10-K 1 d557051d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

Form 10-K

(Mark One)

  x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended June 30, 2013

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: 001-31825

 

 

THE FIRST MARBLEHEAD CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware

(State or other jurisdiction of
incorporation or organization)

 

04-3295311

(I.R.S. Employer
Identification No.)

The Prudential Tower

800 Boylston Street, 34th Floor

Boston, Massachusetts

(Address of principal executive offices)

 

02199-8157

(Zip Code)

Registrant’s telephone number, including area code: (800) 895-4283

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, $0.01 par value   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes ¨     No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   Yes ¨     No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes x     No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes x     No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) of this chapter is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨   Accelerated filer x  

Non-accelerated filer ¨

(Do not check if a
smaller reporting company)

   Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).   Yes ¨     No x

The aggregate market value of the voting and non-voting common equity held on December 31, 2012 by non-affiliates of the registrant (without admitting that any person whose shares are not included in the calculation is an affiliate) was approximately $64,673,019 based on the last reported sale price of the common stock on the New York Stock Exchange on December 31, 2012. For the purposes of the immediately preceding sentence, the term “affiliate” refers to each director, executive officer and greater than 10% stockholder of the registrant as of December 31, 2012 and ownership excludes shares issuable upon vesting of restricted stock units and exercise of outstanding stock options.

Number of shares of the registrant’s common stock outstanding as of September 11, 2013: 112,748,663.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

The registrant intends to file a proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended June 30, 2013. Pursuant to Paragraph G(3) of the General Instructions to Form 10-K, information required by Items 10, 11, 12, 13 and 14 of Part III have been omitted from this report (except for information required with respect to our executive officers and code of ethics, which is set forth under “Executive Officers of the Registrant” and “Code of Ethics” in Part I of this annual report, respectively) and are incorporated by reference to the definitive proxy statement to be filed with the Securities and Exchange Commission.

 

 

 


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THE FIRST MARBLEHEAD CORPORATION

ANNUAL REPORT ON FORM 10-K

For the Fiscal Year Ended June 30, 2013

TABLE OF CONTENTS

 

PART I

     1   

ITEM 1. BUSINESS

     1   

ITEM 1A. RISK FACTORS

     19   

ITEM 1B. UNRESOLVED STAFF COMMENTS

     41   

ITEM 2. PROPERTIES

     41   

ITEM 3. LEGAL PROCEEDINGS

     42   

ITEM 4. MINE SAFETY DISCLOSURES

     44   

PART II

     45   

ITEM  5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

     45   

ITEM 6. SELECTED FINANCIAL DATA

     47   

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS

     49   

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     74   

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     76   

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

     126   

ITEM 9A. CONTROLS AND PROCEDURES

     126   

ITEM 9B. OTHER INFORMATION

     129   

PART III

     129   

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

     129   

ITEM 11. EXECUTIVE COMPENSATION

     129   

ITEM  12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

     129   

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

     130   

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

     130   

PART IV

     130   

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

     130   

FIRSTMARBLEHEAD and MONOGRAM are registered service marks and PREPGATE is a service mark of The First Marblehead Corporation. BORROWSMART is a registered service mark of Tuition Management Systems LLC. UNION FEDERAL is a registered service mark of Union Federal Savings Bank. VOLTA is a service mark of Cology LLC. All other trademarks, service marks or trade names appearing in this annual report are the property of their respective owners.

In addition to historical information, this annual report includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and Section 27A of the Securities Act of 1933, as amended, or the Securities Act. For this purpose, any statements contained herein regarding our strategy, future operations and products, financial performance and liquidity, future funding transactions, projected costs, projected loan portfolio performance, future market position, prospects, plans and outlook of management, and proceedings related to our federal and state income tax returns, including any challenge to the tax refunds previously received as a result of the audit being conducted by the Internal Revenue Service, other than statements of historical facts, are forward-looking statements. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “observe,” “plans,” “projects,” “would,” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guaranty that we actually will achieve the plans,


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intentions or expectations expressed or implied in our forward-looking statements, which involve risks, assumptions and uncertainties. There are a number of important factors that could cause actual results, timing of events, levels of activity or performance to differ materially from those expressed or implied in the forward-looking statements we make. These important factors include our “critical accounting estimates” described in Item 7 of this annual report, and factors including, but not limited to, those set forth under the caption “Risk Factors” in Item 1A of this annual report. Although we may elect to update forward-looking statements in the future, we specifically disclaim any obligation to do so, even if our estimates change, and readers should not rely on those forward-looking statements as representing our views as of any date subsequent to September 13, 2013.


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PART I

Unless otherwise indicated, or unless the context of the discussion requires otherwise, we use the terms “we,” “us,” “our” and similar references to refer to The First Marblehead Corporation and its subsidiaries, on a consolidated basis. We use the terms “First Marblehead” and “FMD” to refer to The First Marblehead Corporation on a stand-alone basis. We use the term “education loan” to refer to private education loans that are not guaranteed by the federal government. Our fiscal year ends on June 30, and we identify our fiscal years by the calendar years in which they end. For example, we refer to the fiscal year ended June 30, 2013 as “fiscal 2013.”

 

Item 1. Business

Overview

We are a specialty finance company focused on the education financing marketplace in the United States. We provide loan programs on behalf of our lender clients for K-12, undergraduate and graduate students and for college graduates seeking to refinance private education loan obligations, as well as tuition planning, tuition billing, refund management and payment technology services. We offer a fully integrated suite of services through our Monogram® loan product service platform, which we refer to as our Monogram platform, as well as certain services on a stand-alone, fee-for-service basis. We partner with lenders to design and administer education loan programs through our Monogram platform, which are typically school-certified. They are designed to be marketed through educational institutions or to prospective borrowers and their families directly and to generate portfolios intended to be held by the originating lender or financed in the capital markets. We also offer a number of other services on a stand-alone, fee-for-service basis in support of our clients, including retail banking, loan origination, portfolio management and securitization services.

On October 19, 2012, we acquired a substantial portion of the operating assets, and assumed certain liabilities, of Cology, Inc. and its affiliates. We refer to Cology, Inc. and its affiliates as the Cology Sellers. We refer to the FMD subsidiary that acquired a substantial portion of the operating assets of the Cology Sellers as Cology LLC. Through Cology LLC, we provide loan processing services to approximately 270 credit union and other lender clients. Our consolidated financial statements for fiscal 2013 reflect revenues and expenses of Cology LLC since the date of acquisition.

Our product and service offerings are part of a change in our revenue model that we have been implementing since fiscal 2009 with a focus on fee-based revenues. Our long-term success depends on the continued development of our four principal revenue lines:

 

   

Partnered lending—We provide customized Monogram-based education loan programs for lenders who wish to hold originated portfolios to maturity. We may provide credit enhancements by funding participation interest accounts, which we refer to as participation accounts, or, in the case of FMD’s subsidiary Union Federal Savings Bank, which we refer to as Union Federal®, deposit accounts, to serve as a first loss reserve for defaulted program loans. In consideration for funding participation accounts, we are entitled to receive a share of the interest income generated on the loans. We are paid for our origination and marketing services at the time approved education loans are disbursed and receive monthly payments for portfolio management services, credit enhancement and administrative services throughout the life of the loan.

 

   

Banking services—Union Federal offers traditional retail banking products, including residential and commercial mortgages, time deposits and money market demand accounts, on a stand-alone basis. In addition, Union Federal generates additional revenues by originating Monogram-based education loan portfolios, subject to regulatory conditions, with the intent of holding them to maturity.

 

   

Capital markets—Our capital markets experience coupled with our loan performance database and risk analytics provide specialized insight into funding options available to our lender clients. We have a right of first refusal should one of our partner lenders wish to sell some or all of its education loan portfolio

 

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prior to maturity. In addition to traditional asset-backed securitizations, funding options may also include whole loan sales or other financing alternatives. We can also earn net interest income by retaining a portion of the equity in any of these transactions.

 

   

Fee-for-service—Loan origination, portfolio management, analytical and structuring services, tuition billing and payment processing and refund management services are each available on a stand-alone, fee-for-service basis. We offer outsourced tuition planning, tuition billing, refund management and payment technology services for universities, colleges and secondary schools through FMD’s subsidiary Tuition Management Systems LLC, which we refer to as TMS. TMS provides such services on behalf of over 700 educational institutions. Through Cology LLC, we earn fees for the processing of education loans on behalf of its approximately 270 credit union and other lender clients.

Education loans are funded by private sector lenders and are not guaranteed by the federal government. They are intended to be used by borrowers who have first utilized other sources of education funding, including family savings, scholarships, grants and federal and state loans. For the 2011-2012 academic year, we believe that there was a “funding gap” in post-secondary education in the United States of approximately $141 billion between the costs of attendance and these sources of education funding, based on information from the National Center for Education Statistics and The College Board. We believe that enrollment in post-secondary education institutions will continue to increase over the next several years, as will costs of attendance. We also believe that education loan products will continue to be necessary for students and their families after applying family savings and exhausting all available scholarships, grants and federal and state loans.

The lifecycle of an education loan, which can be over 20 years long, consists of a series of processes, many of which are highly regulated, and involves many distinct parties. As a result, the activities associated with designing, implementing, financing and administering education loan programs are complex, resource intensive and costly. We offer specialized knowledge, experience and capabilities to assist clients in participating in the education loan market. Our service offerings are intended to serve a range of potential client needs throughout the life-cycle of an education loan. For example, we can assist clients in developing all aspects of an education loan program based on our Monogram platform, or we can provide tailored loan origination, portfolio management and other services to meet their specific needs. In addition, through TMS, we provide students and their families with the opportunity to structure tuition payment plans that meet their financial needs while providing a broad array of tuition payment options.

Our clients in the past have typically been lenders that desired to supplement their existing federal education loan or other consumer lending programs with a private education loan offering. In response to legislative changes that eliminated the Federal Family Education Loan Program, or FFELP, as of July 2010, many lenders have re-evaluated their business strategies related to education lending. We believe that these legislative changes as well as general economic conditions, capital markets disruptions and the declining credit performance of consumer-related loans, including education loans, have contributed to an overall reluctance by many lenders to focus on their education lending business segments. As a result, we believe that there is significant unmet demand for education loans and generally less competition than previously in addressing that demand. As market conditions for other consumer finance segments improve, we believe that more lenders will focus on education lending and consider education loans as part of an array of consumer lending products offered to their customers. One of our primary goals is to educate national and regional lenders on the opportunity to provide education loans in a manner that meets their desired risk control and return objectives. A related challenge, although growth in our partnered lending activities is not contingent upon it, is to successfully finance education loans generated through our Monogram platform through capital market transactions.

Our near-term financial performance and future growth depend, in large part, on growing our client base by successfully marketing our Monogram platform, TMS services and Cology LLC services while transitioning from our prior business model (see “—Prior Business Model” below) to one that is based on fee revenues.

 

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Current Business Model

Since the beginning of fiscal 2009, we have significantly refined our service offerings and added fee-for-service offerings. During fiscal 2010, we completed the development of our Monogram platform, including an enhanced application interface, an expanded credit decisioning model and additional reporting capabilities. We continue to incorporate refinements to our Monogram platform. During fiscal 2011, we began providing services for two lender clients related to school-certified education loan programs, including originating education loans, based on our Monogram platform and began offering tuition planning, tuition billing and payment technology services through TMS. During fiscal 2012, we began performing services for Union Federal related to school-certified education loan programs based on our Monogram platform, including a K-12 loan program, and we began offering refund management services to education institutions and students through TMS. In June 2012, we launched a Monogram-based loan program with a new lender client and in August 2012, we launched a Monogram-based loan consolidation program with an existing client. In October 2012, we began providing loan processing services to credit union and other lender clients through Cology LLC.

Monogram Platform

Our Monogram platform integrates our program design, marketing support, loan origination and portfolio management service offerings. It enables lenders to offer consumers education loans with competitive terms and clear pricing alternatives, with product options based on the credit profiles of qualified applicants. Specifically, a lender can customize the range of loan terms offered to their qualified applicants, such as repayment options, repayment terms and borrower pricing.

The product can be structured to offer lenders and other financial institutions a “make and hold” or “make and sell” loan program. In “make and hold” loan programs, lenders finance the education loans on their balance sheet and generally intend to hold the loans through scheduled repayment, prepayment or default. In “make and sell” loan programs, lenders intend to hold the education loans on their balance sheet for some limited period of time before disposing of the loans in a capital market transaction or whole loan sale. We believe that the education loans generated through our Monogram platform will generally have shorter repayment periods, an increased percentage of borrowers making payments while in school, higher cosigner participation rates, an overall better credit profile and lower estimated default rates in each case when compared to loan products we previously facilitated.

We designed our Monogram platform to generate recurring revenue with less dependence on the securitization market and third-party credit enhancements. In connection with our Monogram platform, we have invested, and may continue to invest, specified amounts of capital as a credit enhancement feature to various lenders’ loan programs. The amount of any contribution offered to a particular lender would be determined by the anticipated size of the lender’s program, the underwriting guidelines of the program and the particular terms of our business relationship with the lender. We believe this approach provides assurances to lenders that we are committed to the quality of our new proprietary scoring models and risk mitigation and pricing strategies. In connection with certain of our lender clients’ Monogram-based loan programs, we have provided credit enhancement by funding participation accounts or, in the case of Union Federal, deposit accounts, to serve as a first-loss reserve for defaulted program loans. We have made initial deposits toward our credit enhancement arrangements and agreed to provide periodic supplemental deposits, up to specified limits, during the disbursement periods under our loan program agreements based on the credit mix and volume of disbursed program loans and adjustments to default projections, if any, for program loans. To the extent that outstanding loan volume decreases as a result of repayment, or if actual loan volumes or default experience are less than reflected in our funded amounts, we are eligible to receive periodic releases of funds. The timing and amount of releases, if any, from the participation accounts are uncertain and vary among the loan programs. In consideration for funding participation accounts, we are entitled to receive a share of the interest income generated on the loans.

As part of our Monogram platform, we monitor the performance of loan accounts after origination and tailor risk mitigation strategies according to the performance patterns of those accounts. We have built a flexible infrastructure to support our portfolio management strategy, which requires extensive operational and data

 

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integration among the loan servicer, multiple default prevention and recovery agencies and us. Finally, we provide extensive customer service to each client, including ongoing analysis and comprehensive reporting of loan performance data.

We offer the following fully integrated suite of services through our Monogram platform or as stand-alone services tailored for our clients’ specific needs:

Program Design

Education loans are a complex asset class that requires sophisticated analytical capabilities combining effective, quantitative underwriting, responsible marketing and dynamic portfolio management. At the core of our Monogram platform resides over 20 years of education loan performance data that we have used to create a suite of proprietary risk models, including proprietary underwriting, fraud and collectability scorecards. We believe that these risk models can be used throughout the lifecycle of an education loan to manage risk, optimize performance and potentially improve profitability.

Lenders face an array of choices in attempting to satisfy their strategic and financial goals, as well as the needs of their borrowers. In designing education loan programs, the factors that lenders generally consider include:

 

   

Borrower creditworthiness and eligibility criteria;

 

   

Loan limits, including minimum and maximum loan amounts on both an annual and aggregate basis;

 

   

Interest rates, including the frequency and method of adjustment;

 

   

Amount of fees charged to the borrower, including origination, guaranty and late fees;

 

   

Repayment terms, including maximum repayment term, minimum monthly payment amounts, rate reduction incentive programs and deferment and forbearance options;

 

   

Appropriate credit enhancement levels to ensure repayment of defaulted principal and interest payments;

 

   

Loan servicing, default management and collection arrangements;

 

   

Asset financing or loan disposition alternatives; and

 

   

Legal compliance with numerous federal laws and regulations as well as numerous state laws that replicate and, in some cases, expand upon, the requirements of federal laws.

We help lender clients design their education loan programs and customize each program for our lender clients in order to satisfy their particular needs. Although we assist lenders in selecting the underwriting criteria to be used in their loan programs, each lender has ultimate control over, and responsibility for, the selection of their underwriting criteria, and we are obligated to comply with the lender’s criteria.

Marketing Support

While creating their loan marketing programs, lenders face choices in the channels and media available to them to reach potential borrowers, including financial aid offices, online advertising, direct mail campaigns, e-mail campaigns and print advertising. As part of our Monogram platform, we can provide marketing support services for a fee based on loan volume disbursed, depending on the level of services provided to each client. With our focus on school-certified loan programs, we also believe that financial aid offices and other school contacts are, and will continue to be, an important distribution channel. In both fiscal 2012 and fiscal 2011, we expanded our national sales team to provide sales and school relationship management in support of loan programs based on our Monogram platform, and we believe that TMS’ relationships with educational institutions and potential borrowers will otherwise complement our distribution strategy. We also believe that there is an opportunity to cross-sell aspects of our Monogram platform on a stand-alone basis to Cology LLC’s credit union clients.

 

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Loan Origination

As part of our Monogram platform, we offer loan origination services for a fee based on either loan volume disbursed or applications processed, depending on the particular terms of the lender client’s contract. We have developed proprietary processing platforms, applications and infrastructure, supplemented by customized vendor solutions, for use in providing loan processing services.

Prospective and current students and their families confront a complicated process when applying for financial aid. We provide online resources and a staff of customer service personnel who understand the terms of our clients’ education loan programs and the financial aid process as a whole. In addition to a customer service function, we can provide personnel to respond to requests for loan materials and loan applications.

Once an applicant submits an application for processing, our customized credit decision software applies parameters that have been configured for each lender client’s specific program and analyzes, often within seconds, the submitted application. This analysis results in a credit decision and also generates specific loan terms offered by the lender client, aligning product options made available to qualified applicants with their credit risk. Once a loan application is complete, we communicate an initial determination to the applicant(s), informing him or her whether the application has passed the credit analysis, been rejected or is in review. Once a loan application passes the credit analysis, and the applicant has selected his or her loan terms from the available options, we generate a credit agreement, which is a legal contract between the applicant, cosigner, if any, and lender that contains the terms and conditions of the loan for the applicant based on lender-specific templates.

Once we have obtained all applicant data, including the signed credit agreement, required certifications from the school or applicant, and any required income or employment verification, we approve the application. We refer to the education loan at this point in the process as having been “facilitated.” Once we disburse loan funds on behalf of the lender, we refer to the loan as fully or partially “disbursed.”

In performing our loan origination services, we are required to comply with applicable laws and regulations relating to loan documentation, disclosure and processing, including consumer protection disclosures. The lenders with which we work generally assume responsibility for compliance with federal and state laws regarding the forms of loan documentation and disclosure, and we are generally responsible for populating such forms in accordance with the program guidelines. We are also responsible for maintaining processes and systems that properly execute the lenders’ origination requirements and administer their credit agreement templates and required disclosures. In addition, we may deliver each lender’s privacy policy, and prepare and deliver disclosures required by the Truth-in-Lending Act, or TILA, as well as various state law disclosures, to borrowers.

We also monitor developments in state and federal requirements for loan processing and implement changes to our systems and processes based on our analysis and input we receive from clients and industry groups.

Portfolio Management

Once loans are disbursed, holders of the loans may outsource the management of such loans to third-party service providers, such as us. In our role as portfolio manager, we monitor the performance of portfolio vendors, including both loan servicers and collection agencies. For portfolio management services, we charge a fee generally based on the aggregate principal balance of education loans under management for the client.

We use a multi-faceted approach to portfolio management. To maximize the performance of each portfolio, we receive updated credit bureau data on each borrower and each cosigner each quarter and use it in combination with monthly performance data and experiential data to re-evaluate the risk profile of the portfolio. We use our proprietary risk models to develop portfolio management strategies and determine the level of resources we apply to each account, including when the account is outsourced to a collection agency and which agency is used in that process. For example, certain collection agencies may specialize in early-stage delinquencies while others may specialize in the collection of defaulted loans. This process requires a highly integrated infrastructure among the loan servicers, collection agencies and us and involves extensive data analysis on each account as it moves through its repayment lifecycle. We believe this approach allows us to manage and control losses over time.

 

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We work with a network of vendors to manage education loans on behalf of our clients. The Pennsylvania Higher Education Assistance Agency, also known as AES and which we refer to as PHEAA, provides servicing of a majority of the loans we facilitate. Generally, loan servicers establish and maintain contact with borrowers whose loans are current and collection agencies establish and maintain contact with borrowers whose loans are delinquent or defaulted. Duties of the portfolio management vendors include, for example, preparing repayment invoices, payment collection, maintaining borrower payment records, responding to borrower inquiries and reporting information to the loan owner. In addition, portfolio vendors may perform skip-tracing services, make collections calls and conduct other collections activities, and report borrower delinquencies or defaults to credit bureaus.

Loan Securitization

Although some lenders originate loans and then hold them for the life of the loan, other lenders originate and then seek to dispose of the loans, either through a sale of whole loans or by means of a securitization. Whole loans can be purchased by other financial institutions or by entities that serve to warehouse the loans for some period of time, pending permanent financing, including loan securitization. In the typical securitization process, a special purpose entity obtains education loans from the originating lenders or their assignees, which relinquish to the special purpose entity their ownership interest in the loans. The debt instruments issued by the special purpose entity to finance the purchase of these education loans are obligations of the special purpose entity, not the originating lenders or their assignees. Through both the structure of those asset-backed securities, or ABS, as well as the composition of the underlying portfolio, risk can be distributed in a manner which may appeal to potential ABS investors.

Securitizations have historically provided several benefits to lenders and developed into a diverse, flexible funding mechanism for the financing of private education loan pools. Among other things, securitization enabled lender clients to sell potentially otherwise illiquid assets in both the public and private securities markets, and to limit credit and interest rate risk. Although this flexibility added to the complexity of the funding process, it also enabled the originating lender to reduce the cost of financing and recycle capital, thereby improving the economics of the loan program and improving loan terms by passing incremental savings back to the borrower.

Structuring securitizations requires a high level of specialized knowledge and experience regarding both the capital markets generally, and the borrower repayment and default characteristics specifically. The process of issuing ABS in a securitization requires compliance with state and federal securities laws, as well as coordination among originating lenders, servicers, securities rating agencies, attorneys, securities dealers, structural advisors, trust management providers and auditors.

We have structured and facilitated 38 securitizations, consisting entirely of education loans, involving debt issuances in the aggregate original principal amount of $17.5 billion. We have securitized loan pools using various financing structures, including both public offerings registered with the Securities and Exchange Commission, or SEC, and private placements, and have utilized various ABS, including borrowings from commercial paper conduits, London Interbank Offered Rate, or LIBOR, floating rate notes, auction-rate debt and senior-subordinate and third-party credit enhanced debt.

We believe that our capital markets experience gives us specialized insight into funding options available to our lender clients. In addition, the extensive database provided by our education loan repayment statistics dating back to 1986 has helped us in the past to optimize the financing of the education loan pools our clients generated. We have used this data to estimate the default, recovery and prepayment characteristics of the different types of loans that constitute a loan pool. We believe that our experience and historical data will assist us in future discussions with rating agencies, insurance providers, underwriters and securities investors relating to financing structures and terms.

We believe that conditions in the capital markets generally improved in fiscal 2013 and fiscal 2012 compared to recent years. In particular, investors in ABS demonstrated increased interest in ABS backed by private education loans, resulting in a reduction in credit spreads applicable to these securities. Additionally, during the third quarter of fiscal 2013, a private education loan ABS issuance by a third party included a

 

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subordinate bond, the first such bond to be included in a new issuance since 2007. The inclusion of this subordinate bond served to increase the advance rate, or amount of funds raised as a percentage of the collateral in the issuance. We believe that these trends during fiscal 2013 indicate that the economics of private education loan ABS are starting to become more attractive to issuers in the private education loan securitization marketplace. However, we have not completed a securitization transaction since fiscal 2008 and if we execute a financing transaction in the capital markets, the structure and economics of any such transaction may be materially different from prior transactions that we have sponsored. Such differences may include lower revenues as a result of comparatively wider credit spreads and lower advance rates.

TMS

TMS offers outsourced tuition planning, tuition billing, refund management and payment technology services for universities, colleges and secondary schools. TMS provides such services on behalf of over 700 educational institutions. Through BorrowSmart®, TMS helps students and their families manage education costs by developing sustainable, low cost tuition payment strategies. In addition, TMS provides solutions to schools for the collection and processing of tuition payments and data. These diverse product and service offerings are marketed as the “TMS Campus Advantage.” These services include:

 

   

Early affordability planning and counseling delivered through multiple channels, which allows students and their families to review and consider a series of education payment options that minimize borrowing through the utilization of payment plans and school specified loan products;

 

   

Flexible payment plans, which aggregate school payments into a single reporting and disbursement interface for schools;

 

   

Comprehensive tuition billing and presentment (paper-based and electronic), which maximize the effectiveness of paper and electronic bills for the student and the school;

 

   

Payment processing, which allows schools to provide choices to their students and their families through multiple channels and methods;

 

   

Student account management through the TMS Student Account Center, a web-based portal that reflects school branding, supports multi-channel access to TMS’ product suite and is tightly integrated with the school’s student information system, allowing schools to outsource billing and payment processing services to TMS while remaining the “system of record;” and

 

   

Refund management services, which facilitate for schools the process of disbursing student account credit balances that occur when payments, loan proceeds and/or financial aid credits exceed charges to the student account. The services allow schools to offer three refund choices: prepaid cards, ACH direct deposit and checks, allowing the schools to streamline their refund operations while reducing their overall disbursement expenses and enhancing the customer experience.

TMS earns enrollment and transaction-based fees from students and families that participate in its various payment plans. Enrollment fee revenue is recognized over the period in which services are provided to customers. Transaction-based fees are recognized in the period the transaction takes place. TMS also earns fees from schools for various billing, payment processing, refund management, implementation and subscription fees. These fees are recognized over the period in which the services are provided. We believe that the size and quality of TMS’ customer base provides an opportunity to expand our school relationships and offer diversified products and services that complement our education finance and loan processing capabilities, including K-12 loan programs, as well as serving as a source of significant recurring revenue.

Cology LLC

Cology LLC is a leading supplier of outsourced loan origination, servicing and technology solutions to education loan providers, including credit unions, community, regional and national banks and educational institutions. Through its services, Cology LLC provides easy market entry options for existing and new

 

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providers, targeted growth strategies to help organizations expand their student lending businesses and customized portfolio management services to help optimize the quality and performance of their education loan assets. These services include:

 

   

Custom program design consultation—helping lenders and providers develop programs that meet the specific needs of their customers and members;

 

   

Implementation and product launch services—providing quality and speed to market;

 

   

Outsourced back-office services, including application intake, underwriting, document collection, disbursement and repayment servicing—providing the people and processes needed to support lender programs without the need for significant infrastructure; and

 

   

Outsourced and remote-access technology solutions—offering the flexibility to manage and administer the programs on a versatile, customizable technology platform.

Cology LLC supports over 600 education loan programs and provides education loan solutions to approximately 270 credit unions, banks and schools nationwide.

We believe that our acquisition of a substantial portion of the operating assets of the Cology Sellers is well aligned with our business model. Cology LLC provides education loan processing and disbursement services as well as offering life-of-loan servicing. We also believe that there is an opportunity to cross-sell aspects of our Monogram platform on a stand-alone basis to Cology LLC’s credit union clients.

Union Federal Banking Services

In addition to originating education loans, Union Federal offers traditional banking services such as residential and commercial mortgage loans and retail savings, money market and time deposit products.

Prior Business Model

Prior to fiscal 2009, we did not charge separate fees for many of our services, but generally entered into agreements with clients giving us the exclusive right to securitize the education loans that they did not intend to hold. We historically recognized substantially all of our income from structuring securitization transactions. As such, the driver of our results of operations and financial condition was the volume of education loans for which we provided outsourcing services from loan origination through securitization.

Historically, asset-backed securitizations were our sole source of permanent financing for clients’ education loan programs. Conditions of the debt capital markets generally, and ABS market specifically, rapidly deteriorated during the second quarter of fiscal 2008. The ability to finance education loans through securitization continued to be constrained through fiscal 2009 and, to a lesser extent, from fiscal 2010 through fiscal 2013. Our business has been and continues to be materially adversely impacted by these market dynamics, as we have not completed a securitization transaction since fiscal 2008.

Our lender clients previously had the opportunity to mitigate their credit risk through a loan repayment guaranty by The Education Resources Institute, Inc., or TERI. The education loans purchased by certain of the securitization trusts, which we refer to as the Trusts, were initially subject to a default repayment guaranty by TERI, while the education loans purchased by other securitization trusts, which we refer to as the NCT Trusts, were, with limited exceptions, not TERI-guaranteed. TERI guaranteed the education loans held by the Trusts, and we historically received reimbursement from TERI for outsourced loan processing services we performed on TERI’s behalf. In April 2008, TERI filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code, which we refer to as the TERI Reorganization. Under TERI’s confirmed plan of reorganization, which became effective in the second quarter of fiscal 2011, TERI rejected its guaranty agreements and settled claims with the Trusts, including contingent guaranty claims based on future loan defaults.

As a result of capital markets disruptions and the TERI Reorganization, many clients elected to terminate some or all of their agreements with us, which resulted in a significant reduction in our facilitated loan volumes during fiscal 2009, fiscal 2010 and fiscal 2011 compared to prior fiscal years. In addition, our financial results for

 

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fiscal 2009, fiscal 2010 and fiscal 2011 were negatively affected by significant write-downs of the estimated fair value of our service revenue receivables and, in fiscal 2009 and fiscal 2010, the portfolio of education loans held-for-sale.

General Developments

We have summarized below certain developments affecting our business since the beginning of fiscal 2013:

 

   

On August 2, 2012, we announced a new private education loan consolidation program with SunTrust Bank based on our Monogram platform, the SunTrust Bank Private Student Loan Consolidation Program. This program provides borrowers the opportunity to refinance their existing education loans into one new loan with a single payment and potentially reduce their current monthly payment and/or interest rate. Approved borrowers are offered the choice of a fixed or variable interest rate, as well as multiple repayment terms.

 

   

Effective September 30, 2012, First Marblehead Education Resources, Inc., or FMER, ceased serving as the special servicer for the NCT Trusts. In addition, pursuant to the terms of FMER’s resignation during fiscal 2012 as special servicer of the Trusts, the transition period during which FMER assisted the new special servicer of the Trusts terminated on November 30, 2012.

 

   

On October 19, 2012, FMD’s subsidiary Cology LLC acquired a substantial portion of the operating assets, and assumed certain liabilities, of the Cology Sellers. Through Cology LLC, we provide loan processing services to approximately 270 credit union and other lender clients.

 

   

On November 12, 2011, we received notice that the Massachusetts Appellate Tax Board, or ATB, had issued an order, which we refer to as the ATB Order, in cases related to the Massachusetts tax treatment of GATE Holdings, Inc., which we refer to as GATE, a former subsidiary of FMD, for fiscal 2004 through fiscal 2006. On April 17, 2013, the ATB issued its opinion confirming the rulings and findings included in the ATB Order, which we refer to as the ATB Opinion. On July 22, 2013, we filed an appeal of certain of the ATB’s findings in the Massachusetts Appeals Court. If we are unsuccessful in an appeal of the ATB Order, we could be required to make additional tax payments, including interest, for GATE’s taxable years ended June 30, 2008 and 2009, which could materially adversely affect our liquidity position. See Note 16, “Commitments and Contingencies—Income Tax Matters,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information.

 

   

Our loss from continuing operations, before income taxes, for fiscal 2013 improved $3.6 million, or 7%, as compared to fiscal 2012. The fiscal 2012 results included a $9.5 million gain from the deconsolidation of certain of the NCT Trusts that we had previously consolidated. Loss from continuing operations, before income taxes, is the most directly comparable generally accepted accounting principle, or GAAP, financial measure to “net operating cash usage,” a non-GAAP financial metric, which we use to approximate the cash required to fund our operations. During fiscal 2013, we reduced our “net operating cash usage” financial metric by $10.6 million, or 20%, from $53.1 million for fiscal 2012 to $42.5 million for fiscal 2013. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations–Liquidity and Capital Resources–Non-GAAP Measure: Net Operating Cash Usage” included in Item 7 of this annual report for additional information.

 

   

For fiscal 2013, total facilitated loan volumes were $298.2 million. Monogram-based facilitated loan volumes for fiscal 2013 were $133.7 million, an increase of 110% as compared to fiscal 2012. Total facilitated loan volume for fiscal 2013 included $164.5 million from Cology LLC since the date of acquisition. Loan disbursements for fiscal 2013 totaled $442.8 million, including $131.9 million of Monogram-based loans and $310.9 million from Cology LLC. Monogram-based loan disbursements for fiscal 2013 were up 129% as compared to fiscal 2012. The disparity between facilitated and disbursed loan volumes was the result of disbursements by Cology LLC following the asset acquisition with respect to loans that were facilitated by the Cology Sellers prior to the asset acquisition.

 

   

Our federal income tax returns have been under audit by the Internal Revenue Service, or IRS, in connection with the sale of the trust certificate to NC Residual Owners Trust, which we refer to as the

 

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Trust Certificate. In connection with the sale of the Trust Certificate, FMD entered into an asset services agreement, which we refer to as the Asset Services Agreement, pursuant to which FMD provided various consulting and advisory services to the purchaser of the Trust Certificate. We announced on August 15, 2013 that, as part of that audit process, we expected to receive a Notice of Proposed Adjustment, or NOPA, from the IRS. On September 10, 2013 we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. In the NOPAs, the IRS asserts that our sale of the Trust Certificate should not be recognized for federal income tax purposes primarily because we retained the economic benefits and burdens of the Trust Certificate, including, among other things, retaining certain repurchase rights and data rights. The IRS further concludes that the transaction should be characterized as a financing instead of a sale and asserts that the sale of the Trust Certificate and the execution of the Asset Services Agreement had the impact of converting taxable income to the owner from an accrual basis to a cash basis. As a result, the NOPAs propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS’ positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments that we estimate to be approximately $300.0 million plus interest, with the interest continuing to accrue until the matter is resolved. The NOPAs do not address tax years beyond June 30, 2011. The NOPAs are only initial IRS positions and not final determinations and, as a result, do not require any tax payment at this time. We did not record an accrual for this matter in our consolidated financial statements at June 30, 2013 or when we received the NOPAs. We plan to vigorously contest the proposed adjustments and we believe we have a strong position as it relates to this matter. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Fiscal Years ended June 30, 2013, June 30, 2012 and June 30, 2011—Overall Results—Continuing Operations—Internal Revenue Service Audit” included in Item 7 of this annual report for additional information.

Outlook

Our long-term success depends on our ability to attract additional lender clients, or otherwise obtain additional sources of interim or permanent financing, such as securitizations or alternative financing transactions. This is particularly true as the level of loan originations for the Union Federal Private Student Loan Program is subject to regulatory limits that are based upon the overall size of Union Federal’s balance sheet and Union Federal’s capital levels, as determined by FMD. To date, we have entered into education loan program agreements based on our Monogram platform with four lender clients, including FMD’s subsidiary Union Federal. While we have demonstrated market demand for Monogram-based education loans, we are uncertain as to the degree of market acceptance that our Monogram platform will achieve, particularly in the current economic environment where lenders continue to evaluate their education lending business models. Additionally, as one of our four partnered lending clients provides the majority of our Monogram-based loan program fees, we are subject to concentration risk as it relates to this revenue stream until we are able to attract additional lender clients. We believe, however, that the credit quality characteristics and interest rates of the loan portfolios originated in the 2011-2012 and the 2012-2013 academic years will be attractive to additional potential lender clients, as well as capital markets participants. We also believe that the ability to permanently finance private education loan portfolios through the capital markets would make our products and services more attractive to lenders and would accelerate improvement in our long-term financial results.

We are uncertain of the volume of education loans to be generated by the Monogram-based loan programs of our four lender clients, or any additional lender clients, including clients acquired through our acquisition of a substantial portion of the operating assets of the Cology Sellers in October 2012. It is our view that returning to profitability will be dependent on a number of factors, including our loan capacity and related volumes, expense management and growth at TMS, Cology LLC and Union Federal and the availability of financing alternatives, including our ability to successfully re-enter the securitization market. In particular, we need to generate loan volumes substantially greater than those that we have generated to date, as well as to develop funding capacity for Monogram-based loan programs at loan volume levels greater than those of our four lender clients with lower

 

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credit enhancement levels and higher capital markets advance rates than those available today. We must also continue to achieve efficiencies in attracting applicants, through loan serialization or otherwise, in order to reduce our overall cost of acquisition. In the case of Cology LLC, we expect to continue to provide loan processing services to the former customers of the Cology Sellers similar to the services provided to them by the Cology Sellers prior to the asset acquisition. In addition, we expect to provide various Monogram-based products and services to these customers to assist them in education loan product design, pricing, marketing, reporting and analysis, as well as education loan portfolio management services.

Competition

Based on the range of services that we offer, we believe that SLM Corporation, also known as Sallie Mae, is our principal competitor. Our business could be adversely affected if Sallie Mae’s private education loan program continues to grow, or if Sallie Mae seeks to market more aggressively to third parties the full range of services that we offer. Other education loan competitors include Wells Fargo & Company and Discover Financial Services. In addition, LendKey Technologies, Inc. and Campus Door Holdings, Inc. compete directly with Cology LLC. Nelnet Business Solutions, TouchNet Information Systems, Inc. and Higher One Holdings, Inc. compete directly with TMS.

To the extent that loan originators, including our clients or former clients, develop an internal capability to provide any of the services that we currently offer, demand for our services would decline. For example, a loan originator that has, or decides to develop, a portfolio management or capital markets function may not engage us for our services. Demand for our services could also be affected by developments with regard to federal loan programs. Historically, lenders in the education loan market have focused their lending activities on federal loans because of the relative size of the federal loan market and because the federal government guarantees repayment of those loans, thereby significantly limiting the lenders’ credit risk. Following the elimination of FFELP as of July 2010, many lenders have re-evaluated their business strategies related to education lending and exited the marketplace altogether. Education lenders are more focused on private education loans and some may seek to develop an internal capability to conduct the services we provide, which could result in a decline in the potential demand for our service offerings. We believe the most significant competitive factors in terms of developing education loan products are technical and legal competence, including in connection with the process of originating education loans, cost, data relating to the performance of education loans, risk analytics capabilities, capital markets experience and reliability, quality and speed of service. We differentiate ourselves from other service providers by the range of services we can provide our clients, in a “turn-key” manner.

Several of our current and potential competitors have longer operating histories and significantly greater financial, marketing, technical or other competitive resources than we or our clients have, including funding capacity. As a result, our competitors or potential competitors may be better able to overcome capital markets dislocations, adapt more quickly to new or emerging technologies and changes in customer preferences or compete for skilled professionals, or may be able to devote greater resources to the promotion and sale of their products and services. In particular, competitors with larger customer bases, greater name or brand recognition or more established customer relationships than those of our clients have an advantage in attracting loan applicants and making education loans on a recurring, or “serialized,” basis. These disadvantages for us are particularly acute as we have only been operating Monogram-based loan programs since fiscal 2011. In addition, competitors may be able to adopt more aggressive pricing policies in order to attract potential clients or borrowers, as applicable. We cannot assure you that we will be able to compete successfully with new or existing competitors. To remain competitive, we need to continue to invest in information technology, sales and marketing, legal, compliance and product development resources.

Proprietary Systems and Processes

Monogram Platform and VoltaSM Platform

In addition to our database that tracks historical education loan performance, we maintain advanced proprietary information processing systems, including our Monogram platform and Cology LLC’s Volta

 

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platform. We use these information systems to analyze loan applications efficiently, expedite loan processing and enhance our other services.

Key benefits of our information processing systems include:

 

   

The ability to analyze and assess loan applications based on a variety of underwriting and product factors, including flexibility to adapt to different product parameters required in customized client implementations;

 

   

A transaction/application processing system that includes automated updating of an applicant’s loan status that a borrower can access online or by telephone;

 

   

Automated preparation and secure electronic delivery of loan documents, including credit agreements and certain legal disclosures;

 

   

Online certification tools enabling financial aid offices to speed loan disbursement by quickly confirming student applicants’ enrollment status and financial need;

 

   

Reporting tools enabling clients to track and sort information about student applicants and borrowers, including application status and disbursement dates;

 

   

Custom built data transmission techniques designed to ensure that data are compiled, integrated and properly migrated both across our enterprise and to external third parties such as servicers, collection and placement agencies and other third-party vendors; and

 

   

Interfaces with internal accounting systems intended to ensure proper booking and tracking of loan information for our clients, as well as support for our capital markets group in its financing activities.

We use a number of leading commercial products to secure, protect, manage and back-up data.

TMS

TMS maintains advanced proprietary systems in connection with the delivery of independent, integrated education payment and refund solutions to schools and students and their families.

Key benefits of TMS’ systems include:

 

   

Algorithms that use “affordability” parameters provided by the students or their families to create a series of education payment options that minimize borrowing through the utilization of payment plans and school specific loan products;

 

   

Billing solutions that deliver enterprise resource planning integration, regulatory compliance, bill presentment, online document management, online marketing tools and payment channel integration;

 

   

Aggregation of school payments across all channels and methods into a single reporting and disbursement interface, allowing a school to deliver choice to its students and families while reducing its workload burden;

 

   

Refund disbursement solutions that enable student choice of refund method and provide school administrators a single reporting and disbursement interface, allowing a school to deliver choice to its students and families while reducing its workload burden;

 

   

Real-time integration solutions for all major student information systems packages, which allows schools to outsource their billing and payment processing services to TMS without compromising information currency and timeliness; and

 

   

Counseling services delivered through “Voice over Internet Protocol” contact management technology that allows integration between TMS’ contact management system and supporting system to create an efficient personalized customer experience with reliable capture of data.

TMS uses a number of leading commercial products to secure, protect, manage and back-up data.

 

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Intellectual Property

FIRSTMARBLEHEAD, the checkered logo, MONOGRAM, MONTICELLO STUDENT LOANS and NATIONAL COLLEGIATE TRUST are registered service marks and GATE, GATE GUARANTEED ACCESS TO EDUCATION and PREPGATE are service marks of FMD. BORROWSMART, HELPING FAMILIES AFFORD EDUCATION, the partial apple logo, RISK REPORTING, THE PROVEN PATH TO PAID STUDENTS IN YOUR CLASSROOMS, TUITION MANAGEMENT SYSTEMS, INC. and TUITIONCHARGE are registered service marks of TMS. UNION FEDERAL is a registered service mark of Union Federal. COLOGY, SABERTOOTH, VOLTA and COLOGY LOAN SERVICING are service marks of Cology LLC. The federal registrations for these registered service marks expire at various times between 2015 and 2020, but the registrations may be renewed for additional 10-year terms provided that we continue to use the trademarks.

Education Loan Market Seasonality

Origination of education loans is generally subject to seasonal trends, with the volume of loan applications increasing during the summer and early fall months with the approach of tuition payment dates. Historically, we have also tended to process an increased volume of loan applications during November, December and January, as students and their families seek to borrow money to pay tuition costs for the spring semester. Historically, this seasonality of loan originations has impacted the amount of processing fees that we earned in a particular quarter and the level of expenses incurred to generate loan application volume and process the higher origination activity, and with respect to fiscal years prior to fiscal 2009, the timing and size of securitization transactions. In addition, TMS’ financial and operational results are also subject to seasonal trends, with plan enrollment activity and expenses generally increasing from March to July as TMS hires temporary staff to meet higher demand for enrollment in tuition payment plans for the succeeding school year.

Union Federal Regulatory Matters

In November 2006, we acquired Union Federal, a community savings bank located in North Providence, Rhode Island. Union Federal is a federally-chartered thrift that is regulated by the Office of the Comptroller of the Currency, or OCC. As a result of our ownership of Union Federal, FMD is a savings and loan holding company subject to regulation, supervision and examination by the Board of Governors of the Federal Reserve System, or the Federal Reserve. See “—Government Regulation” below, “Risk Factors—Risks Related to Regulatory Matters” included in Item 1A of this annual report and Note 25, “Union Federal Regulatory Matters,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information.

In March 2010, the FMD Board of Directors adopted resolutions required by the U.S. Office of Thrift Supervision, or OTS, Union Federal’s regulator at that time, undertaking to support the implementation by Union Federal of its business plan, so long as Union Federal is owned or controlled by FMD, and to notify the OTS (and now the OCC effective in fiscal 2012) in advance of any distribution to our stockholders in excess of $1.0 million per fiscal quarter and any incurrence or guarantee of debt in excess of $5.0 million. These resolutions continue to be applied by the Federal Reserve. Distributions to our stockholders may be further restricted by the Federal Reserve’s required approval in those instances when such distributions exceed the net earnings of the prior 12-month period.

Government Regulation

We provide financial services in connection with the creation, management and disposition of education loans, retail banking, such as mortgages and deposits, and education payment processing. Our business is highly regulated at both the state and federal level, through statutes and regulations that focus upon:

 

   

Safety and soundness of FMD and Union Federal;

 

   

Licensure and examination of industry participants;

 

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Regulation and disclosure of consumer loan and deposit terms;

 

   

Regulation of loan origination processing; and

 

   

Licensure and general regulation of loan collection and servicing.

Failure to conform to any of these statutes or regulations may result in civil and/or criminal fines, and may affect the enforceability of the underlying consumer loan assets.

Many states have statutes and regulations that require the licensure of small loan lenders, loan brokers, credit services organizations, loan arrangers and collection agencies. Some of these statutes are drafted or interpreted to cover a broad scope of activities. While we believe we have satisfied all material licensing, registration and other regulatory requirements that could be applicable to us based on current laws and the manner in which we currently conduct business, we may determine that we need to submit additional license applications, and we may otherwise become subject to additional state licensing, registration and other regulatory requirements in the future. In particular, certain state licenses or registrations may be required if we change our operations, if regulators reconsider their prior guidance or if federal or state laws or regulations are changed. Even if we are not physically present in a state, its regulators may take the position that registration or licensing is required because we provide services to borrowers located in the state by mail, telephone, the Internet or other remote means.

To the extent that our services are conducted through Union Federal, state requirements for licensure are inapplicable. However, as a result of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which we refer to as the Dodd-Frank Act, and the reduced preemption enjoyed by federal savings banks resulting from the Dodd-Frank Act, we may now be subject to state consumer protection laws in each state where we do business and those laws may be interpreted and enforced differently in different states. The Dodd-Frank Act changed the legal standard for federal savings association preemption of state laws so that state laws are now preempted only if those laws stand in conflict with federal laws. This “conflict” preemption standard is consistent with the standard for national bank preemption of state laws.

The Dodd-Frank Act also restructured the regulation of depository institutions. Under the Dodd-Frank Act, the OTS, which historically was the primary federal regulator for FMD and Union Federal, transferred its authority to the Federal Reserve and the OCC on July 21, 2011. On that date, the OCC, the primary federal regulator for national banks, became the primary federal regulator for federal thrifts, including Union Federal, and the Federal Reserve became the primary federal regulator for all savings and loan holding companies that were formerly regulated by the OTS, including FMD. Although the OCC and Federal Reserve are directed to implement existing OTS regulations, orders, resolutions, determinations and agreements for thrifts and their holding companies under the Home Owners’ Loan Act, or HOLA, the transition of supervisory functions from the OTS to the OCC (with respect to Union Federal) and the Federal Reserve (with respect to FMD) are expected, over time, to alter the supervisory approach for Union Federal and FMD. This could, in turn, affect the operations of FMD and Union Federal. The Dodd-Frank Act also will impose consolidated capital requirements on savings and loan holding companies, but they are not effective until five years after enactment.

The Dodd-Frank Act also established the Consumer Financial Protection Bureau, or CFPB, as an independent agency within the Federal Reserve. The CFPB has been given broad powers, including the power to:

 

   

Supervise non-depository institutions, including those that offer or provide education loans;

 

   

Supervise depository institutions with assets of $10 billion or more for compliance with consumer protection laws, as well as the service providers to such institutions;

 

   

Regulate consumer financial products, including education loans, and services offered primarily for personal, family or household purposes;

 

   

Promulgate rules pursuant to, as well as with respect to, unfair, deceptive or abusive practices; and

 

   

Take enforcement action against institutions under its supervision.

 

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The CFPB may institute regulatory measures that directly impact our business operations. The CFPB has initiated an examination program of non-depository institutions (which could include service providers such as FMD’s subsidiary FMER). The Federal Trade Commission, or FTC, maintains parallel authority to enforce Section 5 of the Federal Trade Commission Act prohibiting unfair or deceptive acts or practices against non-depository financial providers, such as FMER, TMS and Cology LLC. The OCC maintains parallel authority to enforce Section 5 of the Federal Trade Commission Act against federal savings associations, such as Union Federal, as well as authority to examine and supervise federal savings associations with assets of less than $10 billion, such as Union Federal, for compliance with consumer protection laws.

The CFPB has significant rulemaking and enforcement powers and the potential reach of the CFPB’s broad new rulemaking powers and enforcement authority on the operations of financial institutions offering consumer financial products or services, including FMD, is currently unknown. In addition, the Dodd-Frank Act established a Student Loan Ombudsman within the CFPB, who, among other things, receives, reviews and attempts to resolve informally complaints from education loan borrowers. To date, the Student Loan Ombudsman has only issued its first Annual Report, which we refer to as the Report. The Report focused on issues relating to private education loan servicing. The Report noted that many private education loans do not have certain borrower protections that are common in federal education loans, such as income-based repayment plans, discharges upon death or military deferments. The Report compared education loan servicing to mortgage loan servicing, noting that, like mortgage borrowers, private education loan borrowers make their payments and inquiries to loan servicers, which are often different than the lender itself. The Report noted that of the approximately 2,900 complaints that the CFPB has received regarding education loans, only 5% concerned borrower issues relating to obtaining the loan, the aspect of the process in which we operate. However, many of the servicing issues noted by the Report could have consequences for us, as they may indicate areas in which the CFPB will seek to create further consumer disclosures or take other actions that relate to the origination process. Especially in light of the concerns noted in the Report that private education loan borrowers may not have fully understood all the terms and conditions of their different loans, we expect private education loan marketing practices to be carefully scrutinized.

As required by the Dodd-Frank Act, the CFPB and the Secretary of Education submitted a report in July 2012, addressing certain aspects of the private education loan market. In this report, the CFPB recommended that the U.S. Congress consider:

 

   

Mandating school certification of borrowed amounts;

 

   

Making private education loans dischargeable in bankruptcy;

 

   

Clarifying the definition of private education loans under TILA to cover products that may serve as economic substitutes (such as credit lines for post-secondary expenses);

 

   

Creating a mechanism to help borrowers better understand their total debt obligations (such as a centralized mechanism similar to the National Student Loan Data System); and

 

   

Whether additional data should be required to enhance consumer decision-making and lender underwriting.

At the same time that it issued the July 2012 report, the CFPB issued revised draft model disclosures for its “Know Before You Owe” campaign designed to provide additional information to consumers. The CFPB also has an Office of Students intended to provide students with tools to facilitate decision making regarding various credit products, including education loans. These initiatives, and similar efforts with respect to other credit and retail banking products, could increase our costs and the complexity of our operations.

The Department of Education issued substantially similar recommendations in the July 2012 report, including that the U.S. Congress consider:

 

   

Both mandating school certification of borrowed amounts and ensuring that students have exhausted federal financial aid before obtaining a private education loan;

 

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Making private education loans dischargeable in bankruptcy, taking into account the tradeoffs between increasing options for financial relief to distressed borrowers and the potential for higher costs and decreased availability of private education loans;

 

   

Excluding from the definition of private education loans all types of federal education loans, and potentially excluding certain private education loans made by non-profit lenders; and

 

   

Creating a centralized mechanism to help borrowers better understand their total student debt obligations.

The Dodd-Frank Act also includes several provisions that could affect our future portfolio funding transactions, if any, including potential risk retention requirements applicable to any entity that organizes and initiates an ABS transaction, new disclosure and reporting requirements for each tranche of ABS, including new loan-level data requirements, and new disclosure requirements relating to the representations, warranties and enforcement mechanisms available to ABS investors.

We will continue to review state registration and licensing requirements, and we intend to pursue registration or licensing in applicable jurisdictions where we are not currently registered or licensed if we elect to operate through an entity that does not enjoy federal preemption of such registration or licensing requirements. We cannot assure you that we will be successful in obtaining additional state licenses or registrations in a timely manner, or at all. If we determine that additional state registrations or licenses are necessary, we may be required to delay or restructure our activities in a manner that will not subject us to such licensing or registration requirements. Compliance with state licensing requirements could involve additional costs or delays, which could have a material adverse effect on our business. Our failure to comply with these laws could lead to, among other things:

 

   

Curtailment of our ability to continue to conduct business in the relevant jurisdiction, pending a return to compliance or processing of registration or a license application;

 

   

Administrative enforcement actions;

 

   

Class action lawsuits;

 

   

The assertion of legal defenses delaying or otherwise affecting the enforcement of loans; and

 

   

Criminal as well as civil liability.

Any of the foregoing could have a material adverse effect on our business.

The consumer assets with which we deal are subject to the full panoply of state and federal regulation, and a defect in such assets could affect our business. Similarly, the growing complexity of regulation of loan origination and collection may affect the cost and efficiency of our operations. We have sought to minimize the risk created by consumer loan regulation in a number of ways. The securitizations that we facilitated have involved sales by financial institutions regulated by the Federal Deposit Insurance Corporation, or FDIC, and other parties which represented and warranted that the assets in question were originated in compliance with all applicable law and were valid, binding and enforceable in accordance with their terms. Similarly, the securitization trusts have benefited from an assignment of representations and warranties made by the lender and by the applicable loan servicer regarding compliance with law in the origination and servicing of loan assets.

In delivering services, our operations must conform to consumer loan regulations that apply to lenders. These regulations include, but are not limited to, compliance with the Consumer Financial Protection Act, TILA, the Higher Education Opportunity Act, the Fair Credit Reporting Act, the USA PATRIOT Act, the Equal Credit Opportunity Act, the Gramm Leach Bliley Act, the Federal Trade Commission Act, the Fair Debt Collection Practices Act and numerous state laws that replicate and expand upon the requirements of federal law. In addition, there is increasing regulation of the type of electronic loan application processing that we conduct, as well as regulation of access to and use of consumer information databases. A growing number of states are imposing disparate and costly requirements on our operations, including protections against identity theft, privacy protection and data security protection. The Fair and Accurate Credit Transactions Act of 2003 imposed significant federal law requirements on loan application processors, including requirements with respect to

 

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resolving address inconsistencies, responding to “red flags” of potential identity theft and identity theft notices, producing notices of adverse credit decisions based on credit scoring and other requirements affecting both automated loan processing and manual exception systems. These requirements strained, and future legislation or regulation may also strain, our systems. Failure to comply with these requirements would interfere with our ability to develop and market our business model for processing services.

Employees

We had 302 employees at June 30, 2013, compared to 306 employees as of June 30, 2012. The slight decrease in employees in fiscal 2013 was due to cost reduction efforts implemented throughout fiscal 2013, largely offset by our hiring of 43 employees from the Cology Sellers in connection with our acquisition of a substantial portion of the operating assets of the Cology Sellers.

We are not subject to any collective bargaining agreements, and we believe our relationships with our employees are good.

Our Corporate Information

We were formed as a limited partnership in 1991 and were incorporated in Delaware in August 1994. Our principal executive offices are located at The Prudential Tower, 800 Boylston Street, 34th Floor, Boston, Massachusetts 02199. The telephone number of our principal executive offices is (800) 895-4283.

Available Information

Our Internet address is www.firstmarblehead.com. The contents of our website are not part of this annual report on Form 10-K, and our Internet address is included in this document as an inactive textual reference only. We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports available free of charge on our website as soon as reasonably practicable after we file such reports with, or furnish such reports to, the SEC. Alternatively, reports filed with or furnished to the SEC are available from the SEC on its website, www.sec.gov, by request from the Public Reference Room at 100 F Street, NE, Washington, D.C. 20549 or by phone at (800) SEC-0330.

Executive Officers of the Registrant

The following table sets forth information regarding our executive officers as of September 13, 2013, including their ages as of such date:

 

Name

   Age     

Position

Daniel Meyers

     50       Chief Executive Officer and Chairman of the Board of Directors

Seth Gelber

     34       Managing Director, President and Chief Operating Officer

Kenneth Klipper

     54       Managing Director and Chief Financial Officer

William Baumer

     52       Managing Director and Chief Risk Officer

Barry Heneghan

     39       Managing Director, Business Development and Product Strategy

Suzanne Murray

     39       Managing Director, General Counsel and Secretary

Set forth below is certain information regarding the business experience of each of the above-named persons.

Daniel Meyers is a co-founder of First Marblehead. He has served as FMD’s Chief Executive Officer and as a Director since September 2008, and as Chairman of the Board of Directors since May 2010. From September 2008 to August 2013, he served as FMD’s President. Mr. Meyers also served as FMD’s Chief Executive Officer and Chairman of the Board of Directors from FMD’s incorporation in 1994 to September 2005 and as President from November 2004 to September 2005. Since October 2006, Mr. Meyers has served as the sole member, Chairman and Chief Executive Officer of Sextant Holdings, LLC, a private investment firm. From 1980 to 1991, Mr. Meyers was involved in arbitrage and derivatives trading at EF Hutton, Prudential Bache Securities, LF

 

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Rothschild Unterberg Towbin and Commodities Corporation, each of which were financial services firms. He began working on ABS financings in 1986. He currently serves as the Chair Emeritus of the Board of the Curry School of Education Foundation, as well as a consulting member of the finance committee of the Board of Visitors at the University of Virginia. Additionally, he is the Chairman of the Board of Steward Medical Group, a unit of Steward Healthcare System, a system of 11 hospitals headquartered in Boston, Massachusetts. He also serves on the Board of the Forum for the Future of Higher Education and is a member of the Education Funding Committee of the Consumer Bankers Association. Mr. Meyers received an A.B. in Economics from Brandeis University and completed the Owner President Management Program at the Harvard Graduate School of Business Administration.

Seth Gelber has served as FMD’s President since August 2013, Chief Operating Officer since August 2012 and as a Managing Director since September 2008. He served as FMD’s Chief Administrative Officer from March 2010 to August 2012 and as FMD’s Senior Vice President, Corporate Development from August 2008 to September 2008. From 2001 to 2006, Mr. Gelber held various positions at FMD in the Capital Markets and Product Strategy groups. Since October 2006, Mr. Gelber has served as President of Sextant Holdings, LLC, a private investment firm, the sole member of which is Mr. Meyers. From 1998 to 2001, Mr. Gelber served as a Legislative Assistant to Congressman Jack Quinn (N.Y.), primarily focused on education, telecommunication and banking legislation. Mr. Gelber received a B.A. from The George Washington University.

Kenneth Klipper has served as FMD’s Chief Financial Officer and as a Managing Director since September 2008 and served as Treasurer and Chief Accounting Officer from November 2006 to April 2011. Mr. Klipper served as FMD’s Senior Vice President, Finance from March 2005 to September 2008. From April 2003 to March 2005, Mr. Klipper served as the Chief Executive Officer of Brown Co., an online brokerage firm owned, at the time, by JPMorgan. He served as the Chief Financial Officer of Brown Co. from January 2003 to April 2003. From May 2002 to January 2003, Mr. Klipper served as the Chief Financial Officer and Chief Operating Officer of Park Street Capital, a fund of funds private equity firm. From January 2000 to April 2002, Mr. Klipper served as the Chief Financial Officer of Tucker Anthony Sutro, Inc., a publicly traded securities brokerage firm. Prior to joining Tucker Anthony, Mr. Klipper served for five years as both the Chief Financial Officer and Controller for the securities brokerage unit of Fidelity Investments, and he held positions with KPMG LLP, a registered public accounting firm, for 11 years. Mr. Klipper received a B.S. from the University of Richmond and is a Certified Public Accountant.

William Baumer has served as FMD’s Chief Risk Officer since September 2007, as a Managing Director since September 2008 and as the Chief Executive Officer of Union Federal Savings Bank since July 2010. Mr. Baumer served as FMD’s Senior Vice President, Compliance from July 2004 to September 2007. From 2003 to June 2004, Mr. Baumer served as the Compliance Manager for the nationwide mortgage operations at Bank of America, N.A. From 2000 to 2003, Mr. Baumer was the Compliance Director-Core Banking for Fleet Boston Financial Corporation, a bank that was acquired by Bank of America, and was responsible for regulatory compliance programs in Fleet’s consumer, commercial and administrative staff units. He joined Fleet in 1984 and held various leadership positions in the Compliance, Audit, Credit and Retail Banking business units. Mr. Baumer received a B.S. from Franklin Pierce College and has earned Certified Regulatory Compliance Manager, Certified Internal Auditor and Certified Anti-Money Laundering Specialist certifications.

Barry Heneghan has served as FMD’s Managing Director, Business Development and Product Strategy since January 2011. From August 2008 to December 2010, he served as a consultant to FMD. Since February 2006, Mr. Heneghan has served as the Chief Executive Officer and President of Think Financial, a student loan marketing company that ceased active operations in August 2008. From 1996 to January 2006, Mr. Heneghan held various positions at FMD in the Business Development, Corporate Development and Product Strategy groups. From 1993 to 1996, Mr. Heneghan served as a Legislative Assistant to Congressman Jack Quinn (N.Y.). Mr. Heneghan received a B.A. from The George Washington University and an M.A. from Pennsylvania State University and attended the London School of Economics.

Suzanne Murray has served as FMD’s General Counsel since August 2012 and as a Managing Director and FMD’s Secretary since May 2012. Ms. Murray served as FMD’s Acting General Counsel from May 2012 to

 

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August 2012 and as FMD’s Senior Counsel, Corporate Law from March 2010 to April 2012. From October 2007 to February 2010, Ms. Murray was a Partner at Goodwin Procter LLP, a law firm, and from October 2000 to September 2007, Ms. Murray was an associate at Goodwin Procter. While at Goodwin Procter, Ms. Murray practiced general corporate and securities law, with an emphasis on mergers and acquisitions, SEC compliance and corporate governance matters. Ms. Murray received a B.A. from Boston College and a J.D. from Boston College Law School.

Code of Ethics

We have adopted a code of conduct that applies to our employees and officers, including our principal executive officer, principal financial officer, principal accounting officer or controller or persons serving similar functions. We have also adopted a statement of business ethics that applies to our directors. We will provide a copy of our code of conduct and statement of business ethics for our directors to any person without charge, upon written request to: Corporate Secretary, The First Marblehead Corporation, The Prudential Tower, 800 Boylston Street, 34th Floor, Boston, Massachusetts 02199. Our code of conduct and statement of business ethics for our directors, as well as our corporate governance guidelines and the charters of the standing committees of the FMD Board of Directors, are posted on our website at www.firstmarblehead.com under the heading “For Investors—Corporate Information—Governance Documents,” and each of these documents is available in print to any stockholder who submits a written request to our corporate secretary. If we amend our code of conduct in the future or grant a waiver under our code of conduct to any of our directors or executive officers, including our principal executive officer, principal financial officer, principal accounting officer or controller or anyone performing similar functions, we intend to post information about such amendment or waiver on our website.

 

Item 1A. Risk Factors

Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below in addition to the other information included in this annual report. If any of the following risks actually occurs, our business, financial condition or results of operations could be adversely affected, which, in turn, could have a negative impact on the price of our common stock. Although we have grouped risk factors by category, the categories are not mutually exclusive. Risks described under one category may also apply to another category, and you should carefully read the entire risk factors section, not just any one category of risk factors.

Risks Related to Our Industry, Business and Operations

Challenges exist in implementing revisions to our business model.

Since the beginning of fiscal 2009, we have taken several measures to adjust our business in response to economic conditions. Most significantly, we refined our service offerings and added fee-for-service offerings such as loan origination services and portfolio management. During fiscal 2010, we completed the development of our Monogram platform, including an enhanced application interface, an expanded credit decisioning model and additional reporting capabilities. We continue to incorporate refinements to our Monogram platform. During fiscal 2011, we began originating Monogram-based education loans under loan program agreements and began offering outsourced tuition planning, tuition billing and payment technology services for educational institutions through TMS. In fiscal 2012, we began offering refund management services to education institutions and students through TMS. In October 2012, we began providing education loan processing and disbursement services to credit unions, banks and schools in the United States, as well as offering life-of-loan servicing, through Cology LLC. Successful sales of our service offerings, particularly our Monogram platform, TMS offerings and Cology LLC offerings, will be critical to stemming our losses and growing and diversifying our revenues and client base in the future.

We are uncertain as to the degree of market acceptance that our Monogram platform will achieve, particularly in the current economic environment where there has been reluctance by many lenders to focus on education lending opportunities. Through September 13, 2013, we have entered into loan program agreements

 

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with four lender clients for Monogram-based loan programs, including FMD’s subsidiary Union Federal. The process of negotiating loan program agreements can be lengthy and complicated. Both the timing and success of contractual negotiations are unpredictable and partially outside of our control, and we cannot assure you that we will successfully identify potential clients or ultimately reach acceptable terms with any particular party with which we begin negotiations.

Moreover, we are uncertain of the extent to which borrowers will choose Monogram-based loans offered by our lender clients, which depends, in part, on competitive factors such as brand and pricing. Several of our current and potential competitors have longer operating histories and significantly greater financial, marketing, technical or other competitive resources than we or our clients have, including funding capacity. As a result, our competitors or potential competitors may be better able to overcome capital markets dislocations, adapt more quickly to new or emerging technologies and changes in customer preferences or compete for skilled professionals, or may be able to devote greater resources to the promotion and sale of their products and services. In particular, competitors with larger customer bases, greater name or brand recognition or more established customer relationships than those of our clients have an advantage in attracting loan applicants and making education loans on a recurring, or “serialized,” basis. We are uncertain of the total application volume for fiscal 2014 and beyond, the extent to which application volume will ultimately result in disbursed loans and the overall characteristics of the disbursed loan portfolio.

Commercial banks have historically served as the initial funding sources for the education loans we facilitate and have been our principal clients. Since the first quarter of fiscal 2008, we have not facilitated securitization transactions to support the long-term funding of education loans, and commercial banks may be facing liquidity and credit challenges from other sources, in particular mortgage, auto loan and credit card lending losses. In addition, the synergies that previously existed between federal and private education loan marketing have been eliminated by legislation that eliminated FFELP. As a result, many lenders have re-evaluated their business strategies related to education lending. In light of legislative and regulatory changes, general economic conditions, capital markets disruptions and the overall credit performance of consumer-related loans, the education loan business may be less attractive to commercial banks than in the past. Demand for our services may not increase unless additional lenders enter or re-enter the marketplace, which could depend in part on capital markets conditions and improved market conditions for other consumer financing segments.

Some of our former clients and competitors have exited the education loan market completely. To the extent that commercial banks exit the education loan market, the number of our prospective clients diminishes. One of our primary challenges is to convince national and regional lenders that they can address this market opportunity in a manner that meets their desired risk control and return objectives. A related challenge is to successfully finance education loans generated through our Monogram platform through capital market transactions. We cannot assure you that we will be successful in either the short-term or the long-term in meeting these challenges.

Our business model depends on our ability to facilitate Monogram-based education loan volumes substantially in excess of those that we have originated to date and those contemplated by our four lender clients’ Monogram-based loan programs. We have been required to expend capital to support loan volume under our Monogram platform. Specifically, a portion of the loan volume to date under our Monogram platform has been originated by FMD’s subsidiary Union Federal and we have been further required to provide credit enhancements for Monogram-based loans originated by certain of our lender clients by funding participation accounts or, in the case of Union Federal, deposit accounts, to serve as a first-loss reserve for defaulted program loans. While we believe that we have sufficient capital resources to continue to provide such support to our Monogram platform under our business model, our ability to return to profitability while maintaining appropriate levels of liquidity will be predicated, in part, on our ability to fund participation accounts at levels lower than we are today, as well as the availability of higher capital markets advance rates, including the continued re-emergence of subordinate bonds in the private education loan securitization market, than are available today.

We will need to facilitate substantial loan volume, achieve market acceptance of our Monogram platform and TMS’ offerings, cross-sell our Monogram platform to Cology LLC clients and continue to manage our expenses, among other things, in order to return to profitability.

 

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Our ability to achieve and sustain profitability is dependent on many factors. Primarily, we believe that the following must occur in order for us to return to profitability:

 

   

We need to facilitate loan volumes substantially in excess of those that we have originated to date, and substantially in excess of those contemplated by our four lender clients’ Monogram-based loan programs. Because the revenues that we expect to generate for Monogram-based loan programs will depend in part on the size, credit mix and actual performance of our lender clients’ loan portfolios, it is difficult for us to forecast the level or timing of our revenues or cash flows with respect to our Monogram platform generally or a specific lender client’s Monogram-based loan program.

 

   

We need to attract additional lender clients, or otherwise obtain additional sources of interim or permanent financing, such as securitizations or alternative financing transactions, particularly given that one of our four partnered lending clients provides the majority of our Monogram-based loan program fees, which subjects us to concentration risk as it relates to this revenue stream. Additionally, the level of loan originations for the Union Federal Private Student Loan Program is subject to regulatory limits that are based upon the overall size of Union Federal’s balance sheet and Union Federal’s capital levels, as determined by FMD. As a result, Union Federal’s business plan includes a limit on the amount of education loans to be held on its balance sheet, and any material change to Union Federal’s business plan would be subject to regulatory conditions as well as prior regulatory approval for any interim or permanent financing of education loan portfolios held by Union Federal, including future securitization transactions. Consequently, we cannot assure you that Union Federal will be able to serve as a meaningful funding lender in the future for Monogram-based loan programs.

 

   

Deployment of our Monogram platform, and disbursed loan volume under our lender clients’ Monogram-based loan programs, has been limited, and we will need to gain widespread market acceptance of our Monogram platform among lenders, and of our lender clients’ Monogram-based loan programs among borrowers, in order to improve our long-term financial condition, results of operations and cash flow. If we do not succeed in doing so, we may need to re-evaluate our business plans and operations.

 

   

Deployment of TMS’ refund management services and its Student Account Center product has been limited, and we will need to gain widespread market acceptance of our refund management services and Student Account Center product among TMS’ existing clients as well as new clients, in order to improve our long-term financial condition, results of operations and cash flow.

 

   

We need to cross-sell aspects of our Monogram platform on a stand-alone basis to Cology LLC’s credit union clients. We cannot assure you that we will be able to achieve widespread market acceptance by these credit union clients of these additional services. Successful sales of our Monogram platform offerings to Cology LLC’s clients will be an important factor in realizing the benefits of the asset acquisition and in diversifying our revenues.

 

   

We need to continue to actively manage our expenses in the current economic environment to better align costs with our current business. In the past we have engaged in cost reduction initiatives and we may need to engage in similar cost reduction initiatives in the future. Despite our efforts to structure our business to operate in a cost-effective manner, some cost reduction measures could have unexpected negative consequences. If we are unable to successfully manage our expenses and run our business in a cost-effective manner, our results of operations would be harmed and it may impact our return to profitability.

We have incurred net losses since fiscal 2008 and could incur losses in the future.

We have generated significant net losses since fiscal 2008, and may continue to incur losses. There can be no assurance that we will report net income in any future period. We must develop new lender client relationships and substantially increase our revenues derived from our Monogram platform, TMS offerings and Cology LLC offerings. We are actively managing our expenses in the current economic environment and in light of the status of our business. To the extent that we are not able to increase our revenues and continue to manage our operating expenses, we will continue to experience net losses.

 

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We have provided credit enhancements in connection with Monogram-based loan programs for certain of our lender clients and may enter into similar arrangements in connection with future loan programs. As a result, we have capital at risk in connection with our lender clients’ loan programs. We may lose some or all of the capital we have provided and our financial results could be adversely affected.

In connection with certain of our lender clients’ Monogram-based loan programs, we have provided credit enhancements by funding participation accounts or, in the case of Union Federal, deposit accounts, to serve as a first-loss reserve for defaulted program loans. We have limited amounts of cash available to offer to prospective clients, and there is a risk that lenders will not enter into loan program agreements with us unless we offer credit enhancement. We expect that the amount of any such credit enhancement arrangement offered to a particular lender would be determined based on the particular terms of the lender’s loan program, including the anticipated size of the lender’s program and the underwriting guidelines of the program, as well as the particular terms of our business relationship with the lender. Should additional lenders require credit enhancement from us as a condition to entering into a loan program agreement, our growth may be constrained by the level of capital available to us. In addition, growth of Union Federal’s Monogram-based loan programs may be constrained by the amount of capital we are able to provide.

We have made deposits pursuant to our credit enhancement arrangements and agreed to provide periodic supplemental deposits, up to specified limits, during the disbursement periods under our loan program agreements based on the credit mix and volume of disbursed program loans and adjustments to default projections for program loans. To the extent that outstanding loan volume decreases as a result of repayments, or if actual loan volumes or default experience are less than our funded amounts, we are eligible to receive periodic releases of funds. The timing and amount of releases, if any, from the participation accounts are uncertain and vary among the loan programs. As of June 30, 2013, the fair value of our funded credit enhancements was $13.1 million. We could lose some or all of the amounts that we have deposited, or will deposit in the future, in the participation accounts, depending on the performance of the portfolio of program loans. Such losses would erode our liquidity position and could damage business prospects for our Monogram platform.

Our Monogram platform is based on proprietary scoring models and risk mitigation and pricing strategies that we have developed. We have limited experience with the actual performance of loan portfolios generated by lenders based on our Monogram platform, and we may need to adjust marketing, pricing or other strategies from time to time based on the distribution of loan volume among credit tiers or competitive considerations. We must closely monitor the characteristics and performance of each lender’s loan portfolio in order to suggest adjustments to the lenders’ programs and tailor our default prevention and collection management strategies. The infrastructure that we have built for such monitoring requires extensive operational and data integration among the loan servicer, multiple default prevention and recovery collection agencies and us. To the extent that our infrastructure is inadequate or we are otherwise unsuccessful in identifying portfolio performance characteristics and trends, or to the extent that lenders are unwilling to adjust their loan programs, our risk of losing amounts deposited in the participation accounts or, in the case of Union Federal, deposit accounts, may increase.

The outsourcing services market for education financing is competitive and if we are not able to compete effectively, our revenues and results of operations may be adversely affected.

We offer our clients and prospective clients, national and regional financial and educational institutions, services in structuring and supporting their education loan programs and tuition payment processing plans. The outsourcing services market in which we operate is competitive with a number of active participants, some of which have longer operating histories and significantly greater financial, marketing, technical or other competitive resources than we or our clients have, including funding capacity. As a result, our competitors or potential competitors may be better able to overcome capital markets dislocations, adapt more quickly to new or emerging technologies and changes in customer preferences or compete for skilled professionals, build upon efficiencies based on a larger volume of loan transactions, fund internal growth and compete for market share, than we are. In particular, competitors with larger customer bases, greater name or brand recognition or more established customer relationships than those of our clients have an advantage in attracting loan applicants at a lower acquisition cost than us. These disadvantages are particularly acute for us because we have only been operating Monogram-based loan programs since fiscal 2011.

 

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Based on the range of services that we offer, we believe that Sallie Mae is our principal competitor. Our business could be adversely affected if Sallie Mae’s private education loan program continues to grow, or if Sallie Mae seeks to market more aggressively to third parties the full range of services that we offer. Other education loan competitors include Wells Fargo & Company and Discover Financial Services. In addition, LendKey Technologies, Inc. and Campus Door Holdings Inc. compete directly with Cology LLC. Nelnet Business Solutions, TouchNet Information Systems, Inc. and Higher One Holdings, Inc. compete directly with TMS.

We may face competition from loan originators, including our clients or former clients, if they choose to develop an internal capability to provide any of the services that we currently offer. For example, a loan originator that has developed, or decides to develop, a portfolio management or capital markets function may not choose to engage us for our services. Historically, lenders in the education loan market have focused their lending activities on federal loans because of the relative size of the federal loan market and because the federal government guarantees repayment of those loans, thereby significantly limiting the lenders’ credit risk. Following the elimination of FFELP, lenders are more focused on private education loans and some may seek to develop an internal capacity to conduct the services that we provide, which could result in a decline in the potential market for our services.

We cannot assure you that we will be able to compete successfully with new or existing competitors. If we are not able to compete effectively, our results of operations may be adversely affected.

The growth of our business could be adversely affected by changes in government education loan programs or expansions in the population of students eligible for loans under government education loan programs.

We focus our business on the market for private education loans, and the majority of our business is concentrated in products for post-secondary education. The availability and terms of loans that the government originates or guarantees affects the demand for private education loans because students and their families often rely on private education loans to bridge a gap between available funds, including family savings, scholarships, grants and federal and state loans, and the costs of post-secondary education. The federal government currently places both annual and aggregate limitations on the amount of federal loans that any student can receive and determines the criteria for student eligibility. These guidelines are generally adjusted in connection with funding authorizations from the U.S. Congress for programs under the Higher Education Act of 1965. Recent federal legislation expanded federal grant and loan assistance, which could weaken the demand for private education loans. The creation of similar federal or state programs that make additional government loan funds available could decrease the demand for private education loans.

Access to alternative means of financing the costs of education may reduce demand for private education loans.

The demand for private education loans could weaken if student borrowers use other vehicles to bridge the gap between available funds and costs of post-secondary education. These vehicles include, among others:

 

   

Home equity loans or other borrowings available to families to finance their education costs;

 

   

Pre-paid tuition plans, which allow students to pay tuition at today’s rates to cover tuition costs in the future;

 

   

Section 529 plans, which include both pre-paid tuition plans and college savings plans, that allow a family to save funds on a tax-advantaged basis;

 

   

Education IRAs, now known as Coverdell Education Savings Accounts, under which a holder can make annual contributions for education savings;

 

   

Government education loan programs, generally, and interest rates on the loans under these programs, specifically; and

 

   

Direct loans from colleges and universities.

 

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If demand for private education loans weakens, we would experience reduced demand for our services, which could have a material adverse effect on our results of operations.

Continuation of the current economic conditions could adversely affect the education loan industry.

High unemployment rates and the unsteady financial sector have adversely affected many consumers, loan applicants and borrowers throughout the country. Loan applicants that have experienced trouble repaying credit obligations may not be able to meet the credit standards of our lender clients’ Monogram-based loan programs, which could limit our lending market or have a negative effect on the rate at which loan applications convert into disbursed loans. In addition, current borrowers may experience more trouble in repaying credit obligations, which could increase loan delinquencies, defaults and forbearance, or otherwise negatively affect loan portfolio performance and the estimated fair value of our service revenue receivables and our participation accounts. Forbearance programs may have the effect of delaying default emergence, and alternative payment plans may reduce the utilization of basic forbearance. In addition, some consumers may find that higher education is an unnecessary investment during turbulent economic times and defer enrollment in educational institutions until the economy improves or turn to less costly forms of secondary education, thus decreasing education loan application and funding volumes. Finally, many lending institutions have been reluctant to lend and have significantly tightened their underwriting standards, and several clients and potential clients have exited the education loan business and may not seek our services as the economy improves. If the adverse economic environment continues, our financial condition may deteriorate for any one of the foregoing reasons.

If our clients do not actively or successfully market and fund education loans, our business will be adversely affected.

We have in the past relied, and will continue to rely in part, on our clients to market and fund education loans to borrowers. If our clients do not devote sufficient time, emphasis or resources to marketing their Monogram-based loan programs or are not successful in these efforts, then we may not reach the full potential of our capacity for disbursed loan volume and our business will be adversely affected. In addition, our lender clients’ Monogram-based loan programs, and related marketing efforts, may not necessarily extend nationwide and, in fact, may focus on a limited geographic footprint.

In addition, if education loans were or are marketed by our clients in a manner that is found to be unfair, deceptive or abusive, or if the marketing, origination or servicing violated or violates any applicable law, federal or state unfair and deceptive practices acts could impose liability or, even in limited circumstances, create defenses to the enforceability of the loan. Investigations by state Attorneys General, the CFPB, the U.S. Congress or others could have a negative impact on lenders’ desire to originate and market education loans. The Higher Education Opportunity Act creates significant additional restrictions on the marketing of education loans.

If we fail to manage our cost reductions effectively, our business could be disrupted and our financial results could be adversely affected.

We have engaged in cost reduction initiatives in the past and we may engage in cost reduction initiatives in the future. These types of cost reduction activities are complex. Even if we carry out these strategies in the manner we expect, we may not be able to achieve the efficiencies or savings we anticipate, or on the timetable we anticipate, and any expected efficiencies and benefits might be delayed or not realized, and our operations and business could be disrupted. Furthermore, we continue to experience negative net operating cash flows. Our continued use of cash to fund operations may necessitate further significant changes to our cost structure if we are unable to grow our revenue base to the level necessary to fund our ongoing operations.

In addition, cost reduction initiatives have placed and will continue to place a burden on our management, systems and resources, generally increasing our dependence on key persons and reducing functional back-ups. We must retain, train, supervise and manage our employees effectively during this period of change in our business and our ability to respond in a timely and effective fashion to unanticipated exigencies of our business model could be negatively affected during this transition. Furthermore, we believe that retaining our employees

 

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may become more difficult as we face an increasingly competitive landscape with respect to talented employees as the economy continues to re-emerge from the financial crisis. We are particularly dependent on the continuing members of our management team and the loss of any of these key employees could adversely affect our business.

As part of our previous cost reduction initiatives we have terminated employees, including members of senior management. Although we believe that our capital resources as of June 30, 2013, which include proceeds of tax refunds under audit, are sufficient to satisfy our operating needs for the succeeding 12 months, we cannot assure you that they will be sufficient, particularly in light of ongoing income tax audits. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Fiscal Years ended June 30, 2013, June 30, 2012 and June 30, 2011—Overall Results—Continuing Operations—Internal Revenue Service Audit” included in Item 7 of this annual report for additional information. Insufficient funds could require us to, among other things, terminate additional employees, which could, in turn, place additional strain on any remaining employees and could further disrupt our business, including our ability to grow and expand our business.

We may outsource some borrower or client service functions in an effort to reduce costs, take advantage of technologies and effectively manage the seasonality associated with education loan volume and tuition payment processing. We rely on our vendors to provide high levels of service and support. Our reliance on external vendors subjects us to risks associated with inadequate or untimely service and could result in problems with service or support that we would not experience if we performed the service functions in-house.

If we are unable to manage our cost reductions, or if we lose key employees or are unable to attract and properly train new employees, our operations and our financial results could be adversely affected.

If competitors or potential competitors acquire or develop an education loan database or advanced loan information processing systems, our business could be adversely affected.

We own a database of historical information on education loan performance that we use to help us enhance our proprietary origination risk score model, determine the terms of portfolio funding transactions and derive the estimates and assumptions we make in preparing our consolidated financial statements and cash flow models. We have also developed a proprietary loan information processing system to enhance our application processing and loan origination capabilities. We believe that our education loan database and loan information processing system provide us with a competitive advantage in offering our services. A third party could create or acquire databases and systems such as ours, especially in light of the transition of our special servicing to third parties. As lenders and other organizations in the education loan market originate or service loans, they compile over time information for their own education loan performance database. Our competitors and potential competitors may have originated or serviced a greater volume of education loans than we have over the past several years, which may have provided them with comparatively greater borrower or loan data, particularly during the most recent economic cycle. If a third party creates or acquires an education loan database or develops a loan information processing system, our competitive positioning, ability to attract new clients and business could be adversely affected.

If we are unable to protect the confidentiality of our proprietary information and processes, the value of our services and technology could be adversely affected.

We rely on trade secret laws and restrictions on disclosure to protect our proprietary information and processes. We have entered into confidentiality agreements with third parties and with most of our employees to maintain the confidentiality of our trade secrets and proprietary information. These methods may neither effectively prevent use or disclosure of our confidential or proprietary information nor provide meaningful protection for our confidential or proprietary information if there is unauthorized use or disclosure.

We own no material patents. Accordingly, our technology, including our loan information processing systems, is not covered by patents that would preclude or inhibit competitors from entering our market. Monitoring unauthorized use of the systems and processes that we have developed is difficult, and we cannot be

 

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certain that the steps that we have taken will prevent unauthorized use of our technology. Furthermore, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our proprietary information. If we are unable to protect the confidentiality of our proprietary information and know-how, the value of our technology and services could be adversely affected.

Our business processes are becoming increasingly dependent upon technological advancement, and we could lose clients and market share if we are not able to keep pace with rapid changes in technology.

Our future success depends, in part, on our ability to process loan applications and tuition-related payments in an automated manner with high-quality service standards. The volume of loan originations and tuition-related payments that we are able to process is based, in large part, on the systems and processes we have implemented and developed. These systems and processes are becoming increasingly dependent upon technological advancement, such as the ability to review applications and process loans and payments over the Internet, accept electronic signatures and provide initial decisions instantly. Our future success also depends, in part, on our ability to develop and implement technology solutions that anticipate and keep pace with continuing changes in technology, industry standards and client preferences. We may not be successful in anticipating or responding to these developments on a timely basis. In addition, the industry in which TMS competes has undergone rapid technological change over the past several years. We have made, and need to continue to make, investments in our technology platform in order to provide competitive products and services to our clients. If competitors in any business line introduce products, services, systems and processes that are better than ours or that gain greater market acceptance, those that we offer or use may become obsolete or noncompetitive. In addition, if we fail to execute our lender clients’ origination requirements or properly administer our clients’ credit agreement templates or required disclosures, if TMS fails to properly administer its tuition payment plans or other services or if Cology LLC fails to properly provide its education loan processing and disbursement services, we could be subject to breach of contract claims and related damages. Any one of these circumstances could have a material adverse effect on our business reputation and ability to obtain and retain clients.

We may be required to expend significant funds to develop or acquire new technologies. If we cannot offer new technologies as quickly as our competitors, we could lose clients and market share. We also could lose market share if our competitors develop more cost effective technologies than those we offer or develop.

Our business could be adversely affected if PHEAA fails to provide adequate, proper or timely services or if our relationship with PHEAA terminates.

As of June 30, 2013, PHEAA served as the sole loan servicer for our Monogram-based loan programs. Our arrangements with PHEAA allow us to avoid the overhead investment in servicing operations, but require us to rely on PHEAA to adequately service the education loans, including collecting payments, responding to borrower inquiries, effectively implementing servicing guidelines applicable to loans and communicating with borrowers whose loans have become delinquent. Reliance on PHEAA and other third parties to perform education loan servicing or collections subjects us to risks associated with inadequate, improper or untimely services. In the case of PHEAA, these risks include the failure to properly administer servicing guidelines, including forbearance programs, and failure to provide notice of developments in prepayments, delinquencies and defaults, and usage rates for forbearance programs, including alternative payment plans. In the case of third party collection agencies, these risks include failure to properly administer collections guidelines and compliance with federal and state laws and regulations relating to interactions with debtors. If our relationship with PHEAA terminates, we would either need to expand our operations or develop a relationship with another loan servicer, which could be time consuming and costly. In such event, our business could be adversely affected.

An interruption in or breach of our information systems, or those of a third party on which we rely, may result in lost business.

We rely heavily upon communications and information systems to conduct our business. Our systems and operations are potentially vulnerable to damage or interruption from network failure, hardware failure, software failure, power or telecommunications failures, computer viruses and worms, penetration of our network by

 

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hackers or other unauthorized users and natural disasters. Any failure, interruption or breach in security of our information systems or the third-party information systems on which we rely could cause underwriting or other delays and could result in fewer loan applications being received, slower processing of applications or tuition-related payments and reduced efficiency in loan processing or our other services, including TMS’ and Cology LLC’s offerings. A failure, interruption or breach in security could also result in an obligation to notify clients in a number of states that require such notification, with possible civil liability and potentially large fines and penalties resulting from such failure, interruption or breach. Although we maintain and periodically test a business continuity and disaster recovery plan, the majority of our infrastructure and employees are concentrated in the Boston, Massachusetts, Providence, Rhode Island and Sacramento, California metropolitan areas. An interruption in services for any reason could adversely affect our ability to activate our contingency plan if we are unable to communicate among locations or employees.

We cannot assure you that systems failures, interruptions or breaches will not occur, or if they do occur that we or the third parties on whom we rely will adequately address them. The precautionary measures that we have implemented to avoid systems outages and to minimize the effects of any data or communication systems interruptions may not be adequate, and we may not have anticipated or addressed all of the potential events that could threaten or undermine our information systems. The occurrence of any systems failure, interruption or breach could significantly impair the reputation of our brand, diminish the attractiveness of our services and harm our business.

If we or one of our third party service providers experience a data security breach and confidential customer information is disclosed, we may be subject to penalties imposed by regulators, civil actions for damages and negative publicity, which could be costly, affect our customer relationships and have a material adverse effect on our business. In addition, state and federal legislative proposals, if enacted, may impose additional requirements on us to safeguard confidential customer information, which may result in increased compliance costs.

Data security breaches suffered by well-known companies and institutions have attracted a substantial amount of media attention, prompting state and federal legislation, legislative proposals and regulatory rule-making to address data privacy and security. Consequently, we may be subject to rapidly changing and increasingly extensive requirements intended to protect the consumer information that we process in connection with education loans and tuition payment plans. Implementation of systems and procedures to address these requirements has increased our compliance costs, and these costs may increase further as new requirements emerge. If we or one of our third party service providers were to experience a data security breach, or if we were to otherwise improperly disclose confidential customer or consumer information, such breach or other disclosure could be costly, generate negative publicity about us and adversely affect our relationships with our clients, including the lenders and educational institutions with which we do business, any of which could have a material adverse effect on our business. In addition, such pending legislative proposals and regulations, if adopted, likely would result in substantial penalties for unauthorized disclosure of confidential consumer information. Failure to comply with those requirements could result in regulatory sanctions imposed on our lender clients and loss of business for us.

We may be unable to integrate our business successfully and realize all of the anticipated benefits of our acquisition of a substantial portion of the operating assets of the Cology Sellers.

Our acquisition of a substantial portion of the operating assets of the Cology Sellers is an important transaction for us. We have made several assumptions regarding cost and revenue synergies in connection with the acquisition, many of which are dependent upon how successful we are in integrating the business of Cology LLC. The difficulties of integrating Cology LLC’s operations include, among other things:

 

   

Retaining customers;

 

   

Consolidating corporate and administrative functions;

 

   

Coordinating sales and marketing functions;

 

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Selling Monogram-based products and services to Cology LLC clients;

 

   

Persuading employees that the First Marblehead and Cology LLC business cultures are compatible, maintaining morale and retaining key employees; and

 

   

Integrating Cology LLC’s accounting, financial reporting, management, information, human resource and other administrative systems to permit effective management, and the lack of control if such integration is delayed or not implemented.

The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of each company’s business and the loss of key personnel. The diversion of management’s attention and any delays or difficulties encountered in connection with the acquisition and the integration of Cology LLC’s operations could harm our business, results of operations, financial condition or prospects and impair the value of goodwill or intangible assets.

We may face risks related to litigation that could result in significant legal expenses and settlement or damage awards.

From time to time, we are subject to claims and litigation, which could seriously harm our business and require us to incur significant costs. In the past, we have been named as a defendant in securities class action lawsuits, and on August 28, 2013, a purported class action was filed in the United States District Court for the District of Massachusetts against FMD and certain of our officers. We are generally obliged, to the extent permitted by law, to indemnify our current and former directors and officers who are named as defendants in these lawsuits. Defending against litigation may require significant attention and resources of management. Regardless of the outcome, such litigation could result in significant legal expenses.

We may also be subject to employment claims in connection with employee terminations. In addition, companies in our industry whose employees accept positions with us may claim that we have engaged in unfair hiring practices. These claims may result in material litigation. We could incur substantial costs defending ourselves or our employees against those claims, regardless of their merits. In addition, defending ourselves from those types of claims could divert our management’s attention from our operations.

If we are a party to material litigation and if the defenses we claim are ultimately unsuccessful, or if we are unable to achieve a favorable settlement, we could be liable for large damage awards that could have a material adverse effect on our business and consolidated financial statements.

Risks Related to Our Financial Reporting and Liquidity

Our liquidity could be adversely affected if the sale of the Trust Certificate does not result in the tax consequences that we expect or if we are unable to successfully resolve the pending state tax matters.

Effective March 31, 2009, we completed the sale of the Trust Certificate. In connection with the sale of the Trust Certificate, FMD entered into the Asset Services Agreement pursuant to which FMD provided various consulting and advisory services to the purchaser of the Trust Certificate. The sale generated a cash refund of federal and state income taxes previously paid of $189.3 million. The federal and state income tax consequences of the sale of the Trust Certificate, however, are complex and uncertain. The IRS has been conducting an audit of our tax returns for fiscal 2007 through fiscal 2010, including a review of the tax treatment of the sale of the Trust Certificate, as well as the $45.1 million income tax refund that we received in October 2010. We announced on August 15, 2013 that, as part of the audit process, we expected to receive a NOPA from the IRS. On September 10, 2013 we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. In the NOPAs, the IRS asserts that our sale of the Trust Certificate should not be recognized for federal income tax purposes primarily because we retained the economic benefits and burdens of the Trust Certificate, including, among other things, retaining certain repurchase rights and data rights. The IRS further concludes that the transaction should be characterized as a financing instead of a sale and asserts that the sale of the Trust Certificate and the execution of the Asset Services Agreement had the impact of converting

 

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taxable income to the owner from an accrual basis to a cash basis. As a result, the NOPAs propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS’ positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments that we estimate to be approximately $300.0 million plus interest, with the interest continuing to accrue until the matter is resolved. The NOPAs do not address tax years beyond June 30, 2011. While we did not record an accrual for this matter in our consolidated financial statements at June 30, 2013 or when we received the NOPAs, such an accrual, if it becomes necessary, could be significant and material. The determination of whether or not to accrue a liability, if any, requires a significant amount of judgment and entails, by necessity, the need to incorporate estimates.

The ongoing IRS audit or any other investigation, audit, appeals proceeding or suit relating to the sale of the Trust Certificate could result in substantial costs. A state taxing authority could also challenge our tax position in connection with the transactions, notwithstanding our receipt of any income tax refund.

In addition, we are involved in several matters relating to the Massachusetts tax treatment of GATE. We took the position in the ATB proceedings that GATE was properly taxable as a financial institution and not as a business corporation and was entitled to apportion its income under applicable provisions of Massachusetts tax law. The Massachusetts Commissioner of Revenue, or the Commissioner, took alternative positions: that GATE was properly taxable as a business corporation, or that GATE was taxable as a financial institution, but was not entitled to apportionment or was subject to 100% Massachusetts apportionment. In December 2009, the Commissioner made additional assessments of taxes, along with accrued interest, of approximately $11.9 million for GATE’s taxable years ended June 30, 2004, 2005 and 2006, and approximately $8.1 million for our taxable years ended June 30, 2005 and 2006. On November 9, 2011, the ATB issued the ATB Order which concurred with our position that GATE was a financial institution but disagreed with our methodology utilized to apportion income. In the third quarter of fiscal 2012, we made a $5.1 million payment that satisfied our obligation to the Massachusetts Department of Revenue for GATE’s taxable years ended June 30, 2004, 2005 and 2006. On April 17, 2013, the ATB issued the ATB Opinion. On July 22, 2013, we filed an appeal of certain of the ATB’s findings in the Massachusetts Appeals Court. The appeal of the ATB’s findings includes a refund claim with respect to the $5.1 million payment made in the third quarter of fiscal 2012. The Commissioner has decided not to appeal the ATB’s other findings. If we are unsuccessful in an appeal of the ATB Order, we could be required to make additional tax payments for GATE’s taxable years ended June 30, 2008 and 2009, which could materially adversely affect our liquidity position. We have accrued a total income tax liability of $25.2 million, including interest, as of June 30, 2013 related to the 2008 and 2009 tax returns for GATE, which amount was included in income taxes payable on our consolidated balance sheet. On June 29, 2013, the Massachusetts Department of Revenue delivered a notice of intent to assess for our taxable years ended June 30, 2008 and June 30, 2009. This assessment included approximately $822 thousand of additional tax liability and an assessment for penalties of $4.1 million. We have accrued for the additional tax liability, including interest, as of June 30, 2013 but have not accrued for the penalties as we believe that it is more likely than not that the penalties will ultimately be abated, which is consistent with the treatment of our taxable years ended June 30, 2004, 2005 and 2006. We cannot predict the outcome of this matter or the timing of such payments, if any, at this time.

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Fiscal Years ended June 30, 2013, June 30, 2012 and June 30, 2011—Overall Results—Continuing Operations—Internal Revenue Service Audit” included in Item 7 of this annual report, Item 3, “Legal Proceedings,” and Note 16, “Commitments and Contingencies—Income Tax Matters,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information on these matters.

If the estimates we make, or the assumptions on which we rely, in preparing our consolidated financial statements prove inaccurate, our actual results may vary materially from those reflected in our consolidated financial statements.

Our consolidated financial statements include a number of estimates, which reflect management’s judgments. Some of our estimates also rely on certain assumptions. The most significant estimates we make

 

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include the determination of which securitization trusts to consolidate, income taxes relating to uncertain tax positions under Accounting Standards Codification, or ASC, 740, Income Taxes, or ASC 740, the valuation of our service revenue receivables and deposits for participation accounts and our determination of goodwill and intangible asset impairment.

In our determination of the fair value of our service revenue receivables and deposits for participation accounts, we use discounted cash flow modeling techniques and certain assumptions to estimate fair value because there are no quoted market prices.

Our key assumptions to estimate fair value include, as applicable:

 

   

Discount rates, which we use to estimate the present value of our future cash flows;

 

   

The annual rate and timing of education loan prepayments;

 

   

The trend of interest rates over the life of the loan pool, including the forward LIBOR curve, which is a projection of future LIBOR rates over time;

 

   

The expected annual rate and timing of education loan defaults, including the effects of various risk mitigation strategies, such as basic forbearance and alternative payment plans and school and lender guarantees;

 

   

The expected amount and timing of recoveries on defaulted education loans; and

 

   

The fees and expenses of the securitization trusts.

Because our estimates rely on quantitative and qualitative factors, including our historical experience, to predict default, recovery and prepayment rates, management’s ability to determine which factors should be more heavily weighted in our estimates, and to accurately incorporate those factors into our loan performance assumptions, are subjective and can have a material effect on valuations.

If the actual performance of the education loan portfolios held by us or our clients who hold Monogram-based loans were to vary appreciably from the assumptions we use, we might need to adjust our key assumptions. Such an adjustment could materially affect our earnings in the period in which our assumptions change. In addition, our actual service revenue receivables or releases from participation accounts could be significantly less than reflected in our current consolidated financial statements. In particular, economic, regulatory, competitive and other factors affecting the key assumptions used in the cash flow model could cause or contribute to differences between actual performance of the portfolios and our other key assumptions.

We have guaranteed the performance of Union Federal’s obligations under a loan purchase and sale agreement and have agreed to provide an indemnity for third-party claims on behalf of Union Federal under an indenture. We may incur substantial costs if we have to perform obligations of Union Federal or indemnify third parties, which could have a material adverse effect on our liquidity or financial condition.

In connection with Union Federal’s sale of an education loan portfolio in October 2009, FMD delivered a performance guaranty to the purchaser of the loan portfolio. See Note 16, “Commitments and Contingencies—Performance Guaranty,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. If Union Federal were to default in the performance of any of its obligations or agreements under the loan purchase and sale agreement, including its indemnification or loan repurchase obligations, FMD would be required to perform such obligations. As a result, we could incur substantial costs pursuant to the performance guaranty if Union Federal were unable to perform its obligations.

In April 2010, FMD and certain of its subsidiaries entered into agreements relating to the restructuring of the education loan warehouse facility of FMD’s indirect subsidiary UFSB Private Loan SPV, LLC, or UFSB-SPV. In connection with the restructuring, FMD agreed, among other things, to provide a separate indemnity for third-party claims by or on behalf of borrowers against the third-party conduit lender under the facility based on loan origination errors under the facility. See Note 16, “Commitments and Contingencies—Indemnifications—Union Federal,” in the notes to our consolidated financial statements included in Item 8 of this annual report for

 

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additional information. As a result, we may incur substantial costs in the event of a claim for damages related to the facility, which could have a material adverse effect on our liquidity or financial condition.

Changes in macro-economic conditions, including interest rates, could affect the value of our additional structural advisory fees, residual receivables, participation accounts and investments available-for-sale, as well as demand for education loans and our services.

Education loans held by us and the securitization trusts facilitated by us typically carry floating interest rates tied to prevailing short-term interest rates. Changes in interest rates could have the following effects on us:

 

   

Higher interest rates would increase the cost of the loan to the borrower, which, in turn, could cause an increase in delinquency and default rates for outstanding education loans, as well as increased use of forbearance programs;

 

   

Higher interest rates, or the perception that interest rates could increase in the future, could cause an increase in full or partial prepayments; or

 

   

Higher interest rates could reduce borrowing for education generally, which, in turn, could cause the overall demand for our services to decline.

In addition to higher interest rates, other factors, such as challenging economic times, including high unemployment rates, can also lead to an increase in delinquency and default rates. If the prepayment or default rates increase for the education loans held by us or our Monogram platform clients, we may experience a decline in the value of service revenue receivables and our participation accounts, as well as a decline in fees related to Monogram-based loan programs in the future, which could cause a decline in the price of our common stock and could also prevent, or make more challenging, any future portfolio funding transactions.

Economic conditions and interest rate risk could also adversely impact the fair value and the ultimate collectability of our investments available-for-sale. Changes in the fair value of investments available-for-sale are recorded as unrealized gains and losses through other comprehensive income, a component of stockholders’ equity. Should an investment be deemed “other than temporarily impaired,” we would be required to write down the carrying value of the investment through earnings. Such write down(s) may have a material adverse effect on our financial condition and results of operations.

If sufficient funds to finance our business and meet our obligations are not available to us when needed or on acceptable terms, we may be required to delay, scale back, otherwise alter our strategy or cease operations.

We have generated significant net losses since fiscal 2008, and we cannot predict at this time when or if we will return to profitability. Furthermore, while we have made progress towards reducing our overall cash needs, we continue to utilize significant levels of cash to fund the many priorities required of a diverse business such as ours. We may require additional funds for our products, operating expenses, including expenditures relating to TMS and Cology LLC, capital in connection with credit enhancement arrangements for Monogram-based loan programs or capital markets financings, the pursuit of regulatory approvals, acquisition opportunities and the expansion of our capabilities. Historically, we have satisfied our funding needs primarily through fees earned from education loan asset-backed securitizations. We have not accessed the securitization market since fiscal 2008, and the securitization market may not be accessible to us in the future or, if available, not on terms that are acceptable to us. We have also satisfied our funding needs through equity financings. We cannot be certain that additional public or private financing would be available in amounts or on terms acceptable to us, if at all.

Although we believe that our capital resources as of June 30, 2013, which include proceeds of tax refunds under audit, are sufficient to satisfy our operating needs for the succeeding 12 months, we cannot assure you that they will be sufficient, particularly in light of ongoing federal and state income tax audits. In particular, as we announced on August 15, 2013, as part of the audit process, we expected to receive a NOPA from the IRS. On September 10, 2013 we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. The NOPAs propose to disallow the loss that generated the tax refunds that we

 

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previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS’ positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments that we estimate to be approximately $300.0 million plus interest, with the interest continuing to accrue until the matter is resolved. The NOPAs do not address tax years beyond June 30, 2011. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Fiscal Years ended June 30, 2013, June 30, 2012 and June 30, 2011—Overall Results—Continuing Operations—Internal Revenue Service Audit” included in Item 7 of this annual report for additional information.

Insufficient funds could require us to delay, scale back or eliminate certain of our products, eliminate our ability to provide credit enhancement commitments to prospective clients relating to Monogram-based loan programs, curtail, delay or terminate plans for TMS or Cology LLC, terminate personnel, further scale back our expenses or cease operations. In addition, our short-term financing needs are subject to regulatory capital requirements related to Union Federal. See Note 25, “Union Federal Regulatory Matters,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information.

A significant portion of the purchase price for our acquisition of TMS and our acquisition of a substantial portion of the operating assets of the Cology Sellers is allocated to goodwill and intangible assets that are subject to periodic impairment evaluations. An impairment loss could have a material adverse impact on our financial condition and results of operations.

At June 30, 2013, we had $20.1 million of goodwill and $24.1 million of intangible assets related to our acquisition of TMS and our acquisition of a substantial portion of the operating assets of the Cology Sellers. As required by current accounting standards, we review intangible assets for impairment either annually or whenever changes in circumstances indicate that the carrying value may not be recoverable.

The risk of impairment to goodwill is higher during the early years following an acquisition. This is because the fair values of these assets align very closely with what we paid to acquire the reporting units to which these assets are assigned. As a result, the difference between the carrying value of the reporting unit and its fair value (typically referred to as “headroom”) is smaller at the time of acquisition. Until this headroom grows over time, due to business growth or lower carrying value of the reporting unit, a relatively small decrease in reporting unit fair value can trigger impairment charges. When impairment charges are triggered, they tend to be material due to the size of the assets involved. TMS’ business would be adversely affected, and impairment of goodwill could be triggered, if any of the following were to occur: higher attrition rates than planned as a result of the competitive environment or our inability to provide products and services that are competitive in the marketplace, lower-than-planned adoption rates of refund management and Student Account Center products, higher-than-expected expense levels to provide services to TMS clients, a lower interest rate environment than depicted by the LIBOR curve, shorter hold periods or lower cash balances than contemplated, which would reduce overall net interest income opportunity for cash that is held by us on behalf of TMS’ school clients, increases in equity returns required by investors and changes in our business model that may impact one or more of these variables. Cology LLC’s business would be adversely affected, and impairment of goodwill could be triggered, if any of the following were to occur: higher attrition rates than planned, a lack of acceptance of Monogram products and services by its credit union clients, higher-than-expected expense levels to provide services to Cology LLC clients and changes in our business model that may impact one or more of these variables.

We may be required to consolidate and deconsolidate VIEs in the future, which would result in significant changes to the presentation of our consolidated financial statements and may result in increased volatility in our reported financial condition and results of operations.

Effective July 1, 2010, we adopted Accounting Standards Update, or ASU, 2009-16, Transfers and Servicing (Topic 860)—Accounting for Transfers of Financial Assets, or ASU2009-16, and ASU 2009-17, Consolidation (Topic 810)—Improvement to Financial Reporting by Enterprises Involved With Variable Interest Entities, or ASU 2009-17, which amended the accounting for consolidation of variable interest entities, or VIEs.

 

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We are required to continually reassess our involvement with each VIE in which we have an interest, both on- and off-balance sheet, and our determination of whether consolidation or deconsolidation of a VIE is appropriate.

ASU 2009-17 requires us to make additional judgments that are subject to change based on new facts and circumstances, and evolving interpretations and practices. Under ASU 2009-17, the determination of whether to consolidate a VIE is based on whether the company is considered to be the primary beneficiary. Such determination is based on both the power to direct the activities of the entity that most significantly impact the entity’s economic performance, and the obligation to absorb losses or the right to receive benefits that could be significant to the entity. The nature of these determinations, made on an entity-by-entity basis, requires a high level of subjectivity and judgment. As a result, determinations that we make from time to time will be susceptible to change.

The accounting for these matters is complex. Changes in circumstances or technical interpretations of ASU 2009-17 could result in additional consolidation or deconsolidation of VIEs, which could materially affect our consolidated financial statements and make analysis of our financial standing difficult. As we continue to execute our business model, we may be required to consolidate future financing transactions in accordance with ASU 2009-17.

We continue to monitor our involvement with nine off-balance sheet VIEs for which we have determined that we are not the primary beneficiary due to the sole, unilateral rights of other parties to terminate us in our role as service provider or due to a lack of obligation on our part to absorb benefits or losses of the VIE that would be significant to that VIE. A significant change to the pertinent rights of other parties or us, or a significant change to the range of possible financial performance outcomes used in our assessment of the variability of cash flows due to us, could cause us to change our determination of whether or not a VIE should be consolidated in future periods. Given the size of each of our VIEs, any decision to consolidate or deconsolidate a VIE could result in significant changes to our reported assets and liabilities and results of operations during the fiscal quarter in which the change occurs and could make comparisons of our financial performance between periods challenging to investors. For example, in fiscal 2011, we consolidated certain securitization trusts that were subsequently deconsolidated in fiscal 2012. See Note 3, “Discontinued Operations,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information.

Risks Related to Asset-Backed Securitizations and Other Funding Sources

Our financial results and future growth may continue to be adversely affected if we are unable to structure securitizations or alternative financings.

Although our Monogram platform has been designed to generate recurring revenues with less dependence on the securitization market and third-party credit enhancement than our prior business model, a return to profitability is dependent on a number of factors, including the facilitation of loan volumes substantially in excess of those that we have originated to date, and substantially in excess of those contemplated by our four lender clients’ Monogram-based loan programs or other financing alternatives, expense management and growth at TMS, Cology LLC and Union Federal. Accordingly, our future financial results and growth may continue to be affected by our inability to structure securitizations or alternative financing transactions involving education loans on terms acceptable to us. In particular, such transactions may enable us to generate fee revenues or access and recycle capital previously deployed as credit enhancement for interim financing facilities. If we are able to facilitate securitizations in the near-term, we expect the structure and economics of the transactions to be substantially different from our past transactions, including lower revenues and lower advance rates.

If our inability to access the ABS market on acceptable terms continues, our revenues may continue to be adversely impacted, and we may continue to generate net losses, which would further erode our liquidity position.

A number of factors, some of which are beyond our control, have adversely affected or may adversely affect our portfolio funding activities and thereby adversely affect our results of operations.

 

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The success of our business may depend on our ability to structure securitizations or other funding transactions for our clients’ loan portfolios. Several factors have had, or may have, a material adverse effect on both our ability to structure funding transactions and the revenue we may generate for providing our structural advisory and other services, including the following:

 

   

Volatility in the capital markets generally or in the education loan ABS sector specifically, which could restrict or delay our access to the capital markets;

 

   

The timing and size of education loan asset-backed securitizations that other parties facilitate, or the adverse performance of, or other problems with, such securitizations, which could impact pricing or demand for our future securitizations, if any;

 

   

Challenges to the enforceability of education loans based on violations of federal or state consumer protection or licensing laws and related regulations, or imposition of penalties or liabilities on assignees of education loans for violation of such laws and regulations;

 

   

Our inability to structure and gain market acceptance for new products or services to meet new demands of ABS investors, rating agencies or credit facility providers; and

 

   

Changes to bankruptcy laws that change the current non-dischargeable status of private education loans, which could materially adversely affect the profitability of the loan portfolios if applied to loans originated prior to the date of the change.

Recent legislation will affect the terms of future securitization transactions.

The SEC has proposed new rules governing ABS issuance that, due to the requirements for risk retention, may affect the desirability of issuing ABS as a funding strategy. In addition, the Dodd-Frank Act grants federal banking regulators substantial discretion in developing specific risk retention requirements for all types of consumer credit products and requires the SEC to establish new data requirements for all issuers, including standards for data format, asset-level or loan-level data, the nature and extent of the compensation of the broker or originator and the amount of risk retention required by loan securitizers.

The Dodd-Frank Act and its implementing regulations, once adopted, will affect the terms of future securitization transactions, if any, that we facilitate and may result in greater risk retention and less flexibility for us in structuring such transactions.

In structuring and facilitating securitizations of our clients’ education loans, administering securitization trusts or providing portfolio management, we may incur liabilities to transaction parties.

We facilitated and structured a number of special purpose trusts that have been used in securitizations to finance education loans that our clients originated, including securitization trusts that have issued auction rate notes. Under applicable state and federal securities laws, if investors incur losses as a result of purchasing ABS that those securitization trusts have issued, we could be deemed responsible and could be liable to those investors for damages. We could also be liable to investors or other parties for certain updated information that we have provided subsequent to the original ABS issuances by the trusts. If we have failed to cause the securitization trusts or other transaction parties to disclose adequately all material information regarding an investment in any securities, if we or the trusts made statements that were misleading in any material respect in information delivered to investors in any securities or if we breached any duties as the structuring advisor, administrator or special servicer of the securitization trusts, it is possible that we could be sued and ultimately held liable to an investor or other transaction party. This risk includes failure to properly administer or oversee servicing or collections guidelines and may increase if the performance of the securitization trusts’ loan portfolios degrades, and rating agencies over the past several years have downgraded various ABS issued by the trusts we facilitated. Investigations by state Attorneys General, as well as private litigation, have focused on auction rate securities, including the marketing and trading of such securities. It is possible that we could become involved in such matters in the future. In addition, under various agreements entered into with underwriters or financial guaranty insurers of those ABS, as well as certain lenders, we are contractually bound to indemnify those persons if an

 

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investor is successful in seeking to recover any loss from those parties and the securitization trusts are found to have made a materially misleading statement or to have omitted material information.

If we are liable to an investor or other transaction party for a loss incurred in any of the securitizations that we have facilitated or structured and any insurance that we may have does not cover this liability or proves to be insufficient, our results of operations or financial position could be materially adversely affected.

We may determine to incur near-term losses based on longer-term strategic considerations.

We may consider long-term strategic considerations more important than near-term economic gains when assessing business arrangements and opportunities, including financing arrangements for education loans. For example, we expect the structure and pricing terms in near-term future securitization transactions, if any, to be substantially different from our past transactions, including lower revenues and lower advance rates. We may nevertheless determine to participate in, or structure, future financing transactions based on longer-term strategic considerations. As a result, net cash flows over the life of a future securitization trust, particularly any trust that we may facilitate in the near-term as we re-enter the securitization market, could be negative as a result of transaction size, transaction expenses or financing costs.

Risks Related to Regulatory Matters

We are subject to, or will become subject to, new supervision and regulations which could increase our costs of compliance and alter our business practices.

Various regulators have increased diligence and enforcement efforts and new laws and regulations have been passed or are under consideration in the U.S. Congress as a result of turbulence in the financial services industry. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and the federal agencies are given significant discretion in drafting the implementing rules and regulations. Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

As a federal savings bank, Union Federal’s primary bank regulator is the OCC. As a thrift holding company, FMD is regulated by the Federal Reserve. The Dodd-Frank Act imposes consolidated capital requirements on savings and loan holding companies, but these requirements are not effective until five years after enactment of the Dodd-Frank Act.

The Dodd-Frank Act established the CFPB as an independent agency within the Federal Reserve. The CFPB has been given broad powers, including the power to:

 

   

Supervise non-depository institutions, including those that offer or provide education loans;

 

   

Supervise depository institutions with assets of $10 billion or more for compliance with consumer protection laws, as well as the service providers to such institutions;

 

   

Regulate consumer financial products, including education loans, and services offered primarily for personal, family or household purposes;

 

   

Promulgate rules with respect to unfair, deceptive or abusive practices; and

 

   

Take enforcement action against institutions under its supervision.

The CFPB may institute regulatory measures that directly impact our business operations. The CFPB has initiated an examination program of non-depository institutions (which could include service providers such as FMER). The FTC maintains parallel authority to enforce Section 5 of the Federal Trade Commission Act prohibiting unfair or deceptive acts or practices against non-depository financial providers, such as FMER, TMS and Cology LLC. The OCC maintains parallel authority to enforce Section 5 of the Federal Trade Commission Act against federal savings associations, such as Union Federal, as well as authority to examine and supervise federal savings associations with assets of less than $10 billion, such as Union Federal, for compliance with consumer protection laws.

 

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The CFPB has significant rulemaking and enforcement powers and the potential reach of the CFPB’s broad new rulemaking powers and enforcement authority on the operations of financial institutions offering consumer financial products or services, including FMD, is currently unknown. In addition, the Dodd-Frank Act established a Student Loan Ombudsman within the CFPB, who, among other things, receives, reviews and attempts to resolve informally complaints from education loan borrowers. To date, the Student Loan Ombudsman has only issued the Report, which noted concerns that private education loan borrowers may not have fully understood all the terms and conditions of their different loans. As a result, we expect private education loan marketing practices to be carefully scrutinized.

The CFPB’s initiatives and similar efforts with respect to other credit and retail banking products, could increase our costs and the complexity of our operations. See “Business—Government Regulation” included in Item 1 of this annual report for additional information.

The Dodd-Frank Act also includes several provisions that could affect our future portfolio funding transactions, if any, including potential risk retention requirements applicable to any entity that organizes and initiates an ABS transaction, new disclosure and reporting requirements for each tranche of ABS, including new loan-level data requirements, and new disclosure requirements relating to the representations, warranties and enforcement mechanisms available to ABS investors. The Dodd-Frank Act may have a material impact on our operations, including through increased operating and compliance costs.

We are subject to regulation as a savings and loan holding company, and Union Federal is regulated extensively. We could incur additional costs in complying with regulations applicable to savings and loan holding companies and savings banks, or significant penalties if we fail to comply.

As a result of our acquisition of Union Federal in November 2006, we became subject to regulation as a savings and loan holding company, and our business is limited to activities that are financial or real-estate related. FMD is subject to regulation, supervision and examination by the Federal Reserve. The Federal Reserve and the OCC each have certain types of enforcement authority over us, including the ability in certain circumstances to review and approve changes in management and compensation arrangements, issue cease-and-desist orders, force divestiture of Union Federal and impose civil and monetary penalties for violations of federal banking laws and regulations or for unsafe or unsound banking practices. Any such actions could adversely affect our reputation, liquidity or ability to execute our business plan. In addition, we could incur additional costs in complying with differing interpretations by these new regulators, or significant penalties if we fail to comply.

Union Federal is subject to regulation, supervision and examination by the OCC and the FDIC. Such regulation covers all banking business, including activities and investments, lending practices, safeguarding deposits, capitalization, risk management policies and procedures, relationships with affiliated companies, efforts to combat money laundering, recordkeeping and conduct and qualifications of personnel. In particular, the failure to meet minimum capital requirements could result in initiation of certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a material adverse effect on our operations and our consolidated financial statements. We have in the past been required to make capital contributions to Union Federal, and regulatory authorities could require us to make additional capital contributions or to take other corrective measures in the future.

We could incur additional costs in complying with regulations applicable to savings and loan holding companies and savings banks, or significant penalties if we fail to comply. Our ability to comply with all applicable laws and rules depends largely on our establishment and maintenance of a system to ensure such compliance, as well as our ability to attract and retain qualified compliance personnel. Further reductions in staffing levels could make it difficult to retain experienced personnel to maintain adequate internal controls related to regulatory matters. If severe failures in internal controls occur, regulatory authorities could impose sanctions on Union Federal or us. We could in the future be subject to supervisory orders to cease and desist, civil monetary penalties or other actions due to claimed noncompliance, which could have an adverse effect on our business, financial condition and operating results.

 

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We may become subject to additional state registration or licensing requirements, which could increase our compliance costs significantly and may result in other adverse consequences.

Many states have statutes and regulations that require the licensure of small loan lenders, loan brokers, credit services organizations, loan arrangers and collection agencies. Some of these statutes are drafted or interpreted to cover a broad scope of activities. While we believe we have satisfied all material licensing, registration and other regulatory requirements that could be applicable to us based on current laws and the manner in which we currently conduct business, we may determine that we need to submit additional license applications, and we may otherwise become subject to additional state licensing, registration and other regulatory requirements in the future. In particular, certain state licenses or registrations may be required if we change our operations, if regulators reconsider their prior guidance or if federal or state laws or regulations are changed. Even if we are not physically present in a state, its regulators may take the position that registration or licensing is required because we provide services to borrowers located in the state by mail, telephone, the Internet or other remote means.

To the extent that our services are conducted through Union Federal, state requirements for licensure are inapplicable. However, as a result of the enactment of the Dodd-Frank Act and the reduced preemption enjoyed by federal savings banks resulting from the Dodd-Frank Act, we may now be subject to state consumer protection laws in each state where we do business and those laws may be interpreted and enforced differently in different states. We will continue to review state registration and licensing requirements, and we intend to pursue registration or licensing in applicable jurisdictions where we are not currently registered or licensed if we elect to operate through an entity that does not enjoy federal preemption of such registration or licensing requirements. We cannot assure you that we will be successful in obtaining additional state licenses or registrations in a timely manner, or at all. If we determine that additional state registrations or licenses are necessary, we may be required to delay or restructure our activities in a manner that will not subject us to such licensing or registration requirements. Compliance with state licensing requirements could involve additional costs or delays, which could have a material adverse effect on our business. Our failure to comply with these laws could lead to, among other things:

 

   

Curtailment of our ability to continue to conduct business in the relevant jurisdiction, pending a return to compliance or processing of registration or a license application;

 

   

Administrative enforcement actions;

 

   

Class action lawsuits;

 

   

The assertion of legal defenses delaying or otherwise affecting the enforcement of loans; and

 

   

Criminal as well as civil liability.

Any of the foregoing could have a material adverse effect on our business.

We may be exposed to liability for failures of third parties with which we do business to comply with the registration, licensing and other requirements that apply to them.

Third parties with which we do, or have done, business, including federal and state chartered financial institutions and non-bank loan marketers, are subject to registration, licensing and governmental regulations, including TILA and other consumer protection laws and regulations. For example, some of the third-party marketers with which we have done or may do business may be subject to state registration or licensing requirements and laws and regulations, including those relating to loan brokers, small loan lenders, credit services organizations, loan arrangers and collection agencies. As a result of the activities that we conduct or may conduct for our clients, it may be asserted that we have some responsibility for compliance by third parties with whom we do business with the laws and regulations applicable to them, whether on contractual or other grounds. If it is determined that we have failed to comply with our obligations with respect to these third parties, we could be subject to civil or criminal liability. Even if we bear no legal liability for the actions of these third parties, the imposition of licensing and registration requirements on them, or any sanctions against them for conducting business without a license or registration, may reduce the volume of loans we process from them in the future.

 

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Failure to comply with consumer protection laws could subject us to civil and criminal penalties or litigation, including class actions, and have a material adverse effect on our business.

We are subject to a broad range of federal and state consumer protection laws applicable to our student lending, mortgage lending and other retail banking activities, including laws governing fair lending, unfair, deceptive and abusive acts and practices, service member protections, interest rates and loan fees, disclosures of loan terms, marketing, brokering, servicing, collections and foreclosure.

Violations or changes in federal or state consumer protection laws or related regulations, or in the prevailing interpretations thereof, may expose us to litigation, result in greater compliance costs, constrain the marketing of education loans, adversely affect the collection of balances due on the loan assets held by securitization trusts or otherwise adversely affect our business. We could incur substantial additional expense complying with these requirements and may be required to create new processes and information systems. Moreover, changes in federal or state consumer protection laws and related regulations, or in the prevailing interpretations thereof, could invalidate or call into question the legality of certain of our services and business practices.

Violations of the laws or regulations governing our operations, or the operations of our clients, could result in the imposition of civil or criminal penalties, the cancellation of our contracts to provide services or our exclusion from participating in education loan programs. These penalties or exclusions, were they to occur, would impair our business reputation and ability to operate our business. In some cases, such violations may render the loan assets unenforceable.

Recent legislative proposals could affect the non-dischargeability of education loans in bankruptcy. If the legislative proposals are enacted, it could adversely affect the loan portfolios under our Monogram platform, including loans for which we have provided credit enhancements with our partnered lenders, and adversely affect the overall desirability of private education loan assets to investors.

Under current law, education loans can be discharged in bankruptcy only upon a court finding of “undue hardship” if the borrower were required to continue to make loan payments. Legislation has been introduced in both houses of Congress that would generally end the bankruptcy exemption from dischargeability for certain private education loans. If enacted as initially proposed, this legislation would apply retroactively to private education loans already made, and would not require the borrower to make any payments before seeking discharge in bankruptcy. This legislation is substantially similar to legislation that was introduced in both houses of Congress in the last Congress. If enacted in this Congress, such legislation may adversely affect the performance of the education loans under our Monogram platform, restrict the availability of capital to fund education loans and increase loan pricing to borrowers to compensate for the additional risk of bankruptcy discharge, which could adversely affect the competitiveness of our Monogram platform and our ability to engage lenders to fund loans based on our Monogram platform.

In addition, the July 2012 report on private education lending released by the CFPB recommended that the U.S. Congress reconsider the advisability of continuing the current non-dischargeable status of private education loans.

Recent litigation has sought to re-characterize certain loan marketers and other originators as lenders; if litigation on similar theories were successful against us or any third-party marketer we work with, the education loans that we facilitate would be subject to individual state consumer protection laws.

A majority of the lenders with which we work are federally-insured banks and credit unions. As a result, they are able to charge the interest rates, fees and other charges available to the most favored lender in their home state. In addition, our lender clients or prospective lender clients may be chartered by the federal government and enjoy preemption from enforcement of state consumer protection laws. In providing our education loan services to our lender clients, we do not act as a lender, guarantor or loan servicer, and the terms of the education loans that we facilitate are regulated in accordance with the laws and regulations applicable to the lenders.

The association between marketers of high-interest “payday” loans, tax-return anticipation loans, or subprime credit cards, and online payment services, on the one hand, and banks, on the other hand, has come

 

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under recent scrutiny. Recent litigation asserts that loan marketers use lenders with a bank charter that authorizes the lender to charge the most favored interest rate available in the lender’s home state in order to evade usury and interest rate caps, and other consumer protection laws imposed by the states where they do business. Such litigation has sought, successfully in some instances, to re-characterize the loan marketer as the lender for purposes of state consumer protection law restrictions. Similar civil actions have been brought in the context of gift cards. Moreover, federal banking regulators and the FTC have undertaken enforcement actions challenging the activities of certain loan marketers and their bank partners, particularly in the context of subprime credit cards. We believe that our activities, and the activities of third parties whose marketing on behalf of lenders may be coordinated by us, are distinguishable from the activities involved in these cases.

Additional state consumer protection laws would be applicable to the education loans we facilitate if we, or any third-party loan marketer engaged by us, were re-characterized as a lender, and the education loans (or the provisions governing interest rates, fees and other charges) could be unenforceable unless we or a third-party loan marketer had the requisite licenses or other authority to make such loans. In addition, we could be subject to claims by consumers, as well as enforcement actions by regulators. Even if we were not required to cease doing business with residents of certain states or to change our business practices to comply with applicable laws and regulations, we could be required to register or obtain licenses or regulatory approvals that could impose a substantial delay or cost to us. There have been no actions taken or threatened against us on the theory that we have engaged in unauthorized lending; however, if such actions occurred, they could have a material adverse effect on our business.

Risks Related to Ownership of Our Common Stock

The price of our common stock may be volatile.

The trading price of our common stock may fluctuate substantially, depending on many factors, some of which are beyond our control and may not be related to our operating performance. These fluctuations could cause you to lose part or all of your investment in your shares of our common stock. Those factors that could cause fluctuations include, but are not limited to, the following:

 

   

The success of our Monogram platform, our fee-for-service offerings, our TMS offerings and our Cology LLC offerings;

 

   

Announcements by us, our competitors or our potential competitors of acquisitions, new products or services, significant contracts, commercial relationships or capital markets activities;

 

   

Actual or anticipated changes in our earnings or fluctuations in our operating results or in the expectations of securities analysts, including as a result of the timing, size or structure of any portfolio funding transactions;

 

   

Developments or the perception of developments in litigation or proceedings in which we are involved, including any challenges to tax refunds previously received in the amounts of $176.6 million and $45.1 million as a result of the ongoing IRS audit of our past tax returns, including as a result of the NOPAs we received on September 10, 2013, the resolution of our appeal of the ATB Order in the cases pertaining to our Massachusetts state income tax return and the purported class action filed against FMD and certain of our officers in the United States District Court for the District of Massachusetts in August 2013;

 

   

Difficulties we may encounter in structuring securitizations or alternative financings, including disruptions in the education loan ABS market or demand for securities offered by securitization trusts that we facilitate, or the loss of opportunities to structure securitization transactions;

 

   

General economic conditions and trends, including unemployment rates and economic pressure on consumer asset classes such as education loans;

 

   

Legislative initiatives affecting federal or private education loans, including initiatives relating to bankruptcy dischargeability and the federal budget and regulations implementing the Dodd-Frank Act;

 

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Changes in the education finance marketplace generally;

 

   

Negative publicity about the education loan market generally or us specifically;

 

   

Regulatory developments or sanctions directed at Union Federal or us;

 

   

Application of accounting policies and pronouncements, and their effects on our reported financial condition and results of operations, including future determinations under ASU 2009-17 to consolidate or deconsolidate VIEs;

 

   

Price and volume fluctuations in the overall stock market and volatility in the ABS market, from time to time;

 

   

Delisting of our common stock from the New York Stock Exchange, or NYSE, for failure to comply with NYSE continued listing standards, including without limitation, the NYSE’s average closing price standard;

 

   

Significant volatility in the market price and trading volume of financial services and process outsourcing companies;

 

   

Major catastrophic events;

 

   

Purchases or sales of large blocks of our common stock or other strategic investments involving us;

 

   

Dilution from raising capital through a stock or other equity instrument issuance; or

 

   

Departures or long-term unavailability of key personnel, including FMD’s Chief Executive Officer, who we believe has unique insights and experience at this point of change in our business and the education loan industry.

Securities class action litigation has often been brought against companies following periods of volatility in the market price of their securities. In August 2013, a purported class action was filed against us and certain of our current officers in the United States District Court for the District of Massachusetts. The plaintiff alleges, among other things, that the defendants made false and misleading statements and failed to disclose material information in various SEC filings, press releases and other public statements concerning our corporate income tax filings. The complaint alleges various claims under the Exchange Act and Rule 10b-5 promulgated thereunder. The complaint seeks, among other relief, class certification, unspecified damages, fees and such other relief as the court may deem just and proper. No class has been certified in the action.

We intend to vigorously assert our defenses, however, there can be no assurance that we will be successful, and regardless of the merits of our defenses, the price of our common stock could be adversely affected by a perception of risk in connection with this lawsuit, including any such perception that may arise out of any developments adverse to us with respect to this lawsuit. In addition, adverse developments and/or an adverse resolution of the lawsuit could have a material effect on our consolidated financial position and results of operations, which could, in turn, have a negative effect on the price of our common stock. Although we carry insurance for these types of claims, we are not presently able to reasonably estimate potential losses, if any, related to the lawsuit and a judgment significantly in excess of our insurance coverage could materially and adversely affect our financial condition, results of operations and cash flows.

Stockholders that own large blocks of our common stock could exercise substantial control over us and could limit your ability to influence the outcome of key transactions, including a change of control.

There are certain investors that hold large blocks of our common stock, which could impact the outcome of key transactions. In addition, our directors and executive officers owned approximately 8.7% of the outstanding shares of our common stock as of June 30, 2013, excluding shares issuable upon vesting of outstanding restricted stock units and shares issuable upon exercise of outstanding vested stock options. These stockholders, if acting together, could substantially influence matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other extraordinary transactions. They may also have interests that differ from yours and may vote in a way with which you disagree and which may be adverse to your interests. The

 

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concentration of ownership may have the effect of delaying, preventing or deterring a change of control of our company, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company and might ultimately affect the market price of our common stock.

Some provisions in our restated certificate of incorporation and amended and restated by-laws may deter third parties from acquiring us.

Our restated certificate of incorporation and amended and restated by-laws contain provisions that may make the acquisition of our company more difficult without the approval of the FMD Board of Directors, including the following:

 

   

Only the FMD Board of Directors, our Chairman of the Board or our President may call special meetings of our stockholders;

 

   

Our stockholders may take action only at a meeting of our stockholders and not by written consent;

 

   

We have authorized undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval;

 

   

Our directors may be removed only for cause by the affirmative vote of a majority of the directors present at a meeting duly held at which a quorum is present, or by the holders of 75% of the votes that all stockholders would be entitled to cast in the election of directors; and

 

   

We impose advance notice requirements for stockholder proposals.

These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing or cause us to take other corporate actions you desire.

Section 203 of the Delaware General Corporation Law may delay, defer or prevent a change in control that our stockholders might consider to be in their best interests.

We are subject to Section 203 of the Delaware General Corporation Law which, subject to certain exceptions, prohibits “business combinations” between a Delaware corporation and an “interested stockholder,” which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of a Delaware corporation’s voting stock, for a three-year period following the date that such stockholder became an interested stockholder. Section 203 could have the effect of delaying, deferring or preventing a change in control that our stockholders might consider to be in their best interests.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

We lease buildings for our executive offices and operations. Our headquarters are located in Boston, Massachusetts, and we have additional offices in Medford, Massachusetts, North Providence, Rhode Island, Warwick, Rhode Island, Mather, California, Scottsdale, Arizona, Bryan, Texas and Bedford, Massachusetts.

The following table summarizes information as of September 13, 2013 with respect to the principal facilities that we lease:

 

Location

  

Principal activities

   Area
(sq. feet)
     Lease
expiration
date

Boston, MA (Boylston Street)

   Headquarters      57,647       2014

Boston, MA (St. James Avenue)

   None      135,719       2014

Medford, MA

   Loan Processing      84,458       2017

 

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Location

  

Principal activities

   Area
(sq. feet)
     Lease
expiration
date

North Providence, RI

   Union Federal      13,064       2017

Warwick, RI

   TMS      27,250       2015

Mather, CA

   Cology LLC      10,297       2016

Scottsdale, AZ

   Cology LLC Headquarters      2,911       2016

Bryan, TX

   Cology LLC Loan Processing      1,944       2015

Bedford, MA

   Information Technology      3,000       2015

In connection with our expense control initiatives, we have sought to reduce our occupancy costs. In particular:

 

   

We have subleased all 135,719 square feet of our Boston, Massachusetts (St. James Avenue) location through April 30, 2014.

 

   

The lease relating to our Medford, Massachusetts location originally covered 153,156 square feet. In November 2010, we amended the lease which, among other things, reduced the rented space by 59,790 square feet as of April 1, 2011 and extended the term of the lease to March 31, 2017. In July 2011, we further reduced the leased space by 8,908 square feet.

 

   

In June 2011, we entered into a sublease agreement reducing our rented space at our corporate headquarters in Boston, Massachusetts (Boylston Street) by 27,587 square feet from July 1, 2011 through the remainder of our lease term.

We do not anticipate significant difficulty in obtaining lease renewals or alternate space as needed.

 

Item 3. Legal Proceedings

Internal Revenue Service Audit

Effective March 31, 2009, we completed the sale of the Trust Certificate. In connection with the sale of the Trust Certificate, FMD entered into the Asset Services Agreement pursuant to which FMD provided various consulting and advisory services to the purchaser of the Trust Certificate. As a result of the sale of the Trust Certificate, as well as our operating losses incurred in fiscal 2009, we recorded an income tax receivable for federal income taxes paid on taxable income in prior fiscal years. In fiscal 2010, we received a total of $189.3 million in federal and state income tax refunds related to our income tax receivables. In April 2010, the IRS commenced an audit of our tax returns for fiscal 2007 through fiscal 2009, including a review of the tax treatment of the sale of the Trust Certificate. Such audits are consistent with the practice of the Joint Committee of Taxation, which requires the IRS to perform additional procedures, up to and including an audit of a taxpayer who receives a tax refund in excess of $2.0 million. The IRS is also auditing our fiscal 2010 tax return in light of the $45.1 million income tax refund that we received in October 2010. We cannot predict the timing or outcome of the IRS audit.

We announced on August 15, 2013 that, as part of the audit process, we expected to receive a NOPA from the IRS. On September 10, 2013 we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. In the NOPAs, the IRS asserts that our sale of the Trust Certificate should not be recognized for federal income tax purposes primarily because we retained the economic benefits and burdens of the Trust Certificate, including, among other things, retaining certain repurchase rights and data rights. The IRS further concludes that the transaction should be characterized as a financing instead of a sale and asserts that the sale of the Trust Certificate and the execution of the Asset Services Agreement had the impact of converting taxable income to the owner from an accrual basis to a cash basis. As a result, the NOPAs propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS’ positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments

 

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that we estimate to be approximately $300.0 million plus interest, with the interest continuing to accrue until the matter is resolved. The NOPAs do not address tax years beyond June 30, 2011. The NOPAs are only initial IRS positions and not final determinations and, as a result, do not require any tax payment at this time.

The determination of whether or not to accrue a liability, if any, requires a significant amount of judgment and entails, by necessity, the need to incorporate estimates. We have considered the requirements of ASC 740, the impact of the NOPAs, along with other information supporting our overall tax position, in our assessment of the ultimate outcome of this matter with the IRS, and based on our analysis, we did not record an accrual related to this matter in our consolidated financial statements at June 30, 2013 or when we received the NOPAs. Such an accrual, if it becomes necessary, could be significant and material to our consolidated financial statements.

The ongoing IRS audit or any other investigation, audit, appeals proceeding or suit relating to the sale of the Trust Certificate could result in substantial costs. A state taxing authority could also challenge our tax position in connection with the transactions, notwithstanding our receipt of any income tax refund.

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Fiscal Years ended June 30, 2013, June 30, 2012 and June 30, 2011—Overall Results—Continuing Operations—Internal Revenue Service Audit” included in Item 7 of this annual report for additional information.

Massachusetts Appellate Tax Board Matters

We are involved in several matters relating to the Massachusetts tax treatment of GATE, a former subsidiary of FMD, including The First Marblehead Corp. v. Commissioner of Revenue, ATB Docket No. C293487, which was instituted on September 5, 2007; GATE Holdings, Inc. v. Commissioner of Revenue, ATB Docket No. C305217, which was instituted on March 16, 2010; The First Marblehead Corp. v. Commissioner of Revenue, ATB Docket No. C305241, which was instituted on March 22, 2010; and GATE Holdings, Inc. v. Commissioner of Revenue, ATB Docket No. C305240, which was instituted on March 22, 2010. We took the position in the ATB proceedings that GATE was properly taxable as a financial institution and not as a business corporation and was entitled to apportion its income under applicable provisions of Massachusetts tax law. The Commissioner took alternative positions: that GATE was properly taxable as a business corporation, or that GATE was taxable as a financial institution, but was not entitled to apportionment or was subject to 100% Massachusetts apportionment. In September 2007, we filed a petition with the ATB seeking a refund of state taxes paid for our taxable year ended June 30, 2004, all of which taxes had previously been paid as if GATE were a business corporation. In December 2009, the Commissioner made additional assessments of taxes, along with accrued interest, of approximately $11.9 million for GATE’s taxable years ended June 30, 2004, 2005 and 2006, and approximately $8.1 million for our taxable years ended June 30, 2005 and 2006. For the 2005 and 2006 taxable years, only one of the two assessments made by the Commissioner would ultimately be allowed. In March 2010, we filed petitions with the ATB contesting the additional assessments against GATE and us. In April 2011, the ATB held an evidentiary hearing on the foregoing, and the parties filed their final briefs in September 2011. On November 9, 2011, the ATB issued the ATB Order regarding these proceedings. The ATB Order reflected the following rulings and findings:

 

   

GATE was properly taxable as a financial institution, rather than a business corporation, for each of the tax years at issue;

 

   

GATE was entitled to apportion its income under applicable provisions of Massachusetts tax law for each of the tax years at issue;

 

   

GATE properly calculated one of the two applicable apportionment factors used to calculate GATE’s financial institution excise tax;

 

   

GATE incorrectly calculated the other apportionment factor, which we refer to as the Property Factor, by excluding all income from trust-owned education loans outside of Massachusetts rather than including such income for the purposes of GATE’s Massachusetts state tax returns; and

 

   

All penalties assessed to FMD and GATE were abated.

 

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In connection with the ATB Order, as well as the expiration of the statute of limitations applicable to GATE’s taxable year ended June 30, 2007, we recognized an income tax benefit of $12.5 million during the second quarter of fiscal 2012. In the third quarter of fiscal 2012, we made a $5.1 million payment that satisfied our obligation to the Massachusetts Department of Revenue for GATE’s taxable years ended June 30, 2004, 2005 and 2006.

On April 17, 2013, the ATB issued the ATB Opinion. We had argued that the loan servicers’ activities, which were conducted outside of Massachusetts on behalf of the trusts, determined the location of the loans for purposes of the Property Factor. The ATB disagreed and determined that the loan servicers’ activities should not be attributed to GATE and further determined that, for purposes of the Property Factor, the trust-owned education loans were located in Massachusetts, GATE’s commercial domicile.

On July 22, 2013, we filed an appeal of the ATB’s findings with regard to the Property Factor in the Massachusetts Appeals Court (No. 2013-P-0935). The appeal of the ATB’s findings includes a refund claim with respect to the $5.1 million payment made in the third quarter of fiscal 2012. The Commissioner has decided not appeal the ATB’s other findings. If we are unsuccessful in an appeal of the ATB Order, we could be required to make additional tax payments, including interest, for GATE’s taxable years ended June 30, 2008 and 2009, which could materially adversely affect our liquidity position. We have accrued a total income tax liability of $25.2 million, including interest, as of June 30, 2013 related to the 2008 and 2009 tax returns for GATE, which amount was included in income taxes payable on our consolidated balance sheet. On June 29, 2013, the Massachusetts Department of Revenue delivered a notice of intent to assess for our taxable years ended June 30, 2008 and June 30, 2009. This assessment included approximately $822 thousand of additional tax liability and an assessment for penalties of $4.1 million. We have accrued for the additional tax liability, including interest, as of June 30, 2013 but have not accrued for the penalties as we believe that it is more likely than not that the penalties will ultimately be abated, which is consistent with the treatment of our taxable years ended June 30, 2004, 2005 and 2006. We cannot predict the outcome of this matter or the timing of such payments, if any, at this time.

Federal Class Action Lawsuit

On August 28, 2013, a purported class action was filed in the United States District Court for the District of Massachusetts against FMD, Daniel Meyers, FMD’s Chief Executive Officer and Chairman of the FMD Board of Directors, and Kenneth Klipper, FMD’s Chief Financial Officer and one of FMD’s Managing Directors. The plaintiff alleges, among other things, that the defendants made false and misleading statements and failed to disclose material information in various SEC filings, press releases and other public statements concerning our corporate income tax filings. The complaint alleges various claims under the Exchange Act and Rule 10b-5 promulgated thereunder. The complaint seeks, among other relief, class certification, unspecified damages, fees and such other relief as the court may deem just and proper. No class has been certified in the above action.

We intend to vigorously assert our defenses. There can be no assurance, however, that we will be successful, and adverse developments and/or an adverse resolution of the lawsuit could have a material effect on our consolidated financial position and results of operations, which could, in turn, have a negative effect on the price of our common stock. In addition, although we carry insurance for these types of claims, we are not presently able to reasonably estimate potential losses, if any, related to the lawsuit and a judgment significantly in excess of our insurance coverage could materially and adversely affect our financial condition, results of operations and cash flows.

We are involved from time to time in routine legal proceedings occurring in the ordinary course of business. In the opinion of management, there are no matters outstanding, other than those referenced above, that would have a material adverse impact on our operations or financial condition.

 

Item 4. Mine Safety Disclosures.

Not applicable.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information and Holders

Our common stock is listed on the NYSE under the trading symbol FMD. The following table sets forth the high and low sales prices of our common stock, as reported by the NYSE, for each quarterly period within our two most recent fiscal years:

 

     High      Low  

Fiscal 2013

     

First Quarter

   $ 1.24       $ 1.00   

Second Quarter

     1.16         0.61   

Third Quarter

     1.09         0.76   

Fourth Quarter

     1.30         0.98   

Fiscal 2012

     

First Quarter

   $ 1.86       $ 1.00   

Second Quarter

     1.40         0.83   

Third Quarter

     1.52         1.18   

Fourth Quarter

     1.25         0.86   

Computershare Trust Company, N.A. is the transfer agent and registrar for our common stock. As of the close of business on September 11, 2013, we had 67 holders of record of our common stock. This number does not include stockholders for whom shares are held in “street” or nominee name.

 

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Performance Graph

The following graph compares the cumulative five-year total return attained by stockholders on our common stock relative to the cumulative total returns of the Dow Jones U.S. index and the Dow Jones U.S. Financial Services index. The graph tracks the performance of a $100 investment in our common stock and in each of the indices (with the reinvestment of all dividends) from June 30, 2008 to June 30, 2013.

 

LOGO

The information included under the heading “Performance Graph” is “furnished” and not “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liabilities of that section, nor shall it be deemed to be “soliciting material” subject to Regulation 14A or incorporated by reference in any filing under the Securities Act or the Exchange Act.

Dividends

We did not declare any dividends during fiscal 2013 or fiscal 2012, and we do not expect to declare any dividends in the foreseeable future. Any decision to pay future dividends will be made by the FMD Board of Directors and will depend upon applicable regulatory approvals and our earnings, financial condition, capital and regulatory requirements and such other factors as the FMD Board of Directors deems relevant. In connection with the termination of the supervisory agreement that we had entered into in July 2009 with the OTS, which was the primary federal regulator of Union Federal prior to the OCC, the FMD Board of Directors adopted resolutions requiring FMD to notify the OCC in advance of any distributions to our stockholders in excess of $1.0 million in any fiscal quarter.

 

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Issuer Purchases of Equity Securities

The following table provides information as of and for the fiscal quarter ended June 30, 2013 regarding shares of our common stock that were repurchased under our 2003 stock incentive plan, as amended and restated, which we refer to as our 2003 Plan, and our 2011 stock incentive plan, which we refer to as our 2011 Plan:

 

    Total number of
shares purchased
    Average price
paid per share
    Total number of shares
purchased as part of publicly
announced  plans or programs
    Maximum number of shares
that may yet be purchased
under the plans or programs

April 1 - 30, 2013

    162,888      $ 1.03        —                N/A

May 1 - 31, 2013

    10,160        1.25        —                N/A

June 1 - 30, 2013

    35,282        1.23                  —                N/A
 

 

 

     

 

 

   

Total Purchases of Equity Securities(1)

    208,330      $ 1.08        —               
 

 

 

     

 

 

   

 

(1) Participants in our 2003 Plan and our 2011 Plan may elect to satisfy tax withholding obligations upon vesting of restricted stock units by delivering shares of our common stock, including shares retained from the restricted stock units creating the tax obligation. Our 2003 Plan was approved by stockholders on November 16, 2009 and has an expiration date of September 14, 2013. Our 2011 Plan was approved by stockholders on November 14, 2011 and has an expiration date of November 14, 2021.

 

Item 6. Selected Financial Data

The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes under the heading, “Financial Statements and Supplementary Data,” included in Item 8 of this annual report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7 of this annual report. We have derived the data from our consolidated financial statements, which were audited by KPMG LLP, an independent registered public accounting firm. The historical results presented here are not necessarily indicative of future results.

 

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The results for fiscal years 2010 and 2009 include the results of UFSB-SPV, a special purpose vehicle that financed certain education loans we originated. UFSB-SPV was deconsolidated on July 1, 2010 with our adoption of ASU 2009-16 and ASU 2009-17.

 

    Fiscal years ended June 30,  
    2013     2012     2011     2010     2009  
    (dollars and shares in thousands, except per share data)  

Consolidated Statements of Operations Data:

         

Revenues:

         

Net interest income:

         

Interest income

  $ 5,685      $ 3,290      $ 1,777      $ 23,029      $ 42,242   

Interest expense

    (1,422     (915     (1,037     (13,158     (17,139
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

    4,263        2,375        740        9,871        25,103   

(Provision) credit for loan losses

    (148     615        (281     (121     (491
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after (provision) credit for loan losses

    4,115        2,990        459        9,750        24,612   

Non-interest revenues:

         

Tuition payment processing fees

    26,668        26,544        12,904                 

Administrative and other fees

    11,595        9,925        10,747        13,103        15,591   

Fair value changes to service revenue receivables

    2,068        947        (23,178     (13,567     (338,067
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest revenues

    40,331        37,416        473        (464     (322,476
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

    44,446        40,406        932        9,286        (297,864

Non-interest expenses:

         

Compensation and benefits

    40,413        42,052        36,690        41,436        40,473   

General and administrative

    53,582        61,101        56,140        57,835        79,620   

Loss on education loans held-for-sale

                         130,955        138,163   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest expenses

    93,995        103,153        92,830        230,226        258,256   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss from operations

    (49,549     (62,747     (91,898     (220,940     (556,120

Other income:

         

Gain from deconsolidation of trusts

           9,514                        

Proceeds from TERI settlement

    702        1,685        8,112                 

Other

    946                               
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income

    1,648        11,199        8,112                 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss from continuing operations, before income taxes

    (47,901     (51,548     (83,786     (220,940     (556,120

Income tax expense (benefit) from continuing operations

    2,296        (17,955     208        (47,072     (162,841
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss from continuing operations

    (50,197     (33,593     (83,994     (173,868     (393,279

Discontinued operations, net of taxes

           1,135,821        (137,567     2,966        3,074   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

  $ (50,197   $ 1,102,228      $ (221,561   $ (170,902   $ (390,205
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income per basic common share:

         

From continuing operations

  $ (0.47   $ (0.30   $ (0.83   $ (1.75   $ (3.95

From discontinued operations

           10.28        (1.37     0.03        0.01   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total basic net (loss) income per common share

    (0.47     9.98        (2.20     (1.72     (3.94
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income per diluted common share:

         

From continuing operations

  $ (0.47   $ (0.30   $ (0.83   $ (1.75   $ (3.95

From discontinued operations

           10.26        (1.37     0.03        0.01   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total diluted net (loss) income per common share

  $ (0.47   $ 9.96      $ (2.20   $ (1.72   $ (3.94
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average shares outstanding:

         

Basic

    107,346        101,575        100,919        99,537        99,081   

Diluted

    107,346        110,667        100,919        99,537        99,081   

 

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    June 30,  
    2013     2012     2011     2010     2009  
    (dollars in thousands)  

Consolidated Balance Sheet Data:

         

Cash and cash equivalents

  $ 81,910      $ 123,497      $ 217,367      $ 331,047      $ 171,254   

Short-term investments, at cost

    55,179        85,007        50,000        50,000          

Restricted cash

    87,338        65,401        124,687        1,026        1,842   

Investments available-for-sale, at fair value

    84,782        68,598        11,019        4,471        8,450   

Education loans held-for-sale, at lower of cost or fair value

                         105,082        344,886   

Education loans held-to-maturity, net of allowance

    62,996        33,095               391          

Mortgage loans held-to-maturity, net of allowance

    12,629        7,811        6,417        8,118        9,469   

Service revenue receivables, at fair value

    14,817        16,341        29,610        53,279        67,475   

Goodwill and intangible assets

    44,259        40,470        42,588        1,194        1,931   

Income taxes receivable

                         12,176        157,210   

Total assets from continuing operations

    472,293        457,805        507,021        585,471        798,244   

Deposits

    163,977        83,428        60,492        108,732        154,462   

Restricted funds due to clients

    86,994        104,981        124,194                 

Income taxes payable

    25,922        23,414        39,979                 

Education loan warehouse facility

                         218,059        230,137   

Total liabilities from continuing operations

    292,966        230,817        250,120        364,197        417,890   

Total stockholders’ equity (deficit)

    179,327        226,988        (879,939 )*      217,252        378,280   

 

* The June 30, 2011 stockholders’ deficit includes an accumulated deficit of $1.13 billion related to the securitization trusts that we previously consolidated. Total stockholders’ equity at June 30, 2013 and June 30, 2012 no longer included this deficit as a result of the deconsolidation of these securitization trusts during fiscal 2012.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis of our financial condition and results of operations together with our “Selected Financial Data” included in Item 6 of this annual report and “Financial Statements and Supplementary Data” included in Item 8 of this annual report. In addition to historical information, this discussion of financial condition and results of operations contains certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those expressed or implied by the forward-looking statements due to applications of our critical accounting policies and factors including, but not limited to, those set forth under the caption “Risk Factors” included in Item 1A of this annual report.

Executive Summary

Overview

We are a specialty finance company focused on the education financing marketplace in the United States. We provide loan programs on behalf of our lender clients for K-12, undergraduate and graduate students and for college graduates seeking to refinance private education loan obligations. We also provide tuition planning, tuition billing, refund management and payment technology services through TMS. TMS provides such services on behalf of over 700 educational institutions. We offer a fully integrated suite of services through our Monogram platform, as well as certain services on a stand-alone, fee-for-service basis. We partner with lenders to design and administer education loan programs through our Monogram platform, which are typically school-certified. They are designed to be marketed through educational institutions or to prospective borrowers and their families directly and to generate portfolios intended to be held by the originating lender or financed in the capital markets. We also offer a number of other services on a stand-alone, fee-for-service basis in support of our clients, including retail banking, loan origination, portfolio management and securitization services.

On October 19, 2012, FMD’s subsidiary Cology LLC acquired a substantial portion of the operating assets, and assumed certain liabilities, of the Cology Sellers. Through Cology LLC, we provide loan processing services to approximately 270 credit union and other lender clients. Our consolidated financial statements for fiscal 2013 reflect revenues and expenses of Cology LLC since the date of acquisition.

 

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For a detailed description of our product and service offerings, see “Business—Overview” included in Item 1 of this annual report.

Loan Processing and Origination

During the first quarter of fiscal 2011, we began providing services for two lender clients related to school-certified education loan programs, including originating education loans, based on our Monogram platform. During fiscal 2012, we began performing services for Union Federal related to school-certified education loan programs based on our Monogram platform, including a K-12 loan program. In June 2012, we launched a Monogram-based loan program with a new lender client and, in August 2012, we launched a Monogram-based loan consolidation program with an existing client. Our Monogram platform continues to provide us with an opportunity to originate, administer, manage and finance education loans, and our lender clients’ Monogram-based loan programs are a significant component of our return to the education financing marketplace. The education loans that we originate on behalf of our partnered lending clients, excluding our subsidiary Union Federal, are not included on our consolidated balance sheets but, rather are included on the balance sheets of our partnered lending clients. As such, none of the references in this annual report to education loans included on our consolidated balance sheets include the education loans processed by us on behalf of our partnered lending clients.

In October 2012, we began to process and disburse education loans through Cology LLC on behalf of its credit union and other lender clients. Cology LLC earns fees primarily based on the number of loan applications, loan certifications and disbursements it processes on behalf of its clients. Because Cology LLC is a loan processer, the education loans that it processes on behalf of its clients are not included on our consolidated balance sheets but, rather, are included on the balance sheets of its clients. As such, none of the references in this annual report to education loans included on our consolidated balance sheets include the education loans processed by Cology LLC on behalf of its clients.

The following table presents our loan facilitation data with respect to our Monogram-based programs for fiscal 2013 and 2012, as well as the education loans processed by Cology LLC for the period since the date of acquisition through June 30, 2013. We use the term “facilitated loan” to mean an education loan that has been approved following receipt of all applicant data, including the signed credit agreement, required certifications from the school and applicant and any required income or employment verification. We use the term “disbursed loan” to mean a loan for which loan funds have been disbursed on behalf of the lender.

 

    Fiscal 2013     Fiscal 2012  
    Partnered
Lending
    Union
Federal
    Monogram Loan
Programs Total
    Cology LLC
(since
acquisition)
    Total     Partnered
Lending
    Union
Federal
    Monogram Loan
Programs Total
 
    (dollars in thousands)  

Facilitated Loans

  $ 101,343      $ 32,404      $ 133,747      $ 164,462      $ 298,209      $ 26,021      $ 37,627      $ 63,648   

Disbursed Loans

    98,260        33,604        131,864        310,949        442,813        23,399        34,301        57,700   

Historically, we have processed the greatest Monogram-based loan application volume during the summer and early fall months, as students and their families seek to borrow money in order to pay tuition costs for the fall semester or the entire academic year. The following table represents our loan origination metrics with respect to our Monogram-based programs held at Union Federal at June 30, 2013 and 2012:

 

     June 30,  
     2013     2012  

Weighted-average FICO score

     752        753   

Co-signers

     83     85

Delinquent loans

     0.45     0.03

The weighted-average FICO score is based on the maximum score of the borrower or co-signer at origination.

 

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Portfolio Performance

Credit performance of consumer-related loans generally has been adversely affected by general economic conditions in the United States over the past four years. These conditions have included higher unemployment rates and deteriorating credit performance, including higher levels of education loan defaults and lower recoveries on such defaulted loans. Although these conditions have lessened to a certain extent recently, they may have a material adverse effect on consumer loan portfolio performance in the future. Our Monogram-based education loan portfolios are not yet fully exposed to significant adverse portfolio performance because a majority of these portfolios have yet to experience any significant seasoning. Consequently, in evaluating loan portfolio performance, we review projected gross default rates and projected post-default recovery rates. Further, we evaluate the loan portfolio performance of the securitization trusts that we previously facilitated. The service revenue receivables from these trusts that remain on our consolidated balance sheets at June 30, 2013 and June 30, 2012 have not been significantly impacted by defaults or recoveries since these trusts possess guarantees that help to partially negate the overall impact of any default activity. Many of these securitization trusts are also cash flowing, seasoned portfolios that, for the most part, have relatively short remaining weighted-average lives.

Capital Markets

We believe that conditions in the capital markets generally improved in fiscal 2013 compared to recent years. In particular, investors in ABS demonstrated increased interest in ABS backed by private education loans, resulting in a reduction in credit spreads applicable to these securities. Additionally, during the third quarter of fiscal 2013, a private education loan ABS issuance by a third party included a subordinate bond, the first such bond to be included in a new issuance since 2007. The inclusion of this subordinate bond served to increase the advance rate, or amount of funds raised as a percentage of the collateral in the issuance. We believe that these trends during fiscal 2013 indicate that the economics of private education loan ABS are starting to become more attractive to issuers in the private education loan securitization marketplace. However, we have not completed a securitization transaction since fiscal 2008 and if we execute a financing transaction in the capital markets, the structure and economics of any such transaction may be materially different from prior transactions that we have sponsored. Such differences may include lower revenues as a result of comparatively wider credit spreads and lower advance rates.

Uncertainties

Our near-term financial performance and future growth depends, in large part, on our ability to successfully and efficiently market our Monogram platform, Cology LLC offerings and TMS offerings so that we may grow and diversify our client base and revenues. Facilitated and disbursed loan volumes are key elements of our financial results and business strategy, and we believe that the results from the 2011-2012 and the 2012-2013 academic years demonstrate market demand for Monogram-based education loans.

We have invested in our distribution capabilities over the course of the past two years, including our school sales force and TMS, but we face challenges in increasing loan volumes. For example, competitors with larger customer bases, greater name or brand recognition, or more established customer relationships than those of our clients, have an advantage in attracting loan applicants at a lower acquisition cost than us and making education loans on a recurring, or “serialized,” basis.

Outlook

Our long-term success depends on our ability to attract additional lender clients, or otherwise obtain additional sources of interim or permanent financing, such as securitizations or alternative financing transactions. This is particularly true as the level of loan originations for the Union Federal Private Student Loan Program is subject to regulatory limits that are based upon the overall size of Union Federal’s balance sheet and Union Federal’s capital levels, as determined by FMD. To date, we have entered into education loan program agreements based on our Monogram platform with four lender clients, including FMD’s subsidiary Union Federal. While we have demonstrated market demand for Monogram-based education loans, we are uncertain as

 

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to the degree of market acceptance that our Monogram platform will achieve, particularly in the current economic environment where lenders continue to evaluate their education lending business models. Additionally, as one of our four partnered lending clients provides the majority of our Monogram-based loan program fees, we are subject to concentration risk as it relates to this revenue stream until we are able to attract additional lender clients. We believe, however, that the credit quality characteristics and interest rates of the loan portfolios originated in the 2011-2012 and the 2012-2013 academic years will be attractive to additional potential lender clients, as well as capital markets participants. We also believe that the ability to permanently finance private education loan portfolios through the capital markets would make our products and services more attractive to lenders and would accelerate improvement in our long-term financial results.

We are uncertain of the volume of education loans to be generated by the Monogram-based loan programs of our four lender clients, or any additional lender clients, including clients acquired through our acquisition of a substantial portion of the operating assets of the Cology Sellers in October 2012. It is our view that returning to profitability will be dependent on a number of factors, including our loan capacity and related volumes, expense management and growth at TMS, Cology LLC and Union Federal, and the availability of financing alternatives, including our ability to successfully re-enter the securitization market. In particular, we need to generate loan volumes substantially greater than those that we have generated to date, as well as to develop funding capacity for Monogram-based loan programs at loan volume levels greater than those of our four lender clients with lower credit enhancement levels and higher capital markets advance rates than those available today. We must also continue to achieve efficiencies in attracting applicants, through loan serialization or otherwise, in order to reduce our overall cost of acquisition. In the case of Cology LLC, we expect to continue to provide loan processing services to the former customers of the Cology Sellers similar to the services provided to them by the Cology Sellers prior to the asset acquisition. In addition, we hope to provide various Monogram-based products and services to these customers to assist them in education loan product design, pricing, marketing, reporting and analysis, as well as education loan portfolio management services.

Changes in any of the following factors could materially affect our financial results:

 

   

Demand for education financing, which may be affected by changes in limitations established by the federal government on the amount of federal loans that a student can receive, the terms and eligibility criteria for loans and grants under federal or state government programs and legislation currently under consideration;

 

   

The extent to which our services and products, including our Monogram platform, Cology LLC offerings and TMS offerings, gain market share and remain competitive at pricing favorable to us;

 

   

The amount of education loan volume disbursed under our lender clients’ Monogram-based loan programs;

 

   

Our ability to sell Monogram products and services to Cology LLC’s customers;

 

   

An adverse outcome in any challenge to federal tax refunds previously received in the amounts of $176.6 million and $45.1 million as a result of the audit of our past tax returns currently being conducted by the IRS, including as a result of the NOPAs we received from the IRS on September 10, 2013 that propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS’ positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal tax adjustments that we estimate to be approximately $300.0 million plus interest, with the interest continuing to accrue until the matter is resolved;

 

   

Regulatory requirements applicable to Union Federal, TMS and FMD, including conditions and approvals relating to the Union Federal Private Student Loan Program, which limit Union Federal’s ability to fund education loans;

 

   

Conditions in the education loan financing market, including the costs or availability of financing, rating agency assumptions or actions, and market receptivity to private education loan asset-backed securitizations;

 

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The underlying loan performance of the Monogram-based loan programs, including the net default rates, and the timing and amounts of receipt of excess credit enhancements, if any, that may be material to us;

 

   

The resolution of our appeal of the ATB Order in the cases pertaining to our Massachusetts state income tax returns;

 

   

Application of critical accounting policies and estimates, which impact the carrying value of assets and liabilities, as well as our determinations to consolidate or deconsolidate a VIE;

 

   

Application of the Dodd-Frank Act, through the supervisory authority of the CFPB, which has the authority to regulate consumer financial products such as education loans, and to take enforcement actions against institutions marketing and selling consumer financial products under its supervision, such as Union Federal, and institutions that act as service providers to originators and processers of education loans, such as our subsidiaries FMER and Cology LLC;

 

   

Applicable laws and regulations, which may affect the terms upon which lenders agree to make education loans, the terms of future portfolio funding transactions, including disclosure and risk retention requirements, recovery rates on defaulted education loans and the cost and complexity of our loan facilitation operations; and

 

   

Departures or long-term unavailability of key personnel.

Results of Operations—Fiscal Years ended June 30, 2013, June 30, 2012 and June 30, 2011

The financial results of operations include FMD and its subsidiaries for the fiscal years then ended. These results are reported through our continuing operations. Previously consolidated securitization trusts and the results of FMD’s subsidiary First Marblehead Data Services, Inc., or FMDS, are included in discontinued operations as discussed below for the fiscal years ended June 30, 2012 and June 2011.

Discontinued Operations

Upon our adoption of ASU 2009-16 and ASU 2009-17, effective July 1, 2010, we consolidated 14 securitization trusts that we facilitated during fiscal 2004 through fiscal 2008. The education loans purchased by the Trusts were initially subject to a default repayment guaranty by TERI, while the education loans purchased by the NCT Trusts were, with limited exceptions, not TERI-guaranteed. Of the 14 securitization trusts consolidated on July 1, 2010, 11 were Trusts and 3 were NCT Trusts. We refer to the consolidated Trusts as the NCSLT Trusts and the consolidated NCT Trusts as the GATE Trusts.

Consistent with our goal of refining our business model and focusing on our Monogram platform and tuition billing and payment processing services, we disposed of certain components of our business in fiscal 2012. In particular, we sold our remaining variable interests in the Trusts, we sold our trust administrator, FMDS, and we resigned as the special servicer of the Trusts, including the NCSLT Trusts. In addition, the new third party owner of FMDS terminated the agreement, effective September 30, 2012, with FMD’s subsidiary FMER for the special servicing of the NCT Trusts, including the GATE Trusts. During the fourth quarter of fiscal 2012, we determined that we no longer had any significant continuing involvement in the operations relating to the NCSLT Trusts and the GATE Trusts. Further, we concluded that this would occur within an appropriate assessment period for both the NCSLT Trusts and the GATE Trusts. As a result, we reported the operations and activities relating to the NCSLT Trusts, the GATE Trusts and FMDS within discontinued operations for fiscal 2012 and fiscal 2011.

See Note 3, “Discontinued Operations,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information.

 

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Overall Results—Continuing Operations

The following table summarizes the results of our consolidated operations:

 

     Fiscal years ended June 30,     Change between periods  
     2013     2012     2011     2013 - 2012     2012 - 2011  
     (dollars in thousands)  

Revenues:

          

Net interest income:

          

Interest income

   $ 5,685      $ 3,290      $ 1,777      $ 2,395      $ 1,513   

Interest expense

     (1,422     (915     (1,037     (507     122   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     4,263        2,375        740        1,888        1,635   

(Provision) credit for loan losses

     (148     615        (281     (763     896   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after (provision) credit for loan losses

     4,115        2,990        459        1,125        2,531   

Non-interest revenues:

          

Tuition payment processing fees

     26,668        26,544        12,904        124        13,640   

Administrative and other fees

     11,595        9,925        10,747        1,670        (822

Fair value changes to service revenue receivables

     2,068        947        (23,178     1,121        24,125   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest revenues

     40,331        37,416        473        2,915        36,943   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     44,446        40,406        932        4,040        39,474   

Total non-interest expenses

     93,995        103,153        92,830        (9,158     10,323   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss from operations

     (49,549     (62,747     (91,898     13,198        29,151   

Total other income

     1,648        11,199        8,112        (9,551     3,087   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss from continuing operations, before income taxes

     (47,901     (51,548     (83,786     3,647        32,238   

Income tax expense (benefit) from continuing operations

     2,296        (17,955     208        20,251        (18,163
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss from continuing operations

     (50,197     (33,593     (83,994     (16,604     50,401   

Discontinued operations, net of taxes

            1,135,821        (137,567     (1,135,821     1,273,388   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

   $ (50,197   $ 1,102,228      $ (221,561   $ (1,152,425   $ 1,323,789   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The net loss from continuing operations for the fiscal year ended June 30, 2013 was $50.2 million, or $(0.47) per common share, compared to a net loss from continuing operations of $33.6 million, or $(0.30) per common share, for the fiscal year ended June 30, 2012. The increase in the net loss year-over-year was primarily attributable to the results for fiscal 2012 which included significant benefits of $9.5 million related to the deconsolidation of the GATE Trusts, which is included in other income, as well as an income tax benefit from continuing operations of $18.0 million. The aggregate of these benefits was $27.5 million, or $0.25 per common share.

The net loss from continuing operations for the fiscal year ended June 30, 2012 was $33.6 million, or $(0.30) per common share, compared to a net loss from continuing operations of $84.0 million, or $(0.83) per common share, for the fiscal year ended June 30, 2011. The decrease in the net loss year-over-year was principally the result of a $24.1 million improvement in the fair value changes of service revenue receivables and a larger income tax benefit of $18.2 million.

Net Interest Income after (Provision) Credit for Loan Losses

For fiscal 2013, net interest income after (provision) credit for loan losses increased by $1.1 million to $4.1 million from $3.0 million in fiscal 2012. The increase resulted from an improved net interest margin due to

 

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an increase in net interest income from higher-yielding investment securities and education loans held by Union Federal. The provision for loan losses decreased by $763 thousand, reflecting higher cash recoveries received during fiscal 2012 on previously defaulted education loans transferred by Union Federal to an indirect subsidiary of FMD in 2009 and a larger education loan portfolio on Union Federal’s balance sheet.

For fiscal 2012, net interest income after (provision) credit for loan losses increased by $2.5 million to $3.0 million from $459 thousand in fiscal 2011. The increase resulted from an improved net interest margin due to the investment by Union Federal of cash into mortgage-backed securities and, to a lesser extent, education loans. The provision for loan losses improved by $896 thousand, reflecting higher cash recoveries received during fiscal 2012 on previously defaulted education loans transferred by Union Federal to an indirect subsidiary of FMD in 2009.

Non-Interest Revenues

Non-interest revenues include tuition payment processing fees earned by TMS, fee-for-service revenues for loan processing and origination and program support and fees related to our Monogram platform, as well as fair value changes related to service revenue receivables. As it relates to fiscal 2012 and fiscal 2011, it also included fees for portfolio management performed on behalf of the securitization trusts that we previously facilitated.

Non-interest revenues were $40.3 million for the fiscal year ended June 30, 2013, up $2.9 million from $37.4 million for the fiscal year ended June 30, 2012. The increase from fiscal 2012 to fiscal 2013 was primarily related to $4.6 million in higher fee income related to our Monogram platform as a result of significantly higher partnered lending loan disbursements, the inclusion of $2.2 million of revenues from Cology LLC for loan processing and increases in the valuation of our service revenue receivables of $1.1 million, partially offset by $5.1 million in lower revenues from special servicing and transition services related to the FMDS sale.

Non-interest revenues were $37.4 million for the fiscal year ended June 30, 2012, up $36.9 million from $473 thousand for the fiscal year ended June 30, 2011. The increase from fiscal 2011 to fiscal 2012 was principally due to the result of a non-cash loss of $26.4 million recorded during the third quarter of fiscal 2011 for changes to the recovery rate assumption used in determining the fair value of the service revenue receivables, discussed below, and an increase of $13.6 million in TMS tuition payment processing fees. Since we did not acquire TMS until December 31, 2010, our fiscal 2011 results only included six months of results of TMS versus a full year of revenue recorded in fiscal 2012. These increases were partially offset by lower administrative and other fees principally due to lower allowable revenues as a result of reductions in expense reimbursements by the NCSLT Trusts and the GATE Trusts under special servicing agreements for default prevention as well as lower education loan balances upon which the administrative fees were based.

Fair value changes to service revenue receivables    We record our service revenue receivables at fair value on our consolidated balance sheet. At June 30, 2013, our service revenue receivables consisted of additional structural advisory fee and residual receivables and represent the estimated fair value of the service revenue receivables expected to be collected over the life of the various separate securitization trusts that have purchased education loans facilitated by us, with no further service obligations on our part. Prior to the sale of our variable interests in the Trusts on November 14, 2011, we recorded asset servicing fee and additional structural advisory fee receivables in the NCSLT Trusts. As compensation for our services related to asset servicing, we were entitled to a monthly asset servicing fee based on the aggregate outstanding principal balance of the education loans owned by the Trusts.

Changes in the estimated fair value of the service revenue receivables due, less any cash distributions received, are recorded in our consolidated statements of operations within the fair value changes to service revenue receivables.

In the absence of market-based transactions, we use cash flow modeling techniques to derive an estimate of fair value for financial reporting purposes. Significant observable and unobservable inputs used to develop our fair value estimates include, but are not limited to, recovery, net default and prepayment rates, discount rates and the forward LIBOR curve. See Note 11, “Fair Value Measurements,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information.

 

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The following table summarizes the details of the fair value changes to additional structural advisory fees, residual receivables and asset servicing fees:

 

     Fiscal years ended June 30,     Change between periods  
     2013      2012     2011     2013 - 2012     2012 - 2011  
     (dollars in thousands)  

Additional structural advisory fees

   $ 198       $ (2,668   $ (15,798   $ 2,866      $ 13,130   

Residuals

     1,870         3,883        (3,220     (2,013     7,103   

Asset servicing fees

             (268     (4,160     268        3,892   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total fair value changes to service revenue receivables

   $ 2,068       $ 947      $ (23,178   $ 1,121      $ 24,125   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

The increase in the fair value changes to service revenue receivables of $24.1 million from fiscal 2011 to fiscal 2012 was largely due to the losses recorded in fiscal 2011 related to decreases in our net recovery rate assumptions for the NCSLT Trusts as compared to fiscal 2012. The increase in the fair value changes to service revenue receivables of $1.1 million from fiscal 2012 to fiscal 2013 was primarily due to fiscal 2012 events which included the sale of the additional structural advisory fee receivables related to the NCSLT Trusts and the related asset servicing agreement.

Non-Interest Expenses

The following table reflects the composition of non-interest expenses:

 

     Fiscal years ended June 30,      Change between periods  
     2013      2012      2011      2013 - 2012     2012 - 2011  
     (dollars in thousands)  

Compensation and benefits

   $ 40,413       $ 42,052       $ 36,690       $ (1,639   $ 5,362   

General and administrative:

             

Third-party services

     15,212         16,393         16,461         (1,181     (68

Depreciation and amortization

     4,347         4,766         8,253         (419     (3,487

Marketing

     5,273         8,433         1,004         (3,160     7,429   

Occupancy and equipment

     11,757         11,272         11,759         485        (487

Servicer fees

     761         738         661         23        77   

Merchant fees

     6,663         6,467         2,640         196        3,827   

Trust related special servicing expenses

     1,639         5,920         7,898         (4,281     (1,978

Other

     7,930         7,112         7,464         818        (352
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total general and administrative

     53,582         61,101         56,140         (7,519     4,961   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total non-interest expenses

   $ 93,995       $ 103,153       $ 92,830       $ (9,158   $ 10,323   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total number of employees at fiscal year-end

     302         306         339        

Compensation and Benefits    Compensation and benefits expenses decreased to $40.4 million in fiscal 2013 from $42.1 million in fiscal 2012. The decrease of $1.6 million year-over-year was primarily due to approximately $700 thousand in lower severance related costs and $553 thousand in lower non-cash compensation partially offset by $348 thousand in higher variable sales compensation. Total headcount decreased in fiscal 2013 due to the implementation of certain expense reduction efforts. These decreases in headcount were largely offset by our hiring of 43 employees from the Cology Sellers in connection with the acquisition of a substantial portion of the operating assets of the Cology Sellers as of October 19, 2012.

Compensation and benefits expenses increased to $42.1 million in fiscal 2012 from $36.7 million in fiscal 2011. The increase was primarily the result of our acquisition of TMS during mid-year of fiscal 2011.

General and Administrative Expenses    General and administrative expenses decreased to $53.6 million in fiscal 2013 from $61.1 million in fiscal 2012. The decrease of $7.5 million was largely driven by a decrease in

 

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trust related special servicing expenses, which declined $4.3 million year-over-year, primarily as a result of the cessation of our special servicing obligations for the NCSLT Trusts. Additionally, marketing costs decreased by $3.2 million year-over-year due to our investment in brand development of Union Federal’s Monogram-based loan programs in fiscal 2012.

General and administrative expenses increased to $61.1 million in fiscal 2012 from $56.1 million in fiscal 2011. The increase of $5.0 million was a result of higher marketing expenses incurred in fiscal 2012 related to loan acquisition and the initial brand development of Union Federal’s Monogram-based loan programs as well as higher merchant fees expenses related to payment processing services performed by TMS as our fiscal 2011 results included only six months of results for TMS. These increases were partially offset by lower depreciation and amortization expenses for certain fixed assets that were fully depreciated and lower trust related special servicing costs for the NCSLT Trusts.

Other Income

We recorded other income of $702 thousand, $1.7 million and $8.1 million for fiscal 2013, fiscal 2012 and fiscal 2011, respectively, due to resolution of certain matters related to the TERI Reorganization. This income represented the forgiveness of notes payable and other liabilities, and cash distributions from the liquidating trust under TERI’s confirmed plan of reorganization. During fiscal 2012, we also recorded income related to the deconsolidation of the securitization trusts previously consolidated of $9.5 million largely relating to the re-establishment of the fair value of the residual interests that were previously eliminated upon the adoption of ASU 2009-17 on July 1, 2010. During fiscal 2013, we recorded other income of $946 thousand related to the gain on the sale of a defaulted loan portfolio, which was transferred by Union Federal to an indirect subsidiary of FMD in 2009.

 

     Fiscal years ended June 30,  
     2013      2012      2011  
     (dollars in thousands)  

Gain from deconsolidation of trusts

   $       $ 9,514       $   

Proceeds from TERI settlement

     702         1,685         8,112   

Other

     946                   
  

 

 

    

 

 

    

 

 

 

Total other income

   $ 1,648       $ 11,199       $ 8,112   
  

 

 

    

 

 

    

 

 

 

Income Taxes

We are subject to federal income tax, as well as income tax in multiple U.S. state and local jurisdictions. Our effective income tax rate is calculated on a consolidated basis. The IRS is auditing our tax returns for fiscal 2007 through fiscal 2010. We also remain subject to federal income tax examinations for fiscal 2011 through fiscal 2013. In addition, we are involved in several matters relating to the Massachusetts tax treatment of GATE, a former subsidiary of FMD. See “—Internal Revenue Service Audit” below as well as Item 3, “Legal Proceedings,” and Note 16, “Commitments and Contingencies—Income Tax Matters,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information regarding these matters.

Our state income tax returns in jurisdictions other than Massachusetts remain subject to examination for various fiscal years ended between June 30, 2009 and June 30, 2013.

Income tax expense from continuing operations for the fiscal year ended June 30, 2013 was $2.3 million as compared to an income tax benefit of $18.0 million in fiscal 2012 and income tax expense of $208 thousand in fiscal 2011. The benefit in fiscal 2012 was primarily the result of the recognition of an income tax benefit of $12.5 million during the second quarter of fiscal 2012 in connection with the ATB Order, as well as the expiration of the statute of limitations applicable to GATE’s taxable year ended June 30, 2007. In addition, a $5.7 million benefit was recorded in the third quarter of fiscal 2012 related to the gain on the sale of FMDS, which was included in discontinued operations.

 

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Beginning in fiscal 2011, we no longer had any taxable income in prior periods to offset current period net operating losses for federal income tax purposes. As a result, we recorded a net operating loss carryforward asset as of June 30, 2013 and June 30, 2012, totaling $45.0 million and $28.0 million, respectively, for which we recorded a full valuation allowance.

Under current law, we do not have remaining taxes paid within available net operating loss carryback periods, and it is more likely than not that our deferred tax assets will not be realized through future reversals of existing temporary differences or available tax planning strategies. Accordingly, we have determined that a valuation allowance was necessary for all of our deferred tax assets not scheduled to reverse against existing deferred tax liabilities as of June 30, 2013 and June 30, 2012. We will continue to review the recognition of deferred tax assets on a quarterly basis.

Internal Revenue Service Audit

Effective March 31, 2009, we completed the sale of the Trust Certificate. In connection with the sale of the Trust Certificate, FMD entered into the Asset Services Agreement pursuant to which FMD provided various consulting and advisory services to the purchaser of the Trust Certificate. As a result of the sale of the Trust Certificate, as well as our operating losses incurred in fiscal 2009, we recorded an income tax receivable for federal income taxes paid on taxable income in prior fiscal years. In fiscal 2010, we received a total of $189.3 million in federal and state income tax refunds related to our income tax receivables. Furthermore, we received a federal income tax refund of $45.1 million in October 2010 related to the operating losses in fiscal 2010, which we applied to taxable income from fiscal 2008. In April 2010, the IRS commenced an audit of our tax returns for fiscal 2007 through fiscal 2009, including a review of the tax treatment of the sale of the Trust Certificate. Such audits are consistent with the practice of the Joint Committee of Taxation, which requires the IRS to perform additional procedures, up to and including an audit of a taxpayer who receives a tax refund in excess of $2.0 million. The IRS is also auditing our fiscal 2010 tax return in light of the $45.1 million income tax refund that we received in October 2010. We cannot predict the timing or outcome of the IRS audit.

We announced on August 15, 2013 that, as part of the audit process, we expected to receive a NOPA from the IRS. On September 10, 2013 we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. In the NOPAs, the IRS asserts that our sale of the Trust Certificate should not be recognized for federal income tax purposes primarily because we retained the economic benefits and burdens of the Trust Certificate, including, among other things, retaining certain repurchase rights and data rights. The IRS further concludes that the transaction should be characterized as a financing instead of a sale and asserts that the sale of the Trust Certificate and the execution of the Asset Services Agreement had the impact of converting taxable income to the owner from an accrual basis to a cash basis. As a result, the NOPAs propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS’ positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments that we estimate to be approximately $300.0 million plus interest, with the interest continuing to accrue until the matter is resolved. The NOPAs do not address tax years beyond June 30, 2011.

The NOPAs are proposed recommendations of the reviewing agent in the IRS field office and, as such, are initial IRS positions and not final determinations, and, as a result, do not require any tax payment at the time of issuance. We have considered the requirements of ASC 740, the impact of the NOPAs, along with other information supporting our overall tax position, in our assessment of the ultimate outcome of this matter with the IRS, and based on our analysis, we did not record an accrual related to this matter in our consolidated financial statements at June 30, 2013 or when we received the NOPAs. Such an accrual, if it becomes necessary, could be significant and material to our consolidated financial statements.

We plan to vigorously contest the proposed adjustments, and we believe we have a strong position as it relates to this matter. The process of resolving this issue, which may include an appeals process with the IRS and litigation

 

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in the U.S. Tax Court and the U.S. Court of Appeals, may extend over multiple years depending on how it progresses through the IRS and, if necessary, the courts. Assuming this matter advances unresolved through the IRS’ administrative process and the courts, we are not required to make tax payments, if any, until the matter is fully resolved, which may be several years from now. However, if we receive an unfavorable outcome from the U.S. Tax Court and appeal, we must post a bond in order to prevent collection of the tax deficiency.

Financial Condition

Total assets increased $14.5 million to $472.3 million at June 30, 2013 from $457.8 million at June 30, 2012. Total stockholders’ equity decreased $47.7 million to $179.3 million at June 30, 2013 from $227.0 million at June 30, 2012. The changes in our financial position from June 30, 2012 to June 30, 2013 are discussed in detail below.

Cash, Cash Equivalents and Short-term Investments

We had combined cash, cash equivalents and short-term investments of $137.1 million and $208.5 million at June 30, 2013 and June 30, 2012, respectively. Of this total, at June 30, 2013, FMD and its non-bank subsidiaries held $110.1 million in interest-bearing and non-interest-bearing deposits, money market funds and certificates of deposit with highly-rated financial institutions. Union Federal held a total of $27.0 million in interest-bearing and non-interest-bearing deposits and money market funds at June 30, 2013. Union Federal is subject to restrictions on the payment of dividends without prior approval from the OCC.

The decrease of $71.4 million was a result of $52.4 million related to net investments in available-for-sale securities, education loans and mortgage loans at Union Federal, $42.5 million to fund operations, $9.1 million in additional deposits for participation accounts and $4.7 million related to cash paid for a substantial portion of the operating assets of the Cology Sellers. These uses were partially offset by net growth in deposits at Union Federal of $40.5 million.

Restricted Cash

At June 30, 2013, restricted cash on our consolidated balance sheets was $87.3 million, of which $86.7 million was held by TMS. Restricted cash at June 30, 2012 was $65.4 million, of which $100.5 million was held by TMS, including $40.0 million held at Union Federal, which was eliminated for purposes of our consolidated balance sheet presentation, and $4.9 million was held by FMD and its other non-bank subsidiaries. The increase of $21.9 million from fiscal 2012 to fiscal 2013 in restricted cash was primarily due to the return of the deposit held at Union Federal back to TMS in fiscal 2013, partially offset by lower outstanding balances.

Restricted cash held by TMS represents tuition payments collected from students or their families on behalf of educational institutions. These cash balances are held in escrow under a trust agreement for the benefit of

 

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TMS’ educational institution clients and are generally subject to cyclicality, tending to peak in August of each school year, early in the enrollment cycle, and to decrease in May, at the end of the school year. During fiscal 2013, TMS’ restricted cash balances ranged from a high of $341.1 million during August 2012 to a low of $38.8 million during May 2013. At times, TMS may deposit a portion of restricted cash in a deposit account at Union Federal. Such deposit is governed by a trust agreement between TMS and a third party trustee. Subject to the capital requirements and other laws, regulations, and restrictions applicable to Union Federal, the cash that is deposited with Union Federal in connection with the tuition payment plans is not restricted and, accordingly, is not included in restricted cash in our consolidated financial statements. In December 2011, we transferred $40.0 million of TMS deposits to Union Federal and, in the fourth quarter of fiscal 2013, this deposit was transferred, in full, back to TMS. Restricted cash held by Cology LLC represents loan origination proceeds and loan payments which it collects and disburses on behalf of its lender clients. Restricted cash held by our other subsidiaries relates to recoveries on defaulted education loans collected on behalf of clients as well as undistributed loan origination proceeds. We record a liability on our consolidated balance sheets representing tuition payments due to our TMS clients, loan origination proceeds and loan payments due to our Cology LLC clients and recoveries on defaulted education loans and education loan proceeds due to schools.

Investments Available-for-Sale

Investments classified as available-for-sale are reported at fair value at our consolidated balance sheet date. Our investment portfolio provides a source of short-term liquidity. Investments available-for-sale principally consisted of mortgage-backed federal agency securities held by Union Federal at both June 30, 2013 and June 30, 2012. The investments available-for-sale increased by $16.2 million from $68.6 million at June 30, 2012 to $84.8 million at June 30, 2013 primarily as a result of Union Federal’s purchase of $32.0 million in mortgage-backed securities, partially offset by $14.4 million in principal repayments during fiscal 2013. The portfolio generated net unrealized losses of $742 thousand at June 30, 2013 and net unrealized gains of $610 thousand at June 30, 2012, which was recognized in other comprehensive income, a component of stockholders’ equity.

See Note 7, “Investments Available-for-Sale,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information

Loans

At June 30, 2013 and June 30, 2012, we classified all education loans and substantially all mortgage loans as held-to-maturity. The net carrying value of loans consisted of the following, as of the dates indicated:

 

     June 30,  
   2013      2012  
   (dollars in thousands)  

Education loans held-to-maturity, net

   $ 62,996       $ 33,095   

Mortgage loans held-to-maturity, net

     12,629         7,811   

Education Loans Held-to-Maturity

The increase of $29.9 million in education loans at June 30, 2013 from June 30, 2012 was principally related to disbursed education loans through our Monogram platform at Union Federal.

The following table summarizes the composition of the net carrying value of our education loans held-to-maturity as of the dates indicated:

 

     June 30,  
   2013     2012  
   (dollars in thousands)  

Gross loan principal outstanding

   $ 64,655      $ 34,404   

Allowance for loan losses

     (1,659     (1,309
  

 

 

   

 

 

 

Education loans held-to-maturity, net of allowance

   $ 62,996      $ 33,095   
  

 

 

   

 

 

 

 

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Allowance for Loan Losses

The following is a roll forward of the net carrying value of education loans held-to-maturity:

 

    Fiscal years ended June 30,  
  2013     2012  
  Gross loans
outstanding
    Allowance for
loan losses
    Net carrying
value
    Gross loans
outstanding
    Allowance for
loan losses
    Net carrying
value
 
    (dollars in thousands)  

Balance, beginning of year

  $ 34,404      $ (1,309   $ 33,095      $ 1,336      $ (1,336   $  

Disbursements of principal to borrowers

    33,555               33,555        34,301               34,301   

Principal receipts from borrowers

    (4,020            (4,020     (1,877            (1,877

Interest capitalized on loans in deferment and forbearance

    377               377        70               70   

(Provision) credit for loan losses

           (11     (11           601        601   

Reserves reclassified from interest receivable for capitalized interest

    31        (31            24        (24       

Net charge-offs:

           

Charge-offs

    (156     156               (240     240          

Recoveries from borrowers

    464        (464            790        (790       
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

    308        (308            550        (550       
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of year

  $ 64,655      $ (1,659   $ 62,996      $ 34,404      $ (1,309   $ 33,095   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

To estimate the allowance for loan losses on our newly originated Monogram-based loan portfolio, we utilized specific default and recovery rates projected for the Monogram-based loan portfolio over the 12-month loss confirmation period. We may also apply qualitative adjustments in determining the allowance for loan losses. Our default experience with this loan portfolio is limited by the seasoning of the portfolio; however, we have utilized our historical database and experience in projecting the level of defaults and recoveries of the Monogram-based loan portfolio relying in part on historical results from our securitization trusts that we previously facilitated for loans that have similar credit characteristics to those in our Monogram-based loan portfolio.

At June 30, 2013 and 2012, there were $189 thousand and $54 thousand, respectively, of educations loans that were in non-accrual status and no education loans that had specific reserves. These loans included $42 thousand and $54 thousand, at June 30, 2013 and June 30, 2012, respectively, of loans that were transferred by Union Federal to an indirect subsidiary of FMD in 2009, prior to the launch of our Monogram platform. For loans greater than 180 days past due, but not yet charged-off, our policy is to evaluate the loans under ASC 310, Receivables, for a specific reserve. At June 30, 2013, there were $110 thousand of education loans that were greater than 180 days past due, which included $77 thousand of Monogram-based education loans issued through Union Federal.

Loans which were transferred by Union Federal to an indirect subsidiary of FMD in 2009, prior to the launch of our Monogram platform, were fully reserved for at June 30, 2013 and 2012.

Overall Education Loan Credit Quality

Management monitors the credit quality of an education loan based on loan status, as outlined below. The impact of changes in loan status, such as delinquency and time in repayment, is incorporated into the quarterly allowance for loan loss calculation through our projection of defaults. The following table represents our loan origination metrics with respect to our Monogram-based programs held at Union Federal at June 30, 2013 and June 30, 2012:

 

     June 30,  
     2013     2012  

Weighted-average FICO score

     752        753   

Co-signers

     83     85

Delinquent loans

     0.45     0.03

The weighted-average FICO score is based on the maximum score of the borrower or co-signer at origination.

 

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The following table provides additional information on the status of education loans outstanding:

 

     June 30,
2013
     As a percentage
of total
    June 30,
2012
     As a percentage
of total
 
     (dollars in thousands)  

Principal of loans outstanding:

          

In basic forbearance

   $ 439         0.7   $ 171         0.5

In school and in deferment

     22,948         35.5        14,781         43.0   

In repayment, including alternative payment plans, classified as:

          

Current: £30 days past due

     40,724         63.0        19,289         56.0   

Delinquent: >30 days past due, but £120 days past due

     355         0.5        109         0.3   

Delinquent: >120 days past due, but £180 days past due

     79         0.1        54         0.2   

In default: >180 days past due, but not yet charged-off

     110         0.2                  
  

 

 

    

 

 

   

 

 

    

 

 

 

Total gross loan principal outstanding

   $ 64,655         100.0   $ 34,404         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

Non-accrual loan principal (>120 days past due)

   $ 189         0.3   $ 54         0.2

Past due loan principal (>90 days, but £120 days past due still accruing interest)

     121         0.2        11           

In alternative payment plans

     784         1.2        263         0.8   

We use the following terms to describe borrowers’ payment status:

In School and in Deferment    Pursuant to the terms of the education loans, a borrower may choose to defer principal and interest payments while carrying a specified academic course load and may be eligible to defer payments for an additional six months after graduation during a grace period. At the end of the deferment period, any remaining accrued but unpaid interest is capitalized and added to principal outstanding.

In Repayment    We determine the repayment status of a borrower, including a borrower making payments pursuant to alternative payment plans, by contractual due dates. A borrower making reduced payments for a limited period of time pursuant to an alternative payment plan will be considered current if such reduced payments are timely made. Under our Monogram platform, borrowers may be in repayment while in school. Payment options while in school include full principal and interest, partial interest and interest only.

Forbearance    Pursuant to the terms of the education loans, a borrower may apply for forbearance, which is a temporary reprieve from making full contractual payments. Forbearance can take many forms, at the option of the creditor. The most common forms of forbearance include the following:

 

   

Basic forbearance—Cessation of all contractual payments for a maximum allowable forbearance period of one year, granted in three-month increments. Although basic forbearance is available as part of our Monogram-based programs, it has not been substantially utilized due to the seasoning of our Monogram-based education loan portfolio.

 

   

Alternative payment plans—Pursuant to an alternative payment plan, a borrower can make a reduced payment for a limited period of time. The amount of the payment varies depending on the program and may be set at a fixed dollar amount, a percentage of contractual required payments or interest-only payments. Generally, approval for alternative payment plans is granted for a maximum of six to 24 months, depending on the program.

The use of forbearance is contemplated at the origination of an education loan and, as noted in the credit agreement with the borrower, is granted at the lender’s discretion. Under both basic forbearance and alternative payment plans, the education loan continues to accrue interest. When forbearance ceases, unpaid interest is capitalized and added to principal outstanding, and the borrower’s required payments are recalculated at a higher amount to pay off the loan, plus the additional accrued and capitalized interest, at the original stated interest rate by the original maturity date. There is no forgiveness of principal or interest, reduction in the interest rate or extension of the maturity date.

 

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Forbearance programs result in a delay in the timing of payments received from borrowers; however, assuming the collection of the forborne amounts, provide for an increase in the gross volume of cash receipts over the term of the education loan due to the additional accrued interest capitalized while in forbearance. Forbearance programs may have the effect of delaying default emergence, and alternative payment plans may reduce the utilization of basic forbearance.

Mortgage Loans Held-to-Maturity

Through our bank subsidiary, Union Federal, we carry a portfolio of mortgage loans held-to-maturity. We establish a general allowance for loan losses for mortgage loans that have similar risk profiles. The allowance allocation factor for the general reserve is based on the historical net charge-off rate, which is then adjusted for current qualitative or environmental factors that are likely to cause estimated credit losses associated with the existing portfolio to differ from historical loss experience. Management considers the risk factors and assesses the impact of current issues and changes in those factors to the portfolio on an ongoing basis. In addition, we establish a specific allowance for loan losses when a loan is deemed to be impaired. Management estimates the credit loss by comparing the loan’s carrying value against either (1) the present value of the expected future cash flows discounted at the loan’s effective interest rate; (2) the loan’s observable market price or (3) the expected realizable fair value of the collateral, in the case of collateral dependent loans. A specific allowance is assigned to the impaired loan for the amount of estimated credit loss. Impaired loans are charged off, in whole or in part, when management believes that the recorded investment in the loan is uncollectible.

The following table summarizes the activity in the allowance for loan losses for mortgage loans:

 

     Fiscal years ended
June 30,
 
         2013             2012      
     (dollars in thousands)  

Balance, beginning of year

   $ 591      $ 882   

Provision (credit) for loan losses

     137        (13

Charge-offs

     (295     (335

Recoveries from borrowers

     7        57   
  

 

 

   

 

 

 

Balance, end of year

   $ 440      $ 591   
  

 

 

   

 

 

 

We place mortgage loans on non-accrual status when they become 90 days past due as to either principal or interest. The following table summarizes the aging of past due mortgage loans:

 

     June 30,  
         2013              2012      
     (dollars in thousands)  

Non-accrual loans:

     

Residential (1-4 family)

   $ 570       $ 1,049   

Commercial/mixed use

     94         220   

Accruing loans:

     

Accruing loans 30-59 days past due

     560         708   

We did not have any accruing mortgage loans that were 60 or more days past due.

Deposits for Participation Interest Accounts

Deposits for participation accounts were reported at fair value on our consolidated balance sheets. Deposits for participation accounts increased by $9.1 million from $4.0 million at June 30, 2012 to $13.1 million at June 30, 2013. The increase year-over-year is primarily attributable to increased fundings in fiscal 2013 due to an increase in disbursed loan volumes for our partnered lending clients.

 

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Goodwill and Intangible Assets

Goodwill represents the excess of the cost of an acquisition over the fair value of the net tangible and other intangible assets acquired. Other intangible assets represent purchased assets that can be distinguished from goodwill because of contractual rights or because the asset can be exchanged on its own or in combination with a related contract, asset or liability. In connection with our acquisition of assets from TMS and the Cology Sellers, we recorded other intangible assets related to the TMS customer list and tradename and the Cology Sellers customer list, each of which we amortize on a straight-line basis over 15 years, and TMS technology, which we amortize on a straight-line basis over six years. We record amortization expense in general and administrative expenses in our consolidated statements of operations.

As it relates to TMS, the customer list intangible asset is related to educational institutions with which TMS had existing tuition programs in place as of December 31, 2010. The trade name intangible asset relates to the name and reputation of TMS in the tuition payment industry. Intangible assets attributable to technology represented the replacement cost of software and systems acquired that are necessary to support operations, net of an obsolescence factor. Goodwill represents the value ascribed to the acquisition of TMS that cannot be separately ascribed to a tangible or intangible asset.

As it relates to Cology LLC, the customer list intangible asset is related to lender clients, including credit unions, banks and schools, with which the Cology Sellers had existing loan origination and servicing programs in place as of October 19, 2012. Goodwill represents the value ascribed to the acquisition of a substantial portion of the operating assets of the Cology Sellers that cannot be separately ascribed to a tangible or intangible asset.

In 2013, we evaluated our goodwill for impairment on May 31, which is our annual impairment testing date, and concluded that the fair market values of the TMS and Cology LLC reporting units were approximately 40% and 15%, respectively, in excess of our recorded book value and, therefore, were not impaired as of that date. In determining whether impairment exists, we assess impairment at the level of the TMS and Cology LLC reporting units. There have been no indicators of impairment since that date.

Various assumptions go into our assessment of whether there is any goodwill impairment to be recorded. The more meaningful assumptions that contribute to the cash flow model used to determine the fair value of the TMS reporting unit include the net retention rate of new and existing clients, the penetration rate achieved in the overall customer portfolio, adoption of refund management and Student Account Center products and pricing, the level of interest income to be earned by TMS on funds received but not yet disbursed to client schools, including the forward LIBOR curve, the level of cash balances and the applicable hold periods, all of which impact net interest income, expense levels at TMS and the discount rate used to determine the present value of the cash flow streams. TMS’ business would be adversely affected if any of the following were to occur: higher attrition rates than planned as a result of the competitive environment or our inability to provide products and services that are competitive in the marketplace, lower-than-planned adoption rates of refund management and Student Account Center products, higher-than-expected expense levels to provide services to TMS’ clients, a lower interest rate environment than depicted by the LIBOR curve, shorter hold periods or lower cash balances than contemplated, which would reduce our overall net interest income opportunity for cash that is held by us on behalf of TMS’ school clients, increases in equity returns required by investors and changes in our business model that may impact one or more of these variables. The more meaningful assumptions that contribute to the cash flow model used to determine the fair value of the Cology LLC reporting unit include loan volume growth, revenues related to the cross-selling of Monogram-based products and services, client attrition, costs required to support the assumed volume of the business, and discount rates. Cology LLC’s business would be adversely affected if any of the following were to occur: higher attrition rates than planned, a lack of acceptance of Monogram products and services by its credit union and other lender clients, higher-than-expected expense levels to provide services to Cology LLC clients and changes in our business model that may impact one or more of these variables.

At June 30, 2013, our net intangible assets balance was $24.2 million, of which $18.7 million related to TMS and $5.4 million related to Cology LLC. During the fiscal year ended June 30, 2013, we recorded amortization expense of $1.9 million related to TMS and $283 thousand related to Cology LLC.

 

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Contractual Obligations

Our consolidated contractual obligations consist of commitments under operating leases.

The following table below summarizes our contractual cash obligations by period at June 30, 2013, excluding the offsetting effect of payments due to us under subleases:

 

Contractual obligations

   Payments due by period  
   Total      Less than
1 year
     1-3 years      3-5 years      More than
5 years
 
     (dollars in thousands)  

Operating lease obligations(1)

   $ 15,938       $ 8,848       $ 5,336       $ 1,754       $   

 

(1) For additional information on our operating leases, see Item 2, “Properties,” in this annual report. We sublease 135,719 square feet of our Boston, Massachusetts (St. James Avenue) location. We expect to collect $2.7 million in sublease revenue over the remaining term of this sublease. On June 10, 2011, we entered into a sublease agreement, effective July 1, 2011, reducing our rented space at our corporate headquarters in Boston, Massachusetts (Boylston Street) by 27,587 square feet. We expect to collect $800 thousand in sublease revenue over the remaining term of this sublease. In addition, effective July 1, 2011, we entered into an amendment to reduce our rented space in our Medford, Massachusetts location by 8,908 square feet, which results in a savings of $718 thousand over the remaining term of the lease.

Total Stockholders’ Equity

Total stockholders’ equity decreased from $227.0 million at June 30, 2012 to $179.3 million at June 30, 2013 as a result of our net loss of $50.2 million and the change in accumulated other comprehensive income of $1.4 million for the net unrealized losses on our investments available-for-sale portfolio, partially offset by an increase of $4.1 million in additional paid-in capital primarily for stock compensation.

Off-Balance Sheet Arrangements

We offer outsourcing services in connection with education loan programs, from program design through securitization of the education loans. We have historically structured and facilitated the securitization of education loans for our clients through a series of special purpose trusts.

The principal uses of the securitization trusts we facilitated have been to generate sources of liquidity for our clients’ and Union Federal’s assets sold into such trusts and make available more funds to students and colleges. See “—Critical Accounting Policies and Estimates—Consolidation” below for a discussion of our determination to not consolidate these securitization trusts.

 

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Consolidated Average Balance Sheet

The following tables reflect our consolidated average balance sheet, net interest income and rates earned and paid on interest-earning assets and interest-bearing liabilities from continuing operations:

 

    Fiscal years ended June 30,  
  2013     2012     2011  
  Average
daily
balance
    Interest     Rate     Average
daily
balance
    Interest     Rate     Average
daily
balance
    Interest     Rate  
    (dollars in thousands)  

Assets:

                 

Interest-bearing cash and cash equivalents

  $ 118,884      $ 186        0.16   $ 168,046      $ 257        0.15   $ 261,673      $ 551        0.21

Short-term investments

    57,200        337        0.59        60,766        290        0.48        52,191        269        0.52   

Interest-bearing restricted cash

    15,497        38        0.24        70,726        482        0.68        41,689        133        0.32   

Investments available-for-sale

    80,050        1,483        1.85        41,502        844        2.03        3,763        181        4.81   

Education loans held-to-maturity

    51,849        3,216        6.20        17,456        1,109        6.35        24,918        288        1.16   

Mortgage loans held-to-maturity

    10,772        425        3.95        7,832        308        3.93        8,050        355        4.40   
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total interest-earning assets

    334,252        5,685        1.70        366,328        3,290        0.90        392,284        1,777        0.45   

Non-interest-bearing cash

    1,320            1,531            1,492       

Allowance for loan losses and lower of cost or fair value adjustments

    (2,018         (2,010         (2,231    

Other assets

    156,446            121,200            88,462       
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 490,000          $ 487,049          $ 480,007       
 

 

 

       

 

 

       

 

 

     

Liabilities:

                 

Time and savings account deposits

  $ 50,050      $ 528        1.05   $ 43,095      $ 408        0.95   $ 48,537      $ 468        0.96

Money market account deposits

    78,249        769        0.98        27,668        257        0.93        20,121        150        0.74   

Other interest-bearing liabilities

    1,996        125        6.25        4,264        250        5.86        7,531        419        5.56   
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total interest-bearing liabilities

    130,295        1,422        1.09        75,027        915        1.22        76,189        1,037        1.36   

All other liabilities

    155,318            174,631            102,060       
 

 

 

       

 

 

       

 

 

     

Total liabilities

    285,613            249,658            178,249       

Stockholders’ equity

    204,387            237,391            301,758       
 

 

 

       

 

 

       

 

 

     

Total liabilities and stockholders’ equity

  $ 490,000          $ 487,049          $ 480,007       
 

 

 

       

 

 

       

 

 

     

Total interest-earning assets

  $ 334,252          $ 366,328          $ 392,284       
   

 

 

       

 

 

       

 

 

   

Net interest income

    $ 4,263          $ 2,375          $ 740     
   

 

 

       

 

 

       

 

 

   

Net interest margin

        1.28         0.65         0.19

 

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Analysis of changes in net interest income

 

     From 2013 to 2012
due to change in
    From 2012 to 2011
due to change in
 
   Volume     Rate     Net
change
    Volume     Rate     Net
change
 
   (dollars in thousands)  

Interest-bearing cash and cash equivalents

   $ (77   $ 6      $ (71   $ (143   $ (151   $ (294

Short-term investments

     (17     64        47        41        (20     21   

Interest-bearing restricted cash

     (134     (310     (444     198        151        349   

Investments available-for-sale

     715        (76     639        767        (104     663   

Education loans held-to-maturity

     2,133        (26     2,107        (475     1,296        821   

Mortgage loans held-to-maturity

     115        2        117        (9     (38     (47
      

 

 

       

 

 

 

Total interest income

         2,395            1,513   
      

 

 

       

 

 

 

Time and savings account deposits

     73        47        120        (52     (8     (60

Money market account deposits

     497        15        512        70        37        107   

Other interest-bearing liabilities

     (141     16        (125     (192     23        (169
      

 

 

       

 

 

 

Total interest expense

         507            (122
      

 

 

       

 

 

 

Net increase in net interest income

       $ 1,888          $ 1,635   
      

 

 

       

 

 

 

Liquidity and Capital Resources

Sources and Uses of Cash

The following is a discussion of sources and uses of cash on a GAAP basis as presented in our consolidated statements of cash flows included in our consolidated financial statements included in Item 8 of this annual report. We also use a non-GAAP financial metric, “net operating cash usage,” when evaluating our cash and liquidity position, discussed in detail under “—Non-GAAP Measure: Net Operating Cash Usage” below.

Net cash used in operating activities from continuing operations for fiscal 2013 was $51.1 million, compared with net cash used in operating activities from continuing operations of $42.2 million for fiscal 2012. The increase in cash used was principally the result of an increase in net funding of participation accounts of $13.6 million for fiscal 2013 coupled with the receipt of $13.0 million from the sale of certain service revenue receivables in the second quarter of fiscal 2012. These changes were partially offset by a $13.2 million lower loss from operations in fiscal 2013 compared to fiscal 2012.

We anticipate continuing to receive fees related to loan processing and origination and portfolio management services as well as fees related to Monogram-based loan programs. We believe that our cash, cash equivalents and investments, coupled with the management of our expenses and these fees, will be adequate to fund our operating losses in the short term as we seek to expand our client and revenue base over the short and long term. We are uncertain, however, as to whether we will be successful in selling our Monogram platform to additional lenders or how much loan volume may be originated by current or any additional lenders in the future.

Net cash used in investing activities from continuing operations for fiscal 2013 was $70.7 million compared to $88.1 million for fiscal 2012. The improvement of $17.4 million was the result of an increase in the net proceeds from short-term investments of $64.8 million and a $39.7 million decline in the net purchases of available-for-sale securities as this portfolio was significantly expanded in fiscal 2012 as part of the asset diversification process at Union Federal. These were partially offset by an $80.0 million decrease in restricted cash and restricted funds due to clients, due to the $40.0 million of TMS deposits that was transferred to Union Federal in fiscal 2012 and returned to TMS in fiscal 2013, and $4.7 million used for the acquisition of a substantial portion of the operating assets of the Cology Sellers.

Net cash provided by financing activities from continuing operations was $80.2 million for fiscal 2013 compared to net cash provided by financing activities of $22.7 million during fiscal 2012, primarily reflecting an increase in deposits.

 

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The OCC regulates all capital distributions by Union Federal directly or indirectly to us, including dividend payments. Union Federal is required to file a notice with the OCC at least 30 days before the proposed declaration of a dividend or approval of a proposed capital distribution by Union Federal’s board of directors. Union Federal must file an application to receive the approval of the OCC for a proposed capital distribution when, among other circumstances, the total amount of all capital distributions (including the proposed capital distribution) for the applicable calendar year exceeds net income for that year to date plus the retained net income for the preceding two years.

A notice or application to make a capital distribution by Union Federal may be disapproved or denied by the OCC if it determines that, after making the capital distribution, Union Federal would fail to meet minimum required capital levels or if the capital distribution raises safety or soundness concerns or is otherwise restricted by statute, regulation or agreement between Union Federal and the OCC or a condition imposed by an OCC agreement. Under the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, an FDIC-insured depository institution such as Union Federal is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is used in the FDICIA).

Sources and Uses of Liquidity

We expect to fund our short-term liquidity requirements primarily through cash and cash equivalents and revenues from operations, and we expect to fund our long-term liquidity requirements through a combination of revenues from operations and various financing vehicles available to us in the ABS markets. We may also utilize issuances of common stock, promissory notes or other securities or the potential sale of certain assets of FMD. We expect to assess our financing alternatives periodically and access the capital markets opportunistically. If our existing resources are insufficient to satisfy our liquidity requirements, or if we were to enter into a strategic arrangement with another company, we may need to sell additional equity or debt securities. Any sale of additional equity or convertible debt securities may result in additional dilution to our stockholders, and we cannot be certain that additional public or private financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to further delay, reduce the scope of or eliminate one or more aspects of our operational activities, which could harm our business.

Our liquidity and capital funding requirements may depend on a number of factors, including:

 

   

Cash necessary to fund our operations, including the operations of Union Federal, TMS and Cology LLC, and capital expenditures;

 

   

The extent to which our services and products, including our Monogram platform, TMS offerings and Cology LLC offerings, gain market share and remain competitive at pricing levels favorable to us;

 

   

The results of the audit conducted by the IRS of our tax returns for fiscal 2007 through fiscal 2010, which could result in challenges to tax refunds previously received in the amounts of $176.6 million in connection with our sale of the Trust Certificate and the $45.1 million income tax refund received in October 2010. In connection with the IRS audit, on September 10, 2013, we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. The NOPAs propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS’ positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments that we estimate to be approximately $300.0 million plus interest, with the interest continuing to accrue until the matter is resolved;

 

   

The profitability of our Monogram platform, which is dependent on, among other things, the amount of loan volume our lender clients are able to generate and costs incurred to acquire such volume;

 

   

The extent to which we fund credit enhancement arrangements or contribute to credit facility providers in connection with our Monogram platform;

 

   

The ability to access wholesale financing opportunities within Union Federal to help meet the liquidity needs generated by Monogram-based loans;

 

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The regulatory capital requirements applicable to Union Federal (see “—Support of Subsidiary Bank” below for additional information) as well as any capital contributions or credit enhancements FMD may make to Union Federal;

 

   

The resolution of our appeal of the ATB Order, which could also affect our state tax liabilities for fiscal 2008 and fiscal 2009; and

 

   

The timing, size, structure and terms of any securitization or other funding transactions that we structure, as well as the composition of the loan pool being securitized.

Liquidity is required for capital expenditures, working capital, business development expenses, business acquisitions, income tax payments, costs associated with alternative financing transactions, general corporate expenses, capital provided in connection with Monogram-based loan program credit enhancement arrangements or capital market transactions and maintaining the regulatory capital of Union Federal. In order to preserve capital and maximize liquidity in challenging market conditions, we have in the past taken certain broad measures to reduce the risk related to education loans and residual receivables on our consolidated balance sheet, change our fee structure, add new products and reduce our overhead expenses. In addition, the FMD Board of Directors has eliminated regular quarterly cash dividends for the foreseeable future.

Deposits

Union Federal has liabilities for retail time, money market and savings deposits accounts. The following table summarizes Union Federal’s time deposits greater than $100 thousand by maturity at June 30, 2013:

 

     (dollars in thousands)  

Within three months

   $ 5,369   

Three to six months

     2,363   

Six months to twelve months

     3,209   

Greater than twelve months

     6,169   
  

 

 

 

Total time deposits >$100 thousand

   $ 17,110   
  

 

 

 

The maturities of these deposits are not directly indicative of the future timing of cash needed for financing activities because they do not take into account the customers that may reinvest their funds into new time deposits or into other types of deposit accounts.

Restricted Funds Due to Clients

As part of our operations, we have cash that is recorded as restricted cash on our consolidated balance sheets because it is deposited with third party institutions and not available for our use. Included in restricted cash on our consolidated balance sheets are tuition payments due to schools, undisbursed loan origination proceeds and loan payments and recoveries on defaulted education loans. We record a liability on our consolidated balance sheets representing tuition payments due to our TMS clients, loan origination proceeds and loan payments due to our Cology LLC clients and recoveries on defaulted education loans and education loan proceeds due to schools.

Lines of Credit

At June 30, 2013, through Union Federal, we had $82.0 million available for borrowing under an unused line of credit with the Federal Home Loan Bank of Boston. There were no borrowings outstanding under this line of credit at June 30, 2013 or June 30, 2012.

Non-GAAP Measure: Net Operating Cash Usage

In addition to providing financial measurements based on GAAP, we present below an additional financial metric that we refer to as “net operating cash usage” that was not prepared in accordance with GAAP. We define “net operating cash usage” to approximate cash requirements to fund our operations. “Net operating cash usage”

 

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is not directly comparable to our consolidated statements of cash flows prepared in accordance with GAAP. Legislative and regulatory guidance discourage the use of, and emphasis on, non-GAAP financial metrics and require companies to explain why a non-GAAP financial metric is relevant to management and investors.

Management and the FMD Board of Directors use this non-GAAP financial metric, in addition to GAAP financial measures, as a basis for measuring and forecasting our core operating performance and comparing such performance to that of prior periods. This non-GAAP financial measure is also used by us in our financial and operational decision-making.

We believe that the inclusion of this non-GAAP financial metric helps investors to gain a better understanding of our results, including our non-interest expenses and liquidity position. In addition, our presentation of this non-GAAP financial measure is consistent with how we expect that analysts may calculate their estimates of our financial results in their research reports and with how clients, investors, analysts and financial news media may evaluate our financial results.

There are limitations associated with reliance on any non-GAAP financial measure because any such measure is specific to our operations and financial performance, which makes comparisons with other companies’ financial results more challenging. Nevertheless, by providing both GAAP and non-GAAP financial measures, we believe that investors are able to compare our GAAP results to those of other companies, while also gaining a better understanding of our operating performance, consistent with management’s evaluation.

“Net operating cash usage” should be considered in addition to, and not as a substitute for, or superior to, financial information prepared in accordance with GAAP. “Net operating cash usage” excludes the effects of income taxes, acquisitions or divestitures, participation account net fundings and changes in other assets and other liabilities that are solely related to short-term timing of cash payments or receipts.

In accordance with the requirements of Regulation G promulgated by the SEC, the table below presents the most directly comparable GAAP financial measure, loss from continuing operations, before income taxes, for the twelve months ended June 30, 2013 and June 30, 2012, and reconciles the GAAP measure to the comparable non-GAAP financial metric:

 

     Twelve Months Ended
June 30,
 
     2013     2012  
     (dollars in thousands)  

Loss from continuing operations, before income taxes

   $ (47,901   $ (51,548

Adjustments to loss from continuing operations, before income taxes:

    

Non-cash gain from deconsolidation of trusts

            (9,514

Fair value changes to service revenue receivables

     (2,068     (947

Cash distributions from service revenue receivables

     3,592        1,216   

Depreciation and amortization

     4,347        4,766   

Stock-based compensation

     4,214        4,647   

TMS deferred revenue

     (496     (1,701

Additions to property and equipment

     (3,465     (1,727

Other, net of cash flows from FMDS in fiscal 2012

     (708     1,738   
  

 

 

   

 

 

 

Non-GAAP net operating cash usage

   $ (42,485   $ (53,070
  

 

 

   

 

 

 

“Net operating cash usage” for the fiscal year ended June 30, 2013 was $42.5 million, a $10.6 million, or 20%, reduction compared to the fiscal year ended June 30, 2012. The decrease of $10.6 million for fiscal 2013 as compared to fiscal 2012 was largely the result of a decrease in non-interest cash expenses of $8.3 million driven principally by decreases of $7.1 million in general and administrative expenses and $1.2 million in compensation and benefits expenses. The decrease in general and administrative expenses was largely due to a decrease of $4.3 million in trust related special servicing expenses as a result of the cessation of our special servicing obligations for the NCSLT Trusts. Increased cash receipts from service revenue receivables of $2.4 million also contributed to the decrease in “net operating cash usage.” The decrease in “net operating cash usage” was partially offset by approximately $3.2 million of cash flows related to FMDS in fiscal 2012 not received in fiscal 2013.

 

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Support of Subsidiary Bank

Union Federal is a federally-chartered thrift that is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can result in initiation of certain mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a direct material effect on our liquidity. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Union Federal must meet specific capital guidelines that involve quantitative measures of Union Federal’s assets and liabilities as calculated under regulatory accounting practices. The capital amounts and classifications, however, are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Union Federal’s equity capital was $21.6 million at June 30, 2013, up from $16.3 million at June 30, 2012, principally due to $5.8 million in capital contributions to Union Federal by FMD during fiscal 2013. Quantitative measures established by regulation to ensure capital adequacy require Union Federal to maintain minimum amounts and ratios of total capital and Tier 1 capital to risk-weighted assets (each as defined in the regulations). As of June 30, 2013 and June 30, 2012, Union Federal was well capitalized under the regulatory framework for prompt corrective action.

Union Federal’s regulatory capital ratios were as follows as of the dates below:

 

     Regulatory Guidelines     June 30,  
     Minimum     Well
Capitalized
          2013                2012       

Capital ratios:

        

Tier 1 risk-based capital

     4.0     6.0     25.2     31.3

Total risk-based capital

     8.0        10.0        26.0        31.7   

Tier 1 (core) capital

     4.0        5.0        11.7        11.0   

FMD is subject to regulation, supervision and examination by the Federal Reserve, as a savings and loan holding company, and Union Federal is subject to regulation, supervision and examination by the OCC.

In March 2010, the FMD Board of Directors adopted resolutions required by the OTS, Union Federal’s regulator at that time, undertaking to support the implementation by Union Federal of its business plan, so long as Union Federal is owned or controlled by FMD, and to notify the OTS (and now the OCC effective in fiscal 2012) in advance of any distributions to our stockholders in excess of $1.0 million per fiscal quarter and any incurrence or guarantee of debt in excess of $5.0 million. These resolutions continue to be applied by the Federal Reserve. Distribution to our stockholders may be further restricted by the Federal Reserve’s required approval in those instances when such distributions exceed the net earnings of the prior 12-month period.

Inflation

Inflation was not a material factor in either revenues or operating expenses during the periods presented.

Critical Accounting Policies and Estimates

Our consolidated financial statements have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at the date of our consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. We base our estimates, assumptions and judgments on our historical experience, economic conditions and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions. Our significant accounting policies are more fully described in Note 2, “Summary of Significant Accounting Policies,” in the notes to our consolidated financial statements included in Item 8 of this annual report.

 

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On an ongoing basis, we evaluate our estimates and judgments, particularly as they relate to accounting policies that we believe are most important to the portrayal of our financial condition and results of operations. We regard an accounting estimate or assumption underlying our consolidated financial statements to be a “critical accounting estimate” where:

 

   

The nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and

 

   

The impact of the estimates and assumptions on our financial condition or operating performance is material.

We have discussed our accounting policies with the Audit Committee of the FMD Board of Directors. We consider the following to be our critical accounting policies:

 

   

Whether to consolidate the financial results of a VIE;

 

   

The determination of goodwill and other intangible asset impairment; and

 

   

Income taxes relating to uncertain tax positions under ASC 740.

Consolidation

We review certain VIEs for which we have previously securitized to determine whether we are the primary beneficiary of the entity. We continually reassess our involvement with each VIE in which we have an interest, both on- and off-balance sheet, and our determination of whether consolidation or deconsolidation of a VIE is appropriate. We monitor matters related to our ability to control economic performance, such as contractual changes in the services we provide, the extent of our ownership and the rights of third parties to terminate us as a service provider. In addition, we monitor the financial performance of each VIE for indications that we may or may not have the right to absorb benefits or the obligation to absorb losses associated with variability in the financial performance of the VIE that could potentially be significant to that VIE. If, for any reason, we determine that we can no longer be considered the primary beneficiary, we would be required to deconsolidate the VIE. Deconsolidation of a VIE is accounted for in the same manner as the sale of a subsidiary, with a gain or loss recorded in our consolidated statements of operations to the extent that proceeds, if any, are more or less than the net assets of the VIE.

Effective July 1, 2010, the Financial Accounting Standards Board amended ASC 810, Consolidation, or ASC 810, and removed the exemption from consolidation for a Qualifying Special Purpose Entity. ASC 810 further requires enterprises to perform analyses to determine if they are the primary beneficiary of a VIE. A primary beneficiary of a VIE is an enterprise that has both:

 

   

The power to direct the activities of a VIE that most significantly impact that VIE’s economic performance; and

 

   

The obligation to absorb losses of the VIE that could potentially be significant to that VIE or the right to receive benefits from the VIE that could potentially be significant to that VIE.

As a result, on July 1, 2010, we consolidated 14 securitization trusts that were facilitated by us because we determined that our services related to default prevention and collections management, for which we can only be removed for cause, combined with the variability that we absorbed as part of our securitization fee structure, made us the primary beneficiary of those trusts. In addition, we deconsolidated our indirect subsidiary UFSB-SPV because we determined that we did not have the power to direct activities that most significantly impact UFSB-SPV’s economic performance. During fiscal 2012, we deconsolidated the 14 securitization trusts we had consolidated as we no longer were the primary beneficiary of these trusts. See Note 3, “Discontinued Operations,” in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information

We also monitor our involvement with nine off-balance sheet VIEs for which we have determined that we are not the primary beneficiary due to the sole, unilateral rights of other parties to terminate us in our role as

 

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service provider or due to a lack of obligation on our part to absorb benefits or losses of the VIE that would be significant to that VIE. A significant change to the pertinent rights of other parties or us, or a significant change to the ranges of possible financial performance outcomes used in our assessment of the variability of cash flows due to us, could cause us to change our determination of whether or not a VIE should be consolidated in future periods. Our determination to consolidate or deconsolidate a VIE may lead to increased volatility in our financial results and make comparisons of results between time periods challenging.

Review of Goodwill and Intangible Assets for Impairment

On December 31, 2010, we completed our acquisition of the assets, liabilities and operations of TMS, formerly a division of KeyBank National Association. On October 19, 2012, Cology LLC acquired a substantial portion of the operating assets, and assumed certain liabilities, of the Cology Sellers. As a result of these acquisitions, we recorded goodwill and intangible assets. We test goodwill for impairment annually and more frequently if circumstances warrant.

Intangible assets acquired consist of the TMS customer lists, technology and tradename and the Cology Sellers customer list. The values of these intangible assets were estimated using valuation techniques, based on discounted cash flow analysis. These intangible assets are being amortized over the period the assets are expected to contribute to our cash flows. These intangible assets are subject to impairment tests in accordance with GAAP, generally, whenever events or changes in circumstances indicate that their carrying amount may not be fully recoverable.

We evaluate goodwill for impairment by comparing the fair values of the operations of the TMS and Cology LLC reporting units to their carrying values, including goodwill. If the fair value of the reporting unit exceeds the carrying value, goodwill is not deemed to be impaired. If the fair value is less than the carrying value, a further analysis is required to determine the amount of impairment, if any.

There are significant judgments involved in determining the fair values of the TMS and Cology LLC reporting units, including assumptions regarding the estimates of future cash flows from existing and new business activities, customer relationships, the value of existing customer contracts, the value of other intangible assets, as well as assumptions regarding what we believe a third party is willing to pay for all of the assets and liabilities of TMS and Cology LLC. The calculation also requires us to estimate the appropriate discount and growth rates to apply to those projected cash flows and an appropriate control premium to apply to arrive at a final fair value. Since the businesses are not publicly traded, and often there is not comparable market data available, there is a higher degree of judgment applied and the use of cash flows is weighted more heavily than the use of market multiples. In the event that we determine that our goodwill or intangible assets are impaired, the recognition of an impairment charge could have an adverse impact on our results of operations in the period that the impairment occurred or on our financial position. For fiscal 2013 and fiscal 2012, we recorded no goodwill impairment. We evaluated goodwill for impairment at our annual impairment testing date of May 31.

Income Taxes

Certain areas of accounting for income taxes require management’s judgment, including determining the adequacy of liabilities for uncertain tax positions. Judgments are made regarding various tax positions, which are often subjective and involve assumptions about items that are inherently uncertain. If actual factors and conditions differ materially from estimates made by management, the actual realization of liabilities for uncertain tax positions could vary materially from the amounts previously recorded.

Deferred tax assets arise from items that may be used as a tax deduction or credit in future income tax returns, for which a financial statement tax benefit has already been recognized. The realization of the net deferred tax asset generally depends upon future levels of taxable income and the existence of prior years’ taxable income to which refund claims could be carried back. Valuation allowances are recorded against those deferred tax assets determined not likely to be realized. Deferred tax liabilities represent items that will require a future tax payment. They generally represent tax expense recognized in our consolidated financial statements for which payment has been deferred, or a deduction taken on our tax return but not yet recognized as an expense in our consolidated financial statements.

 

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Interest rate risk is the primary market risk associated with our operations. Management monitors liquidity and interest rate risk matters. These matters are discussed with the FMD Board of Directors and the Union Federal Board of Directors, as applicable. Interest rate risk is the risk of loss to future earnings due to changes in interest rates. Interest rate risk applies to all of our interest-bearing assets and liabilities, as well as service revenue receivables.

Our risk-based interest-bearing assets are largely made up of our investments available-for-sale, education loans and mortgage loans. The mix of fixed rate versus variable rate instruments for our investments available-for-sale and loan portfolios as of June 30, 2013 are presented in the table below:

 

June 30, 2013

   Amount      Variable      % Variable     Fixed      % Fixed  
     (dollars in thousands)  

Investments available-for-sale

   $ 84,782       $ 16,522         19.5   $ 68,260         80.5

Education loans held-to-maturity

     62,996         62,996         100.0                  

Mortgage loans held-to-maturity

     12,629         3,634         28.8        8,995         71.2   
  

 

 

    

 

 

      

 

 

    
   $ 160,407       $ 83,152         51.8   $ 77,255         48.2
  

 

 

    

 

 

      

 

 

    

As shown above, at June 30, 2013, our education loan portfolio consisted entirely of variable rate loans that generally reprice in accordance with LIBOR. Additionally, approximately 20% of our investments available-for-sale and approximately 29% of our mortgage loan portfolio were also variable rate instruments. As market rates increase or decrease, our variable rate interest-bearing assets are likely to be immediately impacted while our interest-bearing liabilities would be slower to reprice. The balance of the interest-bearing assets in the table above were fixed rate instruments. Of these fixed rate instruments, approximately 88% were available-for-sale securities, which had a weighted average life of 4.0 years. In addition to the interest-bearing assets in the table above, our interest-bearing assets included short-term investments of $55.2 million at June 30, 2013, which consisted of fixed-rate certificates of deposit that have maturities of less than one year.

Our interest-bearing liabilities consisted of customer deposits held at Union Federal, totaling $164.0 million at June 30, 2013. Of these deposits, approximately 76% were comprised of demand deposits, including savings deposits and money market deposits, which are generally subject to daily re-pricing. The remaining approximately 24% of customer deposits represented fixed-rate time deposits, of which approximately 27% had maturities in excess of 12 months from June 30, 2013.

Deposit pricing is subject to regular examination by a committee of senior managers from Union Federal and FMD’s Finance and Governance, Risk and Compliance Departments. The committee considers competitors’ pricing, inflows and outflows of deposit balances and Union Federal’s funding requirements to make pricing decisions in order to attain the desired volume of deposits in each given duration and product type.

Our investment decisions with respect to the interest rate characteristics of our interest-bearing assets are driven by the nature, volume and duration of our interest-bearing liabilities. Generally, our interest-bearing liabilities are either variable-rate instruments or are of a short duration, as discussed above. Accordingly, we generally seek to invest in interest-bearing assets that are subject to frequent repricing or are of limited duration. As noted above, approximately 29% of Union Federal’s mortgage loans, approximately 20% of its available-for-sale securities and all of its education loans had variable interest rates at June 30, 2013. Although these variable interest rate assets generally reprice more frequently and have longer duration than our deposits, interest rate risk with respect to net interest revenues is mitigated by similarities in the interest rate and market risks underlying loan and deposit pricing. We invest our excess cash primarily in money market funds, federal funds sold, time deposits with original maturities of less than one year and U.S. federal agency mortgage-backed securities.

Management regularly reviews a wide variety of interest rate shift scenario results to evaluate interest rate risk exposure, including scenarios showing the effect of steepening or flattening changes in the yield curve. The changes contemplated in these interest rate scenarios would result in immaterial changes to our overall results, largely as a result of a high percentage of assets that possess variable interest rates. Further, increases in interest

 

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rates may have an adverse impact on our consolidated balance sheets as the fixed rate portion of our investments available-for-sale portfolio could continue to experience unrealized losses. Interest rate risk is mitigated with respect to our investments available-for-sale portfolio due to the largely variable rate nature of our interest-bearing assets and liabilities.

We use current market interest rates and our expectations of future interest rates to estimate fair value of service revenue receivables. We believe that this approach adequately reflects the interest rate risk inherent in those estimates.

 

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Item 8. Financial Statements and Supplementary Data

FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

The First Marblehead Corporation:

We have audited the accompanying consolidated balance sheets of The First Marblehead Corporation and subsidiaries (the Company) as of June 30, 2013 and 2012, and the related consolidated statements of operations, comprehensive (loss) income, changes in stockholders’ equity (deficit), and cash flows for each of the years in the three-year period ended June 30, 2013. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of June 30, 2013 and 2012, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 2013, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2013, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated September 13, 2013 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ KPMG LLP

Boston, Massachusetts

September 13, 2013

 

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THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

June 30, 2013 and 2012

(dollars and shares in thousands, except per share amounts)

 

         2013         2012  

ASSETS

    

Cash and cash equivalents

   $ 81,910      $ 123,497   

Short-term investments, at cost

     55,179        85,007   

Restricted cash

     87,338        65,401   

Investments available-for-sale, at fair value

     84,782        68,598   

Education loans held-to-maturity, net of allowance of $1,659 and $1,309

     62,996        33,095   

Mortgage loans held-to-maturity, net of allowance of $440 and $591

     12,629        7,811   

Deposits for participation interest accounts, at fair value

     13,147        4,039   

Service revenue receivables, at fair value

     14,817        16,341   

Goodwill

     20,066        19,548   

Intangible assets, net

     24,193        20,922   

Property and equipment, net

     6,176        4,570   

Other assets

     9,060        8,976   
  

 

 

   

 

 

 

Total assets

   $    472,293      $ 457,805   
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Liabilities:

    

Deposits

   $ 163,977      $ 83,428   

Restricted funds due to clients

     86,994        104,981   

Accounts payable, accrued expenses and other liabilities

     14,884        18,133   

Income taxes payable

     25,922        23,414   

Net deferred income tax liability

     1,189        861   
  

 

 

   

 

 

 

Total liabilities

     292,966        230,817   

Commitments and contingencies:

    

Stockholders’ equity:

    

Preferred stock, par value $0.01 per share; 20,000 shares authorized; 0 and 133 shares issued and outstanding

            1   

Common stock, par value $0.01 per share; 250,000 shares authorized; 120,513 and 110,658 shares issued; 111,547 and 102,002 shares outstanding

     1,204        1,106   

Additional paid-in capital

          456,843        452,726   

Accumulated deficit

     (90,824     (40,627

Treasury stock, 8,966 and 8,656 shares held, at cost

     (187,154     (186,828

Accumulated other comprehensive (loss) income

     (742     610