10-Q 1 y97193e10vq.txt HANOVER DIRECT, INC. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended MARCH 27, 2004 Commission file number 1-08056 HANOVER DIRECT, INC. ----------------------------------------------------- (Exact name of registrant as specified in its charter) DELAWARE 13-0853260 ------------------------ --------------------------------- (State of incorporation) (IRS Employer Identification No.) 115 RIVER ROAD, BUILDING 10, EDGEWATER, NEW JERSEY 07020 -------------------------------------------------- ------------- (Address of principal executive offices) (Zip Code) (201) 863-7300 -------------- (Telephone number) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [ ] NO [X] Common stock, par value $.66 2/3 per share: 220,173,633 shares outstanding (net of treasury shares) as of May 3, 2004. HANOVER DIRECT, INC. TABLE OF CONTENTS
Page ---- Part I - Financial Information Item 1. Financial Statements Condensed Consolidated Balance Sheets - March 27, 2004 and December 27, 2003 ............................................... 2 Condensed Consolidated Statements of Income (Loss) - 13- weeks ended March 27, 2004 and March 29, 2003 .................................................. 4 Condensed Consolidated Statements of Cash Flows - 13- weeks ended March 27, 2004 and March 29, 2003................................................... 5 Notes to Condensed Consolidated Financial Statements.................................. 6 Item 2. Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations............................................................... 18 Item 3. Quantitative and Qualitative Disclosures about Market Risk...................... 27 Item 4. Controls and Procedures......................................................... 27 Part II - Other Information Item 1. Legal Proceedings............................................................... 28 Item 5. Other Information............................................................... 32 Item 6. Exhibits and Reports on Form 8-K................................................ 33 Signatures............................................................................... 34
1 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS HANOVER DIRECT, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS OF DOLLARS, EXCEPT SHARE AMOUNTS)
MARCH 27, DECEMBER 27, 2004 2003 ----------- ------------ (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 2,434 $ 2,282 Accounts receivable, net of allowance for doubtful accounts of $1,069 and $1,105, respectively 12,614 14,335 Inventories 37,646 41,576 Prepaid catalog costs 15,305 11,808 Other current assets 3,294 3,951 --------- --------- Total Current Assets 71,293 73,952 --------- --------- PROPERTY AND EQUIPMENT, AT COST: Land 4,361 4,361 Buildings and building improvements 18,210 18,210 Leasehold improvements 10,108 10,108 Furniture, fixtures and equipment 53,331 53,212 --------- --------- 86,010 85,891 Accumulated depreciation and amortization (59,125) (58,113) --------- --------- Property and equipment, net 26,885 27,778 --------- --------- Goodwill 9,278 9,278 Deferred tax assets 2,213 2,213 Other assets 1,742 1,575 --------- --------- Total Assets $ 111,411 $ 114,796 ========= =========
Continued on next page. 2 HANOVER DIRECT, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (CONTINUED) (IN THOUSANDS OF DOLLARS, EXCEPT SHARE AMOUNTS)
MARCH 27, DECEMBER 27, 2004 2003 ----------- ------------ (UNAUDITED) LIABILITIES AND SHAREHOLDERS' DEFICIENCY CURRENT LIABILITIES: Short-term debt and capital lease obligations $ 15,135 $ 13,468 Accounts payable 38,499 41,880 Accrued liabilities 11,997 12,918 Customer prepayments and credits 5,866 5,485 Deferred tax liability 2,213 2,213 --------- --------- Total Current Liabilities 73,710 75,964 --------- --------- NON-CURRENT LIABILITIES: Long-term debt 8,001 9,042 Series C Participating Preferred Stock, authorized, issued and outstanding 564,819 shares; liquidation preference of $56,482 72,689 72,689 Other 4,097 4,609 --------- --------- Total Non-current Liabilities 84,787 86,340 --------- --------- Total Liabilities 158,497 162,304 --------- --------- SHAREHOLDERS' DEFICIENCY: Common Stock, $0.66 2/3 par value, authorized 300,000,000 shares; 222,294,562 shares issued and 220,173,633 shares outstanding 148,197 148,197 Capital in excess of par value 302,436 302,432 Accumulated deficit (494,373) (494,791) --------- --------- (43,740) (44,162) --------- --------- Less: Treasury stock, at cost (2,120,929 shares) (2,996) (2,996) Notes receivable from sale of Common Stock (350) (350) --------- --------- Total Shareholders' Deficiency (47,086) (47,508) --------- --------- Total Liabilities and Shareholders' Deficiency $ 111,411 $ 114,796 ========= =========
See notes to Condensed Consolidated Financial Statements. 3 HANOVER DIRECT, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS) (IN THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
FOR THE 13- WEEKS ENDED --------------------------- MARCH 27, MARCH 29, 2004 2003 ---------- ---------- NET REVENUES $ 95,312 $ 102,474 ---------- ---------- OPERATING COSTS AND EXPENSES: Cost of sales and operating expenses 59,243 65,539 Special charges (income) (31) 277 Selling expenses 23,276 24,453 General and administrative expenses 10,367 11,278 Depreciation and amortization 1,012 1,183 ---------- ---------- 93,867 102,730 ---------- ---------- INCOME (LOSS) FROM OPERATIONS 1,445 (256) Gain on sale of Improvements -- 1,911 ---------- ---------- INCOME BEFORE INTEREST AND INCOME TAXES 1,445 1,655 Interest expense, net 922 1,448 ---------- ---------- INCOME BEFORE INCOME TAXES 523 207 Provision for Federal income taxes 63 -- Provision for state income taxes 42 15 ---------- ---------- NET INCOME AND COMPREHENSIVE INCOME 418 192 Preferred stock dividends -- 3,632 Earnings Applicable to Preferred Stock (1) -- ---------- ---------- NET INCOME (LOSS) APPLICABLE TO COMMON SHAREHOLDERS $ 417 $ (3,440) ========== ========== NET INCOME (LOSS) PER COMMON SHARE: Net income (loss) per common share - basic and diluted $ .00 $ (.02) ========== ========== Weighted average common shares outstanding - basic (thousands) 220,174 138,316 ========== ========== Weighted average common shares outstanding - diluted (thousands) 220,666 138,316 ========== ==========
See notes to Condensed Consolidated Financial Statements. 4 HANOVER DIRECT, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS OF DOLLARS) (UNAUDITED)
FOR THE 13- WEEKS ENDED --------------------------- MARCH 27, MARCH 29, 2004 2003 ---------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 418 $ 192 Adjustments to reconcile net income to net cash used by operating activities: Depreciation and amortization, including deferred fees 1,077 1,680 Provision for doubtful accounts 87 179 Special charges (income) (31) 277 Gain on the sale of Improvements -- (1,911) Gain on the sale of property and equipment -- (2) Compensation expense related to stock options 4 177 Changes in assets and liabilities: Accounts receivable 1,634 3,186 Inventories 3,930 (294) Prepaid catalog costs (3,497) (3,763) Accounts payable (3,381) 1,708 Accrued liabilities (890) (6,648) Customer prepayments and credits 381 2,178 Other, net (309) (455) ---------- ---------- Net cash used by operating activities (577) (3,496) ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisitions of property and equipment (119) (546) Proceeds from sale of Improvements -- 2,000 Costs related to the early release of escrow funds -- (89) Proceeds from disposal of property and equipment -- 2 ---------- ---------- Net cash (used) provided by investing activities (119) 1,367 ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Net borrowings under Congress revolving loan facility 1,759 5,270 Payments under Congress Tranche A term loan facility (498) (497) Payments under Congress Tranche B term loan facility (450) (450) Payments of long-term debt and capital lease obligations (185) (4) Payment of debt issuance costs (125) (34) Refund (payment) of estimated Richemont tax obligation on Series B Participating Preferred Stock accretion 347 (347) ---------- ---------- Net cash provided by financing activities 848 3,938 ---------- ---------- Net increase in cash and cash equivalents 152 1,809 Cash and cash equivalents at the beginning of the year 2,282 785 ---------- ---------- Cash and cash equivalents at the end of the period $ 2,434 $ 2,594 ========== ========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid for: Interest $ 733 $ 806 Income taxes $ 6 $ 196 Non-cash investing and financing activities: Series B Participating Preferred Stock redemption price increase $ -- $ 3,285
See notes to Condensed Consolidated Financial Statements. 5 HANOVER DIRECT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all information and footnotes necessary for a fair presentation of financial condition, results of operations and cash flows in conformity with generally accepted accounting principles. Reference should be made to the annual financial statements, including the footnotes thereto, included in the Hanover Direct, Inc. (the "Company") Annual Report on Form 10-K for the fiscal year ended December 27, 2003. In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements contain all material adjustments, consisting of normal recurring accruals, necessary to present fairly the financial condition, results of operations and cash flows of the Company and its consolidated subsidiaries for the interim periods. Operating results for interim periods are not necessarily indicative of the results that may be expected for the entire year. Pursuant to Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information," the consolidated operations of the Company are reported as one segment. Uses of Estimates and Other Critical Accounting Policies The condensed consolidated financial statements include all subsidiaries of the Company and all intercompany transactions and balances have been eliminated. The preparation of financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. See "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations," found in the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 2003, for additional information relating to the Company's use of estimates and other critical accounting policies. 2. DIVIDEND RESTRICTIONS The Company is restricted from paying dividends at any time on its Common Stock or from acquiring its capital stock by certain debt covenants contained in agreements to which the Company is a party. 3. NET INCOME (LOSS) PER COMMON SHARE Net income (loss) per common share is computed using the weighted average number of common shares outstanding in accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share" ("FAS 128"). Basic net income per common share is calculated by dividing net income available to common shareholders, reduced for participatory interests, by the weighted average number of common shares outstanding during the period. Diluted net income per common share is calculated using the weighted average number of common shares outstanding adjusted to include the potentially dilutive effect of convertible stock or stock options. The computations of basic and diluted net income (loss) per common share are as follows (in thousands): 6
MARCH 27, 2004 MARCH 29, 2003 -------------- -------------- Net income $ 418 $ 192 Preferred stock dividends -- (3,632) Earnings Applicable to preferred stock (1) -- --------- --------- Net income (loss) applicable to common shareholders $ 417 $ (3,440) ========= ========= Basic net income (loss) per common share $ 0.00 $ (0.02) ========= ========= Weighted-average common shares outstanding 220,174 138,316 ========= ========= Net income (loss) applicable to common shareholders $ 417 $ (3,440) Dilutive securities: Stock options -- -- --------- --------- Diluted net income (loss) $ 417 $ (3,440) ========= ========= Diluted net income (loss) per common share $ 0.00 $ (0.02) ========= ========= Weighted-average common shares outstanding 220,174 138,316 Effect of Dilution: Stock options 492 10 --------- --------- Weighted-average common shares outstanding assuming dilution 220,666 138,326 ========= =========
Diluted net income per common share excluded incremental shares of 3.9 million and 14.4 million for the periods ended March 27, 2004 and March 29, 2003, respectively, related to employee stock options due to their antidilutive effect. 4. COMMITMENTS AND CONTINGENCIES A class action lawsuit was commenced on March 3, 2000 entitled Edwin L. Martin v. Hanover Direct, Inc. and John Does 1 through 10, bearing case no. CJ2000-177 in the State Court of Oklahoma (District Court in and for Sequoyah County). Plaintiff commenced the action on behalf of himself and a class of persons who have at any time purchased a product from the Company and paid for an "insurance charge." The complaint sets forth claims for breach of contract, unjust enrichment, recovery of money paid absent consideration, fraud and a claim under the New Jersey Consumer Fraud Act. The complaint alleges that the Company charges its customers for delivery insurance even though, among other things, the Company's common carriers already provide insurance and the insurance charge provides no benefit to the Company's customers. Plaintiff also seeks a declaratory judgment as to the validity of the delivery insurance. The damages sought are (i) an order directing the Company to return to the plaintiff and class members the "unlawful revenue" derived from the insurance charges, (ii) declaring the rights of the parties, (iii) permanently enjoining the Company from imposing the insurance charge, (iv) awarding threefold damages of less than $75,000 per plaintiff and per class member, and (v) attorneys' fees and costs. On April 12, 2001, the Court held a hearing on plaintiff's class certification motion. Subsequent to the April 12, 2001 hearing on plaintiff's class certification motion, plaintiff filed a motion to amend the definition of the class. On July 23, 2001, plaintiff's class certification motion was granted, defining the class as "All persons in the United States who are customers of any catalog or catalog company owned by Hanover Direct, Inc. and who have at any time purchased a product from such company and paid money that was designated to be an insurance charge." On August 21, 2001, the Company filed an appeal of the order with the Oklahoma Supreme Court and subsequently moved to stay proceedings in the district court pending resolution of the appeal. The appeal has been fully briefed. At a subsequent status hearing, the parties agreed that issues pertaining to notice to the class would be stayed pending resolution of the appeal, that certain other issues would be subject to limited discovery, and that the issue of a stay for any remaining issues would be resolved if and when such issues arise. On January 20, 2004, the plaintiff filed a motion for oral argument with the Court. The Company believes it has defenses against the claims and plans to conduct a vigorous defense of this action. On August 15, 2001, the Company was served with a summons and four-count complaint filed in Superior Court for the City and County of San Francisco, California, entitled Teichman v. Hanover Direct, Inc., Hanover Brands, Inc., Hanover Direct Virginia, Inc., and Does 1-100. The complaint was filed by a California resident, seeking damages and other relief for herself and a class of all others similarly situated, arising out of the insurance fee charged by catalogs and Internet sites operated by subsidiaries of the Company. Defendants, including the Company, have filed motions to dismiss based on a lack of personal jurisdiction over them. In January 2002, plaintiff sought leave to name six additional entities: International Male, Domestications Kitchen & Garden, Silhouettes, Hanover Company Store, Kitchen & Home, and Domestications as co-defendants. On March 12, 2002, the Company was served with the First Amended Complaint in which plaintiff named as defendants the Company, Hanover Brands, Hanover Direct Virginia, LWI Holdings, Hanover Company Store, Kitchen and Home, and Silhouettes. On April 15, 2002, the Company filed a Motion to Stay the Teichman action in favor of the previously filed Martin action and also filed a Motion to quash service of summons 7 for lack of personal jurisdiction on behalf of defendants Hanover Direct, Inc., Hanover Brands, Inc. and Hanover Direct Virginia, Inc. On May 14, 2002, the Court (1) granted the Company's Motion to quash service on behalf of Hanover Direct, Hanover Brands, and Hanover Direct Virginia, leaving only LWI Holdings, Hanover Company Store, Kitchen & Home, and Silhouettes, as defendants, and (2) granted the Company's Motion to Stay the action in favor of the previously filed Oklahoma action, so nothing will proceed on this case against the remaining entities until the Oklahoma case is decided. The Company believes it has defenses against the claims. The Company plans to conduct a vigorous defense of this action. A class action lawsuit was commenced on February 13, 2002 entitled Jacq Wilson, suing on behalf of himself, all others similarly situated, and the general public v. Brawn of California, Inc. dba International Male and Undergear, and Does 1-100 ("Brawn") in the Superior Court of the State of California, City and County of San Francisco. Does 1-100 are Internet and catalog direct marketers offering a selection of men's clothing, sundries, and shoes who advertise within California and nationwide. The complaint alleges that for at least four years, members of the class have been charged an unlawful, unfair, and fraudulent insurance fee and tax on orders sent to them by Brawn; that Brawn was engaged in untrue, deceptive and misleading advertising in that it was not lawfully required or permitted to collect insurance, tax and sales tax from customers in California; and that Brawn has engaged in acts of unfair competition under the state's Business and Professions Code. Plaintiff and the class seek (i) restitution and disgorgement of all monies wrongfully collected and earned by Brawn, including interest and other gains made on account of these practices, including reimbursement in the amount of the insurance, tax and sales tax collected unlawfully, together with interest, (ii) an order enjoining Brawn from charging customers insurance and tax on its order forms and/or from charging tax on the delivery, shipping and insurance charges, (iii) an order directing Brawn to notify the California State Board of Equalization of the failure to pay the correct amount of tax to the state and to take appropriate steps to provide the state with the information needed for audit, and (iv) compensatory damages, attorney's fees, pre-judgment interest, and costs of the suit. The claims of the individually named plaintiff and for each member of the class amount to less than $75,000. On April 15, 2002, the Company filed a Motion to Stay the Wilson action in favor of the previously filed Martin action. On May 14, 2002, the Court denied the Motion to Stay. The Wilson case proceeded to trial before the Honorable Diane Elan Wick of the Superior Court of California for the County of San Francisco, and the Judge, sitting without a jury, heard evidence from April 15-17, 2003. On November 25, 2003, the Court, after hearing evidence and considering post-trial submissions from the parties, entered judgment in plaintiff's favor, requiring Brawn to refund insurance fees collected from consumers for the period from February 13, 1998 through January 15, 2003 with interest from the date paid by June 30, 2004. Plaintiff did not prevail on the tax issues. On January 12, 2004, plaintiff filed a motion requesting approximately $740,000 in attorneys' fees and costs. On February 27, 2004, the Company filed its response to that motion. Plaintiff filed a reply brief on March 13, 2004. A hearing was held on plaintiff's motion on March 18, 2004. The judge ruled on that motion on April 14, 2004, awarding plaintiff's counsel approximately $445,000. The Company has appealed the trial court's decision on the merits of the insurance fees issue as well as the decision on the attorneys' fees issue. The two appeals will likely be consolidated with briefing expected to begin in late May 2004. The Company will be required to post a bond in the amount of approximately $750,000 while the appeal of the attorneys' fees award is proceeding but its counsel does not believe the Company will be required to do so while the appeal on the insurance fees decision is proceeding. The Company plans to conduct a vigorous defense of this action. The potential estimated exposure is in the range of $0 to $4.0 million. Based upon the Company's policy of evaluating accruals for legal liabilities, the Company has not established a reserve due to management determining that it is not probable that an unfavorable outcome will result. A class action lawsuit was commenced on October 28, 2002 entitled John Morris, individually and on behalf of all other persons & entities similarly situated v. Hanover Direct, Inc., and Hanover Brands, Inc. (referred to here as "Hanover"), No. L 8830-02 in the Superior Court of New Jersey, Bergen County -- Law Division. The plaintiff brings the action individually and on behalf of a class of all persons and entities in New Jersey who purchased merchandise from Hanover within six years prior to filing of the lawsuit and continuing to the date of judgment. On the basis of a purchase made by plaintiff in August 2002 of certain clothing from Hanover (which was from a men's division catalog, the only ones which retained the insurance line item in 2002), Plaintiff claims that for at least six years, Hanover maintained a policy and practice of adding a charge for "insurance" to the orders it received and concealed and failed to disclose its policy with respect to all class members. Plaintiff claims that Hanover's conduct was (i) in violation of the New Jersey Consumer Fraud Act, as otherwise deceptive, misleading and unconscionable; (ii) such as to constitute Unjust Enrichment of Hanover at the expense and to the detriment of plaintiff and the class; and (iii) unconscionable per se under the Uniform Commercial Code for contracts related to the sale of goods. Plaintiff and the class seek damages equal to the amount of all insurance charges, interest thereon, treble and punitive damages, injunctive relief, costs and reasonable attorneys' fees, and such other relief as may be just, necessary, and appropriate. On December 13, 2002, the Company filed a Motion to Stay the Morris action in favor of the previously filed Martin action. Plaintiff then filed an Amended Complaint adding International Male as a defendant. Hearing on the Motion to Stay took place on June 5, 2003. The Court granted the Company's Motion to Stay the action and the case was stayed first until December 31, 2003 and subsequently until March 31, 2004. The stay was lifted on March 31, 2004. On April 30, 2004, the Company responded to plaintiff's Amended Complaint by filing a Motion for Summary Judgment that is currently scheduled to be heard by the Court on June 11, 2004. The Company plans to conduct a vigorous defense of this action. 8 On June 28, 2001, Rakesh K. Kaul, the former President and Chief Executive Officer of the Company, filed a five-count complaint (the "Complaint") in New York State Court against the Company, seeking damages and other relief arising out of his separation of employment from the Company, including severance payments of $2,531,352 plus the cost of employee benefits, attorneys' fees and costs incurred in connection with the enforcement of his rights under his employment agreement with the Company, payment of $298,650 for 13 weeks of accrued and unused vacation, damages in the amount of $3,583,800, or, in the alternative, a declaratory judgment from the court that he is entitled to all change of control benefits under the "Hanover Direct, Inc. Thirty-Six Month Salary Continuation Plan," and damages in the amount of $1,396,066 or $850,000 due to the Company's purported breach of the terms of the "Long-Term Incentive Plan for Rakesh K. Kaul" by failing to pay him a "tandem bonus" he alleges was due and payable to him within the 30 days following his resignation. The Company removed the case to the U.S. District Court for the Southern District of New York on July 25, 2001. Mr. Kaul filed an Amended Complaint ("Amended Complaint") in the U.S. District Court for the Southern District of New York on September 18, 2001. The Amended Complaint repeats many of the claims made in the original Complaint and adds ERISA claims. On October 11, 2001, the Company filed its Answer, Defenses and Counterclaims to the Amended Complaint, denying liability under each and every of Mr. Kaul's causes of action, challenging all substantive assertions, raising several defenses and stating nine counterclaims against Mr. Kaul. The counterclaims include (1) breach of contract; (2) breach of the Non-Competition and Confidentiality Agreement with the Company; (3) breach of fiduciary duty; (4) unfair competition; and (5) unjust enrichment. The Company seeks damages, including, without limitation, the $341,803 in severance pay and car allowance Mr. Kaul received following his resignation, $412,336 for amounts paid to Mr. Kaul for car allowance and related benefits, the cost of a long-term disability policy, and certain payments made to personal attorneys and consultants retained by Mr. Kaul during his employment, $43,847 for certain services the Company provided and certain expenses the Company incurred, relating to the renovation and leasing of office space occupied by Mr. Kaul's spouse at 115 River Road, Edgewater, New Jersey, the Company's current headquarters, $211,729 on a tax loan to Mr. Kaul outstanding since 1997 and interest, compensatory and punitive damages and attorneys' fees. The Company moved to amend its counterclaims, and the parties each moved for summary judgment. The Company sought summary judgment: dismissing Mr. Kaul's claim for severance under his employment agreement on the ground that he failed to provide the Company with a general release of, among other things, claims for change of control benefits; dismissing Mr. Kaul's claim for attorneys' fees on the grounds that they are not authorized under his employment agreement; dismissing Mr. Kaul's claims related to change in control benefits based on an administrative decision that he is not entitled to continued participation in the plan or to future benefits thereunder; dismissing Mr. Kaul's claim for a tandem bonus payment on the ground that no payment is owing; dismissing Mr. Kaul's claim for vacation payments based on Company policy regarding carry over vacation; and seeking judgment on the Company's counterclaim for unjust enrichment based on Mr. Kaul's failure to pay under a tax note. Mr. Kaul sought summary judgment: dismissing the Company's defenses and counterclaims relating to a release on the grounds that he tendered a release or that the Company is estopped from requiring him to do so; dismissing the Company's defenses and counterclaims relating to his alleged violations of his non-compete and confidentiality obligations on the grounds that he did not breach the obligations as defined in the agreement; and dismissing the Company's claims based on his alleged breach of fiduciary duty, including those based on his monthly car allowance payments and the leased space to his wife, on the grounds that he was entitled to the car payments and did not involve himself in or make misrepresentations in connection with the leased space. The Company concurrently moved to amend its Answer and Counterclaims to state a claim that it had cause for terminating Mr. Kaul's employment based on, among other things, after acquired evidence that Mr. Kaul received a monthly car allowance and other benefits totaling $412,336 that had not been authorized by the Company's Board of Directors and that his wife's lease and related expense was not properly authorized by the Company's Board of Directors, and to clarify or amend the scope of the Company's counterclaims for reimbursement. On January 7, 2004, the Court granted summary judgment in favor of the Company dismissing Mr. Kaul's claim for severance under his employment agreement on the grounds that he failed to provide the Company with a general release; granted in part the Company's motion for summary judgment on Mr. Kaul's claim for attorneys' fees, finding as a matter of law that Mr. Kaul is not entitled to fees incurred in prosecuting this lawsuit but finding an issue of fact as to the amount of reasonable fees he may have incurred in seeking advice and representation in connection with the termination of his employment; granted summary judgment in favor of the Company dismissing Mr. Kaul's claims related to change in control benefits on the grounds that Mr. Kaul's participation in the plan was properly terminated when his employment was terminated, the plan was properly terminated, and the administrator and appeals committee properly denied Mr. Kaul's claim; granted summary judgment in favor of the Company dismissing Mr. Kaul's claim for a tandem bonus payment on the ground that payment is not owed to him; granted summary judgment in part and denied summary judgment in part on Mr. Kaul's claims for vacation pay, deeming Mr. Kaul to have abandoned claims for vacation pay in excess of five weeks but finding him 9 entitled to four weeks vacation pay based on the Company's policy and finding an issue of fact as to Mr. Kaul's claim for an additional week of vacation pay in dispute for 2000; and denied summary judgment on the Company's counterclaim for payment under a tax note based on disputed issues of fact. The Court dismissed the Company's affirmative defenses as largely moot and the Court granted summary judgment in favor of Mr. Kaul dismissing the Company's counterclaims relating to his non-compete and confidentiality obligations on the grounds that there is no evidence of actual damage to the Company resulting from Mr. Kaul's alleged violations of those obligations; granted summary judgment in favor of Mr. Kaul on the Company's breach of contract and breach of fiduciary duty claims, including those based on his monthly car allowance payments and the leased space to his wife, on the grounds that he did not breach his fiduciary duties in accepting the car payments and would not be unjustly enriched if he kept them, and on the grounds that the Company would not be able to prove fraud in connection with the leased space based on the circumstances, including Mr. Kaul's disclosures. The Court denied in part and granted in part the Company's motion to amend its Answer and Counterclaims. The Court denied the Company's motion for leave to state a claim that it had acquired evidence of cause for terminating Mr. Kaul's employment based on certain reimbursements on the grounds that the payments were authorized, but granted the Company's motion with respect to its claim for reimbursement of amounts paid to the Internal Revenue Service ("IRS") on Mr. Kaul's behalf. The Opinion identifies three remaining issues in the case: (i) Mr. Kaul's claim for attorneys' fees pursuant to Section 12 of the employment agreement; (ii) Mr. Kaul's claim for an additional week of vacation pay in the amount of approximately $11,500; and (iii) the Company's counterclaim for $211,729 plus interest paid to the IRS on Mr. Kaul's behalf. In an attempt to resolve the outstanding issues prior to the entry of a final judgment, conferences were held with the Court on two separate occasions. As a result of these conferences, the parties have tentatively reached a settlement whereby the parties agree to dismiss the following claims: (1) Mr. Kaul agrees to withdraw and release his claims concerning reimbursement of certain attorneys' fees under Section 12 of the employment agreement (but preserves and does not waive, release or limit his claim for attorneys' fees and costs under Section 12 of the employment agreement incurred in connection with the preparation for and litigation of this lawsuit) and reimbursement for an additional week of vacation pay; and (2) the Company agrees to withdraw and release its claims concerning reimbursement of certain attorneys' fees and costs under ERISA, reimbursement of the $211,729 paid to the IRS on Mr. Kaul's behalf, and reimbursement of the $341,803 of severance payments made to Mr. Kaul. The parties also agree that Mr. Kaul shall not appeal that portion of the Opinion concerning the dismissal of certain of Mr. Kaul's ERISA-based claims with respect to the Plan and the Company shall not appeal that portion of the Opinion concerning the dismissal of its claims relating to the leasing and build-out of property or office space located in Edgewood, New Jersey to Mr. Kaul's wife. Mr. Kaul has expressed his intent to now tender a general release to the Company. If he does, in fact, do so, the Company will reject the tender on the grounds, inter alia, that the time to do so has long passed and that the purpose for the general release has been extinguished. After final judgment issues, each party shall have the right to appeal any aspect of the judgment. The Company was named as one of 88 defendants in a patent infringement complaint filed on November 23, 2001 by the Lemelson Medical, Education & Research Foundation, Limited Partnership (the "Lemelson Foundation"). The complaint, filed in the U.S. District Court in Arizona, was not served on the Company until March 2002. In the complaint, the Lemelson Foundation accuses the named defendants of infringing seven U.S. patents, which allegedly cover "automatic identification" technology through the defendants' use of methods for scanning production markings such as bar codes. The Company received a letter dated November 27, 2001 from attorneys for the Lemelson Foundation notifying the Company of the complaint and offering a license. The Court entered a stay of the case on March 20, 2002, requested by the Lemelson Foundation, pending the outcome of a related case in Nevada being fought by bar code manufacturers. The order for the stay in the case involving the Company provides that the Company need not answer the complaint, although it has the option to do so. The Company was invited to join a common interest/joint-defense group consisting of defendants named in the complaint as well as in other actions brought by the Lemelson Foundation. The trial in the Nevada case began on November 18, 2002 and ended on January 17, 2003. On January 23, 2004, following extensive briefing by the parties, the Nevada Court entered judgment declaring that the claims of each of the patents at issue in the Nevada case, including all seven patents asserted by the Lemelson 10 Foundation against the Company in the Arizona case, are unenforceable under the doctrine of prosecution laches, are invalid for lack of written description and enablement, and are not infringed by the bar code equipment manufacturers. Subject to the results of any appeal that may be filed by the parties to the Nevada litigation, the judgment of the Nevada court should preclude assertion of each of the affected patents against all parties, including the Company in the Arizona case. Counsel is now monitoring the Nevada and Arizona cases in order to determine a suitable moment for moving for dismissal of the Lemelson Foundation's claims. The Company has analyzed the merits of the issues raised by the complaint, notified vendors of its receipt of the complaint and letter, evaluated the merits of joining the joint-defense group, and had discussions with attorneys for the Lemelson Foundation regarding the license offer. The Company will not agree to a settlement at this time and thus has not established a reserve. In early March 2003, the Company learned that one of its business units had engaged in certain travel transactions that may have constituted violations under the provisions of U.S. government regulations promulgated pursuant to 50 U.S.C. App. 1-44, which proscribe certain transactions related to travel to certain countries. The Company immediately commenced an inquiry into the matter, incurred resulting charges, made an initial voluntary disclosure to the appropriate U.S. government agency under its program for such disclosures and will submit to that agency a detailed report on the results of the inquiry. In addition, the Company has taken steps to ensure that all of its business units are acting in compliance with the travel and transaction restrictions and other requirements of all applicable U.S. government programs. Although the Company is uncertain of the extent of the penalties, if any, that may be imposed on it by virtue of the transactions voluntarily disclosed, it does not currently believe that any such penalties will have a material effect on its business or financial condition. In addition, the Company is involved in various routine lawsuits of a nature which is deemed customary and incidental to its businesses. In the opinion of management, the ultimate disposition of these actions will not have a material adverse effect on the Company's financial position or results of operations. 5. SPECIAL CHARGES (INCOME) In December 2000, the Company began a strategic business realignment program that resulted in the recording of special charges for severance, facility exit costs and fixed asset write-offs. The actions related to the strategic business realignment program were taken in an effort to direct the Company's resources primarily towards a loss reduction strategy and return to profitability. As of the end of the first quarter of 2004, a liability of approximately $2.1 million was included within Accrued Liabilities and a liability of approximately $3.0 million was included within Other Non-current Liabilities. These liabilities relate to future payments in connection with the Company's strategic business realignment program. They are expected to be satisfied no later than February 2010 and consist of the following (in thousands):
SEVERANCE & REAL ESTATE PERSONNEL LEASE & COSTS EXIT COSTS TOTAL ----- ---------- ----- Balance at December 27, 2003 $ 205 $ 5,589 $ 5,794 2004 revision of previous estimate (31) -- (31) Paid in 2004 (174) (469) (643) ----------- ----------- ----------- Balance at March 27, 2004 $ -- $ 5,120 $ 5,120 =========== =========== ===========
A summary of the liability related to real estate lease and exit costs, by location, as of March 27, 2004 and December 27, 2003 is as follows (in thousands): 11
MARCH 27, DECEMBER 27, 2004 2003 --------- ------------ Gump's facility, San Francisco, CA $ 3,634 $ 3,788 Corporate facility, Weehawken, NJ 1,194 1,447 Corporate facility, Edgewater, NJ 214 261 Administrative and telemarketing facility, San Diego, CA 78 93 --------- ------------ Total Real Estate Lease and Exit Costs $ 5,120 $ 5,589 ========= ============
6. SALE OF IMPROVEMENTS BUSINESS On June 29, 2001, the Company sold certain assets and liabilities of its Improvements business to HSN, a division of USA Networks, Inc.'s Interactive Group, for approximately $33.0 million. In conjunction with the sale, the Company's Keystone Internet Services, Inc. subsidiary (now Keystone Internet Services, LLC) agreed to provide telemarketing and fulfillment services for the Improvements business under a services agreement with HSN for a period of three years. The asset purchase agreement between the Company and HSN provided that if Keystone Internet Services, Inc. failed to perform its obligations during the first two years of the services contract, HSN could receive a reduction in the original purchase price of up to $2.0 million. An escrow fund of $3.0 million, which was withheld from the original proceeds of the sale, had been established for a period of two years under the terms of an escrow agreement between LWI Holdings, Inc. (a wholly-owned subsidiary of the Company), HSN and The Chase Manhattan Bank as a result of these contingencies. The Company recognized a net gain on the sale of approximately $23.2 million, net of a non-cash goodwill charge of $6.1 million, in the second quarter of 2001. During fiscal 2002, the Company recognized approximately $0.6 million of the deferred gain consistent with the terms of the escrow agreement. The Company recognized the remaining net deferred gain of $1.9 million upon the receipt of the escrow balance on March 28, 2003. This gain was reported net of the costs incurred to provide the credit to HSN of approximately $0.1 million. 7. CHANGES IN MANAGEMENT AND BOARD OF DIRECTORS Brian C. Harriss. Brian C. Harriss was appointed as Executive Vice President, Human Resources and Legal and Secretary of the Company effective December 2, 2002 and as Executive Vice President, Finance and Administration effective November 11, 2003. Prior to January 2002, Mr. Harriss had served the Company as Executive Vice President and Chief Financial Officer until his resignation. In connection with the December 2002 appointment, Mr. Harriss and the Company terminated a severance agreement entered into during January 2002 at the time of Mr. Harriss' resignation from the Company during January 2002, and Mr. Harriss waived his rights to certain payments under such severance agreement. Effective February 15, 2004, the position of Executive Vice President, Finance and Administration was eliminated in connection with the Company's ongoing strategic business realignment program. In connection with such change, Mr. Harriss and the Company entered into a severance agreement dated February 15, 2004 providing for $545,500 of cash payments, as well as $55,500 of other benefits, all of which were expensed in the first quarter of 2004 within General and Administrative Expenses. Mr. Harriss is also entitled to receive a payment under the Company's 2003 Management Incentive Plan. Board of Directors. Effective February 15, 2004, Martin L. Edelman resigned from the Company's Board of Directors. Effective April 12, 2004, Paul S. Goodman joined the Company's Board of Directors as a designee of Chelsey Direct, LLC filling the vacancy created by the resignation of Martin L. Edelman. On April 29, 2004, the Board of Directors elected (1) Wayne P. Garten to serve as a member and as the Chairman of the Transactions Committee of the Board of Directors to fill the vacancy created by the resignation of Martin L. Edelman from such positions, (2) William B. Wachtel to serve as a member of the Executive Committee of the Board of Directors to fill the vacancy created by the resignation of Martin L. Edelman from such position, (3) Paul S. Goodman to serve as a member of the Corporate Governance Committee of the Board of Directors to fill the vacancy created by the resignation of Martin L. Edelman from such position, and (4) Donald Hecht to serve as a member of the Compensation Committee to fill the vacancy created by the contemporaneous resignation of Wayne P. Garten from such position. 12 President and Chief Executive Officer. Thomas C. Shull resigned as Chairman of the Board, President and Chief Executive Officer of the Company on May 5, 2004. William B. Wachtel was elected as Chairman of the Board and Wayne P. Garten was elected as President and Chief Executive Officer of the Company effective the same date. In connection with Mr. Shull's resignation, Mr. Shull and the Company agreed in principal to enter into a severance agreement dated as of May 5, 2004 providing for $900,000 of cash payments, $300,000 payable in May 2004 and the balance to be payable in 16 installments of $35,625 payable every two weeks commencing May 21, 2004 with a final payment in the amount of $30,000 to be payable on or about December 31, 2004. The Company will accrue the $900,000 of severance in the second quarter of 2004. In connection with Mr. Garten's election, Mr. Garten and the Company have negotiated the principle terms of an employment agreement for Mr. Garten which will be presented to the Compensation Committee of the Board of Directors for approval shortly. 8. RECENTLY ISSUED ACCOUNTING STANDARDS In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability, many of which had been previously classified as equity or between the liabilities and equity sections of the Condensed Consolidated Balance Sheet. The provisions of SFAS 150 are effective for financial instruments entered into or modified after May 31, 2003, and otherwise are effective at the beginning of the first interim period beginning after June 15, 2003. The standard is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance of SFAS 150 and still existing at the beginning of the interim period of adoption. The Company adopted the provisions of SFAS 150, which resulted in the reclassification of its Series B Participating Preferred Stock to a liability rather than between the liabilities and equity sections of the Condensed Consolidated Balance Sheet. Based upon the requirements set forth by SFAS 150, this reclassification was subject to implementation beginning on June 29, 2003. Upon implementation of SFAS 150, the Company reflected subsequent increases in liquidation preference as an increase in Total Liabilities with a corresponding reduction in capital in excess of par value, because the Company has an accumulated deficit. Accretion was recorded as interest expense. No such accretion has been recorded as interest expense during the 13-week period ended March 27, 2004. The Series C Participating Preferred Stock has been recorded at the maximum amount of future cash payments, thus the Company is currently not required to record interest expense relating to the Series C Participating Preferred Stock. On March 31,2004, the Financial Accounting Standards Board ("FASB") issued Emerging Issues Task Force Issue No. 03-6 "Participating Securities and the Two-Class Method under FASB Statement No. 128" ("EITF 03-6"). SFAS 128 defines earnings per share ("EPS") as "the amount of earnings attributable to each share of common stock" and indicates that the objective of EPS is to measure the performance of an entity over the reporting period. SFAS 128 addresses conditions under which a participating security requires the use of the two-class method of computing EPS. The two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise would have been available to common shareholders, but does not require the presentation of basic and diluted EPS for securities other than common stock. The Company's Series C Participating Preferred Stock is a participating security and, therefore, the Company calculates EPS utilizing the two-class method, however, it has chosen not to present basic and diluted EPS for preferred stock. 9. AMENDMENTS TO CONGRESS LOAN AND SECURITY AGREEMENT On March 25, 2004, the Company amended the Congress Credit Facility to change the definition of Consolidated Net Worth, to amend the Consolidated Working Capital and Consolidated Net Worth covenants to specify minimum levels of Consolidated Working Capital and Consolidated Net Worth that must be maintained during each month commencing January 2004, and to amend the EBITDA covenant to specify minimum levels of EBITDA that must be achieved during the Company's 2004, 2005 and 2006 fiscal years. The Company expects to maintain the minimum levels of these covenants in future periods. In addition, the definition of "Event of Default" was amended by replacing the Event of Default, which would have occurred on the occurrence of a material adverse change in the business, assets, liabilities or condition of the Company and its subsidiaries, with an Event of Default that would occur if certain specific events such as a decrease in consolidated revenues beyond certain specified levels or aging of inventory or accounts payable beyond certain specified levels, were to occur. During the fourth quarter of 2003, the Company re-examined the provisions of the Congress Credit Facility and, based on EITF Issue No. 95-22, "Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements that Include Both a Subjective Acceleration Clause and a Lock-Box Arrangement" ("EITF 95-22") and certain provisions in 13 the credit agreement, the Company has classified its revolving loan facility as short-term debt for the periods ended March 27, 2004 and December 27, 2003. As of March 27, 2004, the Company had $22.3 million of cumulative borrowings outstanding under the Congress Credit Facility, comprising $10.7 million of short-term borrowings under the Revolving Loan Facility, bearing an interest rate of 4.50%, $6.0 million under the Tranche A Term Loan, bearing an interest rate of 4.75%, and $5.6 million under the Tranche B Term Loan, bearing an interest rate of 13.0%. Of the aggregate borrowings, $14.6 million is classified as short-term with $7.7 million classified as long-term on the Company's Condensed Consolidated Balance Sheet. As of December 27, 2003, the Company had $21.5 million of borrowings outstanding under the Congress Credit Facility comprising $9.0 million of short-term borrowings under the revolving loan facility, bearing an interest rate of 4.50%, $6.5 million under the Tranche A Term Loan, bearing an interest rate of 4.75%, and $6.0 million under the Tranche B Term Loan, bearing an interest rate of 13.0%. Of the aggregate borrowings, $12.8 million is classified as short-term with $8.7 million classified as long-term on the Company's Condensed Consolidated Balance Sheet. On or before June 30, 2004, the Company is required to enter into a restatement of the loan agreement with Congress, requiring no changes to the terms of the current agreement. On April 14, 2004, the judge in the Wilson case ruled on a motion filed by the plaintiff requesting attorneys' fees and costs, awarding plaintiff's counsel approximately $445,000. Prior thereto, on November 25, 2003, the Court entered judgment in the Wilson case in plaintiff's favor requiring the Company's Brawn of California subsidiary which conducts the International Male catalog business to refund insurance fees collected from consumers for the period from February 13, 1998 through January 15, 2003 with interest from the date paid by June 30, 2004. The Company is appealing both of these decisions. On or about April 2, 2004, plaintiff's counsel filed a lien against Brawn of California's real property assets in the State of California with respect to the insurance fees judgment. Both the award of attorneys' fees and costs in the amount of $445,000 and the filing of a lien by plaintiff's counsel against Brawn of California's assets for the insurance fees judgment constitute defaults by the Company under the Congress Credit Facility. Congress has agreed to conditionally waive such defaults so long as (1) the Company is diligently defending the Wilson action by all appropriate proceedings and sets aside adequate reserves in accordance with GAAP, (2) no action shall be taken by the plaintiff in the Wilson action against any collateral of Brawn of California or any other borrower or guarantor under the Congress Credit Facility, (3) Brawn shall not enter into any settlement agreement with the plaintiff in the Wilson action without the prior written consent of Congress, (4) Congress' security interests remain senior to any interest of the plaintiff in the Wilson action, and (5) no other event of default exists or occurs. The Company believes that it may be a number of years before all appeals in the Wilson action are exhausted and continues to believe that an unfavorable outcome to the Company is not probable. Although certain of the conditions are outside its control, management of the Company believes, based on discussions with its attorneys, that it can maintain compliance with such conditions through at least December 25, 2004. If the Company were to fail to meet any one of these conditions, Congress would have the ability to exercise all rights and remedies available to it under the Congress Credit Facility including the right to call a default and accelerate the indebtedness due thereunder although Congress, in the past, has shown a willingness to waive its rights rather than call the facility. However, there can be no assurance that Congress will continue to do so in the future. In the event that there is an adverse decision in the future in the Wilson action or the Company does not comply with any of the requirements of the conditional waiver, an event of default would occur under the Congress Credit Facility. Congress would have the right to accelerate the indebtedness under the Congress Credit Facility, and could exercise the rights and remedies available to it under the Congress Credit Facility. Although management of the Company believes that it will be able to comply with the conditional waiver requirements, in the event it were unable to do so, it would be required to seek alternative solutions, including possible settlement of the Wilson action or satisfaction of any liens or renegotiation of the Congress Credit Facility. All indebtedness under the Congress Credit Facility is currently classified as short-term. For more information on the Wilson action, see Note 4 of the Condensed Consolidated Financial Statements. 10. SERIES B PARTICIPATING PREFERRED STOCK On December 19, 2001, as part of the Richemont Transaction, the Company issued to Richemont Finance S.A. ("Richemont") 1,622,111 shares of Series B Participating Preferred Stock. The Series B Participating Preferred Stock had a par value of $0.01 per share. The holders of the Series B Participating Preferred Stock were entitled to ten votes per share on any matter on which the Common Stock voted. In addition, in the event that the Company defaulted on its obligations arising in connection with the Richemont Transaction, the Certificate of Designations of the Series B Participating Preferred Stock or its agreements with Congress, or in the event that the Company failed to redeem at least 811,056 shares of Series B Participating Preferred Stock by August 31, 2003, then the holders of the Series B Participating Preferred Stock, voting as a class, were entitled to elect two members to the Board of Directors of the Company. In the event of the liquidation, dissolution or winding up of the Company, the holders of the Series B Participating Preferred Stock were entitled to a liquidation preference, which was initially $47.36 per share, increasing thereafter to a maximum of $86.85 per share in 2005. For Federal income tax purposes, the increases in the liquidation preference of the Series B Participating Preferred Stock were considered distributions, by the Company to Richemont, deemed made on the commencement dates of the quarterly increases, as discussed above. These distributions may have been taxable dividends to Richemont, provided the Company had accumulated or current earnings and profits ("E&P") for each year in which the distributions were deemed to be made. Under the terms of the Richemont Transaction, the Company was obligated to reimburse Richemont for any U.S. income tax incurred pursuant to the Richemont Transaction. Based on the Company's past income tax filings and its current income tax position, the Company had an E&P deficit as of December 28, 2002 and December 27, 2003. Accordingly, the Company has not incurred a tax reimbursement obligation for fiscal 2002 and 2003. The Company was required to redeem the Series B Participating Preferred Stock on August 23, 2005 consistent 14 with Delaware General Corporation Law. The Company could redeem all or less than all of the then outstanding shares of Series B Participating Preferred Stock at any time prior to that date. At the option of the holders, the Company was required to redeem the Series B Participating Preferred Stock upon a Change of Control or upon the consummation of an Asset Disposition or Equity Sale (all as defined in the Certificate of Designations of the Series B Participating Preferred Stock). The redemption price for the Series B Participating Preferred Stock upon a Change of Control or upon the consummation of an Asset Disposition or Equity Sale was the then applicable liquidation preference of the Series B Participating Preferred Stock plus the amount of any declared but unpaid dividends on the Series B Participating Preferred Stock. As a result of filings made by Richemont and certain related parties with the SEC on May 21, 2003, the Company learned that Richemont sold to Chelsey, on May 19, 2003, all of Richemont's securities in the Company consisting of 29,446,888 shares of Common Stock and 1,622,111 shares of Series B Participating Preferred Stock for a purchase price equal to $40 million. The Company was not a party to such transaction and did not provide Chelsey with any material, non-public information in connection with such transaction, nor did the Company's Board of Directors endorse the transaction. As a result of the transaction, Chelsey purportedly succeeded to Richemont's rights in the Common Shares and the Series B Participating Preferred Stock, including the right of the holder of the Series B Participating Preferred Stock to a liquidation preference with respect to such shares which was equal to $98,202,600 on May 19, 2003, the date of the sale of the Shares, and which could have increased to and capped at $146,168,422 on August 23, 2005, the final redemption date of the Series B Participating Preferred Stock. On November 30, 2003, the Company consummated the transactions contemplated by the Recapitalization Agreement, dated as of November 18, 2003, with Chelsey and recapitalized the Company, completed the reconstitution of the Board of Directors of the Company and settled outstanding litigation between the Company and Chelsey (the "Recapitalization"). In the transaction, the Company exchanged all of the 1,622,111 outstanding shares of the Series B Participating Preferred Stock held by Chelsey for the issuance to Chelsey of 564,819 shares of newly-created Series C Participating Preferred Stock and 81,857,833 additional shares of Common Stock of the Company. Effective upon the closing of the transactions contemplated by the Recapitalization Agreement, the size of the Board of Directors was increased to nine (9) members, and Mr. Donald Hecht was elected to the Company's Board of Directors and the Audit Committee thereof. For a period of two (2) years from the closing of the Recapitalization, five (5) of the nine (9) directors of the Company will at all times be directors of the Company designated by Chelsey and one (1) of the nine (9) directors of the Company will at all times be a director of the Company designated by Regan Partners. Because its Series B Participating Preferred Stock was mandatorily redeemable and thus accounted for as a liability, the Company accounted for the exchange of 1,622,111 outstanding shares of its Series B Participating Preferred Stock held by Chelsey for the issuance of 564,819 shares of newly-created Series C Participating Preferred Stock and 81,857,833 additional shares of Common Stock of the Company to Chelsey in accordance with SFAS No. 15 "Accounting by Debtors and Creditors for Troubled Debt Restructuring." As such, the $107.5 million carrying value of the Series B Participating Preferred Stock as of the consummation date of the exchange was compared with the fair value of the Common Stock of approximately $19.6 million issued to Chelsey as of the consummation date and the total maximum potential cash payments of approximately $72.7 million that could be made pursuant to the terms of the Series C Participating Preferred Stock. Since the carrying value, net of issuance costs of approximately $1.3 million, exceeded these amounts by approximately $13.9 million, pursuant to SFAS No. 15, such excess was determined to be a "gain" and the Series C Participating Preferred Stock was recorded at the amount of total potential cash payments (including dividends and other contingent amounts) that could be required pursuant to its terms. Since Chelsey was a significant stockholder at the time of the exchange and, as a result, a related party, the "gain" was recorded in equity. 11. SERIES C CUMULATIVE PARTICIPATING PREFERRED STOCK On November 30, 2003, as part of the Recapitalization, the Company issued to Chelsey 564,819 shares of Series C Participating Preferred Stock. The Series C Participating Preferred Stock has a par value of $.01 per share. The holders of the Series C Participating Preferred Stock are entitled to one hundred votes per share on any matter on which the Common Stock votes and are entitled to one hundred votes per share plus that number of votes as shall equal 15 the dollar value of any accrued, unpaid and compounded dividends with respect to such share. The holders of the Series C Participating Preferred Stock are also entitled to vote as a class on any matter that would adversely affect such Series C Participating Preferred Stock. In addition, in the event that the Company defaults on its obligations under the Certificate of Designations, the Recapitalization Agreement or the Congress Credit Facility, then the holders of the Series C Participating Preferred Stock, voting as a class, shall be entitled to elect twice the number of directors as comprised the Board of Directors on the default date, and such additional directors shall be elected by the holders of record of Series C Participating Preferred Stock as set forth in the Certificate of Designations. In the event of the liquidation, dissolution or winding up of the Company, effective through December 31, 2005, the holders of the Series C Participating Preferred Stock are entitled to a liquidation preference of $100 per share or an aggregate amount of $56,481,900. Effective October 1, 2008, the maximum aggregate amount of the liquidation preference is $72,689,337, which would occur if the Company elects to accrue unpaid dividends as mentioned below. Commencing January 1, 2006, dividends will be payable quarterly on the Series C Participating Preferred Stock at the rate of 6% per annum, with the preferred dividend rate increasing by 1 1/2% per annum on each subsequent January 1 until redeemed. At the Company's option, in lieu of cash dividends, the Company may instead elect to cause accrued and unpaid dividends to compound at a rate equal to 1% higher than the applicable cash dividend rate. The Series C Participating Preferred Stock is entitled to participate ratably with the Common Stock on a share for share basis in any dividends or distributions paid to or with respect to the Common Stock. The right to participate has anti-dilution protection. The Congress Credit Facility currently prohibits the payment of dividends. The Series C Participating Preferred Stock may be redeemed in whole and not in part, except as set forth below, at the option of the Company at any time for the liquidation preference and any accrued and unpaid dividends (the "Redemption Price"). The Series C Participating Preferred Stock, if not redeemed earlier, must be redeemed by the Company on January 1, 2009 (the "Mandatory Redemption Date") for the Redemption Price. If the Series C Participating Preferred Stock is not redeemed on or before the Mandatory Redemption Date, or if other mandatory redemptions are not made, the Series C Participating Preferred Stock will be entitled to elect one-half (1/2) of the Company's Board of Directors. Notwithstanding the foregoing, the Company will redeem the maximum number of shares of Series C Participating Preferred Stock as possible with the net proceeds of certain asset and equity sales not required to be used to repay Congress pursuant to the terms of the 19th Amendment to the Loan and Security Agreement with Congress (as modified by the 29th Amendment to the Loan and Security Agreement), and Chelsey will be required to accept such redemptions, as set forth in Section 5 of the Certificate of Designations of the Series C Participating Preferred Stock. Pursuant to the terms of the Certificate of Designations of the Series C Participating Preferred Stock, the Company's obligation to pay dividends on or redeem the Series C Participating Preferred Stock is subject to its compliance with its agreements with Congress. 12. AMERICAN STOCK EXCHANGE NOTIFICATION On May 2, 2001, the American Stock Exchange (the "Exchange") notified the Company that it was below certain of the Exchange's continued listing guidelines set forth in the Exchange's Company Guide. The Exchange instituted a review of the Company's eligibility for continuing listing of the Company's common stock on the Exchange. The Company received a letter dated January 9, 2002 from the Exchange confirming that the American Stock Exchange determined to continue the Company's listing on the Exchange pending quarterly reviews of the Company's compliance with the steps of its strategic business realignment program. This determination was made subject to the Company's favorable progress in satisfying the Exchange's guidelines for continued listing and to the Exchange's periodic review of the Company's Securities and Exchange Commission and other filings. The Company received a letter dated November 8, 2002 from the Exchange updating its position regarding the Company's compliance with certain of the Exchange's continued listing standards as set forth in Part 10 of the Exchange's Company Guide. Although the Company had been making favorable progress in satisfying the Exchange's guidelines for continued listing based on its compliance with the steps of its strategic business realignment program shared with the Exchange in 2001 and updated in 2002, the Exchange informed the Company that it had now become strictly subject to the procedures and requirements of Part 10 of the Company Guide. Specifically, the Company must not fall below the requirements of: (i) Section 1003(a)(i) with shareholders' equity of less than 16 $2,000,000 and losses from continuing operations and/or net losses in two out of its three most recent fiscal years; (ii) Section 1003(a)(ii) with shareholders' equity of less than $4,000,000 and losses from continuing operations and/or net losses in three out of its four most recent fiscal years; and (iii) Section 1003(a)(iii) with shareholders' equity of less than $6,000,000 and losses from continuing operations and/or net losses in its five most recent fiscal years. The Exchange requested that the Company submit a plan to the Exchange by December 11, 2002, advising the Exchange of action it has taken, or will take, that would bring it into compliance with the continued listing standards by December 28, 2003. The Company submitted a plan to the Exchange on December 11, 2002, in an effort to maintain the listing of the Company's common stock on the Exchange. On January 28, 2003, the Company received a letter from the Exchange confirming that, as of the date of the letter, the Company had evidenced compliance with the requirements necessary for continued listing on the Exchange. Such compliance resulted from a rule change by the Exchange approved by the Securities and Exchange Commission related to continued listing on the basis of compliance with total market capitalization or total assets and revenues standards as alternatives to shareholders' equity standards including the requirement that each listed company maintain $15.0 million of public float. The letter is subject to changes in the Exchange Rules that might supersede the letter or require the Exchange to re-evaluate its position. The Company's common stock has traded below the minimum level of public float since April 14, 2004. To date, the Company has not received any communication from the Exchange on this issue. 17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table sets forth, for the fiscal periods indicated, the percentage relationship to net revenues of certain items in the Company's Condensed Consolidated Statements of Income (Loss):
13- WEEKS ENDED -------------------------- March 27, March 29, 2004 2003 --------- --------- Net revenues 100.0% 100.0% Cost of sales and operating expenses 62.1 64.0 Special charges 0.0 0.3 Selling expenses 24.4 23.9 General and administrative expenses 10.9 11.0 Depreciation and amortization 1.1 1.1 Income (loss) from operations 1.5 (0.3) Gain on sale of Improvements 0.0 1.9 Interest expense, net 1.0 1.4 Provision for Federal and state income taxes 0.1 0.0 Net income and comprehensive income 0.4% 0.2%
EXECUTIVE SUMMARY Management continues to focus on enhancing shareholder value through the exploration of various avenues that will strengthen the Company's financial position. The Company continues to pursue options to increase liquidity and reduce debt through a review of its senior credit facility with Congress, opportunistic sales of non-core assets and other financing alternatives. These options would enable the Company to retire a portion of the Series C Participating Preferred Stock obligation in addition to providing additional liquidity for operational requirements. RESULTS OF OPERATIONS - 13- WEEKS ENDED MARCH 27, 2004 COMPARED WITH THE 13- WEEKS ENDED MARCH 29, 2003 Net Income. The Company reported net income applicable to common shareholders of $0.4 million or $0.00 per share for the 13- weeks ended March 27, 2004 compared with a net loss of $3.4 million, or $0.02 per share, for the comparable period in fiscal 2003. These amounts were calculated after deducting Series B Participating Preferred Stock dividends and accretion of $3.6 million for the 13- weeks ended March 29, 2003. The weighted average number of shares used in the calculation for basic and diluted net income per common share was 220,173,633 and 220,665,781, respectively, for the 13-week period ended March 27, 2004. The weighted average number of shares used in the calculation for both basic and diluted net loss per common share was 138,315,800 for the 13-week period ended March 29, 2003. The increase in weighted average shares was primarily a result of the Recapitalization consummated on November 30, 2003 (see Notes 10 and 11 to the Company's Condensed Consolidated Financial Statements). The $3.9 million increase in net income was primarily due to: - A favorable impact of $3.6 million due to the Recapitalization and exchange of the Series B for the Series C Participating Preferred Stock with Chelsey. During the 13- weeks ended March 29, 2003 Preferred Stock dividends and accretion were recorded relating to the Series B Participating Preferred Stock. The Series C Participating Preferred Stock has been recorded at the maximum amount of future cash payments; thus the Company is currently not required to record interest expense relating to the Series C Participating Preferred Stock; - A favorable impact of $1.8 million comprising continued reductions in cost of sales and operating expenses and general and administrative expenses and a decrease in depreciation and amortization; - A favorable impact of $0.5 million due to reductions in interest resulting from lower average borrowings and deferred amendment fees which have become fully amortized relating to the Congress Credit Facility; and 18 - A favorable impact of $0.3 million due to the reduction of special charges recorded. partially offset by: - An unfavorable impact of $1.9 million due to the non-recurring deferred gain related to the June 29, 2001 sale of the Company's Improvements business recognized during the 13- weeks ended March 29, 2003; and - An unfavorable impact of $0.4 million due to reduction in variable contribution associated with the decline in net revenues. Net Revenues. Net revenues decreased $7.2 million (7.0%) for the 13-week period ended March 27, 2004 to $95.3 million from $102.5 million for the comparable period in 2003. The decline was primarily attributable to a reduction in circulation for one of the Company's brands in order to limit the investment in catalog production costs and working capital necessary to maintain inventory for this brand. The majority of this reduction occurred in the first quarter of 2004, however, there will be a continuation of this trend, albeit at a lower rate of decline in sales, for the balance of 2004. Internet sales continued to grow, and comprised 32.2% of combined Internet and catalog revenues for the 13- weeks ended March 27, 2004 compared with 26.5% for the comparable fiscal period in 2003, and have increased by approximately $3.1 million, or 12.1%, to $28.6 million for the 13-week period ended March 27, 2004 from $25.5 million for the comparable fiscal period in 2003. Cost of Sales and Operating Expenses. Cost of sales and operating expenses decreased by $6.3 million to $59.2 million for the 13- weeks ended March 27, 2004 as compared with $65.5 million for the comparable period in 2003. Cost of sales and operating expenses decreased to 62.1% of net revenues for the 13-week period ended March 27, 2004 as compared with 64.0% of net revenues for the comparable period in 2003. This decrease was primarily due to a 0.6% decline in merchandise costs associated with a shift from "branded" goods to proprietary goods that have higher product margins for one of the Company's brands, a 0.6% decrease in the inventory obsolescence provision and other inventory write-downs due to maintaining lower inventory levels and an increase in sales of clearance merchandise through the Internet at discounted prices, a 0.5% decrease in product postage costs resulting from utilizing more economical shipping sources and methods, and a 0.2% decrease relating to information technology costs due to declines in equipment rentals and maintenance. Fixed distribution and telemarketing costs as a percentage of net revenues continued to remain constant with the comparable period in 2003. Special Charges (Income). In December 2000, the Company began a strategic business realignment program that resulted in the recording of special charges for severance, facility exit costs and fixed asset write-offs. The actions related to the strategic business realignment program were taken in an effort to direct the Company's resources primarily towards a loss reduction strategy and a return to profitability. Special charges (income) decreased by $0.3 million for the 13- weeks ended March 27, 2004 as compared with the comparable period in fiscal 2003. During the 13- weeks ended March 29, 2003, $0.3 million of additional severance costs were recorded. No additional special charges were recorded during the 13- weeks ended March 27, 2004, although an adjustment was recorded relating to a revision of an estimate of benefit costs previously recorded. Selling Expenses. Selling expenses decreased by $1.2 million to $23.3 million for the 13- weeks ended March 27, 2004 as compared with $24.5 million for the comparable period in 2003. As a percentage of net revenues, selling expenses increased to 24.4% for the 13- weeks ended March 27, 2004 from 23.9% for the comparable period in 2003. This change was due primarily to a 0.4% increase in costs associated with utilizing rented name lists from other mailers and compilers as a primary source of new customers, a 0.2% increase in catalog preparation costs and a 0.1% increase in postage costs. These increases were partially offset by a 0.2% reduction in paper and printing costs. General and Administrative Expenses. General and administrative expenses decreased by $0.9 million to $10.4 million for the 13- weeks ended March 27, 2004 as compared with $11.3 million for the comparable period in 2003. As a percentage of net revenues, general and administrative expenses declined slightly to 10.9% of net revenues for the 13- weeks ended March 27, 2004 compared with 11.0% of revenues for the 13- weeks ended March 29, 2003. Decreases were recognized with a reduction of 0.3% in incentive compensation and legal costs, which were partially offset by a 0.2% increase in the area of merchandising and product development. 19 Depreciation and Amortization. Depreciation and amortization decreased approximately $0.2 million to $1.0 million for the 13- weeks ended March 27, 2004 from $1.2 million for the comparable period in 2003. The decrease was primarily due to capital expenditures that have been fully amortized. Income (Loss) from Operations. The Company's income from operations increased by $1.7 million to $1.4 million for the 13- weeks ended March 27, 2004 from a loss of $0.3 million for the comparable period in 2003. See "Results of Operations - 13- weeks ended March 27, 2004 compared with the 13- weeks ended March 29, 2003 - Net Income and Comprehensive Income" above for further details. Gain on Sale of the Improvements Business. During the 13- weeks ended March 29, 2003, the Company recognized the remaining deferred gain of $1.9 million consistent with the terms of the March 27, 2003 amendment made to the asset purchase agreement relating to the sale of the Improvements business. Effective March 28, 2003, the remaining $2.0 million escrow balance was received by the Company, thus terminating the agreement. See Note 6 of Notes to the Condensed Consolidated Financial Statements. Interest Expense, Net. Interest expense, net, decreased $0.5 million to $0.9 million for the 13- weeks ended March 27, 2004 from $1.4 million for the comparable period in fiscal 2003. The decrease in interest expense is due to lower average cumulative borrowings relating to the Congress Credit Facility and decreases in amortization from deferred financing costs relating to the Company's amendments to the Congress Credit Facility that have become fully amortized. LIQUIDITY AND CAPITAL RESOURCES Net cash used by operating activities. During the 13-week period ended March 27, 2004, net cash used by operating activities was $0.6 million. Cash provided by operations, net of non-cash items, and receipts resulting from a decrease in accounts receivable were more than offset by payments made to increase investment in working capital items such as increased prepaid catalog costs and decreased accrued liabilities and accounts payable. Net cash used by investing activities. During the 13-week period ended March 27, 2004, net cash used by investing activities was $0.1 million. This entire amount comprised capital expenditures, consisting primarily of purchases and upgrades to various information technology hardware and software throughout the Company and purchases of equipment for the Company's Lacrosse, Wisconsin location. Net cash provided by financing activities. During the 13-week period ended March 27, 2004, net cash provided by financing activities was $0.8 million, which was primarily due to net borrowings of $1.8 million under the Congress Credit Facility and a $0.3 million refund relating to withholding taxes remitted on behalf of Richemont for estimated taxes due related to the Series B Participating Preferred Stock. These borrowings were partially offset by $1.0 million in payments made to the Company's lender relating to the Congress Tranche A and Tranche B term loan facilities as well as a payment of $0.1 million to the Company's lender for fees relating to the amendment of the Congress Credit Facility. In addition, payments of $0.2 million were made to lessors relating to obligations under capital leases. Amendments to the Congress Credit Facility. On March 25, 2004, the Company amended the Congress Credit Facility to change the definition of Consolidated Net Worth, to amend the Consolidated Working Capital and Consolidated Net Worth covenants to specify minimum levels of Consolidated Working Capital and Consolidated Net Worth that must be maintained during each month commencing January 2004, and to amend the EBITDA covenant to specify minimum levels of EBITDA that must be achieved during the Company's 2004, 2005 and 2006 fiscal years. The Company expects to maintain the minimum levels of these covenants in future periods. In addition, the definition of "Event of Default" was amended by replacing the Event of Default, which would have occurred on the occurrence of a material adverse change in the business, assets, liabilities or condition of the Company and its subsidiaries, with an Event of Default that would occur if certain specific events such as a decrease in consolidated revenues beyond certain specified levels or aging of inventory or accounts payable beyond certain specified levels, were to occur. In 2003, the Company re-examined the provisions of the Congress Credit Facility and, based on EITF Issue No. 95-22, "Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements that Include Both 20 a Subjective Acceleration Clause and a Lock-Box Arrangement" ("EITF 95-22") and certain provisions in the credit agreement, the Company has classified its revolving loan facility as short-term debt for the periods ended March 27, 2004 and December 27, 2003. Under the Congress Credit Facility, the Company is required to maintain minimum net worth, working capital and EBITDA as defined throughout the term of the agreement. As of March 27, 2004, the Company was in compliance with all covenants set forth under the Congress Credit Facility. As of March 27, 2004, the Company had $22.3 million of cumulative borrowings outstanding under the Congress Credit Facility, comprising $10.7 million of short-term borrowings under the Revolving Loan Facility, bearing an interest rate of 4.50%, $6.0 million under the Tranche A Term Loan, bearing an interest rate of 4.75%, and $5.6 million under the Tranche B Term Loan, bearing an interest rate of 13.0%. Of the aggregate borrowings, $14.6 million is classified as short-term with $7.7 million classified as long-term on the Company's Condensed Consolidated Balance Sheet. As of December 27, 2003, the Company had $21.5 million of borrowings outstanding under the Congress Credit Facility comprising $9.0 million of short-term borrowings under the revolving loan facility, bearing an interest rate of 4.50%, $6.5 million under the Tranche A Term Loan, bearing an interest rate of 4.75%, and $6.0 million under the Tranche B Term Loan, bearing an interest rate of 13.0%. Of the aggregate borrowings, $12.8 million is classified as short-term with $8.7 million classified as long-term on the Company's Condensed Consolidated Balance Sheet. On or before June 30, 2004, the Company is required to enter into a restatement of the loan agreement with Congress, requiring no changes to the terms of the current agreement. Sale of Improvements Business. On June 29, 2001, the Company sold certain assets and liabilities of its Improvements business to HSN, a division of USA Networks, Inc.'s Interactive Group, for approximately $33.0 million. In conjunction with the sale, the Company's Keystone Internet Services, Inc. subsidiary agreed to provide telemarketing and fulfillment services for the Improvements business under a service agreement with HSN for a period of three years. The asset purchase agreement between the Company and HSN provided that if Keystone Internet Services failed to perform its obligations during the first two years of the services contract, the purchaser could receive a reduction in the original purchase price of up to $2.0 million. An escrow fund of $3.0 million, which was withheld from the original proceeds of the sale of approximately $33.0 million, had been established for a period of two years under the terms of an escrow agreement between LWI Holdings, Inc. (a wholly-owned subsidiary of the Company), HSN and The Chase Manhattan Bank as a result of these contingencies. The Company recognized a net gain on the sale of approximately $23.2 million, net of a non-cash goodwill charge of $6.1 million, in fiscal year 2001. During fiscal 2002, the Company recognized approximately $0.6 million of the deferred gain consistent with the terms of the escrow agreement. The Company recognized the remaining net deferred gain of $1.9 million from the receipt of the escrow balance on March 28, 2003. This gain was reported net of the costs incurred to provide the credit to HSN of approximately $0.1 million. American Stock Exchange Notification. On May 2, 2001, the American Stock Exchange (the "Exchange") notified the Company that it was below certain of the Exchange's continued listing guidelines set forth in the Exchange's Company Guide. The Exchange instituted a review of the Company's eligibility for continuing listing of the Company's common stock on the Exchange. The Company received a letter dated January 9, 21 2002 from the Exchange confirming that the American Stock Exchange determined to continue the Company's listing on the Exchange pending quarterly reviews of the Company's compliance with the steps of its strategic business realignment program. This determination was made subject to the Company's favorable progress in satisfying the Exchange's guidelines for continued listing and to the Exchange's periodic review of the Company's Securities and Exchange Commission and other filings. The Company received a letter dated November 8, 2002 from the Exchange updating its position regarding the Company's compliance with certain of the Exchange's continued listing standards as set forth in Part 10 of the Exchange's Company Guide. Although the Company had been making favorable progress in satisfying the Exchange's guidelines for continued listing based on its compliance with the steps of its strategic business realignment program shared with the Exchange in 2001 and updated in 2002, the Exchange informed the Company that it had now become strictly subject to the procedures and requirements of Part 10 of the Company Guide. Specifically, the Company must not fall below the requirements of: (i) Section 1003(a)(i) with shareholders' equity of less than $2,000,000 and losses from continuing operations and/or net losses in two out of its three most recent fiscal years; (ii) Section 1003(a)(ii) with shareholders' equity of less than $4,000,000 and losses from continuing operations and/or net losses in three out of its four most recent fiscal years; and (iii) Section 1003(a)(iii) with shareholders' equity of less than $6,000,000 and losses from continuing operations and/or net losses in its five most recent fiscal years. The Exchange requested that the Company submit a plan to the Exchange by December 11, 2002, advising the Exchange of action it has taken, or will take, that would bring it into compliance with the continued listing standards by December 28, 2003. The Company submitted a plan to the Exchange on December 11, 2002, in an effort to maintain the listing of the Company's common stock on the Exchange. On January 28, 2003, the Company received a letter from the Exchange confirming that, as of the date of the letter, the Company had evidenced compliance with the requirements necessary for continued listing on the Exchange. Such compliance resulted from a rule change by the Exchange approved by the Securities and Exchange Commission related to continued listing on the basis of compliance with total market capitalization or total assets and revenues standards as alternatives to shareholders' equity standards including the requirement that each listed company maintain $15 million of public float. The letter is subject to changes in the Exchange Rules that might supersede the letter or require the Exchange to re-evaluate its position. The Company's common stock has traded below the minimum level of public float since April 14, 2004. To date, the Company has not received any communication from the Exchange on this issue. General. At March 27, 2004, the Company had $2.4 million in cash and cash equivalents, compared with $2.6 million at March 29, 2003. Total cumulative borrowings, including financing under capital lease obligations, as of March 27, 2004, aggregated $23.1 million. Remaining availability under the Congress Credit Facility as of March 27, 2004 was $4.0 million. There were nominal short-term capital commitments (less than $0.2 million) at March 27, 2004. On April 14, 2004, the judge in the Wilson case ruled on a motion filed by the plaintiff requesting attorneys' fees and costs, awarding plaintiff's counsel approximately $445,000. Prior thereto, on November 25, 2003, the Court entered judgment in the Wilson case in plaintiff's favor requiring the Company's Brawn of California subsidiary which conducts the International Male catalog business to refund insurance fees collected from consumers for the period from February 13, 1998 through January 15, 2003 with interest from the date paid by June 30, 2004. The Company is appealing both of these decisions. On or about April 2, 2004, plaintiff's counsel filed a lien against Brawn of California's real property assets in the State of California with respect to the insurance fees judgment. Both the award of attorneys' fees and costs in the amount of $445,000 and the filing of a lien by plaintiff's counsel against Brawn of California's assets for the insurance fees judgment constitute defaults by the Company under the Congress Credit Facility. Congress has agreed to conditionally waive such defaults so long as (1) the Company is diligently defending the Wilson action by all appropriate proceedings and sets aside adequate reserves in accordance with GAAP, (2) no action shall be taken by the plaintiff in the Wilson action against any collateral of Brawn of California or any other borrower or guarantor under the Congress Credit Facility, (3) Brawn shall not enter into any settlement agreement with the plaintiff in the Wilson action without the prior written consent of Congress, (4) Congress' security interests remain senior to any interest of the plaintiff in the Wilson action, and (5) no other event of default exists or occurs. The Company believes that it may be a number of years before all appeals in the Wilson action are exhausted and continues to believe that an unfavorable outcome to the Company is not probable. Although certain of the conditions are outside its control, management of the Company believes, based on discussions with its attorneys, that it can maintain compliance with such conditions through at least December 25, 2004. If the Company were to fail to meet any one of these conditions, Congress would have the ability to exercise all rights and remedies available to it under the Congress Credit Facility including the right to call a default and accelerate the indebtedness due thereunder although Congress, in the past, has shown a willingness to waive its rights rather than call the facility. However, there can be no assurance that Congress will continue to do so in the future. In the event that there is an adverse decision in the future in the Wilson action or the Company does not comply with any of the requirements of the conditional waiver, an event of default would occur under the Congress Credit Facility, Congress would have the right to accelerate the indebtedness under the Congress Credit Facility, and could exercise the rights and remedies available to it under the Congress Credit Facility. Although management of the Company believes that it will be able to comply with the conditional waiver requirements, in the event it were unable to do so, it would be required to seek alternative solutions, including possible settlement of the Wilson action or satisfaction of any liens or renegotiation of the Congress Credit Facility. All indebtedness under the Congress Credit Facility is currently classified as short-term. For more information on the Wilson action, see Note 4 of the Condensed Consolidated Financial Statements. Management continues to focus on enhancing shareholder value through the exploration of various avenues that will strengthen the Company's financial position. The Company continues to pursue options to increase liquidity and reduce debt through a review of its senior credit facility with Congress, opportunistic sales of non-core assets and other financing alternatives. These options would enable the Company to retire a portion of the Series C Participating Preferred Stock obligation in addition to providing additional liquidity for operational requirements. Management believes that the Company has sufficient liquidity and availability under its credit agreement to fund its planned operations through at least December 25, 2004. See "Cautionary Statements," below. Continued flexibility among the Company's major vendors is critical to the maintenance of adequate liquidity as is compliance with the terms and provisions of the Congress Credit Facility as mentioned in Note 9 of the Condensed Consolidated Financial Statements. USES OF ESTIMATES AND OTHER CRITICAL ACCOUNTING POLICIES The condensed consolidated financial statements include all subsidiaries of the Company, and all intercompany transactions and balances have been eliminated. The preparation of financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. See "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations," found in the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 2003, for additional information relating to the Company's use of estimates and other critical accounting policies. 22 NEW ACCOUNTING PRONOUNCEMENTS In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability, many of which had been previously classified as equity or between the liabilities and equity sections of the Condensed Consolidated Balance Sheet. The provisions of SFAS 150 are effective for financial instruments entered into or modified after May 31, 2003, and otherwise are effective at the beginning of the first interim period beginning after June 15, 2003. The standard is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance of SFAS 150 and still existing at the beginning of the interim period of adoption. The Company adopted the provisions of SFAS 150, which resulted in the reclassification of its Series B Participating Preferred Stock to a liability rather than between the liabilities and equity sections of the Condensed Consolidated Balance Sheet. Based upon the requirements set forth by SFAS 150, this reclassification was subject to implementation beginning on June 29, 2003. Upon implementation of SFAS 150, the Company reflected subsequent increases in liquidation preference as an increase in Total Liabilities with a corresponding reduction in capital in excess of par value, because the Company has an accumulated deficit. Accretion was recorded as interest expense. During March 2004, the Financial Accounting Standards Board ("FASB") issued Emerging Issues Task Force Issue No. 03-6 "Participating Securities and the Two-Class Method under FASB Statement No. 128" ("EITF 03-6"). SFAS 128 defines earnings per share ("EPS") as "the amount of earnings attributable to each share of common stock" and indicates that the objective of EPS is to measure the performance of an entity over the reporting period. SFAS 128 addresses conditions under which a participating security requires the use of the two-class method of computing EPS. The two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise would have been available to common shareholders, but does not require the presentation of basic and diluted EPS for securities other than common stock. The Company's Series C Participating Preferred Stock is a participating security and, therefore, the Company calculates EPS utilizing the two-class method, however, it has chosen not to present basic and diluted EPS for preferred stock. See "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations," found in the Company's Annual Report on Form 10-K for the fiscal year ended December 27, 2003 and Note 8 of the Condensed Consolidated Financial Statements for additional information relating to new accounting pronouncements that the Company has adopted. OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS The Company has entered into no "off-balance sheet arrangements" within the meaning of the Securities Exchange Act of 1934, as amended, and the rules thereunder other than operating leases, which are in the normal course of business. Provided below is a tabular disclosure of contractual obligations as of March 27, 2004, as required by Item 303(a)(5) of SEC Regulation S-K. In addition to obligations recorded on the Company's Condensed Consolidated Balance Sheets as of March 27, 2004, the schedule includes purchase obligations, which are defined as legally binding and enforceable agreements to purchase goods or services that specify all significant terms (quantity, price, and timing of transaction). 23 PAYMENT DUE BY PERIOD (IN THOUSANDS)
LESS THAN MORE THAN CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS ----------------------- ----- ------ --------- --------- ------- Long-term Debt Obligations, excluding the Series C Participating Preferred Stock $ 2,289 $ 14,548 $ 7,741 $ -- $ -- Total Minimum Lease Payments Under Capital Lease Obligations 899 629 268 2 -- Operating Lease Obligations 15,487 5,421 4,632 3,751 1,683 Operating Lease Obligations - Restructuring/Discontinued Operations 8,774 3,393 2,457 2,005 919 Purchase Obligations (a) 2,992 1,776 1,216 -- -- Other Long-Term Liabilities Reflected on the Registrant's Balance Sheet under GAAP (b) 72,689 -- -- -- 72,689 ---------- ---------- ---------- ---------- ---------- Total $ 123,130 $ 25,767 $ 16,314 $ 5,758 $ 75,291 ========== ========== ========== ========== ==========
(a) The Company's purchase obligations consist primarily of a total commitment of $2,000,000 to purchase telecommunication services during the period from May 1, 2004 through April 30, 2006; a total commitment of approximately $487,000 to purchase catalog photography services during the period from September 11, 2003 through September 10, 2005, of which approximately $96,000 had been fulfilled as of March 27, 2004, and of which approximately $258,000 should be fulfilled during the next fiscal year and the remaining $133,000 fulfilled by September 10, 2005; a total commitment of $375,000 for list processing services representing the maximum exposure for a service contract which requires a three-month notice of termination for services costing $125,000 per month; a total commitment of $201,000 to purchase various packaging materials from several vendors, under contracts wherein the vendors warehouse varying minimum and maximum levels of materials to ensure immediate availability; and several commitments totaling approximately $151,000 for various consulting services to be provided during the period April 2003 through July 2004, of which approximately $126,000 had been fulfilled as of March 27, 2004. (b) Represents Series C Participating Preferred Stock as disclosed in Note 11 to the Company's Condensed Consolidated Financial Statements. SEASONALITY The Company does not consider its business seasonal. The revenues for the Company are proportionally consistent for each quarter during a fiscal year. The percentage of annual revenues for the first, second, third and fourth quarters recognized by the Company, respectively, were as follows: 2003 - 24.7%, 25.5%, 23.3% and 26.5%; and 2002 - 23.9%, 24.9%, 23.2% and 28.0%. FORWARD-LOOKING STATEMENTS The following statements from above constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995: "Subject to an adverse outcome in the Wilson matter discussed above, management believes that the Company has sufficient liquidity and availability under its credit agreement to fund its planned operations through at least December 25, 2004." CAUTIONARY STATEMENTS The following material identifies important factors that could cause actual results to differ materially from those expressed in the forward-looking statements identified above and in any other forward-looking statements contained elsewhere herein: 24 - A general deterioration in economic conditions in the United States leading to reduced consumer confidence, reduced disposable income and increased competitive activity and the business failure of companies in the retail, catalog and direct marketing industries. Such economic conditions leading to a reduction in consumer spending generally and in-home fashions specifically, and leading to a reduction in consumer spending specifically with reference to other types of merchandise the Company offers in its catalogs or over the Internet, or which are offered by the Company's third party fulfillment clients. - Customer response to the Company's merchandise offerings and circulation changes; effects of shifting patterns of e-commerce versus catalog purchases; costs associated with printing and mailing catalogs and fulfilling orders; effects of potential slowdowns or other disruptions in postal service; dependence on customers' seasonal buying patterns; and fluctuations in foreign currency exchange rates. The ability of the Company to reduce unprofitable circulation and to effectively manage its customer lists. - The ability of the Company to achieve projected levels of sales and the ability of the Company to reduce costs commensurate with sales projections. Increases in postage, printing and paper prices and/or the inability of the Company to reduce expenses generally as required for profitability and/or increase prices of the Company's merchandise to offset expense increases. - The failure of the Internet generally to achieve the projections for it with respect to growth of e-commerce or otherwise, and the failure of the Company to increase Internet sales. The success of the Amazon.com venture. The imposition of regulatory, tax or other requirements with respect to Internet sales. Actual or perceived technological difficulties or security issues with respect to conducting e-commerce over the Internet generally or through the Company's Web sites or those of its third party fulfillment clients specifically. - The ability of the Company to attract and retain management and employees generally and specifically with the requisite experience in e-commerce, Internet and direct marketing businesses. The ability of employees of the Company who have been promoted as a result of the Company's strategic business realignment program to perform the responsibilities of their new positions. - A general deterioration in economic conditions in the United States leading to key vendors and suppliers reducing or withdrawing trade credit to companies in the retail, catalog and direct marketing industries. The risk that key vendors or suppliers may reduce or withdraw trade credit to the Company, convert the Company to a cash basis or otherwise change credit terms, or require the Company to provide letters of credit or cash deposits to support its purchase of inventory, increasing the Company's cost of capital and impacting the Company's ability to obtain merchandise in a timely manner. The ability of the Company to find alternative vendors and suppliers on competitive terms if vendors or suppliers who exist cease doing business with the Company. - The inability of the Company to timely obtain and distribute merchandise, leading to an increase in backorders and cancellations. - Defaults under the Congress Credit Facility, or inadequacy of available borrowings thereunder, reducing or impairing the Company's ability to obtain letters of credit or other credit to support its purchase of inventory and support normal operations, impacting the Company's ability to obtain, market and sell merchandise in a timely manner. - The inadequacy of available borrowings under the Congress Credit Facility preventing the Company from paying vendors or suppliers in a timely fashion. - Continued compliance by the Company with and the enforcement by Congress of financial and other covenants and limitations contained in the Congress Credit Facility, including net worth, net working capital, capital expenditure and EBITDA covenants, and limitations based upon specified percentages of eligible receivables and eligible inventory, and the requirement that the Company maintain $3.0 million of excess credit availability at all times, affecting the ability of the Company to continue to make borrowings under the Congress Credit Facility. - Continuation of the Company's history of operating losses, and the incidence of costs associated with the Company's strategic business realignment program, resulting in the Company failing to comply with certain financial and other covenants contained in the Congress Credit Facility, including net worth, net working capital, capital expenditure and EBITDA covenants and the ability of the Company to obtain waivers from Congress in the event that 25 future internal and/or external events result in performance that results in noncompliance by the Company with the terms of the Congress Credit Facility requiring remediation. - The ability of the Company to realize the aggregate cost savings and other objectives anticipated in connection with the strategic business realignment program, or within the time periods anticipated therefor. The aggregate costs of effecting the strategic business realignment program may be greater than the amounts anticipated by the Company. - The ability of the Company to maintain advance rates under the Congress Credit Facility that are at least as favorable as those obtained in the past due to market conditions affecting the value of the inventory which is periodically re-appraised in order to re-set such advance rates. - The ability of the Company to dispose of assets related to its third party fulfillment business, to the extent not transferred to other facilities. - The initiation by the Company of additional cost cutting and restructuring initiatives, the costs associated therewith, and the ability of the Company to timely realize any savings anticipated in connection therewith. - The ability of the Company to maintain insurance coverage required in order to operate its businesses and as required by the Congress Credit Facility. The ability of the Company to obtain certain types of insurance, including directors' and officers' liability insurance, or to accept reduced policy limits or coverage, or to incur substantially increased costs to obtain the same or similar coverage, due to recently enacted and proposed changes to laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules of the Securities and Exchange Commission thereunder. - The inability of the Company to access the capital markets due to market conditions generally, including a lowering of the market valuation of companies in the direct marketing and retail businesses, and the Company's business situation specifically. - The inability of the Company to sell non-core or other assets due to market conditions or otherwise. - The inability of the Company to redeem the Series C Participating Preferred Stock. - The ability of the Company to maintain the listing of its Common Stock on the American Stock Exchange due to a failure to maintain $15 million of public float or otherwise. - The continued willingness of customers to place and receive mail orders in light of worries about bio-terrorism. - The ability of the Company to sublease, terminate or renegotiate the leases of its vacant facilities in Weehawken, New Jersey and other locations. - The ability of the Company to achieve a satisfactory resolution of the various class action lawsuits that are pending against it, including the Wilson case. The possibility that the Company may be required to post a significant bond or bonds in the Wilson case or the other class action lawsuits when appealing an adverse decision of the courts. - The ability of the Company to evaluate and implement the requirements of the Sarbanes-Oxley Act of 2002 and the rules of the Securities and Exchange Commission thereunder, as well as recent changes to listing standards by the American Stock Exchange, in a cost effective manner. - The ability of the Company to achieve cross channel synergies, create successful affiliate programs, effect profitable brand extensions or establish popular loyalty and buyers' club programs. - Uncertainty in the U.S. economy and decreases in consumer confidence leading to a slowdown in economic growth and spending resulting from the invasion of, war with and occupation of Iraq, which may result in future acts of terror. Such activities, either domestically or internationally, may affect the economy and consumer confidence and spending within the United States and adversely affect the Company's business. 26 - Softness in demand for the Company's products. - The inability of the Company to continue to source goods from foreign sources, particularly India and Pakistan, leading to increased costs of sales. - The possibility that all or part of the summary judgment decision in the matter of Rakesh K. Kaul v. Hanover Direct, Inc. will be overturned on appeal. - Reductions in unprofitable circulation leading to loss of revenue, which is not offset by a reduction in expenses. - Any significant increase in the Company's return rate experience as a result of the recent change in its return policy or otherwise. ITEM 3. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATES: The Company's exposure to market risk relates to interest rate fluctuations for borrowings under the Congress revolving credit facility and its term financing facilities, which bear interest at variable rates. At March 27, 2004, outstanding principal balances under these facilities subject to variable rates of interest were approximately $16.7 million. If interest rates were to increase by one percent from current levels, the resulting increase in interest expense, based upon the amount outstanding at March 27, 2004, would be approximately $0.17 million on an annual basis. In addition, the Company's exposure to market risk relates to customer response to the Company's merchandise offerings and circulation changes, effects of shifting patterns of e-commerce versus catalog purchases, costs associated with printing and mailing catalogs and fulfilling orders, effects of potential slowdowns or other disruptions in postal service, dependence on customers' seasonal buying patterns, fluctuations in foreign currency exchange rates, and the ability of the Company to reduce unprofitable circulation and effectively manage its customer lists. ITEM 4. CONTROLS AND PROCEDURES DISCLOSURE CONTROLS AND PROCEDURES. The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is detailed in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the report it files or submits under the Exchange Act. INTERNAL CONTROL OVER FINANCIAL REPORTING. There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 27 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS A class action lawsuit was commenced on March 3, 2000 entitled Edwin L. Martin v. Hanover Direct, Inc. and John Does 1 through 10, bearing case no. CJ2000-177 in the State Court of Oklahoma (District Court in and for Sequoyah County). Plaintiff commenced the action on behalf of himself and a class of persons who have at any time purchased a product from the Company and paid for an "insurance charge." The complaint sets forth claims for breach of contract, unjust enrichment, recovery of money paid absent consideration, fraud and a claim under the New Jersey Consumer Fraud Act. The complaint alleges that the Company charges its customers for delivery insurance even though, among other things, the Company's common carriers already provide insurance and the insurance charge provides no benefit to the Company's customers. Plaintiff also seeks a declaratory judgment as to the validity of the delivery insurance. The damages sought are (i) an order directing the Company to return to the plaintiff and class members the "unlawful revenue" derived from the insurance charges, (ii) declaring the rights of the parties, (iii) permanently enjoining the Company from imposing the insurance charge, (iv) awarding threefold damages of less than $75,000 per plaintiff and per class member, and (v) attorneys' fees and costs. On April 12, 2001, the Court held a hearing on plaintiff's class certification motion. Subsequent to the April 12, 2001 hearing on plaintiff's class certification motion, plaintiff filed a motion to amend the definition of the class. On July 23, 2001, plaintiff's class certification motion was granted, defining the class as "All persons in the United States who are customers of any catalog or catalog company owned by Hanover Direct, Inc. and who have at any time purchased a product from such company and paid money that was designated to be an insurance charge." On August 21, 2001, the Company filed an appeal of the order with the Oklahoma Supreme Court and subsequently moved to stay proceedings in the district court pending resolution of the appeal. The appeal has been fully briefed. At a subsequent status hearing, the parties agreed that issues pertaining to notice to the class would be stayed pending resolution of the appeal, that certain other issues would be subject to limited discovery, and that the issue of a stay for any remaining issues would be resolved if and when such issues arise. On January 20, 2004, the plaintiff filed a motion for oral argument with the Court. The Company believes it has defenses against the claims and plans to conduct a vigorous defense of this action. On August 15, 2001, the Company was served with a summons and four-count complaint filed in Superior Court for the City and County of San Francisco, California, entitled Teichman v. Hanover Direct, Inc., Hanover Brands, Inc., Hanover Direct Virginia, Inc., and Does 1-100. The complaint was filed by a California resident, seeking damages and other relief for herself and a class of all others similarly situated, arising out of the insurance fee charged by catalogs and Internet sites operated by subsidiaries of the Company. Defendants, including the Company, have filed motions to dismiss based on a lack of personal jurisdiction over them. In January 2002, plaintiff sought leave to name six additional entities: International Male, Domestications Kitchen & Garden, Silhouettes, Hanover Company Store, Kitchen & Home, and Domestications as co-defendants. On March 12, 2002, the Company was served with the First Amended Complaint in which plaintiff named as defendants the Company, Hanover Brands, Hanover Direct Virginia, LWI Holdings, Hanover Company Store, Kitchen and Home, and Silhouettes. On April 15, 2002, the Company filed a Motion to Stay the Teichman action in favor of the previously filed Martin action and also filed a Motion to quash service of summons for lack of personal jurisdiction on behalf of defendants Hanover Direct, Inc., Hanover Brands, Inc. and Hanover Direct Virginia, Inc. On May 14, 2002, the Court (1) granted the Company's Motion to quash service on behalf of Hanover Direct, Hanover Brands, and Hanover Direct Virginia, leaving only LWI Holdings, Hanover Company Store, Kitchen & Home, and Silhouettes, as defendants, and (2) granted the Company's Motion to Stay the action in favor of the previously filed Oklahoma action, so nothing will proceed on this case against the remaining entities until the Oklahoma case is decided. The Company believes it has defenses against the claims. The Company plans to conduct a vigorous defense of this action. A class action lawsuit was commenced on February 13, 2002 entitled Jacq Wilson, suing on behalf of himself, all others similarly situated, and the general public v. Brawn of California, Inc. dba International Male and Undergear, and Does 1-100 ("Brawn") in the Superior Court of the State of California, City and County of San Francisco. Does 1-100 are Internet and catalog direct marketers offering a selection of men's clothing, sundries, and shoes who advertise within California and nationwide. The complaint alleges that for at least four years, members of the class have been charged an unlawful, unfair, and fraudulent insurance fee and tax on orders sent to them by Brawn; that Brawn was engaged in untrue, deceptive and misleading advertising in that it was not lawfully required or permitted to collect insurance, tax and sales tax from customers in California; and that Brawn has engaged in acts of unfair competition under the state's Business and Professions Code. Plaintiff and the class seek (i) restitution and disgorgement of all monies wrongfully collected and earned by Brawn, including interest and other gains made on account of these practices, including reimbursement in the amount of the insurance, tax and sales tax collected unlawfully, together with interest, (ii) an order enjoining Brawn from charging customers insurance and tax on its order forms and/or from charging tax on the delivery, shipping and insurance charges, (iii) an order directing Brawn to notify 28 the California State Board of Equalization of the failure to pay the correct amount of tax to the state and to take appropriate steps to provide the state with the information needed for audit, and (iv) compensatory damages, attorneys' fees, pre-judgment interest, and costs of the suit. The claims of the individually named plaintiff and for each member of the class amount to less than $75,000. On April 15, 2002, the Company filed a Motion to Stay the Wilson action in favor of the previously filed Martin action. On May 14, 2002, the Court denied the Motion to Stay. The Wilson case proceeded to trial before the Honorable Diane Elan Wick of the Superior Court of California for the County of San Francisco, and the Judge, sitting without a jury, heard evidence from April 15-17, 2003. On November 25, 2003, the Court, after hearing evidence and considering post-trial submissions from the parties, entered judgment in plaintiff's favor, requiring Brawn to refund insurance fees collected from consumers for the period from February 13, 1998 through January 15, 2003 with interest from the date paid by June 30, 2004. Plaintiff did not prevail on the tax issues. On January 12, 2004, plaintiff filed a motion requesting approximately $740,000 in attorneys' fees and costs. On February 27, 2004, the Company filed its response to that motion. Plaintiff filed a reply brief on March 13, 2004. A hearing was held on plaintiff's motion on March 18, 2004. The judge ruled on that motion on April 14, 2004, awarding plaintiff's counsel approximately $445,000. The Company has appealed the trial court's decision on the merits of the insurance fees issue as well as the decision on the attorney's fees issue. The two appeals will likely be consolidated with briefing expected to begin in late May 2004. The Company will be required to post a bond in the amount of approximately $750,000 while the appeal of the attorneys' fees award is proceeding but its counsel does not believe the Company will be required to do so while the appeal on the insurance fees decision is proceeding. The Company plans to conduct a vigorous defense of this action. The potential estimated exposure is in the range of $0 to $4.0 million. Based upon the Company's policy of evaluating accruals for legal liabilities, the Company has not established a reserve due to management determining that it is not probable that an unfavorable outcome will result. A class action lawsuit was commenced on October 28, 2002 entitled John Morris, individually and on behalf of all other persons & entities similarly situated v. Hanover Direct, Inc., and Hanover Brands, Inc. (referred to here as "Hanover"), No. L 8830-02 in the Superior Court of New Jersey, Bergen County -- Law Division. The plaintiff brings the action individually and on behalf of a class of all persons and entities in New Jersey who purchased merchandise from Hanover within six years prior to filing of the lawsuit and continuing to the date of judgment. On the basis of a purchase made by plaintiff in August 2002 of certain clothing from Hanover (which was from a men's division catalog, the only ones which retained the insurance line item in 2002), Plaintiff claims that for at least six years, Hanover maintained a policy and practice of adding a charge for "insurance" to the orders it received and concealed and failed to disclose its policy with respect to all class members. Plaintiff claims that Hanover's conduct was (i) in violation of the New Jersey Consumer Fraud Act, as otherwise deceptive, misleading and unconscionable; (ii) such as to constitute Unjust Enrichment of Hanover at the expense and to the detriment of plaintiff and the class; and (iii) unconscionable per se under the Uniform Commercial Code for contracts related to the sale of goods. Plaintiff and the class seek damages equal to the amount of all insurance charges, interest thereon, treble and punitive damages, injunctive relief, costs and reasonable attorneys' fees, and such other relief as may be just, necessary, and appropriate. On December 13, 2002, the Company filed a Motion to Stay the Morris action in favor of the previously filed Martin action. Plaintiff then filed an Amended Complaint adding International Male as a defendant. Hearing on the Motion to Stay took place on June 5, 2003. The Court granted the Company's Motion to Stay the action and the case was stayed first until December 31, 2003 and subsequently until March 31, 2004. The stay was lifted on March 31, 2004. On April 30, 2004, the Company responded to plaintiff's Amended Complaint by filing a Motion for Summary Judgment that is currently scheduled to be heard by the Court on June 11, 2004. The Company plans to conduct a vigorous defense of this action. On June 28, 2001, Rakesh K. Kaul, the former President and Chief Executive Officer of the Company, filed a five-count complaint (the "Complaint") in New York State Court against the Company, seeking damages and other relief arising out of his separation of employment from the Company, including severance payments of $2,531,352 plus the cost of employee benefits, attorneys' fees and costs incurred in connection with the enforcement of his rights under his employment agreement with the Company, payment of $298,650 for 13 weeks of accrued and unused vacation, damages in the amount of $3,583,800, or, in the alternative, a declaratory judgment from the court that he is entitled to all change of control benefits under the "Hanover Direct, Inc. Thirty-Six Month Salary Continuation Plan," and damages in the amount of $1,396,066 or $850,000 due to the Company's purported breach of the terms of the "Long-Term Incentive Plan for Rakesh K. Kaul" by failing to pay him a "tandem bonus" he alleges was due and payable to him within the 30 days following his resignation. The Company removed the case to the U.S. District Court for the Southern District of New York on July 25, 2001. Mr. Kaul filed an Amended Complaint ("Amended Complaint") in the U.S. District Court for the Southern District of New York on September 18, 2001. The Amended Complaint repeats many of the claims made in the original Complaint and adds ERISA claims. On October 11, 2001, the Company filed its Answer, Defenses and Counterclaims to the Amended Complaint, denying liability under each and every of Mr. Kaul's causes of action, challenging all substantive assertions, raising several defenses and stating nine counterclaims against Mr. Kaul. The counterclaims include (1) breach of contract; (2) breach of the Non-Competition and Confidentiality Agreement with the Company; (3) breach of fiduciary duty; (4) unfair competition; and (5) unjust enrichment. The Company seeks damages, including, without limitation, the $341,803 in severance pay and car allowance Mr. Kaul received following his resignation, $412,336 for amounts paid 29 to Mr. Kaul for car allowance and related benefits, the cost of a long-term disability policy, and certain payments made to personal attorneys and consultants retained by Mr. Kaul during his employment, $43,847 for certain services the Company provided and certain expenses the Company incurred, relating to the renovation and leasing of office space occupied by Mr. Kaul's spouse at 115 River Road, Edgewater, New Jersey, the Company's current headquarters, $211,729 on a tax loan to Mr. Kaul outstanding since 1997 and interest, compensatory and punitive damages and attorneys' fees. The Company moved to amend its counterclaims, and the parties each moved for summary judgment. The Company sought summary judgment: dismissing Mr. Kaul's claim for severance under his employment agreement on the ground that he failed to provide the Company with a general release of, among other things, claims for change of control benefits; dismissing Mr. Kaul's claim for attorneys' fees on the grounds that they are not authorized under his employment agreement; dismissing Mr. Kaul's claims related to change in control benefits based on an administrative decision that he is not entitled to continued participation in the plan or to future benefits thereunder; dismissing Mr. Kaul's claim for a tandem bonus payment on the ground that no payment is owing; dismissing Mr. Kaul's claim for vacation payments based on Company policy regarding carry over vacation; and seeking judgment on the Company's counterclaim for unjust enrichment based on Mr. Kaul's failure to pay under a tax note. Mr. Kaul sought summary judgment: dismissing the Company's defenses and counterclaims relating to a release on the grounds that he tendered a release or that the Company is estopped from requiring him to do so; dismissing the Company's defenses and counterclaims relating to his alleged violations of his non-compete and confidentiality obligations on the grounds that he did not breach the obligations as defined in the agreement; and dismissing the Company's claims based on his alleged breach of fiduciary duty, including those based on his monthly car allowance payments and the leased space to his wife, on the grounds that he was entitled to the car payments and did not involve himself in or make misrepresentations in connection with the leased space. The Company concurrently moved to amend its Answer and Counterclaims to state a claim that it had cause for terminating Mr. Kaul's employment based on, among other things, after acquired evidence that Mr. Kaul received a monthly car allowance and other benefits totaling $412,336 that had not been authorized by the Company's Board of Directors and that his wife's lease and related expense was not properly authorized by the Company's Board of Directors, and to clarify or amend the scope of the Company's counterclaims for reimbursement. On January 7, 2004, the Court granted summary judgment in favor of the Company dismissing Mr. Kaul's claim for severance under his employment agreement on the grounds that he failed to provide the Company with a general release; granted in part the Company's motion for summary judgment on Mr. Kaul's claim for attorneys' fees, finding as a matter of law that Mr. Kaul is not entitled to fees incurred in prosecuting this lawsuit but finding an issue of fact as to the amount of reasonable fees he may have incurred in seeking advice and representation in connection with the termination of his employment; granted summary judgment in favor of the Company dismissing Mr. Kaul's claims related to change in control benefits on the grounds that Mr. Kaul's participation in the plan was properly terminated when his employment was terminated, the plan was properly terminated, and the administrator and appeals committee properly denied Mr. Kaul's claim; granted summary judgment in favor of the Company dismissing Mr. Kaul's claim for a tandem bonus payment on the ground that payment is not owed to him; granted summary judgment in part and denied summary judgment in part on Mr. Kaul's claims for vacation pay, deeming Mr. Kaul to have abandoned claims for vacation pay in excess of five weeks but finding him entitled to four weeks vacation pay based on the Company's policy and finding an issue of fact as to Mr. Kaul's claim for an additional week of vacation pay in dispute for 2000; and denied summary judgment on the Company's counterclaim for payment under a tax note based on disputed issues of fact. The Court dismissed the Company's affirmative defenses as largely moot and the Court granted summary judgment in favor of Mr. Kaul dismissing the Company's counterclaims relating to his non-compete and confidentiality obligations on the grounds that there is no evidence of actual damage to the Company resulting from Mr. Kaul's alleged violations of those obligations; granted summary judgment in favor of Mr. Kaul on the Company's breach of contract and breach of fiduciary duty claims, including those based on his monthly car allowance payments and the leased space to his wife, on the grounds that he did not breach his fiduciary duties in accepting the car payments and would not be unjustly enriched if he kept them, and on the ground that the Company would not be able to prove fraud in connection with the leased space based on the circumstances, including Mr. Kaul's disclosures. The Court denied in part and granted in part the Company's motion to amend its Answer and Counterclaims. The Court denied the Company's motion for leave to state a claim that it had acquired evidence of cause for terminating Mr. Kaul's employment based on certain reimbursements on the grounds that the payments were authorized, but granted the Company's motion with respect to its claim for reimbursement of amounts paid to the Internal Revenue Service ("IRS") on Mr. Kaul's behalf. The Opinion identifies three remaining issues in the case: (i) Mr. Kaul's claim for attorneys' fees pursuant to Section 12 of the employment agreement; (ii) Mr. Kaul's claim for an additional week of vacation pay in the amount of 30 approximately $11,500; and (iii) the Company's counterclaim for $211,729 plus interest paid to the IRS on Mr. Kaul's behalf. In an attempt to resolve the outstanding issues prior to the entry of a final judgment, conferences were held with the Court on two separate occasions. As a result of these conferences, the parties have tentatively reached a settlement whereby the parties agree to dismiss the following claims: (1) Mr. Kaul agrees to withdraw and release his claims concerning reimbursement of certain attorneys' fees under Section 12 of the employment agreement (but preserves and does not waive, release or limit his claim for attorneys' fees and costs under Section 12 of the employment agreement incurred in connection with the preparation for and litigation of this lawsuit) and reimbursement for an additional week of vacation pay; and (2) the Company agrees to withdraw and release its claims concerning reimbursement of certain attorneys' fees and costs under ERISA, reimbursement of the $211,729 paid to the IRS on Mr. Kaul's behalf, and reimbursement of the $341,803 of severance payments made to Mr. Kaul. The parties also agree that Mr. Kaul shall not appeal that portion of the Opinion concerning the dismissal of certain of Mr. Kaul's ERISA-based claims with respect to the Plan and the Company shall not appeal that portion of the Opinion concerning the dismissal of its claims relating to the leasing and build-out of property or office space located in Edgewood, New Jersey to Mr. Kaul's wife. Mr. Kaul has expressed his intent to now tender a general release to the Company. If he does, in fact, do so, the Company will reject the tender on the grounds, inter alia, that the time to do so has long passed and that the purpose for the general release has been extinguished. After final judgment issues, each party shall have the right to appeal any aspect of the judgment. The Company was named as one of 88 defendants in a patent infringement complaint filed on November 23, 2001 by the Lemelson Medical, Education & Research Foundation, Limited Partnership (the "Lemelson Foundation"). The complaint, filed in the U.S. District Court in Arizona, was not served on the Company until March 2002. In the complaint, the Lemelson Foundation accuses the named defendants of infringing seven U.S. patents, which allegedly cover "automatic identification" technology through the defendants' use of methods for scanning production markings such as bar codes. The Company received a letter dated November 27, 2001 from attorneys for the Lemelson Foundation notifying the Company of the complaint and offering a license. The Court entered a stay of the case on March 20, 2002, requested by the Lemelson Foundation, pending the outcome of a related case in Nevada being fought by bar code manufacturers. The order for the stay in the case involving the Company provides that the Company need not answer the complaint, although it has the option to do so. The Company was invited to join a common interest/joint-defense group consisting of defendants named in the complaint as well as in other actions brought by the Lemelson Foundation. The trial in the Nevada case began on November 18, 2002 and ended on January 17, 2003. On January 23, 2004, following extensive briefing by the parties, the Nevada Court entered judgment declaring that the claims of each of the patents at issue in the Nevada case, including all seven patents asserted by the Lemelson Foundation against the Company in the Arizona case, are unenforceable under the doctrine of prosecution laches, are invalid for lack of written description and enablement, and are not infringed by the bar code equipment manufacturers. Subject to the results of any appeal that may be filed by the parties to the Nevada litigation, the judgment of the Nevada court should preclude assertion of each of the affected patents against all parties, including the Company in the Arizona case. Counsel is now monitoring the Nevada and Arizona cases in order to determine a suitable moment for moving for dismissal of the Lemelson Foundation's claims. The Company has analyzed the merits of the issues raised by the complaint, notified vendors of its receipt of the complaint and letter, evaluated the merits of joining the joint-defense group, and had discussions with attorneys for the Lemelson Foundation regarding the license offer. The Company will not agree to a settlement at this time and thus has not established a reserve. In early March 2003, the Company learned that one of its business units had engaged in certain travel transactions that may have constituted violations under the provisions of U.S. government regulations promulgated pursuant to 50 U.S.C. App. 1-44, which proscribe certain transactions related to travel to certain countries. The Company immediately commenced an inquiry into the matter, incurred resulting charges, made an initial voluntary disclosure to the appropriate U.S. government agency under its program for such disclosures and will submit to that agency a detailed report on the results of the inquiry. In addition, the Company has taken steps to ensure that all of its business units are acting in compliance with the travel and transaction restrictions and other requirements of all applicable U.S. government programs. Although the Company is uncertain of the extent of the penalties, if any, that may be imposed on it by virtue of the transactions voluntarily disclosed, it does not currently believe that any such penalties will have a material effect on its business or financial condition. 31 In addition, the Company is involved in various routine lawsuits of a nature which is deemed customary and incidental to its businesses. In the opinion of management, the ultimate disposition of these actions will not have a material adverse effect on the Company's financial position or results of operations. ITEM 5. OTHER INFORMATION Board of Directors. Effective February 15, 2004, Martin L. Edelman resigned from the Company's Board of Directors. Effective April 12, 2004, Paul S. Goodman joined the Company's Board of Directors as a designee of Chelsey Direct, LLC filling the vacancy created by the resignation of Martin L. Edelman. On April 29, 2004, the Board of Directors elected (1) Wayne P. Garten to serve as a member and as the Chairman of the Transactions Committee of the Board of Directors to fill the vacancy created by the resignation of Martin L. Edelman from such positions, (2) William B. Wachtel to serve as a member of the Executive Committee of the Board of Directors to fill the vacancy created by the resignation of Martin L. Edelman from such position, (3) Paul S. Goodman to serve as a member of the Corporate Governance Committee of the Board of Directors to fill the vacancy created by the resignation of Martin L. Edelman from such position, and (4) Donald Hecht to serve as a member of the Compensation Committee to fill the vacancy created by the contemporaneous resignation of Wayne P. Garten from such position. President and Chief Executive Officer. Thomas C. Shull resigned as Chairman of the Board, President and Chief Executive Officer of the Company on May 5, 2004. William B. Wachtel was elected as Chairman of the Board and Wayne P. Garten was elected as President and Chief Executive Officer of the Company effective the same date. In connection with Mr. Shull's resignation, Mr. Shull and the Company agreed in principle to enter into a severance agreement dated as of May 5, 2004 providing for $900,000 of cash payments, $300,000 payable in May 2004 and the balance to be payable in 16 installments of $35,625 payable every two weeks commencing May 21, 2004 with a final payment in the amount of $30,000 to be payable on or about December 31, 2004. The Company will accrue the $900,000 of severance in the second quarter of 2004. In connection with Mr. Garten's election, Mr. Garten and the Company have negotiated the principle terms of an employment agreement for Mr. Garten which will be presented to the Compensation Committee of the Board of Directors for approval shortly. Due to the recent changes in management, the Company intends to postpone its 2004 Annual Meeting of Stockholders now scheduled for June 3, 2004 until later in the summer of 2004. At the rescheduled meeting, the Company intends to submit proposals to stockholders to approve (1) an amendment to the Company's Certificate of Incorporation that would reduce the par value of each share of common stock from $0.66 2/3 per share to $0.01 per share and (2) an amendment to the Company's Certificate of Incorporation that would increase the number of shares of Additional Preferred Stock which the Company would have authority to issue and make a corresponding change in the number of shares of all classes of stock which the Company would have authority to issue as well as (3) an amendment to the Company's Certificate of Incorporation that would effect a one-for-ten reverse stock split of the Company's common stock, all as called for by the Recapitalization Agreement dated as of November 18, 2003 between the Company and Chelsey. 32 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 3.1 Amendment to By-laws of the Company 31.1 Certification signed by Wayne P. Garten. 31.2 Certification signed by Charles E. Blue. 32.1 Certification signed by Wayne P. Garten and Charles E. Blue. (b) Reports on Form 8-K: 1.1 Form 8-K, filed March 29, 2004 -- reporting pursuant to Item 5 of such Form the filing of a Form 12b-25 Notification of Late Filing for its Annual Report on Form 10-K for the fiscal year ended December 27, 2003. 1.2 Form 8-K, filed April 2, 2004 -- reporting pursuant to Item 5 of such Form certain letters sent to Chelsey Direct, LLC. 1.3 Form 8-K, filed April 12, 2004 -- reporting pursuant to Item 7 of such Form (information furnished pursuant to Item 12 of such Form) the issuance of a press release announcing operating results for the fiscal year ended December 27, 2003. 1.4 Form 8-K, filed April 12, 2004 -- reporting pursuant to Item 5 of such Form the appointment of Paul S. Goodman as a director. 1.5 Form 8-K, filed April 13, 2004 - reporting pursuant to Item 9 of such Form a statement of guidance as to where the Company sees fiscal year 2004. 1.6 Form 8-K, filed April 16, 2004 - reporting pursuant to Item 9 of such Form an unofficial transcript of its conference call with management to review the operating results for the fiscal year ended December 27, 2003. 1.7 Form 8-K, filed May 6, 2004 - reporting pursuant to Item 5 of such Form the resignation of Thomas C. Shull as Chairman of the Board, President and Chief Executive Officer of the Company and the election of William B. Wachtel as Chairman of the Board and Wayne P. Garten as President and Chief Executive Officer effective immediately. 33 SIGNATURES Pursuant to the requirements 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. HANOVER DIRECT, INC. Registrant By: /s/ Charles E. Blue --------------------------------------------- Charles E. Blue Senior Vice President and Chief Financial Officer (On behalf of the Registrant and as principal financial officer) Date: May 11, 2004 34