans, applicable local building codes, and existing job conditions. Tenant's electrical plans shall be prepared in full knowledge of and in compliance with these Building Standards, and all City, County, State and other governmental ordinances, rules, regulations, and codes relating thereto including, without limitation, the Energy Conservation Requirements of Title 24 of the California Administrative Codes (Title 24"). Tenant's electrical engineer shall be licensed in the State of California and qualified to prepare Tenant's electrical plans. Electrical plans prepared by other than a duly licensed electrical engineer will not be accepted by Landlord for review. 2. Tenant's electrical engineer shall verify that the electrical service available to the Premises is adequate to satisfy Tenant's requirements. 3. All Tenant's Work must be designed in order to comply with Title 24, and include the required signed statement of Title 24 design compliance written on Tenant's electrical plans. 4. Landlord shall provide facilities for the delivery of 120/208 volt 3 phase power from a central distribution point located within the main electric room designated on Landlord's plans (the "Electric Room"). 5. Tenant shall extend service by feeder wires and conduits provided by Tenant to Tenant's Premises from the main electrical switch located in the Electric Room. 6. Except for that portion of electrical work installed by Landlord as set forth in the Work Letter, Tenant shall install all electrical work necessary for the electrical distribution system within the Premises including, without limitation, the main electric disconnect switch, transformers, electrical panels, other disconnect switches, conduit, wire, light fixtures, controls, timers and time clocks, smoke detectors, alarms, and security systems. Tenant, at its expense, shall arrange and pay for electrical service and meters provided by the local electric utility company. 7. Tenant's electrical contractor must provide temporary facilities from Tenant's panel and make application for electrical service to the local utility company for construction power. This should be the first Item accomplished within the Premises by Tenant. Landlord shall pay for utilities as provided in the Lease and Work Letter 8. Transformers shall be floor supported and not suspended from the structure. Noise level should be a maximum of 50 dB average, measured a distance of one (1) foot from the case. 9. Tenant shall connect Tenant's telephone and communications service by feeder wires and conduit as D. required to access Tenant's telephone backboard within the Premises. 10. Tenant's electrical plans shall be submitted to Landlord as a part of the Tenant's Construction Documents Submittal (Section VIII below). Tenant's electrical plans shall include the following: a. Electrical floor plan at 1/8' scale or larger. b. Reflected ceiling plan showing all elements of the proposed design including lighting at 1/8" scale or larger. c. Electrical riser diagram which shall include, without limitation, the size of the main service switch, fuse size at main service switch, and wire size and type from main service switch. d. Electrical panel schedule, including circuit breaker sizes and all connected loads. e. Lighting fixture schedule which shall include type of lamps, mounting, wattages, quantities, and manufacturer's catalog number. Submittals shall also include catalog cuts of all light fixtures proposed for use by Tenant. 54 f. Interior elevations and details sufficient for review of Tenant's electrical system. g. Tri-Water System control diagrams and schematics, as required by the Mechanical Criteria (Section VI.F below). h. Electrical load summary which shall include all connected and demand load calculations. i. Equipment and material specifications. j. Completed Form 5" and "Form 7" with required calculations as required by Title 24. 11. Landlord shall review Tenant's electrical plans in accordance with the Tenant's Construction Documents Submittal for conformance with the provisions hereof. Where Tenant's electrical plans conflict with these Building Standards, the provisions of these Building Standards shall prevail. Landlord's approval shall not be deemed to certify that Tenant's electrical plans comply with building codes or other governmental requirements and shall not relieve Tenant and Tenant's Representatives of the responsibility to verify all job conditions including, without limitation, dimensions, locations and clearances. Tenant is responsible to obtain all necessary permits for the installation of Tenant's temporary power and other electrical work. 12. Landlord shall notify Tenant in writing whether Tenant's electrical plans are approved or rejected by Landlord for specified deficiencies. Tenant's electrical engineer shall make all corrections to bring Tenant's electrical plans into compliance and resubmit in accordance with the requirements of the Tenant's Construction Documents Submittal. E. Plumbing Criteria: 1. Prior to the preparation of Tenant's plumbing plans and specifications for the Premises, Tenants plumbing engineer shall thoroughly familiarize himself with these Building Standards, Landlord's plans, all applicable local building codes, and existing job conditions. Tenant's plumbing plans shall be prepared in full knowledge of and in compliance with these Building Standards, and all City, County, State and other governmental ordinances, rules, regulations and codes relating thereto including, without limitation, requirements of Title 24. Tenant's plumbing engineer shall be licensed in the State of California and qualified to prepare Tenant's plumbing plans. Plumbing plans prepared by other than a duly licensed plumbing engineer will not be accepted by Landlord for review. 2. Landlord shall provide piping laterals for domestic waste, sewer and venting stubbed to locations at each floor, or below the Premises in the case of sewer service, in sizes shown on Landlord's plans. 3. Tenant's plumbing engineer shall verify that the plumbing and related services available to the Premises are adequate to satisfy Tenant's requirements. 4. Tenant shall connect to and extend all piping as may be necessary for Tenant's Work from the stub-ins provided by Landlord. 5. Tenant may provide equipment for the heating of domestic water. Water heaters may either by electric or an instant heat variety. Electric hot water heaters shall sit in metal drain pans connected to an overflow drain source arid have a pressure temperature relief valve discharging into a code approved point of disposal. All hot water heaters must conform with Title 24. 6. Plumbing fixtures and fittings shall be of commercial quality. 7. Tenant shall ensure that all slab penetrations within the Premises are property sealed and remain water-tight to prevent possible damage from leakage. Tenant shall exercise caution during all core drilling activities to prevent damage caused by leakage and falling debris. Any damage resulting from core drilling by Tenant's Contractors shall be at the sole risk and expense of the Tenant. 55 8. Tenant's plumbing subcontractor shall flush and chlorinate all domestic water piping within the Premises and provide a copy of the Test Certification before connecting to Landlord's domestic water system. 9. Tenant's plumbing plans shall be submitted to Landlord as a part of the Tenant's Construction Documents Submittal. Tenant's plumbing plans shall include the following: a. Floor plan at 1/8" scale or larger that shows all fixtures and piping and all connections to Landlord's utility systems. b. Schematic diagram of winter service. c. Schematic diagram of sanitary service. d. Schematic diagram of condensate and water heater relief valve and drip pan drains. e. Schematic diagram of gas service, if applicable. f. Details of floor drains, clean-outs, fixtures and other plumbing sufficient for construction of Tenant's Work. g. Material and fixture specifications. 10. Landlord shall review Tenant's plumbing plans in accordance with the Tenant's Construction Documents Submittal for conformance with the provisions hereof. Where Tenant's plumbing plans conflict with these Building Standards, the provisions of these Building Standards shall prevail. Landlord's approval shall not be deemed to certify that Tenant's plumbing plans comply with building codes or other governmental requirements and shall not relieve Tenant and Tenant's Representatives of the responsibility to verify all job conditions including, without limitation, dimensions, locations and clearances. Tenant is responsible to obtain all necessary permits for the installation of Tenant's plumbing work. 11. Tenant's Contractors shall pressure test any piping systems prior to connection to the system installed by Landlord for the Building. 12. Landlord shall notify Tenant in wring whether Tenant's plumbing plans are approved or rejected by Landlord for specified deficiencies. Tenant's plumbing engineer shall make all corrections to bring Tenant's plumbing plans into compliance and resubmit in accordance with the requirements of the Tenant's Construction Documents Submittal. F. Mechanical Criteria: 1. Prior to the preparation of Tenant's mechanical plans and specifications for the Premises, Tenant's mechanical engineer shall thoroughly familiarize himself with these Building Standards, Landlord's plans, all applicable local building codes, and existing job conditions. Tenant's mechanical plans shall be prepared in full knowledge of and in compliance with these Building Standards, and all City, County, State and other governmental ordinances, rules, regulations and codes relating thereto including, without limitation, requirements of Title 24. Tenant's mechanical engineer shall be licensed in the State of California and qualified to prepare Tenant's mechanical plans. Mechanical plans prepared by other than a duly licensed mechanical engineer will not be accepted by Landlord for review. 2. Landlord will provide a two pipe water loop system for connection to the Tenant's water source heat pump(s). Tenant's mechanical engineer will design the Tri-Water System for the Premises based upon the system installed by Landlord for the Building. Tenant may install an auxiliary system as set forth in the Lease and Work Letter. 3. Tenant's mechanical engineer shall verify that the mechanical services available to the Premises are adequate to satisfy Tenant's requirements. Tenant may install an auxiliary system as set forth in the Lease and Work Letter. 4. Tenant shall not install any mechanical equipment which does not have a recognized service vendor in the Sari Diego area capable of rendering service and repair upon a four (4) hour notice during working hairs. 56 5. All of Tenant's Tri-Water Systems shall be located within Tenant's Premises except an auxiliary system may be installed on the roof, subject to Landlord's approval. Tenant's Tri-Water System equipment, when supported from above, must be supported from the structural steel of the floor or roof above, with appropriate acoustical attenuation, rather than the deck. Support locations and methods shall be subject to the review of the Landlord's structural engineer. 6. Tenant's Tri-Water System must be connected to Tenant's smoke detector in order to shut down the Tri-Water System upon an appropriate signal from the smoke detectors, if required by code. 7. Sheet metal duct work shall meet the thickness and installation standards of SMACNA and should have smooth interiors with all seams, braces, stiffeners, and hangers on the outside of the duct work. Seismic bracing is to be provided per code and SMACNA standards. Flexible duct connectors should be double neoprene coated, 30 oz. glass fabric flexible connectors and should be properly connected to 24 gauge metal fitted on the duct connections at fan or at inlets and outlets. Dampers should be manually operated, opposed blade, and constructed of 24 gauge steel with locking quadrants. 8. Condensate drain piping not exceeding 3/4" in diameter may be piped into the tail piece of Tenant's toilet room lavatory. Piping of any larger. diameter shall be connected directly into the sewer system by method approved by Landlord or Landlord's architect. Copper condensate lines should be insulated to avoid line sweating. 9. Access through Tenant's ceiling for service and inspection of the mechanical equipment must be provided. Access may be through factory access panels or removable ceiling tiles. 10. Tenant's mechanical plans shall be submitted to Landlord as a part of the Tenant's Construction Documents Submittal. Tenant's mechanical plans shall include the following: a. Air distribution duct work at 1/8" scale or larger. b. Equipment schedule with specification. c. Water piping showing valves and connection points. d. Control wiring, including connections to work provided Landlord. e. All connection details. f. Three (3) copies of Tenant's Tri-Water System design calculations. g. Three (3) copies of the necessary calculations and "Form 4" and "Form 6" as required by Title 24. 11. Landlord shall review Tenant's mechanical plans in accordance with the Tenant's Construction Documents Submittal for conformance with the provisions hereof. Where Tenant's mechanical plans conflict with these Building Standards, the provisions of these Building Standards shall prevail. Landlord's approval shall not be deemed to certify that Tenant's mechanical plans comply with building codes or other governmental requirements and shall not relieve Tenant and Tenant's Representatives of the responsibility to verify all job conditions including, without limitation, dimensions, locations and clearances. Tenant is responsible to obtain all necessary permits for the installation of Tenant's mechanical work. 12. Landlord shall notify Tenant in writing whether Tenant's mechanical plans are approved or rejected by Landlord for specified deficiencies. Tenant's mechanical engineer shall make all corrections to bring Tenant's mechanical plans into compliance and resubmit in accordance with the requirements of the Tenant's Construction Documents Submittal. Sprinkler Criteria 57 1. Prior to the preparation of Tenant's sprinkler plans and specifications for the Premises, Tenant's sprinkler designer shall thoroughly familiarize himself with these Building Standards, Landlord's plans, all applicable local building codes, and existing job conditions. Tenant's sprinkler plans shall be prepared in full knowledge of and in compliance with these Building Standards, and all City, County, State and other governmental ordinances, rules, regulations and codes relating thereto. Tenant's sprinkler designer shall be licensed in the State of California and qualified to prepare Tenant's sprinkler plans. Sprinkler plans prepared by other than a duly licensed sprinkler designer will not be accepted by Landlord for review. 2. Tenant's sprinkler designer shall verify that the sprinkler system available to the Premises is adequate to satisfy Tenant's requirements. 3. Tenant's sprinkler plans and the system installed by Tenant's Contractors shall be acceptable to the Fire Marshall and the Fire Insurance Underwriters having jurisdiction in the City of San Diego. 4. Landlord will provide a shell sprinkler system with laterals in the Premises as set forth in Landlord's plans. 5. All sprinkler fire protection systems installed by Tenant's Contractors shall be listed as approved by the Underwriters' Laboratories, Inc., or approved by other appropriate nationally recognized testing laboratories, and of the latest design of the manufacturer. 6. All sprinkler heads are to be semi-recessed, chrome finish. 7. All sprinkler piping installed by Tenant's Contractors shall be free of rust. 8. Landlord shall review Tenant's sprinkler plans in accordance with the Tenant's Construction Documents Submittal for conformance with the provisions hereof. Where Tenant's sprinkler plans conflict with these Building Standards, the provisions of these Building Standards shall prevail. Landlord's approval shall not be deemed to certify that Tenant's sprinkler plans comply with building codes or other governmental requirements and shall not relieve Tenant and Tenant's Representatives of the responsibility to verify all job conditions including, without limitation, dimensions, locations and clearances. Tenant is responsible to obtain all necessary permits for the installation of Tenant's sprinkler work. 9. Landlord shall notify Tenant in writing whether Tenant's sprinkler plans are approved or rejected by Landlord for specified deficiencies. Tenant's sprinkler designer shall make all corrections to bring Tenant's sprinkler plans into compliance and resubmit in accordance with the requirements of the Tenant's Construction Documents Submittal. 10. In constructing or repairing the fire sprinkler system for the Premises, Tenant shall coordinate with Landlord when testing or draining the system for modifications. Tenant's Contractors shall be responsible to make any adjustments as required to secure all necessary approvals. VII. CONSTRUCTION REGULATIONS A. Tenant shall provide Landlord with copies of Tenant's construction contracts prior to the commencement of Tenant's Work. Landlord's review of Tenant's contracts in no way implies Landlord's approval of such contracts, Tenant's Construction Documents, or that the contracts properly reflect the requirements of these Building Standards. B. Tenant's Contractors shall construct Tenant's Work in accordance with Tenant's Construction Documents which have been approved by Landlord and must comply with all City, County, State and governmental ordinances, rule, regulations and codes relating thereto. If the Premises have not been constructed in accordance with approved Tenant's Construction Documents, Landlord may refuse to permit Tenant to open the Premises for business until the Premises do so comply, but Tenant shall not be excused from the performance of all other obligations of Tenant under the Lease. C. Tenant's Contractors shall construct the Premises in accordance with Tenant's Construction Documents as soon as practically possible, at Tenant's expense. Tenant and Tenant's Contractors agree to pursue Tenant's Work diligently to completion. 58 D. All work performed by Tenant or Tenant's Contractors shall be performed in a manner so as to avoid any labor dispute which results or could result in a stoppage or impairment of work, deliveries, or any other services in the Project. If there shall be any such stoppage or impairment or threat thereof as a result of any such labor dispute, Tenant shall immediately undertake such action as may be necessary to eliminate such dispute or potential dispute, including any of the following: 1. Remove all disputants from the job site until such time as the labor dispute no longer exists; 2. Seek an injunction in the event of a breach of contract between Tenant and Tenant's Contractors; and 3. File appropriate unfair labor practice charges in the event of a union jurisdictional dispute. E. Prior to the commencement of construction, Tenant's Contractors shall thoroughly familiarize themselves with all job conditions and the requirements outlined in these Building Standards. F. Upon approval of Tenant's Construction Documents and permit application for the Premises by the applicable governmental agency, Tenant or Tenant's Contractors shall promptly pick up the building permit from said agency. Tenant will pay for the plan check and building permit fees required on the permit application and any other fees required in connection therewith. If required, Tenant shall apply for and obtain all approvals and permits from the County of San Diego Health Department and any other governmental agencies. Tenant shall provide Landlord a copy of Tenant's building permit and the Building Department approved set of Tenant's Construction Documents prior to first inspection. G. Prior to entering the Project or starting construction, Tenant's Contractor must provide Landlord with the following: 1. Intentionally Left Blank 1. A complete list with phone numbers of key personnel of Tenant's Contractors. 2. A certificate of insurance evidencing the required insurance coverage. 3. A construction schedule showing the work schedule, critical path activities, and anticipated completion of Tenant's Work, which schedule shall be subject to Landlord's approval. 4. A copy of acknowledgments executed by Tenant's Contractors of an understanding or an agreement to comply with the requirements of these Building Standards. 5. Intentionally Left Blank 6. Intentionally Left Blank H. Tenant Contractors shall not deviate from approved Tenant's Construction Documents without obtaining prior written permission from Tenant, Landlord, the City Building Department, and other governmental agencies having jurisdiction to approve same. I. Tenant's Work shall be performed in a thorough, first class, and workmanlike manner and shall be in good and usable condition at the date of completion thereof. J. Tenant's Contractors are responsible for scheduling inspections by the City of San Diego Building Department and other inspectors as required to comply with their requirements and all codes and regulations. A copy of all inspection reports shall be submitted available to Landlord at the Premises. In the event Tenant's Contractor are notified of violations of codes by any appropriate governmental authority or Landlord, Tenant's Contractors shall correct such violations within seven (7) calendar days from such date of notification. K. Tenant's construction shall maintain a full-time superintendent or representative on site at all times when construction is being performed in the Premises. 59 L. Tenant's Contractors shall observe the following limitations in the conduct of Tenant's Work: 1. No suspended loads will be attached to the underside of the floor or roof structure, with the exception of normal suspended ceiling, mechanical equipment, plumbing, electrical and telephone conduit, and light fixtures, without Landlord's prior written approval. 2. No load shall be imposed upon any floor areas of the Premises in excess of the design life as set forth in the Lease and Work Letter. M. Tenant's Work shall be coordinated with all other work being performed or to be performed by Landlord and other tenants of the Project to such extent that Tenant's Work will not interfere with, or delay the completion of any other work. Tenant's Contractors shall not damage, injure, interfere with, or delay the completion of any other construction within the Building. Tenant's Contractors shall comply with all procedures and regulations prescribed by Landlord for the integration of Tenant's Work with the work to be performed by Landlord and Landlord's Contractor in connection with the construction. Common Areas and the exterior of the Building must be kept clear of Tenant's and Tenant's Contractors' equipment, merchandise, fixtures, refuse and trash at all times. Any mechanical, electrical or plumbing items which need to be routed outside the Premises must have the written approval of Landlord and any tenant whose space the item will pass through. N. Tenant's Contractors shall be responsible for the repair and replacements of any damage caused by Tenant's Contractors to any other contractor's work in any area of the Building, including cleanup after such corrective work. Tenant's Contractors shall be required to maintain continuous protection of adjacent premises in such a manner as to prevent any damage to such adjacent property and the improvements thereon. Tenant's Contractors shall promptly pay for the repair of any such property or improvements so damaged to restore it to its pre-damaged condition. O. Before work commences, Tenant's Contractors shall be required to properly protect the Premises and Tenant's Work with lights, guard rails and barricades, and to secure Tenant's Work against accident, malicious mischief and theft. P. Tenant's Contractor shall not use any space outside of the Premises and within or on adjacent sidewalks or street side for storage, handing or moving of materials and equipment, or for the location of any field office or facilities required for construction personnel without the prior written authorization of Landlord. Q. Tenant's Contractors shall remove and dispose of all debris and rubbish caused by or resulting from Tenant's Work on a daily basis. Trash receptacles or carts will be allowed to be stored in the Common Areas as mutually agreed by the parties. Upon completion of Tenant's Work, Tenant's Contractors shall remove all temporary structures, surplus materials, debris and rubbish remaining with the Building which has been brought in or created as a result of Tenant's Work. If Tenant's Contractors shall neglect, refuse or fail to remove any temporary structures, surplus materials, debris and rubbish within twenty-four (24) hours after notice to Tenant from Landlord, Landlord may remove or cause same to be removed, and Tenant shall bear the cost of removal and hold Landlord harmless therefrom. R. Tenant shall require that Tenant's Contractors and other agents cause all supplies, merchandise, materials, equipment or trash being delivered to or removed from the Premises across the Common Areas or within the elevators, which requires the use of dollies or hand trucks, to be transported on dollies or hand trucks with soft rubber tires. S. Tenant and Tenant's Contractors shall comply with all applicable safety related laws, codes, rules and regulations governing the performance of Tenant's Work including all applicable safety regulations established by Landlord or Landlord's contractor. Tenant's Contractors shall take all necessary precautions to safeguard all workmen and the public from accident and to preserve all private and public property. T. Tenant's Contractors shall be allowed to post signs on any part of the Premises in a reasonable manner in conformance with applicable restrictions. 60 U. Tenant's Contractors shall provide a fire watch whenever any welding is done in the Premises. The person performing the fire watch must remain within the Premises for at least one (1) hour after the completion of any welding. V. All roof penetrations required by Tenant must be made by an agreed upon roofing contractor at Tenant's expense. Such penetration shall be subject to Landlord's approval as to construction details, size, configuration, location, and support. W. Tenant's Contractors shall obtain approval from Landlord prior to penetrating any floor slab. Landlord's approval shall not relieve Tenant from responsibility for damage to Landlord's Work and/or any other tenant's work because of penetration by Tenant. X. In addition to the requirements of the Lease, and without any limitation thereof, Tenant's Contractors shall (i) comply with all governmental rules and regulations including applicable OSHA standards and (ii) carry worker's compensation and public liability insurance (including property damage), with limits, in form and issued by insurance companies approved in advance by Landlord. Landlord, Tenant, Tenant's Contractor and/or subcontractors procuring the insurance shall be named insured (or named as additional insured) in each policy of said liability insurance, which policy shall have a cross-liability endorsement or its equivalent. Certificates evidencing the foregoing insurance shall be delivered to Landlord before any work is commenced by Tenant's Contractors and before any equipment and/or materials are moved into the Building. Y. Tenant's Contractors shall guarantee that portion of Tenant's Work for which they are responsible against any defects in workmanship and materials for a period of not less than one (1) year after the date of completion of Tenant's Work. This guarantee shall include, without limitation, all expenses and costs incurred in the repair or replacement of the structure of the Building or the Common Areas should the Building or Common Areas be damaged or affected by the defective work, or by the repair or replacement of such defective work. All such warranties or guarantees as to materials or workmanship with respect to Tenant's Work shall be contained in a written agreement between Tenant and Tenant's Contractors. Tenant shall require Tenant's Contractors to include such guarantees in each subcontract, and all such guarantees shall be so written so that same shall inure to the benefit of both Tenant and Landlord, as their respective interests may appear, and so that same may be directly enforced by Tenant or Landlord. Tenant shall provide Landlord with an assignment or other assurance necessary to perfect Landlord's right to enforce any such guarantee. AA. Tenant shall be required to settle and/or bond against any mechanic's or materialman's liens, or other similar liens, filed against the Building as a result of Tenant's Work in accordance with the provisions relating to such liens in the Lease and the Work Letter. Except to the extent caused by the Landlord's negligence or wrongful failure to make payments required under this Lease or Work Letter, Tenant shall reimburse Landlord in full and indemnify, defend, and hold Landlord harmless from and against any liability, cost or expense incurred by Landlord in connection with any such lien. BB. Tenant `s Contractors shall keep the exterior Common Areas in an absolutely clean and neat condition at all times. If Tenant's Contractors violate this regulation on more than one (1) occasion, or fail to immediately cure such default, Landlord may prohibit Tenant's Contractors from entering the Building. CC. Tenant's Contractors shall use restrooms only for personal functions. Cleaning of tools or painting equipment will not be allowed. Any utility sinks will contain water supply, but may not be used for tool or painting equipment cleaning or other construction work. DD. Tenant's Contractors shall provide Landlord with a key for access to the Premises during construction for use in the case of emergencies, and permit the construction of service lines by other tenants, which service lines have been approved by Tenant. VIII. TENANT'S CONSTRUCTION DOCUMENT SUBMITTAL A. Tenant's preliminary plans and specifications: 61 1. Tenant shall submit to Landlord for Landlord's approval three (3) sets of preliminary drawings of Tenant's improvements prepared by Tenant's Architect, which drawings shall indicate Tenant's proposed improvements including, without limitation, floor plans (scale 1/8" = 1'0") describing in reasonable detail the layout of the interior partitions, signage, materials to be used, and indicating the proposed use of each enclosed area. B. Tenant's Construction Documents 1. After Landlord's approval of Tenant's preliminary design drawings, Tenant shall, at Tenant's expense, submit to Landlord for approval three (3) sets of plans and one (1) set of reproducible plans of Tenant's Construction Documents prepared by Tenant's Architect describing the improvements to be completed in the Premises including, without limitation, floor plans (scale 1/8" = 1'0"); elevations, interior partitions; trade fixtures; reflected ceiling plan, including ceiling height(s); location, size and details of signage; areas of unusual floor loading; specifications of all mechanical, plumbing, electrical, telephone, security and sprinkler systems, including the details of the hookup of these systems to LandIord's Work; and all other improvements to be performed by Tenant as a part of Tenant's Work. Details shall be included as required by Section Vl of these Building Standards for each component addressed therein. 2. Construction of the improvements specified on Tenant's Construction Documents shall not commence until Tenant's Construction Documents have been approved by Landlord in writing. 3. If Landlord approves Tenant's Construction Documents and there is a conflict between the Building Standards and the Construction Documents as approved, to the extent the conflict does not affect health and safety or the structural integrity of the Building, the Construction Documents shall control. 4. Any additional changes, expenses or costs (including architects' fees, consultants' fees and attorneys' fees) arising by reason of any subsequent change, modification or alteration of Tenant's Construction Documents, made at the request of Landlord, shall be at the expense of the Tenant. No changes, modifications or alterations shall be made to Tenant's Construction Documents without the prior written consent of Landlord. 5. Landlord's approval of Tenant's Construction Documents or any work or installation made by Tenant shall not constitute a warranty or representation by Landlord that Tenant's drawings, work or installations comply with the requirements of any applicable law, ordinance or regulation, or are safe, sound, merchantable or fit for the purpose intended. Landlord shall have no liability to Tenant in the event Tenant is required to change its drawings or Tenant's Work after the approval thereof by Landlord on account of the failure of such drawings or Tenant's Work to meet applicable governmental requirements or in the event that such drawings or Tenant's Work, directly or indirectly, are defective cause injury to persons or property. 6. Tenant shall furnish to Landlord one (1) complete set of red-lined Construction Documents (plans and specifications) indicating the as-built conditions within thirty (30) days after completion or Tenant's Work. If any clarifications or additions to the as-built plans and specifications are required by Landlord, Tenant shall cause such revisions to be completed within thirty (30) days after request therefor. IX. TENANT IMPROVEMENT STANDARD SPEClFICATIONS A. These Tenant Improvement Building Standards Specifications have been developed as guidelines to establish the minimum standards for materials, product systems or procedures for improvements made to the Premises. The materials or product systems referenced herein are not all inclusive and may be modified by local codes, governmental agencies having jurisdiction, the Landlord or Tenant (with Landlord's written permission). 62 B. Materials, products or systems referenced in this Section will be adhered to by Tenant, Tenant's consultants and Tenant's Contractor unless alternates or substitutions have been authorized by the Landlord in writing. Non-proprietary materials, products or systems referenced in these specifications must be submitted to the Landlord for review and approval. The Landlord reserves the right to reject materials, products or systems that, in the Landlord's reasonable opinion, do not meet or exceed the intended level of building standards for a comparable building as listed in Exhibit P to the Lease. C. Product/Materials Specifications 1. Interior Partitions (*) 2 1/2" X 25 GA. metal studs at 24" o.c. with 5/8 type 'X' gypsum board each side. Height from floor to underside of suspended ceiling or 6" above ceiling. Brace partitions with 2 1/2" x 25 GA metal stud kickers at 48" o.c. (maximum). Texture with medium orange peel finish. 2. Column Wrap (*) 1 5/8" x 25 GA (minimum) metal furring at 24" o.c. with 5/8" gypsum board, one side. Height from floor to 6" above suspended ceiling. Texture flat and smooth. 3. Public Corridor Entry Doors (*) Single leaf or pair of doors, 3'0" x 8'0" x 1 3/4" solid core wood with premium grade hardwood face veneer (balanced and rift cut, free of hearts) to match existing doors with natural finish. Frame to be extruded aluminum with dear finish. Door and frames to be 20 minute labeled. For hardware use the following: 4 Butt Hinges (4.5 z 4.5) Ball Bearing (32D) pr. Lockset - Sargent 8100, level LNH, Function F04, (finish 32D) 1 Closer- Sargent 350, aluminum finish ea. Astregal - Ultra WS 011, aluminum 2 Flush bolts - DCI 900 Series (32D) ea. Coordinator - DCl, 600 Series 1 Wall Bumper - Ives 409 1/2 (SS) ea. Smoke Seals 1 set 1 ea. 2 ea. 1 ea. 4. Interior Doors (*) 3'0" x 8'0" x 1 3/4" solid core wood door, paint grade. Door frames to be extruded aluminum with clear finish. For hardware use the following: 2 pr. Butt Hinges (4.5 x 4.5) 1 ea. Lockset - Sargent 10 line. Lever LLJ, function F75, (26D) 1 ea. Wall Bumper - Ives 409 1/2 (SS) 1 Mutes set 5. Office Light Fixtures 2' x 4' recessed fluorescent fixtures with 3 lamps and 18 cell parabolic lens, aluminum finish. 6. Corridor Light Fixtures 2' x 2' recessed fluorescent fixtures with 2 'U' lamps and 9 cell parabolic lens, aluminum finish. 7. Light Switch Two (2) single pole, 20 amp, 120/205 V with ivory colored face plate. 8. Electrical Wall Outlets Duplex Outlet, Three Prongs with ivory colored face plate. 63 9. Telephone Wall Outlet 2" x 4" (minimum) box with single gang plaster ring and pull string (stub only). Cover plate to be ivory colored. 10. Electrical Supply Panel Feeder wire and one (1) 125A, 24 circuit load center. 11. Exit Signs (if required) Green block letters (6" high with 3/4" stroke) over white background and painted frame with battery powered backup. 12. Acoustic Ceilings A ceiling that has a consistent appearance as viewed from the exterior of the Building. 13. Carpet Carpet to be manufactured by Designweave, Courtyard 36 oz. Zafgtron CFN. Glue carpet directly to floor. 14. Vinyl Composite Tile Armstrong 1/8" Excelon or equal. 15. Resilient Base 2 1/2" high rubber top-set or cove base manufactured by Roppe or equal. 16. Painting One primer plus two finish coats (flat or semi-gloss latex) Frazee paints. Color to be selected from standard finish board. 17. Window Coverings (') Required at all Exterior Windows Window Coverings that have a consistent appearance as viewed from the exterior of the Building. 18. Fire Extinguisher J.L Industries, stock cabinet with ABC #5. 19. Tri-Water System See Section Vl for Mechanical Criteria E. Building standards for this project are based on products, materials and assemblies noted in the preceding Section and finish color boards. Changes to pre-selected finishes or alterations to quantities specified herein will constitute additional services. Landlord's consultants will be compensated for additional services on a per project basis. HNC SOFTWARE INC. Exhibit "E" RULES AND REGULATIQNS FOR PACIFIC CORPORATE PARK 1. The sidewalks, entrances, passages, courts, elevators, vestibules, stairways, corridors or halls shall not be obstructed or used for any purpose other than ingress or egress. 2. No awnings or other projections shall be attached to the outside walls of the Premises. 3. The sashes, sash doom, skylights, windows and doors that reflect or admit light and air into the halls, passageways or other public places in the Premises shall riot be covered or obstructed, nor shall any bottles, parcels or other items be placed on the windowsills. Neither the interior nor the exterior of any windows shall be coated or otherwise sunscreen' without Landlord's prior written consent. 4. No sign, advertisement or notice shall be exhibited, painted or affixed by Tenant on any part of, or so as to be seen from the outside of, its Premises or the Premises without Landlord's prior written consent. In the event of Tenant's violation of the foregoing, landlord may remove the same without any liability and may charge the 64 expense incurred for such removal to Tenant. All signs whether on doors, directories or elsewhere, shall be inscribed, painted or affixed for Tenant by Landlord at the expense of Tenant, and shall be of a size, color and style acceptable to Landlord. 5. Directories for the Premises will be provided exclusively for the display of the name and location of Tenant only; and Landlord reserves the right to exclude any other names therefrom, and each and every name in addition to the name of Tenant placed upon such bulletin board or directory, shall be subject to Landlord's prior written consent (and if approved by Landlord, all costs therefor shall be paid by Tenant). Tenant shall pay for the removal of any such listings or representations upon its departure from its Premises. 6. All doors that open into public corridors shall be kept closed, except when being used for ingress and egress. 7. Tenant shall not mark, paint, drill or bore into, cut or string wires in, lay linoleum or other floor coverings in, or in any way deface any part of its Premises or the Premises, except with Landlord's prior written consent and as Landlord may direct. 8. Intentionally left blank 9. No window or other air conditioning or heating units or other similar apparatus shall be installed or used by Tenant without Landlord's prior written consent. Tenant shall riot be permitted upon the roof at any time. 10. The water, restrooms and other plumbing fixtures shall not be used for any purpose other than those for which they were constructed and no sweepings, rubbish, rags or other substances stored therein. All damages resulting from any misuse of the fixtures by Tenant or its servants, employees, agents, visitors or licensees shall be paid by Tenant. Tenant shall exercise extraordinary care and caution to insure all water faucets or water apparatus in the Premises are entirely shut off before Tenant, its employees, agents or visitors leave the Premises and that all electricity, gas or air conditioning to the Premises is carefully shut off when the Premises is not in use so as to prevent waste or damage. 11. Unless Tenant is leasing an entire Building all movement of freight, furniture, safes or other heavy or bulky items ("Heavy Items") shall be moved prior to 7:00 a.m. or after 6:00 p.m. or on Saturday, Sundays or Holidays. Tenant shall notify Landlord in writing the day before any heavy items which may cause noise, jar or, tremor to the floors or walks which may injure the Premises or Building. 12. Neither Tenant nor its servants, employees, agents, visitors or licensees shall at any time bring or keep upon the Premises any flammable, combustible or explosive fluid, chemical or substance, except for a reasonable quantity of such material reasonably necessary for the conduct of Tenant's business. EXHIBIT E 13. The Premises shall not be used for manufacturing or for the storage of merchandise except as such storage may be incidental to the permitted use of the Premises set forth in the Lease. Tenant shall not, without Landlord's prior written consent, occupancy or permit any portion of the Premises to be occupied or used for the manufacture or sale of liquor or tobacco in any form, or as a barber or manicure shop, or as an employment bureau. The Premises shall not be used for lodging or sleeping. 14. Tenant shall not interfere with occupants of neighboring premises or the other adjacent Building. 15. No bicycles, vehicles, birds or animals of any kind shall be brought into or kept in or about the Premises except as permitted in the Lease or the Work Letter. Tenant shall not cause or permit any unusual or objectionable odors to be produced in or emanate from the Premises. 16. All hand trucks or other moving equipment used in the Building shall be equipped with rubber tires and side guards. 17. No vending or coin operated machines shall be placed within the Premises without Landlord's prior written consent. 65 18. No person shall be employed by Tenant to do Janitorial work in any part of said Premises without Landlord's prior written consent. Any person employed by Tenant to do janitorial, maintenance or similar work with Landlord's consent shall, while in the Premises, be subject to and under the control and direction of Landlord or its agent or representative (but not as an agent or servant of Landlord) and Tenant shall be responsible for all acts of such persons. 19. Landlord shall have the right to prohibit any advertising by Tenant which, in Landlord's discretion tends to impair the reputation of the Building or Project or its desirability as an office park, and upon written notice from Landlord, Tenant shall refrain from or discontinue such advertising. 20. Canvassing, soliciting and peddling in the Premises are prohibited and Tenant shall cooperate to prevent same. 21. Intentionally left blank. 22. Landlord reserves the right to exclude or expel from the Premises any person who, in the judgment of Landlord, is intoxicated or under the influence of liquor or drugs, or who shall in any manner do any act in violation of the Rules and Regulations of the Premises. 23. It is understood and agreed between Landlord and Tenant that no assent or consent to any waiver or any part hereof by Landlord in spirit or letter shall be deemed or taken as made except if same is done in writing by Landlord except as provided in the Lease. 24. Landlord reserves the right at any time to change or rescind any one or more of these Rules or Regulations, or to make such other and further reasonable Rules and Regulations as in Landlord's judgment may from time to time be reasonably necessary for the management, safety, care and cleanliness of the Premises and Premises, and for the preservation of good order therein, as well as for the convenience of other occupants and tenants therein, provided that such changes do not adversely affect Tenants use, enjoyment, access of or to the Premises. Landlord shall not be responsible to Tenant herein or to any other person for the nonobservance of the Rules and Regulations by any other tenant or other person. Tenant shall be deemed to have read these Rules and Regulations and to have agreed to abide by them as a condition to its occupancy of the Premises. Exhibit F: Weather Engineering, Inc. April 6, 1993 Roel Construction Co. 2366 Kurts Street San Diego, California 92130 Attn: Terry Arnett 66 Re: Pacific Corporate Park 5930 and 5935 Cornerstone Court HVAC System Dear Terry: The subject buildings are serviced by a "Tri-Water" water source heat pump system. The central plant, which houses a separate cooling tower, boiler and recirculating pump for each building, is located in the parking area north of building A. The condenser water is piped underground to each building and connected to the fire sprinkler system which is routed throughout both buildings. The individual water source heat pumps are then connected to the fire sprinkler piping as a part of the tenant improvement. The cooling towers installed are rated @ 350 GMP which would provide the equivalent of approximately ?? tons of air conditioning capability for each building. There is a 4 wire energy management loop that is routed from the central plant to each building for connection to future tenant Water Source Heat Pump ("WSHP") units. This allows the tenant to communicate with the central plant .a provide after hours cooling. As part of the tenant improvement buildout, the following should be utilized as guidelines for a minimum standard: 1. Suspend WSHP units above the ceiling utilizing 1 in. spring isolation for vibration and sound attenuation. 2. Type L copper piping with hard solider should be utilized for the condenser water piping to the individual WSHP units. Automatic flow controls are required for each unit. 3. The return air must be ducted and both supply and return ducts must be insulated. 4. Rigid duct to be utilized with flex duct on the last 7 ft. only. 5. Check valves must be installed on the condenser piping to the ndividual WSHP units. 6. Duct shall be sized at .1 in. pressure drop per 100 ft. of duct. 7. Perimeter and interior zones shall not be combined. B. WSHP units shall be equivalent to Carrier, Trane or AAF. 9. Outside air shall be provided @ 20 CFM/person. Should you have any additional questions or comments, please do not hesitate to call. Sincerely, Greg Davis, Weather Engineering, Inc. 67 EXHIBIT F1 Walsh Engineers Letter dated 4/29/93 (To request a copy of this exhibit, please contact the Company.) EXHIBIT G Building Security Service Agreement (To request a copy of this exhibit, please contact the Company.) EXHIBIT G1 Pinkerton's Inc. Schedule of Patrol Service (To request a copy of this exhibit, please contact the Company.) 68 Exhibit H: Recording Requested By: When Recorded Mail To: PacCor Partners 11939 Rancho Bernardo Road, Suite 200 San Diego, California 92128 (Space above this line for recorder's use) NON-DISTURBANCE AGREEMENT THIS AGREEMENT, is dated as of the _____ day of ____________________, 199__, by and between ______________________________________("Lender") and LINSCO/PRIVATE LEDGER, a ____________________ corporation ("Tenant") with respect to the following recitals: RECITALS A. Tenant has entered into an Office Lease dated _______________, 199___ ,("Lease") with PACCOR PARTNERS, a California corporation ("Landlord") as Landlord for certain real property described on Exhibit "A" attached hereto ("Premises"); and B. Lender is the Beneficiary under that certain Deed of Trust dated February ZB, 1990, and recorded March 2, 1990, in Recorder's File No. 90-1 12897, Official Records of the County of San Diego, State of California, which constitutes a lien on the Premises ("Deed of Trust"). NOW, THEREFORE, far valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties agree as follows: 1. Lender agrees that Unless Tenant is in material breach of the Lease, Tenant shall not be named or joined as a party defendant or otherwise in any law suit, action or proceeding under the Deed of Trust or to enforce any rights of Lender under the Deed of Trust or under any note or other obligation secured thereby; (b) So long as Tenant is not in default (beyond any period given Tenant to cure such default) in the payments of rent or in the performance of any of the terms, covenants or conditions of the Lease on Tenant's part to be performed, possession of the Premises by Tenant, and the enjoyment of all rights, privileges and entitlements under the Lease, shall not be disturbed, affected or impaired by (i) any lawsuit, action or proceeding under the Deed of Trust, or the note or any obligation secured thereby, (ii) any foreclosure under the Deed of Trust or the enforcement of any rights of Lender thereunder, (iii) any sale of the Premises under the Deed of Trust or in lieu of any foreclosure thereof, and (iv) any default under the Deed of Trust, or the note or any obligation secured thereby; and (c) All condemnation awards and/or insurance proceeds paid or payable regarding the Premises or any part thereof shall first be applied to any repairs and restoration of the Premises required by the Lease, 2. If Lender or any other person should become fee owner of the Premises by reason of the foreclosure of or sale under the Deed of Trust or otherwise, the Lease shall continue in full force and effect, with or without the execution of a new lease as a direct lease between Tenant and the then fee owner of the Premises, upon all of the same terms, covenants or provisions contained in the Lease and the then fee Page 1 69 owner of the Premises, together with all of the rights and privileges therein contained, between such fee owner of the Premises and Tenant for the balance of the term of the Lease; and Tenant agrees to attorn to and accept such fee owner of the Premises as the Landlord under the Lease and to be bound by and to perform all of the obligations imposed by the Lease upon the Tenant thereunder and Lender, its successors or assigns, or any purchaser at a foreclosure or trustee's sale or otherwise will not disturb the possession of Tenant and will be bound by all of the obligations imposed by the Lease upon the Landlord, provided, however, that Lender, or any purchaser at a foreclosure or trustee's sale or otherwise shall not be: (a) liable for any act or omission of a prior Landlord (including Landlord); or (b) subject to any offsets or defenses which Tenant might have against any prior Landlord (including Landlord) except for the Space Plan Allowance (Section 5.1 of the Lease), Tenant Improvement Allowance (Section 1.10 of the Lease), Refurbishment Allowance (Section 5.7 of the Lease), Security Deposit Amount (Sections 1.8 and 4.5 of the Lease), Relocation Consultant fee (Section 5.6), Moving Allowance (Section 17.1 of the Lease), and Broker's Commission (Section 16.1 of the Lease). 3. The terms of this Agreement shall be binding upon and inure to the benefit of and be enforceable by the respective successors and assigns of the parties hereto. 4. Upon the written request of either Tenant or Lender given to the other at the time of a foreclosure of the Deed of Trust or sale under power of sale therein contained or conveyance in lieu of foreclosure, and if no default then exists under the terms conditions and provisions of the Lease on the part of the requesting party, Tenant and Lender agree to execute a lease of the premises demised by the Lease upon the same terms an conditions as the Lease between Landlord and Tenant, which lease shall cover any unexplored term of the Lease existing prior to such foreclosure, trustee's sale or conveyance in lieu of foreclosure. 5. Subject to the nondisturbance provisions of the Lease, the Lease now is, and shall at all times continue to be, subject and subordinate in each and every respect to the Deed of Trust. 6. Tenant and Lender may each rely upon the terms and provisions of this Agreement. LENDER" "TENANT" THE PAUL REVERE LIFE LINSCO/PRIVATE LEDGER, a INSURANCE COMPANY, a California corporation Massachusetts corporation By: By: ---------------------------- ---------------------------- Its --------------------------- Page 2 70 EXHIBIT I LEASE ESTOPPEL CERTIFICATE Re: Office Lease between PacCor Partners ("Landlord") and Linsco/Private Ledger ("Tenant") dated ____________________________ ("Lease") Area: Approximately 48,984 square feet ("Premises") Dear Sir or Madam: The undersigned Landlord and Tenant of the above-referenced Lease hereby ratify the Lease and certify to _______________________________("Lender") with knowledge that Lender is relying on this certificate in making a mortgage loan on the property of which the Premises as set forth in the Lease is a part, as follows: 1. The term of the Lease commenced on ______________________________, 19__, and the Tenant is in full and complete possession of the Promises and has commenced full occupancy and use of the Premises, such possession have been delivered by the Landlord and having been accepted by the Tenant. 2. The Tenant is paying monthly installments of rent of $______________ which commenced to accrue on the _________ day of _______________ , 199___. 3. No advance rent or other payment ha. been made in connection with the Lease, except rent for the current month and there is no rent abatement, waived rent or other concession under the remaining term of the Lease except as follows ___________________________________________ _______________________________________________________________________ _______________________________________________________________________ 4. Rent has been paid to and including ______________________ , 19 ____ . 5. A security deposit in the amount of $ _________________ is being held by Landlord, which amount is not subject to any set-off or reduction or to any increase for interest or other credit due to Tenant. 6. All obligations and conditions under the Lease to be performed to date by Landlord or Tenant have been satisfied. 7. The Lease is a valid lease and in full force and effect and represents the entire agreement between parties. There is no existing default on the part of the Landlord or the Tenant in any of the terms and conditions thereof and no event has occurred which with the passing of time or giving of notice or both, would constitute an event of default. The Lease has not been amended, modified, supplemented, extended, renewed or assigned except as follows: _______________________________________________________________________ _______________________________________________________________________ _______________________________________________________________________ 8. The Lease provides for a initial term of __________ months; the term of the Lease expires on the _________ day of _________________________, 1999 ____ ; and neither the Lease nor any amendment , modification, amendment, modification, supplement extension renewal or assignment (if any), contain any option for any additional term or except as follows: _______________________________________________________________________ _______________________________________________________________________ _______________________________________________________________________ Page 3 71 9. Except as provided by the Lease Landlord has not rebated, reduced or waived any amounts due from Tenant under the Lease, either orally or in writing, nor 'has Landlord provided financing for, made loans or advances to, or invested in the business of Tenant. 10. Tenant agrees not to prepay rent more than one (1) month in advance without Lender's written approval and agrees to give Lender notice and reasonable opportunity (without obligation) to cure any default by Landlord, before exercising its rights under the Lease. 11. The Lease does not contain, and Tenant does not have any outstanding option or right of first refusal to purchase the Premises or am part thereof or the property of which the Premises are a part. 12. To the best of Tenant's actual current knowledge, there is no apparent or likely contamination of the property or the Premises by Hazardous Materials, and Tenant does not use, nor has Tenant disposed of Hazardous Materials in violation of Environmental Laws on the property of Premises. "Hazardous Material" shall mean any flammable substances, explosives, radioactive materials, hazardous wastes, toxic substances, pollutants, pollution, or related materials or other substances regulated by any of the Environmental Laws. "Environmental Laws" shall mean federal, state or local laws, ordinances, rules, regulations or policies governing the use, storage, treatment, transportation, manufacture, refinement, handling, production or disposal of Hazardous materials, except for substances which are customarily used or found in typical offices, including without limitation copier and printer toner, cleaning supplies, correction fluid and ink. 13. There are no actions, voluntary or involuntary, pending against the Tenant under the bankruptcy laws of the United States or an) state thereof. 14. This certificate shall inure to the benefit of Lender, its successors and assigns and shall be binding upon Tenant and Tenant's heirs, successors and assigns. This certificate shall not be deemed to alter or modify any of the terms, convenience or obligations of the Lease, except to the extent specifically set forth herein. 15. The entity, person, and/or office executing this certificate is empowered by action, resolution, or at law to execute the same. Date: Date: Tenant: LINSCO/PRIVATE LEDGER, a corporation By-. Landlord: PACCOR PARTNERS, a California corporation By: PacCor Management Company a general partner By: -------------------------------------------- Its JANITORIAL Specifications A. Daily - All Common Areas and Tenant Spaces - Five (5) days per week, Sunday through Thursday 1. Dust desks (using care not to disturb paperwork), chairs and all other office furniture. 2. Clean glass desk tops. Page 4 72 3. Vacuum all carpeted areas, using care around wood furniture. 4. Dust mop all interior tile surfaces, then damp mop. 5. Sweep exterior entrance to building, then hose down. 6. Clean all tables, sinks and counter tops in kitchen area. 7. Return furniture to proper position. 8. Remove trash, change liners as needed in offices, lobbies and exterior trash receptacles. 9. Deposit trash to designated trash dumpster. 10. Clean all ash trays and sand urns. 11. Spot clean walls, doors and baseboards. 12. Spot clean around wall switches. 13. Dust window sills. 14. Police all balconies, spot clean as needed. 15. Clean elevator wall surfaces, call buttons, door tracks, polish stainless steel. 16. Police service entrance, if applicable. 17. Police stairwells and landings to remove debris, sweep and mop as necessary. Wipe down hand rails. 18. Clean both sides of lobby glass doors. 19. Vacuum elevator carpet. ED hibit J 06/17/93 20. Dust, mop if necessary, mail area iii lobby. 21. Empty and wipe out all waste paper receptacles in restrooms. 22. Empty all sanitary napkin containers and replace insert. 23. Clean, sanitize and polish all restroom fixtures and stock dispensers, including disinfecting underside and tops of toilet seats. 24. Spot clean tile walls and toilet partitions. 25. Spot clean walls around wash basins. 26. Wet mop floors with germicidal salivation using a two bucket wash/rinse. 27. Refill soap, towel, tissue and seat cover dispensers, as needed. 28. Clean shower and disinfect. 29. Wipe down exercise equipment and mats. 30. Secure all exterior doors upon corn deletion of duties. B. WEEKLY - All Common Areas and Tenant Spaces 1. Concentrated carpet cleaning. Move furniture and plants that can be moved in order to reach all comers and edges. 2. Dust ledges and window sills. 3. Brush down all air conditioning vents. 4. Use lint brush on all upholstered furniture. 5. Clean and polish drinking fountains. 6. Spot clean all carpeted areas. 7. Dust picture frames and all wall hangings. Page 5 73 8. Damp mop and buff all tile surfaces. 9. Clean tenant glass in all occupied areas. 10. Dust and spot clean all baseboards 11. Clean both side of toilet partitions 12. Remove finger prints from woodwork, walls and partitions 13. Dust chair legs and bases of furniture, door frames, etc 14. Clean mirrors in exercise room. 15. Disinfect all athletic facility equipment 16. Sweep all exterior walkways 17. Remove gum from common walkways 18. Empty trash dumpsters and clean dumpster area C. Monthly - All Common Areas and Tenant Spaces 1. Oil all stained wood doors using products approved by Landlord and polish wood furniture 2. Remove finger prints and smudges from light fixtures 3. Polish stainless steel in elevators, including ceiling, if applicable 4. Sweep and damp mop all stairwells and landings 5. Wipe ledges and handrails in stairwells 6. Clean light fixtures in stairwells 7. Dust all high areas 8. Wipe down all plastic and leather furniture 9. Thoroughly vacuum upholstered furniture 10. Interior and exterior lighting to be checked and all necessary bulbs replaces 11. Strip, machine scrub and reapply Landlord approved finish to all tile floors D. Quarterly - All Common Areas and Tenant Spaces 1. Wipe metal framework around doors and windows 2. Lift desk pads where possible and vacuum under desks 3. Dust vertical blinds 4. Clean(acid wash if necessary) exterior entrance walkway to main lobby 5. Clean all exterior building glass E. Semi-Annually - All Common Areas and Tenant Spaces 1. Wash all vinyl baseboards 2. Wash all vinyl wall coverings EXHIBIT K Covenants, Conditions, & Restrictions (To request a copy of this exhibit, please contact the Company.) EXHIBIT L Sign 1 (To request a copy of this exhibit, please contact the Company.) EXHIBIT M Floor-Bearing Loads (To request a copy of this exhibit, please contact the Company.) EXHIBIT N Amended Planned Industrial Development ("PID") Permit No. 85-0830 (To request a copy of this exhibit, please contact the Company.) EXHIBIT O Insurance Quotes (To request a copy of this exhibit, please contact the Company.) EXHIBIT P List of Comparable Buildings to Determine Fair Market Value (To request a copy of this exhibit, please contact the Company.) GLOSSARY OF TERMS USED This Glossary is included for reference purposes only. In the event of an inconsistency behveen definition contained in this Glossary and any definition contained in the body of the Lease, the Le shall control. Defined IN LEASE 6.3 Actual Statement. Written statement setting forth the actual Lease Expenses Difference allocable to such Lease Yeai 7.3 ADA: Americans With Disabilities Act 42 U.S.C. Section 1281 et. seq, Page 6 74 1.11 Additional Insureds: PacC3r Partners, a California general partnership (Landlord); PacCor Management Company, a California corporation (A general partner); PR Land Corp., a Del; corporation (a general partner r) 4.1(b) Additional Rent. means all Monthly Payments and Lease Expense Difference which Ten-required to pay to Landlord under 5 6 of the Lease 1.2 Adjacent Building: Building located at 5930 Cornerstone Court West, San Diego, Califom 7.9(a) Alterations: Any alterations improvements, repairs, additions, installations, or changes of nature in or to the Premises, individually and collectively 11.1(b) Assignment of Lease. enumerated in 11.1(b) (i) thru (v) 17.2 AVAILABILLFY Notice: Landlord's notice to Tenant whenever an Expansion Space becomes, expected to become, available 10.1(c) Award. All compensation, slims or anything of value awarded, paid, or received on A total partial Condemnation of the project 1.7; 4.2 Base Rent Base Rent shall be payable monthly in accordance with the "Schedule of 4.2 Base Rent" set forth in Section 4.2, beginning at an initial monthly rate of $48,984.00 for months and $64,169.04 for months B I-120 Base Year. 12 month period commencing on the first day of the calendar month 6.1(a) immediate following the Commencement Date and ending on the day prior to the first anniversary of st Date BOMA Standards "Method for Measuring FIoor Area in Office Buildings", published by 6.1(g) Bu Owners & Managers Association International Standard as ANSI 265.1-19SQ (Reaffirmed 1'. Approved June 21, 1989 by American National Standards Institute Inc. 1.2 Building; located at 5935 C(,merstone Courl West, San Diego, California Building Operating Expense: all costs and expenses paid or incurred by Landlord or 6.1(b) on Landlord's behalf with respecl to the maintenance and operation of the Building which belong the following categories (abbreviated): items (i) thru (xvii) and excluding items (A) thru (N) 10.1(d) Condemnor. Any public or quasi-public authority, or private corporation or individual, having the power of Condemnation 6.4 Controllable Operating Expenses: Landscaping maintenance, parking lot sweeping, plumbing, Tri-Water System maintenance, janitorial services and supplies, trash removal, security and life safety, pest control, elevator maintenance, parking and walkways, locks and keys, window washing, lighting maintenance, roof maintenance, painting and sealing, general maintenance, paving maintenance, windows, doors, screens, signs, common area maintenance and management fees 5.5 Corrections List: A list written by Landlord and given to Tenant at the conclusion of a walk-through of the Premises and conducted within 5 days after Substantial Completion, of any items not completed in accordance with the Lease, Work Letter, construction documents, construction contracts, Building Standards and/or other applicable codes, laws, regulations or standards 16.1 Cushman: Cushman Realty Corporation, Tenant's exclusive agent 10.1(b) Date of Taking: The date the Condemnor has a right to possession of the property being condemned 10.4 Determination Date: The date upon which the nature and the extent of the taking in a Condemnation proceeding have been determined 6.3 Estimated Statement: Written statement setting forth Landlord's estimate of the amount by which the Lease Expenses for the upcoming Lease Year will be greater or less than the Lease Expenses for the Base Year 1.13 Exhibits: Exhibit "A" (Section 1.3): Description of Premises; Exhibit "B" (Section 1.2): Description of Real Property; Exhibit "C" (Section 5.1): Work Letter; Exhibit "D" (Section 5.5): Building/Tenant Improvement Standards for Pacific Corporate Park; Exhibit "E" (Section 7.14): Rules and Regulations; Exhibit "F" (Section 7.13): Tri-Water System; Exhibit "F1" (Section 7.13a): Walsh Engineers Letter dated 29/93; Exhibit "G" (Section 7.16): Building Security Service Agreement; Exhibit "G1" (Section 7.16): Pinkerton's Inc. Schedule of Patrol Service; Exhibit "H" (Section 13.4): Non-Disturbance Agreement; Exhibit "I" (Section 13.3): Estoppel Certificate; Exhibit "J" (Section 7.15): Janitorial Specifications; Exhibit "K" (Section 7.7): Covenants, Conditions & Restrictions; Exhibit "L" (Section 7.7): Signs; Exhibit "M" (Section 7.5): Floor-Bearing Loads; Exhibit "N" (Section 7.7): Amended Planned Industrial Development ("PID") Permit No. 85-0830; Exhibit "O" (Section 8.2): Insurance Quotes; Exhibit "P" (Section 4.4): List of Comparable Buildings to Determine Fair Market Value 17.2 Expansion Space: Within the first 18 months of the Term any rentable space in the Adjacent Building which was previously leased and becomes vacant, and commencing on the 19th month of the Lease it shall mean any rentable space in the Adjacent Building 3.1 Expiration Date: The last day of the initial Term, to be confirmed in writing by Landlord and Tenant within 15 days after the Commencement Date 3.2 Extended Term: Period of one (1) five (5) year term following the expiration of the Term 4.4 Fair Market Rental Value: the effective value on a monthly EXH.P basis of all expenditures for comparable office space being paid by willing, comparable non-renewal tenants with a credit standing and financial stature equivalent to Tenant, giving appropriate consideration to all relevant economic terms and conditions of the Landlord/Tenant relationship, including without limitation tenant improvement, refurbishment and other allowances, operating expense stops or caps, leasing and other commissions (whether paid to independent parties, to Landlord or to affiliates of Landlord), parking charges or abatements, rental abatements, signing bonuses and similar cash or cash-equivalent tenant concessions. For purposes of determination of Fair Market Rental Value, other comparable space in the Project shall be considered the most comparable space to the Premises and Landlord shall be obligated to furnish to Tenant and any arbitrator copies of all leases of other space in the Project, certified to contain all relevant information with regard to the economic transaction between Landlord and the tenant thereunder. Other than the Project, Landlord and Tenant acknowledge that the most comparable buildings to the Building to be considered in determination of Fair Market Rental Value are listed on Exhibit "P" to the Lease, however, other buildings in the general area may be considered 7.15(a) Good Condition: those comparable portions of the Premises that Tenant at its sole cost is responsible to maintain and repair, all in neat, clean, broom-clean and good condition, with allowance for reasonable wear and tear, except those portions of the Premises to be maintained by Landlord as expressly described in Section 7.15(b) 6.2 Gross Up: Upward adjustment to Common Area Operating Expenses during the Term (including the Base Year) if the Project is less than 95% leased and occupied, in accordance with reasonable and generally accepted accounting principles 7.4 Hazardous Materials: Use, generation, treatment, storage, disposal, release or threatened release of hazardous, toxic or radioactive substance, materials or waste, including without limitation those substances identified in Section 66680 through 66685 of Title 22 of the California Administrative Code, Division 4, Chapter 30, as amended from time to time, and those substances defined as "hazardous substances," "hazardous materials," "hazardous wastes," "pollutants," "contaminants," "chemicals known to the State to cause cancer or reproductive toxicity," "asbestos," "hydrocarbons (including without limitation oil)," "toxic bearing dust" or other similar designations in the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, 42 U.S.C. Sections 9601. et seq., the California Hazardous Materials Transportation Act, 49 U.S.C. Sections 1801, et seq., the Hazardous Substance Account Act, Health & Safety Code Sections 25300, et seq., the Safe Drinking Water and Toxic Enforcement Act of 1986, Health & Safety Code Sections 25249.5, et seq. and any other federal, state or local statutes, laws, ordinances, rules, regulations and precautions. Para. 1 Landlord. PacCor Partners, a California general partnership 8.2 Landlord's Insurance: A policy or policies of "All Risk", general liability, fire and extended coverage insurance, including at least 6 months rental interruption with vandalism and malicious mischief endorsements, coverage with respect to increased costs due to building ordinances, demolition coverage, boiler and machinery insurance, sprinkler leakage coverage in each case to the extent of at least 100% of the full replacement value of the Building and Adjacent Building and any future building on the Project 17.2 Landlord's Last Offer: terms for Expansion Space offered by Landlord to another party which are in the aggregate no less favorable to Landlord than terms last offered to Tenant during the period of Tenant's Right of First Negotiation 7.6a Landlord's Representatives: Landlord's agent(s), employee(s), officer(s) or independent contractor(s) of or retained by Landlord 12.3 Late Charge: Five percent (5%) of any Rent due as an additional sum when Rent is not PAID within 3 business days after notice tv Tenant's Chief Financial Officer of such overdue payment from Landlord to Tenant 'I[1; Lease: Office Lease between Landlord an 3 Tenant plus any Exhibits 16.16 6.1(e) 1,ease Expenses: the sum of (i) Building operating Expenses, and (ii) Tenant's proportionate share (defined as A fraction, the numerator of which is the Rentable Square Footage and the denominator of which is the Project Rentable Area) of Common Area Operating Expenses 6.3 Lease Erpenses Difference: amount by which the Lease Expenses for the upcoming Lease Year will be greater or less than the Lease expenses for the Base Year 6.1(f) Lease Year. each 12 month period during he Term after the Base Year Page 7 75 6.3 Monthly Payment. An amount equal to 1/ 2th of the Lease Expenses Difference as estimated by Landlord in most recently delivered Estimated Statement (if Lease Expenses for the upcoming Lease Year are estimated to be greater than the Lease Expenses for the Base Year) 13.1 Mortgage: Any mortgage, loan secured by a deed of trust, or other written security instrument or agreement affecting the Project that constitutes security for the payment of a debt or performance of an obligation, and all renewals, modifications, consolidations, replacements or extensions thereof now or hereafter affecting the Premises 17.1 Moving Allowance: Forty Thousand Dollars ($40,00.00) for Tenant's moving costs regardless of Tenant's actual moving costs, payable by Landlord within 30 days after the Commencement Date and Tenant's occupancy of Premises 1.12' Notice Address: Landlord: PacCor Partners; Copy to: PacCor > 8.2 Management Company; Tenant: LINSCQ/PRIVATE LEDGER; Copy to Solomon, Ward, Seidenwurm & Smith 9.1(b) Notice to Restore: Tenant's written notice to Landlord of Tenant's election to pay the amount by which the cost of restoration [of Premises to substantially the same condition prior to destruction) exceeds the amount of proceeds received by Landlord from any insurance maintained by Landlord 6.5 Operating Expense Records: All operating expense records to be maintained by Landlord for 5 years and available for inspection and photo copying at PacCor Management Company during normal working hours upon 24 haute written notice 3.2(a) Option Commencement Date: If the option t to Extend (Lease) is exercised, date shall be one (1) day after ihe Expiration Date 3.2(a) Option Expiration Date: If the Option to &tend (Lease) is exercised, date shall be the 5th anniversary of the Expiration Date 3.2(a) Option Notice: written notice of Tenant's exercise of the option to extend Lease, provided at least 9 months before the Expiration Date or otherwise in accordance with the provisions of Section 4.3 1.6; Option to Amend Term: One option to extend. for all or any 3.2 full floor portion of the Premises, following the Expiration Date, for a period of five years. Glossary of Terms Used Page 5 4.5 Personal Property. Includes without limitation trade fixtures, furnishings, equipment and inventory, signs, satellite dish, installed or located in or on the Premises 7.17 Personal Property Taxes: Taxes, assessments, license fees, and other charges levied or assessed against, or based upon the value of Tenant's Personal Property 1.3; Premises: All of the interior of 1he Building Exh. A 11.5 Premium: All sums received by Tenant under the sublease which exceed the Rent attributable to the subleased portion of the Premises, alter deducting (a) thru (c), which final sum is shared equally between Page 8 76 Landlord and Tenant 1.2 Project. (I) the Premises; (ii) the Building located at 5935 Cornerstone Court West, San Diego, California; (iii) Adjacent Building loca1ed at i930 Cornerstone Court West, San Diego, California; (iv) Common Area; (v) Real Property; and (*i) all other improvements on the Real Property or any future improvements, including additional buildings, to the Real Property. 6.1(g) Project Rentable Area: 97,961 square feet plus, if applicable, the rentable square footage of any future buildings in the Project 6.1(II) Prop 13 Protection: Exclusion from the definition of Real Property Taxes of any increase in taxes attributable to sale or transfer of or change of ownership in the Project (or any part thereof) during the initial five (5) years of the Term, as long as Proposition 13 remains in effect in California Exh B Real Property legal description of real property defined on Exhibit "B" 6.1 Real Property Taxes: All real property taxes and general and (l1) special assessments levied or assessed against real property, including without limitation any tax, fee or excise on (r) rents, (ii) the square footage, (iii) the act of entering info this Lease, or (iv) the occupancy of Tenant, or any other tax, or excise, however described ncluding without limitation value-added tax, levied or assessed by the United States, the State waif California or any political subdivision of the State of California, including without limitation any county, c':iy and county, public corporation, district, or any other political entity or public corporation of the state of California as A direct substitution in whole or in part for, or in addition to, any local property taxes or general or special assessments. Notwithstanding anything to the contrary in the preceding sentence, "Real Property Taxes shall no1 mean any municipal, county, state, or federal income, franchise, estate, succession, inheritance or transfer taxes of Landlord; shall also not include, so long AS Proposition 13 remains in effect in California any increase in taxes attributable to any sale or transfer of or change of ownership in the Project (or any part thereof) which occurs during the initial 5 years of the Term 12.5 Receipt Date: Landlord's receipt and acceptance from Tenant, on any date, of Rent or an amount less than rent due 5.7 Refurbishment Allowance. Allowance of Sl f7,136 ($2 x Usable Square Footage) beginning with the 61st month of the Term; provided to Tenant by Landlord within 10 days of Tenant's incurring such expenses 15.2 Reimbursed Rent. That portion of rent at Tenant's address or other location that exceeds Base Rent, attributed solely to the delay in the Commencement Date Moving Storage Cost: Moving and storage costs directly attributable solely to the delay in Commencement Date Glossary of Terms Used Page 6 5.6 Relocation Consultant. Tenant's consultant, to be paid $30,000 allowance by Landlord, for Tenant improvement, build-out and relocation services 4.1(c) Rent. Base Rent and Additional Rent and;my other sum payable by Tenant to Landlord under the Lease Page 9 1.7 Rent Abatement. Concession Tenant receives, amounting to $33,492 for second month plus 4.2 $9,000,00 per month for months 3 through ' 9 of the Term. 1,3 Rentable Square Footage.- 48,984 square feet. 7.14 Rules: Rules and regulations in Exhibit "E" and such other rules as Landlord may from time to Exh E time reasonably adopt for the Real Property and the Project 1.8;4.5 Security Deposit Amount $48,984.00 payable by Tenant upon execution of Lease, by cash or check 7.7 Signs: Signs, monuments, logos or emblems at entrance to the Project, neer the top of ihe Building, on the directory, near Exh L the entrance to the Building and/or on entrance doors of the Premises 5.1 Space Plan Allowance: $97,968.00 5.1 Substantial Completion: Premises approved for occupancy by the City of San Diego Building Department and completion of construction of the Work in accordance with the approved Construction Documents and Change Order. has occurred with the exception of minor details 5.3 Substantially Completed. Date when the C ity of San Diego Building Department approves occupancy of the Premises, at least 15 days prior to Commencement Date Tenant. Linsco/Private Ledger Corp., a California corporation. 1.10 Tenant Improvement Allowance. The amc unt Tenant shall receive from Landlord of $1,494,176.00, for the cost of Tenant's improvements of the Premises, including the cost of architectural fees and permitting costs 8.1 Tenant's Insurance: Policies for Public Liability and Property Damage, Automobile Liability, Workers Compensation, Business Personal property and Loss of Income, procured at Tenant's sole cost and expense 4.5 Tenant's Invitees: Tenant's guests, visitors, customers, invitees and/or licensees 11,1(c) Tenant's Notice. Written notice to Landlord of a form of proposed assignment 1.4(a) Tenant's Occupancy. The easier of (i) the (late when 15 employees of Tenant are occupying the Premises as their primary work place or ( i) date when Tenant first conducts its business on the Premises 4.5 Tenant's Representatives-. Tenant's agent(',), employee(s), officer(5) andlor independent contractor(s) of or retained by Tenant 1.5; Term of Lease: One Hundred Twenty (120) full calendar months 3.1 from and after the Commencement Date, or, if the Commencement Date is not the first day of a month, from and After the first day of the month following the Commencement Date; Commencement Date and Expiration Date to be confirmed in writing by Landlord and Tenant within 15 days after the Glossary of Terms Used Page 7 Page 10 77 7.13(s) Tri-Water System: original water source heat pump system plus second circulating pump Exh F installed by Landlord; Tenant to install improvement or auxiliary system if required by Final Space Plan specifications 1.3 Usable Square Footage: 43,568 square feet. 5.1 Work: shall mean Tenant improvements a' set forth in the approved Construction Documents and approved Change Orders as defined in the Work Letter, also referenced in Work Letter 51.4 as installation and construction of the Tenant improvements by Tenant in accordance with the permitted and approved Construction Documents and Change Orders Exh C Work Letter. Exhibit "C" Glossary of Terms Used Page 8 IN WORK LETTER (Exhibit C") 1.3 Building Plans. best available shell building plans and information delivered to Tenant by Landlord 1.2 Building Standards: Building/Tenant Improvement Standard for Pacific Corporate Park; also referenced in Lease 57.9(c)(viii) and attached to Lease as Exhibit "0" 21 Business days. Monday through Friday, excluding all federal and state holidays l4!I 008 12.1.4 CC&R's: Declaration of Covenants, Conditions and Restrictions for Unit No. 1 of Pacific Corporate Center, dated May 14, 1985 and recorded as Instrument #85-169398; also referenced in Lease 57.7 and attached to Lease as Exhibit "K 9.1 Change Order. Any deviation from the Construction Contract during the construction of the Work, in written form from the Tenant to the General Contractor, except for minor changes that are made by the General Contractor which *ire within normal construction practices in the San Diego Area 5.3 Construction Contract. Tenant's contract with Tenant's licensed general contractor 2.4 Construction Documents. all documents required to obtain a building permit from the City of San Diego for the Work, including any corrections or changes requested by the City of San Diego (consistent with approved Final Space.' Plan, Design Presentation and the Building Standards) 2.3 Design Presentation. meeting to present and discuss the design/development plans in accordance with the Schedule 2.4,1 50% Completion. Construction Documents when fifty percent completed in accordance with the 2.4,1 Schedule, AS determined by Tenant's architect Page 11 78 2.2 Final Space Plan. a final schematic drawing depicting the Premises with walls, doors, windows, columns and structural elements, based on cite visits, other information obtained by Tenant or Tenant's Representatives, and the Building F'lans 1.1 Premises Shell and Stub-In: Shall include: (a) smooth concrete floors; (0) unfinished ceilings in the Premises; (c) finished core area, including elevator(s), toilet room(s), electrical room, telephone room(s), janitorial closet(s) and exit stair(s); (0) dry wall (taped arid/or finished, but not painted) around surfaces of core walls; (e) existing heating, ventilating and air conditioning service; (f) existing sprinkler service within the Building (not including main loops and branch distribution); (g) main electrical panel; (h) exercise room including existing exercise equipment; and (i) life safety systems as required by the applicable San Diego City Municipal Code for a building shell 5.3 General Contractor. Tenant's licensed general contractor Landlord. PacCor Partners, a California general partnership. 10 Landlord Delay Each day or any portion thereof during which any events occur as described in 510.1 through 10.3 2.6 PID. Amended Planned Industrial Development Permit No. S5-OS30 (Exhibit "N" to Lease) Glossary of Terms Used Page 9 8.1 Percentage of Work Completed: Tenant'." General Contractor's approved monthly payment request divided by the total cost of the Work; 2.1 Preliminary Space Plan. a preliminary schematic drawing depicting the Premises with walls, doors, windows, columns and structural elements, based on site visits, other information obtained by Tenant or Tenant's Representatives, and THE best available Building Plans supplied by Landlord 2.1;6 Schedule. Listing of action, Tenant and Landlord responsibilities and due dates Idl oat 13 Special Improvements-. Special Tenant improvements to the Premises which may include computer facilities, auditoriums, cafeterias, dining rooms, internal stairwells, one stairwell outside of the Building and other special facilities incidental to Tenant's operations which will be subject to Landlord's approval Tenant. Linsco/Private Ledger Corp., a California corporation. 16.1 Tenant's Contractors. Collectively, Tenants contractors, vendors or any other party performing work for Tenant Unavoidable Delay. Each day or any portion thereof during which any delays or defaults as described in 611.1 through 511.3 occur Exh C Work Letter. Exhibit "C" to Lease 1.4 Work. Installation and construction of THE Tenant improvements by Tenant in accordance with the permitted and approved construction documents; also referenced in Lease 55.1 to mean Tenant improvements as set forth in the approved Construction Documents and approved Change Orders as defined in the Work letter Page 12 79 FIRST AMENDMENT TO OFFICE BUILDING LEASE BETWEEN PACCOR PARTNERS and LINSCOIPRIVATE LEDGER CORP. QI 010 This First Amendment To Office Building Lease between PacCor Partners and Linsco/Private Ledger Corp. ("First Amendment"), is made and entered into as the 12th day of August, 1993 between PACCOR PARTNERS, a California general partnership ("Landlord") and LINSCOIPRIVATE LEDGER CORP., a California corporation ("Tenant'), with regard to the following: A. Landlord and Tenant entered into an Office Building Lease on June 17, 1993 ("Lease"). B. Landlord and Tenant desire to make certain amendments to the Lease as set forth in this First Amendment. NOW, THEREFORE, for valuable consideration the receipt and sufficiency of which are hereby acknowledged, the parties agree as follows: 1. The following shall be added after the last sentence of Section 4.4: "For purposes of this Section 4.4 only, the rentable square footage of the Premises and/or Building shall be BOMA Rentable Square Footage (defined in Section 6.1(i))." 2. Section 5.1(ii) shall be deleted and substituted in its place is the following: "(ii) "Space Plan Allowance" shall mean the amount of One Hundred Ten Thousand Two Hundred Fourteen Dollars ($110,214.00)." 3. Section 6.1(e) is deleted in its entirety and substituted in its plaice is the following: "(e) "Lease Expenses" shall mean the sum of (i) Building Operating Expenses, and (ii) Tenant's proportionate share (defined as A fraction, the numerator of which is the Rentable Square Footage and the denominator of which i-, the Project Rentable Area as defined below) of Common Area Operating Expenses. For purposes of determining Lease Expenses, Page 13 80 Rentable Square Footage shall be determined by BOMA lamentable Square Footage. Notwithstanding any other provision of this Lease, while Tenant occupies only the Building the Rentable Square Footage shall not exceed fifty percent (50%) of Project Rentable Area." 4. Section 6.1(g) is deleted in its entirety and substituted in its place is the following: "(g) "Project Rentable Area" shall mean 97,968 square feet plus, if applicable, the BQMA Rentable Square Footage of any future buildings in the Project. The Project Rentable Area shall be determined by BQMA Rentable Square Footage." 5. The following shall be added to the Lease as Section 6.1(i): "(i) "BOMA Rentable Squaw Footage" shall mean the square footage of a structure, building and/or premises, calculated in accordance with the method of measuring "Rentable Area" in the Building Owners and Man; gers Association International (SOMA) Standard Method for Measuring Floor Area in Office Buildings, ANSI 265.1-1980 (Reaffirmed 1989)." l4!I 011 6. In Section 12.2 (c) only, the term "Base Rent" shall be deleted and in its place inserted the term "Rent". 7. The following shall be added after the last sentence of Section 17.2: "All references to the rentable square footage of the Expansion Space shall be in accordance with BOMA Rentable Square Footage." 8, The following names shall be inserted in the bank spaces provided in paragraph 20 of the Work Letter: First blank space- Richard C'. King (236-9099) Second blank space: Paul Che miniak (236-9099) Third blank space: Edward C rochowiak (625-4613) 9. Landlord provided Tenant a copy of a Preliminary Title Report for the Project on June 25, 1993. 10. Except as specifically set forth in this First Amendment, all other terms and conditions of the Lease shall remain in full force and effect. IN WITNESS WHEREOF, the parties hereto have executed this First Amendment as of the date first hereinabove set forth, Page 14 81 Landlord: PACCOR PARTNERS, a California general partnership ---------------------------------------------- Tenant: LINSCO/PRIVATE LEDGER CORP., a California Corporation 08/03193 Z SECOND AMENDMENT TO OFFICE BUILDING LEASE BETWEEN PACCOR PAIRTNERS and LINSCOIPRIVATE i EDGER CORP. This Second Amendment To Office Building Lease between PacCor Partners and* Linsco/Private Ledger Corp. ("Second Amendment"), is made and entered into as the day of December, 1993 between PACCOR PARTNERS, a California general partnership ("Landlord") and LINSCOIPRIVATE LEDGER CORP., a California corporation ("Tenant"), with regard to the following: A. Landlord and Tenant entered into an Office: Building Lease dated June 17, 1993 ("PacCor/LPL Lease"). B. Landlord and Tenant amended the PacCor/LPL Lease by First Amendment to Office Building Lease Between PacCor Partners,encl Linsco/Private Ledger Corp. dated August 12, 1993 ("First Amendment") Tht. First Amendment accurately set forth (i) the Rentable Square Footage of the Premises (ii) the amount of the Space Plan Allowance, and (iii) the Project Rentable Area. Furthermore, "Lease Expenses" and "BQMA Rentable Square Footage" were redefined, the names of mutually agreeable arbitrators were inserted into the Work Letter and a few other minor corrections were made to the PacCor/LPL Lease. C. Landlord desires to enter into a lease with HNC, Inc. for the second floor and part of the third floor of the Adjacent Building. HNC, Inc. desires to be granted a right of first negotiation for the balance of the third floor of the Adjacent Building for a period of three (3) years after the commencement o the term of the HNC lease. Page 15 82 D. In order for Landlord to enter into a lease with HNC. Inc., Landlord and Tenant must amend the PacCor/LPL Lease to waive Tenant's right of first negotiation for the third floor of the Adjacent Building for a period not less than three (3) years after the commencement of the term of the HNC lease. E. Tenant is willing to waive its right of first negotiation for the third floor of the Adjacent Building for three (3) years in exchange for a right of first negotiation to the first and second floors of the Adjacent Building, commencing on the Commencement Date of the PacCor/LPL Lease. NOW, THEREFORE, for valuable consideration the receipt and sufficiency of which are hereby acknowledged, the parties agree to amend the PacCor/LPL Lease, as amended, as follows.- 1. Section 17.2 Right OF First Negotiation of the PacCar/LPL Lease shall be deleted in its entirety and the following shall be inserted: 17.2 Right of First Negotiation: Landlord shall notify Tenant in writing whenever an Expansion Space (as defined below) becomes, or is expected to become, available ("Availability Notice"). Such notification shall include the rental rate and other terms and conditions upon which Landlord Is willing to rent expansion Space. Tenant shall have THE right of first negotiation for such Expansion Space for a period of thirty (30) days after Tenant's receipt of the Availability Notice. Landlord shall negotiate in good faith with Tenant for the Expansion Space and if no agreement as to the terms of a proposed lease can be reached within thirty (30) days after Tenant's receipt of the Availability Notice, then Landlord may lease the Expansion Space during A one (1) year period thereafter (following which this right of first negotiation shall BE reinstated) to another party on terms (including the terms included in the definition of Fair Market Rental Value) in the aggregate no less favorable to Landlord than Landlord's last offer to Tenant during such negotiations ("Landlord's Last Offers. If during such one year period Landlord has received a bonafide offer to lease the Expansion Space which Landlord is prepared to accept and the aggregate terms OF such lease are less favorable to Landlord than Landlord's Last Offer, then Landlord shall give notice to Tenant of such terms in writing and Tenant shall thereafter have A right of first refusal, exercisable during a ten (10) business day period following receipt of such notice, to lease such Expansion Space on the terms set forth in such notice, If not timely exercised by Tenant, such right of first refusal shall expire with respect to the particular Expansion Space described in the notice, For purposes of this Section, "Expansion Space" shell mean (a) Page 16 83 any rentable space on the first (1st) and/or second (2nd) floaters) of the Adjacent Building which is available for lease during months one (1) through eighty-four (84) at the Term of the Lease, and (b) any rentable space on the third (3') floor which is available for lease dt.ring months thirty-seven through eighty-four (84) of the Term of the Lease. All rights of fi st negotiation and first refusal pursuant to this Section shall in any event terminate seven (i) years after (he Commencement Date 2. Except as specifically set forth in this Second Amendment, all other terms and conditions of the PacCor/LPL Lease, as amended, shall remain in full force and effect. IN WITNESS WHERFOF, the parties hereto have executed this Second Amendment as of the date first hereinabove set forth. Landlord: PACCOR PARTNEF!S, a California general partnership By: PacCor Management Company, A general partner -------------------------------------------------- ITS: VICE PRESIDENT Tenant: LINSCOIPRIVATE LEDGER CORP., a California Corporation By: Page 17 84 ASSIGNMENT AND ASSUMPTION OF LEASE AND CONSENT OF LANDLORD This Assignment and Assumption of Lease and Consent of Landlord ("Assignment") is made and entered into as of December 30, 1997, by and between Linsco/Private Ledger Corp., a California corporation ("Assignor"), and HNC Software, Inc., a Delaware corporation ("Assignee"), with reference to the facts set forth below. RECITALS A. Assignor and Gateway Colorado Properties, Inc. ("Landlord") are parties to that certain Office Building Lease dated June 17, 1993, as amended by the First Amendment to Office Building Lease dated as of August 12, 1993 ("First Amendment"), and by that certain Second Amendment to Office Building Lease dated as of December, 1993 ("Second Amendment") (collectively, the "Lease"). The Lease covers certain space consisting of approximately 48,984 rentable square feet (the "Premises") containing the entire building located at 5935 Cornerstone Court West, San Diego, California (the "Building"). B. Assignor desires to assign to Assignee its right, title and interest under the Lease and Assignee desires to assume and become responsible for all obligations and liabilities under the Lease. Landlord is willing to consent to the assignment on the terms and conditions as set forth herein. NOW, THEREFORE, in consideration of the recitals and agreements contained herein and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Assignor and Assignee agree as set forth below. 1. Assignment. Assignor hereby assigns to Assignee all of its right, title and interest under the Lease which assignment shall be effective as of the Effective Date (as defined below). The effective date of the assignment of the Lease (the "Effective Date") shall be the date that Assignor vacates the entire Premises to move to its new facility. The parties currently estimate that the Effective Date will occur on September 6, 1998. Assignor shall give written notice to Assignee (the "Effective Date Notice") six (6) months prior to Assignor's then estimated Effective Date (the "Estimated Effective Date"). In addition, Assignor shall give Assignee regular updates as to the status of Assignor's schedule to vacate the Premises and shall promptly notify Assignee of any changes to the Estimated Effective Date, provided that the Estimated Effective Date shall not be earlier than the date set forth in Assignor's Effective Date Notice without Assignee's consent. In addition, Assignor shall give Assignee at least thirty (30) days prior written notice of the actual Effective Date to allow Assignee to schedule its move in to the Premises. If Assignor does not deliver the Effective Date Notice by September 6, 1998, or if the Effective Date does not occur by March 6, 1999, Assignee shall have the right to terminate this Assignment by giving written notice of termination to Assignor, and, upon such termination, neither party shall have any further rights or obligations under this Assignment. On the Effective Date, Assignor shall deliver possession of the Premises to Assignee in the condition required by Section 14.1 of the Lease as such provision applies to the expiration or earlier termination of the Lease and with all Building systems in good 85 working order. Except as provided in the preceding sentence, the Premises shall be delivered to Assignee in its "as-is" condition existing on the date of this Assignment, subject to normal wear and tear between the date of this Assignment and the Effective Date. 2. Assumption. Assignee hereby accepts the assignment, and assumes and agrees, for the benefit of Assignor and Landlord, to be responsible for and further agrees to faithfully perform and be bound by all of the terms, covenants, conditions, provisions and agreements of the Lease from and after the Effective Date. 3. Indemnity. Assignor agrees to indemnify, defend (with counsel reasonably acceptable to Assignee) and hold Assignee and its officers, directors, shareholders, agents, employees and affiliates harmless from and against any and all claims, actions, liabilities, damages, costs and expenses (including, without limitation, attorneys' fees and costs incurred in connection therewith or to enforce this indemnity obligation) arising from or relating to any obligations to be performed by Assignor under the Lease prior to the Effective Date and/or any acts or omissions of Assignor in connection with the Lease prior to the Effective Date. Assignee agrees to indemnify, defend (with counsel reasonably acceptable to Assignor) and hold Assignor and its officers, directors, shareholders, agents, employees and affiliates harmless from and against any and all claims, actions, liabilities, damages, costs and expenses (including, without limitation, attorneys' fees and costs incurred in connection therewith or to enforce this indemnity obligation) arising from or relating to any obligations to be performed by Assignee under the Lease on or after the Effective Date and/or any acts or omissions of Assignee in connection with the Lease on or after the Effective Date. Notwithstanding the foregoing, if Assignee's move-in is phased pursuant to Section 6 below, Assignor's indemnity obligation shall continue, and Assignee's indemnity obligation shall not commence, with respect to each phase until Assignor delivers possession of such phase to Assignee. 4. Security Deposit. Notwithstanding the assignment of the Lease as provided herein, Assignor shall retain all rights to the security deposit delivered to Landlord under the Lease in the amount of $48,984 (the "Security Deposit"). The Security Deposit shall be paid by Landlord directly to Assignor in accordance with the terms of the Lease. Assignee agrees to immediately deliver the Security Deposit to Assignor if the Security Deposit is paid to Assignee notwithstanding the preceding sentence. In addition, Assignee agrees to immediately reimburse Assignor for any deductions from the Security Deposit made by Landlord in accordance with the Lease as a result of Assignee's failure to perform its obligations under the Lease from and after the Effective Date. Assignee shall also be obligated to pay (or to cause Landlord to pay) to Assignor an amount equal to the Security Deposit if Assignee and Landlord (a) terminate the Lease and enter into a new lease of the Premises or (b) modify the material terms of the Lease. 5. Covenants, Representations and Warranties of Assignor. Assignor hereby represents and warrants to Assignee that (i) Assignor has not previously made an assignment of Assignor's rights under the Lease to any other party, (ii) that the Lease is in full force and effect and has not been modified or amended except as provided in the First Amendment and the Second Amendment described above, (iii) the copies of the Lease delivered by Assignor to Assignee are true, correct and 2 86 complete copies of the Lease, (iv) neither Assignor nor, to Assignor's knowledge, Landlord is in default of their respective obligations under the Lease and (v) the Commencement Date of the Lease occurred on June 1, 1994. Such representations and warranties shall be true and correct in all material respects as of the date of this Assignment and as of the Effective Date. Between the date of this Assignment and the Effective Date, Assignor agrees to promptly deliver to Assignee copies of any and all notices relating to the Lease and/or the Premises, to timely perform all of its obligations under the Lease, and not to modify or amend the Lease or exercise any rights or remedies under the Lease without Assignor's prior written approval, which approval shall not be unreasonably withheld. 6. Phased Occupancy. Assignor and Assignee agree to cooperate, in good faith, if Assignor elects to phase-out of the Building at different times. Assignor shall give written notice of such election to Assignee stating the dates on which Assignor intends to vacate each portion of the Building. The parties acknowledge and agree that each phase of the Building to be vacated by Assignor must be sufficiently demised and otherwise appropriate for Assignee's phased move-in and use. In the event of a phased move-in, Assignee shall only be responsible for a proportionate share of the obligation to pay rent and other amounts due under the Lease and the performance of other obligations under the Lease based on a fraction, the numerator of which is the rentable area of the portion of the Premises so occupied by Assignee, and the denominator of which is the total rentable area of the Premises. In such event, Assignor shall remain liable for its proportionate share of all payment and performance obligations under the Lease. In no event shall the phase-out period be longer than six (6) months after the date possession of the first phase of the Building is delivered to Assignee. 7. Termination of Existing Sublease. Assignor, as sublessee, and Assignee, as sublessor, have entered into that certain Sublease dated September 24, 1996 (the "Sublease") relating to space within the building located at 6020 Cornerstone Court West in San Diego, California. The parties agree that the Sublease shall terminate on the date Assignor fully vacates such space in accordance with the Sublease and the parties shall be released of all obligations under the Sublease from and after such date. Assignor shall give Assignee at least six (6) months prior written notice of the date upon which it will vacate such space. 8. Commission. Except for The Irving Hughes Group, Inc. ("Broker"), Assignor and Assignee each represent and warrant to the other that it has not dealt with any party, whether or not licensed, that may be entitled to a commission, finder's fee or similar compensation in connection with this Assignment. Assignor and Assignee each agree to indemnify, defend (with counsel reasonably acceptable to the other) and hold harmless the other party from and against all claims, damages, liabilities, costs and expenses (including attorneys' fees and costs incurred in connection therewith or to enforce this indemnity agreement) arising from or relating to the indemnifying party's breach of the foregoing representation and warranty. 3 87 9. Improvements. Assignee may desire to make improvements to the Premises after the Effective Date. Assignor agrees to cooperate with Assignee to apply for and seek Landlord's consent to such improvements in accordance with the provisions of the Lease. 10. Miscellaneous. In the event any action or proceeding is brought by either party against the other relating to or arising from this Assignment or to enforce or interpret any provision hereof, the prevailing party shall be entitled to recover from the other party all costs and fees incurred in connection therewith, including without limitation, fees and costs of attorneys, experts and consultants in connection with such action or proceeding, the enforcement of any judgment and any appellate proceedings. This Assignment and all terms and conditions contained herein shall be binding upon and inure to the benefit of the successors and assignors of the parties. This Assignment constitutes the entire agreement between the parties with respect to the matters set forth herein and supersedes all prior and contemporaneous agreements and understandings, whether written or oral, pertaining to any such matters, provided that the Sublease shall not be affected excepted as provided herein. This Assignment may not be modified or amended except by a written agreement signed on behalf of each of the parties. This Assignment shall be construed and enforced in accordance with the internal laws of the State of California. This Assignment may be executed in counterparts, each of which, when executed and delivered, shall constitute one fully executed original. 11. Notices. Any notice pursuant to this Assignment shall be in writing and shall be addressed as follows: To Assignor: Linsco/Private Ledger Corp. 5935 Cornerstone Court West San Diego, California 92121 Attn: Douglas Avola To Assignee: HNC Software, Inc. 5930 Cornerstone Court West San Diego, California 92121-3728 Attn: Mr. Hugh D. Gerfin Each party shall have the right upon prior written notice to the other to change its address for notices. Each notice given hereunder shall be effective as follows: (i) upon delivery if by personal delivery, (ii) three (3) business days after mailing if sent by United States Postal Service registered or certified mail, return receipt requested, (iii) one (1) business day after sending if sent by FedEx or a similar nationally-recognized overnight delivery service or (iv) upon sending and confirmation if sent by facsimile. 4 88 IN WITNESS WHEREOF, Assignor and Assignee have executed this Assignment effective as of the date as set forth above. ASSIGNOR: ASSIGNEE: LINSCO/PRIVATE LEDGER CORP., a California HNC SOFTWARE, INC., a Delaware corporation corporation By: By: -------------------------------- ----------------------------- Its: Its: -------------------------------- ----------------------------- 5 89 CONSENT OF LANDLORD In consideration of the covenants and agreements contained in this Assignment, Landlord hereby consents to the foregoing assignment of the Lease by Assignor to Assignee, provided, however, that (i) the consent of Landlord herein shall not be deemed to in any way release or diminish the liability of Assignor to Landlord; and (ii) the consent of Landlord herein shall not be deemed a consent to any future assignment, sublease or transfer of the Premises, all of which shall require Landlord's consent. Such consent shall not be subject to the requirement set forth in Section 11.1(d) of the Lease that any proposed assignment be consummated within 180 days after Landlord's consent, and Landlord's consent shall remain valid and in full force and effect if the assignment becomes effective on the Effective Date as set forth in the Assignment. Landlord confirms that, as of the date of this consent, (a) the Lease is in full force and effect and has not been modified or amended except as provided in the First Amendment and the Second Amendment and (b) Landlord is not aware of any default under the Lease by Assignor. Prior to the Effective Date, Landlord agrees to give Assignee written notice of any default by Assignor under the Lease and to give Assignee an opportunity to cure any such default for a period following such notice equal to the applicable cure period under the Lease. Dated: ____________________ LANDLORD: GATEWAY COLORADO PROPERTIES, INC. By: ----------------------------------------- Its: ------------------------------ 6 EX-23.01 3 EXHIBIT 23.01 1 EXHIBIT 23.01 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statements on Form S-3 (No. 333-22735 and No. 333-46419) of HNC Software Inc. of our report dated January 29, 1998, except as to Note 11 which is as of February 13, 1998, appearing on page 36 of this Form 10-K/A-1. We also consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 33-92902, No. 333-14323, No. 333-18871 and No. 333-46875) of HNC Software Inc. of our report dated January 29, 1998, except as to Note 11 which is as of February 13, 1998, appearing on page 36 of this Form 10-K/A-1. We also consent to the incorporation by reference of our report on the Financial Statement Schedule, which appears on page 62 of this Form 10-K. PRICE WATERHOUSE LLP San Diego, California February 25, 1998 -----END PRIVACY-ENHANCED MESSAGE-----