-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MrPMck20yCIBJvME/FyV9m7AA79/6yaxy8NzGUSwznjs51vTgZWkwTpj39nFJyQ7 y9pksEdciKdUmkFrfAdfHg== 0000950117-99-001836.txt : 19990830 0000950117-99-001836.hdr.sgml : 19990830 ACCESSION NUMBER: 0000950117-99-001836 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19990531 FILED AS OF DATE: 19990827 FILER: COMPANY DATA: COMPANY CONFORMED NAME: LAZARE KAPLAN INTERNATIONAL INC CENTRAL INDEX KEY: 0000202375 STANDARD INDUSTRIAL CLASSIFICATION: WHOLESALE-JEWELRY, WATCHES, PRECIOUS STONES & METALS [5094] IRS NUMBER: 132728690 STATE OF INCORPORATION: DE FISCAL YEAR END: 0531 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-07848 FILM NUMBER: 99700805 BUSINESS ADDRESS: STREET 1: 529 FIFTH AVE CITY: NEW YORK STATE: NY ZIP: 10017 BUSINESS PHONE: 2129729700 MAIL ADDRESS: STREET 1: 529 FIFTH AVE STREET 2: 529 FIFTH AVE CITY: NEW YORK STATE: NY ZIP: 10017 10-K405 1 LAZARE KAPLAN INTERNATIONAL INC. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended MAY 31, 1999 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 1-7848 LAZARE KAPLAN INTERNATIONAL INC. (Exact name of registrant as specified in its charter) DELAWARE 13-2728690 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 529 FIFTH AVENUE, NEW YORK, NY 10017 (Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (212) 972-9700 Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- COMMON STOCK ($1 PAR VALUE) AMERICAN STOCK EXCHANGE PREFERRED SHARE PURCHASE RIGHTS AMERICAN STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No -- -- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] As of July 30, 1999, 8,368,343 of the registrant's common stock were outstanding, and the aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the closing price for the registrant's common equity on the American Stock Exchange at that date was $41,869,549. DOCUMENTS INCORPORATED BY REFERENCE 1999 definitive proxy statement to be filed with the Commission - incorporated by reference into Part III. 1999 Annual Report to Stockholders for the fiscal year ended May 31, 1999 to be filed with the Commission-incorporated by reference into Parts II and IV. Part I Item 1. Description of Business The Company Lazare Kaplan International Inc. ("the Company") was incorporated in 1972 under the laws of the state of Delaware as the successor to a business which was founded by Mr. Lazare Kaplan in 1903. The Company is engaged in the cutting, polishing and selling of ideally proportioned diamonds which it markets internationally under the brand name "Lazare Diamonds'r'". Ideally proportioned diamonds are distinguished from non-ideal cut ("commercial") diamonds by the symmetrical relationship of their facets, which maximizes brilliance, sparkle and fire. Due to these characteristics, Lazare Diamonds command a premium in the marketplace. The Company believes there are only a few other companies worldwide engaged primarily in the production of ideally proportioned diamonds and that it is the largest U.S. producer of ideal cut diamonds through its facility in Puerto Rico. In addition, at its facilities in Moscow, the Company cuts and polishes commercial diamonds which it markets to wholesalers, distributors and, to a growing extent, through retail jewelers. All rough stones purchased by the Company are either selected for manufacturing or resold as rough diamonds in the marketplace. The Company believes that the combination of its cutting and polishing operations and its trading operations enables the Company to purchase larger quantities of rough diamonds from which it may select those rough diamonds best suited for the Company's current needs. The Company's marketing strategy in the selling of Lazare Diamonds is directed primarily toward quality conscious consumers throughout the United States, South America, the Far East and Europe. The Company focuses its distribution efforts for Lazare Diamonds on selectivity with a view towards helping retailers who carry the product maintain a competitive advantage. Lazare Diamonds can be found at some of the most prestigious jewelry stores around the world, including those with international reputations and those known only in their communities as being the highest quality retail jewelers. This strategy helps ensure that the Company's product is presented in an environment consistent with its superior quality and image. The Company also sells to certain jewelry manufacturers and diamond wholesalers. The Company has developed a comprehensive grading system which, when coupled with the "ideal cut" standard, allows jewelers to order inventory by category rather than through the more cumbersome process of visual selection. In addition, the Company designs, manufactures (through independent contractors) and sells a line of high quality jewelry which features Lazare Diamonds. An important element of the Company's strategy is the promotion of the Lazare Diamond brand name. Every Lazare Diamond bears a laser inscription on its outer perimeter, invisible to the naked eye, containing the Lazare Kaplan logo and an identification number unique to the stone. The laser signature also allows consumers to register their Lazare Diamonds with the Company under its program, The Lazare Diamond Registry'r', thereby providing proof of ownership in case of loss or theft. One of the Company's important suppliers of rough diamonds is the Diamond Trading Company ("DTC"), an affiliate of De Beers Centenary AG, a Swiss company ("DeBeers"). Based on published reports, the Company believes that the DTC controls approximately 60% of the value of world rough diamond output. The Company has been a client of the DTC for more than 60 years. In order to diversify its sources of rough diamond supply, however, the Company has broadened its purchasing capabilities throughout Africa and has an office in Antwerp to supplement its rough diamond needs by secondary market purchases. The Company also has expanded its operations and entered into relationships with other primary source suppliers. The Company believes that its success in maintaining quantities and qualities of polished inventory that best meet its customers' needs is achieved through its ability to fully integrate its diverse rough diamond sources. The Company currently has three manufacturing facilities. The Company's domestic 2 manufacturing operation, located in Puerto Rico, is believed by the Company to be the largest diamond cutting facility in the United States. The Company believes its work force in Puerto Rico is the most highly skilled in the world producing ideal cut diamonds. This facility generally produces polished diamonds having weights of 1/5 of a carat and greater. The Company also has two manufacturing facilities in Russia. These facilities are conducted pursuant to agreements with AK Almazi Rossii Sakha (ALROSA) of Russia. The Company's first Russian factory in Moscow, which was equipped and staffed during fiscal year 1997, is operating near its full anticipated manufacturing capacity. The Company's other Russian facility, located in Barnaul, was equipped and staffed at the end of fiscal year 1999. The Company's manufacturing operation which was conducted in cooperation with the Russian Government agency responsible for diamond exports and the Russian national stockpile has suspended production. Diamond Supply The Company's overall revenues are dependent upon the availability of rough diamonds, the world's known sources of which are highly concentrated. Based upon published reports, the Company believes that Angola, Australia, Botswana, Brazil, Ghana, Guinea, Ivory Coast, Namibia, Republic of the Congo, Russia, Sierra Leone and South Africa account for more than 90% of present world rough gem diamond production. In addition, diamond production in Canada commenced during late calendar year 1998, and, according to published reports, is expected to reach $500 million annually. The Central Selling Organization ("CSO"), which is affiliated with De Beers, is the primary world-wide marketing mechanism of the rough diamond industry. The CSO seeks to maintain an orderly and stable market for diamonds by regulating the quantity and selection of rough diamonds that reach the market. This is achieved either by directly owning diamond mines, entering into multi-year purchase agreements with host governments, or by purchasing rough diamonds in the secondary market. Sales for the CSO are made in London by the DTC to a select group of clients ("sightholders") which, according to published reports, number approximately 160, including the Company. Based upon published reports, the Company believes that approximately 60% of the world diamond output is purchased for resale by the DTC and its affiliated companies. In order to maintain their purchasing relationship, the DTC's clients have traditionally been expected to purchase all of the diamonds offered to them by the DTC. Companies that are not sightholders must either purchase their requirements from sightholders or seek access to that portion of the world supply not marketed by the DTC. The DTC has been and continues to be an important supplier of rough diamonds to the Company. The DTC periodically invites its clients to submit their requirements as to the amount and type of stones they wish to purchase. Employees of the Company attend offerings of rough diamonds ("sights") held by the DTC periodically during the year in London. At sights, the Company purchases, at the DTC's stated price, an assortment of rough diamonds known as a "series", the composition of which attempts to take into account the qualitative and quantitative requirements of the Company based on requests submitted to the DTC by the Company. The Company has been a sightholder for more than 60 years. The loss of its status as a sightholder could have a material adverse effect on the Company. In order to diversify its sources of supply, the Company has entered into arrangements with other primary source suppliers and manufacturers. The Company also has established an office in Antwerp to supplement its rough and polished diamond needs by making purchases in the secondary market. In December 1994, the Company reached an agreement with the Empresa Nacional de Diamantes de Angola ("Endiama"), Angola's national diamond mining company, pursuant to which the Company was granted a license to purchase rough diamonds from local Angolan miners and export such rough diamonds for resale. At the time, this was one of three such licenses granted by Endiama. The Company believes that, since this time, Endiama has issued two additional licenses. The agreement entitles the Company to establish buying offices throughout Angola, the first of which was set up during 1995 in Luanda, the capital of Angola. The Company currently has five buying offices located 3 in Angola, including the office in Luanda. The agreement has a term of five years ending on December 31, 1999. The Company has not yet determined whether or not to seek to renew this agreement. Any renewal will, among other things, be dependent upon stability in Angola, market conditions, profitability, if any, of the Company's Angolan operations and the Company's ability to negotiate acceptable terms and conditions. As a result of the intensification of hostilities and a restructuring of the Company's operations in Angola, the Company's purchase of Angolan rough diamonds during the latter part of Fiscal 1999 were significantly reduced. In March 1999, the Company announced that a newly formed, wholly-owned subsidiary, Pegasus Overseas Ltd. ("POL") had entered into an exclusive ten-year agreement with a wholly-owned subsidiary of General Electric Company ("GE") under which POL will market natural diamonds that have undergone a new GE process that enhances certain characteristics of select, natural gemstone diamonds. The process is an additional step which complements the many steps to which a diamond is customarily subjected in the course of being extracted, processed with mechanical and chemical operations and then cut and polished. The process is permanent and irreversible and it does not involve treatments such as irradiation, laser drilling, surface coating or fracture filling and is conducted before the final cutting and polishing by the Company. The process is designed to improve the color, brilliance and brightness of qualifying diamonds without reducing their all-natural content. The process, which was developed and is owned by GE, will be used only on a select, limited range of natural diamonds with qualifying colors, sizes and clarities for both round and fancy cuts. The estimated number of gemstones with characteristics suitable for this process is a small fraction of the overall diamond market. POL will sell only diamonds that have undergone the new GE process. Each diamond sold by POL will be laser inscribed with the brand name "GE POL." POL began offering these diamonds to distributors around the world in late May 1999. The Company believes that it has good relations with its suppliers, that its trade reputation and established customer base will continue to assure access to primary sources of diamonds and that its sources of supply are sufficient to enable the Company to meet its present and foreseeable needs. However, the Company's sources of supply could be affected by political and economic developments in producing countries over which the Company has no control. While the Company believes that alternative sources of supply may be available, any significant disruption of the Company's access to its primary source suppliers could have a material adverse effect on its ability to purchase rough diamonds. The Company has rough diamond supply arrangements in Russia for the cutting and polishing of diamonds in Russia. See "Cutting and Polishing". Cutting and Polishing The Company and its subsidiaries currently have three primary cutting and polishing operations, two located in Russia (of which one is in Moscow and one is in Barnaul) and one located in Puerto Rico. The Company's first factory in Russia was announced in July 1996 when the Company reached an agreement (the "ALROSA I Agreement"), for a term of ten years, with AK Almazi Rossii Sakha (ALROSA) of Russia for the cutting, polishing and marketing of large rough gem diamonds. According to published reports, ALROSA is the largest producer of rough diamonds in Russia with annual production in excess of $1.4 billion, accounting for over 20% of the world's supply of diamonds. Under the terms of the ALROSA I Agreement, the Company has equipped a diamond cutting factory which was completed in February 1997 within the ALROSA facility in Moscow. This facility is staffed by Russian technicians and managed and supervised by Company personnel. Under the ALROSA I Agreement, ALROSA has agreed to supply a minimum of $45 million per year (at rough diamond cost) of large rough gem diamonds selected by the Company as being suitable for processing in this facility. The Company received its first shipment of polished stones produced at this facility during November 1997. During fiscal year 1999, this facility produced in excess of $45 million of polished stones. In March 1999 (in 4 furtherance of a Memorandum of Understanding signed by the Export-Import Bank of the United States ("Eximbank"), ALROSA and the Company) the Company and ALROSA entered into a second agreement (the "ALROSA II Agreement") to expand their relationship in the cutting, polishing and marketing of rough gem diamonds. Under the terms of the ALROSA II Agreement, the Company and ALROSA agreed to refurbish two additional diamond cutting facilities (one of which is not yet operational). These facilities are staffed by Russian technicians and jointly managed and supervised by the Company and ALROSA personnel. ALROSA has agreed to supply a minimum of $100 million per year (at rough diamond cost) for ten years of rough gem diamonds selected by the Company as being suitable for processing in these facilities. The Company received its first test shipment of polished stones produced at these facilities during the fourth quarter of fiscal 1999. These facilities, once they are all fully operational, have the capacity to cut and polish in excess of $150 to 200 million (at rough diamond cost) per year of rough gem diamonds. Under both the ALROSA I and the ALROSA II agreements, the Company sells the resulting polished diamonds through its worldwide distribution network. The proceeds from the sale of these polished diamonds, after reimbursement of costs incurred by each of the parties, generally will be shared equally with ALROSA. These agreements do not require the Company to advance funds for the purchase of rough diamonds. The ALROSA I Agreement served as a long-term off-take arrangement to secure the repayment of $62 million of financing which ALROSA received from a United States commercial bank and to be guaranteed by Eximbank for the purchase by ALROSA of U.S. manufactured mining equipment. This equipment will be used by ALROSA to increase production in its diamond mines. Eximbank has stated that this agreement was the first transaction approved under Eximbank's General Project Incentive Agreement with the Ministry of Finance and the Central Bank of the Russian Federation signed in December 1993. The ALROSA II Agreement will enable ALROSA to receive additional loan guarantees from Eximbank of an additional several hundred million dollars. These guaranties will allow ALROSA to continue purchasing U.S. manufactured mining equipment, expand mining productions and refurbish operations at currently non-functioning Russian diamond cutting factories. The Company had another facility located in Moscow which was conducted in cooperation with the Russian Government organization responsible for diamond policy and the Russian national stockpile. Production from this facility has been suspended and there have been no diamonds exported from this facility since the beginning of calendar year 1997, including those that are already polished by the Company and awaiting export. The Company believes that it will recapture lost sales once these polished diamonds are exported. The Company believes that its factory in Puerto Rico is the largest cutting and polishing facility in the United States. Each rough diamond received in Puerto Rico is evaluated against strict management standards designed to maximize its potential economic contribution to the Company. Expert technicians, assisted by proprietary computer software, determine whether to cut the rough diamond to ideal or commercial proportions or resell the rough diamond. The shape of the rough diamond, its color, clarity, size, potential profitability and salability are among the criteria used in making such determinations. The Company's production workers are compensated principally on a piece rate basis. The Company has an incentive program that rewards its factory managers and supervisors for maximizing the manufactured results based on the following criteria: gross margin, yield (rough weight to polished weight conversion) and efficiency. Rough diamonds selected for cutting are analyzed and where desirable are sorted for sawing or cleaving to achieve the desired shape and to eliminate imperfections. They are then cut and polished into finished gems. Each finished ideal cut diamond (weighing .18 carats and larger) which is marketed as a Lazare Diamond is then inscribed with the Lazare Kaplan logo and its own identification number by the Company's patented laser inscription process. All of these operations are performed by the Company's employees. The Company believes its work force in Puerto Rico is the most highly skilled in the diamond industry. The Company has undertaken a worker training program at its facility in Puerto Rico to ensure a constant flow of skilled labor to satisfy its needs for further growth. 5 The Company believes that it is recognized in the diamond industry for the high quality and brilliance of the gems it cuts and that it also enjoys a reputation as an imaginative and innovative cutter of large and difficult diamonds. Pricing Rough Diamond Prices Through its control of approximately 60% of the value of the world diamond output, the DTC can exert significant control over the pricing of rough and polished diamonds to maintain an orderly market by adjusting rough diamond supplies in the marketplace. Rough diamond prices established by the DTC have been characterized historically by steady increases over the long term; however, prices in the secondary market have experienced a greater degree of volatility, particularly during the late 1970's. Traditionally, the Company has been able to pass along such price increases to its customers. From time to time, however, the Company has absorbed these price increases in the short term to maintain an orderly pricing relationship with its customers. This has, in the past, caused temporary adverse effects on the Company's earnings. However, a large rapid increase in rough diamond prices could materially adversely affect the Company's revenue and operating margins if the increased cost of rough diamonds could not be passed along to its customers in a timely manner. According to published reports, during 1995 there was an emergence of a two-tier market for rough diamonds. The first tier is comprised of better quality rough diamonds, for which the DTC continues to maintain an orderly market. The Company conducts its cutting and polishing operations almost exclusively in this segment of the market. The second tier is comprised of small, less expensive, imperfect rough diamonds. The prices for these diamonds are determined principally by supply and demand. Consequently, there has been considerable volatility in the prices of less expensive diamonds since 1995. Because the Company focuses primarily on better quality rough diamonds, this volatility has not had a significant effect on the Company. Polished Diamond Prices Over the past 60 years, increases in the price of rough diamonds have generally resulted in a corresponding increase in the price of polished diamonds. However, during periods of economic uncertainty, there may be a time lag before the Company is able to increase polished diamond prices. During the period of high inflation in the late 1970's, investors speculated in hard assets, driving polished diamond prices to exceptionally high levels which in turn caused significant increases in the cost of rough diamonds. However, the moderation of inflation during the early 1980's resulted in a sudden and massive shift of investments from hard assets to financial instruments, resulting in dramatic price declines for polished diamonds which caused a market liquidity crisis as prices of some categories of polished diamonds fell below the inventory costs of such diamonds. Since this period in the early 1980's, the Company believes the pricing of polished diamonds has returned to its historical pattern of responding to increases in the pricing of rough diamonds. However, there can be no assurance that volatility in the price of polished diamonds could not occur again. Any rapid decrease in the price of polished diamonds could have a material adverse effect on the Company in terms of inventory reserves, lower sales and lower margins. The Company has broadened its sales base and implemented strict inventory, pricing and purchasing controls which it believes could lessen the impact of fluctuations in the price of rough and polished diamonds. These include computerized rough diamond evaluation programs, automatic economic order quantity models and inventory utilization programs. 6 Marketing, Sales and Distribution Marketing Strategy The Company's sales strategy is directed primarily toward quality conscious consumers throughout the United States, South America, the Far East and Europe. The Company focuses its distribution efforts for Lazare Diamonds on selectivity with a view to helping retailers who carry the product maintain a competitive advantage. Lazare Diamonds can be found at some of the most prestigious jewelry stores around the world, including both those with international reputations and those recognized only in their local communities as being the highest quality retail jewelers. This strategy helps ensure that the Company's product is presented in an environment consistent with its superior quality and image. The Company also sells to certain jewelry manufacturers and diamond wholesalers. The Company has developed a comprehensive grading system for its diamonds which, when coupled with the "ideal cut" standard, allows jewelers to order inventory by category rather than through the more cumbersome process of visual selection. In addition, the Company designs, manufactures (through independent contractors) and sells a line of high quality jewelry that features Lazare Diamonds. A key element of the Company's strategy is the promotion of the Lazare Diamond brand name directly to consumers. The Company is able to market its diamonds under a brand name to retailers because (a) the ideal cut differentiates the Company's diamonds from commercial diamonds in the marketplace and (b) each Lazare Diamond is inscribed with the Company's logo and identification number using the Company's patented laser inscription process, thus authenticating the diamonds. The Company holds a domestic patent, which expires in 2000, and various international patents for this process. In addition, on August 3, 1999, a U.S. patent was issued to the Company for a new and improved laser inscription process. The Company also has international patents-pending for this process. The Company's decision to pursue the brand name strategy is reinforced by two factors - a rising trend among informed consumers to purchase quality, brand name products, and the need among upscale jewelers to set themselves apart in an increasingly competitive market by carrying and promoting a highly differentiated product. Building awareness and acceptance of the Lazare Diamond brand name is accomplished through a comprehensive marketing program which includes sales training, cooperative advertising, sales promotion and public relations. A wide assortment of sales promotion materials has been designed to facilitate jewelers' sales of the Company's diamonds and fine jewelry line to consumers. Public relations events are offered which help build traffic in retail stores. The Company believes these marketing programs have been and will continue to be instrumental in increasing sales. The Company has no current plans to sell its diamonds directly to consumers and intends to continue concentrating its marketing efforts towards the quality retail jeweler. The Lazare Diamond Registry program has been established by the Company to enable consumers to register their Lazare Diamonds with the Company using the laser inscribed identification number, thereby providing proof of ownership in case of loss or theft. Sales and Distribution While the purchase and sale of rough diamonds is concentrated among relatively few parties, industry wide retailing of polished diamonds occurs through over 40,000 jewelry stores in the United States, over 25,000 retailers in Japan and over 60,000 retail stores in Europe. The Company's sales efforts for its polished diamonds are directed primarily toward the fine quality segment of these retailers 7 (the majority of which are independently owned and operated), wholesalers and distributors and, to a lesser extent, to jewelry manufacturers. Full time regional sales representatives located throughout the United States, Hong Kong and Europe, are compensated on a commission basis and handle sales throughout their respective territories. The Company's U.S. sales force is supported by a New York based telemarketing department. Sales to certain of the Company's largest accounts are handled by headquarters personnel. Most of the Company's major accounts are customers of long standing. The Company has been actively working to expand its foreign business activities, particularly in the Far East countries of Japan, Hong Kong, Singapore, Taiwan, Korea and Malaysia and recently throughout South America. After working with its former distributor of over 25 years, in 1999, the Company changed the nature of its distribution in Japan by assuming control of distribution of its products and opening its own office. In this way, the Company has realigned its position with its retail and wholesale customers and shortened its channels of distribution. In addition, this realignment has enabled the Company, without interruption, to assume control of the expansion and maintenance of the Lazare Diamond brand name in Japan. As part of the realignment, the Company retained experienced Japanese staff, giving it immediate and direct access to important customers as well as in depth industry knowledge. The Company believes that this realignment was necessary in order to compete effectively in Japan (the world's second largest market for diamonds and diamond jewelry) in the years to come. The Company continues to maintain its relationship with Seiko Corporation ("Seiko"), one of the world's largest watchmakers. It is anticipated that Seiko will ultimately supply Lazare Diamonds to 300-400 retailers in Japan. Seiko is generally recognized as a leader in consumer brand marketing and has a well developed network of contacts and retailers. The Company uses a comprehensive sorting and inventory classification system for grading color and clarity of its ideal cut polished diamonds. This system, combined with the fact that the Company's stones are uniformly cut to ideal proportions, reduces and in some cases eliminates the need for customers to view diamonds before placing orders. The system enables customers to standardize their inventories, order by mail or telephone and minimize their inventory investment. The percentages of the Company's total domestic and foreign net sales to its customers, which include a combination of both rough diamonds and polished diamonds sales taken together, for the past three fiscal years are set forth below:
Years ended May 31, --------------------------------------- 1999 1998 1997 ---- ---- ---- Percentage of Net Sales to Customers United States 31% 28% 22% Far East 8% 7% 9% Europe, Israel & other 61% 65% 69% ---- ----- ---- 100% 100% 100% ==== ==== ====
The world's rough diamond trading markets are primarily located in Belgium and Israel; therefore, the majority of the Company's rough diamond sales have been transacted with foreign customers. In 1999 and 1998, due to an increase in demand in the United States combined with weaker markets in the Far East, the Company sold a greater percentage of its polished diamonds domestically than it had in prior years. In addition, the Company's sales to customers in Europe, Israel & other, which consisted primarily of rough diamonds, were lower as a percentage of total sales in 1999 as compared to 1998 due to the greater rate of increase in polished diamond sales in the U.S. in 1999 as compared to the prior years, 8 The Company believes that due to the possible international resale of diamonds by its customers, the above percentages may not represent the final location of retail sales of its product. All of the Company's foreign sales, other than those made in Japan, are denominated in United States dollars. Where possible, the Company hedges its sales transactions in Japan to minimize the impact of any foreign currency exposure on its foreign revenue. The profitability of foreign sales of either polished or rough diamonds is consistent with that of domestic sales of similar merchandise. Competition The polished and rough diamond business is highly competitive. While the Company believes that it has achieved a reputation as a leading cutter and distributor of high quality diamonds, it faces competition in sales to its customers in the United States and abroad from many other suppliers. In addition, the Company sells rough diamonds in the competitive world market. A substantial number of cutters and polishers and traders, some of which the Company believes to be larger or to have greater financial resources than the Company, sell diamonds of all qualities to the Company's customers. The Company believes there are significant barriers to entry by potential competitors into the business of manufacturing ideally proportioned diamonds. Among the most important of these barriers are the need for significant working capital to purchase rough diamonds and hold polished inventory, the long-term relationships required to have access to adequate supplies of rough diamonds, the limited number of persons with the skills necessary to consistently cut significant amounts of ideally proportioned diamonds, the difficulty in obtaining access to upscale channels of distribution, the importance of public recognition of an established brand name and the establishment of computer systems to report on and monitor the manufacturing and distribution network. Employees At July 31, 1999, the Company had 191 full-time employees and 7 regional sales representatives. The Company maintains an apprenticeship program at its facility in Puerto Rico, through which it trains its cutters, who are highly skilled workmen. The Company provides paid vacations, sick leave, group life, disability, hospitalization and medical insurance for its employees. The Company has a 401(k) retirement plan for its U.S. and Puerto Rico employees. The Company believes that it has satisfactory relationships with its employees. None of the Company's employees is represented by a union. Item 2. Properties The Company leases office space, a portion of which is devoted to sales rooms, at 529 Fifth Avenue, New York City, for a term expiring September 30, 2003 at an annual rental rate of approximately $278,000 (subject to escalations). The Company also subleases space at the same address to Leon Tempelsman & Son for a like term at a rental rate per square foot which is the same as the Company is paying to the landlord. The Company also owns a manufacturing facility in Caguas, Puerto Rico. The Caguas facility consists of approximately 7,500 square feet. The Company leases office space in Antwerp, Belgium for a term expiring May 31, 2003 at an annual rental rate of 1,500,000 Belgian francs (approximately $39,000). The Company also has a 40% ownership interest in a 330 square meter office in Antwerp, Belgium, a portion of which is devoted to sales rooms. The Company leases office space in Hong Kong for a term expiring April 30, 2000 at an annual 9 rental rate of 354,000 Hong Kong dollars (approximately $46,000). The Company leases office space in Tokyo for a term expiring August 31, 2000 at an annual rental rate of 18,200,000 Japanese Yen (approximately $148,500). The Company believes that its facilities are fully equipped and adequate to fulfill its operating and manufacturing needs. Item 3. Legal Proceedings On or about April 13, 1999, International Diamond Traders CY B.V.B.A. ("IDT") and Avi Neumark ("Neumark"), the President and controlling stockholder of IDT, commenced an action in the U.S. District Court for the Southern District of New York against the Company, Lazare Kaplan Belgium, N.V., a subsidiary of the Company ("LKB"), and Maurice Tempelsman, Leon Tempelsman and Sheldon Ginsberg, each of whom is a director and officer of the Company and a director of LKB. The plaintiffs subsequently amended their complaints to eliminate LKB and Mr. Ginsberg as defendants. The plaintiffs alleged, among other things, that the Company and its principals fraudulently induced IDT to make more than $1.75 million in payments to the Company in connection with an alleged "joint venture" for the purchase of rough diamonds, excluded IDT from this relationship and expropriated its interest, defamed the plaintiffs, causing injury to their business reputation and interfered with plaintiffs' business prospects. The plaintiffs are seeking damages of $1.75 million, together with interest, general, consequential and other damages in an unspecified amount and punitive damages. The plaintiffs further seek the value of half of the alleged profits since September 1998, the date at which the relationship was allegedly wrongfully terminated. In addition, the plaintiffs allege that the Company's Quarterly Report on Form 10-Q for the quarter ended November 30, 1998 inaccurately includes all of the sales of the Company's Angolan operations. The Company believes that the plaintiffs' allegations are without merit and is vigorously defending this action. In a related matter, on or about April 13, 1999, Novel Diamonds Inc. ("Novel") and Lexco Limited ("Lexco") submitted a demand for arbitration to the International Chamber of Commerce naming as respondents, the Company, Lazare Kaplan (Bermuda) Ltd., a wholly-owned subsidiary of the Company, LKN Diamond Company, LTD. ("LKN") and Sheldon Ginsberg. Each of the claimants is controlled by Neumark. The claimants have alleged, among other things, that the respondents are in breach of their obligations to transfer the Company's "rough diamond trading sight" (the "sight") to LKN as was allegedly required by a 1994 shareholders agreement and have improperly barred claimants and Mr. Neumark from access to the "sight" business. As a result of the foregoing, the claimants are seeking damages of $5 million and at least 50% of the profits from the "sight" business since September 1998, plus interest, and 50% of the net asset value of LKN, including the "sight." The Company believes that the claimants' allegations are without merit and is vigorously defending this action. The two above actions followed the institution, earlier in 1999, of an arbitration proceeding jointly submitted by Neumark, IDT and the Company. This matter was voluntarily submitted to arbitration by Neumark, IDT and the Company to resolve all monetary disputes between the parties as a result of the termination of their relationship, except for those that are the subject of the foregoing actions. All matters submitted to arbitration have been substantially resolved with the exception of the following (i) whether there is any goodwill arising from the alleged relationship in Angola, and (ii) if goodwill exists, the value of such goodwill and the amount of the payment, if any, to be made. The Company believes that such claim for goodwill is without merit and is vigorously defending its position that no payment for goodwill is appropriate. If the opposing parties are successful in some or all of above related proceedings, the Company's business could be materially and adversely affected. 10 In addition, Neumark has commenced an action in Delaware Chancery Court against the Company seeking the right to inspect, and make copies of, certain books and records of LKI and LKB. Item 4. Submission of Matters to a Vote of Security Holders None Executive Officers of the Company The following table sets forth information regarding executive officers of the Company.
NAME POSITION AGE - ---- -------- --- Maurice Tempelsman Chairman of the Board 70 Leon Tempelsman Vice Chairman of the 43 Board and President Sheldon L. Ginsberg Executive Vice President and 45 Chief Financial Officer Robert Speisman Senior Vice President - Sales 46
All officers were elected by the Board of Directors at its meeting following the Annual Meeting of Stockholders held in November 1998, and hold office until the Board of Directors meeting following the next Annual Meeting of Stockholders and until their respective successors have been duly elected and qualified. Maurice Tempelsman is the Chairman of the Board and a director of the Company and a general partner of Leon Tempelsman & Son ("LTS"), a partnership with interests in the international diamond and mining industries. He has held these positions since 1984. Maurice Tempelsman is the father of Leon Tempelsman and the father-in-law of Robert Speisman. Leon Tempelsman is the Vice Chairman of the Board, the President and a director of the Company and a general partner of Leon Tempelsman & Son. He has held these positions since 1984. Leon Tempelsman is the son of Maurice Tempelsman and the brother-in-law of Robert Speisman. The Company believes that neither the Tempelsmans nor LTS currently engages directly or indirectly in any activities competitive with those of the Company. Sheldon L. Ginsberg has been Executive Vice President and Chief Financial Officer since February 1996. He was the Vice President and Chief Financial Officer from April 1991 until February 1996. Mr. Ginsberg has been a director of the Company since 1989. Robert Speisman has been the Senior Vice President - Sales of the Company since January 1999. He was Vice President - Sales of the Company from April 1986 until January 1999. Mr. Speisman has been a director of the Company since 1989. Mr. Speisman is the son-in-law of Maurice Tempelsman and the brother-in-law of Leon Tempelsman. Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 11 The Company's common stock (par value $1 per share) is traded on the American Stock Exchange. Market prices and other information with respect to the Company's common stock are hereby incorporated by reference to the Company's Annual Report. Item 6. Selected Financial Data Selected financial data are hereby incorporated by reference to the Company's Annual Report. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's discussion and analysis of financial condition and results of operations is hereby incorporated by reference to the Company's Annual Report. Item 7A. Quantitative and Qualitative Disclosure About Market Risk Not applicable. Item 8. Financial Statements and Supplementary Data (a) The following financial statements and supplementary data are hereby incorporated by reference to the Company's Annual Report. (i) Report of Ernst & Young LLP (ii) Consolidated Statements of Operations for each of the three years in the period ended May 31, 1999. (iii) Consolidated Balance Sheets as at May 31, 1999 and May 31, 1998. (iv) Consolidated Statements of Stockholder's Equity for each of the three years in the period ended May 31, 1999. (v) Consolidated Statements of Cash Flows for each of the three years in the period ended May 31, 1999. (vi) Notes to Consolidated Financial Statements. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures Not applicable. Part III Except for information regarding Executive Officers of the Company, which, in accordance with Instruction G to Form 10-K, is included in Part I hereof, the information called for by Part III (Items 10, 11, 12 and 13) is incorporated by reference herein to the Company's definitive proxy statement to be filed with the Commission within 120 days after the close of its fiscal year ended May 31, 1999. Part IV 12 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. The response to this portion of Item 14 is set forth in Item 8 of Part II hereof. 2. Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts for each of the three years in the period ended May 31, 1999. All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the consolidated financial statements or notes thereto.
13 LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E - -------- -------- -------- -------- -------- Additions -------------------------- Balance at Charged to Charged to Balance at beginning costs and other accounts Deductions end Description of period expenses describe describe of period ----------- --------- --------- -------------- ---------- --------- YEAR ENDED MAY 31, 1999: Allowance for doubtful accounts $143,120 $ 60,000 $ - $ 1,064(A) $202,056 -------- -------- ------- -------- -------- YEAR ENDED MAY 31, 1998: Allowance for doubtful accounts $162,487 $ 60,000 $ - $ 79,367(A) $143,120 -------- -------- ------- -------- -------- YEAR ENDED MAY 31, 1997: Allowance for doubtful accounts $281,265 $(25,000) $ - $ 93,778(A) $162,487 -------- -------- ------- -------- --------
(A) Amounts written off. 14 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (continued) (b) Reports on Form 8-K - The Company filed a Current Report on Form 8-K, responding to Item 5 - "Other Events," on May 10, 1999. (c) Exhibits (3) Articles of Incorporation and Bylaws (a) Certificate of Incorporation, as amended - incorporated herein by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1987 filed with the Commission on August 26, 1987, as amended on January 14, 1988. (b) Certificate of Amendment of Certificate of Incorporation filed with the Secretary of State of the State of Delaware on November 1, 1990 - incorporated herein by reference to Exhibit (3)(b) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1992 filed with the Commission on August 28, 1992. (c) Certificate of Amendment of the Certificate of Incorporation filed with the Secretary of State of the State of Delaware on November 6, 1997 - incorporated by reference to Exhibit 4.1(a) (iii) to Company's Registration Statement for the Lazare Kaplan International Inc. 1997 Long Term Stock Incentive Plan on Form S-8 filed with the Commission on November 14, 1997. (d) Certificate of Designations of Series A Junior Participating Preferred Stock filed with the Secretary of State of the State of Delaware on November 6, 1997 - incorporated by reference to Exhibit 4.1(b) to the Company's Registration Statement on Form S-8 filed with the Commission on November 14, 1997. (e) By-laws, as amended - incorporated herein by reference to Exhibit 3(b) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1987 filed with the Commission on August 26, 1987, as amended on January 14, 1988. (10) Material Contracts (a) Lazare Kaplan International Inc. Amended and Restated 1988 Stock Option Incentive Plan - incorporated herein by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-8 filed with the Commission on November 5, 1990. (b) Lazare Kaplan International Inc. 1997 Long Term Stock Incentive Plan - incorporated herein by reference to Exhibit A to the Company's proxy statement for its Annual Meeting of Stockholders held on November 5, 1997 filed with the Commission on September 17, 1997. (c) Form of Incentive Stock Option Agreement for options granted pursuant to the Lazare Kaplan International Inc. 1997 Long Term Stock Incentive Plan - incorporated herein by reference to Exhibit 4.5(a) to the Company's Registration Statement on Form S-8 filed with the Commission on November 14, 1997. (d) Form of Non-Qualified Stock Option Agreement for options granted pursuant to the Lazare Kaplan International Inc. 1997 Long Term Stock Incentive Plan - incorporated herein by reference to Exhibit 4.5(a) to the Company's Registration Statement on Form S-8 filed with the Commission on November 14, 1997. 15 (e) Note Agreement dated as of May 15, 1991 by and between the Company, Allstate Life Insurance Company, Monumental Insurance Company and PFL Life Insurance Company - incorporated herein by reference to Exhibit 28 to Report on Form 8-K dated May 23, 1991 filed with the Commission on June 4, 1991. (f) First Amendment to Note Agreement, dated as of February 28, 1992, by and between the Company, Allstate Life Insurance Company, Monumental Life Insurance Company and PFL Life Insurance Company - incorporated herein by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1992 filed with the Commission on August 28, 1992. (g) Second Amendment to Note Agreement, dated as of March 25, 1992 by and between the Company, Allstate Life Insurance Company, Monumental Life Insurance Company and PFL Life Insurance Company - incorporated herein by reference to Exhibit 10(e) to Report on Form 10-K of the Company for the fiscal year ended May 31, 1992 filed with the Commission on August 28, 1992. (h) Third Amendment to the Note Agreement, dated as of December 1, 1992 by and between the Company, Allstate Life Insurance Company, Monumental Life Insurance Company and PFL Life Insurance Company - incorporated herein by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1993 filed with the Commission on August 30, 1993. (i) Fourth Amendment to the Note Agreement, dated as of August 25, 1995 by and between the Company, Allstate Life Insurance Company, Monumental Life Insurance Company and PFL Life Insurance Company - incorporated herein by reference to Exhibit 10 to the Quarterly Report on Form 10-Q for the quarterly period ended August 31, 1995 filed with the Commission on October 13, 1995. (j) Loan Agreement, dated May 14, 1996 among the Company, Fleet Bank, N.A. and Bank Leumi Trust Company of New York - incorporated herein by reference to Exhibit 10(i) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1996 filed with the Commission on August 28, 1996. (k) Amendment No. 1, dated as of November 29, 1996, to Loan Agreement, dated May 14, 1996, among the Company, Fleet Bank, N.A. and Bank Leumi Trust Company of New York - incorporated herein by reference to Exhibit 10(1) to Amendment No. 2 to the Company's Registration Statement on Form S-2 filed with the Commission on December 11, 1996. (l) Amendment No. 2, dated as of May 30, 1997, to Loan Agreement, dated May 14, 1996, among the Company, Fleet Bank, N.A. and Bank Leumi Trust Company of New York incorporated herein by reference to Exhibit 10(n) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1997 filed with the Commission on August 28, 1997. (m) Cooperation Agreement, dated July 15, 1996 between the Company and AK Almazi Rossii Sakha - incorporated herein by reference to Exhibit (2) to the Company's Current Report on Form 8-K/A filed with the Commission on November 18, 1996 (certain portions of this agreement have been omitted pursuant to a request for confidential treatment). (n) Cooperation Agreement, dated March 23, 1999 between the Company and AK Almazi 16 Rossii Sakha (certain portions of this agreement have been omitted pursuant to a request for confidential treatment). (o) Processing Agreement, dated as of February 20, 1999, between Pegasus Overseas Ltd. and a wholly-owned subsidiary of General Electric Company (certain portions of this agreement have been omitted pursuant to a request for confidential treatment). (p) Rights Agreement, dated as of July 31, 1997, between the Company and ChaseMellon Shareholder Services, LLC - incorporated herein by reference to Exhibit 99.1 to the Company's Form 8-A filed with the Commission on August 26, 1997. (q) Leon Tempelsman Retirement Benefit Plan of Lazare Kaplan International Inc. incorporated herein by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1997 filed with the Commission on August 28, 1997. (r) Sheldon L. Ginsberg Retirement Benefit Plan of Lazare Kaplan International Inc. incorporated herein by reference to Exhibit 10(p) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1997 filed with the Commission on August 28, 1997. (s) Robert Speisman Retirement Benefit Plan of Lazare Kaplan International Inc. incorporated herein by reference to Exhibit 10(q) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1997 filed with the Commission on August 28, 1997. (13) 1999 Annual Report to Security Holders - incorporated herein by reference to the Company's 1999 Annual Report to Stockholders to be filed with the Commission. (21) Subsidiaries (23) Consent of Ernst & Young LLP (27) Financial Data Schedule 17 SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LAZARE KAPLAN INTERNATIONAL INC. By (s) Sheldon L. Ginsberg --------------------------------------------- Sheldon L. Ginsberg, Executive Vice President and Chief Financial Officer (principal financial and accounting officer) Dated: August 27, 1999 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date - --------- ----- ---- (s) Maurice Tempelsman Chairman of the August 27, 1999 - --------------------------------- Board of Directors (Maurice Tempelsman) (s) Leon Tempelsman Vice Chairman of the August 27, 1999 - --------------------------------- Board of Directors and (Leon Tempelsman) President (principal executive officer) (s) Lucien Burstein Director August 27, 1999 - --------------------------------- (Lucien Burstein) (s) Myer Feldman Director August 27, 1999 - --------------------------------- (Myer Feldman) (s) Sheldon L. Ginsberg Director and Executive August 27, 1999 - --------------------------------- Vice President and Chief (Sheldon L. Ginsberg) Financial Officer (principal financial and accounting officer) (s) Robert Speisman Director August 27, 1999 - --------------------------------- (Robert Speisman)
18 EXHIBIT INDEX (10) (n) Cooperation Agreement, dated March 23, 1999 between the Company and AK Almazi Rossii Sakha (certain portions of this agreement have been omitted pursuant to a request for confidential treatment). (10) (o) Processing Agreement, dated as of February 20, 1999, between Pegasus Overseas Ltd. and a wholly-owned subsidiary of General Electric Company (certain portions of this agreement have been omitted pursuant to a request for confidential treatment). (13) 1999 Annual Report to Security Holders-incorporated herein by reference to the 1999 Annual Report to Stockholders to be filed with the Commission. (21) Subsidiaries (23) Consent of Ernst & Young LLP (27) Financial Data Schedule
19 STATEMENT OF DIFFERENCES The registered trademark symbol shall be expressed as........................'r' The paragraph symbol shall be expressed as...................................[p] The trademark symbol shall be expressed as..................................'TM' EX-10 2 EXHIBIT 10(N) EXHIBIT 10(n) CO-OPERATION AGREEMENT BETWEEN ALROSA AND LAZARE KAPLAN INTERNATIONAL INC.* Joint Stock Company ALROSA, being a legal entity under the laws of the Russian Federation (including any wholly-owned subsidiary thereof) and Lazare Kaplan International Inc., hereinafter referred to as LKI, being a legal entity under the laws of the United States (including any wholly-owned subsidiary thereof), jointly referred to herein as the Parties, have made this Co-Operation Agreement (the "Agreement") on cooperation in the processing of natural diamonds and marketing of the resulting polished diamonds. WHEREAS, ALROSA and LKI are parties to the Cooperation Agreement on the Processing of Natural Diamonds and Marketing of the Resulting Polished Diamonds, dated July 16, 1996 (the "Cooperation Agreement"); WHEREAS, ALROSA and LKI have implemented the Cooperation Agreement (the "Project") and have obtained financing for ALROSA secured by the proceeds from such Project; WHEREAS, ALROSA desires to further increase its participation in the world market of polished diamonds and seeks to obtain large scale debt financing guaranteed by the Export-Import Bank of the United States ("Exim Bank") as well as "untied" financing from commercial banks for activities furthering its leadership role in the world rough diamond production; and WHEREAS, ALROSA, Exim Bank and LKI are parties to the Memorandum of Understanding, dated May 15, 1998, containing the undertaking by the Exim Bank to extend financing to ALROSA, including in cooperation with commercial banks, provided ALROSA and LKI agree to and implement a co-operation and marketing agreement acceptable to Exim Bank; Now, therefore, ALROSA and LKI agree as follows: - -------- * Certain portions of this agreement have been omitted pursuant to a request for confidential treatment. 1 SUBJECT OF AGREEMENT. 1.1 Subject to the provisions of this Agreement, ALROSA and LKI will coordinate their joint activities in: -- selecting the necessary Facilities (as defined hereinafter) and their proper outfitting; -- selecting polishing professionals and staff for work at the Facilities; -- the assembly of diamond lots and determining their Base Cost (as defined hereinafter); -- planning the most efficient way of cutting and polishing such diamonds; -- cutting diamonds at the Facilities including control of the cutting and polishing; -- the certification of agreed upon diamonds; -- marketing and sales of all the resulting polished diamonds in the world market, using LKI and ALROSA sales networks. 2 OBLIGATION OF THE PARTIES. 2.1 The Parties through their authorized representatives shall take joint decisions on the following issues: 2.1.1 Subject to the Minimum Level specified in Article 3.1.3, on the amount and assortment of diamonds jointly assembled for cutting, the timing of such assembly, the Base Cost (denominated in US dollars) of each diamond lot assembled (for diamonds [*] carats and larger, for each rough diamond), the planning and cutting of each diamond lot assembled, and the valuation and sale of the resulting diamonds. 2.1.2 By means of written protocols, on the cost of each rough diamond lot assembled (hereinafter referred to as the "Base Cost"), on the reimbursable expenses of each party related to the implementation of this Agreement by the Parties on an annual basis, on the export price of each shipment of diamonds and on the distribution of the Shared Proceeds (as defined in Article 5.3) from each shipment. 2.2 The Parties express their intent to conduct this cooperation in the spirit of mutual trust, openness and confidentiality. Each Party will keep the other Party fully informed about every material decision that must be taken, consult and agree on each such decision, and include the other Party in all stages of work necessary to fulfill this Agreement. 2.3 ALROSA has the right, and LKI shall provide such an opportunity, for ALROSA's representatives to participate in the sales of polished diamonds in LKI offices, to recommend purchasers from its own clients, to participate in the presentations of the diamonds to perspective purchasers, in the sale negotiations and in documenting final 2 sales. 3 ALROSA OBLIGATIONS. 3.1 In addition to the obligations stated above in Article 2, ALROSA accepts the following obligations: 3.1.1 To provide, or to ensure, as agreed with LKI, initially at its own expense, but for reimbursement of expenses in accordance with this Agreement out of sales proceeds, the facilities necessary for cutting the rough diamonds (the "Facilities"), with premises sufficient to accommodate the equipment and personnel required to process the Minimum Level of rough diamonds, as defined in Paragraph 3.1.3, and to ensure functioning of the Facilities necessary to implement provisions of this Agreement. 3.1.2 To provide, or to ensure, initially at its own expense, but for reimbursement of expenses in accordance with this Agreement out of sales proceeds, the agreed upon number of professional workers and administrative personnel, if any, all of whom to be jointly approved with LKI for all stages of cooperation pursuant to this Agreement. 3.1.3 To provide not less than once a month rough diamonds, in sizes and qualities suitable for efficient processing at the Facilities and sale at the maximum prices, and in volumes and assortment regularly agreed upon by the Parties in the corresponding protocols, and for such Base Costs as may be required to assure the assembly, processing, export (at regular intervals) and sales pursuant to this Agreement of diamonds with an aggregate Base Cost of no less than US$50 million during each six-month period, evenly distributed by carat size within size groups in the assortment agreed upon by the Parties (the "Minimum Level"). 3.1.4 To provide LKI representatives with all documents and information relating to the implementation of this Agreement at all stages of the joint operation in order to fulfill the objectives of this Agreement. 3.1.5 To assist LKI experts in getting visas, work permits and residency permits, as may be required by relevant regulations. 3.1.6 To arrange for all necessary Russian government decisions, export and other permits, licenses, quotas and solutions of related issues arising in connection with this Agreement. 3.1.7 To make the necessary arrangements, including export licenses for the shipping at the contract price, not less than once a month, to LKI offices or a joint trading company established by the Parties outside Russia, for marketing and 3 sale outside Russia, of all the polished diamonds manufactured under this Agreement. Contract price shall not be less than the [*] of the diamonds being shipped and shall not exceed the [*] plus the estimated pre-agreed expenses of the Parties during the relevant period. 4 LKI OBLIGATIONS. 4.1 In addition to the obligations stated above in Article 2, LKI accepts the following obligations for a fee, as provided in Article 5.2 hereof, for the marketing of the polished diamonds outside of Russia: 4.1.1 To provide, initially at its own expense, but for reimbursement of expenses in accordance with this Agreement out of sales proceeds, the technical consultants required for the implementation of this Agreement, such consultants to supervise at all stages the assembling, planning, cutting and polishing process of all diamonds subject to this Agreement. 4.1.2 To provide the required technology, equipment, tools and materials (collectively, "Equipment") agreed to by the Parties, as required by the expected volume of work and workers. The equipment shall be procured pursuant to sales agreement with ALROSA, providing for the terms of payment permitted by Russian law. 4.1.3 To provide, initially at its own expense but for reimbursement out of sales proceeds, prior to receiving each shipment of polished diamonds, an insurance certificate for the amount of the estimated sales price of such shipment (listing ALROSA as beneficiary prior to it receiving from LKI the Base Cost) covering 'all risks' of the processed diamonds during the period of their transportation, storage and delivery to the buyer up to the time of final sale. 4.1.4 If necessary, to certify, or obtain GIA certification for, polished diamonds agreed to by the Parties before each shipment from Russia. 4.1.5 To organize and perform, with the participation of ALROSA representatives and their knowledge of the ALROSA marketing network but retaining by LKI at all times physical possession and control of the diamonds, the sorting, valuation and marketing of all diamonds polished and delivered to LKI outside Russia under this Agreement, utilizing its marketing expertise, analyses, facilities, network and contacts in Antwerp, New York and Tokyo and worldwide, using such advertisement, promotion and marketing technologies, including the timing thereof as may be determined by the Parties in order to realize the maximum price obtainable, and the sale of polished diamonds at such price. ALROSA has the right to introduce its customers who offer a higher price than customers known to LKI. 4 4.1.6 To provide ALROSA with the full information and documents on the performance, costs and results of marketing activities including copies of necessary certificates and other documents. 4.1.7 To help arrange for visas, reception and residence for Russian experts during their joint work outside Russia. 4.1.8 To transfer to the bank account specified by ALROSA (a) no later than [*] after receiving the polished diamonds outside Russia (or on the next succeeding day when banks in New York and Moscow are open) a sum equivalent to [*] of the pre-agreed [*] of the rough diamonds; and (b) no later than [*] from the shipping date of the polished diamonds (or on the next succeeding day when banks in New York and Moscow are open) the remaining amount of the contract price of such diamonds, and (c) no later than [*] from the delivery date (without extending this period), the final portion of the sales price received for such diamonds, minus the amounts remitted to ALROSA pursuant to clauses (a) and (b) above, provided however, that if by such [*] any of the diamonds remain unsold, they will become the property of LKI at their [*]. 4.2 In the event that ALROSA proceeds with the Exim Bank or other financing (a) to take all necessary actions within its control at each stage to assure that the value of diamonds assembled, processed, exported and sold pursuant to this Agreement within each successive 6 month period meet the Minimum Level of US$50 million; and (b) to fully cooperate with ALROSA, Exim Bank, and other financial institutions in the formulation and implementation of such arrangements in connection with this Agreement as may facilitate ALROSA's proceeding with the financing of its operations. 5 PAYMENT. 5.1 ALROSA and LKI shall define the value of each rough diamond lot assembled for processing in accordance with the current sales prices of USO ALROSA (for sizes [*] carats and larger, for each rough diamond) (the "Base Cost"), and confirm it by an appropriate protocol. 5.2 The Parties agree that the amounts to be distributed between them (the "Shared Amount"), as defined in Paragraph 5.3, received from sales of polished diamonds, will be distributed as follows: to ALROSA - [*] to LKI - [*], as its fee for the consultations and marketing of the polished diamonds in the United States and other markets outside Russia. 5.3 The Parties agree that "Shared Proceed" means the amount received from the sales of polished diamonds excluding the cost of rough diamonds (the Base Cost) and 5 all ALROSA and LKI agreed upon expenses related to the implementation of this Agreement, cutting (including expenses related to the use of the Facilities), valuation, processing, export from Russia, transportation, certification, insurance and marketing of polished diamonds pursuant to this Agreement, including all compensation and related payments (such as international travel and living expenses) paid to Russian and foreign professionals and the amortization of the cost of the Equipment. All costs will be jointly agreed upon and confirmed by appropriate protocols. 5.4 ALROSA shall pay to LKI, and will ensure that LKI receives, all sums due to LKI in accordance with this Agreement; such amounts to be paid by a wire transfer, in immediately available funds, to a bank account to be specified by LKI to ALROSA. Unless such payments are effectuated by ALROSA otherwise and unless agreed otherwise by the Parties, such payments shall be made from the bank account of ALROSA in an authorized Russian bank (the "Bank") approved by the Central Bank of Russia ("CB RF), to which revenues from the sale of diamonds by LKI are transferred upon instructions from ALROSA. ALROSA authorizes and instructs the Bank, and will provide the Bank with the necessary written documents as the Bank may require, to ensure that the Bank immediately and unconditionally upon receipt of payments from LKI to ALROSA pursuant to Section 4.1.8 of this Agreement, reimburses LKI for all services rendered and expenses incurred in accordance with the provisions of this Agreement. If in accordance with Russian laws and regulations ALROSA needs to make mandatory conversions of convertible currency proceeds into Rubles, and the remaining amounts are insufficient to reimburse LKI in full as provided in this Article 5.4, ALROSA authorizes and instructs the Bank to effectuate immediate reconversion of Rubles in necessary amounts, in order to make full payments to LKI. If LKI and ALROSA determine that a Bank guarantee is required to secure the payments to LKI provided for in this Agreement, ALROSA and LKI will share the cost of such Bank guarantee equally. 5.5 Notwithstanding any other provisions of this Agreement, during the term of any financing to ALROSA, secured by this Agreement, ALROSA hereby irrevocably instructs LKI, and LKI agrees, to pay all amounts due to ALROSA under this Agreement on the day due by same day wire transfer into the account established by the lender(s) pursuant to such financing. 6 THE TERM OF THE AGREEMENT AND SETTLEMENT OF DISPUTES. 6.1 This Agreement is valid from the moment of signing, and will be valid for 10 years and may be prolonged thereafter by mutual consent of the Parties. 6.2 If the external situation makes it impossible in full or in part for one of the Parties 6 to fulfill any of its obligations under this Agreement due to unforeseen circumstances (force majeure) such as fire, natural disasters, war, military operations of any kind, blockades, or other situations beyond the control of the Parties, the time of fulfillment of such obligation will be delayed for a period equal to the duration of the force majeure circumstances. If such circumstances persist for more than 12 months, either Party may terminate the fulfillment of its obligations. The compensation for any Party suffering losses as a result of such termination will be decided by the Parties when the decision to terminate this Agreement is taken. 6.2.1. The Party that cannot fulfill its obligations due to force majeure circumstances must make clear to the other Party the nature of the circumstances that prevent the fulfillment of the obligation. Proof of existence of such force majeure circumstances and their duration will be based upon information from the Chambers of Trade and Commerce of Russia or the United States, whichever of the country in which the existence of such circumstances of force majeure is claimed to have occurred. 6.3 All disagreements and disputes resulting from or in relation to this Agreement will be resolved in a friendly manner by negotiations. Disputes unresolved by consultations and negotiations will be decided by the International Commercial Arbitration Court of the Russian Federal Chamber of Trade and Commerce. 6.4 Each Party confirms that this Agreement is not an agreement to create a joint venture, partnership, sales or trade agreement or technology transfer agreement. Each Party agrees to keep secret any business, financial, technical or other information received about the other Party in connection with this Agreement and agrees not to undertake any steps that could undermine the effectiveness of this Agreement without obtaining the written consent of the other Party. Each Party represents that this agreement does not violate any of their respective legal obligations or undertakings. 6.5 The present Agreement shall not in any way affect the provisions of the Cooperation Agreement on the Processing of Natural Diamonds and Marketing of the Resulting Polished Diamonds, dated July 16, 1996, entered into by the Parties, as amended from time to time (the "Cooperation Agreement") and shall in no way affect the rights and obligations of the Parties under the Cooperation Agreement. 7 TRANSFER OF RIGHTS OR DUTIES; FULL AGREEMENT. 7.1 No Party can transfer its rights or duties under this Agreement to any other person without the written consent of the other Party, and, if this Agreement is used as security for debt financing to ALROSA, and, as long as such debt financing is outstanding, without the written consent of the relevant creditor. LKI hereby authorizes ALROSA to make such pledge or assignment of its revenues under this Agreement as ALROSA may agree with its creditors. 7 7.2 This Agreement reflects the full mutual understanding of the Parties and any modification therein must be mutually agreed upon by the Parties in writing, and, as long as any debt financing for which this Agreement is used as security is outstanding, by the relevant creditor. 8 LEGAL ADDRESSES. ALROSA Lazare Kaplan International Inc. 678170 Mirny Ul.Lenina 6 529 5th Avenue Teletype: 135818 Almaz New York, NY 10017 U.S. Telex: 135113 Almaz SU Tel: 212 972-9700 Telefax (411) 36-244-51 Fax: 212 972-8561 109017 Moscow 1 Kazachy per.10/12 Teletype: 113258 Vilyi Telex: 414199 Almaz RU Telefax (095) 230-6631
This Agreement is signed in Washington, D.C. on March 23, 1999 in two copies in English and Russian, each of which have equal legal and binding force. In separate letters to be delivered by the Parties' legal counsel, the English and Russian texts of this Agreement shall be certified to be identical. On behalf of ALROSA On behalf of Lazare Kaplan International Inc. /s/ V.A. Shtyrov /s/ M. Tempelsman President Chairman 8 EX-10 3 EXHIBIT 10(O) EXHIBIT 10(o) PROCESSING AGREEMENT* This processing agreement (the "Agreement") is made this 20th day of February, 1999 by and between GE [*] a company whose principal place of business is [*]("GE[*]), and which is an indirect wholly-owned subsidiary of General Electric Company, a New York corporation ("GE"), and Pegasus Overseas Ltd., a company organized under the laws of the Bahamas ("POL"), and which is a direct wholly-owned subsidiary of Lazare Kaplan International Inc., a Delaware corporation ("LKI") (each of GE[*] and POL being a "Party" and collectively, the "Parties"), and sets forth the terms and conditions under which POL will acquire certain [*] and [*] gem diamonds for delivery to GE[*] for processing and, after such gem diamonds have been received back from GE[*], sell such gem diamonds. Certain capitalized terms used but not defined herein have the meanings assigned to them in Attachment A. PART I - SOURCING OF GEM DIAMONDS I. AGREEMENT TO SOURCE DIAMONDS. (A) On a regular basis to the extent practicable in the circumstances, GE[*] shall advise POL regarding GE[*]'s expected schedule for processing gem diamonds and its available capacity for processing gem diamonds meeting the Specifications. (B) POL shall take all steps necessary or appropriate to purchase (at the lowest prices commercially obtainable by it), select, sort and screen [*]and [*] gem diamonds meeting the Specifications (the "Gem Diamonds") and deliver them to the GE[*] or GE facility specified in paragraph VII(I) for processing. Such deliveries shall be made on a [*] basis (or more frequently if POL has accumulated Gem Diamonds having a cost of approximately [*] or more). Each package of Gem Diamonds delivered shall include documentation (i) setting forth the Acquisition Cost for each of the Gem Diamonds included therein, (ii) certifying that any required duty, tax or other fee arising from POL's acquisition and/or delivery of the Gem Diamonds has been or will be paid on a timely basis, (iii) assigning an identification code to each Gem Diamond in the package, and (iv) containing such other customary information, if any, as the parties shall determine to be necessary or useful to consign such package of Gem Diamonds to GE[*] for processing (collectively, the "POL Delivery Documentation"). POL shall indemnify GE[*] and hold GE[*] harmless from and against all costs incurred in connection with POL's acquiring, sorting, screening and delivery of Gem Diamonds to GE[*] (other than the Acquisition Cost and Preparation Costs, which shall be allocated as set forth in paragraphs (D), (E) and (F), below, but including, without limitation, boiling, packing, shipping, insurance, duty and taxes). If GE[*] determines that any gem diamonds delivered by POL do not meet the Specifications as to [*]or [*], GE[*] may decline to accept such Gem Diamonds for processing. In the event of any failure by Gem Diamonds delivered by POL to meet the Specifications, GE[*] shall so notify POL in writing and POL shall identify the source of such Gem Diamonds and suspend purchases from that source until it believes that gem diamonds from such source will again meet the Specifications. - -------- * Certain portions of this agreement have been omitted pursuant to a request for confidential treatment. (C) As an inducement to POL to maximize the amount of Gem Diamonds it delivers hereunder, GE[*] shall advance [*] of the Acquisition Cost and [*] of the Estimated Preparation Costs for those Gem Diamonds delivered to GE[*] for processing hereunder (excluding any gem diamonds which GE[*] declines to accept for processing pursuant to paragraph I(B)). Such payment shall be made by wire transfer to the bank account specified in writing by POL to GE[*] (which may be changed by POL upon ten days' advance written notice to GE[*]) (the "POL Account") within [*] after GE[*]'s receipt of such Gem Diamonds together with the POL Delivery Documentation. Ownership, title and (except as set forth below) risk of loss with respect to the Gem Diamonds purchased, sorted and delivered to GE[*] for processing in accordance with this Agreement shall remain with POL throughout the time that such Gem Diamonds are in GE[*]'s possession, provided that GE[*] shall protect and hold such Gem Diamonds in a separate, safe and secure location for POL property only, using a commercially reasonable degree of care in view of the value of such Gem Diamonds. GE[*] shall maintain, at its expense and for the benefit of POL as named insured, insurance for the Gem Diamonds, covering the Gem Diamonds at all times when they are located at a GE[*] facility (or the facility of a GE[*] Affiliate) for processing or being delivered by GE[*] to POL after processing, pursuant to paragraph II(A). Such insurance shall (i) be provided by a responsible insurance carrier reasonably satisfactory to POL, (ii) cover all risks covered by the types of insurance customarily carried by LKI and its Affiliates for similar inventory and operations, (iii) provide benefits covering no less than the estimated value of such Gem Diamonds (depending upon their stage of completion) as the Parties shall determine, (iv) unless the Parties shall otherwise agree in writing, not provide for any "deductible" to be applied to any loss, and (v) provide that POL receive at least 30 days prior written notice of any material change or termination of the insurance policy. Promptly upon written request therefor, GE[*] shall deliver a Certificate of Insurance to POL, evidencing the foregoing insurance. GE[*] shall be responsible to POL for any uninsured loss or damage resulting in any diminishment of the value of POL's interest in any Gem Diamonds while in GE[*]'s possession or under GE[*]'s control (including Gem Diamonds in transit when GE[*] is responsible for delivery). It is understood and agreed that any insurance payments or payments with respect to uninsured losses of Gem Diamonds received by POL will be distributed pursuant to paragraph III(D) hereof as if they were proceeds received upon sale of such Gem Diamonds. GE[*] will use all reasonable business efforts to avoid the production of Special Inventory Diamonds. Notwithstanding anything to the contrary contained herein, GE[*] shall not have any liability for loss of potential value or other consequential damages as a result of (i) producing Special Inventory Diamonds, (ii) any failure to produce improvement, or a sufficient level of improvement, in any Gem Diamond, or (iii) [*]to Gem Diamonds during the act of processing. (D) The Pre-Processing Cost Factor to be applied during the first [*] is [*] per carat of Prepared Gem Diamond delivered to GE[*] for processing. The Post-Processing Cost Factor to be applied during the first [*] is [*] per carat of Prepared Gem Diamond delivered to GE[*] for processing. The Certification Cost Factor to be applied during the first [*] is [*] per carat of Prepared Gem Diamond delivered to GE[*] for processing. As used herein, the term "Prepared Gem Diamond" means a Gem Diamond that is either (i) [*] or (ii) [*] at 2 the time of delivery to GE[*] for processing, and does not include Gem Diamonds which are [*]upon such delivery. Notwithstanding anything to the contrary set forth in this Agreement, except as the Parties shall agree on a case-by-case basis, the Pre-Processing Costs, Post-Processing Costs and Certification Costs attributable to a Gem Diamond which is [*]when delivered to GE[*] for processing shall be zero, and no Estimated Preparation Costs will be payable by GE[*] in respect thereof. If POL shall determine in good faith that any such Gem Diamond should be [*] and [*] and certified, POL shall separately invoice GE[*] for [*] of the Post-Processing Costs and [*] of the Certification Costs associated with such Gem Diamond, using the Post-Processing Cost Factor and Certification Cost Factor then in effect. Such invoices shall be payable by wire transfer to the POL Account within [*] after GE[*]'s receipt thereof. POL shall supply to GE[*] [*] the so-called "[*] WIP report," identifying which [*]Gem Diamonds have been converted to [*] and [*] Gem Diamonds during the preceding [*]. (E) Within [*] days following the end of each [*] during the term of this Agreement, the Parties shall confer to determine the Pre-Processing Cost Factor, Post-Processing Cost Factor and Certification Cost Factor to be applied during the then current [*] and to determine what changes, if any, should be made in Annex 1 to Attachment A to this Agreement. If any changes are determined to be necessary or desirable, then the Parties shall formally amend Annex 1 in writing. During the pendency of such determination, the Parties will continue to use the factors applicable during the prior [*]. Once the factors have been reset, they shall apply retroactively to the beginning of the [*], and the parties shall account to one another within [*] days thereafter to reconcile any resulting discrepancy in amounts paid before the factors were reset. POL shall use reasonable business efforts to minimize the Pre-Processing Costs, Post-Processing Costs and Certification Costs, including, as necessary, reducing or reassigning any underutilized personnel or other resources when necessary, and shall not exceed the levels of staffing and other resources described in Annex 1 to Attachment A to this Agreement without GE[*]'s prior written consent. In no event shall the total personnel costs included in the Preparation Costs increase by more than [*] in any calendar year. POL and GE[*] shall agree upon the scope and timing of, and conduct, an annual on-site operational review at the facilities of POL's Affiliate in [*] in order to ensure that all reasonable measures are taken to maximize productivity and make efficient use of resources. (F) In addition, within [*] days following the end of each [*] during the term of this Agreement (and, if this Agreement shall expire or be terminated at any time other than the end of a [*], within [*] days after such expiration or termination), the Parties shall confer to determine whether the total amount of Estimated Preparation Costs paid by GE[*] in respect of Gem Diamonds received from POL during such period was equal to [*] of the total Preparation Costs actually paid or incurred by POL during such period. If not, the parties shall account to one another so that the amount paid by GE[*] equals [*] of such actual Preparation Costs. In making any determination hereunder, each Party shall bring forth all such data and documentation as such Party shall consider to be relevant or that the other Party shall reasonably request including, without limitation, (i) itemized invoices from diamond certification laboratories, (ii) itemized invoices from POL's service vendors, 3 and (iii) substantiation of any labor charges and variable material charges for consumable materials applied [*] to the activities of POL and its Affiliates hereunder and included in the Pre-Processing Costs or the Post-Processing Costs. (G) If POL acquires Gem Diamonds meeting the requirements of paragraph I(B) as part of a larger purchase that includes gem diamonds that are not the subject of this Agreement (the "Co-mingled Diamonds") and it is impractical for POL to negotiate with its source of supply a specific purchase price for the Co-mingled Diamonds, POL shall assign to such Co-mingled Diamonds such Acquisition Cost as POL determines to be appropriate in light of all the circumstances. PART II - DELIVERY AND SALE OF GEM DIAMONDS II. DELIVERY OF GEM DIAMONDS TO POL. (A) After processing, at its own expense, the gem diamonds delivered by POL which meet the Specifications (using a process designed to improve color, brightness and brilliance), GE[*] shall return the processed Gem Diamonds and any Unprocessed Gem Diamonds (as defined below) to POL together with documentation (i) certifying that any required duty, tax or other fee arising from GE[*]'s delivery to POL of the Gem Diamonds has been or will be paid on a timely basis, (ii) setting forth the Acquisition Cost of each such Gem Diamond, and (iii) containing such other customary information, if any as the parties shall determine to be necessary or useful for the return of such Gem Diamonds to POL, and accompanied by the same identification code(s) that accompanied the Gem Diamonds when received from POL (collectively, the "GE[*] Delivery Documentation"), on a [*] basis (or more frequently, if GE[*] desires, with respect to quantities having an aggregate market value of approximately [*] or more). GE[*] shall also supply to POL [*] a report identifying which Gem Diamonds have been processed during the preceding [*]. The Parties understand and agree that the Acquisition Cost of a processed Gem Diamond shall not be an accurate indicator of its value, and POL agrees that it shall not use Acquisition Cost as the appropriate measure of a processed Gem Diamond's insurable value after redelivery by GE[*]. For purposes of delivering Gem Diamonds to POL, GE[*] shall use its best efforts to segregate in separate parcels, (i) processed Gem Diamonds whose color, brightness and brilliance have not improved (the "Unimproved Processed Diamonds"), (ii) processed Gem Diamonds whose color, brightness and brilliance have improved, and (iii) any Unprocessed Gem Diamonds as referred to below. GE[*] shall deliver such Gem Diamonds with the GE[*] Delivery Documentation to POL's designated facility located in [*] and GE[*] shall indemnify POL and hold POL harmless from and against all third party costs arising in connection with such processing and delivery to POL, including, without limitation, packing, shipping, insurance, duty and any taxes relating thereto. GE[*] shall also deliver to POL Unprocessed Gem Diamonds which GE[*] determines would, if processed, likely become Special Inventory Diamonds, and any gem diamonds that do not meet the Specifications. Gem diamonds which are not accepted by GE[*] due to failure to meet the Specifications relating to [*]or [*] and for which GE[*] does not make any payment under paragraph I(C), shall no longer be subject to this Agreement, and shall be transferred by POL to an Affiliate 4 for resale. Any other gem diamonds that GE[*] does not process shall be referred to herein as "Unprocessed Gem Diamonds". Within [*] days after the end of each calendar [*], GE[*] shall notify POL in writing of the amount of Special Inventory Diamonds produced during such calendar [*], and POL shall take such steps as shall be necessary to sell and transfer title to such Special Inventory Diamonds to GE[*], upon payment by GE[*] of the Salvage Value thereof. In the event that the Salvage Value for any Special Inventory Diamonds is a negative number, POL shall pay the absolute value of such Salvage Value to GE[*] upon transfer of title to GE[*]. GE[*] may use for its internal purposes or otherwise dispose of (but may not resell on a commercial basis as gem stones) any Special Inventory Diamonds purchased from POL hereunder. (B) If GE[*] develops technical expertise and capability and constructs or acquires necessary equipment to successfully process gem diamonds that are of [*] those referred to in the Specifications (as in effect on the date hereof), GE[*] will promptly modify the Specifications to include such [*] and [*] of gem diamonds. III. SALES AGREEMENT. (A) POL shall sell the Gem Diamonds processed by GE[*] in accordance with the terms of this Agreement. In preparation for sale, POL will, directly or through its Affiliates or third parties, further [*] [*]and [*](at the facility of POL's Affiliate in [*] or such other location as the Parties may agree), as necessary, any [*][*], and [*]and [*]Gem Diamonds successfully processed by GE[*] (including Unimproved Processed Diamonds), and arrange, through LKI, for their certification by the [*] POL shall accumulate the Gem Diamonds in such quantities (and in separate parcels for Gem Diamonds in each of the categories referred to in the third sentence of paragraph II(A)), as POL determines, based upon its knowledge and expertise, will make economically attractive and marketable parcels of Gem Diamonds. Pending sale, POL shall protect and hold such Gem Diamonds in a separate, safe and secure location for GE[*]-processed Gem Diamonds only, using a commercially reasonable degree of care in view of the value of such Gem Diamonds. POL shall maintain, at its expense, insurance for the Gem Diamonds, covering the Gem Diamonds at all times after they are initially purchased by POL and until they are ultimately sold by POL, except when they are (x) located at a GE[*] facility for processing, or (y) being delivered by GE[*] to POL after processing, pursuant to paragraph II(A). Such insurance shall (i) be provided by the same insurance carrier(s) who provide the analogous insurance maintained by LKI, which shall, in any event, be reasonably satisfactory to GE[*] (it being understood and agreed that Lloyd's of London shall be satisfactory as the initial provider of insurance hereunder), (ii) cover all risks covered by the types of insurance customarily carried by LKI and its Affiliates for similar inventory and operations, (iii) provide benefits covering no less than the estimated value of such Gem Diamonds (depending upon their stage of completion) as the Parties shall determine, (iv) unless the Parties shall otherwise agree in writing, not provide for any "deductible" to be applied to any loss, (v) identify GE[*] (following its receipt of the Gem Diamonds under paragraph I(B)) as an additional insured to the extent of [*] of such insured value, and (vi) provide that GE[*] receive at least 30 days prior written notice of any material change or termination of the insurance policy. Promptly upon written request therefor, POL shall deliver a Certificate of Insurance to GE[*], evidencing the foregoing 5 insurance. POL shall be responsible to GE[*] for any uninsured loss or damage resulting in any diminishment of the value of GE[*]'s interest in any Gem Diamonds while in POL's possession or under POL's control (including Gem Diamonds in transit when POL is responsible for delivery, and Gem Diamonds on consignment to POL's customers). POL shall not have any liability for loss of potential value or other consequential damages as a result of (i) any failure to produce improvement, or a sufficient level of improvement, in any Gem Diamond, or (ii) [*]or other [*]to Gem Diamonds during pre-processing or post- processing. POL shall conduct its marketing and sales efforts in accordance with the provisions of paragraph IV and shall not distribute, and shall not encourage or facilitate distribution of the Gem Diamonds by any of its purchasers thereof, in a manner inconsistent therewith, including by way of example and not limitation, without their disclosure of the legend in paragraph IV(A). POL and its Affiliates and GE[*] and its Affiliates shall not make any disclosures, representations or warranties to third parties regarding the processed Gem Diamonds except as expressly contemplated by paragraph IV without mutual written agreement between GE[*] and POL. (B) (1) Using marketing and sales efforts comparable to those used by LKI and its Affiliates for LKI's gem diamond inventory of similar quality, color and size, POL shall, at its own expense, take all steps necessary and appropriate to market and sell all Gem Diamonds received from GE[*] in a commercially prompt manner. Such sales of Gem Diamonds shall be made to third party unaffiliated brokers, wholesalers, dealers, traders, and manufacturers (or in the case of [*] and [*] Gem Diamonds, to third party unaffiliated manufacturers, wholesalers, retailers, brokers, dealers, auction houses and traders), in each case on a basis and in a manner consistent with the terms in this Agreement. POL shall sell Gem Diamonds received from GE[*] at the highest prices commercially obtainable by it. POL shall use its best efforts to sell significant quantities of processed Gem Diamonds to purchasers who have significant wholesale, retail or distribution operations in [*]. (2) Within [*] Business Days following the end of each calendar [*] during the term of this Agreement, POL shall deliver to GE[*] a letter in the form of Attachment C hereto, signed by an officer of POL. (3) For so long as this Agreement shall be in effect, POL shall not (i) market or sell, directly or indirectly (except for the sale of rejected gem diamonds to an Affiliate pursuant to paragraph II(A) and the sale of Unprocessed Gem Diamonds pursuant to paragraph III(C)), or (ii) allow its name to be used in the marketing or sale of, any diamonds other than Gem Diamonds processed by GE[*] under this Agreement. (C) POL shall remit to GE[*], by wire transfer to GE[*]'s bank account as specified in writing to POL (which may be changed by GE[*] upon ten days' advance written notice to POL) (the "GE[*] Account"), a processing fee of [*] per Gem Diamond for each Gem Diamond received hereunder from GE[*] (other than Unprocessed Gem Diamonds) (the "Processing Fee"), which shall be due and payable upon POL's receipt of such Gem Diamonds together with the related GE[*] Delivery Documentation and an invoice for such 6 fee. POL shall remit the Processing Fee by wire transfer to the GE[*] Account within [*] days after receipt of such Gem Diamonds and the related GE[*] Delivery Documentation. If, over any period of [*] months or more, more than [*] of the Gem Diamonds processed by GE[*] hereunder are less then [*] (when delivered by POL for processing), then the Parties shall confer in good faith to determine if it would be appropriate to ascribe a lower Processing Fee to such Gem Diamonds. No Processing Fee shall be payable with respect to Unprocessed Gem Diamonds. Upon receipt of Unprocessed Gem Diamonds from GE[*], POL shall undertake such additional processing as it deems necessary, and sell such Unprocessed Gem Diamonds in accordance with paragraphs III(B) and III(D) hereof. (D) POL shall net against the aggregate gross proceeds received on the sale of each Gem Diamond received hereunder from GE[*] those fees or commissions actually paid to, or collected and retained by, any of the auction houses listed on Attachment B hereto in connection with the sale of such Gem Diamond, and shall remit to GE[*] by wire transfer to the GE[*] Account [*] of such net proceeds, deducting from such payment and retaining the Processing Fee paid, or payable, with respect to such Gem Diamond. Such payment to GE[*], with respect to any given Gem Diamond, shall be made on (i) that [*] which falls on the [*] day after it is sold, or if such [*] day is not a [*], on the last [*] prior to such [*] day, or (ii) if earlier, the [*] following actual receipt by POL of the proceeds of the sale of such Gem Diamond. Notwithstanding the foregoing, remittance to GE[*] with respect to any Gem Diamond sold to an Affiliate of POL shall be made within [*] Business Days after the sale. To the extent provided in paragraph III(E) below, all proceeds from the sale of each Gem Diamond hereunder shall be held in constructive trust for GE[*] pending payment thereof as described herein. It is expressly understood and agreed that such payment includes repayment of the advance made under paragraph I(C) with respect to the sold Gem Diamond, and is final. Except for any Processing Fees which may then still be payable under paragraph III(C), no further payments shall be due from POL to GE[*] with respect to such Gem Diamonds. Except as set forth in paragraph II(A), POL shall not sell or transfer any Gem Diamond received hereunder from GE[*] to an Affiliate of POL unless such transaction, and the proposed price thereof, have received the prior written approval of GE[*]. POL shall submit to GE[*] by facsimile on each [*], photocopies of the sales invoice (with customer identity deleted, except in the case of a sale to any Affiliate of POL) for each Gem Diamond sold on or after the preceding [*], which invoices shall state, the [*], sale price, and a uniquely identifiable code number, for the Gem Diamond sold thereby. In addition, with respect to each [*] sales, POL shall provide to GE[*], within [*] days following the end of each calendar [*], a usage report (the "Usage Report") (i) itemizing, for each transaction within such prior [*] period, the Gem Diamonds sold, the sales revenue received and the funds remitted to GE[*], and (ii) setting forth an inventory of all post-processing Gem Diamonds on-hand at POL as of the end of such prior calendar [*] (other than Special Inventory Diamonds) (including as on-hand any Gem Diamonds POL has placed on consignment). Within [*] days after the execution of this Agreement, POL shall develop and implement a process to specifically identify and track receipt and sales of each (i) [*] and [*] Gem Diamond, and (ii) [*]Gem Diamond of [*] carats or more in weight, covered by this Agreement (including those already in inventory). A first-in, first-out ("FIFO") inventory accounting method may be used for [*]Gem Diamonds of less than 7 [*] carats in weight. (E) (1) POL hereby grants to GE[*] a continuing purchase money security interest and a constructive trust in proceeds (hereinafter, the "security interest") in the amount described below in all inventories of Gem Diamonds purchased for processing hereunder and all products, proceeds, substitutions, and accessions thereof or thereto (all of which are referred to hereinafter as the "Collateral"). With respect to each Gem Diamond (except any Gem Diamond which is rejected by GE[*] at delivery under paragraph I(B) for failure to meet specifications), such security interest shall arise upon the delivery of such Gem Diamond to GE[*] in accordance with paragraph I(B) and continue until remittance of GE[*]'s portion of the proceeds upon the subsequent sale of such Gem Diamond pursuant to paragraph III(D). Such security interest shall at all times have a value equal to the greater of (i) [*] of the total Acquisition Cost, Preparation Costs and Processing Fees paid or incurred by the Parties with respect to the Gem Diamonds contained in such inventory, or (ii) [*] of the total Acquisition Cost paid or incurred by the Parties with respect to the Gem Diamonds contained in such inventory. The foregoing grant of a security interest shall continue in full force and effect for so long as there shall be any unsold Gem Diamonds in inventory hereunder or any payment is due to GE[*] with respect to any sold Gem Diamond. (2) Upon request from GE[*], POL shall execute all such additional agreements or instruments as may reasonably be required by GE[*] in connection with the creation and perfection of the security interest granted herein, including without limitation, financing statements or similar instruments suitable for filing in such jurisdictions and localities as GE[*] may determine. To the extent permitted under applicable law, a photocopy or other reproduction of any financing statement or other instrument executed pursuant to this paragraph III(E)(2) shall be sufficient for filing to perfect the security interests granted herein. It is the intention of the parties that any instrument described in this paragraph shall be sufficient to evidence the security interest in whatever amount it shall represent from time to time, regardless of the value of the security interest at the time such instrument was executed or filed. (3) POL shall keep the Collateral at (i) its facilities or those of its Affiliates in [*] (ii) the facilities of its service vendor in [*], and (iii) the facilities of GE[*] and its Affiliates in [*], or (iv) at such other location(s) as GE[*] shall agree in advance in writing; provided that nothing herein shall prohibit POL from transporting or consigning any Collateral as necessary in connection with its preparation for sale, or sale, in the ordinary course of POL's business. POL shall not use or keep the Collateral in circumstances which violate the conditions of any policy of insurance thereon. To the extent permitted by applicable law, GE[*] shall have the right to receive ownership and physical possession of Gem Diamond inventory having a realizable market value equal to its security interest hereunder in the event of the Bankruptcy of POL. (4) POL hereby represents and warrants to GE[*] that no Lien currently exists against any of its assets including, without limitation, any inventories of Gem Diamonds, which has, 8 or in the event of the Bankruptcy of POL, would have, a superior or equal priority to the security interest created hereby. POL covenants and agrees that, except for Permitted Liens, it shall not create any Lien against, or permit any Lien to attach to, the Collateral which has, or in the event of the Bankruptcy of POL, would have, a superior or equal priority to the security interest created hereby. PART III - GENERAL PROVISIONS IV. OTHER PROVISIONS RELATED TO PROCESSED GEM DIAMONDS. (A) Disclosure of Processing. (1) The following legend shall be contained in (i) each set of GE[*] Delivery Documentation, and (ii) a letter delivered by POL to the management of each of its customers upon the occasion of such customer's receipt of its first delivery of processed Gem Diamonds (other than any Unimproved Processed Diamonds): If the processed gem Diamonds are in a [*]state: Every diamond in this parcel is a natural gem diamond that has been processed to improve its color, brightness and brilliance. Each one is identical to any other natural diamond with the same color, clarity and size. This improvement is permanent and does not require any special care or maintenance. The process applied does not involve irradiation, laser drilling, surface coating or fracture filling, and results in no adverse change in the all-natural contents of the diamond. If the processed gem Diamonds are in a [*], [*] or [*] and [*] state: [This] [Each] diamond [in this group] is a natural gem diamond that has been processed to improve its color, brightness and brilliance. [It] [Each] is identical in all respects to any other natural diamond with the same cut, color, clarity and size. This improvement is permanent and does not require any special care or maintenance. The process applied does not involve irradiation, laser drilling, surface coating or fracture filling, and results in no adverse change in the all-natural contents of the diamond. In addition, such letter delivered by POL to first-time buyers of processed Gem Diamonds shall be accompanied by a copy of the press release, in such form as the Parties shall determine, published by the Parties following the execution of this Agreement. (2) The text of the legends and the letter described in paragraph IV(A)(1) may be modified from time to time, subject to each Party's written consent not to be unreasonably withheld, it being understood that consent would be deemed to be unreasonably withheld if the modification proposed is based upon advice of legal counsel (of the Party proposing modification). In the event of any agreed modification, such modified legends and letters shall thereafter be used to the same extent and in the same manner as specified in this paragraph IV(A). 9 (B) Sample Testing of [*] and [*] Gem Diamonds. POL or its Affiliate has [*] and [*] a sample of processed Gem Diamonds provided to it by GE[*] (the "Sample Diamonds") and has sent the Sample Diamonds to: (1) [*] (2) [*] (3) [*] and (4) [*]for grading as to their quality, clarity and color. POL has provided GE[*] with a copy of all documentation received from each laboratory relating to the inspection and grading of the Sample Diamonds. POL has arranged for the Sample Diamonds to be stored, together with the laboratory reports and any certifications, for safekeeping in a segregated area identifying them as the Sample Diamonds. POL shall bear [*] of the acquisition, cutting and polishing and other incidental costs for the Sample Diamonds and shall own and bear the risk of loss with respect to the Sample Diamonds, but may not sell or dispose of them without GE[*]'s prior written consent. (C) Representations; Indemnities. (1) GE[*] hereby covenants and agrees that GE[*]'s and its Affiliates' activities conducted in connection with this Agreement will be conducted in accordance with this Agreement, that such activities will, to the best of GE[*]'s and GE's knowledge, not violate the rights of any person who is not and has not in the past been affiliated with or employed by POL, LKI or their Affiliates and that such activities and their other businesses will be conducted in accordance with all applicable laws and regulations. GE[*] represents and warrants to POL that as a result of GE[*]'s processing of Gem Diamonds, the color, brightness and brilliance resulting from such processing will not change and is permanent to the same extent that the color, brightness and brilliance of an unprocessed, natural diamond having the same color, brightness and brilliance will not change and is permanent. GE[*] and its Affiliates who conduct activities in connection with this Agreement hereby indemnify and hold harmless, on an after-tax basis, POL and its Affiliates and their employees, officers and directors from and against any loss, cost, liability, expense or obligation (including reasonable attorneys' fees and costs of defense) (collectively, "Losses") incurred by any such indemnified party arising from any claim (including, without limitation, any litigation or other judicial or administrative proceeding or any investigation of any type or nature), or imposed on them by any third party (including any governmental, administrative or similar body, including, without limitation, any taxing authority) (any of the foregoing hereinafter referred to as a "Claim"), arising out of or resulting from a breach by GE[*] or its Affiliates of GE[*]'s covenants, representations or warranties in this Agreement. (2) POL hereby covenants and agrees that POL's and its Affiliates' activities conducted in connection with this Agreement will be conducted in accordance with this Agreement, that such activities will, to the best of POL's and LKI's knowledge, not violate the rights of any person who is not and has not in the past been affiliated with or employed by GE[*], GE or their Affiliates and that such activities and their other businesses will be conducted in accordance with all applicable laws and regulations. POL and its Affiliates who conduct activities in connection with this Agreement hereby indemnify and hold harmless, on an after-tax basis, GE[*] and its Affiliates and their employees, officers, and directors from and against any Losses incurred by any such indemnified party arising from, or imposed on them in connection with, any Claim arising out of or resulting from a breach by POL or its Affiliates of POL's covenants, representations or warranties in this Agreement. 10 (3) (a) Each Party will promptly notify the other Party in writing (in the case of notice to GE[*], with notice being given to the General Manager of GE [*] and in the case of notice to POL, with notice being given to the President of POL) of any Claim or any investigation or inquiry by any independent laboratory or any governmental, regulatory or administrative body or any media organization relating to processed Gem Diamonds, the method of processing, the disclosure or activities referred to in paragraph IV or similar matters. The Parties shall consult with each other regarding defending against or responding to any such Claim, investigation or inquiry, provided, however, that any Party against whom request for indemnity is made under paragraph IV(C)(1) or (2) above and who acknowledges in writing to the other Party its obligation to so indemnify, may, at its election, control the defense, including the selection of counsel, of any Claim which is the subject of such request for indemnity (other than in a proceeding relating to a Claim asserted by a taxing authority, in which case the indemnified party may, at its election, control the defense and select counsel, provided, however, that the indemnifying party shall, subject to the indemnified party's right to control the defense, have a right to participate fully at its expense in such proceeding). (b) Any response by POL or any Affiliate to an inquiry regarding the type, nature, purpose or effect of the processing involving statements other than a response consisting of the same substance as that contained in the disclosure legend in paragraph IV(A), shall require GE[*]'s prior written consent, which shall not be unreasonably withheld. In addition, each Party may, following consultation with the other Party, disclose publicly the information regarding the processing as described in the legends in paragraph IV(A), if it determines that such disclosure is advisable due to a lack of public knowledge, misperception or misunderstanding in the marketplace or advice of counsel. (4) In the event that a Claim is made by any third party, or any governmental or other authority, alleging that the disclosure provided for in paragraph IV(A) hereof, the press release described in the Transition Agreement or any written amendments or modifications to the foregoing are in any way unlawful (an "Other Claim"), each Party will contribute to any (i) amounts payable to any third party (including any judgments or settlements made in favor of such third party), and (ii) legal or other out of pocket expenses in connection with defending against such Other Claim (the amounts referred to in the foregoing clauses (i) and (ii), hereinafter collectively referred to as the "Costs") in the following proportion: [*]) of the Costs will be paid by GE[*] and [*] of the Costs will be paid by POL. (5) (a) In the event that an Other Claim is brought against both Parties, the Parties shall in good faith consult with each other to select single counsel to represent both Parties in any proceeding concerning such Other Claim If the Parties are unable to so select a single counsel, then each Party shall assume the defense of such Other Claim as against itself. The Parties shall cooperate and consult in good faith with each other regarding defending against or responding to such Other Claim. (b) In the event that an Other Claim is brought against only one Party, such named Party will promptly give written notice thereof to the other Party, in the manner provided in paragraph IV(C)(3)(a) above. The Party against which the Other Claim was brought shall 11 have the right to control the defense of such Other Claim with counsel of its choice. The Parties shall cooperate and consult in good faith with each other regarding defending against or responding to such Other Claim; provided, however, that the non-named Party may select separate counsel to protect its interest in such proceeding to the extent possible, if, in good faith, it is believed by such Party that there may be a conflict between their positions in conducting the defense of such Other Claim. (6) In the event that an Other Claim is brought against one Party or both Parties, each Party hereby agrees that neither will, without the prior written consent of the other, settle, compromise or consent to the entry of any judgment relating to such Claim without first having given thirty (30) days' prior written notice to the other Party and conferring in good faith with such other party during such thirty (30) day period regarding any possible alternatives to such settlement, compromise or judgment. (7) Each of the Parties represents and warrants to the other that, to the best of its knowledge and belief, the implementation of this Agreement by means of the compliance of each of them with the provisions herein will not violate any law or regulation. (8) The provisions hereof shall not be deemed to limit either Party's rights in the event of that the other Party shall fail in any way to comply with the disclosure procedures set forth in paragraph IV (A) hereof. V. CONFIDENTIALITY; INTELLECTUAL PROPERTY AND OTHER RIGHTS. (A) (1) Each of POL and GE[*] and their respective Affiliates shall, and shall cause, including by requiring execution of confidentiality agreements consistent herewith, their respective employees, officers, directors and advisers ("Representatives") to, keep secret and confidential, except to the extent permitted by paragraphs III(A) and IV, (a) the existence and terms of this Agreement, (b) the activities conducted pursuant to this Agreement, and (c) all information and data regarding the shipments, costs, sales, prices, and processing schedules, and (2) POL shall, and shall cause its Representatives to, keep secret and confidential all Specifications, processes, effects of processes, equipment, equipment settings and other functional information, technical knowledge, experience, technology, intellectual property or know-how, including any modifications or improvements thereto (the "Technical Information") that may have been or be made available or otherwise learned or acquired in connection with or in contemplation of the activities contemplated by this Agreement (whether before or after the date of this Agreement), in each case except (x) as otherwise expressly permitted by this Agreement, (y) with respect to information covered hereby (other than Technical Information) that has been broadly and publicly disseminated not in violation of any confidentiality obligation applicable to the Party (or its Affiliates or Representatives) seeking to disclose the information or (z) to the extent compelled to be disclosed by court or administrative order or similar judicial process and after giving the other Party reasonable written notice and an opportunity to seek a protective order and in any event after obtaining confidential treatment to the fullest extent available under law. GE[*] shall use its best efforts to prevent disclosure of Technical Information in any manner that would be reasonably expected to have a material adverse 12 effect on the marketability or sale prices for Gem Diamonds processed by GE[*] or its Affiliates under this Agreement, provided that GE[*] and its Affiliates shall be permitted to use and disclose such Technical Information as needed to protect their proprietary and property rights therein, to conduct their businesses, including without limitation to develop technical capability and processes referred to in paragraph II(B) and to the extent it determines is necessary in connection with any of the matters referred to in paragraph IV. To the extent consistent with the foregoing, each Party further agrees to disclose the information referred to above only to its Affiliates and Representatives who need to have such information to assist such Party in fulfilling its obligations and performance under this Agreement and to take measures necessary (including by requiring execution of confidentiality agreements consistent herewith) to ensure such persons maintain the confidentiality of such information in accordance with the terms of this paragraph as applicable to GE[*] and POL. In the event either Party determines, based upon advice of its legal counsel, that this Agreement or any information required to be kept confidential as referred to above, must be disclosed under the Exchange Act, the rules of any national securities exchange or the rules, regulations or requirements of a federal agency or other governmental authority, such Party shall promptly notify the other Party in writing of the nature and extent of the disclosure counsel has advised is required to be made and such other Party's written consent thereto, including with regard to the actual text of any such disclosure, shall be required (but may not be unreasonably withheld) prior to making such disclosure, and in all events the disclosing Party shall obtain confidential treatment for any disclosed information to the fullest extent obtainable without enduring undue hardship or material detriment to its business. Each Party acknowledges that money damages will not be adequate compensation for a breach of this paragraph and thus injunctive relief shall, in addition to other remedies, also be available. (B) All rights and interests to and in all Technical Information are and shall remain fully vested in GE[*] and/or its Affiliates, as applicable, and nothing in this Agreement nor any activities of the Parties or their Affiliates conducted in connection herewith or in contemplation hereof shall be deemed or construed to transfer, license or vest any right, interest, claim or benefit in, to, or under any such Technical Information to POL, LKI, any of their Affiliates, or any other person or entity. Any Technical Information in written form (including copies, summaries, excerpts, analyses or reports reflecting or incorporating any Technical Information) shall be promptly returned to GE[*] upon any termination of this Agreement or, with respect to Technical Information, upon GE[*]'s earlier request. VI. TERMINATION AND RENEWAL. (A) This Agreement may be terminated as follows: (1) If, during the term of this Agreement, without reference to any other costs of either Party, the [*] (calculated in accordance with United States GAAP, consistently applied) received from the sale of Gem Diamonds during any [*]period of [*]calendar [*]is less than the [*] paid or incurred by the Parties with respect to the Gem Diamonds sold during such [*] period, then either Party shall have the right to terminate this Agreement upon [*] months' written notice. Notwithstanding the foregoing, a Party shall not be permitted to 13 terminate this Agreement pursuant to this clause (A)(1) if such Party's breach or non-fulfillment of its obligations under this Agreement materially contributed to the circumstances giving rise to such right of termination. No [*] measurement period used for purposes of this paragraph shall commence prior to the Commencement Date (as that term is defined in that certain Transition Agreement of even date herewith by and between the Parties). (2) In the event that a Party materially breaches this Agreement, the non-breaching Party may terminate this Agreement if the breach is not cured within [*]days after written notice of such breach by the nonbreaching Party to the breaching Party (or may terminate this Agreement immediately in the case of a material breach that is not curable, including without limitation a breach of paragraph IV(A) or paragraph V). (3) In the event a Change of Control occurs or is pending pursuant to a written agreement, the Party that is not undergoing a Change of Control (with respect to itself or an Affiliate) may terminate the Agreement upon [*]prior notice. Each Party shall notify the other Party in writing as much in advance as possible of any such proposed or pending Change of Control. (4) Either GE[*] or POL may terminate this Agreement upon [*]days' advance written notice if: (x) litigation or other judicial, administrative or investigative process or proceeding relating to any of the activities conducted in connection with this Agreement has been formally commenced against it or its Affiliate, and (y) legal counsel for such Party or its Affiliate determines, based upon the information available to it, that it is more likely than not that the outcome of such litigation or other process will be in favor of the person or group that commenced such litigation or other process and will result in (A) a material adverse economic effect, measured in the context of the economics of this Agreement (including, by way of example, [*] or [*]or other monetary award or payment(s)), or (B) permanent injunctive or other similar equitable relief resulting in such an adverse economic effect, or (C) other relief (such as, for example, a declaratory judgment) that, if granted, would, in the good faith judgment of the chief executive officer of a Party or its parent entity, result in such injury to its business reputation or goodwill that had such Party been aware of the likelihood of such litigation or other process occurring, it would not have entered into this Agreement. (5) Notwithstanding anything to the contrary set forth herein, either GE[*] or POL may suspend its performance under this Agreement without liability during the pendency of any litigation or other judicial proceeding relating to this Agreement which is commenced against it or any of its Affiliates by the other Party or any of its Affiliates. (B) Unless earlier terminated as provided above, this Agreement shall have a term ending on December 31, 2009, provided, that it shall be automatically renewed (for a five-year term with similar subsequent possible renewals) unless either Party gives written notice of termination on or before the date that is six months prior to the scheduled termination date. 14 (C) Upon the occurrence of any termination pursuant to paragraph VI(A) or the nonrenewal of this Agreement pursuant to paragraph VI(B), the Parties shall promptly take all necessary and appropriate actions to effectuate the termination of the activities contemplated by this Agreement in an orderly manner consistent with the provisions set forth herein. Any termination of this Agreement shall not terminate or impair any Party's accrued or vested rights hereunder. Without limiting the generality of the foregoing, upon any termination of this Agreement, the Parties shall provide that (i) all Gem Diamonds then in process (whether in possession of GE[*] for processing or at any other pre-sale stage under this Agreement) are brought to completion so as to be ready for sale, (ii) all finished Gem Diamonds are divided into appropriate categories by grade, size, color and shape, and (iii) all such categories are equitably divided between GE[*] and POL such that ownership and physical possession of Gem Diamonds representing [*] of the total estimated market value in each category is transferred to GE[*] by POL, and the remainder retained by POL. Notwithstanding any termination of this Agreement, the following provisions shall survive and continue to apply indefinitely or as otherwise provided below: (i) the indemnity obligations in paragraph IV(C) as they relate to events or occurrences while the Agreement was in effect; (ii) the confidentiality and nondisclosure obligations in paragraph V(A) (except GE[*], its Affiliates and Representatives shall no longer be bound to keep the Technical Information confidential); (iii) the provisions in paragraph V(B) relating to GE[*]'s and its Affiliates' rights with respect to the Technical Information; (iv) paragraph VII(A) (to the extent it relates to provisions of the Agreement still in effect); VII(B) (to the extent provided therein); VII(E) (as it relates to retaining books and records and also as necessary to carry out the audit process for the year in which the Agreement terminated); VII(H) (as it relates to obligations still in effect); and VII(I), (J), and (K); and (v) GE and LKI shall continue to be bound by paragraphs IV(A) and (C), V(A) and (B) (to same extent applicable to GE[*] and POL, respectively), VII(B) (to same extent applicable, if at all, to GE[*] or POL, respectively), VII(H), (I), (J) and (K). VII. MISCELLANEOUS. (A) The Parties shall use their best efforts to ensure that any dispute or controversy relating to the validity, interpretation, implementation, breach or termination of any provision of this Agreement between the Parties (a "Dispute") shall be promptly and amicably settled by discussions between the chief executive officer of each of POL and of the [*] Division of GE (or their respective successors). If no resolution is reached by such persons within 30 days, the matter will be presented for resolution to [*], President and Chief Executive Officer, GE [*] of GE, or his successor and Mr. Maurice Tempelsman, 15 Chairman, LKI or his successor. In the event the Dispute then remains unresolved for an additional 30 day period, either Party may submit the Dispute for resolution by mediation pursuant to the Center for Public Resources Model Procedure for Mediation of Business Disputes as then in effect. Mediation will continue for at least 60 days and if the Dispute then remains unresolved, the Parties shall within 20 days after such 60 day period ends, agree upon a third-party arbitrator or, if they cannot agree, permit the American Arbitration Association to appoint a third-party arbitrator, whose decision will be binding upon the Parties and enforceable in courts having jurisdiction to enforce such decisions. (B) (1) In consideration of the important commitments that each Party makes in this Agreement, during the existence of this Agreement: (i) without the prior written consent of POL, GE[*] and GE shall not, and shall use their best efforts to ensure that each Affiliate of GE or GE[*] does not, whether directly or indirectly for itself or others undertake -- or sell, distribute, offer for sale or market natural gem diamonds that have been subjected to -- the same or similar type of processing of natural gem diamonds (meaning processing to improve color, brightness and brilliance) as is to be conducted pursuant to this Agreement, as such process may be modified or improved during the existence of this Agreement, except as contemplated by this Agreement, and (ii) without the prior written consent of GE[*], POL and LKI shall not, and shall use their best efforts to ensure that each Affiliate of POL or LKI does not, whether directly or indirectly for itself, himself or others, process gem diamonds, or manufacture, cut, polish, finish, purchase, sell, distribute, offer for sale, or market gem diamonds processed in the same or similar way as the Gem Diamonds are processed by GE[*] (meaning processing to improve color, brightness and brilliance), as such process may be modified or improved during the existence of this Agreement, except as contemplated by this Agreement; provided that POL, LKI, or their Affiliates shall not be deemed to have violated this provision if none of them knew, or with reasonable inquiry could have known, that any such gem diamonds had been or were to be so processed, it being understood that knowledge of the employees and Representatives of POL, LKI and each of their Affiliates shall be attributed to each of POL, LKI, and each Affiliate. The Parties agree that in the event this Agreement is terminated pursuant to paragraph VI(A)(2) due to a material breach of this Agreement by a Party, the restrictions in this paragraph VII(B) shall continue to apply to the breaching Party and its Affiliates to the same extent as above for a period of [*] after such termination. No such extension shall apply in the event of a termination of this Agreement by mutual consent of the Parties. (2) The foregoing restrictions in paragraph VII(B)(1) shall not be construed to apply to any (x) Financial Services Business of a Party or of any of its Affiliates, (y) any passive investment activity by any pension or retirement fund or program operated by or for the benefit of any Party or its Affiliates, or (z) any business activity which would otherwise violate the foregoing restrictions which is acquired from or carried on by any entity (an "Acquired Company") which is acquired by, combined with, or otherwise becomes an Affiliate of, any Party after the date hereof, provided that, within one hundred and eighty (180) days after the purchase or other acquisition of the Acquired Company, such party disposes of the relevant portion of the Acquired Company's business or causes such Acquired Company to comply with the foregoing restrictions. 16 (C) POL shall not: (1) actively participate from an office in the United States in (i) arranging, negotiating, or concluding purchases of, or entering into or otherwise concluding supply agreements for, Gem Diamonds, or (ii) marketing or promoting the sale of Gem Diamonds, or soliciting any orders, negotiating any sales contracts, or performing other significant activities in connection with the pursuit and/or consummation of any sales of Gem Diamonds; provided that POL may purchase Gem Diamonds in the United States through a related party acting on its behalf, but only if POL compensates such related party on an arm's length basis for such purchasing activity on its behalf (for purposes of this Agreement, the terms "arm's length" and "related party" are defined in Section 482 of the Internal Revenue Code); (2) represent to any person that POL can be contacted through an office in the United States; (3) accept any orders received by an office in the United States (and instead all such orders shall be promptly referred to an office outside the United States as described below); or (4) notwithstanding anything to the contrary set forth in this Agreement, hold inventory of Gem Diamonds in the United States except on a short-term basis as shall be necessary in connection with the certification of such inventory. POL also agrees that it will maintain, in its own name, one or more offices outside the United States, and that such office or offices shall materially participate in all sales by POL of Gem Diamonds in connection with this Agreement. In particular, and without limiting the foregoing, such office or offices of POL outside the United States shall actively participate in soliciting all orders, negotiating all sales contracts, and performing all other significant activities in connection with the pursuit and/or the consummation of sales of Gem Diamonds in connection with this Agreement. For purposes of this paragraph, POL shall be considered to maintain an office in its own name if such office is maintained by a wholly-owned (direct or indirect) subsidiary of POL and such subsidiary is a dependent agent of POL that has, and regularly exercises, authority to negotiate and conclude contracts on behalf of POL (whether as a disclosed or undisclosed agent). (D) The Parties agree that each Party's respective obligations under this Agreement may be suspended for a reasonable time as a result of an inability to perform in a commercially reasonable manner due to force majeure (including embargoes, acts of God or governmental entities, labor strikes or third party actions not controllable by a Party) and agree to provide prompt written notice to each other regarding the commencement and termination of any such event. (E) Each of GE[*] and POL shall maintain and retain accurate and complete books and records relating to the transactions and activities conducted pursuant to this Agreement, separate and apart from those maintained by any of their respective Affiliates. On an annual basis beginning in [*], coincident with the annual end of [*] determination and 17 reconciliation provided for in paragraphs I(E) and I(F), (i) GE[*] and POL shall conduct a physical inventory of all Gem Diamonds which have been delivered to GE[*] for processing or are at any subsequent stage of completion, and (ii) Ernst & Young shall prepare and submit to the Parties a special report (subject to review by GE[*]'s auditors) reporting the results of its methodical examination and review ("audit") of the books and records maintained by the Parties which reflect or contain information relevant to determining the accuracy of amounts of Gem Diamond inventories, Acquisition Costs (including, without limitation, Acquisition Costs assigned by POL to any Co-mingled Diamonds), Preparation Costs, Pre-Processing Costs, Post-Processing Costs, Certification Costs, the Post-Processing Cost Factor, the Pre-Processing Cost Factor, the Certification Cost Factor, Processing Fees, Salvage Values payments under paragraph III(D), sales revenues, cumulative losses for purposes of paragraph VI(A)(1), information in POL Delivery Documentation, GE[*] Delivery Documentation and Usage Reports, or any other amounts (or information necessary to determine such amounts) payable by or to a Party under this Agreement and such other information as may be mutually agreed by the Parties (collectively, the "Material Information"). Such special report shall be finalized and delivered to the Parties no later than [*] of the relevant year. GE[*] shall pay Ernst & Young's fees, except that POL shall pay any such fees which arise from revalidation of its special report which is requested by GE[*]'s auditors and produces a material change in such report. Prior to commencement of such audit, the Parties shall cause Ernst & Young and GE[*]'s auditors to enter into appropriate confidentiality agreements. Each Party will, and will cause its Representatives to, cooperate fully in such audit. In addition, each of GE[*] and POL and their Representatives shall be entitled, on reasonable advance notice, to have access, at their own expense, to the other Party's (and its Affiliates') books, records, supporting documentation relating to the Material Information (other than customer and supplier names and addresses and other proprietary, competitively sensitive information that is not an essential component of Material Information as may be agreed by the Parties) and to discuss such matters with knowledgeable personnel and advisers of such Party, in each case as necessary to verify the accuracy and completeness thereof. The results of any such independent audit shall be binding upon the Parties and the amounts payable under this Agreement by or to a Party shall be adjusted to correct any errors or miscalculations that are identified as a result of any such audit. POL has committed to GE[*], and GE[*] is relying upon such commitment, that POL will conduct its sourcing activities and selling activities hereunder in a manner that reflects that POL is to receive the synergistic and market benefits of its affiliation with LKI (to be passed along to GE[*] under the purchasing and selling transactions contemplated by this Agreement) but as though POL were not controlled by LKI to the extent such control could be used to deprive POL of any benefit or advantage (including without limitation through transfer pricing or similar dealings) that POL would have as a non-controlled entity. (F) The Parties hereto and any of their Affiliates who perform any activities contemplated by this Agreement are independent contractors. Nothing in this Agreement is intended, or shall be deemed or construed, or be treated by any person, to constitute the establishment of, or result in the existence of, any partnership, agency, franchise or joint venture relationship among any of the Parties or their Affiliates. Except as and to the extent, if any, expressly provided in this Agreement, no Party shall incur debts or make any 18 commitments for or on behalf of the other Party or its Affiliates. The Parties agree that they and their Affiliates will report the transactions described herein in a manner consistent with this Agreement for tax purposes. (G) All amounts payable to a Party under this Agreement shall be denominated and payable in U.S. dollars and no foreign currency exchange rate fluctuations shall be taken into account in determining the amount of any payment. The Parties agree to use their best efforts to take such further actions, including entering into supplemental agreements, amendments to this Agreement and preparing and executing other additional documentation, as reasonably necessary or appropriate to more fully reflect and implement the agreements understandings, intentions and arrangements contemplated by this Agreement. (H) Each of GE on the one hand and LKI on the other hand shall take any and all actions as are reasonably necessary or appropriate to cause and enable (including, if necessary, by providing funding) GE[*] and its relevant Affiliates and POL and its relevant Affiliates, respectively, including any assignee pursuant to paragraph VII(I), to perform their respective obligations under this Agreement in a timely manner and shall be directly responsible for their respective nonperformance or delayed performance. (I) The provisions of this Agreement shall inure to the benefit of the Parties hereto, their Affiliates who perform activities to the extent permitted hereby and their permitted assigns. No Party's rights, obligations or performance under this Agreement may be assigned (with a merger into, or a similar transaction with, another entity in which the Party is not the surviving entity being treated as an assignment) or subcontracted, except that (1) GE[*]'s rights, obligations and performance may be assigned or subcontracted to GE or to an Affiliate of GE reasonably acceptable to POL (written notice to be given prior to any proposed assignment or subcontract subject to such acceptance), and (2) POL's rights, obligations and performance may be assigned or subcontracted to an Affiliate of POL reasonably acceptable to GE[*] (written notice to be given prior to any proposed assignment or subcontract subject to such acceptance). Notwithstanding the foregoing, the Parties understand that GE[*]'s processing will take place at GE's facility located in [*], through a [*]; GE[*] will use its commercially reasonable efforts to relocate such processing activities to GE[*]'s facility located in [*] by [*] Nothing in this Agreement shall give or be construed to give any other person or entity any legal or equitable rights under, or with respect to the subject matter of, this Agreement. This Agreement (including the Attachments hereto and the Specifications), the Confidentiality Agreement dated February 19, 1997 to which LKI and GE are parties, that certain Joint Defense Agreement fully executed on February 4, 1998 by LKI and GE, and that certain Transition Agreement of even date herewith by and among GE, GE[*], LKI and POL contain the entire agreement of the Parties with respect to the subject matter hereof and thereof. This Agreement may be modified only in a writing signed by the Parties and, with respect to any of the matters referred to on the signature page hereof as being binding upon GE and LKI, also signed by GE and LKI. (J) Notices to be given by one Party to the other under this Agreement shall be effective 19 when delivered at the address (or facsimile number) specified below, as the same may be changed from time to time: If to GE[*] to: GE [*] [*] [*] with a copy to: GE [*] [*] and to: General Electric Company 3135 Easton Turnpike, W3A Fairfield, CT 06431 Attention: Senior Counsel for Transactions Fax: 203-373-3008 If to POL: Pegasus Overseas Ltd. c/o Graham, Thompson & Co. Sassoon House Shirley Street and Victoria Avenue P.O. Box N272 Nassau, New Providence, Bahamas Attention: President Fax: 242-328-1069 with a copy to: Lazare Kaplan International Inc. 529 Fifth Avenue New York, NY 10017 Attention: President Fax: 212-697-3197 and to: Paul, Weiss, Rifkind, Wharton & Garrison 1285 Avenue of the Americas New York, NY 10019-6064 Attention: Theodore Sorensen Fax: 212-757-3990 and to: Warshaw Burstein Cohen Schlesinger & Kuh L.L.P. 555 Fifth Avenue New York, NY 10017 Attention: Lucien Burstein Fax: 212-972-9150 (K) This Agreement and the performance hereunder shall be governed by and construed under the laws of the State of New York, without regard to the choice of law rules of such state, and each Party and other signatory hereto and their respective Affiliates which 20 conduct activities in connection with this Agreement shall submit to the jurisdiction of state and federal courts situated in New York, New York for the purpose of facilitating the enforcement of any arbitration award or decision under paragraph VII(A) or injunctive relief as contemplated by paragraph V(A). [Remainder of page intentionally left blank.] 21 IN WITNESS WHEREOF, the Parties have duly executed this Agreement, in one or more counterparts, as of the date first written above. Witness: PEGASUS OVERSEAS LTD. /s/ James L. Barnes By: /s/ Maurice Tempelsman - --------------------------- ------------------------------- James L. Barnes Name: Maurice Tempelsman Title: Chairman GE [*] By: /s/ William A. Woodburn -------------------------------- Name: William A. Woodburn Title: Director The below listed companies shall be subject to and bound by paragraphs III(B)(3), IV(A) and (C), V(A) and (B), and VII(B), (H), (I), (J) and (K) of this Agreement: LAZARE KAPLAN INTERNATIONAL INC. WITNESS: /s/ Maurice Tempelsman /s/ James L. Barnes - -------------------------------- -------------------------------- Name: Maurice Tempelsman James L. Barnes Title: Chairman GENERAL ELECTRIC COMPANY /s/ William A. Woodburn - --------------------------------- Name: William A. Woodburn Title: Vice President and General Manager 22 ATTACHMENT A (A) The following terms used but not defined in the Agreement have the following meanings: "ACQUISITION COST" with respect to any Gem Diamond or package of Gem Diamonds, means [*]) of (i) POL's actual out-of-pocket purchase price for such Gem Diamond(s), and (ii) any additional out-of-pocket costs related to the purchase of Gem Diamonds paid by POL or its Affiliates and approved in writing by GE[*], in each case, without any profit or mark-up thereon, and in the case of a purchase by POL from an Affiliate, without any profit or mark-up on such Affiliate's out-of-pocket costs. In the event that POL acquires Co-mingled Diamonds, POL will make a good faith estimate of the market value of the Co-mingled Diamonds and will apply an appropriate discount to that market value such that as a result the Acquisition Cost for such Gem Diamonds shall be no greater than POL's actual out-of-pocket purchase price for such Gem Diamonds (plus any related additional costs approved as described above), provided that in no event shall the Acquisition Cost be an amount higher than the comparable price at which the individual Gem Diamonds constituting a portion of the Co-mingled Diamonds could be purchased separately from an independent dealer, trader or other third party. "AFFILIATE" means a person that, directly or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with, the first mentioned person. "BANKRUPTCY" means, with respect to any Party, (i) such Party's ceasing to function as a going concern (including inability to meet obligations as they mature), (ii) the appointment of a receiver for such Party's assets, (iii) the initiation of any proceeding by or against such Party under any bankruptcy or insolvency law (which proceeding, if initiated by a third party, has not been dismissed within sixty (60) days after the commencement thereof), (iv) such Party's making of an assignment for the benefit of creditors or entering into any similar arrangement, or (v) (A) the declaration of a material default by any lender to such Party with regard to any debt or obligation for money owed, which default is not cured on or before the expiration of any applicable cure period, and (B) the acceleration of such debt or obligation for money owed, and (C) the continuation of such declaration and acceleration at the time of the determination of such bankruptcy. "BUSINESS DAY" means any day other than a Saturday or Sunday or other day on which the commercial banks in [*] [*] or [*] are required or authorized by law or executive order to close. "CERTIFICATION COST FACTOR" for any [*] or other period means an amount reasonably estimated to represent the per-carat allocation of the Certification Costs for such period over the number of carats of Prepared Gem Diamonds expected to be delivered to GE[*] by POL during such period. "CERTIFICATION COSTS" for any period means the actual amount of the costs listed A-1 in Part C of Annex 1 attached hereto paid or incurred by POL or its Affiliates during such period in obtaining certification of Gem Diamonds as required by Paragraph III(A) of the Agreement from [*]certification laboratories, without any profit or mark-up thereon, and reflecting any discount or rebate paid or credited in any form to POL or its Affiliates. "CHANGE OF CONTROL" means: (A) with respect to LKI (i) the Tempelsman Family ceasing to have beneficial ownership of Voting Shares possessing more than [*]of the total voting power of all outstanding Voting Shares, or (ii) the acquisition in a transaction or series of transactions by a person or a group (within the meaning of Rule 13d-5 and Section 13(d) under the Exchange Act) (a "Group") of beneficial ownership of Voting Shares possessing total voting power greater than the total voting power represented by the Voting Shares beneficially owned by the Tempelsman Family, or (iii) the acquisition in a transaction or series of transactions by a Disqualifying Person, as a person or as part of a Group, of beneficial ownership of Voting Shares possessing at least [*] of the total voting power of all outstanding Voting Shares, if in connection with or as a result of such ownership interest, such Disqualifying Person either (x) does not, at all times thereafter, meet the requirements of Rule 13d-1(b) or (c) under the Exchange Act or (y) has access to information that is subject to the confidentiality and nondisclosure requirements of paragraph V(A), or (iv) the approval by the shareholders of LKI and/or its Board of Directors of a plan for its liquidation, dissolution, merger or consolidation unless, in the case of a merger or consolidation, those persons holding Voting Shares immediately following such transaction have substantially the same proportionate voting rights in respect of such entity as they had in respect of LKI immediately prior to such transaction, or (v) the election or appointment of any person to the Board of Directors of LKI or the resignation of any person or persons on such board if, following such election, appointment or resignation, a majority of the members of such Board ceases to consist of individuals who are Continuing Directors, or (vi) LKI ceasing to be subject to the periodic public reporting requirements of the Exchange Act or the regulations thereunder, provided that the occurrence of the event described in this clause (vi) shall not be deemed in itself to constitute a Change of Control if at all times following such event either Maurice Tempelsman or Leon Tempelsman continues to serve as the chief executive officer or president (or such other highest ranking officer position) and Chairman or Vice Chairman of the Board of Directors of LKI, or (vii) the acquisition in a transaction or series of transactions by a person or a group (other than the Tempelsman Family, or a subsidiary of LKI or another entity controlled by the Tempelsman Family) of a majority of the assets or business of LKI; and (B) with respect to POL (or another Affiliate of LKI performing substantial activities under the Agreement) (i) the Tempelsman Family or LKI (or a subsidiary of LKI) ceasing to own Voting Shares with voting power sufficient to elect a majority of the directors to the Board of Directors of POL or such Affiliate), or (ii) the acquisition in a transaction or series of transactions by a Disqualifying Person, as a person or as part of a Group, of beneficial ownership of Voting Shares possessing at least [*] of the total voting power of all outstanding Voting Shares, if in connection with or as a result of such ownership interest, such Disqualifying Person (x) does not, at all times thereafter, meet the requirements of Rule 13d-1(c) under the Exchange Act (whether or not actually applicable) or (y) has A-2 access to information that is subject to the confidentiality and nondisclosure requirements of paragraph V(A), or (iii) the acquisition in a transaction or series of transactions by a person or a Group (other than the Tempelsman Family, LKI or a subsidiary of LKI) of at least a majority of the assets or business of POL or such Affiliate, or (iv) the approval by the shareholders and/or the Board of Directors of POL or such Affiliate of a plan for liquidation, dissolution, merger or consolidation of POL or such Affiliate unless, in the case of a merger or consolidation, those persons holding Voting Shares immediately following such transaction have substantially the same proportionate voting rights in respect of such entity as they had in respect of POL or such Affiliate immediately prior to such transaction; and (C) with respect to GE[*] (or another Affiliate of GE[*] performing substantial activities under the Agreement) (i) GE (or a subsidiary of GE) ceasing to own Voting Shares with voting power sufficient to elect a majority of the directors to the Board of Directors of GE[*] or such Affiliate, (ii) the acquisition in a transaction or series of transactions by a person or a Group (other than GE or a subsidiary of GE) of at least a majority of the assets or business of GE[*] or such Affiliate, or (iii) the approval by the shareholders and/or the Board of Directors of GE[*] or such Affiliate of a plan for liquidation, dissolution, merger or consolidation of GE[*] or such Affiliate unless, in the case of a merger or consolidation, those persons holding Voting Shares immediately following such transaction have substantially the same proportionate voting rights in respect of such entity as they had in respect of GE[*] or such Affiliate immediately prior to such transaction; and (D) any of the foregoing transactions or events constituting a Change of Control that occurs with respect to any successor or any assignee (under paragraph VII(I)) of any of LKI, POL, GE[*] or any Affiliate as referred to above. "COMPETITIVE BUSINESS" means manufacturing, processing and/or dealing in [*], or engaging in activities intended to produce results that are similar to those resulting from the processing performed by GE[*] pursuant to the Agreement. "CONTINUING DIRECTOR" with respect to any company or similar entity means a member of the Board of Directors of such entity who either (i) was a member of such Board on the date hereof, or (ii) was nominated or appointed (before his initial election) to serve as a member by a majority of the members of such Board who were persons described in clause (i) hereof at the time of such nomination or appointment, or (iii) was nominated or appointed (before his initial election) to serve as a member by a majority of the members of such Board who are persons described in clause (ii) hereof at the time of such nomination or appointment, provided in the case of clauses (ii) and (iii) that such member was not nominated or appointed as a result of or in connection with a proxy solicitation or proposal by a person other than a member of the Tempelsman Family. "CONTROL" (including the terms "CONTROLLED," "CONTROLLED BY" and "UNDER COMMON CONTROL WITH") means the possession, directly or indirectly or as trustee or executor, of the power to direct or cause the direction of the management or policies of a person, whether A-3 through the ownership of stock or as trustee or executor, by contract or credit arrangement or otherwise. "DISQUALIFYING ACTIVITY" means a conviction, guilty plea or plea of no-contest for (i) a felony under U.S. law, (ii) a crime involving dishonesty, fraud or moral turpitude that has or is likely to have a material adverse affect on the business reputation or goodwill of such person, Group or Affiliated entity, or (iii) comparably serious criminal activity under other applicable law. "DISQUALIFYING PERSON" means (i) a person or Group that is engaged in a Competitive Business on the date on which such determination is made or has been so engaged within the last five years, or (ii) a person or Group that has, or has an executive level officer or key employee that has, while an executive level officer or key employee, engaged in a Disqualifying Activity within the period of five years prior to the date on which such determination is made. "ESTIMATED PREPARATION COSTS" means, with respect to any Prepared Gem Diamond, (i) the number of carats in such Gem Diamond, when delivered to GE[*] for processing, multiplied by (ii) the sum of the Pre-Processing Cost Factor, the Post- Processing Cost Factor and the Certification Cost Factor. "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended. "FINANCIAL SERVICES BUSINESS" shall include any activities undertaken in connection with or in furtherance of (i) Financing, (ii) Leasing, (iii) Default Recovery Activities or (iv) Other Financial Services Activities. "Financing" shall include the making, entering into, purchase of, or participation in (i) secured or unsecured loans, conditional sales agreements, debt instruments or transactions of a similar nature, (ii) non-voting preferred equity investments, and (iii) voting equity investments (where such investment in voting equity is made in connection with a transaction referred to in either or both of clauses (i) or (ii) of this definition) which do not result in either (a) the ownership of [*]or greater equity interest in the entity in which such investment is made by the person making such investment and its Affiliates in the aggregate or (b) an acquisition that would at the time of such acquisition cause such person to be an Affiliate of such entity. "Leasing" shall include the leasing, under operating leases, finance leases or rental agreements, of property, whether real, personal, tangible or intangible. "Other Financial Services Activities" shall include the offering, sale, distribution or provision, directly or through any distribution system or channel, of any financial products, financial services, asset management services or products or services or products related or ancillary to any of the foregoing. "Default Recovery Activities" shall include the exercise of any rights or remedies in A-4 connection with any Financing, Leasing or Other Financial Services Activity (whether such rights or remedies arise under any agreement relating to such Financing, Leasing or Other Financial Services Activity, under applicable law or otherwise) or in connection with the purchase or sale of goods and services including, without limitation, any foreclosure, realization or repossession of any collateral or other security for any Financing (including the equity in any entity or business) or Other Financial Services Activities or any property subject to any Leasing. "GAAP" means generally accepted accounting principles, applied consistently with prior periods. "[*] means a period of [*]calendar months ending on either [*] or [*] provided that the first [*] shall be the period beginning on the date of the Agreement and ending on [*] "INDEBTEDNESS FOR MONEY BORROWED" means all obligations for borrowed money, including (i) any obligation owed for all or any part of the purchase price of real property or other assets or for services, (ii) any capital lease obligation, (iii) any obligation of reimbursement, (iv) any guarantee of repayment for money borrowed, and (v) any factored receivables. "LIEN" means any mortgage, lien, pledge, charge, security interest, claim, restriction, encumbrance, or right, title or interest in any third party. "PERMITTED LIENS" means (i) Liens arising from and attaching to pledges or deposits by POL under workers' compensation laws, unemployment insurance laws, social security laws, or similar legislation, or arising from and attaching to deposits to secure public or statutory obligations of POL or deposits as security for contested taxes or import duties or for the payment of rent to any non-Affiliated party; (ii) Liens imposed by law in connection with the provision of goods or services to POL by non-Affiliated third parties, such as carriers' and warehousemen's liens, provided that payment for the goods or services giving rise to the lien is not yet due and payable or is being contested by POL in good faith and by appropriate proceedings; (iii) Liens for POL's taxes, assessments or governmental charges not yet due and payable or the validity of which is being contested in good faith and by appropriate proceedings and for which proper and adequate book reserves have been established by POL to the extent required by GAAP as then in effect, and then only to the extent that a bond has been filed in cases where the filing of a bond is permitted to avoid the creation of a Lien against any of POL's properties. Except to the extent expressly set forth in this paragraph, in no event shall Permitted Liens against the Collateral include any Lien arising from or relating to any Indebtedness for Money Borrowed of POL or any of its Affiliates. "POST-PROCESSING COST FACTOR" for any [*] or other period means an amount reasonably estimated to represent the per-carat allocation of the Post-Processing Costs for such period over the number of carats of Prepared Gem Diamonds expected to be delivered to GE[*] by POL during such period. A-5 "POST-PROCESSING COSTS" for any period means the actual amount of the costs listed in Part B of Annex 1 attached hereto paid or incurred by POL during such period in preparing Gem Diamonds for sale subsequent to processing by GE[*] under the Agreement, without any profit or mark-up thereon, and reflecting any discount or rebate paid or credited in any form to POL or its Affiliates. "PREPARATION COSTS" means the Pre-Processing Costs, the Post-Processing Costs and the Certification Costs. "PRE-PROCESSING COST FACTOR" for any [*] or other period means an amount reasonably estimated to represent the per-carat allocation of the Pre-Processing Costs for such period over the number of carats of Prepared Gem Diamonds expected to be delivered to GE[*] by POL during such period. "PRE-PROCESSING COSTS" for any period means the actual amount of the costs listed in Part A of Annex 1 attached hereto paid or incurred by POL during such period in preparing Gem Diamonds for processing by GE[*], without any profit or mark-up thereon, and reflecting any discount or rebate paid or credited in any form to POL or its Affiliates. "SALVAGE VALUE" when used with reference to Special Inventory Diamonds, means the sum of (i) [*] of the Acquisition Cost of the Gem Diamond from which such Special inventory Diamonds were produced, plus (ii) [*] of the Preparation Cost allocable to such Gem Diamond, less (iii) the portion of such Preparation Cost representing the Post- Processing Costs and the Certification Costs allocable to such Gem Diamond. "SPECIAL INVENTORY DIAMOND" means a Gem Diamond processed by GE[*] that, as a result of such process, has [*]or been [*]into, or is otherwise of, a [*]of less than .[*]of a carat and thus would be, in GE[*]'s good faith judgment, uneconomic to market and sell as a processed Gem Diamond. "SPECIFICATIONS" means the specifications for gem diamonds POL is to purchase and supply to GE[*] as contemplated by the Agreement as provided in writing by GE[*] to POL on or prior to the date hereof and as the same may be modified from time to time by written notice from GE[*] to POL. "SUBSIDIARY" or "SUBSIDIARIES" of any person means any corporation, partnership, joint venture or other legal entity of which such person (either alone or through or together with any other subsidiary) owns, directly or indirectly, 50% or more of the stock or other equity interests, the holders of which are generally entitled to vote for the election of the board of directors or other governing body of such corporation or other legal entity. "TEMPELSMAN FAMILY" means (i) Mr. Maurice Tempelsman; (ii) any descendant (whether biological or adopted) of Mr. Maurice Tempelsman; (iii) the spouse of any person described in clause (i) or (ii) hereof; (iv) the estate of any person described in clause (i), (ii), or (iii) hereof; (v) any trust created by or arising under the will of any person described A-6 in clause (i), (ii), or (iii) hereof; or (vi) a corporation, limited liability company or other entity with respect to which the persons described in clauses (i) - (v) above own Voting Shares possessing at least 51% of the total voting power of all outstanding Voting Shares (or such higher percentage as needed to elect a majority of the board of directors of a company or similar governing body of another organization). "VOTING SHARE" means an outstanding security possessing the right to vote on matters submitted to the stockholders and "voting power" shall mean the right to vote in the election of directors to the board of directors of a company or similar governing body of another organization. A-7 (B) The following terms are defined in the Agreement as indicated below.
TERM AGREEMENT REFERENCE [p] - ---- ------------------------- Agreement Introductory Paragraph Claim IV(C)(I) Collateral III(E) Co-mingled Diamonds I(G) Costs IV(C)(4)(a) Dispute VII(A) FIFO II(E) GE Introductory Paragraph Gem Diamonds I(B) GE[*] Introductory Paragraph GE[*] Account III(C) GE[*] Delivery Documentation II(A) [* ] Initial Marketing Period III(D)(1) LKI Introductory Paragraph Losses IV(C)(1) Material Information VII(E) Other Claim IV(C)(4)(b) Party Introductory Paragraph POL Introductory Paragraph POL Account I(C) POL Delivery Documentation I(B) Prepared Gem Diamond I(D) Processing Fee III(C) Representatives V(A)(1) Sample Diamonds IV(B) Technical Information V(A)(1) Unimproved Processed Diamonds II(A) Unprocessed Gem Diamonds II(A) Usage Report III(C)
A-8 ANNEX 1 PART A - PRE-PROCESSING COSTS The cost of such [*] and other preparation of Gem Diamonds as the Parties shall agree in writing is necessary, including: The actual invoiced costs (net of any discounts or rebates, whether or not appearing on such invoices) of [*] and other preparation performed for POL by third-party vendors, and delivery costs to and from such third-party vendors The compensation and benefits paid to [*] located in [*](currently [*] dedicated full time to the implementation of the Agreement who shall perform certain [*]and other [*]work on Gem Diamonds and coordinate [*] and preparation by third-party vendors Ordinary and necessary travel and living expenses of other experts required to travel for purposes of monitoring or supervising the [*], [*]and preparation of Gem Diamonds The Pre-Processing Costs shall not include the Acquisition Cost, or the costs of boiling, packing, shipping, insurance, duty and taxes paid in connection with delivering Gem Diamonds to GE[*] for processing. PART B - POST-PROCESSING COSTS The costs of such further cutting, polishing and completion by POL or its Affiliates of Gem Diamonds as the Parties shall agree in writing is necessary, including: The compensation and benefits paid to [*] located in [*] dedicated full time to the implementation of the Agreement who shall perform cutting, polishing and other finishing work on Gem Diamonds and [*] POL employee located in [*] dedicated full time to the implementation of the Agreement who shall coordinate activities with [*] certification laboratories [*]toward material handling costs Direct variable material costs for grit, lapping wheels and similar materials consumed by POL and its Affiliates in finishing Gem Diamonds under the Agreement, but excluding indirect costs including, without limitation, electricity, heat, other utilities, plant overhead and depreciation The Post-Processing Costs shall not include the costs of any capital equipment used in performing finishing activities or the Certification Costs. PART C - CERTIFICATION COSTS Certification fees paid to [*] certification laboratories A-9 Material handling costs relating to certification by [*] certification laboratories A-10 ATTACHMENT B Sotheby's, Inc. Christie's, Inc. Phillips International Auctioneers Doyle William Galleries, Inc. ATTACHMENT C [Letterhead of Pegasus Overseas Ltd.] [Date] GE [*] [*] RE: PROCESSING AGREEMENT DATED FEBRUARY 20, 1999 (THE "AGREEMENT") Ladies/Gentlemen: Pegasus Overseas Ltd. ("POL") hereby represents and warrants to you that, with respect to all Gem Diamonds received from you under the Agreement and marketed and sold by POL during the [*] ended __________, it has achieved such sales utilizing marketing methods, procedures, pricing and related arrangements no different from those ordinarily utilized during that [*] by its Affiliates in the sale in comparable markets of comparable diamonds not processed by you, and that [*]. Sincerely, PEGASUS OVERSEAS LTD. By: _______________________ Its: EX-13 4 EXHIBIT 13 LAZARE KAPLAN INTERNATIONAL INC. "Photograph of the side view of a diamond with an enlarged laser inscription which reads "LD 2000 1/2000". [LAZARE KAPLAN LOGO] The leader in ideal cut diamonds for over 90 years. 1999 Annual Report Cover photo: The LD 2000'TM' Millennium Lazare Diamond. To celebrate the millennium, Lazare Kaplan International Inc. introduced a limited edition series of Lazare Diamonds'r'. Each diamond will be inscribed with the commemorative 'LD 2000' insignia and that particular diamond's number in the series (i.e., 1/2000 through 2000/2000), as well as the standard Lazare Diamond logo and unique identification number. [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LAZARE KAPLAN INTERNATIONAL INC. 1999 ANNUAL REPORT Lazare Kaplan International Inc. is engaged in the cutting and polishing of ideal cut diamonds, which it laser inscribes and distributes to quality retail jewelers internationally under the brand name 'Lazare Diamonds'r'. Diamonds, whatever their size, which are cut and polished by Lazare Kaplan craftsmen, are finished to precise proportions, bringing out all of the diamond's natural brilliance, fire and luster. In addition, Lazare Kaplan also cuts and polishes non-ideal cut (commercial) diamonds. These stones are sold through wholesalers and distributors and, to a growing extent, through retail jewelers, Lazare Kaplan's traditional channel of distribution. Lazare Kaplan is also engaged in the buying and selling of uncut rough diamonds. AMERICAN STOCK EXCHANGE The Company's common stock is traded on the American Stock Exchange under the ticker symbol LKI. FORM 10-K Upon written request, a copy of the Company's Form 10-K Annual Report without exhibits for the year ended May 31, 1999 as filed with the Securities and Exchange Commission, will be made available to stockholders without charge. Requests should be directed to the Controller, Ms. James, Lazare Kaplan International Inc., 529 Fifth Avenue, New York, New York 10017. ANNUAL MEETING November 4, 1999 10 A.M. The Cornell Club Six East 44th Street Fifth Floor, Fall Creek Room New York, New York 10017 MARKET PRICES OF COMMON STOCK BY FISCAL QUARTER - -----------------------------------------
FISCAL 1999 ------------------- HIGH LOW - ------------------------------------------ FIRST 12 1/4 8 1/4 SECOND 9 6 1/2 THIRD 8 1/4 6 3/4 FOURTH 9 1/2 6 7/8 - ------------------------------------------
Fiscal 1998 --------------------------- High Low - -------------------------------------- First 18 1/4 15 1/2 Second 17 14 1/8 Third 14 1/4 10 Fourth 12 5/8 10 1/16 - ---------------------------------------
As of July 30, 1999 there were 1,776 stockholders of record of the 8,368,343 issued and outstanding shares of the common stock of the Company, including CEDE & Co. and other institutional holders who held an aggregate of 4,743,043 shares of common stock as nominees for an undisclosed number of beneficial holders. The Company estimates that it has in excess of 2,200 beneficial holders. 1 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- TO OUR SHAREHOLDERS: [TO COME] 2 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- [TO COME] 3 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SELECTED FINANCIAL DATA
- --------------------------------------------------------------------------------------------------- (In thousands, except per share data) 1999 1998 1997 1996 1995 - ----------------------------------------- --------------------------------------------------------- NET SALES 261,853 222,617 259,797 266,321 178,143 - --------------------------------------------------------------------------------------------------- Income/(loss) from continuing operations before income tax provision and minority interest ($11,575) $ 2,295 $ 8,248 $ 7,149 ($ 1,418) - --------------------------------------------------------------------------------------------------- Income/(loss) from continuing operations ($ 6,323) $ 2,724 $ 12,100 $ 7,013 ($ 1,153) - --------------------------------------------------------------------------------------------------- Net income/(loss) ($ 6,323)(2) $ 2,724 $ 11,482 $ 7,013 ($ 1,153) - --------------------------------------------------------------------------------------------------- Basic earnings/(loss) per share from continuing operations (based on the weighted average number of shares) ($ 0.74) $ 0.32 $ 1.69(1) $ 1.14 ($ 0.19) - --------------------------------------------------------------------------------------------------- Basic earnings/(loss) per share (based on the weighted average number of shares) ($ 0.74) $ 0.32 $ 1.61(1) $ 1.14 ($ 0.19) - --------------------------------------------------------------------------------------------------- Diluted earnings/(loss) per share from continuing operations (based on the weighted average number of shares) ($ 0.74) $ 0.31 $ 1.63(1) $ 1.12 ($ 0.18) - --------------------------------------------------------------------------------------------------- Diluted earnings/(loss) per share (based on the weighted average number of shares) ($ 0.74) $ 0.31 $ 1.54(1) $ 1.12 ($ 0.18) - --------------------------------------------------------------------------------------------------- At May 31: Total assets $151,913 $142,330 $130,079 $105,066 $ 99,163 - --------------------------------------------------------------------------------------------------- Long-term debt $ 38,575 $ 23,560 $ 17,145 $ 34,155 $ 26,430 - --------------------------------------------------------------------------------------------------- Working capital $106,581 $111,752 $105,291 $ 74,069 $ 59,290 - --------------------------------------------------------------------------------------------------- Stockholders' equity $ 85,994 $ 93,460 $ 90,544 $ 44,870 $ 37,695 - ---------------------------------------------------------------------------------------------------
Note: No cash dividends were declared or paid by the Company during the past five fiscal years. (1) Reflects the impact of the issuance of 2,130,000 additional shares of common stock during 1997. (2) Includes $2.8 million of fourth quarter losses incurred in the Company's rough diamond buying operations in Angola and $3.4 million of costs associated with the realignment of the Company's Japanese distribution in 1999. 4 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS This Annual Report contains, in addition to historical information, certain forward-looking statements that involve significant risks and uncertainties. Such forward-looking statements are based on management's belief as well as assumptions made by, and information currently available to, management pursuant to the 'safe harbor' provisions of the Private Securities Litigation Reform Act of 1995. The Company's actual results could differ materially from those expressed in or implied by the forward-looking statements contained herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed herein and in Item 1 -- 'Description of Business', Item 3 -- 'Legal Proceedings', and elsewhere in the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1999. The Company undertakes no obligation to release publicly the result of any revisions to these forward- looking statements that may be made to reflect events or circumstances after the date of this Annual Report or to reflect the occurrence of other unanticipated events. This discussion and analysis should be read in conjunction with the Selected Financial Data and the audited consolidated financial statements and related notes of the Company contained elsewhere in this report. In this discussion, the years '1999', '1998' and '1997' refer to the fiscal years ended May 31, 1999, 1998 and 1997, respectively. RESULTS OF OPERATIONS Net Sales Net sales in 1999 of $261,853,000 were 18% greater than net sales of $222,617,000 in 1998. The Company's net revenue from the sale of polished diamonds of $112,573,000 in 1999 was 34% greater than 1998 polished sales of $84,058,000. The increase in polished diamond sales was primarily due to higher sales of polished stones from the Company's new factory in Russia. This was due to the fact that throughout 1999, the Company received regular and consistent shipments from the factory, making more goods available for sale in the current year. In the prior year, the Company did not receive its first shipment from this factory until the second half of the fiscal year. During 1999, the Company experienced increased volume in the United States and in Japan, the first sales increase in Japan in several years. These increases were partially offset by lower sales in Southeast Asia in the first half of 1999 as compared to the prior year. Rough diamond sales were $149,280,000 in 1999, an increase of 8% compared to $138,559,000 in 1998, despite lower purchases and sales in Angola during the second half of 1999. Angola experienced increased military activity between the Government of Angola and the rebel forces during this period which was heavily concentrated in the diamond producing regions. This resulted in fewer, less profitable diamonds available for purchase. Net sales in 1998 of $222,617,000 were 14% lower than net sales of $259,797,000 in 1997. The Company's net revenue from the sale of polished diamonds of $84,058,000 in 1998 was 12% lower than 1997 polished sales. The decrease in polished diamond sales was primarily due to the Company not receiving its first shipments of polished stones from its new factory in Russia until late November 1997, six months into the fiscal year. On a comparative basis, the Company experienced larger shipments during 1997 from its older Russian facility which had suspended production by 1998. Also, adverse economic conditions caused lower sales in Japan and Southeast Asia. Both of these items were partially offset by increased sales volume in the United States market. Rough diamond sales were $138,559,000 in 1998 compared to $164,643,000 in 1997, a decrease of 16%. This decrease was partially attributable to continued lower sales of better quality rough diamonds to the marketplace by DeBeers as well as the Company closing its rough diamond buying operation 5 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS (Continued) in the Republic of the Congo (formerly Zaire) in early calendar year 1997 (i.e. fiscal 1997). The decrease was partially offset by increased rough sales volume associated with the Company's restructuring and expansion of its rough diamond buying operations in Angola during the year. Gross Profit The Company's gross margin on net sales of polished diamonds includes all overhead costs associated with the purchase, sale and manufacture of rough stones (the 'Polished Diamond Gross Margin'). Polished Diamond Gross Margin for 1999 was 13% as compared to 11% in 1998. In 1999 the Polished Diamond Gross Margin was favorably impacted by increased sales volume of large stones produced at the Company's factory in Russia. In addition, during 1999 the Company had increased sales volume of higher margined Lazare Diamonds as compared to 1998. The gross margin on sales of rough stones not selected for manufacturing and sales of rough stones from the rough trading operation, including an allocation of overhead costs estimated to be associated with the purchase and sale of rough stones, has traditionally been approximately 3%. However, in 1999 the Company experienced a negative rough diamond margin of -2% which was caused by adverse results from the Company's operations in Angola, as discussed above. This was compounded by relatively high fixed infrastructure and security costs which could not be quickly reduced, certain purchases which resulted in significant losses upon resale, and the defection of a significant portion of the Company's expatriate rough diamond buying team. As a result, the Company incurred a loss of approximately $4.6 million ($2.8 million, net of tax) from its Angolan activities during the fourth quarter which was included in the cost of goods sold for rough diamonds and, therefore, adversely impacted the rough diamond gross margin. During 1999, the overall gross margin on net sales of both polished diamonds and rough diamonds was 4.5%. This compares to 6.2% in 1998 and 9.1% in 1997. The decrease in 1999 was primarily attributable to the lower rough diamond margin as discussed above. Excluding the effect of the losses sustained in Angola discussed above, the overall gross margin for 1999 would have been 6.3%. The decrease in 1998 was primarily attributable to the decrease in the Polished Diamond Gross Margin. Polished Diamond Gross Margin for 1998 was 11% as compared to 17% in 1997. In 1998 the Polished Diamond Gross Margin was impacted by increased costs of rough diamonds which the Company did not reflect in the selling price of its polished diamonds. In addition, the economic environment in Southeast Asia and Japan during the latter half of 1998 had impacted the Company's sales of larger, better quality stones, which carry higher margins. Selling, General and Administrative Expenses Selling, general and administrative expenses in 1999 of $15,103,000 (5.8% of net sales) increased 10% or $1,382,000 compared with expenses of $13,721,000 (6.2% of net sales) in 1998. The increase was primarily attributable to the opening of the Company's sales office in Japan in the beginning of 1999 partially offset by the capitalization of certain salary and benefit costs for those employees directly involved with the Company's implementation of its new computer system (in accordance with Statement of Position 98-1, 'Accounting for the Costs of Computer Software Developed For or Obtained For Internal Use'). Selling, general and administrative expenses in 1998 of $13,721,000 (6.2% of net sales) increased 11% or $1,355,000 compared with expenses of $12,366,000 (4.8% of net sales) in 1997. The increase was attributable to increases in selling commissions and benefits in 1998, as well as an increase in legal/consulting services and international travel associated with the evaluation of new business opportunities in the year. Sale of Interest in Lazare Kaplan Botswana (Pty) Ltd. In 1998, the Company completed a transaction for the sale of its interest in Lazare Kaplan Botswana 6 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS (Continued) (Pty) Ltd. for $11.1 million and recorded a gain of approximately $3.7 million (net of $485,000 of Botswana taxes) on the transaction. Costs Associated with Realignment of Japanese Distribution After working with its former distributor of over 25 years, in 1999, the Company changed the nature of its distribution in Japan by assuming control of the distribution of its products and opening its own office. In this way, the Company has realigned its position with its retail and wholesale customers and shortened its channels of distribution. In addition, this realignment has enabled the Company, without interruption, to assume control of the expansion and maintenance of the Lazare Diamond brand name in Japan. As part of the realignment, the Company retained experienced Japanese staff, giving it immediate and direct access to important customers as well as in depth industry knowledge. The Company believes that this realignment was necessary in order to compete effectively in Japan (the world's second largest market for diamonds and diamond jewelry) in the years to come. As a result, the Company recorded a one-time, non-recurring charge of approximately $5.6 million ($3.4 million, net of tax) in 1999. Interest Expense Net interest expense was $2,702,000, $2,062,000 and $3,112,000 in 1999, 1998 and 1997, respectively. The increase in 1999 was due to higher average balances outstanding on the Company's lines of credit of $22.2 million compared to $4.2 million in 1998, partially offset by lower interest expense on the Company's Senior Notes due to the reduction of the outstanding balance during the year. The decrease in 1998 was due to lower average balances outstanding on the Company's lines of credit of $4.2 million as compared to $15.1 million in 1997. In addition, interest expense on the Company's Senior Notes decreased by approximately $430,000 during 1998 due to the reduction of the outstanding balance. Income Taxes During 1999 and 1998, the Company recorded a tax benefit of $5,280,000 and $260,000, respectively, primarily in recognition of the net operating losses incurred in those years. During 1997, the Company recorded a tax benefit of $3,375,000 related to the reversal of the valuation allowance that had been provided against the Company's deferred tax assets that arose primarily from net operating loss carryforwards. Discontinued Operation During 1997, the Company discontinued its efforts to organize and participate in the privatization of the mining of the Akwatia and Birim deposits owned and operated by Ghana Consolidated Diamonds Ltd., in Ghana. The write-off of unamortized costs (net of tax benefit of $13,000) was $618,000 in fiscal 1997. Earnings/(Loss) Per Share During 1999, 1998 and 1997, basic earnings/(loss) per share was ($0.74), $0.32 and $1.61, respectively. Diluted earnings per share was ($0.74), $0.31 and $1.54 in 1999, 1998 and 1997, respectively. In 1999, excluding the costs associated with the Company's realignment in Japan and the losses sustained in the Company's Angolan operation, basic and diluted earnings/(loss) per share would have been ($0.02). In 1997, basic and diluted earnings per share included a loss of $.08 and $.09 per share, respectively, from a discontinued operation. Basic earnings per share is computed based upon the weighted average number of common shares outstanding. Diluted earnings per share includes the impact of dilutive stock options. All earnings per share amounts for all periods have been presented and, where necessary, restated to conform to SFAS 128 requirements. FOREIGN OPERATIONS International business represents a major portion of the Company's revenues and profits. All purchases of rough diamonds worldwide are denominated in U.S. dollars. All of the Company's foreign sales are 7 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS (Continued) denominated in U.S. dollars, with the exception of those sales made by the Company's subsidiary, Lazare Kaplan Japan, which are denominated in Japanese yen. Where possible, the Company hedges its sales transactions in Japan to minimize the impact of any foreign currency exposure on its foreign revenue. Therefore, the Company does not experience any material foreign currency exposure in connection with its purchasing and selling activities. The functional currency for Lazare Kaplan Japan is the Japanese yen and, during 1999, the Company recognized foreign currency translation adjustments with regard to the activities of Lazare Kaplan Japan in the amount of $44,000 which are shown as a component of stockholders' equity in the accompanying balance sheet. In addition, the functional currency for Lazare Kaplan Botswana (Pty) Ltd. (interest sold in March 1998) was the U.S. dollar and this subsidiary was not materially affected by foreign currency fluctuations. IMPACT OF YEAR 2000 In connection with the Company's efforts to update and modernize its information systems, as well as to address its Year 2000 issue, during 1998 the Company commenced the implementation of a new, fully integrated computer system. The majority of the costs of this implementation will be capitalized by the Company. The Company is utilizing both internal and external resources to implement and test its new software and hardware and anticipates substantially completing the project during the first quarter of fiscal year 2000. The total cost of the new computer system is expected to be approximately $3.5 million, of which $3.0 million has been incurred to date, including approximately $641,000 of salary and benefit costs (for certain employees who are directly involved with the project) and interest costs capitalized in accordance with Statement of Position 98-1, 'Accounting for the Costs of Computer Software Developed For or Obtained For Internal Use'. In addition, the Company has identified its significant suppliers and other third party service providers and has initiated formal communications to determine the extent to which the Company's operations are vulnerable to the failure of those third parties to remediate their own Year 2000 issues. Contingency plans in the event of unsuccessful implementation of the above project or noncompliance of any of the Company's primary service providers have not been developed. However, the Company believes that any delay in the implementation of its new computer system beyond December 1999 would not have a material adverse effect on the Company's operations or its ability to service its customers. The costs of the computer project and the time frame in which the Company believes it will complete installation of its new computer system, including the Year 2000 compliance, are based on management's best estimates; however, there can be no assurance that these estimates will be achieved and actual results could differ materially from those anticipated. LIQUIDITY -- CAPITAL RESOURCES The Company's working capital at May 31, 1999 was $106,581,000, a decrease of $5,171,000 from May 31, 1998. This decrease was primarily related to the reclassification of a portion of the Company's deferred tax assets to non-current assets. The Company's working capital at May 31, 1998 was $111,752,000, an increase of $6,461,000 from May 31, 1997. This increase was primarily related to higher inventories and accounts receivable partially offset by an increase in accounts payable and other current liabilities and a decrease in cash and cash equivalents. In the fourth quarter of 1998, the Company completed the sale of its interest in Lazare Kaplan Botswana (Pty) Ltd. for $11.1 million in cash. The Company used the proceeds to repay its outstanding non-current bank loans. Fixed asset additions totaled $4,144,000, $2,600,000 and $805,000 in 1999, 1998 and 1997, respectively. In 1998 the Company commenced the design and implementation of a new, fully integrated computer system which is Year 2000 compliant. The 8 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS (Continued) Company incurred $1,900,000 and $1,100,000 in 1999 and 1998, respectively, in connection with this project. The Company expects to incur an additional $500,000 during the upcoming fiscal year in order to complete this project. In addition, in 1998 the fixed asset additions included new laser inscription equipment. In 1997 the fixed asset additions related primarily to machinery and equipment to be used in the Company's manufacturing facilities and buying offices. In May 1996, the Company entered into a long-term unsecured, revolving loan agreement with two banks. The agreement, as amended, provides that the Company may borrow up to $40,000,000 in the aggregate, at an interest rate of any of a) one-eighth of one percent above the bank's prime rate, b) 160 basis points above the London Interbank Offered Rate (LIBOR), or c) 160 basis points above the bank's cost of funds rate. The applicable interest rate is contingent upon the method of borrowing selected by the Company. The term of the loan is through September 1, 2002. The proceeds of this facility are available for the Company's working capital needs and to fund its future annual installments due under the Senior Note Agreement. As of May 31, 1999 and 1998 there was an aggregate balance outstanding of $32,158,000 and $10,700,000, respectively under this agreement. The increase in borrowing in 1999 compared to 1998 was due to the Company having received proceeds of $11.1 million in connection with the sale of its interest in Lazare Kaplan Botswana (Pty) Ltd. in March 1998 which was used to repay outstanding amounts under this facility. The Company was not in compliance with the annual cash flow covenant and the capital expenditure covenant under the revolving loan agreement for the year ended May 31, 1999. The banks have given a waiver to the Company with respect to these covenants for the year ended May 31, 1999. In addition, the banks have amended the cash flow covenant for the August 31, 1999, November 30, 1999 and February 29, 2000 measurement periods, and have amended the capital expenditure covenant for all future measurement periods. In May 1991, the Company, through a private placement, issued $30,000,000 of 9.97% Senior Notes, due May 15, 2001. As of May 31, 1999 and 1998, the balance of Senior Notes outstanding was $8,575,000 and $12,860,000, respectively. The Company was not in compliance with the requirements of the consolidated fixed charge ratio for the year ended May 31, 1999. The Senior Notes were amended in August 1999 to eliminate the requirements of the consolidated fixed charge ratio retroactively for the fiscal quarter ending May 31, 1999, to waive compliance with the consolidated fixed charge ratio for the fiscal quarters ending August 31 and November 30, 1999, and to revise the consolidated fixed charge ratio for the fiscal quarter ending February 29, 2000. Management believes the Company has the ability to meet its current and anticipated financing needs for the next twelve months with the facilities in place and funds from operations, however, given the growth prospects of the Company, it may seek to increase its credit facilities during the upcoming year. Stockholders' equity was $85,994,000 at May 31, 1999, $93,460,000 at May 31, 1998 and $90,544,000 at May 31, 1997. The decrease in 1999 was attributable to the net loss incurred during the period as well as the purchase of treasury stock. The increase in 1998 was attributable to the net income earned during the year. Stockholders received no dividends in 1999, 1998 or 1997. BUSINESS DEVELOPMENTS Under the terms of its agreement with AK Almazi Rossii Sakha (ALROSA) of Russia, the Company equipped a diamond cutting factory which was completed in February 1997 within the ALROSA facility in Moscow. This facility is staffed by Russian technicians and managed and supervised by Company personnel. ALROSA has agreed to supply a minimum of $45 million per year of large rough gem diamonds selected by the Company as being suitable for processing at this facility. In May 1997, the facility completed the production of its first polished stones and the Company received its first shipment of 9 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS (Continued) polished stones produced at this facility during November 1997. Since that time the Company has received regular and consistent shipments of polished stones from the ALROSA facility. The Company is selling the resulting polished gem stones through its worldwide distribution network. The proceeds from the sale of these polished diamonds, after reimbursement of costs incurred by each of the parties, generally are shared equally with ALROSA. This agreement serves as a long-term off-take arrangement to secure the repayment of the $62 million financing which has been received by ALROSA from a United States commercial bank and is guaranteed by the Export-Import Bank of the United States (Eximbank) for the purchase by ALROSA of U.S. manufactured mining equipment. This equipment is being used by ALROSA to increase production in its diamond mines. In March 1999, (in furtherance of a Memorandum of Understanding signed by Eximbank, ALROSA and the Company in July, 1998) the Company and ALROSA entered into a Cooperation Agreement to expand their relationship in the cutting, polishing and marketing of rough gem diamonds. Under the terms of this agreement, the Company and ALROSA agreed to refurbish two new polishing facilities (one of which is not yet operational) in Russia with an annual capacity to cut and polish up to $150 to $200 million of rough diamonds. These facilities will be in addition to the existing facility which is equipped to cut and polish $45 million per year of rough diamonds discussed above. In March 1999, the Company announced that a newly formed, wholly owned subsidiary, Pegasus Overseas Ltd. (POL) had entered into an exclusive ten-year agreement with a wholly owned subsidiary of General Electric Company (GE) under which POL will market natural diamonds that have undergone a new GE process that enhances certain characteristics of select, natural gemstone diamonds. The process is an additional step which complements the many steps to which a diamond is customarily subjected in the course of being extracted, processed with mechanical and chemical operations and then cut and polished. The process is permanent and irreversible and it does not involve treatments such as irradiation, laser drilling, surface coating or fracture filling and is conducted before the final cutting and polishing by the Company. The process is designed to improve the color, brilliance and brightness of qualifying diamonds without reducing their all-natural content. The process, which was developed and is owned by GE, will be used only on a select, limited range of natural diamonds with qualifying colors, sizes and clarities for both round and fancy cuts. The estimated number of gemstones with characteristics suitable for this process is a small fraction of the overall diamond market. POL will sell only diamonds that have undergone the new GE process. Each diamond sold by POL will be laser inscribed with the brand name 'GE POL.' POL began offering these diamonds to distributors around the world during late May 1999. RISKS AND UNCERTAINTIES The world's sources of rough diamonds are highly concentrated in a limited number of countries. Varying degrees of political and economic risk exist in many of these countries. As a consequence, the diamond business is subject to various sovereign risks beyond the Company's control, such as changes in laws and policies affecting foreign trade and investment. In addition, the Company is subject to various political and economic risks, including the instability of foreign economies and governments, labor disputes, war and civil disturbances and other risks that could cause production difficulties or stoppages, restrict the movement of inventory or result in the deprivation or loss of contract rights or the taking of property by nationalization or expropriation without fair compensation. The Company's business is dependent upon the availability of rough diamonds. Based upon published reports, the Company believes that approximately 60% of the world's diamond output is purchased for resale by DeBeers Centenary AG and its affiliated companies. Although DeBeers has historically been one of the Company's major suppliers of rough diamonds, the Company has successfully diversified its sources of supply by entering into arrangements with other 10 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS (Continued) primary source suppliers and has been able to supplement its rough diamond needs by purchasing supplies in the secondary market. While the Company believes that it has good relationships with its suppliers and that its sources of supply are sufficient to meet its present and foreseeable needs, the Company's rough diamond supplies, and therefore, its manufacturing capacity, could be adversely affected by political and economic developments in producing countries over which it has no control. While the Company believes that alternative sources of supply may be available, any significant disruption of the Company's access to its primary source suppliers could have a material adverse effect on its ability to purchase rough diamonds. Further, through its control of the world's diamond output, DeBeers can exert significant control over the pricing of rough and polished diamonds. A large rapid increase in rough diamond prices could materially adversely affect the Company's revenue and operating margins if the increased cost of the rough diamonds could not be passed along to its customers in a timely manner. Alternatively, any rapid decrease in the price of polished diamonds could have a material adverse affect on the Company in terms of inventory losses and lower margins. 11 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended May 31, - ---------------------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) 1999 1998 1997 - ---------------------------------------------------------------------------------------------- ------------------------------------ Net sales (Note 1) $ 261,853 $ 222,617 $ 259,797 Cost of sales (Note 1) 250,035 208,717 236,071 - ---------------------------------------------------------------------------------------------- 11,818 13,900 23,726 - ---------------------------------------------------------------------------------------------- Selling, general and administrative expenses 15,103 13,721 12,366 Interest expense, net of interest income 2,702 2,062 3,112 Costs associated with realignment of Japanese distribution (Note 7) 5,588 - - Gain on sale of consolidated subsidiary (Note 8) - (4,178) - - ---------------------------------------------------------------------------------------------- 23,393 11,605 15,478 - ---------------------------------------------------------------------------------------------- Income/(loss) from continuing operations before income tax provision/(benefit) and minority interest (11,575) 2,295 8,248 Income tax provision/(benefit) (Notes 1 and 3) (5,252) 417 (2,970) - ---------------------------------------------------------------------------------------------- Income/(loss) from continuing operations before minority interest (6,323) 1,878 11,218 Minority interest in loss of consolidated subsidiary (Note 8) - 846 882 - ---------------------------------------------------------------------------------------------- Income/(loss) from continuing operations (6,323) 2,724 12,100 Loss from discontinued operation, net of income tax benefit (Note 13) - - 618 - ---------------------------------------------------------------------------------------------- NET INCOME/(LOSS) $ (6,323) $ 2,724 $ 11,482 - ---------------------------------------------------------------------------------------------- ------------------------------------ EARNINGS/(LOSS) PER SHARE (Note 1) Basic earnings per share from continuing operations $ (0.74) $ 0.32 $ 1.69 - ---------------------------------------------------------------------------------------------- ------------------------------------ Basic earnings per share $ (0.74) $ 0.32 $ 1.61 - ---------------------------------------------------------------------------------------------- ------------------------------------ Average number of shares outstanding during the period 8,488,861 8,499,131 7,151,099 - ---------------------------------------------------------------------------------------------- ------------------------------------ Diluted earnings per share from continuing operations $ (0.74) $ 0.31 $ 1.63 - ---------------------------------------------------------------------------------------------- ------------------------------------ Diluted earnings per share $ (0.74) $ 0.31 $ 1.54 - ---------------------------------------------------------------------------------------------- ------------------------------------ Average number of shares outstanding during the period, assuming dilution 8,488,861 8,669,366 7,442,518 - ---------------------------------------------------------------------------------------------- ------------------------------------
See notes to consolidated financial statements. 12 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEETS
May 31, - --------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT SHARE DATA) 1999 1998 - --------------------------------------------------------------------------------- ------------------- ASSETS CURRENT ASSETS: Cash and cash equivalents (Note 1) $ 5,181 $ 1,222 Accounts receivable, less allowance for doubtful accounts ($202 and $143 in 1999 and 1998, respectively) 32,902 37,747 Inventories, net (Note 1): Rough stones 30,363 23,843 Polished stones 50,991 57,675 ------------------- Total inventories 81,354 81,518 ------------------- Prepaid expenses and other current assets 13,038 12,640 Deferred tax assets -- current (Note 3) 1,450 3,785 - --------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 133,925 136,912 PROPERTY, PLANT AND EQUIPMENT, net (Notes 1 and 2) 8,151 4,734 OTHER ASSETS 2,172 684 DEFERRED TAX ASSETS, net (Note 3) 7,665 - - --------------------------------------------------------------------------------- $151,913 $142,330 - --------------------------------------------------------------------------------- ------------------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable and other current liabilities (Notes 1 and 4) $ 25,186 $ 25,160 Notes payable -- other (Note 5) 2,158 - - --------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 27,344 25,160 SENIOR NOTES AND OTHER LONG-TERM DEBT (Notes 5 and 6) 38,575 23,560 DEFERRED TAX LIABILITIES (Note 3) - 150 - --------------------------------------------------------------------------------- TOTAL LIABILITIES 65,919 48,870 - --------------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES (Note 10) STOCKHOLDERS' EQUITY (Notes 9 and 14) Preferred stock, par value $.01 per share: Authorized, 5,000,000 shares, no shares outstanding - - Common stock, par value $1 per share: Authorized, 20,000,000 shares in 1999 and 1998 Issued 8,535,493 and 8,534,549 shares in 1999 and 1998, respectively 8,535 8,535 Additional paid-in capital 58,149 58,145 Cumulative translation adjustment (Note 1) 44 - Retained earnings 20,479 26,802 - --------------------------------------------------------------------------------- 87,207 93,482 Less treasury stock, 167,150 and 2,000 shares at cost in 1999 and 1998, respectively (1,213) (22) - --------------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 85,994 93,460 - --------------------------------------------------------------------------------- $151,913 $142,330 - --------------------------------------------------------------------------------- -------------------
See notes to consolidated financial statements. 13 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Additional Cumulative Total Common Paid-in Translation Retained Treasury Stockholders' (In thousands, except share data) Stock Capital Adjustment Earnings Stock Equity - ---------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------- Balance, May 31, 1996 $6,176 $26,098 $- $12,596 $ - $44,870 Net income - - - 11,482 - 11,482 Exercise of stock options, 100,696 shares issued 101 519 - - - 620 Sale of common stock, net 2,130 31,442 - - - 33,572 - ---------------------------------------------------------------------------------------------------------- Balance, May 31, 1997 8,407 58,059 - 24,078 - 90,544 Net income - - - 2,724 - 2,724 Exercise of stock options, 127,428 shares issued 128 86 - - - 214 Purchase of treasury stock, 2,000 shares - - - - (22) (22) - ---------------------------------------------------------------------------------------------------------- Balance, May 31, 1998 8,535 58,145 - 26,802 (22) 93,460 Comprehensive income/(loss): Net income/(loss) - - - (6,323) - (6,323) Foreign currency translation - - 44 - - 44 ------------- Comprehensive income/(loss) (6,279) Exercise of stock options, 944 shares issued - 4 - - - 4 Purchase of treasury stock, 165,150 shares - - - - (1,191) (1,191) - ---------------------------------------------------------------------------------------------------------- Balance, May 31, 1999 $8,535 $58,149 $44 $20,479 ($1,213) $85,994 - ---------------------------------------------------------------------------------------------------------- -----------------------------------------------------------------------
See notes to consolidated financial statements. 14 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended May 31, ------------------------------------------------------------------------------------------- (IN THOUSANDS) 1999 1998 1997 ------------------------------------------------------------------------------------------- ----------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income/(loss) $(6,323) $ 2,724 $ 11,482 Adjustments to reconcile net income/(loss) to net cash provided by/(used in) operating activities: Depreciation and amortization 943 2,070 2,376 Provision for uncollectible accounts 60 60 (25) Benefit from deferred income taxes (5,480) (260) (3,375) Minority interest in loss of consolidated subsidiary - (846) (882) Net gain on sale of consolidated subsidiary - (3,693) - Loss from discontinued operation - - 618 (Increase)/decrease in assets and increase/ (decrease) in liabilities: Accounts receivable 4,785 (8,204) (4,114) Rough and polished inventories 164 (25,588) (9,899) Prepaid expenses and other current assets (398) (1,837) (1,625) Other assets (1,704) 66 1,544 Accounts payable and other current liabilities 26 12,628 (1,412) ----------------------------- Net cash provided by/(used in) operating activities (7,927) (22,880) (5,312) ------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (4,144) (2,600) (805) Proceeds from sale of stock in consolidated subsidiary - 11,100 - Proceeds from sale of fixed assets - - 25 ----------------------------- Net cash provided by/(used in) investing activities (4,144) 8,500 (780) ------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Increase/(decrease) in short-term borrowings 2,158 (1,343) (1,657) Increase/(decrease) in long-term borrowings 15,015 6,415 (17,010) Purchase of treasury stock (1,191) (22) - Proceeds from exercise of stock options 4 214 620 Proceeds from issuance of common stock, net - - 33,572 ----------------------------- Net cash provided by/(used in) financing activities 15,986 5,264 15,525 ------------------------------------------------------------------------------------------- Effect of cumulative translation adjustment 44 - - Net increase/(decrease) in cash and cash equivalents 3,959 (9,116) 9,433 Cash and cash equivalents at beginning of year 1,222 10,338 905 ----------------------------- Cash and cash equivalents at end of year $ 5,181 $ 1,222 $ 10,338 ------------------------------------------------------------------------------------------- ----------------------------- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest $ 2,872 $ 2,288 $ 3,573 Income taxes $ 129 $ 716 $ 458 -------------------------------------------------------------------------------------------
See notes to consolidated financial statements. 15 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 1. ACCOUNTING POLICIES - --------------------------------------------------------- a. The Company and its principles of consolidation The Company and its subsidiaries are engaged in the cutting and polishing of rough diamonds and selling of both polished and uncut rough diamonds. The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned. Through March 1998, the Company owned 60% of Lazare Kaplan Botswana (Pty) Ltd. Minority interest represents the minority stockholders' proportionate share of the equity of Lazare Kaplan Botswana (Pty) Ltd. through such date (see Note 8). With effect from January 1, 1998, the Company restructured certain foreign operations. This resulted in the inclusion of all revenue from these operations and an increase in rough diamond sales for the year ended May 31, 1998 of approximately $37 million. All material intercompany balances and transactions have been eliminated. In these notes to consolidated financial statements, the years '1999', '1998' and '1997' refer to the fiscal years ended May 31, 1999, 1998 and 1997, respectively. b. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that could affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates. c. Sales and accounts receivable The Company's net sales to customers in each of the following regions for the years ended May 31, 1999, 1998 and 1997 are set forth below:
1999 1998 1997 - ------------------------------------------ ------------------ United States 31% 28% 22% Far East 8% 7% 9% Europe, Israel & other 61% 65% 69% - ------------------------------------------ 100% 100% 100% - ------------------------------------------ ------------------
No single customer of the Company accounted for 10% or more of the Company's net sales for the fiscal years ended May 31, 1999, 1998 and 1997. Credit is extended based on an evaluation of each customer's financial condition and generally collateral is not required on the Company's receivables. d. Cash and cash equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. e. Inventories Inventories are stated at the lower of cost, using the first-in, first-out method, or market. f. Property, plant and equipment Property, plant and equipment is stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the shorter of asset lives or lease terms. g. Deferred costs The Company deferred the recognition of certain costs for professional fees, travel and total staffing incurred during the construction and training period of the Company's cutting and polishing facility in Botswana. Such costs included only direct and incremental costs incurred during the start-up period. These costs were amortized from June 1, 1993 through March 1998, the date the Company sold its interest in Lazare Kaplan Botswana (Pty) Ltd. (see Note 8). All other deferred costs are amortized over their estimated useful lives, generally less than ten years. h. Asset Impairments The Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by the related assets are less than the carrying amounts of those assets. i. Foreign currency All purchases of rough diamonds worldwide are denominated in U.S. dollars. All of the Company's foreign sales are denominated in U.S. dollars, with the exception of those sales made by the Company's 16 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 subsidiary, Lazare Kaplan Japan, which are denominated in Japanese yen. Where possible, the Company hedges its sales transactions in Japan to minimize the impact of any foreign currency exposure on its foreign revenue. Therefore, the Company does not experience any material foreign currency exposure in connection with its purchasing and selling activities. The functional currency for Lazare Kaplan Japan is the Japanese yen and the Company recognizes foreign currency translation adjustments with regard to the activities of Lazare Kaplan Japan which are shown as a component stockholders' equity in the accompanying balance sheets. In addition, the functional currency for Lazare Kaplan Botswana (Pty) Ltd. (interest sold in March 1998) was the U.S. dollar and this subsidiary was not materially affected by foreign currency fluctuations. j. Advertising Advertising costs are expensed as incurred and were $1,214,000, $1,148,000 and $1,054,000 in 1999, 1998, and 1997, respectively. k. Income taxes The Company provides for income taxes in accordance with Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes', whereby deferred income taxes are determined based upon the enacted income tax rates for the years in which these taxes are estimated to be payable or recoverable. Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) operating loss carryforwards. The Company and its domestic subsidiaries file a consolidated income tax return. The Company's foreign subsidiaries are not subject to Federal income taxes and their provisions for income taxes have been computed based on the effective tax rates, if any, in the foreign countries. There were no taxable dividends paid to the Company from foreign subsidiaries during 1999. l. Earnings/(Loss) per share The Company computes basic earnings per share based upon the weighted average number of common shares outstanding, and diluted earnings per share based upon the weighted average number of common shares outstanding including the impact of dilutive stock options. m. Risks and Uncertainties The world's sources of rough diamonds are highly concentrated in a limited number of countries. Varying degrees of political and economic risk exist in many of these countries. As a consequence, the diamond business is subject to various sovereign risks beyond the Company's control, such as changes in laws and policies affecting foreign trade and investment. In addition, the Company is subject to various political and economic risks, including the instability of foreign economies and governments, labor disputes, war and civil disturbances and other risks that could cause production difficulties or stoppages, restrict the movement of inventory or result in the deprivation or loss of contract rights or the taking of property by nationalization or expropriation without fair compensation. The Company's business is dependent upon the availability of rough diamonds. Based upon published reports, the Company believes that approximately 60% of the world's diamond output is purchased for resale by DeBeers Centenary AG and its affiliated companies. Although DeBeers has historically been one of the Company's major suppliers of rough diamonds, the Company has successfully diversified its sources of supply by entering into arrangements with other primary source suppliers and has been able to supplement its rough diamond needs by purchasing supplies in the secondary market. While the Company believes that it has good relationships with its suppliers and that its sources of supply are sufficient to meet its present and foreseeable needs, the Company's rough diamond supplies, and therefore, its manufacturing capacity, could be adversely affected by political and economic developments in producing countries over which it has no control. While the Company believes that alternative sources of supply may be available, any significant disruption of the 17 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 Company's access to its primary source suppliers could have a material adverse effect on its ability to purchase rough diamonds. Further, through its control of the world's diamond output, DeBeers can exert significant control over the pricing of rough and polished diamonds. A large rapid increase in rough diamond prices could materially adversely affect the Company's revenue and operating margins if the increased cost of the rough diamonds could not be passed along to its customers in a timely manner. Alternatively, any rapid decrease in the price of polished diamonds could have a material adverse affect on the Company in terms of inventory losses and lower margins. n. Stock Incentive Plans The Company accounts for its stock-based compensation plans using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25 'Accounting for Stock Issued to Employees' and related interpretations and makes certain pro forma disclosures (see Note 9). o. Comprehensive Income/(Loss) As of June 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, 'Reporting Comprehensive Income' (SFAS 130). SFAS 130 establishes new rules for the reporting and display of comprehensive income and its components; however, the adoption of SFAS 130 had no impact on the Company's net income/(loss) or stockholders' equity. SFAS 130 requires foreign currency translation adjustments to be included in other comprehensive income. For the year ended May 31, 1999, total comprehensive loss was $6,279,000. p. New Accounting Pronouncements In April 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 98-5, 'Reporting on the Costs of Start-Up Activities'. The SOP broadly defines start-up costs as those one-time activities related to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer, initiating a new process in an existing facility or commencing some new operation. The Company is required to adopt the new standard on June 1, 1999. The SOP requires that start-up costs capitalized prior to adoption be written off as a cumulative effect of a change in accounting principle and any future start-up costs be expensed as incurred. Management expects the adoption of the SOP to result in a charge of approximately $1,750,000 (net of tax) in the first quarter of fiscal year May 31, 2000. This amount is primarily comprised of a) the start-up expenses related to the operations of the Company's newly formed, wholly owned subsidiary, Pegasus Overseas Ltd. and the signing and implementation of its ten year agreement with a wholly owned subsidiary of General Electric Company, and b) the start-up expenses related to the signing and implementation of the March 1999 Cooperation Agreement with AK Almazi Rossii Sakha of Russia. 2. PROPERTY, PLANT AND EQUIPMENT - ------------------------------------------------------------- Property, plant and equipment consists of (in thousands):
May 31, - -------------------------------------------- 1999 1998 - -------------------------------------------- ----------------- Land and buildings $ 2,436 $ 1,526 Leasehold improvements 2,107 1,883 Machinery, tools and equipment 4,247 4,275 Furniture and fixtures 1,850 1,113 Computer hardware and equipment 2,093 1,973 Construction in progress 3,393 1,278 - -------------------------------------------- 16,126 12,048 Less accumulated depreciation and amortization 7,975 7,314 - -------------------------------------------- $ 8,151 $ 4,734 - -------------------------------------------- ----------------- Depreciation and amortization rates: - -------------------------------------------- Buildings 2 TO 3.7% Leasehold improvements 3.7 TO 20% Machinery, tools and equipment 10 TO 25% Furniture and fixtures 10 TO 20% Computer hardware and equipment 10 TO 33% - --------------------------------------------
18 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 Depreciation expense for 1999, 1998 and 1997 was $727,000, $1,082,000 and $1,252,000, respectively. 3. INCOME TAXES - --------------------------------------------------------- The items comprising the Company's net deferred tax assets are as follows (in thousands):
May 31, - ----------------------------------------------- 1999 1998 - ----------------------------------------------- ----------------- Deferred tax assets: Operating loss and other carryforwards $ 9,100 $ 4,350 Other 650 700 Deferred tax liabilities: Depreciation 50 150 - ----------------------------------------------- 9,700 4,900 Less: Valuation allowance (585) (1,265) - ----------------------------------------------- Net deferred tax assets $ 9,115 $ 3,635 - ----------------------------------------------- -----------------
The income tax provision/(benefit) is comprised of the following (in thousands):
Year ended May 31, - ------------------------------------------------ 1999 1998 1997 - ------------------------------------------------ ------------------------- Current: Federal $ - $ 20 $ 192 State and local 28 24 88 Foreign - 633 125 - ------------------------------------------------ 28 677 405 Deferred: Federal, state and local (5,280) (260) (3,375) - ------------------------------------------------ $(5,252) $ 471 $(2,970) - ------------------------------------------------ -------------------------
Income/(loss) before income taxes from the Company's domestic and foreign operations was ($11,102,000) and ($473,000), respectively for the year ended May 31, 1999, $3,615,000 and ($1,320,000), respectively for the year ended May 31, 1998 and $9,224,000 and ($976,000), respectively for the year ended May 31, 1997. The tax provision/(benefit) is different from amounts computed by applying the Federal income tax rate to the income before taxes as follows (in thousands):
- ------------------------------------------------ 1999 1998 1997 - ------------------------------------------------ ------------------------- Tax provision/ (benefit) at statutory rate $(3,936) $ 780 $ 2,594 (Decrease)/increase in taxes resulting from: Differential attributable to foreign operations (58) 149 698 State and local taxes, net of Federal benefit (578) 8 58 Utilization of net operating loss carryforwards - - (2,945) Change in valuation allowance for deferred tax asset (680) (520) (3,375) - ------------------------------------------------ Actual tax provision/(benefit) $(5,252) $ 417 $(2,970) - ------------------------------------------------ -------------------------
The Company has available Federal net operating losses to offset future taxable income which expire as follows (in thousands):
Net Operating Year Losses - --------------------------------------------- ------- 2000 $ 2,000 2001 3,500 2002 500 2007 500 2008 900 2010 400 2013 1,200 2019 11,350 - --------------------------------------------- $20,350 - --------------------------------------------- -------
In addition, the Company has New York State and New York City net operating loss carryforwards of approximately $12,600,000 each, expiring from 2000 to 2014. The Company has Puerto Rico net operating loss carryforwards of approximately $2,000,000 expiring from 2000 through 2005. 19 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 During 1999, the Internal Revenue Service (IRS) completed an examination of the Company's consolidated Federal income tax returns for the taxable years ended May 31, 1995 through 1997 and made no adjustments to those returns as filed. During 1998, the IRS completed an examination of the Company's consolidated Federal income tax returns for the taxable years ended May 31, 1991 through 1994 during which it made an adjustment to the Company's net operating loss carryforwards in an amount of approximately $2.0 million. The tax paid by the Company as a result of these examinations was insignificant. 4. ACCOUNTS PAYABLE AND OTHER CURRENT LIABILITIES - --------------------------------------------------------- Accounts payable and other current liabilities consist of (in thousands):
1999 1998 - -------------------------------------------- ----------------- Accounts payable $13,109 $ 9,816 Accrued expenses 12,077 15,344 - -------------------------------------------- $25,186 $25,160 - -------------------------------------------- -----------------
5. LINES OF CREDIT - --------------------------------------------------------- On May 14, 1996 the Company entered into a long-term unsecured, revolving loan agreement with two banks. The agreement, as amended, provides that the Company may borrow up to $40,000,000 in the aggregate, at an interest rate of any of a) one-eighth of one percent above the bank's prime rate, b) 160 basis points above the London Interbank Offered Rate (LIBOR), or c) 160 basis points above the bank's cost of funds rate. The applicable interest rate is contingent upon the method of borrowing selected by the Company. The term of the loan is through September 1, 2002. The proceeds of this facility are available for the Company's working capital needs and to fund its future annual installments due under the Senior Note Agreement. The revolving loan agreement contains certain provisions that require, among other things, (a) maintenance of defined levels of current working capital and annual cash flow, (b) limitations of borrowing levels, capital expenditures, and rental obligations and (c) limitations on restricted payments, including the amount of dividends. The Company was not in compliance with the cash flow covenant and the capital expenditure covenant under the revolving loan agreement for the years ended May 31, 1999 and 1998. The banks have given a waiver to the Company with respect to these covenants for the year ended May 31, 1999. In addition, the banks have amended the cash flow covenant for the August 31, 1999, November 30, 1999 and February 29, 2000 measurement periods, and have amended the capital expenditure covenant for all future measurement periods. The banks had given a waiver to the Company with respect to these covenants for the year ended May 31, 1998 and amended such covenants for the fiscal 1999 measurement periods. As of May 31, 1999 and 1998 there was an aggregate balance outstanding of $32,158,000 and $10,700,000, respectively, under this agreement. The weighted average interest rate during 1999 and 1998 on the Company's revolving loan was 6.96% and 7.56%, respectively. 6. SENIOR NOTES AND OTHER LONG-TERM DEBT - --------------------------------------------------------- In May 1991, the Company, through a private placement, issued $30,000,000 of unsecured 9.97% Senior Notes, due May 15, 2001. Interest is payable semi-annually every May 15 and November 15. Repayments of $4,285,000 annually commenced on May 15, 1995 and end in 2000 with the remaining principal of $4,290,000 payable on May 15, 2001. As of May 31, 1999 and 1998, the balance of Senior Notes outstanding was $8,575,000 and $12,860,000, respectively. Provisions of the Senior Notes require, among other things, (a) maintenance of defined levels of consolidated tangible net worth and current working capital, (b) limitation of borrowing levels and (c) limitations on restricted payments, including the amount of dividends. Under the provisions of the Senior Notes, the Company is permitted to declare dividends subject to certain limitations set forth in the Senior Note Agreement. The Company was not in compliance with the requirements of the consolidated fixed charge ratio for the year ended May 31, 1999. The Senior Notes were amended in August 1999 to eliminate the requirements of the consolidated fixed charge ratio retroactively for the fiscal quarter ending 20 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 May 31, 1999, to waive compliance with the consolidated fixed charge ratio for the fiscal quarters ending August 31 and November 30, 1999, and to revise the consolidated fixed charge ratio for the fiscal quarter ending February 29, 2000. 7. COSTS ASSOCIATED WITH REALIGNMENT OF JAPANESE DISTRIBUTION - --------------------------------------------------------- After working with its former distributor of over 25 years, in 1999, the Company changed the nature of its distribution in Japan by assuming control of the distribution of its products and opening its own office. In this way, the Company has realigned its position with its retail and wholesale customers and shortened its channels of distribution. In addition, this realignment has enabled the Company, without interruption, to assume control of the expansion and maintenance of the Lazare Diamond brand name in Japan. As part of the realignment, the Company retained experienced Japanese staff, giving it immediate and direct access to important customers as well as in depth industry knowledge. The Company believes that this realignment was necessary in order to compete effectively in Japan (the world's second largest market for diamonds and diamond jewelry) in the years to come. As a result, the Company recorded a one-time, non-recurring charge of approximately $5.6 million ($3.4 million, net of tax) in 1999. 8. SALE OF INTEREST IN LAZARE KAPLAN BOTSWANA (PTY) LTD. - --------------------------------------------------------- In March 1998, the Company completed the sale of its 60% interest in Lazare Kaplan Botswana (Pty) Ltd. for a price of $11.1 million in cash and recorded a gain of approximately $3.7 million on the transaction (net of $485,000 of Botswana taxes). Through March 1998, the Company consolidated the accounts of Lazare Kaplan Botswana (Pty) Ltd. Minority interest represents the minority stockholders' proportionate share of the results of operations and equity of Lazare Kaplan Botswana (Pty) Ltd. through the date of the sale of the Company's interest. 9. STOCK INCENTIVE PLANS - --------------------------------------------------------- A Stock Option Incentive Plan was approved by the Board of Directors on March 11, 1988 (the 1988 Plan). The 1988 Plan has reserved 650,000 shares of the common stock of the Company for issuance to key employees of the Company and its subsidiaries. No future grants may be made under the 1988 Plan, although options may continue to be exercised. A Long-Term Stock Incentive Plan was approved by the Board of Directors on April 10, 1997 (the 1997 Plan). The 1997 Plan has reserved 400,000 shares of the common stock of the Company for issuance to key employees of the Company and its subsidiaries. An increase to 600,000 shares reserved for issuance under the 1997 Plan was approved by the Board of Directors on August 5, 1999 and is subject to stockholder approval at the 1999 Annual Meeting. The purchase price of each share of common stock subject to an incentive option under each of the plans is not to be less than 100 percent of the fair market value of the stock on the day preceding the day the option is granted (110 percent for 10 percent beneficial owners). The Stock Option Committee determines the period or periods of time during which an option may be exercised by the participant and the number of shares as to which the option is exercisable during such period or periods, provided that the option period shall not extend beyond ten years (five years in the case of 10 percent beneficial owners) from the date the option is granted. The Company does not recognize compensation expense when the exercise price of the Company's stock options equals the market price of the underlying stock on the date of the grant. Under Statement of Financial Accounting Standards No. 123 'Accounting for Stock-Based Compensation', pro forma information regarding net income and earnings per share is required as if the Company had accounted for its employee stock options under the fair value method of the Statement. For purposes of pro forma disclosures, the Company estimated the fair value of stock options granted in 1999, 1998 and 1997 at the date of the grant using the Black-Scholes option pricing model. The estimated fair value of the options is amortized as 21 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 an expense over the options' vesting period for the pro forma disclosures. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The following summarizes the assumptions used to estimate the fair value of stock options granted in each year and certain pro forma information: - ------------------------------------------------ 1999 1998 1997 - ------------------------------------------------ ------------------------- Risk-free interest rate 6.00% 6.00% 6.00% Expected option life 5 YEARS 5 years 5 years Expected volatility 37.30% 35.70% 35.90% Expected dividends per share $ 0.00 $ 0.00 $ 0.00 Weighted average estimated fair value per share of options granted at market price $ 3.13 $ 4.30 $ 6.13 Weighted average estimated fair value per share of options granted above market price -- $ 3.94 $ 5.62 Pro forma net income/(loss) (000's) $(7,103) $2,042 $11,312 Pro forma basic earnings/(loss) per share $(0.84) $ 0.24 $ 1.58 Pro forma diluted earnings/(loss) per share $(0.84) $ 0.24 $ 1.52 - ------------------------------------------------ -------------------------
As any options granted in the future will also be subject to the fair value pro forma calculations, the pro forma adjustments for 1999, 1998 and 1997 may not be indicative of future years. A summary of the Plans' activity for each of the three years in the period ended May 31, 1999 is as follows:
Weighted average price Number per of shares Option price share - ----------------------------------------------------------------- --------------------------------------- Outstanding -- June 1, 1996 550,398 $ 5.000-$ 7.625 $ 6.126 Options issued 224,250 $14.750-$ 16.225 $14.882 Options exercised (116,141) $ 5.000-$ 7.625 $ 6.130 - ----------------------------------------------------------------- Outstanding -- May 31, 1997 658,507 $ 5.000-$ 16.225 $ 9.107 Options expired (600) $ 5.000-$ 5.000 $ 5.000 Options issued 169,050 $10.375-$11.4125 $10.498 Options exercised (191,633) $ 5.000-$ 6.6000 $ 5.872 - ----------------------------------------------------------------- Outstanding -- May 31, 1998 635,324 $ 5.125-$ 16.225 $10.456 Options expired (8,834) $ 6.375-$ 7.625 $ 7.578 Options issued 6,500 $ 7.375-$ 7.375 $ 7.375 Options exercised (5,666) $ 6.000-$ 6.375 $ 6.044 - ----------------------------------------------------------------- Outstanding -- May 31, 1999 627,324 $ 5.125-$ 16.225 $10.505 - ----------------------------------------------------------------- --------------------------------------- Exercisable options 433,374 - ----------------------------------------------------------------- --------
The following table summarizes information about stock options at May 31, 1999:
Exercisable stock Outstanding stock options options - --------------------------------------- ------------------ Weighted average Weighted remaining average contractual exercise Range of prices Shares life Shares price - ------------------------------------------------------------ - ------------------------------------------------------------ $ 5.125-$ 6.375 161,081 4.64 years 161,081 $ 5.917 $7.0125-$ 7.625 72,943 6.37 years 66,443 $ 7.178 $10.375-$11.4125 169,050 8.04 years 56,350 $10.498 $14.750-$ 16.225 224,250 7.43 years 149,500 $14.882 - ------------------------------------------------------------
10. COMMITMENTS AND CONTINGENCIES - --------------------------------------------------------- Future minimum payments (excluding sub-lease income) under noncancelable operating leases with 22 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 initial terms of more than one year consist of the following at May 31, 1999 (in thousands):
Operating Year leases - -------------------------------------------- ------ 2000 $ 507 2001 354 2002 317 2003 317 2004 93 Thereafter 0 - -------------------------------------------- $1,588 - -------------------------------------------- ------
Rental expense, including additional charges paid for increases in real estate taxes and other escalation charges and credits for the years ended May 31, 1999, 1998 and 1997, was approximately $542,000, $422,000 and $425,000, respectively. On or about April 13, 1999, International Diamond Traders CY B.V.B.A. ('IDT') and Avi Neumark ('Neumark'), the President and controlling stockholder of IDT, commenced an action in the U.S. District Court for the Southern District of New York against the Company, Lazare Kaplan Belgium, N.V., a subsidiary of the Company ('LKB'), and Maurice Tempelsman, Leon Tempelsman and Sheldon Ginsberg, each of whom is a director and officer of the Company and a director of LKB. The plaintiffs subsequently amended their complaints to eliminate LKB and Mr. Ginsberg as defendants. The plaintiffs alleged, among other things, that the Company and its principals fraudulently induced IDT to make more than $1.75 million in payments to the Company in connection with an alleged 'joint venture' for the purchase of rough diamonds, excluded IDT from this relationship and expropriated its interest, defamed the plaintiffs, causing injury to their business reputation and interfered with plaintiffs' business prospects. The plaintiffs are seeking damages of $1.75 million, together with interest, general, consequential and other damages in an unspecified amount and punitive damages. The plaintiffs further seek the value of half of the alleged profits since September 1998, the date at which the relationship was allegedly wrongfully terminated. In addition, the plaintiffs allege that the Company's Quarterly Report on Form 10-Q for the quarter ended November 30, 1998 inaccurately includes all of the sales of the Company's Angolan operations. The Company believes that the plaintiffs' allegations are without merit and is vigorously defending this action. In a related matter, on or about April 13, 1999, Novel Diamonds Inc. ('Novel') and Lexco Limited ('Lexco') submitted a demand for arbitration to the International Chamber of Commerce naming as respondents, the Company, Lazare Kaplan (Bermuda) Ltd., a wholly-owned subsidiary of the Company, LKN Diamond Company, LTD. ('LKN') and Sheldon Ginsberg. Each of the claimants is controlled by Neumark. The claimants have alleged, among other things, that the respondents are in breach of their obligations to transfer the Company's 'rough diamond trading sight' (the 'sight') to LKN as was allegedly required by a 1994 shareholders agreement and have improperly barred claimants and Mr. Neumark from access to the 'sight' business. As a result of the foregoing, the claimants are seeking damages of $5 million and at least 50% of the profits from the 'sight' business since September 1998, plus interest, and 50% of the net asset value of LKN, including the 'sight'. The Company believes that the claimants' allegations are without merit and is vigorously defending this action. The two above actions followed the institution, earlier in 1999, of an arbitration proceeding jointly submitted by Neumark, IDT and the Company. This matter was voluntarily submitted to arbitration by Neumark, IDT and the Company to resolve all monetary disputes between the parties as a result of the termination of their relationship, except for those that are the subject of the foregoing actions. All matters submitted to arbitration have been substantially resolved with the exception of the following (i) whether there is any goodwill arising from the alleged relationship in Angola, and (ii) if goodwill exists, the value of such goodwill and the amount of the payment, if any, to be made. The Company believes that such claim for goodwill is without merit and is vigorously defending its position that no payment for goodwill is appropriate. 23 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 If the opposing parties are successful in some or all of above related proceedings, the Company's business could be materially and adversely affected. In addition, Neumark has commenced an action in Delaware Chancery Court against the Company seeking the right to inspect, and make copies of, certain books and records of the Company and LKB. 11. PROFIT SHARING PLAN - --------------------------------------------------------- The Company has a profit sharing and retirement plan subject to Section 401(k) of the Internal Revenue Code. The plan covers all full-time employees in the United States and Puerto Rico who complete at least one year of service. Participants may contribute up to a defined percentage of their annual compensation through salary deductions. The Company intends to match employee contributions in an amount equal to $0.50 for every pretax dollar contributed by the employee up to 6% of the first $20,000 of compensation, provided the Company's pretax earnings for the fiscal year that ends in the plan year exceed $3,500,000. During 1998 and 1997 the Company contributed approximately $45,000 and $40,100 for calendar years 1997 and 1996, respectively. The Company did not make a matching contribution during 1999 for calendar year 1998. 24 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 12. GEOGRAPHIC SEGMENT INFORMATION - --------------------------------------------------------- Revenue, gross profit and income/(loss) before income tax provision and minority interest for each of the three years in the period ended May 31, 1999 and identifiable assets at the end of each of those years, classified by geographic area, which was determined by where sales originated from and where identifiable assets are held, were as follows (in thousands):
NORTH ELIMI- CONSOLI- AMERICA EUROPE AFRICA FAR EAST NATIONS DATED - --------------------------------------------------------------------------------------------------- ---------------------------------------------------------------- Year ended May 31, 1999 Net sales to unaffiliated customers $113,017 $ 98,339 $ 36,206 $14,291 $ - $261,853 Transfers between geographic areas 22,798 9,432 70,913 - (103,143) - ---------------------------------------------------------------- Total revenue $135,815 $107,771 $107,119 $14,291 $(103,143) $261,853 ---------------------------------------------------------------- Gross profit/(loss) $ 11,791 $ 689 $ (3,001) $ 2,692 $ (353) $ 11,818 ---------------------------------------------------------------- Income/(loss) from continuing operations before income tax provision and minority interest $ (7,361) $ (96) $ (3,713) $ (52) $ (353) $(11,575) ---------------------------------------------------------------- Identifiable assets at May 31, 1999 $145,493 $ 22,602 $ 34,096 $ 9,719 $ (59,997) $151,913 - --------------------------------------------------------------------------------------------------- ---------------------------------------------------------------- Year ended May 31, 1998 Net sales to unaffiliated customers $107,298 $ 66,401 $ 48,918 $ - $ - $222,617 Transfers between geographic areas 14,460 15,725 52,371 - (82,556) - ---------------------------------------------------------------- Total revenue $121,758 $ 82,126 $101,289 $ - $ (82,556) $222,617 ---------------------------------------------------------------- Gross profit $ 11,814 $ 1,016 $ 4,316 $ - $ (3,246) $ 13,900 ---------------------------------------------------------------- Income/(loss) from continuing operations before income tax provision and minority interest $ 2,211 $ 510 $ (608) $ - $ 182 $ 2,295 ---------------------------------------------------------------- Identifiable assets at May 31, 1998 $128,549 $ 14,834 $ 23,051 $ - $ (24,104) $142,330 - --------------------------------------------------------------------------------------------------- ---------------------------------------------------------------- Year ended May 31, 1997 Net sales to unaffiliated customers $164,109 $ 54,144 $ 41,544 $ - $ - $259,797 Transfers between geographic areas 19,483 12,674 20,213 - (52,370) - ---------------------------------------------------------------- Total revenue $183,592 $ 66,818 $ 61,757 $ - $ (52,370) $259,797 ---------------------------------------------------------------- Gross profit $ 20,159 $ 767 $ 6,019 $ - $ (3,219) $ 23,726 ---------------------------------------------------------------- Income from continuing operations before income tax provision and minority interest $ 6,750 $ 246 $ 820 $ - $ 432 $ 8,248 ---------------------------------------------------------------- Identifiable assets at May 31, 1997 $122,351 $ 10,422 $ 26,653 $ - $ (29,347) $130,079 - --------------------------------------------------------------------------------------------------- ----------------------------------------------------------------
The identifiable assets which are included in the eliminations primarily represent advances to affiliates. These advances are included therein since the Company, which is the parent company, finances the operations of these affiliates. 25 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended May 31, 1999, 1998 and 1997 Revenue and gross profit for each of the three years in the period ended May 31, 1999 classified by product were as follows (in thousands):
POLISHED ROUGH TOTAL - -------------------------------------------------------------------------------------------- ------------------------------ Year ended May 31, 1999 Net sales $112,573 $149,280 $261,853 ------------------------------ Gross profit/(loss) $ 14,415 $ (2,597) $ 11,818 - -------------------------------------------------------------------------------------------- ------------------------------ Year ended May 31, 1998 Net sales $ 84,058 $138,559 $222,617 ------------------------------ Gross profit $ 9,369 $ 4,531 $ 13,900 - -------------------------------------------------------------------------------------------- ------------------------------ Year ended May 31, 1997 Net sales $ 95,154 $164,643 $259,797 ------------------------------ Gross profit $ 16,560 $ 7,166 $ 23,726 - -------------------------------------------------------------------------------------------- ------------------------------
13. DISCONTINUED OPERATION - --------------------------------------------------------- During the fourth quarter of 1997 the Company discontinued its efforts to organize and participate in the privatization of the mining of the Akwatia and Birim deposits owned and operated by Ghana Consolidated Diamonds Ltd., in Ghana. The write-off of unamortized costs (net of tax benefit of $13,000) was $618,000. 14. TREASURY STOCK - --------------------------------------------------------- The Board of Directors authorized the repurchase, at management's discretion, of up to 500,000 shares of the Company's common stock from time to time through March 22, 2000. During 1999 and 1998 the Company purchased 165,150 and 2,000 shares, respectively, of its common stock which are shown as a reduction of stockholders' equity in the accompanying balance sheets. 15. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) - -------------------------------------------------------------------------------- The following is a summary of the results of operations for the years ended May 31, 1999 and 1998 (in thousands, except per share data):
QUARTER - ------------------------------------------------------------------------------------------------ FIRST SECOND THIRD FOURTH - ------------------------------------------------------------------------------------------------ ------------------------------------- 1999 Net sales $68,844 $74,705 $47,045 $71,259 Gross profit $ 3,193 $ 3,743 $ 3,863 $ 1,019 Net income/(loss) $ (547) $ (627) $ 263 $(5,412)(1) Basic earnings/(loss) per share $ (0.06) $ (0.07) $ 0.03 $ (0.64) Diluted earnings/(loss) per share $ (0.06) $ (0.07) $ 0.03 $ (0.64) 1998 Net sales $45,245 $46,848 $60,627 $69,897 Gross profit $ 2,552 $ 4,160 $ 3,667 $ 3,521 Net income/(loss) $ (659) $ 205 $ 45 $ 3,133(2) Basic earnings/(loss) per share $ (0.08) $ 0.02 $ 0.01 $ 0.37 Diluted earnings/(loss) per share $ (0.08) $ 0.02 $ 0.01 $ 0.36
(1) Includes $2.8 million of losses incurred in the Company's rough diamond buying operations in Angola and $3.4 million of costs associated with the realignment of the Company's Japanese distribution. (2) Includes $3.7 million gain associated with the sale of the Company's interest in Lazare Kaplan Botswana (Pty) Ltd. 26 [LAZARE KAPLAN LOGO] - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders Lazare Kaplan International Inc. We have audited the accompanying consolidated balance sheets of Lazare Kaplan International Inc. and subsidiaries as of May 31, 1999 and 1998 and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended May 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lazare Kaplan International Inc. and subsidiaries at May 31, 1999 and 1998 and the consolidated results of their operations and their cash flows for each of the three years in the period ended May 31, 1999 in conformity with generally accepted accounting principles. ERNST & YOUNG LLP August 25, 1999 New York, New York 27 [LAZARE KAPLAN LOGO] LAZARE KAPLAN INTERNATIONAL INC. AND SUBSIDIARIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CORPORATE INFORMATION CORPORATE HEADQUARTERS DIRECTORS AND OFFICERS REGISTRAR AND TRANSFER 529 Fifth Avenue AGENT New York, New York 10017 Maurice Tempelsman Telephone (212) 972-9700 Director; ChaseMellon Transfer Chairman of the Board Services, LLC 85 Challenger Road Leon Tempelsman Overpeck Center Director; Ridgefield Park, NJ 07660 Vice Chairman of the Board and President COUNSEL Lucien Burstein Warshaw Burstein Cohen Director; Schlesinger & Kuh, LLP Secretary 555 Fifth Avenue Partner New York, New York 10017 Warshaw Burstein Cohen Schlesinger & Kuh, LLP INDEPENDENT AUDITORS (attorneys) Ernst & Young LLP Myer Feldman 787 Seventh Avenue Director; New York, New York 10019 Attorney Sheldon L. Ginsberg Director; Executive Vice President and Chief Financial Officer Robert Speisman Director; Senior Vice President - Sales
28 [LAZARE KAPLAN LOGO] - ------------------------------------------------------------------------------ - ------------------------------------------------------------------------------ LAZARE KAPLAN INTERNATIONAL INC., 529 FIFTH AVENUE, NEW YORK, NY 10017 (212) 972-9700 EX-21 5 EXHIBIT 21 LIST OF SUBSIDIARIES OF LAZARE KAPLAN INTERNATIONAL INC.
NAME ORGANIZED UNDER LAWS OF Lazare Kaplan Europe Inc. Delaware Lazare Kaplan Belgium, N.V. Belgium Lazare Kaplan Japan Inc. (Tokyo Branch) Japan Pegasus Overseas Ltd. Bahamas Pegasus Overseas LLC Delaware POCL Bvba Belgium
EX-23 6 EXHIBIT 23 REPORT AND CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of Lazare Kaplan International Inc. of our report dated August 25, 1999 included in the 1999 Annual Report to Stockholders of Lazare Kaplan International Inc. Our audits also included the financial statement schedule of Lazare Kaplan International Inc. listed in Item 14(a)2. This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in 1) Registration Statement (Form S-8, No. 33-20528), Registration Statement (Form S-8, No. 33-37617) and Registration Statement (Form S-8, No. 33-57560), each of which relate to the Lazare Kaplan International Inc. 1988 Stock Option Incentive Plan, 2) Registration Statement (Form S-8, No. 333-40225), which relates to the Lazare Kaplan International Inc. 1997 Long Term Stock Incentive Plan, and 3) Post-Effective Amendment No. 1 to Registration Statement (Form S-8, No. 333-52303), which relates to the Lazare Kaplan International Inc. 401(k) Plan for Savings and Investment of our report dated August 25, 1999 with respect to the consolidated financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the financial statement schedule included in this Annual Report. ERNST & YOUNG LLP New York, New York August 27, 1999 EX-27 7 EXHIBIT 27
5 The Schedule contains summary financial information extracted from the balance sheet and income statement and is qualified in its entirety by reference to such financial statements. 1,000 12-MOS MAY-31-1999 MAY-31-1999 5,181 0 33,104 202 81,354 141,640 16,126 7,975 151,963 27,344 38,575 8,535 0 0 77,459 151,963 261,853 261,853 250,035 250,035 15,103 0 2,702 (11,575) (5,252) (6,323) 0 0 0 (6,323) (0.74) (0.74)
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