10-K 1 v305485_10k.htm FORM 10-K

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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 December 31, 2011

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 000-52611

 

 

 

IMH Financial Corporation

 

(Exact name of registrant as specified in its charter)

 

Delaware 81-0624254

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

   

4900 N. Scottsdale Rd #5000

Scottsdale, Arizona

85251
(Address of principal executive offices) (Zip code)

 

Registrant’s telephone number, including area code:

(480) 840-8400

 

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

None
 

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

Common Stock

Class B-1 Common Stock

Class B-2 Common Stock

Class B-3 Common Stock

Class B-4 Common Stock

Class C Common Stock

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

 

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 R

 

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 R     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 post such files).  Yes R     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.  R

 

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. (Check one):

 

Large accelerated filer ¨ Accelerated filer ¨
   
Non-accelerated filer £ Smaller reporting company R
(Do not check if a smaller reporting company)  

 

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

 

The registrant had 50,000 shares of Common Stock, 3,811,342 shares of Class B-1 Common Stock, 3,811,342 shares of Class B-2 Common Stock, 7,735,169 shares of Class B-3 Common Stock, 627,579 shares of Class B-4 Common Stock and 838,448 shares of Class C Common Stock, which were collectively convertible into 16,873,880 outstanding common shares as of March 30, 2012.

 

DOCUMENTS INCORPORATED BY REFERENCE

NONE

 

 

 
 

  

IMH Financial Corporation

2010 Form 10-K Annual Report

Table of Contents  

 

Part I    
Item 1. Business 4
Item 1A. Risk Factors 18
Item 1B. Unresolved Staff Comments 44
Item 2. Properties 44
Item 3. Legal Proceedings 47
Item 4. Mine Safety Disclosures 49
Part II    
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 50
Item 6. Selected Financial Data 52
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation 60
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 97
Item 8. Financial Statements and Supplementary Data 101
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 101
Item 9A. Controls and Procedures 101
Item 9B. Other Information 102
Part III    
Item 10. Directors, Executive Officers and Corporate Governance 102
Item 11. Executive Compensation 110
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 130
Item 13. Certain Relationships and Related Transactions, and Director Independence 132
Item 14. Principal Accounting Fees and Services 134
Part IV    
Item 15. Exhibits, Financial Statement Schedules 135
Signatures 138

 

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SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7, contains forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) which relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “likely,” “may,” “plan,” “potential,” “should” and “would” or the negative of these terms or other comparable terminology. The forward-looking statements are based on our beliefs, assumptions and expectations of our future performance. These beliefs, assumptions and expectations can change, and actual results and events may differ materially, as a result of many possible events or factors, not all of which are known to us or are within our control. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section in Item 1A of this Form 10-K entitled “Risk Factors.”

 

Except to the extent required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the events described by our forward-looking statements might not occur. We qualify any and all of our forward-looking statements by these cautionary factors. Please keep this cautionary note in mind as you read this Form 10-K.

 

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PART I 

 

Item 1. BUSINESS.

  

Our Company

 

We are a real estate investor and finance company based in the southwest United States with over a decade of experience in various and diverse facets of the real estate lending and investment process, including origination, acquisition, underwriting, documentation, servicing, construction, enforcement, development, marketing, and disposition.

 

The Company’s focus is to invest in, manage and dispose of commercial real estate mortgage investments, and to perform all functions reasonably related thereto, including developing, managing and either holding for investment or disposing of real property acquired through foreclosure or other means. This focus is being enhanced with the combined resources of the Company and its advisors. The Company now also seeks to capitalize on opportunities to invest in selected real estate platforms under the direction of seasoned professionals in those areas. The Company may also consider opportunities to act as a sponsor, providing investment opportunities as a proprietary source of, and/or co-investor in, real estate mortgages and other real estate-based investment vehicles. Through the purchase and sale of such investments, we hope to earn robust, risk-adjusted returns while being recognized as a nimble, creative and prudent lender/investor. Our strategy is designed to re-establish the Company’s access to significant investment capital. By increasing the level and quality of the assets in our portfolio specifically and under management in general, we believe that the Company can grow to ultimately provide its shareholders with favorable risk-adjusted returns on investments and enhanced opportunity for liquidity.

 

The Company continued to experience financial adversity in 2011 at both the portfolio and enterprise level and expended a significant amount of resources as a result of the economic environment, as well as from a legal perspective from the enforcement and foreclosure of several loan assets and litigation involving a group of dissident shareholders. Management anticipates fiscal 2012 to be free from some of these distractions and has begun to streamline and re-purpose the organization with a clear direction with enhanced capabilities. The continued resolution and monetization of the legacy asset portfolio will be essential to the Company’s future success, as the value and liquidity created will be the building blocks for implementing the new strategy. Given the scale and composition of the remaining legacy portfolio, significant efforts will continue to be required in 2012, including continued foreclosures, restructurings, development activities, and asset dispositions. A number of key tactical initiatives are also continuing into 2012 with the near-term goal of further reducing expenses and enhancing systems, while seeking to mitigate legacy problems and maximize the value of legacy assets.

 

Management expects to accelerate the streamlining and re-purposing of the organization, operations, and systems in 2012 to support the Company’s strategic and tactical, financial and operational goals. To achieve greater efficiency and strength, the Company will employ a combination of internal and external professionals to pursue its targeted activities.

 

In addition, given the current legal, tax and market-related constraints to bringing additional capital directly into the Company, management is exploring the possibility of sponsoring investment vehicles or other ventures with institutional investors in vertical market segments in which there is strong investor interest, as well as proven expertise within the Company and/or its advisors. To demonstrate its commitment, distinguish itself from other sponsors, and create very attractive investment opportunities, the Company would expect to contribute cash as well as some of its legacy assets to these sponsored vehicles, in exchange for equity ownership and/or profit participation. There is no assurance, however, that management would pursue any such sponsored vehicles in the near term or at all.

 

As previously described, the Company expects to focus on the creation and implementation of a series of commercial mortgage and real estate investment activities, so as to begin to increase both assets under management and the associated income and value derived therefrom.

 

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In 2011, the Company acquired certain operating assets as a result of foreclosure of the related loans. With such assets, there comes the challenge and cost of day-to-day operations but also the opportunity to revitalize assets and operations that have generally suffered in recent periods. Again, with our combination of internal and external professionals, we expect to re-position these operating assets to produce a market-rate return as portfolio holdings or to dispose of these assets at favorable prices once they have been foreclosed upon and stabilized.

 

We have identified certain portfolio assets that we believe could yield significantly greater returns by developing the properties for future operation and sale, as opposed to selling them now in their as-is condition. The demonstrated ability to create value through the real estate development process is a key aptitude gained through our relationship with our consultants that we anticipate will further distinguish us from other competitors in the marketplace. Through this capability, we believe that we, and ultimately our shareholders, will be afforded the opportunity to earn yields that are not generally available from new, finished product. While development does entail unique risks, with a disciplined approach and experienced team, we believe the risk-adjusted rewards have the potential to be superior.

 

While focused on the foregoing, the Company remains nimble in its objectives and is poised to re-direct its efforts as economic circumstances unfold. Given that the legacy assets are positively correlated with the economic and real estate cycles, and the fact that any new investment activity may benefit from any market disruptions and/or further declines in the value of real estate, in terms of enhanced risk-adjusted returns and reduced competitive pressure, management believes there is an inherent “hedge” in the Company’s current position. If there is a recovery of liquidity and valuations, the liquidity and value of the legacy assets should benefit accordingly, while new originations may face increased yield and scaling pressures. If, on the other hand, conditions do not improve, or worsen, the legacy assets will likely suffer, but the opportunities in new business should be enhanced. We will adjust the relative scaling of these two aspects of the hedge as circumstances dictate.

 

Through our traditional credit analysis coupled with property valuation techniques used by developers, we have acquired or originated real estate assets as of December 31, 2011 with an original investment basis of approximately $590.6 million and a current carrying value of $199.0 million, consisting of commercial real estate mortgage loans with a carrying value of $103.5 million and owned property with a carrying value of $95.5 million. We believe the decline in the carrying value of our real estate assets is reflective of the deterioration of the commercial real estate lending market and the sustained decline in pricing of residential and commercial real estate in the last several years together with the continuing downturn in the general economy and specifically the real estate markets.

 

Our target asset transaction size is typically above the maximum investment size of most community banks, but below the minimum investment size of larger financial institutions, which we believe positions us favorably in an underserved segment of the real estate finance industry. However, these initiatives are dependent upon our successful liquidation of select assets, obtaining debt or equity financing and/or other available alternatives to generate liquidity.  At the time that we are able to generate additional liquidity, we intend to make further investments.

 

Our senior management team, along with our other industry professional advisors, have extensive experience analyzing, structuring, negotiating, originating, purchasing and servicing senior-position commercial real estate mortgage loans and related real estate investments. Over the past decade, we have built a mortgage lending platform and have made over 500 real estate investments and co-investments, and our senior management team has raised nearly $1 billion of capital. For a further discussion of our senior management team’s experience, track record and relationships, see Item 10 entitled “Directors, Executive Officers and Corporate Governance.

 

We are a Delaware corporation that was formed from the conversion of IMH Secured Loan Fund, LLC, a limited liability company that was externally managed by Investors Mortgage Holdings Inc.

 

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See Note 5 in the accompanying consolidated financial statements in this Form 10-K for information about the concentration of our outstanding loans among our borrowers and geographic diversification of our outstanding loans.

 

Our History and Structure

 

We were formed from the conversion of our predecessor entity, IMH Secured Loan Fund, LLC, or the Fund, into a Delaware corporation. The Fund, which was organized in May 2003, commenced operations in August 2003, focusing on investments in senior short-term whole commercial real estate mortgage loans collateralized by first mortgages on real property. The Fund was externally managed by Investors Mortgage Holdings, Inc., or the Manager, which was incorporated in Arizona in June 1997 and is licensed as a mortgage banker by the State of Arizona. Through a series of private placements to accredited investors, the Fund raised $875 million of equity capital from May 2003 through September 2008. Due to the cumulative number of investors in the Fund, the Fund registered under the Exchange Act on April 30, 2007 and began filing periodic reports with the Securities and Exchange Commission, or the SEC.

 

As a result of the unprecedented disruptions in the general real estate and related markets and the rapid decline in the global and U.S. economies, on October 1, 2008, pursuant to its operating agreement, the Fund suspended member redemption requests. In order to preserve liquidity in the ongoing credit crisis, the Fund suspended regular monthly distributions to members in the second quarter of 2009. On June 18, 2010, following approval by members representing 89% of membership units of the Fund voting on the matter, the Fund became internally-managed through the acquisition of the Manager and converted into a Delaware corporation in a series of transactions that we refer to as the Conversion Transactions. The Fund intended the Conversion Transactions to position the Fund to become a publicly traded corporation listed on a stock exchange, create the opportunity for liquidity for Fund members, and create the opportunity to raise additional capital in the public markets, thereby enabling the Fund to better acquire and originate commercial mortgage loans and other real estate related investments with a view to achieving long term value creation through dividends and capital appreciation.

 

On June 18, 2010, we effected the Conversion Transactions, whereby the Fund was converted into a Delaware corporation and became internally managed through the acquisition of the Manager. In the Conversion Transactions, we also acquired IMH Holdings, LLC (“Holdings”), which is a Delaware limited liability company and serves as a holding company for two wholly-owned subsidiaries, IMH Management Services, LLC, an Arizona limited liability company, and SWI Management, LLC, an Arizona limited liability company (“SWIM”). IMH Management Services, LLC provides us and our affiliates with human resources and administrative services and SWIM manages the Strategic Wealth & Income Fund, LLC (the “SWI Fund”).

 

In connection with the Conversion Transactions, we issued 3,811,342 shares of Class B-1 common stock, 3,811,342 shares of Class B-2 common stock, 7,721,055 shares of Class B-3 common stock, 627,579 shares of Class B-4 common stock and 838,448 shares of Class C common stock. We have not determined a specific value for the aggregate shares issued in connection with the Conversion Transactions. However, based on our net tangible book value of approximately $165.3 million as of December 31, 2011, the current estimated book value per share for the shares issued in connection with the Conversion Transactions is $9.79 per share. As part of the Conversion Transactions, the Fund offered members seeking shorter-term liquidity the option of receiving shares, referred to as Class C common stock, which are eligible to be redeemed by us at our option following an initial public offering. We may redeem up to the lesser of $50 million or 30% of the capital raised in such initial public offering, net of underwriting discounts and commissions (the “Maximum Aggregate Redemption Amount”), of Class C common stock at a per share price equal to the initial public offering price per share, net of underwriting discounts and commissions. If we elect to redeem any of the Class C common stock pursuant to this provision, we must redeem it all if the redemption price for all outstanding shares would be less than the Maximum Aggregate Redemption Amount. Any shares of Class C common stock not redeemed in connection with an initial public offering will automatically be converted to Class B common stock as follows: each share of Class C common stock will convert into 0.25 shares of Class B-1 common stock; 0.25 shares of Class B-2 common stock; and 0.50 shares of Class B-3 common stock. Members representing only approximately 5.2% of membership interests in the Fund elected to receive Class C common stock.

 

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The remaining 94.8% received one of three series of Class B common stock (Class B-1, B-2 or B-3) that are subject to restrictions on transfer that lapse, subject to certain exceptions, at various anniversaries following the earlier of (i) the consummation of an initial public offering of our common stock and (ii) the date, if any, on which we send notice to our stockholders stating that the board of directors has determined not to pursue an initial public offering (the “Trigger Date”): 25% at the six month anniversary, 25% upon the nine month anniversary and the remaining 50% on the 12 month anniversary. Shares of class B-1, B-2 and B-3 common stock are also eligible for conversion into shares of common stock and transfer at the option of the holder upon certain change of control events or if, during the period beginning on the five-month anniversary of an initial public offering, the closing price of our common stock is greater than 125% of the initial public offering price for 20 consecutive trading days. All shares of Class B-1, B-2 and B-3 common stock will automatically convert into shares of common stock on the twelve-month anniversary of the Trigger Date. Our board of directors can also approve other transfers. Once the sale of all or a portion of the shares of Class B common stock becomes possible, the sale or potential sale of a substantial number of shares of the common stock into which shares of Class B common stock may convert could depress the market price of all common stock and impair our ability to raise capital through the sale of additional shares.

 

To provide additional incentive for holders of Class B common stock to remain longer-term investors, we agreed to pay, subject to the availability of legally distributable funds, a Special Dividend to Class B stockholders of $0.95 a share to all stockholders who have retained continuous ownership of their shares through the 12 month period following an initial public offering. The aggregate amount of the Special Dividend will be between $15.1 million and $16.0 million depending on the number of outstanding Class C shares that are redeemed in connection with an initial public offering. Shares of Class C common stock that are not redeemed and are converted into shares of Class B common stock will also be eligible for the Special Dividend if held continuously through the 12-month period following an initial public offering. The Special Dividend will not be payable if sufficient legally available funds are not available on the one-year anniversary of consummation of an initial public offering.

 

We acquired the Manager, through the issuance of 716,279 shares of Class B common stock, subject to various restrictions, to the equity holders of the Manager and its affiliates, on June 18, 2010 as part of the Conversion Transactions. Prior to consummation of the Conversion Transactions, we paid management fees to the Manager to serve as our external manager and the Manager was responsible for managing every aspect of our operations, including identifying and funding new loans, evaluating and acquiring loans held by third parties, and periodically analyzing the composition of our portfolio. The Manager has a wholly-owned subsidiary, Investors Mortgage Holdings California, Inc., which is licensed as a real estate broker by the California Department of Real Estate. In connection with the acquisition, Messrs. Albers, Meris and a transferee of Mr. Meris acquired shares of Class B-4 common stock which are subject to additional four-year transfer restrictions. The four-year transfer restrictions applicable to the shares of Class B-4 common stock will terminate if, any time after five months from the first day of trading of our common stock on a national securities exchange, either our market capitalization or book value will have exceeded approximately $730.4 million (subject to upward and downward adjustment upon certain events). The additional four-year transfer restrictions will also terminate if the restrictions on the Class B common stock are eliminated as a result of a change of control under our certificate of incorporation, or if, after entering into an employment agreement approved by our compensation committee, the holder of Class B common stock is terminated without cause, as such term is defined in such holder’s employment agreement. As part of the Conversion Transactions, the former executive officers and employees of the Manager became our executive officers and employees and assumed the duties previously performed by the Manager. We ceased paying management fees to the Manager and we are now entitled to retain all management, origination fees, gains and basis points previously allocated to the Manager.

 

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In the Conversion Transactions, we also acquired IMH Holdings, LLC, or Holdings, which is a Delaware limited liability company and serves as a holding company for two wholly-owned subsidiaries, IMH Management Services, LLC, an Arizona limited liability company, and SWI Management, LLC, an Arizona limited liability company. IMH Management Services, LLC provides us and our affiliates with human resources and administrative services, including the supply of employees, and SWI Management, LLC, or SWIM, acts as the manager for the Strategic Wealth & Income Fund, LLC, or the SWI Fund. At December 31, 2011, the SWI Fund had approximately $11.5 million under management. The SWI Fund is a Delaware limited liability company whose investment strategies and objectives are substantially similar to our strategy. We have a $25,000 equity interest in the SWI Fund, and also receive fee income for managing SWIM. The SWI Fund is a closed-end, five-year fund which is currently scheduled to close by December 2013 and is no longer accepting new member capital.

 

Our Market Opportunity

 

We believe that there are attractive opportunities to acquire, finance and originate commercial real estate mortgage loans and other real estate-related assets as a result of the ongoing disruption in the real estate and financial markets. We believe that some of these assets are attractively priced in relation to their relative risk as a result of the illiquidity and uncertainty in the current market environment. In addition, regulatory and capital adequacy pressures have forced numerous financial institutions both to reduce their new originations and to dispose of existing real estate-related assets at market-clearing prices for timely execution. We believe that the opportunity to acquire and originate commercial real estate mortgage loans remains attractive, particularly for interim loans of short to intermediate term, which we consider to be loans with maturities of up to five years. As a result of limited credit availability in the marketplace, we believe that such loans can now be structured on more favorable lender terms than in the past. We believe that we are positioned to capitalize on such opportunities while remaining flexible to adapt our investment strategy as market conditions change.

 

We believe that opportunistic capital will be well positioned to take advantage of such opportunities as: (a) acquiring real estate-backed loan portfolios at favorable discounts resulting from the stringent requirements imposed upon U.S.-based commercial banks by regulatory agencies in an effort to shore up bank balance sheets and to create more liquidity for those institutions; (b) acquiring distressed assets of other real estate companies at significant discounts; and (c) funding the development or completion of partially developed real estate projects acquired at a discount. We have identified several “turn-around” projects that are located in markets where recovery is underway and tenant demand is attractive.

 

Capitalizing on such opportunities creates a potentially lucrative income stream for our investors in the near term, as well as the possibility of a significant asset value appreciation due to the timely completion, eventual stabilization, and ultimate sale of the real estate collateral at issue.

 

To meet these objectives, we plan to develop a well-diversified portfolio by underlying property type, geography, and borrower concentration risks. We intend to make adjustments to our target portfolio based on real estate market conditions and investment opportunities. We will not forgo what we believe to be an attractive investment because it does not precisely fit our expected portfolio composition.

 

We expect that a portion of our return will be comprised of capital appreciation of the real estate or real estate-related investments in which we invest, including through fixed rate exit fees or a percentage of the increase in the fair values of the real estate that secures the indebtedness underlying our loans. However, our ability to secure or be entitled to these gains is premised on the assumption that the markets in which we are investing will recover and appreciate, in some cases in a substantial manner. There can be no assurance that such recovery or appreciation will occur, or that we will be able to negotiate exit fees in a manner that is favorable to us, or at all. Furthermore, exit fees may not be available on all types of investments, such as subordinated or pooled investments.

 

We intend to continue the process of disposing of portions of our existing loans and real estate assets, or REO assets, individually or in bulk, and to reinvest the proceeds from such dispositions in our target assets. We may also attempt to create additional value from certain of our REO assets that are viable multifamily land parcels by developing them into new communities, in joint ventures or other structures. Such development would generally require 2 to 3 years to complete, at which time the apartment project could be sold or held for income and value.

 

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In addition, we believe opportunities may arise to use our stock or cash to acquire, on attractive terms, real estate-related assets or companies, including real estate investment trusts, or REITs, real estate vehicles, limited partnerships and similar vehicles. Many of these entities are seeking to reposition their portfolios or dispose of assets, and may also have investors who are seeking liquidity or exit options.

 

Our Target Assets

 

Although we have historically focused on the origination of senior short-term commercial bridge loans with maturities of 12 to 36 months oriented toward the availability of permanent take-out financing, because of changes in conditions, we now believe it is wise to expand our business model to include: (a) purchasing of or investing in commercial and other mortgage loans, individually or in pools, generally at a discount, (b) originating mortgage loans collateralized by real property located anywhere in the United States, and (c) pursuing, in an opportunistic manner, other real estate investments, including, among other things, participation interests in loans, whole and bridge loans, commercial or residential mortgage-backed securities, equity or other ownership interests in entities that are the direct or indirect owners of real property, and direct or indirect investments in real property, such as those that may be obtained in a joint venture or by acquiring the securities of other entities which own real property. We believe that our investment focus is more closely tailored to current market circumstances, and accordingly positions us more favorably to capitalize on opportunities currently available in our target markets. Our investment focus also provides us greater flexibility and enhanced diversification than does our current portfolio of assets. We refer to the assets we will target for acquisition or origination as our target assets.

 

We intend to diversify our asset acquisitions across asset classes in interim loans or other short-term loans originated by us, performing, whole or participating interests in commercial real estate mortgage loans we acquire, whole non-performing commercial real estate loans we acquire and in other types of real estate-related assets and real estate-related debt instruments (which may include the acquisition of or financing of the acquisition of residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”), and operating properties), although the exact allocations will depend on the investment opportunities we decide to pursue based on the prevailing market conditions. We expect the diversification of our portfolio to continue to evolve in response to market conditions, including consideration of factors such as asset class, borrower group, geography, transaction size and investment terms.

 

Originating Interim and Longer-Terms Loans.

 

We originated most of the mortgage loans in our current portfolio. In the short to medium term, as the economy improves, we expect our focus to include the origination of senior loans on commercial property that provide interim financing to borrowers seeking short-term capital (with terms generally up to three years) to be used in the acquisition, construction or redevelopment of a property or group of properties. Interim loans contemplate a take-out with the borrower using the proceeds of a permanent mortgage loan to repay our interim loan. This type of interim financing enables the borrower to secure short-term financing pending the arrangement of long-term debt. As a result of the refinancing risk, interim loans typically have a higher interest rate, as well as higher fees and other costs when compared to long-term financing arrangements. In addition to a higher coupon, we expect to charge borrowers origination, extension, modification or similar fees, and when possible, some form of equity or profit participation in connection with loans we complete. As we have from time to time in the past, we also may originate or acquire participations in construction or rehabilitation loans on commercial properties. These loans generally provide 40% to 60% of financing and are secured by first mortgage liens on the property under construction or rehabilitation. Investments in construction and rehabilitation loans generally would allow us to earn origination fees and exit fees.

 

Although we believe there are substantial near-term opportunities to acquire existing longer-term whole mortgage loans, we may also originate whole mortgage loans that provide long-term mortgage financing to commercial property owners and developers as appropriate opportunities emerge and real estate conditions improve over time. Unlike our bridge loans that we often expect to hold to maturity, we expect to originate or acquire longer term commercial mortgage loans with the intention of structuring and selling all or a part of such loans at a markup to market participants.

 

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Acquiring Commercial Mortgage Loans.

 

We have acquired commercial mortgage loans from time to time in the past, but in view of current market conditions, we expect that commercial whole mortgage loans will be one of our primary target assets. We intend to seek to maximize the value of any non-performing commercial mortgage loans we acquire by restructuring, where appropriate, the terms and conditions of the loans to facilitate repayment and generate sustained cash flows or to foreclose on the loans where we believe the value of the asset exceeds the debt and a restructuring is not desirable or achievable on favorable terms. Commercial whole mortgage loans are mortgage loans secured by liens on commercial properties, including office buildings, industrial or warehouse properties, hotels, retail properties, apartments and properties within other commercial real estate sectors. These mortgage loans generally have maturity dates ranging from one to five years and carry either fixed or floating interest rates.

 

In addition to acquiring existing whole commercial mortgage loans, participations in performing commercial loans are another one of our primary target assets. We intend to purchase portions of performing commercial mortgage loans and serve as a participating lender, a strategy that we anticipate will decrease our default risk and provide us ongoing access to revenue-producing assets.

 

Other Opportunities.

 

While we expect to focus primarily on the target assets discussed above, we may from time to time pursue the following alternative strategies:

 

Residential Mortgage-Backed Securities. As we have from time to time in the past, we may invest, if market conditions are appropriate, a small portion of our target assets in RMBS, which are typically pass-through certificates created by the securitization of a pool of mortgage loans that are collateralized by residential real estate properties. Any RMBS investment strategy we decide to pursue may consist of agency, investment grade, or non-investment grade securities, or a combination of such securities. The mortgage loans underlying these securities may be adjustable rate mortgage loans, or ARMs, fixed rate mortgage loans or hybrid ARMs. We do not currently intend to target a specific type of underlying mortgage.

 

Commercial Mortgage-Backed Securities. CMBS are securities that are collateralized by, or evidence ownership interests in, a single commercial mortgage loan or a partial or entire pool of mortgage loans secured by commercial properties. CMBS are generally pass-through certificates that represent beneficial ownership interests in common law trusts whose assets consist of defined portfolios of one or more commercial mortgage loans. They are typically issued in multiple tranches whereby the more senior classes are entitled to priority distributions of specified principal and interest payments from the trust’s underlying assets. The senior classes are often securities which, if rated, would have ratings ranging from low investment grade such as “BBB” to higher investment grades such as “A,” “AA” or “AAA.” The junior, subordinated classes typically would include one or more classes, which, if rated, would have ratings below investment grade.

 

We have not invested in CMBS in the past; however, on a limited basis, we may finance or acquire CMBS that will yield current interest income and, where we consider the return of principal or basis, as applicable, to be likely. We may do so for CMBS from private originators of, or investors in, CMBS and mortgage loans, including savings and loan associations, mortgage bankers, commercial banks, finance companies, investment banks, life insurance companies and other entities. We expect any CMBS to be primarily high investment grade such as “AAA” CMBS, but may also acquire lower rated CMBS. We do not currently intend to target a specific type of underlying mortgage.

 

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Real Estate Owned Properties. We have not historically invested in REO assets, which are properties owned by a lender after foreclosure auction or deed in lieu of foreclosure. We have, however, historically owned and sold real property, as a result of enforcing and foreclosing on our portfolio loans. Accordingly, we are experienced in property ownership considerations as well as the requirements and process of positioning such assets for disposition. In the future, we may elect to acquire REO assets or other distressed or non-performing real estate properties in order to seek to reposition them for profitable disposition. Depending on the nature of the underlying asset, we may pursue repositioning strategies through capital expenditures in order to seek to extract the maximum value from the investment.

 

Our Competitive Strengths

 

We believe the following competitive strengths will help us implement our strategies and distinguish ourselves from our competitors:

 

  · Existing Assets. We intend to actively market and sell a significant portion of our current loans (in whole or in part) and REO assets, individually or in bulk, over the next 12-24 months and redeploy a substantial portion of the sale proceeds in our target assets. As a result of the rapid decline in the economy and substantial disruptions in the real estate and financial markets, we have recorded significant provisions for credit losses on our loans and impairment charges on our REO assets reflecting lower pricing assumptions and a significant increase in discount factors to reflect current market risk. If we sell our assets in an improving economic climate, we believe that the aggregate potential value of our assets may exceed the current aggregate carrying value of those assets. Further, we believe that the potential value of some of the properties securing our mortgage loans may allow us the flexibility, and motivate our borrowers, to restructure loan terms which may enable us to generate current income and ultimately realize attractive returns on those loans.
  · Access to Extensive Pipeline of Industry Relationships. We have long-term relationships through a broad and deep network of market contacts, which we believe have a reputation for performance and creativity, including community banks, real estate owners, developers and financial intermediaries, particularly in the west and southwest, which we believe has received less attention from larger investors. We believe our consulting relationship with New World Realty Advisors, LLC, or NWRA, further enhances our access to industry relationships and expands our geographic reach. We believe this diversified transaction referral network provides us with a significant stream of “first look” lending and acquisition opportunities, which are opportunities to consider a potential investment before it becomes more widely marketed. We believe these relationships will continue to provide us access to potential attractive lending and acquisition opportunities as a greater number of financial institutions seek to reduce their exposure to commercial real estate in order to reduce leverage and meet various capital or regulatory requirements. Through our relationships and those of NWRA, which encompass capital markets, we expect to have access to high quality deal flow to maintain a strong pipeline of investment opportunities.
  · Localized Market Expertise. Our focus for over 13 years on the real estate lending and investment industry in the southwest, along with our extensive network of long-term relationships with banks, real estate owners and developers, mortgage lenders and other strategic partners focused on our target market, provides us with a specialized understanding of the market dynamics and opportunities that we believe is difficult to replicate. Moreover, we believe our specialized focus in our target markets also positions us favorably to engage in repeat business with investment and commercial banks, brokerage firms, public and private real estate investment companies and others that have targeted opportunities in the southwest, but lack our in-depth understanding of, and access to, opportunities in this market.
  · Experienced Management Team with Expertise in Real Estate. Our senior management team has extensive experience originating, acquiring, managing and investing in commercial mortgage loans and other commercial real estate and real estate-related assets through various credit cycles and market conditions. We believe that our senior management team has accumulated a deep and sophisticated understanding of industry trends, market values and the particular characteristics of the regions in which we lend, which has equipped our senior management team with a deep understanding of our target assets. We believe our retention of NWRA further increases our access to such expertise.

 

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  · Strong Underwriting Capabilities. We have a fully integrated in-house underwriting platform, which has extensive experience underwriting, conducting due diligence and valuing real estate and real estate-related investments. We combine traditional credit analysis typically performed by banks with advanced property valuation techniques used by developers, to produce a more comprehensive investment decision process that we believe provides us an advantage relative to the procedures utilized by many of our competitors and enables us to better identify attractive investment opportunities and assess expected performance, risk and returns.
  · Value Added Execution and Asset Management Experience. Our asset management team, further strengthened through our retention of NWRA, has extensive experience creating capital appreciation opportunities through the active management of distressed and non-performing real estate and real estate-related assets in order to extract the maximum amount of value from each asset through, among other things, repositioning, restructuring and intensive management.
  · Speed of Execution. As a significant number of banks have continued to fail, we believe the FDIC and other government agencies are increasingly likely to value participants who can purchase loans on an accelerated timetable and on a highly reliable basis in order to reduce closing risk. We believe that our market knowledge and experience as a real estate lender allows us to underwrite and execute complex transactions quickly, in order to acquire our target assets from these sources.
  · Market-Driven Investment Strategy. Our investment strategy is market-driven, which we believe enables us to adapt to shifts in economic, real estate and market conditions, and to exploit inefficiencies in the applicable markets. Since 1997, we have made or arranged over 500 real estate investments and co-investments with a focus primarily on markets in the southwestern region of the United States. We believe that limited capital and credit availability in the marketplace allows us to structure loans at even more favorable terms than that which we have been able to achieve historically.
  · Tax Attributes. Due to the significant decline in the real estate markets in recent years, the tax basis of our existing assets exceeds the carrying value of such assets by approximately $166 million as of December 31, 2011 in addition to net operating loss carryforwards of approximately $217 million, which we believe, subject to certain limitations, provides an approximation of the “built-in losses” that may be available to offset future taxable income and gain upon the disposition of such assets as well as potential income and gain from new assets we acquire.

 

Our Investment Strategy

 

Our objective is to utilize our real estate experience and industry knowledge to generate attractive risk-adjusted returns, which are returns that are adjusted to reflect the degree of risk involved in producing that return relative to other investments with varying degrees of risk. We will seek to achieve this objective by acquiring, originating and managing our target assets and executing our disposition strategy to opportunistically sell a significant portion of our existing portfolio, individually or in bulk, to generate capital to deploy in our target assets. We intend to pursue investment opportunities in our target assets by:

 

  · Repositioning our Existing Portfolio to Income-Generating Assets. We intend to actively market and sell a significant portion of our currently-owned loans (in whole or in part) and REO assets, individually or in bulk, over the next 18 months and redeploy a substantial proportion of the sale proceeds in our target assets. We plan to redeploy the proceeds from the sale of these primarily non-income earning assets in our target assets.
  · Maintaining Investment Discipline. We intend to continue to capitalize on our fully integrated in-house underwriting platform, experience and market knowledge. We will continue to combine traditional credit analysis typically performed by banks with the advanced property valuation techniques used by developers to support a more comprehensive investment decision process.
  · Selectively Pursuing Opportunities to Acquire Real Estate-Related Companies and Assets. We believe opportunities will emerge to acquire attractively priced real estate-related assets or companies, including REITs, real estate vehicles, limited partnerships as well as commercial, retail, mixed-use, office, industrial, multi-family, student housing, hospitality, self-storage, finished residential lots, residential lots in development, land, leasehold interests and similar vehicles not targeted by larger investors. We expect that our cash or common stock may be an attractive currency for providing liquidity or exit strategies for these companies and their investors and thus will position us to acquire target assets on attractive terms.

 

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  · Leveraging our Relationships to Generate New Sources of Capital. We also believe there may be opportunities to leverage the network of financial advisors that we have built over the years to provide access to capital and various real estate-related and other investment opportunities, either structured by us or introduced to us through our relationships with our network of financial advisors. This network has been responsible for directing considerable investment capital to us and currently provides access to over 40 independent broker dealer firms, through whom we have the ability to reach over 9,000 financial advisors.

 

In implementing our investment strategy, we will utilize our management’s expertise in identifying attractive opportunities within the target asset classes, as well as management’s capabilities related to transaction sourcing, underwriting, execution, asset management and disposition. We expect that our management will make decisions based on a variety of factors, including, but not limited to, expected risk-adjusted returns, credit fundamentals, liquidity, availability of adequate financing, borrowing costs and macro-economic conditions.

 

Unprecedented dislocations in the real estate and capital markets have caused us to incur a significant reduction in loan payoffs from borrowers and an increase in delinquencies, non-performing loans and REO assets, resulting in a substantial reduction in our cash flows. We have taken a number of measures to provide liquidity for us, including, among other things, engaging in efforts to sell whole loans and participation interests in our loans, and to dispose of certain real estate assets.

 

We expect our primary sources of liquidity over the next twelve months to consist of the proceeds generated by the disposition of our portfolio of loans and REO assets. We anticipate redeploying these proceeds to acquire our target assets, which we expect will generate ongoing liquidity. In addition, we may address our liquidity needs by periodically accessing the capital markets, lines of credit and credit facilities available to us from time to time, and cash flows from the sales of whole loans, participations in loans, interest income and loan payoffs from borrowers. Under the terms of the NW Capital loan agreement, such actions would likely require consent by NW Capital.

 

Investment Company Act Exemption

 

We operate our business in a manner such that we will be exempt from registration under the Investment Company Act of 1940, as amended, or the Investment Company Act. We plan to rely on the exemption provided by Section 3(c)(5)(C) of the Investment Company Act. We monitor our portfolio periodically and prior to each investment to confirm that we continue to qualify for the exemption. To qualify for the exemption, we must make investments so that at least 55% of the assets we own on an unconsolidated basis consist of qualifying mortgages and other liens on and interests in real estate, which we refer to as qualifying real estate assets, and so that at least 80% of the assets we own on an unconsolidated basis consist of real estate-related assets, including our qualifying real estate assets.

 

Executive Officers of the Registrant

 

Please see Item 10 for information on our directors, officers and corporate governance.

 

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Employees

 

As of December 31, 2011, we had a total of 33 employees and full-time consultants, 28 of which were full-time employees and 5 which were individual consultants we engaged, in addition to NWRA. Subsequent to December 31, 2011, we implemented various cost saving measures which resulted in a reduction in force, resulting in our current 23 full-time employees and 2 individual consultants, as well as NWRA. Consultants have historically been utilized to provide recommended courses of action with respect to loans in default, disposition strategies for REO assets and support for construction and property management, typically with respect to a specifically defined asset or asset class. Additionally, we have entered into other consulting arrangements for a wide range of consulting services relating to strategy and management of our business, certain portfolio and enforcement related matters, regulatory compliance with Sarbanes-Oxley requirements, and legal services, as well as insurance matters, certain personnel matters, and interactions with various other professional advisors related thereto. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation - Contractual Obligations” for a more detailed discussion regarding these consulting agreements.

 

Competition

 

The industry in which we operate is serviced primarily by numerous conventional mortgage lenders and loan investors, which include commercial banks, insurance companies, mortgage brokers, pension funds, and private and other institutional lenders. There are also a relatively smaller number of non-conventional lenders that are similar to us. If we resume lending operations, we expect to compete with these same lenders as well as new entrants to the competitive landscape who are also focused on originating and acquiring commercial mortgage loans. We continue to compete with many market participants.

 

In addition, we are subject to competition with other investors in real property and real estate-related investments. Numerous REITs, banks, insurance companies and pension funds, as well as corporate and individual developers and owners of real estate, compete with us in seeking real estate assets for acquisition. Many of these competitors have significantly greater financial resources than us.

 

Additionally, as we seek to locate purchasers for real estate we have acquired, or for permanent take-out financing for our borrowers, we are competing with a large number of persons and entities that have acquired real estate, whether through foreclosure or otherwise, and that have originated commercial mortgage loans, in the past few years. Many of these persons and entities utilized leverage to purchase the real estate or fund the loans, and many are selling collateral or accepting permanent take-out financing worth less than the original principal investment in order to generate liquidity and satisfy margin calls or other regulatory requirements.

 

See “Business-Our Competitive Strengths” above for further discussion of factors affecting our competitive position.

 

Regulation

 

Our operations have been and are subject to oversight by various state and federal regulatory authorities, including, without limitation, the Arizona Corporation Commission, or the ACC, the Arizona Department of Revenue, the Arizona Department of Financial Institutions (Banking), the SEC and the Internal Revenue Service.

 

Mortgage Banker Regulations

 

Our operations as a mortgage banker are subject to regulation by federal, state and local laws and governmental authorities. Under applicable Arizona law, regulators will have broad discretionary authority over our activities. Mortgage banker regulation, however, does not generally involve the underwriting, capital ratio or concentration guidelines or requirements that are generally imposed on more traditional lenders. One of our subsidiaries is currently licensed as a mortgage banker by the state of Arizona, and as of the date of this filing, the Company has nearly completed the transfer of our mortgage banker’s license to a different subsidiary.  All applicable paperwork has been filed and this transfer is expected to be completed within the next 45 days.

 

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Investment Company Status

 

We seek to manage our operations to qualify for the exemption provided by Section 3(c)(5)(C) of the Investment Company Act, or the Real Estate Exemption. Under the Real Estate Exemption issuers that (a) are not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and (b) are primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate, are excluded from the definition of “investment company.” We believe that we are not an “investment company” because we believe we satisfy the requirements of the Real Estate Exemption, and we have endeavored to conduct our operations in compliance with the Real Estate Exemption.

 

We are primarily engaged in originating, purchasing or otherwise acquiring mortgages and other liens on, or holding direct interests in, real estate. The staff of the SEC, through no-action letters, has stated that it would regard an issuer as being engaged primarily in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate, within the meaning of Section 3(c)(5)(C) of the Investment Company Act, if (a) at least 55% of the value of the issuer’s assets consists of mortgages and other liens on, and interests in, real estate, or Qualifying Assets, and (b) at least an additional 25% of the value of the issuer’s assets consists of Qualifying Assets or other real estate type interests (including loans in respect of which 55% of the fair market value of each such loan is secured by real estate at the time the issuer acquires the loan) or Real Estate-Related Assets. Not more than 20% of the issuer’s assets may consist of miscellaneous investments, including all other loans held by an issuer, cash, government securities, and investments in partnerships or other businesses not qualifying as either Qualifying Assets or Real Estate-Related Assets.

 

The staff of the SEC has stated that it would regard as Qualifying Assets mortgage loans that are fully secured by real property, and the staff of the SEC has granted no-action relief to permit a participation interest in a mortgage loan fully secured by real property to be considered a Qualifying Asset if the holder of the participation interest controls the unilateral right to foreclose on the mortgage loan in the event of a default. Our actual deployment of proceeds will depend upon the timing and amount of loans originated and funded. As of December 31, 2011, more than 83% of our total assets were invested in assets we consider to be Qualifying Assets and approximately 83% of our total assets were invested in assets we believe to be Qualifying Assets or Real Estate-Related Assets. Until appropriate investments can be identified, our management may invest the proceeds of any future offerings in interest-bearing, short-term investments, including money market accounts and/or U.S. treasury securities. Primarily all of the loans we fund are secured by the underlying real estate and we have foreclosed on several loans resulting in our direct ownership of real estate. If we participate in a loan with a third-party, we seek to be the lead lender in the participation, which, among other things, provides us with the unilateral ability to foreclose on the loan in the event of a default. Accordingly, we believe that we qualify for the Real Estate Exemption. However, the staff of the SEC could take a different view and, although we intend to conduct our operations such that we qualify for the Real Estate Exemption, we might inadvertently become an investment company if, with respect to loans in which we participate, we are not the lead lender, or loans or other assets in our portfolio exceed a percentage of our portfolio that is deemed acceptable by the staff of the SEC.

 

If we were unable to meet these thresholds on an interim basis, we may seek to rely on the exemption provided by Rule 3a-2 under the Investment Company Act, which provides a one-year temporary exemption under certain conditions, while deploying our cash in a manner that complies with the Section 3(c)(5)(c) exemption.

 

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Usury Laws

 

Usury laws in some states limit the interest that lenders are entitled to receive on a mortgage loan. State law and court interpretations thereof applicable to determining whether the interest rate on a loan is usurious and the consequences for exceeding the maximum rate vary. For example, we may be required to forfeit interest above the applicable limit or to pay a specified penalty. In such a situation, the borrower may have the recorded mortgage or deed of trust cancelled upon paying its debt with lawful interest, or the lender may foreclose, but only for the debt plus lawful interest. In the alternative, a violation of some usury laws results in the invalidation of the transaction, thereby permitting the borrower to have the recorded mortgage or deed of trust cancelled without any payment and prohibiting the lender from foreclosing.

 

In California, we only invest in loans which are made or arranged through real estate brokers licensed by the California Department of Real Estate because these loans are exempt from the California usury law provisions. Prior to November 2006, all California loans were brokered to us only by unrelated third-party licensed brokers. In November 2006, we formed a wholly-owned California subsidiary which is licensed by the California Department of Real Estate as a real estate broker. Substantially all California loans are now brokered to us by the California subsidiary.

 

Regulatory Reforms

 

The events of the past few years have led to numerous new laws in the United States and internationally for financial institutions. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or “Dodd-Frank”), which was enacted in July 2010, significantly restructures the financial regulatory regime in the United States. Although the Dodd-Frank Act’s provisions that have received the most public attention generally have been those applying to or more likely to affect larger institutions, it contains numerous other provisions that will affect all financial institutions, including us.

 

The implications of the Dodd-Frank Act for the Company’s businesses will depend to a large extent on the manner in which rules adopted pursuant to the Dodd-Frank Act are implemented by the primary U.S. financial regulatory agencies, as well as on potential changes in market practices and structures in response to the requirements of the Dodd-Frank Act. The Company continues to analyze the impact of rules adopted under Dodd-Frank on the Company’s businesses. However, the full impact will not be known until the rules, and other regulatory initiatives that overlap with the rules, are finalized and their combined impacts can be understood.

 

Other Regulation

 

If we do not adhere to the laws and regulations which apply to us, we could face potential disciplinary or other civil action that could harm our business. The preceding discussion is only intended to summarize some of the significant regulations that affect us and, therefore, is not a comprehensive survey of the field. Recently, substantial new legislation has been adopted or proposed relating to, among other things, financial institutions and private investment vehicles. Many of the adopted laws have been in effect for only a limited time, and have produced limited or no relief to the capital, credit and real estate markets. There can be no assurance that new laws and regulations will stabilize or stimulate the economy in the near term or at all, or that we will not become subjected to additional legislative or regulatory burdens as a result.

 

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Environmental Matters

 

Our REO assets and the operations conducted on real property are subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Under these laws, courts and government agencies may have the authority under certain circumstances to require us, as the owner of a contaminated property, to clean up the property, even if we did not know of or were not responsible for the contamination. These laws also apply to persons who owned a property at the time it became contaminated. In addition to the costs of cleanup, environmental contamination can affect the value of a property and, therefore, an owner’s ability to borrow funds using the property as collateral or to sell the property. These laws and regulations generally govern wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials, and the remediation of contamination associated with disposals. State and federal laws in this area are constantly evolving, and we intend to take commercially reasonable steps to protect ourselves from the impact of these laws, including obtaining environmental assessments of most properties that we acquire. As of the date of this filing, we are unaware of any significant environmental issues affecting the properties we own or properties that serve as collateral under our loans. In addition, we maintain environmental insurance coverage on all properties, subject to certain exclusions, that we believe would limit the amount of liability if such matters were discovered.

 

Available Information

 

Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to reports filed or furnished pursuant to Sections 13(a) and 15(d) of the Exchange Act are available on our website at http://www.imhfc.com as soon as reasonably practicable after IMH electronically files such reports with, or furnishes those reports to, the SEC. The other information on our website is not a part of or incorporated into this document. Stockholders may request free copies of these documents from:

 

IMH Financial Corporation

Attention: Investor Relations

4900 N. Scottsdale Road - Suite 5000

Scottsdale, AZ 85251

(480) 840-8400

 

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Item 1A.        RISK FACTORS

 

Our business involves a high degree of risk. You should carefully consider the following information about risks, together with the other information contained in this Form 10-K. The risks described below are those that we believe are the material risks relating to us. If any of the circumstances or events described below, or others that we did not anticipate, actually arise or occur, our business, prospects, financial condition, results of operations, and cash flows could be harmed. In any such case, the market price of our shares of common stock could decline, and you could lose all or part of your investment. References to “we,” “our,” or “us” generally refer to IMH Financial Corporation and its subsidiaries.

 

Risks Related to Our Business Strategy and Our Operations:

 

An existing SEC investigation could harm our business, including by making it more difficult to raise financing on attractive terms or at all.

 

Following the timeframe in which certain member grievances were filed with the SEC, we received notice from the SEC on June 8, 2010 that it is conducting an investigation related to us, and, in connection with that investigation, the SEC requested certain of our documents. Our present intention is to work cooperatively with the SEC in its investigation; however, we do not believe that we have violated any federal securities laws. Regardless of outcome, the existence of a pending investigation could harm our business, or make it more difficult or impossible to raise additional financing on attractive terms or at all, and distract management’s attention from running our business. Moreover, the outcome of this matter (and other legacy issues) may have a direct and substantial effect on our ability to launch our new investment activities. An adverse resolution of the investigation could also result in fines or disciplinary or other actions that restrict or otherwise harm our business. If the SEC determines to pursue sanctions or an enforcement action, we may have to pursue an alternative execution strategy to minimize the adverse effects of the legacy matters on the success of our strategic initiatives.

 

We may continue to record losses as a result of additional provisions for credit losses or otherwise, which may harm our results of operations.

 

Due primarily to the recording of a provision for credit losses relating to our commercial mortgage loans, we reported net losses of $35.2 million, $117.0 million and $74.5 million for the years ended December 31, 2011, 2010 and 2009, respectively. As of December 31, 2011, our accumulated deficit aggregated $560.8 million. Our historical business model relied on the availability of third-party capital to our borrowers to re-finance short-term commercial real estate bridge loans that we provided to the borrowers to facilitate real estate entitlement and development. However, the erosion of the U.S. and global credit markets in 2008, and 2009, including a significant and rapid deterioration of the commercial mortgage lending and related real estate markets, has substantially curtailed the availability of traditional sources of permanent take-out financing. As a result, we have experienced increased default and foreclosure rates on our commercial real estate mortgage loans. In addition, as a result of these changes, we modified certain commercial real estate mortgage loans, including modifications to the applicable periodic repayment rates and extended maturity dates by two years or longer. We may continue to record net losses in the future as a result of operating deficits, additional provisions for record losses or otherwise, which may further harm our results of operations.

 

While we secured $50 million in financing from the NW Capital loan closing, there is no assurance that we will be successful in selling real estate assets in a timely manner to sufficiently fund operations or obtaining additional financing, and, if available, there are no assurances that the financing will be at commercially acceptable terms. Failure to address this liquidity issue within the timeframe permitted may have a further material adverse effect on our business, results of operations, and financial position.

 

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Our operating expenses have increased and may continue to increase as a result of our active efforts to pursue enforcement on defaulted loans, subsequent foreclosure and our resulting ownership of the underlying collateral.

 

We bear overhead or operating expenses, including costs associated with commercial real estate mortgage loan originations, investor development and operations, and other general overhead costs which the Manager previously was required to bear or voluntarily paid on behalf of the Fund prior to the consummation of the Conversion Transactions. As a result of our active efforts to pursue enforcement on defaulted loans, subsequent foreclosure and our resulting ownership of the underlying collateral, the costs related to these activities have also significantly increased and may continue to increase. These costs are material and may harm our results of operations, cash flow and liquidity.

 

We anticipate that a significant portion of our portfolio will continue to be in the form of non-performing and distressed commercial real estate mortgage loans, or loans that may become non-performing and distressed, which are subject to increased risks relative to performing mortgage loans.

 

As is the case with our current assets, we anticipate that a significant portion of our future assets will continue to be in the form of commercial real estate mortgage loans that we originate or acquire, including non-performing and distressed commercial mortgage loans, which are subject to increased risks of loss. These loans may already be, or may become, non-performing or distressed for a variety of reasons, including, without limitation, because the underlying property is too highly leveraged or the borrower becomes financially distressed, in either case, resulting in the borrower being unable to meet its debt service or repayment obligations to us. These non-performing or distressed commercial real estate mortgage loans may require a substantial amount of workout negotiations or restructuring, which may divert the attention of our management from other activities and entail, among other things, a substantial reduction in the interest rate, capitalization of interest payments, and a substantial write-down of the principal of our loans. However, even if we successfully accomplish these restructurings, our borrowers may not be able or willing to maintain the restructured payments or refinance the restructured commercial real estate mortgage loans upon maturity. In addition, claims may be assessed against us on account of our position as mortgage holder or property owner, including responsibility for tax payments, environmental hazards and other liabilities, which could harm our results of operations, financial condition and our ability to make distributions to our stockholders.

 

In addition, certain non-performing or distressed commercial real estate mortgage loans that we acquire may have been originated by financial institutions that are or may become insolvent or suffer from serious financial stress or are no longer in existence. As a result, the recourse to the selling institution or the standards by which these loans are being serviced or operated may be adversely affected. Further, loans on properties operating under the close supervision of a mortgage lender are, in certain circumstances, subject to certain additional potential liabilities that may exceed the value of our investment.

 

We may continue to foreclose on the remaining loans in our portfolio, which could harm our results of operations and financial condition.

 

As with our current commercial real estate mortgage loans, we may find it necessary or desirable to foreclose on many of the mortgage loans we originate or acquire, and the foreclosure process may be lengthy and expensive. Whether or not we have participated in the negotiation of the terms of any such loans, we cannot assure you as to the adequacy of the protection of the terms of the applicable loan, including the validity or enforceability of the loan and the maintenance of the anticipated priority and perfection of the applicable security interests. Furthermore, claims may be asserted by lenders or borrowers that might interfere with enforcement of our rights. Borrowers may resist mortgage foreclosure actions by asserting numerous claims, counterclaims and defenses against us, including, without limitation, lender liability claims and defenses, even when the assertions may have no basis in fact, in an effort to prolong the foreclosure action and seek to force the lender into a modification of the loan or a favorable buy-out of the borrower’s position in the loan. In some states, foreclosure actions can take several years or more to litigate. At any time prior to or during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure actions and further delaying the foreclosure process and potentially results in a reduction or discharge of a borrower’s mortgage debt. Foreclosure may create a negative public perception of the related mortgaged property, resulting in a diminution of its value. Even if we are successful in foreclosing on a loan, the liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover our cost basis in the loan, resulting in a loss to us. Furthermore, any costs or delays involved in the foreclosure of the loan or a liquidation of the underlying property will further reduce the net proceeds and, thus, increase the loss.

 

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If our exposure to a particular borrower or borrower group increases, the failure by that borrower or borrower group to perform on its loan obligations could harm our results of operations and financial condition.

 

Our investment policy provides that no single loan should exceed 10% of the total of all outstanding loans and that aggregate loans outstanding to one borrower or borrower group should not exceed 20% of the total of all outstanding loans. Following the origination of a loan, however, a single loan or the aggregate loans outstanding to a borrower or borrower group may exceed those thresholds as a result of changes in the size and composition of our overall portfolio.

 

As a result of the foreclosure of the majority of our loan portfolio, as of December 31, 2011, there were 21 remaining outstanding loans. Of those remaining loans, there were three borrowers or borrowing groups whose aggregate outstanding principal totaled $198.2 million, which represented approximately 81% of our total mortgage loan principal outstanding. As of December 31, 2010, there were three borrowers or borrowing groups whose aggregate outstanding principal totaled $206.4 million, which represented approximately 50% of our total mortgage loan principal outstanding. Each of these loans was in non-accrual status as of December 31, 2011 and 2010 due to the shortfall in the combined current fair value of the underlying collateral for such loans, and we recognized no mortgage interest income for these loans during the year ended December 31, 2011 or 2010. When the loan or loans outstanding to a single borrower or borrower group exceed the thresholds described in the initial paragraph of this section, we face heightened exposure to the possibility that the single borrower or borrower group (as opposed to a diversified group of borrowers) will not be able to perform its obligation under the loan, which could cause us to take a number of actions, including the institution of foreclosure proceedings, that could harm our results of operations and financial condition.

 

If we experience additional difficulty in analyzing potential investment opportunities for our assets as a result of recent dislocations in the real estate market or otherwise, we may incur losses that could further impair our financial condition, results of operations and our ability to pay dividends to our stockholders.

 

Our success depends, in part, on our ability to analyze effectively potential investment opportunities in order to assess the level of risk-adjusted returns that we should expect from any particular asset. To estimate the value of a particular asset, we may use historical assumptions that may or may not be appropriate during the current unprecedented downturn in the real estate market and general economy. To the extent that we use historical assumptions that are inappropriate under current market conditions, we may lend on a real estate asset that we might not otherwise lend against, overpay for an asset or acquire an asset that we otherwise might not acquire or be required to later write-down the value of assets acquired on the basis of such assumptions as we have been required to do with our current portfolio, which may harm our results of operations and our ability to pay dividends to our stockholders.

 

In addition, as part of our overall risk management, we analyze interest rate changes and prepayment trends separately and collectively to assess their effects on our assets. In conducting our analysis, we may depend on certain assumptions based upon historical trends with respect to the relationship between interest rates and prepayments under normal market conditions. Recent dislocations in the real estate mortgage market or other developments may change the way that prepayment trends have historically responded to interest rate changes, which may harm our ability to (i) assess the market value of our assets, (ii) implement any hedging strategies we may decide to pursue, and (iii) implement techniques to reduce our prepayment rate volatility. If our estimates prove to be incorrect or our hedges do not adequately mitigate the impact of changes in interest rates or prepayments, we may incur losses that could harm our financial condition, results of operations and our ability to pay dividends to our stockholders.

 

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The supply of commercial mortgage loans available at significant discounts will likely decrease as the economy improves, which could prevent us from implementing our business strategies.

 

Our business strategy includes, among other things, the acquisition and origination of mortgage loans, mezzanine loans, other debt instruments and equity and preferred equity interests or investments, including high yield, short-term, senior secured commercial real estate mortgage loans. However, when the current conditions in the commercial mortgage market, the financial markets and the economy stabilize or improve, the availability of borrowers and projects that meet our underwriting criteria, or commercial mortgage loans that meet our current business objectives and strategies will likely be altered, which could prevent us from implementing this aspect of our business strategy. As a result, any of our current strategies or future strategies we pursue in light of these changes may not be successful. Additionally, the manner in which we compete and the types of assets we seek to acquire will be affected by sudden changes in our industry, the regulatory environment, the role of government-sponsored entities, the role of credit rating agencies or their rating criteria or process, or the U.S. and global economies generally. If we do not effectively respond to these changes, or if our strategies to respond to these changes are not successful, our financial condition and results of operations may be harmed. In addition, we may not be successful in executing our business strategies and even if we successfully implement our business strategies, we may not ever generate revenues or profits.

 

Litigation or claims, including in connection with the Conversion Transactions, may harm our business.

 

We are subject to a number of claims relating to the Conversion Transactions and our historical operations. As discussed more fully under Item 3. Legal Proceedings, three proposed class action lawsuits have been filed in the Delaware Court of Chancery against us and affiliated named individuals and entities, containing similar allegations. An action was also filed on June 14, 2010 by certain Fund members, alleging that fiduciary duties and the duty of disclosure owed to Fund members and to the Fund were breached. We and the named individuals and entities affiliated with us dispute these claims and will defend vigorously against this action. These class action lawsuits were consolidated on October 25, 2010 and a consolidated class action complaint was filed on December 17, 2010. Defendants filed a motion to dismiss on January 31, 2011.  At a hearing on June 13, 2011 on the motion to dismiss, the Court granted defendants’ motion to dismiss without prejudice and the plaintiffs subsequently filed a new complaint on July 15, 2011. In addition, purported members filed a lawsuit against us and affiliated named individuals on December 29, 2010 alleging breach of fiduciary duties in connection with the Conversion Transactions and alleging that we wrongfully rejected a certain member’s requests for records, defamed the member and wrongfully brought a civil action related to the Conversion Transactions. This action has been stayed pending resolution of the consolidated action. We dispute these claims and intend to defend vigorously against these actions. We have been required to devote substantial time and resources to defend against such actions, resolution of any of which in the plaintiff’s favor could significantly harm our business and results of operations.

 

On January 31, 2012, we reached a tentative settlement in principle to resolve all claims asserted by the plaintiffs in the putative class action lawsuit captioned In re IMH Secured Loan Fund Unitholders Litigation (“Litigation”), pending in the Court of Chancery in the State of Delaware against us, certain affiliated and predecessor entities, and certain former and current officers and directors of the Company, other than the claims of one plaintiff. The tentative settlement in principle, memorialized in a Memorandum of Understanding (“MOU”), is described in Item 3. Legal Proceedings.

 

The tentative settlement as written or an alternative resolution will result, among other things, in the imposition of substantial monetary remedies, which could harm our results of operations and financial condition, and/or the imposition of injunctive measures that could substantially limit our operations flexibility and harm our business. Regardless of the merits of these claims, we have incurred significant additional expenses and devoted significant attention to the outcome of these matters. Other parties may also assert claims or legal actions against us, our directors or executive officers or other parties indemnified by us. Although we believe these existing claims are insured (subject to applicable deductions), there can be no guarantee these existing or future claims will be covered by our carrier. Regardless of the merits of such claims or legal actions, we may incur significant additional expenses, liabilities and indemnification obligations, and any uncertainty as to the outcome of litigation could distract management attention from focusing on managing our business and make it more difficult to raise capital on attractive terms or at all. As a result, we could be required to make cash payments at a time when we lack sufficient liquidity to do so, which would force us to sell assets at a significant discount to values that may otherwise be realizable.

 

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If we are required to fund the entire amount of unfunded loans-in-process, our liquidity may be further adversely affected.

 

We have contractual commitments on unfunded commercial mortgage loans to our borrowers in process and interest reserves totaling $26.5 million at December 31, 2011, of which we estimate we will be required to fund no more than $1.7 million in cash. The latter amount excludes amounts of previous commitments that we are no longer obligated to fund because the borrowers are in default, the loans have been modified to lower the funding amount, or the loan funding was contingent on various project milestones which were not met. If we are required to fund any of the unfunded contractual commitments to our borrowers for unfunded commercial mortgage loans-in-process, this could adversely affect our liquidity. For more information about our loan fundings, see the discussion under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations of IMH Financial Corporation — Liquidity and Capital Resources —Requirements for Liquidity — Loan Fundings and Investments.”

 

If our outside consultants or employees are not available to assist us with our loan workouts, we may not be able to realize the full potential value of these loans.

 

Substantially all of our commercial mortgage loans are in default, and currently performing loans may default in the future. We have historically engaged a team of consultants who are physically located at our premises to assist us in negotiating and managing non-performing and distressed loans. We recently internalized most of these consultants, but continue to engage consultants physically resident on our premises to assist our team. We also retained NWRA to provide consulting and advisory services in connection with the development and implementation of an interim recovery and work-out plan and long-term strategic growth plan for us. We rely on these consultants to supplement our loan workout department. Some of these consultants are also employed by other unrelated clients to whom the consultant is obligated to provide time and attention and, thus, these consultants may be unavailable to us from time to time. If employees or consultants are not available to assist us in negotiating and managing non-performing or distressed loans, our rights as a lender or creditor could be compromised and we may not be able to realize the full potential value of these loans.

 

A secondary market for our loans or other assets we acquire may not develop, in which case we may not be able to diversify our assets in response to changes in economic and other conditions, and we may be forced to bear the risk of deteriorating real estate markets, which could increase borrower defaults on our loans and cause us to experience losses.

 

Many of our target assets, including commercial mortgage loan related assets, generally experience periods of illiquidity, such as the current period of delinquencies and defaults with respect to commercial mortgage loans. In addition, a secondary market for our portfolio loans or other assets we acquire may not develop. We will generally bear all the risk of our assets until the loans mature, are repaid or are sold. A lack of liquidity may result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale or the unavailability of financing for these assets. In addition, certain of our target assets, such as bridge loans and other commercial real estate mortgage loans may also be particularly illiquid assets due to their short life, their potential unsuitability for securitization and the greater difficulty of recovery in the event of a borrower’s default.

 

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The potential illiquidity of our assets may make it difficult for us to sell such assets at advantageous times or at favorable prices, including, if necessary, to maintain our exemption from the Investment Company Act. See “Maintenance of our exemption from registration from the Investment Company Act will impose significant limitations on our operations, which may have a material adverse effect on our ability to execute our business strategy” below in these Risk Factors. Moreover, turbulent market conditions, such as those currently in effect, could harm the liquidity of our assets. As a result, our ability to sell our assets and purchase new assets may be relatively limited, which may cause us to incur losses. If we are required to sell all or a portion of our assets quickly, we may realize significantly less than the value at which we have previously recorded our assets. This will limit our ability to mitigate our risk in changing real estate markets and may result in reduced returns to our stockholders.

 

Our access to public capital markets and private sources of financing may be limited and, thus, our ability to make investments in our target assets may be limited.

 

Our access to public capital markets and private sources of financing will depend upon a number of factors over which we have little or no control, including, among others, the following:

 

  · general market conditions;
  · the market’s view of the quality of our assets;
  · the market’s view of our management;

  · the market’s perception of our growth potential;
  · our eligibility to participate in, and access capital from, programs established by the U.S. government;

  · our current and potential future earnings and cash distributions; and
  · the market price of our common stock.

 

The current dislocations and weaknesses in the capital and credit markets could adversely affect one or more private lenders and could cause one or more lenders to be unwilling or unable to provide us with financing or to increase the costs of such financing to us. In addition, several banks and other institutions that historically have been reliable sources of financing have gone out of business, which has reduced significantly the number of lending institutions and the availability of credit. Moreover, the return on our assets and cash available for distribution to our stockholders may be reduced to the extent that market conditions prevent us from leveraging our assets or cause the cost of our financing to increase relative to the income that can be derived from the assets acquired. If we are unable to obtain financing on favorable terms or at all, we may have to curtail our investment activities, which could limit our growth prospects, and we may be forced to dispose of assets at inopportune times in order to maintain our Investment Company Act exemption.

 

Under current market conditions, structured financing arrangements are generally unavailable, the shortage of which has also limited borrowings under warehouse and repurchase agreements that are intended to be refinanced by such financings. Consequently, depending on market conditions at the relevant time, we may have to rely more heavily on additional equity issuances, which may be dilutive to our stockholders, or on more expensive forms of debt financing that require a larger portion of our cash flow from operations, thereby reducing funds available for our operations, future business opportunities, cash dividends to our stockholders and other purposes. We may not have access to such equity or debt capital on favorable terms at the desired times, or at all, which may cause us to curtail our investment activities or to dispose of assets at inopportune times, and could harm our results of operations and growth prospects.

 

We may lack control over certain of our commercial mortgage loans and other investments that we participate in with other lenders, which may result in dispositions of these investments that are inconsistent with our economic, business and other interests and goals.

 

Our ability to manage our portfolio of loans and other investments may be limited by the form in which they are made. Certain of our assets are participations in existing mortgage loans with other lenders, and we may purchase commercial mortgage loans jointly with other lenders, acquire investments subject to rights of senior classes and servicers under inter-creditor or servicing agreements; acquire only a participation interest in an underlying investment; or rely on independent third-party management or strategic partners with respect to the management of an asset. Therefore, we may not be able to exercise control over the loan or investment. Such financial assets may involve risks not present in investments where senior creditors, servicers or third-party controlling investors are not involved. Our rights to enforcement following a borrower default may be subject to the rights of senior creditors or servicers or third-party partners with economic, business or other interests or goals which may be inconsistent with ours. In addition, we may, in certain circumstances, be liable for the actions of our third-party partners. These decisions and judgments may be different than those we would make and may be adverse to us.

 

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Short-term loans that we may originate or acquire may involve a greater risk of loss than traditional investment-grade mortgage loans with fully insured borrowers, which could result in greater losses.

 

We have historically originated or acquired commercial real estate-bridge loans secured by first lien mortgages on properties of borrowers who are typically seeking short-term capital to be used in the acquisition, construction or rehabilitation of properties, and intend to continue to do so. The typical borrower under a short-term loan has usually identified what it believes is an undervalued asset that may have been under-managed or located in a recovering market. If the market in which the asset is located fails to recover according to the borrower’s projections, or if the borrower fails to improve the quality of the asset’s management or the value of the asset, the borrower may not receive a sufficient return on the asset to satisfy the short-term loan, and we bear the risk that we may not recover some or all of our loan amount.

 

In addition, borrowers under a bridge loan usually use the proceeds of a conventional mortgage loan to repay a short-term loan. The risk of a borrower’s inability to obtain permanent financing is increased under current market conditions. Therefore, bridge loans are subject to the risk of a borrower’s inability to obtain permanent financing to repay the short-term loan. Short-term loans are also subject to the risk associated with all commercial mortgage loans — borrower defaults, bankruptcies, fraud, losses and “special hazard” losses that are not covered by standard hazard insurance. In the event of any default under short-term loans held by us as lenders, we bear the risk of loss of principal and non-payment of interest and fees to the extent of any deficiency between the value of the mortgage collateral and the principal amount and unpaid interest accrued under the short-term loan. To the extent we suffer such losses with respect to our short-term loans, the value of our company and the price of our shares of common stock and other securities may be harmed.

 

The subordinated loan assets that we may acquire, which involve greater risks of loss than senior loans secured by income-producing properties, could result in losses that could harm our results of operations and our ability to make distributions to our stockholders.

 

We may acquire subordinated loans secured by junior mortgages on the underlying property or by a pledge of the ownership interests of either the entity owning the property or the entity that owns the interest in the entity owning the property. These types of assets involve a higher degree of risk than long-term senior mortgage lending secured by income-producing real property, because the loan may become unsecured as a result of foreclosure by the senior lender. In addition, these loans may have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of principal. If a borrower defaults on our subordinated loan or debt senior to our loan, or in the event of a borrower bankruptcy, our subordinated loan will be satisfied only after the senior debt is paid in full. Where debt senior to our portfolio loan exists, the presence of intercreditor arrangements between the holder of the mortgage loan and us, as the subordinated lender, may limit our ability to amend our loan documents, assign our loans, accept prepayments, exercise our remedies, and control decisions made in bankruptcy proceedings relating to borrowers. As a result, we may not recover some or all of our investment, which could result in losses to us. In addition, even if we are able to foreclose on the underlying collateral following a borrower’s default on a subordinated loan, we may assume the rights and obligations of the defaulting borrower under the loan and, to the extent income generated on the underlying property is insufficient to meet outstanding debt obligations on the property, we may need to commit substantial additional capital to stabilize the property and prevent additional defaults to lenders with existing liens on the property. Significant losses related to our subordinated loans could harm our results of operations and our ability to issue dividends to our stockholders.

 

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Our due diligence may not reveal all of a borrower’s assets or liabilities and may not reveal other investment risks or weaknesses in a business which could result in loan losses.

 

Before acquiring an asset or making a loan to a borrower, we assess the strength and skills of the asset or potential borrower and other factors that we believe are material to the performance of the asset. In making this assessment and otherwise conducting customary due diligence, we rely on numerous resources reasonably available to us and, in some cases, an investigation by third parties. This process is particularly subjective, and of lesser value than would otherwise be the case, with respect to newly organized entities because there may be little or no information publicly available about those entities. There can be no assurance that our due diligence processes will uncover all relevant facts or problems, or that any particular asset will be successful.

 

We may enter into hedging transactions that could expose us to losses.

 

We may enter into hedging transactions that could require us to fund cash payments in certain circumstances such as the early termination of the hedging instrument caused by an event of default or other early termination event, or the decision by a counterparty to request margin securities it is contractually owed under the terms of the hedging instrument. The amount due upon early termination or as the result of a request for margin securities would be equal to the unrealized loss of the open swap positions with the respective counterparty and could also include other fees and charges. These economic losses would be reflected in our results of operations. Our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time. The need to fund these obligations could harm our financial condition. We also may pursue various hedging strategies to seek to reduce our exposure to adverse changes in interest rates. Our hedging activity will vary in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions. Interest rate hedging could harm or fail to protect us because, among other things:

 

  · interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
  · available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought;

  · the duration of the hedge may not match the duration of the related liability;
  · the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and

  · the hedging counterparty owing money in the hedging transaction may default on its obligation to pay.

 

In addition, hedging instruments involve risk since in the past they have not been traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there were no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was adopted on July 21, 2010, establishes a system of extensive regulation of hedging transactions. However, to a large extent, rules implementing this new regulatory regime are currently being drafted and have not yet become fully effective. Final rules under the Dodd-Frank Act could impose new costs and burdens on us that could impair our ability to enter into hedging transactions or make such transactions more expensive for us. Furthermore, the enforceability of agreements underlying hedging transactions may depend on compliance with applicable statutory and commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in its default. Default by a party with whom we enter into a hedging transaction may result in unrealized losses or the loss of unrealized profits and force us to cover our commitments, if any, at the then current market price. It may not always be possible to dispose of, close out or terminate a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. A liquid secondary market may not exist for any hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses to us. Moreover, there can be no assurance that the hedging agreement would qualify for hedge accounting or that our hedging activities would have the desired beneficial impact on our financial performance and liquidity. Should we choose to terminate a hedging agreement, there could be significant costs and cash requirements involved to fulfill our initial obligation under the hedging agreement. The risks above relating to any of our hedging transactions may harm our results of operations and limit our ability to make distributions to our stockholders.

 

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Recent legislative and regulatory initiatives could harm our business.

 

The U.S., state and foreign governments have taken or are considering extraordinary actions in an attempt to address the worldwide financial crisis and the severe decline in the global economy, and to seek to address the perceived underlying causes of the financial crisis to prevent or mitigate the recurrence. These actions or other actions under consideration may not ultimately be successful or beneficial to us and could result in unintended consequences or new regulatory requirements which may be difficult or costly to comply with. On July 21, 2010, the Dodd-Frank Act was signed into law in the U.S. Among other things, the Dodd-Frank Act creates of a Financial Services Oversight Council to identify emerging systemic risks and improve interagency communication, creates a Consumer Financial Protection Agency authorized to promulgate and enforce consumer protection regulations relating to financial products, which would affect both banks and non-bank finance companies, imposes a comprehensive new regulatory regime on financial markets, including derivatives and securitization markets, and creates an Office of National Insurance within Treasury. While the bill has been signed into law, a number of provisions of the law remain to be implemented through the rulemaking process at various regulatory agencies. We are unable to predict what the final form of these rules will be when implemented by the respective agencies, but we believe that certain aspects of the new legislation, including, without limitation, the additional cost of higher deposit insurance and the costs of compliance with disclosure and reporting requirements and examinations by the new Consumer Financial Protection Agency, could have a significant impact on our business, financial condition and results of operations. Additionally, we cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect us. For example, bankruptcy legislation could be enacted that would hinder the ability to foreclose promptly on defaulted mortgage loans or permit limited assignee liability for certain violations in the mortgage origination process, any or all of which could adversely affect our business or result in us being held responsible for violations in the mortgage loan origination process even when we were not the originator of the loan.

 

Other laws, regulations, and programs at the federal, state and local levels are under consideration that seek to address the economic climate and real estate and other markets and to impose new regulations on various participants in the financial system. These or other actions could harm our business, results of operations and financial condition. Further, the failure of these or other actions and the financial stability plan to stabilize the economy could harm our business, results of operations and financial condition.

 

Our business is subject to regulation by several government agencies and a disciplinary or civil action that occurs as a result of an actual or alleged violation of any rules or regulations to which we are subject could harm our business.

 

We are subject to extensive regulation and oversight by various state and federal regulatory authorities, including, without limitation, the Arizona Corporation Commission, the Arizona Department of Revenue, the Arizona Department of Financial Institutions (Banking) and the SEC. Many of these authorities have generally increased their scrutiny of the entities they regulate following recent events in the homebuilding, finance and capital markets sectors. We are also subject to various federal and state securities laws regulating the issuance and sale of securities. We also in the future may be required to obtain various approvals and/or licenses from federal or state governmental authorities, or government sponsored entities in connection with our mortgage-related activities. There is no assurance that we will be able to obtain or maintain any or all of the approvals that we need in a timely manner. In the event that we do not adhere to these license and approval requirements and other laws and regulations which apply to us, we could face potential fines or disciplinary or other civil action that could restrict or otherwise harm our business.

 

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We received notice from the SEC on June 8, 2010 that it is conducting an investigation related to us, as well as requests for documents. Our present intention is to work cooperatively with the SEC in its investigation, but we do not believe that we have violated any federal securities laws. Regardless of the ultimate outcome, the existence of a pending investigation could harm our business or make it more difficult or impossible to raise additional financing on attractive terms or at all.

 

In addition, prior to the Conversion Transactions, following the suspension of certain of the activities of the Fund, including the suspension of our willingness to execute redemption requests from holders of membership units in the Fund, certain of the members requested that their redemption requests be honored due to financial hardships or other reasons. In each instance, we responded that we would not grant such requests and were treating all of the members uniformly. While we have not been served with any lawsuits from any of the members relating to our decision to not grant such requests, certain of the members have filed grievances with the SEC and possibly other regulatory agencies related to the Manager’s administration of the Fund, and we are unable to predict the outcome of any such grievances.

 

Maintenance of our exemption from registration under the Investment Company Act will impose significant limitations on our operations, which may have a material adverse effect on our ability to execute our business strategy.

 

We currently conduct our business in a manner that we believe will allow us to avoid being regulated as an investment company under the Investment Company Act and intend to continue to do so. If we become subject to the Investment Company Act, we would be required to comply with numerous additional regulatory requirements and restrictions, any or all of which could harm the sustainability of our operations and our ability to pay dividends, and force us to discontinue the business. We believe that we have qualified for an exemption from regulation under the Investment Company Act. Pursuant to Section 3(c)(5)(C) of the Investment Company Act, entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate” are exempted from regulation thereunder. The staff of the SEC has provided limited guidance on the availability of this exemption, expressing the position that the SEC would regard an issuer as being engaged primarily in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate if (i) at least 55% of the value of the issuer’s assets consists of mortgages and other liens on, and interests in, real estate (“Qualifying Assets”), and (ii) at least an additional 25% of the value of the issuer’s assets consists of Qualifying Assets or other real estate type interests (including loans in respect of which 55% of the fair market value of each such loan is secured by real estate at the time the issuer acquires the loan) or Real Estate-Related Assets. Not more than 20% of the issuer’s assets may consist of miscellaneous investments, including all other loans held by an issuer, cash, government securities, and investments in partnerships or other businesses not qualifying as either Qualifying Assets or Real Estate-Related Assets. Mortgage-related securities that do not represent all of the certificates issued with respect to the underlying pool of mortgages may also not qualify under this 55% test. Therefore, our ownership of these types of loans and equity interests may be limited by the provisions of the Investment Company Act. To the extent we do not comply with the SEC staff’s 55% test, another exemption or exclusion from registration as an investment company under the Investment Company Act or other interpretations of the Investment Company Act, we may be deemed an investment company. If we fail to maintain an exemption or other exclusion from registration as an investment company we could, among other things, be required either to substantially change the manner in which we conduct our operations to avoid being required to register as an investment company, effect sales of our assets in a manner that, or at a time when, we would not otherwise choose to do so, or register as an investment company, any of which could have an adverse effect on us and the market price of our common stock. If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our capital structure (including our ability to use leverage), management, operations, transactions with affiliated persons (as defined in the Investment Company Act), portfolio composition, including restrictions with respect to diversification and industry concentration and other matters. As of December 31, 2011, more than 83% of our total assets were invested in assets we consider to be Qualifying Assets and approximately 83% of our total assets were invested in assets we believe to be Qualifying Assets or Real Estate-Related Assets.

 

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If the market value or income potential of our real estate-related investments declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase our real estate investments and income or liquidate our non-qualifying assets in order to maintain our exemption from the Investment Company Act. In view of the illiquid nature of certain of our real estate and real estate-related investments, we may not be able to liquidate our non-qualifying assets at opportune times or prices, if at all, in order to maintain our Investment Company Act exemption. Similarly, we may not have sufficient capital or access to capital at favorable prices, if at all, if we were required to increase our qualifying real estate assets in order to maintain our Investment Company Act exemption. If the value of our assets fluctuates dramatically, our ability to maintain compliance may be particularly difficult, which may cause us to make investment decisions that we otherwise would not make absent Investment Company Act considerations. Moreover, as the real estate market evolves, we may determine that the commercial real estate market does not offer the potential for attractive risk-adjusted returns pursuant to an investment strategy that is consistent with our intention to operate in a manner to maintain our exemption from registration under the Investment Company Act. For example, if we believe the maintenance of our exemption under the Investment Company Act imposes undue limitations on our ability to generate attractive risk-adjusted returns to our investors, our board of directors may approve the wind down of our assets and liquidation of our business.

 

If we were required to register as an investment company under the Investment Company Act but failed to do so, the SEC could bring an action to enjoin us from further violating the Investment Company Act. Also, there can be no assurance that the laws and regulations governing the Investment Company Act status of our company, including the Division of Investment Management of the SEC providing more specific or different guidance regarding the treatment of assets as qualifying real estate assets or real estate-related assets, will not change in a manner that adversely affects our operations. As a result, the Investment Company Act may limit our ability to generate returns for our stockholders.

 

The NW Capital loan is potentially dilutive to our shareholders and NW Capital has substantial approval rights over our operations. Their interests may not coincide with yours and they may make decisions with which you disagree.

 

Under the terms of the NW Capital loan agreement, NW Capital has substantial approval rights over our operations. NW Capital or its affiliates, upon conversion of the loan to Series A preferred stock, which in turn is convertible into common stock, would beneficially own approximately 23.7% of our common stock. This ownership may increase further as a result of deferred interest on the notes or paid-in-kind dividends on the Series A preferred stock, if NW Capital elects to purchase any notes not subscribed to in a potential rights offering to existing stockholders required in the MOU, or if NW Capital consummates a proposed $10 million tender offer for shares of our Class B and Class C common stock. In addition, if NW Capital converts the loan into Series A preferred stock, it will hold a majority of outstanding preferred stock and effectively have the ability to control the appointment of two directors to our board of directors. The preferred directors have approval rights over nominations of directors elected by holders of common stock and, along with the lead investor (as defined in the Certificate of Designation) will also have the power to exercise control over most of the rights, powers and preferences of holders of Series A preferred stock without a vote of the holders of Series A preferred stock. Without the consent of these two directors, we may not undertake certain actions, including the creation of shares of our common stock on parity or senior to the NW Capital loan, changing the total number of our board of directors and consenting to the transfer of shares of Series A preferred stock. Further, certain actions, including breaching any of our material obligations to the holders of Series A preferred stock under the Certificate of Designation, if a material adverse event occurs under the the Certificate of Designation or if any certification, representation or warranty made by us under the NW Capital loan or in the Certificate of Designation shall have been false or misleading in any material respect as of the issuance date of the Series A preferred stock, could result in a default under the terms of the Series A preferred stock, which could allow the lead investor to require us to redeem the Series A preferred stock. NW Capital’s interests may not always coincide with our interests as a company or the interests of our other stockholders. Furthermore, an affiliate of NW Capital is expected to be nominated to our board of directors upon the issuance of the Series A preferred stock and we have entered into a long-term advisory services contract with an affiliate of NW Capital for the provision of various services.

 

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As a result, of its substantial beneficial equity interest in us, NW Capital has considerable influence over our corporate affairs and actions, and this makes it difficult or impossible to enter into certain transactions without the support of NW Capital. Accordingly, NW Capital could cause us to enter into transactions or agreements that you would not approve or make decisions with which you may disagree.

 

The NW Capital loan agreement contains restrictive covenants relating to our operations, which could limit our business, results of operations, ability to pay dividends to our stockholders and the market value of our common stock.

 

The NW Capital loan agreement contains certain restrictive covenants, which limit certain actions we might otherwise take without NW Capital’s consent. These restrictive covenants include our ability to sell, encumber or otherwise transfer certain assets, declare or pay any dividend or take similar actions, incur any additional indebtedness until after the second anniversary of the NW Capital loan pursuant to certain lines of credit if pledged asset coverage values are met, or issue any equity securities, in each case subject to certain exceptions. In addition, we may not increase or decrease the number of members on our board of directors, or establish any board committee other than in the ordinary course of business or take certain actions with respect to employee benefit plans and incentive compensation plans. If we fail to meet or satisfy any of these covenants, we would be in default under the loan agreement, and NW Capital could elect to declare loans outstanding to us due and payable, require the posting of additional collateral and enforce their respective interests against existing collateral from us. A default also could limit significantly our financing alternatives, which could cause us to curtail our investment activities or prematurely dispose of assets.

 

Any borrowing by us will increase our risk, which may reduce the return on our assets, reduce cash available for distribution to our stockholders and increase losses.

 

Subject to market conditions and availability, we have used and may continue to use borrowings to generate additional liquidity for the payment of operating expenses, costs relative to the ownership of REO assets, obligations under our loans to borrowers or to finance our assets or make other investments. As of December 31, 2011, we had secured $50 million in financing from NW Capital for the purpose of funding remaining loan obligations, anticipated development costs for REO assets, and working capital needs. We expect that additional borrowings may be necessary or advisable from time to time. However, our ability to borrow from sources other than NW Capital is limited by the covenants in the NW Capital loan agreement which restricts the amount of indebtedness we can incur and our ability to secure any such additional indebtedness. Any borrowings will require us to carefully manage our cost of funds and we may not be successful in this effort. We may borrow funds from a number of sources, including repurchase agreements, resecuritizations, securitizations, warehouse facilities and bank credit facilities (including term loans and revolving facilities), and the terms of any indebtedness we incur may vary. Given current market conditions, we may also seek to take advantage of available borrowings, if any, under government sponsored debt programs to acquire all types of commercial real estate mortgage loans and other real estate-related assets, to the extent such assets are eligible for funding under such programs. Although we are not currently required to maintain any particular assets-to-equity leverage ratio, the amount of leverage we may deploy will depend on our available capital, our ability to access financing arrangements, our estimated stability of cash flows generated from the assets in our portfolio and our assessment of the risk-adjusted returns associated with those assets, our ability to enter into repurchase agreements, resecuritizations, securitizations, warehouse facilities and bank credit facilities (including term loans and revolving facilities), our ability to participate in and obtain funding under programs established by the U.S. government, available credit limits and financing rates, the type or amount of collateral required to be pledged and our assessment of the appropriate amount of leverage for the particular assets we are funding.

 

Borrowing subjects us to a number of other risks, including, among others, the following:

  

  · if we are unable to repay any indebtedness or make interest payments on any loans we incur, our lenders would likely declare us in default, result in acceleration of debt (and any other debt containing a cross-default or cross-acceleration provision) and could require that we repay all amounts outstanding under our loan facilities, which we may be unable to pay from internal funds or refinance on favorable terms or at all;

 

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  · our inability to borrow unused amounts under our financing arrangements, even if we are current in payments on our borrowings under those arrangements;
  · the potential loss of some or all of our assets securing the loans to foreclosure or sale;
  · our debt may increase our vulnerability to adverse economic and industry conditions with no assurance that investment yields will increase with higher financing costs;
  · we may be required to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for operations, future business opportunities, stockholder distributions or other purposes;
  · we may not be able to refinance debt that matures prior to the investment it was used to finance on favorable terms, or at all; and
  · some lenders may require as a condition of making a loan to us that the lender receive a priority on mortgage repayments received by us on our mortgage portfolio, thereby requiring the first dollars we collect to go to our lenders.

  

Any of these risks could harm our business and financial condition.

 

Any repurchase agreements and bank credit facilities that we may use in the future to finance our assets may require us to provide additional collateral or pay down debt.

 

We have used and may continue to utilize repurchase agreements and bank credit facilities (including term loans and revolving facilities) to finance our operations if such financing becomes available to us on acceptable terms. In the event we utilize such financing arrangements, they would involve the risk that the market value of the loans pledged or sold by us to the repurchase agreement counterparty or provider of the bank credit facility may decline in value, in which case the lender may require us to provide additional collateral or to repay all or a portion of the funds advanced. We may not have the funds available to repay our debt at that time, which would likely result in defaults unless we are able to raise the funds from alternative sources, which we may not be able to achieve on favorable terms or at all. A lender’s requirement that we post additional collateral would reduce our liquidity and limit our ability to leverage our assets. If we cannot meet these requirements, the lender could accelerate our indebtedness, increase the interest rate on advanced funds and terminate our ability to borrow funds from it, which could harm our financial condition and ability to implement our business plan. In addition, in the event that a lender to us files for bankruptcy or becomes insolvent, the loans to us may become subject to bankruptcy or insolvency proceedings, thus depriving us, at least temporarily, of the benefit of these assets. Such an event could restrict our access to bank credit facilities and increase our cost of capital. The providers of repurchase agreement financing and bank credit facilities may also require us to maintain a certain amount of cash or set aside assets sufficient to maintain a specified liquidity position that would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose which could reduce our return on assets. In the event that we are unable to meet these collateral obligations, our financial condition and prospects could deteriorate rapidly.

 

To the extent that we obtain debt financing as a borrower, we expect that certain of our financing facilities may contain restrictive covenants relating to our operations, which could harm our business, results of operations, ability to pay dividends to our stockholders and the market value of our common stock.

 

If or when we obtain debt financing as a borrower, lenders (especially in the case of bank credit facilities) may impose restrictions on us that would affect our ability to incur additional debt, make certain acquisitions, reduce liquidity below certain levels, pay dividends to our stockholders, redeem debt or equity securities and impact our flexibility to determine our operating policies and business strategies. For example, the existing NW Capital loan documents contain negative covenants that limit, among other things, our ability to repurchase shares of our common stock, distribute more than a certain amount of our net income or funds from operations to our stockholders, hold portfolio mortgage loans for longer than established time periods, employ leverage beyond certain amounts, sell assets, engage in mergers or consolidations, grant liens, and enter into transactions with affiliates. If we fail to meet or satisfy any of these covenants, we would be in default under these agreements, and our lenders could elect to declare loans outstanding to us due and payable, terminate their commitments, require the posting of additional collateral and enforce their respective interests against existing collateral from us. We also may be subject to cross-default and acceleration rights and, with respect to collateralized debt, requirements for us to post additional collateral, and foreclosure rights upon default. A default also could limit significantly our financing alternatives, which could cause us to curtail our investment activities or prematurely dispose of assets.

 

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If we are unable to sell our existing assets, or are only able to do so at a loss, we may be unable to implement our investment strategy in the timeframe sought or at all.

 

We are marketing a significant portion of our existing assets, individually or in bulk, to generate liquidity and capital to redeploy in our target assets and implement our investment strategy. In addition, we are pursuing enforcement (in most cases foreclosure) on almost all our loans that are currently in default, and expect to take ownership of the underlying collateral and position the asset for future monetization. As a result of the rapid decline in the economy and substantial disruptions in the real estate, capital, credit and other markets, we may be unable to sell our existing assets or be required to do so at a price below our adjusted carrying value, which could harm our business and our ability to implement our investment strategy.

 

If we do not resume our mortgage lending activities or investing activities, we will not be able to grow our business and our financial results and financial condition will be harmed.

 

We suspended certain of our activities as of October 1, 2008, including, among other things, the funding and origination of any new commercial mortgage loans. This election was made in order to preserve our capital and to seek to stabilize our operations and liquid assets in order to assist us in our efforts to meet our future obligations, including those pursuant to current loan commitments we have made to borrowers. The inability to fund new loans or instruments prevents us from capitalizing on interest or other fee paying assets, and managing interest rate and other risk as our existing assets are sold, restructured or refinanced, which could harm our results and financial condition.

 

Due to the decline of the economy and real estate and credit markets, we anticipate defaults on our commercial mortgage loan assets and foreclosures to continue, which may harm our business.

 

We are in the business of acquiring, originating, marketing and selling commercial mortgage loans and, as such, we are at risk of default by borrowers. Any failure of a borrower to repay the mortgage loans or to pay interest on such loans will reduce our (i) revenue and distributions, if any, to stockholders, and (ii) potentially, the trading price of our common stock. At December 31, 2011, 18 of our 21 loans with outstanding principal balances totaling $238.0 million were in default, of which 16 with outstanding principal balances totaling $144.4 million were past their respective scheduled maturity dates, and the remaining two loans have been deemed non-performing based on value of the underlying collateral in relation to the respective carrying value of the loans. We are exercising enforcement action which could lead to foreclosure upon 17 of the 18 loans in default.  Of these 17 loans upon which we are exercising enforcement action, we completed foreclosure on five loans (resulting in the addition of four properties) subsequent to December 31, 2011 with a net carrying value of $5.8 million.  We are continuing to work with the borrower with respect to the remaining one loan in default in order to seek to maintain the entitlements on the related project and, thus, the value of our existing collateral. In addition, during the year ended December 31, 2011, we foreclosed on 12 loans (resulting in 10 property additions) and took title to the underlying collateral with net carrying values totaling $13.7 million as of December 31, 2011. The actual net realizable value of such properties may not exceed the carrying value of these properties at December 31, 2011. Due to the decline of the economy and real estate and credit markets and our intent to proactively pursue foreclosure of loans in default so we can dispose of REO assets, we anticipate defaults and foreclosures to continue, which will likely result in continuing high levels of non-accrual loans and REO assets, which are generally non-interest earning assets. As such, we anticipate our mortgage loan interest income to remain at significantly reduced levels until we invest the proceeds from the disposition of REO assets or other debt or equity financing in new investments and begin generating income from those investments.

 

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Our borrowers are exposed to risks associated with owning real estate, and unexpected expenses or liabilities resulting from such ownership could reduce the likelihood that our borrowers will be able to develop or sell the real estate that serves as collateral for our loans, which will increase the likelihood that our borrowers will default on the loans that we fund or acquire.

 

Among other matters, our borrowers are subject to risks, expenses and liabilities associated with owning real estate, including, among others:

 

  · the expense of maintaining, operating, developing and protecting the real estate that serves as collateral for our loans;
  · the risk of a decline in value of such real estate due to market or other forces;
  · the absence of financing for development and construction activities, if financing is required;
  · the risk of default by tenants who occupy such real estate and have rental obligations to the owners of such real estate;
  · the risks of zoning, rezoning, and many other regulatory matters affecting such real estate;
  · acts of God, including earthquakes, floods and other natural disasters, which may result in uninsured losses;
  · acts of war or terrorism;
  · adverse changes in national and local economic and market conditions;
  · changes in, related costs of compliance with, or fines or private damage awards for failure to comply with existing or future federal, state and local laws and regulations, fiscal policies and zoning ordinances;
  · costs of remediation and liabilities associated with environmental conditions;
  · the potential for uninsured or under-insured property losses;
  · the impact of economic, market, environmental and political conditions on the ability to market or develop properties;
  · financial and tort liability risks, including construction defect claims, associated with the ownership, development and construction on such real estate; and
  · market risk and the possibility that they will not be able to develop, sell or operate such real estate to generate the income expected from such real estate.

  

Any or all of these risks, if not properly managed by the borrower, could impose substantial costs or other burdens on our borrower or such real estate, or result in a reduction in the value of such real estate, thereby increasing the likelihood of default by the borrower on our portfolio loan and reducing or eliminating our ability to make distributions to our stockholders. In addition, to the extent we foreclose on any such real estate securing our portfolio loans, we become directly subject to these same risks.

 

Acquiring ownership of property, through foreclosure or otherwise, subjects us to the various risks of owning real property and we could incur unexpected costs and expenses, which could harm our business.

 

We have acquired real property in connection with foreclosures of our commercial mortgage loans in which we have invested, and we may acquire additional real property in this manner in the future. As of December 31, 2011, we owned 41 properties with an aggregate net carrying value of $95.5 million and had commenced enforcement action on 17 additional loans. As an owner of real property, we will incur some of the same obligations and be exposed to some of the same risks as the borrower was prior to our foreclosure on the applicable loan. See the risk factor above starting with “Our borrowers are exposed to risks associated with owning real estate.

 

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If commercial property borrowers are unable to generate net income from operating the property, we may experience losses on those loans.

 

The ability of a commercial mortgage loan borrower to repay a loan secured by an income-producing property, such as a multi-family or commercial property, typically is dependent primarily upon the successful operation of the property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income producing property can be affected by, among other things, tenant mix, success of tenant businesses, property management decisions, property location and condition, competition from comparable types of properties, changes in laws that increase operating expenses or limit rents that may be charged, any need to address environmental contamination at the property, the occurrence of any uninsured casualty at the property, changes in national, regional or local economic conditions or specific industry segments, declines in regional or local real estate values, declines in regional or local rental or occupancy rates, increases in interest rates, real estate tax rates and other operating expenses, changes in governmental rules, regulations and fiscal policies, including environmental legislation, acts of God, terrorism, social unrest and civil disturbances.

 

Although we have recourse to the borrower or, in some cases, guarantors of the borrower, most of our commercial mortgage loans are enforced against insolvent and/or financially distressed borrowers, which means in practice that there is generally no recourse against the borrower’s assets other than the underlying collateral. In the event of any default under a recourse or non-recourse commercial mortgage loan held directly by us, we generally bear a risk of loss of principal to the extent of any deficiency between the value of the collateral (or our ability to realize such value through foreclosure) and the principal and accrued interest on the mortgage loan, which could harm our results of operations and cash flow from operations, limit amounts available for distribution to our stockholders, and impair the value of our securities. In the event of the bankruptcy of a commercial mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the commercial mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law. Foreclosure of a commercial mortgage loan can be an expensive and lengthy process, which could have a substantial negative effect on our anticipated return on the foreclosed commercial mortgage loan.

 

We rely on the value of our real estate collateral to protect our commercial mortgage loans, and that real estate collateral is subject to appraisal errors and the collateral’s realizable value is subject to decrease based on events beyond our control, which may result in losses on our loans.

 

We depend upon the value of our real estate collateral to protect the commercial mortgage loans that we make or acquire. We depend upon the skill of independent appraisers and other techniques to value the collateral of the commercial mortgage loans we hold. However, notwithstanding the experience of the appraisers we select or approve, they may make mistakes or may err in their judgment. Also, the realizable value of the real estate securing our loans may decrease due to subsequent events, such as the precipitous decline in value experienced as a result of the real estate market downturn. As a result, the value of the collateral may be less than anticipated at the time the applicable commercial mortgage loan was originated or acquired. In this regard, in recent periods, the real estate markets across the United States have declined. If the value of the collateral supporting our commercial mortgage loans declines and a foreclosure sale occurs, we may not recover the full amount of our commercial mortgage loan, thus reducing the amount of our cash available, if any, and may harm our business.

 

Our underwriting standards and procedures may not protect us from loan defaults, which could harm our business.

 

Due to the nature of our business model, we believe the underwriting standards and procedures we use are different from conventional lenders. While several procedures in our underwriting process are similar to those of traditional lenders, there are also some differences that provide us with more flexibility in underwriting and closing loans. Due to the nature of our loan approval process, there is a risk that the underwriting we performed did not, and the underwriting we perform in the future will not, reveal all material facts pertaining to the borrower and the collateral, and there may be a greater risk of default by our borrowers which, as described above, could harm our business. In addition, the underwriting standards we applied to our existing assets did not anticipate the current unprecedented downturn in the real estate market and general economy, and as a result we may recognize additional losses from loan defaults.

 

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Guarantors of our loans may not have sufficient assets to support their guarantees, which could make enforcing such guarantees difficult and costly and could harm our operations.

 

Our commercial mortgage loans are not insured or guaranteed by any federal, state or local government agency. Our loans may be guaranteed by individuals or entities which are typically affiliated with the borrower. These guarantors may not have sufficient assets to back up their guarantees in whole or in part, and collections pursuant to any such guarantees may be difficult and costly. Consequently, if there is a default on a particular commercial mortgage loan and the guarantee, our only recourse may be to foreclose upon the mortgaged real property. The value of the foreclosed property may have decreased and may not be equal to the amount outstanding under the corresponding loan, resulting upon sale in a decrease of the amount of our cash available, if any, and may harm our business.

 

We have limited experience in managing and developing real estate and, following a foreclosure, we may not be able to manage the real estate we foreclose upon or develop the underlying projects in a timely or cost-effective manner, or at all, which could harm our results of operations.

 

We have limited experience in managing and developing real estate. When we acquire real estate through foreclosure on one of our loans or otherwise, we may seek to complete the underlying projects, either alone or through joint ventures. We may not be able to manage the development process in a timely or cost-effective manner or at all.

 

We require third-party assistance in managing or developing projects, and may obtain such assistance in the future either through joint ventures or selling the rights to manage or develop projects in whole, and we may be unable to find such assistance at an attractive cost or at all. Even if we are able to locate such assistance, we may be exposed to the risks associated with the failure of the other party to complete the development of the project as expected or desired. These risks include the risk that the other party would default on its obligations, necessitating that we complete the other components ourselves (including providing any necessary financing).

 

If we enter into joint ventures to manage or develop projects, such joint ventures involve certain risks, including, without limitation, that:

 

  · we may not have voting control over the joint venture;
  · we may not be able to maintain good relationships with the joint venture partners;
  · the joint venture partner may have economic or business interests that are inconsistent with our interests;
  · the joint venture partner may fail to fund its share of operations and development activities, or to fulfill its other commitments, including providing accurate and timely accounting and financial information to us; and
  · the joint venture or venture partner could lose key personnel.

 

Any one or more of these risks could harm our results of operations.

 

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We may experience a decline in the fair value of our assets, which could harm our results of operations, financial condition, our ability to make distributions to our stockholders and the value of our common stock.

 

A decline in the fair value of our assets may require us to recognize a provision for credit losses or impairment charge against such assets under accounting principles generally accepted in the United States, or GAAP, if we were to determine that, with respect to any assets in unrealized loss positions, we do not have the ability and intent to hold such assets to maturity or for a period of time sufficient to allow for recovery to the amortized cost of such assets. If such a determination were to be made, we would recognize unrealized losses through earnings and write down the amortized cost of such assets to a new cost basis, based on the fair value of such assets on the date they are considered to be impaired. For example, during the years ended December 31, 2011, 2010 and 2009, we recorded provisions for credit losses totaling $1.0 million, $47.5 million and $79.3 million, respectively, as well as impairment charges on REO assets of $1.5 million, $46.9 million and $8.0 million for the same periods, respectively. For further information, see the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations for the Years Ended December 31, 2011, 2010 and 2009 — Costs and Expenses — Provision for Credit Losses.” We could be required to record additional valuation adjustments in the future. Even in the absence of decreases in the value of real estate, we may be required to recognize provisions for credit losses as a result of the accrual of unpaid taxes on collateral underlying a loan. We also may be required to recognize impairment charges if we reclassify particular REO assets from being held for development to being held for sale. Such a provision for credit losses or impairment charges reflect non-cash losses at the time of recognition; subsequent disposition or sale of such assets could further affect our future losses or gains, as they are based on the difference between the sale price received and carrying value of such assets at the time of sale. If we experience a decline in the fair value of our assets, our results of operations, financial condition, our ability to make distributions to stockholders and the value of our securities could be harmed.

 

Some of our assets are and will be recorded at fair value and, as a result, there will be uncertainty as to the value of these assets.

 

The fair value of our assets may not be readily determinable, requiring us to make certain estimates and adjustments. We will value certain of these investments quarterly at fair value, as determined in accordance with applicable accounting guidance, which may include unobservable inputs. Because such valuations are subjective, the fair value of certain of our assets may fluctuate over short periods of time and our determinations of fair value may differ materially from the values that would have been used if a ready market for these assets existed. The value of our common stock could be harmed if our determinations regarding the fair value of these assets were materially higher than the values that we ultimately realize upon their disposal.

 

Valuations of certain assets may be difficult to obtain or unreliable. In general, third-party dealers and pricing services heavily disclaim their valuations. Dealers may claim to furnish valuations only as an accommodation and without special compensation, and so they may disclaim any and all liability for any direct, incidental or consequential damages arising out of any inaccuracy or incompleteness in valuations, including any act of negligence or breach of any warranty. Depending on the complexity and illiquidity of an asset, valuations of the same asset can vary substantially from one dealer or pricing service to another. Therefore, conflicts of interest exist to the extent that we are involved in the determination of the fair value of our investments. Additionally, our results of operations for a given period could be harmed if our determinations regarding the fair value of these investments were materially higher than the values that we ultimately realize upon their disposal. The valuation process has been particularly challenging recently as market events have made valuations of certain assets more difficult, unpredictable and volatile.

 

If we refinance existing loans at lower rates, the corresponding reduction in interest income and decline in the value of such loans may harm our results of operations.

 

Substantially all of the variable rate loans we own contain provisions for interest rate floors, which have allowed us to benefit from interest rate terms in excess of the current Prime rate. However, given current market conditions and the likely necessity to extend loans to 24-month terms, or longer, we have negotiated in the past, and expect to continue to renegotiate in the future, certain of the commercial mortgage loans in our portfolio at terms that are more reflective of current market rates, which may be lower than current contractual rates. The corresponding reduction in interest income and decline in the value of such loans may harm our results of operations.

 

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Increases in interest rates could adversely affect the value of our assets and cause our interest expense to increase, which could result in reduced earnings or losses and negatively affect our profitability as well as the cash available for distribution to our stockholders and the value of our securities.

 

Certain of our assets will generally decline in value if long-term interest rates increase. Declines in market value may ultimately reduce earnings or result in losses to us, which may negatively affect our business. A significant risk associated with our target assets is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates increased significantly, the market value of these investments would decline, and the duration and weighted average life of the investments would increase.

 

In addition, in a period of rising interest rates, our operating results will depend in large part on the difference between the income from our assets and financing costs. We anticipate that, in most cases, the income from such assets will respond more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest income, which is the difference between the interest income we earn on our interest-earning investments and the interest expense we incur in financing these assets. Increases in these rates will tend to decrease our net income and the market value of our assets.

 

Rising interest rates may also cause our target assets that were originated or acquired prior to an interest rate increase to provide yields that are below prevailing market interest rates. If rising interest rates cause us to be unable to acquire a sufficient volume of our target assets with a yield that is above our borrowing cost, our ability to satisfy our investment objectives and to generate income and pay dividends may be harmed. An increase in interest rates may cause a decrease in the volume of certain of our target assets, which could harm our ability to acquire target assets that satisfy our investment objectives and to generate income and make distributions to our stockholders.

 

The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.” Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because we expect our investments, on average, generally will bear interest based on longer-term rates than our borrowings, a flattening of the yield curve would tend to decrease our net income and the market value of our net assets. Additionally, to the extent cash flows from assets that return scheduled and unscheduled principal are reinvested, the spread between the yields on the assets and available borrowing rates may decline, which would likely decrease our net income. It is also possible that short-term interest rates may exceed longer-term interest rates (a yield curve inversion), in which event our borrowing costs may exceed our interest income and we could incur operating losses. As a result of the foregoing, significant fluctuations in interest rates could harm affect our results of operations, financial conditions, our ability to make dividends to our stockholders and the value of our securities.

 

An increase in prepayment rates on our loans or the risk of prepayments as a result of declining interest rates could reduce the value of our loans or require us to invest in assets with lower yields than existing investments.

 

The value of our assets may be harmed by prepayment rates on mortgage loans. If we purchase assets at a premium to par value, when borrowers prepay their mortgage loans faster than expected, these prepayments may reduce the expected yield on such loans because we will have to amortize the related premium on an accelerated basis. Our loans do not currently provide for any prepayment penalties or fees. Conversely, if we purchase assets at a discount to par value, when borrowers prepay their mortgage loans slower than expected, the decrease in corresponding prepayments on the mortgage assets may reduce the expected yield on such loans because we will not be able to accrete the related discount as quickly as originally anticipated. Prepayment rates on loans may be affected by a number of factors, including, without limitation, the availability of mortgage credit, the relative economic vitality of the geographic area in which the related properties are located, the servicing of the mortgage loans, possible changes in tax laws, other opportunities for investment, and other economic, social, geographic, demographic, legal and other factors beyond our control. Consequently, such prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from prepayment or similar risks. In periods of declining interest rates, prepayment rates on mortgage loans generally increase. If general interest rates decline at the same time, we are likely to reinvest the proceeds of such prepayments received during such periods in assets yielding less than the yields on the assets that were prepaid. In addition, as a result of the risk of prepayment, the market value of the prepaid assets may benefit less than other fixed income assets from declining interest rates.

 

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Our loans generally contain provisions for balloon payments upon maturity, which are riskier than loans with fully amortized payments and which increases the likelihood that a borrower may default on the loan.

 

Substantially all of our existing loans provide for monthly payment of interest only with a “balloon” payment of principal payable in full upon maturity of the loan. To the extent that a borrower has an obligation to pay us mortgage loan principal in a large lump sum payment, its ability to repay the loan may depend upon its ability to sell the property, obtain suitable refinancing or otherwise raise a substantial amount of cash. A borrower may not have sufficient resources available to make a balloon payment when it becomes due. As a result, these loans may involve a higher risk of default than amortizing loans.

 

Competition for buyers of real estate that we own, or for permanent take-out financing for our borrowers, places severe pressure on asset values, and we may not be able to realize the full value of any of our assets as a result.

 

The industry in which we operate is serviced primarily by conventional mortgage lenders and loan investors, which include commercial banks, insurance companies, mortgage brokers, pension funds, and private and other institutional lenders. There are also a relatively smaller number of non-conventional lenders that are similar to us. If we resume lending operations, we expect to compete with these same lenders as well as new entrants to the competitive landscape who are also focused on originating and acquiring commercial mortgage loans. We continue to compete with many market participants. Additionally, as we seek to locate purchasers for real estate we have acquired, or for permanent take-out financing for our borrowers, we are competing with a large number of persons and entities that have acquired real estate, whether through foreclosure or otherwise, and that have originated commercial mortgage loans, in the past few years. Many of these persons and entities utilized leverage to purchase the real estate or fund the loans, and many are selling collateral or accepting permanent take-out financing worth less than the original principal investment in order to generate liquidity and satisfy margin calls or other regulatory requirements. If we are not able to compete successfully, our ability to realize value from our existing loans may be harmed or delayed, and we may not be able to grow our asset portfolio.

 

Our historical focus on originating and acquiring construction loans exposes us to risks associated with the uncertainty of completion of the underlying project, which may result in losses on those loans.

 

We have historically originated and acquired, and may continue to originate and acquire, construction loans, which are inherently risky because the collateral securing the loan typically has not been built or is only partially built. As a result, if we do not fund our entire commitment on a construction loan, or if a borrower otherwise fails to complete the construction of a project, there could be adverse consequences to us associated with the loan, including: a loss of the potential value of the property securing the loan, especially if the borrower is unable to raise funds to complete it from other sources; claims against us for failure to perform our obligations as a lender under the loan documents; increased costs for the borrower that the borrower is unable to pay, that could lead to default on the loan; a bankruptcy filing by the borrower that could make it difficult to collect on the loan on a timely basis, if at all; and abandonment by the borrower of the collateral for our loan, which could significantly decrease the value of the collateral.

 

Risks of cost overruns and non-completion of renovation of the properties underlying rehabilitation loans may result in losses.

  

We have historically originated and acquired, and may continue to originate and acquire, rehabilitation loans. The renovation, refurbishment or expansion by a borrower of a mortgaged property involves risks of cost overruns and non-completion. Estimates of the costs of improvements to bring an acquired property up to standards established for the market position intended for that property may prove inaccurate. Other risks may include: rehabilitation costs exceeding original estimates, possibly making a project uneconomical; environmental risks; and rehabilitation and subsequent leasing of the property not being completed on schedule. If such renovation is not completed in a timely manner, or if renovation costs are more than expected, the borrower may experience a prolonged impairment of net operating income and may not be able to make payments to us on our loan on a timely basis or at all, which could result in significant losses to us.

 

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We may acquire non-Agency residential mortgage-backed securities, or RMBS, collateralized by subprime and Alt A mortgage loans, which are subject to increased risks that could result in losses.

 

We may acquire non-Agency RMBS, which are backed by residential real estate property but, in contrast to Agency RMBS, their principal and interest are not guaranteed by federally chartered entities such as the Federal National Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage Corporation, or Freddie Mac and, in the case of the Government National Mortgage Association, or Ginnie Mae, the U.S. Government. We may acquire non-Agency RMBS backed by collateral pools of mortgage loans that have been originated using underwriting standards that are less restrictive than those used in underwriting “prime mortgage loans” and “Alt A mortgage loans.” These lower standards include mortgage loans made to borrowers having imperfect or impaired credit histories, mortgage loans where the amount of the loan at origination is 80% or more of the value of the mortgage property, mortgage loans made to borrowers with low credit scores, mortgage loans made to borrowers who have other debt that represents a large portion of their income and mortgage loans made to borrowers whose income is not required to be disclosed or verified. Due to current economic conditions, including fluctuations in interest rates and lower home prices, as well as aggressive lending practices, subprime mortgage loans have in recent periods experienced increased rates of delinquency, foreclosure, bankruptcy and loss, and they are likely to continue to experience delinquency, foreclosure, bankruptcy and loss rates that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. Thus, because of the higher delinquency rates and losses associated with subprime mortgage loans, the performance of non-Agency RMBS backed by subprime mortgage loans that we may acquire could be adversely affected, which could materially and adversely impact our results of operations, financial condition and business.

 

Past or future actions to manage us through the recession may not be successful, in part or at all, and a failure of any one or more of these actions could harm us.

 

We have taken various actions to seek to manage us through the recession, including, among other things, marketing certain of our whole loans and participation interests for sale, and disposing of REO properties that were acquired by us through foreclosure. We also continue to evaluate other options. Many of the challenges being faced by us are beyond our control, including a lack of adequate lender credit availability in the marketplace, the general illiquidity in financial markets in the United States, and the decline in real estate prices and the prices of real estate-related assets. These or other actions we may take may not be successful, in part or at all, and a failure of any one or more of these actions could harm us.

 

Our loans and real estate assets are concentrated geographically and a further downturn in the economies or markets in which we operate could harm our asset values.

 

We have commercial and residential mortgage loans and real property in Arizona, California, New Mexico, Idaho, and Utah, and previously in Texas and Nevada. Declines in general economic conditions and real estate markets in these states have been worse than in certain other areas of the United States and the world. Because we are generally not diversified geographically and are not required to observe any specific geographic diversification criteria, a further downturn in the economies of the states in which we own real estate or have commercial mortgage loans, or a further deterioration of the real estate market in these states, could harm our loan and real estate portfolio.

  

We may have difficulty protecting our rights as a secured lender, which could reduce the value or amount of collateral available to us upon foreclosure and harm our business.

 

We believe that our loan documents enable us to enforce our rights thereunder with our borrowers. However, the rights of borrowers and the rights of other secured lenders may limit our practical realization of those benefits. For example:

 

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  · Foreclosure is subject to the delays in the legal processes involved. Judicial foreclosure could involve protracted litigation. Although we expect to generally use non-judicial foreclosure, which is generally quicker, our collateral may deteriorate and decrease in value during any delay in the foreclosure process.
  · The borrower’s right of redemption following foreclosure proceedings can delay or deter the sale of our collateral and can, for practical purposes, require us to own and manage any property acquired through foreclosure for an extended period of time.
  · Unforeseen environmental hazards may subject us to unexpected liability and procedural delays in exercising our rights.
  · The rights of junior secured creditors in the same property can create procedural hurdles for us when we foreclose on collateral.
  · We may not be able to obtain a deficiency judgment after we foreclose on collateral. Even if a deficiency judgment is obtained, it may be difficult or impossible to collect on such a judgment.
  · State and federal bankruptcy laws can temporarily prevent us from pursuing any actions against a borrower or guarantor, regardless of the progress in any suits or proceedings and can, at times, permit our borrowers to incur liens with greater priority than the liens held by us.
  · Lawsuits alleging lender liabilities, regardless of the merit of such claims, may delay or preclude foreclosure.

We may be subject to substantial liabilities if claims are made under lender liability laws.

 

A number of judicial decisions have upheld the right of borrowers to sue lending institutions on the basis of various evolving legal theories, collectively termed “lender liability.” Generally, lender liability is founded on the premise that a lender has either violated a duty, whether implied or contractual, of good faith and fair dealing owed to the borrower or has assumed a degree of control over the borrower resulting in the creation of a fiduciary duty by the lender to the borrower or its other creditors or stockholders. Such claims may arise and we may be subject to significant liability if a claim of this type did arise.

 

If potential losses are not covered by insurance, we could lose the capital invested in the damaged properties as well as the anticipated future cash flows from the loans secured by those properties.

 

Through foreclosure, as a lender, we have acquired a substantial number of real property assets. We carry comprehensive liability, fire, extended coverage, earthquake, business interruption and rental loss insurance covering all of our properties under various insurance policies. Furthermore, we maintain title insurance to protect us against defects affecting the security for our loans. We select policy specifications and insured limits which we believe to be appropriate given the perceived relative risk of loss, the cost of the coverage and our understanding of industry practice. We do not carry insurance for generally uninsured losses such as loss from riots, war or nuclear reactions. Our policies are insured subject to certain limitations, including, among others, large deductibles or co-payments and policy limits which may not be sufficient to cover losses. In addition, we may discontinue certain policies on some or all of our properties in the future if the cost of premiums for any of these policies exceeds, in our judgment, the value of the coverage relative to the perceived risk of loss. If we, or one or more of our borrowers, experiences a loss which is uninsured or which exceeds policy limits or which our carriers will not or cannot cover, we could lose the capital invested in REO assets or in loans secured by damaged properties as well as the anticipated future cash flows from the assets or loans secured by those properties (or, in the event of foreclosure, from those properties themselves).

  

We may be exposed to liabilities for risks associated with the use of hazardous substances on any of our properties.

 

Under various U.S. federal, state and local laws, an owner or operator of real property may become liable for the costs of removal of certain hazardous substances released on its property. These laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of such hazardous substances. The presence of hazardous substances may harm an owner’s ability to sell real estate or borrow using real estate as collateral. To the extent that an owner of a property underlying one of our loans becomes liable for removal costs, the ability of the owner to make payments to us may be reduced, which in turn may diminish the value of the relevant mortgage asset held by us and our ability to make distributions to our stockholders. If we acquire a property through foreclosure or otherwise, the presence of hazardous substances on such property may harm our ability to sell the property and we may incur substantial remediation costs, which could harm our results of operations, financial condition, our ability to make distributions to our stockholders and the value of our securities.

 

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Other Risk Factors

 

We may not be able to utilize our built-in losses as anticipated, which could result in greater than anticipated tax liabilities.

 

Due to the significant decline in the real estate markets in recent years, we believe that the tax basis of our existing assets exceeds the fair market value of such assets by approximately $166 million. In addition we had net operating loss carryforwards of approximately $217 million as of December 31, 2011. Subject to certain limitations, such “built-in losses” may be available to offset future taxable income and gain from our existing assets as well as potentially income and gain from new assets we acquire. Our ability to use our built-in losses is dependent upon our ability to generate taxable income in future periods. In addition, the use of our built-in losses is subject to various limitations. For example, there will be limitations on our ability to use our built-in losses or other net operating losses if we undergo a “change in ownership” for U.S. federal income tax purposes. In addition, it is possible that our built-in losses may not be fully available or usable in the manner anticipated. To the extent these limitations occurred or governmental challenges were asserted and sustained with respect to such built-in losses, we may not be permitted to use our built-in losses to offset our taxable income, in which case our tax liabilities could be greater than anticipated.

 

The decline in economic conditions and disruptions to markets may not improve for the foreseeable future, which could cause us to suffer continuing operating losses, adversely affect our liquidity, and create other business problems for us.

 

The global and U.S. economies experienced a rapid decline in 2008 and 2009 from which they have not recovered. The real estate and other markets suffered unprecedented disruptions, causing many major institutions to fail or require government intervention to avoid failure, which has placed severe pressure on liquidity and asset values. These conditions were brought about largely by the erosion of U.S. and global credit markets, including a significant and rapid deterioration of the mortgage lending and related real estate markets.

 

These events have caused, among other things, numerous foreclosures and an excess of residential housing inventory and finished residential lots, and a glut of stalled residential and commercial real estate projects. Excess inventory could result in a decline in the values of real estate that we own or that secures the loans we hold in our portfolio. This, in turn, could reduce the proceeds we realize upon sale and that are available to our borrowers to repay our portfolio mortgage loans.

 

The foregoing could result in defaults on our portfolio mortgage loans and might require us to record reserves with respect to non-accrual loans, write-down our REO assets, and realize credit losses with respect to our portfolio mortgage loans. These factors could harm our business, financial condition, results of operations and cash flows.

  

As a consequence of the difficult economic environment, we have recorded significant losses, resulting primarily from significant provisions for credit losses and impairment charges resulting in substantial decreases in the net carrying value of our assets. Economic conditions or the real estate and other markets generally may not improve in the near term, in which case we could continue to experience additional losses and write-downs of assets, and could face capital and liquidity constraints and other business challenges.

 

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We depend on key personnel and an error in judgment or the loss of their services could harm our business.

 

Our success depends upon the experience, skill, resources, relationships, contacts and continued efforts of certain key personnel. If any of these individuals were to make an error in judgment in conducting our operations, our business could be harmed. If any of these individuals were to cease employment with us, our business and operating results could suffer. Our future success also depends in large part upon our ability to hire and retain highly skilled managerial, operational and marketing personnel. Competition for such personnel is intense. Should we be unable to attract and retain such key personnel, our ability to make prudent investment decisions may be impaired, which could harm our results of operations and prospects.

 

We will face conflicts of interest that may arise with respect to our business activities and also may limit the allocation of investments to us.

 

We may face conflicts of interest with other funds managed by us. For example, one of our wholly-owned subsidiaries, SWI Management, LLC, or SWIM, is the manager of the SWI Fund and has obligations to the SWI Fund and its members pursuant to the operating agreement between SWIM and the SWI Fund. The SWI Fund, which had approximately $11.5 million under management as of December 31, 2011, is a real estate investment fund with target asset classes that are substantially similar to ours. The management fees we receive from SWIM for managing the SWI Fund may be less than the income we would receive from investment opportunities allocated to SWI Fund that we may have otherwise been able to invest in.

 

Any policy or procedural protections we adopt to address potential conflicts of interest may not adequately address all of the conflicts that may arise or may not address such conflicts in a manner that results in the allocation of a particular investment opportunity to us or is otherwise favorable to us. Since our executive officers are also executive officers of SWIM (or a committee thereof), the same personnel may determine the price and terms of the investments for both us and other entities managed by us or affiliated with our executive officers, and there can be no assurance that any procedural protections, such as obtaining market prices or other reliable indicators of value, will prevent the consideration we pay for these investments from exceeding the fair market value or ensure that we receive terms for a particular investment that are as favorable as those available to a third-party.

 

We may compensate broker-dealers to eliminate contingent claims under existing selling agreements, which could result in additional expense for us or dilution of our stockholders.

 

The Manager was also a party to selling agreements with certain broker-dealers who assisted the Manager in raising equity capital for us, which provided for a 2% selling commission and either a 25 or 50 basis point trailing commission. Pursuant to amendments to such selling agreements, certain broker-dealers representing approximately 97% of the Fund’s committed capital agreed to forego these amounts and accept, in lieu of such obligation, a pro rata portion (representing either the 25 or 50 basis points described above) of 50% of any amount “earned and received” by the Manager under the terms of the Fund’s operating agreement, which provided that the Manager receives 25% of any net proceeds (including late fees and penalties and excluding repayment of principal and contractual note interest rates) from the sale of a foreclosed asset. Because the operating agreement has been terminated pursuant to the Conversion Transactions, no fees will be payable to the Manager pursuant to the operating agreement, but the broker-dealers may argue that they should nonetheless receive from us 50% of any amounts “earned and received” that would have been otherwise payable to the Manager under the Fund’s operating agreement had the operating agreement still been in effect or, alternatively, that they are entitled to the trailing commission under the original selling agreement. Although we may terminate the selling agreements at any time (but not the commissions and additional compensation payable for certain investments or in connection with certain investors), we have not entered into any agreements, arrangements or understandings to terminate the selling agreement or any trailing obligations because we believe the relationships with the broker-dealers established through these selling agreements remain useful to our business. If we terminate the selling agreements, we may decide to compensate the broker-dealers to eliminate any residual contingent commission claims on gains or trailing commissions under the selling agreements or for future services provided by the broker-dealers through the issuance of warrants or equity, payment of fees or otherwise, which could result in additional expense for us or dilution of our stockholders.

 

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Accounting rules for certain of our assets are highly complex and involve significant judgment and assumptions, and changes in such rules, accounting interpretations or our assumptions could harm our ability to timely and accurately prepare our financial statements.

 

Accounting rules for commercial mortgage loan sales and securitizations, valuations of financial instruments, asset consolidations and other aspects of our anticipated operations are highly complex and involve significant judgment and assumptions. These complexities could lead to a delay in the preparation of financial information and the delivery of this information to our stockholders. Changes in accounting rules, interpretations or our assumptions could undermine our ability to prepare timely and accurate financial statements, which could result in a lack of investor confidence in our publicly filed information and could harm the market price of our common stock.

 

If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could cause us to fail to meet our reporting obligations or cause investors to lose confidence in our reported financial information, which could lead to a decline in the value of our common stock.

 

Substantial work has been required, and may continue to be required, to implement, document, assess, test and remediate our system of internal controls. This process has been and will continue to be both costly and challenging for us. Implementing any appropriate changes to our internal controls may entail substantial costs to modify our existing financial and accounting systems, take a significant period of time to complete, and distract us from the operation of our business. These changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or a consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could impair our ability to operate our business.

 

In addition, the existence of any material weakness in our internal control over financial reporting could also result in errors in our financial statements that could require us to restate our financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information, all of which could lead to a decline in the value of our common stock. We are required, pursuant to Section 404 of the Sarbanes-Oxley Act, to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting. This assessment includes disclosure of material weaknesses, if any, identified by our management in our internal control over financial reporting, although our auditors are not required to issue an attestation report on effectiveness of our internal controls. If in the future we are unable to assert that our internal control over financial reporting is effective, investors could lose confidence in the accuracy and completeness of our financial reports, which would have a material adverse effect on the price of our common stock.

 

Our ability to change our business, leverage and financing strategies without stockholder consent could result in harm to our financial condition, results of operations and ability to pay dividends to stockholders.

 

We may change our business and financing strategies without a vote of, or notice to, our stockholders, which could result in our making investments and engaging in business activities that are different from, and possibly riskier than, other businesses. In particular, a change in our business strategy, including the manner in which we allocate our resources across our commercial mortgage loans or the types of assets we seek to acquire, may increase our exposure to interest rate risk, default risk and real estate market fluctuations. In addition, we may in the future use leverage at times and in amounts deemed prudent by our management in its discretion, and such decisions would not be subject to stockholder approval. Changes to our strategies regarding the foregoing could harm our financial condition, results of operations and our ability to pay dividends to our stockholders.

 

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Risks Related to our Common Stock

 

We have not established a minimum dividend and distribution level and we may not have the ability to pay dividends and other distributions to you in the future.

 

We declared dividends of $0.03 per share to holders of record of our common stock for each of the quarters ended June 30, 2011, September 30, 2011 and December 31, 2011, and no dividends were declared or paid during 2010. We have not established a minimum distribution level and we may not be able to make any distributions at all. In addition, some of our distributions may include a return of capital. All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition and other factors as our board of directors may deem relevant from time to time, subject to the availability of legally available funds.

 

Under the terms of our loan agreement with NW Capital, during the eight quarters following the closing of the NW Capital loan on June 7, 2011, we can pay quarterly dividends to our common stockholders in an amount not to exceed 1% per annum of the net book value of the common stock as of the date of the NW Capital loan agreement. If the NW Capital loan has been converted into Series A preferred stock, the Certificate of Designation of the Series A preferred stock will limit our ability to pay dividends on the common stock. Generally, no dividend may be paid on the common stock during any fiscal year unless all accrued dividends on the Series A preferred stock have been paid in full. See Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities – Dividends” below for further discussion regarding limitations on our ability to declare and pay dividends to shareholders.

 

Offerings of debt securities, which would be senior to our common stock in liquidation, or equity securities, which would dilute our existing stockholders’ interests, may be senior to our common stock for the purposes of distributions, and may harm the market price of our common stock.

 

In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes, preferred stock or common stock, although our ability to obtain additional debt is limited under the terms of the NW Capital loan described elsewhere in this Form 10-K. The MOU described in Item 3. “Legal Proceedings” contemplates that we will make two additional offerings of debt securities. The terms of our charter documents do not preclude us from issuing additional debt or equity securities. Our certificate of incorporation permits our board of directors, without your approval, to authorize the issuance of common or preferred stock in connection with equity offerings, acquisitions of securities or other assets of companies, divide and issue shares of preferred stock in series and fix the voting power and any designations, preferences, and relative, participating, optional or other special rights of any preferred stock, including the issuance of shares of preferred stock that have preference rights over the common stock with respect to dividends, liquidation, voting and other matters or shares of common stock that have preference rights over your common stock with respect to voting. Additional equity offerings by us may dilute your interest in us or reduce the market price of our common stock, or both. Any preferred stock could have a preference on distribution payments that could limit our ability to make a distribution to our stockholders. If we issue additional debt securities, we could become more highly leveraged, resulting in (i) an increase in debt service that could harm our ability to make expected distributions to our stockholders, and (ii) an increased risk of default on our obligations. If we were to liquidate, holders of our debt and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets before the holders of our common stock. Except for the rights offering and note exchange required by the MOU, because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Thus, you will bear the risk that any future offerings by us could reduce the market price of our common stock and dilute your interest in us.

 

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Certain provisions of our certificate of incorporation, bylaws, debt instruments and the Delaware General Corporation Law could make it more difficult for a third-party to acquire us, even if doing so would benefit our stockholders.

 

Certain provisions of the Delaware General Corporation Law, or DGCL, may have the effect of deterring hostile takeovers or otherwise delaying or preventing changes in our management or in the control of our company, including transactions in which our stockholders might otherwise receive a premium over the fair market value of their securities. In particular, Section 203 of the DGCL may, under certain circumstances, make it more difficult for a person who would be an “interested stockholder” (defined generally as a person with 15% or more of a corporation’s outstanding voting stock) to effect a “business combination” (defined generally as mergers, consolidations and certain other transactions, including sales, leases or other dispositions of assets with an aggregate market value equal to 10% or more of the aggregate market value of the corporation) with the corporation for a three-year period. Under Section 203, a corporation may under certain circumstances avoid the restrictions imposed by Section 203. Moreover, a corporation’s certificate of incorporation or bylaws may exclude a corporation from the restrictions imposed by Section 203. We have not made this election, and accordingly we are subject to the restrictions of Section 203 of the DGCL. Furthermore, upon any “change of control” transaction, the restrictions on transfer applicable to the shares of our Class B and Class C common stock will terminate, which could act to discourage certain change of control transactions.

 

Item 1B.                 UNRESOLVED STAFF COMMENTS.

 

The SEC provided us a comment letter on March 27, 2012 with respect to certain required disclosures in our periodic filings. Specifically, they have requested us to include certain required financial disclosures, including audited financial statements relative to our largest non-performing loan that is secured by certain operating properties. We have omitted such disclosure in the accompanying consolidated financial statements because, in our opinion, such information may not be reliable. In addition, the SEC has requested that we modify certain of our disclosures pertaining to borrower concentrations, although we have not revised such disclosures because we believe such amended disclosures may be prejudicial from a business and competitive perspective while providing little, if any, beneficial disclosure to the Company’s existing and prospective stockholders. While we believe our the accompanying consolidated financial statements are fairly presented, we may be required to amend this 10-K filing pending our resolution of such matters with SEC staff.

 

Item 2.                    PROPERTIES.

 

The majority of properties owned by us were acquired through foreclosure of various loans in our loan portfolio.  In addition, we lease our primary executive and administrative offices, which are located in Scottsdale, Arizona. Our office is comprised of approximately 28,000 square feet of office space under a lease that expires in 2017, although we are evaluating our facility needs in light of economic conditions. In March 2012, we executed a lease for new office space. We believe that our office facilities are currently adequate for us to conduct present business activities.

 

A description of our REO and operating properties with a total net carrying value of $95.5 million as of December 31, 2011 follows (dollar amounts in thousands):

 

Description   Location  Date Acquired    Units/Acres 
        
115 residential lots and commercial development   Apple Valley, CA  1/23/08     78.5 acres 
Vacant land planned for residential development   Rancho Mirage, CA  3/26/08     20 acres 
Vacant land planned for residential development   Dewey, AZ  3/28/08     160 acres 
Residential lot subdivision located on the Bolivar Peninsula   Crystal Beach, TX  4/1/08     413 lots 
Vacant land planned for development of 838 residential lots in housing subdivision   Liberty Hill, TX  7/1/08     232 acres 
160.67 acres of vacant land and 57.18 acres of land having a preliminary plat   Casa Grande, AZ  7/8/08     218 acres 
Vacant land   Pinal County, AZ  7/8/08     160 acres 
Finished lots within the Flagstaff Ranch Golf Community   Flagstaff, AZ  7/9/08     59 lots 
Improved, partially improved, and unimproved lots, as well as 3.9 acres of commercial property   Bullhead City, AZ  3/14/08     79 lots and 3.9 acres commercial 
Residential land planned for 205 residential lots   Flagstaff, AZ  2/3/09     47.4 acres 
Vacant land planned for commercial development   Phoenix, AZ  3/5/09     3.47 acres 

 

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Vacant land planned for commercial development   Apple Valley, MN   5/15/09   15 acres  
Vacant land planned for mixed-use development   Inver Grove Heights, MN   7/29/09   39.5 acres  
9-story medical office building, 33% leased   Stafford, TX   7/7/09   193,000 square feet  
A 14.76% interest in an LLC which owns 188 acres of vacant land zoned for residential and commercial development   Phoenix, AZ   10/27/09   27.8 acres (14.76% of 188 acres)  
A 14.76% interest in an LLC which owns 80 acres of vacant land zoned for general rural usage   Pinal County, AZ   10/27/09   11.8 acres (14.76% of 80 acres)  
9 finished residential lots within a 38-lot subdivision ranging in size from 2.18 acres to 6.39 acres   Sedona, AZ   12/31/09   9 lots  
Vacant land planned for a residential  subdivision   Denton County, TX   1/5/10   330 acres  
Undeveloped land planned for mixed-use development   Denton County, TX   1/5/10   47.3 acres  
Vacant land being considered for residential development   Brazoria County, TX   1/5/10   188 acres  
101-unit assisted living facility   Las Vegas, NV   1/29/10   101 units  
68-unit assisted living facility   Phoenix, AZ   3/16/10   68 units  
Single lot within Laughlin Ranch community   Bullhead City, AZ   6/19/10   .5 acres  
252 lots within the Simonton Ranch Master Planned Community   Camp Verde, AZ   7/15/10   64.84 acres  
Vacant land planned for Cottonwood Retail Center   Casa Grande, AZ   7/14/10   8.8 acres  
33 townhome lots planned for 2 bedroom units along a small lake   Yavapai County, AZ   7/22/10   1.56 acres  
Vacant land slated for intermediate commercial   Fountain Hills, AZ   7/23/10   4.01 acres  
Vacant land and retails buildings   Tempe, AZ   9/15/10   3.74 acres  
Vacant land zoned for residential development   Canyon County, ID   10/21/10   398.64 acres  
Vacant land   Buckeye, AZ   10/21/10   93.59 acres  
Vacant land   Buckeye, AZ   10/21/10   77.50 acres  
93 finished single-family residential lots   Pinal County, AZ   11/16/10   93 lots  
               
Vacant land - 1.56 acre commercial, 6.24 acre mixed residential/commercial   Daly City, CA   12/10/10   7.80 acres  
Vacant land - undeveloped land, with initial approvals for development as a master planned community   Tucson, AZ   1/6/11   579.18 acres  
Three story office building   Albuquerque, NM   2/24/11    0.98 acres  
Partially completed single family residential lots   Fresno, CA   9/15/11    38.06 acres  
Vacant land zoned for low density residential   Tulare County, CA   9/16/11    38.04 acres  
331 residential lots   Sacramento, CA   9/21/11    51.7 acres  
207 finished lots and 5 completed homes   Tulare County, CA   10/14/11    60.5 acres  
Vacant land parcel   Coconino County, AZ   10/28/11   2.91 acres  
97 finished residential lots and vacant land   Canyon County, ID   11/8/11   126.5 acres  
               
Total Net Carrying Value at December 31, 2011           $ 95,476  
               
Vacant undeveloped land   Mesa, AZ   1/11/12   5.41 acres  
Vacant undeveloped land   Yavapai County, AZ   1/18/12   5.1 acres  
177 finished residential lots   Bullhead City, AZ   2/28/12   53.85 acres  
18-hole championship golf course and clubhouse   Bullhead City, AZ   2/28/12   243.18 acres  
Total Net Carrying Value as of Report Date           $ 103,980  

 

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Properties by Development Classification

 

The following summarizes our REO properties by development classification as of December 31, 2011 (in thousands except unit data):

 

Properties Owned by Classification  #   Value 
Pre-entitled land for investment   4   $6,891 
Pre-entitled land processing entitlements   12    19,832 
Entitled property land held for investment   9    17,680 
Entitled land IMH funded infrastructure only construction   4    10,413 
Entitled land IMH funded vertical construction   1    2,408 
Entitled improved land positioned for future construction   7    10,341 
Existing structure held for investment   3    8,300 
Existing structure with operations   1    19,611 
Total as of December 31, 2011   41   $95,476 

 

Other information about our REO assets is included in Note 6 of the accompanying consolidated financial statements.

 

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Item 3. LEGAL PROCEEDINGS.

  

We may be a party to litigation as the plaintiff or defendant in the ordinary course of business in connection with loans that go into default, or for other reasons, including, without limitation, claims or judicial actions relating to the Conversion Transactions. While various asserted and unasserted claims exist, resolution of these matters cannot be predicted with certainty and, we believe, based upon currently available information, that the final outcome of such matters will not have a material adverse effect, if any, on our results of operations or financial condition.

 

As we have previously reported, various disputes have arisen relating to the consent solicitation/prospectus used in connection with seeking member approval of the Conversion Transactions. Three proposed class action lawsuits were subsequently filed in the Delaware Court of Chancery (on May 25, 2010, June 15, 2010 and June 17, 2010) against us and certain affiliated individuals and entities. The May 25 and June 15, 2010 lawsuits contain similar allegations, claiming, in general, that fiduciary duties owed to Fund members and to the Fund were breached because, among other things, the Conversion Transactions were unfair to Fund members, constituted self-dealing and because the information provided about the Conversion Transactions and related disclosures was false and misleading. The June 17, 2010 lawsuit focuses on whether the Conversion Transactions constitute a “roll up” transaction under the Fund’s operating agreement, and seeks damages for breach of the operating agreement. We and our affiliated co-defendants dispute these claims and have vigorously defended ourselves in these actions.

 

As we previously reported, an action also was filed on June 14, 2010 in the Delaware Court of Chancery against us and certain affiliated individuals and entities by Fund members Ronald Tucek and Cliff Ratliff and LGM Capital Partners, LLC (also known as The Committee to Protect IMH Secured Loan Fund, LLC). This lawsuit claims that certain fiduciary duties owed to Fund members and to the Fund were breached during the proxy solicitation for the Conversion Transactions.  As described below, these claims were consolidated into the putative class action lawsuit captioned In re IMH Secured Loan Fund Unitholders Litigation pending in the Court of Chancery in the State of Delaware against us, certain affiliated and predecessor entities, and certain former and current of our officers and directors (“Litigation”) as Count Six wherein they alleged a unique remedy for proxy expenses. On or about February 22, 2012, we entered into an agreement in principle with LGM Capital Partners, LLC to resolve its claims set forth in Count Six of the Litigation for an amount of $75,000 and a full and final release of all of its claims.

 

As previously reported, the parties in the four above-referenced actions were ordered to consolidate the four actions for all purposes by the Delaware Court of Chancery, which also ordered that a consolidated complaint be filed, to be followed by consolidated discovery, and designated the plaintiffs’ counsel from the May 25, 2010 and June 17, 2010 lawsuits as co-lead plaintiffs’ counsel. The consolidated class action complaint was filed on December 17, 2010. After defendants filed a motion to dismiss that complaint, the Chancery Court ordered plaintiffs to file an amended complaint. On July 15, 2011, plaintiffs filed a new amended complaint entitled “Amended and Supplemental Consolidated Class Action Complaint” (“ACC”). On August 29, 2011, defendants filed a Motion to Dismiss in Part the ACC. Plaintiffs filed their brief in opposition on September 28, 2011 and defendants filed their reply brief on November 2, 2011. Oral argument on our motion to dismiss was scheduled to take place on February 13, 2012. We and our affiliated co-defendants dispute the claims in this lawsuit and have vigorously defended ourselves in that litigation.

 

On January 31, 2012, we reached a tentative settlement in principle to resolve all claims asserted by the class plaintiffs in the Litigation, including the ACC, other than the claims of one plaintiff. The tentative settlement in principle, memorialized in a Memorandum of Understanding (“MOU”) previously filed with our 8-K dated February 6, 2012, is subject to certain class certification conditions, confirmatory discovery and final court approval (including a fairness hearing). The MOU contemplates a full release and settlement of all claims, other than the claims of the one non-settling plaintiff, against us and the other defendants in connection with the claims made in the Litigation. The following are some of the key elements of the tentative settlement:

 

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·we will offer $20.0 million of 4% five-year subordinated notes to members of the Class in exchange for 2,493,765 shares of IMH common stock at an exchange rate of $8.02 per share; 
·we will offer to Class members that are accredited investors $10.0 million of convertible notes with the same financial terms as the convertible notes previously issued to NW Capital;
·we will deposit $1.6 million in cash into a settlement escrow account (less $0.23 million to be held in a reserve escrow account that is available for use by us to fund our defense costs for other unresolved litigation) which will be distributed (after payment of notice and administration costs and any amounts awarded by the Court for attorneys' fees and expense) to Class members in proportion to the number of our shares held by them as of June 23, 2010;
·we will enact certain agreed upon corporate governance enhancements, including the appointment of two independent directors to our board of directors upon satisfaction of certain conditions (but in no event prior to December 31, 2012) and the establishment of a five-person investor advisory committee (which may not be dissolved until such time as we have established a seven-member board of directors with at least a majority of independent directors); and
·provides additional restrictions on the future sale or redemption of our common stock held by certain of our executive officers.

 

We have vigorously denied, and continue to vigorously deny, that we have committed any violation of law or engaged in any of the wrongful acts that were alleged in the Litigation, but we believe it is in our best interests and the interests of our stockholders to eliminate the burden and expense of further litigation and to put the claims that were or could have been asserted to rest.  

 

There can be no assurance that the court will approve the tentative settlement in principle. Further, the judicial process to ultimately settle this action is estimated to take a minimum of six to nine months or longer. If not approved, the tentative settlement as outlined in the MOU may be terminated and we will continue to vigorously defend this action.

 

As previously reported, on December 29, 2010, an action was filed in the Superior Court of Arizona, Maricopa County, by purported Fund members David Kurtz, David L. Kurtz, P.C., Lee Holland, William Kurtz, and Suzanne Sullivan against us and certain affiliated individuals and entities. The plaintiffs made numerous allegations against the defendants in that action, including allegations that fiduciary duties owed to Fund members and to the Fund were breached because the Conversion Transactions were unfair to Fund members, constituted self-dealing, and because information provided about the Conversion Transactions and related disclosures was false and misleading. In addition, the plaintiffs alleged that the Fund wrongfully rejected the defendants’ books and records requests, defamed David Kurtz, and wrongfully brought a civil action related to the Conversion Transactions. The plaintiffs also claim that IMH breached an agreement to settle all of the Kurtz claims for $2 million. The plaintiffs seek the return of their original investments in the Fund, damages for defamation and invasion of privacy, punitive damages, and their attorneys’ fees and costs totaling approximately $2.2 million, plus an unspecified amount of punitive damages.  Defendants filed a motion to stay this lawsuit in favor of the consolidated action pending in Delaware.  As previously reported, the Court granted defendants’ motion to stay and stayed this action pending the outcome of the above-referenced consolidated action pending in the Delaware Court of Chancery.  Plaintiffs’ motion for reconsideration of the Court’s denial of their motion to stay was denied by the Court on September 19, 2011, reaffirming the stay of this case pending the outcome of the Delaware litigation.   We dispute plaintiffs’ allegations and we intend to defend ourselves vigorously against these claims if this action is recommenced. The pending settlement in the Delaware Litigation described in the MOU should dispose of some of the Kurtz claims, but various other claims will remain.  The dismissed claims will streamline the litigation but will not necessarily reduce the amount of damages being claimed by Kurtz.

 

On September 29, 2011, an action was filed in the 268th Judicial District Court of Fort Bend County, Texas by Atrium Medical Centers LP, against us and affiliated named entities. The plaintiff is a tenant in one of our rental properties and alleged loss of profit and cost of delay in performance concerning certain maintenance and repairs at the rental property. On March 1, 2012, we entered into a settlement agreement with the tenant, the key terms of which included the plaintiff/tenant entering into a new lease in exchange for rental concessions from the Company.

 

48
 

  

On June 8, 2010, we received a copy of a formal order of investigation from the SEC dated May 19, 2010 authorizing an investigation into possible violations of the federal securities laws. As previously reported, the Company has received subpoenas requesting that we produce certain documents and information. We are cooperating fully with the SEC investigation. The Company cannot predict the scope, timing, or outcome of the SEC investigation at this time.

 

We believe that we have always been, and currently are in compliance with all regulations that materially affect us and our operations, and that we have acted in accordance with our operating agreement prior to its termination as a result of the Conversion Transactions. However, there can be no guarantee that this is the case or that the above-described or other matters will be resolved favorably, or that we or our affiliates may not incur additional significant legal and other defense costs, damage or settlement payments, regulatory fines, or limitations or prohibitions relating to our or our affiliates’ business activities, any of which could harm our operations.

 

Item 4. Mine Safety Disclosures

  

Not applicable

 

49
 

 

PART II

 

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

  

We are required to file reports with the SEC in accordance with Section 12(g) of the Exchange Act. Our shares have not been traded or quoted on any exchange or quotation system. There is no public market in which shareholders may sell their shares.

 

Shareholders

 

As of March 30, 2012, there were approximately 4,662 holders of record for each of our outstanding Classes of B-1, B-2 and B-3 common stock totaling 15,357,853 shares, three holders of record of our outstanding 627,579 shares of Class B-4 common stock, 424 holders of record of our outstanding 838,448 shares of Class C common stock, and one holder of record of our outstanding 50,000 shares of unrestricted common stock.

 

Dividends

 

The declaration and amount of dividends is subject to the availability of legally distributable funds, the discretion of our board of directors and restrictions to pay dividends under the terms of the NW Capital loan agreement and the Certificate of Designation for the Series A Preferred Stock, once any such Series A preferred stock is outstanding. During the years ended December 31, 2011, we declared dividends of $0.03 per share during each of the quarters ended June 30, 2011, September 30, 2011 and December 31, 2011. There were no dividends declared or paid during the year ended December 31, 2010.

 

Under the terms of our loan agreement with NW Capital, during the eight quarters following the closing of the NW Capital loan on June 7, 2011, we can pay quarterly dividends to our common stockholders in an amount not to exceed 1% per annum of the net book value of the common stock as of the date of the NW Capital loan agreement. If the NW Capital loan has been converted into Series A preferred stock, the Certificate of Designation of the Series A preferred stock will limit our ability to pay dividends on the common stock. Generally, no dividend may be paid on the common stock during any fiscal year unless all accrued dividends on the Series A preferred stock have been paid in full. However, if no default event has occurred (other than the non-payment of dividends on the Series A preferred stock) and subject to certain other conditions, if the conversion date of the NW Capital loan is prior to the first eight quarters after the NW Capital loan closing, for the balance of the first eight quarters following the NW Capital loan closing, we may pay per share dividends to holders of common stock out of legally available funds up to an amount equal to 1% per annum of the net book value of the common stock as of December 31 of the immediately preceding year, pro-rated for any portion of a year in which dividends may not be paid, regardless of whether dividends are paid on the Series A preferred stock. The directors elected by holders of the Series A preferred stock can also approve other payments of dividends on the common securities. Subject to the availability of legally distributable funds, we anticipate that we will pay dividends totaling $1.6 million during the year ending December 31, 2012.

 

Recent Sales of Unregistered Securities

 

Our common stock is not currently listed or traded on any exchange. Because of the lack of an established market for our common shares, we cannot estimate the prices at which our common shares would trade in an active market.

 

Mr. Albers, our former CEO, sold 1,423 shares of B-1 common stock, 1,423 shares of B-2 common stock, 2,849 shares of B-3 common stock and 313,789 shares of B-4 common stock for $8.02 per share to an NW Capital affiliate in June 2011 in connection with his separation from employment with us. See “Item 11. Executive Compensation — Compensation Discussion and Analysis – Restriction on Shares of Class B-4 Common Stock” for a further description of this transaction.

 

50
 

  

As of December 31, 2011, the NW Capital loan that we entered into in June of 2011 is convertible into approximately 5,219,207 shares of Series A Preferred Stock (subject to increase upon NW Capital’s deferral of accrued interest), which will then be convertible into an equal number of shares of our common stock. See Note 9 of the Notes to our consolidated financial statements for a more detailed description of the NW Capital loan and the Series A preferred stock. We relied on the exemption provided in Section 4(2) of the Securities Act for the issuance of the convertible debt to NW Capital.

 

ITH Partners was granted 50,000 shares of common stock in connection with the placement of the senior convertible loan with NW Capital in June 2011. ITH Partners was also granted options to purchase 150,000 shares of our common stock within 10 years of the grant date at an exercise price per share of $9.58, the conversion price of the NW Capital convertible loan, with vesting to occur in equal monthly installments over a 36 month period beginning August 2011. We relied on the exemption provided in Section 4(2) of the Securities Act for the issuance of these securities to ITH Partners. Additionally, an employee was granted 14,114 shares of B-3 common stock during the year ended December 31, 2011 in connection with his employment agreement. We relied on the exemption provided in Section 4(2) of the Securities Act for the issuance of these securities to the employee.

 

Equity Compensation Plan Information

 

During the year ended December 31, 2011, we granted stock options to our executives, certain employees and certain consultants under our approved 2010 Stock Incentive Plan. The stock options have a ten year term, vest over a three year period and have an exercise price of $9.58 per share. Following is information with respect to outstanding options, warrants and rights as of December 31, 2011:

  

Plan Category  Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
   Weighted-average
exercise price of
outstanding
options, warrants
and rights
   Number of securities remaining
available for future issuance
under equity compensation
plans (excluding securities
reflected in column (a)
 
   (a)   (b)   (c) 
Equity compensation plans approved by security holders   800,000   $9.58    400,000 
                
Equity compensation plans  not approved by security holders   -    -    - 
                
Total   800,000         400,000 

 

Issuer Purchases of Equity Securities

 

There were no purchases of our common stock by us or any “affiliated purchasers” (as defined in 240.10b-18(a)(3) of the Exchange Act) during the year ended December 31, 2011.

 

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Item 6.                    SELECTED FINANCIAL DATA

 

The following tables show financial data of IMH Financial Corporation (as successor to the Fund), including the results of operations from the June 18, 2010, the acquisition date of the Manager and Holdings, for the periods indicated. The summary financial data are derived from our audited consolidated financial statements and other financial records. The summary consolidated statements of financial condition data as of December 31, 2011 and 2010 and the summary consolidated statements of income data for each of the three years in the period ended December 31, 2011 have been derived from our audited consolidated financial statements and accompanying notes included elsewhere in this Form 10-K and should be read together with those consolidated financial statements and accompanying notes. The summary consolidated statements of financial condition data as of December 31, 2009, 2008 and 2007, and the summary consolidated statements of income data for the years ended December 31, 2008 and 2007 have been derived from audited consolidated financial statements not included in this Form 10-K. The summary consolidated financial and other data should be read together with the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with our consolidated financial statements and accompanying notes included elsewhere in this Form 10-K. Dollar amounts are presented in thousands.

 

52
 

  

   As of and for the Years Ended December 31, 
   2011   2010   2009   2008   2007 
Summary balance sheet items                         
Cash and cash equivalents  $21,322   $831   $963   $23,815   $73,604 
Mortgage loan principal outstanding   245,190    417,340    544,448    613,854    510,797 
Valuation allowance   (141,687)   (294,140)   (330,428)   (300,310)   (1,900)
Mortgage loans held for sale, net of valuation allowance   103,503    123,200    214,020    313,544    508,897 
Real estate held for development, net   44,920    36,661    69,085    62,781    - 
Real estate held for sale, net   30,945    31,830    12,082    -    - 
Operating Properties Acquired through Foreclosure   19,611    20,981    23,064    -    - 
Total assets   240,327    231,330    337,796    414,804    590,559 
Long term obligations   60,315    16,458    4,182    -    - 
Total liabilities   75,072    29,967    15,928    6,753    13,726 
Total stockholders' equity  $165,255   $201,363   $321,868   $408,051   $576,833 
                          
Summary income statement                         
Mortgage loan income  $1,327   $1,454   $21,339   $65,497   $47,929 
Total revenue   3,733    3,756    22,522    67,420    49,763 
Operating expenses (excluding interest expense)   27,327    24,415    9,433    2,454    968 
Provision for credit losses   1,000    47,454    79,299    296,000    1,900 
Impairment of real estate owned   1,529    46,856    8,000    27,175    - 
Total costs and expenses   38,928    120,796    96,999    325,707    4,088 
Net income (loss) from continuing operations  $(35,195)  $(117,040)  $(74,477)  $(258,287)  $45,675 
                          
Earnings/Dividends per share data                         
Net income (loss) from continuing operations per share  $(2.09)  $(7.05)  $(4.63)  $(17.41)  $4.87 
Dividends declared per common share  $0.09   $-   $0.73   $2.54   $1.63 
                          
Loan related items                         
Note balances originated  $7,953   $3,537   $47,557   $329,952   $428,777 
Number of notes originated   3    4    3    23    38 
Average note balance originated  $2,651   $1   $15,852   $14,346   $11,284 
Number of loans outstanding   21    38    55    62    61 
Average loan carrying value  $4,929   $3,242   $3,891   $5,057   $8,343 
% of portfolio principal – fixed interest rate   61.8%   54.0%   50.4%   31.3%   30.3%
% of portfolio principal – variable interest rate   38.2%   46.0%   49.6%   68.7%   69.6%
Weighted average interest rate – all loans   10.48%   11.16%   11.34%   12.18%   12.44%
Principal balance % by state:                         
Arizona   80.0%   67.7%   55.5%   47.9%   44.8%
California   12.0%   22.4%   28.3%   28.9%   33.7%
Texas   0.0%   0.0%   3.2%   9.1%   6.3%
Idaho   0.0%   1.3%   5.0%   8.1%   9.6%
Other   8.0%   8.6%   8.0%   6.0%   5.6%
Total   100.0%   100.0%   100.0%   100.0%   100.0%
                          
Credit Quality                         
Extension fees included in mortgage loan principal  $7,664   $14,797   $18,765   $10,895   $6,204 
Interest payments over 30 days delinquent   3,491    4,999    7,530    1,134    2,741 
Principal balance of loans past scheduled maturity   144,405    280,322    347,135    210,198    133,532 
Carrying Value of loans in non accrual status   96,284    113,493    192,334    95,624    73,346 
Valuation allowance   (141,687)   (294,140)   (330,428)   (300,310)   (1,900)
Valuation allowance as % of loan principal outstanding   57.8%   70.5%   60.7%   48.9%   0.4%
Net Charge-offs  $153,453   $83,742   $49,181   $-   $- 

 

1. As described elsewhere in this Form 10-K, effective June 18, 2010, the Company converted IMH Secured Loan Fund, LLC from a Delaware limited liability company into a Delaware corporation name IMH Financial Corporation. The per share information in the “Earnings/Distributions per share” section of this table is presented on a retrospective basis, assuming the conversion occurred and the member units were exchanged for common shares during each respective period.
   
2. Prior to the effective date of the Conversion Transactions on June 18, 2010, substantially all mortgage loans were held to maturity.  In connection with our revised business strategy, subsequent to June 18, 2010, all mortgage loans were deemed held for sale.

  

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   December 31, 
   2011   2010   2009 
Average Balance Sheets*               
Cash and cash equivalents  $16,637   $2,753   $7,719 
Mortgage loan principal outstanding   327,452    497,870    584,551 
Valuation allowance   (214,314)   (326,187)   (306,712)
Mortgage loans, net   113,138    171,682    277,840 
Real estate owned, net   93,537    105,754    79,292 
Other assets   19,398    17,407    18,884 
Total assets  $242,709   $297,596   $383,735 
                
Total liabilities   57,335    23,861    9,517 
Total stockholders' equity   185,374    273,735    374,218 
Total liabilities and owners' equity  $242,709   $297,596   $383,735 

 

* The average balance sheets were computed using the quarterly average balances during each period presented.

 

   Years Ended 
   December 31, 
   2011   2010   2009 
Analysis of Mortgage Loan Income by Loan Classification               
                
Pre-entitled Land:               
Held for Investment  $-   $-   $60 
Processing Entitlements   421    86    6,977 
Entitled Land:               
Held for Investment   98    173    2,385 
Infrastructure under Construction   46    326    2,163 
Improved and Held for Vertical Construction   -    -    1,384 
Construction and Existing Structures:               
New Structure - Construction in process   178    501    1,058 
Existing Structure Held for Investment   423    38    1,201 
Existing Structure- Improvements   161    330    6,111 
Total Mortgage Loan Income  $1,327   $1,454   $21,339 

  

Pre-entitled Land:   This category refers to land that does not have final governmental approvals to begin developing or building on the site.

 

Held for Investment:   The borrower does not intend to process the entitlements during the term of our loan.

 

Processing Entitlements:   The borrower intends to process the entitlements during the term of the loan. The loan may include proceeds allocated for entitlement costs.

 

Entitled Land:   This category refers to land that has final governmental approval to begin developing the site.

 

Held for Investment:   The borrower does not intend to develop the land during the term of the loan. The word “develop”, in this context, refers to installing the utilities, streets, landscaping etc., but does not include vertical construction.

 

Infrastructure under Construction:   The borrower intends to develop the land during the term of the loan. The loan may include proceeds allocated for development costs.

 

Improved and Held for Vertical Construction:   The land is fully developed; utilities, streets, landscaping, etc. are completed. The borrower does not intend to begin vertical construction during the term of the loan.

 

Construction & Existing Structures:   This category refers to construction loans or loans where the collateral consists of completed structures.

 

New Structure — Construction in-process:   The loan is providing construction proceeds to build a vertical structure. All governmental approvals have been received and the infrastructure is complete.

 

Existing Structure Held for Investment:   The collateral consists of existing structures; no construction is needed.

 

Existing Structure — Improvements:   The collateral consists of existing structures, and loan proceeds are available through the loan to renovate or build additions.

 

The term “entitlement” in our business, and as reflected above, refers to the legal method of obtaining the necessary city, county or state approvals to develop land for a particular use. The term “processing entitlements” is synonymous with “obtaining approvals.”

 

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   December 31, 
   2011   2010   2009 
Mortgage Loan Principal Balances by Loan Classification               
Pre-entitled Land:               
Held for Investment  $6,484   $6,100   $13,834 
Processing Entitlements   75,248    139,452    185,608 
Entitled Land:               
Held for Investment   15,735    73,462    101,942 
Infrastructure under Construction   39,397    55,532    69,839 
Improved and Held for Vertical Construction   5,870    26,096    47,227 
Construction and Existing Structures:               
New Structure - Construction in process   45,372    46,808    46,325 
Existing Structure Held for Investment   2,000    12,775    23,640 
Existing Structure- Improvements   55,084    57,115    56,033 
Total Mortgage Loan Balances  $245,190   $417,340   $544,448 

 

   December 31, 
   2011   2010   2009 
Average Mortgage Loan Principal Balances by Loan Classification**               
Pre-entitled Land:                   
Held for Investment      $6,177   $12,773   $12,478 
Processing Entitlements       102,899    175,364    193,261 
Entitled Land:                   
Held for Investment       35,784    86,465    116,521 
Infrastructure under Construction       52,605    64,437    66,399 
Improved and Held for Vertical Construction       22,073    40,336    47,909 
Construction and Existing Structures:                   
New Structure - Construction in process     45,779    46,496    40,329 
Existing Structure Held for Investment     6,681    14,613    26,394 
Existing Structure- Improvements     55,452    57,384    81,260 
Total Average Mortgage Loan Balances      $327,450   $497,868   $584,551 

 

** Amounts were computed using the quarterly average balances for each of the periods presented

 

   December 31, 
   2011   2010   2009 
Average Interest Rate by Loan Classification***               
Pre-entitled Land:               
Held for Investment     7.5%   9.5%   10.8%
Processing Entitlements     10.1%   9.4%   9.6%
Entitled Land:                   
Held for Investment     11.9%   12.6%   12.4%
Infrastructure under Construction     10.8%   10.6%   11.0%
Improved and Held for Vertical Construction     12.4%   12.3%   12.1%
Construction and Existing Structures:                   
New Structure - Construction in process     10.0%   10.4%   11.5%
Existing Structure Held for Investment     12.1%   12.1%   12.0%
Existing Structure- Improvements     13.0%   12.5%   12.4%
Total Overall Average Interest Rate   11.0%   11.4%   11.5%

 ***Average Interest Rate by Loan Classification were computed by taking an average balance over the trailing 5 quarters 

Average Yield****  2011   2010   2009 
Pre-entitled Land:               
Held for Investment   0.0%   0.0%   0.5%
Processing Entitlements   0.4%   0.0%   3.6%
Entitled Land:               
Held for Investment   0.3%   0.2%   1.9%
Infrastructure under Construction   0.1%   0.5%   3.6%
Improved and Held for Vertical Construction   0.0%   0.0%   2.9%
Construction and Existing Structures:               
New Structure - Construction in process   0.4%   1.1%   2.7%
Existing Structure Held for Investment   6.3%   0.3%   4.6%
Existing Structure- Improvements   0.3%   0.6%   8.9%
Overall Average Yield   1.0%   0.3%   3.7%

****Average Yield is computed using Mortgage Loan Income by Loan Classification as a percent of Average Mortgage Loan Balances by Loan Classification

Note: Overall Average Yields have decreased due to loans being placed in non-accrual status

 

Return on Equity and Assets Ratio  2011   2010   2009 
Return on assets   (16.0)%   (22.1)%   (19.4)%
Return on equity   (21.0)%   (24.0)%   (19.9)%
Dividend payout ratio   1.3%   0.0%   (15.7)%
Equity to assets ratio   76.5%   92.1%   97.5%

 

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   As of and Year Ended 
   December 31, 
   2011   2010   2009   2008   2007 
Allocation of Valuation Allowance by Loan Classification                         
Pre-entitled Land:                         
Held for Investment  $(4,865)  $(4,695)  $(9,623)  $(3,242)  $- 
Processing Entitlements   (56,634)   (123,090)   (134,742)   (122,266)   (1,900)
Entitled Land:                         
Held for Investment   (13,418)   (67,038)   (80,750)   (79,279)   - 
Infrastructure Under Construction   (29,347)   (43,920)   (39,441)   (24,863)   - 
Improved and Held for Vertical Construction   (2,232)   (20,547)   (28,696)   (38,522)   - 
Construction & Existing Structures:                         
New Structure - Construction In-Process   (34,302)   (30,293)   (30,106)   (28,547)   - 
Existing Structure Held for Investment   -    (4,557)   (7,070)   (2,954)   - 
Existing Structure - Improvements   (889)   -    -    (637)   - 
Allowance for Loan Loss/ Valuation Allowance  $(141,687)  $(294,140)  $(330,428)  $(300,310)  $(1,900)
                          
 Rollforward of Valuation Allowance by Loan Classifications                         
                          
Balance at the beginning of period  $(294,140)  $(330,428)  $(300,310)  $(1,900)  $- 
                          
Additions to Valuation Allowance                         
Pre-entitled Land:                         
Held for Investment  $(170)  $(2,096)  $(6,381)  $(3,242)  $- 
Processing Entitlements   5,070    (24,647)   (24,851)   (120,366)   (1,900)
Entitled Land:                         
Held for Investment   (73)   (7,279)   (9,851)   (79,279)   - 
Infrastructure Under Construction   (1,084)   (3,185)   (11,990)   (24,863)   - 
Improved and Held for Vertical Construction   (542)   (629)   801    (38,522)   - 
Construction & Existing Structures:                         
New Structure - Construction In-Process   (4,119)   (7,736)   (3,218)   (26,137)   - 
Existing Structure Held for Investment   807    (1,831)   (4,116)   (2,954)   - 
Existing Structure - Improvements   (889)   (51)   (19,693)   (637)   - 
Total provision for credit losses  $(1,000)  $(47,454)  $(79,299)  $(296,000)  $(1,900)
                          
Charge-Offs:                         
Pre-entitled Land:                         
Held for Investment  $-   $7,024   $-   $-   $- 
Processing Entitlements   61,386    36,300    12,375    -    - 
Entitled Land:                         
Held for Investment   53,692    20,992    8,380    -    - 
Infrastructure Under Construction   15,658    (1,295)   (2,588)   -    - 
Improved and Held for Vertical Construction   18,857    8,778    9,025    -    - 
Construction & Existing Structures:                         
New Structure - Construction In-Process   110    7,548    1,659    -    - 
Existing Structure Held for Investment   3,750    4,344    -    -    - 
Existing Structure - Improvements   -    51    20,330    -    - 
Total Charge-Offs  $153,453   $83,742   $49,181   $-   $- 
Recoveries                         
Total Recoveries  -   $-   $-   $-   $- 
                          
Net Change in Valuation Allowance  $152,453   $36,288   $(30,118)  $(296,000)  $(1,900)
Other changes to Valuation Allowance   -    -    -    (2,410)   - 
Balance at end of period  $(141,687)  $(294,140)  $(330,428)  $(300,310)  $(1,900)
                          
Ratio of net charge-offs during the period to average loans outstanding during the period   45.0%   16.8%   8.4%   0.0%   0.0%

  

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   December 31, 
   2011   2010   2009   2008   2007 
Scheduled Maturities - One year or less                         
Pre-entitled Land:                         
Held for Investment  $6,484   $6,100   $13,834   $7,178   $- 
Processing Entitlements   70,749    139,451    185,609    195,168    203,166 
Entitled Land:                         
Held for Investment   15,735    73,462    101,942    89,786    135,060 
Infrastructure under Construction   39,397    55,532    27,953    57,908    60,037 
Improved and Held for vertical Construction   5,870    26,096    47,227    13,904    14,800 
Construction and Existing Structures:                         
New Structure - Construction in process   45,371    5,330    12,653    43,814    70,864 
Existing Structure Held for Investment   2,000    10,391    23,641    37,482    26,870 
Existing Structure- Improvements   55,084    3,932    -    97,777    - 
Total Scheduled Maturities - One year or less  $240,690   $320,294   $412,859   $543,017   $510,797 
                          
Scheduled Maturities - One to five years                         
Pre-entitled Land:                         
Held for Investment  $-   $-   $-   $-   $- 
Processing Entitlements   4,500    -    -    5,735    - 
Entitled Land:                         
Held for Investment   -    -    -    24,520    - 
Infrastructure under Construction   -    1    41,886    -    - 
Improved and Held for vertical Construction   -    -    -    40,582    - 
Construction and Existing Structures:                         
New Structure - Construction in process   -    41,478    33,670    -    - 
Existing Structure Held for Investment   -    2,384    -    -    - 
Existing Structure- Improvements   -    53,183    56,033    -    - 
Total Scheduled Maturities - One to five years   4,500    97,046    131,589    70,837    - 
Total Loan Principal  $245,190   $417,340   $544,448   $613,854   $510,797 

 

Scheduled Maturities - One to Five Years by Interest Type  December 31, 
Fixed Interest Rates  2011   2010   2009   2008   2007 
Pre-entitled Land:                         
Held for Investment  $-   $-   $-   $-   $- 
Processing Entitlements   4,500    -    -    1,929    - 
Entitled Land:                         
Held for Investment   -    -    -    3,500    - 
Infrastructure under Construction   -    -    41,884    -    - 
Improved and Held for vertical Construction   -    -    -    10,461    - 
Construction and Existing Structures:                         
New Structure - Construction in process   -    41,478    32,054    -    - 
Existing Structure Held for Investment   -    2,000    -    -    - 
Existing Structure- Improvements   -    53,183    56,033    -    - 
Total Scheduled Maturities - Fixed interest rate   4,500    96,661    129,971    15,890    - 
Variable Interest Rates                         
Pre-entitled Land:                         
Held for Investment   -    -    -    -    - 
Processing Entitlements   -    -    -    3,807    - 
Entitled Land:                         
Held for Investment   -    -    -    21,020    - 
Infrastructure under Construction   -    -    -    -    - 
Improved and Held for vertical Construction   -    -    -    30,120    - 
Construction and Existing Structures:                         
New Structure - Construction in process   -    -    1,618    -    - 
Existing Structure Held for Investment   -    384    -    -    - 
Existing Structure- Improvements   -    -    -    -    - 
Total Scheduled Maturities - Variable interest rate   -    384    1,618    54,947    - 
Total Loan Principal due One to Five Years  $4,500   $97,045   $131,589   $70,837   $- 

  

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   December 31, 
   2011   2010   2009   2008   2007 
                     
Performing Loans                         
Pre-entitled Land:                         
Held for Investment  $-   $-   $-   $-   $- 
Processing Entitlements   4,500    -    -    146,460    119,175 
Entitled Land:                         
Held for Investment   -    1,201    -    37,146    135,060 
Infrastructure under Construction   -    -    7,645    40,653    44,557 
Improved and Held for vertical Construction   -    -    -    35,102    14,800 
Construction and Existing Structures:                         
New Structure - Construction in process   719    2,395    4,805    6,694    45,087 
Existing Structure Held for Investment   2,000    2,384    -    23,393    18,620 
Existing Structure- Improvements   -    3,932    -    97,777    - 
Total Performing Loans  $7,219   $9,912   $12,450   $387,225   $377,299 
                          
Loans in Default - Non-Accrual                         
Pre-entitled Land:                         
Held for Investment  $6,484   $6,100   $13,834   $-   $- 
Processing Entitlements   70,748    139,451    185,608    46,636    64,743 
Entitled Land:                         
Held for Investment   15,735    72,261    101,942    3,300    - 
Infrastructure under Construction   39,397    55,532    62,194    17,255    - 
Improved and Held for vertical Construction   5,870    26,096    40,051    14,632    - 
Construction and Existing Structures:                         
New Structure - Construction in process   44,653    44,414    39,102    13,800    2,253 
Existing Structure Held for Investment   -    10,391    23,640    -    8,250 
Existing Structure- Improvements   55,084    53,183    56,033    -    - 
    Total Loans in Default - Non-Accrual  $237,971   $407,428   $522,404   $95,623   $75,246 
                          
Loans in Default - Other                         
Pre-entitled Land:                         
Held for Investment  $-   $-   $-   $7,178   $- 
Processing Entitlements   -    -    -    7,806    19,247 
Entitled Land:                         
Held for Investment   -    -    -    73,861    - 
Infrastructure under Construction   -    -    -    -    15,480 
Improved and Held for vertical Construction   -    -    7,176    4,752    - 
Construction and Existing Structures:                         
New Structure - Construction in process   -    -    2,418    23,320    23,525 
Existing Structure Held for Investment   -    -    -    14,089    - 
Existing Structure- Improvements   -    -    -    -    - 
Total Loans in Default - Other   -    -    9,594    131,006    58,252 
Total Loans in Default  $237,971   $407,428   $531,998   $226,629   $133,498 
                          
Total Loan Principal  $245,190   $417,340   $544,448   $613,854   $510,797 
                          
Loans in Default by Basis for Default                         
Loans past maturity date, or other                         
Pre-entitled Land:                         
Held for Investment  $6,484   $6,100   $13,834   $7,178   $- 
Processing Entitlements   70,748    139,451    181,801    52,791    83,990 
Entitled Land:                         
Held for Investment   15,735    72,261    80,922    73,714    - 
Infrastructure under Construction   39,397    24,762    20,308    17,255    15,480 
Improved and Held for vertical Construction   5,870    26,096    17,106    8,923    - 
Construction and Existing Structures:                         
New Structure - Construction in process   44,653    1,261    9,522    36,246    25,778 
Existing Structure Held for Investment   -    10,391    23,641    14,089    8,250 
Existing Structure- Improvements   55,084    -    -    -    - 
Total past maturity date  $237,971   $280,322   $347,134   $210,196   $133,498 
Loans past due on interest                         
Pre-entitled Land:                         
Held for Investment  $-   $-   $-   $-   $- 
Processing Entitlements   -    -    3,807    1,650    - 
Entitled Land:                         
Held for Investment   -    -    21,020    3,447    - 
Infrastructure under Construction   -    30,770    41,886    -    - 
Improved and Held for vertical Construction   -    -    30,120    10,461    - 
Construction and Existing Structures:                         
New Structure - Construction in process   -    43,153    31,998    875    - 
Existing Structure Held for Investment   -    -    -    -    - 
Existing Structure- Improvements   -    53,183    56,033    -    - 
Total past due on interest   -    127,106    184,864    16,433    - 
                          
Total loans in default by basis of default  $237,971   $407,428   $531,998   $226,629   $133,498 

 

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   Years Ended December 31,   Years Ended December 31, 
   2011 Compared to 2010   2010 Compared to 2009 
   Increase (Decrease) due to   Increase (Decrease) due to 
   Volume   Rate   Net   Volume   Rate   Net 
Pre-entitled Land:                              
Held for Investment  $(660)  $660   $-  $33   $(93)  $(60)
Processing Entitlements   (6,522)   6,857    335   (1,826)   (5,065)   (6,891)
                               
Entitled Land:                              
Held for Investment   (6,386)   6,311    (75)   (3,697)   1,485    (2,212)
Infrastructure under Construction   (1,242)   962    (280)   (222)   (1,615)   (1,837)
Improved and Held for Vertical Construction   (2,228)   2,228    -   (901)   (483)   (1,384)
                               
Construction and Existing Structures:                              
New Structure - Construction in process   (75)   (248)   (323)   728    (1,285)   (557)
Existing Structure Held for Investment   (960)   1,345    385   (1,402)   239    (1,163)
Existing Structure- Improvements   (240)   71    (169)   (2,961)   (2,820)   (5,781)
Total change in mortgage loan income  $(18,312)  $18,186   $(127)  $(10,247)  $(9,637)  $(19,885)

 

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

  

The following discussion of our financial condition and results of operations should be read in conjunction with the sections of this Form 10-K entitled “Risk Factors,” “Special Note About Forward-Looking Statements,” “Business” and our audited financial statements and the related notes thereto and other detailed information as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009 included elsewhere in this Form 10-K. This discussion contains forward-looking statements reflecting current expectations that involve risks and uncertainties. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in the section entitled “Risk Factors” included elsewhere in this Form 10-K. This discussion contains forward-looking statements, which are based on our assumptions about the future of our business. Our actual results may differ materially from those contained in the forward-looking statements. Please read “Special Note About Forward-Looking Statements” for additional information regarding forward-looking statements used in this Form 10-K. Unless specified otherwise and except where the context suggests otherwise, references in this section to the “company,” “we,” “us,” and “our” refer to IMH Financial Corporation and its consolidated subsidiaries, except the financial information of the Manager and Holdings is only consolidated with the financial information of IMH Financial Corporation from June 18, 2010, the date on which the Manager and Holdings were acquired. Undue reliance should not be placed upon historical financial statements since they are not necessarily indicative of expected results of operations or financial condition for any future periods.

 

Overview

 

Our Company

 

We are a real estate investor and finance company based in the southwest United States with over a decade of experience in various and diverse facets of the real estate lending and investment process, including origination, acquisition, underwriting, documentation, servicing, construction, enforcement, development, marketing, and disposition.

 

The Company’s focus is to invest in, manage and dispose of commercial real estate mortgage investments, and to perform all functions reasonably related thereto, including developing, managing and either holding for investment or disposing of real property acquired through foreclosure or other means. This focus is being enhanced with the combined resources of the Company and its advisors. The Company now also seeks to capitalize on opportunities to invest in selected real estate platforms under the direction of seasoned professionals in those areas. The Company may also consider opportunities to act as a sponsor, providing investment opportunities as a proprietary source of, and/or co-investor in, real estate mortgages and other real estate-based investment vehicles. Through the purchase and sale of such investments, we hope to earn robust, risk-adjusted returns while being recognized as a nimble, creative and prudent lender/investor. Our strategy is designed to re-establish the Company’s access to significant investment capital. By increasing the level and quality of the assets in our portfolio specifically and under management in general, we believe that the Company can grow to ultimately provide its shareholders with favorable risk-adjusted returns on investments and enhanced opportunity for liquidity.

 

The Company continued to experience financial adversity in 2011 at both the portfolio and enterprise level and expended a significant amount of resources as a result of the economic environment, as well as from a legal perspective from the enforcement and foreclosure of several loan assets and litigation involving a group of dissident shareholders. Management anticipates fiscal 2012 to be free from some of these distractions and has begun to streamline and re-purpose the organization with a clear direction with enhanced capabilities. The continued resolution and monetization of the legacy asset portfolio will be essential to the Company’s future success, as the value and liquidity created will be the building blocks for implementing the new strategy. Given the scale and composition of the remaining legacy portfolio, significant efforts will continue to be required in 2012, including continued foreclosures, restructurings, development activities, and asset dispositions. A number of key tactical initiatives are also continuing into 2012 with the near-term goal of further reducing expenses and enhancing systems, while seeking to mitigate legacy problems and maximize the value of legacy assets.

 

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Management expects to accelerate the streamlining and re-purposing of the organization, operations, and systems in 2012 to support the Company’s strategic and tactical, financial and operational goals. To achieve greater efficiency and strength, the Company will employ a combination of internal and external professionals to pursue its targeted activities.

 

In addition, given the current legal, tax and market-related constraints to bringing additional capital directly into the Company, management is exploring the possibility of sponsoring investment vehicles or other ventures with institutional investors in vertical market segments in which there is strong investor interest, as well as proven expertise within the Company and/or its advisors. To demonstrate its commitment, distinguish itself from other sponsors, and create very attractive investment opportunities, the Company would expect to contribute cash as well as some of its legacy assets to these sponsored vehicles, in exchange for equity ownership and/or profit participation. There is no assurance, however, that management would pursue any such sponsored vehicles in the near term or at all.

 

As previously described, the Company expects to focus on the creation and implementation of a series of commercial mortgage and real estate investment activities so as to begin to increase both assets under management and the associated income and value derived therefrom.

 

In 2011, the Company acquired certain operating assets as a result of foreclosure of the related loans. With such assets, there comes the challenge and cost of day-to-day operations but also the opportunity to revitalize assets and operations that have generally suffered in recent periods. Again, with our combination of internal and external professionals, we expect to re-position these operating assets to produce a market-rate return as portfolio holdings or to dispose of these assets at favorable prices once they have been foreclosed upon and stabilized.

 

We have identified certain portfolio assets that we believe could yield significantly greater returns by developing the properties for future operation and sale, as opposed to selling them now in their as-is condition. The demonstrated ability to create value through the real estate development process is a key aptitude gained through our relationship with our consultants that we anticipate will further distinguish us from other competitors in the marketplace. Through this capability, we believe that we, and ultimately our shareholders, will be afforded the opportunity to earn yields that are not generally available from new, finished product. While development does entail unique risks, with a disciplined approach and experienced team, we believe the risk-adjusted rewards have the potential to be superior.

 

While focused on the foregoing, the Company remains nimble in its objectives and is poised to re-direct its efforts as economic circumstances unfold. Given that the legacy assets are positively correlated with the economic and real estate cycles, and the fact that any new investment activity may benefit from any market disruptions and/or further declines in the value of real estate, in terms of enhanced risk-adjusted returns and reduced competitive pressure, management believes there is an inherent “hedge” in the Company’s current position. If there is a recovery of liquidity and valuations, the liquidity and value of the legacy assets should benefit accordingly, while new originations may face increased yield and scaling pressures. If, on the other hand, conditions do not improve, or worsen, the legacy assets will likely suffer, but the opportunities in new business should be enhanced. We will adjust the relative scaling of these two aspects of the hedge as circumstances dictate.

 

Through our traditional credit analysis coupled with property valuation techniques used by developers, we have acquired or originated real estate assets as of December 30, 2011 with an original investment basis of approximately $590.6 million and a current carrying value of $199.0 million, consisting of commercial real estate mortgage loans with a carrying value of $103.5 million and owned property with a carrying value of $95.5 million. We believe the decline in the carrying (fair) value of our real estate assets is reflective of the deterioration of the commercial real estate lending market and the sustained decline in pricing of residential and commercial real estate in the last several years together with the continuing downturn in the general economy and specifically the real estate markets.

 

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On June 18, 2010, we became an internally managed real estate finance company formed through the conversion of IMH Secured Loan Fund, LLC, or the Fund, into a Delaware corporation named IMH Financial Corporation and the acquisition by IMH Financial Corporation of Investors Mortgage Holdings Inc., or the Manager, which managed the Fund prior to its acquisition, and IMH Holdings, LLC, or Holdings. Holdings is a holding company for two wholly-owned subsidiaries: IMH Management Services, LLC, an Arizona limited liability company, and SWI Management, LLC, an Arizona limited liability company. IMH Management Services, LLC provides us and our affiliates with human resources and administrative services, including the supply of employees, and SWI Management, LLC, or SWIM, acts as the manager for the Strategic Wealth & Income Company, LLC, or the SWI Fund. We refer to these conversion and acquisition transactions as the Conversion Transactions.

 

Since the Conversion Transactions have been consummated, the Manager is now internalized, the former executive officers and employees of the Manager are now our executive officers and employees and they have assumed the duties previously performed by the Manager, and we no longer pay management fees to the Manager. We are entitled to retain all management, origination fees, gains and basis points previously allocated to the Manager.

 

Factors Affecting Our Financial Results

 

General Economic Conditions Affecting the Real Estate Industry

 

The global and U.S. economies experienced a rapid and significant decline since the third quarter of fiscal 2008 from which they have not yet recovered. The real estate, credit and other markets suffered unprecedented disruptions, causing many major institutions to fail or require government intervention to avoid failure, which has placed severe pressure on liquidity and asset values. These conditions were brought about largely by the erosion of U.S. and global credit markets, including a significant and rapid deterioration of the mortgage lending and related real estate markets. In this regard, we continue to operate under very difficult conditions.

 

Originating, acquiring and investing in short-term commercial real estate bridge loans to facilitate real estate entitlement and development, and other interim financing, have historically constituted the heart of our business model. This model relies on mortgage capital availability. However, we believe current market conditions have materially diminished the traditional sources of permanent take-out financing on which our historical business model depends. We believe it will take 12 to 24 months or longer for markets and capital sources to begin to normalize, although there can be no assurance that the markets will stabilize in this timeframe or at all. Economic conditions have continued to have a material and adverse impact on us. As of December 31, 2011, 18 of our 21 portfolio loans with principal balances totaling $237.9 million, representing 97.1% of our total loan principal outstanding, were in default and were in non-accrual status. In addition, as of December 31, 2011, the valuation allowance on such loans totaled $141.7 million, representing 57.8% of the principal balance of such loans. We have taken enforcement action on 17 of the 18 loans in default that we anticipate will result in foreclosure. During the year ended December 31, 2011, we foreclosed on 12 loans (resulting in 10 property additions) and took title to the underlying collateral with net carrying values totaling $13.7 million as of December 31, 2011.

 

We continue to examine all material aspects of our business for areas of improvement and recovery on our assets. However, if the real estate market does not return to its historical levels of activity and credit markets do not re-open more broadly, we believe the realization of a full recovery of our cost basis in our mortgage and real estate loans is unlikely to occur in a reasonable time frame or at all, and we may be required to dispose of certain or all of our assets at a price significantly below our initial cost and possibly below current carrying values. While we have secured $50 million in financing from NW Capital, if we are not able to liquidate a sufficient portion of our assets, our liquidity will continue to dissipate. Nevertheless, we believe that our cash and cash equivalents of $21.3 million coupled with the proceeds that we anticipate from the disposition of our loans and real estate held for sale will allow us to fund current operations over the next 12 months.

 

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Revenues

 

Prior to the Conversion Transactions, we historically generated income primarily from interest and fees on our mortgage loans, including default interest, penalties and fees, as well as interest income from money market, short-term investments or similar accounts in which we temporarily invest excess cash. As a result of the June 18, 2010 consummation of the Conversion Transactions, to the extent we are able to generate excess liquidity from asset sales or from the issuance of debt or equity capital, we expect to generate additional revenues from loan originations, modification and processing fees historically retained by the Manager. In addition to our historical sources of revenue, we expect to generate revenues from disposition of existing and newly acquired assets and from the application of those proceeds in new assets. We expect in the short-term that we will derive a greater proportion of our capital from dispositions of our REO properties and from the disposition of loans and other assets we own or acquire than from the interest and fee income from commercial mortgage loans originated by us. As economic conditions improve and our investment strategy is implemented, we expect interest and fee income from commercial real estate mortgage loans to again become a greater focus for us and a greater portion of our revenues. We also expect to continue to benefit from management fees for management services provided by SWIM to SWI Fund.

 

Mortgage Loan Income. Revenues generated from mortgage loan investments include contractual note rate interest, default interest and penalty fees collected, and accretion on loans acquired at a discount. Changes to the amount of our loan assets directly affect the amount of interest and fee income we are able to achieve. Due to the increase in defaults and foreclosures, mortgage loan investment revenues have decreased in recent periods. As a result of the acquisition of the Manager effective June 18, 2010, we expect to also generate revenues from loan originations, processing and modifications. Such amounts, net of direct costs, are to be amortized over the lives of the respective loans as an adjustment to yield using the effective interest method.

 

We have also modified certain loans in our portfolio, which has resulted in an extended term of maturity on such loans of two years or longer and, in some cases, has required us to accept an interest rate reflective of current market rates, which are lower than in prior periods. We may decide to modify loans in the future primarily in an effort to seek to protect our collateral. Additionally, on a limited basis, we have financed the sale of loan collateral by existing borrowers and sales of certain REO assets to unrelated parties, and it is anticipated that we will engage in similar lending activities in the future. This effort effectively replaces a non-performing loan to a defaulting seller with a new performing loan to the buyer. Although we have in the past modified certain loans by extending the maturity dates or changing the interest rates thereof on a case by case basis, we do not have in place at this time a specific loan modification program or initiative. Rather, as in the past, we may modify any loan, in our sole discretion, based on the then applicable facts and circumstances.

 

Rental Income. Rental income is attributable to the foreclosure of a loan that was secured by an operating property. We anticipate an increase in rental income as the occupancy levels of the property improves. However, as we plan to dispose of a substantial portion of our existing REO assets, we do not currently anticipate substantial rental income in future periods unless we acquire additional operating properties through foreclosure or other means.

 

Asset Disposition Income. Revenues from asset dispositions have not historically been a significant component of revenues, but as we dispose of existing REO assets and new REO assets we acquire through the foreclosure of loans, we expect to realize gains on the disposition of these assets to the extent they are sold above their carrying value (or losses if sold below carrying values), particularly over the next 12 to 24 months as we seek to market and sell substantially all of our existing loans and REO assets. The recognition of revenues from such dispositions will depend on our ability to successfully market existing loans and REOs and the timing of such sales.

 

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Investment and Other Income. Investment and other income consists of interest earned on certain notes receivable from a tenant, management and related fees earned from SWI Fund, and investment income on short-term investments. Until we are able to generate cash proceeds from the sale of assets or the issuance of debt or equity capital to invest in our target assets, we do not anticipate a substantial change in investment and other income.

 

Defaults and Foreclosures. Due to the decline of the economy and real estate and credit markets and our intent to proactively pursue foreclosure of loans in default so we can dispose of REO assets, we anticipate defaults and foreclosures to continue, which will likely result in continuing high levels of non-accrual loans and REO assets, which are generally non-interest earning assets. As such, we anticipate our mortgage loan interest income to remain at significantly reduced levels until we invest the proceeds from the disposition of our existing assets or other debt or equity financing we may undertake in the future in new investments and begin generating income from those investments.

 

Expenses

 

As a result of the consummation of the Conversion Transactions, we became responsible for expenses previously borne by the Manager that are not reflected in our historical financial statements prior to June 18, 2010. These expenses are only partially offset by the elimination of management fees, as discussed further below. Moreover, as a result of our active efforts to pursue enforcement on defaulted loans, subsequent foreclosure and our resulting ownership of the underlying collateral, we have incurred significant costs and expenses for consulting, valuation, legal, property tax and other expenses related to these activities.

 

As a result of our continued active enforcement together with our assumption of additional expenses in connection with the acquisition of the Manager, we incurred significant costs relating to legal and other professional fees and we expect expenses to continue to remain at high levels for the next 12 months. However, we expect expenses associated with the foreclosure on loans and disposition of REO assets to decrease through the planned disposition of a substantial part of our portfolio over the next 12 to 24 months.

 

Operating Expenses for Real Estate Owned. Operating expenses for REO assets include direct operating costs associated with such property, including property taxes, home owner association dues, property management fees, utilities, repairs and maintenance, licenses, and other costs and expenses associated with the ownership of real estate. While we expect such operating expenses for REO assets to remain at high levels and potentially increase as we continue enforcement action on loans in default, we anticipate such costs to decrease proportionately as we dispose of existing and newly acquired REO assets and redeploy the proceeds in our target asset classes.

 

Professional Fees. Professional fees consist of: legal fees for enforcement, litigation, SEC reporting and other purposes; fees for external valuation services; fees paid for asset management services relating to portfolio management; fees for external accounting, audit and tax services; fees for strategic consulting services; fees for non-capitalized information technology costs; and other general consulting costs. While we expect to continue to incur such expenses, we believe such expenses will decrease over the 12 month period ending December 31, 2012 as we dispose of existing assets. We expect these fees to initially increase as we seek to dispose of REO assets, but expect these expenses to stabilize thereafter assuming we conduct our operations substantially consistent with current levels.

 

Default and Related Expenses. Default and related expenses include direct expenses related to defaulted loans, foreclosure activities or property acquired through foreclosure. These expenses include certain legal and other direct costs, as well as personnel and consulting costs directly related to defaulted loans and foreclosure activities. Because 18 of our 21 loans are currently in default and our intent is to actively pursue foreclosures on loans in default, we anticipate our default and related expenses in future periods will remain at similar levels during the year ending December 31, 2012.

 

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General and Administrative Expenses. General and administrative expenses consist of various costs such as compensation and benefits for employees, rent, insurance, utilities and related costs. Prior to the June 18, 2010 consummation of the Conversion Transactions, the Manager paid most of these expenses, although we paid the Manager a management fee for management services provided by the Manager. Effective January 1, 2012, we have taken a number of cost saving measures to reduce our overhead which we believe will result in lower general and administrative expenses in fiscal 2012. However, variable cost components of such expenses are expected to increase as our activities expand.

 

Interest Expense. Interest expense includes interest incurred in connection with the NW Capital loan, loan participations issued to third parties, and borrowings from various banks. We expect interest expense to increase in 2012 as we recognize a full year of interest on the NW Capital loan that closed in June 2011. In addition, we expect to incur additional interest expense (and potentially other expenses) upon execution of the rights offering and note exchange as outlined in the MOU. However the amount and timing of such interest is dependent on the timing of the final settlement of the MOU.

 

Depreciation and Amortization Expense. We record depreciation and amortization on property and equipment used in our operations. This expense is expected to increase as we expand our business operations following the internalization of the Manager and as we acquire operating properties with depreciable assets through foreclosure or other purchase.

 

Provision for Credit Losses. The provision for credit losses on the loan portfolio is based on our estimate of fair value, using data primarily from reports prepared by third-party valuation firms, of the underlying real estate that serves as collateral of the loan portfolio. Current asset values have dropped significantly in many of the areas where we have a security interest in collateral securing our loans, which has resulted in significant non-cash provisions for credit losses during the years ended December 31, 2010 and 2009, and to a lesser extent in 2011. While we believe our current valuation allowance is sufficient to minimize future losses, we may be required to recognize additional provisions for credit losses in the future. In the absence of a change in valuation of the collateral securing our loans, our provision for credit losses is expected to increase by approximately $1.0 million on a quarterly basis for additional unpaid property taxes applicable to the related loan collateral. Currently all of our portfolio loans are held for sale as we intend to actively market and sell a significant portion of our currently-owned loans, individually or in bulk, over the 12 to 24 months as a means of raising additional capital to pursue our investment objectives.

 

Impairment Charges on Real Estate Owned.  Our estimate of impairment charges on REO assets largely depends on whether the particular REO asset is held for development or held for sale. This classification depends on various factors, including our intent to sell the property immediately or further develop and sell the property over time, and whether a formal plan of disposition has been adopted, among other factors. Real estate held for sale is carried at the lower of carrying amount or fair value, less estimated selling costs, which is primarily based on valuation reports prepared by third-party valuation firms. Reductions in the fair value of assets held for sale are recorded as impairment charges. Real estate held for development is carried at the transferred value upon foreclosure, less cumulative impairment charges. Impairment charges on real estate owned consist of charges to REO assets in cases where the estimated future undiscounted cash flows of the property is below current carrying value and the reduction in asset value is deemed to be other than temporary. Current asset values have dropped significantly in many of the areas where we hold real estate, which resulted in significant impairment losses on our REO assets. We may also be required to recognize additional impairment losses on our REO assets if our disposition plan for such assets change or if such assets are disposed of below their current carrying values. If management undertakes a specific plan to dispose of REO assets within twelve months and the real estate is transferred to held for sale status, the fair value of the real estate may be less than the estimated future undiscounted cash flows of the property when the real estate was held for development, and that difference may be material. Currently, a limited portion of our REO assets are reported as held for sale in our financial statements. However, we intend to actively market and sell a significant portion of our REO assets, individually or in bulk, over the next 12 to 24 months as a means of raising additional capital to pursue our investment objectives.

 

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Liquidity and Capital Resources. Our ability to generate sufficient revenues to fund operations and the amount we are able to invest in our target assets depends on our liquidity and access to debt or equity capital. We expect the proceeds from the disposition of REO assets and recent liquidity events, including the sale of certain loans and real estate held for sale, will provide the liquidity necessary to operate our business. Despite management’s efforts, there is no assurance that we will be successful in selling real estate assets in a timely manner to sufficiently fund operations or obtaining additional financing, and if available, there are no assurances that the financing will be at commercially acceptable terms. Failure to address this liquidity issue within the timeframe permitted may have a further material adverse effect on our business, results of operations, and financial position.

 

Non-Cash Stock-Based Compensation. Our 2010 Stock Incentive Plan has been approved by the board of directors and provides for award of stock options, stock appreciation rights, restricted stock units and other performance based awards to our officers, employees, directors and certain consultants.  The maximum number of shares of common stock that may be issued under such awards shall not exceed 1,200,000 common shares, subject to increase to 1,800,000 shares after an initial public offering.  During the year ended December 31, 2011, we issued 800,000 stock options to directors, executive officers, employees and consultants providing services to us, which was recorded as stock-based compensation based on the fair value at the time of issuance of the award and recognized on a straight-line basis over the employee’s requisite service period (generally the vesting period of the equity grant). In addition, in accordance with the terms of the consulting agreement with ITH Partners, we issued 50,000 shares of our common stock in connection with our closing of the NW Capital loan. The stock options and shares issuable upon exercise will not be registered under the Securities Act and accordingly may not be resold other than pursuant to Rule 144 or another available exemption from registration under the Securities Act.

 

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RESULTS OF OPERATIONS

 

The following discussion compares the historical results of operations on a GAAP basis for the fiscal years ended December 31, 2011, 2010, and 2009. Unless otherwise noted, all comparative performance data included below reflect year-over-year comparisons.

 

Results of Operations for the Years Ended December 31, 2011, 2010 and 2009

 

Revenues

 

(dollars in thousands)  

   Years Ended December 31,   Years Ended December 31, 
Revenues  2011   2010   $ Change   % Change   2010   2009   $ Change   % Change 
Mortgage Loan Income  $1,327   $1,454   $(127)   (8.7)%  $1,454   $21,339   $(19,885)   (93.2)%
Rental Income   1,847    1,665    182    10.9%   1,665    955    710    74.3%
Investment and Other Income   559    637    (78)   (12.2)%   637    228    409    179.4%
Total Revenue  $3,733   $3,756   $(23)   (0.6)%  $3,756   $22,522   $(18,766)   (83.3)%

 

Mortgage Loan Income.  During the year ended December 31, 2011, income from mortgage loans was $1.3 million, a decrease of $0.1 million, or 8.7%, from $1.4 million for the year ended December 31, 2010. The year over year decrease in mortgage loan income is attributable to the on-going decrease in the income-earning portion of our loan portfolio. While the total loan portfolio principal outstanding was $245.2 million at December 31, 2011 as compared to $417.3 million at December 31, 2010, the income-earning loan balance decreased to $7.2 million from $9.9 million for the same periods, respectively. Additionally, the average portfolio interest rate (including performing and nonperforming loans) was 10.48% per annum at December 31, 2011, as compared to 11.16% per annum at December 31, 2010.

 

During the year ended December 31, 2010, income from mortgage loans was $1.5 million, a decrease of $19.9 million, or 93.2%, from $21.3 million for the year ended December 31, 2009. The year over year decrease in mortgage loan income is attributable to the decrease in the income-earning portion of our loan portfolio. While the total loan portfolio was $417.3 million at December 31, 2010 as compared to $544.4 million at December 31, 2009, the income-earning loan balance decreased significantly to $9.9 million from $22.0 million for the same periods, respectively. Additionally, the average portfolio interest rate (including performing and nonperforming loans) was 11.16% per annum at December 31, 2010, as compared to 11.34% per annum at December 31, 2009.

 

As of December 31, 2011, 18 of our 21 portfolio loans were in non-accrual status, as compared to 30 of our 38 loans at December 31, 2010. As such, in the absence of acquiring or originating new loans, we anticipate mortgage income to remain at minimal levels or potentially further decrease in future periods. During the year ended December 31, 2011, in connection with the sale of certain loans and REO assets, we financed three new loans with an aggregate principal balance of $7.9 million and a weighted-average interest rate of 10.9%. Similarly, during the year ended December 31, 2010, in connection with the sale of certain loans and REO assets, we financed four new loans with an aggregate principal balance of $3.5 million and a weighted-average interest rate of 7.18%.

 

Rental Income.   Rents and other income resulted from the foreclosure of a loan in third quarter of 2009 that was secured by an operating medical office building. During the year ended December 31, 2011, we recognized rental income of $1.8 million, an increase of $0.1 million or 10.9% from the year ended December 31, 2010 of $1.7 million. The slight increase in rental income is attributed to additional rents earned from existing tenants.

 

During the year ended December 31, 2010, we recognized rental income of $1.7 million, an increase of $0.7 million or 74.3% for the year ended December 31, 2009 of $1.0 million. The year over year increase in rental income was attributed to a full year of rental income in 2010 as compared to 2009. We are actively pursuing other tenants to improve the occupancy of this property and anticipate an increase in related income in 2012.

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Investment and Other Income.  Investment and other income is comprised of interest earned on certain notes receivable from a tenant for tenant improvements made on one of our operating properties, as well as fees earned from our management of the SWI Fund. During the year ended December 31, 2011, investment and other income was $0.5 million, a decrease of $0.1 million, or 12.2%, from $0.6 million for the year ended December 31, 2010. The decrease in investments and other income is primarily attributable to reduced interest earned on the tenant note receivable resulting from principal paydowns during the year, which was offset by a full year of management-related fees earned on the SWI Fund.

 

During the year ended December 31, 2010, investment and other income was $0.6 million, an increase of $0.4 million, or 179.4%, from $0.2 million for the year ended December 31, 2009. The increase from fiscal 2009 to 2010 was primarily attributable to interest earned on the tenant notes receivable and approximately half a year of management-related fees earned on the SWI Fund.

 

Costs and Expenses

 

Expenses (dollars in thousands)

 

   Years Ended December 31,   Years Ended December 31, 
Expenses:  2011   2010   $ Change   % Change   2010   2009   $ Change   % Change 
                                 
Property Taxes for REO  $2,929   $2,543   $386    15.2%  $2,543   $2,415   $128    5.3%
Other Operating Expenses for REO   2,533    2,317    216    9.3%   2,317    1,784    533    29.9%
Professional Fees   8,277    6,331    1,946    30.7%   6,331    3,204    3,127    97.6%
Management Fees   -    109    (109)   (100.0)%   109    574    (465)   (81.0)%
Default and Related Expenses   767    564    203    36.0%   564    700    (136)   (19.4)%
General and Administrative Expenses   10,232    3,720    6,512    175.1%   3,720    54    3,666    6788.9%
Organizational Costs   300    -    300    (100.0)%   -    -    -    N/A 
Offering Costs   209    6,149    (5,940)   (96.6)%   6,149    -    6,149    N/A 
Interest Expense   9,072    2,071    7,001    338.0%   2,071    267    1,804    675.7%
Restructuring charges   204    -    204    N/A    -    -    -    N/A 
Depreciation and Amortization Expense   1,796    1,473    323    21.9%   1,473    702    771    109.8%
Loss (Gain) on Disposal of Assets   (201)   1,209    (1,410)   (116.6)%   1,209    -    1,209    N/A 
Loss on Settlement   281    -    281    N/A    -    -    -    N/A 
Provision for Credit Losses   1,000    47,454    (46,454)   (97.9)%   47,454    79,299    (31,845)   (40.2)%
Impairment of REO   1,529    46,856    (45,327)   (96.7)%   46,856    8,000    38,856    485.7%
                                         
Total Costs and Expenses  $38,928   $120,796   $(81,868)   (67.8)%  $120,796   $96,999   $23,797    24.5%

 

Property Taxes and Other Operating Expenses for Real Estate Owned.    Such expenses include property taxes, home owner association dues, utilities, and repairs and maintenance.  During the years ended December 31, 2011, property taxes and other operating expenses for REO assets were $5.5 million, and increase $0.6 million or 12.4%, from $4.9 million for the year ended December 31, 2010.

 

During the years ended December 31, 2010 and 2009, operating expenses for REO assets were $4.9 million and $4.2 million, respectively, an increase of $0.7 million or 15.7%. Of these totals, property taxes accounted for $2.9 million, $2.5 million and $2.4 million for the years ended December 31, 2011, 2010 and 2009, respectively. The increase in operating expenses for REO assets is attributable to the increasing number of properties acquired through foreclosures. We held 41, 39 and 20 REO properties at December 31, 2011, 2010 and 2009, respectively. We expect such costs and expenses to increase as we continue to exercise remedies on loans in default and to decrease as we dispose of real estate held for sale.

 

Professional Fees.   Professional fees consist of: legal fees for enforcement, litigation, SEC reporting and other purposes; fees for external valuation services; fees paid for asset management services relating to portfolio management; fees for external accounting, audit and tax services; fees for strategic consulting services; fees for non-capitalized information technology costs; and other general consulting costs. During the year ended December 31, 2011, professional fees expense was $8.3 million, an increase of $2.0 million, or 30.7%, from $6.3 million for the year ended December 31, 2010. The year over year increase is attributed to principally to higher legal, strategic consulting and information technology consulting fees, offset by lower valuation costs, asset management fees, and lower accounting and audit costs.

 

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During the years ended December 31, 2010 and 2009, professional fees were $6.3 million and $3.2 million, respectively, an increase of $3.1 million or 97.6%. The increase in these costs was attributed to numerous factors including the increasing defaults and foreclosures in our loan portfolio, the cost of valuation services provided in connection with our on-going evaluation of the portfolio, increased litigation related fees and the costs of public reporting, including requirements under the Sarbanes-Oxley Act and related requirements. Also, certain costs that the Manager elected to pay in previous periods (but was not contractually required to pay), such as public reporting costs, are now borne by us.

 

Management Fees.   During the year ended December 31, 2010, management fee expense was $0.1 million, a decrease of $0.5 million, or 81.0%, from $0.6 million for the year ended December 31, 2009. Management fee expense as a percentage of mortgage interest income was 7.5% and 2.7% for the years ended December 31, 2010 and 2009, respectively. The decrease in management fee expense for the years ended December 31, 2010 and 2009 is directly related to the significant decline in the “Earning Asset Base” of our loan portfolio at December 31, 2010 and 2009, as previously described, and the elimination of the payment of management fees, which became effective upon acquisition of the Manager on June 18, 2010. As such, there was no management fee expense recorded in fiscal 2011.

 

Default and Related Expenses.   During the year ended December 31, 2011, default and related expenses were $0.8 million, an increase of $0.2 million, or 36.0%, from $0.6 million for the year ended December 31, 2010. During the year ended December 31, 2010, default and related expenses were $0.6 million, a decrease of $0.1 million, or 19.4%, from $0.7 million for the year ended December 31, 2009. Default and related expenses vary based on the level of enforcement and number of defaults and foreclosures experienced by us in the related periods. However, a significant portion of other costs relating to defaults are included in professional fees.

 

General and Administrative Expenses.    In connection with the acquisition of the Manager effective June 18, 2010, we became responsible for various general and administrative expenses previously incurred by the Manager, including, but not limited to, rents, salaries and other operational costs.  During the year ended December 31, 2011, general and administrative expenses were $10.2 million, an increase of $6.5 million, or 175.1%, from $3.7 million for the year ended December 31, 2010. There were minimal general and administrative expenses during fiscal 2009. The increase in general and administrative expenses is attributed to a full year of expenses in 2011 as compared to 2010, which reflects expenses incurred for the period June 18, 2010 (date of acquisition) through December 31, 2010. The approximate amount of fund-related expenses paid by the Manager (not included in the accompanying financial statements) was $2.7 million for the period January 1, 2010 through June 18, 2010 (date of acquisition) and $5.9 million for the year ended December 31, 2009.

 

In addition, we incurred certain non-recurring costs relating to the separation of our former CEO, including payments made or payable by us totaling $1.2 million under the terms of his separation agreement, as well as a charge of $1.2 million for the excess of the amount paid by an affiliate of NW Capital for the purchase of the common shares owned by the former CEO over the deemed fair value of the stock as determined by an independent valuation firm, which is recorded as compensation expense. Also, general and administrative expense for the year ended December 31, 2011 includes stock-based compensation expense of $0.2 million and $0.1 million relating to the settlement of certain litigation. Finally, we also incurred $0.5 million in operating costs relating to Infinet.

 

Organizational Costs. During the year ended December 31, 2011, we incurred organizational costs of $0.3 million relating to the start-up of Infinet, an exploratory business venture and our wholly-owned subsidiary. No such costs were incurred during the years ended December 31, 2010 or 2009.

 

Offering Costs.    During the year ended December 31, 2011 and 2010, we incurred and wrote-off offering costs incurred totaling $0.2 million and $6.2 million, respectively. During the year ended December 31, 2010, we wrote-off all previously capitalized incremental and current costs totaling $6.2 million relating to the proposed initial public offering due to the indefinite postponement of that offering. Because the consummation of any prospective initial public offering is not probable in the near term, we expensed all such costs until we have a definitive timeline established for any prospective initial public offering. No such write-offs occurred during the years ended December 31, 2009.

 

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Interest Expense.   Interest expense includes interest incurred in connection with the NW Capital loan, loan participations issued to third parties, borrowings from the Manager and borrowings from various banks. During the year ended December 31, 2011, interest expense was $9.1 million as compared to $2.1 million for the year ended December 31, 2010, an increase of $7.0 million or 338.0%. The increase in interest expense is attributed to interest incurred on the $50.0 million NW Capital loan as well as the amortization of the related deferred financing costs.

 

During the year ended December 31, 2010, interest expense was $2.1 million, an increase of $1.8 million, or 675.7%, from $0.3 million for the year ended December 31, 2009. Interest expense for the year ended December 31, 2010 was incurred in connection with the previous borrowings from the Manager, which were paid off in the second quarter of 2010, and $16.9 million in notes payable, which were secured in 2010. Interest expense for the year ended December 31, 2009 was incurred in connection with a $6.0 million borrowing from the Manager.

 

Restructuring Charges.  During the year ended December 31, 2011, the Company’s management approved a plan to undertake a series of actions to restructure its business operations in an effort to reduce operating expenses and refocus resources on pursuing other target market opportunities more closely in alignment with the Company’s revised business strategy. In connection with this plan, we recorded restructuring charges of $0.2 million during the year ended December 31, 2011. No such amounts were incurred in fiscal 2010 or 2009.

 

Depreciation and Amortization Expense.  During the year ended December 31, 2011, depreciation and amortization expenses was $1.8 million, an increase of $0.3 million or 21.9% from $1.5 million for the year ended December 31, 2010. The increase in 2011 depreciation is attributed to an adjustment to the estimated useful life of certain assets that resulted in an acceleration of depreciation for such assets.

 

During the year ended December 31, 2010, depreciation and amortization expenses was $1.5 million, an increase of $0.8 million or 109.8% from $0.7 million for the year ended December 31, 2009. This increase is due to a full year of depreciation in 2010 relating to the acquisition of an operating property acquired through foreclosure in mid-2009.

 

Gain/Loss on Disposal of Assets.   During the year ended December 31, 2011, we sold certain loans and REO assets for $22.5 million (net of selling costs) and recognized a net gain of $0.2 million.  During the year ended December 31, 2010, we sold certain loans and REO assets for $12.6 million (net of selling costs) and recognized a net loss of $1.2 million.  No such transactions occurred during the years ended December 31, 2009.

 

Loss on Settlement.   On January 31, 2012, we reached a tentative settlement in principle to resolve certain claims asserted by the plaintiffs in the Litigation. The tentative settlement in principle, memorialized in the MOU, is subject to certain class certification conditions, confirmatory discovery and final court approval (including a fairness hearing). One of the key elements of the tentative settlement includes a cash deposit by us of $1.65 million into a settlement escrow account (less specified amounts to be held in a reserve escrow account for use by us to fund our defense costs for other unresolved litigation) which will be distributed (after payment of notice and administration costs and any amounts awarded by the Court for attorneys' fees and expense) to Class members in proportion to the number of our shares held by them as of June 23, 2010. During the year ended December 31, 2011, we recorded a loss on settlement equal to the amount of the cash payment required of $1.65 million, net of related anticipated insurance proceeds of approximately $1.3 million.

 

Provision for Credit Losses.    Asset values have dropped significantly in many areas where we have a security interest in collateral securing our loans, which resulted in significant non-cash provisions for credit losses during the years ended December 31, 2010 and 2009, and to a lesser extent during the year ended December 31, 2011. Based on the valuation analysis performed on our loan portfolio during the years ended December 31, 2011, 2010 and 2009, we recorded provision for credit losses of $1.0 million, $47.5 million and $79.3 million, respectively.

 

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Impairment of Real Estate Owned.  Similarly, the value of real estate owned has suffered similar declines in value during the years ended December 31, 2011, 2010 and 2009. For REO assets, we performed an analysis to determine the extent of impairment in valuation for such assets deemed to be other than temporary. Moreover, during the third quarter of 2010, we changed the classification of certain REO assets that were previously held for development to held for sale in connection with our new business strategy following the Conversion Transactions. Based on our analysis, during the years ended December 31, 2011, 2010 and 2009, we recorded impairment charges in the amount of $1.5 million, $46.9 million and $8.0 million, respectively.

 

Loan Originations, Loan Types, Borrowers, the Underwriting Process and Loan Monitoring

 

Lending Activities

 

As of December 31, 2011, our loan portfolio consisted of 21 first mortgage loans with a carrying value of $103.5 million. In comparison, as of December 31, 2010, our loan portfolio consisted of 38 first mortgage loans with a carrying value of $153.2 million. Given the non-performing status of the majority of the loan portfolio and the suspension of significant lending activities, there has been limited loan activity during the year ended December 31, 2011. Except for the origination of three loans totaling $8.0 million relating to the financing of a portion of the sale of certain REO assets during 2011, no new loans were originated during the year ended December 31, 2011.  Similarly, we originated only four loans during 2010 totaling $3.5 million relating to the partial financing of the sale of certain REO assets. As of December 31, 2011 and 2010, the valuation allowance represented 57.8% and 70.5%, respectively, of the total outstanding loan principal balances.

 

Lien Priority

 

Historically, all mortgage loans have been collateralized by first deeds of trust (mortgages) on real property, and generally include a personal guarantee by the principals of the borrower. Often the loans are secured by additional collateral. However, during 2010, we agreed to subordinate portions of our first lien mortgages to certain third-party lenders. As of December 31, 2011 and 2010, we had subordinated two first lien mortgages to third-party lenders in the amount of $20.4 million and $18.0 million, respectively (approximately 34% and 4% of the outstanding principal for each loan at December 31, 2011, respectively). One such subordination with a balance of $17.8 million was granted in order to provide liquidity to the borrower to complete the construction of the project, an obligation for which we had been responsible under the original loan terms. Under the terms of the subordination agreement, we may purchase or pay off the loan to the third-party lender at par. The second subordination with a balance of $2.6 million was subject to an intercreditor agreement which stipulates that the lender must notify us of any loan default or foreclosure proceedings, and we have the right, but not the obligation, to cure any event of default or to purchase the liens. The liens totaling $2.6 million are collateralized by just six of the 55 parcels that comprise the collateral for this loan. During the year ended December 31, 2011, we paid off one of the previous senior liens in the amount of $1.6 million on this loan, which was treated as a protective advance under the loan.

 

While subordinations of our first lien positions are not expected to be a common occurrence in the future, we may find it necessary to do so in an effort to maximize the opportunity for recovery of our investment. Independent title companies handle all loan closings and independent third-party companies, with our oversight, provide construction inspections and loan document management services for the majority of the mortgage loan note obligations that contain construction components.

 

As we have done historically, we will acquire almost exclusively first mortgages and trust deeds unless a second mortgage on a different property is offered as additional credit support. Even in those cases, we will not advance funds solely in respect of a second mortgage. However, we may accept any reasonable financing terms or make additional acquisitions we deem to be in our interests.

 

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Changes in the Loan Portfolio Profile

 

Effective October 1, 2008, we elected to suspend certain of our activities, including the origination and funding of any new loans. Accordingly, our ability to change the composition of our loan portfolio was significantly reduced. In addition, in an effort to seek to preserve our collateral, certain existing loans have been modified, often times by extending maturity dates, and, in the absence of available credit financing to repay our loans, we will likely modify additional loans in the future or foreclose on those loans.

 

Although we have in the past modified certain loans in our portfolio by extending the maturity dates or changing the interest rates thereof on a case by case basis, we do not have in place at this time a specific loan modification program or initiative. Rather, as in the past, we may modify any loan, in our sole discretion, based on the applicable facts and circumstances, including, without limitation: (i) our expectation that the borrower may be capable of meeting its obligations under the loan, as modified; (ii) the borrower’s perceived motivation to meet its obligations under the loan, as modified; (iii) whether we perceive that the risks are greater to us if the loan is modified, on the one hand, or not modified, on the other hand, and foreclosed upon; (iv) whether the loan is expected to become fully performing within some period of time after any proposed modification; (v) the extent of existing equity in the collateral net of the loan, as modified; (vi) the creditworthiness of the guarantor of the loan; (vii) the particular borrower’s track record and financial condition; and (viii) market based factors regarding supply/demand variables bearing on the likely future performance of the collateral. In the future, we expect to modify loans on the same basis as above without any reliance on any specific loan modification program or initiative.

 

Mortgage Loan Sales

 

During the year ended December 31, 2011, we sold seven mortgage loans for $13.2 million (net of selling costs), of which we financed $7.8 million, and recognized a loss on sale of $0.1 million. During the year ended December 31, 2010, we sold five mortgage loans for $5.6 million (net of selling costs), of which we financed $1.1 million, and recognized a gain on sale of $0.1 million.

 

Geographic Diversification

 

Our mortgage loans consist of loans where the primary collateral is located in Arizona, California, New Mexico, Idaho and Utah. The concentration of our loan portfolio in Arizona and California, markets in which values have been severely impacted by the decline in the real estate market, totals 92.0% and 90.1% at December 31, 2011 and 2010, respectively. Since we have effectively stopped funding new loans, as a result of other factors, our ability to diversify our portfolio is significantly impaired.  The change in the geographic diversification of our loans is primarily attributed to the foreclosure and transfer of loans to REO assets.

 

While our geographic concentration has been focused primarily in the southwestern United States, we expect to further diversify our investments geographically if attractive opportunities arise when we recommence lending activities.

 

See “Note 5 – Mortgage Investments, Loan Participations and Loan Sales” in the accompanying consolidated financial statements and Part II, Item 6. - "Selected Financial Data" for additional information regarding the geographic diversification of our loan portfolio.

 

Interest Rate Information

 

Our loan portfolio includes loans that carry variable and fixed interest rates. All variable interest rate loans are indexed to the Prime rate with interest rate floors. At December 31, 2011 and 2010, respectively, the Prime rate was 3.25% per annum.

 

Despite these interest rates, the majority of our existing loans are in non-accrual status. At December 31, 2011, three of our 21 portfolio loans were performing and had an average principal balance of $2.4 million and a weighted average interest rate of 10.6%. At December 31, 2010, eight of our 38 portfolio loans were performing and had an average principal balance of $1.2 million and a weighted average interest rate of 10.1%. For additional discussion regarding the impact of pro forma increases or decreases in the Prime rate, see “Quantitative and Qualitative Disclosures about Market Risk” located elsewhere in this Form 10-K.

 

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See Note 5 – “Mortgage Investments, Loan Participations and Loan Sales” in the accompanying consolidated financial statements and Part II, Item 6. - "Selected Financial Data" for additional information regarding interest rates for our loan portfolio.

 

Loan and Borrower Attributes

 

The collateral supporting our loans generally consists of fee simple real estate zoned for residential, commercial or industrial use. The real estate may be in any stage of development from unimproved land to finished buildings with occupants or tenants.

 

From a collateral standpoint, we believe the level of risk decreases as the borrower obtains governmental approvals (i.e., entitlements) for development. When the ultimate goal is to build an existing structure that can be sold or rented, in general, fully entitled land that is already approved for construction is more valuable than a comparable piece of land that has received no entitlement approvals. Each municipality or other governmental agency has its own variation of the entitlement process; however, in general, the functions tend to be relatively similar. In general, the closer to completion a construction project may be, the lower the level of risk that construction will be delayed.

 

Substantially all of our existing loans are in some stage of development and do not generate cash flow for purposes of servicing our debt. Further, as a loan’s collateral progresses through its various stages of development, the value of the collateral generally increases more than the related costs of such improvements. Accordingly, as is customary in our industry, interest has historically been collected through the establishment of “interest reserves” that are included as part of the “loan- to-value” analysis made during the original and any subsequent underwriting process. Interest on loans with unfunded interest reserves is added to the loan balance with the offsetting accounting entry to interest income.

 

Our existing borrowers generally consist of land developers, homebuilders, commercial property developers and real estate investors. In general, our loans have historically had a term of three to 24 months and are full-recourse, meaning one or more principals of the borrower personally guaranty the debt. Typically, the borrower is a single purpose entity that consists of one or more members that serve as guarantors to the loan.

 

Upon maturity of any loan, if the borrower requests an extension of the loan or is unable to payoff our loan or refinance the property, the request is analyzed using our underwriting procedures to determine whether the collateral value remains intact and/or whether an advance of additional interest reserves is warranted. If the value of the collateral does not meet our requirements and the borrower is unable to offer additional concessions, such as additional collateral, we typically begin enforcement proceedings which may result in foreclosure. Valuation of the underlying collateral for all loans is subject to quarterly analysis to determine whether any impairment is warranted. If a loan enters default status and is deemed to be impaired because the underlying collateral value is insufficient to recover all loan amounts due, we generally cease the capitalization of interest into the loan balance.

 

We also classify loans into categories based on the underlying collateral’s projected end-use for purposes of identifying and managing loan concentration and associated risks. As of December 31, 2011, the original projected end-use of the collateral under our loans was comprised of 46.8% residential, 30.7% mixed-use, 22.1% commercial and the balance for industrial. As of December 31, 2010, the original projected end-use of the collateral under our loans was comprised of 48.8% residential, 35.1% mixed-use, 15.8% commercial and the balance for industrial.

 

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With our suspension of the funding of new loans, the concentration of loans by type of collateral and end-use is expected to remain consistent within our current portfolio. As of December 31, 2011 and 2010, respectively, the concentration of loans by type of collateral and end-use was relatively consistent over these periods. Changes in classifications are primarily a result of foreclosures of certain loans.

 

We intend to continue the process of disposing of a significant portion of our existing assets, individually or in bulk, and to utilize the proceeds for operating purposes or, to the extent excess funds are available, to reinvest the proceeds from such dispositions in our target assets. Accordingly, we intend to introduce additional loan and other asset types as a further means of classifying our assets.

 

At December 31, 2011, approximately 60% of the valuation allowance was attributable to residential-related projects, 40% to mixed-use projects and the balance to commercial and industrial projects. We estimate that, as of December 31, 2010, approximately 54% of the valuation allowance is attributable to residential-related projects, 44% to mixed-use projects, and the balance to commercial and industrial projects.

 

See “Note 5 – Mortgage Investments, Loan Participations and Loan Sales” in the accompanying consolidated financial statements and Part II, Item 6. - "Selected Financial Data" for additional information regarding the classification of our loan portfolio.

 

Changes in the Portfolio Profile — Scheduled Maturities

 

The outstanding principal balance of mortgage loans, net of the valuation allowance, as of December 31, 2011 and 2010, have scheduled maturity dates within the next several quarters as follows:

 

December 31, 2011  
Quarter  #   Amount   Percent 
Matured   16   $144,405    58.9%
Q1 2012   2    2,719    1.1%
Q3 2012   2    93,566    38.2%
Q3 2013   1    4,500    1.8%
Total   21    245,190    100.0%
Less: Valuation Allowance        (141,687)     
                
Net Carrying Value       $103,503      

 

Of the total of matured loans as of December 31, 2011, approximately 14% matured in the year ended December 31, 2008, 53% matured in the year ended December 31, 2009, 6% matured in the year ended December 31, 2010 and 27% matured in the year ended December 31, 2011.

 

From time to time, we may extend a mortgage loan’s maturity date in the normal course of business. In this regard, we have modified certain loans, extending maturity dates in some cases to two or more years, and we expect we will modify additional loans in the future in an effort to seek to preserve our collateral. Accordingly, repayment dates of the loans may vary from their currently scheduled maturity date. If the maturity date of a loan is not extended, we classify and report the loan as matured.

 

See “Note 5 – Mortgage Investments, Loan Participations and Loan Sales” in the accompanying consolidated financial statements and Part II, Item 6. - "Selected Financial Data" for additional information regarding loan modifications.

 

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Operating Properties and Real Estate Held for Development or Sale

 

REO assets are reported as either operating properties, held for development or held for sale, depending on whether we plan to hold operating assets received in foreclosure, develop land-related assets prior to selling them or instead sell them in the immediate future, and whether they meet the criteria to be classified as held for sale under GAAP. The estimation process involved in the valuation of REO assets is inherently uncertain since it requires estimates as to the consideration of future events and market conditions. Our estimate of fair value is based on our intent regarding the proposed development of the related asset, if deemed appropriate, as opposed to a sale of such property on an as-is basis. In such cases, we evaluate whether we have the intent, resources and ability to carry out the execution of our disposition strategy under normal operating circumstances, rather than a forced disposition under duress. Economic, market, environmental and political conditions, such as exit prices and absorption rates, may affect management’s plans for development and marketing of such properties. In addition, the implementation of such plans could be affected by the availability of financing for development and construction activities, if such financing is required. Accordingly, the ultimate realization of our carrying values of our real estate properties is dependent upon future economic and market conditions, the availability of financing, and the resolution of political, environmental and other related issues, many of which are beyond our control.

 

At December 31, 2011, we held total REO assets of $95.5 million, of which $44.9 million was held for development, $30.9 million was held for sale, and $19.6 million was held as operating property. At December 31, 2010, we held total REO assets of $89.5 million, of which $36.7 million was held for development, $31.8 million was held for sale and $21.0 million was held as operating property. Such assets are located in California, Texas, Arizona, Minnesota, Nevada, New Mexico and Idaho.

 

We continue to evaluate various alternatives for the ultimate disposition of these investments, including partial or complete development of the properties prior to sale or disposal of the properties on an as-is basis. Project development alternatives may include, either through joint venture or on a project management basis, the development of the project through entitlement prior to sale, completion of various improvements or complete vertical construction prior to sale. For additional information regarding these properties, see the section titled Item 2. “Business — Properties.”

 

During the year ended December 31, 2011, we foreclosed on 12 loans (resulting in 10 property additions) and took title to the underlying collateral with net carrying values totaling $13.7 million as of December 31, 2011. During the year ended December 31, 2010, we foreclosed on twenty loans and took title to the underlying collateral with net carrying values totaling $32.9 million as of December 31, 2010. Additionally, we acquired an additional lot held for sale in 2010 in connection with the acquisition of the Manager with a carrying value of $39,000. The number of REO property additions does not necessarily correspond directly to the number of loan foreclosures as some loans have multiple collateral pieces that are viewed as distinct REO projects or, alternatively, we may have foreclosed on multiple loans to one borrower relating to the same REO project.

 

REO Sales

 

We are periodically approached on an unsolicited basis by third parties expressing an interest in purchasing certain REO assets. However, except for those assets designated for sale, management had not developed or adopted any formal plan to dispose of these assets or such assets do not meet one or more of the GAAP criteria as being classified as held for sale (e.g., the anticipated disposition period may extend beyond one year). During 2011, we sold seven REO assets or portions thereof for $9.4 million (net of selling costs), of which we financed $0.2 million, for a gain of $0.3 million. During the year ended December 31, 2010, we sold five REO assets or portions thereof for $6.9 million (net of selling costs), of which we financed $2.2 million, resulting in a gain on disposal of real estate of $1.2 million. All REO assets owned by us are located in California, Arizona, Texas, Minnesota, Nevada and Idaho.

 

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REO Planned Development

 

Costs related to the development or improvements of the real estate assets are generally capitalized and costs relating to holding the assets are generally charged to expense. Cash outlays for capitalized development costs totaled $0.7 million, $1.6 million and $2.5 million during the years ended December 31, 2011, 2010 and 2009, respectively. In addition, costs and expenses related to operating, holding and maintaining such properties (including property taxes), which are expensed and included in operating expenses for REO assets in the accompanying consolidated statement of operations, totaled approximately $5.5 million, $4.9 million and $4.2 million for the years ended December 31, 2011, 2010 and 2009, respectively. The nature and extent of future costs for such properties depends on the holding period of such assets, the level of development undertaken, our projected return on such holdings, our ability to raise funds required to develop such properties, the number of additional foreclosures and other factors. While our assets are generally available for sale, we continue to evaluate various alternatives for the ultimate disposition of these investments, including partial or complete development of the properties prior to sale or disposal of the properties on an as-is basis.

 

REO Classification

 

As of December 31, 2011, approximately 46% of our REO assets were originally projected for development of residential real estate, 18% was scheduled for mixed-used real estate development, and 36% was planned for commercial or industrial use. As of December 31, 2010, approximately 39% was originally projected for development of residential real estate, 24% was scheduled for mixed-used real estate development, and 37% was planned for commercial use. We are currently evaluating our use and disposition options with respect to these projects. The real estate held for sale consists of improved and unimproved residential lots, completed residential units and completed commercial properties located in California, Arizona, Texas, Nevada and Idaho.

 

We intend to continue the process of disposing of a significant portion of our existing assets, individually or in bulk, which we anticipate will result in the further reclassification of an additional portion of our REO assets as held for sale.

 

See “Note 6 – Operating Properties and Real Estate Held for Development or Sale” in the accompanying consolidated financial statements for additional information.

 

Important Relationships Between Capital Resources and Results of Operations

 

 Summary of Existing Loans in Default

 

We continue to experience loan defaults as a result of depressed real estate market conditions and lack of takeout financing in the marketplace. Loans in default may encompass both non-accrual loans and loans for which we are still accruing income, but are delinquent as to the payment of accrued interest or are past scheduled maturity. At December 31, 2011, 18 of our 21 loans with outstanding principal balances totaling $238.0 million were in default, of which 16 with outstanding principal balances totaling $144.4 million were past their respective scheduled maturity dates, and the remaining two loans have been deemed non-performing based on the value of the underlying collateral in relation to the respective carrying value of the loans. At December 31, 2010, 30 of our 38 loans with outstanding principal balances totaling $407.4 million were in default, of which 25 with outstanding principal balances totaling $280.3 million were past their respective scheduled maturity dates, and the remaining five loans were in default as a result of delinquency on outstanding interest payments or were deemed non-performing based on the value of the underlying collateral in relation to the respective carrying value of the loan. In light of current economic conditions and in the absence of a recovery of the credit markets, it is anticipated that many, if not most, loans with scheduled maturities within one year will not be paid off at the scheduled maturity.

 

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Of the 30 loans that were in default at December 31, 2010, 15 of these loans remained in default status as of December 31, 2011, 12 such loans were foreclosed upon, three loans were sold and three new loans were added during the year ended December 31, 2011.

 

We are exercising enforcement action which could lead to foreclosure upon 17 of the 18 loans in default.  Of these 17 loans upon which we are exercising enforcement action, we completed foreclosure on five loans (resulting in the addition of four properties) subsequent to December 31, 2011 with a net carrying value of $5.8 million.  The timing of foreclosure on the remaining is dependent on several factors including applicable states statutes, potential bankruptcy filings by the borrowers, our ability to negotiate a deed-in-lieu of foreclosure and other factors.

 

As of December 31, 2011, two of the loans that are in non-accrual status relate to a borrowing group that is not in technical default under the loan terms. However, due to the value of the underlying collateral for these collateral dependent loans, we have deemed it appropriate to maintain these loans in non-accrual status.

 

We are continuing to work with the borrower with respect to the remaining one loan in default in order to seek to maintain the entitlements on the related project and, thus, the value of our existing collateral. These negotiations may result in a modification of the existing loan.

 

See “Note 5 – Mortgage Investments, Loan Participations and Loan Sales” in the accompanying consolidated financial statements and Part II, Item 6. - "Selected Financial Data" for additional information regarding loans in default.

 

Valuation Allowance and Fair Value Measurement of Loans and Real Estate Held for Sale

 

We perform a valuation analysis of our loans not less frequently than on a quarterly basis. Evaluating the collectability of a real estate loan is a matter of judgment. We evaluate our real estate loans for impairment on an individual loan basis, except for loans that are cross-collateralized within the same borrowing groups. For cross-collateralized loans within the same borrowing groups, we perform both an individual loan evaluation as well as a consolidated loan evaluation to assess our overall exposure to those loans. In addition to this analysis, we also complete an analysis of our loans as a whole to assess our exposure for loans made in various reporting periods and in terms of geographic diversity. The fact that a loan may be temporarily past due does not result in a presumption that the loan is impaired. Rather, we consider all relevant circumstances to determine if, and the extent to which, a valuation allowance is required. During the loan evaluation, we consider the following matters, among others:

 

  · an estimate of the net realizable value of any underlying collateral in relation to the outstanding mortgage balance, including accrued interest and related costs;
  · the present value of cash flows we expect to receive;
  · the date and reliability of any valuations;
  · the financial condition of the borrower and any adverse factors that may affect its ability to pay its obligations in a timely manner;
  · prevailing economic conditions;
  · historical experience by market and in general; and
  · evaluation of industry trends.

 

We perform an evaluation for impairment on all of our loans in default as of the applicable measurement date based on the fair value of the underlying collateral of the loans because our loans are considered collateral dependent, as allowed under applicable accounting guidance. Impairment for collateral dependent loans is measured at the balance sheet date based on the then fair value of the collateral in relation to contractual amounts due under the terms of the applicable loan. In the case of the loans that are not deemed to be collateral dependent, we measure impairment based on the present value of expected future cash flows. Further, the impairment, if any, must be measured based on the fair value of the collateral if foreclosure is probable. All of our loans are deemed to be collateral dependent.

 

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Similarly, REO assets that are classified as held for sale are measured at the lower of carrying amount or fair value, less estimated cost to sell. REO assets that are classified as held for development are considered “held and used” and are evaluated for impairment when circumstances indicate that the carrying amount exceeds the sum of the undiscounted net cash flows expected to result from the development and eventual disposition of the asset.  If an asset is considered impaired, an impairment loss is recognized for the difference between the asset’s carrying amount and its fair value, less estimated cost to sell. If we elect to change the disposition strategy for our real estate held for development, and such assets were deemed to be held for sale, we would likely record additional impairment charges, and the amounts could be significant.

 

In determining fair value, we have adopted applicable accounting guidance which establishes a framework for measuring fair value in accordance with GAAP, clarifies the definition of fair value within that framework, and expands disclosures about the use of fair value measurements. This accounting guidance applies whenever other accounting standards require or permit fair value measurement.

 

Under applicable accounting guidance, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability, or the “exit price”, in an orderly transaction between market participants at the measurement date. Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are (a) independent of the reporting entity; that is, they are not related parties; (b) knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information, including information that might be obtained through due diligence efforts that are usual and customary; (c) able to transact for the asset or liability; and (d) willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so.

 

See “Note 7 – Fair Value” in the accompanying consolidated financial statements for a summary of procedures performed.

 

Valuation Conclusions

 

Based on the results of our evaluation and analysis, while some loans experienced declines in fair value, other loans improved in fair value resulting in a net increase in the valuation allowance as of December 31, 2011. For the years ended December 31, 2011, 2010 and 2009, we recorded provisions for credit losses, net of recoveries, of $1.0 million, $47.5 million and $79.3 million, respectively. As of December 31, 2011, the valuation allowance totaled $141.7 million, representing 57.8% of the total outstanding loan principal balances. As of December 31, 2010, the valuation allowance totaled $294.1 million, representing 70.5% of the total loan portfolio principal balances. The provision for credit loss recorded during the year ended December 31, 2011 was primarily attributed to one of our larger loans secured by a hospitality asset that experienced a significant decrease in operating performance. However, based on our analysis, since this is our only loan secured by a hospitality asset, we do not believe the decline in related value should extend nor be extrapolated to our other real estate assets. The reduction in the valuation allowance in total and as a percentage of loan principal is primarily attributed to the transfer of the allowance associated with loans on which we foreclosed and the charge off of valuation allowance on loans which were sold during fiscal 2011.

 

In addition, during the years ended December 31, 2011 and 2010, we recorded impairment charges of $1.5 million and $46.9 million, respectively, relating to the further write-down of certain real estate acquired through foreclosure during the respective periods.

 

With the existing valuation allowance recorded as of December 31, 2011, we believe that, as of that date, the fair value of our loans and REO assets held for sale is adequate in relation to the net carrying value of the related assets and that no additional valuation allowance is considered necessary. While the above results reflect management’s assessment of fair value as of December 31, 2011 and 2010 based on currently available data, we will continue to evaluate our loans in fiscal 2012 and beyond to determine the adequacy and appropriateness of the valuation allowance and to update our loan-to-value ratios. Depending on market conditions, such updates may yield materially different values and potentially increase or decrease the valuation allowance for loans or impairment charges for REO assets.

 

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Valuation of Real Estate Held for Development and Operating Properties

 

Valuation of REO assets is based on our intent and ability to execute our disposition plan for each asset and the proceeds to be derived from such disposition, net of estimated selling costs, in relation to the carrying value of such assets. REO assets for which management determines it is likely to dispose of such assets without further development are valued on an “as is” basis based on current valuations using comparable sales. If management determines that it has the intent and ability to develop the asset over future periods in order to realize a greater value, management will perform a valuation on an “as developed” basis, net of estimated selling costs but without discounting of cash flows, to determine whether any impairment exists. Management does not write up the carrying value of real estate assets held for development if the proceeds from disposition are expected to exceed the carrying value of such assets. Rather, any gain from the disposition of such assets is recorded at the time of sale. REO assets that are classified as held for sale are measured at the lower of carrying amount or fair value, less estimated cost to sell.

 

REO assets that are classified as held for development are considered “held and used” and are evaluated for impairment when, based on various criteria set forth in applicable accounting guidance, circumstances indicate that the carrying amount exceeds the sum of the undiscounted net cash flows expected to result from the development and eventual disposition of the asset. If an asset is considered impaired, an impairment loss is recognized for the difference between the asset’s carrying amount and its fair value, less cost to sell.

 

We recorded impairment charges of $1.5 million, $46.9 million and $8.0 million relating to the impairment in value of REO assets deemed to be other than temporary impairment, during the years ended December 31, 2011, 2010 and 2009, respectively. The impairment charges in 2010 and 2009 were primarily a result of a change in management’s disposition strategy for selected REO assets from a development approach to a disposal approach based on recent values consistent with the change in business strategy resulting from the Conversion Transactions. In 2011, the impairment charges were primarily to adjust the fair value of our REO held for sale.

 

If we elect to change the disposition strategy for our real estate held for development, and such assets were deemed to be held for sale, we would likely record additional impairment charges, and the amounts could be significant. However, given our valuation methodology for valuing such assets, we do not expect such amounts to be of the levels previously recorded. As of December 31, 2011 and 2010, approximately 93% of our REO carrying value assets were based on an “as is” valuation while only 7% were valued on an “as developed” basis. We believe the estimated net realizable values of such properties equal or exceed the current carrying values of our investment in the properties as of December 31, 2011.

 

See “Note 6 – Operating Properties and Real Estate Held for Development or Sale” in the accompanying consolidated financial statements for procedures performed in estimating the amount of undiscounted cash flows for REO held for development and in determining the level of additional development we expect to undertake for each project and for further information regarding our REO assets.

 

Leverage to Enhance Portfolio Yields

 

We have not historically employed a significant amount of leverage to enhance our investment yield. However, we have recently secured a limited amount of debt and may deem it beneficial, if not necessary, to employ additional leverage for us in the future.

 

Current and Anticipated Borrowings

 

On June 7, 2011, we entered into and closed funding of a $50.0 million senior secured convertible loan with NW Capital. The loan matures on June 6, 2016 and bears interest at a rate of 17% per year. The lender elected to defer all interest due through December 7, 2011 and 5% of the interest accrued from December 8, 2011 to December 31, 2011. Thereafter, the lender, at its sole option, may make an annual election to defer a portion of interest due representing 5% of the total accrued interest amount, with the balance (12%) payable in cash. NW Capital has made the election to defer the 5% interest for the year ending December 31, 2012. Deferred interest is capitalized and added to the outstanding loan balance on a quarterly basis. Interest is payable quarterly in arrears beginning on January 1, 2012, and thereafter each April, July, October and January during the term of the loan.

 

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In addition, we are required to pay an exit fee (“Exit Fee”) at maturity equal to 15% of the then outstanding principal, unpaid accrued and deferred interest and other amounts owed under the loan agreement. The Exit Fee is considered fully earned under the terms of the loan agreement and has been recorded as a liability with an offsetting amount reflected as a discount to the convertible note payable. The Exit Fee and discount of $10.4 million was estimated assuming the lender elects its annual interest deferral option over the term of the loan. This amount is being amortized to interest expense over the term of the loan using the effective interest method. The loan is severally, but not jointly, guaranteed by substantially all of our existing and future subsidiaries, subject to certain exceptions and releases, and is secured by a security interest in substantially all of our assets. The loan may not be prepaid prior to December 7, 2014 and is subject to substantial prepayment fees and premiums. At the time of prepayment, if any, we would also be required to buy back all of the common shares then held by NW Capital or its affiliates which were acquired from our former CEO or from any tender offer by NW Capital at a purchase price equal to the greater of (a) NW Capital’s original purchase price and (b) the original purchase price plus 50% of the excess book value over the original purchase price.

 

We are obligated to redeem all outstanding shares of Series A preferred stock on the fifth anniversary of the loan date in cash, at a price equal to 115% of the original purchase price, plus all accrued and unpaid dividends (whether or not earned or declared), if any, to and including the date fixed for redemption, without interest. In addition, the Series A preferred stock has certain redemption features in the event of default or the occurrence of certain other events.

 

The proceeds from the loan may be used: for working capital and funding our other general business needs; for certain obligations with respect to our real property owned, and, as applicable, the development, redevelopment and construction with respect to certain of such properties; for certain obligations with respect to, and to enforce certain rights under, the collateral for our loans; to originate and acquire mortgage loans or other investments; to pay costs and expenses incurred in connection with the convertible loan; and for such other purposes as may be approved by NW Capital in its discretion.See “Note 9 – Notes Payable” in the accompanying consolidated financial statements for additional information regarding this loan.

 

As described elsewhere in this Form 10-K, on January 31, 2012, we reached a tentative settlement in principle to resolve claims asserted by the plaintiffs in the Litigation, the terms of which have been memorialized in the MOU. Under the terms of the tentative settlement, if approved, we have agreed to offer $20.0 million of 4% five-year subordinated notes to members of the Class in exchange for 2,493,765 shares of IMH common stock at an exchange rate of $8.02 per share. In addition, we have agreed to offer to class members that are accredited investors $10.0 million of convertible notes with the same economic terms as the convertible notes previously issued to NW Capital. There can be no assurance that the court will approve the tentative settlement in principle. Further, the judicial process to ultimately settle this action is estimated to take a minimum of six to nine months or longer.

 

Other Notes Payable Activity

 

In January 2010, we entered into a settlement agreement with respect to litigation involving the responsibility and ownership of certain golf club memberships attributable to certain property acquired through foreclosure. Under the terms of the settlement agreement, we agreed to execute two promissory notes for the golf club memberships totaling $5.3 million. The notes are secured by the security interest on the related lots, are non-interest bearing and mature on December 31, 2012. Due to the non-interest bearing nature of the loans, in accordance with applicable accounting guidance, we imputed interest on the notes at our incremental borrowing rate of 12% per annum and recorded the notes net of the discount. The discount is being amortized to interest expense over the term of the notes and totaled approximately $0.5 million and $0.1 million for the years ended December 31, 2011 and 2010, respectively. The net principal balance of the notes payable at December 31, 2011 was $4.7 million and the remaining unamortized discount was approximately $0.6 million.

 

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All other debt that was outstanding at December 31, 2010 was repaid in fiscal 2011 utilizing funds from the proceeds of the NW Capital loan or from the sale of the related assets that served as collateral for such debt. See Note 9 – “Notes Payable” in the accompanying consolidated financial statements for further information regarding notes payable activity.

 

Our investment policy, the assets in our portfolio and the decision to utilize leverage are periodically reviewed by our board of directors as part of their oversight of our operations. We may employ leverage, to the extent available and permitted, through borrowings to finance our assets or operations, to fund the origination and acquisition of our target assets and to increase potential returns to our stockholders. Although we are not required to maintain any particular leverage ratio, the amount of leverage we will deploy for particular target assets will depend upon our assessment of a variety of factors, which may include the anticipated liquidity and price volatility of the target assets in our portfolio, the potential for losses and extension risk in our portfolio, the gap between the duration of our assets and liabilities, including hedges, the availability and cost of financing the assets, our opinion of the creditworthiness of our financing counterparties, the health of the U.S. economy and commercial mortgage markets, our outlook for the level, slope, and volatility of interest rates, the credit quality of our target assets, the collateral underlying our target assets, and our outlook for asset spreads relative to the LIBOR curve. Our charter and bylaws do not limit the amount of indebtedness we can incur, and our board of directors has discretion to deviate from or change our indebtedness policy at any time. We intend to use leverage for the sole purpose of financing our portfolio and not for the purpose of speculating on changes in interest rates.

 

Nevertheless, under the NW Capital loan agreement and the Certificate of Designation for Series A Preferred Stock, we are subject to numerous borrowing restrictions. We are not permitted to sell, convey, mortgage, grant, bargain, encumber, pledge, assign or transfer any interest in any REO or loan collateral, whether voluntarily or involuntarily, without the prior written consent of NW Capital. Moreover, we are not allowed to create, incur, assume or permit to exist any lien on any REO or loan collateral, except for permitted encumbrances or liens, and other than the loan and certain permitted borrowings at the time of closing of the NW Capital loan, we may not incur any other debt, except for anticipated rights offering and notes exchange debt, in each case without the prior written consent of NW Capital. However, since our liquidity strategy is largely dependent on the sale of current assets, we do not expect NW Capital’s approval to sell such assets to be unreasonably withheld.

 

However, after two years following the loan closing date, as long as we maintain a pledged asset coverage value of at least $250 million, and we are in compliance with the NW Capital loan, we are permitted to borrow funds under one or more lines of credit from an institutional lender, but such debt may not be secured by the NW Capital loan collateral. The amount of permitted borrowings is subject to minimum tangible net worth requirements, leverage ratio, a fixed charge coverage ratio and a loan-to-value maximum.

 

Liquidity and Capital Resources

 

We require liquidity and capital resources to acquire and originate our target assets, as well as for costs, expenses and general working capital needs, including maintenance and development costs for REO assets, general and administrative operating costs, management fees and loan enforcement costs, interest expense on the NW Capital loan (or preferred dividends upon conversion), participations and loans, repayment of principal on borrowings and other expenses. We also may require liquidity if we choose to redeem up to 838,448 shares of our Class C common stock in an initial public offering, less underwriting discounts and commissions, and subject to availability of legally distributable funds, to pay a one-time special dividend in respect to our Class B common stock, as well as the payment of any future dividends or other distributions we might declare. We expect our primary sources of liquidity over the next twelve months to consist of the net proceeds from the NW Capital loan and proceeds from the disposition of a substantial portion of our existing assets. However, given the lack of significant sales activity experienced and the actual prices that may be realized from the sale of loans and REO assets, the disposition of these assets may not have a significant effect on our liquidity. We anticipate redeploying these proceeds to acquire our target assets, which will generate periodic liquidity from cash flows from dispositions of these assets through sales and interest income. In addition to the net proceeds of the NW Capital loan and the disposition of our existing portfolio of loans and REO assets, we expect to address our liquidity needs by periodically accessing the capital markets, lines of credit and credit facilities or pursuing other available alternatives which may become available to us, subject to the restrictions provided under the NW Capital loan agreement. We discuss our capital requirements and sources of liquidity in further detail below.

 

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Financial Statement Presentation and Liquidity

 

Our financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. Due to unprecedented dislocations in the real estate and capital markets, we have experienced a significant reduction in loan payoffs from borrowers and an increase in delinquencies, non-performing loans and REO assets, resulting in a substantial reduction in our historical cash flows. We have taken a number of measures to provide liquidity, including, among other things, securing financing from the NW Capital loan, engaging in efforts to sell whole loans and participate interests in our loans, and to dispose of certain real estate. We have also consummated the Conversion Transactions in an effort to ultimately position us for an initial public offering, the net proceeds of which will help us in addressing our liquidity needs. In addition, we expect to continue to pursue the sale of a substantial portion of our existing REO assets and loans in order to assist us in addressing our liquidity needs and re-commence investing activities.

 

In October 2008, we suspended all of the Fund’s lending activities, member investment capital raising and all other non-core operations. We took this action because we believed that the market for permanent take-out financing for our borrowers had materially diminished due to the macroeconomic problems in the real estate, credit and capital markets, concerns about the continued existence of many major national and international financial institutions, and the ability, willingness and timeliness of the federal government to intervene. Further, member redemption requests accelerated during 2008, particularly in August and September 2008. Further, to adequately protect our available cash reserves for purposes of honoring our contractual commitments for remaining unfunded loan obligations, as well as retaining a liquidity reserve for funding ongoing operations, all new lending activity was ceased. Lastly, in the context of our expectations of materially lower borrower payoffs and pay downs resulting from the absence of available permanent take-out financing from third-party lenders, we concluded that the viability of our historical business model was at risk, and deemed it ill-advised to raise capital from new investors at that time in light of the deterioration of the real estate, credit and other relevant markets.

 

We have engaged NWRA and other consultants to provide asset management services, and have explored various options, including the pledging of loans in exchange for borrowings from commercial banks or private investment funds, and the possibility of private or public equity or debt offerings. During 2011, we saw an increased level of market activity and unsolicited offers received from interested third parties to purchase our assets. To date, we have closed a limited number of these liquidity transactions due to the continued disruptions in the real estate-related credit markets. However, we have sold a sufficient number of assets to continue operating the business and administrating the loans and real estate. The sales of such assets thus far have been primarily based on distressed valuation pricing because of the substantial supply of assets in the market. Effective March 2011, in connection with the resignation of our previous consultants, we entered into an agreement with NWRA to provide a diagnostic review of us and our existing assets, the development and, subject to our review, modification and approval of recommended actions, implementation of a plan for originating, analyzing and closing new investment transactions, and an assessment of our business and capital market alternatives.

 

In addition, we have secured $50 million in debt financing from NW Capital to allow us the time and resources necessary to meet liquidity requirements and dispose of assets in a reasonable manner and on terms more favorable to us. However, the dislocations and uncertainty in the economy, and in the real estate, credit, and other markets, have created an extremely challenging environment that will likely continue for the foreseeable future, and we cannot assure you that we will be able to dispose of assets in a timely manner or on terms favorable to us.

 

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While we were successful in securing $50 million in financing from the NW Capital loan closing in June 2011, there is no assurance that we will be successful in selling existing real estate assets or implementing our investment strategy in a timely manner in order to sufficiently fund on-going operations or obtain additional financing if needed, and if available, there are no assurances that the financing will be at commercially acceptable terms or permitted by NW Capital. Failure to generate sustainable earning assets may have a further adverse effect on our business, results of operations and financial position.

 

Prior to its acquisition of the Manager, the Fund had no employees, management group or independent board of directors, and was dependent on the Manager for those functions. Accordingly, lenders and other organizations in the past preferred that the Manager function as an intermediary in business transactions rather than contracting directly with the Fund. With the acquisition of the Manager effective June 18, 2010, we are now acting in such matters on our own behalf.

 

Requirements for Liquidity

 

We require liquidity and capital resources for various financial needs, including to acquire and originate our target assets, as well as for cost, expenses and general working capital needs, including, maintenance and development costs for REO assets, general and administrative operating costs, management fees and loan enforcement costs, interest expense on participations and loans, repayment of principal on borrowings, payment of outstanding property taxes and other liabilities and costs.

 

We expect our primary sources of liquidity over the next twelve months to consist of the net proceeds generated by the NW Capital loan and the disposition of a substantial portion of our existing loan and REO assets. However, there can be no assurance that we will be able to dispose of existing assets held for sale at the prices sought or in the timeframe anticipated. We anticipate redeploying these proceeds to acquire our target assets, which will generate periodic liquidity from current investment earnings, as well as cash flows from dispositions of these assets through sale and loan participations. We discuss our capital requirements and sources of liquidity in further detail below (amounts in thousands).

 

Sources of Liquidity     
Cash in Bank  $21,300 
Sale of Loans and REO Assets   79,000 
Proceeds from Mortgage Payments   4,300 
Rental Income   2,800 
Investment Income   4,700 
Total  $112,100 
      
Requirements for Liquidity     
Acquisition of Target Assets  $(60,300)
Loans-in-Process Funding   (1,700)
Repayment of Borrowings   (5,300)
Operating Expenses for REO   (2,900)
Real Estates Taxes on REO   (1,900)
Real Estates Taxes on Loans Sold   (3,500)
Development of REO   (6,000)
Professional Fees   (4,500)
General and Administrative Expenses   (6,100)
Default and Related Expenses   (1,200)
Interest Payments   (5,400)
Accounts Payable and Accrued Taxes   (11,700)
Dividends to Stockholders   (1,600)
Total  $(112,100)

 

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The information in the table above constitutes forward-looking information and is subject to a number of risks and uncertainties, including those set forth under the heading entitled “Risk Factors,” which may cause our sources and requirements for liquidity to differ from those estimates. To the extent that the net proceeds from the sources of liquidity reflected in foregoing table are not realized in the amount or time-frame anticipated, the shortfall would reduce the timing and amount of our ability to undertake and consummate the acquisition of target assets by a corresponding amount.

 

Loan Fundings and Investments

 

We require adequate liquidity to acquire our target assets and fund initial loan advances to the borrowers. We anticipate that the net proceeds available from the NW Capital loan, coupled with the cash generated from the disposition of selected assets, after deducting operating and reserve funds, will be available for investment in the target assets, which is assumed to be redeployed evenly over the 12-month period into income producing assets. Based on our assumptions, we anticipate acquiring $60.3 million of target assets over the next 12 months. Currently we have not identified specific assets to acquire, but as discussed in Business — Our Target Assets, our acquisition of the target assets will be facilitated by our access to an extensive pipeline of industry relationships, our localized market expertise, our experienced management team, our strong underwriting capabilities and our market driven investment strategy.

 

We expect our loan funding requirements to decrease over the shorter term and our requirements for funds to acquire commercial mortgage loans to increase as we focus more on this asset class as discussed in “Business — Our Target Assets.” Our initial loan funding amounts are typically less than the full face amount of the mortgage loan amount, in order to provide for future disbursements for construction, development, and interest. As is customary in the commercial lending business, our loan terms may require the establishment of funded or unfunded interest reserves which are included as part of the note commitment and considered in the loan to value ratios at the time of underwriting. In some cases, the borrower may elect to pay interest from its own sources. On certain loans, upon their initial funding, the reserve for future interest payments is deposited into a controlled disbursement account in the name of the borrower for our benefit. These accounts, which are held in the name of the borrowers, are not included in the consolidated balance sheets.

 

At December 31, 2011, none of our 21 borrowers had established funded or unfunded interest reserves. At December 31, 2010, of our 38 borrowers, two of our borrowers had established unfunded interest reserves, three borrowers had funded interest reserves available, and 33 of our borrowers were obligated to pay interest from their own alternative sources.

 

During the years ended December 31, 2011, 2010, and 2009, mortgage loan interest satisfied by the use of unfunded interest reserves was $0, $26,000 (or 1.8%) and $3.8 million (17.8%), respectively, of total mortgage loan interest income for each year. During the years ended December 31, 2011, 2010 and 2009, mortgage loan interest satisfied by the use of funded interest reserves was $0.1 million (6.0%), $0.1 million (6.3%) and $8.2 million (38.5%), respectively, of total mortgage loan interest income for each year.

 

Estimated future lending commitments at December 31, 2011 consisted of $1.7 million reserved for property taxes. This amount is recorded on the consolidated balance sheets and is shown net of loans held for sale. As of December 31, 2011 and 2010, undisbursed loans-in-process and interest reserves balances were as follows (in thousands):

 

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   December 31, 2011   December 31, 2010 
   Loans Held       Loans Held     
  for Sale   Total   for Sale   Total 
Undispersed Loans-in-Process per                    
Note Agreement  $26,527   $26,527   $56,094   $56,094 
Less: amounts not to be funded   (24,827)   (24,827)   (44,626)   (44,626)
Undispersed Loans-in-Process per                    
Financial Statements  $1,700   $1,700   $11,468   $11,468 

 

A breakdown of loans-in-process expected to be funded is presented below (in thousands):

 

   December 31,   December 31, 
Loans-in-Process Allocation:  2011   2010 
Unfunded Interest Reserves  $-   $6,034 
Construction/Operations Commitments   -    2,466 
Reserve for Protective Advances   -    1,268 
Real Estate Taxes   1,700    1,700 
Total Loan-in-Process  $1,700   $11,468 

 

While the contractual amount of unfunded loans-in-process and interest reserves totaled $26.5 million and $56.1 million at December 31, 2011 and 2010, respectively, we estimate that we will fund approximately $1.7 million for real estate taxes subsequent to December 31, 2011. The difference of $24.8 million, which is not expected to be funded, relates to loans that are in default, loans that have been modified to lower the funding amount and loans whose funding is contingent on various project milestones, many of which have not been met to date and are not expected to be met given current economic conditions. Accordingly, these amounts are not reflected as funding obligations in the accompanying financial statements. We may be required to fund additional protective advances for other loans in our portfolio but such amounts, if any, are not required under the loan terms and are not determinable at this time.

 

With available cash and cash equivalents of $21.3 million at December 31, 2011 and other available sources of liquidity, including potential loan participations, loan sales or sales of REO assets, we expect to meet our obligation to fund these undisbursed amounts in the normal course of business.

 

At December 31, 2011 and 2010, approximately 84.7% and 95.4%, respectively, of our total assets consisted of mortgage loans and REO assets. Until appropriate investments can be identified, our management may invest excess cash in interest-bearing, short-term investments, including money market accounts and/or U.S. treasury securities.

 

Maintenance and Development Costs for Real Estate Owned and Operating Properties

 

We require liquidity to pay costs and fees to preserve and protect our loan collateral and the real estate we own. Operating properties and real estate held for development or sale consists primarily of properties acquired as a result of foreclosure or purchase. At December 31, 2011 and 2010, our REO assets were comprised of 41 properties and 39 properties, respectively, acquired primarily through foreclosure, with carrying values of $95.5 million and $89.4 million, respectively. Costs related to the development or improvement of the assets are capitalized and costs relating to holding the assets are charged to expense. Costs related to the development or improvements of the real estate assets are generally capitalized and costs relating to holding the assets are generally charged to expense. Cash outlays for capitalized development costs totaled $0.7 million, $1.6 million and $2.5 million during the years ended December 31, 2011, 2010 and 2009, respectively. In addition, costs and expenses related to operating, holding and maintaining such properties (including property taxes), which are expensed and included in operating expenses for REO assets in the accompanying consolidated statement of operations, totaled approximately $5.5 million, $4.9 million and $4.2 million for the years ended December 31, 2011, 2010 and 2009, respectively. Based on our existing REO assets, we expect to incur approximately $2.9 million annually relating to the on-going operations and maintenance of such assets in 2012, as well as property taxes of $1.9 million. Additionally, based on the assumed timing and amount of our anticipated liquidity sources, we anticipate spending approximately $6.0 million over the next 12 month period in connection with our development of REO assets held for development. However, the nature and extent of future costs for such properties depends on the level of development undertaken, the number of additional foreclosures and other factors.

 

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Professional Fees   

 

We require liquidity to pay for professional fees which consist of outside consulting expenses for a variety of legal services, asset management, audit fees for public reporting related expenses, and valuation services. During the years ended December 31, 2011 and 2010, these expenses averaged approximately $0.7 million and $0.5 million per month, respectively. We expect such expenses to decrease in 2012 as we seek to dispose of REO assets and have undertaken measures to significantly reduce this expense in 2012. We expect this expense to stabilize at approximately $0.4 million per month after the disposition of current REO assets, assuming we conduct our operations substantially consistent with current levels. We anticipate such expenses will total approximately $4.5 million over the next 12 months.

 

Default and Related Expenses  

 

We require liquidity to pay for default and related expenses which consist of direct expenses related to defaulted loans, foreclosure activities or property acquired through foreclosure. These expenses include certain legal and other direct costs, as well as personnel and consulting costs directly related to defaulted loans and foreclosure activities. These expenses currently average less than $0.1 million per month. Because 18 of our 21 loans are currently in default and our intent is to actively pursue foreclosures on loans in default, we anticipate our default and related expenses in future periods will remain at approximately $0.1 million per month, or $1.2 million over the next twelve month period. This amount may increase if we are required to expend additional resources for current or future litigation.

 

General and Administrative Operating Costs  

 

In addition to the expenses historically borne by the Fund, we also now require liquidity to pay various general and administrative costs previously absorbed by the Manager. As a result, our expenses include compensation and benefits, rent, insurance, utilities and other related costs of operations. Excluding non-recurring expenses in 2011, such costs currently approximate $0.7 million per month. With certain cost cutting measures that we began to implement in early 2012 (including the elimination of Infinet related costs), we anticipate annual general and administrative expenses to approximate $6.1 million in 2012. However, the variable components of such expenses may increase as our activities expand.

 

Debt Service

 

We also require liquidity to pay interest expense on loan participations and from our borrowings and for notes payable, including the NW Capital loan. During the years ended December 31, 2011 and 2010, we repaid loan principal totaling $13.8 million and $4.1 million, respectively. We incurred interest expense on related indebtedness of $9.1 million and $2.1 million during the years ended December 31, 2011 and 2010, respectively, but paid only $1.1 million and $1.0 million during the same periods, respectively. Based on our existing indebtedness, we expect to incur interest expense of approximately $14.4 million over the 12-month period from January 1, 2012 through December 31, 2012, but pay interest of only $5.4 in cash. The difference between interest expensed and interest paid relates to the non-cash amortization of deferred loan fees on related debt and the capitalization of deferred interest on the NW Capital loan. Additionally, based on the existing terms of our current indebtedness, we expect to repay $5.3 million in principal over the next 12-month period which consists of the Flagstaff Golf Notes which mature in December 2012.

 

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On June 7, 2011, we closed on a $50 million loan from NW Capital. Interest on this interest-only loan accrues at the rate of 17% per year, payable in arrears, on January 1, 2012, and thereafter on April, July, October and January of each year during the term of the loan. In lieu of receiving cash, NW Capital may elect to receive 5% per annum of the 17% per annum interest rate in the form of deferred interest until the stated maturity or earlier redemption (and made such an election for 2012). The stated maturity date is June 6, 2016, but we may repay the principal balance in whole, not in part, on December 31, 2014 or June 30, 2015. The loan is convertible into shares of Series A preferred stock that are in turn convertible into common stock.

 

Until we generate additional liquidity from the disposition of our assets, we may seek additional short-term debt or alternative financing depending on the amount of net proceeds generated from the disposition of assets and the relative attractiveness and availability of debt financing and other factors, subject to restrictions imposed by the NW Capital loan agreement.

 

Accounts Payable and Accrued Taxes.

 

As of December 31, 2011 and 2010, our consolidated balance sheets include $7.1 million and $6.7 million, respectively, of unpaid accounts payable and accrued expenses, $5.3 million and $4.6 million, respectively, of accrued property taxes for our real estate held for development, and $0.6 million and $1.9 million, respectively, of liabilities pertaining to assets held for sale (comprised primarily of accrued property taxes). A significant portion of the accounts payable balance relates to legal fees incurred in connection with the Conversion Transactions, the NW Capital loan and various litigation. We anticipate that the majority of property taxes due will be paid from the proceeds derived from the sale of loans and real estate assets.

 

Dividends and Other Distributions

 

We also require liquidity to fund dividends out of legally distributable funds to our stockholders. We declared dividends of $0.03 per share to holders of record of our common stock for each of the quarters ended June 30, 2011, September 30, 2011 and December 31, 2011.

 

The NW Capital loan is convertible into IMH Financial Corporation Series A preferred stock at any time prior to maturity at an initial conversion rate of 104.3 shares of our Series A preferred stock per $1,000 principal amount of the loan, subject to adjustment. Dividends on the Series A preferred stock will accrue from the issue date at the rate of 17% of the issue price per year, compounded quarterly in arrears. A portion of the dividends on the Series A preferred stock (generally 5% per annum) is payable in additional shares of stock. Generally, no dividend may be paid on the common stock during any fiscal year unless all accrued dividends on the Series A preferred stock have been paid in full. However, the lender has agreed to allow the payment of dividends to common stockholders for up to the first eight quarters following the loan closing in an annual amount of up to 1% of the net book value of the Company’s common stock as of the immediately preceding December 31. Subject to the availability of legally distributable funds, we anticipate that we will pay dividends totaling approximately $1.6 million during the year ending December 31, 2012.

 

We will also require liquidity to pay a one-time dividend of $0.95 per share of Class B common stock, or the Special Dividend, to the holders of all issued and outstanding shares of Class B common stock on the 12-month anniversary of the consummation of an initial public offering, subject to the availability of legally distributable funds at that time, although we don’t anticipate that this will occur within the next 12 months. We intend to declare and pay dividends from time to time on the outstanding shares of our common stock from funds legally available (if any) for that purpose, subject to restrictions placed on such dividends.

 

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Sources of Liquidity

 

We expect our primary sources of liquidity over the next twelve months to consist of the proceeds generated by (i) borrowings primarily from the NW Capital loan and (ii) the disposition of our existing assets (including loans and REOs), the total of which we project will net approximately $79.0 million in cash. We are required to deposit cash receipts into a cash management account for disbursement pursuant to the terms of a budget agreed to by us and NW Capital and otherwise pay certain amounts owed under the loan. We anticipate redeploying these proceeds to acquire various performing real estate related assets, which will generate periodic liquidity from cash flows from dispositions of these loans through sales and loan participations as well as interest income. In addition to the net proceeds from the NW Capital loan and the disposition of our existing assets, we expect to address our liquidity needs by periodically accessing the capital markets, lines of credit and credit facilities which may become available to us, subject to restrictions imposed by the NW Capital loan agreement. Historically, our sources of liquidity consisted primarily of investments by members of the Fund, sales of participations in loans, interest income and loan payoffs from borrowers, and disposition of REO assets. We have at times in past accessed bank lines of credit, though we have not historically relied on significant leverage or bank financing to fund our operations or investments. We discuss our primary expected future and historical sources of liquidity in more detail below.

 

If we are unable to achieve our projected sources of liquidity from the disposition of REO and loan assets, we would not be able to purchase the desired level of target assets and it is unlikely that we would be able to achieve our investment income projections.

 

Borrowings

 

We received net proceeds of $42.5 million in the $50 million NW loan that closed on June 7, 2011. We are required to deposit cash receipts into a management account for disbursement pursuant to the terms of a budget agreed to by us and NW Capital and otherwise pay certain amounts owed under the loan. We also anticipate raising approximately $10 million in financing through a rights offering to our shareholders at terms substantially the same as the NW Capital loan, although we have not included such amounts in our liquidity table due to the unknown timing of this anticipated event.

 

Until we generate additional liquidity from dispositions of assets, we may seek to obtain additional short-term debt or alternative financing, depending on the amount of proceeds generated from the disposition of assets and the relative attractiveness and availability of debt financing and other factors.

 

In addition, as described elsewhere in this Form 10-K, on January 31, 2012, we reached a tentative settlement in principle to resolve claims asserted by the plaintiffs in the Litigation, the terms of which have been memorialized in the MOU. Under the terms of the tentative settlement, if approved, we have agreed to offer $20.0 million of 4% five-year subordinated notes to members of the Class in exchange for 2,493,765 shares of IMH common stock at an exchange rate of $8.02 per share. In addition, we have agreed to offer to class members that are accredited investors $10.0 million of convertible notes with the same economic terms as the convertible notes previously issued to NW Capital. There can be no assurance that the court will approve the tentative settlement in principle. Further, the judicial process to ultimately settle this action is estimated to take a minimum of six to nine months or longer. As a result, we have not factored the effect of these events in the foregoing analysis.

 

Equity Issuances

 

We intend to raise equity capital through accessing the equity or debt capital markets from time to time in the future. We historically addressed liquidity requirements in substantial part through member investments and reinvestments, but effective October 1, 2008, we elected to suspend the acceptance of any additional member investments and the ability of the members to reinvest earnings that may have otherwise been distributed to them. We accordingly do not consider new member investment to be a current source of liquidity. Moreover, the NW Capital loan and related agreements limit the issuance of new equity to the following:

 

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·Upon prior written consent of the lender, we may issue equity or common stock in the ordinary course of business. However, we may issue up to an aggregate of $7.5 million of shares of common stock without lender consent if the board of directors has adopted a resolution that it is necessary to provide sufficient liquidity to pay debt service on the NW Capital loan due within the succeeding 12 months and exempted securities in accordance with the approved budget.
·Without prior written consent of the lender, we shall not enter into, terminate or approve the terms of any stock incentive grant for any member of management. However, nothing shall prevent the issuance of stock options for 1.2 million shares of common stock provided for under the approved stock compensation plan.
·We are permitted to apply our assets to the redemption or acquisition of any shares of common stock held by employees, advisors, officers, directors, consultants and service providers on terms approved by the Board.

 

Participations and Whole Loans Sold

 

In connection with our new business strategy, we anticipate disposing of a significant portion of our existing loans over the next 12 to 24 months, individually or in bulk. As of December 31, 2011 and 2010, all of our loans are held for sale. We are actively marketing certain loans for sale to prospective buyers and are generally receptive to valid reasonable offers. Because our loans are reported at current fair value, we expect to identify buyers and dispose of a significant portion of these loans over the next 12 months. During the year ended December 31, 2011, we sold seven mortgage loans for $13.2 million (net of selling costs), of which we financed $7.8 million, and recognized a loss on sale of $0.1 million. During the year ended December 31, 2010, we sold five mortgage loans for $5.6 million (net of selling costs), of which we financed $1.1 million, and recognized a gain on sale of $0.1 million. We expect future investments in mortgages to be held for sale or participation. 

 

Disposition of Loans and Real Estate Owned  

 

At December 31, 2011, we held total REO assets of $95.5 million, of which $44.9 million was held for development, $30.9 million was held for sale, and $19.6 million was held as operating property. At December 31, 2010, we held total REO assets of $89.5 million, of which $36.7 million was held for development, $31.8 million was held for sale and $21.0 million was held as operating property. We are actively marketing several of these assets to prospective buyers and are generally receptive to valid, reasonable offers made on our assets held for sale.

 

During the year ended December 31, 2011, we sold seven REO assets or portions thereof for $9.4 million (net of selling costs), of which we financed $0.2 million, for a gain of $0.3 million. During the year ended December 31, 2010, we sold five REO assets or portions thereof for $6.9 million (net of selling costs), of which we financed $2.2 million, resulting in a gain on disposal of real estate of $1.2 million.

 

We anticipate disposing of a significant portion of our existing REO assets, individually or in bulk, over the next 12 to 24 months. Because our assets held for sale are reported at current fair value, we expect to identify buyers and dispose of a significant portion of these assets over the next 12 months. As we complete development of our real estate held for development, we anticipate that proceeds from the disposition of real estate will increase in the future. However, there can be no assurance that such real estate will be sold at a price in excess of the current carrying value of such real estate.

 

We are projecting that we will generate approximately $79.0 million from loan and REO sales, net of selling costs and foreclosure costs over the next 12 months. Moreover, we estimate that the proceeds from the sale of loans will be reduced by approximately $3.5 million relating to the payment of related property taxes on such loans that are not recorded in our financial statements as of December 31, 2011. However, there can be no assurance that such assets will be sold at a price in excess of the current carrying value of such assets, net of valuation allowances.  

 

We believe that the projected sales amount is reasonable based on our understanding of the market and the properties involved, our long-term experience with the valuation of similar loans and related real property and our understanding and expectation of the continuing market recovery in the applicable geographic areas. In our Annual Report on Form 10-K for the year ended December 31, 2010, our projections for sources of liquidity in 2011 included the potential sale of approximately $77 million of loans and REO assets, while our actual sales of loans and REO assets in 2011 generated approximately $15.1 million of liquidity based on net sales prices totaling $22.5 million (net of amounts financed). This difference did not arise from an inability to sell additional assets. Instead, the closing of the NW Capital loan in June 2011 allowed us to further evaluate our options with respect to our legacy assets and to await further improvement in the market for the sale of such assets. Similarly, in 2012, to the extent that other sources of liquidity become available to us, we may again determine to postpone loan and asset sales if we believe that would be advantageous to the Company. To the extent that we do not sell the full amount of loans and REO assets and do not replace the projected liquidity with other sources, we will have less money to invest in our target assets and may not meet our projections for generating investment income.

 

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Loan Payments

 

The repayment of a loan at maturity creates liquidity. During the years ended December 31, 2011 and 2010, we received loan principal payments totaling $7.1 million and $6.7 million, respectively. Excluding loan balances past scheduled maturity, our loans have scheduled maturities through 2012 totaling $96.3 million. However, due to the state of the economy and the compressed nature of the real estate, credit and other markets, loan defaults have continued to rise and are expected to rise further and there can be no assurance that any part of these loans will be repaid, or when they will be repaid. As we acquire new loans in connection with our new business strategy, we anticipate that the collateral securing such loans and the related terms will allow for timely payoff or that liquidity will be generated from the sale or participation of such loans. As of December 31, 2011, we are projecting that we will collect $4.3 million in principal payments from existing borrowers over the next 12 months, which represents the performing balance of notes maturing in 2012. 

 

Rental Income

 

We generate rental income from the leasing of operating properties that we own. Rental income for the year ended December 31, 2011, 2010 and 2009 was $1.8 million, $1.5 million and $1.0 million, respectively, and was derived from an operating property acquired through foreclosure in 2009 which had an occupancy rate of approximately 31% at December 31, 2011. Given active marketing efforts to secure additional tenants and improve occupancy, we are estimating that rental income will increase to $2.8 million over the next 12 months based on current leasing arrangements, anticipated additional leases that we expect to close on, and anticipated foreclosure of additional operating properties in our portfolio. 

 

Loan Origination Fees and Investment Income

 

In the case of an extension of the maturity of a loan, we typically charge the borrower a fee for re-evaluating the loan and processing the modification. Borrowers do not customarily pay this fee out of their own funds, but instead usually pay the fee out of available loan proceeds, or by negotiating an increase in the loan amount sufficient to pay the fee. However, to the extent that we extended a loan in the past, we did not generate liquidity because the Manager, and not the Fund, received the modification fee, if any. After consummation of the Conversion Transactions, we will receive any origination or modification fees. Loan origination fees are reported as adjustment to yield in mortgage income over the respective loan period.

 

We expect to realize investment income from such investments which may come in the form of origination and modification fees, interest income, accretion of discounts on such investments, rental income, income from operating properties acquired through foreclosure, and profit participations. The amounts and proportion of such income is dependent on the amount and timing of the deployment of our capital into our various target assets.

 

Interest payments and repayments of loans by our borrowers are governed by the loan documents and by our practices with respect to granting extensions. A majority of our portfolio loans had provisions for interest reserves for the initial term of the loan, which required that a specified portion of the mortgage loan note total be reserved for the payment of interest. When that portion is exhausted, the borrower is required to pay interest from other sources. If the interest is funded in cash when the loan closes, then interest payments are made monthly from a segregated controlled disbursement cash account which is controlled by us and held in the name of the borrower. If the interest reserve is not funded at the closing of the loan, then the interest payment is accrued by adding the amount of the interest payment to the loan balance, and we use our general cash reserves to distribute that interest to the members or loan participants. The receipt of interest income paid in cash by our borrowers creates liquidity; however, our practice of utilizing unfunded interest reserves uses liquidity. See “Liquidity and Capital Resources – Requirements for Liquidity - Loan Fundings and Investments” for additional discussion of funded and unfunded interest reserves.

 

In addition to originating commercial mortgage loans, our on-going investment strategy will include the acquisition of various attractively priced real estate-related assets, including portfolios of performing, distressed and/or non-performing commercial whole mortgage loans and bridge loans from the FDIC, community banks, commercial banks, insurance companies, real estate funds, and other governmental agencies and financial institutions, as well as potential investment in residential and commercial mortgage-backed securities, REO assets or other distressed or non-performing real estate properties in order to seek to reposition them for profitable disposition. We expect to realize investment income from such investments which may come in the form of origination and modification fees, interest income, accretion of discounts on such investments, rental income, and profit participations. The amounts and proportion of such income is dependent on the amount and timing of the deployment of our capital into our various target assets.

 

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We anticipate generating investment income of $4.7 million over the 12-month period ending December 31, 2012, provided we achieve our projections for sources of liquidity. Our projection of investment income is based upon the assumption that the net proceeds available for investment, coupled with the cash generated from the disposition of assets (which we assume will occur ratably over the 12 month period), will be redeployed evenly over the 12 month period into income producing assets, net of presumed maturities, generating an estimated average annualized yield of 14.5% on target assets. This amount, coupled with income from existing performing assets totaled the amount reflected in the liquidity table. We believe this amount is reasonable based on the historical performance of our past loan portfolios assuming a return to normalized lending in 2012. The actual amount of investment income will depend on the actual timing of the disposition of existing assets, actual redeployment of cash proceeds, actual yields on such investments, actual maturities and similar variables.

 

Anticipated Tax Benefits

 

Because of the significant declines in the real estate markets in recent years, we have approximately $166 million of built-in unrealized tax losses in our portfolio of loans and REO assets and approximately $217 million of net operating loss carryforwards. Subject to certain limitations, these built-in losses may be available to reduce or offset future taxable income and gains related to the disposition of our existing assets and may allow us to reduce taxable income from future transactions. Our ability to use our built-in losses is subject to various limitations. For example, there will be limitations on our ability to use our built-in losses or other net operating losses if we undergo a “change in ownership” for U.S. federal income tax purposes. To the extent we are able to reduce tax payable through the use of our built-in losses, the amount of reduction will be available to be deployed in new fund investment in additional assets, pay distributions to our stockholders in the form of dividends or address other liquidity requirements.

 

Cash Flows for the years ended December 31, 2011, 2010 and 2009

 

Cash Provided By (Used In) Operating Activities.  

 

Cash used in operating activities was $25.8 million and $19.6 million for the years ended December 31, 2011 and 2010, respectively, and cash provided by operating activities was $13.4 million for the year ended December 31, 2009. Cash provided by (used in) operating activities includes the cash generated from mortgage interest, rental income, and investment and other income, offset by amounts paid for operating expenses for real estate owned, professional fees, general and administrative costs, and interest on borrowings. The decrease in cash provided by operating activities from 2009 to 2011 is attributed to the decrease in the income-earning assets in our real estate portfolio and resulting mortgage income coupled with increases in operating costs on REO assets, professional fees for litigation, loan enforcement, and public reporting compliance, general and administrative expenses, and interest expense.

 

Cash Provided By (Used In) Investing Activities.  

 

Net cash provided by investing activities was $17.7 million and $9.2 million for the years ended December 31, 2011 and 2010, respectively, and cash used in investing activities was $21.2 million for the year ended December 31, 2009. The increase in cash from investing activities is attributed to proceeds from the sale of real estate assets and loans ($15.6 million, $9.1 million, and $1.1 million during the years ended December 31, 2011, 2010 and 2009, respectively). In addition, the amount of mortgage loan fundings has decreased significantly since 2009 ($3.7 million, $1.7 million and $30.3 million during the years ended December 31, 2011, 2010 and 2009, respectively). Mortgage loan collections totaled $7.1 million, $6.7 million and $10.6 million during the years ended December 31, 2011, 2010 and 2009, respectively. Additionally, we decreased the amount invested in real estate owned which totaled $0.8 million, $1.6 million and $2.5 million during the years ended December 31, 2011, 2010 and 2009, respectively. We also utilized $3.3 million in connection with acquisition of the Manager during the year ended December 31, 2010. No such amounts were incurred in the corresponding periods in 2011 or 2009.

 

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Cash Provided By (Used In) Financing Activities.  

 

Net cash provided by financing activities was $28.6 million and $10.2 million for the years ended December 31, 2011 and 2010, respectively, and net cash used in financing activities was $15.1 million for the year ended December 31, 2009. The primary reason for the increase in cash flows from financing activities in fiscal 2011 and 2010 is from proceeds generated from borrowings, net of debt issuance costs ($43.4 million, $16.0 million and $6.0 million during the years ended December 31, 2011, 2010 and 2009, respectively). Payments on borrowings totaled $13.8 million, $5.8 million and $4.4 million during the years ended December 31, 2011, 2010 and 2009, respectively. During the years ended December 31, 2011 and 2009, dividends or distributions paid to shareholders or members totaled $1.0 million and $16.7 million, respectively. There were no dividends or distributions paid during fiscal 2010.

 

Contractual Obligations

 

Prior to the Conversion Transactions, our contractual obligations were largely limited to lending obligations to our borrowers under the related loans. We assumed certain obligations in connection with the Conversion Transactions. In addition, we entered into various new agreements during 2011 giving rise to additional contractual obligations.

 

A summary of our some of our significant consulting arrangements in 2011 follows:

 

ITH Partners Consulting Agreement

 

We entered into an amended and restated consulting agreement dated April 20, 2011 with ITH Partners, LLC (“ITH Partners”), a consulting firm we have retained since 2009, in which we engaged ITH Partners to provide various consulting services. Services to be provided by ITH Partners include assisting us with strategic and business development matters, performing diligence on, and analytical work with respect to, our loan portfolio and prospective asset purchases and sales; advising us with respect to the work of our valuation consultants and related issues; interfacing with various parties on our behalf; advising us with respect to liquidity strategies including debt and equity financing alternatives; advising us regarding the selection of an independent board of directors and committees thereof; advising us with respect to liability insurance and directors and officers insurance; and other advice to us from time to time as requested by us.

 

The initial term of the consulting agreement is four years and is automatically renewable for three more years unless terminated by the affirmative vote of 70% of the board of directors and with 60 days notice prior to renewal.  The consulting services agreement is otherwise terminable by us for cause, as defined in the agreement, with 10 business days’ notice to ITH Partners. The total annual base consulting fee equals $0.8 million plus various other fees, as described below, based on certain milestones achieved or other occurrences.

 

Special Payments.  In accordance with our consulting agreement, ITH Partners received a one-time fee of $1.9 million in connection with the $50 million debt financing secured in the NW Capital loan closing. This amount is included in deferred financing costs and is being amortized over the term of the loan.

 

Equity Securities.  In accordance with the consulting agreement, we made a one-time issuance to ITH Partners of 50,000 shares of our common stock in connection with the NW Capital loan closing.  The fair value of the stock issuance was recorded as a component of deferred financing costs and is being amortized over the term of the loan.

 

Stock Options. Additionally, on July 1, 2011, ITH was granted options to purchase 150,000 shares of our common stock within 10 years of the grant date at an exercise price per share of $9.58, the conversion price of the NW Capital convertible loan, with vesting to occur in equal monthly installments over a 36 month period beginning August 2011.

 

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Legacy Asset Performance Fee.   ITH Partners is entitled to a legacy asset performance fee equal to 3% of the positive difference derived by subtracting (i) 110% of our December 31, 2010 carrying value of any asset then owned by us from the (ii) the gross sales proceeds, if any, from sales of any legacy asset (on a legacy asset by asset basis without any offset for losses realized on any individual asset sales).

 

Strategic Advisory Fee.   If during the term, we enter into purchase or sale transactions pursuant to which ITH Partners advised us, we have agreed to pay ITH Partners a transaction fee in an amount equal to the greater of (i) $0.5 million or (ii) 3% of the aggregate fair market value of any securities issued and/or any cash paid or received, plus the amount of any indebtedness assumed, directly or indirectly, in connection with a definitive purchase or sale transactions agreement.

 

Product Origination Fee.   We have agreed to pay ITH Partners a product origination fee in consideration for ITH Partners’ origination of new products for Infinet in an amount of not less than $100,000 for each new product which generates more than $25 million of gross invested capital.

 

Payments Upon Non-Renewal, Termination Without Cause or Constructive Termination Without Cause.  In the event of non-renewal of the consulting agreement or termination without cause, ITH Partners will be entitled to (i) a lump sum payment equal to one to two times the average annual base consulting fees in the year of the event and the prior two years, and (ii) accelerated vesting of all outstanding equity awards.

 

Juniper Capital Partners, LLC

 

We entered into a separate consulting agreement with Juniper Capital Partners, LLC (“Juniper Capital”), an affiliate of NW Capital, dated June 7, 2011, pursuant to which we engaged Juniper Capital to perform a variety of consulting services to us. Services to be provided include assisting us with strategic and business development matters, advising us with respect to the formation, structuring, business planning and capitalization of various special purpose entities, and advising us with respect to leveraging our relationships to access market opportunities, as well as strategic partnering opportunities with us. The initial term of the consulting agreement is four years and is automatically renewable for three more years unless terminated by the affirmative vote of 70% of the board of directors and with 90 days’ notice. The consulting services agreement is otherwise terminable by us for cause, as defined in the agreement, with 60 business days’ notice to Juniper Capital. The annual consulting fee under this agreement is $0.3 million.

 

NWRA Advisory Agreement

 

Effective March 2011, we entered into an agreement with NWRA to provide certain consulting and advisory services in connection with the development and implementation of an interim recovery and workout plan and long-term strategic growth plan for us.  The engagement includes a diagnostic review of the Company, a review of our existing REO assets and loan portfolio, development and implementation of specific workout strategies, as well as the development and implementation of a plan for originating, analyzing and closing new investment transactions. Upon stabilization of legacy assets and a period of growth, NWRA will also provide an assessment of our capital market alternatives.

 

Services.  The services contemplated under this agreement include:

 

  · Obtain Understanding of the Company Operations and Legacy Assets – this includes an assembly and analysis of the current asset management and disposition plan for legacy assets; current organizational structure, payroll and overhead; current and projected cash flows and asset valuations and appraisals; status of current and anticipated foreclosure or guaranty enforcement action; litigation and SEC matters; shareholder relations program and broker-dealer network; insurance programs; tax losses; and SWI Fund portfolio and performance.
  · Formulate Interim Recovery Plan and Long-Term Strategic Plan– The interim recovery plan is to improve daily operations and enhance asset values and liquidity and includes recommendations for streamlining and optimizing staff and functions for efficiency and effectiveness, implementing state-of-the-art accounting and asset origination, management technologies, reducing overhead, developing individual asset restructuring,  and development, and disposition plans.

 

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The long-term strategic plan is designed to position us for a major capital event, (such as an initial public offering) and to guide the selection of our strategic direction and infrastructure, including policies for investments, loan management, human resources, investment committees, etc.

 

  · Implementation of Interim Recovery Plan – upon approval of an interim recovery plan, NWRA will coordinate, advise and support implementation of the corporate reorganization, operational improvements and asset level workouts.
  · Implementation of Long-Term Strategic Plan – once the interim recovery plan’s objectives are met, NWRA will coordinate, advise and support implementation of the long-term strategic plan, including implementation of investment and asset management strategies and initiatives to re-initiate shareholder dividend and enhance enterprise value.  At our request, NWRA may provide information and analysis to support investment or credit committee deliberations.

 

Monthly fee.  This agreement includes a non-contingent monthly fee of $125,000 and a success fee component, plus out-of-pocket expenses.

 

Success Fees. The success fee includes capital advisory fee and associated right of first offer to provide advisory services (subject to separate agreement), development fee and associated right of first offer to serve as developer (subject to separate agreement), an origination fee equal to 1% of the total amount or gross purchase price of any loans made or asset acquired identified or underwritten by NWRA and legacy asset performance fee equal to 10% of the positive difference between realized gross recovery value and 110% of the December 31, 2010 carrying value, calculated on a per REO or loan basis.  No offsets between positive and negative differences are allowed.

 

Term. The agreement may be subject to termination only under certain conditions.  Otherwise, the agreement remains in effect for four years. Thereafter, this agreement can only be terminated by an affirmative super majority vote of the board of directors and with 60-day written notice.  If not terminated, the agreement may be extended for an additional three years. If the tentative settlement described in the MOU is approved, the NWRA agreement is expected to be amended such that the agreement may be terminable by our board of directors upon the repayment in full of the NW Capital loan, provided that the indebtedness has not been converted to preferred or common equity.

 

The anticipated timing of payment for these and other obligations as of December 31, 2011 is as follows (amounts in thousands):

 

   Payments due by period 
Contractual Obligations  Total   Less than 1
year
   1 - 3 years   3 - 5 years   More than
5 years
 
Principal Payments for Long-Term Debt Obligations (1)  $83,326   $4,712   $-   $78,614   $- 
Interest Payments (1)   32,993    5,963    14,275    12,755    - 
Funding commitments to borrowers   1,700    1,700    -    -    - 
Operating Lease Obligations (2)   5,181    830    2,867    1,484    - 
Consulting fee (3)   8,883    2,645    5,290    948    - 
Total  $132,082   $15,850   $22,432   $93,800   $-